17.2The Benefits of Financial Distress with Committed Stakeholders

The last section emphasized that when stakeholders commit resources to doing busi-

ness with a firm, they are effectively betting on the long-term viability of that firm. If

the firm does well, the stakeholders will do well; if the firm does poorly, the stake-

holders are likely to be hurt financially. Hence, in a competitive market, the terms of

trade between the firm and the stakeholders are determined in part by the viability of

the firm’s future prospects.

This section examines how debt affects the relationship between a firm and its

stakeholders in situations where the parties are not transacting in a competitive market.

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For example, the firm might be dealing with a union or a monopoly supplier. Alterna-

tively, the firm might be dealing with an ongoing supplier or employees who have

invested in specialized equipment or developed specialized human capital. After spe-

cialized investments in human or physical capital have been made, the relationships

between customers and suppliers, employees and employers, and governments and cor-

porations develop into bilateral monopoly relationships. In bilateral monopolies, the

terms of trade (for example, prices and wages) between the parties are open to nego-

tiation. In such cases, the financial distress of a firm may provide it with a negotiating

advantage because suppliers and employees must then consider how their wage and

price demands affect the firm’s future viability.

Bargaining with Unions

One of the best examples of the influence of debt on bargaining outcomes is the rela-

tionship between a large firm and the union representing the firm’s employees. By

increasing leverage, the firm can reduce its employees’demands by exploiting their fear

that a wage increase will push the firm towards bankruptcy. Without attractive alterna-

tive sources of employment, unionized employees gain less from achieving higher

wages if the higher wages substantially increase the probability that the firm will

become bankrupt. Hence, high debt ratios may effectively facilitate employee conces-

sions during business downturns.¹¹

Example 17.4 illustrates how debt financing can affect the way that a firm bargains

with its unions.

Example 17.4:Debt and Bargaining Power

Bergland Auto Parts will be renegotiating its wage contracts within 12 months.The union is

aggressive and would like to increase wages from $15 per hour to $22 per hour.Manage-

ment recognizes that an increase in wages of this magnitude will lower profits from $80 mil-

lion to $30 million.How can Bergland increase its bargaining power so that the union will

not demand more than $20 per hour, which lowers profits to only $35 million?

Answer:One solution would be for Bergland to issue enough debt and repurchase shares

with the proceeds, so that the increased debt requires $35 million in additional interest pay-

ments.Profits will then decline to $45 million prior to the renegotiated loan contract.The

union recognizes that with this additional debt the firm will be unable to meet its debt pay-

ments if forced to pay $22 per hour, and the firm will be put in a fairly unstable position, that

is, zero profit, if forced to pay $20 per hour.Any wage demand above $20 per hour gener-

ates losses and would not be sustainable in the long run.

Result 17.2

Financial distress can benefit some firms by improving their bargaining positions with theirstakeholders.

Chrysler’s financial distress in the late 1970s illustrates the potential benefits as

well as the costs of financial distress. As a consequence of its financial distress,

Chrysler had to sell its cars at a lower price, which reflected the potential problems

associated with servicing the product of a bankrupt company. Contrary to the discussion

in the last section, however, financial distress did not force Chrysler to increase wages

¹¹Bronars and Deere (1991), Dasgupta and Sengupta (1993), and Perotti and Spier (1994) describe

how leverage can be used to improve bargaining outcomes.

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to compensate employees for their greater job uncertainty. Instead, Chrysler used its

financial distress to its advantage to force employees to make wage concessions. In this

sense, financial distress was beneficial to the firm.

Although Chrysler may have benefited from financial distress in its negotiations

with unions, it is unlikely, given the firm’s costs of financial distress, that the company

purposely put itself in such a position. However, Frank Lorenzo, the former CEO of

Texas Air, has been accused of purposely putting firms in financial distress in order to

obtain wage concessions.

Bankruptcy and Wage Contracts at Texas Air

Texas Air acquired Continental Airlines and Eastern Airlines in highly leveraged transac-

tions. In 1983, Continental was able to use bankruptcy to abrogate its labor contracts and

obtain lower wages since the airline was not considered viable with its original wage struc-

ture and the new debt level. Perhaps because of this controversial use of bankruptcy, a law

was passed in 1984 that made it more difficult for bankrupt firms to abrogate union con-

tracts. For this and other reasons, Lorenzo was not as successful at obtaining wage con-

cessions at Eastern; the firm went bankrupt in 1989 and subsequently liquidated its assets.¹²

Bargaining with the Government

Both local and national communities can sometimes be thought of as stakeholders that

can be hurt in the event of the demise of a major corporation. For example, the auto-

mobile plant shutdowns in the 1980s had a negative ripple effect throughout Michigan,

affecting movie theaters, retailers, restaurants, and a number of other local establish-

ments that had no direct links to the auto industry. Because of these spillover costs,

both national and local governments have provided subsidies, such as loan guarantees,

to a number of distressed firms to keep them from failing. The U.S. government

guaranteed loans to Chrysler and received warrants in return (see Chapter 8). Massey-

Ferguson, described in this chapter’s opening vignette, received guarantees from the

Canadian government on a preferred stock issue in return for a promise not to lay off

workers in Canada. In both cases, the financial distress was beneficial to the firms

because it allowed them to obtain below-market financing that they otherwise would

not have obtained.

We believe that the costs of financial distress for Chrysler and Massey-Ferguson

largely outweigh the benefits of the government subsidies. However, the potential gov-

ernment subsidy is definitely a consideration that will tilt firms toward using more debt

financing. It should be stressed that governments subsidize failing firms not because of

their concern for the firm’s debt holders, but because of their concern for nonfinancial

stakeholders such as organized union employees who may have political importance.

Since the combined political power of the stakeholders of relatively small firms is not

likely to be great, only the largest firms should expect government subsidies in the

event of financial distress.

¹²Eastern’s

demise was obviously not in the interest of the union employees, most of whom lost their

jobs. However, the unions may have benefited from their refusal to go along with Lorenzo’s “high

leverage” negotiating ploy. By allowing Eastern to fail, the unions probably made the strategy of

increasing debt to obtain union concessions appear more risky and less attractive to other airlines that

might be considering the strategy in the future.

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