Litigation Risk and Debt Contracting: Evidence from a Natural Experiment

Journal of Law and Economics, Forthcoming

49 Pages Posted: 20 May 2020

See all articles by Zhihong Chen

Zhihong Chen

Hong Kong University of Science and Technology

Ningzhong Li

University of Texas at Dallas

Jianghua Shen

Hong Kong University of Science & Technology (HKUST)

Date Written: February 19, 2020

Abstract

In June 2001, Nevada changed its state corporate law by substantially reducing the legal liability of directors and officers for breaching fiduciary duties owed to the corporation. We examine the impact of the reduced litigation risk caused by this legislative change on Nevada-incorporated firms’ loan contract terms and related borrower-lender agency conflicts. Using a difference-in-differences analysis, we find that this legislative change leads to less favorable loan contract terms for Nevada-incorporated firms: higher spread and more restrictive covenants. In addition, after the legislative change, Nevada-incorporated firms with severe borrower-lender agency conflicts take more risk, increase payout through stock repurchase, and reduce capital investment and equity issuance. Collectively, these results suggest that the reduced litigation risk exacerbates the borrower-lender agency conflicts.

Keywords: Litigation risk, loan contracts, agency conflicts, Nevada corporate law

JEL Classification: G30, K41

Suggested Citation

Chen, Zhihong and Li, Ningzhong and Shen, Jianghua, Litigation Risk and Debt Contracting: Evidence from a Natural Experiment (February 19, 2020). Journal of Law and Economics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3583834

Zhihong Chen

Hong Kong University of Science and Technology ( email )

Clear Water Bay
Kowloon
Hong Kong
Hong Kong
(852)-2358-7574 (Phone)
(852)-2358-1693 (Fax)

Ningzhong Li (Contact Author)

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

Jianghua Shen

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

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