Lawyers impact debtor-creditor relations in many ways. From determining the contours of debt agreements to assisting in debt renegotiation and the bankruptcy process, lawyers are highly involved in lending relationships. But how large are legal transaction costs for debtor corporations, and what factors determine corporate spending on lawyers? In a paper recently published in the Journal of Empirical Legal Studies, I analyze the impact of India’s 2002 Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, which allowed secured creditors to seize collateral from debtor companies, bypassing the court system. This law represented a large increase in Indian creditor rights and led to a wave of collateral seizures. I find that firms most exposed to the effects of the law—companies with large shares of tangible assets, which can readily serve as collateral—saw a significant decrease in fees paid to lawyers and legal advisors. A one standard deviation increase in pre-reform asset tangibility is associated with a subsequent decrease in legal expenditures equal to 6.5% (29.83%) of the mean (median) spending on lawyers. The results indicate that legal transaction costs associated with foreclosure avoidance are sizable and can be eliminated by strengthening contract enforcement.
Before the reform, Indian secured creditors were in an unusually weak position compared to their counterparts in other economies: they had no right to seize collateral without initiating decades-long court cases, even when the debtor was not in bankruptcy. Therefore, SARFAESI vindicated creditors’ ability to execute foreclosures when the debtor was not in bankruptcy. By allowing creditors to avoid the regular judicial system, the legislation eliminated debtors’ ability to spend on lawyers for the years (or even decades)-long foreclosure proceedings that would earlier take place in civil courts. Secured creditors could now either just seize the collateral, or force debtor firms to renegotiate the debt out of court, with both these mechanisms entailing lower legal expenditures than the litigation that characterized the pre-SARFAESI regime. Banks aggressively used their powers under SARFAESI to increase foreclosures, and debt-related civil litigation fell by almost 40% after the legislation. Therefore, legal costs associated with foreclosure avoidance decreased, because debtor firms were no longer able to deploy their lawyers to prevent secured creditors from seizing collateral.
At the same time, SARFAESI also increased the probability of legal costs associated with the bankruptcy process for firms that were close to insolvency. This increase in bankruptcy costs could be driven by the fact that some debtor firms will be unable to successfully renegotiate their debt. Debtor firms that were unable to renegotiate their debt are more likely to have failed India’s ‘cash flow’ test for insolvency and declared bankruptcy. Consistent with SARFAESI having a heterogeneous impact on affected firms, I find that firms that were both more exposed to the legislation (with more tangible assets) and less likely to successfully restructure their debt (with multiple lending relationships) became more likely to file for bankruptcy after SAFAESI. Beyond failed debt restructurings, managers at debtor firms could also opportunistically declare bankruptcy in order to evade seizure of their assets by secured creditors. Secured creditors were not allowed to seize the debtor’s assets during the operation of the bankruptcy automatic stay, even after the passage of SARFAESI. Such opportunistic declarations would increase legal costs, given that it is expensive for firms to navigate the Indian insolvency process. Therefore, whether due to failed debt renegotiations or opportunistic bankruptcy declarations, SARFAESI may have increased legal spending by affected firms that were close to insolvency.
To ascertain the differential effect of SARFAESI, I look at its effect on firms that filed for bankruptcy around the passage of the legislation. Consistent with bankruptcy having significant legal transaction costs, I find that the decrease in legal spending is attenuated for firms that filed with the federal bankruptcy court after SARFAESI. I also find that the decrease in legal spending was smaller for firms with objectively higher bankruptcy risk before SARFAESI, as measured using four different proxies: the Altman Z-score, the presence of multiple creditors, higher pre-reform credit risk, or the existence of controllers deriving higher private reputational benefits of control, as proxied by membership in business groups.
The welfare effects of the reduction in legal spending after SARFAESI depend on the unit of analysis. At the firm level, the net welfare effects are uncertain. On the one hand, companies will spend less on outside lawyers and can reallocate these funds to productive endeavors. On the other hand, debtor corporations may suffer from the seizure of their productive assets. However, the paper’s results suggest that stronger creditor rights could have positive welfare effects at the societal level. Before SARFAESI, a large fraction of Indian judicial resources was consumed by lawyers litigating debt contracts where debtor firms had clearly defaulted. Such debt contract litigation contributed to the decades-long delays and backlog in the Indian civil court system. Backlogs in court systems, and specifically in the adjudication of debt contracts, are associated with significant economic costs. This paper’s results are consistent with debtor companies reducing the resources they devoted to litigating debt contracts, thereby placing less stress on court systems.
By using the quasi-natural setting of the increase in Indian secured creditors’ rights and the comprehensive data on legal spending by firms, the paper adds to the literatures on the effect of creditor rights, the economic significance of the direct costs of bankruptcy, and the consequences of agency costs of debt. The main policy implication of the empirical analysis is that a large fraction of legal transaction costs exists because of weak contracting institutions such as high enforcement costs for debt agreements. Improving contract enforcement can eliminate many of these legal transaction costs. The reduction in legal spending by firms affected by SARFAESI may be seen as improving social welfare, by reducing the resources spent on litigating straightforward corporate defaults and alleviating the backlogs that plague India’s congested court systems.
The full paper can be accessed here.
Dhruv Aggarwal is an Assistant Professor of Law at the Pritzker School of Law, Northwestern University.
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