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Financial contracts and the legal treatment of informed investors

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  • Mitchell Berlin
  • Loretta J. Mester

Abstract

The authors explore the economic rationale for equitable subordination, a legal doctrine that permits a firm's claimants to seek to subordinate an informed investor's financial claim in bankruptcy court. Fear of equitable subordination is often cited as a reason that banks in the U.S. are wary of taking an active management role in their borrowing firms. The authors show that an optimally designed menu of claims for a large investor will include features that resemble equitable subordination. The authors' model provides a partial rationale for a financial system in which powerful creditors do not generally hold blended debt and equity claims.

Suggested Citation

  • Mitchell Berlin & Loretta J. Mester, 1999. "Financial contracts and the legal treatment of informed investors," Working Papers 99-8, Federal Reserve Bank of Philadelphia.
    • Handle: RePEc:fip:fedpwp:99-8
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