Exogenously Unsecured Creditors and the Pricing and Use of Secured Debt

An important advantage of secured relative to unsecured debt is that it provides better protection against dilution from other creditors of the firm. While covenants may provide unsecured lenders protection from dilution arising from the issuance of additional debt, they are less likely to be effective in insulating unsecured lenders from dilution arising from litigation and other non-debt related claims on a firm's assets; claimants we refer to as exogenously unsecured creditors. In this paper we empirically examine the impact of litigation claims on the pricing of secured relative to unsecured debt and the relation between the likelihood of litigation claims and the use of secured debt. We find that litigation claims are associated with a significant increase in the spread between a firm's secured and unsecured debt claims, particularly for unrated firms and those with below investment grade credit ratings. We also find that the propensity of material litigation claims is negatively related to firms' reliance on secured debt