Corporate Governance

Creditor Rights and Corporate Risk-Taking

By Harvard Law School Program on Corporate Governance

In a recent working paper Creditor Rights and Corporate Risk-Taking, we study the effect of creditor rights in bankruptcy on corporate risk-taking. In particular, we ask: What effect does the strength of creditor rights have on firms? investment decisions? In other words, while a harsh penalty in default reduces fraud and opportunistic behavior by debtors, might it also inhibit entrepreneurial, bona-fide risky investment?

Our empirical analysis uses as an explanatory variable the variation of creditor rights across countries in their bankruptcy codes, documented by La Porta et al. (1998), which are largely a function of the country?s legal origin and exogenous to the nature of the country?s overall corporate investments. We employ several different measures of corporate risk-taking and examine their relationship to creditor rights across countries and over time.

We find that stronger creditor rights in a country are associated with a greater propensity to do diversifying acquisitions, across industries as well as across countries. The value effect of diversifying acquisitions ? as measured by abnormal stock-market returns at the acquisition announcement ? is negative for countries with stronger creditor rights. And, diversifying (but not focusing) acquisitions in countries with stronger creditor rights are associated with lower subsequent profitability. We also find that, in countries with stronger creditor rights, firms choose a mode of operation that reduces cash flow risk. Overall, these results are strongest (statistically as well as economically) for the creditor rights corresponding to (i) whether there is no automatic stay on the debtor?s assets in bankruptcy and (ii) whether management is dismissed in bankruptcy. We also find that, in countries with stronger creditor rights, companies have lower financial leverage. These results are notable because proponents of stronger creditor rights posit that they have a positive effect on lending. However, stronger creditor rights may inhibit borrowing, resulting in overall lower corporate leverage. In addition, in countries with strong creditor rights, target firms whose assets have high recovery value in default (or distress) are more likely to be acquired by firms whose assets have low recovery value. This is because a high recovery value of assets enables firms in distress to defer default by liquidating some of these assets and using the proceeds to service debt. Thus, by acquiring a high-recovery target, a low-recovery firm reduces or defers the likelihood of default in case of distress.

All of the above effects of stronger creditor rights ? greater propensity to engage in diversifying acquisitions, the resulting reduced value and operating performance, lower cash flow risk, lower financial leverage, and greater propensity of low recovery firms to acquire high recovery targets ? are also observed with a strengthening (and vice-versa for weakening) of a country?s creditor rights.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on January 04, 2010 (boomark / email).