AGENCY PROBLEMS OF DEBT, CONVERTIBLE SECURITIES, AND DEVIATIONS FROM ABSOLUTE PRIORITY IN BANKRUPTCY

It has been suggested that convertible debt can be used to reduce the tendency toward excessive risk taking in a firm that includes debt in its capital structure. We show that the ability of convertible debt to perform this function is greatly reduced if stakeholders can trade in derivative securities with payoffs contingent on the cash flows of th e firm. We show, further, that bankruptcy courts cna ensure the same r esult precisely by deviating from absolute priority. Our model explain s two real-world phenomena; one, why bankruptcy law seems to be struct ured in such a way as to favor equity holders and facilitate deviation s from absolute priority, and two, why small firms are more likely to use convertible debt.