M. Suresh Sundaresan
Optimal Corporate Securities Values in the Presence of Chapter 7 and Chapter 11
Coauthor(s): Mark Broadie, Mikhail Chernov.
Adobe Acrobat PDF
In a contingent claims framework, with a single issue of debt and full information, we show that
the presence of a bankruptcy code with automatic stay, absolute priority rules, and potential debt
forgiveness, can lead to significant conflicts of interest between the borrowers and lenders. In the
first-best outcome, the code can add significant value to both parties by way of higher debt capacity,
lower spreads, and improvement in the overall value of the firm. If the control is given to borrowers
about ex-ante timing of entering into bankruptcy and the ex-post decision to liquidate once the
firm goes into bankruptcy, most of the benefits of the code are appropriated by the borrowers
at the expense of the creditors. We show that the lenders can restore the first-best outcome, in
large measure, by seizing this control or by ex-post transfer of control rights which allows them to
decide when to liquidate the firm that has been taken to the chapter 11 process by the borrowers.
Irrespective of who is in control, our model implies, based on the term structure of probabilities
of default and liquidation, that firms are more likely to default on average and are less likely to
liquidate on average relative to the benchmark model of Leland (1994).
Sundaresan, M. Suresh, Mark Broadie, and Mikhail Chernov. "Optimal Corporate Securities Values in the Presence of Chapter 7 and Chapter 11." Columbia Business School, June 2004.