Conflicts in Bankruptcy and the Sequence of Debt Issues

We present a model that shows how interactions between creditor groups in bankruptcy can affect the debt issuance decisions of firms. In particular, we suggest that deviations from APR should be priced and can affect the issuing decisions of junior and senior debt. Our model suggests that once firms issue debt with one level of seniority, they have an incentive to alternate, and subsequent issues will have a different seniority level. When we introduce explicit costs of conflict in our model, we find that as these costs increase, firms will tend to stay with one class of debt. The empirical implications of our model are consistent with the somewhat surprising fact that most firms issue debt at one seniority level only, and quite a few of them never issue any senior debt. We also find that companies that issue only senior subordinated debt are much smaller than those that issue senior debt, while those that issue at both levels are intermediate on most financial measures. This is broadly consistent with our theoretical analysis. Our model is also supported by the fact that companies that issue only senior debt pay lower spreads than companies that issue at both levels. Finally, we study a sample of firms in bankruptcy and again find significant relationships between corporate characteristics and the types of debts that they issue, as predicted by the model.