Abstract
Financial distress has significant consequences on firms and their employees (Brown & Matsa, 2016). Financial distress is often a result of firm-specific, macroeconomic, or corporate governance factors (Habib et al., 2020). Upon onset of distress, firms often need to undertake various restructuring or corrective actions to ensure their survival (Koh et al., 2015; Whitaker, 1999). The objectives of any restructuring exercise are to ensure going concern status, achieve a turnaround, and avoid bankruptcy or liquidation events. During such times, firms face significant financial and resource constraints and must optimise their resources to retain their going concern status and assist in its revival.
Human capital is an indispensable resource for firms (Crook et al., 2011) and the firm’s most crucial asset, even more so than physical resources (see Zorn et al., 2017). Human capital is important for organizational resilience (Shela et al., 2023) and firm risk (Schmalz, 2013). However, upon the onset of distress and bankruptcy, firms face some unique challenges concerning human capital, such as employee exits and supply challenges, as fresh, talented applicants (who may contribute to firm recovery) are reluctant to board distressed companies. Hence, scholars conjecture that ‘distress reinforces distress’ (Brown & Matsa, 2016, p. 546).’
The strategic choice concerning human capital at times of distress is made further complex for constrained firms due to underlying financial stress and consequent inability to maintain liquid funds to honour wage commitments (Schmalz, 2013). At such times, firms may resort to cost-cutting and downsizing strategies while at the same time requiring employees to maintain operations. Firms, therefore, face some critical choices during distress that have significant implications for their revival/turnaround. Firms also face challenges such as an increase in bankruptcy costs due to wage differentials required to compensate applicants for joining highly leveraged firms (Chemmanur et al., 2013).
Hence, against this backdrop, it is crucial to examine how research has perceived human capital dimensions in distressed settings and whether the same has evolved as a distinct stream requiring specialized attention. This article aims to provide a conceptual framework and interlinkages of issues faced in the distress lifecycle (pre-distress, distress and bankruptcy stages). This subject is particularly important, especially in countries that have seen significant distress in recent times and where a substantial workforce presently works for distressed firms. This discussion will be pertinent for researchers, managers and creditors of firms whose financial recovery hinges on a successful turnaround.
Prior to delving into the topic, it is essential to note that financial distress, insolvency, and bankruptcy are separate, and it is necessary to distinguish between them. Past literature has shown no consistent definition of financial distress, with research often using varied accounting or market and other metrics (Platt & Platt, 2006). ‘Financial distress arises when the firm’s operating decisions yield less satisfactory results’ (Platt & Platt, 2006, p. 155). Such an event results in a decline in firm performance from previous levels, due to which there may be insufficient cash flows to meet its obligations (Whitaker, 1999). Insolvency occurs when a firm is unable to settle its obligations (Habib et al., 2020). Bankruptcy occurs and is an acknowledgement of debt problems and a framework to protect the firm’s assets from creditors (Platt & Platt, 2006). As Rico et al. (2021) articulated, ‘insolvency refers to the inability to make debt repayments while bankruptcy refers to a formal court proceeding’.
While there is no separate categorization of human capital in distress settings in existing literature, the subject is Interrelated to several scholarly sub-streams, such as labour and finance, distress, turnaround, human resources and bankruptcy. Our analysis reveals that research in this domain is broadly classified around the following perspectives: (a) consequences of firm distress on human capital inflow and outflow, (b) interactions of human capital with firm capital structure, (c) human capital and firm strategic choices (downsizing/retrenchment), (d) human capital and firm strategic choices (compensation/incentives) and (e) linkages with broader organizational crisis literature. We structure the analysis in this article accordingly.
We may also view this domain in the context of the broader organizational crisis management literature. While most studies examine the issue of organizational preparedness and response against the backdrop of social, political and economic crises (for instance, those caused by macro events such as the global financial crisis of 2007–2009; see Farndale et al., 2019), this article positions distress and bankruptcy as a specific sub-category of economic crisis unique to firms. The firm-specific crisis may still retain the dominant features of a crisis as being complex, disruptive and with major consequences for firm survival (Bundy. 2017). Focusing on this angle has distinct challenges, but our approach complements the organizational crisis literature that calls for a more focused human resources development (HRD) approach in dealing with an organizational crisis (see Wang et al., 2009).
Our study contributes to existing research by calling for more specialized and integrated academic, research and practitioner focus on human capital dimensions in distressed firms while showing the distinct issues faced by such firms. Distress and bankruptcy have certain implications on human capital (such as job/wage loss). This article discusses the ex-ante interactions of such likely bankruptcy scenarios on human capital and firm strategies. We argue that such ex-ante interactions have consequences across each stage of the distress lifecycle (pre-distress, distress and bankruptcy). From a firm’s strategy perspective, an enhanced and integrated ex-ante understanding remains crucial for turnaround and survival outcomes (see Figure 1).
An Enhanced Understanding of Ex-ante Interactions of Bankruptcy Scenario Can Lead to Successful Strategies Across the Distress Lifecycle#.
Further, the dimensions of human capital in each stage of the distress lifecycle are distinct and often challenging, and their management is crucial to declining firms. Managerial implications for near distress or distressed firms are that managers need to adopt a more integrated ex-ante perspective and considered strategy, depending on the nature of the firm decline, rather than react to distress events as they unfold, which can often be sudden (Amankwah-Amoah, 2018). Further, this article highlights several dimensions of human capital in distressed settings that remain under-researched and
The article is organized as follows. The following section discusses the methodology. We then provide our perspective on human capital and distress. Next, we analyse various research streams related to the domain. We then integrate with a discussion and present a conceptual framework. This is followed by a section that outlines some future research directions. Finally, we conclude.
