Bondholder Stockholder Conflict

Question 1

Gertner and Scharfstein 1991 JF

Answer 1

Coordination problem between bondholders prevents reorganzation via distress exchange. Chapter 11 mitigates this problem, increasing investment. This may or may not lead to efficient investment, depending on whether distress induces underinvestement or overinvestment.

Underinvestment stems from bank debt being senior, bonds being short term, or bond being protected by seniority covenants. Overinvestment arisis from junior bank debt, long-term bonds, or strippable seniority convenants with exit consents.

Question 2

Hart 1993 InCollection

Answer 2

Soft debt allows firm to take advantage of tax and market-completion beneifits, while avoiding distress costs. Efficient investment insured by managerial incentive based on total (net) market value.

1. first-best can be achieved by making all of a firm’s debt soft; that is, all
2. debt should be junior (management should be given the right to issue unlimited amounts of additional debt senior to existing debt)
3. and postponable (all debt should be in the form of payment-in-kind [PIK] bonds, which give management the right to postpone debt payments at management’s direction).
4. reason is that, by issuing such soft claims, the firm can take advantage of all the tax and market-completion benefits of debt without incurring any bankruptcy or financial-distress costs.
5. Efficient investment choices can be ensured by putting management on an incentive scheme that rewards it according to the firm’s total (net) market value,

Question 3

Leland 1994 JF

Answer 3

Positive net worth covenants protect debt holders from shareholders transferring wealth through increasing firm risk, by causing value of debt & equity to both be declining in risk.

Question 4

Hart and Moore 1995 AER

Answer 4

With a capital structure comprised of simple debt and equity, higher new investment profits are associated with lower leverage. Conversely, higher assets in place profits are associated with higher LT debt. Thus, if profits are higher for new investments it explains the negative correlation between total profits and leverage.

Takeover threat induces management to credibly commit to not overinvesting by swapping debt for equity, in order to induce shareholders not to tender offer. Thus, increases in leverage and market value will move together.

Question 5

Zwiebel 1996 AER

Answer 5

Focuses on on managerial, not shareholder, optimaility. Management voluntarily take on debt to credibly constrain empire-building, but dynamically balance this with need to maintain flexibility in order to ensure sufficient investment efficiency so as to prevent control challenges. A policy of dividend payments coordinated with debt follows as a direct implication.