The Impact of Pro-Reorganization Bankruptcy Reforms on Corporate Debt Structure
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The law and finance literature highlights the significance of bankruptcy regimes in fostering financial market development and promoting economic growth. The key concept established is that the degree of creditor rights in bankruptcy laws determines the relative negotiating power between creditors and debtors and often influences the anticipated recovery value of distressed assets. Consequently, bankruptcy law shapes credit supply and availability ex-ante. However, no consensus has been reached regarding the extent to which creditor rights should be safeguarded in bankruptcy proceedings.
Bankruptcy laws that strictly uphold creditor rights can encourage lending and stimulate credit supply. Nevertheless, excessive creditor protection might result in the liquidation of economically viable firms, as secured creditors often have diminished incentives to negotiate with debtors and are more inclined to push for a swift sale of the collateral to avert losses. Conversely, relaxing creditor rights protection within bankruptcy laws may facilitate the reorganization and restructuring of financially distressed firms, albeit potentially at the expense of disincentivising lenders to lend.
Since the early 2000s, many jurisdictions with traditionally creditor-oriented laws have revised their bankruptcy laws, aiming to preserve business as ongoing concerns in line with the spirit of Chapter 11 of the US Bankruptcy Code 1978. These reforms offer an ideal setting to investigate the influence of bankruptcy laws on corporate finance. In our paper, we use bankruptcy law reforms in six jurisdictions—France, Spain, Germany, Italy, Hong Kong, and Singapore—as quasi-natural experiments and apply a difference-in-differences model to examine how corporate debt reacts to pro-reorganization legal changes.
To conduct our empirical study, we construct a sample of firms headquartered in the above-mentioned jurisdictions and collect detailed debt structure information from the S&P Capital IQ database. Using this sample, we analyse how pro-reorganization bankruptcy reforms affect firms' total debt ratio and debt structures. We further collect information about bank loans and public bonds issued by these firms and use these data to study the impact of bankruptcy reforms on debt contract terms. By conducting firm-, loan- and bond-level studies, we draw a complete picture of how bankruptcy reform can shape firm debt policies.
Our findings are summarized as follows:
First, we find that firms affected by these bankruptcy reforms borrow from more diversified debt sources, resulting in a less concentrated debt structure. This effect is likely driven by the possible tightened credit supply following the bankruptcy reforms. As the reforms weaken creditors' rights when firms default, creditors may increase credit screening and monitoring and reduce lending to firms. Additionally, the provision of an automatic stay reduces the protection given to secured creditors, causing the liquidation value of collateral to fall. This makes it more difficult for firms to borrow using tangible assets as collateral. These adaptations can inhibit firms' debt borrowing from a single source. Thus, firms must rely on multiple types of debt to support their investments or daily operations when credit supply is tightened, resulting in more diversified debt structures. Consistent with this view, we find that the impact of pro-reorganization bankruptcy reform on debt diversification is predominantly observed in firms that are more vulnerable to a potential tightening of credit supply, such as financially constrained firms, firms that are close to default, and firms vulnerable to suffering a greater loss in collateral value. Also, we find that firms significantly reduce the use of secured debt after the bankruptcy reforms.
Second, we demonstrate that the impact of the law change that promotes reorganization is not uniform, affecting some kinds of firms more than others. More specifically, financially constrained firms experienced lower leverage and investments due to reduced credit supply, possibly triggered by bankruptcy law changes. This would suggest that a single uniform pro-reorganization bankruptcy law may not be optimal for all kinds of firms in bankruptcy. Instead, consideration needs to be given as to whether there needs to be a menu of creditor-oriented or debtor-oriented bankruptcy proceedings that firms can invoke, as opposed to one-size-fits-all bankruptcy proceedings that apply to all kinds of firms. If a menu approach is not selected, consideration should be given to whether certain kinds of firms dominate the economy in the jurisdiction that would most benefit from the reforms.
Third, we illustrate the interaction between contractual-based and legal-regulatory creditor protection. We find that the reforms lead to higher interest rates in loan and bond markets, suggesting creditors require high-risk premiums to compensate for the weakening of their rights in bankruptcy. We also find that firms reduced their average debt maturity after the reforms. We reaffirm this finding of shortened maturity in bank loans and public bonds analyses. This evidence demonstrates how creditors respond to legal changes by relying on protections found in contractual terms—higher interest rates and shorter maturity—to counterbalance the reduced legal protection.
In recent years, countries worldwide have revised their bankruptcy systems to promote reorganization and preserve the business as a going concern. For example, the EU Directive on Preventive Restructuring 2019/1023 sets down minimum rules for restructuring frameworks and required EU member states to implement it in national law by July 2021, with an option of an additional 12 months for implementation. However, the ex-ante effects of these reforms on corporate debt financing are often elusive. Our analysis suggests that bankruptcy law reforms promoting debt restructuring could potentially negatively impact credit supply and impede the debt financing of some kinds of firms.
Xiaotian Liu of the School of Accounting at the Shanghai University of International Business and Economics.
Yaxuan Qi is a professor in the Department of Economics and Finance at the City University of Hong Kong.
Wai Yee Wan is a professor in the School of Law at the City University of Hong Kong.
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