Citation
Three essays in financial economics and law

Material Information

Title:
Three essays in financial economics and law
Creator:
Liu, Wei-lin
Publication Date:
Language:
English
Physical Description:
vii, 129 leaves : ill. ; 29 cm.

Subjects

Subjects / Keywords:
Bank management ( jstor )
Cost accounting ( jstor )
Debt ( jstor )
Debtors ( jstor )
Investors ( jstor )
Law enforcement ( jstor )
Lenders ( jstor )
Marginal costs ( jstor )
National debt ( jstor )
Signals ( jstor )
Dissertations, Academic -- Finance, Insurance and Real Estate -- UF ( lcsh )
Finance, Insurance and Real Estate thesis, Ph. D ( lcsh )
Genre:
bibliography ( marcgt )
non-fiction ( marcgt )

Notes

Thesis:
Thesis (Ph. D.)--University of Florida, 1997.
Bibliography:
Includes bibliographical references (leaves 125-128).
General Note:
Typescript.
General Note:
Vita.
Statement of Responsibility:
by Wei-lin Liu.

Record Information

Source Institution:
University of Florida
Holding Location:
University of Florida
Rights Management:
The University of Florida George A. Smathers Libraries respect the intellectual property rights of others and do not claim any copyright interest in this item. This item may be protected by copyright but is made available here under a claim of fair use (17 U.S.C. §107) for non-profit research and educational purposes. Users of this work have responsibility for determining copyright status prior to reusing, publishing or reproducing this item for purposes other than what is allowed by fair use or other copyright exemptions. Any reuse of this item in excess of fair use or other copyright exemptions requires permission of the copyright holder. The Smathers Libraries would like to learn more about this item and invite individuals or organizations to contact the RDS coordinator (ufdissertations@uflib.ufl.edu) with any additional information they can provide.
Resource Identifier:
028030673 ( ALEPH )
37852798 ( OCLC )

Downloads

This item has the following downloads:


Full Text










THREE ESSAYS IN FINANCIAL ECONOMICS AND LAW







By

WEI-LIN LIU


















A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY UNIVERSITY OF FLORIDA 1997
















To My Wife Yan Li














ACKNOWLEDGMENTS

I arn deeply indebted to Tracy Lewis and Charles Hadlock, who provided guidance, support and inspiration. My gratitude to both of them for their generous help throughout this work is beyond what words can describe. I also wish to express my thanks to David Sappington, Joel Houston and members of my committee.














TABLE OF CONTENTS



ACKN OW LED G M ENT S ............................................................................................... iii

ABSTRACT .................................................................................................................... vi

CHAPTERS

I INTROD U CTION ............................................................................................. I
M otivating and Com pensation Investm ent A dvisors .......................................... 1
Setting Standards for Credible Compliance and Law Enforcement .................... 2
Monitoring and The Optimal Mix of Public and Private Debt Claims ................ 3

2 MOTIVATING AND COMPENSATING
IN VESTM EN T A D V ISORS ............................................................................. 5
Introduction ....................................................................................................... 5
A Sim ple D iscrete M odel ................................................................................... 7
The G eneral Tw o-State M odel ......................................................................... 13
Extension ......................................................................................................... 24
Conclusions ..................................................................................................... 26

3 SETTING STANDARDS FOR CREDIBLE COMPLIANCE AND
LAW EN FO RCEM EN T .................................................................................. 34
Introduction ..................................................................................................... 34
Elem ents of The Basic M odel .......................................................................... 37
A nalysis of The Sim ple Case ........................................................................... 42
Privately Inform ed Enforcer ............................................................................ 46
H heterogenous Parties ....................................................................................... 49
Setting Optim al Fines ...................................................................................... 53
Conclusions ..................................................................................................... 55

4 MONITORING AND THE OPTIMAL MIX OF PUBLIC AND PRIVATE
D EBT CLA IM S ............................................................................................... 58
Introduction ..................................................................................................... 58
Elem ents of The M odel .................................................................................... 64
The Mix of Long-Term Public and Bank Debt Claims ..................................... 69
The O ptim al Bank D ebt ................................................................................... 73

iv








The Optimal Mix.. 85
Em pirical Im plications .................................................................................... go
C onclusions ..................................................................................................... 92

5 C O N C LU SIO N S ............................................................................................. 96

APPENDIX A: PROOFS 0 F THE MAIN RESULTS IN CHAPTER TWO ................. 98

APPENDIX B: PROOFS 0 F THE MAIN RESULTS IN CHAPTER THREE ............ 108

APPENDIX C: PROOFS 0 F THE MAIN RESULTS IN CHAPTER FOUR .............. 117

R E FE R E N C E S ............................................................................................................. 125

BIOGRAPHICAL SKETCH ......................................................................................... 129

































v














Abstract of Dissertation Presented to the Graduate School of
the University of Florida in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy

THREE ESSAYS IN FINANCIAL ECONOMICS AND LAW By

WEI-LIN LIU

August 1997

Chairman: David Brown
Co-Chairman: Tracy Lewis
Major Department: Finance

The dissertation is a collection of studies in financial economics and law. The first chapter introduces the thesis. The second chapter analyzes the problem of how an investor can compensate an investment advisor to both motivate the advisor to diligently collect information and elicit truthful revelation of his private information. I find that the structure of an optimal compensation scheme depends both on the technology of information collection and on the accuracy level of the information that the advisor is induced to achieve. I identify instances in which the design of an optimal compensation scheme is independent of whether the information acquired by the advisor is publicly observable or not.

The third chapter examines the problem of setting optimal legal standards when enforcers of the standards must be motivated to detect violations. I find that some divergence between the marginal benefits and the marginal costs of providing care by potential violators is required to control enforcement costs. Furthermore, the setting of vi








standards may effectively substitute for the setting of fines when penalties for violations are fixed. In particular, it is found that imposing maximal fines may be welfare reducing.

The fourth chapter explores the issue of how firms optimally design their debt structures by using both public and private debt. The principal finding is that in general the optimal debt structures are a mix of long-term public debt and private debt with varying repayment schedules. In addition, I show how financial intermediaries can produce information through monitoring the firms they lend to, and I extend the notion of delegated monitoring to the case when there are multiple classes of creditors.

































vii














CHAPTER I

INTRODUCTION



This dissertation is a collection of studies in financial economics and law. The second chapter analyzes the problem of how best an investor can compensate an investment advisor to both motivate the advisor to diligently collect information and elicit truthful revelation of his private information. The third chapter examines the problem of setting legal standards when enforcers of the standards must be motivated to detect violations. The fourth chapter explores the issue of how firms optimally design their debt structures by using both public and private debt.

Motivating and Compensating Investment Advisors

Individual investors generally do not have the expertise to assess prospective investment opportunities, and they may rely on investment advisors for expert opinions. In designing the advisor's compensation scheme, however, two problems arise: 1) it must motivate the advisor to diligently collect information, and 2) it must induce the advisor to truthfully reveal his information to the investor. In chapter 2, 1 derive the optimal compensations schemes which satisfy both of these conditions.

I first analyze the case in which the advisor's information is publicly observable. I find that the optimal payment scheme rewards the advisor more richly for correctly predicting an outcome, if expending effort best enhances his ability to predict that outcome.

I








2

When the advisor's information is not publicly observable, I find that the need to induce the advisor to expend effort generally interferes with the need to elicit truthful revelation. I show that in general there exists a critical level of effort. If the advisor is induced to expend an effort higher than the critical one, whether his information is publicly observable or not is immaterial. If the advisor is induced to expend an effort lower than the critical one, the two needs interact. In this case, the advisor is rewarded more richly if he correctly predicts the outcome less likely to occur.

The analysis in chapter 2 extends previous analysis by Kilhstrom (1986) who assumes that the advisor's information is publicly observable and that the advisor's effort improves the accuracy of his infon-nation equally. The results in Bhattacharya and Pfleiderer (1987) and Stoughton (1995) rely critically on the symmetry property of the information technology. In my analysis, this assumption is relaxed in a binary signal setting.

Setting Standards for Credible Compliance and Law Enforcement

Chapter 3 analyzes the problem of setting socially optimal legal standards when enforcers of the standards must be motivated to oversee potential violators. Beginning with Becker (1968), research in enforcement of legal standards has focused on the setting of fines as a primary tool of enforcement. In contrast, this analysis characterizes how the setting of legal standards affects the behavior of complying parties, law enforcers, and the net social surplus generated by the regulations.

The analysis in chapter 3 reveals that it is desirable to induce potential violators of the standards to provide care levels that either exceed or fall short of the surplus maximizing level. In some instances, a slight loosening of standards will decrease enforcement costs.








3

Such instances arise whenever looser standards cause enforcers to reduce their effort because the marginal returns from monitoring decrease as the probability of noncompliance decreases. For other applications, monitoring effort may fall as the probability of noncompliance increases. For these cases, it will be desirable to set tighter standards and induce greater care in order to reduce the enforcers' expenditures on effort.

Two extensions of this result are also presented. In the first instance, the possibility that the costs of monitoring effort vary by the enforcers' abilities to observe and process information is considered. These costs are known privately by the enforcers. It is shown that the presence of asymmetric information reinforces the main finding that standards are distorted to reduce enforcement costs. In the second extension, the possibility that parties differ in the costs they incur in taking care is examined. It is shown that the main finding can be generalized to this case as well.

In addition, the analysis examines the relationship between fines and standards. It is shown that imposing the largest fine is not necessarily desirable because increases in fines may increase costly enforcement effort.

Monitoring and the Optimal Mix of Public and Private Debt Claims

Chapter 4 explores the issue of how firms optimally design their debt structures by using both public debt and private debt. The theory of finance suggests that financial intermediaries can act as delegated monitors and provide flexibility allowing for modifications of loan contracts when needed. However, previous studies have only provided partial analysis of private lenders' incentives to monitor. In addition, existing literature does not provide adequate explanations of the need for firms to finance with both private debt and








4

public debt. Moreover, no explanation has been offered to justify the notion of delegated monitoring in the presence of multiple classes of debtors.

This analysis provides some answers to these important issues, My analysis is based on the assumption that firms' objective in designing optimal debt structures is to credibly commit to repay debtors at minimum cost. I find that the optimal debt structure is in general strict mixes of public and private debt. Public debt provides several benefits: 1), it allows the firm to pay out profits without perturbing bank's incentive for monitoring; 2) it allows the firm to maximize the lenders' total benefit per unit of monitoring effort, thereby reducing the amount of monitoring required to ensure initial financing. I show that in the optimal debt structure, the public debt is generally long-term while the maturity of private debt depends on the severity of agency problems. In addition, I find that when firms raise external financing by optimally combining public and private debt, they prefer to align the public lenders incentive over monitoring with that of the private lenders. Thus, private lenders act as delegated monitors in the presence of multiple classes of creditors.

My analysis is closely related to that of Hart and Moore (1991). Besides sharing similar assumptions, my analysis extends Hart and Moore's analysis by accommodating asymmetric information and by recognizing the negotiation costs involved in dealing with dispersed public debt holders. My analysis also differs from those of Park(1994) and Raja and Winton (1995) in that I emphasize the inherent incompleteness of debt contracts and do not rely on covenants to provide banks with monitoring incentives.














CHAPTER 2
MOTIVATING AND COMPENSATING INVESTMENT ADVISORS Introduction

Investing profitably requires accurate information. Often, an investor may not have the knowledge or the skill to collect and process relevant information about investment opportunities. The investor must rely on the expertise of an investment advisor. In structuring optimal compensation schemes for the advisor, two problems arise: 1) inducing the advisor to diligently collect information; and 2) inducing the advisor to reveal his information to the investor. This paper characterizes optimal compensation schemes which satisfy both of these two requirements.

To characterize the optimal compensation schemes, we employ the following model. An investor can invest in a risk free asset with a known return and a risky asset whose return depends on the states of nature. Initially, the investor and the advisor share the same prior about the probability of each state occurring. By expending effort, however, the advisor can privately observe a signal correlated with the state of nature. Expending greater effort improves the accuracy of the signal. The investor makes his investment decisions based on the advisor's reported signal. Subsequently, the actual return from the risky asset is publicly observed, and the advisor is compensated based upon his report and the realized return'.



'Alternatively, our model can be interpreted as one in which no communication takes place. The investor pre-announces the investment schedule and the advisor implements the schedule after a signal is acquired. The decision made by the advisor in implementing

5








6

When the signal is publicly observable, the investor's only concern is to motivate the advisor to expend effort. In this case, we find that the advisor is more richly rewarded for correctly predicting a state if exerting effort produces the greatest percentage increase in his ability to predict that state. This follows because to best motivate the advisor, the investor desires to compensate him more for a correct prediction which is most indicative of the effort expended. Thus, the optimal compensation scheme rewards the advisor more for a correct prediction if the probability of achieving it is most sensitive to the effort expended.

When the signal is not publicly observable, the investor must be concerned with both motivating the advisor and eliciting truthful revelation of the private signal. We find that there exists a critical effort level: When the advisor is induced to expend an effort higher than the critical one, the investor's inability to observe the signal is inconsequential for the design of optimal payment scheme; In contrast, when the advisor is induced to expend an effort lower than the critical one, the need to elicit truthful revelation of the observed signal interacts with the need to motivate the advisor. In the latter case, the payment to the advisor depends both on whether he predicts the state correctly and on which state occurs. The payment is larger when the advisor correctly predicts the less likely state. The intuition for this result is the following. If the advisor is rewarded a fixed amount whenever he makes a correct prediction, he will choose to predict the state most likely to occur (based on the prior) if he shirks. In doing so, however, the advisor loses the opportunity of being rewarded for correctly predicting the less likely state. To motivate the advisor, the investor must impose sufficient opportunity cost on him for not expending effort. By rewarding the



the investment schedule is, however, observable and can be contracted upon.








7

advisor more for correctly predicting the less likely state, shirking and making predictions based only on the prior become less attractive. The new payment scheme can both motivate the advisor and induce truthful revelation.

Before proceeding, we relate our analysis to earlier studies in the literature. The study by Kilhstrom(1986), which is most closely related to our analysis, analyzes how to induce an advisor to work diligently when his informative signal is publicly observable. We extend his analysis by allowing the advisor's signal to be private information. The extension enables us to investigate how the need to elicit truthful revelation interacts with the need to motivate the advisor.

Also related to our analysis is the work of Bhattacharya and Pfleiderer(1985) who study the problem of screening of agents (advisors) endowed with information technologies that differ in the accuracy levels of the signals produced, and subsequently eliciting truthful revelation of the privately observed signals. Acquiring the signal is assumed to be costless. This model is modified in a later paper by Stoughton (1993) who studies a moral hazard problem similar to ours'. The results in both of the two studies, however, rely critically on the symmetric information structure that they employ, whereby the distribution of states of the nature is symmetric conditional on any signal. Our analysis, on the other hand, does not require this assumption.

A Simple Discrete Model

A risk neutral investor can invest in a risky asset or a riskless asset. The riskless asset yields a return R with certainty. The return of the risky asset depends on the state of nature: It returns rH>R in the favorable state and rL







8

investor's prior belief of the probability of the two states is nH and ntL, respectively. For simplicity, we assume nHrH+7rLrL=R.

The investor can acquire additional information about the state of nature by hiring an advisor. By expending effort, the advisor, who initially shares the same prior as the investor, can observe a signal x, with x{Xa,X.L}, correlated with the realized state. The correlation between the signal and the state is characterized by the conditional distribution function f(xilrj,e), ijc{H,L}. There are two effort levels, e=eL and e=eH>eL. For notational ease, we set f(xiIri,eH)=pi and f(xIrj,eL)=q-, i,j e { H,L }. The advisor's effort improves the accuracy of the signal in the Blackwell sense. We capture this idea by assuming pi>qi, ie{H,L}.

The advisor's utility function VA(WA)-C(e) is separable in income and effort, where VA(WA) is the utility of the end of period payoff WA and C(e) is the cost for expending effort e. We assume that the advisor is liquidity constrained and enjoys limited liability protection2. The advisor's reservation utility is normalized to zero.

The investor can not observe the advisor's effort and the signal he observes. He makes the investment decision based on the advisor report. Contingent upon a report x, he chooses to invest Xi(x) in the risky asset. The investor has an endowment of Wo>O, and borrowing and short-selling are not allowed, so that 0<.(x) _W0.

The timing in the model is as follows. First, the investor makes a take-it-or-leave-it offer to the advisor, specifying a compensation scheme w(x,r), which depends on both the


2This assumption implies that the advisor can not signal the investor his private information by taking a position in the risky asset. For the latter approach, see Leland and Pyle (1977), Allen (1990).








9

advisor's report and the state of nature publicly observed ex post. Second, if the advisor accepts the offer, he selects the level of effort to expend. Otherwise, the game is terminated. Third, the advisor observes a signal and makes a report to the investor. The advisor's report amounts to a prediction of future state. Reporting XH (xL) amounts to predicting the occurrence of good (bad) state. Fourth, the investor makes and implements the optimal investment decision based on the advisor's report. Finally, the realized return of the risky asset is publicly observed and the advisor is paid as promised.

The optimal investment decision is determined, in equilibrium, for a given equilibrium strategy of the advisor. Specifically, the advisor is assumed to truthfully reveal his privately observed signal. Recall, a risk neutral investor ranks the investment opportunities by their expected payoffs. This implies that the optimal investment decision is: ,(xL)=0 and X(xH)=WO, which is independent of the advisor's compensations.

We assume that it is desirable to motivate the advisor to acquire the more informative signals. The investor's objective is to induce the advisor to expend effort and truthfully reveal his signals at minimum cost. Inducing truthful revelation implies the following constraint.

Er[w(x,r) I eHx] _Er[W(X 1,r) eH,xl Vx,x'. (2-1)

Inducing the advisor to expend effort requires Exr[w(x,r) I eH,X] -EEx{MaxxEr[W(x ,r) Ix,eL] I eL} (2-2) Finally, we add the individual rationality constraint, which ensures that the advisor will accept the contract, and the limited liability constraint.

Exr[W(x,r) I eHx] E 0 (2-3)








10

w(x,r) 0, Vx,r (2-4)

The investor's problem is then

Min Ex,r[w(x,r)]

s.t (2-1), (2-2), (2-3) and (2-4).

Lemma 2.1: Constraint (2-1) implies w(xH,rH)>w(xL,rH) and w(xL,rL)-w(xH,rL)

The proof of lemma 1 is straightforward, and is omitted. The (2-4) constraint implies that the right hand side of (2-2) is nonnegative. Thus, (2-2) and (2-4) imply (2-3), and we will ignore (2-3). Simple rearrangement indicates both (2-1) and (2-2) can be expressed in terms of the two differences w(xHrH)-w(xL,rH) and w(xL,rL)-w (xH rL ). This implies that (2-2) and (2-1) continue to hold under a simultaneous decrease of w(x,r), Vx,r, provided the two differences remain unchanged. Lemma 2.1 and investor's cost minimizing then imply w(xLrH)=w(xL,rH)=0 in the optimal contract. That is, the advisor will not be compensated if he makes a wrong prediction. The advisor is only compensated when he makes a correct prediction. In the following, we denote w(xH,rH) by YG and w(xL,rL) by Y,. YG and YB represent the bonuses awarded to the advisor for correctly predicting the good and the bad state respectively.

Constraint (2-1) implies the following two inequalities, PHTHYG (1 -PL) LYB,

PLLYB_ (1- PH)HYG'
These two constraints ensure that the advisor will truthfully reveal signals xH and xL given he has expended effort eH. Contracts satisfying the two inequalities are represented by the shaded area in figure 2-1. Contracts satisfying the first constraint lie under the line OH.








11
Contracts satisfying the second lie above OL. The small cone enclosed by the dotted lines OH' and OL' contains contracts that induce truthful revelation at effort eL'. Figure 2-1 reveals that the set of truth-telling contracts at eL is a subset of the set of truth-telling contracts at efi. This implies that it is easier to induce truthful revelation when the advisor is better informed. Figure 2-1 also indicates that simple profit sharing contracts are not incentive compatible. Consider, the payment scheme corresponding to point K. This payment scheme awards the advisor only when investment yields a net profit. Such a contract does not induce the advisor to truthfully reveal an unfavorable signal and results in over-investment in the risky asset.

Feasible contracts must satisfy constraint (2-2) in addition to (2- 1). Consider first contracts lie in the cone enclosed by the dotted lines in fig.2- 1. These contracts induce truthful revelation at both the high and the low effort levels. For these contracts, constraint (2-2) implies the following inequality,

(PH-qH)7tHYG+(PL-qL)nLYB E

Contracts satisfying this inequality lie above the line AB (figure 2-2). Thus, the first subset of feasible contracts lie inside the inner cone and above the line AB. Next, consider contracts lie above OH' but under OH. These contracts induce truth-telling at e~ but not at eL. At eLI the advisor always prefers to report XL. For these contracts, (2-2) implies [PHnrHYG-( l-qLYJLYB+(PL-qL)nLYB E

Contracts satisfying this constraint lie under line AC. Thus, the second part of feasible contracts lie above AH' and under AC. Similarly, contracts lying under OL' but above OL



'These contracts satisfy the same constraint as (2- 1) with p replaced by q.








12

induce truthful revelation only at eH,. At eLI the advisor always prefers to report XH. Applying (2-2) to these contracts provides



The final part of feasible contract lies under BL' and above BD. Feasible contracts which satisfy all constraints are represented by the shaded area in figure 2-2. This shaded area lies strictly inside the cone which contains the contracts eliciting truthful revelation at effort eH. It follows that constraint (2-2) implies (2- 1). A formal proof of this is quite simple and is omitted.

The investor's problem is to find the minimum cost contract from contracts in the shaded region in figure 2-2. Figure 2-3 depicts the investor's iso-cost lines. The cost associated with the iso-cost line increases in the north-east direction. It is instructive to consider first the case in which the advisor's signal is publicly observable. In this case, the investor's only concern is to induce the advisor to choose the high effort level. All payment schemes lying above the line MN are feasible. It is evident from figure 2-3, the optimal contract corresponds to either point M or point N depending on the slopes of iso-cost lines. If the iso-cost lines are steeper than the line MN, point M represents the optimal payment scheme. Such a contract compensates the advisor only when he correctly predicts the unfavorable state. Simple calculation reveals that iso-cost lines are steeper if PH/PL (PHqH)/(pcLq). This condition can be written in a more suggestive form, (PL-qL)/PO (PH-qH)/PH. The left hand side of the inequality is the percentage improvement of the accuracy of signal XL. The right hand side is the percentage improvement of the accuracy of signal XH. Thus, the advisor is more richly rewarded for correctly predicting bad investments if exerting extra








13

effort produces the greatest percentage increase in the advisor's ability to predict the bad state. Correctly predicting the bad state is more indicative that the advisor is diligently collecting information. Similarly, if exerting high level of effort produces the greatest percentage increase in the advisor's ability to predict the good state, he is more richly rewarded when he correctly predicts the good state. In figure 2-3, this corresponds to the flatter iso-cost lines. Returning to the case when the advisor's signal is not publicly observable, feasible contracts lie within the shaded cone. Since points M and N lie outside of the shaded area, the optimal payment scheme in the previous case is no longer incentive compatible. Instead, the optimal payment scheme is the point at which the iso-cost line is just touching the shaded cone. Again, depending on the slope of iso-cost lines, the optimal contract corresponds to either A or B. Figure 2-3 indicates that the investor continues to reward the advisor more richly for correctly predicting a state if exerting high level of effort produces the greatest percentage increase in the advisor's ability to predict that state. In contrast to the previous case, however, the advisor is compensated for both correctly predicting the favorable and the unfavorable state. Thus, the need to induce the advisor to expend effort interacts with the need to elicit truthful revelation. The interaction makes it more costly to induce the advisor to expend effort (as indicated in figure 2-3, the new optimal contract lies on a higher iso-cost line).

The General Two State Model

In this section, we extend our analysis to a more general setting. Specifically, we assume there is a continuum of effort level, ec[O,+-). To focus on the interaction between the two incentive concerns, we assume the correlation between the signal and the states








14

satisfies f(xLIrL,e)=f(xHprH,e)=O(e) with 0'(e)>0, 0"(e)<0 and lime~ ~0(e)=1. Thus, expending effort improves the accuracy of the two signals equally. The concavity condition reflects decreasing marginal returns to effort. The advisor is strictly risk averse, with VA'(WA)>0 and VA"(WA)<0. The cost function C(e) satisfies C"(e)>0, C"'(e)_ 0 and C'(e)>0 (except for e=0). Furthermore, we assume that VA(0)=C(0)=C'(0)=0 and VI (0)=+4. It will be convenient to regard the cost as a function of 0 instead of e. The one-to-one correspondence between e and 0 ensures that the function C(0) is well defined. It follows from our assumption that C(0) satisfies C'(0)>0 (except for 0=1/2), C"(0)>0 and C(/2)=C'( 2)=0. The inverse of VA will be denoted by h, and we assume that h is thrice continuously differentiable. We will denote WO[U(r-R)+tL(R-rL)] by p. 9 is the marginal return from improving the accuracy of the signal. The investor's problem, [I-P], is formally stated as follows.

Maxe,(.),w(.,.)Ex,r[WoR+(x)(r-R)-w(x,r) 0]


subject to

xeArgmaxx,Er[VA(w(x',r))x, 0] VXG {XL,XH } (2-5)

OeArgmaxeEx{Maxx,Er[VA(W(x',r)) -C(O') x,O'] 10} (2-6)

Ex,r[VA(w(x,r))- C(O) 0]> U=O0 (2-7)

w(x,r)>O X(XLXH} r{rL,rH} (2-8)

Before proceeding, we present two results. First, we show that the investor's problem



4The assumptions C'(0)=0, VA'(0)=+o and WHrH+rLrL=R ensure that it is desirable for the investor to hire the advisor.








15

has the following equivalent formulation [I-P']: MaxX(x),w(-,-)Ex,r[WoR +(x)(r-R) -w(x,r) 01]

subject to

II(xHXLIIj(xl,X) VXi,XjE { XL,XH } (2-9)

0EArgMaxe,[L(xH'XLI 0')-C(O')] (2-10)

L(xHXL 0)-C(0)> 0 (2-11)

w(x,r) 0 Xe{XL,XH} re{rLrH} (2-12)


where II(xi,x) =Max0,[L(xi,xa O')- C(O')] Vxi,xe { xxH } (2-13)

L(xi,x O') =f(x 1 O')Er(VA(w(xir)) xH,O')+f(xL1 O/)Er(VA(w(xjr)) XLO') 0'e[1/2,1)" (2-14) Proposition 2.1: The investor's problem [I-P] is equivalent to [I-P']6.

The advisor's strategy consists of choosing a level of accuracy in the first stage and subsequently choosing a reporting rule in the second stage. Let { 0,(xi,x) } denote such a strategy, with xi,xjf{xH,XL}. Under this strategy, the advisor chooses an accuracy level 0 in the first stage and reports xi or xj when the acquired signal is xH or xL. It is easy to see that L(xix@ 0)-C(0) is the expected payoff to the advisor when he adopts the strategy { 0,(xi,x) }. On the other hand, II(xi,x) is the maximum expected payoff to the advisor if he chooses a second stage rule of report (xi,xj), independent of the choice of 0 in the first stage. Constraint (2-9) requires that the payment scheme II(xi,x,.), as a function of the rule of report,


5f(xHI0') and f(xLIO') are the marginal probability of the occurrence of signal XH and XL at accuracy level 0'.

6Throughout the dissertation, all proofs are relegated to the appendix.








16

attains its maximum when the advisor reports truthfully. Constraint (2-10) requires that the advisor's payoff, when he always reports truthfully, attains a maximum at 0--the accuracy level induced by the investor's contract.

Second, we show the following lemma which will help to simplify the constraints. Lemma 2.2:(1)II(xL,XL)=L(XL,XLi 0=1/2) and II(XH,XH)=L(xH,XH 0=1/2);

(2)If a payment scheme satisfies constraints (2), II(xH,XL)2l(xH,XH) and II(xH,XL)_ll(XL,XL) for 0>1/2, then

i) w(xH,rH)>W(XL,rH) and w(xL,rL)>W(XH,rL); ii)II(xL,xH)=L(xL,XH 0= 1/2).

If the advisor always announces XL or XH independent of the actual signal observed, his expected profit must be independent of the accuracy of the signal. Since improving accuracy is costly, the advisor optimally exerts no effort. This is reflected in Lemma 2.2 (1).

Part (2) ii) of the lemma implies that the investor must pay the advisor a strictly positive bonus when he correctly predicts the state. This follows because the state rH (rL) is more likely to occur conditional on xH (XL). The bonus is necessary to induce the advisor to truthfully reveal his private signal7.

Given Lemma 2.2, we can simplify [I-P'] to the following problem [I-P"].

MaxO,(x),w(.,-)Ex,rWR +.(x)(r-R) -w(x,r) 0] subject to




7The ordering in the payment scheme is similar to the monotonicity observed in the standard models with adverse selection Baron and Myerson (1982), Laffont and Tirole (1986). The single crossing property there corresponds to the condition 0>1/2.








17

1 1
Exr[ A(w(x,r)) 0]-C()O) ExMax Er[VA(w(x ',r))| x, l] 0 '= (2-15)
2 2

O eArgmaxo/Ex,r[VA(w(x,r)) '] (2-16)

w(x,r)>0O x{xL,xH} re{rL,rH} (2-17)

In simplifying [I-P'], we have dropped the individual rationality constraint (2-11) since it is guaranteed by the limited liability constraint. Constraints in [I-P"] closely resemble those in the discrete model. The effort levels eH and eL corresponds to the effort level which generates the investor's desired accuracy and zero effort level. The difference arises from the continuous nature of effort levels. Again, it is instructive to consider the problem in which the advisor's signal is publicly observable--reduced problem. The reduced problem, [RP], is similar to [I-P"] but without the first constraint. Without the limited liability constraint, the reduced problem corresponds exactly to the problem investigated by Kilhstrom (1986). The solution of the reduced problem is summarized in the following lemma. In the lemma, 0RP refers to the optimal accuracy level. Lemma 2.3: At the solution to the reduced problem: i)the compensation scheme is w(xH,rL)=w(xL,rH)=0 and w(xL,rL)=w(xH,rH)=h(C'(ORP)); ii)the optimal level of accuracy 0RP solves Max[013-0h(C'(0))] and 1/2
Based on our analysis in the discrete model, the result in lemma 2.3 is well anticipated. Since expending effort improves the accuracy of the two signals equally, our previous analysis indicates that the investor should be indifferent between rewarding the








18

advisor for correctly predicting the favorable or the unfavorable state. Advisor's risk aversion implies that he should be subject to minimum risk exposure. Therefore, the investor pays the advisor a fixed amount whenever he makes a correct prediction, i.e W(XL,rL)=W(XH,rH). The result of lemma 2.3 is illustrated in figure 2-4.

To solve [I-P"], we adopt the two step approach in Grossman and Hart (1983). First we characterize the optimal payment scheme for implementing a given level of accuracy. Second we determine the optimal accuracy level. The problem for the first step is to minimize Exr[w(x,r) 10] subject to the same constraints as in [I-P"].

Since the solution in the case 7Li7H is exactly symmetric to that in the case rH !7>L, we assume "H-!1L in the ensuing analysis. Simple rearrangements reveal that all the constraints can be expressed in terms of VA(w(xH,rH))-VA(W(XL,rH)) and VA(W(XL, rL))

-VA(w(xHrL)). This implies that the payment scheme remains to be feasible under a simultaneous decrease of w(x,r) Vx,r, provided the two differences remain unchanged. The following result is then obvious.

Lemma 2.4.1: In the optimal solution, W(XH,rL)=W(XL,rH)=O.

Similar to the discrete model, we denote VA(W(XH,rH)) by YG' and VA(W(XL,rL)) by YB. Y,' and YB' represent the two bonuses received when the advisor correctly predicts the two states. Incorporating the constraints (2-16) and (2-17) produces the set of feasible contracts indicated in figures 2-5 and 2-6 (the shaded cone). Depending on the level of accuracy that the investor desires to implement, two possibilities arise. In the first case, the




8To find the corresponding solution for the case 7tL tH, one simply interchange the subscript L and H.








19
tangency point T lies inside of the shaded cone of feasible contracts. In this case, the need to motivate the advisor is not in conflict with the need to elicit truthful revelation. The solution is then the same as the reduced problem. The advisor is paid a fixed amount whenever he makes a correct prediction. In the second case, the tangency point lies outside of the shaded cone. The optimal contract in the reduced problem is no longer incentive compatible. The optimal solution corresponds to the point at which the investor's iso-cost curve is just touching the shaded area. The two incentive concerns interact with one another and the constraint for truthful revelation becomes binding. As an intermediate case, the tangency point lies at the corner of the shaded area. The corresponding accuracy is fonnally stated in the following definition.

Definition 2.1:Let a=limo61{O- C(0) we define C'(0)

00 to be the solution to 0 C(0) = TCH if>7rtH>1/2, 00 H=1/2, if 7 ,1/2, and C'/(0)


00H=+l ifrtH_>a9.

For an accuracy level 0<0H, the tangency point lies outside of the shaded area. For 0_0H, the tangency point lies inside of the shaded area. We summarize the optimal reward scheme in the following.

Lemma 2.4: Let a2(0)=(1-O)C/(O)+C(O) and a(O)=OC/(O)-C(O) the optimal



9The existence of a finite a follows from that 0- C(0) is both monotonic and bounded above. Since C'(0=1/2)=O, 0 C(0) is d(0ned at 0=1/2 by continuous C(0)
extension.








20

payment scheme implementing a given accuracy level 0 is i)if 0 OH w(xHrH)=w(xL,rL)=h(C'(O));
al(0) a2(0)
ii)if 0<0H w(xH,rH)=h( )
Lemma 4.2 indicates that the critical accuracy 0H separates the accuracy levels into two regions. The intuition behind this is the following. In exploiting the information advantage by exerting no effort and always reporting XH (or x ), the advisor loses the opportunity of profiting from correctly predicting the state at XL (or xH). Under a symmetric payment scheme (part i) of lemma 4.2), such loss in profit increases with the accuracy level induced. Above the critical accuracy level 0H, this loss is larger than the advisor's cost saving from exerting no effort. Therefore, the symmetric payment scheme is sufficient to ensure that the advisor chooses the accuracy level induced and reports truthfully. Below 0oH, the symmetric payment scheme does not impose enough opportunity cost on the advisor. Consequently, it is insufficient to ensure that the advisor chooses the induced accuracy level and reports truthfully. The investor must reallocate the payment among the two instances when the advisor correctly predicates the states, so as to impose sufficient opportunity cost on the advisor. Given [H!7_rL, OH is more likely to occur based on the prior. Under a symmetric payment scheme, the advisor will always report XH if he chooses to expend no effort. To prevent this, the investor decreases the payment when the advisor correctly predicts the favorable state and increases the payment when the advisor correctly predicts the unfavorable state. The new payment scheme thus increases the advisor's opportunity cost for not expending effort. In this case, the need to elicit truthful revelation interacts with the need to motivate the advisor to expend effort.








21

In the second step, the investor chooses the accuracy level to maximize his profit by employing the payment scheme specified in lemma 4.1 and 4.2. The following proposition summarizes the solution to the full problem. In the proposition, OsB denotes the second best accuracy level.

Proposition 2.2: At the solution to [I-P], w(xHrL)=W(XL,rH)=O and i)if ORP-> 0H, then 0SB=0RP and W(xflirH)=W(XL,rL)=h(C'(OSB)); ii)if 00H>ORP then the optimal compensation scheme is w(xH,rH)=h(a,(OsB) )
and OSB< 0H solves the problem
a___(0)0
Maxo,[1/2,0o]{0 P 0 [r/h/a () +rTLh(a2(O) )] 7rH TEL


Part i) of proposition 2.2 follows directly from lemma 2.4. If the optimal accuracy level induced in the reduced problem is higher than 0H, the optimal payment scheme in the reduced problem is incentive compatible in the full problem. Clearly, it is also the optimal solution to the full problem.

Part ii) of proposition 2.2 indicates that, when 0H>ORP, the optimal asymmetric payment scheme implementing 0SB, in the region (1/2,00), dominates all the symmetric payment schemes implementing accuracy levels higher than 0H. The second best optimal payment scheme assumes the form indicated in part (ii) of lemma 4.2. In this case, the solution to the full problem is different from that in the reduced problem. The advisor is paid more when he correctly predicts the state less likely to occur.

Finally, we briefly discuss the problem of the uniqueness of the second best solution.








22

The second best solution is unique if O)RP 00OH. However, when the optimal payment scheme is asymmetric, iLe when O~p
The implication of the assumption is as follows. If there are two distinct Os both solving [I-P"], the advisor is strictly better off under the higher 0 that solves [J-P"]. This follows from the fact that the expected total payoff to the investor's profit is the same under the two Os, and the fact that the investor's profit from investment is strictly increasing in 0. Therefore, assumption 2.1 amounts to assuming that when the investor is indifferent between implementing two different ()SB he will implement the one most preferred by the advisor. Under assumption 2. 1, the second best solution is unique. Proposition 2.3: There exists a largest 0 which solves the optimization problem in proposition 2.2 and hence the second best solution is unique under assumption 2.1.

The relations between the optimal accuracy levels are in general ambiguous. This is due to the dependence of OSB on the advisor's risk premium function. However, under the condition h "'(O)AO ", the second best accuracy level is strictly smaller than the first best accuracy level.

Proposition 2A4 Given h "'1(0) ORP



'01f m-H=139/144 and ORP<00H, then the second order derivative of the objective function in proposition 2.2 is positive at 0=3/4 when the inverse utility function is h(x)=x2/2. "1The third derivative of h(.) is positive when the advisor has constant or increasing risk aversion. It also holds when the advisor's risk aversion decreases slowly.








23

The following proposition indicates, under more restrictive conditions, the second best accuracy is also lower than that of the reduced problem. Proposition 2.5: Assuming h '"(0)0 ,

i)If ORP-00H, then 0SB=0RP

ii)If 6RP<00H and 0SB<_H, then OSB
When 0sB>nH and 0RP<00H, 0SB is not necessarily smaller than 0RP as illustrated by the following example.

Example: Suppose the cost of information collection is C1(6)=a(0-1/2)2/2. The investor's inverse utility function is h(x)=x2/2, and the prior is 7rH=3/4. For this case, we find 00H=1. From lemma 2.3, 0RP
Our next result compares the investor's profits PF, PRP and PsB for the first best, the reduced problem and the second best respectively. Proposition 2.6: i)The investor's profits are ordered by PFB>PRP-PsB. The second inequality holds strictly when ORP<0OH.

ii)Let Pa(nH) be the investor's profit in the second best solution. For fixed 3, Pa (h ) is continuously decreasing in nH, for 2nH
Similar to the discrete model, the investor's profit decreases as the signal becomes the advisor's private information. This is due to the loss in risk sharing when the investor


12In changing H, we maintain the assumption that the expected payoff of the risky asset is the same as that of the risk free asset so that the optimal investment decision is unchanged.








24

must reallocate the payment between the two instances when the advisor correctly predicts the state.

The intuition for part ii) of proposition 2.6 is the following. From lemma 2.2, the advisor optimally exerts no effort and always reports either x. or XL if he deviates from the strategy induced by the contract. As prior TUH increases, the advisor is more certain about the state occurring. Therefore, it becomes more profitable for the advisor to exert no effort and predict the state most likely to occur. The cost of motivating the advisor increases. Consequently, the investor's profit decreases.

Extension

In the analysis so far, we have assumed that the ex post realization of state is costlessly observable. Sometimes return from investment not undertaken may never be observable. Such instances often arise for firms with firm-specific investment opportunities. To optimally compensate the manager, the assumption above must be relaxed.

In the following, we show that the analysis in the previous section can be directly applied to this case. To this end, we assume that the return from investment not undertaken can not be observed ex post. To facilitate comparison with results in the previous section, we assume 7rH t7rL. Given the optimal investment decision, the risky project is not undertaken if an unfavorable signal XL is reported. The assumption that the realization of state is not observed if the project is not undertaken implies that the compensation contingent on the unfavorable report must be independent of the state, Le W(XLrL)=W(XLrH),

The investor's problem in the extended model is similar to [I-P] except that we need to add the constraint w(xLrL)=w(xLrH). In employing proposition 2.1 and lemma 2.2 to








25

reduce [I-P] to [I-P"], it is not necessary to assume w(xL,rL)*W(XLrH). It follows immediately that the optimization problem corresponding to the extended model is the following.

Maxo,x(x),w(-,-)Exr[WOR +(x)(r-R)-w(x,r) 0]


Exr[VA(w(x,r)) 0] -C(O)>Ex {MaxxE r[ VA(w(x',r)) 0 =Ixl 0 = }1) (2-18)
2 2

0 eargmaxOExr[VA(w(x,r)) 0'] (2-19)

w(x,r) 0 xexLx} r{r, rH)} (2-20)


w(xL,rL)=W(XL,rH) (2-21)

Again, we consider the problem of implementing a given 0 at minimum cost. The following lemma describes such minimum cost payment scheme. Lemma 2.5: The minimum cost payment scheme implementing accuracy level 0 is w(xH,rL)=0,

w(xH,rH)=al(0)/TrH+a2()/rCL, W(XL,rL)=w(xLrH)=a2(0)/rL, where a (0) and a2(0) are given in lemma 4.2.

The proof of lemma 2.5 proceeds in the same way as that of lemma 2.4.2, and is therefore omitted. Similar to the previous analysis, lemma 2.5 indicates that the payment is strictly positive at the unfavorable report. This is necessary to induce truthful revelation when the unfavorable signal is observed. In contrast to the previous model, the payment for correctly predicting good state is strictly higher than that at unfavorable report. When the state rL is never observable if the project is not undertaken, the investor can not discern whether the manager's prediction is correct or not when he predicts the unfavorable state.








26

In this case, the only way in which the investor can verify manager's prediction is when the manager predicts the favorable state. Thus, the only indication that manager has expended effort is the correct prediction of favorable state. Consequently, he is rewarded more in such instances.

Conclusion

Our analysis focuses on how an investor best motivates a privately informed advisor to expend effort. The need to motivate the advisor stipulates that he should be rewarded more richly for correctly predicting the state if expending effort is most effective in enhancing his ability to predict that state. The presence of the unobservability of signal generally interferes with the need to motivate the advisor. Our analysis reveals that when the investor induces the advisor to acquire quite accurate information, whether the signal is publicly or privately observed is inconsequential. In other cases where the investor requires a lower accuracy level, inducing the advisor to reveal his information strictly increases the investor's cost of contracting with the advisor. Further, we find, under fairly general conditions, that the effect of moral hazard and hidden information in the investor- advisor relationship is to reduce the amount of effort that the advisor is induced to supply. The investor's profits also decrease if the investor is unable to monitor effort or to observe the investor's signal.

In considering directions for future research, we suspect that the methodology developed here might fruitfully be applied to examining other agency relationships. For instance, examples in which a company seeks the advice of a marketing expert on developing new sales strategy or a resource company consults with a geologist concerning








27

oil or minerals exploration have elements in common with investor--advisor relationship that we analyzed here.

Further extensions of our analysis would involve relaxing or modifying some of the simplifying assumptions we have employed. First, our binary information structure might be extended to allow for multiple signals and multiple states of nature. We suspect, however, that our main qualitative results, as summarized in Proposition 2.2, will continue to hold in the more general setting. Second, our single-investor and single-advisor relationship might be modified to allow for multiple advisors who supply the investor with independent assessments of investment prospects. A promising approach to modeling this case appears in the work of Dewatripont and Tirole (1995) on the use of advocates in agency relationships. Finally, our single period investor- -advisor relationship might be modified to extend to several periods. Interesting issues arise in this setting as the advisor may modify his behavior to maintain or enhance his reputation. Reputational concerns may reduce the advisor's tendency to shirk or to misrepresent the signal he observes. These and other related issues await further research.



























28 Y E3 H ......
































. .











































...... ..
............
..........
... .........
.. ........
























K YG














Figure 2-1








29





YB





H


H' C /
M





//



S L L
/
/
/ /
/,
//
/ k



0 N Y



Figure 2-2








30




YB








\C
M\










\D






N G

Figure 2-3 Slopeof MN -(pg qg)/(Pb" qb)
Slope of iso-cost line (dotted line) Pg / Pb








31 ya




























45





Figure 2-4









32






YB






















...........







45 y





Figure 2-5








33








YB






















45 YG





Figure 2-6













CHAPTER
SETTING LEGAL STANDARDS FOR CREDIBLE COMPLIANCE Introduction

For most parties the threat of being fined or punished provides incentives to take care not to harm others. For instance, motorists may obey traffic regulations, industrial firms may resist fouling the air, and manufacturers may produce safe toys all to avoid fines for violation of standards.

The chance that a party will be fined not only depends on his action, but also on the effort that law enforcers exert to insure compliance. Recent experience reveals that it is difficult for public officials to control the behavior of enforcement agencies.' This suggests that law enforcers need to be motivated to detect violators, perhaps by rewarding them according to their success in discovering violations.'

In such a setting the equilibrium interaction between potential offenders and law enforcers will determine how regulations are observed and enforced. The amount of effort


'Most recently displeasure with the performance of the Internal Revenue's Service prompted Congress to cut the agency's compliance budget. Previous to this Congress had similarly intervened in the affairs of the FTC and the EPA to correct what it perceived as inappropriate enforcement of government policy.

'This approach differs significantly from most of the formal literature on law enforcement and monitoring, as exemplified by Baron and Besanko (1984), Border and Sobel (1987) and Mookherjee and Yng (1992, 1994). These analyses assume that law enforcers can commit to a monitoring strategy independent of whether the strategy uncovers violators in equilibrium. A notable exception is Graetz et al (1986) who assume that enforcers are motivated by the fines they collect from prosecuting violators.

34








35

enforcers exert will depend on the perceived likelihood that parties have violated standards, and the likelihood of violation will depend on how vigorously the law is enforced. In turn the behavior of offenders and enforcers will be shaped by the standards determining if a party has violated the law. Examples of standards include a maximum number of product failures a manufacturer can experience before violating a safety code, or a minimum concentration of effluents found in a water sample that cause a waste discharger to violate emission regulations.

Beginning with Becker (1968) most analyses of the economics of enforcement have taken legal standards as given, and focused on the setting of fines as the primary tool of enforcement. In practice, though, the ability of enforcers to vary statutory fines is restricted by political, moral and legal constraints. In contrast, agencies may have some discretion in setting standards for determining when a party's actions are harniful. The primary goal of this chapter is to characterize how the setting of legal standards affects the behavior of complying parties, law enforcers, and the net social surplus generated by the regulation. Another goal of the chapter is to examine the extent to which setting standards and fines are substitute instruments for law enforcement,

Under optimal circumstances, where law enforcers can costlessly detect violations, offending parties should be induced to select care so that the marginal cost of care equals the social marginal benefit. However, we find that when enforcers must be invented to monitor compliance, it is desirable to induce care levels that either exceed or fall short of the surplus maximizing level.

The intuition for this finding is that some distortions in care are required to reduce the








36

cost of law enforcement. Suppose standards are initially set so that the marginal costs and benefits from taking care are equated. Then a slight variation in standards will not appreciably affect net benefits,' but it will cause a nontrivial adjustment in the enforcer's costs and effort. In some instances a slight loosening of standards will decrease enforcement costs. This will arise whenever looser standards causes enforcers to reduce their effort because the marginal returns from monitoring decrease as the probability of noncompliance decreases. We refer to this as the compIements case because monitoring effort and standards are complementary inputs in determining the probability of a violation. In this instance, it will be desirable to loosen standards and induce less care in order to reduce the costs of enforcement.

For other applications monitoring effort may fall as the probability of noncompliance increases. This will arise if the returns from monitoring compliance in order to prove a violation will diminish as the degree of noncomplying behavior increases.' For this case, referred to as the substitutes case it will be desirable to set tighter standards and induce greater care in order to reduce the enforcer's expenditure on effort.

This is the central result of the chapter which is formally derived in Section 3. In Section 4 we consider the possibility that the costs of monitoring effort vary by the enforcer's ability to observe and process information. These costs are known privately by the enforcer. We show that the presence of asymmetric information reinforces our main finding that



'To a first order, a small change in standards has no effect on net benefits since marginal benefits and marginal costs of care are the same. 'For instance, it may not be necessary to expend much effort by employing sophisticated measuring devices to detect excessive discharge of effluents when polluters are in obvious violation of the law.








37

violation standards are distorted to reduce enforcement costs.

In section 5 we examine the possibility that parties differ in the costs they incur in taking care. We show how our main finding generalizes to this case, and demonstrate the optimality of allowing the highest cost parties to pay a fixed fee which absolves them from prosecution for a violation. Further, we demonstrate that corrupt enforcers can collude with potential offenders to similarly offer high cost parties protection from the law in exchange for a bribe.

In section 6 we examine the relationship between fines and standards. We find that in contrast to Becker (1968), it is not necessarily desirable to impose the largest fine. Increases in fines may increase costly enforcement effort,

The chapter is concluded in section 7 with a summary of results and suggestions for further research. The elements of our model are introduced in the next section and all formal results are derived in the appendix. We relegate the discussion of related findings in the literature to those sections of the chapter where the results for comparison with the literature are presented.

Elements of the Basic Model

There exists a party who can exert some care denoted by q > 0 to avoid harming other individuals. For instance q, may be the discretion a motorist exercises to avoid an accident; q may be the control of emissions by a waste discharger, or q may be product quality a manufacturer supplies to avoid breakdowns. The party incurs a monetary cost or disutility of supplying q, denoted by C(q) which is increasing and strictly convex with C '(0) = 0.








38

Social benefits from q are given by Bq, where B > 0, is the constant marginal benefit. 5

The government sets a standard, denoted by s, as a criterion for determining if a party has exercised proper care. Depending on the application, s may be a speed limit which motorists must obey, or a maximum allowable concentration of pollutants in a discharger's water or air sample. To avoid the daunting task of explicitly modeling the bureaucratic and legal process by which violators are prosecuted we adopt a simpler reduced form description of the enforcement process. We assume that given s and q there is a probability that the party will be successfully cited for violating the standard denoted by fi(qse) e- [0, 1 ], where e is the effort the law enforcer supplies to monitor the party. We assume that this probability is decreasing as the party supplies more care at a decreasing rate with P q < 0, and Pqq > 0 whenever e> 0, A tightening of standards increases the citation probability, fi, > 0 for e > 0. Further f is increasing in the enforcer's effort, at a decreasing rate so that fie > 0, fee < 0. This implies that the burden of proof falls on the enforcer to demonstrate that a violation has occurred. Finally, we assume that the sign

(Pe) = sign (-Pq) which means that an increase in standards or a decrease in care both have the same qualitative effect on the enforcer's marginal returns from effort, fie. 6

As mentioned in the introduction, we distinguish between two cases describing how



'This specification of care benefits is made for simplicity and is not essential for the foregoing analysis.

6 A simple specification that satisfies our assumptions is)5 (qse) = p(8,e) where 8 = s q measures the gap between the standard and the care provided, and P,, P68 > 0. In the context of pollution standards, 6 might measure the difference between acceptable and actual effluent concentration in a water or air sample for example.








39

did 0, and an increase in standards increases the marginal returns to monitoring. This might arise, for instance, if a party is cited whenever he is simultaneously violating the law and he is being monitored by the enforcer. In that case a tightening of standards will increase the probability that the party is in fact violating the law, which will therefore increase the enforcer's returns from monitoring. In the substitutes case, and a tightening of standards reduces the marginal returns to monitoring. This situation arises ,for example, if the enforcer knows whether a party has violated the law, but he must expend effort to prove the violation has occurred. When standards are tightened violations of the law are easier to demonstrate. Consequently, the enforcer's expenditure of effort required to prove a violation is reduced. '


7An example of a monitoring technology satisfying all the assumptions we have posited for the substitutes case is

r S g~q)
P(q,s,e) = f f IA e)dA s gq

0 s < g(q)
where

f (X Ie) =B(e)e 'B('); ;X 0
B(e) = e/(1 +e)
tq)= ln(l +q) ;q>O


In this example, a agent exercises care q to produce a product with quality [I (q). The
enforcer observes a signal of quality, (j, given by

a = Lq) + X

Exerting greater effort allows the enforcer to observe quality with greater precision








40

If cited the party pays a fine, F > 0 for his offense. Consequently, the expected penalty for a violation is given by P (q, s, e) FPi(q, s, e). Throughout most of our analysis we assume that F is fixed, thus allowing us to focus on the setting of standards as the primary tool for shaping compliance and enforcement behavior.8 Later in section 6 we examine the implications of varying the level of the fines, as well as the extent to which fines and standards are substitute instruments for law enforcement.


as reflected in the specification for f(X e). One can easily verify that this
specification satisfies our assumptions for the substitutes case

A slight variation on the first example allows us to produce another
monitoring technology which satisfies all of our assumptions for the complements
case. Here we assume that

o = lt(q) + {1 -exp[-(X + g(e)/B(e))]}

where


g(e) = -21n( e)


Then for s E ( i(q) + 1 eg(e)B(e), ji(q) + 1)


5(q,s,e) = fln[1 -(s-g(q)] -g(e)/B(e) f(A e)dX
0

which satisfies the assumptions required for the complements case.

'This treatment of fines differs from the economics of crime literature, as exemplified by Becker (1968), Stigler (1970), Polinsky and Shavell (1979), Malik (1990), Andreoni (1991) and Mookerherjee and P'ng (1992, 1994), which typically treats variations in fines as a primary enforcement tool. In reality the level of fines is set by the legislative branch, and the ability to adjust statutory penalties is restricted as noted by Graetz et al (1986). Harrington (1988) points out that the fines for violation of environmental standards are constrained to be quite small.








41

Enforcement of the standard is delegated to a single agency, who supplies effort to monitor potential offenders.' There is a cost borne by the agency personnel of supplying effort given by the function, D(e), which is strictly increasing and convex in effort with D '(0) = 0 We make the realistic assumption that it is not possible for public officials to commit the agency to an enforcement policy or to know how diligently the agency enforces standards. Any agency model is likely to be deficient in describing some aspects of bureaucratic behavior, nonetheless we require some paradigm to proceed. We therefore assume that the agency selects an enforcement strategy to maximize the expected sum of fines collected net of the costs of enforcement effort. 10, 11

The interaction between the party and the enforcer is modeled as a game. The party chooses care q(e;s), given the enforcer's effort and the standard where q (e; s) = argmax { U(q, e, s) z-- -P (q, s, e) C (q) The enforcer chooses effort e(q;s) given the
q
party's care decision and the standard, where

e (q; s) = argmaxf II(q, e, s) =P (q, e, s) -D(e) +
E





'We are assuming that economies of scale in collecting and processing information dictate that enforcement be centralized.

"This approach is also employed by Graetz et al (1986) in their analysis of tax compliance. Our results do not change significantly if we assume more generally that the agency is rewarded based on some increasing function of the fines collected. For instance, promotion of agency personnel may be conditioned on their success at prosecuting violators. "Alternatively, we might imagine that enforcement is undertaken by a private firm selected by the government. The relative advantages of employing private versus public law enforcement are discussed in Becker and Stigler (1974), Landes and Posner (1975) and Polinsky (1980).








42

Tis a government transfer paid to the agency to insure it breaks even.'2 A Nash equilibrium to this game consists of a decision pair {q(s), e(s)} such that q(s) = q(e(s);s) and e(s) = e(q(s),s). Below we demonstrate that such an equilibrium exists and that it is unique given S.

We assume that the government's objective function, V = (Bq T) + U + X II, is the societal benefit of care net of government subsidies to the enforcer (Bq-T), plus the utility of the party, U, plus the enforcer's profit, discounted by X < 1. The discounting of enforcer profits derives from the fact that the government's primary constituency is the public at large, including the care providing parties.3 In this case the government limits the agency's profit to zero. Rewriting V, the government's problem [G-P] becomes max V(s) = max B(q(s)) C(q(s)) D(e(s)) [G-P]

The government selects a standard s to maximize the net benefit of inducing a given level of care, including the costs of enforcement given the Nash equilibrium behavior of the party and the enforcer.

Analysis of the Simple Case

For a given standard, s, the corresponding Nash equilibrium care level and enforcement effort are characterized by

-Pq(q,e,s)-C'(q) 0 (3.1)

P,(q,e,s)- D'(e) = 0 (3.2)


12Altematively ,T is a tax which allows the government to collect excess revenues, when the agency generates positive profits.

'1In the symmetric information case of section 3 the government sets T = P-D, so that H = 0, and the government's objective function simplifies to become Bq-C -D








43

Given e, and s, the party selects care to equate the marginal reduction in expected fines to the marginal cost of care. The enforcer optimally responds to q and s by selecting effort to equate the increase in expected fines to the marginal cost of effort. Given our assumptions we have:

Proposition 3. 1: A unique Nash equilibrium exists satisfying (3.1),(3.2) The reaction functions for the party and the enforcer and the resulting Nash equilibrium for the case of complements and substitutes are displayed respectively in Figures 3-1 and 3-2. When the standard and enforcement effort are complements, an increase in care decreases the probability of noncompliance which causes the enforcer to allocate less effort as indicated by the negatively sloped reaction function e(q:s) in Figure 3 1. A decrease in enforcement effort induces less care as reflected by the positive slope of the q(e:s) reaction function. By contrast in the substitutes case, Figure 3-2 reveals that an increase in care induces greater effort from the enforcer, whereas greater enforcement effort causes the party to be less careful."



The Nash equilibrium characterized by (3. 1) and (3.2) corresponds to a given standard, s. To investigate how the equilibrium behavior of the party and enforcer vary with different standard levels we introduce the following assumption Assumption 3. 1: (dqlds), > (dq(e(s),s)1ds)j

de=O de(s)=o

Assumption 3.1 provides sufficient conditions for determining how enforcement effort varies



"This result arises because the marginal reduction in expected fines ftom increasing care is decreased when enforcement effort is increased in the substitutes case.








