Firms capital structure and the bankruptcy law design Bruno Funchal and Mateus Clovis FUCAPE Business School, Vitória, Brazil

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1 The current issue and full text archive of this journal is available at JFEP 1,3 264 Firms capital structure and the bankruptcy law design Bruno Funchal and Mateus Clovis FUCAPE Business School, Vitória, Brazil Abstract Purpose The purpose of this paper is to study the effect of changes in creditors priority defined by the bankruptcy law on firms capital structure. Design/methodology/approach Taking advantage of the Brazilian bankruptcy law reform as an experiment and using publicly traded firms balance sheet data, it compares Brazilian firms capital structure before and after the new law, using fixed-effects panel regression. The empirical results are in line with theories that predict the effects on the capital structure due to changes in creditors expectations. Findings This paper finds evidence of an increase in the debt portion of the capital structure. Originality/value The paper contributes the law and finance empirical literature, pointing out that change in creditors protection induces significant changes in the firms financing policy. Keywords Capital structure, Bankruptcy, Government policy, Regulation, Law, Brazil Paper type Research paper Journal of Financial Economic Policy Vol. 1 No. 3, 2009 pp q Emerald Group Publishing Limited DOI / I. Introduction The goal of this paper is to study the impact of institutional changes more specifically changes in the bankruptcy law on firms financing choices, in other words, their capital structure. Since, the seminal paper of Modigliani and Miller (1958), scholars have discussed the capital structure choice. The most important departures from Modigliani and Miller s assumptions that make capital structure relevant to a firm s value are known. Empirical studies have reported some stylized facts on capital structure choice, but this evidence is largely based on firms in the USA (Titman and Wessels, 1988), and it is not at all clear how these facts relate to different economic environments. Hence, one cannot only rely on existing findings in economics and corporate finance, because countries differ in their economic environments. In the empirical field, Booth et al. (2001), using data from developing countries, studied the stylized facts about capital structure beyond the developed countries. They found that the variables relevant to explain capital structure in the USA and Europe are also relevant in developing countries, despite the differences in institutional factors. Rajan and Zingales (1995) analyzed factors that influence the capital structure, including the institutional differences, across the G-7 countries. Our paper focuses on one particular institution: the bankruptcy law. We analyze how relevant creditors priority is for the firms capital structure, especially in an institutional setting that provides a low level of creditors protection. We base this analysis on the 2005 Brazilian bankruptcy law reform. Scott (1977) theoretically addressed the relationship between capital structure and bankruptcy. He argued that when firms sell secured debt, they are not only selling a JEL classification G32, G33, G38, K00

2 promise of future repayment, but also rather the right to be the first in order of priority in case of bankruptcy. Thus, the priority order defined by the bankruptcy law has a significant value since it reduces the chance that debtors will not be repaid. This value impacts the debt cost of debt and as a consequence the capital structure. Taking advantage of the 2005 Brazilian bankruptcy law reform as an experiment, this paper measures the impact of changes in the design of the bankruptcy law, mainly due to the abrupt change in creditors priority, on firms choice of capital structure. Intuitively, since the new bankruptcy law has improved creditors priority, their expectations about recovery in insolvency states should increase. The more creditors expect to receive in bankruptcy, the less they will require firms to pay in solvency, thus reducing the cost of capital. A lower cost of debt financing encourages firms to increase the share of debt in their capital structure. By estimating an econometric model (panel with fixed effects) to measure the effect of the changes in creditors priority order on firm-level capital structure, we find an increase of approximately 8.4 percent, on average, of the share of debt in the capital structure. This effect is divided into increases of 3.6 and 4.8 percent in the share of shortand long-term debt, respectively. Moreover, during the studied period, Brazil was experiencing a period of high appreciation in its capital markets, making equity financing more attractive. This feature reinforces the effect of bankruptcy reform on the share of debt. This result suggests that reforms of the bankruptcy law design that modify the priority of stakeholders have a significant impact on firms financing policy. Therefore, policy makers should keep in mind that by improving creditors priority, the cost of debt will be reduced, making firms less credit constrained and motivating an increase in their share of debt in the capital structure. The remainder of the paper is organized as follows: Section II discusses the Brazilian bankruptcy reform and its potential effects; Section III presents the empirical results; and Section IV concludes. Firms capital structure 265 II. The Brazilian bankruptcy law reform The former legal framework for corporate insolvency in Brazil was very fragmented, with the core of legislation for bankruptcy proceedings enacted in Despite providing both liquidation and reorganization mechanisms to prevent or reduce the liquidation of enterprises, in practice, the insolvency process was ineffective at maximizing asset values and protecting creditor rights in liquidation. The bankruptcy priority rule specified the following priority order: first, labor claims; second, tax claims; third, secured creditors claims; and finally, unsecured creditors claims (including trade credit). The process of disposing of assets was also slow and highly ineffective, because of court and procedural inefficiency, lack of transparency, and the so-called problema da sucessão, whereby tax, labor, and other liabilities were transferred to the buyer of a liquidated asset sold in liquidation, which deteriorated the market value of an insolvent company s assets. In addition, the priority given to labor and tax claims had the practical effect of eliminating any protection to other creditors. The former reorganization procedure (called concordata) was a process that postponed debt payment only and did not deal with firms restructuring. On June 9, 2005, the new legislation on bankruptcy (Law 11,101/05) took effect. The new liquidation procedure introduced six key changes. First, labor credits are limited

