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Review of Accounting Studies
Published in: Review of Accounting Studies 1/2021

19-08-2020

State contract law and the use of accounting information in debt contracts

Authors: Colleen Honigsberg, Sharon P. Katz, Sunay Mutlu, Gil Sadka

Published in: Review of Accounting Studies | Issue 1/2021

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Abstract

This paper examines the relation between state contract law and the use of accounting information in debt contracts. Contract theory suggests that balance sheet based covenants resolve debtholder-shareholder conflicts ex ante, whereas income statement based covenants serve as trip- wires that trigger the switch of control rights ex post. It is more difficult for lenders to exert their control rights ex post if the contract law is more favorable to debtors (i.e., the law is pro-debtor), suggesting that balance sheet based covenants are more efficient in these jurisdictions. We therefore test and find evidence that lenders using pro-debtor (pro-lender) law are more (less) likely to rely on balance sheet based covenants. We measure reliance using both the weight of balance sheet covenants relative to income statement covenants and the covenant strictness. Our analysis further shows that contracts with performance pricing grids are less likely to include interest increasing grids when the law is more favorable to debtors. The results provide initial evidence that contract law is an important determinant for the design of debt contracts.
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Appendix
Available only for authorised users
Footnotes
1
Honigsberg et al. (2014) document that the higher interest rates are limited to out-of-state borrowers, who opt into favorable (more pro-debtor) state laws.
 
2
Christensen and Nikolaev (2012) classify covenants as capital covenants and performance covenants. Although there is a difference in terminology, these classifications measure the same construct as balance sheet-based covenants and income-statement covenants, respectively.
 
3
We perform additional robustness tests and analyses that we do not tabulate for brevity (e.g., we re-estimate our performance pricing model at the facility rather than deal level and obtain weaker but consistent results).
 
4
Within country designs are not limited to US settings. Recent work analyzing changes in bankruptcy laws in Italy has shown that bankruptcy laws affect loan interest rates and firm investment decisions (Bonetti 2017; Rodano et al. 2016).
 
5
In the context of commercial contracts, courts will enforce the contracting parties’ choice of law only if that state has a “reasonable relationship” to the contract. However, the “reasonable relationship” term has been interpreted very broadly in recent decades (Eisenberg and Miller 2010). Additionally, in an effort to create work for state-licensed attorneys, many states have enacted statutes that are meant to ensure choice of law clauses in commercial contracts are enforced. Combined, these factors provide parties to commercial contracts with substantial flexibility in selecting the law that will govern their agreement (Eisenberg and Miller 2010).
 
6
Using a sample of over 3000 debt contracts, Honigsberg et al. (2014) show that the borrower’s state of incorporation differs from the state law governing the debt contract more than 90% of the time.
 
7
Bankruptcy proceedings do not affect our analysis. When firms file for bankruptcy, the bankruptcy courts will apply the law that was selected in the contract. Further, although there are some differences in procedure that are controlled by the local jurisdiction, bankruptcy law itself is federal.
 
8
In their review of the literature on debt covenants, Armstrong et al. (2010) note that debtholders value some accounting attributes but not others, and they urge researchers to analyze factors that lead debtholders to favor certain types of accounting information.
 
9
Aghion and Bolton (1992) show two types of efficient control allocations: unilateral and contingent control allocations. The unilateral control allocation regime assigns control to the borrower (and in some cases to the lender) by aligning the interests of the lender and borrower at the initiation of the contract, while the contingent control allocation regime reallocates control between the lender and borrower based on signals during the term of the contract.
 
10
Covenants that include a mix of both balance sheet and income statement numbers (e.g., debt to EBITDA ratio) are classified as income statement-based covenants, because income statement numbers are flow numbers that use the stock number as a scalar. Balance sheet-based covenants include balance sheet numbers only. See Appendix 2 for covenant mix classifications.
 
11
See, e.g., Layne v. Ft. Carson Nat’l Bank, 655 P.2d 856 (Colo. 1982) (borrower sued bank after a 5% increase in the interest rate, alleging that the bank acted in bad faith); Homelife Props. Ltd. v. Fahey Banking Co., 2010 Ohio Misc. LEXIS 522 (borrower sued bank, alleging that it improperly tried to increase the interest rate on a commercial loan); First Nat’l Mont. Bank v. McGuinness, 705 P2d 579 (borrowers sued bank after the bank informed the borrowers that the interest rate would be raised on the final year of a contract extension).
 
13
We identified the number of lender liability lawsuits by relying on Cappello (2009), the leading treatise on lender liability. This treatise is focused on the branch of law that seeks to protect borrowers—not equity holders or other stakeholders—from unfair lending practices. To eliminate cases unrelated to state law, we eliminated all cases brought exclusively under federal law (e.g., the bankruptcy code). The hundreds of remaining cases in the treatise largely consist of claims arising under contract law, deceptive practices statutes, environmental law, fiduciary relationships, and sales of collateral.
 
14
The intuition is that parties are more likely to settle rather than litigate when the legal rules are certain, because they can anticipate how the courts will rule and will not waste time and money in litigation. Hence it is only worthwhile to litigate when the case outcome is uncertain.
 
