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Agency Problems of Debt, Convertible Securities, and Deviations from Absolute Priority in Bankruptcy

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  • Frierman, Michael
  • Viswanath, P V
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    Abstract

    It has been suggested that convertible debt can be used to reduce the tendency toward excessive risk taking in a firm that includes debt in its capital structure. We show that the ability of convertible debt to perform this function is greatly reduced if stakeholders can trade in derivative securities with payoffs contingent on the cash flows of the firm. We show, further, that bankruptcy courts can ensure the same result precisely by deviating from absolute priority. Our model explains two real-world phenomena; one, why bankruptcy law seems to be structured in such a way as to favor equity holders and facilitate deviations from absolute priority, and two, why small firms are more likely to use convertible debt. Copyright 1994 by the University of Chicago.

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    Bibliographic Info

    Article provided by University of Chicago Press in its journal Journal of Law & Economics.

    Volume (Year): 37 (1994)
    Issue (Month): 2 (October)
    Pages: 455-76

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    Handle: RePEc:ucp:jlawec:v:37:y:1994:i:2:p:455-76

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    Web page: http://www.journals.uchicago.edu/JLE/

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    Cited by:
    1. Bigus, Jochen, 2002. "Bankruptcy law, asset substitution problem, and creditor conflicts," International Review of Law and Economics, Elsevier, vol. 22(2), pages 109-132, August.
    2. Viswanath, P. V. & Frierman, Mike, 1995. "Asset fungibility and equilibrium capital structures," Journal of Economics and Business, Elsevier, vol. 47(4), pages 319-334, October.
    3. Buttwill, Klas & Wihlborg, Clas, 2005. "The Efficiency of the Bankruptcy Process. An International Comparison," Ratio Working Papers 65, The Ratio Institute.
    4. Graff, Richard A. & Kairys Jr., Joseph P., 2005. "Property Rights and Corporate Finance," Working Papers in Economics 174, University of Gothenburg, Department of Economics.
    5. Wihlborg, Clas, 2002. "Insolvency and Debt Recovery Procedures in Economic Development: An Overview of African Law," Working Paper Series UNU-WIDER Research Paper , World Institute for Development Economic Research (UNU-WIDER).

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