Litigation Risk and Debt Contracting: Evidence from a Natural Experiment

Zhihong Chen is Associate Professor of Accounting at the Hong Kong University of Science and Technology; Ningzhong Li is associate professor, at the University of Texas at Dallas Naveen Jindal School of Management; and Jianghua Shen is Assistant Professor of Accounting at Xiamen University. This post is based on their recent paper, forthcoming in the Journal of Law and Economics.

Nevada is second to Delaware in attracting out-of-state incorporations, with 8% of all public incorporations by firms in states outside the firms’ headquarters states. In June 2001, Nevada changed its state corporate law by substantially reducing the legal liability for breaching fiduciary duties (the legislative change, hereafter). Under the new Nevada corporate law, by default, directors and officers (D&Os) of firms incorporated in Nevada are not liable for breaching their fiduciary duties unless their behaviors involved intentional misconduct, fraud, or a knowing violation of law, whereas prior to the change, by default, D&Os have such liability. This legislative change was implemented swiftly and applied to all firms incorporated under Nevada corporate law without a requirement for shareholder approval. In our paper forthcoming in the Journal of Law and Economics, we use the exogenous decrease in legal liability of D&Os due to the legislative change to study how litigation risk affects loan contract terms and related borrower-lender agency conflicts.

Agency theory suggests that borrowers and lenders have major conflicts when borrowers are insolvent or close to insolvency. To the extent that D&Os owe fiduciary duties to the lenders when a borrowing firm is insolvent and possibly when it is in the “zone” or “vicinity” of insolvency, the legislative change reduces the lenders’ legal tools to enforce their rights. Therefore, we predict that the legislative change will exacerbate borrower-lender conflicts. Anticipating the increased conflicts, lenders will impose more unfavorable loan contract terms, such as higher interest rates and more restrictive covenants.

While the legislative change may also reduce litigation risk from shareholders and exacerbate agency conflicts between managers and shareholders, the effect of aggravated shareholder-manager conflicts on the lenders is ambiguous. If managers are more likely to expropriate shareholders, such as through shirking or diverting corporate resources for self-dealing that reduces firm value, creditors are hurt because their payoff depends on the firm value. However, when managers’ interests are not aligned with shareholders’, managers are less likely to help shareholders expropriate creditors, which benefits the creditors. It is also possible that managers’ self-dealing behaviors could benefit creditors, for instance, through taking lower-risk projects if managers prefer lower risk.

We adopt a difference-in-differences approach to examine the effect of the legislative change on loan contract terms. Specifically, we compare the changes in the loan contract terms of Nevada-incorporated borrowers in the four-year window around the legislative change (June 1999 to May 2003) with corresponding changes for a sample of non-Nevada borrowers with similar credit risk. Consistent with our prediction that the legislative change exacerbates the agency conflict between borrowers and lenders, we find that the legislative change leads to less favorable loan contract terms: a higher loan spread and more restrictive covenants. After the legislative change, on average, the loan spread of loans issued by borrowers incorporated in Nevada increase by about 33%; the number of financial covenants increase by about 48%, while the number of general covenants increase by about 138%.

To understand the mechanisms through which the legislative change impacts loan contract terms, we further investigate how the legislative change affects firms’ behaviors that potentially benefit shareholders at the expense of lenders. Specifically, we investigate the following opportunistic behaviors: increasing the riskiness of existing assets, even by investing in negative net present value (NPV) projects, to shift risk to lenders; distributing proceeds from assets liquidation to shareholders; and forgoing positive NPV projects because the payoffs will accrue to lenders. We find that Nevada-incorporated firms with severe borrower-lender conflicts significantly increase risk-taking and stock repurchase and significantly reduce investment and equity issuance after the legislative change. These results suggest that the legislative change does exacerbate the agency conflicts between Nevada-incorporated firms and their lenders, which contributes to the increase in loan spread and covenant restrictiveness.

Taken together, our findings indicate that an exogenous decrease in legal liability of D&Os exacerbates borrower-lender conflicts, leading to more unfavorable loan contract terms, such as higher interest rates and more restrictive covenants. Our study adds to understanding of the economic consequence of litigation risk faced by firms and/or their D&Os, as well as the interaction between debt contracting and legal environments.

The complete paper is available here.

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