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Finance Seminar

Author:

• Giovanni Favara
  Federal Reserve Board

• Erwan Morellec
  Swiss Finance Institute

• Enrique Schroth
  City University London

• Philip Valta
  University of Geneva

We show that the prospect of a successful debt renegotiation in default reduces shareholder-debtholder conflicts and induces shareholders of leveraged firms to invest more and take on less risk. We identify these effects in the data using a panel of 18,602 firms across 41 countries with heterogeneous bankruptcy codes. We find that the effects of debt renegotiation operate through their interactions with the probability of default and shareholders’ recovery conditional on default. A difference-in-differences analysis of firms’ investment and risk taking responses to bankruptcy reforms that make debt more renegotiable confirms the cross-country evidence.