Creditor Rights and Legal Transaction Costs

Abstract

I estimate the relationship between increased creditor rights and legal expenditures of debtor corporations by evaluating a securitization law in India allowing secured creditors to seize collateral. The law decreased spending on legal proceedings used by firms to avoid foreclosure. Firms most affected by the law—with high proportions of tangible assets creditors could seize as collateral—significantly decreased spending on lawyers after the legislation. However, some debtor firms affected by the legislation filed for bankruptcy to take advantage of the automatic stay and prevent creditors from seizing their assets. These firms would have incurred legal costs related to the bankruptcy process. Consistent with this intuition, the post-reform decrease in legal costs is smaller for firms that were closer to insolvency or filed for bankruptcy after the legislation. The results indicate that legal transaction costs associated with foreclosure avoidance are sizable and can be eliminated by strengthening contract enforcement.

Keywords: creditor rights, capital structure, transaction costs, legal process

JEL Classification: G32, G33, G34, G38, K22, K41