Can Bankruptcy Laws Mitigate Business Cycles? Evidence from. Creditor Rights, Debt Financing, and Investment

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1 Can Bankruptcy Laws Mitigate Business Cycles? Evidence from Creditor Rights, Debt Financing, and Investment Yaxuan Qi, Lukas Roth, and John K. Wald * October 23, 2013 Abstract We examine how legal creditor rights affect investment and financing over the business cycle. Using firm-level data from 40 countries, we find that creditor rights play an important role in increasing investment and debt financing during economic downturns, but have little impact during expansions. We also find that the negative relation between creditor rights and the cost of debt is concentrated during recessions. The beneficial effects of creditor rights are stronger for firms that are more likely to have severe shareholder-bondholder agency problems. Overall, the results suggest that better creditor protection laws help moderate the decline in investment and debt financing during recessions. Keywords: Business Cycles, Agency Costs, Creditor Rights, Investment, Debt Financing JEL Codes: E02, E32, F44, G31, G32 * Yaxuan Qi is at the City University of Hong Kong, yaxuanqi@cityu.edu.hk; Lukas Roth is at the University of Alberta, lukas.roth@ualberta.ca; and John K. Wald is at the University of Texas at San Antonio, john.wald@utsa.edu. We thank Christopher James, David McLean, Todd Mitton, David Reeb, Philip Valta, Andrey Ukhov, Mengxin Zhao, and seminar participants at the City University of Hong Kong, Rensselaer Polytechnic Institute, and Texas State University for helpful suggestions. We are grateful to the Social Sciences and Humanities Research Council of Canada for financial support. 1

2 1. Introduction Fluctuations in investment are an important driver of business cycles. 1 Specifically, the biggest source of variation in GDP is changes in gross investment, and the biggest source of fluctuations in gross investment is business capital investment. By better understanding the determinants that impact corporate investment across the business cycle, we aim to identify which factors can moderate the decline in lending and investment during recessions. Specifically, we identify creditor rights as one mechanism which can reduce agency problems in recessions and therefore mitigate the decline in debt financing and investment which follows a negative economic shock. A substantial theoretical literature (Bernanke and Gertler, 1989; Carlstrom and Fuerst, 1997; and Kiyotaki and Moore, 1997) considers how agency problems can amplify economic shocks and consequently worsen economic contractions. In these models, during economic downturns, firms net worth deteriorates and the cost of state verification (Townsend, 1979) soars. This exacerbates frictions in the external capital markets and leads to an increase in the expected agency costs between borrowers and lenders, making it more difficult for firms to raise capital for their investments. Thus, economic downturns deteriorate net worth, increase agency costs, and decrease investment, which further amplifies the recession. This theoretical literature suggests that if a particular institutional factor can mitigate agency costs, firms subject to these better institutions will suffer a smaller decrease in debt financing and investment during recessions. We focus on creditor protection laws as a prior literature shows that stronger creditor protection is associated with greater availability of credit, a lower cost of debt, and a longer debt 1 For instance, Krugman and Wells (2012, p. 753) write, Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. In fact, most recessions originate as a fall in investment spending. 2

3 maturity (see Djankov, McLiesh, and Shleifer, 2007; Qian and Strahan, 2007; and Bae and Goyal, 2009). Thus, we hypothesize that stronger creditor protection laws mitigate agency problems during recessions, and that these laws allow for greater credit availability during economic downturns. 2 Moreover, the existing theory suggests that the relation between creditor protection and investment and debt financing will be strongest for firms with high expected agency costs. Our study is also broadly related to the literature which shows that legal investor protection contributes to financial market development and economic growth by improving firms access to external financing (see, e.g., La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 1997, 1998; Demirguc-Kunt and Maksimovic, 1998, 1999; and Castro, Clementi, and MacDonald, 2004). However, this existing literature does not examine whether the effects of legal investor protections differ over the business cycle. Thus, to our knowledge, this is the first paper to examine the differential impact of legal institutions, and specifically creditor protections, over the business cycle. Our primary analysis is a firm-level study for a large sample of firms from 40 countries during expansions and recessions. We define a time period as including a recession if any two consecutive quarterly real GDP growth rates were negative during the year. Alternatively, we use the real GDP annual growth rate during the year as a proxy for macroeconomic conditions. To measure creditor protection in a country we use the creditor rights index obtained from 2 An alternative possibility is that weaker creditor protection laws may be associated with greater investment during recessions, as countries with weak creditor rights favor debt forgiveness. This debt forgiveness could lead to greater risk taking by firms and thus greater investment. Such a finding would be consistent with Acharya and Subramanian (2009), who show that greater creditor rights imply lower innovation, and Acharya, Amihud, and Litov (2011) who find reduced risk-taking for companies in greater creditor rights regimes. 3

