Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely to occur, thereby making debt financing more costly. Together, these results support the view that APR violations create an impediment to efficient financial contracting.Journal of Economic LiteratureClassification Numbers: G33, G38, K20

We present an information-based explanation for spinoffs. When the various divisions of a firm are spun off into several firms that have separate stock market listings, the number of traded securities increases. This makes the price system more informative. It improves the quality of the investment decisions made by managers and reduces uninformed investors' uncertainty about the value of the divisions. Both effects serve to increase the sum total of the market values of the spun-off divisions above the market value of the original firm.Journal of Economic LiteratureClassification Numbers: G14, G34.

This paper develops a model of price determination in insurance markets. Insurance is provided by firms that are subject to default risk. Demand for insurance is inversely related to insurer default risk and is imperfectly price elastic because of information asymmetries and private information in insurance markets. The model predicts that the price of insurance, measured by the ratio of premiums to discounted losses, is inversely related to insurer default risk and that insurers have optimal capital structures. Price may increase or decrease following a loss shock that depletes the insurer's capital, depending on factors such as the effect of the shock on the price elasticity of demand. Empirical tests using firm-level data support the hypothesis that the price of insurance is inversely related to insurer default risk and provide evidence that prices declined in response to the loss shocks of the mid-1980s.Journal of Economic LiteratureClassification Numbers: G22, G32, G33

We consider the design of securities that govern the distribution of cash flows and control rights for an investment project. An entrepreneur, endowed with managerial talent, contracts with an outside investor for required capital. Optimal contracts stipulate that the ownership of control and the distribution of cash flows are specified on a state contingent basis to manage the distortions that develop from the use of outside financing and so make the best use of the advantage in project management enjoyed by insiders. Our results illustrate that the use of warrants and convertible securities, which transfer control of the firm to outsiders in good states, and bankruptcy, which transfers control to outsiders in bad states, are related features of optimal contracts. Our model also indicates that firms will benefit from direct access to two types of bankruptcy processes resembling Chapter 7 and Chapter 11 (including deviations from absolute priority) of the bankruptcy code. This results differs from observed practices since stockholders cannot waive their rights for protection under Chapter 11. We show that when direct access to Chapter 7 is highly valuable, market participants have found clever ways to obtain it.Journal of Economic LiteratureClassification Numbers: G32 and G33.

When monitoring is not contractible—so investors monitor only when, at that time, they expect to benefit from doing so—efficient contracts sometimes induce managers to makefalsereports to investors. Because of monitoring discretion, management misrepresentation can produce Pareto improvements by reducing monitoring costs. When costs of renegotiation are small, optimal contracts necessarily induce misrepresentation. Discretionary monitoring also generates an equilibrium role for multiple-security capital structures. When an optimal contract has two investors, securityholder conflict arises endogenously as a means of reducing monitoring costs. It is efficient to write the contract so that one investor's decision to monitor hurts the other investor.Journal of Economic LiteratureClassification Number: G32.