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Incomplete Contracts

  • Alan Schwartz

    ()

    (Law School)

Parties to lending agreements can create priority rankings in two ways: by securing a lender or by protecting the lender's debt with financial covenants. Protected debt turns into high priority debt because the early lender will permit covenant violations only if a later lender agrees to subordinate its claim. The Bankruptcy Code sustains both forms of priority by according secured debt senior status and by enforcing subordination agreements among creditors. The latter priority is not controversial but several recent reform proposals would reduce the secured lender's priority. This article argues that creditors who lend early in a firm's life are concerned about debt dilution, which can occur even when all of the borrower's later projects have positive values. It then shows that the equilibrium financial contract for private debt has strong borrowers protecting the early debt with financial covenants, and it suggests that weak borrowers protect the early debt with security. Thus security and financial covenants may be substitutes. "Covenant equilibria" are argued to be efficient. That these equilibria closely resemble "security equilibria," and that arguments for the inefficiency of the secured lender's priority are weak, both argue that the Bankruptcy Code's current respect for both forms of priority should continue. The article also argues that financial covenants should be made binding on later lenders whose advances would cause covenant violations.

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Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm73.

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Date of creation: 21 Jul 1997
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Handle: RePEc:ysm:somwrk:ysm73
Contact details of provider: Web page: http://icf.som.yale.edu/

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