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Litigation Risk and Debt Contracting: Evidence from a Natural Experiment

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  • Zhihong Chen
  • Ningzhong Li
  • Jianghua Shen

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.

Suggested Citation

  • Zhihong Chen & Ningzhong Li & Jianghua Shen, 2020. "Litigation Risk and Debt Contracting: Evidence from a Natural Experiment," Journal of Law and Economics, University of Chicago Press, vol. 63(4), pages 595-630.
    • Handle: RePEc:ucp:jlawec:doi:10.1086/708735
    DOI: 10.1086/708735
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    Cited by:

    1. Delis, Manthos D. & Hasan, Iftekhar & To, Thomas Y. & Wu, Eliza, 2024. "The bright side of bank lobbying: Evidence from the corporate loan market," Journal of Corporate Finance, Elsevier, vol. 86(C).
    2. Sandvik, Jason, 2020. "Board monitoring, director connections, and credit quality☆," Journal of Corporate Finance, Elsevier, vol. 65(C).
    3. Maren Forier & Nadine Lybaert & Maarten Corten & Niels Appermont & Tensie Steijvers, 2023. "The flip side of the coin: how entrepreneurship-oriented insolvency laws can complicate access to debt financing for growth firms," European Journal of Law and Economics, Springer, vol. 56(3), pages 461-495, December.

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