# As detailed in this article, certain commonalities of key issues exist across the distress lifecycle, differentiated by the degree of severity amongst others (for instance, attracting and retaining Human Capital during distress can be even more challenging than at the pre-distress/near-distress stage). Hence, an ex-ante understanding of interactions and dynamics in the context of human capital across the distress lifecycle is crucial for timely and considered strategic actions.
METHODOLOGY
Conceptual papers are distinct from literature reviews as, unlike traditional literature reviews, they do not include methodology sections; they aim to ‘make connections between multiple bodies of literature and knowledge bases’ (Callahan, 2010, p. 3), while offering an enhanced perspective and understanding ‘of a concept or phenomenon’ (see Jaakkola, 2020, p. 21). Other subtle differences exist between conceptual papers and literature reviews, and while conceptual pieces draw from literature reviews, the latter is not an end objective of a conceptual paper but a tool (see Callahan, 2010; Gilson & Goldberg, 2015; Jaakkola, 2020). This article presents a conceptual analysis resembling a theory synthesis classification (Jaakkola, 2020), distinct from pure review articles. However, briefly discussing our study methodology would only add value to the article in the interest of transparency.
The literature for this study has primarily been sourced from e-databases using keywords (including combinations thereof) such as human capital, distress, bankruptcy, downsizing, retrenchment, organizational crisis, and compensation. As the domain is contemporary with an active and growing research interest, the papers have been sourced from reputed and peer-reviewed journals (including a few working papers relevant to the study). The initial part of the decade witnessed several literature reviews and meta-analysis studies (for instance, Crook et al., 2011; Datta et al., 2010; Dierendonck & Jacobs, 2012; Park & Shaw, 2013) on certain research sub-streams which have been included in this study. This article’s primary focus is distressed settings, and studies with relation/interlinkages to the subject have been included. The final set of studies referred to in this study has been sourced from a diversified group of 46 journals (across research streams such as human resources, finance, economics, management, law, business and psychology), reflecting the interdisciplinary nature of the subject. Table A1 in the Appendix provides the list of journals referred to in this study.
This study is primarily integrative and aimed at analysing human capital dimensions in distressed settings. It is not an exhaustive analysis of all related research thus far on the subject. For every research stream, such as downsizing and compensation, may be viewed as a separate topic by itself with a significant volume of research, the presentation of which would be outside the scope of this article. However, this study focuses on key challenges and issues in these sub-streams. It translates the same into a framework for analysing the dimensions of human capital in distressed settings.
HUMAN CAPITAL AND DISTRESS
Human Capital
Human capital is a broadly used term with debate on its constituents and measures. Several studies have recognized human capital as a multidimensional construct (see Khan & Quadus, 2018). Schultz (1961) defined human capital as a ‘set of knowledge, skills, and attributes that reside in an individual and that are used by him/her’ (Vidotto et al., 2017, p. 317). Other scholars have defined human capital as ‘a unit-level resource created from the emergence of individual’s knowledge, skills, abilities and other characteristics (KSAOs)’ (Ployhart & Moliterno, 2011, p. 128). Past literature has considered values and norms to also comprise human capital (Khan & Quadus, 2018). Vidotto et al. (2017) identified frequently used components of human capital (talent, education, experience, knowledge, skills, attitudes, creativity and leadership). Noting the lack of appropriate measures, they contributed with a multi-parameter scale across three dimensions (leadership and motivation, qualifications and satisfaction/creativity). On the other hand, Khan and Quadus (2018) broadly classified human capital constituents under demographic and psychographic while assessing its impact on firm performance.
From the literature, it is thus revealed that human capital is a set of qualities embedded in employees, creating value for the firm, and there are varying measures. However, studies in this domain have also used the term human capital as a form of capital (like physical capital) for the firm (Schultz, 1961) to often refer to people/employees without necessarily disentangling its embedded constituents (e.g., Brown & Matsa, 2016). Our objective for this study is not to unbundle human capital into its various constituents. Instead, we focus on integrating many research streams examining the interactions and impact of distress on human capital (employees/people) in terms of their entry/exits/strategic impact across the distress lifecycle. Therefore, we refer to employees/people as a form of organizational capital (human capital).
However, to the extent the level of individual human capital (knowledge, attitude, skills, etc.) can help the firm evaluate employees who are assets and costs (Vidotto et al., 2017), their constituents are relevant. Amankwah-Amaoh (2018) observed, ‘the detrimental effects of departure of highly skilled individuals from declining firms include hampering turnaround efforts and depleting the knowledge base of the firm’ (p. 741). Hence, in times of distress, we assume that firms will be more concerned with the turnover of employees (whether comprising senior management, middle management or support staff) with a high human capital quotient, whose departure may negatively affect them across the distress lifecycle. However, the specific attributes of employees the firm deems valuable may be firm-specific and can vary depending on each firm’s human capital perspective. For instance, some distressed firms may value collective memory (Ployhart & Moliterno, 2011), while others may value more specific skills/expertise, such as experience in turnaround (Amankwah-Amaoh, 2018). Talent-dependent firms may focus specifically on talented employees and their turnover impact on the firm’s fragility (Baghai et al., 2021). Much, therefore, depends on the nature of firms and their perspective of human capital constituents vital to them in their specific distress situation.