3 JFEP 1,3 266 to an amount equaling 150 times the minimum monthly wage[1]. Second, secured credits are now given priority over tax credits. Third, unsecured credits are given priority above some of the tax credits. Fourth, the distressed firm may be sold (preferably as a whole) before the creditors list is constituted, which can speed up the process and increase the value of the bankruptcy estate. Fifth, tax, labor, and other liabilities are no longer transferred to the buyer of an asset sold in liquidation. Finally, any new credit extended during the reorganization process is given first priority in the event of liquidation. The first two changes have had a direct impact on secured creditors priority. Since under the former bankruptcy law, secured creditors came after all labor and tax claims, the priority given to secured creditors has increased significantly. The third one has increased unsecured creditors priority. The fourth, fifth, and sixth changes, in turn, are expected to increase the value of firms in bankruptcy and as a consequence the amount recovered by creditors. The more creditors expect to receive in the insolvency state, the less they will require firms to pay in the solvency state, thus reducing the cost of capital. Brazil s new reorganization procedure was inspired by Chapter 11 in the US bankruptcy code. Whereas the previous law did not permit any renegotiation between the interested parties and only a few parties were entitled to recover their assets, now managers make a sweeping proposal for recuperation that must either be accepted by workers, secured creditors and unsecured creditors (including trade creditors) or the distressed firm will be liquidated. Creditors play a more significant role in the procedure than previously, including negotiating and voting for the reorganization plan. Table I summarizes the main changes in the Brazilian bankruptcy law. Some data on creditors recovery rate will help to illustrate the main effects of the bankruptcy law reform. Before the reform, the recovery rate in the case of bankruptcy was a mere US$0.002 on the dollar in Brazil, while the average of Latin American and Organization for Economic Cooperation and Development (OECD) countries was US$0.27 and 0.66, respectively[2]. Basically, the reason for such low recovery was the priority order, since creditors ranked behind labor and tax claims. Thus, the remaining amount from the bankruptcy process used to pay creditors was usually insignificant or nil. New law Former law Table I. The main changes in the Brazilian bankruptcy law Liquidation Priority order Secured creditors Unsecured creditors Liabilities Reorganization Postbankruptcy credit Role of creditors Second in the priority order: after labor claims limited to 150 minimum monthly wages Fourth in the priority order: after labor, secured creditors, and some tax claims Tax, labor, and other liabilities are no longer transferred to the buyer of an asset sold in liquidation First to receive if the firm goes to liquidation Creditors negotiate and vote for the reorganization plan Third in the priority order: after labor and tax claims Fourth in the priority order: after labor, secured creditors, and tax claims Tax, labor, and other liabilities were transferred to the buyer of a liquidated property sold in liquidation Third to receive if the firm goes to liquidation, after labor and tax claims None

