Bankruptcy litigation and optimal debt contracts

Abstract

In a credit market where only the borrower directly observes the outcome of a debt-financed investment project, a successful borrower may falsely claim project failure and repudiate. Collateral and the bank's option to force the borrower into filing for bankruptcy provide repayment incentives. Bankruptcy does not necessarily lead to liquidation of the borrower's assets, but may also imply reorganization. Given feasibility, the equilibrium debt contract is affected by the bank's commitment to exercise the bankruptcy option, the quality of the court's information and the penalty imposed on the borrower convicted for cheating. Collateral increases with project risk.