Debt-Equity Conflict and the Incidence of Secured Credit

Classic finance theory observes that while debt can mitigate the conflict between equity and management, its issuance creates a conflict between debt and equity. We search for evidence of this conflict in the incidence of secured debt, which can be used by financially distressed firms to finance unduly risky projects for the benefit of equity at the expense of unsecured creditors. Skeptics of the debt-equity conflict’s practical importance believe that distressed-firm management avoids secured credit, which may compel equity to relinquish control of a firm. Consistent with the classic account, our controlled study shows a significant run-up of secured credit, as a proportion of assets and of liabilities, prior to bankruptcy filings of publicly traded firms. Together with recent evidence of inefficiency as firms approach bankruptcy, our results support proposals for the subordination of secured debt to nonconsensual claims and for enhanced enforcement of covenants against the issuance of secured credit.