4 As a consequence, of the bankruptcy reform, in 2006 creditors recovery rate increased to US$0.12 on the dollar in Brazil, while the average of Latin American and OECD countries remained stable (US$0.29 and 0.67, respectively)[3]. The effects on debt financing: a simple model The relationship between the bankruptcy design and its effects on cost of capital can be illustrated using a simple model. Suppose that:. H1 the borrowing firm is run by an owner/manager;. H2 capital markets are competitive;. H3 creditors can predict their mean pay-offs in the default state; and. H4 creditors and the firm are risk-neutral. Firms capital structure 267 We make the first assumption because we are not dealing with the corporate governance problem. The second assumption is realistic. The third rests on the view that professional creditors have considerable experience with default, and the fourth is more accurate when applied to firms than to individual persons. The borrowing firm has a project that requires capital, I, which the firm must raise externally. The firm promises to repay creditors the sum, F (where F ¼ Ið1 þ rþ). The project can return a value, v, where the firm is solvent if v $ F and insolvent if v, F.Two states of nature are possible in the future, one if the firm is solvent and the other if it is not. The solvency and insolvency states return to the firm v solv and v ins, respectively, where v solv $ F. v ins. The probability of solvency is p solv ; the probability of insolvency is ð1 2 p solv Þ. This implies that the expected value of the project is EðvÞ ¼p solv v solv þð1 2 p solv Þv ins. The bankruptcy system costs c to run. A bankruptcy system can thus distribute to the creditors of an insolvent firm at most the sum v ins 2 c, so the repayment to creditors is F if the firm is solvent and v ins 2 c if it goes bankrupt and if creditors are the first to receive in the priority rule. Because the credit market is competitive, F is the largest sum that creditors can demand to fund the project. For simplicity, the risk-free interest rate is assumed to be zero, so that a borrowing firm s interest rate is a function only of the riskiness of its project and the properties of the bankruptcy system in place. Creditors that lend I should expect to receive I in return. This expectation can be written as follows: I ¼ p solv F þð1 2 p solv Þðv ins 2 cþ F ¼ I 2 ð1 2 p solvþðv ins 2 cþ : p solv If the bankruptcy law decrees, the priority of tax (t) and/or labor (l ) claims over secured creditors claims, creditors will receive the maximum between the zero and ðv ins 2 c 2 l 2 tþ. Then, the financing condition for creditors is: I ¼ p solv F þð1 2 p solv Þmaxðv ins 2 c 2 l 2 t; 0Þ: Notice that creditors insolvency recovery may fall to zero in this situation, which would strongly increase the cost of capital, and therefore, an improvement in creditors priority raises their recovery rate, as occurred in Brazil right after the new law went into force.

5 JFEP 1,3 268 If the expected value that creditors recover in insolvency states increases (that is, maxðv ins 2 c 2 l 2 t; 0Þ rises to maxðv ins 2 c 2 l; 0Þ, where l is the labor claims limited to 150 times the monthly minimum wage), then F declines, diminishing the interest rate charged by creditors. The more that creditors expect to receive in the insolvency state, the less they will require the firm to repay in the solvency state. The firm s interest rate is r ¼ðF=IÞ 2 1, which is increasing in F. Denoting by v u ins, c u and l u the per-unit-of-investment (I ¼ 1) counterparts of v ins, c and l, we also have: r ¼ ð1 2 p solvþ 1 2 max v u ins p 2 c u 2 l u ; 0 ; solv which is decreasing in recovery rate in insolvency states: P1. The priority of creditors claims over labor and/or tax claims decreases the cost of capital. Therefore, the increase in recovery rate is a natural consequence of an improvement in creditors priority, as evidenced in Brazil. Figure 1, which presents the evolution in creditors recovery rate, shows an abrupt increase in this rate after the reform. Since the new law took effect in June 2005, all the procedures thereafter have followed the new rule, increasing the recovery rate from 0.2 on the dollar in 2004 to 12, 14 and 17 on the dollar in 2006, 2007, and 2008, respectively. As expected by P1, there was a reduction in the cost of debt to Brazilian firms (Figure 2). Notice that the downward trend starts just after the Brazilian bankruptcy reform, and, therefore, ceteris paribus, more projects tend to be financed using debt instead of equity. III. Empirical results In this paper, we used firm-specific accounting data[4] for 389 publicly traded firms from 2002 to 2007[5]. We considered as firm share of debt in the capital structure[6], the sum of short-term debt, long-term debt, and accounts payable[7] divided by the firm value (total debt plus market value). We also separately analyzed the effect on the short-term debt share (short-term debt plus accounts payable divided by the firm value) and long-term debt share (long-term debt divided by firm value), used as proxies of unsecured and secured debt, respectively. Since the priority changes differently for secured and unsecured creditors, we expect different effects on both types of credit. Figure 1. Evolution of creditors recovery rate 20 Creditors recovery rate Source: Doing business World Bank Cents on the dollar