Further, while focusing on human capital at the employee level, this study does not cover board and corporate governance dynamics (see Mukherjee & Bonestroo, 2021), which, while important as a determinant and a consequence of distress (Habib et al., 2020), in our opinion warrants separate research emphasis.
Distress
This study focuses on financial distress, distinct from economic distress. Economic distress occurs when there is a decline in the firm’s operating performance, which may be due to ‘operational inefficiencies’ (Senbet & Wang, 2012, p. 254) or industry factors (Whitaker, 1999). On the other hand, financial distress implies difficulties a firm faces in honouring its commitments to creditors and relates to its financial structure (Senbet & Wang, 2012). However, the two are not mutually exclusive, and economic distress can also cause financial distress, but not necessarily (Whitaker, 1999). The subtle difference is that economic distress can happen even if a firm has no debt or creditors (Senbet & Wang, 2012), while financial distress impacts levered firms (Baghai et al., 2021; Matsa, 2018). While financial distress can lead to bankruptcy, economic distress in the absence of creditors can lead to liquidation and failure (Senbet & Wang, 2012). This article focuses on the ex-ante interactions of possible bankruptcy events in financially distressed firms (in the human capital context). However, while economic distress can also interact with human capital, research has noted the difficulty in segregating its distinct effects (Brown & Matsa, 2016; Pedersen, 2021).
There is no consistent definition of financial distress (Platt & Platt, 2006), and research has often used financial distress as a generic term for default, bankruptcy and insolvency (Habib et al., 2020). There are intuitive yardsticks, such as default on current obligations (Whitaker, 1999). However, in the early stages of financial distress, the firm may still not default due to the presence of alternate sources of funds (Whitaker, 1999). Hence, Whitaker observed financial distress as a condition in which ‘firm performance declines from previous levels’ (Whitaker, 1999, p. 125), due to which there may be insufficient cash flows to meet debt obligations. Other scholars have similarly defined financial distress as a lower-than-expected performance when the value of a firm’s total assets is insufficient to meet creditor claims (Balasubramanian et al., 2019). Financial distress is a ‘low cash flow state in which the firm faces financial losses without being insolvent’ (Purnanandam, 2008, p. 707).
However, while we discuss the ex-ante effects of possible bankruptcy scenarios (in the human capital context) on highly leveraged firms, we exclude purely financially constrained firms (that may not be distressed) in this study. Research has strived to distinguish financial distress and constraints, often using detailed indices/proxies for measurement (for instance, see Hadlock & Pierce, 2010; Kaplan & Zingales, 1997, 2000; Whited & Wu, 2006). Whited and Wu (2006) observed that financial constraints may characterize not only distressed firms (close to bankruptcy) but even otherwise healthy companies (for instance, young companies may face a lack of financing avenues to fund their growth plans). They also differ in their usage of extra funds. Research has also often argued (and often with contrary views) that constrained firms may use additional cash to fund profitable investments, while distressed firms use extra money to retire debt (see Kaplan & Zingales, 1997; Kim & Park, 2015). Hence while distressed firms are usually financially constrained, not all financially constrained firms are distressed (Brown & Matsa, 2012; Senbet & Wang, 2012). In this study, we focus on interactions of human capital in financially distressed firms across the distress lifecycle rather than purely financially constrained firms. Such firms may not be distressed, and therefore, whose interactions with human capital we believe warrant a separate research focus (for instance, Caggese & Cunat, 2008; Caggese et al., 2019; Kao & Chen, 2020).
Assimilating the various perspectives/definitions, in this study, we refer to financial distress as an intermediate situation in which a firm (which may or may not be constrained) faces persistent challenges or an abnormal situation (relative to its previous levels) due to several reasons (including economic distress), leading to delays and/or defaults (technical or financial) in meeting its commitments/obligations towards its creditors, thereby facing a greater likelihood of insolvency and bankruptcy.
THEIR CONSEQUENCES AND INTERACTIONS
Consequences of Distress on Human Capital (Inflow and Outflow)
A section of literature has touched upon the consequences of financial distress on human capital, primarily voluntary exits by employees. Literature has noted that credit events such as defaults are associated with a decline in employment (Matsa, 2018). Agrawal and Matsa (2013) showed that employment in sample firms in the United States decreased by 27% in two years following bond default, with almost half of the decline occurring in the year preceding default. Falato and Liang (2016) analysed US firms and argued that job loss occurs much earlier in the distress cycle upon violating creditor loan covenants (technical default). The authors found a 10% decrease in employment per year and an increase in the probability of layoffs following loan covenant violations. They argued that loan covenant violation represents firm distress events and often restricts the firm’s access to further finance. Job cuts following covenant violations are significantly magnified in difficult macroeconomic situations and a weaker environment of employee rights.
The specific composition of employees lost during distress was examined by Baghai et al. (2021). Using firm-level data from Sweden, the authors recorded that talented workers are 50% more likely to exit the firm voluntarily as firms approach financial distress. The authors differentiated their study by focusing on the composition of employees lost and observed that fresh hiring in distressed firms is precisely due to the loss of talented employees.
