Aurora Borealis
1 April 2014 CFA Institute Journal Review

Creditor Rights and Capital Structure: Evidence from International Data (Digest Summary)

  1. Marc L. Ross, CFA

Studying data across 48 countries, the authors discover consistent evidence of an inverse correlation between strong creditor rights and long-term leverage. Firm and country characteristics appear to influence the link between creditor protection and the use of long-term debt.

What’s Inside?

The authors examine the relationship between creditor rights and firm capital structures. Specifically, they empirically assess two competing views on the impact of creditor rights on firms’ use of debt. Their results indicate that creditor rights have a significantly negative effect on firms’ use of long-term debt.

Furthermore, the link between creditor protections and long-term debt is a function of decisions made by corporate borrowers and characteristics of the legal system of the country in which these decisions are made. The authors conclude that strong creditor protections discourage firms from issuing long-term debt because managers and shareholders fear losing control of their firms in the event of financial distress.

How Is This Research Useful to Practitioners?

The authors contribute to the literature on investor protection and corporate finance by identifying creditor protections as a critical institutional factor that influences the makeup of a firm’s capital structure across countries. Researchers and practitioners will appreciate the authors’ findings because they offer guidance on how creditor rights across countries affect the capital-raising decision. The findings may also be relevant to policymakers and risk managers who are considering the benefits and costs of using long-term debt.

The results of the study shed light on the two competing theories of how creditor rights affect long-term debt issuance. The first theory, a supply-side view, suggests that creditor protections have a positive effect on firms’ use of debt because strong creditor rights allow borrowing firms to attain more favorable terms—for example, a lower interest rate. The second theory, a demand-side view, suggests that creditor protections have a negative effect on debt use because strong creditor protections deter managers from issuing long-term debt because they fear they will lose control of the firms in the event of financial distress.

The authors’ findings indicate that demand-side forces generally dominate, although supply-side influences do prevail in certain situations. An important corollary to this aversion to issuing long-term debt is the tendency of managers to prefer equity, or in the authors’ terms, “safe capital.”

How Did the Authors Conduct This Research?

The authors examine the relationship between creditor rights and long-term debt using a sample of 151,855 firm-year observations on 17,452 unique firms from 48 countries in the Worldscope database over the 20-year period from 1991 to 2010. The primary measure of leverage they consider is the long-term debt ratio (ratio of long-term debt to the book value of total assets). A key explanatory variable used by the authors is the creditor rights index, which is the sum of four legal metrics of creditor protection: no automatic stay, secured creditor paid first, restrictions on reorganization, and no management stay. Each metric is assigned a value of 1 or 0, depending on whether a country’s bankruptcy code provides creditors with that specific type of protection. The authors also control for country- and firm-level variables that affect corporate capital structure. Additionally, they take measures to ensure that such large economies as the United States and Japan do not skew their findings.

To evaluate the effect of creditor rights on the amount of firms’ debt issuance from year to year, the extent to which investments are financed with various sources of funds, and the effect of creditor rights on target leverage ratios and on firms with varying amounts of debt, the authors use regression analysis. They document that a one-unit increase in the creditor rights index is associated with a decrease in a firm’s long-term debt ratio of approximately two percentage points.

They conclude with an examination of the effect of firm and country characteristics on the degree to which the demand side affects capital raising. In certain circumstances, firm- and country-level factors may diminish the impact of demand-side forces when firms have limited options for fundraising and when the need to raise funds outweighs the risk of losing management control. This situation can arise in less profitable firms and less developed financial markets.

Abstractor’s Viewpoint

Can a legal system in which creditor protection prevails mitigate potential moral hazard? This study is unique in the authors’ focus on the effect of creditor rights on the long-term debt financing decision. Their conclusions tend to support the effects of the demand side on companies’ willingness and ability to assume long-term financing obligations. But supply-side considerations may prevail in certain less developed legal systems and should not be ruled out entirely. The need for capital can sometimes trump the risk of losing management control that could occur in bankruptcy.

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