44

with the tightness of the standards. To interpret this condition, note that (dq (e (s),s)ds) Imeasures the response of care to an increase in standards required for the
de(s) =0
enforcer to maintain a constant level of effort. The expression (dq/ds) Ireflects the actual de =0
change in care for an increase in standards undertaken by the party assuming enforcement effort in unchanged. Assumption 1 requires that the actual change in care undertaken by the party is insufficient to maintain the enforcement effort at a constant level. This simply implies that a change in standards will induce a nonzero response from the enforcement agency. Assumption 3.1 is satisfied for the example where P (q, e, s) = p (s-q, e)'5

The effect of tightening the standard on equilibrium care and enforcement is characterized by:

Proposition 3.2: A tightening of standards always leads to greater care. Given Assumption 3. 1, tighter standards lead to more enforcement effort in the complements case, and it leads to less effort in the substitutes case.

According to Proposition 3.2, the party always increases care as standards tighten to partially reduce the probability of being cited. Despite this increase in care, the opportunity for the enforcer to find a violation increases with a tightening of standards. This leads to an increase in effort when standards and effort are complements as the enforcer's marginal return from effort increases. In contrast, when effort and standards are substitutes the enforcer reduces effort since there is less need for monitoring to convict the party.



"5When

P(q,e,s)=P(s-q,e)=P(8,e), then (dq/ds)l = 1 >P66/(P88 + C") = (dq(e(s),s)ds)j
de =0 de(s) =0








45

The government sets a standard to maximize the net benefits from care, including enforcement costs. If enforcement were costless, it would be optimal to set standards to induce care levels which equate the marginal benefit and marginal cost of care. This prescription for setting standards will not be optimal, however, when enforcement is costly. For suppose we begin with such a standard and assume that effort and standards are complements. A small reduction in standards. will decrease care, but, there will be virtually no effect on net benefits since the marginal benefits and marginal costs of care are approximately equal. However, a small reduction in standards will cause enforcement effort costs to decrease by a non negligible amount. Consequently a small reduction in standards below the level which would cause the marginal benefits and costs of care to be equated, will result in an increase in net surplus inclusive of compliance costs. A similar argument establishes that when standards and enforcement effort are substitutes, it is optimal to increase standards above the level which would induce the net benefit maximizing level of care, This is the intuition underlying the following proposition, In that proposition we refer to q* as the care level which maximizes the net benefits from care (excluding enforcement costs) and s(q*) as the standard which induces q* in equilibrium. Proposition 3.3: Let 9 be the solution to [GP]. In the complements case, 9 < s(q *)and B C(q(s)) > 0 as the optimal standard induces less than the net surplus maximizing level of care, In the substitutes case, 9 > s (q *) and B C '(q (s)) < 0 as the optimal standard induces more than the net surplus maximizing level of care, Proposition 3.3 shows how the enforcement monitoring technology influences the standards for due care, as well as the care level provided in equilibrium. When standards and effort are








46

complements, then standards must be relaxed to prevent enforcers from being overzealous in ensuring compliance. This could possibly explain why some safety and environmental standards appear to be too lax from the view point of the general public. Landes and Posner (1975) have similarly noted that it may be necessary to reduce violation fines to prevent over investment by private enforcers.

The results for the substitutes case are perhaps more surprising. One's intuition might suggest that when enforcement is costly this would add to the costs of inducing parties to take care thus making it optimal to induce lower care. However in the substitutes case, compliance costs are reduced by making it easier for enforcers to convict parties by tightening the standards, but tighter standards induce the parties to supply greater care.

Privately Informed Enforcer

In this section we extend our basic model to consider instances in which the enforcer's cost of effort is private knowledge. Such cases may arise when the cost of monitoring varies by the diligence required to apprehend offenders, by the nature of the offense, or by the characteristics of the parties. All of these attributes may be privately known by the enforcement agency. Hidden information may present difficulties for the government, if it operates under a fixed budget, and the agency claims its costs of enforcement are high. The government must insure the agency staff are adequately compensated to insure their participation, but it also must minimize the expenditures required to run the agency. We focus here on how care standards are optimally set under these circumstances."



"To our knowledge the impact of privately informed enforcers on the design of optimal fines and standards has not been analyzed in the literature.








47

Suppose that the cost of effort is given by D(e, 0) where 0Ois a cost parameter known privately by the enforcer, with the properties that D. (e, 0), De 0 (e, 0) > 0 so that total cost and marginal cost of enforcement are increasing in 6 17 The government is unaware of the realization of 0, but it knows that 6 is distributed according to the density f (0) > forO e [O6].

We assume that the timing of the interaction between the government, the agency and the party is: first, the agency observes a. Second, the government offers the agency a menu of contracts {T(),s()}, where the dependence of the pair on 0, denotes that it is intended for the agency of type 0. 18 T is a reimbursement paid by the government to the agency to help cover its enforcement expenses. Third, the agency selects a preferred contract. The contract choice is public knowledge and the parties update their beliefs about the type of the enforcer based on the agency's contract choice. Fourth, simultaneously the parties choose their level of care, and the agency selects enforcement effort. Finally the agency collects fines from those parties found to be in violation of the standard.

Let II (Q'l 0) denote the agency's expected profit who selects the contract

{T( 0), s (0')} when their type is 0, where



q (s (0'), 0') i s the equilibrium care level for the standard s (0') given that the enforcer has chosen the contract intended for type 0'. The enforcer's contract choice affects the parties' beliefs about the enforcer which influences their choice of care. The equilibrium enforcement


"7We continue to assume that D is increasing and strictly convex in e, and thatD(O, ) = 0. "8That is, the menu is designed so that type 0 will choose {T(0),s(0)}








48

effort e (s (0), 0) depends on the standard, as well as on 0 which is the enforcer's type.

The government's problem [GP-A] for this case is to choose f{T(O), s(8)) to

max E. 1 V(s(0), 0)) [GP-A]

where E.~ is the expectation taken with respect to 0, and such that for all OE [ 0 U]: (i) the agency breaks even, ,H(0) =-H (0 10) : 0, (ii) the party picks the contract which is intended for it, 11(0 10) > 1(0'I 0).

In what follows, we focus on the separating equilibria solution to [GP-A] in which each type 0 is induced to select a separate contract.'19 As a convenient benchmark for this solution to [GP-A] consider the complete information case, analyzed in section 3, where the government and the party know the agency's cost parameter, 0, at the time of contracting. Let s *(0) be the standard which induces the party to choose the net benefit maximizing care, q *,in equilibrium. Refer to 9 (0) as the optimal standard given the agency is known to be of type, 0. We then have:

Proposition 3.4: In the separating solution to [GP-A] the optimal standard, .9 (0) satisfies

(i) 9 (0) :5 (0) :g s *(0) for the complements case, and (ii) R(0) i~(0) s (0) for the substitutes case (with strict inequality for 0 > 0 in both cases). The presence of a privately informed agency causes a greater distortion in standards away "9Another possible policy for the government is to offer pooling or semi-pooling contracts in which several different types of enforcers are induced to accept the same contract. In this case, the enforcer's choice of a contract would not necessarily reveal his type. Such a policy might be beneficial if it were less costly to enforce standards when the enforcer's type was not known by the care providers. Deriving conditions under which pooling or separating contracts are preferred seems quite difficult, and therefore determining the optimal form of contract remains an open question. Although we focus on separating contracts in our discussion, we demonstrate in the appendix that Proposition 3.4 also holds for the case of pooling contracts








49

from s *(0), the level which induces the net benefit maximizing care. This arises because the agency will try to overstate its costs to obtain a more favorable contract from the government. In the case of complements the government reacts by reducing compliance standards which decreases the enforcer's effort. This renders it less attractive for a low cost enforcer to claim to be high cost, by reducing the number of effort units over which he can exercise his cost advantage. As a result of the reduction in standards the party provides less care as q (S (0)) < q ((E))) < q .

When effort and care are substitutes the government increases the standards, thus reducing the incentives for the enforcer to monitor. Again this makes it less attractive for a low cost enforcer to pretend to be high cost, because it reduces the number of effort units over which he may exercise his cost advantage. This tightening of standards induces the party to increase its care as q (9 (0)) > q ((0)) > q .

Heterogenous Parties

In this section we examine desired alterations in optimal standards when there is a heterogenous population of parties varying according to their cost of taking care. Variations in cost arise because the parties have access to Merent methods to reduce the harmful effects of their behavior". Further we assume that the parties are privately informed about their cost of taking care. As in the previous cases we've studied, the government sets a uniform standard which parties must adhere to. However, with a heterogenous population, the






"For instance, firms may differ according to the costs they incur to reduce pollution.








50

government may grant higher cost parties immunity from the standard, if they pay a fix fee.21 This arrangement saves high cost parties the expense of meeting standards, while reducing the enforcer's monitoring costs.22

We model the heterogenous party population by assuming that an individual's cost of care is given by C(q, gi), whereas is a privately observed cost parameter. Total and marginal costs are increasing in gx, with, C4, Cq > 0, for q > 0.23 The density of parties of type g in the population, which is normalized to one is given by g(ga) > 0 for gte[,]. We assume the government offers parties the choice of either paying a fixed assessment, A to the enforcer, which exempts them from being cited, or the choice of trying to meet the standards. Let q (s,pg) = argmax(-P(e(s),q(s),s) C(q,,u)), be party type u's optimal care to avoid being fined. Given A, and q, type u's response is to pay A and avoid providing care if (-P(q(s,kt)e(s),s) C(q(s,/z),g)) _< -A, otherwise the party provides care q(s,A). For a given A, some subset of the highest cost individuals e(A/,] for/a
The government's problem, for the case of heterogenous parties, [GP-P] is to choose



21Alternatively, parties may self report their violations to the agency, where upon they are assessed a fixed fee. as in Kaplow and Shavell (1994). 'In theory if the set of potential offenders was known by the government, a menu of different standards and fines could be offered to separate out offenders by their cost of taking care. This approach is employed by Mookherjee and P'ng(1994) in their analysis of marginal deterrence of crime. Such fine tuning of standards is impractical however when the identity of the offenders is unknown at the time standards are determined. 23We continue to assume that C is increasing and strictly convex in q with Cq(O,/A) =0








51

the assessment A to

max E.~ < {Bq (s,gu) CQq (g,s),g)}I D (F(14)e (s)) [GP-P] The maximand in [GP-P] represents the expected net benefit of care minus the enforcement costs taken over the population of parties investing in positive care levels. Those parties gt > A who exempt themselves, contribute zero net benefits and impose zero enforcement costs on society. The solution to [GP-P] is characterized in the following proposition. In that proposition we refer to as the optimal standard, and s *as the standard that maximizes E < ,{Bq(s,A) C(q(s,1j),g)}

Proposition 3.5: In the solution to [GP-P] (i) no parties are exempted from standards when B is sufficiently large, (ii) when exemption occurs A < F, and A satisfies v (A) =Bq (,A) C (q (, A), A) D '(F(&) e (sD)e (S-) = 0 (iii) 9 < s *for the case of complements, and (iv) > s for the case of substitutes. Part (i) of Proposition 3.5 indicates that parties are exempted only if the benefits from taking care are sufficiently small, otherwise even high cost care providers are induced to provide care. Part (ii ) indicates when exemption arises that higher cost parties opt to pay the assessment rather than risk paying a higher fine if they are cited. The assessment is set at a level so that only those parties with a negative care contribution to social welfare net of marginal enforcement costs, v (g), seek exemption. Parts (iii) and (iv) verify that the same distortion in standards arises when parties are heterogenous as when they are homogenous.

When exemptions are possible, dishonest enforcers may also take bribes from parties not wanting to provide care. To analyze this possibility, suppose for now that government sanctioned exemptions are not offered, perhaps because the benefits from care are too large.








52

imagine that the enforcer offers any party an exemption from being monitored if the party pays the enforcer a bribe equal to Y Assume also that such illegal activity goes unnoticed by the government, and that agreements between parties and the enforcer are kept. 24Given the standard, s, the enforcer's problem, [EP] is to set the level of the bribe, Y and enforcement effort e(s) to

max E.t ~ {P(q (s,k),e,s) } D(F(1u')e) + (1 -F(~A')) Y + T [EU] where all parties Ai e (u', ,A] pay the bribe and type [u/ is indifferent to paying the bribe and investing in care. The solution to the enforcer's problem is characterized in, Proposition 3.6: In the solution to [EP], (i) the enforcer always offers a bribe Y < F which the higher cost parties uE~ (Au, -At] pay. (ii) Y satisfies


(1 F(1) Y(dkt'IdY)f(j1)) =- {P(q(s,g'),e(s),s) D'(F([z')e(s))e(s)}(dg'/ldY)f(p/) According to Proposition 6 the enforcer always offers a bribe which some non neglible subset of the higher cost parties agree to pay for exempting themselves from being cited. The optimal bribe, characterized by the equality in (ii) sets the enforcer's marginal revenue from an increase in the bribe to the marginal increase in the collection of fines as more types invest in care in response to an increase in the bribe.

Propositions 3.5 and 3.6 suggest that if illegal bribes cannot be detected, high cost parties will always exempt themselves from fines by paying the enforcer a fee. In cases where the benefits from care are large, the fee will be a bribe paid to the enforcer, as assessments for exemptions will not be sanctioned by the government. In cases where the benefits from care "O0ne rationale for why corrupt agents may trust one another to honor agreements is that they may want to maintain a reputation for being reliable. See Tirole (1992) for one approach to modeling collusion between corrupt individuals.








53

are small, the fee may be a government sanctioned assessment, if A is less than Y2 Setting Optimal Fines

To this point in our analysis we have assumed the level of fine for a violation, F, is fixed exogenously. Here we investigate whether increases in F are welfare improving. Becker (1968) first observed that larger fines deter parties from breaking the law and thus reduce enforcement effort required to insure compliance. As we demonstrate, this argument may fail to apply when the enforcer's effort supply depends on the probability that the party is in compliance.6

Suppose the fine, E, is increased. This will cause the government to adjust its optimal standard, S, and it will induce both the party and the enforcer to adjust their behavior. Let de/dF and dq/dF represent respectively the rate of change in equilibrium enforcement effort and care as F is increased. Then the increase in welfare from a change in F can be written as dV/dF = (B-Cq)(dq/dF) -De(de/dF)

= {(Cq)De (de/dF)/(dq/dF)}De (dq/dF)

()0 as (de/ds)/(dq/ds) ()(deldF) /dq/dF) (3-3)

where the first line of (3-3) follows from the Envelope Theorem, the second line follows from


"We conjecture that A will be less than Y for B sufficiently small, although we have so far been unable to verify this.

"6Several analyses have discovered reasons why maximal fines may be not be desired. Malik (1990) demonstrates that increasing fines may increase agent's avoidance behavior, thus leading to higher enforcement costs. Andreoni (1992) argues that juries are less apt to convict offenders when fines are more severe, thus reducing the deterrence power of maximal fines. Polinsky and Shavell (1979) argue that maximal fines are welfare decreasing in that some offenses should not be deterred if marginal benefits of the crime exceed the marginal costs. Stigler( 1970) and Mookherjee and Png (1994) show that fines should be varied continuously in order to maintain marginal deterrence in enforcement.








54

the first by rearranging terms and the last line follows from the condition for setting optimal standards, (dV/ds = 0)27

A necessary and sufficient condition for ordering (de/ds)/(dq/ds) and (de/dF)/(dq/dF) and thus determining whether increasing fines is welfare enhancing is given in Proposition 3.7: (de/ds)/(dq/ds) (>) (de/dF)/(dq/dF) as d/ds { -Pe/Pq () 0. To interpret (3-3) note that under the optimal standard (de/ds)/(dq/ds) represents the rate at which enforcement effort and care may vary while keeping total surplus constant. In the complements case, too little care is allocated. An increase in F will induce the party to provide more care, but it will also cause the enforcer to expend more effort. If the rate at which extra effort expended for an increase in care is sufficiently small ( less than (de/ds)/(dq/ds)) then increasing the fine will increase welfare. Otherwise increasing the fine will reduce welfare, if it will induce too much enforcement effort to be expended. A similar argument serves to confirm this intuition for the case of substitutes.

Proposition 3.7 provides necessary and sufficient conditions for an increase in the fine to be welfare decreasing. It's easy to verify that in the substitutes case where P., < 0, that d/ds{-PePq} < 0. This implies that a small increase in the violation fine is welfare decreasing and it provides an interesting exception to Becker's argument for maximal fines. The intuition supporting this finding is that in the substitutes case, the level of care induced is excessive in order to limit enforcement effort. (see Proposition 3.3) An increase in the fine reduces welfare, by causing parties to further increase care which also induces enforcers to expend more effort.


27The optimal standard satisfies dV/ds = 0 or B-Cq)/De =(de/ds)/(dq/ds).








55

Conclusion

Our analysis offers one rationale for the divergence between the marginal benefits and the marginal costs from taking care which often arise in practice. Pollution and safety standards may either be set too loose or too stringent to discourage enforcers from exerting excess effort. Whether standards are set too low or too high depends on the available technology for identifying violators.

Our analysis also reveals the importance of setting standards, not only to influence compliance, but also to shape the behavior of enforcers. In circumstances where penalties are fixed, varying standards may be one of the few tools policy makers have to affect compliance and reduce enforcement expenses. In instances where fines can be varied as well, it may be counterproductive to set maximal fines which encourage overzealous law enforcement.








56












q es) e (q, s)































Figure 3-1 Complements Case: Pe,>0








57













q e(q, s) q(e, s)





























e

Figure 3-2 Complements Case: Pes












CHAPTER 4
MONITORING AND THE OPTIMAL MIX OF PUBLIC AND PRIVATE DEBT CLAIMS

Introduction

Two of the most important functions of intermediated lending are that it facilitates delegated monitoring and provides flexibility. The theory of finance suggests that diverse groups of public lenders do not sufficiently monitor the firms to which they provide funds: It points to free rider problems and inefficient monitoring technologies as contributing reasons. In contrast, financial intermediaries are often assumed to have a unique advantage in performing monitoring. Intermediaries can act as delegated monitors by monitoring and controlling borrowers on behalf of other lenders, and in turn produce information'. Moreover, conflicts of interests and legal restrictions render negotiations with dispersed public lenders very costly, if not impossible. In contrast, concentrated lending by intermediaries enables negotiations to occur at ease, and provides flexibility allowing modifications of loan contracts as circumstances necessitate.

Despite the success in our understandings of intermediated lending, important questions remain unanswered (or only partially answered): 1) Given intermediaries' advantages in performing monitoring, what is their incentive to actually provide monitoring? 'See Berlin and Loeys (1988), Campbell and Kracaw (1980) and Diamond (1984). Empirical evidences based on loan announcement are documented in Billet, Flannery and Garfinkel (1995), James (1987) and Lummer and McConnell (1989), Fama (1985) provides another piece of evidence.

58








59

2) Casual observations of firms' capital structures reveal that they frequently borrow from both intermediaries and public debt market. Given the advantages of intermediated lending, why do firms demand public lending as well? 3) The notion that intermediaries act as delegated monitors assumes that public debtors' incentives over monitoring are in accordance with that of intermediaries'. Given that firms choose their debt structures, why do they desire to align the two incentives? This paper provides some answers to these questions.

To analyze these issues, we employ the following model: A wealth constrained manager must seek external financing to start a project, which lasts two periods and produces cash flows only on the final date, The distribution of the final cash flow depends on the interim states which are privately observed by the manager. The project provides positive NPV only in the favorable state. There are two sources of external financing, public lending and intermediated lending (private lending). Costly monitoring and costless interim renegotiation are feasible only with intermediated lending. Besides being the residual claimant of the cash flow from the project, the manager enjoys non-transferable private control rents, provided the project is continued at interim. The existence of control rents is the source of potential misalignment of preferences between the manager and the lenders over the interim continuation decision: In pursuit of the control rents, the manager may prefer to continue the project even if liquidation benefits the lenders. We assume that for lenders to break even, interim liquidation in the unfavorable state must occur with positive probability and it must strictly benefit the lenders.

To raise initial financing, the firm must assure lenders of an expected repayment equal to the amount of fund lent. The divergence of preference, between lenders and the manager,








60

over the interim continuation decision implies that monitoring may be required to ensure timely liquidation and initial financing. Our analysis is based on the observation that while monitoring can facilitate initial financing by mitigating agency problems, it introduces deadweight costs: I)There is a cost for expending monitoring effort; 2)Liquidation destroys the manager's control rent. Thus, in designing the optimal debt structure, the manager has two goals: I)To credibly payout the cash flows so that the required level of monitoring for initial financing is n- inirnized; 2) To structure the private debt claim to induce the required level of monitoring. The main result of this analysis is that in general the manager can not achieve both of his two goals by relying entirely on private debt financing, and the optimal debt structure is a mix of both public and private debt. To derive this result, we proceed in several steps.

We first analyze the case in which the manager's private rent is sufficiently small. In this case, liquidation in the unfavorable state generates positive surplus, and therefore is efficient. We find that if the firm borrows long-terrn bank debt, which requires a repayment only after the cash flow from the project is realized, then in the unfavorable state the project is liquidated through renegotiation independent of whether the bank is informed or not. The need to borrow public debt arises because the bank's debt claim must be renegotiated to induce liquidation, so the division of surplus from liquidation can not be specified through ex ante contracting. If the bank is the only lender, the firm can extract most of the surplus from liquidation when it commands large bargaining power, and initial financing may become


'Henceforth, we will use the term "bank" to represent all types of institutions which can provide similar functions in our model. These institutions may include insurance companies, pension finds, etc.







61

infeasible. Unlike the bank lender, however, public debtors can free ride on the benefit of negotiations without making concessions of their claims in liquidation. By equating public debtors' claims in liquidation to the surplus generated, the firm can credibly pay out the surplus and enable initial financing without monitoring.

When the private rent is sufficiently large, the manager never desires to liquidate the project. Feasibility of initial financing requires involuntary liquidation in the unfavorable state. Therefore, the firrds initial borrowing must include bank debt requiring a repayment when the interim state is realized. Such a debt claim confers the interim control rights upon the bank, allowing it to force liquidation. Given the control rights, the bank can benefit from better information which enables it to timely liquidate the project in the unfavorable state. Thus, the bank's desire to maximize the value of the control rights motivates it to monitor.

When the manager raises initial financing only from a bank, we find that the optimal bank debt requires repayments both at interim and on the final date. Moreover, the size of the final repayment depends on the relative bargaining power between the manager and the bank lender. When the manager commands larger bargaining power, initial financing requires that the final repayment be sufficiently large. If the final repayment is small, the bank never forgives the interim repayment and the project can only be continued through renegotiation. When the manager commands large bargaining power, he can extract most of the surplus from continuation, and initial financing becomes infeasible. Increasing the promised final repayment increases the bank's expected payoff. This follows because if renegotiation breaks down, the bank can choose between its payoff in liquidation and its payoff when it forgives the -interim repayment and allow the project to continue. Increasing the promised final







62

repayment raises the bank's reservation level, and therefore increases its expected payoff from continuation. When the bank commands large bargaining power, initial financing is always ensured. In this case, the manager desires to control the bank's benefit from being informed in order to reduce the costs associated with monitoring. We show that there exists a bank debt claim so that the bank's payoff, when it is informed of the favorable state, is equal to the promised interim repayment. By optimally setting this repayment, the firm can reduce the amount of bank monitoring.

In general, however, it is strictly suboptimal for the firm to raise initial financing only form a banic To minimize the level of monitoring required by initial financing, the manager desires to maximize the bank's benefit per unit of monitoring effort. On the other hand, to induce the minimum level of monitoring, the manager must structure the bank's debt claim to control its benefit from monitoring. Thus, when the project is financed only by a bank, the manager's two goals are in conflict with each other.

In addition to bank debt, the firm can raise initial financing by also borrowing public debt. We consider the two cases in which the firm borrows either long-term or short-term public debt. In both cases, we find that by financing the project with a mix of public and bank debt, the firm can separate its two goals in designing the optimal debt structure: It can regulate the bank's incentive to monitor without interfering its desire to minimize the required level of monitoring for initial financing. To minimize the required level of monitoring, the manager desires to maximize the lenders' (the bank's and the public lenders') total expected payoff when the bank is uninfonned. If the project is financed by a mix of public and private debt claims, then, for any fixed payoff scheme for the bank, the manager can maximize this








63

payoff by paying out cash flow form the project to the public debtors. Furthermore, by giving the public debtors a share of the proceeds from the liquidation, the manager can control the bank's benefit from monitoring, so that the desired level of monitoring is induced.

In comparing the optimal mix of bank debt and long-term public debt and that of bank debt and short-term public debt, we find that the former strictly dominates the latter. With short-term debt claims, the public lenders are repaid in full whenever the project is refinanced and allowed to continue by the bank. In this case, the public lenders can never strictly benefit from timely liquidation in the unfavorable state, which arises only when the bank is informed. In contrast, with long-term debt claim, the public lenders' payoff is state contingent and they can benefit from timely liquidation. Thus, long-term public debt claim allows the firm to align the public debtors' incentive over monitoring with that of the bank's, so that the debtors' total marginal benefit from monitoring is maximized, further reducing the required level of monitoring for initial financing. When the project is financed by the optimal mix, the bank acts as a delegated monitor.

There is an extensive literature on optimal debt structures. Our analysis is most closely related to that of Hart and Moore (199 1). We share similar premises that managers design debt structures to credibly assure the lenders of their repayments. The main difference between the two is that Hart and Moore assume that there is no asymmetric information and renegotiation is ffictionless. Therefore, there are no differences between public lending and bank lending in their analysis. Our analysis is also related to those by Rajan (1992), Park (1994), and Rajan and Winton (1995). Rajan (1992) analyzes the bank hold-up problem. He argues that firms can use public debt to mitigate the distortion in managers' incentives to








64

expend effort caused by banks' opportunism. Both Park (1994) and Rajan and Winton (1995) demonstrate that optimal enforcement of debt covenant can provide banks with incentive to monitor. Our analysis, on the other hand, is based entirely on the distribution of cash flows. Diamond (1991, 1993) investigates how firms having private information choose their debt structures. In our analysis, prior information is symmetric among agents.

The rest of the paper is organized as follows. In section 1, we outline our model. In section II, we consider the case in which the manager's private rent is sufficiently small. In section 11, we analyze the bank's incentive to monitor and derive the optimal bank debt. In section IV, we derive the optimal mix. Section V presents empirical evidence and section VI concludes.

Elements of The Model

There are three dates, t=0O, 1,2. There is an indivisible project which requires an initial investment of 10 at t=O. The project returns a stochastic cash flow of r at t=2 distributed over the compact support [0,X]. The distribution of r is denoted as F(r 10) and depends on the interim State OC{OHOL. F(rJ 0H) strictly dominates F(r IO() according to first-order stochastic dominance. If the project is terminated at t=1I, the firm's assets can be liquidated at L<0. The terminal value of the assets at t=2 is zero. The parameters satisfy Assumption 4.0: fordF(r (H>J>LfrdF(r 0. (4-1)


Assumption 4. 1: L gE0[f'rdF(r 10)]. (4-2)

Assumption 4.0 indicates that the project provides positive NPV in the favorable state while liquidation yields more cash flow in the unfavorable state. Assumption 4.1 says that, at t=1,







65

continuing the project is more profitable than liquidation when the belief about the occurrence of the two states coincides with the prior. It implies that without additional information lender(s) perceives continuation as more profitable than liquidation. To ascertain the profitability of liquidation, lender(s) must acquire additional information.

The manager, having no wealth of his own, must seek external financing. There are two types of lenders--banks and public lenders. Unlike public lenders, a bank lender can have access to a costly monitoring technology which generates an interim signal correlated with the realized state. We assume that only the bank lender who lent at t=O can observe a signal at t=1i. The bank's signal is, however, not verifiable, and therefore can not be contracted upon. By expending effort ec[0,1], the banker can observe the realized interim state with probability e and remain uninformed with probability 1-e4. Expending effort e costs the bank ti(e). We assume *i'(e)>O, *"(e)>O and *(e=O)=O. At t=O, there is competitive supply of public and bank financing. The prevailing interest rate is normalized to zero. This implies that, ex ante, lenders are willing to provide financing if the expected returns from their claims equal the amount lent. At t=l, the supply of public financing remains perfectly competitive. The only type of contract between the firm and its lenders is the standard debt contract which specifies a repayment schedule and contains a covenant. Following the incomplete contract approach, we assume that the interim decisions are not contractible. Therefore, the interim


3This is consistent with most of the empirical findings. See Billett, Flannery and Garfinkel (1995), James (1987), Lummer and McConnell (1991). 4Formally, this corresponds to the information structure in which the signal space consists of three elements, SH, SL, A}. The correlations between the signals and the interim states are f(sH IOH=ef(c IOH)=l-e, f(SL I OL)=e and f(OI OL)=l-e. The signal 4 is completely uninformative, and the signal sH (SL) perfectly reveals the state OH (OL)







66

continuation decision can not be explicitly constrained by the covenant, and the party who has the interim control rights can unilaterally decide on the actions to be taken'. All agents are assumed to be risk neutral.

At t=O, the manager attempts to raise the capital needed to start the project. Apart from being the residual claimant of the t=2 cash flow, the manager enjoys a non-transferable and state-contingent private control rent C(O), with C(OM)>C(OL), provided that the project is continued to t=2'. The private control rent is the source of potential misalignment of incentives, between the manager and its lenders, over the interim continuation decision. To raise initial financing, the manager must credibly assure lenders of an expected repayment equal to the funds they initially provide. We assume that the return from the project also satisfies the following condition.

X X
Assumption 4.2: vf, rdF(r 10,) + vL>I,)>Eo [f rdF(r I E))]. (4-3)

Assumption 4.2 indicates that the t=O expected cash flow is less than the initial investment if the project is always continued to t=2; It exceeds the initial investment if the project is only continued in state OH. For lenders to break even, liquidation in state OL Must occur with strictly positive probability and it must strictly benefit the lenders. To simplify our notations, we introduce the following definition.



'This arises either when an informed bank's signal is not verifiable or if the costs of describing interim actions are prohibitively high.

'The control rent may not be actual monetary benefit for the manager. In our analysis, it merely serves as a measure of the divergence of preference, between lenders and the manager, over the interim continuation decision. For further discussions, see Aghion and Bolton (199 1). Hart and Moore (199 1) endogenize the control rent by giving the manager some bargaining power through his ability to quit.








67
x
Definition 4. 1: r(0) =frdF(r 10), OC {OH, OI. (4-4)
0
The information structure is specified as follows. At t=O, information is symmetric among a agents, with common prior of the favorable and the unfavorable state being VH and VL respectively. The manager can costlessly observe the interim state and the signal acquired by the bank. Thus, at t1, the manager knows whether the bank is informed or not. On the other hand, public debtors observe neither the realized state nor the signal acquired by the bank.

If the project is financed at t=O, the firm and the bank can costlessly renegotiate at t--1. Renegotiations occur either because there are needs to modify the terms of the bank loan or because the firm needs to request additional financing. The renegotiation process is specified as follows. We assume that both the bank and the firm can initiate renegotiation. In bargaining over a new contract, the firm can, with probability A, make a take-it-or-leave-it offer which the bank can accept or reject; With probability 1 -X, the bank can make a take-itor-leave-it offer which the firm can accept or reject. Thus, A, is a measure of the firm's bargaining power7. In the event that renegotiation breaks down, two possibilities arise: 1 )If the firm has short-term bank debt outstanding, then the bank can either force liquidation or forgive the short-termn repayment and allow the project to continue (if possible)'; 2) If the firm 'There are many factors which can affect the size of X. For example, the bank's reputational concerns, the length of the firm-bank relationship, and the firms' accessibility to alternative sources of capital, can all affect the relative bargaining power. 8Since this assumption will turn out to be rather important for our analysis, we provide some justifications. First, banks are not prohibited by law from forgiving repayments due. Second, as is easily seen if the bank only holds short-term debt claim, it will not forgive the t1l repayment if renegotiation breaks down. However, when it holds both short-term and longterm claims, it may choose to forgive the t=1 repayment in the interest of capturing a larger








68

only has long-ten-n debt obligation(s) outstanding, the existing contract(s) stands. On the other hand, we assume that it is impossible for the firm to renegotiate with the existing public debtholders'. The firm can, however, raise financing from the interim competitive capital market, in which case the firm makes a take-it-or-leave-it offer to investorslo,

As a preliminary analysis, we demonstrate the existence of demand for bank debt. Suppose the firm tries to raise initial financing by only borrowing public debt. With public lenders, monitoring and interim renegotiation are both infeasible. Without monitoring, public lenders can not acquire additional information about the realized state, and, by assumption 4. 1, they will not choose to liquidate the project. Since renegotiation is infeasible, the firm will never choose to liquidate the project. Thus, the project is always continued, and by assumption 4.2 public debtors will not finance the project. To raise initial financing the firm's initial borrowing must include bank debt.

When the firm's initial borrowing includes bank debt, the lender's (or lenders') t O expected payoff can be written as



t=2 payoff. This is similar to a debt restructuring except that the latter is usually furnished under a new contract. The difference arises because in the present setting, financial distress occurs with certainty. Therefore, the result of a t=1 restructuring is partially reflected in the ex ante contract. Finally, this assumption accords our definition of the interim control rights to that of Grossman and Hart (1986). According to these authors, the party who has the control rights can unilaterally decide on the course of action in the absence of negotiation. In our model, the there are two possible interim actions--continuation and liquidation. By allowing the bank to forgive the t=1 repayment, short-term bank debt claim confers the control rights on the bank in the sense of Grossman and Hart (1986) 'This assumption may be justified by the presence of free rider problem in exchange offers. See Gertner and Scharfstein (1994).
"We assume that lenders in the capital market are sufficiently diverse so that the firm can make the offer to investors other than the existing ones.








69




where R, and k~ are the lender's (or lenders') payoff when the bank is informed and uninformed respectively, and e is the bank's monitoring effort. To raise initial financing, the expected payoff, in (4-5), must be at least as large as the initial investment, I0. The analysis in this paper is based on the observation that there are deadweight costs associated with monitoring"1: 1) There is a cost *I(e) for expending monitoring effort e; And 2) as a result of monitoring, the project must be liquidated when the bank is informed of the unfavorable state. Liquidation destroys the manager's private rent, which may exceed the liquidation value of the assets (see the discussion in section III). Thus, the manager desires to minimize the level of monitoring required by initial financing. To minimize the required level of monitoring, the manager must maximidze the lender's (or lenders') payoff when the bank is uninformned, R., and, when positive level of monitoring is required by initial financing, the lender's (or lenders') marginal benefit of monitoring, R, -kn. Furthermore, he must structure the bank's debt claim to induce the minimum level of monitoring.

The Mix of Long-Term Public and Bank Debt Claims

The manager raises initial financing by borrowing from a bank and public lenders. In return, he promises a t=2 repayment S2 to the bank and t2 to public lenders. The bank's and the firm's expected payoff in state 0 is denoted as Rb(S2,t2 10) and Rf(s2,t2 10) respectivel y12.


"We assume throughout the paper that all rents extracted by the lenders in excess to the initial funds lend are prepaid. Thus, the manager's objective is to maximize the total t=O expected surplus, while ensuring initial financing. "2Both of the payoffs incorporate any contractual specifications which may affect them, including, for example, the relative seniority between the public and bank debt claims.








70

The mix also specifies the payoffs to the bank and to the public debtors in liquidation, denoted as L' and LP' respectively. In analyzing the mixes of long-term debt claims, we make Assumption 4.3: CL: L-r(OJ)1. (4-6)

Assumption 4.3 implies that liquidation in state 0L generates positive surplus, and hence is efficient. Since the manager can not renegotiate with the public lenders, it falls on the bank to bribe the manager and induce liquidation. Consider the interim renegotiation when the bank is informed. In this case, the firm and the bank negotiate under symmetric information and the their total payoff is maximized"4. If the project is continued, the firm's and the bank's individual rationality conditions imply that the existing contract will not be replaced. If the project is liquidated, the total cash flow available to the firm and the bank is L'. Thus, negotiation leads to liquidation in state 0L if and only if Lb [R/s2,t2l (L) +R b(s2,t2 I L) +CL].(47


Condition (4-7) indicates that it is individually rational for the bank to bribe the manager and induce liquidation in state 0L. When the bank is uninformed, the analysis is more involved and




"IJfCL>L-r(OD), then the project can not be financed by a mix of long-term debt. This follows because the manager can always continue the project without raising additional financing at t--1. To induce liquidation in state 0L' lenders must offer the manager a bribe of at least CL. This leaves the lenders (both the bank lender and the public debtors) with a t0O expected payoff no greater than
VH r(O1H) +VL[L-CL] EO[r(O)].
By assumption 4.2, this is smaller than the initial investment 10. Therefore lenders will refuse to provide initial financing.
"I1n general, when one of the parties in the negotiation is wealth constrained, symmetric information is not sufficient to ensure the optimality of bilateral bargaining. In the present case, monetary transfer is from the bank, who is not subject to wealth constraint, to the manager, and therefore optimality is ensured.








71

is relegated to the appendix. We summarize the result in the following lemma. Lemma 4.1 If the bank is uninformed, then in the unique equilibrium of interim negotiation": i)If S2 and t2 satisfy (4-7) and

Lb [R s2,t2 I (H) +CH] :EO1Rb(s2,t2 0 )], (4-8)

then the project is liquidated in state 0L and continued in state 0H, independent of who makes the offer;

ii)For all S2 and t2 which do not satisfy (4-7) or (4-8), the project is either always liquidated or always continued when the firm makes an offer.

In the following, we focus on debt structures which satisfy conditions (4-7) and (4-8). Condition (4-8) indicates that when the firm makes an offer in state 0H, continuing the project returns it a. larger payoff than that in liquidation. It ensures that the project is always continued in the favorable state. In (4-8), the bank's payoff in continuation is its expected return, reflecting that the bank is uninformed. If the debt structure satisfies conditions (4-7) and (4-8), then, independent of the bank's information, the equilibrium for the interim negotiation is separating: The project is liquidated in state OL and continued in state 0H. The manager desires to maximize the total surplus while ensuring initial financing. Given the above liquidation policy, the total surplus is independent of the promised repayments to the debtholders. Thus, to ensure initial financing, the manager desires to maximize the lenders'






"It is well known that negotiation under asymmetric information generally leads to multiple equilibria when the informed party can also propose offers. Throughout this analysis, we require that the equilibrium satisfy the divinity criterion of Banks and Sobel (1987).








72

(the sum of the bank's and the public debtor's profit) expected payoff'". The following proposition characterizes the optimal solution. Proposition 4. 1: At optimal, s2t2=X and

Lb >Rb(s2,t2 IOL)+CL' (4-9)

The project is liquidated in state OL and continued in state E)H, and the bank does not monitor.

In the optimal solution, the bank's monitoring effort is zero. Equation (4-5) implies that the lenders' t=0O expected payoff consists of only Ra Since the total promised repayment to the lenders, s2+t2, equals the maximum profit from the project, they acquire the entire cash flow from the project in state OH. To induce liquidation in state 0L, however, the bank must offer the manager a bribe CL. The lenders'--the bank and the public lenders--t=O expected profit is

R U=V~r(OH)+VL[L-CL]. (4-10)

Thus, if the payoff, in (4-10), exceeds the initial investment, 10, project can be financed by a mix of long-term public and bank debt.

The optimal solution has the following two properties. First, since the continuation decision is independent of the bank's information, there is no need for monitoring. There are two reasons why the interim equilibrium is separating even when the bank is uninformed: 1)Since the manager's control rent is sufficiently small, he can recoup the loss of private rent when the project is liquidated; 2)Since the manager has the interim control rights, he is not harmed by revealing the unfavorable state.


"6From part ii) of lemima 4. 1, debt structures which do not satisfy (4-6) or (4-7) reduces both the total surplus and the contractible cash flow. Consequently, they are suboptimal.







73

Next, consider condition (4-9) in proposition 4. 1. The left hand side of the equality is the total payoff to the bank and the firm when the project is liquidated in state OL The right hand side is their total payoff if the project is continued, Condition (4-9) indicates that the bank and the firm do not strictly benefit from liquidation; The public debtors extract the entire surplus from liquidation. As has been pointed out previously, the manager desires to maximize the t=O expected payoff to the lenders. Since the bank's debt claim is not renegotiated when the project is continued, the firm can credibly pay out the profit from continuation through ex ante contracting. However, when the project is liquidated, the bank's debt claim must be renegotiated. If the bank is the only lender, the division of the surplus from liquidation can not be specified through ex ante contracting. Instead, it is divided according to the relative bargaining power. When the manager commands large bargaining power, he can extract most of the surplus from liquidation. The bank's benefit from liquidation diminishes and, by assumption 4.2, it may refuse to provide initial financing. Unlike the bank lender, however, public debtors can free ride on the benefit of the negotiation between the bank and the firm without making concessions of their claims in liquidation. Thus, by borrowing a mix of bank debt and public debt, the firm can credibly pay out the surplus generated from liquidation to the public lenders. The optimal debt structure maximizes debtors' total payoff when the bank is uninformed, Ru, and initial financing is ensured without the firm incurring any cost of monitoring, This provides an explanation why the firm may desire to diversify its borrowing".


"Raja (1992) argues that bank's opportunism may cause public debt to be more desirable than bank debt, Our finding extends Raja's result in three aspects: 1) It indicates that a mixed debt structure can be desirable; 2) Diversified borrowing also arises when the firm commands large








74

Optimal Bank Debt

When the manager's control rent becomes large, that is, when the divergence of preference between the manger and the lenders is large, liquidation through interim renegotiation is no longer feasible, Therefore, the firm can not finance the project by using a mix of long-term public and bank debt. Specifically, we will assume the following in the ensuing analysis.

Assumption 4.47 CL>L. (4-11)

In this case, feasibility of initial financing requires involuntary liquidation. This implies that the firm's initial borrowing must include short-term debt. A short-term debt claim transfers the t--l control rights to the lender when the manager can not make a repayment. Given the control rights, the lender can force liquidation without having to bribe the manager.

By assumption 4. 1, without additional information lenders' consider continuation as more profitable than liquidation, and the firm can always continue the project by promising a sufficiently large t=2 repayment. Since initial financing requires that the project be liquidated in the unfavorable state with strictly positive probability, the firm must structure the debt claim to induce monitoring by the bank lender. To find the minimum level of monitoring required by initial financing, notice that the maximum value for k, the lender's (or lenders') expected payoff when the bank is uninformed, is Ea[r(0)] and the maximum value for R,, the lender's (or lenders') expected payoff when the bank is uninformed, is VHr(0H)+vLL. The minimum level of monitoring required by initial financing, e*, is then



bargaining power; 3)Diversified borrowing may be desirable even in the absence of moral hazard problem.








75

defined by

EO[r(O)] +vLe [L -r(6L)] -qj(e *) =I (4-12)


In the ensuing analysis, we make

Assumption 4.5: d*(e vL[L -r(OLA (4-13)
de *


To interpret assumption 4.5, suppose that the firm can structure the debt claims so that both & and 1 attain their maximum values. The right hand side of (4-13) is the lender's (or lenders') total marginal benefit of monitoring which must (weakly) exceed the bank's marginal benefit from monitoring. Assumption 4.5 ensures that it is feasible for the firm to both minimize and induce the amount of monitoring required by initial financing.

In this section, we assume that, ex ante, the firm only borrows from a bank. At t=1, however, it can acquire additional financing from the market and/or by negotiating with the bank. Besides motivating the analysis in the next section, this section derives the optimal debt structure for a firm which initially does not have access to the public debt market. Short-Term Bank Debt

The manager raises initial financing by borrowing from a bank and promises to repay s, at t=1. In the discussion of short-term bank debt, we assume that the firm does not raise financing from the interim market. To continue the project, the manager must renegotiate with the bank. If the renegotiation breaks down, the project will be liquidated and the bank gets L while the manager gets nothing. These are the bank's and the firm's reservation levels in the renegotiation. Consider the renegotiation when the bank is informed. In state OH, when








76

the bank makes an offer, it can demand the entire return from the project by proposing a continuation contract S2 b=X11. When the firm makes an offer, it promises a t=2 repayment which returns the bank an expected payoff equal to its reservation level, L. In state OL, the project must be liquidated. When the bank is uninformed, the analysis is slightly more complicated and is relegated to the appendix. The result is summarized in the following lemma.

Lemma 4.2: When the bank is uninformed, there is a unique equilibrium in the interim renegotiation. In this equilibrium, the project is always continued and i) the firm proposes the pooling continuation contract s,'which yields the bank an expected return equal to its reservation level L;

ii)the bank proposes the pooling continuation contract Sb=X.

The intuition for lemma 4.2 is quite simple. With short-term debt claim, the bank can unilaterally decide to terminate the project. If the manager's offer is state contingent, the bank can infer each realized state. It will refuse the offer indicating the unfavorable state and terminate the project. The manager thus offers the same contract in both states, and the feasibility of continuation follows from assumption 1. When the bank makes an offer, it can demand the entire t=2 cash flow by proposing a continuation contract S2 b=X. Alternatively,



"In the negotiation between the firm and the bank, the parties can reach a new contract which specifies a t=1 repayment to the bank. The project is then liquidated and the bank is paid according to the new contract, Such a contract is termed a liquidation contract. Alternatively, the parties can reach a new contract which specifies a t=2 repayment. The project is then allowed to continue. Such a contract is termed a continuation contract. Throughout the paper, offers with subscript I indicate t=1 repayments and correspond to liquidation contracts. Offers with subscript 2 indicate t=2 repayments and correspond to continuation contracts. All offers are described in terms of the payments to the bank.








77

the bank can offer a menu of contracts which screens out the unfavorable state and induce liquidation. However, the manager will reveal the unfavorable state only if he is bribed, at least, his private rent CL. By assumption 4.3, this is infeasible. Part ii) of lemma 4.2 then follows.

It follows from the above discussion that the bank's t=O expected profit and monitoring effort are

PQ(X) =( 1 -X)E6Ir(O)] -'XL +e(l -.X)vL[L -r(OL)] -11(e), (4-14) d*l(e) -(1 -X)vL[L-r(OL)]. (4-15)

de

Equation (4-14) indicates that the bank's profit is independent of the manager's private rent. This follows because the short-term debt claim transfers the interim control rights to the bank, allowing it to force liquidation without bribing the manager. However, the bank's expected payoff depends on its bargaining power, 1-k. At t=1, the bank acquires the control of the firm's assets. To continue the project, the manager must purchase the assets back from the bank through renegotiation"9. The expected price he must pay increases with the bank's bargaining power. Consequently, the bank's expected payoff increases with its bargaining power.

Equation (4-15) indicates that the bank's marginal profit of monitoring is positive and is increasing in the bank's bargain power, 1-A. When the bank only holds long-term debt claim, its marginal profit of monitoring is zero because it can not act upon better information "~ Hart and Moore (1989, 1995) show that the need to purchase control rights from the debtors can serve to discipline the manager by forcing him to pay out excess cash, thereby mitigating the free cash flow problem suggested by Jensen (1986).








78

without the control rights. Given the control rights, however, the bank can benefit from better information which allows it to timely liquidate the project in the unfavorable state. Thus, maximizing the value of the control rights motivates the bank to monitor".

To assess the feasibility and desirability of short-term bank debt financing, let X* be defined as PAX*) 10. From assumption 4.5, O;,*, short-term bank debt financing is infeasible. In this case, the manager can repossess the assets at a small average price, whenever the project is allowed to continue. He extracts most of the surplus from continuation, and the bank can not recoup the initial fund lent. On the other hand, if the firm's bargaining power is sufficiently small, so that X! X *, short-term bank debt financing is feasible. However, except when X*=O, the monitoring effort induced strictly exceeds the minimum level of monitoring e*. This follows because when the firm raises initial financing by using only bank debt, the bank acquires the entire benefit from monitoring and the monitoring effort supplied exceeds e*. Thus, the firm's desire to minimize the required level of monitoring through maximizing the marginal benefit of monitoring, and its desire to induce the minimum level of monitoring through controlling the bank's benefit from monitoring are in conflict with each other.

Bank Debt Requiring Both Short-Term and Long-Term Repayments

The manager raises initial financing by borrowing from a bank. In return, he promises to repay s1>0 at t=1 and s at t=2. At t=l, the manager can finance the repayment, q by



20park(l 995), Raja and Winton (1995) show that an alternative way to confer control right upon the bank is to combine covenant with long term bank loan.







79
raising funds from the public debt market and/or, by negotiating with the bank. To raise financing from the market, the manager makes a take-it-or-leave-it offer to investors. This offer consists of the amount of money the manager intends to borrow and, in exchange, the debt claim. Since the public debt market remains competitive at t=l, this debt claim is determined by investors' individual rationality conditions. It follows that at interim the manager's strategic decision involves choosing the amount of financing to be raised from the market. For simplicity, we assume that the firtn's offer is observable by the bank, while public lenders do not observe the outcome of the negotiation between the firm and the bank. The timing of the interim game is specified as follows. First, the firm decides whether or not to raise financing from the market, and the amount of financing to be raised. After acquiring the fund, the firm makes a repayment to the battle'. If the bank is not fully repaid, then the manager must still negotiate with the bank, The following lemma summarizes the manager's equilibrium strategy.

Lemma 4.3: In the interim equilibrium induced by the optimal bank debt, i)if L>Rb(S21 OH) and the firm raises financing from the interim market, then its equilibrium offers must be separating;

ii) if L:gRb(S21 0.), then the firm never raises financing from the interim market.

Part i) of lemma 4.3 indicates that if the firm raises financing from the interim market, its equilibrium offers must be separating: Its offer when the batik is informed of the favorable



2'Here, we make two assumptions. First, we assume that in equilibrium the firm will not make an offer to investors if the offer will be rejected. This assumption will hold if there is flotation costs in issuing public debt. Second, we assume that the manager can carry the funds to t=2, but he can not divert the money to gain private benefit.








80

state must be different from that when the bank is uninformed. This follows from the following two reasons. First, it is strictly suboptimal for the firm to renegotiate with the bank after it has made a repayment, because borrowing from public lenders reduces the total surplus over which the firm and the bank bargain. The firm is strictly better off directly negotiate with the bank without making a repayment. Thus, if the firm raises financing from the interim market, it will borrow a sufficient amount so that after the repayment the bank will forgive the residual t7-1 repayment. On the other hand, since the firm is the residual claimant of the t--2 cash flow, it also desires to minimize the promised t=2 repayment to public lenders, and therefore the amount of financing to be raised. These two considerations suggest that the firm desires to raise an amount of financing from the market so that after the repayment, the bank is just willing to forgive the residual t= I repayment and allow the project to continue. Second, the t--2 claim specified in the initial contract is more valuable to the bank when it is informed of the favorable state than when it is uninformed. Therefore, it will allow the project to continue with a smaller repayment in the former case. These two reasons suggest that the interim equilibrium must be separating. Note that this feature of the equilibrium indicates that at interim the market can perfectly infer the bank's information, In other words, the bank's information is transmitted to the market".

Part ii) of lemma 4.3 indicates that when the promised t=2 repayment is sufficiently


'The bank's decision to forgive the t-- I residual repayment can also be interpreted as that the bank automatically provides refinancing in an amount equal to the residual repayment due. According to this interpretation, for a fixed t=2 repayment, the bank provides a larger amount of refinancing when it is informed of favorable state. In other words, the bank charges a lower interest for the interim refinancing when it is informed of the favorable state. Thus, in equilibrium investors revise their belief upward when the bank charges a lower interest for refinancing.








81

large, the manager never desires to raise financing from the interim market. To see this, note that, if the negotiation breaks down when the bank is informed of the state OH, it can get a payoff L by liquidating the firm or a payoff &b(s, I H by forgiving s, and allowing the project to continue. If L R(s2l OH), the bank prefers to let the project continue when the negotiation fails. Therefore, if the manager does not raise financing from the market and forces the negotiation to break down23, the bank will not liquidate the project. Anticipating that continuation is ensured without making a repayment, the manager will not raise financing from the interim market. When the bank is uninformed, the same reasoning indicates that the manager will not raise interim financing from the market if L:!EjObs21 0)]. Consider now the case when

EO[Rb(S2 I )]
Since EJ1&(s210)]



'The manager can force the negotiation to break down by, for example, rejecting any of the bank's offer and offer a t=2 repayment of zero. 24This can be easily ensured by setting a sufficiently large t= 1 repayment senior.







82
the market. The project is then continued through negotiation.

Before describing the optimal bank debt, we explain figure 4-1. In the figure, S2U is the promised t=2 repayment which returns the bank, when it is uninformed, an expected payoff equal to the liquidation value of the assets, L. If the firm's promised t=2 repayment exceeds s, the uninformed bank will forgive the t=1 repayment if renegotiation breaks down. Otherwise, it will choose to liquidate the project. Similar interpretation applies to s2n when the bank is informed of the favorable state. Since s2"(X)_s2u, the uninformed bank will forgive the t=1 repayment if the promised t=2 repayment is equal to s2u(). The expected payoff it will receive is the same as that when the project is continued through renegotiation. Similar interpretation applies to s2n(X) when the bank is informed of the state OH. From the figure, it is clear that S2u(,=1)=S2u and S2H(XA=1)=2H.

Consider first the case when the manager has large bargaining power so that X>)X*, and financing by short-term bank debt is infeasible. We denote the bank's expected payoff, in state 0, from a promised t=2 repayment x as tlb(xI O). As will soon become clear, we only need to focus on structures in which L-Rb(S2 OH), where s2 is the firm's promised t=2 repayment in the initial contract. The following proposition characterizes the optimal bank debt when the firm commands large bargaining power. Proposition 4,2: i)If in the optimal bank debt s2_ s2u, then s2 =X and the t=0 bank's expected payoff is Pb(X=1), where Pb(X) is defined in (4-14); ii)If in the optimal bank debt s2H()
XL +(1 -X)Eo[Rb(X 0)] +e(s2)vL(1-))[L -Rb(X 0L) +A(s2)] -tV(e(s2)), (4-17)







83

de(s2)


A(s2) is continuous and strictly increasing in s2 with A(S2=S2H(X))=O.
From fig.4-1, if s2 ts2U, the bank will forgive the t=1 repayment both when it is informed of the favorable state and when it is uninformed. Therefore, its expected payoff in continuation is completely specified by the initial contract. Clearly, the bank's t=O expected payoff is increasing in s2. Its monitoring effort, however, is decreasing in s2. This follows because the bank's payoff in continuation is independent of its information when the favorable state is realized. In the unfavorable state, the bank's loss of profit from allowing the project to continue decreases with s2. Thus, the benefit from timely liquidation diminishes and the bank's monitoring effort decreases as S2 increases. Since the manager desires to minimize monitoring as long as he can raise initial financing, he chooses to set s2 at its maximum. In this case, the bank acquires all the cash flow from the project when it is continued. Comparing with the case of short-term debt claim, the bank is effectively assuming full interim bargaining power, and initial financing becomes feasible.

Debt claim described in part ii) of proposition 4.2 becomes optimal when s2H(X)







84

both the bank's t=O expected payoff and its monitoring effort are continuously increased. When initial financing only requires a small increase in the bank's t=O expected payoff, the contract in part ii) of proposition 4.2 becomes optimal, because while ensuring initial financing it reduces the amount of monitoring.

Consider next the case when the bank has large bargaining power, so that X<),*. In this case, financing by short-term bank debt is undesirable because of the bank's oversupply of monitoring. The following proposition characterizes the optimal bank debt claim. Proposition 4.3: With the optimal debt claim, the bank's t=O expected payoff equals the initial investment 10. At interim, when the bank is uninformed, its payoff is the same as that with short-term claim. This outcome can be implemented by a repayment schedule in which the t=1 promised repayment is senior and the t=2 repayment is arbitrarily small. In the interim equilibrium induced by this structure, the firm seeks financing from the interim market only when the bank is informed of the state OH.

Fon-n part ii) of lemma 4.3, the firm can not increase the total surplus for the bank and itself by raising financing from the interim market, because the firm is fairly priced by the market. It follows that, independent of whether the firm raises financing from the market or not, the uninformed bank's payoff can not exceed that with short-term claim. To induce the desired level of monitoring, the finn must reduce the bank's payoff when it is informed of the favorable state. This, as is indicated by proposition 4.3, can be implemented by a senior, and "almost' short-term, bank debt clain-L As is shown in the appendix, in the interim equilibrium, the firm raises financing from the market when the bank is informed of the favorable state, so that after the repayment the bank is just indifferent between liquidating the firm and forgiving








85

the residual short-term repayment. Thus, when the bank is informed of the favorable state, its payoff is equal to the promised t=1 repayment. By optimally setting the value of this repayment, the firm can induce the desired level of monitoring.

The discussion in this section indicates that, in general, the firm prefers to borrow bank debt requiring repayments both at interim and on the final date. Such a repayment schedule gives the firm more latitude in achieving its two goals in designing the optimal debt structure. Optimal bank debt generates two types of outcome. In the first instance, as indicated by part 1) of proposition 4.2, both the bank's payoff when it is uninformed, Ru and its marginal benefit from monitoring, R,, are maximized, Therefore, the required level of monitoring for initial financing is minimized. However, the firm can not further adjust the level of monitoring induced and there is an over supply of monitoring effort. In the second instance, as indicated in part ii) of proposition 4.2 and proposition 4.3, the firm can adjust the level of monitoring supplied, but neither Ru nor 4 is maximized. Consequently, the amount of monitoring required by initial financing is not minimized. Thus, if the firm raises initial financing by only borrowing from a bank, it can not simultaneously achieve both of its two goals.

