When managers cannot commit: Capital structure under inalienable managerial entrenchment

CEOs are infrequently fired for poor performance (Jensen and Murphy, 1990). While financial distress is associated with higher managerial turnover, studies show that incumbent managers often retain control of the firm even in bankruptcy. In this paper, we study how inalienable managerial entrenchment – when it is costly to fire a manager even after poor performance – affects a manager's ability to issue debt prior to financial distress as a strategic commitment to avoiding investment projects generating negative returns. Zwiebel's 1996 influential model of dynamic capital structure examines when shareholders prefer to remove competent managers ex ante in a setting with varying manager types and manager actions. He describes how a manager of intermediate ability can avoid takeover by issuing debt. His model assumes that a poorly performing manager will be fired by an unpaid creditor; there is no ex ante entrenchment when the firm is in financial distress. We focus on the subset of managers who issue debt in Zwiebel's case and show that a firm's capital structure depends on the extent to which entrenchment is inalienable. When entrenchment is only partly responsive to poor performance, managers whose type is above an ability cutoff cannot issue debt as a commitment to avoiding projects generating negative returns. The higher the ex post entrenchment cost, the lower the ability cutoff. Managers whose type is above this cutoff are immediately taken over by the shareholder, and so are unable to secure employment in either period. This leads to a non-monotonic relationship between manager type and the probability of immediate takeover.