Do Country-Level Creditor Protections Affect Firm-Level Debt Structure Concentration?
Kose John, Mahsa S Kaviani, Lawrence Kryzanowski, Hosein Maleki
Review of Finance, Volume 25, Issue 6, November 2021, Pages 1677–1725, https://doi.org/10.1093/rof/rfab011
One major consideration for firms’ financing and investment decisions is the probability of an inefficient liquidation. The literature provides two major drivers of inefficient liquidation: the strength of creditor protection rights in the economy, and coordination failure among creditors. Creditor protection law regulate conflicts between the firm and creditors at the event of default. The bankruptcy literature suggests that these rights can be excessive and by increasing liquidation bias, may lead to ex-post inefficiencies. Moreover, the optimal contracting literature highlights that coordination failure among creditors exacerbates the probability of successful renegotiation of distressed debt especially when firms form diverse debt structures by using debts with a variety of contractual features. Despite the centrality of inefficient liquidations in corporate decisions, little is known about how its two main drivers are related.
To address this question, we focus on the debt structure of firms, and develop a trade-off model of debt-type concentration. We posit that firms choose concentrated debt structures based on a trade-off between strategic default and inefficient liquidation. By forming concentrated debt structures at a given level of debt and thus reducing the complexity of debt structures, managers can facilitate coordination among different claimants and increase the probability of successful renegotiation of distressed debt.
Forming concentrated debt structures can also be costly for the firm as it increases the probability of strategic default by the manager, motivating creditors to increase interest rates. Therefore, an optimal debt structure trades off the benefits (increasing the probability of a successful debt renegotiation) and costs (higher probability of strategic default) of a concentrated structure. Based on this trade-off framework, precisely because stronger creditor rights are associated with a higher probability of inefficient liquidation, the trade-off shifts towards minimizing the inefficient liquidation. Thus, firms become more likely to choose concentrated debt structures.
We examine this theoretical prediction by studying the relationship between the strength of creditor rights at the country level and the choice of debt structure concentrations at the firm level. Consistent with the above predictions, we find that the debt structure of firms is significantly more concentrated in countries where creditor rights are better protected. Ceteris paribus, a one-unit increase in the strength of creditor rights increases the debt concentration of firms by 3% to 7%, depending on the specification. This is a large economic effect. For example, a 3% increase in a firm’s debt concentration is equivalent to migrating from a debt structure that is equally distributed across seven debt types to one that is equally distributed across only six debt types. Our results remain to a battery of robustness tests that address plausibly endogeneity concerns.
This study extends the literature on the impact of legal institutions on corporate finance, by showing how different levels of creditor protection in a country can influence the corporate debt structures therein. It also extends the literature on the conflicts of interest between different debt holders and how these potential conflicts impact the optimal choice and combination of different debt types.