Employee well-being, firm leverage, and bankruptcy risk

Abstract

Employees of liquidating firms are likely to lose income and non-pecuniary benefits of working for the firm, which makes bankruptcy costly for employees. This paper examines whether firms take these costs into account when deciding on the optimal amount of leverage. We find that firms with leading track records in employee well-being significantly reduce the probability of bankruptcy by operating with lower debt ratios. Moreover, we observe that firms with better employee track records have better credit ratings, even when we control for differences in firm leverage.

Introduction

Bankruptcy is costly for employees as it results in possible losses of income and firm-specific human capital. Jacobsen et al. (1993) exploit administrative data in the US and find that high-tenure workers separating from distressed firms on average suffer long-term losses of 25% per year. They further find that the losses begin mounting before employees’ actual separation, and that the losses are also large for employees finding new jobs in similar firms. Besides the loss of income, employees also lose non-pecuniary benefits of working for the firm.

In a theoretical paper, Berk et al. (forthcoming) argue that the cost borne by employees is potentially the single most important indirect cost of bankruptcy. Companies with an interest in employee well-being are therefore likely to reduce the chance of bankruptcy, compared to firms with lower interests in employee well-being. Since bankruptcy occurs when firms cannot fulfill their debt payments, an obvious way of reducing the probability of financial distress is decreasing the firm’s leverage.

This paper examines whether firms that score high on an employee well-being index have lower debt ratios than peers with lower scores. Our measure for employee well-being is based on KLD data and covers decisions and penalties involving employee safety, the degree to which employees are involved in the firm, the strength or weakness of the retirement benefits program, profit sharing programs, workforce reduction policies, and a firm’s relations with unions.

We find that a higher score for employee well-being, measured on an aggregate level, is associated with a lower debt-assets ratio. More specifically, each extra point on the employee well-being scale lowers the debt ratio by about 0.015, ceteris paribus. We also find that various disaggregate measures of employee well-being show a significant relation to leverage. We report that firms with high scores for employee involvement, health and safety policies, and workforce reduction policies have on average lower leverage than firms with low scores.

Because firms generally do not rebalance their capital structure frequently, the observed book leverage of firms does not necessarily represent their target leverage. Retained earnings, for example, could move the firm away from its target. We therefore also test the relation between firms’ employee well-being scores and the decision to issue or repurchase debt or equity. Focusing on debt-equity decisions at the time of leverage changes allows us to examine the effects of employee well-being on the target leverage of firms, instead of possible deviations from it. We find that firms with high employee well-being scores are especially more likely to issue equity instead of debt when they require external financing. We also find that firms with good employee relations are more likely to repurchase debt instead of equity when they have a financing surplus, but the economic and statistical significance of this relation is less strong than for issue decisions.

As a final test we examine the relation between employee well-being and credit ratings. Credit ratings assess the creditworthiness of the firm: a firm with a good credit rating is more likely to be able to repay its loans, and thus has a lower probability of bankruptcy. Although leverage is a strong predictor for a firm’s credit rating, the rating also depends on other factors, like the riskiness of the investments of the firm. By examining credit ratings, we are able to assess whether the reduced leverage of firms with a high score for employee well-being is not mitigated by other factors that potentially increase the probability of financial distress.

We find that firms with high scores for employee well-being have better credit ratings. The median credit rating for firms with positive scores for employee well-being is BBB, while it is BB for firms with non-positive employee well-being scores. After controlling for a range of firm characteristics (including book leverage), we find that the relation between employee well-being and credit ratings is significant at the 1% level. Hence, we conclude that a firm’s interest in employee well-being is associated with a higher creditworthiness of the firm.

This paper makes several contributions. We contribute to empirical studies that relate firms’ leverage to a range of firm characteristics. Most related in this aspect are Titman and Wessels, 1988, Kale and Shahrur, 2007, who respectively show that product uniqueness and relation-specific investments by suppliers and customers are negatively related to firms’ debt ratios. Both of these studies are in line with Titman’s (1984) argument that customers, workers, and suppliers of firms that produce unique or specialized products suffer relatively high costs in the event that these firms liquidate. We also contribute to the literature on corporate social responsibility (CSR)¹ and leverage. Barnea and Rubin (2006) claim that managers and large blockholders may want to over-invest in CSR for their private benefit, since CSR improves their reputation as being good global citizens. They find that firms with higher leverage have lower social ratings, and argue that high leverage prevents overinvestment in CSR because of high interest payments and more active monitoring by creditors. Hong and Kacperczyk (2009) argue that there is a societal norm to not fund operations that promote vice, and that equity investors are more subject to societal norms than bondholders. In line with this argument, they find some evidence that companies from sin sectors have higher debt ratios. We mainly differ from these papers by focusing on a disaggregate level of CSR, as different aspects of CSR can have different effects on corporate decisions, and an overall measure is therefore not necessarily informative (see Derwall and Verwijmeren, 2007). One of the most direct and interesting relations on a disaggregate level – regarding employee well-being and leverage – has thus far been relatively neglected, and this paper tries to fill that gap.

The remainder of this paper is organized as follows. We describe our data in Section 2. Section 3 presents the empirical results. The conclusion is presented in Section 4.