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August 18, 2014

Borrowers Beware! When It Comes to Business Loans and Defaults, Not All State Laws Are Created Equal

Columbia Business School study finds that New York’s tough contract laws make it the most favorable state for lenders


NEW YORK—Businesses seeking bank loans need to carefully consider the different state laws that may apply to their commercial debt contract, or risk greater penalties or losses if they default, according to a new Columbia Business School study. The research, to appear in an upcoming issue of the Journal of Law and Economics, shows that an increasing number of lenders structure their deals using the law of New York, the state generally considered to be the most lender-friendly, and that the borrowers using these pro-lender laws face significantly more severe repercussions upon default.

“When you consider that 10–20 percent of companies report being in violation of their covenants in any given year, there can be substantial financial implications for a borrower that defaults on a loan in a pro-lender state,” says Sharon Katz, co-author and associate professor of accounting at Columbia Business School. “Therefore, business leaders should explore their options and be savvy in understanding the different state laws that may govern their contracts.”

The research, titled “State Contract Law and Debt Contracts,” is co-authored by Sharon Katz and Colleen Honigsberg of Columbia Business School, and Gil Sadka from the University of Texas at Dallas. Some key takeaways on the differences between pro-lender and pro-debtor contracts include:

Pro-Lender Contracts Pro-Debtor Contracts
  1. Banks are better able to enforce the specific language of the contract
  2. Roughly 80 percent of the borrowers come
    from out-of-state (e.g., a Texas-based borrower using New York law)
  3. Larger loans and longer maturities
  4. Significantly fewer violations are expected and the consequences of default, such as reductionsin future investment, are more severe
  5. Top pro-lender states: New York and Illinois
  1. Courts are more likely to void clauses they deem to violate the borrower’s fundamental rights
  2. Roughly 30 percent of the borrowers come from out-of-state (i.e., most borrowers are local)
  3. Borrowers required to pay a higher yield, and put more cash collateral at risk
  4. More violations are expected, but the consequences of default are less severe
  5. Top pro-borrower state: California

Notably, the research shows New York is winning the competition on contract law as the most lender-friendly state, with liability laws that strongly favor banks. On the other end of the spectrum, California is the least lender-friendly state, with liability laws that are better for borrowers. Because banks generally have more leverage in selecting what state governs the contract, New York has become increasingly more dominant the past 20 years in competing for commercial contracts, and currently represents 70 percent of all US substantial debt contracts (up from 46 percent in 1996). Approximately 80 percent of borrowers for these contracts are out-of-state businesses or lenders. 

“We found evidence suggesting that states are competing for these debt contracts,” said Colleen Honigsberg, co-author of the research and Ph.D. candidate at Columbia Business School. “Not surprisingly, this can be lucrative for lawyers, particularly in pro-lender states like New York, which leads the nation in attracting debt contracts.”

The Research

Researchers created an index reflecting how lender-friendly each state’s contract law is and combed through more than 3,000 commercial debt contracts from all 50 states available through the SEC’s EDGAR database. The team matched each contract, including the state law under which it was contracted and any covenant violations, as well as the outcome of those violations, to data from DealScan that includes loan characteristics such as maturity date, yield, and whether collateral was put up, and to financial statement data from Compustat.  

States were then classified according to whether they are favorable to lenders (pro-lender) or favorable to debtors (pro-debtor) based on two metrics: the Pro-Debtor Index (which captures distinct features of state law that are related to contract enforcement and that differ across states); and the perceived litigation risk (which measures the rate of litigation using the reported number of lawsuits).

Using these rankings of state contract law, researchers identify characteristics of contracts, borrowers, and lenders across states to better understand the economic consequences associated with contract law.

The Results

There are significant differences in borrower-lender agreements across states.  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 related violations—is left up to individual states. An alleged breach of good faith in a pro-lender state may be quickly resolved in favor of the lender, while a lender who takes similar action in a pro-borrower state could face liability or a long litigation battle. Further, there may be large disparities in the interpretation of the contract clauses. For example, in California, certain loan clauses may be challenged as unconstitutional under the state Constitution, whereas in New York, the same clause will be firmly upheld.

The researchers found that these differences in state law were associated with significant differences in contract terms. Notably, borrowers who used friendly law, such as California law, were also required to put more cash collateral at risk. Additionally, out-of-state borrowers who opted into favorable law had to pay higher yields.

However, while the borrowers using pro-debtor law had tougher contract terms, they were penalized much less when they defaulted. Although all borrowers who violate a loan covenant may face restricted access to sources of cash, be forced to be conservative in investing in the operations and growth of their businesses, and be limited in their ability to negotiate an agreement, the borrowers using law from pro-lender states were far more affected than borrowers using law from pro-debtor states. Because the lenders who had more power under the state law imposed tougher investment restrictions on borrowers, the study shows the need for borrowers to consider the financial implications associated with the law governing their contracts.

To learn more about the cutting-edge research being conducted at Columbia Business School, please visit www.gsb.columbia.edu.

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About Columbia Business School

Columbia Business School is the only world–class, Ivy League business school that delivers a learning experience where academic excellence meets with real–time exposure to the pulse of global business. Led by Dean Glenn Hubbard, the School’s transformative curriculum bridges academic theory with unparalleled exposure to real–world business practice, equipping students with an entrepreneurial mindset that allows them to recognize, capture, and create opportunity in any business environment. The thought leadership of the School’s faculty and staff, combined with the accomplishments of its distinguished alumni and position in the center of global business, means that the School’s efforts have an immediate, measurable impact on the forces shaping business every day. To learn more about Columbia Business School’s position at the very center of business, please visit