The Optimal Mix

The analysis in the previous section assumes that the manager raises initial financing only from a bank. Returning to the discussion of the optimal mix, we will analyze in this section the two cases in which the firm acquires initial financing by borrowing, in addition to bank debt, either short-term or long-term public debt. For ease of exposition, however, we will assume away interim market. A complete analysis, which takes into considerations of the








86

interim public debt market, proceeds in the same way as in the previous section.



Mixed structure with bank debt and long-term public debt

The firm raises initial financing by borrowing from a bank and public lenders. In return, it promises the bank a repayment sj>O at t=1 and s2 at t=2, and the public lenders a repayment t, at t=2. The bank's and the public lenders' payoff in state 0 from the promised t=2 repayments s2 and t2 are denoted as Rb(s2,t2 0) and RP(s2,t2I 0)25. In addition, the mixed structure specifies the bank's and the public lenders' payoffs in liquidation. We denote the bank's payoff in liquidation as Lb. Lengthy but straightforward calculations provide the following result.

Lemma 4.4: In the optimal mix, Lb_
Lemma 4.4 implies that at interim the bank will forgive the t=1 repayment both when it is informed of the favorable state and when it is uninformed. Thus, the bank's monitoring effort and the debtor's total t=O expected profit (the bank's and the public debtors') are dIj(e) =LLb -Rb(s2,t2 0)], (4-19)
de

(1 -e)E[Rb(s2,t2 10) +Rp(s2,t2 10)] +e[vfl(Rb (s2,t2 I0H) +Rp(S2,t2 I OH)) + vLL] -+0(e).(4-20)

Equations (4-19) and (4-20) imply the following. First, a comparison between (4-5) and (420) indicates that both R,, the creditors' payoff when the bank is informed, and. R, the creditors' payoff when the bank is uninformed, depend only on the sum s2+t2. Second, the debtors' marginal benefit from timely liquidation, or from monitoring, can be written as 25Again, these payoffs incorporate any contractual specifications which may affect them, including, for example, the relative seniority between the public and bank debt claims.








87

VL1Lb-Rb(S2,t2I 09] +VL[L-Lb-Rp(S212 09].A (4-21)

Equation (4-21) reveals that, in contrast to the case when the firm raises initial financing only from a bank, the debtors' total marginal benefit of monitoring is no longer the same as the bank's marginal benefit from monitoring. The public debt claim breaks this linkage, allowing the manager to separate the tasks of maximizing the lenders' total benefit of monitoring and inducing the bank to supply the desired level of monitoring. To minimize the required level of monitoring, the manager desires to maximize the sum s,+t2 Inducing the desired level of monitoring requires that the manager optimally distribute the benefit of monitoring between the bank and the public lenders. The next proposition characterizes the optimal mix. Proposition 4.4 In the optimal mix,



ii)The bank's monitoring effort is e*;

iii)L-Lb-Rp(S2,t2I (k) ;

iv)i the optimal mix, if the payoffs in liquidation are determined by seniority then the public debt claim t2 is senior to the t--2 bank debt claim S2*

Part i) and ii) of proposition 4.4 indicates that with the optimal mix of claims, the firm can both minimize and induce the required level of monitoring for initial financing. The public debt claim plays two roles. First, for any fixed payoff scheme for the bank, and so for any fixed level of monitoring, it allows the firm to minimize the required amount of financing by paying out the entire cash flow from the project. Second, by giving the public debtors a share of the proceeds from liquidation, the firm can control the bank's benefit from timely liquidation, and therefore the monitoring effort supplied. Thus, with two debt instruments,








88
the firm can regulate the bank's incentive to monitor without interfering its desire to minimize the required level of monitoring for initial financing.

Part ii) of proposition 4.4 asserts that when the project is financed by the optimal mix, the public lenders benefit from the bank's monitoring. Therefore, their incentive over monitoring, is aligned with that of the bank's. To see this, notice that the change in the debtors' t=O expected payoff, under a small change in the bank's monitoring effort, is be[L -L b -Rb(S21 t2 I OLA (4-22)

If the public lenders' marginal benefit is negative, then a decrease in the bank's monitoring effort increases debtor's t=O expected payoff. It follows that the firm is strictly better off reducing the the amount of monitoring. Consequently, at optimal, the public lenders' benefit of monitoring must be positive. In fact, the firm prefers to maximize the public lenders' share of the benefit of monitoring, provided the bank supplies the level of monitoring required by initial financing. This follows because while allocating the benefit to the bank can equally increase the debtors' total benefit from monitoring, the firm must incur an increased cost from the increased monitoring by the bank. By allocating this benefit to the public lenders, the firm can increase the debtors' total benefit of monitoring without incurring any additional cost. Thus, when the project is financed by the optimal mix, the bank acts as a delegated monitor.

The reason for part iii) of proposition 4.4 is simple. Lemma 4.4 implies that the promised t=2 repayment to the bank must be strictly larger than its payoff in liquidation. When s2 is senior to t2, the bank's payoff in liquidation must be strictly larger than Lb, if 4







89

benefit of monitoring between the bank and public lenders. Such a mix is therefore suboptimal.

Finally, notice that, in order for the firm to align the public lenders' and the bank's incentive over monitoring and maximize the debtors' total benefit of monitoring, the public debtors' payoff must be state contingent, so that they can benefit from timely liquidation. As we shall see, this is precisely the reason why long-term public debt is strictly preferred to short-term public debt by the firm.

Mixed structure with bank debt and short-term public debt

The firm raises initial financing by borrowing from both a bank and public lenders. In return, it promises to repay the bank s,>O at t=l andS2at t=2, and the public lenders tj at t--l. In addition, the mixed structure defines the payoff in liquidation. We denote the bank's payoff in liquidation as 4.

At t--I, the firm must renegotiate with the bank. The analysis of the renegotiation is similar to that when the firm only borrows from the bank. The only difference is that the bank's reservation level is increased by tj, because at interim the bank must invest an additional tj to finance the firm's repayment to the public debtors. A complete analysis, however, is not necessary for comparing a mixed structure with short-term public debt and the optimal mix with long-term public debt. We first present the result, followed by an explanation.

Proposition 4.5: A mixed structure with short-term public debt is strictly dominated by the optimal mix with long-term public debt.

Like a long-term debt claim, a short-term public debt claim also allows the firm to








90

maximize the debtors' payoff when the bank is uninformed, and adjust the level of monitoring induced. By increasing t1, the firm pledges to pay out more t=2 profit from the project to the bank. This profit is ultimately paid to the public debtors. In addition, by giving the public debtors a share of the proceeds from liquidation, the firm can control the bank's supply of monitoring. Despite the similarities, there is a crucial difference between the short-term and long-term public debt claim. The payoff to the public debtors with long-term claims is state contingent, so that they can benefit from the bank's monitoring. In contrast, the payoff to public lenders with short-term claims is decision dependent. They are fully repaid whenever the project is continued, and they can not benefit ftom timely liquidationS21 Therefore, the lenders' total marginal benefit of monitoring is not maximized. It follows that short-term public debt is strictly dominated by its long-term counterpart in the mixed structures.

Empirical Implications

In this section, we list some of the empirical implications of our analysis. Regulation

Fonn the discussion in section 3, when agency problems are not sever, i.e. when CL is small, firms can rely entirely on long term debt. For firms with less discretion over future investment decisions, the agency problems are likely to be small. We would expect that those firms rely more on long-term debt financing. Managers in regulated firms typically have more constrained decision sets comparing to those for managers in the unregulated firms. Our analysis suggests that regulation should increase the average maturity of debt. Barclay and



"In fact, it can be easily shown that in the optimal mix with short-term public debt, the public lenders' marginal benefit of monitoring is zero.








91

Smith (1995) find that regulation increases the proportion of the long-term debt by 6.6 percentage points.



Firm size

The analysis in section 4 indicates that debt maturity is intimately related to the relative bargaining power between firms and their banks. Our analysis suggests that firms with large bargaining power over their private lenders must rely more on long-term borrowing. This can effectively enhance the banWs bargaining power and enable initial financing. Taking firm size as a proxy for firms'relative bargaining power, our analysis implies that as firm size increases the maturity of private debt increases. In practice, small firms tend to rely more on short-term bank loans. On the other hand, medium size firms frequently seek financing through private placement, which are usually long-term. Our analysis squares well with this empirical regularity.

Our analysis in section 4 indicates that firms which do not have access to the public debt market may suffer from over-monitoring. Excessive monitoring arises either because a firm can not raise capital from interim public debt market or it can not borrow long-term public debt. It follows that the cost of monitoring is likely to be higher for small firms. This implies that the interest rate of private debt to small firms should, on average, be higher than that to larger firms.

Riskiness

Consider two firms with projects which have the same t=O expected return and t=l liquidation value, but differ in their riskiness. Equation (4-21) implies that the firm with the







92

riskier project demands less monitoring, because the benefit of monitoring increases with the riskiness of the project. It follows that firms with riskier project will finance their project with less bank debt and more public debt. This provides an explanation for the recent empirical finding by Houston and James (1995). In this study, they find that firms with more growth opportunities rely less on bank loan if they borrow only from a single bank. In contrast, for firms with multiple banking relationships, the proportion of bank financing increases. When a firm borrows from a single bank, the bank captures all the benefit from monitoring and it will supply a high level of monitoring. If the firm maintains multiple banking relationships, the benefit of monitoring is shared among the banks and monitoring supplied is lowered. In effect, multiple bank lending creates a quasi-public debt market. Since the cash flows of growth firms are likely to be more volatile than those of more matured firms, our analysis suggests that the change in the proportion of bank debt arises because riskier firms demand less monitoring.

Conclusion

This paper analyzes how firms can optimally design debt structures to facilitate initial financing at minimum costs. Our analysis provides some answers to the questions raised in the introductory section. First, to induce a bank to monitor, it must be given the interim control rights. Given the control rights, the bank can benefit from better information, which allows it to timely liquidate the project in the unfavorable state. The bank's incentive to maximize the value of the control rights motivates it to monitor. Second, the need to diversify a firm's borrowing arises both when the manager's private rent is sufficiently small, so that in the unfavorable state the project can always be liquidated through renegotiation,







93

and when the manager's private rent is sufficiently large, so that initial financing requires involuntary liquidation. In the first instance, the private debt claim must be renegotiated to allow liquidation. If the firm only borrows from a bank, the division of the surplus from liquidation can not be specified through ex ante contracting. Borrowing public debt allows the firm to credibly pay out the surplus generated from liquidation and facilitate initial financing without incurring any cost of monitoring. In the second instance, the bank must be allocated the interim control rights, so that it can force liquidation without bribing the manager. The control rights also induces monitoring, allowing the bank to ascertain the profitability of liquidation. To minimize the costs associated with monitoring, however, the manager desires to minimize the amount of monitoring required by initial financing. Furthermore, the firm must structure the bank's debt claim to induce the minimum level of monitoring. To minimize the required level of monitoring, the manager desires to maximize the creditors benefit per unit of monitoring effort. To induce the desired level of monitoring, the manager must control the bank's benefit from monitoring. If the firm raises initial financing only from a bank, then the bank acquires all the benefit from monitoring and the manager's two goals are in conflict with each other. Borrowing public debt allows the firm to minimize the required level of monitoring and control the bank's incentive to monitoring through optimally allocating the benefit of monitoring between the bank and the public lenders. Third, the need to control the bank's benefit from monitoring requires that the public lenders be given a share of the benefit from monitoring. Thus, when the project is financed by the optimal mix of long-term public debt and bank debt, the manager prefers to align their incentives over monitoring. The bank thus acts as a delegated monitor.




Full Text

PAGE 1

7+5(( (66$<6 ,1 ),1$1&,$/ (&2120,&6 $1' /$: %\ :(,/,1 /,8 $ ',66(57$7,21 35(6(17(' 72 7+( *5$'8$7( 6&+22/ 2) 7+( 81,9(56,7< 2) )/25,'$ ,1 3$57,$/ )8/),//0(17 2) 7+( 5(48,5(0(176 )25 7+( '(*5(( 2) '2&725 2) 3+,/2623+< 81,9(56,7< 2) )/25,'$

PAGE 2

7R 0\ :LIH
PAGE 3

$&.12:/('*0(176 DP GHHSO\ LQGHEWHG WR 7UDF\ /HZLV DQG &KDUOHV +DGORFN ZKR SURYLGHG JXLGDQFH VXSSRUW DQG LQVSLUDWLRQ 0\ JUDWLWXGH WR ERWK RI WKHP IRU WKHLU JHQHURXV KHOS WKURXJKRXW WKLV ZRUN LV EH\RQG ZKDW ZRUGV FDQ GHVFULEH DOVR ZLVK WR H[SUHVV P\ WKDQNV WR 'DYLG 6DSSLQJWRQ -RHO +RXVWRQ DQG PHPEHUV RI P\ FRPPLWWHH

PAGE 4

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

PAGE 5

7KH 2SWLPDO 0L[ (PSLULFDO ,PSOLFDWLRQV &RQFOXVLRQV &21&/86,216 $33(1',; $ 3522)6 2 ) 7+( 0$,1 5(68/76 ,1 &+$37(5 7:2 $33(1',; % 3522)6 2 ) 7+( 0$,1 5(68/76 ,1 &+$37(5 7+5(( $33(1',; & 3522)6 2 ) 7+( 0$,1 5(68/76 ,1 &+$37(5 )285 5()(5(1&(6 %,2*5$3+,&$/ 6.(7&+ Y

PAGE 6

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

PAGE 7

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

PAGE 8

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nV FRPSHQVDWLRQ VFKHPH KRZHYHU WZR SUREOHPV DULVH f LW PXVW PRWLYDWH WKH DGYLVRU WR GLOLJHQWO\ FROOHFW LQIRUPDWLRQ DQG f LW PXVW LQGXFH WKH DGYLVRU WR WUXWKIXOO\ UHYHDO KLV LQIRUPDWLRQ WR WKH LQYHVWRU ,Q FKDSWHU GHULYH WKH RSWLPDO FRPSHQVDWLRQV VFKHPHV ZKLFK VDWLVI\ ERWK RI WKHVH FRQGLWLRQV ILUVW DQDO\]H WKH FDVH LQ ZKLFK WKH DGYLVRUfV LQIRUPDWLRQ LV SXEOLFO\ REVHUYDEOH ILQG WKDW WKH RSWLPDO SD\PHQW VFKHPH UHZDUGV WKH DGYLVRU PRUH ULFKO\ IRU FRUUHFWO\ SUHGLFWLQJ DQ RXWFRPH LI H[SHQGLQJ HIIRUW EHVW HQKDQFHV KLV DELOLW\ WR SUHGLFW WKDW RXWFRPH

PAGE 9

:KHQ WKH DGYLVRUnV LQIRUPDWLRQ LV QRW SXEOLFO\ REVHUYDEOH ILQG WKDW WKH QHHG WR LQGXFH WKH DGYLVRU WR H[SHQG HIIRUW JHQHUDOO\ LQWHUIHUHV ZLWK WKH QHHG WR HOLFLW WUXWKIXO UHYHODWLRQ VKRZ WKDW LQ JHQHUDO WKHUH H[LVWV D FULWLFDO OHYHO RI HIIRUW ,I WKH DGYLVRU LV LQGXFHG WR H[SHQG DQ HIIRUW KLJKHU WKDQ WKH FULWLFDO RQH ZKHWKHU KLV LQIRUPDWLRQ LV SXEOLFO\ REVHUYDEOH RU QRW LV LPPDWHULDO ,I WKH DGYLVRU LV LQGXFHG WR H[SHQG DQ HIIRUW ORZHU WKDQ WKH FULWLFDO RQH WKH WZR QHHGV LQWHUDFW ,Q WKLV FDVH WKH DGYLVRU LV UHZDUGHG PRUH ULFKO\ LI KH FRUUHFWO\ SUHGLFWV WKH RXWFRPH OHVV OLNHO\ WR RFFXU 7KH DQDO\VLV LQ FKDSWHU H[WHQGV SUHYLRXV DQDO\VLV E\ .LOKVWURP f ZKR DVVXPHV WKDW WKH DGYLVRUnV LQIRUPDWLRQ LV SXEOLFO\ REVHUYDEOH DQG WKDW WKH DGYLVRUnV HIIRUW LPSURYHV WKH DFFXUDF\ RI KLV LQIRUPDWLRQ HTXDOO\ 7KH UHVXOWV LQ %KDWWDFKDU\D DQG 3IOHLGHUHU f DQG 6WRXJKWRQ f UHO\ FULWLFDOO\ RQ WKH V\PPHWU\ SURSHUW\ RI WKH LQIRUPDWLRQ WHFKQRORJ\ ,Q P\ DQDO\VLV WKLV DVVXPSWLRQ LV UHOD[HG LQ D ELQDU\ VLJQDO VHWWLQJ 6HWWLQJ 6WDQGDUGV IRU &UHGLEOH &RPSOLDQFH DQG /DZ (QIRUFHPHQW &KDSWHU DQDO\]HV WKH SUREOHP RI VHWWLQJ VRFLDOO\ RSWLPDO OHJDO VWDQGDUGV ZKHQ HQIRUFHUV RI WKH VWDQGDUGV PXVW EH PRWLYDWHG WR RYHUVHH SRWHQWLDO YLRODWRUV %HJLQQLQJ ZLWK %HFNHU f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

PAGE 10

6XFK LQVWDQFHV DULVH ZKHQHYHU ORRVHU VWDQGDUGV FDXVH HQIRUFHUV WR UHGXFH WKHLU HIIRUW EHFDXVH WKH PDUJLQDO UHWXUQV IURP PRQLWRULQJ GHFUHDVH DV WKH SUREDELOLW\ RI QRQFRPSOLDQFH GHFUHDVHV )RU RWKHU DSSOLFDWLRQV PRQLWRULQJ HIIRUW PD\ IDOO DV WKH SUREDELOLW\ RI QRQFRPSOLDQFH LQFUHDVHV )RU WKHVH FDVHV LW ZLOO EH GHVLUDEOH WR VHW WLJKWHU VWDQGDUGV DQG LQGXFH JUHDWHU FDUH LQ RUGHU WR UHGXFH WKH HQIRUFHUVf H[SHQGLWXUHV RQ HIIRUW 7ZR H[WHQVLRQV RI WKLV UHVXOW DUH DOVR SUHVHQWHG ,Q WKH ILUVW LQVWDQFH WKH SRVVLELOLW\ WKDW WKH FRVWV RI PRQLWRULQJ HIIRUW YDU\ E\ WKH HQIRUFHUVf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f LQFHQWLYHV WR PRQLWRU ,Q DGGLWLRQ H[LVWLQJ OLWHUDWXUH GRHV QRW SURYLGH DGHTXDWH H[SODQDWLRQV RI WKH QHHG IRU ILUPV WR ILQDQFH ZLWK ERWK SULYDWH GHEW DQG

PAGE 11

SXEOLF GHEW 0RUHRYHU QR H[SODQDWLRQ KDV EHHQ RIIHUHG WR MXVWLI\ WKH QRWLRQ RI GHOHJDWHG PRQLWRULQJ LQ WKH SUHVHQFH RI PXOWLSOH FODVVHV RI GHEWRUV 7KLV DQDO\VLV SURYLGHV VRPH DQVZHUV WR WKHVH LPSRUWDQW LVVXHV 0\ DQDO\VLV LV EDVHG RQ WKH DVVXPSWLRQ WKDW ILUPVn REMHFWLYH LQ GHVLJQLQJ RSWLPDO GHEW VWUXFWXUHV LV WR FUHGLEO\ FRPPLW WR UHSD\ GHEWRUV DW PLQLPXP FRVW ILQG WKDW WKH RSWLPDO GHEW VWUXFWXUH LV LQ JHQHUDO VWULFW PL[HV RI SXEOLF DQG SULYDWH GHEW 3XEOLF GHEW SURYLGHV VHYHUDO EHQHILWV f LW DOORZV WKH ILUP WR SD\ RXW SURILWV ZLWKRXW SHUWXUELQJ EDQNnV LQFHQWLYH IRU PRQLWRULQJ f LW DOORZV WKH ILUP WR PD[LPL]H WKH OHQGHUVn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f %HVLGHV VKDULQJ VLPLODU DVVXPSWLRQV P\ DQDO\VLV H[WHQGV +DUW DQG 0RRUHnV DQDO\VLV E\ DFFRPPRGDWLQJ DV\PPHWULF LQIRUPDWLRQ DQG E\ UHFRJQL]LQJ WKH QHJRWLDWLRQ FRVWV LQYROYHG LQ GHDOLQJ ZLWK GLVSHUVHG SXEOLF GHEW KROGHUV 0\ DQDO\VLV DOVR GLIIHUV IURP WKRVH RI 3DUNf DQG 5DMD DQG :LQWRQ f LQ WKDW HPSKDVL]H WKH LQKHUHQW LQFRPSOHWHQHVV RI GHEW FRQWUDFWV DQG GR QRW UHO\ RQ FRYHQDQWV WR SURYLGH EDQNV ZLWK PRQLWRULQJ LQFHQWLYHV

PAGE 12

&+$37(5 027,9$7,1* $1' &203(16$7,1* ,19(670(17 $'9,6256 ,QWURGXFWLRQ ,QYHVWLQJ SURILWDEO\ UHTXLUHV DFFXUDWH LQIRUPDWLRQ 2IWHQ DQ LQYHVWRU PD\ QRW KDYH WKH NQRZOHGJH RU WKH VNLOO WR FROOHFW DQG SURFHVV UHOHYDQW LQIRUPDWLRQ DERXW LQYHVWPHQW RSSRUWXQLWLHV 7KH LQYHVWRU PXVW UHO\ RQ WKH H[SHUWLVH RI DQ LQYHVWPHQW DGYLVRU ,Q VWUXFWXULQJ RSWLPDO FRPSHQVDWLRQ VFKHPHV IRU WKH DGYLVRU WZR SUREOHPV DULVH f LQGXFLQJ WKH DGYLVRU WR GLOLJHQWO\ FROOHFW LQIRUPDWLRQ DQG f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fV UHSRUWHG VLJQDO 6XEVHTXHQWO\ WKH DFWXDO UHWXUQ IURP WKH ULVN\ DVVHW LV SXEOLFO\ REVHUYHG DQG WKH DGYLVRU LV FRPSHQVDWHG EDVHG XSRQ KLV UHSRUW DQG WKH UHDOL]HG UHWXUQ AWHQWDWLYHO\ RXU PRGHO FDQ EH LQWHUSUHWHG DV RQH LQ ZKLFK QR FRPPXQLFDWLRQ WDNHV SODFH 7KH LQYHVWRU SUHDQQRXQFHV WKH LQYHVWPHQW VFKHGXOH DQG WKH DGYLVRU LPSOHPHQWV WKH VFKHGXOH DIWHU D VLJQDO LV DFTXLUHG 7KH GHFLVLRQ PDGH E\ WKH DGYLVRU LQ LPSOHPHQWLQJ

PAGE 13

:KHQ WKH VLJQDO LV SXEOLFO\ REVHUYDEOH WKH LQYHVWRUn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n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f LI KH VKLUNV ,Q GRLQJ VR KRZHYHU WKH DGYLVRU ORVHV WKH RSSRUWXQLW\ RI EHLQJ UHZDUGHG IRU FRUUHFWO\ SUHGLFWLQJ WKH OHVV OLNHO\ VWDWH 7R PRWLYDWH WKH DGYLVRU WKH LQYHVWRU PXVW LPSRVH VXIILFLHQW RSSRUWXQLW\ FRVW RQ KLP IRU QRW H[SHQGLQJ HIIRUW %\ UHZDUGLQJ WKH WKH LQYHVWPHQW VFKHGXOH LV KRZHYHU REVHUYDEOH DQG FDQ EH FRQWUDFWHG XSRQ

PAGE 14

DGYLVRU PRUH IRU FRUUHFWO\ SUHGLFWLQJ WKH OHVV OLNHO\ VWDWH VKLUNLQJ DQG PDNLQJ SUHGLFWLRQV EDVHG RQO\ RQ WKH SULRU EHFRPH OHVV DWWUDFWLYH 7KH QHZ SD\PHQW VFKHPH FDQ ERWK PRWLYDWH WKH DGYLVRU DQG LQGXFH WUXWKIXO UHYHODWLRQ %HIRUH SURFHHGLQJ ZH UHODWH RXU DQDO\VLV WR HDUOLHU VWXGLHV LQ WKH OLWHUDWXUH 7KH VWXG\ E\ .LOKVWURPf ZKLFK LV PRVW FORVHO\ UHODWHG WR RXU DQDO\VLV DQDO\]HV KRZ WR LQGXFH DQ DGYLVRU WR ZRUN GLOLJHQWO\ ZKHQ KLV LQIRUPDWLYH VLJQDO LV SXEOLFO\ REVHUYDEOH :H H[WHQG KLV DQDO\VLV E\ DOORZLQJ WKH DGYLVRUnV VLJQDO WR EH SULYDWH LQIRUPDWLRQ 7KH H[WHQVLRQ HQDEOHV XV WR LQYHVWLJDWH KRZ WKH QHHG WR HOLFLW WUXWKIXO UHYHODWLRQ LQWHUDFWV ZLWK WKH QHHG WR PRWLYDWH WKH DGYLVRU $OVR UHODWHG WR RXU DQDO\VLV LV WKH ZRUN RI %KDWWDFKDU\D DQG 3IOHLGHUHUf ZKR VWXG\ WKH SUREOHP RI VFUHHQLQJ RI DJHQWV DGYLVRUVf HQGRZHG ZLWK LQIRUPDWLRQ WHFKQRORJLHV WKDW GLIIHU LQ WKH DFFXUDF\ OHYHOV RI WKH VLJQDOV SURGXFHG DQG VXEVHTXHQWO\ HOLFLWLQJ WUXWKIXO UHYHODWLRQ RI WKH SULYDWHO\ REVHUYHG VLJQDOV $FTXLULQJ WKH VLJQDO LV DVVXPHG WR EH FRVWOHVV 7KLV PRGHO LV PRGLILHG LQ D ODWHU SDSHU E\ 6WRXJKWRQ f ZKR VWXGLHV D PRUDO KD]DUG SUREOHP VLPLODU WR RXUVf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

PAGE 15

LQYHVWRUnV SULRU EHOLHI RI WKH SUREDELOLW\ RI WKH WZR VWDWHV LV WLK DQG Q/ UHVSHFWLYHO\ )RU VLPSOLFLW\ ZH DVVXPH A+U+;/U/ 5 7KH LQYHVWRU FDQ DFTXLUH DGGLWLRQDO LQIRUPDWLRQ DERXW WKH VWDWH RI QDWXUH E\ KLULQJ DQ DGYLVRU %\ H[SHQGLQJ HIIRUW WKH DGYLVRU ZKR LQLWLDOO\ VKDUHV WKH VDPH SULRU DV WKH LQYHVWRU FDQ REVHUYH D VLJQDO [ ZLWK [H^[+[/` FRUUHODWHG ZLWK WKH UHDOL]HG VWDWH 7KH FRUUHODWLRQ EHWZHHQ WKH VLJQDO DQG WKH VWDWH LV FKDUDFWHUL]HG E\ WKH FRQGLWLRQDO GLVWULEXWLRQ IXQFWLRQ IO;MOUAHf LMH^+/` 7KHUH DUH WZR HIIRUW OHYHOV H H/ DQG H H+!H/ )RU QRWDWLRQDO HDVH ZH VHW I[LOULH+f SL DQG I[MOUMH/f TM LMH^+/` 7KH DGYLVRUfV HIIRUW LPSURYHV WKH DFFXUDF\ RI WKH VLJQDO LQ WKH %ODFNZHOO VHQVH :H FDSWXUH WKLV LGHD E\ DVVXPLQJ Sc!T LH^+/` 7KH DGYLVRUnV XWLOLW\ IXQFWLRQ 9$:$f&Hf LV VHSDUDEOH LQ LQFRPH DQG HIIRUW ZKHUH 9$:$f LV WKH XWLOLW\ RI WKH HQG RI SHULRG SD\RII :$ DQG &Hf LV WKH FRVW IRU H[SHQGLQJ HIIRUW H :H DVVXPH WKDW WKH DGYLVRU LV OLTXLGLW\ FRQVWUDLQHG DQG HQMR\V OLPLWHG OLDELOLW\ SURWHFWLRQ 7KH DGYLVRUnV UHVHUYDWLRQ XWLOLW\ LV QRUPDOL]HG WR ]HUR 7KH LQYHVWRU FDQ QRW REVHUYH WKH DGYLVRUnV HIIRUW DQG WKH VLJQDO KH REVHUYHV +H PDNHV WKH LQYHVWPHQW GHFLVLRQ EDVHG RQ WKH DGYLVRU UHSRUW &RQWLQJHQW XSRQ D UHSRUW [ KH FKRRVHV WR LQYHVW $[f LQ WKH ULVN\ DVVHW 7KH LQYHVWRU KDV DQ HQGRZPHQW RI :R! DQG ERUURZLQJ DQG VKRUWVHOOLQJ DUH QRW DOORZHG VR WKDW $[f: 7KH WLPLQJ LQ WKH PRGHO LV DV IROORZV )LUVW WKH LQYHVWRU PDNHV D WDNHLWRUOHDYHLW RIIHU WR WKH DGYLVRU VSHFLI\LQJ D FRPSHQVDWLRQ VFKHPH Z[Uf ZKLFK GHSHQGV RQ ERWK WKH 7KLV DVVXPSWLRQ LPSOLHV WKDW WKH DGYLVRU FDQ QRW VLJQDO WKH LQYHVWRU KLV SULYDWH LQIRUPDWLRQ E\ WDNLQJ D SRVLWLRQ LQ WKH ULVN\ DVVHW )RU WKH ODWWHU DSSURDFK VHH /HODQG DQG 3\OH f $OOHQ f

PAGE 16

DGYLVRUnV UHSRUW DQG WKH VWDWH RI QDWXUH SXEOLFO\ REVHUYHG H[ SRVW 6HFRQG LI WKH DGYLVRU DFFHSWV WKH RIIHU KH VHOHFWV WKH OHYHO RI HIIRUW WR H[SHQG 2WKHUZLVH WKH JDPH LV WHUPLQDWHG 7KLUG WKH DGYLVRU REVHUYHV D VLJQDO DQG PDNHV D UHSRUW WR WKH LQYHVWRU 7KH DGYLVRUnV UHSRUW DPRXQWV WR D SUHGLFWLRQ RI IXWXUH VWDWH 5HSRUWLQJ [+ ?f DPRXQWV WR SUHGLFWLQJ WKH RFFXUUHQFH RI JRRG EDGf VWDWH )RXUWK WKH LQYHVWRU PDNHV DQG LPSOHPHQWV WKH RSWLPDO LQYHVWPHQW GHFLVLRQ EDVHG RQ WKH DGYLVRUnV UHSRUW )LQDOO\ WKH UHDOL]HG UHWXUQ RI WKH ULVN\ DVVHW LV SXEOLFO\ REVHUYHG DQG WKH DGYLVRU LV SDLG DV SURPLVHG 7KH RSWLPDO LQYHVWPHQW GHFLVLRQ LV GHWHUPLQHG LQ HTXLOLEULXP IRU D JLYHQ HTXLOLEULXP VWUDWHJ\ RI WKH DGYLVRU 6SHFLILFDOO\ WKH DGYLVRU LV DVVXPHG WR WUXWKIXOO\ UHYHDO KLV SULYDWHO\ REVHUYHG VLJQDO 5HFDOO D ULVN QHXWUDO LQYHVWRU UDQNV WKH LQYHVWPHQW RSSRUWXQLWLHV E\ WKHLU H[SHFWHG SD\RIIV 7KLV LPSOLHV WKDW WKH RSWLPDO LQYHVWPHQW GHFLVLRQ LV ;[/f DQG $[+f : ZKLFK LV LQGHSHQGHQW RI WKH DGYLVRUnV FRPSHQVDWLRQV :H DVVXPH WKDW LW LV GHVLUDEOH WR PRWLYDWH WKH DGYLVRU WR DFTXLUH WKH PRUH LQIRUPDWLYH VLJQDOV 7KH LQYHVWRUnV REMHFWLYH LV WR LQGXFH WKH DGYLVRU WR H[SHQG HIIRUW DQG WUXWKIXOO\ UHYHDO KLV VLJQDOV DW PLQLPXP FRVW ,QGXFLQJ WUXWKIXO UHYHODWLRQ LPSOLHV WKH IROORZLQJ FRQVWUDLQW (U>Z^[Uf H+F@!(U>Z^[ nUf ? H+M? 9[[ f ,QGXFLQJ WKH DGYLVRU WR H[SHQG HIIRUW UHTXLUHV ([-Z[Uf H+[? (!([L0D[[(U>Z[ nUf?[Hc? ? Hcf f )LQDOO\ ZH DGG WKH LQGLYLGXDO UDWLRQDOLW\ FRQVWUDLQW ZKLFK HQVXUHV WKDW WKH DGYLVRU ZLOO DFFHSW WKH FRQWUDFW DQG WKH OLPLWHG OLDELOLW\ FRQVWUDLQW ([U?Z[Uf?H+A?(!f f

PAGE 17

Z[Uf! 9[U f 7KH LQYHVWRUnV SUREOHP LV WKHQ 0LQ ([U>Z[Uf@ VW f f f DQG f /HPPD &RQVWUDLQW f LPSOLHV Z[+U+f!Z[/U+f DQG Z[/U/f!Z[+U/f 7KH SURRI RI OHPPD LV VWUDLJKWIRUZDUG DQG LV RPLWWHG 7KH f FRQVWUDLQW LPSOLHV WKDW WKH ULJKW KDQG VLGH RI f LV QRQQHJDWLYH 7KXV f DQG f LPSO\ f DQG ZH ZLOO LJQRUH f 6LPSOH UHDUUDQJHPHQW LQGLFDWHV ERWK f DQG f FDQ EH H[SUHVVHG LQ WHUPV RI WKH WZR GLIIHUHQFHV Z[+U+fZ[/U+f DQG Z[/U/fZ[+ U/f 7KLV LPSOLHV WKDW f DQG f FRQWLQXH WR KROG XQGHU D VLPXOWDQHRXV GHFUHDVH RI Z[Uf 9[U SURYLGHG WKH WZR GLIIHUHQFHV UHPDLQ XQFKDQJHG /HPPD DQG LQYHVWRUnV FRVW PLQLPL]LQJ WKHQ LPSO\ Z[/UQf Z[/U+f LQ WKH RSWLPDO FRQWUDFW 7KDW LV WKH DGYLVRU ZLOO QRW EH FRPSHQVDWHG LI KH PDNHV D ZURQJ SUHGLFWLRQ 7KH DGYLVRU LV RQO\ FRPSHQVDWHG ZKHQ KH PDNHV D FRUUHFW SUHGLFWLRQ ,Q WKH IROORZLQJ ZH GHQRWH Z[+U+f E\ <* DQG Z[/U/f E\
PAGE 18

&RQWUDFWV VDWLVI\LQJ WKH VHFRQG OLH DERYH 2/ 7KH VPDOO FRQH HQFORVHG E\ WKH GRWWHG OLQHV 2+n DQG 2/n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f LQ DGGLWLRQ WR f &RQVLGHU ILUVW FRQWUDFWV OLH LQ WKH FRQH HQFORVHG E\ WKH GRWWHG OLQHV LQ ILJ 7KHVH FRQWUDFWV LQGXFH WUXWKIXO UHYHODWLRQ DW ERWK WKH KLJK DQG WKH ORZ HIIRUW OHYHOV )RU WKHVH FRQWUDFWV FRQVWUDLQW f LPSOLHV WKH IROORZLQJ LQHTXDOLW\ 3Kn4KAK<*S/T/f7&/<% ( &RQWUDFWV VDWLVI\LQJ WKLV LQHTXDOLW\ OLH DERYH WKH OLQH $% ILJXUH f 7KXV WKH ILUVW VXEVHW RI IHDVLEOH FRQWUDFWV OLH LQVLGH WKH LQQHU FRQH DQG DERYH WKH OLQH $% 1H[W FRQVLGHU FRQWUDFWV OLH DERYH 2+n EXW XQGHU 2+ 7KHVH FRQWUDFWV LQGXFH WUXWKWHOOLQJ DW H+ EXW QRW DW H/ $W H/ WKH DGYLVRU DOZD\V SUHIHUV WR UHSRUW [/ )RU WKHVH FRQWUDFWV f LPSOLHV >S+b@ <* T/A/<%OOS/T/A/<%A ( &RQWUDFWV VDWLVI\LQJ WKLV FRQVWUDLQW OLH XQGHU OLQH $& 7KXV WKH VHFRQG SDUW RI IHDVLEOH FRQWUDFWV OLH DERYH $+n DQG XQGHU $& 6LPLODUO\ FRQWUDFWV O\LQJ XQGHU 2/n EXW DERYH 2/ 7KHVH FRQWUDFWV VDWLVI\ WKH VDPH FRQVWUDLQW DV f ZLWK S UHSODFHG E\ T

PAGE 19

LQGXFH WUXWKIXO UHYHODWLRQ RQO\ DW H+ $W H/ WKH DGYLVRU DOZD\V SUHIHUV WR UHSRUW [+ $SSO\LQJ f WR WKHVH FRQWUDFWV SURYLGHV 3KfAKAK<*>S/WU/<%
PAGE 20

HIIRUW SURGXFHV WKH JUHDWHVW SHUFHQWDJH LQFUHDVH LQ WKH DGYLVRUnV DELOLW\ WR SUHGLFW WKH EDG VWDWH &RUUHFWO\ SUHGLFWLQJ WKH EDG VWDWH LV PRUH LQGLFDWLYH WKDW WKH DGYLVRU LV GLOLJHQWO\ FROOHFWLQJ LQIRUPDWLRQ 6LPLODUO\ LI H[HUWLQJ KLJK OHYHO RI HIIRUW SURGXFHV WKH JUHDWHVW SHUFHQWDJH LQFUHDVH LQ WKH DGYLVRUnV DELOLW\ WR SUHGLFW WKH JRRG VWDWH KH LV PRUH ULFKO\ UHZDUGHG ZKHQ KH FRUUHFWO\ SUHGLFWV WKH JRRG VWDWH ,Q ILJXUH WKLV FRUUHVSRQGV WR WKH IODWWHU LVRFRVW OLQHV 5HWXUQLQJ WR WKH FDVH ZKHQ WKH DGYLVRUn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nV DELOLW\ WR SUHGLFW WKDW VWDWH ,Q FRQWUDVW WR WKH SUHYLRXV FDVH KRZHYHU WKH DGYLVRU LV FRPSHQVDWHG IRU ERWK FRUUHFWO\ SUHGLFWLQJ WKH IDYRUDEOH DQG WKH XQIDYRUDEOH VWDWH 7KXV WKH QHHG WR LQGXFH WKH DGYLVRU WR H[SHQG HIIRUW LQWHUDFWV ZLWK WKH QHHG WR HOLFLW WUXWKIXO UHYHODWLRQ 7KH LQWHUDFWLRQ PDNHV LW PRUH FRVWO\ WR LQGXFH WKH DGYLVRU WR H[SHQG HIIRUW DV LQGLFDWHG LQ ILJXUH WKH QHZ RSWLPDO FRQWUDFW OLHV RQ D KLJKHU LVRFRVW OLQHf 7KH *HQHUDO 7ZR 6WDWH 0RGHO ,Q WKLV VHFWLRQ ZH H[WHQG RXU DQDO\VLV WR D PRUH JHQHUDO VHWWLQJ 6SHFLILFDOO\ ZH DVVXPH WKHUH LV D FRQWLQXXP RI HIIRUW OHYHO HH>rrf 7R IRFXV RQ WKH LQWHUDFWLRQ EHWZHHQ WKH WZR LQFHQWLYH FRQFHUQV ZH DVVXPH WKH FRUUHODWLRQ EHWZHHQ WKH VLJQDO DQG WKH VWDWHV

PAGE 21

VDWLVILHV I[/OU/Hf I[+OU+Hf Hf ZLWK nHf!2 Hf2 DQG OLPHfHf O 7KXV H[SHQGLQJ HIIRUW LPSURYHV WKH DFFXUDF\ RI WKH WZR VLJQDOV HTXDOO\ 7KH FRQFDYLW\ FRQGLWLRQ UHIOHFWV GHFUHDVLQJ PDUJLQDO UHWXUQV WR HIIRUW 7KH DGYLVRU LV VWULFWO\ ULVN DYHUVH ZLWK 9$:$f! DQG 9$:$f 7KH FRVW IXQFWLRQ &Hf VDWLVILHV &Hf! &Hf! DQG &Hf! H[FHSW IRU H f )XUWKHUPRUH ZH DVVXPH WKDW 9$f &f &nf DQG 9$ f rr ,W ZLOO EH FRQYHQLHQW WR UHJDUG WKH FRVW DV D IXQFWLRQ RI LQVWHDG RI H 7KH RQHWRRQH FRUUHVSRQGHQFH EHWZHHQ H DQG HQVXUHV WKDW WKH IXQFWLRQ &f LV ZHOO GHILQHG ,W IROORZV IURP RXU DVVXPSWLRQ WKDW &f VDWLVILHV &f!2 H[FHSW IRU f &f!2 DQG &f &nf 7KH LQYHUVH RI 9$ ZLOO EH GHQRWHG E\ K DQG ZH DVVXPH WKDW K LV WKULFH FRQWLQXRXVO\ GLIIHUHQWLDEOH :H ZLOO GHQRWH :>W+U+5f./5U/f@ E\ S 3 LV WKH PDUJLQDO UHWXUQ IURP LPSURYLQJ WKH DFFXUDF\ RI WKH VLJQDO 7KH LQYHVWRUnV SUREOHP >,3@ LV IRUPDOO\ VWDWHG DV IROORZV 0D[4 .f0Zf([;:6 .[fU5fZ^[Uf @ VXEMHFW WR [H$UJPD[[(U>\$Z[n ff_r@ 9[H^[/[+` f 4F$UJPD[4([^0D[[(U>9$Z[nUff&4nf?[4n@ 2n` f (;WU>9$Z[Uf\&4f?@! 8 f Z[UfA [H?[/U!F+` UH^U/U+` f %HIRUH SURFHHGLQJ ZH SUHVHQW WZR UHVXOWV )LUVW ZH VKRZ WKDW WKH LQYHVWRUnV SUREOHP 7KH DVVXPSWLRQV &f 9f rr DQG Q+U+W/U/ 5 HQVXUH WKDW LW LV GHVLUDEOH IRU WKH LQYHVWRU WR KLUH WKH DGYLVRU

PAGE 22

KDV WKH IROORZLQJ HTXLYDOHQW IRUPXODWLRQ >,3nM 0D[t;[f0f([;:A +[fU5f Z[Uf @ VXEMHFW WR 9[f;MH ^[/[+` f GH$UJ0D[4>/[+MF/?nf&nfM f /[+U./ f &f f Z[Uf! [H^[OAKnL UH^U/U+f f Z 3URSRVLWLRQ 7KH LQYHVWRUnV SUREOHP >,3@ LV HTXLYDOHQW WR >,3nM 7KH DGYLVRUnV VWUDWHJ\ FRQVLVWV RI FKRRVLQJ D OHYHO RI DFFXUDF\ LQ WKH ILUVW VWDJH DQG VXEVHTXHQWO\ FKRRVLQJ D UHSRUWLQJ UXOH LQ WKH VHFRQG VWDJH /HW ^;M;Mf` GHQRWH VXFK D VWUDWHJ\ ZLWK [A[A[A;O` 8QGHU WKLV VWUDWHJ\ WKH DGYLVRU FKRRVHV DQ DFFXUDF\ OHYHO LQ WKH ILUVW VWDJH DQG UHSRUWV [ RU ;M ZKHQ WKH DFTXLUHG VLJQDO LV [+ RU [/ ,W LV HDV\ WR VHH WKDW /[L[M_f&f LV WKH H[SHFWHG SD\RII WR WKH DGYLVRU ZKHQ KH DGRSWV WKH VWUDWHJ\ ^k[Af` 2Q WKH RWKHU KDQG ,,[L[Mf LV WKH PD[LPXP H[SHFWHG SD\RII WR WKH DGYLVRU LI KH FKRRVHV D VHFRQG VWDJH UXOH RI UHSRUW [c;Mf LQGHSHQGHQW RI WKH FKRLFH RI LQ WKH ILUVW VWDJH &RQVWUDLQW f UHTXLUHV WKDW WKH SD\PHQW VFKHPH QA;Mf DV D IXQFWLRQ RI WKH UXOH RI UHSRUW I[+Onf DQG I[/Onf DUH WKH PDUJLQDO SUREDELOLW\ RI WKH RFFXUUHQFH RI VLJQDO [+ DQG [/ DW DFFXUDF\ OHYHO n WKURXJKRXW WKH GLVVHUWDWLRQ DOO SURRIV DUH UHOHJDWHG WR WKH DSSHQGL[

PAGE 23

DWWDLQV LWV PD[LPXP ZKHQ WKH DGYLVRU UHSRUWV WUXWKIXOO\ &RQVWUDLQW f UHTXLUHV WKDW WKH DGYLVRUnV SD\RII ZKHQ KH DOZD\V UHSRUWV WUXWKIXOO\ DWWDLQV D PD[LPXP DW f§WKH DFFXUDF\ OHYHO LQGXFHG E\ WKH LQYHVWRUnV FRQWUDFW 6HFRQG ZH VKRZ WKH IROORZLQJ OHPPD ZKLFK ZLOO KHOS WR VLPSOLI\ WKH FRQVWUDLQWV /HPPD 7f,,n[O[Of /[O[O_ f DQG ,,[+[+f /[+[+ f f,I D SD\PHQW VFKHPH VDWLVILHV FRQVWUDLQWV f Q[+[/f!,,[+[+f DQG ,,[+[/f!Q[/[/f IRU !O WKHQ Lf Z[+U+f!Z[/U+f DQG Z[/U/f!Z[+U/f f,,[O[Kf /[O[K f ,I WKH DGYLVRU DOZD\V DQQRXQFHV [/ RU [+ LQGHSHQGHQW RI WKH DFWXDO VLJQDO REVHUYHG KLV H[SHFWHG SURILW PXVW EH LQGHSHQGHQW RI WKH DFFXUDF\ RI WKH VLJQDO 6LQFH LPSURYLQJ DFFXUDF\ LV FRVWO\ WKH DGYLVRU RSWLPDOO\ H[HUWV QR HIIRUW 7KLV LV UHIOHFWHG LQ /HPPD f 3DUW f LLf RI WKH OHPPD LPSOLHV WKDW WKH LQYHVWRU PXVW SD\ WKH DGYLVRU D VWULFWO\ SRVLWLYH ERQXV ZKHQ KH FRUUHFWO\ SUHGLFWV WKH VWDWH 7KLV IROORZV EHFDXVH WKH VWDWH U+ U/f LV PRUH OLNHO\ WR RFFXU FRQGLWLRQDO RQ [+ [/f 7KH ERQXV LV QHFHVVDU\ WR LQGXFH WKH DGYLVRU WR WUXWKIXOO\ UHYHDO KLV SULYDWH VLJQDO *LYHQ /HPPD ZH FDQ VLPSOLI\ >,3@ WR WKH IROORZLQJ SUREOHP >,3@ mfZZY: m}rf @ VXEMHFW WR 7KH RUGHULQJ LQ WKH SD\PHQW VFKHPH LV VLPLODU WR WKH PRQRWRQLFLW\ REVHUYHG LQ WKH VWDQGDUG PRGHOV ZLWK DGYHUVH VHOHFWLRQ %DURQ DQG 0\HUVRQ f /DIIRQW DQG 7LUOH f 7KH VLQJOH FURVVLQJ SURSHUW\ WKHUH FRUUHVSRQGV WR WKH FRQGLWLRQ !O

PAGE 24

4($UJPD[4O([U>9$Z[Uff @ f Z[Uf! [H?[OMFK` UH^U'U+f f ,Q VLPSOLI\LQJ >,3@ ZH KDYH GURSSHG WKH LQGLYLGXDO UDWLRQDOLW\ FRQVWUDLQW f VLQFH LW LV JXDUDQWHHG E\ WKH OLPLWHG OLDELOLW\ FRQVWUDLQW &RQVWUDLQWV LQ >,3@ FORVHO\ UHVHPEOH WKRVH LQ WKH GLVFUHWH PRGHO 7KH HIIRUW OHYHOV H+ DQG H/ FRUUHVSRQGV WR WKH HIIRUW OHYHO ZKLFK JHQHUDWHV WKH LQYHVWRUnV GHVLUHG DFFXUDF\ DQG ]HUR HIIRUW OHYHO 7KH GLIIHUHQFH DULVHV IURP WKH FRQWLQXRXV QDWXUH RI HIIRUW OHYHOV $JDLQ LW LV LQVWUXFWLYH WR FRQVLGHU WKH SUREOHP LQ ZKLFK WKH DGYLVRUnV VLJQDO LV SXEOLFO\ REVHUYDEOHUHGXFHG SUREOHP 7KH UHGXFHG SUREOHP >53@ LV VLPLODU WR >,3@ EXW ZLWKRXW WKH ILUVW FRQVWUDLQW :LWKRXW WKH OLPLWHG OLDELOLW\ FRQVWUDLQW WKH UHGXFHG SUREOHP FRUUHVSRQGV H[DFWO\ WR WKH SUREOHP LQYHVWLJDWHG E\ .LOKVWURP f 7KH VROXWLRQ RI WKH UHGXFHG SUREOHP LV VXPPDUL]HG LQ WKH IROORZLQJ OHPPD ,Q WKH OHPPD 53 UHIHUV WR WKH RSWLPDO DFFXUDF\ OHYHO /HPPD $W WKH VROXWLRQ WR WKH UHGXFHG SUREOHP LfWKH FRPSHQVDWLRQ VFKHPH LV Z[+U/f Z[/U+f DQG Z[/U/f Z[+U+f K&53ff LLfWKH RSWLPDO OHYHO RI DFFXUDF\ 53 VROYHV 0D[H>SK&nff@ DQG 53)% 3URRI RI WKH OHPPD IROORZV IURP .LOKVWURP f +RZHYHU IRU FRPSOHWHQHVV ZH SURYLGH D GHULYDWLRQ LQ WKH DSSHQGL[ %DVHG RQ RXU DQDO\VLV LQ WKH GLVFUHWH PRGHO WKH UHVXOW LQ OHPPD LV ZHOO DQWLFLSDWHG 6LQFH H[SHQGLQJ HIIRUW LPSURYHV WKH DFFXUDF\ RI WKH WZR VLJQDOV HTXDOO\ RXU SUHYLRXV DQDO\VLV LQGLFDWHV WKDW WKH LQYHVWRU VKRXOG EH LQGLIIHUHQW EHWZHHQ UHZDUGLQJ WKH

PAGE 25

DGYLVRU IRU FRUUHFWO\ SUHGLFWLQJ WKH IDYRUDEOH RU WKH XQIDYRUDEOH VWDWH $GYLVRUnV ULVN DYHUVLRQ LPSOLHV WKDW KH VKRXOG EH VXEMHFW WR PLQLPXP ULVN H[SRVXUH 7KHUHIRUH WKH LQYHVWRU SD\V WKH DGYLVRU D IL[HG DPRXQW ZKHQHYHU KH PDNHV D FRUUHFW SUHGLFWLRQ LH Z[/U/f Z[+U+f 7KH UHVXOW RI OHPPD LV LOOXVWUDWHG LQ ILJXUH 7R VROYH >,3M ZH DGRSW WKH WZR VWHS DSSURDFK LQ *URVVPDQ DQG +DUW f )LUVW ZH FKDUDFWHUL]H WKH RSWLPDO SD\PHQW VFKHPH IRU LPSOHPHQWLQJ D JLYHQ OHYHO RI DFFXUDF\ 6HFRQG ZH GHWHUPLQH WKH RSWLPDO DFFXUDF\ OHYHO 7KH SUREOHP IRU WKH ILUVW VWHS LV WR PLQLPL]H ([ U>Z[Uf @ VXEMHFW WR WKH VDPH FRQVWUDLQWV DV LQ >,3M 6LQFH WKH VROXWLRQ LQ WKH FDVH LV H[DFWO\ V\PPHWULF WR WKDW LQ WKH FDVH WFK!WLO ZH DVVXPH 7+!L/ LQ WKH HQVXLQJ DQDO\VLV 6LPSOH UHDUUDQJHPHQWV UHYHDO WKDW DOO WKH FRQVWUDLQWV FDQ EH H[SUHVVHG LQ WHUPV RI 9$Z[+U+ff9$Z[/U+ff DQG 9$Z[/U/ff 9$Z[+U/ff 7KLV LPSOLHV WKDW WKH SD\PHQW VFKHPH UHPDLQV WR EH IHDVLEOH XQGHU D VLPXOWDQHRXV GHFUHDVH RI Z[Uf 9[U SURYLGHG WKH WZR GLIIHUHQFHV UHPDLQ XQFKDQJHG 7KH IROORZLQJ UHVXOW LV WKHQ REYLRXV /HPPD ,Q WKH RSWLPDO VROXWLRQ Z[+U/f Z[/U+f 6LPLODU WR WKH GLVFUHWH PRGHO ZH GHQRWH 9$Z[+U+ff E\ <*n DQG 9$Z[/U/ff E\
PAGE 26

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nV LVRFRVW FXUYH LV MXVW WRXFKLQJ WKH VKDGHG DUHD 7KH WZR LQFHQWLYH FRQFHUQV LQWHUDFW ZLWK RQH DQRWKHU DQG WKH FRQVWUDLQW IRU WUXWKIXO UHYHODWLRQ EHFRPHV ELQGLQJ $V DQ LQWHUPHGLDWH FDVH WKH WDQJHQF\ SRLQW OLHV DW WKH FRPHU RI WKH VKDGHG DUHD 7KH FRUUHVSRQGLQJ DFFXUDF\ LV IRUPDOO\ VWDWHG LQ WKH IROORZLQJ GHILQLWLRQ 'HILQLWLRQ /HW D OLP ^‘ ` ZH GHILQH &f r+ WR EH WKH VROXWLRQ WR f§AA 7f LIF!U+! r + LI Q  DQG &f r+ LIUF+!D )RU DQ DFFXUDF\ OHYHO r+ WKH WDQJHQF\ SRLQW OLHV RXWVLGH RI WKH VKDGHG DUHD )RU !r+ WKH WDQJHQF\ SRLQW OLHV LQVLGH RI WKH VKDGHG DUHD :H VXPPDUL]H WKH RSWLPDO UHZDUG VFKHPH LQ WKH IROORZLQJ /HPPD /HW Df Of&f&f DQG Df &f&f WKH RSWLPDO 7KH H[LVWHQFH RI D ILQLWH D IROORZV IURP WKDW AA LV ERWK PRQRWRQLF DQG ERXQGHG DERYH 6LQFH &n f 2 LV GHILQHG DW E\ FRQWLQXRXV & f H[WHQVLRQ

PAGE 27

SD\PHQW VFKHPH LPSOHPHQWLQJ D JLYHQ DFFXUDF\ OHYHO LV LfLI !r+ Z[+U+f Z[/U/f K&nff D Df Df LLfLI K Z[+U+f Kf§f§fZ[/U>f Kf§f§f QQ Q/ /HPPD LQGLFDWHV WKDW WKH FULWLFDO DFFXUDF\ r+ VHSDUDWHV WKH DFFXUDF\ OHYHOV LQWR WZR UHJLRQV 7KH LQWXLWLRQ EHKLQG WKLV LV WKH IROORZLQJ ,Q H[SORLWLQJ WKH LQIRUPDWLRQ DGYDQWDJH E\ H[HUWLQJ QR HIIRUW DQG DOZD\V UHSRUWLQJ [+ RU ?f WKH DGYLVRU ORVHV WKH RSSRUWXQLW\ RI SURILWLQJ IURP FRUUHFWO\ SUHGLFWLQJ WKH VWDWH DW [/ RU [+f 8QGHU D V\PPHWULF SD\PHQW VFKHPH SDUW Lf RI OHPPD f VXFK ORVV LQ SURILW LQFUHDVHV ZLWK WKH DFFXUDF\ OHYHO LQGXFHG $ERYH WKH FULWLFDO DFFXUDF\ OHYHO r+ WKLV ORVV LV ODUJHU WKDQ WKH DGYLVRUnV FRVW VDYLQJ IURP H[HUWLQJ QR HIIRUW 7KHUHIRUH WKH V\PPHWULF SD\PHQW VFKHPH LV VXIILFLHQW WR HQVXUH WKDW WKH DGYLVRU FKRRVHV WKH DFFXUDF\ OHYHO LQGXFHG DQG UHSRUWV WUXWKIXOO\ %HORZ r+ WKH V\PPHWULF SD\PHQW VFKHPH GRHV QRW LPSRVH HQRXJK RSSRUWXQLW\ FRVW RQ WKH DGYLVRU &RQVHTXHQWO\ LW LV LQVXIILFLHQW WR HQVXUH WKDW WKH DGYLVRU FKRRVHV WKH LQGXFHG DFFXUDF\ OHYHO DQG UHSRUWV WUXWKIXOO\ 7KH LQYHVWRU PXVW UHDOORFDWH WKH SD\PHQW DPRQJ WKH WZR LQVWDQFHV ZKHQ WKH DGYLVRU FRUUHFWO\ SUHGLFDWHV WKH VWDWHV VR DV WR LPSRVH VXIILFLHQW RSSRUWXQLW\ FRVW RQ WKH DGYLVRU *LYHQ LK!WWO A LV PRUH OLNHO\ WR RFFXU EDVHG RQ WKH SULRU 8QGHU D V\PPHWULF SD\PHQW VFKHPH WKH DGYLVRU ZLOO DOZD\V UHSRUW [+ LI KH FKRRVHV WR H[SHQG QR HIIRUW 7R SUHYHQW WKLV WKH LQYHVWRU GHFUHDVHV WKH SD\PHQW ZKHQ WKH DGYLVRU FRUUHFWO\ SUHGLFWV WKH IDYRUDEOH VWDWH DQG LQFUHDVHV WKH SD\PHQW ZKHQ WKH DGYLVRU FRUUHFWO\ SUHGLFWV WKH XQIDYRUDEOH VWDWH 7KH QHZ SD\PHQW VFKHPH WKXV LQFUHDVHV WKH DGYLVRUnV RSSRUWXQLW\ FRVW IRU QRW H[SHQGLQJ HIIRUW ,Q WKLV FDVH WKH QHHG WR HOLFLW WUXWKIXO UHYHODWLRQ LQWHUDFWV ZLWK WKH QHHG WR PRWLYDWH WKH DGYLVRU WR H[SHQG HIIRUW

