Capital Structure as a Bargaining Tool: The Role of High Leverage in Contract Renegotiation

This paper presents a strategic model of temporary leverage. When repayment of senior debt relies upon future investment, shareholders may credibly alter their incentives to invest through an exchange of junior debt for equity. The subsequent contractual renegotiation leads to concessions by senior creditors. Although our analysis applies in general to conflicts between shareholders and senior claimants, we focus on the conflict between shareholders and risk averse workers. It is shown that the strategic use of debt leads to an inefficient allocation of risk. These results are robust to the possibility of junior debt renegotiation. 

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