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Formal Bankruptcy: Strategic Debt Service with Senior and Junior Creditors

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  • Adriana Breccia

    (University of York)

Abstract

A crucial aspect of debt restructuring is the redistribution of value among many diverse interests, differing in priority, collateral and bargaining power. Focusing on renegotiable debt contracts in a continuous-time framework, we characterise the U.S corporate bankruptcy renegotiation (Chapter 11) in a game-theoretic framework. In formal bankruptcy, the equity holders can renegotiate with one creditor at a time. Unlike previous studies, this allows us to endogenise not only the bankruptcy threshold but also the impairment strategy. Moreover, our game-theoretic setting allows us to explicitly introduce and accommodate varying bargaining powers of claimants. First, we show that there exists a unique sequence of equilibrium restructuring plans and impairment strategies which allows us to derive simple and intuitive closed-form solutions for pricing different classes of debt. Secondly, the model provides a theoretical explanation for cases of seniority reversal. Thirdly, we derive sufficient conditions for the senior credit spread to be smaller than the junior one at all levels of the state variable.

Suggested Citation

  • Adriana Breccia, 2004. "Formal Bankruptcy: Strategic Debt Service with Senior and Junior Creditors," Birkbeck Working Papers in Economics and Finance 0411, Birkbeck, Department of Economics, Mathematics & Statistics.
  • Handle: RePEc:bbk:bbkefp:0411
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