It is well known that bankruptcy codes–the legal frameworks that govern financial distress and adjudicate the resolution of default on debt contracts–vary substantially across countries. In some countries, such as the UK, the code overwhelmingly favors debtholders, particularly secured debtholders. In others, equityholders are accorded substantial rights. For example, Chapter 11 of the US code allows the firm to suspend interest and principal payments on debt for at least 120 days during which equityholders have the exclusive right to come up with a proposal for reorganization.
The bankruptcy code is evidently itself a leading determinant of the costs of financial distress. As such, one might expect that equity and debt-friendly codes have very different implications for observed capital structures; for example, it appears plausible that “hard” bankruptcy codes (ones that favor debtholders) should lead to lower use of debt. A cross-country study by Rajan and Zingales (1995) offers mixed evidence on this. It finds that at an aggregate level, firms in Germany and the UK (two countries with debt-friendly codes relative to the US) are much less leveraged than US firms. However, the study finds that other G-7 countries too use more leverage than the UK and Germany (and as much or more leverage than the US), though their bankruptcy codes are not as equity-friendly as the US code.
From a theoretical perspective, these findings point to the need to develop models that link bankruptcy codes to capital-structures and to identify factors that influence this relationship. In this paper, we make two contributions, each of independent interest. First, we develop a rich theoretical model of capital-structure choice in which deadweight losses from bankruptcy are endogenously determined as a consequence of the agency costs that arise under different codes. To our knowledge, this is the first theoretical model in the literature linking capital-structure choice to the bankruptcy code. The model identifies key determinants of capital-structure choice under either code. Second, we examine empirical support for the model’s implications using data from the US and the UK. We find strong backing for the theoretical predictions.
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