Endogeneity Tests and Robustness Checks

Endogeneity. Endogeneity of creditor rights is not likely to be a major concern (Acharya et al., 2011). Reverse causality, for instance, is not likely because creditor rights are largely predetermined by a country’s legal origin (La Porta et al., 1998) and it is hard to imagine that the high leverage costs of individual firms would influence a county’s legal setting. However, the effect of creditor rights can be driven by unobserved country

30 _{In unreported additional analysis, we revisiting Favara et al. (2017) using our research setting. Consistently,}

we find creditor rights to be negatively associated with capital expenditure and asset growth, and positively associated with asset volatility. The results suggest that creditor rights intensify the underinvestment and risk-

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characteristics (Favara et al., 2017). We address this endogeneity concern of creditor rights by introducing the financial crisis analysis.

The 2008–2009 global financial crisis is an exogenous shock from the perspective of any single firm. While the financial crisis did not likely change the creditor rights legal system of a particular country in the short period, it did greatly modify the hold-up incentives of creditors. The unexpected liquidity scarcity from the crisis can threaten the survival of the firms that are highly leveraged. Therefore, powerful creditors may be biased toward actions that help preserve their own shares at the expense of other stakeholders, such as quick seizing of firm assets or liquidation. Consequently, one should expect even more pronounced negative consequences of creditor rights during the crisis period. To test this conjecture, we follow Lins et al. (2013) and define years 2008 and 2009 as the financial crisis period (DURING CRISIS). The following years in our sample are defined as AFTER CRISIS. Table 2.4 reports the results of financial crisis analyses. We include additional interaction terms between the crisis indicators, and creditor rights and high leverage variables. In line with our expectations, the results suggest that compared to the pre-crisis period, the dark-side effects of creditor rights have significantly intensified (nearly doubled) during the past global financial crisis, and are relatively weak after the financial crisis. Thus, we find supportive evidence that the negative effects of creditor rights on the costs of high leverage are not likely driven by unobserved factors.

In addition, endogeneity can be a problem for HLEV, as indicated by Opler and Titman (1994), because a decline in sales and profitability can induce firms to increase leverage. These problems are mitigated by our research design, however. First, we employ two-year lags between the high leverage measure and sales growth to mitigate reverse

causality. Second, we avoid capturing adjustments to firm leverage by measuring a firm’s financial condition relative to its country peers, which it cannot control, and by using a firm’s long-term debt ratio in calculating leverage, because it is harder for managers to adjust long-term debt than short-term debt (Campello, 2006). Nevertheless, we further address potential endogeneity of HLEV using the 2SLS approach and the system GMM technique developed by Blundell and Bond (1998); Table 2.5 reports the results. To instrument for HLEV, we employ its own values over the past two years, in the spirit of Campello (2003). In the first stage (Model 1), we obtain the fitted value of HLEV by regressing HLEV on a series of control variables and the two instrumental variables. The model shows a highly significant and positive correlation between each instrument and HLEV, implying that firms’ financial policy tends to be sticky. The first-stage F-statistics reported at the bottom of the table are much larger than the threshold value of 10, confirming that the instruments are relevant. In Models 2 and 3, we report the second-stage results using the fitted values of HLEV. Consistent with our main results, the coefficients in both models load significantly negatively, lending further support to the idea that the dark-side effects of creditor rights dominate when a firm is highly leveraged. To examine the exogeneity of the instruments, we regress the residuals of the 2SLS models on the instruments and control variables. As indicated by the exogeneity test (p-value is 0.33 for Model 2 and 0.35 for Model 3), the instruments are jointly insignificant. This test cannot reject the null hypothesis of no correlation between the residuals and instruments, which suggests that our instruments are exogenous. In the system GMM models, SALES_Gt-1

(one-year lagged sales growth) is added as an independent variable. Models 4 and 5 report the results. We continue to find that strong creditor rights significantly increase the costs

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of high leverage. Taken together, the results indicate that endogeneity concerns are not likely to be driving our main results.31

Sample composition. As the descriptive statistics suggest, our sample is dominated by U.S. and Japanese firms, which together account for 51% of the observations. To reduce the influence of this uneven sample distribution, in Table 2.6 we repeat the baseline regressions after removing firms from the U.S. (Models 1 and 2), Japan (Models 3 and 4), and both countries (Models 5 and 6). Additionally, we employ weighted least squares, which assigns each country a weight equal to the reciprocal of its number of observations (Models 7 and 8). All of these models show consistent and highly significant results, which supports the view that high leverage induces agency conflicts among stakeholders and rival predation, and the costs of high leverage are greater under strong creditor rights.

Alternative definitions of key variables. In Table 2.7, we check the robustness of our baseline models to alternative measures of high leverage and creditor rights. First, as we discuss above, our main proxies for high leverage employ long-term debt because it is less subject to adjustment than short-term debt and therefore more exogenous (Campello, 2006). However, to facilitate comparison with earlier research (e.g., Opler and Titman,

31 _{It is also worth noting that the coefficients in the 2SLS and system GMM models are somewhat larger than}

those in the baseline models. This means that our baseline models do capture some managerial leverage adjustments. Specifically, firms that face higher (lower) costs of high leverage are more likely to decrease (increase) their leverage. This endogeneity issue therefore leads to a higher proportion of firms with small high leverage costs in our high leverage sample, pushing the coefficient estimates toward zero. Nonetheless, the baseline models load significantly negatively, which suggests that our main effects are so strong that they overcome the offsetting effect of this endogeneity problem.

1994), in Models 1 and 2 of Table 2.7 we use the total debt ratio, which incorporates short- term debt. We find that the coefficient on HLEV×CRIGHTS is negative and significant (at the 1% level), ruling out concerns that our main results hinge on the particular measure of HLEV. Second, to check whether our results are sensitive to the lag structure of our variables, in Models 3 and 4 we lag HLEV and CRIGHTS by three years. We find that the effects of high leverage persist. Third, recent research suggests that the effect of investor protection depends not only on the rules and regulations offering such protection but also on the enforcement of those rules and regulations (e.g., Aggarwal et al., 2009). However, creditor rights may not be as strong as the rules suggest if enforcing those rights is time consuming, costly, and inefficient. To explore this possibility, in Models 5 to 7 we replace CRIGHTS with three alternative creditor protection indexes from Djankov et al. (2008) that capture different aspects of debt contract enforcement: the amount of time it takes for creditors’ claims to be honored after a firm defaults (TIME), the estimated cost of insolvency proceedings (COST), and the efficiency with which the insolvency process is resolved in terms of the value losses (EFFICIENCY). The results show that the interactions between these three creditor rights enforcement proxies and the high leverage dummy enter significantly at the 1% level, implying that the costs of high leverage are higher if creditors can enforce their contracts quickly, at low cost, and with high value preservation.

Fourth, we adopt an alternative measure of creditor rights protection following Favara et al. (2012). Based on Djankov et al.’s (2008) survey, Favara et al. (2012) construct RENEGOTIATION FAILURE index, which gauges the difficulty shareholders will face if they attempt to renege on the outstanding debt, whether through a formal insolvency procedure or outside court. Higher value of the index suggests stronger protection of

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creditors’ rights. Appendix D shows the detailed definition of this index. Again, we find this alternative measure of creditor rights continues to intensify the costs of high leverage, suggesting that our findings are not likely to be driven by our particular use of key variables.