Disagreement and Capital Structure Complexity

Corporate bankruptcies often involve complicated, fragmented capital structures with many layers of debt and legal entity structures with many subsidiaries. Why do capital structures evolve this way, given that they make distress more costly to resolve? I suggest an answer based in investor disagreement about the value of assets that back loans. When investors disagree, firms have the incentive to exploit the disagreement by issuing asset-backed claims to optimists about those assets.

This capital structure fragmentation minimizes the borrower’s cost of funds ex ante by maximizing creditors’ perceived recoveries, but it also creates costly valuation disputes in bankruptcy. I show that disagreement about collateral values can cause inefficient liquidations. Reorganization, in which prebankruptcy creditors receive securities in the ongoing firm, allows parties to agree to disagree about the value of their entitlements. This promotes settlement and reduces costly litigation over valuation relative to a going-concern sale for cash.