PAGE 28

,Q WKH VHFRQG VWHS WKH LQYHVWRU FKRRVHV WKH DFFXUDF\ OHYHO WR PD[LPL]H KLV SURILW E\ HPSOR\LQJ WKH SD\PHQW VFKHPH VSHFLILHG LQ OHPPD DQG 7KH IROORZLQJ SURSRVLWLRQ VXPPDUL]HV WKH VROXWLRQ WR WKH IXOO SUREOHP ,Q WKH SURSRVLWLRQ 6% GHQRWHV WKH VHFRQG EHVW DFFXUDF\ OHYHO 3URSRVLWLRQ $W WKH VROXWLRQ WR >,3@ Z[+U/f Z[/U+f DQG LfLI 53!r+ WKHQ 6% 53 DQG Z[+U+f Z[/U/f K&n6%ff LLfLI rK!US WKHQ WKH RSWLPDO FRPSHQVDWLRQ VFKHPH LV DR+f D"r1f Z[+U+f Kf§ fZ[YU/f W f ,K 7,O DQG 6% r+ VROYHV WKH SUREOHP ]]7 f Df 0D[4H>LHr@^3f§f ./KAf§f@ f 3DUW Lf RI SURSRVLWLRQ IROORZV GLUHFWO\ IURP OHPPD ,I WKH RSWLPDO DFFXUDF\ OHYHO LQGXFHG LQ WKH UHGXFHG SUREOHP LV KLJKHU WKDQ r+ WKH RSWLPDO SD\PHQW VFKHPH LQ WKH UHGXFHG SUREOHP LV LQFHQWLYH FRPSDWLEOH LQ WKH IXOO SUREOHP &OHDUO\ LW LV DOVR WKH RSWLPDO VROXWLRQ WR WKH IXOO SUREOHP 3DUW LLf RI SURSRVLWLRQ LQGLFDWHV WKDW ZKHQ r+!53 WKH RSWLPDO DV\PPHWULF SD\PHQW VFKHPH LPSOHPHQWLQJ 6% LQ WKH UHJLRQ r+f GRPLQDWHV DOO WKH V\PPHWULF SD\PHQW VFKHPHV LPSOHPHQWLQJ DFFXUDF\ OHYHOV KLJKHU WKDQ r+ 7KH VHFRQG EHVW RSWLPDO SD\PHQW VFKHPH DVVXPHV WKH IRUP LQGLFDWHG LQ SDUW LLf RI OHPPD ,Q WKLV FDVH WKH VROXWLRQ WR WKH IXOO SUREOHP LV GLIIHUHQW IURP WKDW LQ WKH UHGXFHG SUREOHP 7KH DGYLVRU LV SDLG PRUH ZKHQ KH FRUUHFWO\ SUHGLFWV WKH VWDWH OHVV OLNHO\ WR RFFXU )LQDOO\ ZH EULHIO\ GLVFXVV WKH SUREOHP RI WKH XQLTXHQHVV RI WKH VHFRQG EHVW VROXWLRQ

PAGE 29

7KH VHFRQG EHVW VROXWLRQ LV XQLTXH LI 53!r+ +RZHYHU ZKHQ WKH RSWLPDO SD\PHQW VFKHPH LV DV\PPHWULF LH ZKHQ 532+ WKH LQYHVWRUnV REMHFWLYH IXQFWLRQ LV JHQHUDOO\ QRW FRQFDYH 7KH IROORZLQJ WLHEUHDN UXOH JXDUDQWHHV WKH XQLTXHQHVV RI WKH VHFRQG EHVW VROXWLRQ $VVXPSWLRQ ,I WKHUH DUH PXOWLSOH VHFRQG EHVW VROXWLRQV ZH DVVXPH WKDW WKH LQYHVWRU ZLOO LPSOHPHQW WKH VROXWLRQ ZLWK WKH KLJKHVW DFFXUDF\ OHYHOODUJHVW f 7KH LPSOLFDWLRQ RI WKH DVVXPSWLRQ LV DV IROORZV ,I WKHUH DUH WZR GLVWLQFW V ERWK VROYLQJ >,3@ WKH DGYLVRU LV VWULFWO\ EHWWHU RII XQGHU WKH KLJKHU WKDW VROYHV >,3@ 7KLV IROORZV IURP WKH IDFW WKDW WKH H[SHFWHG WRWDO SD\RII WR WKH LQYHVWRUnV SURILW LV WKH VDPH XQGHU WKH WZR V DQG WKH IDFW WKDW WKH LQYHVWRUn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nV ULVN SUHPLXP IXQFWLRQ +RZHYHU XQGHU WKH FRQGLWLRQ KnGf! Q WKH VHFRQG EHVW DFFXUDF\ OHYHO LV VWULFWO\ VPDOOHU WKDQ WKH ILUVW EHVW DFFXUDF\ OHYHO 3URSRVLWLRQ *LYHQ Kn^4f! 53)% ,,I W+ DQG 53r+ WKHQ WKH VHFRQG RUGHU GHULYDWLYH RI WKH REMHFWLYH IXQFWLRQ LQ SURSRVLWLRQ LV SRVLWLYH DW ZKHQ WKH LQYHUVH XWLOLW\ IXQFWLRQ LV K[f [ Q7KH WKLUG GHULYDWLYH RI Kf LV SRVLWLYH ZKHQ WKH DGYLVRU KDV FRQVWDQW RU LQFUHDVLQJ ULVN DYHUVLRQ ,W DOVR KROGV ZKHQ WKH DGYLVRUnV ULVN DYHUVLRQ GHFUHDVHV VORZO\

PAGE 30

7KH IROORZLQJ SURSRVLWLRQ LQGLFDWHV XQGHU PRUH UHVWULFWLYH FRQGLWLRQV WKH VHFRQG EHVW DFFXUDF\ LV DOVR ORZHU WKDQ WKDW RI WKH UHGXFHG SUREOHP 3URSRVLWLRQ $VVXPLQJ =]f!2 Lf,I 53!Hr+ WKHQ 6% 5S LLf,I 53 SM DQG J%7&% WKHQ J%F5S :KHQ VE!,K DQUSrK! VE LV QRW QHFHVVDULO\ VPDOOHU WKDQ 53 DV LOOXVWUDWHG E\ WKH IROORZLQJ H[DPSOH ([DPSOH 6XSSRVH WKH FRVW RI LQIRUPDWLRQ FROOHFWLRQ LV &f DOf 7KH LQYHVWRUnV LQYHUVH XWLOLW\ IXQFWLRQ LV K[f [ DQG WKH SULRU LV W+ )RU WKLV FDVH ZH ILQG r+ )URP OHPPD 530D[^r+R/` )RU 53 ZH ILQG SD %XW IRU ZH ILQG SD 6LQFH 53 LV VWULFWO\ LQFUHDVLQJ LQ SD 7KXV ZKHQ SD ZH KDYH USF VE 2XU QH[W UHVXOW FRPSDUHV WKH LQYHVWRUnV SURILWV 3)% 353 DQG 36% IRU WKH ILUVW EHVW WKH UHGXFHG SUREOHP DQG WKH VHFRQG EHVW UHVSHFWLYHO\ 3URSRVLWLRQ Lf7KH LQYHVWRUnV SURILWV DUH RUGHUHG E\ 3)%!35)!36% 7KH VHFRQG LQHTXDOLW\ KROGV VWULFWO\ ZKHQ 53r+ LLf)HW 3DWXKf EH WKH LQYHVWRUnV SURILW LQ WKH VHFRQG EHVW VROXWLRQ )RU IL[HG S 3D b f LV FRQWLQXRXVO\ GHFUHDVLQJ LQ WLK IRU W+O 6LPLODU WR WKH GLVFUHWH PRGHO WKH LQYHVWRUnV SURILW GHFUHDVHV DV WKH VLJQDO EHFRPHV WKH DGYLVRUnV SULYDWH LQIRUPDWLRQ 7KLV LV GXH WR WKH ORVV LQ ULVN VKDULQJ ZKHQ WKH LQYHVWRU ,,Q FKDQJLQJ WLK ZH PDLQWDLQ WKH DVVXPSWLRQ WKDW WKH H[SHFWHG SD\RII RI WKH ULVN\ DVVHW LV WKH VDPH DV WKDW RI WKH ULVN IUHH DVVHW VR WKDW WKH RSWLPDO LQYHVWPHQW GHFLVLRQ LV XQFKDQJHG

PAGE 31

PXVW UHDOORFDWH WKH SD\PHQW EHWZHHQ WKH WZR LQVWDQFHV ZKHQ WKH DGYLVRU FRUUHFWO\ SUHGLFWV WKH VWDWH 7KH LQWXLWLRQ IRU SDUW LLf RI SURSRVLWLRQ LV WKH IROORZLQJ )URP OHPPD WKH DGYLVRU RSWLPDOO\ H[HUWV QR HIIRUW DQG DOZD\V UHSRUWV HLWKHU [+ RU [/ LI KH GHYLDWHV IURP WKH VWUDWHJ\ LQGXFHG E\ WKH FRQWUDFW $V SULRU WLK LQFUHDVHV WKH DGYLVRU LV PRUH FHUWDLQ DERXW WKH VWDWH RFFXUULQJ 7KHUHIRUH LW EHFRPHV PRUH SURILWDEOH IRU WKH DGYLVRU WR H[HUW QR HIIRUW DQG SUHGLFW WKH VWDWH PRVW OLNHO\ WR RFFXU 7KH FRVW RI PRWLYDWLQJ WKH DGYLVRU LQFUHDVHV &RQVHTXHQWO\ WKH LQYHVWRUn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f Z[/U+f 7KH LQYHVWRUnV SUREOHP LQ WKH H[WHQGHG PRGHO LV VLPLODU WR >,3@ H[FHSW WKDW ZH QHHG WR DGG WKH FRQVWUDLQW Z[/U/f Z[/U+f ,Q HPSOR\LQJ SURSRVLWLRQ DQG OHPPD WR

PAGE 32

UHGXFH >,3@ WR >,3@ LW LV QRW QHFHVVDU\ WR DVVXPH Z[/U/frZ[/U+f ,W IROORZV LPPHGLDWHO\ WKDW WKH RSWLPL]DWLRQ SUREOHP FRUUHVSRQGLQJ WR WKH H[WHQGHG PRGHO LV WKH IROORZLQJ 0D[4 ?^[?ZZf([;:IL +[fU5fZ[Uf @ ([U>9$Z[Uff @&4f!([^0D[[eU>9$Z[ Uff _[@ _f f H DUJPV/;Ge[U> 9$Z[Uff ? @ f Z[Uf! MFHL[MM&Mf UH^U/U+f f Z[/U/f Z[/U+f f $JDLQ ZH FRQVLGHU WKH SUREOHP RI LPSOHPHQWLQJ D JLYHQ DW PLQLPXP FRVW 7KH IROORZLQJ OHPPD GHVFULEHV VXFK PLQLPXP FRVW SD\PHQW VFKHPH /HPPD 7KH PLQLPXP FRVW SD\PHQW VFKHPH LPSOHPHQWLQJ DFFXUDF\ OHYHO LV Z[+U/f Z[+U+f DfW+DfW/ Z[/U/f Z[/U+f DfWU/ ZKHUH DMf DQG DMf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nV SUHGLFWLRQ LV FRUUHFW RU QRW ZKHQ KH SUHGLFWV WKH XQIDYRUDEOH VWDWH

PAGE 33

,Q WKLV FDVH WKH RQO\ ZD\ LQ ZKLFK WKH LQYHVWRU FDQ YHULI\ PDQDJHUn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nV FRVW RI FRQWUDFWLQJ ZLWK WKH DGYLVRU )XUWKHU ZH ILQG XQGHU IDLUO\ JHQHUDO FRQGLWLRQV WKDW WKH HIIHFW RI PRUDO KD]DUG DQG KLGGHQ LQIRUPDWLRQ LQ WKH LQYHVWRUf§DGYLVRU UHODWLRQVKLS LV WR UHGXFH WKH DPRXQW RI HIIRUW WKDW WKH DGYLVRU LV LQGXFHG WR VXSSO\ 7KH LQYHVWRUnV SURILWV DOVR GHFUHDVH LI WKH LQYHVWRU LV XQDEOH WR PRQLWRU HIIRUW RU WR REVHUYH WKH LQYHVWRUnV VLJQDO ,Q FRQVLGHULQJ GLUHFWLRQV IRU IXWXUH UHVHDUFK ZH VXVSHFW WKDW WKH PHWKRGRORJ\ GHYHORSHG KHUH PLJKW IUXLWIXOO\ EH DSSOLHG WR H[DPLQLQJ RWKHU DJHQF\ UHODWLRQVKLSV )RU LQVWDQFH H[DPSOHV LQ ZKLFK D FRPSDQ\ VHHNV WKH DGYLFH RI D PDUNHWLQJ H[SHUW RQ GHYHORSLQJ QHZ VDOHV VWUDWHJ\ RU D UHVRXUFH FRPSDQ\ FRQVXOWV ZLWK D JHRORJLVW FRQFHUQLQJ

PAGE 34

RLO RU PLQHUDOV H[SORUDWLRQ KDYH HOHPHQWV LQ FRPPRQ ZLWK LQYHVWRUDGYLVRU UHODWLRQVKLS WKDW ZH DQDO\]HG KHUH )XUWKHU H[WHQVLRQV RI RXU DQDO\VLV ZRXOG LQYROYH UHOD[LQJ RU PRGLI\LQJ VRPH RI WKH VLPSOLI\LQJ DVVXPSWLRQV ZH KDYH HPSOR\HG )LUVW RXU ELQDU\ LQIRUPDWLRQ VWUXFWXUH PLJKW EH H[WHQGHG WR DOORZ IRU PXOWLSOH VLJQDOV DQG PXOWLSOH VWDWHV RI QDWXUH :H VXVSHFW KRZHYHU WKDW RXU PDLQ TXDOLWDWLYH UHVXOWV DV VXPPDUL]HG LQ 3URSRVLWLRQ ZLOO FRQWLQXH WR KROG LQ WKH PRUH JHQHUDO VHWWLQJ 6HFRQG RXU VLQJOHLQYHVWRU DQG VLQJOHDGYLVRU UHODWLRQVKLS PLJKW EH PRGLILHG WR DOORZ IRU PXOWLSOH DGYLVRUV ZKR VXSSO\ WKH LQYHVWRU ZLWK LQGHSHQGHQW DVVHVVPHQWV RI LQYHVWPHQW SURVSHFWV $ SURPLVLQJ DSSURDFK WR PRGHOLQJ WKLV FDVH DSSHDOnV LQ WKH ZRUN RI 'HZDWULSRQW DQG 7LUOH f RQ WKH XVH RI DGYRFDWHV LQ DJHQF\ UHODWLRQVKLSV )LQDOO\ RXU VLQJOH SHULRG LQYHVWRUDGYLVRU UHODWLRQVKLS PLJKW EH PRGLILHG WR H[WHQG WR VHYHUDO SHULRGV ,QWHUHVWLQJ LVVXHV DULVH LQ WKLV VHWWLQJ DV WKH DGYLVRU PD\ PRGLI\ KLV EHKDYLRU WR PDLQWDLQ RU HQKDQFH KLV UHSXWDWLRQ 5HSXWDWLRQDO FRQFHUQV PD\ UHGXFH WKH DGYLVRUnV WHQGHQF\ WR VKLUN RU WR PLVUHSUHVHQW WKH VLJQDO KH REVHUYHV 7KHVH DQG RWKHU UHODWHG LVVXHV DZDLW IXUWKHU UHVHDUFK

PAGE 35


PAGE 36


PAGE 37


PAGE 38

)LJXUH

PAGE 39

)LJXUH

PAGE 40

)LJXUH

PAGE 41

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f0RVW UHFHQWO\ GLVSOHDVXUH ZLWK WKH SHUIRUPDQFH RI WKH ,QWHUQDO 5HYHQXHnV 6HUYLFH SURPSWHG &RQJUHVV WR FXW WKH DJHQF\nV FRPSOLDQFH EXGJHW 3UHYLRXV WR WKLV &RQJUHVV KDG VLPLODUO\ LQWHUYHQHG LQ WKH DIIDLUV RI WKH )7& DQG WKH (3$ WR FRUUHFW ZKDW LW SHUFHLYHG DV LQDSSURSULDWH HQIRUFHPHQW RI JRYHUQPHQW SROLF\ 7KLV DSSURDFK GLIIHUV VLJQLILFDQWO\ IURP PRVW RI WKH IRUPDO OLWHUDWXUH RQ ODZ HQIRUFHPHQW DQG PRQLWRULQJ DV H[HPSOLILHG E\ %DURQ DQG %HVDQNR f %RUGHU DQG 6REHO f DQG 0RRNKHUMHH DQG 3nQJ f 7KHVH DQDO\VHV DVVXPH WKDW ODZ HQIRUFHUV FDQ FRPPLW WR D PRQLWRULQJ VWUDWHJ\ LQGHSHQGHQW RI ZKHWKHU WKH VWUDWHJ\ XQFRYHUV YLRODWRUV LQ HTXLOLEULXP $ QRWDEOH H[FHSWLRQ LV *UDHW] HW DO f ZKR DVVXPH WKDW HQIRUFHUV DUH PRWLYDWHG E\ WKH ILQHV WKH\ FROOHFW IURP SURVHFXWLQJ YLRODWRUV

PAGE 42

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f PRVW DQDO\VHV RI WKH HFRQRPLFV RI HQIRUFHPHQW KDYH WDNHQ OHJDO VWDQGDUGV DV JLYHQ DQG IRFXVHG RQ WKH VHWWLQJ RI ILQHV DV WKH SULPDU\ WRRO RI HQIRUFHPHQW ,Q SUDFWLFH WKRXJK WKH DELOLW\ RI HQIRUFHUV WR YDU\ VWDWXWRU\ ILQHV LV UHVWULFWHG E\ SROLWLFDO PRUDO DQG OHJDO FRQVWUDLQWV ,Q FRQWUDVW DJHQFLHV PD\ KDYH VRPH GLVFUHWLRQ LQ VHWWLQJ VWDQGDUGV IRU GHWHUPLQLQJ ZKHQ D SDUW\n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

PAGE 43

FRVW RI ODZ HQIRUFHPHQW 6XSSRVH VWDQGDUGV DUH LQLWLDOO\ VHW VR WKDW WKH PDUJLQDO FRVWV DQG EHQHILWV IURP WDNLQJ FDUH DUH HTXDWHG 7KHQ D VOLJKW YDULDWLRQ LQ VWDQGDUGV ZLOO QRW DSSUHFLDEO\ DIIHFW QHW EHQHILWV EXW LW ZLOO FDXVH D QRQWULYLDO DGMXVWPHQW LQ WKH HQIRUFHUnV FRVWV DQG HIIRUW ,Q VRPH LQVWDQFHV D VOLJKW ORRVHQLQJ RI VWDQGDUGV ZLOO GHFUHDVH HQIRUFHPHQW FRVWV 7KLV ZLOO DULVH ZKHQHYHU ORRVHU VWDQGDUGV FDXVHV HQIRUFHUV WR UHGXFH WKHLU HIIRUW EHFDXVH WKH PDUJLQDO UHWXUQV IURP PRQLWRULQJ GHFUHDVH DV WKH SUREDELOLW\ RI QRQFRPSOLDQFH GHFUHDVHV :H UHIHU WR WKLV DV WKH FRPSOHPHQWV FDVH EHFDXVH PRQLWRULQJ HIIRUW DQG VWDQGDUGV DUH FRPSOHPHQWDU\ LQSXWV LQ GHWHUPLQLQJ WKH SUREDELOLW\ RI D YLRODWLRQ ,Q WKLV LQVWDQFH LW ZLOO EH GHVLUDEOH WR ORRVHQ VWDQGDUGV DQG LQGXFH OHVV FDUH LQ RUGHU WR UHGXFH WKH FRVWV RI HQIRUFHPHQW )RU RWKHU DSSOLFDWLRQV PRQLWRULQJ HIIRUW PD\ IDOO DV WKH SUREDELOLW\ RI QRQFRPSOLDQFH LQFUHDVHV 7KLV ZLOO DULVH LI WKH UHWXUQV IURP PRQLWRULQJ FRPSOLDQFH LQ RUGHU WR SURYH D YLRODWLRQ ZLOO GLPLQLVK DV WKH GHJUHH RI QRQFRPSO\LQJ EHKDYLRU LQFUHDVHV )RU WKLV FDVH UHIHUUHG WR DV WKH VXEVWLWXWHV FDVH LW ZLOO EH GHVLUDEOH WR VHW WLJKWHU VWDQGDUGV DQG LQGXFH JUHDWHU FDUH LQ RUGHU WR UHGXFH WKH HQIRUFHUnV H[SHQGLWXUH RQ HIIRUW 7KLV LV WKH FHQWUDO UHVXOW RI WKH FKDSWHU ZKLFK LV IRUPDOO\ GHULYHG LQ 6HFWLRQ ,Q 6HFWLRQ ZH FRQVLGHU WKH SRVVLELOLW\ WKDW WKH FRVWV RI PRQLWRULQJ HIIRUW YDU\ E\ WKH HQIRUFHUn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

PAGE 44

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f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f ZKLFK LV LQFUHDVLQJ DQG VWULFWO\ FRQYH[ ZLWK & f

PAGE 45

6RFLDO EHQHILWV IURP T DUH JLYHQ E\ %T ZKHUH % LV WKH FRQVWDQW PDUJLQDO EHQHILW 7KH JRYHUQPHQW VHWV D VWDQGDUG GHQRWHG E\ DV D FULWHULRQ IRU GHWHUPLQLQJ LI D SDUW\ KDV H[HUFLVHG SURSHU FDUH 'HSHQGLQJ RQ WKH DSSOLFDWLRQ PD\ EH D VSHHG OLPLW ZKLFK PRWRULVWV PXVW REH\ RU D PD[LPXP DOORZDEOH FRQFHQWUDWLRQ RI SROOXWDQWV LQ D GLVFKDUJHUnV ZDWHU RU DLU VDPSOH 7R DYRLG WKH GDXQWLQJ WDVN RI H[SOLFLWO\ PRGHOLQJ WKH EXUHDXFUDWLF DQG OHJDO SURFHVV E\ ZKLFK YLRODWRUV DUH SURVHFXWHG ZH DGRSW D VLPSOHU UHGXFHG IRUP GHVFULSWLRQ RI WKH HQIRUFHPHQW SURFHVV :H DVVXPH WKDW JLYHQ DQG T WKHUH LV D SUREDELOLW\ WKDW WKH SDUW\ ZLOO EH VXFFHVVIXOO\ FLWHG IRU YLRODWLQJ WKH VWDQGDUG GHQRWHG E\ 3TVHf H >@ ZKHUH H LV WKH HIIRUW WKH ODZ HQIRUFHU VXSSOLHV WR PRQLWRU WKH SDUW\ :H DVVXPH WKDW WKLV SUREDELOLW\ LV GHFUHDVLQJ DV WKH SDUW\ VXSSOLHV PRUH FDUH DW D GHFUHDVLQJ UDWH ZLWK 3T DQG 3TT ZKHQHYHU H! $ WLJKWHQLQJ RI VWDQGDUGV LQFUHDVHV WKH FLWDWLRQ SUREDELOLW\ 3V IRU H )XUWKHU 3 LV LQFUHDVLQJ LQ WKH HQIRUFHUnV HIIRUW DW D GHFUHDVLQJ UDWH VR WKDW 3H 3HH 7KLV LPSOLHV WKDW WKH EXUGHQ RI SURRI IDOOV RQ WKH HQIRUFHU WR GHPRQVWUDWH WKDW D YLRODWLRQ KDV RFFXUUHG )LQDOO\ ZH DVVXPH WKDW WKH VLJQ 3HVf VLJQ a3HTf ZKLFK PHDQV WKDW DQ LQFUHDVH LQ VWDQGDUGV RU D GHFUHDVH LQ FDUH ERWK KDYH WKH VDPH TXDOLWDWLYH HIIHFW RQ WKH HQIRUFHUnV PDUJLQDO UHWXUQV IURP HIIRUW 3H $V PHQWLRQHG LQ WKH LQWURGXFWLRQ ZH GLVWLQJXLVK EHWZHHQ WZR FDVHV GHVFULELQJ KRZ 7KLV VSHFLILFDWLRQ RI FDUH EHQHILWV LV PDGH IRU VLPSOLFLW\ DQG LV QRW HVVHQWLDO IRU WKH IRUHJRLQJ DQDO\VLV $ VLPSOH VSHFLILFDWLRQ WKDW VDWLVILHV RXU DVVXPSWLRQV LV3 TVHf S^Hf ZKHUH VT PHDVXUHV WKH JDS EHWZHHQ WKH VWDQGDUG DQG WKH FDUH SURYLGHG DQG SS ,Q WKH FRQWH[W RI SROOXWLRQ VWDQGDUGV PLJKW PHDVXUH WKH GLIIHUHQFH EHWZHHQ DFFHSWDEOH DQG DFWXDO HIIOXHQW FRQFHQWUDWLRQ LQ D ZDWHU RU DLU VDPSOH IRU H[DPSOH

PAGE 46

GGV 3 f LQFUHDVH LQ VWDQGDUGV DIIHFWV WKH LQFHQWLYHV IRU HQIRUFHUV WR PRQLWRU ,Q WKH FRPSOHPHQWV FDVH GOGV 3Hf DQG DQ LQFUHDVH LQ VWDQGDUGV LQFUHDVHV WKH PDUJLQDO UHWXUQV WR PRQLWRULQJ 7KLV PLJKW DULVH IRU LQVWDQFH LI D SDUW\ LV FLWHG ZKHQHYHU KH LV VLPXOWDQHRXVO\ YLRODWLQJ WKH ODZ DQG KH LV EHLQJ PRQLWRUHG E\ WKH HQIRUFHU ,Q WKDW FDVH D WLJKWHQLQJ RI VWDQGDUGV ZLOO LQFUHDVH WKH SUREDELOLW\ WKDW WKH SDUW\ LV LQ IDFW YLRODWLQJ WKH ODZ ZKLFK ZLOO WKHUHIRUH LQFUHDVH WKH HQIRUFHUfV UHWXUQV IURP PRQLWRULQJ ,Q WKH VXEVWLWXWHV FDVH DQG D WLJKWHQLQJ RI VWDQGDUGV UHGXFHV WKH PDUJLQDO UHWXUQV WR PRQLWRULQJ 7KLV VLWXDWLRQ DULVHV IRU H[DPSOH LI WKH HQIRUFHU NQRZV ZKHWKHU D SDUW\ KDV YLRODWHG WKH ODZ EXW KH PXVW H[SHQG HIIRUW WR SURYH WKH YLRODWLRQ KDV RFFXUUHG :KHQ VWDQGDUGV DUH WLJKWHQHG YLRODWLRQV RI WKH ODZ DUH HDVLHU WR GHPRQVWUDWH &RQVHTXHQWO\ WKH HQIRUFHUfV H[SHQGLWXUH RI HIIRUW UHTXLUHG WR SURYH D YLRODWLRQ LV UHGXFHG $Q H[DPSOH RI D PRQLWRULQJ WHFKQRORJ\ VDWLVI\LQJ DOO WKH DVVXPSWLRQV ZH KDYH SRVLWHG IRU WKH VXEVWLWXWHV FDVH LV 3TVHf L XIDf I ? HfG; V STf R ?[Tf ZKHUH I; Hf %HfH ; %Hf H?Hf ?L^Tf OQO Tf T! ,Q WKLV H[DPSOH D DJHQW H[HUFLVHV FDUH T WR SURGXFH D SURGXFW ZLWK TXDOLW\ S Tf 7KH HQIRUFHU REVHUYHV D VLJQDO RI TXDOLW\ D JLYHQ E\ D SAf ; ([HUWLQJ JUHDWHU HIIRUW DOORZV WKH HQIRUFHU WR REVHUYH TXDOLW\ ZLWK JUHDWHU SUHFLVLRQ

PAGE 47

,I FLWHG WKH SDUW\ SD\V D ILQH ) IRU KLV RIIHQVH &RQVHTXHQWO\ WKH H[SHFWHG SHQDOW\ IRU D YLRODWLRQ LV JLYHQ E\ 3T V Hf )3T V Hf 7KURXJKRXW PRVW RI RXU DQDO\VLV ZH DVVXPH WKDW ) LV IL[HG WKXV DOORZLQJ XV WR IRFXV RQ WKH VHWWLQJ RI VWDQGDUGV DV WKH SULPDU\ WRRO IRU VKDSLQJ FRPSOLDQFH DQG HQIRUFHPHQW EHKDYLRU /DWHU LQ VHFWLRQ ZH H[DPLQH WKH LPSOLFDWLRQV RI YDU\LQJ WKH OHYHO RI WKH ILQHV DV ZHOO DV WKH H[WHQW WR ZKLFK ILQHV DQG VWDQGDUGV DUH VXEVWLWXWH LQVWUXPHQWV IRU ODZ HQIRUFHPHQW DV UHIOHFWHG LQ WKH VSHFLILFDWLRQ IRU $ Hf 2QH FDQ HDVLO\ YHULI\ WKDW WKLV VSHFLILFDWLRQ VDWLVILHV RXU DVVXPSWLRQV IRU WKH VXEVWLWXWHV FDVH $ VOLJKW YDULDWLRQ RQ WKH ILUVW H[DPSOH DOORZV XV WR SURGXFH DQRWKHU PRQLWRULQJ WHFKQRORJ\ ZKLFK VDWLVILHV DOO RI RXU DVVXPSWLRQV IRU WKH FRPSOHPHQWV FDVH +HUH ZH DVVXPH WKDW R Q"f ^OH[S>; JHf%Hff@` ZKHUH JHf ,Q 7KHQ IRU V H 3TVHf ? H Of Sf LHm\r? _Lf Of ZKLFK VDWLVILHV WKH DVVXPSWLRQV UHTXLUHG IRU WKH FRPSOHPHQWV FDVH 7KLV WUHDWPHQW RI ILQHV GLIIHUV IURP WKH HFRQRPLFV RI FULPH OLWHUDWXUH DV H[HPSOLILHG E\ %HFNHU f 6WLJOHU f 3ROLQVN\ DQG 6KDYHOO f 0DOLN f $QGUHRQL f DQG 0RRNHUKHLMHH DQG 3nQJ f ZKLFK W\SLFDOO\ WUHDWV YDULDWLRQV LQ ILQHV DV D SULPDU\ HQIRUFHPHQW WRRO ,Q UHDOLW\ WKH OHYHO RI ILQHV LV VHW E\ WKH OHJLVODWLYH EUDQFK DQG WKH DELOLW\ WR DGMXVW VWDWXWRU\ SHQDOWLHV LV UHVWULFWHG DV QRWHG E\ *UDHW] HW DO f +DUULQJWRQ f SRLQWV RXW WKDW WKH ILQHV IRU YLRODWLRQ RI HQYLURQPHQWDO VWDQGDUGV DUH FRQVWUDLQHG WR EH TXLWH VPDOO

PAGE 48

(QIRUFHPHQW RI WKH VWDQGDUG LV GHOHJDWHG WR D VLQJOH DJHQF\ ZKR VXSSOLHV HIIRUW WR PRQLWRU SRWHQWLDO RIIHQGHUV 7KHUH LV D FRVW ERUQH E\ WKH DJHQF\ SHUVRQQHO RI VXSSO\LQJ HIIRUW JLYHQ E\ WKH IXQFWLRQ 'Hf ZKLFK LV VWULFWO\ LQFUHDVLQJ DQG FRQYH[ LQ HIIRUW ZLWK nf :H PDNH WKH UHDOLVWLF DVVXPSWLRQ WKDW LW LV QRW SRVVLEOH IRU SXEOLF RIILFLDOV WR FRPPLW WKH DJHQF\ WR DQ HQIRUFHPHQW SROLF\ RU WR NQRZ KRZ GLOLJHQWO\ WKH DJHQF\ HQIRUFHV VWDQGDUGV $Q\ DJHQF\ PRGHO LV OLNHO\ WR EH GHILFLHQW LQ GHVFULELQJ VRPH DVSHFWV RI EXUHDXFUDWLF EHKDYLRU QRQHWKHOHVV ZH UHTXLUH VRPH SDUDGLJP WR SURFHHG :H WKHUHIRUH DVVXPH WKDW WKH DJHQF\ VHOHFWV DQ HQIRUFHPHQW VWUDWHJ\ WR PD[LPL]H WKH H[SHFWHG VXP RI ILQHV FROOHFWHG QHW RI WKH FRVWV RI HQIRUFHPHQW HIIRUWn 7KH LQWHUDFWLRQ EHWZHHQ WKH SDUW\ DQG WKH HQIRUFHU LV PRGHOHG DV D JDPH 7KH SDUW\ FKRRVHV FDUH THVf JLYHQ WKH HQIRUFHUnV HIIRUW DQG WKH VWDQGDUG ZKHUH T H Vf DUJPD[ ^8T H Vf 3 T VHf& Tf` 7KH HQIRUFHU FKRRVHV HIIRUW HTVf JLYHQ WKH T SDUW\nV FDUH GHFLVLRQ DQG WKH VWDQGDUG ZKHUH H Vf DUJPD[ ^b H Vf 3 T H Vf 'Hf7` r:H DUH DVVXPLQJ WKDW HFRQRPLHV RI VFDOH LQ FROOHFWLQJ DQG SURFHVVLQJ LQIRUPDWLRQ GLFWDWH WKDW HQIRUFHPHQW EH FHQWUDOL]HG 7KLV DSSURDFK LV DOVR HPSOR\HG E\ *UDHW] HW DO f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f /DQGHV DQG 3RVQHU f DQG 3ROLQVN\ f

PAGE 49

7LV D JRYHUQPHQW WUDQVIHU SDLG WR WKH DJHQF\ WR LQVXUH LW EUHDNV HYHQ $ 1DVK HTXLOLEULXP WR WKLV JDPH FRQVLVWV RI D GHFLVLRQ SDLU ^TVf HVf` VXFK WKDW TVf THVfVf DQG HVf HTVfVf %HORZ ZH GHPRQVWUDWH WKDW VXFK DQ HTXLOLEULXP H[LVWV DQG WKDW LW LV XQLTXH JLYHQ :H DVVXPH WKDW WKH JRYHUQPHQWnV REMHFWLYH IXQFWLRQ 9 %T 7f 8 ;,, LV WKH VRFLHWDO EHQHILW RI FDUH QHW RI JRYHUQPHQW VXEVLGLHV WR WKH HQIRUFHU %T7f SOXV WKH XWLOLW\ RI WKH SDUW\ 8 SOXV WKH HQIRUFHUnV SURILW GLVFRXQWHG E\ ; 7KH GLVFRXQWLQJ RI HQIRUFHU SURILWV GHULYHV IURP WKH IDFW WKDW WKH JRYHUQPHQWnV SULPDU\ FRQVWLWXHQF\ LV WKH SXEOLF DW ODUJH LQFOXGLQJ WKH FDUH SURYLGLQJ SDUWLHV ,Q WKLV FDVH WKH JRYHUQPHQW OLPLWV WKH DJHQF\fV SURILW WR ]HUR 5HZULWLQJ 9 WKH JRYHUQPHQWfV SUREOHP >*3@ EHFRPHV PD[ 9Vf PD[ %TVff &TVff 'HVff >*3@ 7KH JRYHUQPHQW VHOHFWV D VWDQGDUG WR PD[LPL]H WKH QHW EHQHILW RI LQGXFLQJ D JLYHQ OHYHO RI FDUH LQFOXGLQJ WKH FRVWV RI HQIRUFHPHQW JLYHQ WKH 1DVK HTXLOLEULXP EHKDYLRU RI WKH SDUW\ DQG WKH HQIRUFHU $QDO\VLV RI WKH 6LPSOH &DVH )RU D JLYHQ VWDQGDUG WKH FRUUHVSRQGLQJ 1DVK HTXLOLEULXP FDUH OHYHO DQG HQIRUFHPHQW HIIRUW DUH FKDUDFWHUL]HG E\ 3TJHVf&;Tf f 3H^THVf'nHf f A$OWHUQDWLYHO\ 7 LV D WD[ ZKLFK DOORZV WKH JRYHUQPHQW WR FROOHFW H[FHVV UHYHQXHV ZKHQ WKH DJHQF\ JHQHUDWHV SRVLWLYH SURILWV ,Q WKH V\PPHWULF LQIRUPDWLRQ FDVH RI VHFWLRQ WKH JRYHUQPHQW VHWV 7 3' VR WKDW ,, DQG WKH JRYHUQPHQWnV REMHFWLYH IXQFWLRQ VLPSOLILHV WR EHFRPH %T& '

PAGE 50

*LYHQ H DQG V WKH SDUW\ VHOHFWV FDUH WR HTXDWH WKH PDUJLQDO UHGXFWLRQ LQ H[SHFWHG ILQHV WR WKH PDUJLQDO FRVW RI FDUH 7KH HQIRUFHU RSWLPDOO\ UHVSRQGV WR T DQG V E\ VHOHFWLQJ HIIRUW WR HTXDWH WKH LQFUHDVH LQ H[SHFWHG ILQHV WR WKH PDUJLQDO FRVW RI HIIRUW *LYHQ RXU DVVXPSWLRQV ZH KDYH 3URSRVLWLRQ $ XQLTXH 1DVK HTXLOLEULXP H[LVWV VDWLVI\LQJ ff 7KH UHDFWLRQ IXQFWLRQV IRU WKH SDUW\ DQG WKH HQIRUFHU DQG WKH UHVXOWLQJ 1DVK HTXLOLEULXP IRU WKH FDVH RI FRPSOHPHQWV DQG VXEVWLWXWHV DUH GLVSOD\HG UHVSHFWLYHO\ LQ )LJXUHV DQG :KHQ WKH VWDQGDUG DQG HQIRUFHPHQW HIIRUW DUH FRPSOHPHQWV DQ LQFUHDVH LQ FDUH GHFUHDVHV WKH SUREDELOLW\ RI QRQFRPSOLDQFH ZKLFK FDXVHV WKH HQIRUFHU WR DOORFDWH OHVV HIIRUW DV LQGLFDWHG E\ WKH QHJDWLYHO\ VORSHG UHDFWLRQ IXQFWLRQ HTVf LQ )LJXUH $ GHFUHDVH LQ HQIRUFHPHQW HIIRUW LQGXFHV OHVV FDUH DV UHIOHFWHG E\ WKH SRVLWLYH VORSH RI WKH THVf UHDFWLRQ IXQFWLRQ %\ FRQWUDVW LQ WKH VXEVWLWXWHV FDVH )LJXUH UHYHDOV WKDW DQ LQFUHDVH LQ FDUH LQGXFHV JUHDWHU HIIRUW IURP WKH HQIRUFHU ZKHUHDV JUHDWHU HQIRUFHPHQW HIIRUW FDXVHV WKH SDUW\ WR EH OHVV FDUHIXO 7KH 1DVK HTXLOLEULXP FKDUDFWHUL]HG E\ f DQG f FRUUHVSRQGV WR D JLYHQ VWDQGDUG 7R LQYHVWLJDWH KRZ WKH HTXLOLEULXP EHKDYLRU RI WKH SDUW\ DQG HQIRUFHU YDU\ ZLWK GLIIHUHQW VWDQGDUG OHYHOV ZH LQWURGXFH WKH IROORZLQJ DVVXPSWLRQ $VVXPSWLRQ GTOGVf_ ^GT H VfVfGVf GH GHVf $VVXPSWLRQ SURYLGHV VXIILFLHQW FRQGLWLRQV IRU GHWHUPLQLQJ KRZ HQIRUFHPHQW HIIRUW YDULHV 7KLV UHVXOW DULVHV EHFDXVH WKH PDUJLQDO UHGXFWLRQ LQ H[SHFWHG ILQHV IURP LQFUHDVLQJ FDUH LV GHFUHDVHG ZKHQ HQIRUFHPHQW HIIRUW LV LQFUHDVHG LQ WKH VXEVWLWXWHV FDVH

PAGE 51

ZLWK WKH WLJKWQHVV RI WKH VWDQGDUGV 7R LQWHUSUHW WKLV FRQGLWLRQ QRWH WKDW GTH VfVfGVf PHDVXUHV WKH UHVSRQVH RI FDUH WR DQ LQFUHDVH LQ VWDQGDUGV UHTXLUHG IRU WKH GHVf HQIRUFHU WR PDLQWDLQ D FRQVWDQW OHYHO RI HIIRUW 7KH H[SUHVVLRQ GTGVf UHIOHFWV WKH DFWXDO GH FKDQJH LQ FDUH IRU DQ LQFUHDVH LQ VWDQGDUGV XQGHUWDNHQ E\ WKH SDUW\ DVVXPLQJ HQIRUFHPHQW HIIRUW LQ XQFKDQJHG $VVXPSWLRQ UHTXLUHV WKDW WKH DFWXDO FKDQJH LQ FDUH XQGHUWDNHQ E\ WKH SDUW\ LV LQVXIILFLHQW WR PDLQWDLQ WKH HQIRUFHPHQW HIIRUW DW D FRQVWDQW OHYHO 7KLV VLPSO\ LPSOLHV WKDW D FKDQJH LQ VWDQGDUGV ZLOO LQGXFH D QRQ]HUR UHVSRQVH IURP WKH HQIRUFHPHQW DJHQF\ $VVXPSWLRQ LV VDWLVILHG IRU WKH H[DPSOH ZKHUH 3THVf SVTHf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nV PDUJLQDO UHWXUQ IURP HIIRUW LQFUHDVHV ,Q FRQWUDVW ZKHQ HIIRUW DQG VWDQGDUGV DUH VXEVWLWXWHV WKH HQIRUFHU UHGXFHV HIIRUW VLQFH WKHUH LV OHVV QHHG IRU PRQLWRULQJ WR FRQYLFW WKH SDUW\ :KHQ 3THVf 3^VTHf 3^EHf WKHQ GTGVf? !3-3 &f GTHVfVfGVf? GH GHVf

PAGE 52

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r DV WKH FDUH OHYHO ZKLFK PD[LPL]HV WKH QHW EHQHILWV IURP FDUH H[FOXGLQJ HQIRUFHPHQW FRVWVf DQG VTrf DV WKH VWDQGDUG ZKLFK LQGXFHV Tr LQ HTXLOLEULXP 3URSRVLWLRQ /HW 6 EH WKH VROXWLRQ WR >*3@ ,Q WKH FRPSOHPHQWV FDVH V erf DQG % &TVMf DV WKH RSWLPDO VWDQGDUG LQGXFHV OHVV WKDQ WKH QHW VXUSOXV PD[LPL]LQJ OHYHO RI FDUH ,Q WKH VXEVWLWXWHV FDVH V VTrf DQG % & TVff DV WKH RSWLPDO VWDQGDUG LQGXFHV PRUH WKDQ WKH QHW VXUSOXV PD[LPL]LQJ OHYHO RI FDUH 3URSRVLWLRQ VKRZV KRZ WKH HQIRUFHPHQW PRQLWRULQJ WHFKQRORJ\ LQIOXHQFHV WKH VWDQGDUGV IRU GXH FDUH DV ZHOO DV WKH FDUH OHYHO SURYLGHG LQ HTXLOLEULXP :KHQ VWDQGDUGV DQG HIIRUW DUH

PAGE 53

FRPSOHPHQWV WKHQ VWDQGDUGV PXVW EH UHOD[HG WR SUHYHQW HQIRUFHUV IURP EHLQJ RYHU]HDORXV LQ HQVXULQJ FRPSOLDQFH 7KLV FRXOG SRVVLEO\ H[SODLQ ZK\ VRPH VDIHW\ DQG HQYLURQPHQWDO VWDQGDUGV DSSHDU WR EH WRR OD[ IURP WKH YLHZ SRLQW RI WKH JHQHUDO SXEOLF /DQGHV DQG 3RVQHU f KDYH VLPLODUO\ QRWHG WKDW LW PD\ EH QHFHVVDU\ WR UHGXFH YLRODWLRQ ILQHV WR SUHYHQW RYHU LQYHVWPHQW E\ SULYDWH HQIRUFHUV 7KH UHVXOWV IRU WKH VXEVWLWXWHV FDVH DUH SHUKDSV PRUH VXUSULVLQJ 2QHnV LQWXLWLRQ PLJKW VXJJHVW WKDW ZKHQ HQIRUFHPHQW LV FRVWO\ WKLV ZRXOG DGG WR WKH FRVWV RI LQGXFLQJ SDUWLHV WR WDNH FDUH WKXV PDNLQJ LW RSWLPDO WR LQGXFH ORZHU FDUH +RZHYHU LQ WKH VXEVWLWXWHV FDVH FRPSOLDQFH FRVWV DUH UHGXFHG E\ PDNLQJ LW HDVLHU IRU HQIRUFHUV WR FRQYLFW SDUWLHV E\ WLJKWHQLQJ WKH VWDQGDUGV EXW WLJKWHU VWDQGDUGV LQGXFH WKH SDUWLHV WR VXSSO\ JUHDWHU FDUH 3ULYDWHO\ ,QIRUPHG (QIRUFHU ,Q WKLV VHFWLRQ ZH H[WHQG RXU EDVLF PRGHO WR FRQVLGHU LQVWDQFHV LQ ZKLFK WKH HQIRUFHUn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

PAGE 54

6XSSRVH WKDW WKH FRVW RI HIIRUW LV JLYHQ E\ 'H f ZKHUH LV D FRVW SDUDPHWHU NQRZQ SULYDWHO\ E\ WKH HQIRUFHU ZLWK WKH SURSHUWLHV WKDW '4H f 'HJHf VR WKDW WRWDO FRVW DQG PDUJLQDO FRVW RI HQIRUFHPHQW DUH LQFUHDVLQJ LQ 7KH JRYHUQPHQW LV XQDZDUH RI WKH UHDOL]DWLRQ RI EXW LW NQRZV WKDW LV GLVWULEXWHG DFFRUGLQJ WR WKH GHQVLW\ f IRUH > @ :H DVVXPH WKDW WKH WLPLQJ RI WKH LQWHUDFWLRQ EHWZHHQ WKH JRYHUQPHQW WKH DJHQF\ DQG WKH SDUW\ LV ILUVW WKH DJHQF\ REVHUYHV 6HFRQG WKH JRYHUQPHQW RIIHUV WKH DJHQF\ D PHQX RI FRQWUDFWV ^7fVf` ZKHUH WKH GHSHQGHQFH RI WKH SDLU RQ GHQRWHV WKDW LW LV LQWHQGHG IRU WKH DJHQF\ RI W\SH 7 LV D UHLPEXUVHPHQW SDLG E\ WKH JRYHUQPHQW WR WKH DJHQF\ WR KHOS FRYHU LWV HQIRUFHPHQW H[SHQVHV 7KLUG WKH DJHQF\ VHOHFWV D SUHIHUUHG FRQWUDFW 7KH FRQWUDFW FKRLFH LV SXEOLF NQRZOHGJH DQG WKH SDUWLHV XSGDWH WKHLU EHOLHIV DERXW WKH W\SH RI WKH HQIRUFHU EDVHG RQ WKH DJHQF\nV FRQWUDFW FKRLFH )RXUWK VLPXOWDQHRXVO\ WKH SDUWLHV FKRRVH WKHLU OHYHO RI FDUH DQG WKH DJHQF\ VHOHFWV HQIRUFHPHQW HIIRUW )LQDOO\ WKH DJHQF\ FROOHFWV ILQHV IURP WKRVH SDUWLHV IRXQG WR EH LQ YLRODWLRQ RI WKH VWDQGDUG /HW Q_f GHQRWH WKH DJHQF\nV H[SHFWHG SURILW ZKR VHOHFWV WKH FRQWUDFW ^7f Vf` ZKHQ WKHLU W\SH LV ZKHUH Q_f 3JffHffff'Hfff)f TV4f4f LV WKH HTXLOLEULXP FDUH OHYHO IRU WKH VWDQGDUG n f JLYHQ WKDW WKH HQIRUFHU KDV FKRVHQ WKH FRQWUDFW LQWHQGHG IRU W\SH 7KH HQIRUFHUnV FRQWUDFW FKRLFH DIIHFWV WKH SDUWLHVn EHOLHIV DERXW WKH HQIRUFHU ZKLFK LQIOXHQFHV WKHLU FKRLFH RI FDUH 7KH HTXLOLEULXP HQIRUFHPHQW :H FRQWLQXH WR DVVXPH WKDW LV LQFUHDVLQJ DQG VWULFWO\ FRQYH[ LQ H DQG WKDWfJ2f 7KDW LV WKH PHQX LV GHVLJQHG VR WKDW W\SH ZLOO FKRRVH ^ff`

PAGE 55

HIIRUW Hfff GHSHQGV RQ WKH VWDQGDUG DV ZHOO DV RQ ZKLFK LV WKH HQIRUFHUnV W\SH 7KH JRYHUQPHQWnV SUREOHP >*3$@ IRU WKLV FDVH LV WR FKRRVH ^f f` WR PD[ (H 9f ff >*3$@ ZKHUH (H LV WKH H[SHFWDWLRQ WDNHQ ZLWK UHVSHFW WR DQG VXFK WKDW IRU DOO > @ Lf WKH DJHQF\ EUHDNV HYHQ ,, f ,, f LLf WKH SDUW\ SLFNV WKH FRQWUDFW ZKLFK LV LQWHQGHG IRU LW _f ,,_f ,Q ZKDW IROORZV ZH IRFXV RQ WKH VHSDUDWLQJ HTXLOLEULD VROXWLRQ WR >*3$@ LQ ZKLFK HDFK W\SH LV LQGXFHG WR VHOHFW D VHSDUDWH FRQWUDFW $V D FRQYHQLHQW EHQFKPDUN IRU WKLV VROXWLRQ WR >*3$@ FRQVLGHU WKH FRPSOHWH LQIRUPDWLRQ FDVH DQDO\]HG LQ VHFWLRQ ZKHUH WKH JRYHUQPHQW DQG WKH SDUW\ NQRZ WKH DJHQF\nV FRVW SDUDPHWHU DW WKH WLPH RI FRQWUDFWLQJ /HW r f EH WKH VWDQGDUG ZKLFK LQGXFHV WKH SDUW\ WR FKRRVH WKH QHW EHQHILW PD[LPL]LQJ FDUH Tr LQ HTXLOLEULXP 5HIHU WR V f DV WKH RSWLPDO VWDQGDUG JLYHQ WKH DJHQF\ LV NQRZQ WR EH RI W\SH :H WKHQ KDYH 3URSRVLWLRQ ,Q WKH VHSDUDWLQJ VROXWLRQ WR >*3$@ WKH RSWLPDO VWDQGDUG V f VDWLVILHV Lf f A f rf IRU WKH FRPSOHPHQWV FDVH DQG LLf f f rf IRU WKH VXEVWLWXWHV FDVH ZLWK VWULFW LQHTXDOLW\ IRU LQ ERWK FDVHVf 7KH SUHVHQFH RI D SULYDWHO\ LQIRUPHG DJHQF\ FDXVHV D JUHDWHU GLVWRUWLRQ LQ VWDQGDUGV DZD\ $QRWKHU SRVVLEOH SROLF\ IRU WKH JRYHUQPHQW LV WR RIIHU SRROLQJ RU VHPLSRROLQJ FRQWUDFWV LQ ZKLFK VHYHUDO GLIIHUHQW W\SHV RI HQIRUFHUV DUH LQGXFHG WR DFFHSW WKH VDPH FRQWUDFW ,Q WKLV FDVH WKH HQIRUFHUnV FKRLFH RI D FRQWUDFW ZRXOG QRW QHFHVVDULO\ UHYHDO KLV W\SH 6XFK D SROLF\ PLJKW EH EHQHILFLDO LI LW ZHUH OHVV FRVWO\ WR HQIRUFH VWDQGDUGV ZKHQ WKH HQIRUFHUnV W\SH ZDV QRW NQRZQ E\ WKH FDUH SURYLGHUV 'HULYLQJ FRQGLWLRQV XQGHU ZKLFK SRROLQJ RU VHSDUDWLQJ FRQWUDFWV DUH SUHIHUUHG VHHPV TXLWH GLIILFXOW DQG WKHUHIRUH GHWHUPLQLQJ WKH RSWLPDO IRUP RI FRQWUDFW UHPDLQV DQ RSHQ TXHVWLRQ $OWKRXJK ZH IRFXV RQ VHSDUDWLQJ FRQWUDFWV LQ RXU GLVFXVVLRQ ZH GHPRQVWUDWH LQ WKH DSSHQGL[ WKDW 3URSRVLWLRQ DOVR KROGV IRU WKH FDVH RI SRROLQJ FRQWUDFWV

PAGE 56

IURP rf WKH OHYHO ZKLFK LQGXFHV WKH QHW EHQHILW PD[LPL]LQJ FDUH 7KLV DULVHV EHFDXVH WKH DJHQF\ ZLOO WU\ WR RYHUVWDWH LWV FRVWV WR REWDLQ D PRUH IDYRUDEOH FRQWUDFW IURP WKH JRYHUQPHQW ,Q WKH FDVH RI FRPSOHPHQWV WKH JRYHUQPHQW UHDFWV E\ UHGXFLQJ FRPSOLDQFH VWDQGDUGV ZKLFK GHFUHDVHV WKH HQIRUFHUnV HIIRUW 7KLV UHQGHUV LW OHVV DWWUDFWLYH IRU D ORZ FRVW HQIRUFHU WR FODLP WR EH KLJK FRVW E\ UHGXFLQJ WKH QXPEHU RI HIIRUW XQLWV RYHU ZKLFK KH FDQ H[HUFLVH KLV FRVW DGYDQWDJH $V D UHVXOW RI WKH UHGXFWLRQ LQ VWDQGDUGV WKH SDUW\ SURYLGHV OHVV FDUH DV Jff TV4ff Tr :KHQ HIIRUW DQG FDUH DUH VXEVWLWXWHV WKH JRYHUQPHQW LQFUHDVHV WKH VWDQGDUGV WKXV UHGXFLQJ WKH LQFHQWLYHV IRU WKH HQIRUFHU WR PRQLWRU $JDLQ WKLV PDNHV LW OHVV DWWUDFWLYH IRU D ORZ FRVW HQIRUFHU WR SUHWHQG WR EH KLJK FRVW EHFDXVH LW UHGXFHV WKH QXPEHU RI HIIRUW XQLWV RYHU ZKLFK KH PD\ H[HUFLVH KLV FRVW DGYDQWDJH 7KLV WLJKWHQLQJ RI VWDQGDUGV LQGXFHV WKH SDUW\ WR LQFUHDVH LWV FDUH DV FI ff "3ff Tr +HWHURJHQRXV 3DUWLHV ,Q WKLV VHFWLRQ ZH H[DPLQH GHVLUHG DOWHUDWLRQV LQ RSWLPDO VWDQGDUGV ZKHQ WKHUH LV D KHWHURJHQRXV SRSXODWLRQ RI SDUWLHV YDU\LQJ DFFRUGLQJ WR WKHLU FRVW RI WDNLQJ FDUH 9DULDWLRQV LQ FRVW DULVH EHFDXVH WKH SDUWLHV KDYH DFFHVV WR GLIIHUHQW PHWKRGV WR UHGXFH WKH KDUPIXO HIIHFWV RI WKHLU EHKDYLRU )XUWKHU ZH DVVXPH WKDW WKH SDUWLHV DUH SULYDWHO\ LQIRUPHG DERXW WKHLU FRVW RI WDNLQJ FDUH $V LQ WKH SUHYLRXV FDVHV ZHnYH VWXGLHG WKH JRYHUQPHQW VHWV D XQLIRUP VWDQGDUG ZKLFK SDUWLHV PXVW DGKHUH WR +RZHYHU ZLWK D KHWHURJHQRXV SRSXODWLRQ WKH )RU LQVWDQFH ILUPV PD\ GLIIHU DFFRUGLQJ WR WKH FRVWV WKH\ LQFXU WR UHGXFH SROOXWLRQ

