Creditor Rights and Related-Party Transactions: Evidence from the Implementation of the Insolvency Reforms in India

ABSTRACTManuscript Type: EmpiricalResearch Question/Issue: This study examines the impact of creditor rights on R&D intensity (R&D/total assets). We argue that managers in countries with strong creditor rights have more incentives to reduce cash flow risk and therefore limit expenditures on R&D more than managers located in countries with weak creditor rights.Research Findings/Insights: Using a sample of over 21,000 firms from 41 countries, our research is one of the first to document that strong creditor rights are indeed associated with reduced R&D intensity. This negative relationship is observed in market‐based countries, but not in bank‐based countries. Moreover, the results show that the negative effect of creditor rights on R&D intensity is usually stronger (more negative) for firms facing or near financial distress. We observe that the determinants for R&D intensity consist of both country and firm level variables and firm level variables appear to be more important in explaining the variance of R&D intensity.Theoretical/Academic Implications: This study documents an important link between creditor rights and R&D intensity. Our empirical procedure specifically accounts for the fact that R&D intensity and debt are likely to be jointly determined.Practitioner/Policy Implications: This research is important to policy makers interested in understanding the determinants of firms' R&D intensity. In particular, our study suggests a possible harmful effect of strong creditor rights, namely the possibility that R&D intensity will be lowered.

Do creditor rights and information sharing affect the performance of foreign banks?

This paper examines the effect of host economy creditor rights and information sharing on the profit performance of foreign banks vis-a-vis domestic banks for a global sample of commercial banks over the 2005-2009 period. To this end, we employ the recent foreign bank ownership dataset of Claessens and Van Horen (2014) and measure performance as profit efficiency using the alternative profit function. Results from the Battese and Coelli (1995) stochastic frontier analysis model show that creditor rights exert a positive effect on efficiency that strengthens for foreign banks. On the other hand, information sharing exerts a negative effect on profit efficiency which strengthens for foreign banks. The results for information sharing show some variability across different levels of development of the host economy. Moreover, the transparency of the host economy moderates the effect of creditor rights and information sharing on foreign bank efficiency. We also examine the effect of “institutional distance” in creditor rights and information sharing between the home and host economy on foreign bank efficiency. The effect of creditor rights “institutional distance” on foreign bank efficiency is negative, while it turns positive for information sharing. These findings highlight the importance of strong creditor rights for foreign bank performance and are useful for both regulators in host economies and foreign bank managers.

Creditor rights, bank competition, and stability: International evidence

Stronger creditor rights reduce credit costs and thus may allow firms to increase leverage and investments, but also increase distress costs and thus may prompt firms to lower leverage and undertake risk-reducing but unprofitable investments. Using a German bankruptcy law reform, on average, we find evidence consistent with the latter. We also hypothesize and find evidence that the effect of creditor rights depends on the firm type (most importantly, the firm size), as it influences the effect of creditor rights on credit costs and distress costs and thus which effect outweighs. Our understanding not only reconciles the mixed empirical evidence of existing studies, but also 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 prevailing overweight.

We examine how legal creditor rights are related to debt financing and corporate investment over the business cycle. Using firm-level data from 40 countries, we find that creditor rights are associated with greater debt financing and investment during economic downturns, but creditor rights have a significantly smaller effect during expansions. The beneficial effects of creditor rights during recessions are stronger for firms that are more likely to have severe shareholder-bondholder agency problems. We also find that during recessions (relative to expansions) strong creditor rights are associated with a smaller decline in net capital flows. Our findings are consistent with credit market frictions increasing during recessions, and with stronger creditor rights decreasing the negative effects of these frictions. Overall, the results suggest that better creditor protection laws help moderate the decline in debt financing and investment during recessions.

Creditor protection, shareholder protection and investment efficiency: New evidence

We describe related party (RP) transactions and investigate financial incentive and monitoring determinants for firms engaged in RP transactions. Our sample consists of 1,261 firms included in the S&P 1500. RP transactions are common in our sample, but vary substantially as to transaction type and disclosure. The most common RP transactions are loans, which are now largely prohibited by Section 402 of Sarbanes Oxley. Method of disclosure - financial statement footnote or proxy - appears largely driven by dollar-based materiality concerns. We also analyze two broad classes of determinants of RP transactions - financial incentives and monitoring. We find weaker corporate governance is associated with RP transactions, an inverse relationship between CEO and director's cash compensation and RP transactions, and a positive association between CEO stock options and RP transactions. However, director and officer ownership are not associated with RP transactions. Overall our results suggest associations between director and officer compensation, corporate governance and related party transactions.

