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August 5, 2014 | Research Feature

Pro-borrower or Pro-lender?

Commercial contract laws that govern lending can generate big business for states — but borrower beware.


When taking out a loan to support expanded operations or entering a new market, businesses may not consider which state laws apply to the commercial debt contract that governs the loan. A business may not even be aware it has a choice. But it does: in many states, neither borrower nor lender need have any connection to the state they contract in.

Why does it matter? Because debt contract laws differ across the United States, and, according to new research from Professor Sharon Katz, Columbia Business School doctoral candidate Colleen Honigsberg, and Gil Sadka of the University of Texas, Dallas, there are substantial economic implications to the laws. The researchers first examined the relationship between commercial contracting laws in different US states and the terms and volume of debt contracts between borrowers and lenders. Then they examined how violations of these contracts under different states’ laws impact additional investments and borrowing. How do states benefit from commercial contracts law? What does it mean for businesses that depend on easy access to loans to operate and grow? What does it mean for lenders?

To answer their questions, the researchers first created an index reflecting how lender-friendly each state’s contract law is: New York is the most lender-friendly state, with liability laws established that unequivocally favor banks; California is the least lender-friendly state, with liability laws that are better for borrowers. The researchers then combed through more than 3,000 commercial debt contracts from all 50 states available through the SEC’s EDGAR database. They matched each contract, including the state law under which it was contracted and any violations, as well as the outcome of those violations, to data from DealScan, which includes loan characteristics such as maturity date, yield, and whether collateral was put up, and to financial statement data from Compustat.

As with any loan, the terms of commercial contracts vary depending on the size of the loan, the length of the loan, whether the bank and firm have done business together before, and what the loan will be used for. But less obvious considerations also apply. For example, there is an implicit covenant of good faith in all US commercial contracts, but interpretation of good faith — and the violation thereof — is left up to individual states. An alleged breach of good faith in one state may be quickly resolved in favor of the lender, while a lender who takes similar action in another state could face liability or a long litigation battle. Banks have more leverage than borrowers in choosing which state to contract in. Perhaps unsurprisingly, then, the researchers found that most debt contracts end up being governed by the two most pro-lender states: New York and Illinois. (The Mattels, McKessons, and Amgens of the world are exceptions: some borrowers have more leverage because of their financial strength, and other borrowers may be able to contract under more favorable law because of either their geographic location or because they are willing to pay higher yields.)

The researchers found that in cases where borrowers were able to negotiate contracts in California and other debtor-friendly states, they tended to put up more cash collateral, which is easier for lenders to seize if a firm defaults. They also found many more contract violations in pro-borrower states. But the repercussions are much more severe in pro-lender states: when these borrowers violate financial covenants in debt contracts, such as when a borrower fails to maintain a minimum level of equity,  lenders are permitted to significantly alter the terms of the loan, hiking up interest rates or even calling the full loan due. As a result, those borrowers face restricted access to sources of cash and are forced to be conservative in investing in the operations and growth of their businesses. The researchers did find that companies on the West Coast were more successful than others in getting lenders to agree to use California for their debt contracts, but found that this came at a price: those firms that opted to contract in states with more borrower-friendly law paid higher yields.

The researchers found evidence that states compete to attract debt contracts to their states — contract law can be lucrative for litigators, particularly in pro-lender states. New York is increasingly the winner: 20 years ago less than 50 percent of all commercial US debt contracts were written under New York State law. Today, about 70 percent are. Notably, over 80 percent of the borrowers using law from pro-lender states such as New York and Illinois are located in another state such as Texas or Washington. That adds up to big litigation business: while a Texas bank that uses New York contract law can litigate over a breach of a debt contract in Texas, that litigation will require the expertise of New York lawyers. Indeed, the researchers found that the financial sector comprises a larger percent of overall GDP in New York and other lender-friendly states like Illinois and North Carolina, which also attract a good deal of debt contract business.

As for borrowers, the researchers caution them to look closely at governing states’ contract law. When a firm must contract in a pro-lender state, it should assess the potential costs it might face if it were to violate the contract. And if a firm is successful in negotiating terms in a more borrower-friendly state, says Katz, “It should choose wisely, understanding that there is a trade-off involved in selecting a borrower-friendly state — while the borrower may benefit in the event of a breach, it may also face collateral requirements and pay a higher yield.”

Sharon Katz is associate professor of accounting at Columbia Business School.

Read the Research

Colleen Honigsberg, Sharon Katz, Gil Sadka

"State Contract Law and Debt Contracts"

View abstract/citation 


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