A recent study co-authored by HKUST’s Arthur K. Morris sheds light on how laws and taxes that affect the renegotiation of debt contracts—making the process easier or cheaper, for example—influence the way companies and lenders design these agreements at the outset. The researchers explore how changes in laws can affect these early choices, revealing how laws shape financial deals and what this means for businesses and lenders.

Dr. Morris and co-authors performed statistical analysis of debt contract data before and after an important law change (TD9599) in the U.S. to examine how renegotiation costs influence initial contract terms and renegotiation behavior. “TD9599 lowered the expected costs of renegotiation by $5.61 million on average,” they say, “providing a significant source of plausibly exogenous variation in renegotiation costs.”

As expected, they found that “borrowers and lenders define initial debt contracts with ex post renegotiation costs in mind.” Their results indicate that when tailoring debt contracts, practitioners should pay close attention to the regulatory and tax landscape to elicit desired renegotiation behaviors and generate optimal financing outcomes.

“Lower monetary renegotiation costs influence the equilibrium debt contract,” the researchers specify, “a finding that is important for policy makers and practitioners because it suggests that tax policies that reduce renegotiation costs are not neutral to debt contract design and, therefore, to the lending relationship.”

Furthermore, based on the finding that renegotiation frequency increases post-law change, managers should prepare for more or less frequent renegotiations when legal or tax environments change. Indeed, shifts in legal and tax policy can reshape the very foundation of debt contracts, with far-reaching implications for borrowers, lenders, and regulators.