Financial Contracts and the Legal Treatment of Informed Investors

Working Paper No. 99-10

42 Pages Posted: 29 Sep 1999

See all articles by Mitchell Berlin

Mitchell Berlin

Federal Reserve Bank of Philadelphia - Research Department

Loretta J. Mester

Federal Reserve Banks - Federal Reserve Bank of Cleveland; University of Pennsylvania - The Wharton School

Date Written: August 1999

Abstract

The authors explore the economic rationale for equitable subordination, a legal doctrine that permits a firm's claimants to seek to subordinate an informed investor's financial claim in bankruptcy court. Fear of equitable subordination is often cited as a reason that banks in the U.S. are wary of taking an active management role in their borrowing firms. The authors show that an optimally designed menu of claims for a large investor will include features that resemble equitable subordination. The authors' model provides a partial rationale for a financial system in which powerful creditors do not generally hold blended debt and equity claims.

JEL Classification: G20, G32,G33, K22, P50

Suggested Citation

Berlin, Mitchell and Mester, Loretta J., Financial Contracts and the Legal Treatment of Informed Investors (August 1999). Working Paper No. 99-10. Available at SSRN: https://ssrn.com/abstract=179909 or http://dx.doi.org/10.2139/ssrn.179909

Mitchell Berlin (Contact Author)

Federal Reserve Bank of Philadelphia - Research Department ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
215-574-3822 (Phone)
215-574-4364 (Fax)

Loretta J. Mester

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

University of Pennsylvania - The Wharton School

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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