Creditor Rights and Legal Transaction Costs

Abstract

I estimate the relationship between increased creditor rights and legal expenditures of debtor corporations by analyzing the effect of a major securitization law in India allowing secured creditors to seize collateral. While the law decreased spending on legal proceedings commonly used by firms to avoid foreclosure, it increased the probability of legal costs associated with bankruptcy. 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. A one standard deviation increase in pre-reform asset tangibility corresponds with a subsequent decrease in legal spending equal to 6.5% (29.83%) of the mean (median) amount. This decrease in legal costs is smaller for firms with higher bankruptcy risk, more creditors, higher credit risk, and higher agency costs. 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