Management Ownership and Risk-Shifting Investment*
Nobuyuki Teshima†
School of Commerce
Senshu University

ABSTRACTThis study analyzes the relationship between management ownership and its risk-shifting
incentive. We first present a simple model showing that the risk-shifting incentive ofmanagement of financially distressed firms increases as the management ownership of thefirm increases. Empirically, we test the hypothesis that under the former Japanese Corporate
Reorganization Law, firms with higher management ownership are more likely to use legal
rather than private reorganization. Since the reorganization process under the law virtuallyeliminates the possibility of risk-shifting investment, creditors are more likely to prefer thelegal process to private process, when management ownership is higher. Empirical results
are consistent with the hypothesis.
JEL Classification: G32; G33; G34
Key Words: Management Ownership; Risk Shifting; Debt Restructuring;
Reorganization; Bankruptcy

1. Introduction
A firm’s shareholders and creditors have conflicting interests. Shareholders, bearing limited
liability for paying creditors’ claims, have an incentive for the firm to pursue projects with higher riskeven if they have lower value to the firm ( Jensen and Meckling 1976). This may particularly be thecase when the likelihood of a firm’s defaulting on its debt is higher (Brealey et al. 2007: ch.18). Whenthe management’s ownership in a financially distressed firm is higher, their interests are more alignedwith those of the shareholders. As a result, management ownership can be most harmful when a* I acknowledge the helpful comments and suggestions of Hiroshi Maruyama, Hiroyuki Seshimo, Akinobu Shuto, Kazuyuki Suda,
Konari Uchida and seminar participants at the Research Institute for Economics & Business Administration, Kobe University andat Nanzan University.
† Corresponding Author. Address Senshu University, 2-1-1, Higashimita, Tama-ku, Kawasaki-shi, Kanagawa 214-8580, JAPAN
Telephone +81(44)900-7937 E-mail teshima@isc.senshu-u.ac.jp
Received May 8, 2012; accepted June 30, 2012
Copyright©2012 Research Institute for Economics & Business Administration – Kobe University.

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firm is near default.1 This study first presents a simple model regarding the relationship between
management ownership and its risk-shifting incentive. The model suggests that, in a financiallydistressed firm, the management with higher ownership is more likely to pursue risk-shifting
investment that may lead to a high payoff for the shareholders and a low payoff for the creditors.
When creditors of a financially distressed firm perceive the level of the management’s riskshifting incentive, the creditors’ perception will influence the negotiation for the debt restructuring.
In this context, the former Japanese Corporate Reorganization Law (Kaisha Kosei Ho) provides aunique opportunity to test the implication. Filing for legal reorganization under the law virtuallyeliminates the possibility of risk-shifting investment that could impair the value of creditors’ claims.2
Following the filing, the entire management is dismissed and replaced by court-appointed receivers.3
Charged with the responsibility of prudent management of the firm’s assets, the receivers propose areorganization plan in cooperation with creditors and implement it once it is approved by the court.4
Also, as absolute priority is strictly observed under the law, the existing equity becomes worthless.
Therefore, the former management can influence the investment decision neither as management nor
as shareholders. These complete changes in management and ownership structure will remove theconcern for risk-shifting investment from the creditors.
On the other hand, legal reorganization or bankruptcy generally costs the firm more than aprivate reorganization (Gilson 1991; Gilson et al. 1990; Franks and Torous 1994; Wruck 1990).
Therefore, the creditors may as well demand the change in management and ownership structure,
before entering legal reorganization process (Gilson and Vetsuypens 1994). We assume, however,
it is very difficult for the creditors to implement these changes privately. 5 In fact, when a private
reorganization plan is agreed upon with creditors, management team usually remains and ownership
structure is wholly unchanged (see Section 3.1), suggesting that it is actually difficult for the creditors
to privately implement these changes. Accordingly, we can assume that the creditors are more likely
to resort to the legal reorganization process when they feel stronger need for these structural changes.
Put differently, under the former Japanese law, to incumbent management and existing
shareholders private reorganization is more favorable, because the management has good chance
to remain in office and the existing equity does not become worthless. Therefore, we presume thatthe management of a financially distressed firm first seeks to restructure its debt under private
reorganization and it depends largely on the creditors’ reaction whether the firm files for the law
or not.6 We hypothesize accordingly that management ownership which is related to the creditors’
perception of its risk-shifting incentive affects the choice between private and legal reorganization.
We do not explicitly consider the incentive effect of management stock options. The sample period of our empirical study is from1990 to 1998, while management stock options were not introduced in Japan until 1997.
2
For details of the former Japanese Corporate Reorganization Law, see Schumm (1988). The law was enacted in 1952 byintroducing Chapter 10 of the U.S. Bankruptcy Code then existing. Since the law was revised overall in 2002, we use the samples
before the revision in our empirical test.
3
As a result of the revision of the law, it has been made possible for an incumbent director to remain in the firm as a receiver if thedirector is not apparently responsible for the firm’s financial difficulties. (In Japanese firms, directors generally perform the role that
their counterparts in the U.S. perform as executive managers.)
4
Usually the receivers are experienced practitioners such as lawyers. Compensation for the receivers is set by the court.
5
For example, changing the management may not be enough for the creditors, since the resigning management who remains asshareholders can influence the new management who has been in most cases their subordinates (see Section 3.1). Also, insider
trading regulations will make it difficult to let the management sell off their shares.
6
In U.S. bankruptcy literature, it is reported that many firms entering Chapter 11 do so only after attempting to resolve theirfinancial difficulties privately (Franks and Torous 1994).
1Teshima: Management Ownership and Risk-Shifting Investment