6 Interest rate Source: Brazilian central bank Firms cost of debt Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Table II reports the descriptive statistics of our variable of interest (share of debt in the capital structure). Notice that the share of debt (total, short-term, and long-term) presents a downward trend from the period before to after the bankruptcy reform. The mean of the share of debt went down from 51 percent before the new law to 35 percent afterward, which means in relative terms a reduction of 31 percent of debt in the capital structure (16 percent of 51 percent). This downward trend is somewhat unexpected. We observe in the descriptive statistics, for the pre- and post-bankruptcy reform period, a reduction in the share of debt, although we expect a contrary tendency due to a reduction in the cost of capital (P1). The explanation for this trend is the significant increase of the market value of Brazilian firms, and since the market value is used to measure the share of debt (total debt divided by the firm value, where the firm value is total debt plus market value), this increase directly affected our capital structure metric. Figure 3 shows that the level of the São Paulo Stock Market Index (IBOVESPA) fluctuated between 9,000 and 25,000 points from 2002 to 2004, while it fluctuated between 25,000 and 65,000 points in This trend encouraged firms to finance themselves by issuing equity, reducing the portion of debt in the capital structure. Firms capital structure 269 Figure 2. Evolution of firms cost of debt Mean SD Before the bankruptcy law reform ( ) Total debt Short-term debt Long-term debt After the bankruptcy law reform ( ) Total debt Short-term debt Long-term debt All period ( ) Total debt Short-term debt Long-term debt Table II. Descriptive statistics share of debt

7 JFEP 1,3 270 Points 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 IBOVESPA Figure 3. São Paulo Stock Market Index (IBOVESPA) Source: Economatica Period Thus, two important issues must be observed: first, it is important to set the São Paulo Stock Market Index (in logs) as a control for the capital market trend in our empirical model; second, the Brazilian economic environment provides a unique characteristic for this research, since the reform was enacted in a period where equity financing was very attractive, reinforcing the potential impact of the bankruptcy reform on debt share in the capital structure. In addition, the São Paulo Stock Exchange, we used as control variables the amount of firms assets in thousands of Brazilian Reais[8] (logarithm) and macroeconomic data, such as the logarithm of the real gross domestic product (GDP) in millions of Brazilian Reais (logarithm), inflation index[9], risk-free interest rate (SELIC and the benchmark rate) and Brazilian global bonds in basis points. The GDP variable was used to control our estimation for business cycles. The inflation and the risk-free interest rates were included to control for the trend of prices and the risk-free component of the cost of debt, respectively, common to all firms, and the Brazilian Global Bonds to control for the risk perception of investors. The data were obtained from both the Economatica and Ipeadata databases ( Table III summarizes the descriptive statistics of all control variables. To estimate the impact of changes in creditors priority brought by the new Brazilian bankruptcy law on firms share of debt (total, short-term, and long-term), we used a panel regression with cross-firm fixed effects, represented by the following functional form: share_debt it ¼ a i þ g 1 d_br t þ GX it þ 1 it : The main results come from the bankruptcy law reform dummy (d_br), which assumes zero for the pre-reform period ( ) and one for the post-reform period ( ). The set of controls is represented by the vector X it. The results of regression (1) reported in Table IV indicate that the bankruptcy law reform had a significant impact on the capital structure[10],[11]. Panels A-C show that due to the bankruptcy reform, firms increased their share of debt by 8.4 percent, of which 3.6 percent represents short-term debt and 4.8 percent long-term debt. In relative terms, the share of total debt went up approximately 17 percent (8.4 percent of 51 percent), while the share of long-term debt increased 25 percent and the short-term debt only 11 percent. This empirical result is aligned with our theoretical predictions. Intuitively, the improvement in creditors priority reduces their risk of not getting repaid, making debt ð1þ