15
Common law was traditionally very friendly to lenders, but over time a series of borrower friendly cases have muddled the law in certain jurisdictions and created uncertainty. As an example, consider the most famous lender liability case: K.M.C. Co. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985). In this case, the lender refused to provide additional funds that were available under the borrower’s line of credit, because the lender believed that the borrower posed a credit risk. When the borrower went out of business and sued the lender for violating the duty of good faith, the jury awarded the borrower $7,500,000. The case was highly unusual at the time, because the lender was found liable for taking an action that was expressly permitted by the contract terms. As many would expect, the frequency of similar claims spiked after this case. What had previously seemed clear in the law—that the lender could withhold funds if the contract permitted him to do so—was now uncertain. As such, plaintiffs had incentives to bring litigation in instances where there was previously no reason for them to waste their time. Hence this case illustrates the idea that uncertainty in this particular area of law is bad for lenders.
 
16
Demerjian (2011) uses a subset of the covenants used by Christensen and Nikolaev (2012). For consistency, we follow the classification of Christensen and Nikolaev (2012) as described in Appendix 2.
 
18
In addition to controlling for year fixed effects, we conduct three pseudo-falsification tests with the New York subsample (untabulated): (1) we estimate the same regression over the pre period from 1995 to 2003, assuming a pseudo-change in year 2000; (2) we estimate the same regression over the post period from 2004 to 2017, assuming a pseudo-change in year 2011; and (3) we estimate the model over the sample of contracts governed by states other than New York during the full sample period, assuming a pseudo-change in year 2004. These pseudo change indicators do not show significant coefficients.
 
19
In untabulated tests, we experiment with less restrictive variations of this approach, identifying subsamples where (i) the home state of the lead lender is the same as the contract law, (ii) the home state of the borrower is the same as the contract law, and (iii) the lead lender and borrower are from the same state. In all such cross-sectional tests, the interaction term is positive and statistically significant.
 
20
Our descriptive analyses show that deals with bank dependent borrowers are more frequently governed by pro lender state contract laws.
 
21
We are grateful to an anonymous reviewer for suggesting this proxy for bargaining power. Although untabulated, we also use borrowers with non-investment grade debt (S&P long-term bond rating lower than BBB) as a proxy for bank dependence and find similar results.
 
22
In an untabulated analysis, we tested whether our results are stronger for the sample of firms with highly volatile income by interacting net income volatility with the Pro-Debtor Index. Although our main result continued to hold, the interaction term was not significant, suggesting that our results are not driven by firms with high income volatility. Similarly, our results are robust to controlling for income and cash volatility in the model.
 
23
In untabulated tests, we find no evidence of association between the state contract law and the inclusion of interest decreasing performance pricing grids.
 
24
We use the presence of security as a benchmark because prior literature has shown that the security feature of the loan is an important determinant of performance pricing grid design (Christensen and Nikolaev 2012; Hollander and Verriest 2016).
 
25
We perform performance pricing tests across two alternative sample specifications (untabulated). First we estimate model (3) over the sample of loans that include performance pricing grids. Results are robust, albeit weaker. Second, since the performance pricing grids are designed at the facility level, we estimate the model (3) at facility level, recalculating deal-level control variables at the facility level. The results resemble those reported in Table 7.
 
26
We estimated our Performance Pricing model over within sample settings reported in Tables 3 and 4 for robustness. Due to the many fixed effects and small sample sizes, the logit model cannot be estimated in many cases and yields insignificant results when converged.
 
27
For example, in Diversified Foods, Inc. v. First National Bank of Boston (1991), Me. Super. LEXIS 84, the borrower sued the lender, alleging that the lender violated the duties of good faith and fair dealing by taking actions such as raising the APR. In evaluating the borrower’s claims, the court looked at the borrower’s actions preceding the lender’s alleged breaches and stressed repeatedly that the borrower had voluntarily breached the contract by, for example, violating the covenant related to intercompany advances. The lender, the court stated, simply exercised its rights under the loan agreement in response to the borrower’s breaches. In effect, the borrower’s voluntary breach created a defense for the lender against lender liability claims.
 
28
We developed this algorithm after reading numerous debt contracts to identify their governing law.
 
29
We use the firms’ primary state of operations as their home states, not the state where the firms are incorporated.
 
30
We check several diagnostics (untabulated) to assess the validity of our instrumental variable approach, following Larcker and Rusticus (2010). We find a partial R-squared of 37% with a significant first-stage partial F-statistic, which supports the choice of instruments. However, the Durbin-Wu-Hausman tests yield insignificant chi-square statistics for endogeneity, which can be seen as evidence of lack of endogeneity.
 
31
Dealscan typically treats these agreements as new agreements and assigns a new unique deal identifier.
 
32
We do not include renegotiation events that are coded as “amended” in Roberts’ (2015) sample, as these events do not lead to a new contract.
 
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Metadata
Title
State contract law and the use of accounting information in debt contracts
Authors
Colleen Honigsberg
Sharon P. Katz
Sunay Mutlu
Gil Sadka
Publication date
19-08-2020
Publisher
Springer US
Published in
Review of Accounting Studies / Issue 1/2021
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-020-09559-4

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