77

In our empirical test, we use a sample of Japanese firms which have been reorganized either
legal or private process while the former law is effective. The results support our hypothesis andsuggest that the former Japanese Corporate Reorganization Law helps to curb management’s valuedecreasing investment or so-called moral hazard. If the incumbent management is prone to suchinvestment, creditors will prevent them by resorting to the law.
The remainder of the paper is organized as follows. Section 2 develops a simple model thatgenerates predictions about the relationship between management’s ownership and its risk-shifting
incentive. It also postulates a testable hypothesis concerning the choice of the reorganization process
under the former Japanese law. Section 3 explains our sample selection process and defines variables
used in our empirical test. Section 4 reports and discusses the empirical results. Section 5 concludes
the paper.

2. Model and Testable Hypothesis
In this section, we first analyze the investment decision by the management of a financiallydistressed firm. We present a model that generates predictions of how management’s ownershipaffects its risk-shifting incentive. The model is adapted from the credit rationing model (Stiglitz andWeiss 1981; Bester and Hellwig 1987). However, our analysis focuses on the conflicting interests ofstakeholders rather than on credit rationing by lenders.
We consider a firm that must choose between two mutually exclusive investments: projects A
and B. Project A’s chance of success is pA , and it will generate gross return RA if successful. Project
B’s chance of success is pB , and it will generate gross return RB if successful. The gross return ofboth projects is assumed to be zero in the case of failure. Both projects have the same investment
period, during which the risk-free interest rate is assumed to be zero. It is also assumed thatboth projects require identical initial investment, I, which is raised by issuing stock and debt. The
following relationship between expected returns of the two projects is assumed to hold: pA RA > I >pB RB. In addition, project B is assumed to have a higher return if successful (RB > RA). Given these
two assumptions, the relationship pA > pB holds. In sum, project B is inefficient and riskier thanproject A.7 It may be useful to suppose an existing firm, with project A being an extension of existing
businesses and project B an unrelated speculative venture.
Let us assume that the firm’s debt consists of a discount bond with face value F, which maturesat the end of the investment period. We assume that the original level of F is exogenously determinedon the basis of the costs and benefits of debt financing.8 Let us further assume that management
holds an exogenous fraction m (0 ≤ m ≤ 1) of the firm’s total outstanding shares and is risk neutral.9
Management will choose between the two projects so as to maximize its own expected payoff.
As pointed out by Brealey et al. (2007: ch.18), the risk-shifting problem is of practical importance when a financially distressedfirm ventures to gamble for resurrection. We assume that such an investment is not efficient. Bradley and Rosenzweig (1992) also
refer to risk-shifting as the decision to carry out negative net present value projects (p.1052).
8
For example, if the firm is to issue debt with a face value of F*, the creditors, assumed to be risk neutral, will pay the amount of pA F* forthe debt, as long as they perceive that project A is to be chosen. The capital contribution by the shareholders will then be I - pA F*.
9
We assume the management’s risk neutrality for simplicity, since our principal objective is to analyze how the creditors will
respond to the reorganization plan prepared by the management. We also assume that management compensation does not varywith investment outcome. Jensen and Murphy (1990) report that management wealth is tied to shareholders’ wealth mostly bymanagement shareholdings.
7

