Debt and Insolvency

Abstract

Legal rules play a powerful but understudied role in security design. This article presents two new theoretical results about the design of debt contracts. The results derive from the premise that firms must avoid legal insolvency when issuing new debt because insolvency at issuance would trigger severe operational limitations on the issuer. I first show that legal insolvency limits debt capacity, limiting the amount of money that a firm can raise with debt. I next show that legal insolvency limits the yield that firms can promise new creditors, helping to explain why there is no market for ultra-high-yield new issue debt. The article’s results demonstrate that legal insolvency probably has important – if largely unnoticed – effects in limiting debt capacity and debt yields. More generally, the article illustrates the usefulness of better understanding legal solvency requirements, a legal mechanism that has received too little attention in the understanding of debt and security design.