The legal protection provided to creditors to enforce their contracts with debtors is central to the functioning of credit markets. These include the rights afforded to lenders in bankruptcy, collateral laws, the efficiency of judicial debt recovery, and extra-judicial rights to seize and liquidate collateral. The literature examining the real effects of strengthening creditor rights on firms has focused exclusively on their capital structure choices, capital investments, and risk taking. However, surprisingly little is known regarding the effect of creditor protection on the firm’s choice between capital and labor. This is particularly important given that the financing environment is a key determinant of capital and labor allocation decisions within firms and these labor-capital decisions impact firm value.
For our research setting, we use a strengthening of creditor rights brought about by the enactment of Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act (SARFAESI Act henceforth) of 2002 in India. SARFAESI in Act of 2002 was aimed at reducing the caseload of debt recovery tribunal courts. To that end, the Act allowed secured creditors to seize assets after a 60-day demand notice without having to go through the court proceedings. However, the unintended consequence of the Act was that it strengthened the rights of the creditors immensely in comparison to the borrowers, resulting in a higher threat of liquidation for borrower firms. We exploit the cross-sectional variation in firms’ pre-SARFAESI access to collateral is able assets to generate exposure to the law and employ a differences-in-differences strategy to compare the outcomes of firms with a higher proportion of tangible assets (treatment group) to those firms with a lower proportion of tangible assets (control group) after SARFAESI relative to before the law change. Since tangible assets are more easily securitized, it is reasonable to assume that SARFAESI law would affect firms with more tangible assets as compared with the firms with less tangible assets.
The main results of our paper are that after the enactment of SARFAESI Act, more affected firms differentially increased the total number of employees by 7.9% - 9.1% and reduced their capital investments (fixed capital and plant and machinery) by 25% in comparison with less affected firms. In addition, we also find that more affected firms increased their expenditure on rented plant & machinery. These empirical results suggest that firms with a higher proportion of tangible assets chose to rent plant and machinery as opposed to investing in them due to higher exposure of the SARFAESI Act. This phenomenon could be explained by the fact that after the SARFAESI Act, fixed capital owned by firms could be seized and liquidated easily in the event of default. Furthermore, we find that as a result of SARFAESI, more affected firms reduced the amount of secured formal loans in the short-term and in turn increased their reliance on trade credit, in essence substituting away from secured credit towards unsecured credit. Taken together, the empirical evidence lends support to our hypothesis that a higher threat of liquidation after SARFAESI for more affected firms led them to substitute capital with labor, and substitute secured debt with unsecured debt.
We further examine the heterogeneous effects of the SARFAESI Act across different regions and industries. Specifically, we divide this analysis into three parts – variations in a) judicial efficiency (measured by the fraction of cases disposed of by courts in a year), b) labor regime (whether the region has pro-worker or pro-employer labor laws) and c) capital-labor substitution elasticity. We employ a differences-in-differences-in-differences (DIDID) method for this analysis. First, creditors in states with high judicial efficiency will have lesser incentive to invoke the SARFAESI Act as the judicial system is meeting their needs. In contrast, creditors in states with low judicial efficiency will have a higher incentive to utilize the SARFAESI Act to seize assets in the event of default by circumventing the court proceedings. Our empirical analysis finds evidence corroborating this hypothesis. We find that more affected firms differentially hire more workers and invest less in capital in states that had a lower pre-SARFAESI judicial efficiency. Second, hiring/firing permanent workers is hard in pro-worker regimes when compared to pro-employer regimes. To that end, we expect firms in pro-worker states to hire more contract workers (temporary workers) as opposed to permanent workers to retain flexibility in employment decisions. On the other hand, we expect to find firms in pro-employer states to increase total employment irrespective of the type of worker as firms have greater bargaining power in employment decisions and are unaffected by labor regimes. Since labor regimes largely impact employment decision, we do not expect capital investment decisions to vary significantly across different labor regimes. Our empirical analysis lends support this idea. Third, firms in industries with a higher elasticity of substitution have greater ease of substituting capital with labor. Hence, we expect to find firms in industries with a higher elasticity of substitution to differentially hire more workers and invest less in capital. The empirical analysis is consistent with this conjecture.
Our findings have important implications for policymakers. From the firms’ perspective, our results show that firms with high tangible assets face a greater threat of liquidation as the SARFAESI Act has tipped the balance of power towards the creditors and away from the borrowing firm. In addition, our findings suggest as a result of a higher threat of liquidation, affected firms increase employment, reduce capital investments, and substitute secured formal credit with trade credit. These findings indicate that due to strong creditor rights, firms can change their inputs of production in unexpected ways. As more countries make changes in their financial contracting environment, policy makers must consider the effects of these changes on firms’ input choices as these choices have implications for long run economic growth.
Shahwat Alok is Assistant Professor at Indian School of Business.
Ritam Chaurey is Assistant Professor, at Johns Hopkins School of Advanced International Studies.
Vasudha Nukala is PhD Student in Finance, Olin Business School, Washington University in St. Louis