DP6307 | Bankruptcy Codes and Innovation

Publication Date

18/05/2007

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Abstract

Do legal institutions governing financial contracts affect the nature of real investments in the economy? We develop a simple model and provide evidence that the answer to this question is yes. We consider a levered firm's choice of investment between innovative and conservative technologies, on the one hand, and of financing between debt and equity, on the other. Bankruptcy code plays a central role in these choices by determining whether the firm is continued or liquidated in case of financial distress. When the code is creditor-friendly, excessive liquidations cause the firm to shy away from innovation. In contrast, by promoting continuation upon failure, a debtor-friendly code induces greater innovation. This effect remains robust when the firm attempts to sustain innovation by reducing its debt under creditor-friendly codes. Employing patents as a proxy for innovation, we find support for the real as well as the financial implications of the model: (1) In countries with weaker creditor rights, technologically innovative industries create disproportionately more patents and generate disproportionately more citations to these patents relative to other industries; (2) This difference of difference result is further confirmed by within-country analysis that exploits time-series changes in creditor rights, suggesting a causal effect of bankruptcy codes on innovation; (3) When creditor rights are stronger, innovative industries employ relatively less leverage compared to other industries; and (4) In countries with weaker creditor rights, technologically innovative industries grow disproportionately faster compared to other industries. Finally, while overall financial development fosters innovation, stronger creditor rights weaken this effect, especially for highly innovative industries.