Bankruptcy law, asset substitution problem, and creditor conflicts

We argue that there may be an additional goal of bankruptcy law to mitigate possible conflicts of interest among senior and junior debt. If a firm is heavily in debt, senior and junior debt can be affected differently by changes in firm's risk. The senior creditor tends to lose by risk-increasing, the junior creditor tends to lose by risk-decreasing. The entrepreneur and one creditor could cooperate and change investment policy jointly to the cost of the remaining creditor (coalition problem). This might even work, if asset substitution is not efficient. We ask, whether there are counterbalancing provisions of bankruptcy law which mitigate coalition problems. Deviations from absolute priority in Chapter I I of the U.S. Bankruptcy Code tend to complicate the forming of coalitions, since the entrepreneur usually receives quite a large return without coalition. With respect to Germany, the Bankruptcy Code provides more outside options to the creditors, thereby defining threat points. This makes it also more difficult to form coalitions. (C) 2002 Elsevier Science Inc. All rights reserved.