Contractual Resolutions of Financial Distress

Abstract

In a financial contracting model we study the optimal debt structure to resolve financial distress. We show that a debt structure where two distinct debt classes co-exist − one class fully concentrated and with control rights upon default, the other dispersed and without control rights − removes the controlling creditor's liquidation bias when investor protection is strong. These results rationalize the use and the performance of floating charge financing, debt financing where the controlling creditor takes the entire business as collateral, in countries with strong investor protection. More broadly, our theory predicts that the efficiency of contractual resolutions of financial distress should increase with investor protection.JEL classification: G33, K22.

Debt Rescheduling with Multiple Lenders: Relying on the Information of Others

“…An interpretation is that the debt contracts give each lender a foreclosure right equal to L + e, so that the sum of foreclosure rights exceeds assets in place. See also Gennaioli and Rossi (2014), who discuss the role of asymmetric debt structures for mitigating liquidation bias. 11.…”

“…Our explanation is therefore novel. With respect to the issue of coordination failures and liquidation bias, Gennaioli and Rossi (2014) discuss the use of floating charge debt and a dual class of debt. We take the short-term debt contract form as exogenous and stress instead the effects of information asymmetries on the lenders' incentives to reschedule loans.…”

Debt Rescheduling with Multiple Lenders: Relying on the Information of Others

“…Our explanation is therefore novel. With respect to the issue of coordination failures and liquidation bias, Gennaioli and Rossi (2012) discuss the use of ‡oating charge debt and a dual class of debt. We take the short-term debt contract form as exogenous and stress instead the e¤ects of information asymmetries on the lenders' incentives to reschedule loans.…”

“…An interpretation is that the debt contracts give each lender a foreclosure right equal to L + ", so that the sum of foreclosure rights exceeds assets in place. See alsoGennaioli and Rossi (2012) who discuss the role of asymmetric debt structures for mitigating liquidation bias.…”