Agency Problems of Debt, Convertible Securities, and Deviations from Absolute Priority in Bankruptcy
It has been suggested that convertible debt can be used to reduce the tendency toward excessive risk taking in a firm that includes debt in its capital structure. We show that the ability of convertible debt to perform this function is greatly reduced if stakeholders can trade in derivative securities with payoffs contingent on the cash flows of the firm. We show, further, that bankruptcy courts can ensure the same result precisely by deviating from absolute priority. Our model explains two real-world phenomena; one, why bankruptcy law seems to be structured in such a way as to favor equity holders and facilitate deviations from absolute priority, and two, why small firms are more likely to use convertible debt. Copyright 1994 by the University of Chicago.
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- Brown, David T, 1989. "Claimholder Incentive Conflicts in Reorganization: The Role of Bankruptcy Law," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 109-23.
- Weiss, Lawrence A., 1990. "Bankruptcy resolution: Direct costs and violation of priority of claims," Journal of Financial Economics, Elsevier, vol. 27(2), pages 285-314, October.
- Stephen A. Ross, 1977. "The Determination of Financial Structure: The Incentive-Signalling Approach," Bell Journal of Economics, The RAND Corporation, vol. 8(1), pages 23-40, Spring.
- John, Kose, 1987. " Risk-Shifting Incentives and Signalling through Corporate Capital Structure," Journal of Finance, American Finance Association, vol. 42(3), pages 623-41, July.
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