Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting

40 Pages Posted: 17 Aug 2016 Last revised: 27 Oct 2019

See all articles by Zhengqing Gui

Zhengqing Gui

Wuhan University - Economics and Management School

Ernst-Ludwig von Thadden

Universitaet Mannheim; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Xiaojian Zhao

Monash University - Department of Economics; The Chinese University of Hong Kong, Shenzhen

Date Written: October 25, 2019

Abstract

This paper studies a financial contracting problem where a firm privately observes its cash flow and faces a limited liability constraint. The firm's collateral is piecemeal divisible and can only be liquidated continuously by resorting to the service of a costly third party, typically associated with bankruptcy. In this situation, multi-class collateralized debt is optimal, in which the firm makes several debt-like promises with a seniority structure. The decision over continuous and piecemeal liquidation depends on both the cost of introducing the third party and the firm's funding need. Allowing the firm to refinance ex-post through surreptitious liquidation may reduce the firm's ex-ante payoff, consistent with covenants in debt contracts prohibiting the sale of assets.

Keywords: financial contracting, incentive-compatibility, limited liability, indivisible collateral, costly liquidation

JEL Classification: D86, G30

Suggested Citation

Gui, Zhengqing and von Thadden, Ernst-Ludwig and Zhao, Xiaojian, Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting (October 25, 2019). Available at SSRN: https://ssrn.com/abstract=2824425 or http://dx.doi.org/10.2139/ssrn.2824425

Zhengqing Gui (Contact Author)

Wuhan University - Economics and Management School ( email )

Hubei
China

Ernst-Ludwig Von Thadden

Universitaet Mannheim ( email )

Department of Economics
Mannheim, 68131
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Xiaojian Zhao

Monash University - Department of Economics ( email )

Australia

HOME PAGE: http://https://sites.google.com/site/xjzhao81/

The Chinese University of Hong Kong, Shenzhen ( email )

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