PAGE 57

JRYHUQPHQW PD\ JUDQW KLJKHU FRVW SDUWLHV LPPXQLW\ IURP WKH VWDQGDUG LI WKH\ SD\ D IL[ IHH 7KLV DUUDQJHPHQW VDYHV KLJK FRVW SDUWLHV WKH H[SHQVH RI PHHWLQJ VWDQGDUGV ZKLOH UHGXFLQJ WKH HQIRUFHUfV PRQLWRULQJ FRVWV :H PRGHO WKH KHWHURJHQRXV SDUW\ SRSXODWLRQ E\ DVVXPLQJ WKDW DQ LQGLYLGXDOnV FRVW RI FDUH LV JLYHQ E\ &T cMf ZKHUHT LV D SULYDWHO\ REVHUYHG FRVW SDUDPHWHU 7RWDO DQG PDUJLQDO FRVWV DUH LQFUHDVLQJ LQ T ZLWK &X &TT IRU T 7KH GHQVLW\ RI SDUWLHV RI W\SH T LQ WKH SRSXODWLRQ ZKLFK LV QRUPDOL]HG WR RQH LV JLYHQ E\ JMMf IRU TH>cT@ :H DVVXPH WKH JRYHUQPHQW RIIHUV SDUWLHV WKH FKRLFH RI HLWKHU SD\LQJ D IL[HG DVVHVVPHQW $ WR WKH HQIRUFHU ZKLFK H[HPSWV WKHP IURP EHLQJ FLWHG RU WKH FKRLFH RI WU\LQJ WR PHHW WKH VWDQGDUGVn /HW TVTf DUJPD[ 3 H VfTVfVf &TDff EH SDUW\ W\SH 7V RSWLPDO FDUH WR DYRLG EHLQJ ILQHG *LYHQ $ DQG T W\SH V UHVSRQVH LV WR SD\ $ DQG DYRLG SURYLGLQJ FDUH LI 3TVTfHVfVf &^T^VTfcMff $ RWKHUZLVH WKH SDUW\ SURYLGHV FDUH TVJf )RUD JLYHQ $ VRPH VXEVHW RI WKH KLJKHVW FRVW LQGLYLGXDOV cL]  cL@ IRU T T ZLOO HOHFW WR SD\ WKH DVVHVVPHQW $ 7KH FXWRII W\SH c ZLOO MXVW EH LQGLIIHUHQW EHWZHHQ LQYHVWLQJ LQ FDUH DQG SD\LQJ WKH DVVHVVPHQW WR DYRLG EHLQJ FLWHG 7KH JRYHUQPHQWnV SUREOHP IRU WKH FDVH RI KHWHURJHQRXV SDUWLHV >*33@ LV WR FKRRVH f$OWHUQDWLYHO\ SDUWLHV PD\ VHOI UHSRUW WKHLU YLRODWLRQV WR WKH DJHQF\ ZKHUH XSRQ WKH\ DUH DVVHVVHG D IL[HG IHH DV LQ .DSORZ DQG 6KDYHOO f ,Q WKHRU\ LI WKH VHW RI SRWHQWLDO RIIHQGHUV ZDV NQRZQ E\ WKH JRYHUQPHQW D PHQX RI GLIIHUHQW VWDQGDUGV DQG ILQHV FRXOG EH RIIHUHG WR VHSDUDWH RXW RIIHQGHUV E\ WKHLU FRVW RI WDNLQJ FDUH 7KLV DSSURDFK LV HPSOR\HG E\ 0RRNKHUMHH DQG 3nQJf LQ WKHLU DQDO\VLV RI PDUJLQDO GHWHUUHQFH RI FULPH 6XFK ILQH WXQLQJ RI VWDQGDUGV LV LPSUDFWLFDO KRZHYHU ZKHQ WKH LGHQWLW\ RI WKH RIIHQGHUV LV XQNQRZQ DW WKH WLPH VWDQGDUGV DUH GHWHUPLQHG :H FRQWLQXH WR DVVXPH WKDW & LV LQFUHDVLQJ DQG VWULFWO\ FRQYH[ LQ T ZLWK &Tf

PAGE 58

WKH DVVHVVPHQW $ WR PD[ (f X L%O !Af f ')SfHVff >*33@ 7KH PD[LPDQG LQ >*33@ UHSUHVHQWV WKH H[SHFWHG QHW EHQHILW RI FDUH PLQXV WKH HQIRUFHPHQW FRVWV WDNHQ RYHU WKH SRSXODWLRQ RI SDUWLHV LQYHVWLQJ LQ SRVLWLYH FDUH OHYHOV 7KRVH SDUWLHV cMO ZKR H[HPSW WKHPVHOYHV FRQWULEXWH ]HUR QHW EHQHILWV DQG LPSRVH ]HUR HQIRUFHPHQW FRVWV RQ VRFLHW\ 7KH VROXWLRQ WR >*33@ LV FKDUDFWHUL]HG LQ WKH IROORZLQJ SURSRVLWLRQ ,Q WKDW SURSRVLWLRQ ZH UHIHU WR V DV WKH RSWLPDO VWDQGDUG DQG r DV WKH VWDQGDUG WKDW PD[LPL]HV (fU-?%TVAf a &TVIf^f` 3URSRVLWLRQ ,Q WKH VROXWLRQ WR >*33@ Lf QR SDUWLHV DUH H[HPSWHG IURP VWDQGDUGV ZKHQ % LV VXIILFLHQWO\ ODUJH LLf ZKHQ H[HPSWLRQ RFFXUV $ ) DQG MO VDWLVILHV Yf %TVMOf & TVMOfMOf 'I)MOfHVffHVf LLLf V VrIRU WKH FDVH RI FRPSOHPHQWV DQG LYf V V r IRU WKH FDVH RI VXEVWLWXWHV 3DUW Lf RI 3URSRVLWLRQ LQGLFDWHV WKDW SDUWLHV DUH H[HPSWHG RQO\ LI WKH EHQHILWV IURP WDNLQJ FDUH DUH VXII FLHQWO\ VPDOO RWKHUZLVH HYHQ KLJK FRVW FDUH SURYLGHUV DUH LQGXFHG WR SURYLGH FDUH 3DUW LL f LQGLFDWHV ZKHQ H[HPSWLRQ DULVHV WKDW KLJKHU FRVW SDUWLHV RSW WR SD\ WKH DVVHVVPHQW UDWKHU WKDQ ULVN SD\LQJ D KLJKHU ILQH LI WKH\ DUH FLWHG 7KH DVVHVVPHQW LV VHW DW D OHYHO VR WKDW RQO\ WKRVH SDUWLHV ZLWK D QHJDWLYH FDUH FRQWULEXWLRQ WR VRFLDO ZHOIDUH QHW RI PDUJLQDO HQIRUFHPHQW FRVWV YLf VHHN H[HPSWLRQ 3DUWV LLLf DQG LYf YHULI\ WKDW WKH VDPH GLVWRUWLRQ LQ VWDQGDUGV DULVHV ZKHQ SDUWLHV DUH KHWHURJHQRXV DV ZKHQ WKH\ DUH KRPRJHQRXV :KHQ H[HPSWLRQV DUH SRVVLEOH GLVKRQHVW HQIRUFHUV PD\ DOVR WDNH EULEHV IURP SDUWLHV QRW ZDQWLQJ WR SURYLGH FDUH 7R DQDO\]H WKLV SRVVLELOLW\ VXSSRVH IRU QRZ WKDW JRYHUQPHQW VDQFWLRQHG H[HPSWLRQV DUH QRW RIIHUHG SHUKDSV EHFDXVH WKH EHQHILWV IURP FDUH DUH WRR ODUJH

PAGE 59

,PDJLQH WKDW WKH HQIRUFHU RIIHUV DQ\ SDUW\ DQ H[HPSWLRQ IURP EHLQJ PRQLWRUHG LI WKH SDUW\ SD\V WKH HQIRUFHU D EULEH HTXDO WR < $VVXPH DOVR WKDW VXFK LOOHJDO DFWLYLW\ JRHV XQQRWLFHG E\ WKH JRYHUQPHQW DQG WKDW DJUHHPHQWV EHWZHHQ SDUWLHV DQG WKH HQIRUFHU DUH NHSW *LYHQ WKH VWDQGDUG V WKH HQIRUFHUnV SUREOHP >(3@ LV WR VHW WKH OHYHO RI WKH EULEH < DQG HQIRUFHPHQW HIIRUW HVf WR PD[ (AA^3TVAfHVf` ')AnfHf )WIff < 7 >(8@ ZKHUH DOO SDUWLHV e cM @ SD\ WKH EULEH DQG W\SH cL LV LQGLIIHUHQW WR SD\LQJ WKH EULEH DQG LQYHVWLQJ LQ FDUH 7KH VROXWLRQ WR WKH HQIRUFHUnV SUREOHP LV FKDUDFWHUL]HG LQ 3URSRVLWLRQ ,Q WKH VROXWLRQ WR >(3@ Lf WKH HQIRUFHU DOZD\V RIIHUV D EULEH < ) ZKLFK WKH KLJKHU FRVW SDUWLHV D 0 @ SD\ LLf < VDWLVILHV L9f <^GcLn6G
PAGE 60

DUH VPDOO WKH IHH PD\ EH D JRYHUQPHQW VDQFWLRQHG DVVHVVPHQW LI $ LV OHVV WKDQ < 6HWWLQJ 2SWLPDO )LQHV 7R WKLV SRLQW LQ RXU DQDO\VLV ZH KDYH DVVXPHG WKH OHYHO RI ILQH IRU D YLRODWLRQ ) LV IL[HG H[RJHQRXVO\ +HUH ZH LQYHVWLJDWH ZKHWKHU LQFUHDVHV LQ ) DUH ZHOIDUH LPSURYLQJ %HFNHU f ILUVW REVHUYHG WKDW ODUJHU ILQHV GHWHU SDUWLHV IURP EUHDNLQJ WKH ODZ DQG WKXV UHGXFH HQIRUFHPHQW HIIRUW UHTXLUHG WR LQVXUH FRPSOLDQFH $V ZH GHPRQVWUDWH WKLV DUJXPHQW PD\ IDLO WR DSSO\ ZKHQ WKH HQIRUFHUnV HIIRUW VXSSO\ GHSHQGV RQ WKH SUREDELOLW\ WKDW WKH SDUW\ LV LQ FRPSOLDQFH 6XSSRVH WKH ILQH ) LV LQFUHDVHG 7KLV ZLOO FDXVH WKH JRYHUQPHQW WR DGMXVW LWV RSWLPDO VWDQGDUG V DQG LW ZLOO LQGXFH ERWK WKH SDUW\ DQG WKH HQIRUFHU WR DGMXVW WKHLU EHKDYLRU /HW GHOG) DQG GTOG) UHSUHVHQW UHVSHFWLYHO\ WKH UDWH RI FKDQJH LQ HTXLOLEULXP HQIRUFHPHQW HIIRUW DQG FDUH DV ) LV LQFUHDVHG 7KHQ WKH LQFUHDVH LQ ZHOIDUH IURP D FKDQJH LQ ) FDQ EH ZULWWHQ DV G9G) %&TfGTG)f 'HGHG)f ^%&Tf'H GHG)fGTG)f`'H GTG)f L DV GHOGVfOGTOGVf M M ^GHOG)f GTOG)f f ZKHUH WKH ILUVW OLQH RI f IROORZV IURP WKH (QYHORSH 7KHRUHP WKH VHFRQG OLQH IROORZV IURP :H FRQMHFWXUH WKDW $ ZLOO EH OHVV WKDQ < IRU % VXIILFLHQWO\ VPDOO DOWKRXJK ZH KDYH VR IDU EHHQ XQDEOH WR YHULI\ WKLV f6HYHUDO DQDO\VHV KDYH GLVFRYHUHG UHDVRQV ZK\ PD[LPDO ILQHV PD\ EH QRW EH GHVLUHG 0DOLN f GHPRQVWUDWHV WKDW LQFUHDVLQJ ILQHV PD\ LQFUHDVH DJHQWnV DYRLGDQFH EHKDYLRU WKXV OHDGLQJ WR KLJKHU HQIRUFHPHQW FRVWV $QGUHRQL f DUJXHV WKDW MXULHV DUH OHVV DSW WR FRQYLFW RIIHQGHUV ZKHQ ILQHV DUH PRUH VHYHUH WKXV UHGXFLQJ WKH GHWHUUHQFH SRZHU RI PD[LPDO ILQHV 3ROLQVN\ DQG 6KDYHOO f DUJXH WKDW PD[LPDO ILQHV DUH ZHOIDUH GHFUHDVLQJ LQ WKDW VRPH RIIHQVHV VKRXOG QRW EH GHWHUUHG LI PDUJLQDO EHQHILWV RI WKH FULPH H[FHHG WKH PDUJLQDO FRVWV 6WLJOHU f DQG 0RRNKHUMHH DQG 3nQJ f VKRZ WKDW ILQHV VKRXOG EH YDULHG FRQWLQXRXVO\ LQ RUGHU WR PDLQWDLQ PDUJLQDO GHWHUUHQFH LQ HQIRUFHPHQW

PAGE 61

WKH ILUVW E\ UHDUUDQJLQJ WHUPV DQG WKH ODVW OLQH IROORZV IURP WKH FRQGLWLRQ IRU VHWWLQJ RSWLPDO VWDQGDUGV G9GV f $ QHFHVVDU\ DQG VXIILFLHQW FRQGLWLRQ IRU RUGHULQJ GHGVfGTGVf DQG GHG)fGTG)f DQG WKXV GHWHUPLQLQJ ZKHWKHU LQFUHDVLQJ ILQHV LV ZHOIDUH HQKDQFLQJ LV JLYHQ LQ 3URSRVLWLRQ GHGVfGTGVf GHG)fGTG)f DV GGV ^3-3Tf MR 7R LQWHUSUHW f QRWH WKDW XQGHU WKH RSWLPDO VWDQGDUG GHGVfGTGVf UHSUHVHQWV WKH UDWH DW ZKLFK HQIRUFHPHQW HIIRUW DQG FDUH PD\ YDU\ ZKLOH NHHSLQJ WRWDO VXUSOXV FRQVWDQW ,Q WKH FRPSOHPHQWV FDVH WRR OLWWOH FDUH LV DOORFDWHG $Q LQFUHDVH LQ ) ZLOO LQGXFH WKH SDUW\ WR SURYLGH PRUH FDUH EXW LW ZLOO DOVR FDXVH WKH HQIRUFHU WR H[SHQG PRUH HIIRUW ,I WKH UDWH DW ZKLFK H[WUD HIIRUW H[SHQGHG IRU DQ LQFUHDVH LQ FDUH LV VXIILFLHQWO\ VPDOO OHVV WKDQ GHGVfGTGVff WKHQ LQFUHDVLQJ WKH ILQH ZLOO LQFUHDVH ZHOIDUH 2WKHUZLVH LQFUHDVLQJ WKH ILQH ZLOO UHGXFH ZHOIDUH LI LW ZLOO LQGXFH WRR PXFK HQIRUFHPHQW HIIRUW WR EH H[SHQGHG $ VLPLODU DUJXPHQW VHUYHV WR FRQILUP WKLV LQWXLWLRQ IRU WKH FDVH RI VXEVWLWXWHV 3URSRVLWLRQ SURYLGHV QHFHVVDU\ DQG VXIILFLHQW FRQGLWLRQV IRU DQ LQFUHDVH LQ WKH ILQH WR EH ZHOIDUH GHFUHDVLQJ ,WnV HDV\ WR YHULI\ WKDW LQ WKH VXEVWLWXWHV FDVH ZKHUH 3HV WKDW GGV^3-3T` 7KLV LPSOLHV WKDW D VPDOO LQFUHDVH LQ WKH YLRODWLRQ ILQH LV ZHOIDUH GHFUHDVLQJ DQG LW SURYLGHV DQ LQWHUHVWLQJ H[FHSWLRQ WR %HFNHUnV DUJXPHQW IRU PD[LPDO ILQHV 7KH LQWXLWLRQ VXSSRUWLQJ WKLV ILQGLQJ LV WKDW LQ WKH VXEVWLWXWHV FDVH WKH OHYHO RI FDUH LQGXFHG LV H[FHVVLYH LQ RUGHU WR OLPLW HQIRUFHPHQW HIIRUW VHH 3URSRVLWLRQ f $Q LQFUHDVH LQ WKH ILQH UHGXFHV ZHOIDUH E\ FDXVLQJ SDUWLHV WR IXUWKHU LQFUHDVH FDUH ZKLFK DOVR LQGXFHV HQIRUFHUV WR H[SHQG PRUH HIIRUW 7KH RSWLPDO VWDQGDUG VDWLVILHV G9GV RU %&Tf'H GHGVfGTGVf

PAGE 62

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

PAGE 63

)LJXUH &RPSOHPHQWV &DVH 3HV!

PAGE 64

)LJXUH &RPSOHPHQWV &DVH 3HV

PAGE 65

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f f *LYHQ LQWHUPHGLDULHVn DGYDQWDJHV LQ SHUIRUPLQJ PRQLWRULQJ ZKDW LV WKHLU LQFHQWLYH WR DFWXDOO\ SURYLGH PRQLWRULQJ" 6HH %HUOLQ DQG /RH\V f &DPSEHOO DQG .UDFDZ f DQG 'LDPRQG f (PSLULFDO HYLGHQFHV EDVHG RQ ORDQ DQQRXQFHPHQW DUH GRFXPHQWHG LQ %LOOHW )ODQQHU\ DQG *DUIPNHO f -DPHV f DQG /XPPHU DQG 0F&RQQHOO f )DPD f SURYLGHV DQRWKHU SLHFH RI HYLGHQFH

PAGE 66

f &DVXDO REVHUYDWLRQV RI ILUPVn FDSLWDO VWUXFWXUHV UHYHDO WKDW WKH\ IUHTXHQWO\ ERUURZ IURP ERWK LQWHUPHGLDULHV DQG SXEOLF GHEW PDUNHW *LYHQ WKH DGYDQWDJHV RI LQWHUPHGLDWHG OHQGLQJ ZK\ GR ILUPV GHPDQG SXEOLF OHQGLQJ DV ZHOO" f 7KH QRWLRQ WKDW LQWHUPHGLDULHV DFW DV GHOHJDWHG PRQLWRUV DVVXPHV WKDW SXEOLF GHEWRUVn LQFHQWLYHV RYHU PRQLWRULQJ DUH LQ DFFRUGDQFH ZLWK WKDW RI LQWHUPHGLDULHVn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f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

PAGE 67

RYHU WKH LQWHULP FRQWLQXDWLRQ GHFLVLRQ LPSOLHV WKDW PRQLWRULQJ PD\ EH UHTXLUHG WR HQVXUH WLPHO\ OLTXLGDWLRQ DQG LQLWLDO ILQDQFLQJ 2XU DQDO\VLV LV EDVHG RQ WKH REVHUYDWLRQ WKDW ZKLOH PRQLWRULQJ FDQ IDFLOLWDWH LQLWLDO ILQDQFLQJ E\ PLWLJDWLQJ DJHQF\ SUREOHPV LW LQWURGXFHV GHDGZHLJKW FRVWV Of7KHUH LV D FRVW IRU H[SHQGLQJ PRQLWRULQJ HIIRUW f/LTXLGDWLRQ GHVWUR\V WKH PDQDJHUfV FRQWURO UHQW 7KXV LQ GHVLJQLQJ WKH RSWLPDO GHEW VWUXFWXUH WKH PDQDJHU KDV WZR JRDOV Of7R FUHGLEO\ SD\RXW WKH FDVK IORZV VR WKDW WKH UHTXLUHG OHYHO RI PRQLWRULQJ IRU LQLWLDO ILQDQFLQJ LV PLQLPL]HG f 7R VWUXFWXUH WKH SULYDWH GHEW FODLP WR LQGXFH WKH UHTXLUHG OHYHO RI PRQLWRULQJ 7KH PDLQ UHVXOW RI WKLV DQDO\VLV LV WKDW LQ JHQHUDO WKH PDQDJHU FDQ QRW DFKLHYH ERWK RI KLV WZR JRDOV E\ UHO\LQJ HQWLUHO\ RQ SULYDWH GHEW ILQDQFLQJ DQG WKH RSWLPDO GHEW VWUXFWXUH LV D PL[ RI ERWK SXEOLF DQG SULYDWH GHEW 7R GHULYH WKLV UHVXOW ZH SURFHHG LQ VHYHUDO VWHSV :H ILUVW DQDO\]H WKH FDVH LQ ZKLFK WKH PDQDJHUnV SULYDWH UHQW LV VXIILFLHQWO\ VPDOO ,Q WKLV FDVH OLTXLGDWLRQ LQ WKH XQIDYRUDEOH VWDWH JHQHUDWHV SRVLWLYH VXUSOXV DQG WKHUHIRUH LV HIILFLHQW :H ILQG WKDW LI WKH ILUP ERUURZV ORQJWHUP EDQN GHEW ZKLFK UHTXLUHV D UHSD\PHQW RQO\ DIWHU WKH FDVK IORZ IURP WKH SURMHFW LV UHDOL]HG WKHQ LQ WKH XQIDYRUDEOH VWDWH WKH SURMHFW LV OLTXLGDWHG WKURXJK UHQHJRWLDWLRQ LQGHSHQGHQW RI ZKHWKHU WKH EDQN LV LQIRUPHG RU QRW 7KH QHHG WR ERUURZ SXEOLF GHEW DULVHV EHFDXVH WKH EDQNf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

PAGE 68

LQIHDVLEOH 8QOLNH WKH EDQN OHQGHU KRZHYHU SXEOLF GHEWRUV FDQ IUHH ULGH RQ WKH EHQHILW RI QHJRWLDWLRQV ZLWKRXW PDNLQJ FRQFHVVLRQV RI WKHLU FODLPV LQ OLTXLGDWLRQ %\ HTXDWLQJ SXEOLF GHEWRUVf FODLPV LQ OLTXLGDWLRQ WR WKH VXUSOXV JHQHUDWHG WKH ILUP FDQ FUHGLEO\ SD\ RXW WKH VXUSOXV DQG HQDEOH LQLWLDO ILQDQFLQJ ZLWKRXW PRQLWRULQJ :KHQ WKH SULYDWH UHQW LV VXIILFLHQWO\ ODUJH WKH PDQDJHU QHYHU GHVLUHV WR OLTXLGDWH WKH SURMHFW )HDVLELOLW\ RI LQLWLDO ILQDQFLQJ UHTXLUHV LQYROXQWDU\ OLTXLGDWLRQ LQ WKH XQIDYRUDEOH VWDWH 7KHUHIRUH WKH ILUPnV LQLWLDO ERUURZLQJ PXVW LQFOXGH EDQN GHEW UHTXLULQJ D UHSD\PHQW ZKHQ WKH LQWHULP VWDWH LV UHDOL]HG 6XFK D GHEW FODLP FRQIHUV WKH LQWHULP FRQWURO ULJKWV XSRQ WKH EDQN DOORZLQJ LW WR IRUFH OLTXLGDWLRQ *LYHQ WKH FRQWURO ULJKWV WKH EDQN FDQ EHQHILW IURP EHWWHU LQIRUPDWLRQ ZKLFK HQDEOHV LW WR WLPHO\ OLTXLGDWH WKH SURMHFW LQ WKH XQIDYRUDEOH VWDWH 7KXV WKH EDQNfV GHVLUH WR PD[LPL]H WKH YDOXH RI WKH FRQWURO ULJKWV PRWLYDWHV LW WR PRQLWRU :KHQ WKH PDQDJHU UDLVHV LQLWLDO ILQDQFLQJ RQO\ IURP D EDQN ZH ILQG WKDW WKH RSWLPDO EDQN GHEW UHTXLUHV UHSD\PHQWV ERWK DW LQWHULP DQG RQ WKH ILQDO GDWH 0RUHRYHU WKH VL]H RI WKH ILQDO UHSD\PHQW GHSHQGV RQ WKH UHODWLYH EDUJDLQLQJ SRZHU EHWZHHQ WKH PDQDJHU DQG WKH EDQN OHQGHU :KHQ WKH PDQDJHU FRPPDQGV ODUJHU EDUJDLQLQJ SRZHU LQLWLDO ILQDQFLQJ UHTXLUHV WKDW WKH ILQDO UHSD\PHQW EH VXIILFLHQWO\ ODUJH ,I WKH ILQDO UHSD\PHQW LV VPDOO WKH EDQN QHYHU IRUJLYHV WKH LQWHULP UHSD\PHQW DQG WKH SURMHFW FDQ RQO\ EH FRQWLQXHG WKURXJK UHQHJRWLDWLRQ :KHQ WKH PDQDJHU FRPPDQGV ODUJH EDUJDLQLQJ SRZHU KH FDQ H[WUDFW PRVW RI WKH VXUSOXV IURP FRQWLQXDWLRQ DQG LQLWLDO ILQDQFLQJ EHFRPHV LQIHDVLEOH ,QFUHDVLQJ WKH SURPLVHG ILQDO UHSD\PHQW LQFUHDVHV WKH EDQNfV H[SHFWHG SD\RII 7KLV IROORZV EHFDXVH LI UHQHJRWLDWLRQ EUHDNV GRZQ WKH EDQN FDQ FKRRVH EHWZHHQ LWV SD\RII LQ OLTXLGDWLRQ DQG LWV SD\RII ZKHQ LW IRUJLYHV WKH LQWHULP UHSD\PHQW DQG DOORZ WKH SURMHFW WR FRQWLQXH ,QFUHDVLQJ WKH SURPLVHG ILQDO

PAGE 69

UHSD\PHQW UDLVHV WKH EDQNfV UHVHUYDWLRQ OHYHO DQG WKHUHIRUH LQFUHDVHV LWV H[SHFWHG SD\RII IURP FRQWLQXDWLRQ :KHQ WKH EDQN FRPPDQGV ODUJH EDUJDLQLQJ SRZHU LQLWLDO ILQDQFLQJ LV DOZD\V HQVXUHG ,Q WKLV FDVH WKH PDQDJHU GHVLUHV WR FRQWURO WKH EDQNfV EHQHILW IURP EHLQJ LQIRUPHG LQ RUGHU WR UHGXFH WKH FRVWV DVVRFLDWHG ZLWK PRQLWRULQJ :H VKRZ WKDW WKHUH H[LVWV D EDQN GHEW FODLP VR WKDW WKH EDQNfV SD\RII ZKHQ LW LV LQIRUPHG RI WKH IDYRUDEOH VWDWH LV HTXDO WR WKH SURPLVHG LQWHULP UHSD\PHQW %\ RSWLPDOO\ VHWWLQJ WKLV UHSD\PHQW WKH ILUP FDQ UHGXFH WKH DPRXQW RI EDQN PRQLWRULQJ ,Q JHQHUDO KRZHYHU LW LV VWULFWO\ VXERSWLPDO IRU WKH ILUP WR UDLVH LQLWLDO ILQDQFLQJ RQO\ IRUP D EDQN 7R PLQLPL]H WKH OHYHO RI PRQLWRULQJ UHTXLUHG E\ LQLWLDO ILQDQFLQJ WKH PDQDJHU GHVLUHV WR PD[LPL]H WKH EDQNfV EHQHILW SHU XQLW RI PRQLWRULQJ HIIRUW 2Q WKH RWKHU KDQG WR LQGXFH WKH PLQLPXP OHYHO RI PRQLWRULQJ WKH PDQDJHU PXVW VWUXFWXUH WKH EDQNfV GHEW FODLP WR FRQWURO LWV EHQHILW IURP PRQLWRULQJ 7KXV ZKHQ WKH SURMHFW LV ILQDQFHG RQO\ E\ D EDQN WKH PDQDJHUfV WZR JRDOV DUH LQ FRQIOLFW ZLWK HDFK RWKHU ,Q DGGLWLRQ WR EDQN GHEW WKH ILUP FDQ UDLVH LQLWLDO ILQDQFLQJ E\ DOVR ERUURZLQJ SXEOLF GHEW :H FRQVLGHU WKH WZR FDVHV LQ ZKLFK WKH ILUP ERUURZV HLWKHU ORQJWHUP RU VKRUWWHUP SXEOLF GHEW ,Q ERWK FDVHV ZH ILQG WKDW E\ ILQDQFLQJ WKH SURMHFW ZLWK D PL[ RI SXEOLF DQG EDQN GHEW WKH ILUP FDQ VHSDUDWH LWV WZR JRDOV LQ GHVLJQLQJ WKH RSWLPDO GHEW VWUXFWXUH ,W FDQ UHJXODWH WKH EDQNfV LQFHQWLYH WR PRQLWRU ZLWKRXW LQWHUIHULQJ LWV GHVLUH WR PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ IRU LQLWLDO ILQDQFLQJ 7R PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ WKH PDQDJHU GHVLUHV WR PD[LPL]H WKH OHQGHUVf WKH EDQNfV DQG WKH SXEOLF OHQGHUVff WRWDO H[SHFWHG SD\RII ZKHQ WKH EDQN LV XQLQIRUPHG ,I WKH SURMHFW LV ILQDQFHG E\ D PL[ RI SXEOLF DQG SULYDWH GHEW FODLPV WKHQ IRU DQ\ IL[HG SD\RII VFKHPH IRU WKH EDQN WKH PDQDJHU FDQ PD[LPL]H WKLV

PAGE 70

SD\RIIE\ SD\LQJ RXW FDVK IORZ IRUP WKH SURMHFW WR WKH SXEOLF GHEWRUV )XUWKHUPRUH E\ JLYLQJ WKH SXEOLF GHEWRUV D VKDUH RI WKH SURFHHGV IURP WKH OLTXLGDWLRQ WKH PDQDJHU FDQ FRQWURO WKH EDQNf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f SD\RII LV VWDWH FRQWLQJHQW DQG WKH\ FDQ EHQHILW IURP WLPHO\ OLTXLGDWLRQ 7KXV ORQJWHUP SXEOLF GHEW FODLP DOORZV WKH ILUP WR DOLJQ WKH SXEOLF GHEWRUVf LQFHQWLYH RYHU PRQLWRULQJ ZLWK WKDW RI WKH EDQNfV VR WKDW WKH GHEWRUVf WRWDO PDUJLQDO EHQHILW IURP PRQLWRULQJ LV PD[LPL]HG IXUWKHU UHGXFLQJ WKH UHTXLUHG OHYHO RI PRQLWRULQJ IRU LQLWLDO ILQDQFLQJ :KHQ WKH SURMHFW LV ILQDQFHG E\ WKH RSWLPDO PL[ WKH EDQN DFWV DV D GHOHJDWHG PRQLWRU 7KHUH LV DQ H[WHQVLYH OLWHUDWXUH RQ RSWLPDO GHEW VWUXFWXUHV 2XU DQDO\VLV LV PRVW FORVHO\ UHODWHG WR WKDW RI +DUW DQG 0RRUH f :H VKDUH VLPLODU SUHPLVHV WKDW PDQDJHUV GHVLJQ GHEW VWUXFWXUHV WR FUHGLEO\ DVVXUH WKH OHQGHUV RI WKHLU UHSD\PHQWV 7KH PDLQ GLIIHUHQFH EHWZHHQ WKH WZR LV WKDW +DUW DQG 0RRUH DVVXPH WKDW WKHUH LV QR DV\PPHWULF LQIRUPDWLRQ DQG UHQHJRWLDWLRQ LV IULFWLRQOHVV 7KHUHIRUH WKHUH DUH QR GLIIHUHQFHV EHWZHHQ SXEOLF OHQGLQJ DQG EDQN OHQGLQJ LQ WKHLU DQDO\VLV 2XU DQDO\VLV LV DOVR UHODWHG WR WKRVH E\ 5DMDQ f 3DUN f DQG 5DMDQ DQG :LQWRQ f 5DMDQ f DQDO\]HV WKH EDQN KROGXS SUREOHP +H DUJXHV WKDW ILUPV FDQ XVH SXEOLF GHEW WR PLWLJDWH WKH GLVWRUWLRQ LQ PDQDJHUVf LQFHQWLYHV WR

PAGE 71

H[SHQG HIIRUW FDXVHG E\ EDQNVf RSSRUWXQLVP %RWK 3DUN f DQG 5DMDQ DQG :LQWRQ f GHPRQVWUDWH WKDW RSWLPDO HQIRUFHPHQW RI GHEW FRYHQDQW FDQ SURYLGH EDQNV ZLWK LQFHQWLYH WR PRQLWRU 2XU DQDO\VLV RQ WKH RWKHU KDQG LV EDVHG HQWLUHO\ RQ WKH GLVWULEXWLRQ RI FDVK IORZV 'LDPRQG f LQYHVWLJDWHV KRZ ILUPV KDYLQJ SULYDWH LQIRUPDWLRQ FKRRVH WKHLU GHEW VWUXFWXUHV ,Q RXU DQDO\VLV SULRU LQIRUPDWLRQ LV V\PPHWULF DPRQJ DJHQWV 7KH UHVW RI WKH SDSHU LV RUJDQL]HG DV IROORZV ,Q VHFWLRQ ZH RXWOLQH RXU PRGHO ,Q VHFWLRQ ,, ZH FRQVLGHU WKH FDVH LQ ZKLFK WKH PDQDJHUnV SULYDWH UHQW LV VXIILFLHQWO\ VPDOO ,Q VHFWLRQ ,, ZH DQDO\]H WKH EDQNnV LQFHQWLYH WR PRQLWRU DQG GHULYH WKH RSWLPDO EDQN GHEW ,Q VHFWLRQ ,9 ZH GHULYH WKH RSWLPDO PL[ 6HFWLRQ 9 SUHVHQWV HPSLULFDO HYLGHQFH DQG VHFWLRQ 9, FRQFOXGHV (OHPHQWV RI 7KH 0RGHO 7KHUH DUH WKUHH GDWHV W O 7KHUH LV DQ LQGLYLVLEOH SURMHFW ZKLFK UHTXLUHV DQ LQLWLDO LQYHVWPHQW RI DW W 7KH SURMHFW UHWXUQV D VWRFKDVWLF FDVK IORZ RI U DW W GLVWULEXWHG RYHU WKH FRPSDFW VXSSRUW >;@ 7KH GLVWULEXWLRQ RI U LV GHQRWHG DV )U f DQG GHSHQGV RQ WKH LQWHULP VWDWH H^+/` )U_Qf VWULFWO\ GRPLQDWHV )U > A DFFRUGLQJ WR ILUVWRUGHU VWRFKDVWLF GRPLQDQFH ,I WKH SURMHFW LV WHUPLQDWHG DW W O WKH ILUPfV DVVHWV FDQ EH OLTXLGDWHG DW /, 7KH WHUPLQDO YDOXH RI WKH DVVHWV DW W LV ]HUR 7KH SDUDPHWHUV VDWLVI\ $VVXPSWLRQ I[UG)U ? 4Kf!,T!/! [UG)U f f -R -R $VVXPSWLRQ /(4>-;UG)U _f@ f $VVXPSWLRQ LQGLFDWHV WKDW WKH SURMHFW SURYLGHV SRVLWLYH 139 LQ WKH IDYRUDEOH VWDWH ZKLOH OLTXLGDWLRQ \LHOGV PRUH FDVK IORZ LQ WKH XQIDYRUDEOH VWDWH $VVXPSWLRQ VD\V WKDW DW W O

PAGE 72

FRQWLQXLQJ WKH SURMHFW LV PRUH SURILWDEOH WKDQ OLTXLGDWLRQ ZKHQ WKH EHOLHI DERXW WKH RFFXUUHQFH RI WKH WZR VWDWHV FRLQFLGHV ZLWK WKH SULRU ,W LPSOLHV WKDW ZLWKRXW DGGLWLRQDO LQIRUPDWLRQ OHQGHUVf SHUFHLYHV FRQWLQXDWLRQ DV PRUH SURILWDEOH WKDQ OLTXLGDWLRQ 7R DVFHUWDLQ WKH SURILWDELOLW\ RI OLTXLGDWLRQ OHQGHUVf PXVW DFTXLUH DGGLWLRQDO LQIRUPDWLRQ 7KH PDQDJHU KDYLQJ QR ZHDOWK RI KLV RZQ PXVW VHHN H[WHUQDO ILQDQFLQJ 7KHUH DUH WZR W\SHV RI OHQGHUVf§EDQNV DQG SXEOLF OHQGHUV 8QOLNH SXEOLF OHQGHUV D EDQN OHQGHU FDQ KDYH DFFHVV WR D FRVWO\ PRQLWRULQJ WHFKQRORJ\ ZKLFK JHQHUDWHV DQ LQWHULP VLJQDO FRUUHODWHG ZLWK WKH UHDOL]HG VWDWH :H DVVXPH WKDW RQO\ WKH EDQN OHQGHU ZKR OHQW DW W FDQ REVHUYH D VLJQDO DW W O 7KH EDQNfV VLJQDO LV KRZHYHU QRW YHULILDEOH DQG WKHUHIRUH FDQ QRW EH FRQWUDFWHG XSRQ %\ H[SHQGLQJ HIIRUW HH>O@ WKH EDQNHU FDQ REVHUYH WKH UHDOL]HG LQWHULP VWDWH ZLWK SUREDELOLW\ H DQG UHPDLQ XQLQIRUPHG ZLWK SUREDELOLW\ H ([SHQGLQJ HIIRUW H FRVWV WKH EDQN L_LHf :H DVVXPH L_nHf! L_UHf! DQG LMH f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f -DPHV f /XPPHU DQG 0F&RQQHOO f A)RUPDOO\ WKLV FRUUHVSRQGV WR WKH LQIRUPDWLRQ VWUXFWXUH LQ ZKLFK WKH VLJQDO VSDFH FRQVLVWV RI WKUHH HOHPHQWV ^V+V/-f` 7KH FRUUHODWLRQV EHWZHHQ WKH VLJQDOV DQG WKH LQWHULP VWDWHV DUH IV+_+f HIf_+f OBHIVL-/f H DQG I0/f OH 7KH VLJQDO FMf LV FRPSOHWHO\ XQLQIRUPDWLYH DQG WKH VLJQDO V+ V/f SHUIHFWO\ UHYHDOV WKH VWDWH + /f

PAGE 73

FRQWLQXDWLRQ GHFLVLRQ FDQ QRW EH H[SOLFLWO\ FRQVWUDLQHG E\ WKH FRYHQDQW DQG WKH SDUW\ ZKR KDV WKH LQWHULP FRQWURO ULJKWV FDQ XQLODWHUDOO\ GHFLGH RQ WKH DFWLRQV WR EH WDNHQ $OO DJHQWV DUH DVVXPHG WR EH ULVN QHXWUDO $W W WKH PDQDJHU DWWHPSWV WR UDLVH WKH FDSLWDO QHHGHG WR VWDUW WKH SURMHFW $SDUW IURP EHLQJ WKH UHVLGXDO FODLPDQW RI WKH W FDVK IORZ WKH PDQDJHU HQMR\V D QRQWUDQVIHUDEOH DQG VWDWHFRQWLQJHQW SULYDWH FRQWURO UHQW &f ZLWK &Kf!&Of SURYLGHG WKDW WKH SURMHFW LV FRQWLQXHG WR W 7KH SULYDWH FRQWURO UHQW LV WKH VRXUFH RI SRWHQWLDO PLVDOLJQPHQW RI LQFHQWLYHV EHWZHHQ WKH PDQDJHU DQG LWV OHQGHUV RYHU WKH LQWHULP FRQWLQXDWLRQ GHFLVLRQ 7R UDLVH LQLWLDO ILQDQFLQJ WKH PDQDJHU PXVW FUHGLEO\ DVVXUH OHQGHUV RI DQ H[SHFWHG UHSD\PHQW HTXDO WR WKH IXQGV WKH\ LQLWLDOO\ SURYLGH :H DVVXPH WKDW WKH UHWXUQ IURP WKH SURMHFW DOVR VDWLVILHV WKH IROORZLQJ FRQGLWLRQ $VVXPSWLRQ ?+M;UG)U ? 4+f YO/!,T!(T> -;UG)U f@ f $VVXPSWLRQ LQGLFDWHV WKDW WKH W H[SHFWHG FDVK IORZ LV OHVV WKDQ WKH LQLWLDO LQYHVWPHQW LI WKH SURMHFW LV DOZD\V FRQWLQXHG WR W ,W H[FHHGV WKH LQLWLDO LQYHVWPHQW LI WKH SURMHFW LV RQO\ FRQWLQXHG LQ VWDWH + )RU OHQGHUV WR EUHDN HYHQ OLTXLGDWLRQ LQ VWDWH / PXVW RFFXU ZLWK VWULFWO\ SRVLWLYH SUREDELOLW\ DQG LW PXVW VWULFWO\ EHQHILW WKH OHQGHUV 7R VLPSOLI\ RXU QRWDWLRQV ZH LQWURGXFH WKH IROORZLQJ GHILQLWLRQ 7KLV DULVHV HLWKHU ZKHQ DQ LQIRUPHG EDQNfV VLJQDO LV QRW YHULILDEOH RU LI WKH FRVWV RI GHVFULELQJ LQWHULP DFWLRQV DUH SURKLELWLYHO\ KLJK 7KH FRQWURO UHQW PD\ QRW EH DFWXDO PRQHWDU\ EHQHILW IRU WKH PDQDJHU ,Q RXU DQDO\VLV LW PHUHO\ VHUYHV DV D PHDVXUH RI WKH GLYHUJHQFH RI SUHIHUHQFH EHWZHHQ OHQGHUV DQG WKH PDQDJHU RYHU WKH LQWHULP FRQWLQXDWLRQ GHFLVLRQ )RU IXUWKHU GLVFXVVLRQV VHH $JKLRQ DQG %ROWRQ f +DUW DQG 0RRUH f HQGRJHQL]H WKH FRQWURO UHQW E\ JLYLQJ WKH PDQDJHU VRPH EDUJDLQLQJ SRZHU WKURXJK KLV DELOLW\ WR TXLW

PAGE 74

[ 'HILQLWLRQ Uf -UF)U_f H^+/` f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nV EDUJDLQLQJ SRZHU ,Q WKH HYHQW WKDW UHQHJRWLDWLRQ EUHDNV GRZQ WZR SRVVLELOLWLHV DULVH Of,I WKH ILUP KDV VKRUWWHUP EDQN GHEW RXWVWDQGLQJ WKHQ WKH EDQN FDQ HLWKHU IRUFH OLTXLGDWLRQ RU IRUJLYH WKH VKRUWWHUP UHSD\PHQW DQG DOORZ WKH SURMHFW WR FRQWLQXH LI SRVVLEOHf f ,I WKH ILUP 7KHUH DUH PDQ\ IDFWRUV ZKLFK FDQ DIIHFW WKH VL]H RI $ )RU H[DPSOH WKH EDQNnV UHSXWDWLRQDO FRQFHUQV WKH OHQJWK RI WKH ILUPEDQN UHODWLRQVKLS DQG WKH ILUPVn DFFHVVLELOLW\ WR DOWHUQDWLYH VRXUFHV RI FDSLWDO FDQ DOO DIIHFW WKH UHODWLYH EDUJDLQLQJ SRZHU 6LQFH WKLV DVVXPSWLRQ ZLOO WXUQ RXW WR EH UDWKHU LPSRUWDQW IRU RXU DQDO\VLV ZH SURYLGH VRPH MXVWLILFDWLRQV )LUVW EDQNV DUH QRW SURKLELWHG E\ ODZ IURP IRUJLYLQJ UHSD\PHQWV GXH 6HFRQG DV LV HDVLO\ VHHQ LI WKH EDQN RQO\ KROGV VKRUWWHUP GHEW FODLP LW ZLOO QRW IRUJLYH WKH W O UHSD\PHQW LI UHQHJRWLDWLRQ EUHDNV GRZQ +RZHYHU ZKHQ LW KROGV ERWK VKRUWWHUP DQG ORQJn WHUP FODLPV LW PD\ FKRRVH WR IRUJLYH WKH W O UHSD\PHQW LQ WKH LQWHUHVW RI FDSWXULQJ D ODUJHU

PAGE 75

RQO\ KDV ORQJWHUP GHEW REOLJDWLRQVf RXWVWDQGLQJ WKH H[LVWLQJ FRQWUDFWVf VWDQGV 2Q WKH RWKHU KDQG ZH DVVXPH WKDW LW LV LPSRVVLEOH IRU WKH ILUP WR UHQHJRWLDWH ZLWK WKH H[LVWLQJ SXEOLF GHEWKROGHUV 7KH ILUP FDQ KRZHYHU UDLVH ILQDQFLQJ IURP WKH LQWHULP FRPSHWLWLYH FDSLWDO PDUNHW LQ ZKLFK FDVH WKH ILUP PDNHV D WDNHLWRUOHDYHLW RIIHU WR LQYHVWRUV $V D SUHOLPLQDU\ DQDO\VLV ZH GHPRQVWUDWH WKH H[LVWHQFH RI GHPDQG IRU EDQN GHEW 6XSSRVH WKH ILUP WULHV WR UDLVH LQLWLDO ILQDQFLQJ E\ RQO\ ERUURZLQJ SXEOLF GHEW :LWK SXEOLF OHQGHUV PRQLWRULQJ DQG LQWHULP UHQHJRWLDWLRQ DUH ERWK LQIHDVLEOH :LWKRXW PRQLWRULQJ SXEOLF OHQGHUV FDQ QRW DFTXLUH DGGLWLRQDO LQIRUPDWLRQ DERXW WKH UHDOL]HG VWDWH DQG E\ DVVXPSWLRQ WKH\ ZLOO QRW FKRRVH WR OLTXLGDWH WKH SURMHFW 6LQFH UHQHJRWLDWLRQ LV LQIHDVLEOH WKH ILUP ZLOO QHYHU FKRRVH WR OLTXLGDWH WKH SURMHFW 7KXV WKH SURMHFW LV DOZD\V FRQWLQXHG DQG E\ DVVXPSWLRQ SXEOLF GHEWRUV ZLOO QRW ILQDQFH WKH SURMHFW 7R UDLVH LQLWLDO ILQDQFLQJ WKH ILUPfV LQLWLDO ERUURZLQJ PXVW LQFOXGH EDQN GHEW :KHQ WKH ILUPfV LQLWLDO ERUURZLQJ LQFOXGHV EDQN GHEW WKH OHQGHUfV RU OHQGHUVff W H[SHFWHG SD\RII FDQ EH ZULWWHQ DV W SD\RII 7KLV LV VLPLODU WR D GHEW UHVWUXFWXULQJ H[FHSW WKDW WKH ODWWHU LV XVXDOO\ IXUQLVKHG XQGHU D QHZ FRQWUDFW 7KH GLIIHUHQFH DULVHV EHFDXVH LQ WKH SUHVHQW VHWWLQJ ILQDQFLDO GLVWUHVV RFFXUV ZLWK FHUWDLQW\ 7KHUHIRUH WKH UHVXOW RI D W O UHVWUXFWXULQJ LV SDUWLDOO\ UHIOHFWHG LQ WKH H[ DQWH FRQWUDFW )LQDOO\ WKLV DVVXPSWLRQ DFFRUGV RXU GHILQLWLRQ RI WKH LQWHULP FRQWURO ULJKWV WR WKDW RI *URVVPDQ DQG +DUW f $FFRUGLQJ WR WKHVH DXWKRUV WKH SDUW\ ZKR KDV WKH FRQWURO ULJKWV FDQ XQLODWHUDOO\ GHFLGH RQ WKH FRXUVH RI DFWLRQ LQ WKH DEVHQFH RI QHJRWLDWLRQ ,Q RXU PRGHO WKH WKHUH DUH WZR SRVVLEOH LQWHULP DFWLRQVf§FRQWLQXDWLRQ DQG OLTXLGDWLRQ %\ DOORZLQJ WKH EDQN WR IRUJLYH WKH W O UHSD\PHQW VKRUWWHUP EDQN GHEW FODLP FRQIHUV WKH FRQWURO ULJKWV RQ WKH EDQN LQ WKH VHQVH RI *URVVPDQ DQG +DUW f 7KLV DVVXPSWLRQ PD\ EH MXVWLILHG E\ WKH SUHVHQFH RI IUHH ULGHU SUREOHP LQ H[FKDQJH RIIHUV 6HH *HUWQHU DQG 6FKDUIVWHLQ f :H DVVXPH WKDW OHQGHUV LQ WKH FDSLWDO PDUNHW DUH VXIILFLHQWO\ GLYHUVH VR WKDW WKH ILUP FDQ PDNH WKH RIIHU WR LQYHVWRUV RWKHU WKDQ WKH H[LVWLQJ RQHV

PAGE 76

Hf5XH5P 5XH55XfP nf ZKHUH 5c DQG 5f DUH WKH OHQGHUfV RU OHQGHUVff SD\RII ZKHQ WKH EDQN LV LQIRUPHG DQG XQLQIRUPHG UHVSHFWLYHO\ DQG H LV WKH EDQNfV PRQLWRULQJ HIIRUW 7R UDLVH LQLWLDO ILQDQFLQJ WKH H[SHFWHG SD\RII LQ f PXVW EH DW OHDVW DV ODUJH DV WKH LQLWLDO LQYHVWPHQW 7KH DQDO\VLV LQ WKLV SDSHU LV EDVHG RQ WKH REVHUYDWLRQ WKDW WKHUH DUH GHDGZHLJKW FRVWV DVVRFLDWHG ZLWK PRQLWRULQJ f 7KHUH LV D FRVW LfHf IRU H[SHQGLQJ PRQLWRULQJ HIIRUW H $QG f DV D UHVXOW RI PRQLWRULQJ WKH SURMHFW PXVW EH OLTXLGDWHG ZKHQ WKH EDQN LV LQIRUPHG RI WKH XQIDYRUDEOH VWDWH /LTXLGDWLRQ GHVWUR\V WKH PDQDJHUfV SULYDWH UHQW ZKLFK PD\ H[FHHG WKH OLTXLGDWLRQ YDOXH RI WKH DVVHWV VHH WKH GLVFXVVLRQ LQ VHFWLRQ ,,,f 7KXV WKH PDQDJHU GHVLUHV WR PLQLPL]H WKH OHYHO RI PRQLWRULQJ UHTXLUHG E\ LQLWLDO ILQDQFLQJ 7R PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ WKH PDQDJHU PXVW PD[LPL]H WKH OHQGHUfV RU OHQGHUVff SD\RII ZKHQ WKH EDQN LV XQLQIRUPHG 5A DQG ZKHQ SRVLWLYH OHYHO RI PRQLWRULQJ LV UHTXLUHG E\ LQLWLDO ILQDQFLQJ WKH OHQGHUfV RU OHQGHUVff PDUJLQDO EHQHILW RI PRQLWRULQJ 5 5A )XUWKHUPRUH KH PXVW VWUXFWXUH WKH EDQNfV GHEW FODLP WR LQGXFH WKH PLQLPXP OHYHO RI PRQLWRULQJ 7KH 0L[ RI /RQJ7HUP 3XEOLF DQG %DQN 'HEW &ODLPV 7KH PDQDJHU UDLVHV LQLWLDO ILQDQFLQJ E\ ERUURZLQJ IURP D EDQN DQG SXEOLF OHQGHUV ,Q UHWXUQ KH SURPLVHV D W UHSD\PHQW V WR WKH EDQN DQG W WR SXEOLF OHQGHUV 7KH EDQNnV DQG WKH ILUPnV H[SHFWHG SD\RII LQ VWDWH LV GHQRWHG DV 5VWf DQG 5IVWf UHVSHFWLYHO\ :H DVVXPH WKURXJKRXW WKH SDSHU WKDW DOO UHQWV H[WUDFWHG E\ WKH OHQGHUV LQ H[FHVV WR WKH LQLWLDO IXQGV OHQG DUH SUHSDLG 7KXV WKH PDQDJHUfV REMHFWLYH LV WR PD[LPL]H WKH WRWDO W H[SHFWHG VXUSOXV ZKLOH HQVXULQJ LQLWLDO ILQDQFLQJ %RWK RI WKH SD\RIIV LQFRUSRUDWH DQ\ FRQWUDFWXDO VSHFLILFDWLRQV ZKLFK PD\ DIIHFW WKHP LQFOXGLQJ IRU H[DPSOH WKH UHODWLYH VHQLRULW\ EHWZHHQ WKH SXEOLF DQG EDQN GHEW FODLPV

PAGE 77

7KH PL[ DOVR VSHFLILHV WKH SD\RIIV WR WKH EDQN DQG WR WKH SXEOLF GHEWRUV LQ OLTXLGDWLRQ GHQRWHG DV /M DQG /S^ UHVSHFWLYHO\ ,Q DQDO\]LQJ WKH PL[HV RI ORQJWHUP GHEW FODLPV ZH PDNH $VVXPSWLRQ &//U/f f $VVXPSWLRQ LPSOLHV WKDW OLTXLGDWLRQ LQ VWDWH / JHQHUDWHV SRVLWLYH VXUSOXV DQG KHQFH LV HIILFLHQW 6LQFH WKH PDQDJHU FDQ QRW UHQHJRWLDWH ZLWK WKH SXEOLF OHQGHUV LW IDOOV RQ WKH EDQN WR EULEH WKH PDQDJHU DQG LQGXFH OLTXLGDWLRQ &RQVLGHU WKH LQWHULP UHQHJRWLDWLRQ ZKHQ WKH EDQN LV LQIRUPHG ,Q WKLV FDVH WKH ILUP DQG WKH EDQN QHJRWLDWH XQGHU V\PPHWULF LQIRUPDWLRQ DQG WKH WKHLU WRWDO SD\RII LV PD[LPL]HG ,I WKH SURMHFW LV FRQWLQXHG WKH ILUPfV DQG WKH EDQNfV LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQV LPSO\ WKDW WKH H[LVWLQJ FRQWUDFW ZLOO QRW EH UHSODFHG ,I WKH SURMHFW LV OLTXLGDWHG WKH WRWDO FDVK IORZ DYDLODEOH WR WKH ILUP DQG WKH EDQN LV /A 7KXV QHJRWLDWLRQ OHDGV WR OLTXLGDWLRQ LQ VWDWH / LI DQG RQO\ LI L HMVYr I MFM ‘ f &RQGLWLRQ f LQGLFDWHV WKDW LW LV LQGLYLGXDOO\ UDWLRQDO IRU WKH EDQN WR EULEH WKH PDQDJHU DQG LQGXFH OLTXLGDWLRQ LQ VWDWH / :KHQ WKH EDQN LV XQLQIRUPHG WKH DQDO\VLV LV PRUH LQYROYHG DQG ,,I &/!/U/f WKHQ WKH SURMHFW FDQ QRW EH ILQDQFHG E\ D PL[ RI ORQJWHUP GHEW 7KLV IROORZV EHFDXVH WKH PDQDJHU FDQ DOZD\V FRQWLQXH WKH SURMHFW ZLWKRXW UDLVLQJ DGGLWLRQDO ILQDQFLQJ DW W O 7R LQGXFH OLTXLGDWLRQ LQ VWDWH / OHQGHUV PXVW RIIHU WKH PDQDJHU D EULEH RI DW OHDVW &/ 7KLV OHDYHV WKH OHQGHUV ERWK WKH EDQN OHQGHU DQG WKH SXEOLF GHEWRUVf ZLWK D W H[SHFWHG SD\RII QR JUHDWHU WKDQ Y+U+fY/>/&/@(>Uf@ %\ DVVXPSWLRQ WKLV LV VPDOOHU WKDQ WKH LQLWLDO LQYHVWPHQW 7KHUHIRUH OHQGHUV ZLOO UHIXVH WR SURYLGH LQLWLDO ILQDQFLQJ ,Q JHQHUDO ZKHQ RQH RI WKH SDUWLHV LQ WKH QHJRWLDWLRQ LV ZHDOWK FRQVWUDLQHG V\PPHWULF LQIRUPDWLRQ LV QRW VXIILFLHQW WR HQVXUH WKH RSWLPDOLW\ RI ELODWHUDO EDUJDLQLQJ ,Q WKH SUHVHQW FDVH PRQHWDU\ WUDQVIHU LV IURP WKH EDQN ZKR LV QRW VXEMHFW WR ZHDOWK FRQVWUDLQW WR WKH PDQDJHU DQG WKHUHIRUH RSWLPDOLW\ LV HQVXUHG

PAGE 78

LV UHOHJDWHG WR WKH DSSHQGL[ :H VXPPDUL]H WKH UHVXOW LQ WKH IROORZLQJ OHPPD /HPPD ,I WKH EDQN LV XQLQIRUPHG WKHQ LQ WKH XQLTXH HTXLOLEULXP RI LQWHULP QHJRWLDWLRQ Lf,I V DQG W VDWLVI\ f DQG f@ f WKHQ WKH SURMHFW LV OLTXLGDWHG LQ VWDWH / DQG FRQWLQXHG LQ VWDWH + LQGHSHQGHQW RI ZKR PDNHV WKH RIIHU LLf)RU DOO V DQG W ZKLFK GR QRW VDWLVI\ f RU f WKH SURMHFW LV HLWKHU DOZD\V OLTXLGDWHG RU DOZD\V FRQWLQXHG ZKHQ WKH ILUP PDNHV DQ RIIHU ,Q WKH IROORZLQJ ZH IRFXV RQ GHEW VWUXFWXUHV ZKLFK VDWLVI\ FRQGLWLRQV f DQG f &RQGLWLRQ f LQGLFDWHV WKDW ZKHQ WKH ILUP PDNHV DQ RIIHU LQ VWDWH + FRQWLQXLQJ WKH SURMHFW UHWXUQV LW D ODUJHU SD\RII WKDQ WKDW LQ OLTXLGDWLRQ ,W HQVXUHV WKDW WKH SURMHFW LV DOZD\V FRQWLQXHG LQ WKH IDYRUDEOH VWDWH ,Q f WKH EDQNnV SD\RII LQ FRQWLQXDWLRQ LV LWV H[SHFWHG UHWXUQ UHIOHFWLQJ WKDW WKH EDQN LV XQLQIRUPHG ,I WKH GHEW VWUXFWXUH VDWLVILHV FRQGLWLRQV f DQG f WKHQ LQGHSHQGHQW RI WKH EDQNfV LQIRUPDWLRQ WKH HTXLOLEULXP IRU WKH LQWHULP QHJRWLDWLRQ LV VHSDUDWLQJ 7KH SURMHFW LV OLTXLGDWHG LQ VWDWH / DQG FRQWLQXHG LQ VWDWH + 7KH PDQDJHU GHVLUHV WR PD[LPL]H WKH WRWDO VXUSOXV ZKLOH HQVXULQJ LQLWLDO ILQDQFLQJ *LYHQ WKH DERYH OLTXLGDWLRQ SROLF\ WKH WRWDO VXUSOXV LV LQGHSHQGHQW RI WKH SURPLVHG UHSD\PHQWV WR WKH GHEWKROGHUV 7KXV WR HQVXUH LQLWLDO ILQDQFLQJ WKH PDQDJHU GHVLUHV WR PD[LPL]H WKH OHQGHUVn ,W LV ZHOO NQRZQ WKDW QHJRWLDWLRQ XQGHU DV\PPHWULF LQIRUPDWLRQ JHQHUDOO\ OHDGV WR PXOWLSOH HTXLOLEULD ZKHQ WKH LQIRUPHG SDUW\ FDQ DOVR SURSRVH RIIHUV 7KURXJKRXW WKLV DQDO\VLV ZH UHTXLUH WKDW WKH HTXLOLEULXP VDWLVI\ WKH GLYLQLW\ FULWHULRQ RI %DQNV DQG 6REHO f

