Bankruptcy law, creditors’ rights, and cash holdings: Evidence from a quasi-natural experiment in India
Introduction
Very few studies have examined the impact of creditors’ rights on corporate cash holdings (Kyrolainen et al., 2013; Yung and Nafar, 2014; Martins, 2019). However, the findings of cross-country investigations are inconclusive as all three possible results, i.e., positive (Yung and Nafar, 2014), negative (Kyrolainen et al., 2013; Seifert and Gonenc, 2016), and neutral (Martins, 2019) have been reported in the literature. We can attribute this inconclusive result to four major methodological limitations. First, they suffer from the bias of omitted variables to a great extent and are, therefore, likely to yield biased and imprecise results (Jayaratne and Strahan, 1996). Second, there is a possibility of wrong classification of countries into good and bad rights groups. For example, Allen et al. (2012) argue that weak and inefficient enforcement of creditors’ rights make such rights as good as dead for all practical purposes even when they are present on paper. Ignoring this aspect could lead to the wrong classification of countries, and thus, wrong results. Third, cash holdings are also affected by shareholders’ rights. Although some studies, such as those by Yung and Nafar (2014) and Kyrolainen et al. (2013), try to control for differences in the shareholders’ rights across countries using indicator variables, it is impossible to entirely capture these differences as there is no uniformity in such rights across countries. Therefore, this measurement error may confound the impact of creditors’ rights on corporate cash holdings. Lastly, the conditioning role of demand side factors has not been accounted for in these studies. For example, Ermel (2019) points out that the impact of creditors’ rights on cash holdings is conditioned on the tangibility of firms. Also, the creditors’ rights do not affect the cash policy of zero debt firms. Combining these firms with levered firms without considering this aspect is likely to yield erroneous results. Therefore, it is our staunch belief that the definitive answer to this research question cannot be found using such a research approach alone. Country-specific studies that do not suffer from these limitations are needed. Hence, we employed a unique natural experimental setting in which an exogenous change in creditors’ rights was used to examine two important aspects of the relationship between creditors’ rights and cash holdings. One aspect is the relationship between creditors’ rights and the level of cash holdings, and the second is the relationship between creditors’ rights and the value of cash holdings.
India implemented the Insolvency and Bankruptcy Code (IBC) as a robust mechanism to resolve corporate bankruptcies. Prior to the implementation of IBC, multiple agencies exercised simultaneous jurisdiction over the bankruptcy resolution and hence made such a provision practically dead for the creditors. For example, 10 years were required to resolve a bankruptcy with a recovery rate of about 15% in the pre-IBC period (Chakrabarti et al., 2008). Such a weak right would fail to incentivize/disincentivize the suppliers and users of credit in the market. However, once the IBC was implemented, creditors’ rights became a dominant force in determining the use of credit.1 Therefore, we used this change in law as a natural setting to examine the impact of creditors’ rights on corporate cash holdings. However, not all firms are affected by this change in creditors’ rights. Creditors’ rights affect the firms’ financial and cash policies only when they have some net exposure to debt. If firms have zero net exposure to debt or adhere to a non-positive net debt (NAPD2) policy, this change in creditors’ rights would not affect their cash policy. Therefore, we used the NAPD firms as the control group and the levered firms as the treatment group in our natural experimental set up. The changes in the level and value of cash holdings of the control and treatment firms between the pre- and post-IBC periods were compared to reveal the true impact of creditors’ rights on the cash holdings.
The existing theories provide no direct or first-order causal link between the creditors’ rights and cash holdings. Their relationship is established indirectly through the financial policy since cash holdings and external credit are treated as substitutes for the financing firm's investments (Almeida et al., 2011; Elyasiani and Movaghari, 2020) and perform the same role in managing the agency and information asymmetry problem (Akhtar et al., 2020). Thus, creditors’ rights affect the incentives of the suppliers and users of debt in supplying and utilizing the debt (Singh et al., 2021). For example, weak creditors’ rights make the cost of supply of credit very high for the suppliers and low for the users since assets are not transferred to creditors automatically in the event of bankruptcy (Kyrolainen et al., 2013). This condition disincentivizes the suppliers to supply more credit to the firms. Consequently, firms may retain excess amounts of cash with a precautionary motive to finance future growth opportunities (Faulkender and Wang, 2006). Thus, this ability of firms with excess cash to utilize future growth opportunities would enhance their value in the capital markets (Denis, 2011; Khatib et al., 2021). Therefore, in the context of ill-defined creditors’ rights, the interactions of supply and demand side factors result in a negative relationship with excess cash and a positive relationship with the value of such excess cash in the market (Seifert and Gonenc, 2016). Improvement in creditors’ rights will completely change the direction of the situation, i.e., excess cash would be less useful in financing future growth opportunities. Therefore, firms would maintain less of excess cash with them since the capital markets would otherwise penalize them.
By using excess cash as the dependent variable (Yung and Nafar, 2014), we showed that improvement in creditors’ rights decreased the level and the value of excess cash for those firms that treat external credit and internal cash as substitutes to finance their investments. This negative relationship supports the finding of Kyrolainen et al. (2013) and Seifert and Gonenc (2016) but contradicts the results of Yung and Nafar (2014). However, when firms do not depend on external debt to finance their growth, creditors’ rights do not impact the cash policy.
Our study is closely related to the work of Ermel (2019) which examines the effect of the implementation of a bankruptcy law on the cash holdings of Brazilian firms. We extended this research by exploring the impact of bankruptcy law on the level of excess cash and its value in capital markets.
The rest of the paper has been organized as follows: in the second section, we have developed the hypothesis to be tested. In the third section, the data and methodological aspects of our study have been discussed. The results have been presented and discussed in the fourth section. Finally, conclusions have been drawn in the fifth section.
Section snippets
Hypothesis development
As discussed in the previous section, creditors’ rights would affect the cash policy of the firms by moderating the access to and use of credit (Kyrolainen et al., 2013). When creditors have strong rights, the marginal return of excess cash is always lower than that of the opportunity cost of the investors. Therefore, firms would maximize the shareholders’ value only by reducing their excess cash (Seifert and Gonenc, 2016). When creditors do not enjoy strong rights, firms may maximize the
Variable construction
Table 1 provides information about the construction of the variables used in this study.
Data
The required data to test the research question was taken from the Prowess database. The data period ranged from 2011 to 2019. We selected all the non-financial firms listed on the Bombay Stock Exchange. We excluded the firms without complete information for all the years of the study period.3
Results and discussion
We had an intuition that the impact of IBC on cash holdings would depend on its impact on the incentives of suppliers and users of credit. On the supply side, IBC would incentivize the creditors to lend more as their rights are protected in the post-IBC period. On the demand side, the users of credit, i.e., corporate firms, would now have better access to external credit to fund their growth projects. We represented this change in creditors’ rights by using an indicator dummy, Reg_Dummy, which
Conclusions
In this study, we have examined the impact of creditors’ rights on the corporate cash policy in a natural experimental set up. Our findings have provided supporting evidence to the substitution hypothesis, i.e., external financing and internal cash holdings act as substitutes in financing firm growth. Furthermore, our study has shown that both supply and demand side factors would ultimately determine the optimum cash and financial policies of the corporate firms. These results confirm two
Author statement
We hereby confirm that the mentioned co-authors have contributed to the manuscript in the following way
Dr. Nemiraja Jadiyappa: Idea conceptualization, Hypotheses development and writing of the manuscript
Dr. Santosh Shrivastava: Data collection, analysis and writing of methodology section
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