Investment Incentives, Bankruptcies and Reverse Convertible Debt

35 Pages Posted: 20 May 2015

See all articles by Neil A. Doherty

Neil A. Doherty

University of Pennsylvania - Insurance & Risk Management Department; University of Pennsylvania - Business & Public Policy Department

Scott E. Harrington

University of Pennsylvania - Wharton School

Date Written: March 1, 1995

Abstract

The combination of risky cash flows, leverage and absolute priority rules in bankruptcy create a well known agency problem; shareholders face incentives to take risky, as opposed to value maximizing, investment projects. Recently, it has been argued that deviation from absolute priority rules in bankruptcy or workouts mitigates this problem. Working with the principle of contract theory that ex ante welfare gains can be maximized by pre-commitment (if contracts are resistant to re-negotiation), we consider efficiency gains from pre-commitment to such alternatives to absolute priority. The instrument is an inversion of convertible debt in which the conversion option is held by the owners. This instrument can be designed so that the conversion option is less costly ex post (i.e., after issue of debt) to bondholders than the default put implicitly embedded in non convertible debt. This design not only lessens the ex ante incentive problem but avoids the transaction costs of bankruptcies and workouts. Finally, we show that this form of debt is re-negotiation proof.

Keywords: reverse convertible debt, bankruptcy, pre-commitment

JEL Classification: G32, G33

Suggested Citation

Doherty, Neil A. and Harrington, Scott E., Investment Incentives, Bankruptcies and Reverse Convertible Debt (March 1, 1995). Available at SSRN: https://ssrn.com/abstract=2608144 or http://dx.doi.org/10.2139/ssrn.2608144

Neil A. Doherty (Contact Author)

University of Pennsylvania - Insurance & Risk Management Department ( email )

Philadelphia, PA 19104-6365
United States
215-898-7652 (Phone)
215-898-0310 (Fax)

University of Pennsylvania - Business & Public Policy Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6372
United States

Scott E. Harrington

University of Pennsylvania - Wharton School ( email )

3641 Locust Walk
Colonial Penn Center
Philadelphia, PA 19104-6358
United States
215-898-9403 (Phone)
215-573-2157 (Fax)

HOME PAGE: http://scottharringtonphd.com/

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