4 Djankov, McLiesh, and Shleifer (2007). This index is compiled for each year from 1978 to 2003 and ranges from zero to four with higher scores corresponding to stronger creditor protection. We consider how debt financing changes during recessions with differences in creditor rights, and we find that greater creditor rights are associated with a significant increase in debt financing during recessions. However, creditor rights are not significantly associated with debt financing during expansions. A one unit increase in creditor rights implies 52% greater debt financing as a fraction of total assets during recessions. Additionally, we consider the relation between creditor rights and the cost of debt during recessions and expansions. We find that the negative relation between creditor rights and debt yields primarily holds during recessions. Thus, better creditor rights help firms to access debt markets in recessions, and this suggests a greater potential investment for firms in stronger creditor protection countries during economic downturns. Existing papers (Qian and Strahan, 2007; and Bae and Goyal, 2009) show that the cost of debt is lower for companies in high creditor rights regimes. We show that these relations are more pronounced during recessions. Thus, consistent with our other results, bond yields increase less during recessions for firms in countries with strong creditor protection, suggesting that strong creditor rights moderate bond yield variations over the business cycle. We also examine the relation between creditor rights and firm investment over the business cycle, and we find that stronger creditor rights are positively associated with investment in recessions but not significantly related to investment during expansions. Comparing recessions to expansions, a one unit increase in creditor rights implies an increase of 7.6% in capital expenditures as a fraction of total assets during recessions. This finding supports the notion that 4

5 creditor rights help mitigate the increased agency problems which occur during recessions, and that the economic magnitude of this effect is sizable. 3 If creditor rights matter during recessions because of increased agency costs, then we expect that firms with larger expected agency problems will be more impacted by differences in creditor protection laws. To test this proposition, we split the sample into firms which are expected to have more or fewer agency problems, and we proxy for expected agency problems using firm leverage and revenue. 4 Repeating our analysis for these subsamples, we find that the impact of creditor rights in recessions is more pronounced for firms with more severe expected agency conflicts. These empirical tests are consistent with an increase in agency conflicts between bondholders and stockholders during recessions. To further examine whether the agency cost of debt indeed increases in recessions, we graphically examine the use of bond covenants in corporate bonds during recessions and expansions. 5 Bond covenants are used to mitigate agency problems, and firms with greater bondholder-shareholder agency problems are more likely to use bond covenants. 6 We find that firms with better bond ratings use more covenants during recessions than expansions, whereas firms with very weak bond ratings do not issue debt at all during recessions. These results suggest that agency costs increase during recessions, and that firms with most severe agency problems are shut out of the credit markets during economic downturns altogether. 3 We also examine whether these laws affect equity issuance or cash holdings over the business cycle. We find no effects on either equity or cash holdings. 4 Note that given the theory, we focus on shareholder-bondholder agency problems rather than on managershareholder or majority-minority owner agency issues. As we discuss below, this theory is reflected in the empirical findings. 5 For this analysis, we only use U.S. corporate bonds, as detailed covenant information for non-u.s. bonds is scarce. 6 See, for instance, Smith and Warner (1979), Malitz (1986), Begley and Feltham (1999), Nash, Netter, and Poulsen (2003), Billett, King, and Mauer (2007), and Qi, Roth, and Wald (2011). 5

6 Our study contributes to the literature as follows. First, we show that stronger creditor protection laws imply a smaller decrease in debt financing and investment during recessions. This empirical evidence is consistent with the implications of theoretical models such as Bernanke and Gertler (1989) and others. In sum, our results support the notion that agency costs vary with business cycles, and thus, creditor protection is more important in recessions than in expansions. Second, our study extends the law and finance literature by showing how creditor protection laws influence firms debt financing and investment behavior differently during recessions than expansions. Third, our results complement a recent literature that studies how business cycles affect external financing and firm investment (see, e.g., Erel, Julio, Kim, and Weisbach, 2012; and McLean and Zhao, 2012). These papers along with ours emphasize the importance of considering the impact of macroeconomic conditions in examining corporate behavior. The remainder of the paper proceeds as follows. Section 2 provides a review of the relevant literature and develops our hypotheses. Section 3 discusses the data and methods employed by this study. Section 4 presents the results of our empirical tests, and section 5 concludes. 2. Related Literature and Research Design Our paper is partly motivated by the macroeconomic literature that provides a theory of how agency problems can alter business cycles. Bernanke and Gertler (1989) show that increased agency problems due to deteriorating net worth can lead to higher costs of external finance, decrease the firm s ability to obtain financing, and therefore decrease investment and further deepen the economic contraction. Carlstrom and Fuerst (1997) extend this model to show how 6

