Optimal Financial Contracts for Large Investors: The Role of Lender Liability

Abstract

This paper explores the optimal financial contract for a large investor with potential control over a firm's investment decisions. The authors show that an optimally designed menu of claims for a large investor will include features resembling a U.S. version of lender liability doctrine, equitable subordination. This doctrine permits a firm's claimants to seek to subordinate a controlling investor's financial claim in bankruptcy court, but only under well-specified conditions. Specifically, the authors show that this doctrine allows a firm to strike an efficient balance between two concerns: (i) inducing the large investor to monitor, and (ii) limiting the influence costs that arise when claimants can challenge existing contracts in bankruptcy court. The paper also provides a partial rationale for a financial system in which powerful creditors do not generally hold blended debt and equity claims.