Corporate Governance

The Design of Corporate Debt Structure and Bankruptcy

By Harvard Law School Program on Corporate Governance

In our paper, The Design of Corporate Debt Structure and Bankruptcy, forthcoming in the Review of Financial Studies, we analyze the design of bankruptcy rules and debt structure in an optimal-contracting perspective. If cash flow is not verifiable and only the asset value of the firm is verifiable, then when a firm borrows from a single creditor and has all bargaining power, its debt capacity is limited to the value of its asset base. The reason is that the creditor can never expect to receive more than the asset value in liquidation and in renegotiation. However, when a firm borrows from more than one creditor, it can increase its debt capacity by pledging its asset base to more than one creditor by giving each the right to foreclose individually. If the debt structure of the firm is designed appropriately, this creates a commitment for the firm to pay out more in good states to prevent the exercise of individual foreclosure rights and thus raises the firm?s debt capacity. Having multiple creditors thus helps to reduce the negative effects of the lack of commitment in contracting by distinguishing between individual foreclosure rights and joint liquidation rights achieved under bankruptcy.

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Full post as published by The Harvard Law School Corporate Governance Blog on June 02, 2010 (boomark / email).