An Incomplete Contracts Approach to Corporate Bankruptcy

Abstract

This paper integrates the problem of designing corporate bankruptcy rules into a theory of optimal debt structure. We show that, in an incomplete contract framework with imperfect renegotiation, having multiple creditors increases a firm's debt capacity while increasing its incentives to default strategically. The optimal debt contract gives creditors claims that are jointly inconsistent in case of default. Bankruptcy rules, therefore, are a necessary part of the overall financing contract, to make claims consisitent and to prevent a value reducing run for the assets of the firm. Furthermore, a too unequal allocation of security rights is not optimal, and creditors are not treated asymmetrically in default under the optimal contract.bankruptcy; debt structure; contracts