Bankruptcy Rules and Debt Contracting

Typical corporate finance folklore tells us that existing proportionate priority and absolute priority rules in bankruptcy have evolved in order to eliminate inefficiencies that result when lenders rush to retrieve their assets from a firm in financial distress. This paper shows that when a firm is faced with a moral hazard problem, first-come, first served rules reduce lenders’ incentives to free ride on the monitoring efforts of each other. As a result, these rules may reduce the total social cost of loan contracts compared to other bankruptcy rules. The bankruptcy rules described here mimic important contractual arrangements found in real-world debt contracts.