The Effect of Creditor Rights on Corporate Leverage and Investments: The Role of the Firm Type

Abstract

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.