Financial Contracting Under Imperfect Enforcement (original) (raw)
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Legal enforcement, default and heterogeneity of project-financing contracts
Annals of Finance, 2014
This paper employs mechanism design to study how imperfect legal enforcement impacts simultaneously on the availability (or scale) of credit for investment and interest rates. The analysis combines two standard ingredients of the development and contract literatures: limited commitment, which encapsulates the idea that contract enforcement is imperfect, and asymmetric information about cash flows, which justifies debt contracts and default under some circumstances. Costly use of courts may be optimal, which differs from most limited commitment models, where punishments are just threats, never applied in optimal arrangements. Paradoxically, liquidation by courts only happens in equilibrium when courts are imperfect. Numerical solutions for several parametric specifications, allowing for heterogeneity on initial wealth are provided. In all such solutions, wealthier individuals borrow with lower interest rates and run higher scale enterprises, which is consistent with stylized facts. The reliability of courts has a consistently positive effect on the scale of projects. However its effect on interest rates is subtler and depends on the degree of curvature of the production function.
This paper analyzes how an enforcement mechanism that resembles a court affects firm finance. We construct a model of enforcement which shows the following: (i) Firm default due to inability to pay and unwillingness to pay are equilibrium phenomena that arise endogenously and co-exist. (ii) The parameters that characterize enforcement have a highly non-linear influence on firm finance. (iii) Equilibrium credit rationing can occur for plausible parameter values. (iv) We identify a new type of credit rationing that is inherent in the underlying legal system. (iv) We provide complete characterizations of the effect of the enforcement parameters on the contract interest rate and the bankruptcy probability. These results help explain recent puzzles in empirical evidence on how the legal environment affects financial structure.
Moral Hazard and Capital Structure Dynamics
SSRN Electronic Journal, 2002
We base a contracting theory for a start-up firm on an agency model with observable but nonverifiable effort, and renegotiable contracts. Two essential restrictions on simple contracts are imposed: the entrepreneur must be given limited liability, and the investor's earnings must not decrease in the realized profit of the firm. All message game contracts with pure strategy equilibria (and no third parties) are considered. Within this class of contracts/equilibria, and regardless of who has the renegotiating bargaining power, debt and convertible debt maximize the entrepreneur's incentives to exert effort. These contracts are optimal if the entrepreneur has the bargaining power in renegotiation. If the investor has the bargaining power, the same is true unless debt induces excessive effort. In the latter case, a non-debt simple contract achieves efficiency -the non-contractibility of effort does not lower welfare. Thus, when the non-contractibility of effort matters, our results mirror typical capital structure dynamics: an early use of debt claims, followed by a switch to equity-like claims.
SSRN Electronic Journal, 2012
We investigate Project Finance as a private response to ine¢ ciencies created by weak legal protection of outside investors. We o¤er a new illustration that law matters by demonstrating that for large investment projects, Project Finance provides a contractual and organizational substitute for investor protection laws. Project Finance accomplishes this by making cash ‡ows veri…able, thereby enhancing debt capacity. Two features of Project Finance make cash ‡ows veri…able: (i) contractual arrangements made possible by structuring the Project Company as a single, discrete project legally separate from the sponsor; and (ii) private enforcement of these contracts through a network of project accounts that ensures lender control of project cash ‡ows. Comparing the incidence of bank loans for Project Finance with regular corporate loans for large investments ("Corporate Debt Finance"), we show that Project Finance is more likely in countries with weaker laws against insider stealing and weaker creditor rights in bankruptcy. Our identi…cation relies on di¤erence-in-di¤erence tests that exploit exogenous country-level changes in legal rules.
Capital Structure under Costly Enforcement a
Scand J Econ, 2008
We consider financial structure and repayment behavior in a setting where cash flows are private information to the entrepreneur and the cost of enforcing repayment differs across security holders. If enforcement costs are lower for shareholders than for creditors, a mixed capital structure with debt and equity can obtain in equilibrium. Under a mixed capital structure, creditors intervene in low cash-flow states while shareholders intervene in high cash-flow states. Moreover, strategic defaults, costly bankruptcy, shareholder intervention, and violation of absolute priority occur with positive probability on the equilibrium path. Several of the predictions from our framework are consistent with evidence not readily explainable by existing theories.
Financial contracting and misreporting with limited enforcement, firm financing and growth
Cogent Economics & Finance
This article employs a dynamic stochastic general equilibrium framework to examine asymmetric information and limited contract enforcement in financial markets, where firms have access to both internal and external sources of finance. It considers limited enforcement of financial contract in the form of firm's ability to misreport and default on output when it is still solvent, that is, a form of institutional weaknesses in holding defaulters to account. The model shows how institutional weakness in the form of limited enforceability of financial contracts affects fluctuations in key macroeconomic variables such as output, employment and investment via its impact on interest rates, risk premium, default risk and leverage. The findings show that limited contract enforcement amplifies the effects of shocks and lower small firm funding. The sensitivity analysis shows that weak contract enforcement affects firm growth and also leads to welfare losses to the society. This study is relevant for developing countries, where there is often poor quality of institutions and the paper suggests that improving such quality has the potential to improve the prospects of such countries.
What is the role of legal systems in financial intermediation? Theory and evidence
Journal of Financial Intermediation, 2009
We develop a theory and empirical test of how the legal system affects the relationship between a venture investor and an entrepreneur. The theory uses a double moral hazard framework to show how optimal contracts and investor actions depend on the quality of the legal system. The empirical evidence is based on a sample of European venture capital deals. The main results are that with better legal protection, investors give more non-contractible support and demand more downside protection, and they develop more value-adding skills. These predictions are stongly supported by the empirical analysis. We also find that the investor's legal system is more important that of the company in determining these effects, and that legal system effects persist within civil law countries. le * We are grateful to all the venture capital firms which provided us with data. We received valuable comments from
What Role of Legal Systems in Financial Intermediation? Theory and Evidence
SSRN Electronic Journal, 2000
How does the relationship between an investor and entrepreneur depend on the legal system? In a double moral hazard framework, we show how optimal contracts, corporate governance, and investor actions depend on the legal system. With better legal protection, investors want to exercise more governance, give more non-contractible support, and demand more downside protection. Moreover, investors in better legal systems have stronger incentives to develop the competencies necessary to provide governance and value-adding support. We test these predictions using a hand-collected dataset of European venture capital deals. The empirical results confirm the model predictions and show that both the investor's and entrepreneur's legal systems matter.
Expropriation Risk, Governance Control and Equilibrium Financial Contract
1997
We present a model of financial contracting in the presence of asymmetric information between entrepreneur and investor. Either liquidation threat or governance control can be used to protect investor's interests against expropriation risk. The two parties first agree to a financial arrangement which assigns to the parties the "governance right" to choose the level of governance control and the "contracting right" to design the financing contract.