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We study the effects of a court decision granting creditors the power to force into bankruptcy corporate debtors whose liabilities exceed their assets even if they are current on their payments. We find that bond prices responded positively to the court ruling, perhaps because of expectations that early resolutions of future cases of financial distress would benefit creditors. We also find that firms affected by the court ruling did not reduce their risk, but increased their reported net worth through equity injections and aggressive accounting. As a result, the informativeness of these firms’ financial statements decreased. Although it may well be the case that the overall effect of the court ruling on social welfare was positive, we argue that empowering creditors to force firms into bankruptcy using a balance sheet test for insolvency may involve adverse effects, increasing borrowers’ incentives to present biased financial statements.

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