While the above literature has shown significant voluntary employee exits upon onset of distress, Brown and Matsa (2016) highlight challenges on the supply side. Through a survey of online job portal forms, the authors recorded the impact of financial distress on firms’ ability to attract quality job applicants. They found no evidence that reduced numbers of job applicants for distressed firms are due to diminishing labour demand. On the contrary, findings suggest distressed firms continue to hire due to higher employee turnover and the reluctance of employees to ‘remain aboard a sinking ship’ (p. 546). Brown and Matsa found that ‘job seekers accurately perceive a firm’s financial condition’ (p. 507), which impacts their decision to apply for employment in such firms. The authors argue that workers prefer to avoid distressed firms due to diminished job security, which impacts supply. However, they observed that when states provide unemployment insurance, these effects are, to some extent, moderated.
The underlying factors governing an employee’s decision to stay or quit a declining firm were examined by Jiang et al. (2017), who noted the subject is thinly researched. The authors attributed voluntary exits (jumping ship behaviour) of employees in firms to the theory of ‘network embeddedness’ (p. 2061), broadly defined as the influence of social ties/networks on employees. They argued that when employees voluntarily exit declining firms, they incur opportunity costs (losing access to the firm’s resources) but also garner certain benefits (avoiding the stigma associated with declining firms) and need to balance the two effects. Employees with moderate levels of social capital (external ties beyond their workplace) are more likely to leave declining firms as they can generate suitable external job opportunities, compared to employees with a low level of social capital, who are often unable to do the same. Employees with high social capital need less to exit from a firm as their network acts as a cushion (against stigmatization). The authors also recorded that a high level of firm-level networks (peer and inter-firm social networks) lowers employee motivation to exit as they lose out on personally benefitting from these networks.
However, in a recent study, Amankwah-Amoah (2018) stressed the need to view distressed firms’ human capital inflow and outflow paradigm from a more integrated perspective. The authors found that fear of stigmatization and the desire for better opportunities are the primary reasons skilled employees leave distressed firms. On the other hand, the firm’s need for fresh expertise governs new inflows and facilitates turnaround. External consultants play a pivotal role in bringing necessary expertise and serve as the link between inflow and outflow dimensions.
Interaction of Human Capital and Firm Capital Structure
Other research has focussed on labour interaction with firm financial policies. Studies have shown that human capital frictions interact ex-ante with a firm’s capital structure even before actual distress, especially in high-leverage settings, as leverage is an important precursor of distress and bankruptcy (see Baghai et al., 2021; Berk et al., 2010).
Some scholars have suggested that human capital costs constitute indirect costs of bankruptcy (also referred to in literature in this domain as labour costs of financial distress), which can offset debt tax benefits and explain why some firms do not leverage enough despite available tax benefits. Berk et al. (2010) reported that the human cost of bankruptcy has received minimal attention. Assuming that ‘employment contracts do not survive bankruptcy’ (p. 914), Berk et al. observed that the indirect human cost of bankruptcy due to wage loss that occurs upon bankruptcy filing is sufficient to offset the tax benefits of debt. In a subsequent study, Graham et al. (2019) examined bankruptcy filings in the United States and, following up with employees post-bankruptcy, quantified the effect of wage decline as a significant constituent of indirect bankruptcy cost. Graham et al. recorded a 10% decline in employee wages upon bankruptcy filings and cumulatively by 67% (over seven years) following filing (wage differentials estimated at 2.3% of firm value upon a drop in credit rating to BBB), which is a sufficient set off against tax benefits of debt and a significant determinant of capital structure.
While the preceding studies reveal how the loss of wages upon bankruptcy ex-ante impacts a firm’s capital structure, other studies empirically established how high leverage has consequences in the form of higher labour costs (wage differentials), which constitute a counterbalance to tax benefits of debt. Chemmanur et al. (2013) recorded that high leverage leads to high ex-ante CEO and average worker compensation (for leveraged firms) to compensate for higher bankruptcy probability. The implication for high-leverage firms is that indirect bankruptcy costs lead to ex-ante higher labour costs that are large enough to ‘offset the incremental tax benefits of debt’ (Chemmanur et al., 2013, p. 478). Another study examining labour frictions on corporate finance also observed that unemployment risk increases with firm leverage. Workers then seek higher wages to compensate for this unemployment risk impacting capital structure choice. Firms reduce leverage to minimize wage bills arising from unemployment risk, especially in industries prone to layoffs (Agrawal & Matsa, 2013). The authors quantified wage differentials for unemployment to be about ‘60 bps of firm value for a typical BBB-rated firm’ (p. 449). They, however, observed that firms can afford higher leverages in states with unemployment insurance since they do not need to provide unemployment risk compensation. A recent study added to these findings while observing that the effect of leverage on wage differentials has been thinly studied (Lin et al., 2019). It reconfirmed that high-leverage companies must offer workers more salaries to compensate for potential bankruptcy.
Other perspectives on labour and finance interactions also exist in studies in this domain. Baghai et al. (2021), using data from Swedish firms, examined the increased turnover of talented employees in distressed firms as they approach bankruptcy to be an important cost of financial distress. They observed the exit of talented employees increases firm fragility and leads to conservative ex-ante capital structure choices for talent-dependent firms. In another study, Bae et al. (2011) recorded the fair treatment of employees is attached to greater ‘reputation capital’ (p. 131). Therefore, such firms have relatively lower leverage, while the converse is true for firms that treat employees poorly (more pronounced for distressed firms). Further, human capital, as a possible explanation for ‘puzzling’ negative net debt (net of cash balances) phenomena in certain firms, was attributed to the transferable characteristic of human capital (relative to physical capital) by Lambrecht and Pawlina (2013). Lambrecht and Pawlina argued that as firms cannot borrow against human capital, managers have to invest in human capital, and the firm’s negative debt position reflects this imbalance.