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The Japanese Accounting Review, 2 (2012), 75-85

Creditors cannot effectively specify by contract which project is chosen, since they cannot verify it.
Let us first examine the relationship between the face value of the firm’s debt and the
management’s choice of project. If the project succeeds, the management will receive its shareof the residual return; in contrast, if the project fails, the management’s share will be worthless.
Management’s expected payoff from project A, πA , and from project B, πB , can be expressed asfollows:
πA = pA m ( RA − F )(1)

πB = pB m ( RB − F )(2)

In Figure 1, the lines labeled p A and p B express management’s expected payoff from projects
A and B, respectively, as functions of F. Given the assumptions pA > pB and pA RA > pB RB, if the facevalue of the debt is zero, management’s expected payoff from project A is greater than that fromproject B. Further, the absolute value of the slope of line p A (the rate at which management’s expected
payoff decreases with an increase in debt) is greater than that of line p B. Also, given the assumption
RB > RA, the two lines intersect at a point where management’s expected payoff is positive (see Figure1). We refer to the face value of the debt at the intersection as , F , which is expressed as follows:

pA RA
pA

F

p B RBpB(3)

Figure 1: Management’s Expected Payoff as a Function of Face Value of Debt
Management’s
expected payoff
A

B

F

RA

RB

Face value of debt

When the face value of the debt is smaller (larger) than F the management chooses project A (projectB). Therefore, F is the maximum amount of debt for which the management chooses the efficient project.
The firm will not issue debt with a face value exceeding F . That would induce the firm(management) to choose project B, imposing negative net present value on shareholders. 10 We
10If the firm is to make the most of the tax benefit of debt financing, it will issue debt with a face value of F, the contractual interest
payment being（1 - pA)F. (Here we assume that the management will choose project A when the face value of the debt is exactly F.)Teshima: Management Ownership and Risk-Shifting Investment

79

assume, however, that an exogenous shock could occur after the firm’s financing but before themanagement’s final decision regarding the choice of the project. The firm’s financial conditions will
be deteriorated by the shock and the firm’s total liabilities L will exceed F.11 We analyze how this willaffect the management’s investment decision. In this situation, management’s incentive to choose
project B over project A, πB - πA , is expressed as
πB − πA = pB m ( RB − L ) − pA m ( RA − L )(4)

Let us examine the impact of management ownership on this risk-shifting incentive bydifferentiating equation (4) with respect to m:d ( πB − πA )dm

= L ( pA − pB ) − ( pA RA − pB RB )(5)

