Optimal Financial Contracts for Large Investors: The Role of Lender Liability

FRB Philadelphia Working Paper No. 00-1

35 Pages Posted: 29 Mar 2000

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: February 2000

Abstract

This paper explores the optimal financial contract for a large investor with potential control over a firm's investment decisions. The authors show that an optimally designed menu of claims for a large investor will include features resembling a U.S. version of lender liability doctrine, equitable subordination. This doctrine permits a firm's claimants to seek to subordinate a controlling investor's financial claim in bankruptcy court, but only under well-specified conditions. Specifically, the authors show that this doctrine allows a firm to strike an efficient balance between two concerns: (i) inducing the large investor to monitor, and (ii) limiting the influence costs that arise when claimants can challenge existing contracts in bankruptcy court.

The paper also 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., Optimal Financial Contracts for Large Investors: The Role of Lender Liability (February 2000). FRB Philadelphia Working Paper No. 00-1. Available at SSRN: https://ssrn.com/abstract=213815 or http://dx.doi.org/10.2139/ssrn.213815

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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