By Professor Dhruv Aggarwal (Northwestern Pritzker School of Law)
Editor’s Note: We will post an argument summary for the Purdue Pharma bankruptcy oral hearing (that occurred on Monday, 12/4/2023) later this week.
In a new paper, I estimate the relationship between increased creditor rights and the legal expenditures of debtor corporations. The empirical setting for the paper is a unique quasi-natural experiment from a major Indian securitization law that allowed secured creditors to seize collateral from debtor companies, bypassing the court system. This law represented a large increase in Indian creditor rights and led to a wave of collateral seizures. I find that firms most exposed to the effects of the law—companies with large shares of tangible assets, which can readily serve as collateral—saw a significant decrease in fees paid to lawyers and legal advisors. A one standard deviation increase in pre-reform asset tangibility is associated with a subsequent decrease in legal expenditures equal to 6.5% (29.83%) of the mean (median) spending on lawyers.
Securitization has two distinct effects on the legal expenditures of debtor corporations, which I term foreclosure avoidance and bankruptcy-related costs. The former refers to the legal proceedings debtors undertake to prevent creditors from seizing the fixed assets contractually designated as collateral. The latter encompasses the debtor’s expected costs of navigating the governmental scheme of reorganization or liquidation, both of which could ultimately lead to the elimination of the corporate entity or loss of managerial control over the firm. By allowing creditors to avoid the regular judicial system, the legislation eliminated debtors’ need (or ability) to spend on lawyers for the decades-long foreclosure proceedings that would earlier take place in civil courts. This reduced the legal costs of foreclosure avoidance in general. However, it also increased the probability of legal costs associated with the bankruptcy process for firms for which the foreclosures would plunge them into insolvency. Bankruptcy in India is a long-drawn and heavily litigated process that takes years to resolve, and implicates high legal costs. Resolving whether debtors’ overall legal spending would increase or decrease after the securitization reform is thus an empirical question.
The results, showing a decrease in legal spending for firms with high asset tangibility, suggest that foreclosure avoidance on average accounts for a larger share of legal costs for firms affected by SARFAESI than bankruptcy-related costs. However, consistent with the legislation increasing expected bankruptcy-related legal costs, I find that the decrease in legal spending is at least partially offset for firms at high risk of bankruptcy, multiple creditors, high pre-reform credit risk, and higher agency costs as proxied by membership in business groups.
By using the quasi-natural setting of the increase in secured creditors’ rights and the comprehensive data on legal spending by Indian firms, the paper adds to the literatures on the effect of creditor rights, the market for lawyers, and the consequences of agency costs of debt. The main policy implication of the empirical analysis is that a large fraction of legal transaction costs exists because of weak contracting institutions such as high enforcement costs for debt agreements. Improving contract enforcement can eliminate many of these legal transaction costs.
Click here to read the full article.