Template-Type: ReDIF-Paper 1.0
Title: Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting
Author-Name: Zhengqing Gui
Author-Email: zgui@ust.hk
Author-Name: Ernst-Ludwig von Thadden
Author-Email: vthadden@uni-mannheim.de
Author-Name: Xiaojian Zhao
Author-Email: xjzhao81@gmail.com
Classification-JEL: D86, G33
Keywords: Financial contracting, incentive-compatibility, limited liability, indivisible collateral, costly liquidation

Abstract:We characterize an optimal financial contract when the firm’s realized cash flow is
unobservable to the investor and the firm’s collateral can only be liquidated partially
by resorting to the services of a costly third party. An optimal contract may exhibit
a piecewise structure and vary with the liquidation cost and the firm’s actual liquidity
shortage. Partial liquidation and wholesale transfers of collateral can coexist in an
optimal contract. In contrast to part of the literature, the incentive-compatibility
constraint incorporates the firm’s limited liability, and may be slack at the optimum.
Allowing the firm to overcome an ex-post liquidity shortage by borrowing surreptitiously
from a third party may reduce the firm’s ex-ante expected utility.

Note: 
Length: 38
Creation-Date: 2018-12
Revision-Date: 
File-URL: https://www.crctr224.de/research/discussion-papers/archive/dp064
File-Format: application/pdf
Handle: RePEc:bon:boncrc:CRCTR224_2018_064