Governance failure and its impact on financial distress

• DOI: https://doi.org/10.1108/CG-08-2020-0347
• Published date: 02 September 2021
• Date: 02 September 2021
• Pages: 1416-1439
• Subject Matter: Strategy,Corporate governance
• Author: Sourour Hazami-Ammar,Amal Gafsi

Governance failure and its impact on

f‌inancial distress

Sourour Hazami-Ammar and Amal Gafsi

Abstract

Purpose –The purpose of this paper is to examinethe effects of corporate governance failure, excess

remuneration and entrenchment of managers, company variables and corporate governance variables

on the company’sfinancial distress risk (DETR)in the French context.

Design/methodology/approach –Using the regression analysis, this paper is based on 201

observations about 67 companies of SBF 120 from 2015 to 2017. Data are collected on the Thomson

Reutersdatabase and in the referenced documents,which are published on the internet.

Findings –The research findings reveal that firm’s DETR is influenced negatively by excess

remuneration and entrenchment of managers. In addition,there is a positive and significant relationship

between DETR and company variables (performance and ownership structure) and corporate

governance variables (power structure). However, a company’s size and board of directors’

independencedo not affect firms’ DETR.

Practical implications –The impact highlightedbetween remuneration and entrenchmentof managers

and the financial distress of the company is explained by the intention of managers to work for

announcinggood short-term performance indicatorsthat are most favorable to them.

Originality/value –The shareholder/manager agency problem can be changed when business

performancetends to decline. Certainly, the manageriallatitude adopted by the managers is used as an

external careerismstrategy. Its positive impact on the reductionof the firm’s financial distress can benefit

shareholderswho aim to sell their securities in the shortterm.

Keywords Financial distress, Entrenchment, Corporate governance failure, Excess remuneration

Paper type Research paper

1. Introduction

In recent years, the business world has witnessed an upward trend in managers’

remuneration for top-ranked companies. High differences are observed between the

executive and employee compensation (Teulon, 2013). Entrenched managers can restrict

the board. The over-compensation and entrenchment, as two examples of corporate

governance failures, are supposed to influence the company’s financial distress (Appiah

and Chizema, 2015). In this article, we are trying to approve or disapprove of the

relationship between them. Our choice of this subject is not arbitrary. Indeed, nowadays,

research related to executive compensation and entrenchment attracts not only the

attention of researchers but also the media and even the public. In this regard, firms

themselves are undergoing a profound transformation due to the massive introduction of

stock option compensation. At the same time, the firm’s perception of the impact of the

managers’ retrenchment on financial health is not unanimous. Organizations are going

through a transition phase, especiallywith regard to their attitudes and understanding of the

basis and effectiveness of existing governance mechanisms. This is accompanied by a

change in the balance of power between the shareholders and the managers who are

committed to running the business. Our research highlights this transformation in a context

that is characterized by a crisis of legitimacy and trust among the managers of large listed

Sourour Hazami-Ammar is

based at the Department of

Accounting and Taxation,

IHEC, University of Sfax,

Tunisia. Amal Gafsi is

based at the Department of

Finance, IHEC, Sfax

University, Tunisia.

Received 26 August 2020

Revised 26 November 2020

4 January 2021

11 March 2021

25 March 2021

15 April 2021

22 April 2021

Accepted 11 May 2021

The authors would like to

thank the reviewers for their

suggestions on this

manuscript. They would also

like to acknowledge

Prof. Gabriel Eweje, the editor

in chief of corporate

governance for his support.

PAGE 1416 jCORPORATE GOVERNANCE jVOL. 21 NO. 7 2021, pp. 1416-1439, ©Emerald Publishing Limited, ISSN 1472-0701 DOI 10.1108/CG-08-2020-0347

French companies (Chapas, 2005;Liu and Taylor, 2008). This change is felt at the level of

regulations, choke the manager; as it requires the disclosure of more and more information

(biography-detailed compensation) (Nerantzidis and Tsamis, 2017). Although this subject

was taboo a few years ago, it becomes legitimized as one of the matters around which

many questions revolve around, after suspecting the contribution of some managers (for

example, following the denunciation of their remuneration). The fact of considering the

managers’ market and seeing it as an asset, has created changes and perverse effects.

Therefore, the large companies’ executives encounter new internal and external challenges

and they must face the crisis of legitimacy. In addition, the significance of the financial

distress risk exposes the boards of directors to a number of potential challenges, to restore

the financial situation. On the one hand, it is important that the manager spare no effort to

drive the company in the direction that is beneficial to it. On the other hand, it is also

strongly important to know how to encourage this manager to maintain his position in the

time of distress and to contain the significant risk in relation to human capital. In case of

financial distress, boards of directors might need to structure the incentive compensation

mechanisms differently. First, the nature of the shareholder/manager agency problem can

be changed in case of the decline of the firm’s performance. Second, financial distress

increases the magnitude of the agency problem of the debt holder/shareholder. The board

of directors may consider structuring the manager’s employment contract to reduce the

probable agency costs, which willnow be borne by the shareholders of the company.

In this article, our choice of financial distress, as a dependent variable, is not arbitrary.

Regarding the compensation, the literature has already shown that there is no relationship

between the performance of the company (book value or market value) and the

compensation of executives. Broye and Moulin(2010) verified through several performance

measures (return on assets (ROA), return on equity (ROE) and profitability ratio), that a

higher level of performance does not imply a higher remuneration and vice versa. The

relationship between the remuneration and the entrenchment of the managers as two

instances of corporate governance failure is also not arbitrary;it represents the originality of

the paper as well. Certainly, an entrenched manager is being enriched at the expense of

the interest of the shareholder. Therefore, in this article, we consider only the negative

impact of entrenchment. To protect himself,the manager entrenches himself and relates his

future to that of the company without being concerned with his contribution to its

performance. The managers try to justify the company’s dependence on them by using

tricks (Shleifer and Vishny, 1989). In other words, they choose to invest only in areas that

allow them to master perfectly their human capital. In case of a revocation, the shareholder

has to think twice to assess the loss of value that the company will have to bear. According

to the literature, executive compensation influences the financial distress of the firm

(Vallascas and Hagendorff, 2013). Employee incentive compensation certainly allows

maintaining talent, but it also influences default risk (Chang et al., 2008). The apprehension

about corporate governance failures through their effects on the managers’ decisions is

particularly a relevant field of study (Parker et al.,2002). The suboptimal impact, of excess

remunerations and entrenchment on financial distress, is studied through the sudden

increase in debts (free cash flow theory: Jensen, 1986) and the weakening of disciplinary

mechanisms, figure below (Figure 1).

Moreover, like Eminet et al. (2009), we consider that the managers can benefit

simultaneously from their accumulated share capital over the years and the structure of the

board of directors. The social network promotes entrenchment. By occupying a prestigious

position, a well-entrenched manager grants himself a high remuneration. A board of

directors, which functions normally according to the rules, finds it difficult to take retaliatory

actions against this executive power, as the latter can damage the company’s image.

Under those circumstances, the board of directors’ control is not very effective. To our

knowledge, there is no study incorporatingthe effects of these two research variables at the

same time and their impacts on financial distress. The negative impact on the financial

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