State Contract Law and Debt Contracts
Posted: 23 Jun 2013 Last revised: 20 May 2016
Date Written: July 29, 2014
This paper examines the relationship between debt contracts and state contract law. We first develop an index to evaluate whether each state's law is favorable or unfavorable to lenders. We then analyze how the contract terms, the frequency of covenant violations, and the repercussions of covenant violations vary across states. We find that cash collateral is most likely to be used when the contract is governed by law that is favorable to debtors, and that out-of-state borrowers who use favorable law pay higher yield spreads. Additionally, when the law is favorable to lenders, there are significantly fewer covenant violations and the repercussions of covenant violations --- measured as changes in the borrower's investment policy --- are more severe. We also compare the characteristics of relevant parties across states, and the results provide support for the theory that there is a market for contracts similar to the market for incorporations.
Keywords: debt contracts, legal environment, corporate finance, law and economics
JEL Classification: G30, K12, M21, M41
Suggested Citation: Suggested Citation