Shareholder Opportunism in a World of Risky Debt
Vol. 123 No. 5
Modern finance is increasingly dominated by derivatives and similar contracts that create contingent debts, which become payable only upon the occurrence of an uncertain future event. This Article identifies a pervasive opportunism hazard created by contingent debt that lawmakers and scholars have overlooked. If liability on a firm’s contingent debt is especially likely to be triggered when the firm is insolvent, the contract that creates the debt transfers wealth from the firm’s creditors to its shareholders. A firm therefore has incentive to engage in correlation-seeking – that is, to incur contingent debts that correlate, or that through asset purchases can be made to correlate, with the firm’s insolvency risk. The consequence is an overuse of contingent debt that destroys social wealth through overinvestment, higher borrowing costs, financial distress, and potential systemic risk.