Litigation Risk and Debt Structure Choice

Abstract

We investigate the effectiveness of security in protecting creditors from dilution arising from litigation and other non-debt related claims; claims we refer to as exogenously unsecured. Consistent with this security affording greater protection from dilution, we find that disclosures of litigation claims are associated with a significant increase in the spread between a firm’s unsecured and secured and debt claims. More important, we find that the propensity of material litigation claims is negatively related to firms’ reliance on secured debt. Our findings are consistent with the notion that collateral provides protection from litigation claims, and thus is an additional motivation for firms to borrow on a secured basis, even in circumstances where covenants on unsecured claims might be effective in mitigating the agency costs of debt.

Keywords: Litigation, Debt Structure, Dilution, Priority

JEL Classification: G32, G33