Litigation Risk and the Dispersion of Debt Financing: Evidence from Natural Experiments

An optimal debt structure balances the benefits of deterring strategic defaults against the costs of liquidation inefficiencies. This study builds on the role of litigation risk in this cost-benefit trade-off and examines whether threats of lawsuits affect firms’ debt dispersion decisions (i.e., the extent to which firms rely on multiple types of debt simultaneously). Exploiting a matching-based fixed effect difference-in-differences design around two legal events that generate exogenous variations in litigation risk, I find that firms increase debt dispersion upon an increase in litigation risk. Consistent with litigation risk mitigating creditor coordination problems, the effect is stronger for firms facing higher distress risk. Further tests suggest that the mitigation of creditor coordination problems occurs through improved corporate oversight. Beyond debt types, I also demonstrate that litigation risk is associated with firms’ creditor composition as well as debt maturity dispersion. Overall, I document a new channel through which litigation risk affects firm value by advancing our knowledge of an important yet often neglected aspect of debt.