7 these dynamics can explain the observed positive autocorrelation in output growth. Additionally, Kiyotaki and Moore (1997) show that if durable assets serve as collateral for loans, a small shock can reduce the ability of firms to get loans. Thus, small temporary shocks can cause large fluctuations in output and prices. Prior empirical tests of this literature primarily focus on the impact of collateral. For instance, Gan (2007) considers how a shock to collateral values of Japanese firms significantly impacts these firms abilities to obtain financing and undertake investment. Benmelech and Bergman (2011) find that a bankruptcy by one airline can significantly reduce the collateral value of other industry participants, thereby impacting the cost of debt financing for other airlines. Kahle and Stulz (2012) consider how the recent financial crisis affects firms investment and financing. They find that collateral and net worth are important in determining investment and financing policies. Chaney, Sraer, and Thesmar (2012) find that shocks to real estate values can have a large impact on U.S. corporate investment. Overall, these empirical findings are consistent with the collateral channel affecting investment as in Kiyotaki and Moore (1997). Related to these studies is Erel et al. (2011), which shows how a firm s financing over the business cycle depends on the firm s credit quality and on macroeconomic conditions. McLean and Zhao (2012) also consider how the relation between the firm s investment, Tobin s q, and cash flows depends on the business cycle, with firms responding more to Tobin s q during expansions and more to cash flows during recessions. While the existing literature emphasizes the importance of collateral, we instead analyze the impact of creditor legal protection on mitigating agency problems over the business cycle. 7

8 Our study is related to a substantial literature that discusses the importance of legal institutions on financial and economic development. Empirical studies in this literature focus on how cross-country differences in laws and institutions affect corporate behavior, financial sectors, and aggregate economic growth. This largely follows works by La Porta et al. (1997, 1998), and Demirguc-Kunt and Maksimovic (1998) who show the importance of legal and institutional factors in explaining the ability of firms to obtain external financing. Djankov, McLiesh, and Shleifer (2007) examine how creditor rights affect development of private credit markets, and Demirguc-Kunt and Maksimovic (1999) study the impact of creditor protection on firms debt maturity structures. Qian and Strahan (2007) and Bae and Goyal (2009) show how greater creditor protection laws imply reductions in the cost of debt capital in private loan contracts. However, Acharya and Subramanian (2009) show that greater creditor rights imply lower innovation, and Acharya, Amihud, and Litov (2011) find reduced risk-taking for companies in greater creditor rights regimes. In contrast to these studies, we examine the differential impact of creditor protection laws over the business cycle on firm debt financing, the cost of debt, and investment. Bernanke and Gertler (1989) suggest that increased agency problems during recessions lower a firm s capacity to access external debt financing, leading to a decline in investment during economic downturns. Thus, the first question we investigate is whether creditor protection laws impact debt financing differently over the business cycle, and therefore whether stronger creditor protection moderates the decline in debt financing in recessions. To address this question, we employ firm-level regressions using data from 40 countries. We regress debt financing on the interaction between a creditor rights index and a variable that measures macroeconomic conditions as well as a set of control variables. If agency problems increase 8

9 during recessions and if creditor protection laws mitigate these agency costs, then the coefficient estimate on the interaction term between creditor protection and macroeconomic conditions should be positive. That is, a positive coefficient estimate suggests that creditor rights have a greater impact on debt financing during recessions than expansions, and that creditor rights help smooth the dynamics of debt financing over the business cycle. Additionally, we extend this analysis by examining whether the cost of debt has a different relation with creditor protection laws over the business cycle. The second question we examine is whether greater creditor protection has a different effect on investment during recessions than expansions, and thus whether creditor rights help moderate investment dynamics over the business cycle. We consider a similar regression at the firm level, regressing the firm s capital expenditures on the interaction between a creditor rights index and a variable that measures macroeconomic conditions as well as a set of control variables. The coefficient estimate on these interaction terms captures the differential effect of creditor rights on investment over the business cycle. A positive coefficient estimate on the interaction term would suggest that better creditor protection has a greater association with investment during economic downturns than upturns. Given that investment is lower during recessions than expansions, a positive coefficient is consistent with greater creditor rights moderating the decline in investment during recessions. In further tests we examine whether the effects of creditor rights in recessions are greater for firms with more severe bondholder-stockholder agency problems. To highlight the effect of creditor protection laws in mitigating increased agency conflicts during recessions, we split our sample into firms with high and low expected agency costs. We re-estimate the firm-level regressions separately for these subsamples. If creditor rights are important in mitigating agency 9

10 conflicts during recessions, we would expect that the coefficient estimate on the interaction term between creditor rights and the macroeconomic variable is greater for the high agency-cost subsamples. 3. Data In this section, we describe our main variables of interest and the selection of controls. Table 1 provides detailed definitions of the variables we employ in this study Investment, Debt Financing, and Firm Characteristics We gather our firm-level variables from international financial statement data using the Worldscope database and corporate bond data from FISD. The dependent variables for our study are the amount of debt financing, the cost of debt, and firm investment. We measure debt financing as the change in total debt from the firm s balance sheet over the fiscal year divided by lagged total assets. Alternatively, we measure debt financing as the difference between longterm debt issuance and repayment divided by lagged total assets. We measure the cost of debt as the logarithm of the yield spread, that is, the yield-to-maturity on the bond less the yield of nearest maturity Treasury bond. We limit the yield spread analysis to fixed coupon bonds only. We measure firm investment as capital expenditures divided by lagged total assets. Alternatively, we measure firm investment as capital expenditures plus R&D expenses divided by lagged total assets; as capital expenditures divided by PPE (property, plant, and equipment); or as the change in total assets divided by lagged total assets. We use a number of firm-level control variables that the literature has shown to be important for our analysis. We measure firm size with the logarithm of total assets. We measure 10

