Chen, Li and Shen, ‘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 this legislative change leads 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 take more risk, increase payout through stock repurchase, and reduce capital investment and equity issuance. Collectively, these results suggest that the reduced litigation risk exacerbates the borrower-lender agency conflicts.

Chen, Zhihong and Li, Ningzhong and Shen, Jianghua, Litigation Risk and Debt Contracting: Evidence from a Natural Experiment (February 19, 2020). Journal of Law and Economics, forthcoming.

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