Lending and borrowing are familiar to most of us. Families getting a loan for a car or a new house and business owners looking to expand operations are both borrowing money from a lender, creditor or bank.

Many laws regulate this relationship between lenders and borrowers, determining the rights that each party has. However, this can become a tug-of-war in which the laws benefit or protect one party over the other. Research on corporate bankruptcy from the Broad College’s Department of Finance shows how some laws could stand to benefit both sides.

Shifting the balance during bankruptcy

Headshot of Nuri Ersahin, assistant professor of finance

Nuri Ersahin, assistant professor of finance

“My research is analyzing what happens when you give creditors more rights during corporate bankruptcy,” Nuri Ersahin, assistant professor of finance, explained. “So, when creditors, lenders or banks have more rights during the bankruptcy process of a firm, is this good for the firm or not, before the bankruptcy actually happens?”

Ersahin answers this question in his paper “Creditor Rights, Technology Adoption and Productivity: Plant-Level Evidence,” recently published in Review of Financial Studies.

The specific set of laws that Ersahin examined in his research are anti-recharacterization laws, which have so far been passed in a few states such as Texas, Alabama, Louisiana and Delaware. Under these laws, if a business declares bankruptcy, the lender is protected and can more easily seize assets back from the borrower.

Ersahin talked through the thought process of the borrower in this situation: “From the firm perspective, why would this be good for me prior to bankruptcy, if the creditor has more leniency [during the bankruptcy]? The basic idea is that if creditors have more rights [during bankruptcy], it becomes much easier to borrow money up front and start a business because the creditor feels safer and is more willing to lend you the money now.”

The data confirmed this idea, revealing that firms can borrow more and even boost their productivity overall in states where these laws are in place.

Boost for borrowers

“My results suggest that stronger creditor rights relax borrower constraints up front and help firms adopt production technologies that are more efficient,” Ersahin said.

Using plant-level microdata from manufacturing firms provided by the U.S. Census, Ersahin found that productivity levels increased by 2.6%. What’s driving this productivity increase? Firms using the borrowed money to ramp up investments in in technology and human capital.

“I looked at the productivity of plants belonging to firms who are incorporated in those states where the laws have been changed,” he said. “Firms who borrowed more adopted more advanced technology by investing in newer capital and IT. They also hired more skilled employees. These two are the drivers of the increased productivity.”

More to explore

So, if these laws create a win-win for lenders and borrowers at the manufacturing plant level, could this also be the case for small-business owners and entrepreneurs? Ersahin said that more research is needed to answer that question.

“We don’t have conclusive evidence on this [dynamic] about whether creditors should have more rights in their relationship with individual entrepreneurs too,” he said. “At the end of the day, creditors are becoming a more important stakeholder that can have a long-lasting impact on how the economy operates.”

And as far as understanding how things play out when a company does declare bankruptcy, that remains to be seen. Ersahin’s research only looked at benefits to firms that have not yet declared bankruptcy, but this may become even more important as companies face hardships related to the COVID-19 pandemic.

“Right now, there is no research showing bankrupt companies under these laws,” he said. “Bankruptcy laws and how we manage bankruptcy will be more important in months to come, given that many companies may face bankruptcy these days.”