Debt and Insolvency

34 Pages Posted: 20 Jun 2018 Last revised: 18 Feb 2019

Date Written: August 26, 2018


Legal rules play a powerful but understudied role in security design. This article presents two new theoretical results about the design of debt contracts. The results derive from the premise that firms must avoid legal insolvency when issuing new debt because insolvency at issuance would trigger severe operational limitations on the issuer. I first show that legal insolvency limits debt capacity, limiting the amount of money that a firm can raise with debt. I next show that legal insolvency limits the yield that firms can promise new creditors, helping to explain why there is no market for ultra-high-yield new issue debt. The article’s results demonstrate that legal insolvency probably has important – if largely unnoticed – effects in limiting debt capacity and debt yields. More generally, the article illustrates the usefulness of better understanding legal solvency requirements, a legal mechanism that has received too little attention in the understanding of debt and security design.

Keywords: Law and Finance, Security Design, Debt Capacity, Debt Yields, Insolvency, Capital Structure

JEL Classification: G30, G31, G32, G33, K00, K20, K22

Suggested Citation

Heaton, J.B., Debt and Insolvency (August 26, 2018). Review of Banking and Financial Law, Forthcoming. Available at SSRN: or

J.B. Heaton (Contact Author)

J.B. Heaton, P.C. ( email )

20 West Kinzie
17th Floor
Chicago, IL 60654
United States
(312) 487-2600 (Phone)


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