State Contract Law and Debt Contracts

Posted: 23 Jun 2013 Last revised: 20 May 2016

Colleen Honigsberg

Stanford Law School

Sharon P. Katz

Columbia Business School - Accounting, Business Law & Taxation

Gil Sadka

University of Texas at Dallas

Date Written: July 29, 2014

Abstract

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

Honigsberg, Colleen and Katz, Sharon P. and Sadka, Gil, State Contract Law and Debt Contracts (July 29, 2014). Journal of Law and Economics, Vol. 57 (2014). Available at SSRN: https://ssrn.com/abstract=2283176 or http://dx.doi.org/10.2139/ssrn.2283176

Colleen Honigsberg

Stanford Law School ( email )

559 Nathan Abbott Way
Stanford, CA 94305
United States

Sharon P. Katz (Contact Author)

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
New York, NY 10027
United States

Gil Sadka

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

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