Costly State Verification and Multiple Investors: The Role of Seniority

Abstract

Many financial claims specify fixed maximum payments, varying seniority, and absolute priority for more senior investors. These features are motivated in a model where a firm’s manager contracts with several investors and firm output can only be verified privately at a cost. Debt-like contracts of varying seniority generally dominate symmetric contracts, and, when investors are risk neutral, it is optimal to use debt-like contracts where more senior claims have absolute priority over more junior claims. In addition to motivating several features of debt and preferred stock, the model offers an explanation for structures used in leveraged buyouts, asset-backed securitizations, and reinsurance contracts.