When L > F, equation (5) takes a positive value. This means that when management has riskshifting incentive, it is greater as management ownership is higher.
More practically, let us suppose that a firm is financed by rolling over its debt securities.
When the firm’s financial condition unexpectedly deteriorates and its liabilities exceed F ,management will find it difficult to roll over its maturing debt because investors in credit markets
perceive risk-shifting incentive of management. In this circumstance, management may as well
ask creditors for debt restructuring such as by extension of maturity. 12 Creditors’ reaction to thisprivate reorganization plan will vary by the level of management ownership of the firm, especiallywhen legal reorganization is such an alternative that will eliminate the concern for risk-shifting
investment. As management ownership is higher, they perceive greater risk-shifting incentive andtend to resort to legal process.
The former Japanese Reorganization Law provided creditors with such legal alternative. Upon
filing under the law, the entire management is dismissed and replaced by court-appointed receivers
charged with prudent management of the firm’s property. Also, as absolute priority is strictly
observed under the law, the existing equity becomes worthless. Therefore, the former management
can influence the investment decision neither as management nor as shareholders. These completechanges in management and ownership structure will remove the concern for risk-shifting
investment from the creditors.
Consequently, we postulate a testable hypothesis that when the former Japanese Corporate
Reorganization Law is effective, the greater management ownership in a financially distressed firm
increases the likelihood that private negotiation with creditors fail and the firm is reorganizedunder the law.13

In practice, when a firm’s financial conditions deteriorate, its total liabilities, including obligations to suppliers, employees, andspeculative lenders, may accumulate and exceed F in the model.
12
It is also difficult for a financially distressed firm to issue equities except for distributing equities to creditors as a medium of debt
restructuring.
13
Kim and Kwok (2009) hypothesize that management ownership affects the likelihood of bankruptcy. However, their hypothesis depends
on the assumption that shareholders retain more value in bankruptcy (Chapter 11) than in private reorganization, which does not seemplausible at least in Japan.
11

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80

Table 1: Debt Restructuring Implemented Under Private Reorganization
Debt Restructuring Scheme

Number of Cases
Applicable
18
12
13
7

Extension of maturity(58.1%)
Reduction of principal(38.7%)
Reduction of interest(41.9%)
Distribution of equity securities(22.6%)
Note: The percentage of firms in our private reorganization sample that restructured debt on specified

terms is provided in parentheses. Extension of maturity includes cases such as where the loan amount wasincreased simultaneously when the maturity was extended.

3. Samples and Variables
To test the hypothesis, we perform a comparison of univariate and logistic regression
analyses. In this section, we explain the construction of our sample and the definition of variables
used in the test.
3.1 Sample
We use a sample of nonfinancial firms, listed on Japanese exchanges, that restructured debt
under the former Corporate Reorganization Law or through private reorganization from 1990 to
1998.14 Sixteen listed nonfinancial firms filed under the law in the period and they constitute our legal
reorganization sample. No firm filed under the law more than once.
Following previous studies (Gilson 1989, 1990; Gilson et al. 1990; Brown et al. 1993; Franks
and Torous 1994), we constructed our private reorganization sample by conducting a keyword search,specifically in the news articles of the Nihon Keizai Shimbun, Japan’s equivalent of the Wall Street
Journal, for the period between 1990 and 1998.15 Using the keywords such as “debt (interest) waiver,”“debt (interest) relief,” “debt (interest) moratorium,” “financial support,” and “reorganization,” we sought
articles involving listed firms that had agreed with creditors to restructure debt out of court. To beconsistent with our legal reorganization sample, we chose nonfinancial firms that reorganized privately
for the first time in or after 1990. As a consequence, 31 firms emerged as our private reorganization
sample.16 The terms of debt restructuring implemented by these firms are shown in Table 1.
The distribution of sampling years is presented in Table 2. One firm sampled for private
reorganization in 1993 is also sampled for legal reorganization in 1997.17 Table 3 shows the industry
distribution of our sample firms and it is roughly the same between the two samples. Data used in ourempirical analysis were collected from financial reports for the accounting year ending immediately
For a listed Japanese firm seeking debt restructuring while continuing its business, filing for the former Corporate Reorganization
Law had been the only alternative to the private negotiation. A new bankruptcy law, the Civil Rehabilitation Law (Minji Saisei
Ho), was enacted in 2000, and it has been used in conjunction with the Corporate Reorganization Law. Under the new law,
incumbent management is supposed to remain in control to prepare and implement the reorganization plan. We constrain our
analysis for the period before the enforcement of this third alternative.
15
Since debt restructuring as well as bankruptcy are observed only for financially distressed firms in Japan, we did not restrict our
keyword search to firms with stock price declines or downgraded bond ratings.
16
All the creditors that agreed on debt restructuring out of court were banks and insurance companies, consistent with previous
studies (Gilson 1989; Gilson and Vetsuypens 1994).
17
Gilson et al. (1990) admit the same firm to both samples if the interval between a private and a legal reorganization exceeds one
year. In our sample, a firm mentioned in the text underwent a private and a legal reorganization with an interval of nearly four years.
14Teshima: Management Ownership and Risk-Shifting Investment

