Abstract
We explore the optimal financial contract for a large investor with potential control over a firm's investment decisions. An optimal menu of claims resembles a U.S. version of lender liability doctrine—equitable subordination. This doctrine permits the court to subordinate a controlling investor's claim in bankruptcy, but only under well-specified conditions. It allows a firm to strike an efficient balance between: (i) inducing the large investor to monitor, and (ii) limiting the influence costs that arise when claimants can challenge existing contracts. We provide a partial rationale for a financial system in which powerful creditors do not hold blended debt and equity claims. Journal of Economic Literature Classification Numbers: G20, G33, K22.
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