We examine how legal creditor rights are related to debt financing and corporate investment over the business cycle. Using firm-level data from 40 countries, we find that creditor rights are associated with greater debt financing and investment during economic downturns, but creditor rights have a significantly smaller effect during expansions. The beneficial effects of creditor rights during recessions are stronger for firms that are more likely to have severe shareholder–bondholder agency problems. We also find that during recessions (relative to expansions) strong creditor rights are associated with a smaller decline in net capital flows. Our findings are consistent with credit market frictions increasing during recessions, and with stronger creditor rights decreasing the negative effects of these frictions. Overall, the results suggest that better creditor protection laws help moderate the decline in debt financing and investment during recessions.

We use exogenous changes in creditor rights from staggered enactments of anti‐recharacterization laws to show that enhanced creditor rights lead to economically significant increases in dividend payments. This impact is more pronounced for firms that are financially constrained, poorly governed, informationally opaque, and prone to agency problems. Our detailed loan‐contract results show that stronger creditor rights provide greater access to credit markets, and it is through this channel that firms are able to redirect more funds toward shareholder payouts. Overall, our findings suggest that improving the rights of one stakeholder can create positive spillover effects for other stakeholders.

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.

Do legal institutions governing financial contracts affect the nature of real investments in the economy? We develop a simple model and provide evidence that the answer to this question is yes. We consider a levered firm's choice of investment between innovative and conservative technologies, on the one hand, and of financing between debt and equity, on the other. Bankruptcy code plays a central role in these choices by determining whether the firm is continued or liquidated in case of financial distress. When the code is creditor-friendly, excessive liquidations cause the firm to shy away from innovation. In contrast, by promoting continuation upon failure, a debtor-friendly code induces greater innovation. This effect remains robust when the firm attempts to sustain innovation by reducing its debt under creditor-friendly codes. Employing patents as a proxy for innovation, we find support for the real as well as the financial implications of the model: (1) In countries with weaker creditor rights, technologically innovative industries create disproportionately more patents and generate disproportionately more citations to these patents relative to other industries; (2) This difference of difference result is further confirmed by within-country analysis that exploits time-series changes in creditor rights, suggesting a causal effect of bankruptcy codes on innovation; (3) When creditor rights are stronger, innovative industries employ relatively less leverage compared to other industries; and (4) In countries with weaker creditor rights, technologically innovative industries grow disproportionately faster compared to other industries. Finally, while overall financial development fosters innovation, stronger creditor rights weaken this effect, especially for highly innovative industries.

We examine related party (RP) transactions using agency and contracting theory as guides. Agency theory suggests opportunistic behavior can generate RP transactions; however, RP transactions can also result from or be managed via contracting. We therefore investigate associations between RP transactions and compensation-based incentives, monitoring mechanisms, and links to executive compensation for a sample of 1,261 firms. We find RP transactions are associated with weaker corporate governance, CEO stock options, and inversely associated with CEO and director's cash compensation. In a direct analysis of CEO compensation, we find a positive association between unexpected CEO compensation and RP transactions with companies the firm partially owns (i.e. investments) suggesting that CEO's are compensated for running more complex organizations. Finally, we examine returns in the period following RP disclosure. The results suggest lower future returns for simple RP transactions involving directors, officers and major shareholders. However, future returns are marginally higher for companies engaged in RP transaction with investments. Our compensation and returns analyses suggest related party transactions with investments appear to be associated with efficient contracting, while simple transactions with directors, officers and shareholders are associated with opportunism.

ABSTRACTThis study investigates whether an increase in the costs associated with related party transactions (RPTs) for controlling owners affects the volume of such transactions. We exploit the implementation of the Insolvency and Bankruptcy Code (IBC) in India in 2016 as a quasi‐natural experiment that likely raised the costs of engaging in RPTs by strengthening creditor rights. Using a difference‐in‐differences design, we find that the enhanced enforcement environment following the IBC led to a significant decline in RPT activity by controlling shareholders. This decline is primarily driven by a reduction in opportunistic RPTs. Furthermore, the average market reaction to the IBC implementation is more pronounced for firms with higher pre‐reform levels of opportunistic RPTs, consistent with investors valuing the curtailment of tunneling behavior.

We analyze the link between creditor rights and firms’ investment policies, proposing that stronger creditor rights in bankruptcy reduce corporate risk-taking. In cross-country analysis, we find that stronger creditor rights induce greater propensity of firms to engage in diversifying acquisitions, which result in poorer operating and stock-market abnormal performance. In countries with strong creditor rights, firms also have lower cash flow risk and lower leverage, and there is greater propensity of firms with low-recovery assets to acquire targets with high-recovery assets. These relationships are strongest in countries where management is dismissed in reorganization, and are observed in time-series analysis around changes in creditor rights. Our results question the value of strong creditor rights as they have an adverse effect on firms by inhibiting management from undertaking risky investments.