11 Tobin s q as (total assets book value of equity + market value of equity) / total assets. We calculate cash flow as net income plus amortization and depreciation divided by total assets, leverage as the ratio of total debt to total assets, and tangibility as the ratio of PPE to total assets. Total assets, Tobin s q, leverage, and tangibility are lagged one year to mitigate endogeneity concerns. Our key independent variables, the creditor rights index and our measures of recessions, are effectively exogenous as neither is significantly affected by individual firm-level investment or borrowing. We winsorize all variables at the 1% and 99% level to avoid having outliers drive the results. Further, we control for industry fixed effects using the 30 Fama/French industry classifications obtained from Ken French s website Measures of International Business Cycles To examine how business cycles and creditor protection laws impact firm investment policy and financing behavior, we construct business cycle measures for all the countries we consider. Our primary data source to create these measures is the International Financial Statistics (IFS) database from the International Monetary Fund (IMF). We use quarterly GDP data and quarterly GDP deflators to calculate quarterly real GDP growth rates for each country in our sample. 7 We use the seasonally adjusted data series for Australia, Canada, France, Germany, Italy, Japan, Mexico, Netherlands, New Zealand, South Africa, Spain, Switzerland, United Kingdom, and United States. For other countries, IFS does not provide seasonal adjusted quarterly GDP data and we use the X-12-ARIMA approach from the U.S. Census Bureau to adjust the GDP data for seasonality (see Brockman, Liebenberg, and Schutte, 2010). 8 We merge real quarterly GDP growth rates with firm-level data based on a firm s fiscal year end date. We 7 Monthly GDP data is available for a few countries over recent years only. 8 In practice, using unadjusted GDP growth rates to construct the recession variables does not impact our findings. 11

12 define a firm as being subject to a recession if any two consecutive quarterly real GDP growth rates in the country where the firm is domiciled were negative during the firm s fiscal year. Alternatively, instead of using an indicator variable to identify business cycles, we use the annual real GDP growth rate to measure macroeconomic conditions in our tests (see, e.g., Erel et al., 2012) Measures of Legal Institutions We use an index of aggregate creditor rights to measure a country s creditor protection laws. The creditor rights index is time varying and compiled for each year from 1978 to The data are obtained from Djankov, McLiesh, and Shleifer (2007). Starting from a score of zero, the creditor rights index is incremented by one as each of the following requirements is met: (1) there are restrictions, such as creditor consent or minimum dividends, for a debtor to file for reorganization; (2) secured creditors are able to seize their collateral after the reorganization petition is approved, i.e., there is no automatic stay or asset freeze; (3) secured creditors are paid from the proceeds of liquidating a bankrupt firm before other creditors such as the government or workers; and (4) management does not retain administration of its property pending the resolution of the reorganization. The creditor rights index ranges from zero to four with higher scores corresponding to stronger creditor protection. An advantage of the creditor rights index is that it is compiled for each year and thus allows us to have a time-varying measure of creditor protection laws over our sample period. However, this creditor rights index is only available up to Currently, there exists no alternative index that captures creditor rights laws for a large number of countries over an extended time period. One approach is to extrapolate the index for future years using the index 12

13 values of However, as Kadiyala and John (2012) show, a number of countries changed their bankruptcy and creditor protection laws in recent years. Hence, extrapolating the creditor rights index for years after 2003 will not capture these reforms, and this can lead to biases in the analysis post We therefore choose to report our primary results for the 1980 (start of firmlevel data coverage) to 2003 (end of creditor rights data) time period. As a robustness check, we extrapolate the creditor rights scores up to We follow Qian and Strahan (2007) and control for the overall legal environment and investor protection laws by including legal origin dummy variables in our regression. We also control for other determinants of a country s legal institutions to protect creditors in addition to the creditor rights index. Specifically, following Qian and Strahan (2007), we control for legal formalism and legal rights. The legal formalism index is obtained from Djankov et al. (2003) and measures substantive and procedural statutory intervention in judicial cases at lower-level civil trial courts. The index ranges from zero to seven where seven means a higher level of control or intervention in the judicial process. The legal rights index, obtained from World Bank Group s Doing Business Website (see Djankov, McLiesh, and Shleifer, 2007), measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. This index ranges from zero to ten, with higher scores indicating that collateral and bankruptcy laws are better designed to allow access to credit. In contrast to the creditor rights index, none of these other indexes is time-varying. In order to control for the country s initial economic development, we include the logarithm of the per capita GDP in 1980 measured in U.S. dollars. We use the initial GDP per capita in 1980 rather than annual GDP per capita to avoid collinearity between the annual GDP 13