How human capital is financed is a question addressed by Schmalz (2013), who showed the importance of the perspective of human capital on ex-ante financial policies and the management of the human capital risk of firms. A firm that views employees as assets difficult to replace would like to insure them in bad times and hence would ex-ante adopt a conservative and liquid capital structure (with more reliance on equity financing) provided they are unconstrained or have the flexibility to raise equity. In contrast, a firm (and specifically constrained firms) that views employees as external suppliers would then typically be governed by more debt and would burn up cash trying to preserve employees during bad times (which would also result in inefficient firing). Schmalz thus concludes that a conservative capital structure aids in managing human capital risk and has a positive signalling effect, which can help the firm attract manpower during times of requirement.
Human capital frictions, such as costs associated with unemployment, unionization, and labour protection, all have a significant bearing on a firm’s financial policies (see Matsa, 2018). For instance, Matsa discusses that firms adopt less leverage in countries where labour regulations make firing difficult as they lack the flexibility to downsize in distress. Matsa concluded that while scholars continue to research the causal relations between labour and finance, future studies need to further research the relationship between various labour frictions and capital structure. Additionally, bankruptcy laws offer varying levels of employee protection in certain countries, with courts in some jurisdictions playing a more active role in protecting employee rights (Blazy et al., 2011; Stef, 2018). Ellul and Pagano (2019), for instance, observed that unconstrained firms use more leverage in countries where bankruptcy laws bestow higher seniority rights to employees (than creditors) in bankruptcy (specifically in liquidations) to keep their bargaining power intact. Further, not only capital structure but labour law restrictions also can impact bankruptcy filing. Stef (2018) showed how national labour regulations that inhibit ex-ante layoffs lead to more bankruptcy filings, and the trade-off between layoffs and bankruptcy risk is an area for further research.
Strategic Choices for Distressed Firms: Downsizing/Retrenchment
Healthy and distressed firms often resort to workforce reduction exercises (Zorn et al., 2017). A voluminous literature exists on the subject of downsizing, despite which ‘very little can be said with certainty regarding antecedents and consequences of employee downsizing’ (Datta et al., 2010, p. 337). Datta et al. suggest that for methodological uniformity, there is a need to include environmental factors that could also lead to downsizing and recommend integrating individual and organizational outcomes. Using meta-analysis, Park and Shaw (2013) examined the impact of employee turnover and organizational performance. The authors found employee turnover leads to decreased organizational performance (with more robust results for voluntary turnover). Another meta-analysis research examined the influence of fairness on the organizational commitment of downsizing survivors/victims as an important factor in the lack of positive results in this domain (Dierendonck & Jacobs, 2012). The authors found procedure fairness (how layoffs are implemented) more significant than distributive fairness (adequacy of severance payments) for survivors/victims while recording the moderating role of culture.
Other standalone studies have delved into the impact of layoffs/downsizing. Powell and Yawson (2012) compared the impact of internal restructuring choices (divestitures and downsizing) on firm survival in the United Kingdom. They found divestitures (more prevalent in healthy firms) improved the likelihood of survival, while layoffs (which occur in healthy and distressed firms) increased the speed and probability of bankruptcy. Zorn et al. (2017) added to the adverse findings on downsizing and argued that downsizing (whether by distressed or healthy firms) increases bankruptcy likelihood. Using a sample of US firms, Zorn et al. (2017) noted, ‘downsizing interrupts organisation routine, reduces the productivity and increases the stress of remaining employees, and impedes knowledge transfer and organisational learning’ (p. 25). The authors noted that intangible resources help prevent bankruptcy and stressed the negative psychological consequences of downsizing on surviving employees (stress and insecurity). In a recent study, Rico et al. (2021) examined the retrenchment strategies of SMEs in bankruptcy and observed that employee retrenchment is associated with higher liquidation events and that only debt reduction has a beneficial impact. Rico et al. also suggested that the design of a bankruptcy system needs to govern the choice of which form of retrenchment leads to the preservation of firm value.
The impact of downsizing on retained staff (downsizing survivors) was examined by Arshad (2016), who studied the adverse effects on surviving employees’ sense of job security. Arshad discussed how downsizing results in violations of psychological contracts (PCVs) between firms and employees, arguing that PCV violations lead to the greater intention of downsized survivors to quit. Cultural factors moderate this effect. Drawing upon literature that has already established a positive relationship between PCV breach and employee turnover, they argue that such violations have cost implications for organizations regarding productivity and finding replacements. Organizations can, however, also repair employees’ trust in the context of violations, which is also called ‘trust repair’ (Kahkonen et al., 2021). Future research might identify the ideal strategy for repairing employee trust violations (Kahkonen et al., 2021).
However, other research shows that downsizing does not always have negative implications. Brauer and Laamanen (2014) argued that downsizing does not have a uniform impact, and the extent to which it occurs creates differential results. The authors recorded how only moderate scale downsizing may negatively impact firm performance (through disruption of organizational routine). Small-scale downsizing may lead to performance improvement, while large-scale downsizing may create a new way of working for the organization. Using a sample of firms, Kao and Chen (2020) showed firms with fewer financial constraints that used repeated downsizing for process improvement recorded greater production efficiency and reduced PCV. Caggese et al. (2019) noted that financial constraints and focus on short-term cash gains often govern firms’ choice on the type of employees laid off, often resulting in wrong decisions and poor outcomes. Using a sample of Swedish firms, the authors observe financially unconstrained firms ‘fire more long-tenured workers than short-tenured ones because the value of recent hires drives the company’s profitability and may be less affected by temporary drops in profitability’ (Caggese et al., 2019, p. 590). In contrast, the authors recorded that constrained firms often inadvertently lay off highly skilled short-term workers due to a more short-term focus.
