The Impact of Legal Sanctions on Moral Hazard when Debt Contracts are Renegotiable

This research investigates how bankruptcy law influences the design of debt contracts and the investments choices. We model a lending relationship between a small firm and a monopolistic bank who decides the level of the interest rate. The firm may perform asset substitution, which is sanctioned by the Law through legal sanctions. These apply in case of costly bankruptcy only. This way of resolving financial distress can be avoided yet, if a private agreement is achieved. First, – when sanctions are high – we show costly bankruptcy may be preferred by honest firms over private negotiation: thus, costly bankruptcy cannot be avoided under a severe legal environment. However, as the bank internalizes the rules of default, debt contracts are designed so that this situation never happens at equilibrium (“legal efficiency”). Second, a peculiar legislation may incite banks to accept generalized moral hazard (“economic inefficiency”). Then, the legislator can indirectly enforce economic efficiency. However he must consider effects beyond the simple comparison between the levels of legal sanctions and of bankruptcy costs, and focus on the impact of such legal sanctions on the design of debt contract. Simulated results show that even small changes of legal sanctions may have drastic effects on the firm’s investment policy. Besides, it appears that extreme severity (i.e. 100% of the manager’s wealth is subject to legal sanctions) is not needed to ensure economic efficiency. Last, in some situations, the legislator may have the choice between several levels of legal sanctions all leading to economic efficiency: when choosing between them, the legislator affects the profit sharing only.