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Market Conditions and Contract Design: Variations in Debt Contracting

30 Pages Posted: 1 May 2012 Last revised: 27 Feb 2013

Albert H. Choi

University of Virginia School of Law

George G. Triantis

Stanford Law School

Date Written: February 26, 2013

Abstract

Scholars have cataloged rigidities in contract design. Some have observed that boilerplate provisions are remarkably resistant to change, even in the face of shocks such as adverse judicial interpretations. Empirical studies of debt contracts and collateral, in contrast, suggest that covenant and collateral terms are customized to the characteristics of the borrower and evolve in response to changes in market conditions, such as expansion and contraction in credit supply. Building on the adverse selection and moral hazard theories of covenants and collateral, we demonstrate that an expansion (contraction) of credit will lead not only to a decrease (increase) in the interest rate but also a reduction (expansion) of covenants and collateral through lessening (worsening) adverse selection and moral hazard problems. We conclude with some empirical implications of this analysis.

Keywords: contracts, corporate finance, bargaining power, adverse selection, moral hazard

JEL Classification: D82, K12, K22, L14

Suggested Citation

Choi, Albert H. and Triantis, George G., Market Conditions and Contract Design: Variations in Debt Contracting (February 26, 2013). New York University Law Review, Forthcoming; Stanford Law and Economics Olin Working Paper No. 428; Virginia Law and Economics Research Paper No. 2012-07. Available at SSRN: https://ssrn.com/abstract=2048621

Albert H. Choi

University of Virginia School of Law ( email )

580 Massie Road
Charlottesville, VA 22903
United States

George G. Triantis (Contact Author)

Stanford Law School ( email )

559 Nathan Abbott Way
Stanford, CA 94305-8610
United States

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