Legal-system arbitrage and the theory of multinational corporate finance

This paper develops a new theory of multinational capital structure based on legal-system arbitrage: The optimal capital structure for the multinational minimizes the value of the ex post opportunism options created by the diverse legal systems under which the multinational operates. This theory explains the complex mix between parent and subsidiary financing observed in most multinationals, even in the absence of both tax differentials and private information. Optimal capital structures minimize the default premia associated with the multinational's overall financing package by equating the marginal enforceability of debt contracts in the host and headquarters countries. Consistent with extant empirical research, the analysis shows that multinational utilization of local financing will be positively related to the creditor-friendliness of the local legal system. Further, the model provides an explanation for the fact that multinationals do not simply obtain all their financing in the location featuring the most creditor-friendly legal regime. In addition, the model produces many new empirical predictions regarding issues such as the venue selected by the multinational for restructuring, the optimal allocation of capital within the multinational, and the impact of currency risk on credit spreads and financing policy.