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Working Paper

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.

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Longhofer, Stanley. 1994. “Bankruptcy Rules and Debt Contracting.” Federal Reserve Bank of Cleveland, Working Paper No. 94-15.