Optimal Debt Design and the Role of Bankruptcy

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  • 1 January 2003
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      • Published in RePEc
Abstract
This paper integrates the problem of designing corporate bankruptcy rules into a theory of optimal debt structure. We show that, in an incomplete-contracts 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 consistent and to prevent a value reducing run for the assets of the firm. It is not optimal to treat creditors asymmetrically in default, but creditors may be protected by different security rights.
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