Gambling for Redemption or Ripoff, and the Impact of Superpriority *

Abstract

Asset substitution by firms is gambling implemented by switching to inefficient and risky projects. Gambling using derivatives is more precise, gambling only to what is needed, with negligible efficiency loss. Optimal gambling can be small-scale "Gambling for redemption," which benefits both owners and (surprisingly) bondholders, or large-scale "gambling for ripoff," which benefits owners but hurts bondholders. Gambling at scale is available under weak property rights or in the U.S. with Qualified Financial Contracts (QFCs), which have "superpriority" in bankruptcy. The anticipation of gambling at scale reduces firm borrowing and overall value. 

Keywords: law and economics, corporate finance, gambling, asset substitution, superpriority, QFCs, bankruptcy, superpriority laws, derivatives safe harbors

JEL Classification: G00, G01, G30, G32, G33