14 growth rate and our recession dummy variable. The GDP data is obtained from the IMF International Financial Statistics database. We exclude financial firms (first SIC-digit of 6) and public administration firms (first SIC-digit of 9) from our sample as measures of investment and debt financing are not easily comparable for these types of firms. Further, we exclude firms with total assets less than $10 million or firms that do not have publicly traded equity. We also require that countries have data for at least three consecutive years in order to better construct business cycle indicators. Our final sample consists of 134,862 firm-year observations covering 18,979 firms across 40 countries. 4. Empirical Results 4.1. Summary Statistics Table 2 provides summary statistics by country. The countries with the most firm-year observations falling in a recession, as measured with our recession dummy, are Argentina (67%), Peru (54%), and Brazil (46%), and the countries with the lowest fraction of firm-year observations during recessions are China, Hungary, Ireland, and Morocco (0%). These latter countries have relatively few firm-year observations, and our results are not driven by these observations. As for the creditor rights variable, this index is widely distributed with a range in value from zero to four, with countries like Colombia, France, Mexico, and Peru having a score of zero and Hong Kong and New Zealand having a score of four. Overall, the U.S. has the most observations, followed by Japan and the U.K. Table 3 provides summary statistics on our sample. Our recession dummy indicates that recessions occur in 16% of firm-year observations, and the average annual real GDP growth rate 14

15 is 3%. Firm-level capital expenditure is on average 7.2% of total assets. Firms increase debt financing by an average of 2.5% of total assets per year. Splitting the sample into periods of recessions and expansions, on average, capital expenditures are 7.3% and 6.4% of total assets in expansions and recessions, respectively. Similarly, debt financing is, on average, 2.7% of total assets in economic upturns and drops to 1.1% during downturns (untabulated). These two differences are statistically significant at the 1% level. Panel B of Table 3 reports correlations between some of the variables of interest. As expected, new debt financing and capital expenditures are negatively correlated with recessions. Creditor rights are positively associated with debt financing as well as with capital expenditures, although these correlation coefficients are close to zero Debt Financing, Business Cycles, and Creditor Rights We begin by examining the primary channel through which creditor rights impacts investment; that is, through better access to debt markets during economic downturns. Thus, we analyze how creditor rights are related to a firm s debt financing behavior around recessions with regressions which use debt financing as the dependent variable. Debt financing is calculated as the change in total debt as a fraction of total assets. All regressions include firm size, Tobin s q, cash flow, leverage, and tangibility as control variables. Following McLean and Zhao (2012) and Kaplan and Zingales (1997), all right-hand side variables are lagged one year, with the exception of cash flow, which is from the concurrent year. The regressions also include industry and time dummies, and we control for the general legal environment and development of a country using legal origin dummies and the logarithm of the initial GDP per capita. To allow for 15

16 differences in coefficients over the business cycle, we interact the independent variables with the recession variable. 9 The regression in, column 1 of Table 4 includes creditor rights and an interaction term with the recession dummy. Consistent with our hypotheses, creditor rights have a greater impact on firms debt financing during recessions compared to expansions the coefficient on the interaction term between creditor rights and recession is positive and significant at the 1% level. Figure 1 graphically illustrates these results by showing that stronger creditor rights are associated with significantly greater debt financing during recessions. In contrast, creditor rights have no significant impact on debt financing during expansions. For the recessions subsample, a change from weak creditor rights (score of zero) to strong creditor rights (score of four) is associated with a 2 percentage point increase in debt financing. 10 In column 2 of Table 4, we add the legal rights index as an additional measure of creditor protection, and in column 3 we include a measure of legal formalism. Neither of these variables nor their interactions with the recession dummy is significantly related to debt financing, and the coefficient estimate on the interaction between creditor rights and the recession dummy is only marginally impacted by the addition of these variables. Column 4 of Table 4 provides a regression with country fixed effects. Across all specifications, the coefficient on the interaction between creditor rights and the recession dummy is positive and significant, and this suggests that the effect of creditor protection laws on debt financing is mainly concentrated during economic downturns. 9 Note that the recession variable is dropped from this specification because it is collinear with the totality of the interaction terms. 10 Similar to the investment regressions, when we estimate the debt financing regressions separately for recessions and expansions we find that creditor rights is positively and significantly associated with debt financing during recessions (coefficient of with p-value of less than 5%) but not during expansions (coefficient of with p-value greater than 10%). 16

