Monthly Archives: January 2020

Classic finance theory—from the framework created by Jensen and Meckling—observes that while debt can mitigate the conflict between equity and management, the issuance of credit creates a conflict between debt and equity. To explore the latter conflict, we take advantage of the insight that once a firm creates a debt-equity conflict through the issuance of debt, if the firm’s management, on behalf of equity, is to exploit the firm’s creditors, the optimal vehicle for such exploitation is additional debt, senior debt in particular. Despite recent conjecture that risk averse managers eschew the exploitation of credit, we predict, and find, that the debt-equity conflict, fueled by distressed firms’ issuance of secured credit, is a live problem for firms, one worthy of consideration.

Consistent with our hypothesis, critics of secured finance, argue that financially vulnerable firms use priority credit to externalize (at least in an ex post sense) the risk of failure. On this view, the winners are a coalition of a debtor’s shareholders and secured creditors, which share investment’s upside, at the expense of the debtor’s unsecured creditors, who bear the downside. And because the debtor may be more interested in enhanced risk that favors junior interests than expected return to the firm, the expected loss may well exceed the expected gain. The threat of such inefficient overinvestment has led some to call for a reduction in secured credit’s priority.

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