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E-MailThis post comes to us from Ernst-Ludwig von Thadden, Professor of Economics and Finance at the University of Mannheim, Erik Berglöf, Chief Economist and Special Adviser to the President at the European Bank for Reconstruction and Development, and Gérard Roland, Professor of Economics and Political Science at the University of California, Berkeley.
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.
Our theory provides a bridge between corporate finance and the legal theory of debtor-creditor law. The key distinction in debtor-creditor law in most jurisdictions is that between debt collection law and bankruptcy law. The former governs the interaction between the debtor and a single creditor, the latter the interaction between the debtor and several creditors. Our analysis shows how this same distinction can be made in a contract-theoretic approach to debt. Individual foreclosure rights (corresponding to debt-collection law) are crucial to generate repayment incentives, but need to be complemented by collective liquidation rights (corresponding to bankruptcy law) in order to maximize ex-post efficiency.
Our results on debt structure and overleverage under multiple creditors depend on the fact that creditors have unilateral foreclosure rights that they can exercise in case of default, independently of what other creditors decide. These rights should be seen as an important element of investor protection. The renegotiation procedure modeled in this paper emphasizes the effect of these rights since renegotiation is assumed to happen on an individual basis. The ensuing non-cooperative game between creditors forces the debtor to respect contractual claims as given by individual foreclosure rights whenever he wants to avoid default. The key assumption in this approach is that it is difficult and costly to bring the creditors together to renegotiate the debt contract collectively. Only bankruptcy brings all the contracting parties together at one table, but in bankruptcy the debtor has given up his residual ownership rights, and the procedure is mostly concerned with the reconciliation of individual liquidation claims. This is the classical “vis attractiva” of bankruptcy.
Yet, it is theoretically conceivable that the debtor can unite the group of creditors and extract from them joint concessions under the threat of bankruptcy. If such workouts are frictionless, debt structure becomes irrelevant, because individual collection rights have no bite in enforcing claims. As documented, e.g., by Asquith, Gertner, and Scharfstein (1994) and Gilson (1997), however, frictions in such negotiations are usually substantial and increase with the number of creditors. One important reason for these frictions is the hold-up problem of individual creditors, which is precisely the reason for institutionalized bankruptcy rules. Further reasons (which we ignore in this paper) include the aggregation of asymmetric information among multiple creditors and the legal uncertainty accompanying out-of-court debt renegotiations, if individual creditors have the possibility of contesting the new arrangement in court.
Our model relies on the classical Rawlsian justification of legislation as a substitute for contracting in the “original position” (Rawls, 1971), an approach to law, and bankruptcy law in particular, that is wide-spread in legal thinking. The classic text of Jackson (1986), for example, when exploring the foundations of bankruptcy law, only argues that a “collective system of debt collection law” is needed, relegating the issue of private contracting to a footnote. Building on this approach to the foundations of bankruptcy law, our contribution is to make the hypothetical private contract explicit.
The full paper is available for download here.
