Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting
40 Pages Posted: 17 Aug 2016 Last revised: 27 Oct 2019
Date Written: October 25, 2019
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: Suggested Citation