Creditor Rights and Legal Transaction Costs

ABSTRACT I estimate the relationship between increased creditor rights and legal expenditures of debtor corporations by evaluating a securitization law in India allowing secured creditors to seize collateral. The law reduced spending on legal proceedings used by firms to avoid foreclosure, because debt‐related litigation decreased. Firms most affected by the law—with high proportions of tangible assets creditors could seize as collateral—significantly decreased spending on lawyers after the legislation. However, some debtor firms affected by the legislation filed for bankruptcy, either because they failed to successfully renegotiate debt with their multiple creditors or because they took advantage of the automatic stay to prevent creditors from seizing their assets. These firms would have incurred legal costs related to the bankruptcy process. Consistent with this intuition, the post‐reform decrease in legal costs is smaller for firms that filed for bankruptcy after the legislation or were already closer to insolvency before the reforms. The results indicate that legal transaction costs associated with foreclosure avoidance are sizable and can be eliminated by strengthening contract enforcement.