Creditor Rights and Corporate Debt Structure∗

Much of our understanding of creditor rights is based on the notion that better enforcement of contracts reduces borrowing costs, thereby relaxing financial constraints. But what if these rights are too strong? We empirically investigate this question by examining the effect of a securitization reform that strengthened secured creditors rights on corporate debt structure. Strikingly, we find that the reform led to a reduction in secured debt, total debt, debt maturity, and asset growth. These results suggest that strengthening of creditor rights may lead to adverse effects and that firms alter their debt structures to contract around these inefficiencies. JEL Codes: F34, F37, G21, G28, G33, K39. ∗I would like to thank Patrick Bolton, Charlie Calomiris, Denis Gromb, Ray Fisman, Daniel Paravisini and Bernard Salanie for many invaluable discussions and comments. In addition, I would like to thank Andres Almazan, Viral Acharya, Ken Ahern, Ken Ayotte, Tim Baldenius, Mike Barclay, Alex Butler, Tomer Berkowitz, Pierre Chiappori, Sid Dastidar, Doug Diamond, Francisco Perez-Gonzalez, Maria Guadalupe, Charlie Hadlock, George Hall, Oliver Hart, Rainer Haselmann, Christopher Hennessy, Laurie Hodrick, Hagit Levy, Bentley Macleod, Ulf Nielsson, Manju Puri, Raghu Rajan, Adriano Rampini, Tano Santos, Florian Schulz, Amit Seru, Cliff Smith, Suresh Sundaresan, Elu von Thadden, Jean Tirole, Paolo Volpin and seminar participants at Alberta, Brandeis, Columbia, Duke, HKUST, Illinois, Michigan, London Business School, MSU, NYU, Rice, Rochester, UCSD, UC Davis, UNC, Wisconsin, Batten Conference, ALEA and WFA for valuable comments. I would also like to thank the officials at the Bank of Baroda, Reserve Bank of India, ICICI, State Bank of India and Dena Bank, for helping me understand the Indian banking industry. In particular, I would like to thank the Y.V Reddy, Rakesh Mohan, R.B. Barman, Anil Khandelwal, Saibal Ghosh and Sundando Roy for their generous support, feedback and valuable comments. The usual disclaimer on errors applies here as well. †London Business School. Please refer all correspondence to Vikrant Vig ([email protected]). The seminal paper by La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998) titled “Law and Finance,” and subsequent literature have linked creditor rights with financial development by documenting a positive correlation between an index of creditor rights and the size of credit markets in cross-country regressions.1 These findings provide additional support for the view that ownership protection, particularly in credit markets, foster financial development by lowering the cost of credit. The major function attributed to law, according to this view, is that it empowers creditors to enforce their contracts. An interesting contrast, however, is provided by the bankruptcy literature on the merits of Chapter 11 and bankruptcy reorganization, which has suggested that creditor rights could be excessive and lead to ex-post inefficiencies in the form of a liquidation bias (see Aghion, Hart, and Moore (1992); Hart, La Porta, Lopez-de Silanes, and Moore (1997))2. In light of these seemingly opposing views, the question of how far the law should go in protecting creditors naturally arises. This paper revisits the positive link between greater creditor protection and expansion of credit and asks whether there are situations in which strengthening creditor rights could lead to a decline in credit usage by firms. Specifically, the paper exploits a quasi-natural experiment in India, the passage of a mandatory secured transactions law, the SARFAESI Act (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act 2002), to investigate the effect of law on corporate debt structure. Prior to the SARFAESI Act, the slow and rigid judicial process created severe bottlenecks in the recovery of security interests. To liquidate the firm, secured lenders would have to go through a prolonged judicial process, during which the value of collateral considerably depreciated in value. The reform significantly increased the rights of secured creditors by allowing them to bypass the lengthy and judicial process and seize and liquidate the assets of the defaulting firm, thus improving the ability of lenders to access the collateral of the firm. Using this securitization reform that strengthens the rights of secured creditors, and employing a difference-in-differences (DID henceforth) methodology, the paper attempts to identify the effects of the change in law on the quantity of secured credit used by firms. Remarkably, in light of the Law and Finance literature, which predicts an increase in secured debt, this paper finds that an increase in the rights of secured creditors actually led to a 5.2 percent decrease in the usage of secured debt by firms. This paper attempts to identify the cause of this response 1La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997); Levine (1998, 1999); Djankov, McLiesh, and Shleifer (2005); Beck, Demirgc-Kunt, and Levine (2004); Haselmann, Pistor, and Vig (2009); Visaria (2006) 2See also Strömberg (2000), Pulvino (1998) and Povel (1999)