8 Mean Before the bankruptcy law reform ( ) GDP (logarithm) INFLATION (index) SELIC (%) GB (index) IBOV (index) 15,755 4,260 ASSETS (logarithm) After the bankruptcy law reform ( ) GDP (logarithm) INFLATION (index) SELIC (%) GB (index) IBOV (index) 40,428 12,188 ASSETS (logarithm) All period ( ) GDP (logarithm) INFLATION (index) SELIC (%) GB (index) IBOV (index) 28,320 15,351 ASSETS (logarithm) SD Firms capital structure 271 Table III. Descriptive statistics control variables financing cheaper and as a consequence, motivating firms to resort to debt. Thus, despite the downward trend of debt financing (as seen in Table II), the bankruptcy reform induced an increase of the share of debt in the capital structure. But why do we observe a stronger effect on long-term debt compared with short-term debt? This can be explained by the difference in the change of priorities to secured debtors and unsecured creditors. The Brazilian reform benefits secured creditors more than unsecured ones because they have passed to second in priority, just after labor claims (limited to 150 times the minimum monthly wage) (Table I). To better understand the capital structure choice, now we explore firms heterogeneous responses to the bankruptcy reform. We study firms capital structure choice as a function of their relative size, using total assets (logarithm) as a measure of firms size. Firms with more assets should be less sensitive to the reform since they can finance themselves by debt more easily using their assets as collateral. To analyze heterogeneity, we add one term in regression (1): share_debt it ¼ a i þ g 1 d_br t þ g 2 ðd_br t ASSETS it ÞþGX it þ 1 it ; where the interaction of the bankruptcy reform dummy and the logarithm of firm assets (d_br ASSETS) captures the firm-size effect. Table V presents the results[10],[11]. Panels A and C show that the bankruptcy reform provided an increase in the debt portion, which is stronger for smaller firms, since the interacted variable d_br ASSETS has a negative sign. This impact is significant for the share of total and long-term debt. However, the result is not the same for short-term debt alone (Panel B). Since such debt does not require collateral, it is also expected that the amount of assets should not affect unsecured debt financing. ð2þ

9 JFEP 1,3 272 Table IV. Panel regression with fixed effects: share of debt Coefficient Robust SE p-value Panel A: dependent variable: total debt Intercept d_br ASSETS GDP GB SELIC IBOV Number of observations: 1,541, R 2 : 0.106, F-statistic: Panel B: dependent variable: short-term debt Intercept d_br ASSETS GDP GB SELIC IBOV Number of observations: 1,541, R 2 : 0.037, F-statistic: Panel C: dependent variable: long-term debt Intercept d_br ASSETS GDP GB SELIC IBOV Number of observations: 1,541, R 2 : 0.093, F-statistic: Notes: This table presents the results of panel robust regressions, with fixed effects, of the firms share of debt on bankruptcy reform variable (d_br), which is represented by a dummy variable codified as 0 before 2005 and 1 after 2005; Panel A presents results for total debt share, while Panels B and C present results partitioning by short- and long-term debt share; we control for the logarithm of firms assets (ASSETS) and for macroeconomic variables as the logarithm of GDP, Brazilian risk-free interest rate (SELIC), the logarithm of São Paulo Stock Market Index (IBOV) and Brazilian Global Bonds in hundreds of points (GB) Figures 4 and 5 show the heterogeneous effect of the Brazilian bankruptcy law reform. Computing the reform effect stratified by quartiles[12], we observe that it is stronger for firms that hold lower amounts of assets. The share of total and long-term debt increases almost 15 and 12 percent, respectively, for the smaller firms, while it increases only 6 and 2 percent, respectively, for bigger firms. Therefore, we can conclude that although the change in bankruptcy law design has had a significant effect on firms financing policy, it has had more relevance and benefits for smaller firms. IV. Conclusion The main goal of this paper was to study the impact of changes in creditors priority order on firms capital structure. To measure this effect, we took advantage of the recent

