Optimal Resolutions of Financial Distress by Contract

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.

This version: October 2007

Institute of Economic Research, Hitotsubashi University

2008-04

English(eng)

technical report

VoR

AA11590659

50

CEI Working Paper Series

https://hdl.handle.net/10086/29281