Contractual Resolutions of Financial Distress

• Authors: Nicola Gennaioli and Stefano Rossi.
• BSE Working Paper: 651 | September 15
• Keywords: Investor protection , Financial Distress , Financial Contracting
• JEL codes: G33, K22
• Investor protection
• Financial Distress
• Financial Contracting

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. Our theory predicts that the efficiency of contractual resolutions of financial distress should increase with investor protection.