81

Table 2: Distribution of Sampling YearsYear

Private Reorganization

Legal Reorganization

1991

3

0

1990

0

1992

0

4

1993

2

5

1994

2

4

1995

0

2

1996

1

1

1997

0

8

1998

6

4

Total

5

31

16

Note: The sampling year is defined as the year in which an article on debt restructuring first appears forprivate reorganization and the year in which bankruptcy protection is filed for legal reorganization.

Industry

Table 3: Industry Distribution of the Sample

Manufacturing
Construction

Distribution and warehousing
Real estate
OthersTotal

Private Reorganization
14(45.2%)

5(16.1%)

8

3

1

31

Note: Percentage shares are provided in parentheses.

(25.8%)(9.7%)(3.2%)(100.0%)Legal Reorganization
6(37.5%)

4(25.0%)

5

0

1

16

(31.3%)(0.0%)(6.3%)(100.0%)prior to the bankruptcy filing for the legal reorganization sample, and those immediately prior to thenewspaper article for the private reorganization sample.
In our sample of privately reorganized firms, an average 73.7% of all directors prior to thereorganization remained the directors at the end of the subsequent accounting year. The ratio of surviving
directors is more than a half in 29 firms (93.5% of the private reorganization sample). Furthermore, thepresident remained in position in 23 firms (74.2% of the sample) at the subsequent accounting year
end. Even among the firms where the presidents resigned, their successors usually were promoted fromamong the firms’ senior directors.18 Hence, privately reorganized firms show considerable continuityof management team.19 Also, the entities and their order in top 10 largest shareholder list and their
18
19

One firm accepted a new president from its main bank. This is the only exception.
For comparison, it has been reported that turnover of all directors during a two-year period is on average 24.0% and the average
likelihood of presidential turnover during a two-year period is 30.1% for Japanese firms listed in the Fortune Global 500, which arearguably financially healthy (Kaplan 1994).

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The Japanese Accounting Review, 2 (2012), 75-85