10 Coefficient Robust SE p-value Panel A: dependent variable: total debt Intercept d_br d_br*assets ASSETS GDP GB SELIC IBOV Number of observations: 1,541, R 2 : 0.144, F-statistic: Panel B: dependent variable: short-term debt Intercept d_br d_br*assets ASSETS GDP GB SELIC IBOV Number of observations: 1,541, R 2 : 0.032, F-statistic: Panel C: dependent variable: long-term debt Intercept d_br d_br*assets ASSETS GDP GB SELIC IBOV Number of observations: 1,541, R 2 : 0.097, F-statistic: Notes: This table presents the results of panel robust regressions, with fixed effects, of the firms share of debt on bankruptcy reform variable (d_br), which is represented by a dummy variable codified as 0 before 2005 and 1 after 2005; Panel A presents results for total debt share, while Panels B and C present results partitioning by short- and long-term debt share; we control for the logarithm of firms assets (ASSETS) and for macroeconomic variables as the logarithm of GDP, Brazilian risk-free interest rate (SELIC), the logarithm of São Paulo Stock Market Index (IBOV) and Brazilian Global Bonds in hundreds of points (GB) Firms capital structure 273 Table V. Panel regression with fixed effects: heterogeneous effect on share of debt Brazilian bankruptcy law reform, whose main change is the improvement of secured and unsecured creditors priority. Using data from firms balance-sheets and despite the trend for a fall in the share of debt in the capital structure during , we found that the reform has brought an increase of 8.4 percent, on average, of the debt share. This effect is divided into respective increases of 3.6 and 4.8 percent in the short-term and long-term debt share. This is explained by the improvement in creditors priority, since this reduces the chance of not being repaid, decreasing the cost of debt and as a result motivating firms to resort to debt funding. We can also conclude that the bankruptcy law reform had a different effect on firms financing policy depending on firm size, benefiting smaller firms more.

11 JFEP 1,3 274 Figure 4. Bankruptcy law effect on the share of total debt Share of total debt variation Min Max Assets percentile 0.12 Share of long-term debt variation Figure 5. Bankruptcy law effect on the share of long-term debt 0 Min Max Assets percentile Notes 1. Brazil has a minimum monthly wage, called the salário mínimo, rather than a minimum hourly wage. 2. Doing Business 2005 World Bank. 3. Doing Business 2007 World Bank. 4. Brazilian firms follow Brazilian Generally Accepted Accounting Principles in their financial reports. 5. Our study excludes all financial firms, since the reform did not apply to them. 6. The end of the fiscal year. 7. We add accounts payable since trade credit is a relevant source of firms financing (see Love et al. (2007) and Nilsen (2002) for more details), and they were directly benefited by the reform.

12 8. Brazilian Reais is the national currency. 9. Base year Inflation was dropped due to multicollinearity. 11. Since the residuals in all regressions are heteroskedastic, we use robust standard errors in all specifications. 12. The effect is calculated in the following way: ^g 1 þ g^ 2 ASSETS Quartile : Firms capital structure 275 References Booth, L., Aivazian, V., Dermirguc-Kunt, A. and Maskimovic, V. (2001), Capital structure in developing countries, The Journal of Finance, Vol. 56, pp Love, I., Preve, L.A. and Sarria-Alende, V. (2007), Trade credit and bank credit: evidence from recent financial crises, Journal of Financial Economics, Vol. 83, pp Modigliani, F. and Miller, M.H. (1958), The cost of capital, corporation finance, and the theory of investment, American Economic Review, Vol. 48, pp Nilsen, J.H. (2002), Trade credit and the bank lending channel, Journal of Money, Credit, and Banking, Vol. 34, pp Rajan, R. and Zingales, L. (1995), What do we know about capital structure? Some evidence from international data, Journal of Finance, Vol. 50, pp Scott, J.H. Jr (1977), Bankruptcy, secured debt, and optimal capital structure, The Journal of Finance, Vol. 32, pp Titman, S. and Wessels, R. (1988), The determinants of capital structure choice, Journal of Finance, Vol. 48, pp About the authors Bruno Funchal did his PhD in Economics at the Getúlio Vargas Foundation, Brazil. He finished his post-doc in Mathematical Economics at the National Institute of Pure and Applied Mathematics, Brazil and is a Full Professor at the FUCAPE Business School. Bruno Funchal is the corresponding author and can be contacted at: bfunchal@fucape.br Mateus Clovis is a Master in Accounting at the FUCAPE Business School. To purchase reprints of this article please reprints@emeraldinsight.com Or visit our web site for further details:

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