Creditor Rights and Corporate Risk-Taking

Abstract

We propose that stronger creditor rights in bankruptcy reduce corporate risk-taking. Employing country-level data, we find that strong creditor rights are associated with a greater propensity of firms to engage in diversifying mergers, and this propensity changes in response to changes in the country creditor rights. Also, in countries with stronger creditor rights companies’ operating risk is lower, and acquirers with low-recovery assets prefer targets with high-recovery assets. These relationships are strongest in countries where management is dismissed in reorganization, suggesting an agency-cost effect. Our results suggest that there might be a dark side to strong creditor rights in that they can induce costly risk avoidance in corporate policies. Thus, stronger creditor rights may not necessarily be optimal.