Abstract
This paper examines the relationship between debt contract and the process of resolving financial distress, through either debt restructuring or bankruptcy procedure. It effectively justifies the popularity of the standard debt contract by demonstrating that the standard debt contract is the optimal debt contract for small business with the costly random verification scheme. Although this result is quite different from Townsend (1979) and Williamson (1986,1987), it is compatible with their results and serves as a good supplement. This paper relates credit rationing directly to bankruptcy cost. It is shown that credit rationing, characterized as a loan amount granted less than requested, becomes more severe as bankruptcy cost rises. This result supports 1994 amendments to the Bankruptcy Code since it shows that simplifying bankruptcy procedure for small business reduces credit rationing, therefore, enhance lending.
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