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Bankruptcy rules and debt contracting: on the relative efficiency of absolute priority, proportionate priority, and first-come, first-served rules

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  • Stanley D. Longhofer
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    Abstract

    An analysis showing that allowing creditors to "run" on a firm in financial distress is socially valuable, since it compensates them for monitoring the firm's condition; in contrast, strict adherence to absolute and proportionate priority rules allows lenders to free ride on the monitoring efforts of others, exacerbating the firm's moral hazard problem.

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    File URL: http://www.clevelandfed.org/Research/Workpaper/1994/wp9415.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 9415.

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    Date of creation: 1994
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    Handle: RePEc:fip:fedcwp:9415

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    Keywords: Bankruptcy;

    References

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    1. Aghion, P. & Hart, O. & Moore, J., 1992. "The Economics of Bankruptcy Reform," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 92-11, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 52(4), pages 647-63, October.
    3. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(3), pages 709-37, August.
    4. Mitchell Berlin & Loretta J. Mester, 1992. "Debt covenants and renegotiation," Working Papers 92-9, Federal Reserve Bank of Philadelphia.
    5. Boyd, J.h. & Smith, B.D., 1991. "The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification," RCER Working Papers 289, University of Rochester - Center for Economic Research (RCER).
    6. Oliver Hart & John Moore, 1998. "Default And Renegotiation: A Dynamic Model Of Debt," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 113(1), pages 1-41, February.
    7. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(4), pages 305-360, October.
    8. Allan C. Eberhart & Lemma W. Senbet, 1993. "Absolute Priority Rule Violations and Risk Incentives for Financially Distressed Firms," Financial Management, Financial Management Association, Financial Management Association, vol. 22(3), Fall.
    9. Diamond, Douglas W, 1991. "Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 99(4), pages 689-721, August.
    10. Michelle J. White, 1980. "Public Policy Toward Bankruptcy: Me-First and Other Priority Rules," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 11(2), pages 550-564, Autumn.
    11. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, American Economic Association, vol. 71(3), pages 393-410, June.
    12. Robert Gertner & David Scharfstein, 1991. "A Theory of Workouts and the Effects of Reorganization Law," NBER Technical Working Papers, National Bureau of Economic Research, Inc 0103, National Bureau of Economic Research, Inc.
    13. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, Elsevier, vol. 21(2), pages 265-293, October.
    14. Dionne, G. & Viala, P., 1992. "Optimal Design of Financial Contracts and Moral Hazard," Cahiers de recherche, Universite de Montreal, Departement de sciences economiques 9219, Universite de Montreal, Departement de sciences economiques.
    15. Douglas W Diamond, 1992. "Bank Loan Maturity and Priority when Borrowers can Refinance," CEPR Financial Markets Paper, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ 0022, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
    16. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(2), pages 147-175, November.
    17. Eberhart, Allan C & Moore, William T & Roenfeldt, Rodney L, 1990. " Security Pricing and Deviations from the Absolute Priority Rule in Bankruptcy Proceedings," Journal of Finance, American Finance Association, American Finance Association, vol. 45(5), pages 1457-69, December.
    18. Krasa, Stefan & Villamil, Anne P, 1994. "Optimal Multilateral Contracts," Economic Theory, Springer, Springer, vol. 4(2), pages 167-87, March.
    19. Charles W. Calomiris & Charles M. Kahn & Stefan Krasa, 1991. "Optimal contingent bank liquidation under moral hazard," Working Paper Series, Issues in Financial Regulation, Federal Reserve Bank of Chicago 91-13, Federal Reserve Bank of Chicago.
    20. Michael C. Jensen, 1991. "Corporate Control And The Politics Of Finance," Journal of Applied Corporate Finance, Morgan Stanley, Morgan Stanley, vol. 4(2), pages 13-34.
    21. White, Michelle J, 1983. " Bankruptcy Costs and the New Bankruptcy Code," Journal of Finance, American Finance Association, American Finance Association, vol. 38(2), pages 477-88, May.
    22. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, American Economic Association, vol. 81(3), pages 497-513, June.
    23. Berkovitch, Elazar & Kim, E Han, 1990. " Financial Contracting and Leverage Induced Over- and Under-Investment Incentives," Journal of Finance, American Finance Association, American Finance Association, vol. 45(3), pages 765-94, July.
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