Secured and unsecured debt in creditor-friendly bankruptcy

Abstract

This article develops a continuous-time asset pricing model for valuing corporate securities in the presence of both secured and unsecured debt. We consider a framework where creditors dominate the negotiation process. This is consistent with the increasing influence of creditors in bankruptcy. We show that the unsecured creditors are incentivized to liquidate the firm prematurely relative to the first-best threshold. However, if the firm’s liquidation value is very low, it should complement its secured debt with unsecured debt as a form of insurance to avoid early liquidations. Our results have important implications for the debt structure and the resolution of financial distress of modern firms with substantial intangible assets.