17 We further consider whether the sum of the coefficients on the creditor rights index and on the interaction between creditor rights and recession is significantly different from zero, and we report the p-values for this test in the last row of Table 4. In all models, the sum of these variables is significantly different from zero (with p-values less than 5%). Thus, stronger creditor rights have a greater impact on debt financing during recessions than in expansions, and similar to our findings on firm investment, the decline in debt financing during recessions is moderated by greater creditor rights. In terms of economic magnitude, based on the results of column 1 of Table 4, an increase of one unit in creditor rights implies an insignificant change in debt financing during expansions, and a significant increase during recessions of percentage points (= ). Given average debt financing of 1.06% during recessions, this implies a 52% (= 0.548/1.06) increase in debt financing with an increase of one in creditor rights. Table 5 repeats the regressions of Table 4 using the real GDP growth rate rather than a recession dummy to proxy for macroeconomic conditions. In all specifications, the coefficient on the interaction between creditor rights and the real GDP growth rate is negative and significant, again implying that creditor rights are associated with increased borrowing if GDP growth is low. The coefficients on the other control variables in Tables 4 and 5 are largely consistent with our expectations. We find that firms with greater tangibility, measured with PPE to total assets, and highly valued firms, measured with Tobin s q, have greater debt financing, and highly levered firms have lower debt financing. For the most part, the interaction terms between the control variables and the recession variables are not significantly different from zero. 17

18 4.3. Cost of Debt, Business Cycles, and Creditor Rights Qian and Strahan (2007) and Bae and Goyal (2009) show that bank loans have lower spreads and longer maturities for companies in high creditor rights regimes, and Qi, Roth, and Wald (2010) show that Eurobonds and Yankee bonds have lower spreads if they are from high creditor rights regimes. We therefore examine whether our results on firm investment and debt financing extend to the relation between the cost of debt and creditor rights. We expect that strong creditor rights reduce spreads, and that this effect is more pronounced in recessions than in expansions. We consider a sample of corporate Yankee bonds (bonds issued by non-u.s. issuers) issued between 1980 and 2003 from the Fixed Income Securities database (FISD). 11 Dropping bonds issued by governments, bonds with missing offering yields, convertible bonds, and bonds with floating rate coupons results in a sample of 1,726 Yankee bonds issued by 757 firms from 37 countries. The countries with the largest number of observations are Canada (28%) and United Kingdom (22%). After merging the bond sample with firm-level data we obtain a smaller sample of 291 bonds from 19 countries. We use the log of bond yield spread at the time of the bond issue to measures the cost of debt (see, e.g., Elton, Gruber, Agrawal, and Mann, 2001; Maxwell and Stephens, 2003; and Qi, Roth, and Wald, 2010). We calculate the yield spread as the difference between the offering yield and the yield on the maturity equivalent U.S. Treasury bond. If there is no maturity equivalent Treasury security available to match the maturity of the corporate bond, the yield to maturity on the Treasury security is calculated as a linear interpolation between the two closest maturity matches. 11 We exclude domestic U.S. bonds because adding these issues would make the sample 94% U.S. based, thus swamping our results for non-u.s. issuers. 18

19 In addition to the control variables we employ in our previous tests, we consider term spread, measured as the difference between the yields on one and ten year Treasury bonds; and default spread, calculated as the difference between the yields on Baa and Aaa rated corporate bonds. Further, we control for various bond characteristics including the log of maturity, log of offering amount, and indicator variables for whether the bond is callable, putable, or secured, and whether it is a high-yield issue. These bond characteristics may be jointly determined with the bond s offering yield, and we therefore estimate our models with and without these bond controls. Table 6 provides regressions of how spreads vary with recessions, creditor rights, and their interactions. We use the recession dummy to measure macroeconomic conditions. 12 The model in column 1 controls for log of initial GDP per capita, and term and default spread, column 2 adds firm fixed effects, column 3 includes firm controls, column 4 includes firm and bond controls, and column 5 is estimated with country fixed effects. Note that the sample size drops from 1,726 observations in models 1 and 2 to 291 observations in columns 3 to 5 when firm and bond characteristics are included. In all specifications, the coefficient on the interaction between creditor rights and the recession dummy is negative and significant with p-values of less than 5% (in four out of five models). Thus, creditor rights have a significantly greater effect on the cost of debt during recessions than expansions. Overall, the evidence we find on the relation between creditor rights, recessions, and the cost of debt is consistent with our prior tests. Greater creditor rights moderate fluctuations in yield spreads over the business cycle. 12 The results hold when we use real GDP growth the proxy for macroeconomic conditions. For brevity, we do not report these results in separate tables. 19

