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Optimal Resolutions of Financial Distress by Contract

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  • Gennaioli, Nicola
  • Rossi, Stefano

Abstract

We 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.

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Bibliographic Info

Paper provided by Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University in its series CEI Working Paper Series with number 2008-6.

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Length: 50 p.
Date of creation: Apr 2008
Date of revision:
Handle: RePEc:hit:hitcei:2008-6

Note: This version: October 2007
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Keywords: Corporate Bankruptcy; Creditor Protection; Financial Contracting;

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  1. 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.
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Cited by:
  1. Shleifer, Andrei & McLiesh, Caralee & Hart, Oliver & Djankov, Simeon, 2008. "Debt Enforcement Around the World," Scholarly Articles 2961825, Harvard University Department of Economics.
  2. 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.
  3. World Bank, 2009. "Good Governance in Public-Private Partnerships : A Resource Guide for Practitioners," World Bank Other Operational Studies 12665, The World Bank.

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