PAGE 79

WKH VXP RI WKH EDQNnV DQG WKH SXEOLF GHEWRUnV SURILWf H[SHFWHG SD\RII 7KH IROORZLQJ SURSRVLWLRQ FKDUDFWHUL]HV WKH RSWLPDO VROXWLRQ 3URSRVLWLRQ $W RSWLPDO VW ; DQG e}+9 7KH SURMHFW LV OLTXLGDWHG LQ VWDWH / DQG FRQWLQXHG LQ VWDWH + DQG WKH EDQN GRHV QRW PRQLWRU ,Q WKH RSWLPDO VROXWLRQ WKH EDQNfV PRQLWRULQJ HIIRUW LV ]HUR (TXDWLRQ f LPSOLHV WKDW WKH OHQGHUVf W H[SHFWHG SD\RII FRQVLVWV RI RQO\ 5X 6LQFH WKH WRWDO SURPLVHG UHSD\PHQW WR WKH OHQGHUV VAWM HTXDOV WKH PD[LPXP SURILW IURP WKH SURMHFW WKH\ DFTXLUH WKH HQWLUH FDVK IORZ IURP WKH SURMHFW LQ VWDWH + 7R LQGXFH OLTXLGDWLRQ LQ VWDWH / KRZHYHU WKH EDQN PXVW RIIHU WKH PDQDJHU D EULEH &/ 7KH OHQGHUVnf§WKH EDQN DQG WKH SXEOLF OHQGHUVf§W H[SHFWHG SURILW LV 5X Y$4KfY-Oa&Lf 7KXV LI WKH SD\RII LQ f H[FHHGV WKH LQLWLDO LQYHVWPHQW SURMHFW FDQ EH ILQDQFHG E\ D PL[ RI ORQJWHUP SXEOLF DQG EDQN GHEW 7KH RSWLPDO VROXWLRQ KDV WKH IROORZLQJ WZR SURSHUWLHV )LUVW VLQFH WKH FRQWLQXDWLRQ GHFLVLRQ LV LQGHSHQGHQW RI WKH EDQNfV LQIRUPDWLRQ WKHUH LV QR QHHG IRU PRQLWRULQJ 7KHUH DUH WZR UHDVRQV ZK\ WKH LQWHULP HTXLOLEULXP LV VHSDUDWLQJ HYHQ ZKHQ WKH EDQN LV XQLQIRUPHG Of6LQFH WKH PDQDJHUfV FRQWURO UHQW LV VXIILFLHQWO\ VPDOO KH FDQ UHFRXS WKH ORVV RI SULYDWH UHQW ZKHQ WKH SURMHFW LV OLTXLGDWHG f6LQFH WKH PDQDJHU KDV WKH LQWHULP FRQWURO ULJKWV KH LV QRW KDUPHG E\ UHYHDOLQJ WKH XQIDYRUDEOH VWDWH )URP SDUW LLf RI OHPPD GHEW VWUXFWXUHV ZKLFK GR QRW VDWLVI\ f RU f UHGXFHV ERWK WKH WRWDO VXUSOXV DQG WKH FRQWUDFWLEOH FDVK IORZ &RQVHTXHQWO\ WKH\ DUH VXERSWLPDO

PAGE 80

1H[W FRQVLGHU FRQGLWLRQ f LQ SURSRVLWLRQ 7KH OHIW KDQG VLGH RI WKH HTXDOLW\ LV WKH WRWDO SD\RII WR WKH EDQN DQG WKH ILUP ZKHQ WKH SURMHFW LV OLTXLGDWHG LQ VWDWH / 7KH ULJKW KDQG VLGH LV WKHLU WRWDO SD\RII LI WKH SURMHFW LV FRQWLQXHG &RQGLWLRQ f LQGLFDWHV WKDW WKH EDQN DQG WKH ILUP GR QRW VWULFWO\ EHQHILW IURP OLTXLGDWLRQ 7KH SXEOLF GHEWRUV H[WUDFW WKH HQWLUH VXUSOXV IURP OLTXLGDWLRQ $V KDV EHHQ SRLQWHG RXW SUHYLRXVO\ WKH PDQDJHU GHVLUHV WR PD[LPL]H WKH W H[SHFWHG SD\RII WR WKH OHQGHUV 6LQFH WKH EDQNfV GHEW FODLP LV QRW UHQHJRWLDWHG ZKHQ WKH SURMHFW LV FRQWLQXHG WKH ILUP FDQ FUHGLEO\ SD\ RXW WKH SURILW IURP FRQWLQXDWLRQ WKURXJK H[ DQWH FRQWUDFWLQJ +RZHYHU ZKHQ WKH SURMHFW LV OLTXLGDWHG WKH EDQNfV GHEW FODLP PXVW EH UHQHJRWLDWHG ,I WKH EDQN LV WKH RQO\ OHQGHU WKH GLYLVLRQ RI WKH VXUSOXV IURP OLTXLGDWLRQ FDQ QRW EH VSHFLILHG WKURXJK H[ DQWH FRQWUDFWLQJ ,QVWHDG LW LV GLYLGHG DFFRUGLQJ WR WKH UHODWLYH EDUJDLQLQJ SRZHU :KHQ WKH PDQDJHU FRPPDQGV ODUJH EDUJDLQLQJ SRZHU KH FDQ H[WUDFW PRVW RI WKH VXUSOXV IURP OLTXLGDWLRQ 7KH EDQNfV EHQHILW IURP OLTXLGDWLRQ GLPLQLVKHV DQG E\ DVVXPSWLRQ LW PD\ UHIXVH WR SURYLGH LQLWLDO ILQDQFLQJ 8QOLNH WKH EDQN OHQGHU KRZHYHU SXEOLF GHEWRUV FDQ IUHH ULGH RQ WKH EHQHILW RI WKH QHJRWLDWLRQ EHWZHHQ WKH EDQN DQG WKH ILUP ZLWKRXW PDNLQJ FRQFHVVLRQV RI WKHLU FODLPV LQ OLTXLGDWLRQ 7KXV E\ ERUURZLQJ D PL[ RI EDQN GHEW DQG SXEOLF GHEW WKH ILUP FDQ FUHGLEO\ SD\ RXW WKH VXUSOXV JHQHUDWHG IURP OLTXLGDWLRQ WR WKH SXEOLF OHQGHUV 7KH RSWLPDO GHEW VWUXFWXUH PD[LPL]HV GHEWRUVf WRWDO SD\RII ZKHQ WKH EDQN LV XQLQIRUPHG 5A DQG LQLWLDO ILQDQFLQJ LV HQVXUHG ZLWKRXW WKH ILUP LQFXUULQJ DQ\ FRVW RI PRQLWRULQJ 7KLV SURYLGHV DQ H[SODQDWLRQ ZK\ WKH ILUP PD\ GHVLUH WR GLYHUVLI\ LWV ERUURZLQJ 5DMD f DUJXHV WKDW EDQNnV RSSRUWXQLVP PD\ FDXVH SXEOLF GHEW WR EH PRUH GHVLUDEOH WKDQ EDQN GHEW 2XU ILQGLQJ H[WHQGV 5DMDnV UHVXOW LQ WKUHH DVSHFWV f ,W LQGLFDWHV WKDW D PL[HG GHEW VWUXFWXUH FDQ EH GHVLUDEOH f 'LYHUVLILHG ERUURZLQJ DOVR DULVHV ZKHQ WKH ILUP FRPPDQGV ODUJH

PAGE 81

2SWLPDO %DQN 'HEW :KHQ WKH PDQDJHUfV FRQWURO UHQW EHFRPHV ODUJH WKDW LV ZKHQ WKH GLYHUJHQFH RI SUHIHUHQFH EHWZHHQ WKH PDQJHU DQG WKH OHQGHUV LV ODUJH OLTXLGDWLRQ WKURXJK LQWHULP UHQHJRWLDWLRQ LV QR ORQJHU IHDVLEOH 7KHUHIRUH WKH ILUP FDQ QRW ILQDQFH WKH SURMHFW E\ XVLQJ D PL[ RI ORQJWHUP SXEOLF DQG EDQN GHEW 6SHFLILFDOO\ ZH ZLOO DVVXPH WKH IROORZLQJ LQ WKH HQVXLQJ DQDO\VLV $VVXPSWLRQ &O!/ f ,Q WKLV FDVH IHDVLELOLW\ RI LQLWLDO ILQDQFLQJ UHTXLUHV LQYROXQWDU\ OLTXLGDWLRQ 7KLV LPSOLHV WKDW WKH ILUPfV LQLWLDO ERUURZLQJ PXVW LQFOXGH VKRUWWHUP GHEW $ VKRUWWHUP GHEW FODLP WUDQVIHUV WKH W O FRQWURO ULJKWV WR WKH OHQGHU ZKHQ WKH PDQDJHU FDQ QRW PDNH D UHSD\PHQW *LYHQ WKH FRQWURO ULJKWV WKH OHQGHU FDQ IRUFH OLTXLGDWLRQ ZLWKRXW KDYLQJ WR EULEH WKH PDQDJHU %\ DVVXPSWLRQ ZLWKRXW DGGLWLRQDO LQIRUPDWLRQ OHQGHUVf FRQVLGHU FRQWLQXDWLRQ DV PRUH SURILWDEOH WKDQ OLTXLGDWLRQ DQG WKH ILUP FDQ DOZD\V FRQWLQXH WKH SURMHFW E\ SURPLVLQJ D VXIILFLHQWO\ ODUJH W UHSD\PHQW 6LQFH LQLWLDO ILQDQFLQJ UHTXLUHV WKDW WKH SURMHFW EH OLTXLGDWHG LQ WKH XQIDYRUDEOH VWDWH ZLWK VWULFWO\ SRVLWLYH SUREDELOLW\ WKH ILUP PXVW VWUXFWXUH WKH GHEW FODLP WR LQGXFH PRQLWRULQJ E\ WKH EDQN OHQGHU 7R ILQG WKH PLQLPXP OHYHO RI PRQLWRULQJ UHTXLUHG E\ LQLWLDO ILQDQFLQJ QRWLFH WKDW WKH PD[LPXP YDOXH IRU 5 WKH OHQGHUfV RU OHQGHUVff H[SHFWHG SD\RII ZKHQ WKH EDQN LV XQLQIRUPHG LV (>Uf@ DQG WKH PD[LPXP YDOXH IRU 5A WKH OHQGHUfV RU OHQGHUVff H[SHFWHG SD\RII ZKHQ WKH EDQN LV XQLQIRUPHG LV YKIKfYO/ 7KH PLQLPXP OHYHO RI PRQLWRULQJ UHTXLUHG E\ LQLWLDO ILQDQFLQJ Hr LV WKHQ EDUJDLQLQJ SRZHU f'LYHUVLILHG ERUURZLQJ PD\ EH GHVLUDEOH HYHQ LQ WKH DEVHQFH RI PRUDO KD]DUG SUREOHP

PAGE 82

GHILQHG E\ eH>Uf@9 ?/U4-?AH f ,Q WKH HQVXLQJ DQDO\VLV ZH PDNH $VVXPSWLRQ GW\H fY _;U f@ f GHr 7R LQWHUSUHW DVVXPSWLRQ VXSSRVH WKDW WKH ILUP FDQ VWUXFWXUH WKH GHEW FODLPV VR WKDW ERWK DQG 5c DWWDLQ WKHLU PD[LPXP YDOXHV 7KH ULJKW KDQG VLGH RI f LV WKH OHQGHUfV RU OHQGHUVff WRWDO PDUJLQDO EHQHILW RI PRQLWRULQJ ZKLFK PXVW ZHDNO\f H[FHHG WKH EDQNf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fV DQG WKH ILUPfV UHVHUYDWLRQ OHYHOV LQ WKH UHQHJRWLDWLRQ &RQVLGHU WKH UHQHJRWLDWLRQ ZKHQ WKH EDQN LV LQIRUPHG ,Q VWDWH + ZKHQ

PAGE 83

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f WKH ILUP SURSRVHV WKH SRROLQJ FRQWLQXDWLRQ FRQWUDFW V ZKLFK \LHOGV WKH EDQN DQ H[SHFWHG UHWXUQ HTXDO WR LWV UHVHUYDWLRQ OHYHO / LLfWKH EDQN SURSRVHV WKH SRROLQJ FRQWLQXDWLRQ FRQWUDFW VE ; 7KH LQWXLWLRQ IRU OHPPD LV TXLWH VLPSOH :LWK VKRUWWHUP GHEW FODLP WKH EDQN FDQ XQLODWHUDOO\ GHFLGH WR WHUPLQDWH WKH SURMHFW ,I WKH PDQDJHUf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

PAGE 84

WKH EDQN FDQ RIIHU D PHQX RI FRQWUDFWV ZKLFK VFUHHQV RXW WKH XQIDYRUDEOH VWDWH DQG LQGXFH OLTXLGDWLRQ +RZHYHU WKH PDQDJHU ZLOO UHYHDO WKH XQIDYRUDEOH VWDWH RQO\ LI KH LV EULEHG DW OHDVW KLV SULYDWH UHQW &/ %\ DVVXPSWLRQ WKLV LV LQIHDVLEOH 3DUW LLf RI OHPPD WKHQ IROORZV ,W IROORZV IURP WKH DERYH GLVFXVVLRQ WKDW WKH EDQNnV W H[SHFWHG SURILW DQG PRQLWRULQJ HIIRUW DUH 3IR0O ;f(J>UP;/H +fYL>,UHLf@.D f IH O ƒfY>.Wf@ f (TXDWLRQ f LQGLFDWHV WKDW WKH EDQNfV SURILW LV LQGHSHQGHQW RI WKH PDQDJHUnV SULYDWH UHQW 7KLV IROORZV EHFDXVH WKH VKRUWWHUP GHEW FODLP WUDQVIHUV WKH LQWHULP FRQWURO ULJKWV WR WKH EDQN DOORZLQJ LW WR IRUFH OLTXLGDWLRQ ZLWKRXW EULELQJ WKH PDQDJHU +RZHYHU WKH EDQNfV H[SHFWHG SD\RII GHSHQGV RQ LWV EDUJDLQLQJ SRZHU $ $W W O WKH EDQN DFTXLUHV WKH FRQWURO RI WKH ILUPfV DVVHWV 7R FRQWLQXH WKH SURMHFW WKH PDQDJHU PXVW SXUFKDVH WKH DVVHWV EDFN IURP WKH EDQN WKURXJK UHQHJRWLDWLRQ 7KH H[SHFWHG SULFH KH PXVW SD\ LQFUHDVHV ZLWK WKH EDQNfV EDUJDLQLQJ SRZHU &RQVHTXHQWO\ WKH EDQNfV H[SHFWHG SD\RII LQFUHDVHV ZLWK LWV EDUJDLQLQJ SRZHU (TXDWLRQ f LQGLFDWHV WKDW WKH EDQNfV PDUJLQDO SURILW RI PRQLWRULQJ LV SRVLWLYH DQG LV LQFUHDVLQJ LQ WKH EDQNfV EDUJDLQ SRZHU $ :KHQ WKH EDQN RQO\ KROGV ORQJWHUP GHEW FODLP LWV PDUJLQDO SURILW RI PRQLWRULQJ LV ]HUR EHFDXVH LW FDQ QRW DFW XSRQ EHWWHU LQIRUPDWLRQ +DUW DQG 0RRUH f VKRZ WKDW WKH QHHG WR SXUFKDVH FRQWURO ULJKWV IURP WKH GHEWRUV FDQ VHUYH WR GLVFLSOLQH WKH PDQDJHU E\ IRUFLQJ KLP WR SD\ RXW H[FHVV FDVK WKHUHE\ PLWLJDWLQJ WKH IUHH FDVK IORZ SUREOHP VXJJHVWHG E\ -HQVHQ f

PAGE 85

ZLWKRXW WKH FRQWURO ULJKWV *LYHQ WKH FRQWURO ULJKWV KRZHYHU WKH EDQN FDQ EHQHILW IURP EHWWHU LQIRUPDWLRQ ZKLFK DOORZV LW WR WLPHO\ OLTXLGDWH WKH SURMHFW LQ WKH XQIDYRUDEOH VWDWH 7KXV PD[LPL]LQJ WKH YDOXH RI WKH FRQWURO ULJKWV PRWLYDWHV WKH EDQN WR PRQLWRU 7R DVVHVV WKH IHDVLELOLW\ DQG GHVLUDELOLW\ RI VKRUWWHUP EDQN GHEW ILQDQFLQJ OHW $r EH GHILQHG DV 3Er$rf )URP DVVXPSWLRQ $r DQG $r RQO\ ZKHQ f KROGV ZLWK HTXDOLW\ ,I WKH ILUPfV EDUJDLQLQJ SRZHU LV VXIILFLHQWO\ ODUJH VR WKDW $!$r VKRUWWHUP EDQN GHEW ILQDQFLQJ LV LQIHDVLEOH ,Q WKLV FDVH WKH PDQDJHU FDQ UHSRVVHVV WKH DVVHWV DW D VPDOO DYHUDJH SULFH ZKHQHYHU WKH SURMHFW LV DOORZHG WR FRQWLQXH +H H[WUDFWV PRVW RI WKH VXUSOXV IURP FRQWLQXDWLRQ DQG WKH EDQN FDQ QRW UHFRXS WKH LQLWLDO IXQG OHQW 2Q WKH RWKHU KDQG LI WKH ILUPfV EDUJDLQLQJ SRZHU LV VXIILFLHQWO\ VPDOO VR WKDW $$r VKRUWWHUP EDQN GHEW ILQDQFLQJ LV IHDVLEOH +RZHYHU H[FHSW ZKHQ $r WKH PRQLWRULQJ HIIRUW LQGXFHG VWULFWO\ H[FHHGV WKH PLQLPXP OHYHO RI PRQLWRULQJ Hr 7KLV IROORZV EHFDXVH ZKHQ WKH ILUP UDLVHV LQLWLDO ILQDQFLQJ E\ XVLQJ RQO\ EDQN GHEW WKH EDQN DFTXLUHV WKH HQWLUH EHQHILW IURP PRQLWRULQJ DQG WKH PRQLWRULQJ HIIRUW VXSSOLHG H[FHHGV Hr 7KXV WKH ILUPfV GHVLUH WR PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ WKURXJK PD[LPL]LQJ WKH PDUJLQDO EHQHILW RI PRQLWRULQJ DQG LWV GHVLUH WR LQGXFH WKH PLQLPXP OHYHO RI PRQLWRULQJ WKURXJK FRQWUROOLQJ WKH EDQNfV EHQHILW IURP PRQLWRULQJ DUH LQ FRQIOLFW ZLWK HDFK RWKHU %DQN 'HEW 5HTXLULQJ %RWK 6KRUW7HUP DQG /RQJ7HUP 5HSD\PHQWV 7KH PDQDJHU UDLVHV LQLWLDO ILQDQFLQJ E\ ERUURZLQJ IURP D EDQN ,Q UHWXUQ KH SURPLVHV WR UHSD\ VA2 DW W O DQG 6 DW W $W W O WKH PDQDJHU FDQ ILQDQFH WKH UHSD\PHQW A E\ 3DUNf 5DMD DQG :LQWRQ f VKRZ WKDW DQ DOWHUQDWLYH ZD\ WR FRQIHU FRQWURO ULJKW XSRQ WKH EDQN LV WR FRPELQH FRYHQDQW ZLWK ORQJ WHUP EDQN ORDQ

PAGE 86

UDLVLQJ IXQGV IURP WKH SXEOLF GHEW PDUNHW DQGRU E\ QHJRWLDWLQJ ZLWK WKH EDQN 7R UDLVH ILQDQFLQJ IURP WKH PDUNHW WKH PDQDJHU PDNHV D WDNHLWRUOHDYHLW RIIHU WR LQYHVWRUV 7KLV RIIHU FRQVLVWV RI WKH DPRXQW RI PRQH\ WKH PDQDJHU LQWHQGV WR ERUURZ DQG LQ H[FKDQJH WKH GHEW FODLP 6LQFH WKH SXEOLF GHEW PDUNHW UHPDLQV FRPSHWLWLYH DW W O WKLV GHEW FODLP LV GHWHUPLQHG E\ LQYHVWRUVf LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQV ,W IROORZV WKDW DW LQWHULP WKH PDQDJHUfV VWUDWHJLF GHFLVLRQ LQYROYHV FKRRVLQJ WKH DPRXQW RI ILQDQFLQJ WR EH UDLVHG IURP WKH PDUNHW )RU VLPSOLFLW\ ZH DVVXPH WKDW WKH ILUPfV RIIHU LV REVHUYDEOH E\ WKH EDQN ZKLOH SXEOLF OHQGHUV GR QRW REVHUYH WKH RXWFRPH RI WKH QHJRWLDWLRQ EHWZHHQ WKH ILUP DQG WKH EDQN 7KH WLPLQJ RI WKH LQWHULP JDPH LV VSHFLILHG DV IROORZV )LUVW WKH ILUP GHFLGHV ZKHWKHU RU QRW WR UDLVH ILQDQFLQJ IURP WKH PDUNHW DQG WKH DPRXQW RI ILQDQFLQJ WR EH UDLVHG $IWHU DFTXLULQJ WKH IXQG WKH ILUP PDNHV D UHSD\PHQW WR WKH EDQN ,I WKH EDQN LV QRW IXOO\ UHSDLG WKHQ WKH PDQDJHU PXVW VWLOO QHJRWLDWH ZLWK WKH EDQN 7KH IROORZLQJ OHPPD VXPPDUL]HV WKH PDQDJHUfV HTXLOLEULXP VWUDWHJ\ /HPPD ,Q WKH LQWHULP HTXLOLEULXP LQGXFHG E\ WKH RSWLPDO EDQN GHEW LfLI /!5EV Kf DQG WKH ILUP UDLVHV ILQDQFLQJ IURP WKH LQWHULP PDUNHW WKHQ LWV HTXLOLEULXP RIIHUV PXVW EH VHSDUDWLQJ LLf LI /5EV_ 2Kf WKHQ WKH ILUP QHYHU UDLVHV ILQDQFLQJ IURP WKH LQWHULP PDUNHW 3DUW Lf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

PAGE 87

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fV LQIRUPDWLRQ ,Q RWKHU ZRUGV WKH EDQNfV LQIRUPDWLRQ LV WUDQVPLWWHG WR WKH PDUNHW 3DUW LLf RI OHPPD LQGLFDWHV WKDW ZKHQ WKH SURPLVHG W UHSD\PHQW LV VXIILFLHQWO\ 7KH EDQNf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

PAGE 88

ODUJH WKH PDQDJHU QHYHU GHVLUHV WR UDLVH ILQDQFLQJ IURP WKH LQWHULP PDUNHW 7R VHH WKLV QRWH WKDW LI WKH QHJRWLDWLRQ EUHDNV GRZQ ZKHQ WKH EDQN LV LQIRUPHG RI WKH VWDWH + LW FDQ JHW D SD\RII / E\ OLTXLGDWLQJ WKH ILUP RU D SD\RII 5EV+f E\ IRUJLYLQJ 6M DQG DOORZLQJ WKH SURMHFW WR FRQWLQXH ,I /5A_ kff WKH EDQN SUHIHUV WR OHW WKH SURMHFW FRQWLQXH ZKHQ WKH QHJRWLDWLRQ IDLOV 7KHUHIRUH LI WKH PDQDJHU GRHV QRW UDLVH ILQDQFLQJ IURP WKH PDUNHW DQG IRUFHV WKH QHJRWLDWLRQ WR EUHDN GRZQ WKH EDQN ZLOO QRW OLTXLGDWH WKH SURMHFW $QWLFLSDWLQJ WKDW FRQWLQXDWLRQ LV HQVXUHG ZLWKRXW PDNLQJ D UHSD\PHQW WKH PDQDJHU ZLOO QRW UDLVH ILQDQFLQJ IURP WKH LQWHULP PDUNHW :KHQ WKH EDQN LV XQLQIRUPHG WKH VDPH UHDVRQLQJ LQGLFDWHV WKDW WKH PDQDJHU ZLOO QRW UDLVH LQWHULP ILQDQFLQJ IURP WKH PDUNHW LI /(>5EV_ f@ &RQVLGHU QRZ WKH FDVH ZKHQ ::f@AArf f 6LQFH (H>5EVf@/ LI WKH QHJRWLDWLRQ EUHDNV GRZQ WKH EDQN ZLOO QRW IRUJLYH WKH W O UHSD\PHQW ZKHQ LW LV XQLQIRUPHG +RZHYHU LQ WKH LQWHULP HTXLOLEULXP LQGXFHG E\ WKH RSWLPDO EDQN GHEW FODLP WKH ILUP ZLOO QRW UDLVH ILQDQFLQJ IURP WKH PDUNHW 7R VHH WKLV QRWLFH WKDW DQ LQFUHDVH LQ WKH EDQNf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fV RIIHU DQG RIIHU D W UHSD\PHQW RI ]HUR 7KLV FDQ EH HDVLO\ HQVXUHG E\ VHWWLQJ D VXIILFLHQWO\ ODUJH W O UHSD\PHQW VHQLRU

PAGE 89

WKH PDUNHW 7KH SURMHFW LV WKHQ FRQWLQXHG WKURXJK QHJRWLDWLRQ %HIRUH GHVFULELQJ WKH RSWLPDO EDQN GHEW ZH H[SODLQ ILJXUH ,Q WKH ILJXUH VX LV WKH SURPLVHG W UHSD\PHQW ZKLFK UHWXUQV WKH EDQN ZKHQ LW LV XQLQIRUPHG DQ H[SHFWHG SD\RII HTXDO WR WKH OLTXLGDWLRQ YDOXH RI WKH DVVHWV / ,I WKH ILUPfV SURPLVHG W UHSD\PHQW H[FHHGV V WKH XQLQIRUPHG EDQN ZLOO IRUJLYH WKH W O UHSD\PHQW LI UHQHJRWLDWLRQ EUHDNV GRZQ 2WKHUZLVH LW ZLOO FKRRVH WR OLTXLGDWH WKH SURMHFW 6LPLODU LQWHUSUHWDWLRQ DSSOLHV WR V+ ZKHQ WKH EDQN LV LQIRUPHG RI WKH IDYRUDEOH VWDWH 6LQFH VX$f!VX WKH XQLQIRUPHG EDQN ZLOO IRUJLYH WKH W O UHSD\PHQW LI WKH SURPLVHG W UHSD\PHQW LV HTXDO WR VX$f 7KH H[SHFWHG SD\RII LW ZLOO UHFHLYH LV WKH VDPH DV WKDW ZKHQ WKH SURMHFW LV FRQWLQXHG WKURXJK UHQHJRWLDWLRQ 6LPLODU LQWHUSUHWDWLRQ DSSOLHV WR V+$f ZKHQ WKH EDQN LV LQIRUPHG RI WKH VWDWH + )URP WKH ILJXUH LW LV FOHDU WKDW VXN Of VX DQG V+$ Of V+ &RQVLGHU ILUVW WKH FDVH ZKHQ WKH PDQDJHU KDV ODUJH EDUJDLQLQJ SRZHU VR WKDW $!$r DQG ILQDQFLQJ E\ VKRUWWHUP EDQN GHEW LV LQIHDVLEOH :H GHQRWH WKH EDQNfV H[SHFWHG SD\RII LQ VWDWH IURP D SURPLVHG W UHSD\PHQW [ DV 5[_ kKf $V ZLOO VRRQ EHFRPH FOHDU ZH RQO\ QHHG WR IRFXV RQ VWUXFWXUHV LQ ZKLFK /5EV_+f ZKHUH 6M LV WKH ILUPfV SURPLVHG W UHSD\PHQW LQ WKH LQLWLDO FRQWUDFW 7KH IROORZLQJ SURSRVLWLRQ FKDUDFWHUL]HV WKH RSWLPDO EDQN GHEW ZKHQ WKH ILUP FRPPDQGV ODUJH EDUJDLQLQJ SRZHU 3URSRVLWLRQ Lf,I LQ WKH RSWLPDO EDQN GHEW V!VX WKHQ VA; DQG WKH W EDQNfV H[SHFWHG SD\RII LV 3Er$ f ZKHUH 3Er$f LV GHILQHG LQ f LLf,I LQ WKH RSWLPDO EDQN GHEW V+$fVVX WKHQ WKH W EDQNfV H[SHFWHG SD\RII DQG PRQLWRULQJ HIIRUW DUH rOOf>6-LHf@WH}f},f>cO,_Hcfrf@WUW-ff f

PAGE 90

GAH6Uff $ YL Lf>L"r DHVf f $Vf LV FRQWLQXRXV DQG VWULFWO\ LQFUHDVLQJ LQ V ZLWK $V V+$ff )URP ILJ LI V!VX WKH EDQN ZLOO IRUJLYH WKH W O UHSD\PHQW ERWK ZKHQ LW LV LQIRUPHG RI WKH IDYRUDEOH VWDWH DQG ZKHQ LW LV XQLQIRUPHG 7KHUHIRUH LWV H[SHFWHG SD\RII LQ FRQWLQXDWLRQ LV FRPSOHWHO\ VSHFLILHG E\ WKH LQLWLDO FRQWUDFW &OHDUO\ WKH EDQNfV W H[SHFWHG SD\RII LV LQFUHDVLQJ LQ V ,WV PRQLWRULQJ HIIRUW KRZHYHU LV GHFUHDVLQJ LQ b 7KLV IROORZV EHFDXVH WKH EDQNfV SD\RII LQ FRQWLQXDWLRQ LV LQGHSHQGHQW RI LWV LQIRUPDWLRQ ZKHQ WKH IDYRUDEOH VWDWH LV UHDOL]HG ,Q WKH XQIDYRUDEOH VWDWH WKH EDQNfV ORVV RI SURILW IURP DOORZLQJ WKH SURMHFW WR FRQWLQXH GHFUHDVHV ZLWK V 7KXV WKH EHQHILW IURP WLPHO\ OLTXLGDWLRQ GLPLQLVKHV DQG WKH EDQNfV PRQLWRULQJ HIIRUW GHFUHDVHV DV V LQFUHDVHV 6LQFH WKH PDQDJHU GHVLUHV WR PLQLPL]H PRQLWRULQJ DV ORQJ DV KH FDQ UDLVH LQLWLDO ILQDQFLQJ KH FKRRVHV WR VHW V DW LWV PD[LPXP ,Q WKLV FDVH WKH EDQN DFTXLUHV DOO WKH FDVK IORZ IURP WKH SURMHFW ZKHQ LW LV FRQWLQXHG &RPSDULQJ ZLWK WKH FDVH RI VKRUWWHUP GHEW FODLP WKH EDQN LV HIIHFWLYHO\ DVVXPLQJ IXOO LQWHULP EDUJDLQLQJ SRZHU DQG LQLWLDO ILQDQFLQJ EHFRPHV IHDVLEOH 'HEW FODLP GHVFULEHG LQ SDUW LLf RI SURSRVLWLRQ EHFRPHV RSWLPDO ZKHQ V+$fVX DQG $ LV MXVW DERYH $r 8QGHU WKHVH FRQGLWLRQV WKH EDQNfV W H[SHFWHG SD\RII IURP D VKRUWn WHUP FODLP LV MXVW EHORZ WKH UHTXLUHG LQLWLDO LQYHVWPHQW 7KXV ZLWK D VOLJKW LQFUHDVH LQ WKH EDQNfV H[SHFWHG SD\RII LQLWLDO ILQDQFLQJ EHFRPHV IHDVLEOH ,I V+$fVX WKH ILUP FDQ LQFUHDVH WKH EDQNfV H[SHFWHG SD\RII E\ SURPLVLQJ D W UHSD\PHQW V VR WKDW V+$fVVX )URP ILJ FRPSDULQJ ZLWK WKH VKRUWWHUP FODLP WKLV FRQWUDFW UHWXUQV WKH EDQN D KLJKHU SD\RII ZKHQ LW LV LQIRUPHG RI VWDWH + :KHQ WKH EDQN LV XQLQIRUPHG LW UHWXUQV WKH EDQN WKH VDPH SD\RII %\ FRQWLQXRXVO\ LQFUHDVLQJ V RYHU WKH LQWHUYDO >V+$fVXf

PAGE 91

ERWK WKH EDQNfV W H[SHFWHG SD\RII DQG LWV PRQLWRULQJ HIIRUW DUH FRQWLQXRXVO\ LQFUHDVHG :KHQ LQLWLDO ILQDQFLQJ RQO\ UHTXLUHV D VPDOO LQFUHDVH LQ WKH EDQNfV W H[SHFWHG SD\RII WKH FRQWUDFW LQ SDUW LLf RI SURSRVLWLRQ EHFRPHV RSWLPDO EHFDXVH ZKLOH HQVXULQJ LQLWLDO ILQDQFLQJ LW UHGXFHV WKH DPRXQW RI PRQLWRULQJ &RQVLGHU QH[W WKH FDVH ZKHQ WKH EDQN KDV ODUJH EDUJDLQLQJ SRZHU VR WKDW ;;r ,Q WKLV FDVH ILQDQFLQJ E\ VKRUWWHUP EDQN GHEW LV XQGHVLUDEOH EHFDXVH RI WKH EDQNfV RYHUVXSSO\ RI PRQLWRULQJ 7KH IROORZLQJ SURSRVLWLRQ FKDUDFWHUL]HV WKH RSWLPDO EDQN GHEW FODLP 3URSRVLWLRQ :LWK WKH RSWLPDO GHEW FODLP WKH EDQNfV W H[SHFWHG SD\RII HTXDOV WKH LQLWLDO LQYHVWPHQW $W LQWHULP ZKHQ WKH EDQN LV XQLQIRUPHG LWV SD\RII LV WKH VDPH DV WKDW ZLWK VKRUWWHUP FODLP 7KLV RXWFRPH FDQ EH LPSOHPHQWHG E\ D UHSD\PHQW VFKHGXOH LQ ZKLFK WKH W O SURPLVHG UHSD\PHQW LV VHQLRU DQG WKH W UHSD\PHQW LV DUELWUDULO\ VPDOO ,Q WKH LQWHULP HTXLOLEULXP LQGXFHG E\ WKLV VWUXFWXUH WKH ILUP VHHNV ILQDQFLQJ IURP WKH LQWHULP PDUNHW RQO\ ZKHQ WKH EDQN LV LQIRUPHG RI WKH VWDWH + )RUP SDUW LLf RI OHPPD WKH ILUP FDQ QRW LQFUHDVH WKH WRWDO VXUSOXV IRU WKH EDQN DQG LWVHOI E\ UDLVLQJ ILQDQFLQJ IURP WKH LQWHULP PDUNHW EHFDXVH WKH ILUP LV IDLUO\ SULFHG E\ WKH PDUNHW ,W IROORZV WKDW LQGHSHQGHQW RI ZKHWKHU WKH ILUP UDLVHV ILQDQFLQJ IURP WKH PDUNHW RU QRW WKH XQLQIRUPHG EDQNfV SD\RII FDQ QRW H[FHHG WKDW ZLWK VKRUWWHUP FODLP 7R LQGXFH WKH GHVLUHG OHYHO RI PRQLWRULQJ WKH ILUP PXVW UHGXFH WKH EDQNfV SD\RII ZKHQ LW LV LQIRUPHG RI WKH IDYRUDEOH VWDWH 7KLV DV LV LQGLFDWHG E\ SURSRVLWLRQ FDQ EH LPSOHPHQWHG E\ D VHQLRU DQG fDOPRVWf VKRUWWHUP EDQN GHEW FODLP $V LV VKRZQ LQ WKH DSSHQGL[ LQ WKH LQWHULP HTXLOLEULXP WKH ILUP UDLVHV ILQDQFLQJ IURP WKH PDUNHW ZKHQ WKH EDQN LV LQIRUPHG RI WKH IDYRUDEOH VWDWH VR WKDW DIWHU WKH UHSD\PHQW WKH EDQN LV MXVW LQGLIIHUHQW EHWZHHQ OLTXLGDWLQJ WKH ILUP DQG IRUJLYLQJ

PAGE 92

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f RI SURSRVLWLRQ ERWK WKH EDQNfV SD\RII ZKHQ LW LV XQLQIRUPHG DQG LWV PDUJLQDO EHQHILW IURP PRQLWRULQJ 5M DUH PD[LPL]HG 7KHUHIRUH WKH UHTXLUHG OHYHO RI PRQLWRULQJ IRU LQLWLDO ILQDQFLQJ LV PLQLPL]HG +RZHYHU WKH ILUP FDQ QRW IXUWKHU DGMXVW WKH OHYHO RI PRQLWRULQJ LQGXFHG DQG WKHUH LV DQ RYHU VXSSO\ RI PRQLWRULQJ HIIRUW ,Q WKH VHFRQG LQVWDQFH DV LQGLFDWHG LQ SDUW LLf RI SURSRVLWLRQ DQG SURSRVLWLRQ WKH ILUP FDQ DGMXVW WKH OHYHO RI PRQLWRULQJ VXSSOLHG EXW QHLWKHU 5X QRU + LV PD[LPL]HG &RQVHTXHQWO\ WKH DPRXQW RI PRQLWRULQJ UHTXLUHG E\ LQLWLDO ILQDQFLQJ LV QRW PLQLPL]HG 7KXV LI WKH ILUP UDLVHV LQLWLDO ILQDQFLQJ E\ RQO\ ERUURZLQJ IURP D EDQN LW FDQ QRW VLPXOWDQHRXVO\ DFKLHYH ERWK RI LWV WZR JRDOV 7KH 2SWLPDO 0L[ 7KH DQDO\VLV LQ WKH SUHYLRXV VHFWLRQ DVVXPHV WKDW WKH PDQDJHU UDLVHV LQLWLDO ILQDQFLQJ RQO\ IURP D EDQN 5HWXUQLQJ WR WKH GLVFXVVLRQ RI WKH RSWLPDO PL[ ZH ZLOO DQDO\]H LQ WKLV VHFWLRQ WKH WZR FDVHV LQ ZKLFK WKH ILUP DFTXLUHV LQLWLDO ILQDQFLQJ E\ ERUURZLQJ LQ DGGLWLRQ WR EDQN GHEW HLWKHU VKRUWWHUP RU ORQJWHUP SXEOLF GHEW )RU HDVH RI H[SRVLWLRQ KRZHYHU ZH ZLOO DVVXPH DZD\ LQWHULP PDUNHW $ FRPSOHWH DQDO\VLV ZKLFK WDNHV LQWR FRQVLGHUDWLRQV RI WKH

PAGE 93

LQWHULP SXEOLF GHEW PDUNHW SURFHHGV LQ WKH VDPH ZD\ DV LQ WKH SUHYLRXV VHFWLRQ 0L[HG VWUXFWXUH ZLWK EDQN GHEW DQG ORQJWHUP SXEOLF GHEW 7KH ILUP UDLVHV LQLWLDO ILQDQFLQJ E\ ERUURZLQJ IURP D EDQN DQG SXEOLF OHQGHUV ,Q UHWXUQ LW SURPLVHV WKH EDQN D UHSD\PHQW V! DW W O DQG 6 DW W DQG WKH SXEOLF OHQGHUV D UHSD\PHQW W DW W 7KH EDQNfV DQG WKH SXEOLF OHQGHUVf SD\RII LQ VWDWH IURP WKH SURPLVHG W UHSD\PHQWV 6 DQG W DUH GHQRWHG DV 5EVWf DQG 5SVWf ,Q DGGLWLRQ WKH PL[HG VWUXFWXUH VSHFLILHV WKH EDQNfV DQG WKH SXEOLF OHQGHUVf SD\RIIV LQ OLTXLGDWLRQ :H GHQRWH WKH EDQNnV SD\RII LQ OLTXLGDWLRQ DV /E /HQJWK\ EXW VWUDLJKWIRUZDUG FDOFXODWLRQV SURYLGH WKH IROORZLQJ UHVXOW /HPPD ,Q WKH RSWLPDO PL[ /E(H>5EVW_ f@ /HPPD LPSOLHV WKDW DW LQWHULP WKH EDQN ZLOO IRUJLYH WKH W O UHSD\PHQW ERWK ZKHQ LW LV LQIRUPHG RI WKH IDYRUDEOH VWDWH DQG ZKHQ LW LV XQLQIRUPHG 7KXV WKH EDQNnV PRQLWRULQJ HIIRUW DQG WKH GHEWRUnV WRWDO W H[SHFWHG SURILW WKH EDQNnV DQG WKH SXEOLF GHEWRUVnf DUH f Hf(4>5EVW 4f5SVW f@ H>Y+5EVW4+f 5SVW G+ff YO/@L_Hff (TXDWLRQV f DQG f LPSO\ WKH IROORZLQJ )LUVW D FRPSDULVRQ EHWZHHQ f DQG f LQGLFDWHV WKDW ERWK 5c WKH FUHGLWRUVf SD\RII ZKHQ WKH EDQN LV LQIRUPHG DQFf 5 WKH FUHGLWRUVf SD\RII ZKHQ WKH EDQN LV XQLQIRUPHG GHSHQG RQO\ RQ WKH VXP VW 6HFRQG WKH GHEWRUVf PDUJLQDO EHQHILW IURP WLPHO\ OLTXLGDWLRQ RU IURP PRQLWRULQJ FDQ EH ZULWWHQ DV $JDLQ WKHVH SD\RIIV LQFRUSRUDWH DQ\ FRQWUDFWXDO VSHFLILFDWLRQV ZKLFK PD\ DIIHFW WKHP LQFOXGLQJ IRU H[DPSOH WKH UHODWLYH VHQLRULW\ EHWZHHQ WKH SXEOLF DQG EDQN GHEW FODLPV

PAGE 94

Y/>/E 5EVWf@ Y/_; /E 5SVW > f@ f (TXDWLRQ f UHYHDOV WKDW LQ FRQWUDVW WR WKH FDVH ZKHQ WKH ILUP UDLVHV LQLWLDO ILQDQFLQJ RQO\ IURP D EDQN WKH GHEWRUVf WRWDO PDUJLQDO EHQHILW RI PRQLWRULQJ LV QR ORQJHU WKH VDPH DV WKH EDQNfV PDUJLQDO EHQHILW IURP PRQLWRULQJ 7KH SXEOLF GHEW FODLP EUHDNV WKLV OLQNDJH DOORZLQJ WKH PDQDJHU WR VHSDUDWH WKH WDVNV RI PD[LPL]LQJ WKH OHQGHUVf WRWDO EHQHILW RI PRQLWRULQJ DQG LQGXFLQJ WKH EDQN WR VXSSO\ WKH GHVLUHG OHYHO RI PRQLWRULQJ 7R PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ WKH PDQDJHU GHVLUHV WR PD[LPL]H WKH VXP VW ,QGXFLQJ WKH GHVLUHG OHYHO RI PRQLWRULQJ UHTXLUHV WKDW WKH PDQDJHU RSWLPDOO\ GLVWULEXWH WKH EHQHILW RI PRQLWRULQJ EHWZHHQ WKH EDQN DQG WKH SXEOLF OHQGHUV 7KH QH[W SURSRVLWLRQ FKDUDFWHUL]HV WKH RSWLPDO PL[ 3URSRVLWLRQ ,Q WKH RSWLPDO PL[ LfVW ; LLf7KH EDQNfV PRQLWRULQJ HIIRUW LV Hr LLLf//E5SVW/f!2 LYf,Q WKH RSWLPDO PL[ LI WKH SD\RIIV LQ OLTXLGDWLRQ DUH GHWHUPLQHG E\ VHQLRULW\ WKHQ WKH SXEOLF GHEW FODLP W LV VHQLRU WR WKH W EDQN GHEW FODLP V 3DUW Lf DQG LLf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fV EHQHILW IURP WLPHO\ OLTXLGDWLRQ DQG WKHUHIRUH WKH PRQLWRULQJ HIIRUW VXSSOLHG 7KXV ZLWK WZR GHEW LQVWUXPHQWV

PAGE 95

WKH ILUP FDQ UHJXODWH WKH EDQNnV LQFHQWLYH WR PRQLWRU ZLWKRXW LQWHUIHULQJ LWV GHVLUH WR PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ IRU LQLWLDO ILQDQFLQJ 3DUW LLf RI SURSRVLWLRQ DVVHUWV WKDW ZKHQ WKH SURMHFW LV ILQDQFHG E\ WKH RSWLPDO PL[ WKH SXEOLF OHQGHUV EHQHILW IURP WKH EDQNnV PRQLWRULQJ 7KHUHIRUH WKHLU LQFHQWLYH RYHU PRQLWRULQJ LV DOLJQHG ZLWK WKDW RI WKH EDQNnV 7R VHH WKLV QRWLFH WKDW WKH FKDQJH LQ WKH GHEWRUVf W H[SHFWHG SD\RII XQGHU D VPDOO FKDQJH LQ WKH EDQNfV PRQLWRULQJ HIIRUW LV 6HOL9:A/f@ f ,I WKH SXEOLF OHQGHUVf PDUJLQDO EHQHILW LV QHJDWLYH WKHQ D GHFUHDVH LQ WKH EDQNfV PRQLWRULQJ HIIRUW LQFUHDVHV GHEWRUfV W H[SHFWHG SD\RII ,W IROORZV WKDW WKH ILUP LV VWULFWO\ EHWWHU RII UHGXFLQJ WKH WKH DPRXQW RI PRQLWRULQJ &RQVHTXHQWO\ DW RSWLPDO WKH SXEOLF OHQGHUVf EHQHILW RI PRQLWRULQJ PXVW EH SRVLWLYH ,Q IDFW WKH ILUP SUHIHUV WR PD[LPL]H WKH SXEOLF OHQGHUVf VKDUH RI WKH EHQHILW RI PRQLWRULQJ SURYLGHG WKH EDQN VXSSOLHV WKH OHYHO RI PRQLWRULQJ UHTXLUHG E\ LQLWLDO ILQDQFLQJ 7KLV IROORZV EHFDXVH ZKLOH DOORFDWLQJ WKH EHQHILW WR WKH EDQN FDQ HTXDOO\ LQFUHDVH WKH GHEWRUVf WRWDO EHQHILW IURP PRQLWRULQJ WKH ILUP PXVW LQFXU DQ LQFUHDVHG FRVW IURP WKH LQFUHDVHG PRQLWRULQJ E\ WKH EDQN %\ DOORFDWLQJ WKLV EHQHILW WR WKH SXEOLF OHQGHUV WKH ILUP FDQ LQFUHDVH WKH GHEWRUVf WRWDO EHQHILW RI PRQLWRULQJ ZLWKRXW LQFXUULQJ DQ\ DGGLWLRQDO FRVW 7KXV ZKHQ WKH SURMHFW LV ILQDQFHG E\ WKH RSWLPDO PL[ WKH EDQN DFWV DV D GHOHJDWHG PRQLWRU 7KH UHDVRQ IRU SDUW LLLf RI SURSRVLWLRQ LV VLPSOH /HPPD LPSOLHV WKDW WKH SURPLVHG W UHSD\PHQW WR WKH EDQN PXVW EH VWULFWO\ ODUJHU WKDQ LWV SD\RII LQ OLTXLGDWLRQ :KHQ 6M LV VHQLRU WR W WKH EDQNfV SD\RII LQ OLTXLGDWLRQ PXVW EH VWULFWO\ ODUJHU WKDQ /E LI // ,W IROORZV WKDW ZKHQ 6 LV VHQLRU WKH EDQNfV SD\RII LQ OLTXLGDWLRQ LV / 7KXV WKH EDQN DFTXLUHV DOO WKH SURFHHGV IURP OLTXLGDWLRQ DQG WKH PDQDJHU FDQ QRW RSWLPDOO\ DOORFDWH WKH PDUJLQDO

PAGE 96

EHQHILW RI PRQLWRULQJ EHWZHHQ WKH EDQN DQG SXEOLF OHQGHUV 6XFK D PL[ LV WKHUHIRUH VXERSWLPDO )LQDOO\ QRWLFH WKDW LQ RUGHU IRU WKH ILUP WR DOLJQ WKH SXEOLF OHQGHUV DQG WKH EDQNfV LQFHQWLYH RYHU PRQLWRULQJ DQG PD[LPL]H WKH GHEWRUVf WRWDO EHQHILW RI PRQLWRULQJ WKH SXEOLF GHEWRUVn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nV SD\RII LQ OLTXLGDWLRQ DV /E $W W O WKH ILUP PXVW UHQHJRWLDWH ZLWK WKH EDQN 7KH DQDO\VLV RI WKH UHQHJRWLDWLRQ LV VLPLODU WR WKDW ZKHQ WKH ILUP RQO\ ERUURZV IURP WKH EDQN 7KH RQO\ GLIIHUHQFH LV WKDW WKH EDQNnV UHVHUYDWLRQ OHYHO LV LQFUHDVHG E\ WO EHFDXVH DW LQWHULP WKH EDQN PXVW LQYHVW DQ DGGLWLRQDO WM WR ILQDQFH WKH ILUPfV UHSD\PHQW WR WKH SXEOLF GHEWRUV $ FRPSOHWH DQDO\VLV KRZHYHU LV QRW QHFHVVDU\ IRU FRPSDULQJ D PL[HG VWUXFWXUH ZLWK VKRUWWHUP SXEOLF GHEW DQG WKH RSWLPDO PL[ ZLWK ORQJWHUP SXEOLF GHEW :H ILUVW SUHVHQW WKH UHVXOW IROORZHG E\ DQ H[SODQDWLRQ 3URSRVLWLRQ $ PL[HG VWUXFWXUH ZLWK VKRUWWHUP SXEOLF GHEW LV VWULFWO\ GRPLQDWHG E\ WKH RSWLPDO PL[ ZLWK ORQJWHUP SXEOLF GHEW /LNH D ORQJWHUP GHEW FODLP D VKRUWWHUP SXEOLF GHEW FODLP DOVR DOORZV WKH ILUP WR

PAGE 97

PD[LPL]H WKH GHEWRUVf SD\RII ZKHQ WKH EDQN LV XQLQIRUPHG DQG DGMXVW WKH OHYHO RI PRQLWRULQJ LQGXFHG %\ LQFUHDVLQJ WE WKH ILUP SOHGJHV WR SD\ RXW PRUH W SURILW IURP WKH SURMHFW WR WKH EDQN 7KLV SURILW LV XOWLPDWHO\ SDLG WR WKH SXEOLF GHEWRUV ,Q DGGLWLRQ E\ JLYLQJ WKH SXEOLF GHEWRUV D VKDUH RI WKH SURFHHGV IURP OLTXLGDWLRQ WKH ILUP FDQ FRQWURO WKH EDQNfV VXSSO\ RI PRQLWRULQJ 'HVSLWH WKH VLPLODULWLHV WKHUH LV D FUXFLDO GLIIHUHQFH EHWZHHQ WKH VKRUWWHUP DQG ORQJWHUP SXEOLF GHEW FODLP 7KH SD\RII WR WKH SXEOLF GHEWRUV ZLWK ORQJWHUP FODLPV LV VWDWH FRQWLQJHQW VR WKDW WKH\ FDQ EHQHILW IURP WKH EDQNnV PRQLWRULQJ ,Q FRQWUDVW WKH SD\RII WR SXEOLF OHQGHUV ZLWK VKRUWWHUP FODLPV LV GHFLVLRQ GHSHQGHQW 7KH\ DUH IXOO\ UHSDLG ZKHQHYHU WKH SURMHFW LV FRQWLQXHG DQG WKH\ FDQ QRW EHQHILW IURP WLPHO\ OLTXLGDWLRQV 7KHUHIRUH WKH OHQGHUVn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f PDUJLQDO EHQHILW RI PRQLWRULQJ LV ]HUR

PAGE 98

6PLWK f ILQG WKDW UHJXODWLRQ LQFUHDVHV WKH SURSRUWLRQ RI WKH ORQJWHUP GHEW E\ SHUFHQWDJH SRLQWV )LUP VL]H 7KH DQDO\VLV LQ VHFWLRQ LQGLFDWHV WKDW GHEW PDWXULW\ LV LQWLPDWHO\ UHODWHG WR WKH UHODWLYH EDUJDLQLQJ SRZHU EHWZHHQ ILUPV DQG WKHLU EDQNV 2XU DQDO\VLV VXJJHVWV WKDW ILUPV ZLWK ODUJH EDUJDLQLQJ SRZHU RYHU WKHLU SULYDWH OHQGHUV PXVW UHO\ PRUH RQ ORQJWHUP ERUURZLQJ 7KLV FDQ HIIHFWLYHO\ HQKDQFH WKH EDQNnV EDUJDLQLQJ SRZHU DQG HQDEOH LQLWLDO ILQDQFLQJ 7DNLQJ ILUP VL]H DV D SUR[\ IRU ILUPVn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f LPSOLHV WKDW WKH ILUP ZLWK WKH

PAGE 99

ULVNLHU SURMHFW GHPDQGV OHVV PRQLWRULQJ EHFDXVH WKH EHQHILW RI PRQLWRULQJ LQFUHDVHV ZLWK WKH ULVNLQHVV RI WKH SURMHFW ,W IROORZV WKDW ILUPV ZLWK ULVNLHU SURMHFW ZLOO ILQDQFH WKHLU SURMHFW ZLWK OHVV EDQN GHEW DQG PRUH SXEOLF GHEW 7KLV SURYLGHV DQ H[SODQDWLRQ IRU WKH UHFHQW HPSLULFDO ILQGLQJ E\ +RXVWRQ DQG -DPHV f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fV LQFHQWLYH WR PD[LPL]H WKH YDOXH RI WKH FRQWURO ULJKWV PRWLYDWHV LW WR PRQLWRU 6HFRQG WKH QHHG WR GLYHUVLI\ D $QQfV ERUURZLQJ DULVHV ERWK ZKHQ WKH PDQDJHUfV SULYDWH UHQW LV VXIILFLHQWO\ VPDOO VR WKDW LQ WKH XQIDYRUDEOH VWDWH WKH SURMHFW FDQ DOZD\V EH OLTXLGDWHG WKURXJK UHQHJRWLDWLRQ

PAGE 100

DQG ZKHQ WKH PDQDJHUf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fV GHEW FODLP WR LQGXFH WKH PLQLPXP OHYHO RI PRQLWRULQJ 7R PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ WKH PDQDJHU GHVLUHV WR PD[LPL]H WKH FUHGLWRUV EHQHILW SHU XQLW RI PRQLWRULQJ HIIRUW 7R LQGXFH WKH GHVLUHG OHYHO RI PRQLWRULQJ WKH PDQDJHU PXVW FRQWURO WKH EDQNfV EHQHILW IURP PRQLWRULQJ ,I WKH ILUP UDLVHV LQLWLDO ILQDQFLQJ RQO\ IURP D EDQN WKHQ WKH EDQN DFTXLUHV DOO WKH EHQHILW IURP PRQLWRULQJ DQG WKH PDQDJHUfV WZR JRDOV DUH LQ FRQIOLFW ZLWK HDFK RWKHU %RUURZLQJ SXEOLF GHEW DOORZV WKH ILUP WR PLQLPL]H WKH UHTXLUHG OHYHO RI PRQLWRULQJ DQG FRQWURO WKH EDQNfV LQFHQWLYH WR PRQLWRULQJ WKURXJK RSWLPDOO\ DOORFDWLQJ WKH EHQHILW RI PRQLWRULQJ EHWZHHQ WKH EDQN DQG WKH SXEOLF OHQGHUV 7KLUG WKH QHHG WR FRQWURO WKH EDQNfV EHQHILW IURP PRQLWRULQJ UHTXLUHV WKDW WKH SXEOLF OHQGHUV EH JLYHQ D VKDUH RI WKH EHQHILW IURP PRQLWRULQJ 7KXV ZKHQ WKH SURMHFW LV ILQDQFHG E\ WKH RSWLPDO PL[ RI ORQJWHUP SXEOLF GHEW DQG EDQN GHEW WKH PDQDJHU SUHIHUV WR DOLJQ WKHLU LQFHQWLYHV RYHU PRQLWRULQJ 7KH EDQN WKXV DFWV DV D GHOHJDWHG PRQLWRU

PAGE 101

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fV LQYHVWPHQW KRUL]RQ 7KHVH LVVXHV DZDLW IXWXUH VWXGLHV

PAGE 102

)LJXUH

PAGE 103

&+$37(5 &21&/86,216 7KLV GLVVHUWDWLRQ KDV H[SORUHG WKUHH LVVXHV LQ ILQDQFLDO HFRQRPLFV DQG ODZ UDQJLQJ IURP RSWLPDO FRPSHQVDWLRQ VFKHPHV IRU LQYHVWPHQW DGYLVRUV WR ILUPfV RSWLPDO GHEW VWUXFWXUHV 7KH HPSKDVLV RI WKLV VWXG\ KDV EHHQ WR DSSO\ LQIRUPDWLRQ HFRQRPLFV WR H[DPLQH SUREOHPV WKH VROXWLRQV WR ZKLFK GHSHQG FULWLFDOO\ RQ WKH DOORFDWLRQV RI LQIRUPDWLRQ DPRQJ DJHQWV 7KH PDLQ ILQGLQJV RI WKLV VWXG\ FDQ EH VXPPDUL]HG DV IROORZV )LUVW LQ GHVLJQLQJ FRPSHQVDWLRQ VFKHPHV IRU LQYHVWPHQW DGYLVRUV VKRZ WKDW ERWK WKH DGYLVRUVf WHFKQRORJLHV RI LQIRUPDWLRQ FROOHFWLRQ DQG DJHQWVf SULRUV DUH FUXFLDO LQ GHWHUPLQLQJ WKH VWUXFWXUHV RI FRPSHQVDWLRQ VFKHPHV 7KH RSWLPDO SD\PHQW VFKHPH UHZDUGV WKH DGYLVRU PRUH ULFKO\ IRU FRUUHFWO\ SUHGLFWLQJ DQ RXWFRPH LI H[SHQGLQJ HIIRUW EHVW HQKDQFHV KLV DELOLW\ WR SUHGLFW WKDW RXWFRPH :KHQ WKH DGYLVRUn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

