Creditor Rights and R&D Expenditures

• Author: Halit Gonenc,Bruce Seifert
• Published date: 01 January 2012
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00881.x
• Date: 01 January 2012

Creditor Rights and R&D Expenditures

Bruce Seifert and Halit Gonenc

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines the impact of creditor rights on R&D intensity (R&D/total assets). We argue

that managers in countries with strong creditor rights have more incentives to reduce cash f‌low risk and therefore limit

expenditures on R&D more than managers located in countries with weak creditor rights.

Research Findings/Insights: Using a sample of over 21,000 f‌irms from 41 countries, our research is one of the f‌irst to

document that strong creditor rights are indeed associated with reduced R&D intensity. This negative relationship is

observed in market-based countries, but not in bank-based countries. Moreover, the results show that the negative effect of

creditor rights on R&D intensity is usually stronger (more negative) for f‌irms facing or near f‌inancial distress. We observe

that the determinants for R&D intensity consist of both country and f‌irm level variables and f‌irm level variables appear to

be more important in explaining the variance of R&D intensity.

Theoretical/Academic Implications: This study documents an important link between creditor rights and R&D intensity.

Our empirical procedure specif‌ically accounts for the fact that R&D intensity and debt are likely to be jointly determined.

Practitioner/Policy Implications: This research is importantto policy makers interested in understanding the determinants

of f‌irms’ R&D intensity. In particular, our study suggests a possible harmful effect of strong creditor rights, namely the

possibility that R&D intensity will be lowered.

Keywords: Corporate Governance, Creditor Rights, Corporate Innovation, R&D Intensity

INTRODUCTION

R&D can be extremely important to both companies and

countries. At the f‌irm level, successful R&D invest-

ments can lead to new and better products and cheaper ways

to manufacture them and therefore to increased cash f‌lows.

At the country level, those investments can be a catalyst for

economic growth.1R&D expenditures can be substantial.

Israel, for example, spends over four per cent of its GDP on

R&D and the US is forecasted to spend more than 400 billion

dollars in R&D in 2011.2

While stockholders generally have a favorable view of

R&D3because they get to reap most of the benef‌its, creditors

havemixed emotions about R&D spending. On the one hand,

creditors realize that for many companies R&D investments

are essential and these f‌irms cannot ultimately survive

without it. On the other hand, creditors worry that R&D

expenditures may not be successful and therefore earnings

and cash f‌lows will be less than desired and possibly, that

their promised payments in terms of interest and principal

will not materialize. R&D spending is risky. Not only are

outcomes highly uncertain but there is a great chance that

R&D on a particular project/areawill not be successful. Even

if R&D turns out to be successful, it may be years before the

benef‌its show up. The fact that there is a huge variance of

outcomes associated with R&D intensity (R&D/total assets)

and the fact that creditors do not share in any of the prof‌its

above their promised payouts make creditors wary about

spending for R&D. Creditors will likely focus on the

increased risk of more R&D intensity and not the additional

benef‌its because they do not get any extra cash f‌low above

their promised payments and therefore will probably prefer

less to more spending on R&D. Shi (2003) provides empirical

support for the idea that bondholders are worried more

about the risk of R&D intensity than its benef‌its.

Creditors have many powers and use their powers to

inf‌luence corporate decisions. Traditionally many research-

ers stressed the powers of creditors during periods of bank-

ruptcy. More recently, researchers have documented the

inf‌luence of creditors in investment decisions (Nini, Smith,

& Suf‌i, 2009), capital structure choices (Roberts & Suf‌i, 2009),

shareholder payouts (Brockman & Unlu, 2009) and innova-

tive activities (Acharya & Subramanian, 2009). Creditors

have powers because when a f‌irm violates a private credit

*Address for correspondence: Bruce Seifert, Department of BusinessAdministration,

College of Business and PublicAdministration, Old Dominion University, Norfolk, VA

23529-0221. Tel: 757-683-3552; Fax:757-683-5639; E-mail: bseifert@odu.edu

3

Corporate Governance: An International Review, 2012, 20(1): 3–20

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00881.x

agreement, the agreement is generally renegotiated (as

opposed to being called) and the terms of the agreement

change as additional restrictions (for example, less invest-

ments, less debt, and fewer payouts) are imposed on the

f‌irm.

When f‌irms are close to f‌inancial distress, managers will

likely take actions to prevent this possibility. Managers who

fear that f‌inancial distress is a possibility may undertake

actions designed to reduce risk such as diversifying opera-

tions, employing less debt, and reducing capital expendi-

tures. Strong creditor rights may make managers’ lives

worse during these times. Managers may discover that

under strong creditor rights their decision-making powers

are reduced more and the possibility of losing their jobs is

greater than under weak creditor rights. Under these cir-

cumstances, it would seem reasonable that managers might

try more risk reducing activities under strong creditor rights

than under weak creditor rights.