The choice of an incumbent CEO or new leadership is also important to firms in distress and bankruptcy. The incumbent leadership is often blamed for the firm’s decline (Hung & Tsai, 2020). Chiu and Walls (2019) showed that a new CEO could positively impact the firm in the context of corporate social performance. The effects are, however, moderated to some extent under financial distress. Alternatively, it has been argued that an incumbent CEO may be better suited to assist in its revival by curtailing the adverse effects of managerial optimism (Hung & Tsai, 2020). Hence, given the importance of leadership to outcomes, CEO retention is another crucial strategic choice firms must make during financial distress.
Strategic Choices for Distressed Firms: Compensation/Incentives
Even before distress occurs, potential bankruptcy scenarios (wage loss/unemployment risk) can influence the ex-ante capital structure and compensation policies (see Lin et al. 2019, who noted the impact of leverage on salaries is thinly researched). High-leveraged firms need to pay higher wages/salaries to incentivize labour to join the firm to compensate for higher bankruptcy risk. This act of compensation for ex-post unemployment/wage loss risk impacts capital structure (Agrawal & Matsa, 2013; Graham et al., 2019). Once leveraged firms reach distress, firms use distress as a bargaining tool (Lin et al., 2019) to drive down pay. In a related study, Pedersen (2021) also showed that employees of distressed firms who face an increased risk of entering bankruptcy due to exogenous shocks will accept pay cuts. Hence, we can observe wage impact in either situation, requiring strategic decisions across high leverage, distress and bankruptcy.
On potential retention strategies for employees in bankrupt firms, incentive plans are an area of debate. Key employee retention plans (KERPs) are an essential feature of healthy firms, while bankrupt firms actively utilize KERPs for retaining employees. Goyal and Wang (2017) found KERPs to be an efficient solution for manpower retention when employees have employment options. The authors noted that KERP is not new, with almost 40% of US large bankrupt firms using them. Studying a sample of Chapter 11 firms, they tested both views of KERPs: (a) as an efficient contractual tool for employee retention and (b) the opposition view that it favours entrenched managers (who enrich themselves at the cost of creditors). They found support for KERPs’ beneficial impact as a tool for employee retention. KERPs are likely to be adopted by firms with greater creditor control and complex operations, with a higher risk of employee turnover. Also, incumbent CEOs are less likely to be covered under KERP than turnaround specialists. The authors, however, noted that KERPs could also be an outcome of bargaining between employees and firm creditors, and further research is required.
Other scholars have reaffirmed the importance of incentives in distressed firms. For instance, Chang et al. (2016) showed that firms with a higher probability of distress would need to compensate new CEO hires for adverse career impact in the event of distress, but such compensation is more in the form of equity-based instruments. Canil and Rosser (2018) stressed that the nature of incentives matters for incumbent CEOs, and firms adjust their incentive decisions (options/stocks) depending on the nature of the decline (financial or operational). If firms decline for financial reasons, they provide options, while when firms decline due to operational factors, they grant more stocks. Following up with a sample of US firms following distress, the authors conclude that such adjustments matter for firm survival and successful outcomes.
In another study, Maskara and Miller (2018) examined the effectiveness of ‘golden parachutes’ as a popular tool for senior-level compensation and whether they lead to lower liquidation outcomes. By studying outcomes across a sample of distressed US firms, Maskara and Miller found that hiring CEOs with golden parachutes leads to a lower probability of liquidation, primarily where CEOs are employed within one year of bankruptcy filings. But, equipping incumbent CEOs with golden parachutes does not lead to the same outcome. However, the authors noted hiring CEOs without golden parachutes does not necessarily lead to liquidation; reputational motivation factors lead them to perform effectively.
Linkages to Organizational Crisis Literature
This domain may also be viewed in the context of the broader organizational crisis management literature. Distress and bankruptcy can be considered a specific sub-category of economic crisis unique to firms with significant interactions with human capital. Some studies argue that the linkages between HRD and crisis management are relatively underexplored. Existing interventions are primarily administrative in nature and post-crisis rather than at a pre-emptive and strategic level. A lack of consensus exists in the literature while having significant implications for firms (Bundy et al., 2017; Farndale, 2019; Wang et al., 2009). In a review, Bundy et al. (2017) defined a crisis as ‘an event perceived by managers and stakeholders to be highly salient, unexpected, and potentially disruptive—can threaten an organisation’s goals and have a profound implication for its relationship with stakeholders’ (p. 1662). Wang et al. (2009) observed that the definition of crisis is complex. Crises can stem from economic, social, political, industrial and environmental factors and can be gradual or sudden. While Wang et al. advocated for a more significant strategic role for HRD in organizations for pre-empting crisis and for facilitating organizational learning, Bundy et al. (2017) strived to integrate the internal perspective (pre-crisis prevention, crisis management and post-crisis organizational learning) and external perspective (stakeholder management comprising relationships, perceptions and social evaluation). They also noted that in crisis, the cognitive ability of managers and stakeholders is depressed, leading to further challenges in crisis management. Farndale et al. (2019) classified crisis as caused by macro events, economic, political and social factors and argued that distressed firms’ strategies must be linked with macro-economic factors. They observed that there is often no standard procedure in a sudden economic crisis. Therefore, from an HR perspective, firms must find a balance ‘at the intersection of flexibility and social accessibility’ (Farndale et al., 2019, p. 2).