PAGE 104

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

PAGE 105

$33(1',; $ 3522)6 2) 7+( 0$,1 5(68(76 ,1 &+$37(5 3URRI RI 3URSRVLWLRQ 7KH SURRI RI WKH HTXLYDOHQFH EHWZHHQ >,3@ DQG >,3@ UHOLHV RQ WKH IROORZLQJ WZR REVHUYDWLRQV )LUVW WKH RQO\ GLIIHUHQFH EHWZHHQ >,3@ DQG >,3@ LV LQ UHSODFLQJ FRQVWUDLQWV f DQG f LQ >,3@ E\ FRQVWUDLQWV f DQG f LQ >,3n@ 7KXV LI LW FDQ EH VKRZQ WKDW D SD\PHQW VFKHPH VDWLVILHV f DQG f LII LW VDWLVILHV f DQG f LH f DQG f DUH HTXLYDOHQW WR f DQG f WKH HTXLYDOHQFH EHWZHHQ WKH WZR IRUPXODWLRQV LV WKHQ HVWDEOLVKHG 6HFRQG D SD\PHQW VFKHPH VDWLVILHV f DQG f LII ^[+[/f` LV D 1DVK HTXLOLEULXP VWUDWHJ\ IRU WKH DGYLVRU 7KXV LI LW FDQ EH VKRZQ WKDW D SD\PHQW VFKHPH VDWLVILHV f DQG f LII > [+[/f` LV D 1DVK HTXLOLEULXP VWUDWHJ\ IRU WKH DGYLVRU WKH HTXLYDOHQFH EHWZHHQ FRQVWUDLQWV ff DQG FRQVWUDLQWV f DQG f LV WKHQ HVWDEOLVKHG ,W WKHQ IROORZV IURP WKH ILUVW REVHUYDWLRQ >,3@ DQG >,3n@ DUH HTXLYDOHQW 7KH IROORZLQJ SURRI VKRZV WKDW D SD\PHQW VFKHPH VDWLVILHV f DQG f LII ^ [+[/f` LV D 1DVK HTXLOLEULXP 1HFHVVLW\ ,I FRPSHQVDWLRQ VFKHPH Z[Uf [H^[+[/` UH^U+U/` ` VDWLVILHV FRQVWUDLQWV f DQG f WKHQ IRU DQ\ VWUDWHJ\ >n [c;Mf` /[L[Mnf&nf 0D[D>/[L[Mnf&nf@ ,,[L[Mf,,[+[/f %\ f ,,[K[Of /[K[O_f&f 7KXV ^ [K;Of` LV D 1DVK HTXLOLEULXP VWUDWHJ\ 6XIILFLHQF\ LI ^ [+[/f` LV D 1DVK HTXLOLEULXP VWUDWHJ\ WKHQ

PAGE 106

/[K[O_nf&nf/[K[O_f&f 9n +HQFH H$UJPD[>/[+[/_nf&nf@ )XUWKHU IRU DQ\ VWUDWHJ\ ^A [[f` ;;M6;K;O/[f;M nf&nf/[K[O f&f LPSOLHV Q[[Mf 0D[H>/[[-_f&nf@/[+[/_f&f Q[+[/f ^ 2IH?f` LV WKXV D 1DVK HTXLOLEULXP VWUDWHJ\ LII WKH SD\PHQW VFKHPH VDWLVILHV FRQVWUDLQWV f DQG f ,W IROORZV IURP WKH GLVFXVVLRQ DERYH WKDW IRUPXODWLRQV >,3@ DQG > ,3n@ DUH HTXLYDOHQW 3URRI RI /HPPD 6WUDLJKWIRUZDUG f Lf 6LQFH WKH SD\PHQW VFKHPH VDWLVILHV FRQVWUDLQW f ZH KDYH Q[+[/f /[+[/_f&f Q[+[/f!,,[+[+f LPSOLHV 2WL9$Z[/U-f 9$^Z[ZU/ff@ fWW>9$^Z[+U+ff 9$Z^[fff@ &f $ f DQG Q[+[/f!Q[/[/f LPSOLHV p.+?9$^Z^[ZU+ff9$Z[/U+ff?! 4fQ/?9$Z[/U/ff9$^Z[+U/ff? &f $f $Of[OHff$f[Hf IROORZHG E\ VLPSOH UHDUUDQJHPHQW SURYLGHV A+>9$Z[+U+ff9$Z[/U+ff@Of!&f !O LPSOLHV Z[+U+f!Z/U+f 6LPLODU GHULYDWLRQ SURYLGHV Z[X[,f!Z[+[/f f LLf )RU DQ\ nH>OOf SDUW Lf LPSOLHV /[O[K_nf LV VWULFWO\ GHFUHDVLQJ LQ n DQG WKH UHVXOW IROORZV

PAGE 107

3URRI RI /HPPD ,ff%HLQJ ULVN QHXWUDO WKH LQYHVWRU ZLOO LQYHVW : LQ WKH ULVN\ DVVHW LI (>U [@ !5 DQG ]HUR DPRXQW RWKHUZLVH 6LPSOH FDOFXODWLRQ SURYLGHV WKDW (>U_[+@!5 DQG (>U_[+@5 IRU DQ\ $V ZLOO EH VKRZQ WKH HTXLOLEULXP DFFXUDF\ US! 7KXV $[Of DQG $[Kf : )ROORZLQJ *URVVPDQ DQG +DUW f WKH VROXWLRQ FDQ EH GHULYHG E\ ILUVW VROYLQJ IRU WKH RSWLPDO FRPSHQVDWLRQ VFKHPH LPSOHPHQWLQJ D JLYHQ OHYHO RI DFFXUDF\ DQG WKHQ RSWLPL]H RYHU LQ WKH VHFRQG VWHS 7KH VROXWLRQ WR WKH ILUVW VWHS ZLOO HDVLO\ IROORZ RQFH ZH HVWDEOLVK WKH IROORZLQJ WZR IDFWV )DFW /HW I[f EH D IXQFWLRQ ZLWK I[f! DQG In[f ,I DI[fODfI[f DI\fO DfI\f ZKHUH [!\!\![ DQG DHOf WKHQ D[ODf[!D\ODf\ 7R VKRZ WKLV OHW EHOf EH VXFK WKDW D[,ODf[ E\OEf\ 7KH H[LVWHQFH RI E LV REYLRXV 'HILQH WZR UDQGRP YDULDEOHV ;= ZLWK GHQVLW\ IXQFWLRQV J[; ;f DJ[; [f OD DQG J]= \Mf E J]= \f OE ; DQG = GLIIHU E\ D VLQJOH PHDQ SUHVHUYLQJ VSUHDG 036f ,W IROORZV WKDW DI[fODfI[fEI\,fOEfI\f 5RWKVFKLOG DQG 6WLJOLW] ff 7KXV E!D DQG D[ODf[ E\OEf\!D\ODf\ )DFW OLPH&nf rr 7KLV LV VKRZQ DV IROORZV LI OLPHBf&Hf LV ILQLWH WKHQ S VXSH&Hf LV ILQLWH 7KXV IRU 9H! H VW &Hf!SH 6LQFH &Hf LV VWULFWO\ FRQYH[ WKXV &;HA&;Hf !HHf&nHf IRU 9Hc!H &KRRVH HM VW HH H&nHf 7KHQ &IR f!&HfH!S ZKLFK IRUPV D FRQWUDGLFWLRQ 7KXV OLPHBf&Hf OLPH-O&f } 8VH RI VWULFW FRQYH[LW\ LPSOLHV &nf

PAGE 108

OLPH&f a 7KH RSWLPL]DWLRQ SUREOHP FRUUHVSRQGLQJ WR WKH ILUVW VWHS LV WKH IROORZLQJ 0LQZf([eZ[Uf _@ VW f§/9_f &f G4 Z[Uf! [HEFAUH^U/U+f :H KDYH UHSODFHG FRQVWUDLQW f LQ WKH UHGXFHG SUREOHP E\ LWV ILUVW RUGHU FRQGLWLRQ DQG KDYH GURSSHG WKH LQGLYLGXDO UDWLRQDOLW\ FRQVWUDLQW 7KH YDOLGLW\ IROORZV IURP WKH FRQFDYLW\ RI /[K[O_f&f DQG WKDW WKH OLPLWHG OLDELOLW\ FRQVWUDLQW JXDUDQWHHV LQGLYLGXDO UDWLRQDOLW\ EH VDWLVILHG 6LQFH (U>Z[+Uf_@ >L+Z[+U+fW/Z[/U/f@Of>W+Z[/U+f7W/Z[+U/f@ DQG /[K[O_ f >b9$Z[+U+ffL/9$Z[/U2f+7&+9$Z[/U+ffL/9$Z[+U/ff GY ,W IROORZV IURP IDFW IRU JLYHQ W+9$Z[+U+ff7&/9$Z[/U/f WFKZ[K U+fUW/Z[/U/f LV PLQLPL]HG DW Z[+U+ff Z[/U/f 6LPLODUO\ 7W+Z[/U+fL/Z[+U/f LV PLQLPL]HG DW Z[/U+f Z[+U/f IRU D JLYHQ 7U+9$Z[/U+ffW/9$Z[+U/ff 7KXV DW RSWLPDO (U>Z[Uf_@ Z[+U+fOfZ[+U/f /[K[O_ f 9$Z[+U+ff9$Z[+U/ff &nf G 7KH OLPLWHG OLDELOLW\ FRQVWUDLQW IRU Z[+U/f PXVW ELQG ,I RWKHUZLVH D VLPXOWDQHRXV GHFUHDVH LQ Z[+U+f DQG Z[+U/f ZKLOH OHDYLQJ 9$Z[+U+ff9$Z[+U/ff XQFKDQJHG ZLOO UHVXOW LQ D GHFUHDVH LQ (U>Z[Uf @ :H FRQFOXGH WKDW WKH RSWLPDO FRPSHQVDWLRQ VFKHPH

PAGE 109

LPSOHPHQWLQJ D JLYHQ G!9 PXVW EH VXFK WKDW Z[+U+ff Z[/U,f K&ff DQG Z[/U+f Z[+U/f LLf ,Q WKH VHFRQG VWHS WKH LQYHVWRU RSWLPL]H RYHU XVLQJ WKH SD\PHQW VFKHPH GHULYHG LQ VWHS RQH LH 0D[>f>SK&ff@ )DFW LPSOLHV LQ RSWLPL]LQJ RYHU ZH FDQ UHVWULFW WKH UDQJH RI WR >0@ 0 7KH H[LVWHQFH RI 53 IROORZV IURP WKH FRQWLQXLW\ RI >Sa K&nff@ LQ 7KH ILUVW RUGHU GHULYDWLYH RI >3K&nff@ ZLWK UHVSHFW WR LV VWULFWO\ SRVLWLYH DW 7KLV LPSOLHV A 7R VKRZ 53 A QRWLFH & f 2 DQG &f!2 LPSO\ &f f& f&nf &n f 2 DQG &f!2 LPSO\ &nf f&f&f 7KXV AOGK& nff@ K& ff&f] n^& ff!>L&ff@ GY GR 5HFDOO 53 DQG )% VDWLVI\ A>mDff@WHU 3 A>n!&Hff@_HL!A>$Dff@OHHf 7KH PRQRWRQLFLW\ RI K&ff LQ LPSOLHV USIE 3URRI RI /HPPD )URP OHPPD WKH RSWLPL]DWLRQ SUREOHP FDQ EH VLPSOLILHG DV IROORZV 0QZYf^ >Q+Z[+U+fQ/K @` L Z[fUfffH>O f& f &f& nf &f@ n$W Z[Uf 9 [U ,Q WKLV FDVH QR FRQWUDFWLQJ RFFXUV

PAGE 110

‘.O9$Z[/U>ff &4f7L+9$Z[+U+ff ,W FDQ EH HDVLO\ YHULILHG WKDW WKH REMHFWLYH IXQFWLRQ LQ WKH VLPSOLILHG SUREOHP LV VWULFWO\ FRQYH[ 7KH VWULFW FRQYH[LW\ RI &f LPSOLHV WKH FORVHG LQWHUYDO FRQVWUDLQLQJ A+9$Z[+U+ff LV QRQHPSW\ 7KH FRQWLQXLW\ RI WKH REMHFWLYH IXQFWLRQ LQ Z[+U+f DQG WKH FRQWLQXLW\ RI K LPSOLHV WKH VROXWLRQ WR WKH UHGXFHG SUREOHP H[LVWV 6WUDLJKWIRUZDUG FDOFXODWLRQ LQGLFDWHV WKH ILUVW RUGHU GHULYDWLYH HYDOXDWHG DW WKH ULJKW HQG RI WKH LQWHUYDO LV VWULFWO\ QHJDWLYH LI DQG RQO\ LI r+ 6WULFW FRQYH[LW\ RI WKH REMHFWLYH IXQFWLRQ LPSOLHV WKDW WKH FRQVWUDLQWV DUH QRW ELQGLQJ DQG WKH ILUVW RUGHU FRQGLWLRQ LV VXIILFLHQW LI !r+ 7KH ILUVW RUGHU FRQGLWLRQ SURYLGHV Z[+U+ff Z[/U/f K&nff 6WULFW FRQYH[LW\ DOVR LPSOLHV WKH REMHFWLYH IXQFWLRQ UHDFKHV PLQLPXP DW Q+9$Z[+U+ff &nf&f ZKHQ r+ 3URRI RI 3URSRVLWLRQ ,I 53!r+ WKHQ 3+ /HPPD LPSOLHV WKDW WKH REMHFWLYH IXQFWLRQ LV >3 K&ff@ IRU !r+ DQG LV ^3>nQ+KDf7F+fKDf78/f7&/@` IRU r+ 7KH VWULFW FRQYH[LW\ RI K LPSOLHV 7&+KDf.+fKDf7L/fL/!K&ff ,W IROORZV 0D[>,A@>3aAf§f9rf§f@ A[HH>B/f>SA&ff@ f 7LII 7O/ f 0D[4H.Of>A4K^&?P 7KXV VE pUS ,I rK!US OHPPD LQGLFDWHV WKDW WKH REMHFWLYH IXQFWLRQ LV >3K&nffO LI ] f D"f Q !r+ DQG LV >S]f§f.+./K^Af§ff@ IRUr+ >SK&ff@ LV VWULFWO\ 78 U W 7& -

PAGE 111

FRQFDYH LQ 53r+ LPSOLHV f§ >S]&ff@_H HR2 2Q WKH RWKHU KDQG G4 + Df Df >SIFf§f.+./K-f§0H r >SIF&nff@_H HR >30&ff@ IRU DQ\ !r+ 7KXV 6% PXVW EH WKH VROXWLRQ WR WKH SUREOHP f B mf Df 0D[ [ R > 44KAf§f.+Q/KAf§ff@ fZf .+ Q/ )XUWKHUPRUH WKH ILUVW RUGHU GHULYDWLYHV RI WKH REMHFWLYH IXQFWLRQ HYDOXDWHG DW DQG r+ DUH VWULFWO\ SRVLWLYH DQG QHJDWLYH UHVSHFWLYHO\ 7KXV 6%r+ 3URRI RI 3URSRVLWLRQ ,I r+ LV VPDOOHU WKDQ WKHQ ERWK RI RSWLPL]DWLRQ SUREOHPV LQ SURSRVLWLRQ LQYROYHV RSWLPL]LQJ FRQWLQXRXV IXQFWLRQV RYHU FRPSDFW VHWV 7KH VROXWLRQ VSDFHV RI WKH WZR SUREOHPV DUH WKXV FRPSDFW VXEVHWV RI UHDO OLQH DQG D PD[LPXP H[LVWV LQ HLWKHU FDVH ,I HLWKHU r+ LV WKHQ IDFW LQ WKH SURRI RI OHPPD FDQ EH XVHG WR UHVWULFW WKH UDQJH RI WR D FRPSDFW VHW LQ WKH RSWLPL]DWLRQ SUREOHP SURSRVLWLRQ 7KH SUHYLRXV DUJXPHQW FDQ DJDLQ EH DSSOLHG WR \LHOG D FRPSDFW VROXWLRQ VSDFH ZKLFK FRQWDLQV D PD[LPXP 3URRI RI 3URSRVLWLRQ Lf7KLV IROORZV GLUHFWO\ IURP SDUW Lf RI SURSRVLWLRQ LLf,I 5Sr+ DQG VEWWK WKH QHFHVVDU\ FRQGLWLRQ IRU 6% WR EH WKH RSWLPDO DFFXUDF\ OHYHO ,I +r WKH UDQJH RI WKH LV RSHQ RQ WKH ULJKW ,Q WKLV FDVH IDFW LQ WKH SURRI RI OHPPD FDQ EH XVHG WR VKRZ WKH H[LVWHQFH RI WKH VROXWLRQ

PAGE 112

LV Q G PU DLf DfQOO 3 f§ >QfK fQ/K f@`_H G4 7 + 7OU n6% 7KH VWULFW FRQYH[LW\ RI K LPSOLHV IOf D4f >fmrf§,RH !K& ff + 7KH FRQGLWLRQ K f! LPSOLHV DfYL LDDOf PIOf fAf§0OHHAFnAnFHALDHf nr r f§ f§ f§ G4 Q + ‘. + ,U 6% !&fKn&nf L H HF 7KH VHFRQG LQHTXDOLW\ IROORZV IURP WKH DVVXPSWLRQ 6%W+ 7KXV &nffOHO 3 f§,%8WV$If§f@f_HH !UnnFnff G4 G4 7 + G4 6LQFH f§]& ff LV VWULFWO\ LQFUHDVLQJ LQ ZH FRQFOXGH 6%53 G4 3URRI RI 3URSRVLWLRQ ,f6LQFH WKH H[SHFWHG WRWDO SD\RII IURP WKH LQYHVWPHQW LV LQFUHDVLQJ LQ DQG WKDW WKH DJHQW GRHV QRW HDUQ DQ\ UHQWV XQGHU WKH ILUVW EHVW VROXWLRQ /HPPD LPSOLHV 3)%!353 7R FRPSDUH 36% ZLWK 353 ZH FRQVLGHU WKH IROORZLQJ WKUHH FDVHV &DVH 53!r+ 3URSRVLWLRQ LPSOLHV 36% 353 &DVH r+!53 7KH SURILW IRU WKH LQYHVWRU LV

PAGE 113

Df Df 3WALf§fLAAff@_H HV%>S0DfDff@ + 8 U >S H4KFnP@? 6% :KHQ WKH VLJQDO LV REVHUYDEOH WKH LQYHVWRU GHULYHV D SURILW >S]&ff@_H HA 6LQFH 53 VROYHV $IIOXF4WS22LL&A2ff@ ZH KDYH >S22A&nL2IIOOHA !P4K&nPf?H GV% 7KH LQYHVWRU GHULYHV D VWULFWO\ VPDOOHU SURILW LQ WKH VHFRQG EHVW FDVH WKDQ WKDW LQ WKH UHGXFHG SUREOHP LH 36%353 LLf)RU IL[HG S GHILQH bF E\ > f§ LX ZKHUH 53 LV WKH RSWLPDO DFFXUDF\ OHYHO A53 LQ WKH UHGXFHG SUREOHP )ROORZLQJ 3URSRVLWLRQ WKH LQYHVWRUnV SURILW LV D FRQVWDQW 3V IRU L+W+F LH r+53 )RU LK!WLKF WKH RSWLPDO SD\PHQW VFKHPH LV JLYHQ E\ 3URSRVLWLRQ Df Df /HW VQ+f 3k>UFAL fL/K f@ WKHQ WKH LQYHVWRUnV SURILW LV WKH IROORZLQJ + H[SUHVVLRQ ZKHUH KrWWKf LV GHILQHG DV LQ 'HILQLWLRQ &RQVLGHU WZR SULRUV WFK DQG WFK VXFK WKDW L +FL A K %\ GHILQLWLRQ ERLKfERWFKf )XUWKHU LW LV HDVLO\ VHHQ WKDW V2AfAkAf 9KrWLKf 7KXV LI 3DU+f!3DU+f WKHQ VWWKf PXVW EH PD[LPL]HG DW VRPH SRLQW AXFK WKDW +R7+fA+2WW+f 6LQFH 53+rQ+f LW IROORZV WKDW f§MWAf_ H 7KXV -IL : +!

PAGE 114

+RW+f 1RZ GHILQH SULRU WWK E\ %BDHL@ &nf B ,W IROORZV WKDW 6LQFH V7L+f 3D7U+f DQG 3DW+f!V7W+f ZH KDYH 3DL+f!3DW+f!3D9f :H FDQ FRQWLQXH WR DSSO\ WKH SURFHGXUH DQG FRQVWUXFW WKH VHTXHQFH ^7+Q Q rr` ZLWK 7LQrWU+QWW+Q 7KXV WKH VHTXHQFH PXVW FRQYHUJH WR L+n!L+? )URP WKH SURFHGXUH RI FRQVWUXFWLQJ WKH VHTXHQFH 3DL+Qf V+RL+Qf77+Qf )URP 'HILQLWLRQ KrWXKf LV FRQWLQXRXV LQ UW+ 7KH FRQWLQXLW\ RI WKH IXQFWLRQ VQ+f LPSOLHV WKDW OLPQB3DL+Qf V+r9:f 6LQFH LW IROORZV WKDW KrWLKf!US ,W IROORZV IURP WKLV LQHTXDOLW\ WKDW 3WWKnf! /HW V&4Af EH PD[LPL]HG DW 2 LH 3D7+nf VRL+nf 7KHQ 3DL+nf! 3DW+Qff!VRL+Qff LPSOLHV OLPQB-3DL+Qff 3D7+nf 7KLV WKHQ IRUPV D FRQWUDGLFWLRQ 7KXV ZH FRQFOXGH WKDW 3DL+f3DL+f

PAGE 115

$33(1',; % 3522)6 2) 7+( 0$,1 5(68/76 ,1 &+$37(5 3URRI RI 3URSRVLWLRQ 7KH DVVXPSWLRQV RQ 3 THVf DQG RQ & Tf DQG' Hf VXIILFH WR LQVXUH 8THVfLV VWULFWO\ FRQFDYH LQ T DQG ,, THVf LV VWULFWO\ FRQFDYH LQ H ,I ZH IXUWKHU UHTXLUH WKDW TH S m WKHQ E\ 7KHRUHP RI )ULHGPDQ f D SXUH VWUDWHJ\ 1DVK HTXLOLEULXP H[LVWV 7KH FRQGLWLRQV RQ 3THVf &Tf DQG 'LHf IXUWKHU LQVXUH WKDW WKH 1DVK HTXLOLEULXP LV LQWHULRU ZLWK HT f DQG WKDW LW LV FKDUDFWHUL]HG E\ WKH ILUVW RUGHU FRQGLWLRQV f DQG f LQ WKH WH[W )LQDOO\ XQLTXHQHVV RI HTXLOLEULXP IROORZV E\ YHULI\LQJ WKDW WKH UHDFWLRQ IXQFWLRQ RI WKH SDUW\ DQG RI WKH HQIRUFHU DUH FRQWLQXRXV DQG KDYH VORSHV RI RSSRVLWH VLJQV LQGLFDWLQJ D XQLTXH HTXLOLEULXP DW WKH VLQJOH SRLQW RI LQWHUVHFWLRQ 3URRI RI 3URSRVLWLRQ 7RWDOO\ GLIIHUHQWLDWLQJ HTV f DQG f LQ WKH WH[W ZLWK UHVSHFW WR V \LHOGV WKH IROORZLQJ 3 F 3 f TH GTGV 3 f TV 3 9 H 3 HH HHf Y GHOGV 3 ? HV&UDPHUfV UXOH DSSOLHG WR &Of LPSOLHV

PAGE 116

GT B 3TV 3HH AHHf 3 TH3H GV $ %f f§ A3TT &A3Jc 3Q3Y DV S GV $ TH % f ZKHUH $ 3TT &TTf 3HH 'HHf 3TH 7KH VLJQ RI GTGV IROORZV LPPHGLDWHO\ IURP RXU DVVXPSWLRQV DERXW 3 DQG 7R YHULI\ WKH VLJQ RI GHGV UHZULWH %f VR WKDW GH >3VH 3 ` TV A &rf 3TH GV K 3 & f Y TT TTn $ cGT GTHVfVf 3TT &TTf 3TH >6n c GV $ GH An ,, %f A DV 3 A !f 3 TH VH E\ $VVXPSWLRQ 3URRI RI 3URSRVLWLRQ 7KH RSWLPDO VWDQGDUG "VDWLVILHV a % & ff§ f§ GV T GV H GV %f 6ROYLQJ IRU % &Tf IURP %f \LHOGV

PAGE 117

% & f§ H GV GT GV ,W IROORZV IURP %f DQG 3URSRVLWLRQ WKDW %f &M DV f§ GV. 3f VH %f )LQDOO\ VLQFH &TT DQG T LV LQFUHDVLQJ LQ LW IROORZV IURP %f WKDW Va V r DV 3VH %f 3URRI RI 3URSRVLWLRQ )LUVW ZH SURYLGH QHFHVVDU\ DQG VXIILFLHQW FRQGLWLRQV IRU VDWLVI\LQJ WKH FRQGLWLRQV Lf DQG LLf RI >*3$@ LQ WKH WH[W $SSO\LQJ URXWLQH DUJXPHQWV VHH *XHVQHULH DQG /DIIRQW ff RQH FDQ UHDGLO\ VKRZ WKDW WKH VFKHGXOHV ^ f f` DUH GLIIHUHQWLDEOH DOPRVW HYHU\ZKHUH DQG WKDW WKH HIIRUW OHYHO LQGXFHG Hf f PXVW EH QRQLQFUHDVLQJ LQ n ZKHUH n )XUWKHU Qnf Q n Df A r Qn_f EVf m Q4 FMfff ZKHUH WKH VHFRQG OLQH RI %f IROORZV IURP WKH (QYHORSH 7KHRUHP 6LQFH f LV GHFUHDVLQJ SDUW Lf LV LQVXUHG SURYLGHG ,, f %,2f

PAGE 118

,OO &RPELQLQJ %f %f SDUWV Lf DQG LLf RI >*3$@ DUH VDWLVILHG SURYLGHG H Qf I 'T HV4f4f4fG4 %OOf 6XEVWLWXWLQJ IRU ,, fIURP & f LQWR >*3$@ LQWHJUDWLQJ E\ SDUWV DQG UHDUUDQJLQJ WHUPV \LHOGV PD[ ef eVff PD[eH c%ff &"ff 'Hff $f =! Hfff f f O $fZKHUHZH KDYH GHOHWHG WKH DUJXPHQWV RI Tf DQG Hf IRU QRWDWLRQDO FRQYHQLHQFH 5HZULWLQJ 9 Vff LQ WHUPV RI )ff % ff & fff Hff DQG UHFRJQL]LQJ WKDW =fLV LPSOLFLWO\ D IXQFWLRQ RI f DQG ZH KDYH 9 Vff 9 Lff ;f 'f Vff A %f f $VVXPLQJ D VHSDUDWLQJ VROXWLRQ WR >*3$@ /HW f DUJPD[ 9 ff Vf f DUJPD[ 9 f f rf 7KHQ HPSOR\LQJ VWDQGDUG UHYHDOHG SUHIHUHQFH DUJXPHQWV IRU DOO H >@ 9 ff )Vff % f 9 Mff D 9 Iff %f ZLWK VWULFW LQHTXDOLW\ IRU $GGLQJ % f DQG %f DQG VLPSOLI\LQJ \LHOGV

PAGE 119

;f>'HVf4f =fHff@ r 7KLV LPSOLHV VLQFH ; WKDW %f If DV G GV4f 'T ff %$*f %XW G GVGf 'fV ff 'f GH GV V % f ZKHUH WKH VHFRQG OLQH RI % f IROORZV IURP 3URSRVLWLRQ &ROOHFWLQJ % f DQG % f ZH KDYH f f r IRU 3VT %f f f r IRU 3VT % f ZLWK VWULFW LQHTXDOLW\ IRU WKXV SURYLQJ 3URSRVLWLRQ 3URRI RI 3URSRVLWLRQ 7KH VROXWLRQ WR >*33@ DV SRVHG LQ WKH WH[W LV FKDUDFWHUL]HG E\ WKH ILUVW RUGHU FRQGLWLRQV ( $ >% &"PfPf@ 0O 'n )$0ff GH GV GV %f

PAGE 120

3$f a &IR:f 'n)tfHVffHVf $ Yf %f ZKHUH %f DQG %f FRUUHVSRQG UHVSHFWLYHO\ WR WKH PD[LPL]DWLRQ RI >*33@ ZLWK UHVSHFW WR V DQG S ‘ 7KH 1DVK HTXLOLEULXP FDUH DQG HQIRUFHPHQW OHYHOV SVf DQG HVf DUH FKDUDFWHUL]HG E\ 3TT0H VfVf FJT?LVf@Lf S S %f 3H^T0HV?Vf 'n )IfH Vff )cLf %f )LUVW ZH SURYH SDUWV LLLf DQG LYf RI WKH 3URSRVLWLRQ 'LIIHUHQWLDWLQJ %f DQG %f WRWDOO\ ZUW V \LHOGV 3 TT n GT 3QH n GH 3 F Ge G6! TH G6! TV TT ? Gf S S %f ( $S ? ‹8 S A 0 HT?GVf GHA ?GV M ?aGfIA?\V? % f &RPELQLQJ %f DQG %f RQH REWDLQV GH GV $ % ZKHUH %f $ ( ? 3TAf§ O 3 A +3 & 3 > HT TT TT TH %f

PAGE 121

% ( 0 A n 3 & A 3, =9n)WILf ,W IROORZV IURP $VVXPSWLRQ DQG %f %f WKDW GH A DV 3 ? TH r GV TH TV ,Q DGGLWLRQ %f DQG %f DOVR LPSO\ WKDW A 0f GV TH f GH` ? %V 3 TV A &"f %f %f %f ZKHUH WKH LQHTXDOLW\ IROORZV IURP %f 6XEVWLWXWLQJ %f DQG %f LQWR WKH ILUVW RUGHU FRQGLWLRQ IRU V %f DOORZV RQH WR YHULI\ SDUWV LLLf DQG LYf RI 3URSRVLWLRQ 7R YHULI\ SDUW Lf QRWLFH WKDW IRU % VXIILFLHQWO\ ODUJH 9Sf LV VWULFWO\ SRVLWLYH IRU DOO S DV ERWK WHUPV &T SVf MLf DQG n‘f HVf LQ %f DUH ERXQGHG DERYH VLQFH T SVf DQG HVf DUH ERXQGHG ZKLOH WKH WHUP % T^?LVf LV DUELWUDULO\ ODUJH +HQFH S S DQG QR SDUW\ W\SHV DUH H[HPSWHG ZKHQ WKH PDUJLQDO EHQHILWV RI FDUH DUH VXIILFLHQWO\ ODUJH 7R YHULI\ SDUW LLf QRWLFH WKDW IRU D W\SH ZKLFK GHFLGHV WR H[HPSW KLPVHOI $ PLQ STHVfVf &TcLff ) %f RU $ ) 7KLV FRPSOHWHV WKH SURRI RI 3URSRVLWLRQ 3URRI RI 3URSRVLWLRQ *LYHQ V WKH ILUVW RUGHU FRQGLWLRQ IRU < LQ WKH VROXWLRQ WR WKH HQIRUFHUfV SUREOHP >(3@ VWDWHG LQ WKH WH[W LV

PAGE 122

3A2AV;H&V;Vf ')QfHffHf (3@ 7KHUHIRUH J J 5HDUUDQJLQJ %f DQG QRWLQJ WKDW LW KROGV ZLWK HTXDOLW\ \LHOGV WKH H[SUHVVLRQ DSSHDULQJ LQ 3URSRVLWLRQ )LQDOO\ WKH UHVXOW WKDW < ) IROORZV IURP QRWLQJ WKDW ) PLQ aSTHVfVf &T?Lff ) %f T IRU DOO J J 3URRI RI 3URSRVLWLRQ $FFRUGLQJ WR HT f LQ WKH WH[W G9 GHOGV GHOG) f§ DV G) GTGV GTG) UU U GHOGV c GHOG) 7KH H[SUHVVLRQV IRU DQG DUH JLYHQ E\ GTOGV GTOG) GHGD SHWf ? 3TH a SHH $"f ‘ D 6) % f GTGD S S $ I 3 3 $ f ; 3 f Y TH HH Tn 9 TH s HH ?YnD HTf ZKHUH

PAGE 123

3 $ f§ $ V SL U HT $ 3 & T TT TT %f %f ,W LV HDV\ WR GHPRQVWUDWH WKDW WKH 5+6 RI %f LV LQFUHDVLQJ LQ $D VR WKDW GHGV n GTGV GHG) GTWG) 3 ? B H \ ? Lf %f ZKHUH RQH FDQ HDVLO\ YHULI\ WKH ODVW HTXLYDOHQFH LQ %f

PAGE 124

$33(1',; & 3522)6 2) 7+( 0$,1 5(68/76 ,1 &+$37(5 3URRI RI /HPPD $VVXPLQJ WKDW WKH EDQN LV XQLQIRUPHG FRQVLGHU ILUVW WKDW WKH ILUP PDNHV RIIHUV /HW WKH HTXLOLEULXP RIIHU EH *Mf L +/ *f LV WKH RIIHU PDGH E\ WKH ILUP LQ VWDWH &RQVLGHU ILUVW VHSDUDWLQJ HTXLOLEULXPV ZLWK *+fA*/f &DVH 6 3URMHFW LV OLTXLGDWHG DW + DQG FRQWLQXHG DW / ,Q WKLV FDVH *AKf UHSUHVHQWV D W O UHSD\PHQW WR WKH EDQN DQG FRUUHVSRQGV WR D OLTXLGDWLRQ FRQWUDFW */f UHSUHVHQWV D W UHSD\PHQW WR WKH EDQN DQG LV D FRQWLQXDWLRQ FRQWUDFW ,Q VWDWH / WKH ILUPnV DQG WKH EDQNnV LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQV UHTXLUHV WKDW 5;*PWLHRLL\VALHR ‘ZRUQ WAHM FLf 6LQFH 5I[W/f LV FRQWLQXRXVO\ GHFUHDVLQJ LQ [ WKXV *+f6 5EIF( Of LV FRQWLQXRXVO\ LQFUHDVLQJ LQ [ WKXV */f!V 7RJHWKHU WKH\ LPSO\ *If b ,Q VWDWH 4 WKH ILUPfV LQGLYLGXDO UDWLRQDOLW\ UHTXLUHV :RFHAAALHMFA Ff ,Q DGGLWLRQ LQFHQWLYH FRPSDWLELOLW\ UHTXLUHV WKDW WKH ILUP LQ VWDWH / ZLOO QRW FKRRVH WR OLTXLGDWH WKH SURMHFW E\ SURSRVLQJ WKH OLTXLGDWLRQ FRQWUDFW *+f LH 5IHWL_H/f&//On*+f &f

PAGE 125

7RJHWKHU &f DQG &f LPSO\ :0M, /f&/!/On*.f!5O6W_ Kf&f & f %XW 5IVW_+fA5IV!W_2/f DQG &+f!&/f LPSO\ WKDW VXFK D VHSDUDWLQJ HTXLOLEULXP LV LQIHDVLEOH &DVH 6 3URMHFW LV OLTXLGDWHG LQ VWDWH / DQG FRQWLQXHG LQ VWDWH + ,Q WKLV FDVH *+f UHSUHVHQWV D W UHSD\PHQW WR WKH EDQN DQG FRUUHVSRQGV WR D FRQWLQXDWLRQ FRQWUDFW */f UHSUHVHQWV D W O UHSD\PHQW WR WKH EDQN DQG FRUUHVSRQGV WR D OLTXLGDWLRQ FRQWUDFW $JDLQ LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQV IRU WKH ILUP DQG WKH EDQN LPSO\ *Kf V ,Q VWDWH / WKH OLTXLGDWLRQ FRQWUDFW PXVW VDWLVI\ WKH IROORZLQJ FRQVWUDLQWV ::V5ALHMF */fA5E6MW /f 5I&VW_+f&+!/E*/f &f 7KH ILUVW WZR FRQVWUDLQWV DUH WKH ILUPnV DQG WKH EDQNnV LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQV 7KH ODVW FRQVWUDLQW LV WKH LQFHQWLYH FRPSDWLELOLW\ FRQVWUDLQW ZKLFK HQVXUHV WKDW WKH ILUP LQ VWDWH + ZLOO SUHIHU WR FRQWLQXH WKDQ WR OLTXLGDWH WKH SURMHFW */f VDWLVI\LQJ WKHVH FRQVWUDLQWV H[LVWV LI /Ef>5IVW_/f&/@!5fVW_/f &f ,I WKLV LQHTXDOLW\ KROGV VHSDUDWLQJ HTXLOLEULXP H[LWV DQG */f 0D[^5EVW/f/EF>5IVW+f&+ @`‘ &f &RQVLGHU QH[W SRROLQJ HTXLOLEULXP ZLWK *+f */f &DVH 3O 5HQHJRWLDWLRQ OHDGV WR OLTXLGDWLRQ LQ ERWK VWDWHV ,Q WKLV FDVH ERWK *+f DQG */f DUH OLTXLGDWLRQ FRQWUDFWV DQG LQ HTXLOLEULXP WKH\

PAGE 126

PXVW EH WKH VDPH :H GHQRWH WKHP E\ */ 7KH LQGLYLGXDO UDWLRQDOLW\ FRQVWUDLQWV IRU WKH ILUP DQG WKH EDQN DUH (Ef*/!5IVW K/*c M *A(H&5A,kf@ &f *O VDWLVI\LQJ WKHVH FRQVWUDLQWV H[LWV LI /ELA5IVW Kf&K (H>5EVWf@ &f ,I &f KROGV WKH PDQDJHU SURSRVHV */ (>5EVWf@ &DVH 3 5HQHJRWLDWLRQ OHDGV WR FRQWLQXDWLRQ LQ ERWK LQWHULP VWDWHV ,Q WKLV FDVH ERWK *c/f DQG *Of DUH FRQWLQXDWLRQ FRQWUDFWV DQG LQ HTXLOLEULXP WKH\ PXVW EH WKH VDPH :H GHQRWH WKHP E\ *F $JDLQ LQGLYLGXDO UDWLRQDOLW\ FRQVWUDLQWV UHTXLUH *F V 7KH RXWFRPHV RI WKLV HTXLOLEULXP LV WKH VDPH DV WKDW ZLWKRXW LQWHULP UHQHJRWLDWLRQ :H HVWDEOLVK WKH XQLTXHQHVV LQ WZR VWHSV 6WHS ,I $f KROGV WKHQ WKH SRROLQJ HTXLOLEULXP 3O LV WKH XQLTXH HTXLOLEULXP ,Q WKLV FDVH ERWK WKH VHSDUDWLQJ HTXLOLEULXP 6 DQG WKH SRROLQJ HTXLOLEULXP 3 DUH IHDVLEOH :H VKRZ KRZHYHU GLYLQLW\ FULWHULRQ XSVHWV WKHVH WZR HTXLOLEULXPV /HW EH D OLTXLGDWLRQ FRQWUDFW VDWLVI\LQJ :W5IAW Kf&K@!* n!(>5EVWf@ & f ,Q WKH HTXLOLEULXP 6 LV VWULFWO\ SUHIHUUHG E\ WKH ILUP LQ ERWK VWDWHV %\ GLYLQLW\ EDQNnV FRQMHFWXUH DERXW WKH VWDWHV ZKHQ IDFHG ZLWK WKH RIIHU LV WKH VDPH DV WKH SULRU 6LQFH *Ln!(>5EVW_f@ WKH EDQN ZLOO DFFHSW VXFK DQ RIIHU 7KLV XSVHWV WKH VHSDUDWLQJ HTXLOLEULXP 6DPH UHDVRQLQJ LQGLFDWHV WKDW GLYLQLW\ FULWHULRQ DOVR XSVHWV WKH SRROLQJ HTXLOLEULXP 3 6WHS ,I &f KROGV DQG

PAGE 127

/E^>5IVW/f&/ @N(H>5EVMWf@ & f WKHQ WKH VHSDUDWLQJ HTXLOLEULXP 6 LV WKH XQLTXH HTXLOLEULXP ,Q WKLV FDVH SRROLQJ HTXLOLEULXP 3 LV FOHDUO\ LQIHDVLEOH 6XSSRVH WKH HTXLOLEULXP LV WKH SRROLQJ HTXLOLEULXP 3 /HW *n EH D OLTXLGDWLRQ FRQWUDFW ZKLFK VDWLVILHV 5IVW @ 4QM&A/En*M !5IVW/f&/ *A5A,2&f ,I VXFK D FRQWUDFW *n H[LVWV WKH PDQDJHU ZLOO GHYLDWH DQG RIIHU WKH OLTXLGDWLRQ FRQWUDFW *cn LQ VWDWH / %\ WKH GLYLQLW\ FULWHULRQ DQG &f WKH EDQN ZLOO DFFHSW VXFK RIIHU 7KLV WKHQ XSVHWV WKH SURSRVHG SRROLQJ HTXLOLEULXP 3 VDWLVI\LQJ WKH WZR FRQVWUDLQWV H[LWV LI &f KROGV :KHQ WKH EDQN PDNHV DQ RIIHU LW RIIHUV D PHQX )+f)/f` ZKHUH )f LV WKH FRQWUDFW LQWHQGHG IRU WKH ILUP LQ VWDWH c L +/ )URP WKH DERYH DQDO\VLV D PHQX ZKLFK LQGXFHV OLTXLGDWLRQ LQ VWDWH + DQG FRQWLQXDWLRQ LQ VWDWH / FDQ QRW EH LQFHQWLYH FRPSDWLEOH ,I WKH PHQX LQGXFHV FRQWLQXDWLRQ LQ ERWK VWDWH WKHQ WKH EDQNfV DQG WKH ILUPfV LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQV LPSO\ WKDW )+f )/f V 7KLV LV WKH VDPH RXWFRPH DV WKDW ZLWKRXW UHQHJRWLDWLRQ ,I WKH PHQX LQGXFHV OLTXLGDWLRQ LQ ERWK VWDWHV WKH ILUPfV LQFHQWLYH FRPSDWLELOLW\ FRQGLWLRQ UHTXLUHV WKDW )+f )/f )/ 7KH ILUPfV LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQ UHTXLUHV )A5VAO 2MA&K 7KXV WKH EDQN ZLOO FKRRVH WR RIIHU )/ 5IVW+f&+ )LQDOO\ WKH EDQN FDQ RIIHU D PHQX ZKLFK LQGXFHV OLTXLGDWLRQ LQ VWDWH / DQG FRQWLQXDWLRQ LQ VWDWH 4M 7KH ILUPfV LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQ UHTXLUHV WKDW )+f V 7KH FRQWUDFW )/f PXVW VDWLVI\ WKH LQFHQWLYH FRPSDWLELOLW\ FRQGLWLRQ DQG WKH LQGLYLGXDO UDWLRQDOLW\ FRQGLWLRQ IRU WKH ILUP )IHML5IHWMLHR4

PAGE 128

AI6A AKf&K!)Of &f )Of VDWLVI\LQJ &f H[LWV LI WKH FRQGLWLRQ &f KROGV LQ ZKLFK FDVH WKH EDQN ZLOO SURSRVH )/f 5IVW_/f&/ &f ,W LV HDVLO\ VHHQ WKDW ZKHQ FRQGLWLRQV &f DQG & f KROG WKH EDQN ZLOO SURSRVH WKH PHQX ZKLFK LQGXFHV OLTXLGDWLRQ LQ VWDWH / DQG FRQWLQXDWLRQ LQ VWDWH + 3URRI RI /HPPD &RQVLGHU ILUVW WKH PDQDJHU PDNHV WKH RIIHU ,I WKH PDQDJHU RIIHUV D VHSDUDWLQJ FRQWUDFW WKH EDQN FDQ SHUIHFWO\ LQIHU WKH UHDOL]HG VWDWH 6LQFH /!U/f WKH EDQN ZLOO UHIXVH WKH RIIHU LQGLFDWLQJ WKH VWDWH / DQG OLTXLGDWH WKH ILUP 7KXV WKH HTXLOLEULXP PXVW EH SRROLQJ %\ DVVXPSWLRQ WKH ILUP FDQ RIIHU D FRQWLQXDWLRQ FRQWUDFW V LQ ERWK VWDWHV VXFK WKDW & f 7KLV FRQWUDFW VDWLVILHV WKH EDQNnV LQGLYLGXDO UDWLRQDOLW\ FRQVWUDLQW DQG ZLOO EH DFFHSWHG E\ EDQN 7KH SURMHFW LV DOZD\V FRQWLQXHG &RQVLGHU QH[W WKH EDQN PDNHV WKH RIIHU 7KH XQLQIRUPHG EDQN RIIHUV D PHQX ^*Kf*Of` $VVXPLQJ ILUVW WKDW WKH PHQX LV VHSDUDWLQJ LH *(L fA*4 f ,W LV HDVLO\ VHHQ WKDW D VHSDUDWLQJ PHQX ZKLFK LQGXFHV FRQWLQXDWLRQ LQ VWDWH / DQG OLTXLGDWLRQ LQ VWDWH + FDQ QRW EH LQFHQWLYH FRPSDWLEOH )RFXVLQJ RQ WKH RSSRVLWH FDVH WKH LQFHQWLYH FRPSDWLELOLW\ FRQVWUDLQWV DUH F+[ nf*HfffG)_Hff!*Lf *4Kf & f

PAGE 129

/*Of&O I U*40ffG)U /f &f *2Kf 7KH ILUVW LQHTXDOLW\ HQVXUHV LQ VWDWH + WKH ILUP ZLOO FKRRVH WKH FRQWUDFW *+f UDWKHU WKDQ *Of 7KH VHFRQG HQVXUHV DW / WKH ILUP FKRRVHV WKH FRQWUDFW */f &RPELQLQJ WKH WZR FRQVWUDLQWV SURYLGHV U*H+\fG)U?If+f!/*G/f!&/>; U*HfffG)U _/f &f rn JKf JZf %\ DVVXPSWLRQ &f FDQ QRW EH VDWLVILHG ,W IROORZV WKDW WKH EDQN SURSRVHV D SRROLQJ PHQX LH*+f */f %\ DVVXPSWLRQ WKH EDQN SURSRVHV D SRROLQJ FRQWUDFW GHPDQGLQJ WKH HQWLUH W FDVK IORZ LH VO; 3URRI RI 3URSRVLWLRQ 6LQFH ZH RQO\ QHHG WR VKRZ H[LVWHQFH ZH SURYH WKH SURSRVLWLRQ E\ FRQVWUXFWLQJ VXFK D UHSD\PHQW VFKHGXOH :H UHTXLUH VMrArf VDWLVI\ WKH IROORZLQJ FRQGLWLRQV &RQGLWLRQ ;f -$ UG)U f ;/!V>! $f(4M;UG)U ? f ;/ & f &RQGLWLRQ Vc =fnZfAf >'n-IfV)U?G,IfGU &f ‘, R >'0)U?G fGU &f ZKHUH DQG VA,A2A./ &RQGLWLRQ VWr LV VHQLRU ZLWK VHQLRULW\ SURWHFWHG 6r LV MXQLRU DQG DOORZV WKH ILUP WR LVVXH DGGLWLRQDO SXEOLF GHEW XS WR 'Pf+f )URP DVVXPSWLRQ V[r DQG 6r VDWLVI\LQJ WKH FRQGLWLRQV H[LVW :H FODLP WKDW LQ WKH

PAGE 130

XQLTXH HTXLOLEULXP WKH ILUP UDLVHV ,Pn+f E\ LVVXLQJ SXEOLF GHEW ZLWK IDFH YDOXH DQG VHQLRU WR VAZKHQ WKH EDQN LV LQIRUPHG RI WKH IDYRUDEOH VWDWH :KHQ WKH EDQN LV XQLQIRUPHG WKH SURMHFW LV FRQWLQXHG WKURXJK UHQHJRWLDWLRQ 7KH SURMHFW LV OLTXLGDWHG ZKHQ WKH EDQN LV LQIRUPHG RI WKH VWDWH / :H SURYH WKLV FODLP LQ WZR VWHSV 6WHS 7KH ILUP ZLOO QRW UDLVH 7Pn+f IURP WKH PDUNHW H[FHSW ZKHQ WKH EDQN LV LQIRUPHG RI WKH VWDWH + &RQVLGHU ILUVW WKH FDVH ZKHQ WKH EDQN LV XQLQIRUPHG 6XSSRVH WKH ILUP GHYLDWHV DQG LVVXHV WKH VHQLRU SXEOLF GHEW ZLWK IDFH YDOXH 'Pn+f WKHQ I0)U?H+fGU e>LUr1r9U_HfGU@ &f 'f-4+f M UL n'Pp+f6 @ 7KH ULJKW KDQG VLGH RI &f LV WKH EDQNnV H[SHFWHG SURILW IURP WKH SURPLVHG W UHSD\PHQW Vr LI WKH SURMHFW LV FRQWLQXHG 7KH OHIW KDQG VLGH LV QR JUHDWHU WKDQ WKH EDQNnV SD\RII LI WKH SURMHFW LV OLTXLGDWHG DIWHU WKH UHSD\PHQW ,Pf+f 7KXV ZKHQ WKH EDQN LV XQLQIRUPHG LW ZLOO QRW IRUJLYH VA,A2Qf 7KH ILUP PXVW VWLOO QHJRWLDWH ZLWK WKH EDQN IRU WKH DGGLWLRQDO ILQDQFLQJ 7KH ILUP LV VWULFWO\ EHWWHU RII DFTXLULQJ WKH HQWLUH DGGLWLRQDO ILQDQFLQJ WKURXJK QHJRWLDWLQJ ZLWK WKH EDQN 6XSSRVH WKH ILUP UDLVHV ,PX VXFK WKDW Vr,PX LV WKH VDPH DV WKH EDQNnV H[SHFWHG SD\RII LQ FRQWLQXDWLRQ 7KHQ WKH EDQN ZLOO IRUJLYH VA,A DQG DOORZ WKH SURMHFW WR FRQWLQXH 7KH ILUPnV SURILW LV [UG)U?tf6@UP &f %\ FRQGLWLRQ RQH FDQ HDVLO\ VHH WKDW WKH ILUP LV VWULFWO\ EHWWHU RII QHJRWLDWLQJ ZLWK WKH EDQN 7KXV ZKHQ WKH EDQN LV XQLQIRUPHG WKH ILUP QHYHU UDLVHV FDSLWDO IURP WKH PDUNHW

PAGE 131

&RQVLGHU QH[W WKH FDVH ZKHQ WKH EDQN LV LQIRUPHG RI WKH VWDWH / ,I WKH ILUP UDLVHV &+f WKHQ &f 7KXV WKH EDQN ZLOO QRW IRUJLYH Vr 6LQFH Vc r!/!6 ff9&6,K; G LV FOHDU WKDW WKH EDQN ZLOO OLTXLGDWH WKH ILUP &RQVHTXHQWO\ WKH ILUP ZLOO QRW UDLVH ,Pn+f LQ WKLV FDVH 7KXV LI WKH ILUP DWWHPSWV WR UDLVH FDSLWDO IURP WKH PDUNHW LW ZLOO PDNH DQ RIIHU RWKHU WKDQ ,Pn+f ,W IROORZV WKHQ WKH PDUNHW ZLOO NQRZ WKH UHDOL]DWLRQ RI / 6LQFH VA$/ E\ DVVXPSWLRQ WKH SURMHFW PXVW EH OLTXLGDWHG ZKHQ WKH EDQN LV LQIRUPHG RI WKH VWDWH / 6WHS :H VKRZ WKDW WKH XQLTXH HTXLOLEULXP VWUDWHJ\ IRU WKH ILUP LQ VWDWH + DQG ZLWK WKH EDQN LQIRUPHG LV WR UDLVH VHQLRU GHEW ^An4KA'-AKf` IURP WKH PDUNHW ,I WKH ILUP UDLVHV ,-AKf DQG UHSD\ WKH EDQN WKH EDQNnV SD\RII LQ OLTXLGDWLRQ LV c r ,Pnc/f DQG LV WKH VDPH DV LWV SD\RII LI WKH SURMHFW LV FRQWLQXHG XQGHU WKH H[LWLQJ FRQWUDFW 7KXV WKH EDQN ZLOO IRUJLYH VA,-AQf 7KH ILUPnV SURILW LQ WKLV FDVH LV I$UG)U_ff>6fff@IIf f! &f $OWHUQDWLYHO\ WKH ILUP FDQ DFTXLUH ILQDQFLQJ E\ RQO\ QHJRWLDWH ZLWK WKH EDQN DQG JHW n[UG)U?4IIf/@ &f R )URP FRQGLWLRQ WKH ILUP VWULFWO\ SUHIHUV WR UDLVH ,Pn+f IURP WKH PDUNHW

PAGE 132

5()(5(1&(6 $JKLRQ 3 DQG 3 %ROWRQ f f $Q ,QFRPSOHWH &RQWUDFWV $SSURDFK WR )LQDQFLDO &RQWUDFWLQJf 5HYLHZ RI (FRQRPLF 6WXGLHV $QGUHRQL f5HDVRQDEOH 'RXEW DQG WKH 2SWLPDO 0DJQLWXGH RI )LQHV 6KRXOG WKH 3HQDOW\ )LW WKH &ULPH"f 5DQG -RXUQDO RI (FRQRPLFV f %DQNV -HIIUH\ DQG 6REHO f f(TXLOLEULXP 6HOHFWLRQ LQ 6LJQDOLQJ *DPHVf (FRQRPHWULFD %DUFOD\ 0 DQG & 6PLWK -5 f f7KH 0DWXULW\ 6WUXFWXUH RI &RUSRUDWH 'HEWf -RXUQDO RI )LQDQFH %DURQ DQG %HVDQNR f f5HJXODWLRQ $V\PPHWULF ,QIRUPDWLRQ DQG $XGLWLQJf 5DQG -RXUQDO RI (FRQRPLFV f %DURQ' DQG 5 0\HUVRQ f 5HJXODWLQJ D 0RQRSROLVW ZLWK 8QNQRZQ &RVWV (FRQRPHWULFD %HFNHU *6 f f&ULPH DQG 3XQLVKPHQW $Q (FRQRPLF $SSURDFKf -RXUQDO RI 3ROLWLFDO (FRQRP\ %HFNHU f f$ 7KHRU\ RI &RPSHWLWLRQ $PRQJ 3UHVVXUH *URXSV IRU 3ROLWLFDO ,QIOXHQFHf 4XDUWHUO\ -RXUQDO RI (FRQRPLFV %HFNHU *6 DQG *6WLJOHU f f/DZ (QIRUFHPHQW 0DOIHDVDQFH DQG WKH &RPSHQVDWLRQ RI (QIRUFHUVf -RXUQDO RI /HJDO 6WXGLHV %HUOLQ 0 DQG /RH\V f f%RQG &RYHQDQWV DQG 'HOHJDWHG 0RQLWRULQJf -RXUQDO RI )LQDQFH %KDWWDFKDU\D 6 DQG 3 3IOHLGHUHU f 'HOHJDWHG 3RUWIROLR 0DQDJHPHQW -RXUQDO RI (FRQRPLF 7KHRU\ %LOOHWW 0 0 )ODQQHU\ DQG *DUIPNHO f f7KH (IIHFW RI /HQGHU ,GHQWLW\ RQ D %RUURZLQJ )LUPfV (TXLW\ 5HWXUQf -RXUQDO RI )LQDQFH

