Litigation Risk and Debt Contracting: Evidence from a Natural Experiment

Abstract

In June 2001, Nevada changed its state corporate law by substantially reducing the legal liability of directors and officers for breaching fiduciary duties owed to the corporation. We examine the impact of the reduced litigation risk caused by this legislative change on Nevada-incorporated firms’ loan contract terms and related borrower-lender agency conflicts. Using a difference-in-differences analysis, we find that the legislative change led to less favorable loan contract terms for Nevada-incorporated firms: higher spread and more restrictive covenants. In addition, after the legislative change, Nevada-incorporated firms with severe borrower-lender agency conflicts took more risk, increased payout through stock repurchase, and reduced capital investment and equity issuance. Collectively, these results suggest that the reduced litigation risk exacerbates the borrower-lender agency conflicts.