Agency Cost and Court Action in Bankruptcy Proceedings in a Simple Real Option Model

While legally considered the residual interest, equity holders are often given a very small share of the liquidation value of a bankrupt corporation, even when liquidation value does not cover all other claims with higher priority.  Such expected residual value for equity holders can lead to changed corporate investment incentive which counteracts the well-documented sub-optimal operation for a firm in financial distress.  This paper constructs a model illustrating the agency problem in sub-optimal investment of a firm in financial distress and how court action in compensating equity restores the proper incentive.  Such court action that violates the priority rule is ex ante rational and result in higher social benefit, even though it seems expost unfair