DISCUSSION AND SYNTHESIS
This article has debated the significance of human capital in distressed settings. Firms face unique challenges and complex strategic choices in high leverage (pre-distress) and distressed and bankruptcy conditions. Some studies have shown the importance of employees at times of financial distress when there are fewer alternatives and suggested that adopting a more considered human capital strategy (for instance, in the downsizing context) can even ward off bankruptcy events (Zorn et al., 2017). As human capital is a critical intangible resource at times of distress, a firm’s strategy for human capital forms an essential restructuring component. Our article contributes to research in the following ways:
First, by connecting various strands of related literature, we highlight the distinct challenges and complex choices (with critical consequences) distressed firms face in the context of human capital. Our study highlights that managing human capital in distressed firms entails walking a tightrope between significant and often overlapping events depending on the nature and speed of a firm’s decline. These include voluntary exits, especially for the talented (Baghai et al., 2021), and supply-side challenges due to the hesitance of labour to join distressed firms (Brown & Matsa, 2016). Additionally, they face certain complex choices in an environment of resource constraints. For instance, firms may need to cut costs and consider downsizing while offering higher pay to induce talent to join them (necessary for their revival). Hasty layoffs may precipitate a firm crisis, leading to a shortfall of human capital when required the most, and also negatively impact existing survivors (Arshad, 2016; Powell & Yawson, 2012). Urgent remedial action (such as trust repair) may then need to follow such steps by the firm, the absence of which can lead to further human capital exits (Kahkonen et al., 2021), hastening firm decline. Prevalent regulations vary across jurisdictions and may also impact human capital strategy in distress (see Blazy et al., 2011; Ellul & Pagano, 2019; Stef, 2018). Employees’ cognitive abilities are also considered depressed during a crisis (Bundy et al., 2017), further aggravating issues. Distressed firms also need to strike a delicate balance when deciding on incentive schemes like KERPs (Goyal & Wang, 2017), which are complex to implement given criticisms from creditors (more so if a firm has undertaken a downsizing recently, signalling cost-cutting intentions). Further, the proper sequencing of strategies thus becomes crucial in distressed times as they have a powerful signalling effect and can help garner their acceptability from stakeholders. Hence, distressed firms need to grapple with unique human capital challenges and complex choices that are distinct from regular firms and have profound implications on firm outcomes.
Then, by integrating several related research streams, we highlight the significant ex-ante interactions of potential human capital consequences in bankruptcy on firms. While adverse human capital consequences may be a fallout of distress/bankruptcy, their ex-ante implications commence early in the distress lifecycle across several dimensions. For instance, they are visible in increased human capital turnover in levered firms long before financial default (Falato & Liang, 2016). Such interactions are also seen in ex-ante compensation choices of levered firms (Chemmanur et al., 2013) due to the reluctance of fresh supply to join, given the increased bankruptcy risk. These interactions also take place with a firm’s financial policies. A firm, for instance, may adopt a more conservative ex-ante capital structure due to potential wages and employment loss in bankruptcy (indirect costs of bankruptcy [Berk et al., 2010]) or as an adjustment for higher compensation demanded by human capital supply for joining levered firms. The capital structure choice may also be ex-ante impacted by the labour orientation of bankruptcy regimes. For instance, research has shown bankruptcy regimes favouring employees’ rights may ex-ante induce a firm to adopt higher leverage to counter labour’s bargaining power during bankruptcy (Ellul & Pagano, 2019). The ex-ante interactions are also visible in a firm’s decision to downsize. However, relevant bankruptcy or labour laws may restrict employee dismissal (Matsa, 2018), influencing ex-ante firm survival strategies. Failing to recognize the implications of such interactions (especially early in the distress lifecycle) can result in unconsidered firm strategies, causing human capital to become both a consequence and precipitator of distress. Hence, this article stresses a need for upfront recognition of the ex-ante interactions of bankruptcy and their consequences across the distress lifecycle.
Next, considering the distinct human capital challenges in distressed firms and the many ex-ante implications of likely bankruptcy on firms, we call for an enhanced ex-ante managerial understanding of the human capital issues and interactions across the distress lifecycle. Extant literature, however, tends to analyse these various streams as discrete events, ignoring their convergence. While research on different dimensions of human capital in firms continues to evolve, it is noteworthy that it is vital during all distress lifecycle stages (high leverage, distress and bankruptcy). Each stage, in turn, brings distinct and inevitable consequences for the firm and is often challenging, and their management is crucial to declining firms. For instance, during pre-distress, a possible bankruptcy scenario induces ex-ante employee turnover, complicates retention strategies, and drives up wages (to compensate human capital for joining the firm). However, in distress, firms negotiate with employees to drive down wages, and firms must strike a delicate balance between these two dynamics (see Lin et al., 2019). Further, relevant bankruptcy laws play a crucial role during bankruptcy and, depending on their orientation, have ex-ante implications on strategies. Additionally, not all business declines are gradual, and some may be caused by sudden shocks (Amankway-Amoah, 2018), leading managers to simultaneously account for all the above to ensure the firm is a going concern. The subject, therefore, calls for an enhanced ex-ante practitioner understanding of human capital complexities from the firm strategy perspective. We present a conceptual framework depicting the interconnections between bankruptcy and the pre-distress scenario and the importance of human capital strategies in the distress lifecycle. Figure 1 presents the conceptual framework, while Figure 2 shows some distinct but related issues in each stage of the distress lifecycle. A more enhanced ex-ante managerial understanding of human capital’s unique issues and interactions across the distress lifecycle can result in more timely and considered strategies to prevent distress, bankruptcy and liquidation events.
