Optimal Resolutions of Financial Distress by Contract
Bocconi University - Department of Finance; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research
Krannert School of Management; Centre for Economic Policy Research (CEPR)
In a financial contracting model, we characterize which debt structures can optimally resolve financial distress as a function of investor protection against tunneling. If investor protection is strong, the first best can be implemented under a debt structure consisting of two classes of debt: one that gives control upon default to a large creditor and induces him to internalize the upside of efficient reorganization, and a second, fully dispersed debt class without control rights. If instead investor protection is low, the second best can be implemented by dispersing control rights among creditors lending under standard "straight debt" contracts.
Floating charge financing successfully combines the features of our optimal debt structure in countries with strong investor protection and no restrictions to private contracting on bankruptcy.
Number of Pages in PDF File: 39
Keywords: Corporate bankruptcy, Creditor Protection, Financial contracting
JEL Classification: G33, K22
Date posted: July 12, 2006 ; Last revised: October 26, 2008