The purpose of this blog post is to briefly present a segment of my doctoral dissertation proposal. One of the goals of my dissertation is to analyse the initiation problem in insolvency law from a behavioural perspective. Insolvency proceedings frequently do not start until it is too late and most of a company’s value has been depleted. This initiation problem is one of the prevalent causes of the ex-ante inefficiency of insolvency law across multiple jurisdictions.
Background
Stakeholders (managers, shareholders and creditors) are not inherently incentivised to initiate insolvency proceedings (Adler et al., 2006; Warren et al., 2014) . Thus, incentives are needed either in the form of positive sanctions (carrots) or negative sanctions (sticks) (De Geest & Dari-Mattiacci, 2013, p. 354) . Cepec and Kovač (2016, pp. 85–86) identify the following insolvency law instruments which can be characterised as carrots: (a) the debtor in possession rule, (b) deviations from the absolute priority rule, and (c) bonuses for managers in cases of timely initiation of insolvency proceedings. Conversely, the following insolvency law constructs can be characterised as sticks: (a) tort or civil liability, (b) professional disqualification, and (c) misdemeanour and criminal liability.
Cepec and Kovač (2016, p. 99) promote a mixed-sticks-and-carrots incentive mechanism for a timely initiation of insolvency proceedings as empirical evidence suggests that exclusive use of carrots or sticks leads to sub-optimal initiation. Other research on this topic generally favours carrots, as sticks may pose risks for shareholders/managers, the limited resources of managers may inhibit the effectiveness of financial sanctions, and sticks may impose unnecessary transaction costs. Nevertheless, excessive risk- shifting incentives of managers and shareholders may warrant the use of sticks (Eidenmüller, 2007, p. 244–245) . Adler et al. (2006; 2013) have found a correlation between abandoning the debtor in possession rule (i.e., a carrot) and the deterioration of firms’ financial and economic health at the time of their insolvency filing. Furthermore, Drescher (2013) has found that insolvency filing bonuses (a carrot) prompt initiation, while mandatory external advisors as well as a combination of advisor and bonus does not.
Research gap and research focus
The current literature on my topic of interest is largely subjective and lacks empirical evidence concerning stakeholders’ motivation to file for insolvency promptly. Furthermore, De Geest, Dari-Mattiacci (2007, p. 5) , Cepec, and Kovač (2016, p. 80) base their arguments on rational choice theory. Thus, my dissertation aims to enhance their framework by incorporating psychological and behavioural factors, as humans often exhibit bounded rationality, bounded willpower and bounded self-interest (Jolls et al., 1998, p. 1476; Simon, 1955) .
My dissertation will, inter alia, seek to answer the following research questions:
(1) Why do managers not promptly initiate insolvency proceedings despite the provided incentive mechanisms?
(2) How should incentive mechanisms for initiating insolvency be adapted to promote the timely initiation of insolvency proceedings in light of behavioural considerations?
I foresee three possible groups of reasons for initiation delays (Q1). First, managers may not be aware of their obligations in the vicinity of insolvency. Second, notions like stigma and shame may influence managers (Braithwaite, 1989) as there is a stigma narrative associated with insolvency in policy debates, legislative discussions and academic literature in selected jurisdictions (Ghio and Thomson, 2023). Third, relying on heuristics when making judgments leads to biases (Gonzalez, 2014, p. 251) . The most obvious biases that could be at play in the managers’ decisions not to file for insolvency: (over)optimism bias and overconfidence bias (Baird, 1991, p. 229; Wilson, 2016, p. 309) . Drescher’s 2013 study has been a pioneering effort in exploring managerial decision-making related to initiation of insolvency proceedings. His research reveals a correlation between timely initiation and risk aversion as well as, interestingly, overconfidence.
To gain a better understanding of the factors leading to delayed initiation of insolvency proceedings, I aim to take some of the previous research a step further to explore the decision-making process of a diverse cohort of managers who have previously initiated (late) insolvency proceedings. Furthermore, my dissertation will put forth specific recommendations on how to craft the incentive mechanisms given the reasons for late initiation identified under the first research question. These proposals will incorporate insights from behavioural sciences, such as the effectiveness of nudges (Thaler & Sunstein, 2009) .
Methodology
To uncover the reasons behind managerial delays in initiating insolvency, I will utilise semi-structured interviews (a qualitative research method that combines a pre-determined set of open questions with the flexibility for the interviewer to probe deeper into specific themes or responses as they emerge) with company managers and insolvency administrators. Furthermore, I will shadow insolvency administrators in their work environment. After identifying potential causes for initiation delays, I will develop and test enhanced incentive mechanisms to encourage managers to initiate insolvency proceedings promptly. This will be done using a vignette study, in which I will create various hypothetical scenarios that simulate decision-making in financial distress. I will then introduce various incentives, nudges, and debiasing techniques at different stages to observe their effects.
Conclusion
From a rational choice perspective, managers seem to have sufficient incentives to prompt initiation, yet insolvency proceedings are generally commenced too late. Through my doctoral project, I aim to gain a comprehensive understanding of managerial reasoning nearing insolvency, which will enable lawmakers to craft appropriate incentives that promote timely initiation. Additionally, I seek to establish a causal relationship between specific incentive mechanisms and their impact on the timing of insolvency initiation in order to suggest improved incentive mechanisms that could help overcome the initiation problem.
*This research blog was written by Lana K. Gotvan, PhD candidate at the University of Ljubljana.
About BWILC and the PhD Workshop
This research was presented and discussed at the last PhD Workshop on European and International Insolvency law, organised by the Stichting Bob Wessels Insolvency Law Collection (BWILC). Since 2018, BWILC maintains the private insolvency law book collections of Prof. em. Bob Wessels, extended with the collections of the late Prof. Ian Fletcher and the late Gabriel Moss QC, in addition to books that have been kindly donated by scholars and practitioners from around the world. To browse or visit this unique collection, click here.
Since 2019, BWILC organises an annual PhD Workshop for PhD students from Europe and beyond. At this workshop, PhD candidates can present their ideas, but also the challenges and questions they are confronted with in a two-day workshop attended by their peers and senior academics. At the end of the workshop, organised in alternately in Leiden and another city, prizes are awarded for the best presentations.
For information about the next PhD Workshop, click here.