Recent studies (Acharya, Amihud, & Litov, 2011; Acharya

& Subramanian, 2009) indicate that managers in f‌irms

located in countries with strong creditor rights do, in fact,

engage in more diversifying acquisitions, which result in

poorer performance. These managers also lower cash f‌low

risk, lower leverage, and have fewer innovations. Our paper

focuses on another avenue managers might take to reduce

risk, which is to limit R&D expenditures. We examine

whether R&D intensity is, on average, greater in countries

with weak creditor rights than in countries with strong

creditor rights.

Our paper is one of the f‌irst to examine the linkage

between creditor rights and R&D intensity. We investigate

this relationship using data for more than 140,000 f‌irm-year

observations belonging to over 21,000 f‌irms from 41 coun-

tries. To account for the fact that R&D intensity and debt are

likely jointly determined, our empirical procedure treats

both R&D intensity and the debt ratio as endogenous. Our

analysis also specif‌ically incorporates the impact of intellec-

tual property rights on R&D decisions.

Our regressions and correlation analysis suggest that

strong creditor rights decrease R&D intensity across all of

our samples with the exception of bank-based countries. In

general, we f‌ind that the impact of creditor rights is more

negative for f‌irms that are in f‌inancial distress or near

f‌inancial distress. Our results are consistent with the view

that managers worry more about the negative conse-

quences of f‌inancial distress (for themselves and their

company) in countries that have strong creditor rights than

in countries with weak creditor rights. As a result, f‌irms

reduce risk more in countries with strong creditor rights.

One of these risk-reducing strategies is limiting R&D

intensity.

Another important f‌inding of our research is that deter-

minants of R&D intensity are largely invariant across our

samples. In addition to the generally negative impact of

creditor rights on R&D intensity, we f‌ind that patent rights,

market to book ratios, and equity ratios all have a positive

impact on R&D intensity while concentrated ownership has

a negative inf‌luence. We observe that the determinants for

R&D intensity consist of both country and f‌irm level vari-

ables and f‌irm level variablesappear to be more important in

explaining the variance of R&D intensity.

In addition, the determinants of the leverage equation (in

our case the equity ratio) are basically the same across our

samples. Cash f‌low and market to book ratios both have a

positive effect on the f‌irm’s use of equity, while size and a

measure of adverse selection reduce the amount of equity

employed by f‌irms.

The rest of the paper is as follows. In the next section, we

brief‌ly review some relevant literature and then we describe

the data, our hypotheses, and our methodology. We then

present our f‌indings and f‌inally our conclusions.

RELEVANT LITERATURE

R&D Investment and Financing of R&D

A number of authors (for example, Bhagat & Welch, 1995)

have argued that R&D can be viewed as an investment for a

f‌irm. There are, however, differences between these expen-

ditures and other investments. As Hall (2002) points out, 50

per cent or more of the expenditures for R&D can be tied up

in salaries and wages of scientists and engineers. Since the

knowledge base of these key individuals can be lost if these

people are f‌ired or leave the f‌irm, R&D intensity should

remain relatively constant year to year. Another difference

between R&D and other investments is that there is a high

degree of uncertainty (outcomes) associated with these

expenditures. As Hall argues, there is a small probability of

great success attached to R&D expenditures.

A problem that is likely worse for R&D than for other

investments is the information asymmetric issue. Scientists,

engineers, and insiders have more information than inves-

tors do, and f‌irm insiders do not want to reveal this infor-

mation to outsiders (especially their competitors) to solve

this problem (Bhattacharya & Ritter, 1983). Bhagat and

Welch (1995) and Bah and Dumontier (2001) argue that this

can explain the use of internally generated funds to support

R&D intensity.

Hall (1992) and Himmelberg and Petersen (1994) f‌ind that

there is a positive relationship between R&D intensity and

cash f‌low4for US f‌irms. Brown and Petersen (2009) show

that the relationship between R&D and cash f‌low is still

strong, unlike the relationship between physical investment

and cash f‌low that has decreased over the years. Brown,

Fazzari, and Petersen (2009) observe a signif‌icant relation-

ship between cash f‌low (as well as external equity) and R&D

intensity for young high-tech companies, but not for mature

high-tech f‌irms.

Research has shown that stronger intellectual property

rights leads to more R&D intensity [see, for example, Wu

(2009) for OECD countries and Lin, Lin, and Song (2010) for

evidence from China]. Firms should conduct more R&D if

they feel there is little chance that their R&D efforts will be

stolen or imitated.

It has also been argued that debt should not be used to

f‌inance R&D. In most cases R&D does not have much liqui-

dation value in the event of bankruptcy. In addition, f‌irms

with high R&D expenditures probably ref‌lect high growth

opportunities and hence suffer from the underinvestment

problem (Myers, 1977) and thus equity is probably better

suited to f‌inance R&D. Bhagat and Welch (1995) show that

there is a negative relation between last year’s debt ratio for

4CORPORATE GOVERNANCE

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