Weak Creditor Rights and Insider Opportunism: Evidence from an Emerging Market

Abstract

We document insider opportunism in an insolvency regime that is characterized by weak creditor rights and uses an accounting rule to determine bankruptcy eligibility. Using a unique dataset of bankrupt firms from India, we show insiders manage earnings downward before filing for bankruptcy via inventory and trade receivable accruals. A battery of robustness tests confirm accrual behavior is not merely driven by poor performance. Downward earnings management before bankruptcy filing is associated with more payment transactions to insiders post-bankruptcy. Low pre-bankruptcy accruals are associated with poor post-filing performance as well as greater loss of market value on bankruptcy announcement. Our results are consistent with insiders gaming the accounting-based entry rule to obtain bankruptcy protection and extracting private benefits from bankrupt firms. Our study highlights the importance of strong creditor rights for generating positive economic outcomes (La Porta et al. (1997)).