20 4.4. Investment, Business Cycles, and Creditor Rights: Firm-level Analysis We next turn to our firm-level analysis of the impact of creditor protection laws on corporate investment policy over the business cycle. Table 7 presents our estimates from regressing investment as a fraction of total assets on creditor rights, a recession dummy, and other controls. Column 1 of Table 7 presents the results of our basic specification, similar to column 1 of Table 4. The coefficient on the interaction term between recession and creditor rights provides the differential impact of creditor rights in recessions compared to expansions. Consistent with our expectations, the interaction between recession and creditor rights is significantly positively associated with firm investment (p-value less than 1%). This finding suggests that creditor rights have a significantly greater impact on firm investment in economic downturns than in upturns. Figure 2 graphically illustrates the effect of creditor rights during expansions and recessions based on this analysis. The graph shows that weak creditor rights are associated with significantly lower capital investment during recessions for example, for the recession subsample, an increase from weak creditor rights (score of zero) to strong creditor rights (score of four) implies an increase in investments of about 38%. In contrast, during expansions, differences in creditor rights imply little variation in investment. 13 In column 2 of Table 7 we add the legal rights index as an additional control for creditor protection (see Djankov, McLiesh, and Shleifer, 2007). Consistent with creditor protection mattering more during recessions, the coefficient on the interaction between the legal rights index and the recession dummy is positive and significant. In column 3 of Table 7 we consider the legal formalism index from Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2003); 13 When we estimate the investment regressions separately for recessions and expansions, our results are consistent with the findings in Table 7. Creditor rights are positively and significantly associated with investment during recessions (coefficient of with p-value less than 1%) but not during expansions (coefficient of with p- value greater than 10%). 20

21 however, neither this index nor its interaction with the recession dummy is significant in this specification. Overall, the inclusion of these additional institutional variables has only a small effect on the interaction between creditor rights and the recession dummy. In column 4 of Table 7, we provide a regression with country fixed effects. 14 Overall, across all these specifications, the coefficient on the interaction between creditor rights and the recession dummy is positive and significant, again suggesting that better creditor rights have a greater impact on corporate investment during recessions than expansions. In the last row of Table 7, we report p-values for the test that the sum of the coefficients on creditor rights and the interaction between creditor rights and the recession dummy is different from zero. For all models, this sum is significantly different from zero (with p-values less than 1%), whereas the coefficient on creditor rights by itself is not different from zero except in the country fixed effect specification, where the creditor rights variable picks up the investment effects of within country changes in creditor rights. Thus, our findings suggest that greater creditor rights are associated with greater investment during recessions when agency conflicts are potentially high, and creditor rights have little impact on investment during expansions. In terms of economic magnitude, the findings in column 1 of Table 7 show that an increase of one unit in the creditor rights index implies a (= ) percentage point increase in capital expenditure during recessions, and no significant change during expansions. Given that the average capital expenditure is 6.43% of total assets during recessions, a one unit increase in creditor rights implies an increase in capital expenditure of 7.6% (= 0.489/6.43) during recessions and no significant change during expansions. 14 In our sample, out of the 40 countries, there are 8 countries for which the creditor rights variable changed over time, Canada, Denmark, Finland, Israel, Japan, Sweden, Thailand, and the U.K. 21

22 In Table 8 we consider the annual real GDP growth rate as an alternative measure of economic activity for similar specifications to those provided in Table 7. The estimated coefficient on the interaction between the real GDP growth rate and creditor rights is in all cases negative, and again this finding implies that creditor rights have a positive effect on firm investment if GDP growth is lower. The estimated coefficient on this interaction term is significant in three out of the four models. In both Tables 7 and 8 the estimated coefficients on the other control variables are, on the whole, consistent with our expectations. Firms with greater cash flow and firms with more growth opportunities, as measured by Tobin s q, generally invest more. Further, large firms and firms with greater leverage invest more during recessions. While firms with more tangible assets invest more, they also see a greater decline in investment during recessions. This is consistent with prior empirical studies on the collateral channel (see, e.g., Gan, 2007; Benmelech and Bergman, 2011; and Chaney, Sraer, and Thesmar, 2012) Agency Cost Subsamples Our results show that the impact of creditor protection on corporate investment policy, debt financing, and the cost of debt is concentrated during recessions. If these different effects of creditor rights are due to increased agency costs during recessions, we expect that the impact of creditor rights in recessions should be more pronounced for firms which have greater expected agency problems. To this end, we split our data into subsamples containing firms which we expect to have more or fewer agency problems, and we repeat our previous analysis using these subsamples. 15 Myers (1977), for instance, discusses how firms with greater outstanding long- 15 Because of the small sample size of the cost of debt sample, we are unable to perform meaningful splits within that sample. 22

23 term debt have a greater bondholder-shareholder conflict, and are more likely to not undertake profitable investment opportunities. Jensen and Meckling (1976) show how shareholders of firms with more debt have greater incentives to change to riskier projects, even if this implies a decrease in overall firm value. These agency conflicts are more pronounced if the firm is closer to bankruptcy, as limited liability causes the incentives for shareholders and bondholders to diverge. Thus, we proxy for bondholder-shareholder agency problems with leverage and revenue, and we expect that firms with high leverage or low revenue are more affected by agency problems. Another variable which may be related to bondholder-shareholder conflicts is bond ratings. We gather rating data but find that these data are not available for most of the firms in our sample. A number of other variables, such as corporate governance or ownership measures, are also used in the literature to proxy for agency problems; however, these are related to measures of owner-manager agency problems, not shareholder-bondholder conflicts, and hence, these measures are not useful for our analysis. Table 9 presents the results for debt financing for subsamples based on variables which are related to bondholder-stockholder agency costs. The first two columns of Table 9 consider firms with leverage that is higher or lower than the median industry leverage. Columns 3 and 4 split the sample into firms with leverage greater than or less than 40%, and columns 5 and 6 consider firms with leverage greater than or less than 50%. Finally, columns 7 and 8 consider firms with revenue less than or greater than the industry median. 16 The results suggest that creditor rights have a positive impact on debt financing during recessions for both the high and low potential agency conflict subsamples. However, the estimated coefficients on the interaction 16 In unreported analyses we also split the samples by country median and industry-country median, and find similar results. 23

