Incentive-compatibility, limited liability and costly liquidation in financial contracting

Zhengqing Gui, Ernst Ludwig von Thadden, Xiaojian Zhao

Research output: Contribution to journalArticleResearchpeer-review

Abstract

This paper studies a financial contracting problem where a firm privately observes its cash flow and faces a limited liability constraint. The firm's collateral is piecemeal divisible and can only be liquidated continuously by resorting to the service of a costly third party, typically associated with bankruptcy. In this situation, multi-class collateralized debt is optimal, in which the firm makes several debt-like promises with a seniority structure. The decision over continuous and piecemeal liquidation depends on both the cost of introducing the third party and the firm's funding need. Allowing the firm to refinance ex-post through surreptitious liquidation may reduce the firm's ex-ante payoff, consistent with covenants in debt contracts prohibiting the sale of assets.

Original languageEnglish
Pages (from-to)412-433
Number of pages22
JournalGames and Economic Behavior
Volume118
DOIs
Publication statusPublished - 1 Nov 2019

Keywords

  • Costly liquidation
  • Financial contracting
  • Incentive-compatibility
  • Indivisible collateral
  • Limited liability

Cite this