holding shares were wholly unchanged in the privately reorganized firms. The fact that management andownership structure is stable through private negotiation suggests that it is difficult for the creditors tochange it in private negotiation and thus if legal process is an alternative to facilitate the change, they arelikely to resort to it when they want such structural change.
3.2 Variables
In the logistic regression analysis, the dependent variable is an indicator variable that takes thevalue 1 for private renegotiation and 0 for legal reorganization. Among the explanatory variables,
management ownership (MOWN) is defined as the ratio of the shares effectively held by the directors—
that is, shares held by directors themselves, their family, and their private shareholding entities—to thetotal shares outstanding.20
The other explanatory variables are proxies for factors that earlier studies have found to affectthe decision between private and legal reorganization. First, a firm will lose its premium as a going
concern—the excess of market value over liquidation value—if its assets are sold. Since bankruptcy
involves higher likelihood of assets being sold, stakeholders enjoying the going-concern premium are
more inclined to accept reorganization out of court (Gilson 1991). Also, it has been empirically shownthat a firm is more likely to restructure debt privately if its going-concern premium is high (Gilson et al.
1990). We use the price-to-book ratio, PBR, as the proxy for a firm’s premium as a going concern.21
Second, research has shown that firms that successfully restructure their debt privately are moresolvent than those filing for legal reorganization, which may be related to the difference in operating
performance (Franks and Torous 1994). To control for this effect, we use the ratio of book value of total
liabilities to total assets, L/A, as an explanatory variable.
Third, conflicting interests among creditors make a private debt restructuring agreement moredifficult, despite being less costly for creditors (Brown 1989). Gilson et al. (1990) and Asquith et al.
(1994) find that the likelihood of bankruptcy increases as the number of creditors or number of debt
contracts increases, suggesting that debt recontracting becomes more difficult as the number of creditors
increases. Following Gilson et al. (1990), we use the standardized number of creditors (number ofcreditors per ¥ 1,000 of debt), CREDITORS, as a proxy for the severity of conflict among creditors.22
Fourth, the management presumably possesses more information than the creditors about thefirm’s financial situation and its future prospects. When this informational asymmetry is severe,
creditors more likely will not restructure debt privately because management’s reorganization
plan becomes more difficult to evaluate (Giammarino 1989). As a proxy for the extent of thisinformational asymmetry, we use the ratio of directors who are bankers or ex-bankers to the total
number of directors (BANKBOARD).23 We assume that the larger the variable, the lesser is theinformational asymmetry. Also, it has been suggested that a Japanese firm is more likely to agree
to private debt restructuring with its lenders when it has a closer relationship with its main bank(Suzuki and Wright 1985; Hoshi et al. 1990). The variable BANKBOARD can be a proxy for the
Directors’ family members and private shareholding entities are selected from the top 10 shareholders list in financial reports andidentified using Okabunushi soran [Large Shareholders Overview] published by Toyo keizai. We also use a management ownership variable
composed only of shares held by directors themselves. The results, however, are qualitatively similar to those presented hereunder.
21
The value of PBR is set to 0 for firms with negative net worth (four firms in the private reorganization sample; two firms in thelegal reorganization sample).
22
When we use the actual number of creditors instead of the standardized number or CREDITORS, it is insignificant in both theunivariate comparison and logistic regression. The other results are qualitatively similar to those presented in this paper.
23
As mentioned earlier, all the private debt restructurings in our sample are implemented under agreement with banks and insurancecompanies. There is no case where a director has a concurrent position or past career at insurance company.
20Teshima: Management Ownership and Risk-Shifting Investment

83

Table 4: Summary Statistics and Univariate Comparison
Private Reorganization(31firms)
Variable

Mean Median Min.

Max.

MOWN
PBR
L/A
CREDITORSBANKBOARD
MV

0.038 0.003 0.000 0.307
3.41 1.44 0.00 44.64
0.91 0.91 0.44 1.48
0.48 0.22 0.02 2.82
0.10 0.07 0.00 0.50
114,966 41,368 5,340 794,705

Legal Reorganization(16 firms)
Mean Median Min.

Max.

0.111 0.060 0.001 0.455
1.72 1.39 0.00 4.44
0.87 0.89 0.57 1.31
0.85 0.63 0.18 2.46
0.07 0.08 0.00 0.22
55,145 16,952 1,674 346,082

p-value of
Wilcoxon-Mann-Whitney
test for difference
0.009 **
0.719
0.459
0.008 **
0.537
0.157

Note: MOWN is the ratio of the shares held by the directors, their family members, and their private shareholding
entities. PBR is the price to book ratio. L/A is the ratio of the book value of total liabilities to total assets.
CREDITORS is the number of creditors per ¥ 1,000 of debts. BANKBOARD is the ratio of directors installedfrom banks to total directors. MV is the market value of the firm (¥ 1 million). **p<0.01 (two-tailed test).

intimacy between the firm and its main bank.24
Finally, the sales volume of Japanese firms has been found to correlate negatively with theprobability of bankruptcy (Suzuki and Wright 1985). We use the natural logarithm of the firm’s
market value (MV) to control for the effect of firm size. Greater market value also could be associatedwith lower management ownership.

