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

Zhengqing Gui, Ernst-Ludwig von Thadden and Xiaojian Zhao

Games and Economic Behavior, 2019, vol. 118, issue C, 412-433

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.

Keywords: Financial contracting; Incentive-compatibility; Limited liability; Indivisible collateral; Costly liquidation (search for similar items in EconPapers)
JEL-codes: D86 G33 (search for similar items in EconPapers)
Date: 2019
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Working Paper: Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:gamebe:v:118:y:2019:i:c:p:412-433

DOI: 10.1016/j.geb.2019.09.011

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