Optimal Resolutions of Financial Distress by Contract
AbstractWe study theoretically the possibility for the parties to efficiently resolve financial distress by contract as opposed to exclusively rely on state intervention. We characterize which financial contracts are optimal depending on investor protection against fraud, and how efficient is the resulting resolution of financial distress. We find that when investor protection is strong, issuing a convertible debt security to a large, secured creditor who has the exclusive right to reorganize or liquidate the firm yields the first best. Conversion of debt into equity upon default allows contracts to collateralize the whole firm to that creditor, not just certain physical assets, thereby inducing him to internalize the upside from efficient reorganization. Concentration of liquidation rights on such creditor avoids costly inter-creditor conflicts. When instead investor protection is weak, the only feasible debt structure has standard foreclosure rights, even if it induces over-liquidation. The normative implications are that lifting legal restrictions on floating charge financing, convertibles and concentration of liquidation rights, and increasing investor protection against fraud should improve the efficiency of resolutions of financial distress.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University in its series CEI Working Paper Series with number 2008-6.
Length: 50 p.
Date of creation: Apr 2008
Date of revision:
Note: This version: October 2007
Contact details of provider:
Postal: 2-1 Naka, Kunitachi, Tokyo 186-8603
Web page: http://cei.ier.hit-u.ac.jp/
More information through EDIRC
Corporate Bankruptcy; Creditor Protection; Financial Contracting;
Find related papers by JEL classification:
- G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
- K22 - Law and Economics - - Regulation and Business Law - - - Business and Securities Law
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-05-10 (All new papers)
- NEP-BEC-2008-05-10 (Business Economics)
- NEP-CTA-2008-05-10 (Contract Theory & Applications)
- NEP-LAW-2008-05-10 (Law & Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Dan Bernhardt & Ed Nosal, 2004.
Journal of Finance,
American Finance Association, vol. 59(6), pages 2655-2684, December.
- Cornelli, Francesca & Felli, Leonardo, 1997.
"Ex-ante efficiency of bankruptcy procedures,"
European Economic Review,
Elsevier, vol. 41(3-5), pages 475-485, April.
- Schwartz, Alan, 1997.
"Contracting about Bankruptcy,"
Journal of Law, Economics and Organization,
Oxford University Press, vol. 13(1), pages 127-46, April.
- Erik Berglof & Ernst-Ludwig von Thadden, 1994. "Capital Structure with Multiple Investors," CEPR Financial Markets Paper 0044, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
- Julian R Franks & Kjell G Nyborg, 1994.
"Control Rights, Debt Structure, and the Loss of Private Benefits: The Case of the UK Insolvency Code,"
CEPR Financial Markets Paper
0047, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
- Franks, Julian R & Nyborg, Kjell G, 1996. "Control Rights, Debt Structure, and the Loss of Private Benefits: The Case of the U.K. Insolvency Code," Review of Financial Studies, Society for Financial Studies, vol. 9(4), pages 1165-1210.
- Ernst-Ludwig VON THADDEN & Erik BERGLÖF & Gérard ROLAND, 2003. "Optimal Debt Design and the Role of Bankruptcy," Cahiers de Recherches Economiques du DÃ©partement d'EconomÃ©trie et d'Economie politique (DEEP) 03.13, Université de Lausanne, Faculté des HEC, DEEP.
- Povel, Paul, 1999. "Optimal "Soft" or "Tough" Bankruptcy Procedures," Journal of Law, Economics and Organization, Oxford University Press, vol. 15(3), pages 659-84, October.
- Josh Lerner & Antoinette Schoar, 2005. "Does Legal Enforcement Affect Financial Transactions? The Contractual Channel in Private Equity," The Quarterly Journal of Economics, MIT Press, vol. 120(1), pages 223-246, January.
- Kenneth Ayotte & Hayong Yun, . "Matching Bankruptcy Laws to Legal Environments," American Law & Economics Association Annual Meetings 1018, American Law & Economics Association.
- Lambert-Mogiliansky, Ariane & Sonin, Konstantin & Zhuravskaya, Ekaterina, 2000. "Capture of Bankruptcy: Theory and Evidence from Russia," CEPR Discussion Papers 2488, C.E.P.R. Discussion Papers.
- Alberto Bisin & Adriano Rampini, 2006. "Exclusive contracts and the institution of bankruptcy," Economic Theory, Springer, vol. 27(2), pages 277-304, January.
- Julian R. Franks & Kjell G. Nyborg & Walter N. Torous, 1996. "A Comparison of UK, US and German Insolvency Codes," Financial Management, Financial Management Association, vol. 25(3), Fall.
- Nicola Gennaioli & Stefano Rossi, 2010.
"Judicial Discretion in Corporate Bankruptcy,"
Review of Financial Studies,
Society for Financial Studies, vol. 23(11), pages 4078-4114, November.
- Shleifer, Andrei & McLiesh, Caralee & Hart, Oliver & Djankov, Simeon, 2008.
"Debt Enforcement Around the World,"
2961825, Harvard University Department of Economics.
- World Bank, 2009. "Good Governance in Public-Private Partnerships : A Resource Guide for Practitioners," World Bank Other Operational Studies 12665, The World Bank.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Reiko Suzuki).
If references are entirely missing, you can add them using this form.