4. Empirical Results
Table 4 shows the summary statistics of the variables and the p-value of the Wilcoxon-MannWhitney test for the difference between the two samples. Management ownership is significantly larger
in the legal reorganization sample, which is consistent with the hypothesis that greater management
ownership increases the likelihood that the firm will restructure its debt under a legal procedure. The
variable CREDITORS is significantly larger in the legal reorganization sample, possibly suggesting greaterdifficulty in recontracting debt when the number of creditors is larger (Gilson et al. 1990).
Results of the logistic regression are presented in Table 5. As mentioned, the dependent variable is anindicator variable that takes the value 1 for private reorganization and 0 for legal reorganization. A positive(negative) estimated coefficient of an explanatory variable suggests that the larger (smaller) the variable,
the more likely the firm will restructure its debts under private (legal) reorganization. The coefficient of
MOWN is negative and statistically significant, again consistent with the hypothesis. Coefficients of allother explanatory variables have the expected signs, although they are not statistically significant.25
Alternatively, the fraction of the shares held by financial institutions is used to control for the effect of informational asymmetry
and the relationship with banks. It is, however, insignificant in the univariate comparison and logistic regression. The other results
are qualitatively similar to those presented in this paper.
25
Although a univariate comparison shows a significant difference in CREDITORS, it is not statistically significant in the logistic
regression. This is possibly due to the negative correlation between CREDITORS and MV. The negative correlation can be
explained as follows: The larger the size of the firm, the greater the firm’s borrowings from one creditor and thus the smaller thenumber of creditors per unit of debt. Franks and Torous (1994) also report that the number of debt securities is not significantly
different between private and legal reorganizations. Our result is consistent with their conjecture that the potential recontracting
problems in private reorganization may be exaggerated.
24

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84

Table 5: Logistic Regression Results
Independent Variable
Constant(1)(2)−6.824 *−7.708(0.037)MOWN−11.826 **(0.008)PBR–13.034 *(0.015)0.048(0.679)L/A−0.204(0.918)CREDITORS−0.088(0.881)BANKBOARD
lnMV
Pseudo R(0.098)5.840

0.798 *

2

(0.016)0.271(0.141)0.851 *

(0.032)0.344

Note: The dependent variable is an indicator variable that takes value 1 for private reorganization and 0 for
legal reorganization. See Table 4 for the definitions of the independent variables. The p-values are shown inparentheses. **p<0.01, *p<0.05 (two-tailed test).

5. Conclusion
We present a simple model analyzing the relationship between management ownership and its
risk-shifting incentive. The model suggests that when a firm falls into financial distress, managementwith higher ownership has a greater incentive to shift wealth from creditors to shareholders byimplementing a risky project.
When creditors of a financially distressed firm perceive the level of the management’s riskshifting incentive, the creditors’ perception will influence the negotiation for the debt restructuring.
The former Japanese Corporate Reorganization Law provides a unique opportunity to test the
implication. Filing for legal reorganization under the law virtually eliminates the possibility of
inefficient and risky investment which could impair the value of the creditors’ claims. Consequently,
we postulate a testable hypothesis that when the law is effective, the greater management ownershipin a financially distressed firm increases the likelihood that private negotiation with creditors fail andthe firm is reorganized under the law. Our empirical results are consistent with our hypothesis.
Our results suggest that the former Japanese Corporate Reorganization Law helps to curb valuedecreasing investment or so-called moral hazard by management. If incumbent management is prone
to such investment, creditors may forestall them by resorting to legal reorganization or bankruptcy.
The law was revised overall in 2002 and it has been made possible for an incumbent director toTeshima: Management Ownership and Risk-Shifting Investment

85

remain in the firm as a receiver if the director is not apparently responsible for the firm’s financial
difficulties. Moreover, Japan enacted another bankruptcy law, the Civil Rehabilitation Law (Minji
Saisei Ho) in 2000, which has been used in conjunction with the former and current Corporate
Reorganization Law. Under the Civil Rehabilitation Law, incumbent management is supposed toremain in control to prepare and implement the reorganization plan. Also, the existing equity may
retain its value. The two bankruptcy laws are expected to be used appropriately on a case-to-casebasis in Japan. However, if the Civil Rehabilitation Law is used too easily, risk-shifting investment or
moral hazard by financially distressed firms may not be so forestalled as before. This fact finding is asubject for future research.

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