Bankruptcy, Warrants, and State-Contingent Changes in the Ownership of Control

Journal of Financial Intermediation, Vol. 6 No. 4

Posted: 27 Jan 1998

See all articles by Jaime F. Zender

Jaime F. Zender

University of Colorado at Boulder - Department of Finance

Avner Kalay

Tel Aviv University - Faculty of Management; University of Utah - David Eccles School of Business

Abstract

We consider the design of securities that govern the distribution of cash flows and control rights for an investment project. An entrepreneur, endowed with managerial talent, contracts with an outside investor for required capital. Optimal contracts stipulate that the ownership of control and the distribution of cash flows are specified on a state contingent basis to manage the distortions that develop from the use of outside financing and so make the best use of the advantage in project management enjoyed by insiders. Our results illustrate that the use of warrants and convertible securities, which transfer control of the firm to outsiders in good states, and bankruptcy, which transfers control to outsiders in bad states, are related features of optimal contracts. Our model also indicates that firms will benefit from direct access to two types of bankruptcy processes resembling Chapter 7 and Chapter 11 (including deviations from absolute priority) of the bankruptcy code. This result differs from observed practices since stockholders cannot waive their rights for protection under Chapter 11. We show that when direct access to Chapter 7 is highly valuable, market participants have found clever ways to obtain it.

JEL Classification: G32, G33

Suggested Citation

Zender, Jaime F. and Kalay, Avner, Bankruptcy, Warrants, and State-Contingent Changes in the Ownership of Control. Journal of Financial Intermediation, Vol. 6 No. 4. Available at SSRN: https://ssrn.com/abstract=50560

Jaime F. Zender (Contact Author)

University of Colorado at Boulder - Department of Finance ( email )

Boulder, CO 80309
United States
303-554-1665 (Phone)
303-492-4689 (Fax)

HOME PAGE: http://www-bus.colorado.edu/faculty/Zender/

Avner Kalay

Tel Aviv University - Faculty of Management ( email )

P.O. Box 39010
Ramat Aviv, Tel Aviv, 69978
Israel
972 3 6406298 (Phone)
972 3 6406330 (Fax)

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States
801-581-5457 (Phone)

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