How do creditor rights affect firms’ financial and investment decisions and what are the economic consequences of liquidation-oriented vs. continuation-friendly bankruptcy laws? The law and finance literature (see, e.g., La Porta et al. (1998), Djankov, Mcliesh, and Shleifer (2007)) campaigns for strong creditor rights. These scholars argue that high levels of contract enforcement – i.e., a law which stipulates the dismissal of the incumbent management upon bankruptcy filing, and grants secured creditors strong power to seize their collateralized assets by forcing the firm to liquidate – lead to higher recovery rates. This, in turn, increases the supply of (secured) debt, reduces interest costs, relaxes firms’ financial constraints, and finally fosters economic growth.
In contrast to this supply-side argument, a more recent demand-side view revisits and questions the positive effects of creditor rights (see, e.g., Vig (2013), Ayotte and Morrison (2009)). These authors suggest that creditor rights can be excessive and may actually result in ex post inefficiencies caused by the secured creditors’ incentives to induce a fire sale of firm assets. Consequently, borrowers can feel threatened by a liquidation-oriented bankruptcy regime. Hence, strong creditor rights – initially established to promote credit expansion – may actually prompt firms to reduce their demand for debt. Besides the negative effects of excessive creditor rights on firms’ financial policies, Acharya, Amihud, and Litov (2011) claim that a law which mandates managers to leave the firm upon bankruptcy filing and assigns secured creditors strong liquidation rights will also generate severe management incentives to adjust corporate investments. It thereby decreases the likelihood of having to bear these (private) costs of financial distress. In particular, managers may choose (unprofitable) diversifying investments that reduce the probability of distress. Further, they will be tempted to hoard high-recovery fixed assets that – in spite of their low profitability – can be easily converted into cash and deter bankruptcy application in situations of financial distress.
While creditor rights can have both positive and negative effects on firms’ profitability and economic growth, the extant literature does not provide a conclusive answer on the actual benefits and perils of creditor protection. In this respect, three important empirical questions naturally arise: 1) How do firms modify their capital structure in response to changes in creditor rights? 2) Do firms also adjust their investments in order to circumvent the adverse effects of excessively strong creditor rights? 3) What are the different economic consequences of strong vs. weak creditor rights?
Our paper sheds light on these questions by using Germany’s bankruptcy code reform (ESUG) of 2012. The previous liquidation-oriented legislation demanded the immediate dismissal of the incumbent management upon bankruptcy filing and caused a firm break-up in 99% of cases by granting secured creditors strong liquidation rights. ESUG’s turnaround-friendly regime, on the contrary, allows management to stay in unrestricted corporate control and greatly facilitates a firm’s continuation by blocking enforcement of secured creditors’ liquidation attempts. ESUG, therefore, strongly reduces both the private management costs and the inefficient liquidation costs of bankruptcy. Thereby, it provokes a shift in the widely-used La Porta et al. (1998) creditor rights index – which varies between 4 (strong creditor rights) and 0 (poor creditor rights) – from a score of 3.5 to a score of 1. This corresponds – according to cross-country supply-side evidence of Djankov, Mcliesh, and Shleifer (2007) – to an expected decline in the private-credit-to-GDP ratio of approximately 20 percentage points.
In addition to its power, ESUG also fulfills the other requirements of a natural experiment, and thus provides a unique opportunity to study the causal effects of creditor rights on firms’ decisions. In particular, by affecting predominantly high-tangibility firms, ESUG allows us to construct both a treatment and a control group of firms and obtain causal inference by applying a Difference-in-Differences identification methodology.
Our first set of results show that ESUG’s lower creditor rights induce treated firms to increase financial leverage and tilt their debt composition toward unsecured debt compared to the sample of control firms. The increase in leverage complies with the demand-side view of creditor rights and stands in contrast to the law and finance literature – which would have predicted a sharp decrease in corporate leverage. It implies that the benefits of a reduction in distress costs (demand-side view) outweigh the disadvantages of increased interest-rates (supply-side theory). ESUG, therefore, clearly reduces firms’ overall expected bankruptcy costs. Our finding, with regard to the substitution of secured debt with unprotected debt, suggests that ESUG lowers the interest-rate spread between the two and motivates firms to prefer the less binding unsecured debt. In other words, the interest-advantage of secured debt has become so small that it does not outweigh its higher costs in terms of ongoing administrative and reporting costs for the collateralization and in terms of restrictions to operational flexibility and lower managerial discretion.
Second, we provide evidence that creditor rights affect firms’ investment choice by showing that, upon ESUG approval, treated firms strongly reduce both enlarging actions and investments in redeployable assets. These results are in line with the demand-side view by Acharya, Amihud, and Litov (2011) who argue that whenever firms/managers face adverse bankruptcy legislations, they reduce the probability of distress by engaging in risk-reducing (but unprofitable) diversifications. Thereby, they further increase their ability to autonomously prevent bankruptcy application by accumulating unprofitable, but quickly-salable, high-recovery assets. Thus, the drop in creditor rights prompts firms to eliminate protection mechanisms previously set in place to contract around the adverse pre-ESUG bankruptcy provisions. The transmission channel of a protection mechanism is confirmed by the fact that treated firms take on higher levels of (value-improving) risk and become more profitable after the reform.
By investigating the effects of the 2012 bankruptcy code reform in Germany – which represents a decided shift from a liquidation-oriented bankruptcy law to a continuation-friendly procedure – we provide evidence of the downside effects of excessively strong creditor rights. We show that strong rights provoke firms to take action in order to reduce the likelihood of financial distress by carrying less debt and deviating from the otherwise optimal investment strategy. Thus, the excessive creditor rights of the pre-ESUG regime did not only produce ex post deadweight losses in the form of inefficient liquidation. They also motivated firms to contract around a liquidation-oriented legislation by avoiding risky but profitable investment decisions, which reveals also ex ante inefficiencies of excessively strong creditor protection.
The post-ESUG corporate landscape turns out to be more profitable but also riskier. The higher risk stems from the new bankruptcy incentives that let firms be more willing to accept common entrepreneurial challenges. In addition, firms are more vulnerable to downturns due to their higher financial leverage and reduced availability of high-recovery assets. This justifies our policy proposition that weak creditor rights must be accompanied by centralized and experienced jurisdictions. As German firms seem to rely on the new healing power of the turnaround-friendly post-ESUG code, courts should be ready to cater to these legitimate expectations not only by drawing from legal know-how but also by acquiring and developing business- and industry-specific competences. As the European Commission is currently exploring a harmonized bankruptcy framework across all Member States with the aim of increasing the possibilities for corporate restructurings, the empirical findings described in our paper may provide useful guidelines for this endeavor.
Aras Canipek is a PhD Student at the Graduate School of Decision Sciences and Corporate Finance Department of University of Konstanz
Axel Kind is Professor at University of Konstanz – where he holds the Chair of Corporate Finance – and Adjunct Professor at University of Basel and University of St. Gallen
Sabine Wende is Assistant Professor of Finance at University of Cologne