An Integrated Framework of View (Key Effects Across the Distress Lifecycle).
Finally, we call for considering human capital in distressed settings as a distinct academic stream, considering the complexities, interactions and importance of the subject to firm survival. The last decade has seen growing research in labour and finance and interest in many issues analysed in this article. These include voluntary employee exits, labour supply issues in distressed settings, factors governing employee’s choices to stay or quit declining firms, the impact of leverage and bankruptcy on wages, the ex-ante impact of bankruptcy on capital structure, differential downsizing strategies, and its efficacy, impact on downsized survivors and KERPs in distressed/bankrupt settings. Arguably, some of these issues overlap in standard management research (for instance, staffing attraction, turnover, retention, compensation, etc.). Still, the implications of these factors in distressed and bankruptcy settings are neglected even though they are often acute. They demand urgent resolution in an environment of resource constraints and creditor/regulatory complications, often requiring complex choices to ensure survival. Further, human capital issues are distinct across the distress lifecycle and need to be recognized, as, in bankruptcy settings, existing contracts may be legitimately repudiated (see Berk et al., 2010). Thus, due to distress being a unique situation, this article calls for a more distinct academic focus on human capital in distressed firms as a specialized and integrated stream.
FUTURE RESEARCH DIRECTION
The analysis has shown human capital dimensions in distressed settings are distinct, and distress brings consequences and complex choices to firms, which can impact turnaround/survival. The ex-ante implications brought about by the potential bankruptcy scenario contribute to the complexity. Hence, this article has suggested a more composite and integrated focus on human capital in distressed firms. However, many dimensions of human capital in distressed settings remain under-researched, with significant potential for further investigation, for instance, the ex-ante impact of potential bankruptcy on human capital (compensation, turnover, retention, incentives and firm strategies). Future studies may also focus on the appropriate sequencing of human capital strategies in distressed settings as firms may remain vulnerable to quick collapse, and the time gap between distress and bankruptcy is often compressed. Literature has also observed that bankruptcy is a traumatic experience for stakeholders, including employees (Boratynska, 2016). Future research may also focus on resolving softer issues as a relevant retention strategy.
Further, while growing research examines labour and finance interactions (through separate sub-streams), few studies (such as Rico et al., 2021) have examined the distinct implications of human capital within bankruptcy settings, especially in creditor-friendly bankruptcy laws. Research has increasingly shown how bankruptcy laws’ labour orientation can impact a firm’s human capital and financial policies. However, bankruptcy codes can also have other significant implications, involving the suspension of the existing management and induction of a court-appointed Insolvency Professional responsible for maintaining the company during the bankruptcy process (Baxi, 2023). Insolvency professionals are responsible for several functions, including the management of debtor’s affairs and creditor claims and may not have the specialized resources, funds or expertise to deal with the complex challenges bankruptcy brings to human capital. Further, creditors responsible for voting may be driven by limited objectives of recovery and may not prioritize human capital. Rico et al. (2021), for instance, noted that ‘overzealous secured creditors’ may push for deeper employee retrenchment, hastening organizational failure.
CONCLUSION
This article has drawn on related research streams of literature to illustrate some distinct dimensions of human capital and the complexity of choices faced by firms in distressed settings while providing a framework of view across the distress lifecycle (high leverage, distress and bankruptcy). We call for a more integrated and specialized focus (managerial, academic and research), considering distinct challenges and dynamic interactions of bankruptcy scenarios (potential unemployment risk/wage loss) on firms across the distress lifecycle. The interactions demand a deeper ex-ante understanding of bankruptcy scenarios, which may also depend on the type of bankruptcy codes and orientation towards labour issues. These impact ex-ante strategic choices and can influence firm turnaround/survival, rendering correct timing and sequencing of such strategies critical. The domain has current relevance. Several countries have undertaken bankruptcy reforms, leading to a significant workforce working for distressed companies, especially in countries with large non-performing loans. A more composite perspective on the subject would aid in early managerial focus and pre-emptive strategic action to moderate the negative impact of distress on human capital and ultimately avoid bankruptcy and liquidation outcomes.
LIMITATIONS
This study has discussed many research streams on human capital in distressed settings. We acknowledge that many of the discussed streams (such as labour and finance, compensation, retention and downsizing) are vast, with a significant volume of literature. However, this study is primarily integrative and aims to highlight the unique issues, key interactions, and some critical choices firms face in the context of human capital in distress. It is not an exhaustive analysis of each research sub-stream. Further, while focusing on human capital at the employee level, this study does not cover board and corporate governance dynamics (see Mukherjee & Bonestroo, 2021), which, while important as a determinant and a consequence of distress (see Habib et al., 2020), in our opinion warrants separate research emphasis. Further, we acknowledge other evolving research streams, such as the impact of creditor rights on the capital–labour mix of Industries/Firms (see Ghosh, 2023; Shashwat et al., 2022), which future research may integrate with this inquiry for a more exhaustive analysis of the subject.
Footnotes
DECLARATION OF CONFLICTING INTERESTS
The authors declares no potential conflict of interest concerning this article’s research, authorship and publication.
FUNDING
The authors has received no financial support for this article’s research, authorship and publication.
NOTES
APPENDIX
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