State Contract Law and Debt Contracts

In our recent JLE paper, State Contract Law and Debt Contracts, we examine the association between state contract law and debt contracts. A recent stream of papers in finance and economics studies the role debt contracts play in mitigating agency problems between equity and debt holders (for example, Baird and Rasmussen, 2006; Chava and Roberts, 2008; Roberts and Sufi, 2009; Nini, Smith, and Sufi, 2009). This area of literature examines both the contract terms and the implications of covenant violations. While these studies generally treat contract law as a uniform product across states and assume that all contracts are enforced in a similar fashion, in practice lenders and borrowers select the state law that will govern the contract. Because the legal rights of both parties vary depending on the law chosen, the state contract law may be associated with enforcement. To examine this relationship, we first categorize each state’s contract law by whether it is favorable or unfavorable to lenders, and then we examine the characteristics of the contracts and the relevant parties across states. Lastly, we test whether the contract terms, frequency of covenant violations, and repercussions of covenant violations are related to the state contract law.

We begin by classifying states according to whether they are favorable to lenders (pro-lender) or favorable to debtors (pro-debtor). In our primary analysis, we present two metrics to represent the state law. The first metric is the Pro-debtor Index, which captures six distinct features of state law that are related to contract enforcement and that differ across states. The second metric is the perceived litigation risk, which measures the rate of litigation using the reported number of lawsuits (see, for a use of such methodology, Jingyu et al., 2012; Heninger, 2001; Francis, Philbrick, and Schipper, 1994). For robustness, we supplement our two primary rankings of state law with two additional metrics: (1) an alternative classification based on the frequency of litigation, and (2) a measure in which we rank the states based on the average number of lenders per loan. All of our different rankings clearly identify New York as the most pro-lender state and California as the most pro-debtor state.

Using these rankings of state contract law, we provide descriptive statistics on the characteristics of contracts, borrowers, and lenders across states to better understand how borrowers and lenders self-select into different legal regimes. The analysis suggests that there are significant differences in borrower-lender pairs across states, most notably that they are more likely to use pro-lender law when the borrower is highly leveraged and when the deal size is larger. Our findings also suggest that borrowers and lenders with operations in fewer states are more likely to use the law of the state in which they are primarily located, but that parties with significant multistate operations are more likely to use law from pro-lender states. This suggests that the costs and benefits to using out-of-state law vary depending on the geographic characteristics of the borrower and lender.

The observed self-selection is consistent with the legal argument that states compete to provide law for commercial contracts, and that New York has been particularly successful in courting commercial contracts (Eisenberg and Miller, 2010). In our data, we find that New York law is used most frequently and is especially popular with multistate lenders. It is also noteworthy that the states that have developed more pro-lender law are the ones in which the financial sector contributes a greater percentage of the state’s gross domestic product (GDP). Given that state legislators can affect the state’s contract law, it is important to acknowledge the role of the state itself in setting contract law.

We then examine how the contract terms, the frequency of covenant violations, and the consequences of violations vary with the original choice of contract law. We first document that cash collateral, which is defined as cash and cash equivalent assets that are pledged as security for a loan, is used most frequently when the contract is governed by pro-debtor law, and that out-of-state borrowers who use pro-debtor law pay a premium. We next show that the frequency of financial covenant violations increases as the law becomes more favorable to debtors. Financial covenants are accounting-based measures of performance with which the borrower must comply (for example, a financial covenant might require that the borrower’s debt can be no more than a certain percentage of the borrower’s assets). A borrower who violates a covenant must inform the lender, and such violations are considered “technical default” and provide lenders with contractual rights to make substantial changes to the loan agreement, including the right to demand immediate repayment. Prior literature has shown that creditors use the contractual rights granted by covenant violations to force the borrower to implement a more conservative investment policy (Roberts and Sufi, 2009; Nini, Smith, and Sufi, 2012). To test whether there is an association between the legal regime and the repercussions of covenant violations, we test whether changes in firm investment policy post-violation—measured as changes in net debt issuance, acquisitions, capital expenditures, and physical property post-violation (for example, Roberts and Sufi, 2009; Nini, Smith, and Sufi, 2012)—are uniform across legal regime. Our analysis shows that when the contract is governed by pro-lender law, there are significantly fewer covenant violations, but the repercussions of those violations are significantly more severe.

Our findings should be interpreted with caution because parties to the contract are able to select their governing law and because state legislators can affect the governing law in each state. As a result, the associations reported in the paper are descriptions of an equilibrium sorting of borrowers and creditors. However, regardless of whether our results arise due to self-selection or because parties respond to differences in the law itself, they indicate that the contract law is an important consideration in understanding the relationship between borrowers and lenders.

We contribute to the literature in several ways. First, as the first empirical paper to test differences in state contract law, we address the issue of how to measure contract law and we provide a ranking of states based on the degree to which each state’s contract law is favorable or unfavorable to lenders. Second, we provide the first descriptive evidence that the variation in state contract law is associated with real differences in firm financing, investment policy, and contract terms. Third, our analysis provides initial evidence consistent with the legal theory that there is a market for contracts. We document that New York, the primary state for debt contracts and a state widely known for its efforts to attract commercial contracts, has increased its dominance since the mid-1990s. We note, however, that we cannot identify whether New York’s dominance has increased due to its more pro-lender laws.

The full paper is available for download here.