Reorganization of Failing Financial Firms: A Capital Structure Solution

Document Type

Article

Publication Date

Winter 2018

Abstract

"The underlying rationale of joint-stock companies is that equity holders bear the largest proportional risk of an enterprise, and are rewarded with the most control over the firm and all of its upside risk. Equity owners are lowest in the debt hierarchy: their claims come after all other legitimate claimants of a defaulted enterprise. However, they are the highest in the hierarchy of control: in principle they select the directors of the enterprise who in turn select its management. This article argues that the rationale behind equity owner control should be extended in the debt and control hierarchies at least one more level. The unsecured debt of a firm should have a junior-most tranche, and control of the firm should devolve on the owners of that debt automatically and immediately upon the failure of the firm. Although the reorganization proposal described in this article would function effectively for any failing enterprise, this article considers the important and challenging problem of restructuring a failing systemically important financial institution (SIFI)."

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This article was originally published in Cato Journal, volume 38, issue 1, in 2018.

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Cato Institute

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