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Incentive-compatibility, limited liability and costly liquidation in financial contracting

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  • Gui, Zhengqing
  • von Thadden, Ernst-Ludwig
  • Zhao, Xiaojian

Abstract

This paper studies a financial contracting problem where a firm privately observes its cash flow and faces a limited liability constraint. The firm's collateral is piecemeal divisible and can only be liquidated continuously by resorting to the service of a costly third party, typically associated with bankruptcy. In this situation, multi-class collateralized debt is optimal, in which the firm makes several debt-like promises with a seniority structure. The decision over continuous and piecemeal liquidation depends on both the cost of introducing the third party and the firm's funding need. Allowing the firm to refinance ex-post through surreptitious liquidation may reduce the firm's ex-ante payoff, consistent with covenants in debt contracts prohibiting the sale of assets.

Suggested Citation

  • Gui, Zhengqing & von Thadden, Ernst-Ludwig & Zhao, Xiaojian, 2019. "Incentive-compatibility, limited liability and costly liquidation in financial contracting," Games and Economic Behavior, Elsevier, vol. 118(C), pages 412-433.
    • Handle: RePEc:eee:gamebe:v:118:y:2019:i:c:p:412-433
    DOI: 10.1016/j.geb.2019.09.011
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    More about this item

    Keywords

    Financial contracting; Incentive-compatibility; Limited liability; Indivisible collateral; Costly liquidation;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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