24 terms are greater for the high-agency-cost subsamples, and this difference is significant for three out of four subsample splits. For example, focusing on the high/low leverage subsamples in columns 1 and 2, the coefficients on the interaction term are for firms with high leverage and for firms with low leverage, and the difference is significant at the 5% level. In Table 10 we consider investment regressions for similar subsamples. In all models the coefficient on the interaction between creditor rights and recession is positive and significant with p-values less than 1%, and the coefficients are larger for the subsamples which we expect to have greater agency problems. However, the differences in estimated coefficients from these subsamples are statistically significant at the 10% level in columns 5 and 6, which report results for the 50% leverage cutoff subsamples. In columns 7 and 8, which show results for the revenue subsamples, the difference in coefficients is not significant with a p-value of 13%. In sum, these measures of expected agency problems are related to how creditor rights affect firm investment and debt financing during recessions, and the results are consistent with the notion that strong creditor rights are most important during recessions for firms with high agency costs Alternative Analyses and Robustness Tests We consider a number of additional tests to ensure the robustness of our findings Country-level Analysis In unreported regressions, we consider the effect of creditor rights on country-level investment in a simple regression using country-level fixed effects. We define investment as the ratio of gross fixed capital formation to GDP using IFS data. We find that the interaction 24

25 between recessions and creditor rights is consistently positive in this analysis, and the results hold either with a recession dummy or with lagged GDP growth. This analysis provides another view that our firm-level analysis is reflected in macroeconomic data. However, because of the number of additional macroeconomic controls that could be included in such a macroeconomic analysis, we focus instead on our firm-level analyses Equity Issuance and Cash Holdings In unreported regressions we consider equity financing and cash holdings as dependent variables in our analyses. Neither creditor protection laws nor other institutional features affect the relation between recession and equity financing or cash holdings. Thus, creditor protection laws mitigate the drop in investment during recessions through changes in debt financing, not through changes in equity financing or through changes in cash holdings Graphical Analysis of Agency Costs over the Business Cycle We also consider a graphical analysis of how agency problems between borrowers and lenders increase around recessions using data from U.S. bond issues. 17 Smith and Warner (1979) describe how covenants are included in debt contracts to reduce the incidence of various types of agency conflicts, and we therefore use the number of covenants included in bond contracts as a measure of expected agency conflicts. 18 We examine the number of covenants included in U.S. corporate bonds by firm rating during recessions and expansions. We obtain data on the use of covenants in U.S. corporate bonds from the Mergent s Fixed Income Securities Database (FISD) database. Our sample contains 46,141 bonds issued from 1990 to We constrain this analysis to the U.S. as covenant data for international bonds is limited. 18 An existing literature documents how covenant use is tied to agency issues; see, for instance, Malitz, 1986; Begley and Feltham, 1999; Nash, Netter, and Poulsen, 2003; Billett, King, and Mauer, 2007; and Qi, Roth, and Wald,

26 Figure 3 shows Moody s bond ratings on the horizontal axis (from 2 (C rating) to 22 (Aaa rating)) and the average number of covenants included in bonds on the vertical axis. As expected, lower rated bonds include more debt covenants than higher rated bonds. Moreover, during recessions, the number of covenants used by high rated bonds increases significantly. There are no observations for the number of covenants issued by firms with ratings 2 through 4 in recessions, suggesting that firms with low ratings are unable to issue bonds during recessions. This graphical analysis shows that agency problems increase during recessions, and it suggests that these agency problems can be severe enough to shut low rated firms out of credit markets during recessions Alternative Variables In unreported regressions we consider the anti-self-dealing index from Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2008) as another control variable in our regressions. Including this variable does not change our primary results, and the coefficients on anti-selfdealing are largely insignificant. As we are primarily concerned with the agency costs between creditors and shareholders, rather than between shareholders and management, this result is expected. Further, as we control for legal origin variables, this additional variable may not provide much additional information. We also consider an anti-director index, rather than the anti-self-dealing index, and again we find similar results. We consider several alternative variable definitions as additional robustness tests. For instance, we use an alternative measure of recession, equal to one if the annual real GDP growth rate is negative, rather than if it is negative for two consecutive quarters of the year. Our results hold for both investment and debt financing. Further, our results are robust to using seasonally- 26