Optimal Resolutions of Financial Distress by Contract

Nicola Gennaioli and Stefano Rossi

No 2008-6, CEI Working Paper Series from Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University

Abstract: We study theoretically the possibility for the parties to efficiently resolve financial distress by contract as opposed to exclusively rely on state intervention. We characterize which financial contracts are optimal depending on investor protection against fraud, and how efficient is the resulting resolution of financial distress. We find that when investor protection is strong, issuing a convertible debt security to a large, secured creditor who has the exclusive right to reorganize or liquidate the firm yields the first best. Conversion of debt into equity upon default allows contracts to collateralize the whole firm to that creditor, not just certain physical assets, thereby inducing him to internalize the upside from efficient reorganization. Concentration of liquidation rights on such creditor avoids costly inter-creditor conflicts. When instead investor protection is weak, the only feasible debt structure has standard foreclosure rights, even if it induces over-liquidation. The normative implications are that lifting legal restrictions on floating charge financing, convertibles and concentration of liquidation rights, and increasing investor protection against fraud should improve the efficiency of resolutions of financial distress.

Keywords: Corporate Bankruptcy; Creditor Protection; Financial Contracting (search for similar items in EconPapers)
JEL-codes: G33 K22 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2008-04
New Economics Papers: this item is included in nep-bec, nep-cta and nep-law
Note: This version: October 2007
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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