Legal institutions, strategic default, and stock returns

This paper studies the impact of legal institutions on stock returns. More specifically, we examine how differences in debt enforcement and creditor protection around the world affect stock returns of individual firms. We hypothesize that if legal institutions prevent shareholders from engaging in strategic default, then, all else equal, firms in countries with better creditor protection and efficient debt enforcement should earn, on average, higher equity returns. We test this hypothesis using a comprehensive sample of publicly traded firms from 46 countries over the period 1989 to 2005. Adjusting stock returns for factors such as the market, liquidity, size, book-to-market, and momentum, we find results that strongly support our hypothesis. Distressed firms in countries with institutional environments that allow for efficient debt enforcement earn, on average, significantly higher returns than firms located in institutional environments that favor deviations from priority rules.