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Financial contracts and the legal treatment of informed investors

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  • Mitchell Berlin
  • Loretta J. Mester

Abstract

The authors explore the economic rationale for equitable subordination, a legal doctrine that permits a firm's claimants to seek to subordinate an informed investor's financial claim in bankruptcy court. Fear of equitable subordination is often cited as a reason that banks in the U.S. are wary of taking an active management role in their borrowing firms. The authors show that an optimally designed menu of claims for a large investor will include features that resemble equitable subordination. The authors' model provides a partial rationale for a financial system in which powerful creditors do not generally hold blended debt and equity claims.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 99-8.

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Date of creation: 1999
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Handle: RePEc:fip:fedpwp:99-8

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Keywords: Bankruptcy;

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  14. Berlin, Mitchell & John, Kose & Saunders, Anthony, 1996. "Bank Equity Stakes in Borrowing Firms and Financial Distress," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 9(3), pages 889-919.
  15. Admati, Anat R & Pfleiderer, Paul, 1994. " Robust Financial Contracting and the Role of Venture Capitalists," Journal of Finance, American Finance Association, American Finance Association, vol. 49(2), pages 371-402, June.
  16. Thakor, Anjan V., 1996. "The design of financial systems: An overview," Journal of Banking & Finance, Elsevier, Elsevier, vol. 20(5), pages 917-948, June.
  17. Zender, Jaime F, 1991. " Optimal Financial Instruments," Journal of Finance, American Finance Association, American Finance Association, vol. 46(5), pages 1645-63, December.
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  19. Oliver Hart & John Moore, 1994. "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management," NBER Working Papers 4886, National Bureau of Economic Research, Inc.
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