Creditor Rights, Corporate Leverage and Investments, and the Firm Type

Abstract

Stronger creditor rights reduce credit costs and thus may allow firms to increase leverage and investments. Yet, they also increase distress costs and thus may prompt firms to lower leverage and undertake risk-reducing but unprofitable investments. Using a German bankruptcy reform, on average, we find evidence consistent with the latter hypothesis. We also hypothesize and find evidence that the effect of creditor rights on corporate leverage and investments depends on the firm type (particularly, firm size), as it influences the effect that creditor rights have on credit costs and distress costs and thus which effect dominates. Our understanding reconciles mixed empirical evidence and has important implications for optimal bankruptcy design. In particular, it points to a menu of procedures in which a debtor-friendly and creditor-friendly procedure co-exist and thus allow different types of firms to utilize the procedure that suits them best.

Keywords: creditor rights, bankruptcy law, corporate leverage, corporate investments

JEL Classification: G31, G32, G33, G34, G38, K22