PAGE 133

%RUGHU & DQG 6REHO f f6DPXUDL $FFRXQWLQJ $ 7KHRU\ RI $XGLWLQJ DQG 3OXQGHUf 5HY (FRQ 6WXGLHV &DPSEHOO 7 DQG : .UDFDZ f f,QIRUPDWLRQ 3URGXFWLRQ 0DUNHW 6LJQDOLQJ DQG 7KH 7KHRU\ RI )LQDQFLDO ,QWHUPHGLDWLRQf -RXUQDO RI )LQDQFH 'HZDWULSRQW 0 DQG 7LUOH f $GYRFDWHV 8QLYHUVLW GH 7RXORXVH :RUNLQJ 3DSHU 'LDPRQG' f f)LQDQFLDO ,QWHUPHGLDWLRQ DQG 'HOHJDWHG 0RQLWRULQJf 5HYLHZ RI (FRQRPLF 6WXGLHV 'LDPRQG f f0RQLWRULQJ DQG 5HSXWDWLRQ 7KH &KRLFH %HWZHHQ %DQN /RDQV DQG 'LUHFWO\ 3ODFHG 'HEWf -RXUQDO RI 3ROLWLFDO (FRQRP\ 'LDPRQG f f6HQLRULW\ DQG 0DWXULW\ RI 'HEW &RQWUDFWVf -RXUQDO RI )LQDQFLDO (FRQRPLFV )DPD ( f f:KDW LV 'LIIHUHQW $ERXW %DQNV"f -RXUQDO RI 0RQHWDU\ (FRQRPLFV *HUWQHU 5 DQG 6FKDUIVWHLQ f f$ 7KHRU\ RI :RUNRXWV DQG 7KH (IIHFWV RI 5HRUJDQL]DWLRQ /DZf -RXUQDO RI )LQDQFH *HUWQHU 5 5 *LEERQV DQG 6FKDUIVWHLQ f f6LPXOWDQHRXV 6LJQDOLQJ WR 7KH &DSLWDO DQG 3URGXFW 0DUNHWf 5DQG -RXUQDO RI (FRQRPLFV *UDHW] 0 f f 7KH 7D[ &RPSOLDQFH *DPH 7RZDUG DQ ,QWHUDFWLYH 7KHRU\ RI /DZ (QIRUFHPHQWf -RXUQDO RI /DZ (FRQRPLFV DQG 2UJDQL]DWLRQ *URVVPDQ 6 DQG 2 +DUW f $Q $QDO\VLV RI WKH 3ULQFLSDO$JHQW 3UREOHP (FRQRPHWULFD *URVVPDQ 6 DQG 2+DUW f f7KH &RVW DQG %HQHILWV RI 2ZQHUVKLS $ 7KHRU\ RI 9HUWLFDO DQG /DWHUDO ,QWHJUDWLRQf -RXUQDO RI 3ROLWLFDO (FRQRP\ +DUULQJWRQ : f f (QIRUFHPHQW /HYHUDJH ZKHQ 3HQDOWLHV DUH 5HVWULFWHGf -RXUQDO RI 3XEOLF (FRQRPLFV +DUW 2 DQG 0RRUH f f'HIDXOW DQG 5HQHJRWLDWLRQf /RQGRQ 6FKRRO RI %XVLQHVV :RUNLQJ 3DSHU +DUW 2 DQG 0RRUH f f$ 7KHRU\ RI 'HEW %DVHG RQ 7KH ,QDOLHQDELOLW\ RI +XPDQ &DSLWDOf 4XDUWHUO\ -RXUQDO RI (FRQRPLFV

PAGE 134

+RXVWRQ DQG & -DPHV f f,QIRUPDWLRQ 0RQRSRO\ DQG WKH 0L[ RI 3ULYDWH DQG 3XEOLF 'HEW &ODLPVf 8QLYHUVLW\ RI )ORULGD :RUNLQJ 3DSHU -DPHV & f f6RPH (YLGHQFH RQ WKH 8QLTXHQHVV RI %DQN /RDQVf -RXUQDO RI )LQDQFLDO (FRQRPLFV -HQVHQ 0 f f$JHQF\ &RVWV RI )UHH &DVK )ORZ &RUSRUDWH )LQDQFH DQG 7DNHRYHUVf $PHULFDQ (FRQRPLF 5HYLHZ .DSORZ / DQG 6 6KDYHOO f f2SWLPDO /DZ (QIRUFHPHQW ZLWK 6HOI5HSRUWLQJ RI %HKDYLRUf -RXUQDO RI 3ROLWLFDO (FRQRP\ .LOKVWURP 5 f 2SWLPDO &RQWUDFWV IRU 6HFXULW\ $QDO\VWV DQG 3RUWIROLR 0DQDJHUV :KDUWRQ 6FKRRO :RUNLQJ 3DSHU /DIIRQW DQG 7LUOH f 8VLQJ &RVW 2EVHUYDWLRQ WR 5HJXODWH )LUPV -RXUQDO RI 3ROLWLFDO (FRQRP\ /DIIRQW -DQG 7LUOH f f7KH 3ROLWLFV RI *RYHUQPHQW 'HFLVLRQ 0DNLQJ 5HJXODWRU\ ,QVWLWXWLRQVf -RXUQDO RI /DZ (FRQRPLFV DQG 2UJDQL]DWLRQ /DIIRQW -DQG 7LUOH f f7KH 3ROLWLFV RI *RYHUQPHQW 'HFLVLRQ 0DNLQJ $ 7KHRU\ RI 5HJXODWRU\ &DSWXUHf 4XDUWHUO\ -RXUQDO RI (FRQRPLFV /DQGHV : DQG 5 3RVQHU f f7KH 3ULYDWH (QIRUFHPHQW RI WKH /DZf -RXUQDO RI /HJDO 6WXGLHV /XPPHU 6 DQG 0F&RQQHOO f f)XUWKHU (YLGHQFH RQ WKH %DQN /HQGLQJ 3URFHVV DQG WKH &DSLWDO 0DUNHW 5HVSRQVHV WR %DQN /RDQ $JUHHPHQWf -RXUQDO RI )LQDQFLDO (FRQRPLFV 0DOLN $ f f$YRLGDQFH 6FUHHQLQJ DQG 2SWLPXP (QIRUFHPHQWf 5DQG -RXUQDO RI (FRQRPLFV 0RRNKHUMHH 3 f f0DUJLQDO 'HWHUUHQFH LQ (QIRUFHPHQW RI /DZf -RXUQDO RI 3ROLWLFDO (FRQRP\ 0RRNKHUMHH DQG 3QJ f f0RQLWRULQJ YLVDYLV ,QYHVWLJDWLRQ LQ (QIRUFHPHQW RI /DZf $PHULFDQ (FRQRPLF 5HYLHZ 0\HUVRQ 5 f ,QFHQWLYH &RPSDWLELOLW\ DQG WKH %DUJDLQLQJ 3UREOHP (FRQRPHWULFD

PAGE 135

3DUN & f f0RQLWRULQJ DQG 'HEW 6HQLRULW\ 6WUXFWXUHf 8QLYHUVLW\ RI &KLFDJR :RUNLQJ 3DSHU 3ROLQVN\ 0 f f3ULYDWH YV 3XEOLF (QIRUFHPHQW RI )LQHVf -RXUQDO RI /HJDO 6WXGLHV 3ROLQVN\ 0 DQG 6 6KDYHOO f f7KH 2SWLPDO 7UDGHRII EHWZHHQ WKH 3UREDELOLW\ DQG 0DJQLWXGH RI )LQHf $PHULFDQ (FRQRPLF 5HYLHZ 5DMD 5 f f ,QVLGHUV DQG 2XWVLGHUV 7KH &KRLFH %HWZHHQ ,QIRUPHG DQG $UPfV/HQJWK 'HEWf -RXUQDO RI )LQDQFH 5DMDQ5 DQG $ :LQWRQ f f&RYHQDQWV DQG &ROODWHUDO DV ,QFHQWLYHV WR 0RQLWRUf -RXUQDO RI )LQDQFH 5RWKVFKLOG 0 DQG 6WLJOLW] f ,QFUHDVLQJ 5LVN $ 'HILQLWLRQ -RXUQDO RI (FRQRPLF 7KHRU\ 6WLJOHU *HRUJH f f7KH 2SWLPXP (QIRUFHPHQW RI /DZVf -RXUQDO RI 3ROLWLFDO (FRQRP\ 6WRXJKWRQ 1 f 0RUDO +D]DUG DQG 3RUWIROLR 0DQDJHPHQW 3UREOHP -RXUQDO RI )LQDQFH 7LUOH f f+LHUDUFKLHV DQG %XUHDXFUDFLHV RQ WKH 5ROH RI &ROOXVLRQ LQ 2UJDQL]DWLRQf -RXUQDO RI /DZ (FRQRPLFV DQG 2UJDQL]DWLRQ 7LUOH f f&ROOXVLRQ DQG WKH 7KHRU\ RI 2UJDQL]DWLRQVf 'RFXPHQW 'H 7UDYDLO

PAGE 136

%,2*5$3+,&$/ 6.(7&+ :HL/LQ /LX UHFHLYHG D EDFKHORUfV GHJUHH LQ SK\VLFV LQ IURP )OLQGHUV 8QLYHUVLW\ RI 6RXWK $XVWUDOLD DQG D PDVWHUfV GHJUHH LQ SK\VLFV LQ IURP 9LUJLQLD 7HFK +H HQWHUHG WKH JUDGXDWH SURJUDP LQ ILQDQFH LQ

PAGE 137

, FHUWLI\ WKDW KDYH UHDG WKLV VWXG\ DQG WKDW LQ P\ RSLQLRQ LW FRQIRUPV WR DFFHSWDEOH VWDQGDUGV RI VFKRODUO\ SUHVHQWDWLRQ DQG LV IXOO\ DGHTXDWH LQ VFRSH DQG TXDOLW\ DV D GLVVHUWDWLRQ IRU WKH GHJUHH RI 'RFWRU RI 3KLORVRSK\ 8tr f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a -RHO +RXVWRQ $VVRFLDWH 3URIHVVRU RI )LQDQFH ,QVXUDQFH DQG 5HDO (VWDWH FHUWLO\ WKDW KDYH UHDG WKLV VWXG\ DQG WKDW LQ P\ RSLQLRQ LW FRQIRUPV WR DFFHSWDEOH VWDQGDUGV RI VFKRODUO\ SUHVHQWDWLRQ DQG LV IXOO\ DGHTXDWH LQ VFRSH DQG TXDOLW\ DV D GLVVHUWDWLRQ IRU WKH GHJUHH RI 'RFWRU RI 3KLORVRSK\ MS 0LFKDHO 5\QJDHUW $VVRFLDWH 3URIHVVRU RI )LQDQFH ,QVXUDQFH DQG 5HDO (VWDWH

PAGE 138

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


xml version 1.0 encoding UTF-8
REPORT xmlns http:www.fcla.edudlsmddaitss xmlns:xsi http:www.w3.org2001XMLSchema-instance xsi:schemaLocation http:www.fcla.edudlsmddaitssdaitssReport.xsd
INGEST IEID EC0OV6V1F_IPJRJR INGEST_TIME 2014-08-14T22:48:38Z PACKAGE AA00024928_00001
AGREEMENT_INFO ACCOUNT UF PROJECT UFDC
FILES


THREE ESSAYS IN FINANCIAL ECONOMICS AND LAW
By
WEI-LIN LIU
A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY
UNIVERSITY OF FLORIDA
1997

To My Wife Yan Li

ACKNOWLEDGMENTS
I am deeply indebted to Tracy Lewis and Charles Hadlock, who provided guidance,
support and inspiration. My gratitude to both of them for their generous help throughout this
work is beyond what words can describe. I also wish to express my thanks to David
Sappington, Joel Houston and members of my committee.

TABLE OF CONTENTS
ACKNOWLEDGMENTS iii
ABSTRACT vi
CHAPTERS
1 INTRODUCTION 1
Motivating and Compensation Investment Advisors 1
Setting Standards for Credible Compliance and Law Enforcement 2
Monitoring and The Optimal Mix of Public and Private Debt Claims 3
2 MOTIVATING AND COMPENSATING
INVESTMENT ADVISORS 5
Introduction 5
A Simple Discrete Model 7
The General Two-State Model 13
Extension 24
Conclusions 26
3 SETTING STANDARDS FOR CREDIBLE COMPLIANCE AND
LAW ENFORCEMENT 34
Introduction 34
Elements of The Basic Model 37
Analysis of The Simple Case 42
Privately Informed Enforcer 46
Heterogenous Parties 49
Setting Optimal Fines 53
Conclusions 55
4 MONITORING AND THE OPTIMAL MIX OF PUBLIC AND PRIVATE
DEBT CLAIMS 58
Introduction 58
Elements of The Model 64
The Mix of Long-Term Public and Bank Debt Claims 69
The Optimal Bank Debt 73
iv

The Optimal Mix 85
Empirical Implications 90
Conclusions 92
5 CONCLUSIONS 96
APPENDIX A: PROOFS O F THE MAIN RESULTS IN CHAPTER TWO 98
APPENDIX B: PROOFS O F THE MAIN RESULTS IN CHAPTER THREE 108
APPENDIX C: PROOFS O F THE MAIN RESULTS IN CHAPTER FOUR 117
REFERENCES 125
BIOGRAPHICAL SKETCH 129
v

Abstract of Dissertation Presented to the Graduate School of
the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy
THREE ESSAYS IN FINANCIAL ECONOMICS AND LAW
By
WEI-LIN LIU
August 1997
Chairman: David Brown
Co-Chairman: Tracy Lewis
Major Department: Finance
The dissertation is a collection of studies in financial economics and law. The first
chapter introduces the thesis. The second chapter analyzes the problem of how an investor
can compensate an investment advisor to both motivate the advisor to diligently collect
information and elicit truthful revelation of his private information. I find that the structure
of an optimal compensation scheme depends both on the technology of information
collection and on the accuracy level of the information that the advisor is induced to achieve.
I identify instances in which the design of an optimal compensation scheme is independent
of whether the information acquired by the advisor is publicly observable or not.
The third chapter examines the problem of setting optimal legal standards when
enforcers of the standards must be motivated to detect violations. I find that some
divergence between the marginal benefits and the marginal costs of providing care by
potential violators is required to control enforcement costs. Furthermore, the setting of
vi

standards may effectively substitute for the setting of fines when penalties for violations are
fixed. In particular, it is found that imposing maximal fines may be welfare reducing.
The fourth chapter explores the issue of how firms optimally design their debt
structures by using both public and private debt. The principal finding is that in general the
optimal debt structures are a mix of long-term public debt and private debt with varying
repayment schedules. In addition, I show how financial intermediaries can produce
information through monitoring the firms they lend to, and I extend the notion of delegated
monitoring to the case when there are multiple classes of creditors.
Vll

CHAPTER 1
INTRODUCTION
This dissertation is a collection of studies in financial economics and law. The
second chapter analyzes the problem of how best an investor can compensate an investment
advisor to both motivate the advisor to diligently collect information and elicit truthful
revelation of his private information. The third chapter examines the problem of setting
legal standards when enforcers of the standards must be motivated to detect violations. The
fourth chapter explores the issue of how firms optimally design their debt structures by using
both public and private debt.
Motivating and Compensating Investment Advisors
Individual investors generally do not have the expertise to assess prospective
investment opportunities, and they may rely on investment advisors for expert opinions. In
designing the advisor's compensation scheme, however, two problems arise: 1) it must
motivate the advisor to diligently collect information, and 2) it must induce the advisor to
truthfully reveal his information to the investor. In chapter 2, I derive the optimal
compensations schemes which satisfy both of these conditions.
I first analyze the case in which the advisor’s information is publicly observable. I
find that the optimal payment scheme rewards the advisor more richly for correctly
predicting an outcome, if expending effort best enhances his ability to predict that outcome.
1

2
When the advisor's information is not publicly observable, I find that the need to
induce the advisor to expend effort generally interferes with the need to elicit truthful
revelation. I show that in general there exists a critical level of effort. If the advisor is
induced to expend an effort higher than the critical one, whether his information is publicly
observable or not is immaterial. If the advisor is induced to expend an effort lower than the
critical one, the two needs interact. In this case, the advisor is rewarded more richly if he
correctly predicts the outcome less likely to occur.
The analysis in chapter 2 extends previous analysis by Kilhstrom (1986) who
assumes that the advisor's information is publicly observable and that the advisor's effort
improves the accuracy of his information equally. The results in Bhattacharya and Pfleiderer
(1987) and Stoughton (1995) rely critically on the symmetry property of the information
technology. In my analysis, this assumption is relaxed in a binary signal setting.
Setting Standards for Credible Compliance and Law Enforcement
Chapter 3 analyzes the problem of setting socially optimal legal standards when
enforcers of the standards must be motivated to oversee potential violators. Beginning with
Becker (1968), research in enforcement of legal standards has focused on the setting of fines
as a primary tool of enforcement. In contrast, this analysis characterizes how the setting of
legal standards affects the behavior of complying parties, law enforcers, and the net social
surplus generated by the regulations.
The analysis in chapter 3 reveals that it is desirable to induce potential violators of
the standards to provide care levels that either exceed or fall short of the surplus maximizing
level. In some instances, a slight loosening of standards will decrease enforcement costs.

3
Such instances arise whenever looser standards cause enforcers to reduce their effort because
the marginal returns from monitoring decrease as the probability of noncompliance
decreases. For other applications, monitoring effort may fall as the probability of
noncompliance increases. For these cases, it will be desirable to set tighter standards and
induce greater care in order to reduce the enforcers’ expenditures on effort.
Two extensions of this result are also presented. In the first instance, the possibility
that the costs of monitoring effort vary by the enforcers’ abilities to observe and process
information is considered. These costs are known privately by the enforcers. It is shown
that the presence of asymmetric information reinforces the main finding that standards are
distorted to reduce enforcement costs. In the second extension, the possibility that parties
differ in the costs they incur in taking care is examined. It is shown that the main finding
can be generalized to this case as well.
In addition, the analysis examines the relationship between fines and standards. It
is shown that imposing the largest fine is not necessarily desirable because increases in fines
may increase costly enforcement effort.
Monitoring and the Optimal Mix of Public and Private Debt Claims
Chapter 4 explores the issue of how firms optimally design their debt structures by
using both public debt and private debt. The theory of finance suggests that financial
intermediaries can act as delegated monitors and provide flexibility allowing for
modifications of loan contracts when needed. However, previous studies have only provided
partial analysis of private lenders’ incentives to monitor. In addition, existing literature does
not provide adequate explanations of the need for firms to finance with both private debt and

4
public debt. Moreover, no explanation has been offered to justify the notion of delegated
monitoring in the presence of multiple classes of debtors.
This analysis provides some answers to these important issues. My analysis is based
on the assumption that firms' objective in designing optimal debt structures is to credibly
commit to repay debtors at minimum cost. I find that the optimal debt structure is in general
strict mixes of public and private debt. Public debt provides several benefits: 1), it allows
the firm to pay out profits without perturbing bank's incentive for monitoring; 2) it allows
the firm to maximize the lenders' total benefit per unit of monitoring effort, thereby reducing
the amount of monitoring required to ensure initial financing. I show that in the optimal
debt structure, the public debt is generally long-term while the maturity of private debt
depends on the severity of agency problems. In addition, I find that when firms raise
external financing by optimally combining public and private debt, they prefer to align the
public lenders incentive over monitoring with that of the private lenders. Thus, private
lenders act as delegated monitors in the presence of multiple classes of creditors.
My analysis is closely related to that of Hart and Moore (1991). Besides sharing
similar assumptions, my analysis extends Hart and Moore's analysis by accommodating
asymmetric information and by recognizing the negotiation costs involved in dealing with
dispersed public debt holders. My analysis also differs from those of Park(1994) and Raja
and Winton (1995) in that I emphasize the inherent incompleteness of debt contracts and do
not rely on covenants to provide banks with monitoring incentives.

CHAPTER 2
MOTIVATING AND COMPENSATING INVESTMENT ADVISORS
Introduction
Investing profitably requires accurate information. Often, an investor may not have
the knowledge or the skill to collect and process relevant information about investment
opportunities. The investor must rely on the expertise of an investment advisor. In
structuring optimal compensation schemes for the advisor, two problems arise: 1) inducing
the advisor to diligently collect information; and 2) inducing the advisor to reveal his
information to the investor. This paper characterizes optimal compensation schemes which
satisfy both of these two requirements.
To characterize the optimal compensation schemes, we employ the following model.
An investor can invest in a risk free asset with a known return and a risky asset whose return
depends on the states of nature. Initially, the investor and the advisor share the same prior
about the probability of each state occurring. By expending effort, however, the advisor can
privately observe a signal correlated with the state of nature. Expending greater effort
improves the accuracy of the signal. The investor makes his investment decisions based on
the advisor’s reported signal. Subsequently, the actual return from the risky asset is publicly
observed, and the advisor is compensated based upon his report and the realized return1.
^tentatively, our model can be interpreted as one in which no communication takes
place. The investor pre-announces the investment schedule and the advisor implements
the schedule after a signal is acquired. The decision made by the advisor in implementing
5

6
When the signal is publicly observable, the investor's only concern is to motivate the
advisor to expend effort. In this case, we find that the advisor is more richly rewarded for
correctly predicting a state if exerting effort produces the greatest percentage increase in his
ability to predict that state. This follows because to best motivate the advisor, the investor
desires to compensate him more for a correct prediction which is most indicative of the
effort expended. Thus, the optimal compensation scheme rewards the advisor more for a
correct prediction if the probability of achieving it is most sensitive to the effort expended.
When the signal is not publicly observable, the investor must be concerned with both
motivating the advisor and eliciting truthful revelation of the private signal. We find that
there exists a critical effort level: When the advisor is induced to expend an effort higher
than the critical one, the investor's inability to observe the signal is inconsequential for the
design of optimal payment scheme; In contrast, when the advisor is induced to expend an
effort lower than the critical one, the need to elicit truthful revelation of the observed signal
interacts with the need to motivate the advisor. In the latter case, the payment to the advisor
depends both on whether he predicts the state correctly and on which state occurs. The
payment is larger when the advisor correctly predicts the less likely state. The intuition for
this result is the following. If the advisor is rewarded a fixed amount whenever he makes
a correct prediction, he will choose to predict the state most likely to occur (based on the
prior) if he shirks. In doing so, however, the advisor loses the opportunity of being
rewarded for correctly predicting the less likely state. To motivate the advisor, the investor
must impose sufficient opportunity cost on him for not expending effort. By rewarding the
the investment schedule is, however, observable and can be contracted upon.

7
advisor more for correctly predicting the less likely state, shirking and making predictions
based only on the prior become less attractive. The new payment scheme can both motivate
the advisor and induce truthful revelation.
Before proceeding, we relate our analysis to earlier studies in the literature. The
study by Kilhstrom(1986), which is most closely related to our analysis, analyzes how to
induce an advisor to work diligently when his informative signal is publicly observable. We
extend his analysis by allowing the advisor's signal to be private information. The extension
enables us to investigate how the need to elicit truthful revelation interacts with the need to
motivate the advisor.
Also related to our analysis is the work of Bhattacharya and Pfleiderer(1985) who
study the problem of screening of agents (advisors) endowed with information technologies
that differ in the accuracy levels of the signals produced, and subsequently eliciting truthful
revelation of the privately observed signals. Acquiring the signal is assumed to be costless.
This model is modified in a later paper by Stoughton (1993) who studies a moral hazard
problem similar to ours’. The results in both of the two studies, however, rely critically on
the symmetric information structure that they employ, whereby the distribution of states of
the nature is symmetric conditional on any signal. Our analysis, on the other hand, does not
require this assumption.
A Simple Discrete Model
A risk neutral investor can invest in a risky asset or a riskless asset. The riskless
asset yields a return R with certainty. The return of the risky asset depends on the state of
nature: It returns rH>R in the favorable state and rL
8
investor's prior belief of the probability of the two states is tih and nL, respectively. For
simplicity, we assume TCHrH+TCLrL=R.
The investor can acquire additional information about the state of nature by hiring
an advisor. By expending effort, the advisor, who initially shares the same prior as the
investor, can observe a signal x, with xe{xH,xL}, correlated with the realized state. The
correlation between the signal and the state is characterized by the conditional distribution
function fCXjlr^e), i,je{H,L}. There are two effort levels, e=eL and e=eH>eL. For notational
ease, we set f(xilri,eH)=pi and f(xjlrj,eL)=qj, i,je{H,L}. The advisor’s effort improves the
accuracy of the signal in the Blackwell sense. We capture this idea by assuming p¡>q,,
ie{H,L}.
The advisor's utility function VA(WA)-C(e) is separable in income and effort, where
VA(WA) is the utility of the end of period payoff WA and C(e) is the cost for expending effort
e. We assume that the advisor is liquidity constrained and enjoys limited liability
protection2. The advisor's reservation utility is normalized to zero.
The investor can not observe the advisor's effort and the signal he observes. He
makes the investment decision based on the advisor report. Contingent upon a report x, he
chooses to invest A(x) in the risky asset. The investor has an endowment of Wo>0, and
borrowing and short-selling are not allowed, so that 0 The timing in the model is as follows. First, the investor makes a take-it-or-leave-it
offer to the advisor, specifying a compensation scheme w(x,r), which depends on both the
2This assumption implies that the advisor can not signal the investor his private
information by taking a position in the risky asset. For the latter approach, see Leland
and Pyle (1977), Allen (1990).

9
advisor's report and the state of nature publicly observed ex post. Second, if the advisor
accepts the offer, he selects the level of effort to expend. Otherwise, the game is terminated.
Third, the advisor observes a signal and makes a report to the investor. The advisor's report
amounts to a prediction of future state. Reporting xH (\) amounts to predicting the
occurrence of good (bad) state. Fourth, the investor makes and implements the optimal
investment decision based on the advisor's report. Finally, the realized return of the risky
asset is publicly observed and the advisor is paid as promised.
The optimal investment decision is determined, in equilibrium, for a given
equilibrium strategy of the advisor. Specifically, the advisor is assumed to truthfully reveal
his privately observed signal. Recall, a risk neutral investor ranks the investment
opportunities by their expected payoffs. This implies that the optimal investment decision
is: X(xL)=0 and A(xH)=W0, which is independent of the advisor's compensations.
We assume that it is desirable to motivate the advisor to acquire the more informative
signals. The investor's objective is to induce the advisor to expend effort and truthfully
reveal his signals at minimum cost. Inducing truthful revelation implies the following
constraint.
Er[w{x,r) | eH¿c]>Er[w{x ',r) \ eHyx\ Vx,x. (2-1)
Inducing the advisor to expend effort requires
ExJw(x,r) | ewx] -E>Ex{Maxx,Er[w(x \r) \x,e¡\ | e¡\ (2-2)
Finally, we add the individual rationality constraint, which ensures that the advisor will
accept the contract, and the limited liability constraint.
Exr\w(x,r)\eH^\-E>()
(2-3)

10
w(x,r)>0, Vx,r (2-4)
The investor's problem is then
Min Exr[w(x,r)]
s.t (2-1), (2-2), (2-3) and (2-4).
Lemma 2.1: Constraint (2-1) implies w(xH,rH)>w(xL,rH) and w(xL,rL)>w(xH,rL)
The proof of lemma 1 is straightforward, and is omitted. The (2-4) constraint
implies that the right hand side of (2-2) is nonnegative. Thus, (2-2) and (2-4) imply (2-3),
and we will ignore (2-3). Simple rearrangement indicates both (2-1) and (2-2) can be
expressed in terms of the two differences w(xH,rH)-w(xL,rH) and w(xL,rL)-w(xH ,rL).
This implies that (2-2) and (2-1) continue to hold under a simultaneous decrease of w(x,r),
Vx,r, provided the two differences remain unchanged. Lemma 2.1 and investor's cost
minimizing then imply w(xL,rn)=w(xL,rH)=0 in the optimal contract. That is, the advisor will
not be compensated if he makes a wrong prediction. The advisor is only compensated when
he makes a correct prediction. In the following, we denote w(xH,rH) by YG and w(xL,rL)
by Yb. Yg and YB represent the bonuses awarded to the advisor for correctly predicting the
good and the bad state respectively.
Constraint (2-1) implies the following two inequalities,
pH7iHYG>(l-pL)7rLYB,
Pl%Yb > (1 -Ph)71;h Yq-
These two constraints ensure that the advisor will truthfully reveal signals xH and xL given
he has expended effort eH. Contracts satisfying the two inequalities are represented by the
shaded area in figure 2-1. Contracts satisfying the first constraint lie under the line OH.

11
Contracts satisfying the second lie above OL. The small cone enclosed by the dotted lines
OH' and OL' contains contracts that induce truthful revelation at effort eL3. Figure 2-1
reveals that the set of truth-telling contracts at eL is a subset of the set of truth-telling
contracts at eH. This implies that it is easier to induce truthful revelation when the advisor
is better informed. Figure 2-1 also indicates that simple profit sharing contracts are not
incentive compatible. Consider, the payment scheme corresponding to point K. This
payment scheme awards the advisor only when investment yields a net profit. Such a
contract does not induce the advisor to truthfully reveal an unfavorable signal and results in
over-investment in the risky asset.
Feasible contracts must satisfy constraint (2-2) in addition to (2-1). Consider first
contracts lie in the cone enclosed by the dotted lines in fig.2-1. These contracts induce
truthful revelation at both the high and the low effort levels. For these contracts, constraint
(2-2) implies the following inequality,
(Ph'Qh^hYG+(pL-qL)nLYB > E
Contracts satisfying this inequality lie above the line AB (figure 2-2). Thus, the first subset
of feasible contracts lie inside the inner cone and above the line AB. Next, consider
contracts lie above OH' but under OH. These contracts induce truth-telling at eH but not at
eL. At eL, the advisor always prefers to report xL. For these contracts, (2-2) implies
[pH%] YG-( 1-qL^LYBl+lpL-qL^LYB^ E
Contracts satisfying this constraint lie under line AC. Thus, the second part of feasible
contracts lie above AH' and under AC. Similarly, contracts lying under OL' but above OL
3These contracts satisfy the same constraint as (2-1) with p replaced by q.

12
induce truthful revelation only at eH. At eL, the advisor always prefers to report xH. Applying
(2-2) to these contracts provides
(Ph'Qh^hYG+[pLtrLYB-( 1 Yg] > E
The final part of feasible contract lies under BL' and above BD. Feasible contracts which
satisfy all constraints are represented by the shaded area in figure 2-2. This shaded area lies
strictly inside the cone which contains the contracts eliciting truthful revelation at effort eH.
It follows that constraint (2-2) implies (2-1). A formal proof of this is quite simple and is
omitted.
The investor's problem is to find the minimum cost contract from contracts in the
shaded region in figure 2-2. Figure 2-3 depicts the investor's iso-cost lines. The cost
associated with the iso-cost line increases in the north-east direction. It is instructive to
consider first the case in which the advisor's signal is publicly observable. In this case, the
investor's only concern is to induce the advisor to choose the high effort level. All payment
schemes lying above the line MN are feasible. It is evident from figure 2-3, the optimal
contract corresponds to either point M or point N depending on the slopes of iso-cost lines.
If the iso-cost lines are steeper than the line MN, point M represents the optimal payment
scheme. Such a contract compensates the advisor only when he correctly predicts the
unfavorable state. Simple calculation reveals that iso-cost lines are steeper if pH/pL^(pH-
qH)/(PL-qt)- This condition can be written in a more suggestive form, (pL-qL)/pL> (pH-q^/PH-
The left hand side of the inequality is the percentage improvement of the accuracy of signal
xL. The right hand side is the percentage improvement of the accuracy of signal xH. Thus,
the advisor is more richly rewarded for correctly predicting bad investments if exerting extra

13
effort produces the greatest percentage increase in the advisor's ability to predict the bad
state. Correctly predicting the bad state is more indicative that the advisor is diligently
collecting information. Similarly, if exerting high level of effort produces the greatest
percentage increase in the advisor's ability to predict the good state, he is more richly
rewarded when he correctly predicts the good state. In figure 2-3, this corresponds to the
flatter iso-cost lines. Returning to the case when the advisor's signal is not publicly
observable, feasible contracts lie within the shaded cone. Since points M and N lie outside
of the shaded area, the optimal payment scheme in the previous case is no longer incentive
compatible. Instead, the optimal payment scheme is the point at which the iso-cost line is
just touching the shaded cone. Again, depending on the slope of iso-cost lines, the optimal
contract corresponds to either A or B. Figure 2-3 indicates that the investor continues to
reward the advisor more richly for correctly predicting a state if exerting high level of effort
produces the greatest percentage increase in the advisor's ability to predict that state. In
contrast to the previous case, however, the advisor is compensated for both correctly
predicting the favorable and the unfavorable state. Thus, the need to induce the advisor to
expend effort interacts with the need to elicit truthful revelation. The interaction makes it
more costly to induce the advisor to expend effort (as indicated in figure 2-3, the new
optimal contract lies on a higher iso-cost line).
The General Two State Model
In this section, we extend our analysis to a more general setting. Specifically, we
assume there is a continuum of effort level, ee[0,+°°). To focus on the interaction between
the two incentive concerns, we assume the correlation between the signal and the states

14
satisfies f(xLlrL,e)=f(xHlrH,e)=0(e) with 0'(e)>O, 0"(e) effort improves the accuracy of the two signals equally. The concavity condition reflects
decreasing marginal returns to effort. The advisor is strictly risk averse, with VA,(WA)>0
and VA"(WA)<0. The cost function C(e) satisfies C"(e)>0, C"(e)>0 and C(e)>0 (except for
e=0). Furthermore, we assume that VA(0)=C(0)=C'(0)=0 and VA (0)=+°°4. It will be
convenient to regard the cost as a function of 0 instead of e. The one-to-one correspondence
between e and 0 ensures that the function C(0) is well defined. It follows from our
assumption that C(0) satisfies C(0)>O (except for 0=1/2), C"(0)>O and C(1/2)=C'(1/2)=0. The
inverse of VA will be denoted by h, and we assume that h is thrice continuously
differentiable. We will denote W0[7tH(rH-R)+KL(R-rL)] by p. P is the marginal return from
improving the accuracy of the signal. The investor's problem, [I-P], is formally stated as
follows.
Maxe A(-) m-,-)Ex,XWS+Hx)(r-R)-w(x,r) | 0]
subject to
xEArgmaxx,Er[VA(w(x' /))|*,0] Vxe{xL,xH} (2-5)
6eArgmaxQ,Ex{Maxx,Er[VA(w(x,,r))-C(Q’)\x,Q'] | O'} (2-6)
EJVA(w(x,r))-C(Q)\0]> U=0 (2-7)
w(x,r)^0 xe\xLr>cH} re{rL,rH} (2-8)
Before proceeding, we present two results. First, we show that the investor's problem
4The assumptions C(0)=0, V/(0)=+°° and nHrH+7tLrL=R ensure that it is desirable for the
investor to hire the advisor.

15
has the following equivalent formulation [I-P'j:
Max&mM-,-)Ex,XW^ +Hx)(r-R) -w(x,r) | 0]
subject to
> n (xpXj) Vx„Xje {xL,xH}
(2-9)
deArgMaxQ,[L(xHjcL\0')-C(0')j
(2-10)
L(xHrKL 10) - C(0) > 0
(2-11)
w(x,r)>0 xe\xL7Xj¡i re{rL,rH)
(2-12)
w
Proposition 2,1: The investor's problem [I-P] is equivalent to [I-P'j6.
The advisor's strategy consists of choosing a level of accuracy in the first stage and
subsequently choosing a reporting rule in the second stage. Let {0,(Xj,Xj)} denote such a
strategy, with x^x^x^Xl}. Under this strategy, the advisor chooses an accuracy level 0 in
the first stage and reports x, or Xj when the acquired signal is xH or xL. It is easy to see that
L(xi,xj|0)-C(0) is the expected payoff to the advisor when he adopts the strategy {©.(x,^)}.
On the other hand, II(xi,xj) is the maximum expected payoff to the advisor if he chooses a
second stage rule of report (x¡,Xj), independent of the choice of 0 in the first stage.
Constraint (2-9) requires that the payment scheme nfx^), as a function of the rule of report,
5f(xHl0') and f(xLl0') are the marginal probability of the occurrence of signal xH and xL at
accuracy level 0'.
throughout the dissertation, all proofs are relegated to the appendix.

16
attains its maximum when the advisor reports truthfully. Constraint (2-10) requires that the
advisor's payoff, when he always reports truthfully, attains a maximum at 0—the accuracy
level induced by the investor's contract.
Second, we show the following lemma which will help to simplify the constraints.
Lemma 2.2:(T)II(xl.xl)=L(xl.xl| 6=1/2) and II(xH,xH)=L(xH,xH 10=1/2);
(2)If a payment scheme satisfies constraints (2), n(xH,xL)>II(xH,xH) and II(xH,xL)>n(xL,xL)
for 0>l/2, then
i) w(xH,rH)>w(xL,rH) and w(xL,rL)>w(xH,rL);
ü)II(xl,xh)=L(xl,xh 10=1/2).
If the advisor always announces xL or xH independent of the actual signal observed,
his expected profit must be independent of the accuracy of the signal. Since improving
accuracy is costly, the advisor optimally exerts no effort. This is reflected in Lemma 2.2 (1).
Part (2) ii) of the lemma implies that the investor must pay the advisor a strictly
positive bonus when he correctly predicts the state. This follows because the state rH (rL) is
more likely to occur conditional on xH (xL). The bonus is necessary to induce the advisor
to truthfully reveal his private signal7.
Given Lemma 2.2, we can simplify [I-P7] to the following problem [I-P"].
10]
subject to
7The ordering in the payment scheme is similar to the monotonicity observed in the
standard models with adverse selection Baron and Myerson (1982), Laffont and Tiróle
(1986). The single crossing property there corresponds to the condition 0>l/2.

17
deArgm&xQ/Exr[VA(w(x,r)) | 0;]
(2-16)
w(x,r)>0 xG{xLrK¡) re{rvrH)
(2-17)
In simplifying [I-P/], we have dropped the individual rationality constraint (2-11)
since it is guaranteed by the limited liability constraint. Constraints in [I-P"] closely
resemble those in the discrete model. The effort levels eH and eL corresponds to the effort
level which generates the investor's desired accuracy and zero effort level. The difference
arises from the continuous nature of effort levels. Again, it is instructive to consider the
problem in which the advisor's signal is publicly observable-reduced problem. The reduced
problem, [RP], is similar to [I-P"] but without the first constraint. Without the limited
liability constraint, the reduced problem corresponds exactly to the problem investigated by
Kilhstrom (1986). The solution of the reduced problem is summarized in the following
lemma. In the lemma, 0RP refers to the optimal accuracy level.
Lemma 2.3: At the solution to the reduced problem:
i)the compensation scheme is w(xH,rL)=w(xL,rH)=0 and w(xL,rL)=w(xH,rH)=h(C(0RP));
ii)the optimal level of accuracy 0RP solves Maxe[0(3-0h(C(0))] and 1/2<0RP<0FB<1.
Proof of the lemma follows from Kilhstrom (1984). However, for completeness, we provide
a derivation in the appendix.
Based on our analysis in the discrete model, the result in lemma 2.3 is well
anticipated. Since expending effort improves the accuracy of the two signals equally, our
previous analysis indicates that the investor should be indifferent between rewarding the

18
advisor for correctly predicting the favorable or the unfavorable state. Advisor's risk
aversion implies that he should be subject to minimum risk exposure. Therefore, the
investor pays the advisor a fixed amount whenever he makes a correct prediction, i.e
w(xL,rL)=w(xH,rH). The result of lemma 2.3 is illustrated in figure 2-4.
To solve [I-P"j, we adopt the two step approach in Grossman and Hart (1983). First
we characterize the optimal payment scheme for implementing a given level of accuracy.
Second we determine the optimal accuracy level. The problem for the first step is to
minimize Ex r[w(x,r) 10] subject to the same constraints as in [I-P"j.
Since the solution in the case is exactly symmetric to that in the case tch>til8,
we assume 7TH>7iL in the ensuing analysis. Simple rearrangements reveal that all the
constraints can be expressed in terms of VA(w(xH,rH))-VA(w(xL,rH)) and VA(w(xL,rL))
-VA(w(xH,rL)). This implies that the payment scheme remains to be feasible under a
simultaneous decrease of w(x,r) Vx,r, provided the two differences remain unchanged. The
following result is then obvious.
Lemma 2.4.1: In the optimal solution, w(xH,rL)=w(xL,rH)=0.
Similar to the discrete model, we denote VA(w(xH,rH)) by YG' and VA(w(xL,rL)) by
Yb'. Yq and YB' represent the two bonuses received when the advisor correctly predicts the
two states. Incorporating the constraints (2-16) and (2-17) produces the set of feasible
contracts indicated in figures 2-5 and 2-6 (the shaded cone). Depending on the level of
accuracy that the investor desires to implement, two possibilities arise. In the first case, the
8To find the corresponding solution for the case rrL>7tH, one simply interchange the
subscript L and H.

19
tangency point T lies inside of the shaded cone of feasible contracts. In this case, the need
to motivate the advisor is not in conflict with the need to elicit truthful revelation. The
solution is then the same as the reduced problem. The advisor is paid a fixed amount
whenever he makes a correct prediction. In the second case, the tangency point lies outside
of the shaded cone. The optimal contract in the reduced problem is no longer incentive
compatible. The optimal solution corresponds to the point at which the investor's iso-cost
curve is just touching the shaded area. The two incentive concerns interact with one another
and the constraint for truthful revelation becomes binding. As an intermediate case, the
tangency point lies at the comer of the shaded area. The corresponding accuracy is formally
stated in the following definition.
Definition 2.1:Let a=lim0 ,{0—, we define
C'(Q)
0°H to be the solution to 9-——, ifa>nH>l/2, 0° H= 1/2, if n ^=1/2, and
C7(0)
0°H=+1 if7iH>a9.
For an accuracy level 0<0°H, the tangency point lies outside of the shaded area. For 0>0°H,
the tangency point lies inside of the shaded area. We summarize the optimal reward scheme
in the following.
Lemma 2,4: Let a2(0)=(l-0)C/(0)+C(0) and a1(0)=0C/(0)-C(0) , the optimal
9The existence of a finite a follows from that 0- JíiíEL is both monotonic and
bounded above. Since C(0=1/2)=O, 9- undefined at 0=1/2 by continuous
C(0)
extension.

20
payment scheme implementing a given accuracy level 0 is
i)if 0>0°H w(xH,rH)=w(xL,rL)=h(C'(0));
a a,(0) a7(0)
ii)if 0<0 h w(xH,rH)=h(——) nn nL
Lemma 4.2 indicates that the critical accuracy 0°H separates the accuracy levels into
two regions. The intuition behind this is the following. In exploiting the information
advantage by exerting no effort and always reporting xH (or \), the advisor loses the
opportunity of profiting from correctly predicting the state at xL (or xH). Under a symmetric
payment scheme (part i) of lemma 4.2), such loss in profit increases with the accuracy level
induced. Above the critical accuracy level 0°H, this loss is larger than the advisor's cost
saving from exerting no effort. Therefore, the symmetric payment scheme is sufficient to
ensure that the advisor chooses the accuracy level induced and reports truthfully. Below 0°H,
the symmetric payment scheme does not impose enough opportunity cost on the advisor.
Consequently, it is insufficient to ensure that the advisor chooses the induced accuracy level
and reports truthfully. The investor must reallocate the payment among the two instances
when the advisor correctly predicates the states, so as to impose sufficient opportunity cost
on the advisor. Given 7ih>ttl, 0^ is more likely to occur based on the prior. Under a
symmetric payment scheme, the advisor will always report xH if he chooses to expend no
effort. To prevent this, the investor decreases the payment when the advisor correctly
predicts the favorable state and increases the payment when the advisor correctly predicts
the unfavorable state. The new payment scheme thus increases the advisor's opportunity cost
for not expending effort. In this case, the need to elicit truthful revelation interacts with the
need to motivate the advisor to expend effort.

21
In the second step, the investor chooses the accuracy level to maximize his profit by
employing the payment scheme specified in lemma 4.1 and 4.2. The following proposition
summarizes the solution to the full problem. In the proposition, 0SB denotes the second best
accuracy level.
Proposition 2.2: At the solution to [I-P], w(xH,rL)=w(xL,rH)=0 and
i)if 0RP>0°H, then 0SB=0RP and w(xH,rH)=w(xL,rL)=h(C'(0SB));
ii)if 0°h>6rp then the optimal compensation scheme is
a,(0cH) (0cR)
w(xH,rH)=h(— -) 7Ih TZl
and 0SB< 0°H solves the problem
, zzT (0) a7(0)
MaxBe[V2e°]{0P-0[V*(——) +nLh(-l—)\ .
Part i) of proposition 2.2 follows directly from lemma 2.4. If the optimal accuracy
level induced in the reduced problem is higher than 0°H, the optimal payment scheme in the
reduced problem is incentive compatible in the full problem. Clearly, it is also the optimal
solution to the full problem.
Part ii) of proposition 2.2 indicates that, when 0°H>0RP, the optimal asymmetric
payment scheme implementing 0SB, in the region (1/2,0°H), dominates all the symmetric
payment schemes implementing accuracy levels higher than 0°H. The second best optimal
payment scheme assumes the form indicated in part (ii) of lemma 4.2. In this case, the
solution to the full problem is different from that in the reduced problem. The advisor is
paid more when he correctly predicts the state less likely to occur.
Finally, we briefly discuss the problem of the uniqueness of the second best solution.

22
The second best solution is unique if 0RP>0°H. However, when the optimal payment scheme
is asymmetric, i.e when 0RP<0OH, the investor's objective function is generally not concave10.
The following tie-break rule guarantees the uniqueness of the second best solution.
Assumption 2,1: If there are multiple second best solutions, we assume that the investor will
implement the solution with the highest accuracy level(largest 0).
The implication of the assumption is as follows. If there are two distinct 0s both
solving [I-P"], the advisor is strictly better off under the higher 0 that solves [I-P"]. This
follows from the fact that the expected total payoff to the investor's profit is the same under
the two 0s, and the fact that the investor's profit from investment is strictly increasing in 0.
Therefore, assumption 2.1 amounts to assuming that when the investor is indifferent between
implementing two different 0SB he will implement the one most preferred by the advisor.
Under assumption 2.1, the second best solution is unique.
Proposition 2.3: There exists a largest 0 which solves the optimization problem in
proposition 2.2 and hence the second best solution is unique under assumption 2.1.
The relations between the optimal accuracy levels are in general ambiguous. This
is due to the dependence of 0SB on the advisor's risk premium function. However, under the
condition h'"(d)> 0 n, the second best accuracy level is strictly smaller than the first best
accuracy level.
Proposition 2.4: Given h'"(d)>0 , 0RP<0FB.
I0If 7tH=139/144 and 0RP<0°H, then the second order derivative of the objective function
in proposition 2.2 is positive at 0=3/4 when the inverse utility function is h(x)=x2/2.
nThe third derivative of h(.) is positive when the advisor has constant or increasing risk
aversion. It also holds when the advisor's risk aversion decreases slowly.

23
The following proposition indicates, under more restrictive conditions, the second
best accuracy is also lower than that of the reduced problem.
Proposition 2.5: Assuming Zz///(0)>O ,
i)If 0RP>e°H, then 0SB=0Rp
ii)If 0RP<0 pj and 0gB When 0sb>7Ih an(J 0rp the following example.
Example: Suppose the cost of information collection is C1(0)=a(0-l/2)2/2. The investor's
inverse utility function is h(x)=x2/2, and the prior is 7tH=3/4. For this case, we find 0°H=1.
From lemma 2.3, 0RP find p/a2=.42666. Since 0RP is strictly increasing in p/a2. Thus, when p/a2=.42666, we
have 0rpc.9=0sb.
Our next result compares the investor's profits PFB, PRP and PSB for the first best, the
reduced problem and the second best respectively.
Proposition 2.6: i)The investor's profits are ordered by PFB>PRF>PSB. The second inequality
holds strictly when 0RP<0°H.
ii)Fet Pa(tuh) be the investor's profit in the second best solution. For fixed p, Pa (% ) is
continuously decreasing in tih, for 1/2<7tH Similar to the discrete model, the investor's profit decreases as the signal becomes
the advisor's private information. This is due to the loss in risk sharing when the investor
I2In changing 7%, we maintain the assumption that the expected payoff of the risky asset
is the same as that of the risk free asset so that the optimal investment decision is
unchanged.

24
must reallocate the payment between the two instances when the advisor correctly predicts
the state.
The intuition for part ii) of proposition 2.6 is the following. From lemma 2.2, the
advisor optimally exerts no effort and always reports either xH or xL if he deviates from the
strategy induced by the contract. As prior tih increases, the advisor is more certain about
the state occurring. Therefore, it becomes more profitable for the advisor to exert no effort
and predict the state most likely to occur. The cost of motivating the advisor increases.
Consequently, the investor's profit decreases.
Extension
In the analysis so far, we have assumed that the ex post realization of state is
costlessly observable. Sometimes return from investment not undertaken may never be
observable. Such instances often arise for firms with firm-specific investment opportunities.
To optimally compensate the manager, the assumption above must be relaxed.
In the following, we show that the analysis in the previous section can be directly
applied to this case. To this end, we assume that the return from investment not undertaken
can not be observed ex post. To facilitate comparison with results in the previous section,
we assume Given the optimal investment decision, the risky project is not
undertaken if an unfavorable signal xL is reported. The assumption that the realization of
state is not observed if the project is not undertaken implies that the compensation
contingent on the unfavorable report must be independent of the state, i.e w(xL,rL)=w(xL,rH).
The investor's problem in the extended model is similar to [I-P] except that we need
to add the constraint w(xL,rL)=w(xL,rH). In employing proposition 2.1 and lemma 2.2 to

25
reduce [I-P] to [I-P"], it is not necessary to assume w(xL,rL)*w(xL,rH). It follows
immediately that the optimization problem corresponding to the extended model is the
following.
MaxQ \(x\w(w)Ex,XWS +Hx)(r-R)-w(x,r) 10]
Exr[VA(w(x,r)) 10]-C(Q)>Ex{Maxx£r[VA(w(x 7,r)) 16=1*] 10=1} (2-18)
Qeargmaxe,Ex r[ VA(w(x,r)) 107] (2-19)
w(x,r)> 0 xeixjjPCj) re{rL,rH) (2-20)
w(xL,rL)=w(xL,rH) (2-21)
Again, we consider the problem of implementing a given 0 at minimum cost. The
following lemma describes such minimum cost payment scheme.
Lemma 2.5: The minimum cost payment scheme implementing accuracy level 0 is
w(xH,rL)=0,
w(xHTH)=al(0)/-n:H+a2(0)/'n:L, w(xL,rL)=w(xL,rH)=a2(0)/7rL, where aj(0) and a^O) are given
in lemma 4.2.
The proof of lemma 2.5 proceeds in the same way as that of lemma 2.4.2, and is
therefore omitted. Similar to the previous analysis, lemma 2.5 indicates that the payment
is strictly positive at the unfavorable report. This is necessary to induce truthful revelation
when the unfavorable signal is observed. In contrast to the previous model, the payment for
correctly predicting good state is strictly higher than that at unfavorable report. When the
state rL is never observable if the project is not undertaken, the investor can not discern
whether the manager's prediction is correct or not when he predicts the unfavorable state.

26
In this case, the only way in which the investor can verify manager's prediction is when the
manager predicts the favorable state. Thus, the only indication that manager has expended
effort is the correct prediction of favorable state. Consequently, he is rewarded more in such
instances.
Conclusion
Our analysis focuses on how an investor best motivates a privately informed advisor
to expend effort. The need to motivate the advisor stipulates that he should be rewarded
more richly for correctly predicting the state if expending effort is most effective in
enhancing his ability to predict that state. The presence of the unobservability of signal
generally interferes with the need to motivate the advisor. Our analysis reveals that when
the investor induces the advisor to acquire quite accurate information, whether the signal is
publicly or privately observed is inconsequential. In other cases where the investor requires
a lower accuracy level, inducing the advisor to reveal his information strictly increases the
investor's cost of contracting with the advisor. Further, we find, under fairly general
conditions, that the effect of moral hazard and hidden information in the investor—advisor
relationship is to reduce the amount of effort that the advisor is induced to supply. The
investor's profits also decrease if the investor is unable to monitor effort or to observe the
investor's signal.
In considering directions for future research, we suspect that the methodology
developed here might fruitfully be applied to examining other agency relationships. For
instance, examples in which a company seeks the advice of a marketing expert on
developing new sales strategy or a resource company consults with a geologist concerning

27
oil or minerals exploration have elements in common with investor-advisor relationship that
we analyzed here.
Further extensions of our analysis would involve relaxing or modifying some of the
simplifying assumptions we have employed. First, our binary information structure might
be extended to allow for multiple signals and multiple states of nature. We suspect,
however, that our main qualitative results, as summarized in Proposition 2.2, will continue
to hold in the more general setting. Second, our single-investor and single-advisor
relationship might be modified to allow for multiple advisors who supply the investor with
independent assessments of investment prospects. A promising approach to modeling this
case appeal's in the work of Dewatripont and Tiróle (1995) on the use of advocates in agency
relationships. Finally, our single period investor-advisor relationship might be modified
to extend to several periods. Interesting issues arise in this setting as the advisor may modify
his behavior to maintain or enhance his reputation. Reputational concerns may reduce the
advisor's tendency to shirk or to misrepresent the signal he observes. These and other related
issues await further research.

28
Yb
Figure 2-1

29
Yb
Figure
2-2

30
Yb
Slope of MN -(pg - qg )/ (Pb ’ %)
Slope of iso-cost line (dotted line)

Figure 2-4

32
Figure 2-5

33
Figure 2-6

CHAPTER 3
SETTING LEGAL STANDARDS FOR CREDIBLE COMPLIANCE
Introduction
For most parties the threat of being fined or punished provides incentives to take care
not to harm others. For instance, motorists may obey traffic regulations, industrial firms may
resist fouling the air, and manufacturers may produce safe toys all to avoid fines for violation
of standards.
The chance that a party will be fined not only depends on his action, but also on the
effort that law enforcers exert to insure compliance. Recent experience reveals that it is
difficult for public officials to control the behavior of enforcement agencies.1 This suggests
that law enforcers need to be motivated to detect violators, perhaps by rewarding them
according to their success in discovering violations.2
In such a setting the equilibrium interaction between potential offenders and law
enforcers will determine how regulations are observed and enforced. The amount of effort
‘Most recently displeasure with the performance of the Internal Revenue's Service prompted
Congress to cut the agency's compliance budget. Previous to this Congress had similarly
intervened in the affairs of the FTC and the EPA to correct what it perceived as inappropriate
enforcement of government policy.
2This approach differs significantly from most of the formal literature on law enforcement and
monitoring, as exemplified by Baron and Besanko (1984), Border and Sobel (1987) and
Mookherjee and P'ng (1992, 1994). These analyses assume that law enforcers can commit
to a monitoring strategy independent of whether the strategy uncovers violators in
equilibrium. A notable exception is Graetz et al (1986) who assume that enforcers are
motivated by the fines they collect from prosecuting violators.
34

35
enforcers exert will depend on the perceived likelihood that parties have violated standards,
and the likelihood of violation will depend on how vigorously the law is enforced. In turn the
behavior of offenders and enforcers will be shaped by the standards determining if a party has
violated the law. Examples of standards include a maximum number of product failures a
manufacturer can experience before violating a safety code, or a minimum concentration of
effluents found in a water sample that cause a waste discharger to violate emission
regulations.
Beginning with Becker (1968) most analyses of the economics of enforcement have
taken legal standards as given, and focused on the setting of fines as the primary tool of
enforcement. In practice, though, the ability of enforcers to vary statutory fines is restricted
by political, moral and legal constraints. In contrast, agencies may have some discretion in
setting standards for determining when a party's actions are harmful. The primary goal of this
chapter is to characterize how the setting of legal standards affects the behavior of complying
parties, law enforcers, and the net social surplus generated by the regulation. Another goal
of the chapter is to examine the extent to which setting standards and fines are substitute
instruments for law enforcement.
Under optimal circumstances, where law enforcers can costlessly detect violations,
offending parties should be induced to select care so that the marginal cost of care equals the
social marginal benefit. However, we find that when enforcers must be incented to monitor
compliance, it is desirable to induce care levels that either exceed or fall short of the surplus
maximizing level.
The intuition for this finding is that some distortions in care are required to reduce the

36
cost of law enforcement. Suppose standards are initially set so that the marginal costs and
benefits from taking care are equated. Then a slight variation in standards will not appreciably
affect net benefits,3 but it will cause a nontrivial adjustment in the enforcer's costs and effort.
In some instances a slight loosening of standards will decrease enforcement costs. This will
arise whenever looser standards causes enforcers to reduce their effort because the marginal
returns from monitoring decrease as the probability of noncompliance decreases. We refer
to this as the complements case because monitoring effort and standards are complementary
inputs in determining the probability of a violation. In this instance, it will be desirable to
loosen standards and induce less care in order to reduce the costs of enforcement.
For other applications monitoring effort may fall as the probability of noncompliance
increases. This will arise if the returns from monitoring compliance in order to prove a
violation will diminish as the degree of noncomplying behavior increases.4 For this case,
referred to as the substitutes case it will be desirable to set tighter standards and induce
greater care in order to reduce the enforcer's expenditure on effort.
This is the central result of the chapter which is formally derived in Section 3. In
Section 4 we consider the possibility that the costs of monitoring effort vary by the enforcer's
ability to observe and process information. These costs are known privately by the enforcer.
We show that the presence of asymmetric information reinforces our main finding that
3To a first order, a small change in standards has no effect on net benefits since marginal
benefits and marginal costs of care are the same.
4For instance, it may not be necessary to expend much effort by employing sophisticated
measuring devices to detect excessive discharge of effluents when polluters are in obvious
violation of the law.

37
violation standards are distorted to reduce enforcement costs.
In section 5 we examine the possibility that parties differ in the costs they incur in
taking care. We show how our main finding generalizes to this case, and demonstrate the
optimality of allowing the highest cost parties to pay a fixed fee which absolves them from
prosecution for a violation. Further, we demonstrate that corrupt enforcers can collude with
potential offenders to similarly offer high cost parties protection from the law in exchange for
a bribe.
In section 6 we examine the relationship between fines and standards. We find that
, in contrast to Becker (1968), it is not necessarily desirable to impose the largest fine.
Increases in fines may increase costly enforcement effort.
The chapter is concluded in section 7 with a summary of results and suggestions for
further research. The elements of our model are introduced in the next section and all formal
results are derived in the appendix. We relegate the discussion of related findings in the
literature to those sections of the chapter where the results for comparison with the literature
are presented.
Elements of the Basic Model
There exists a party who can exert some care denoted by q > 0 to avoid harming other
individuals. For instance q, may be the discretion a motorist exercises to avoid an accident;
q may be the control of emissions by a waste discharger, or q may be product quality a
manufacturer supplies to avoid breakdowns. The party incurs a monetary cost or disutility
of supplying q, denoted by C(q) which is increasing and strictly convex with C 7(0) = 0.

38
Social benefits from q are given by Bq, where B > 0, is the constant marginal benefit.5
The government sets a standard, denoted by 5, as a criterion for determining if a party
has exercised proper care. Depending on the application, 5 may be a speed limit which
motorists must obey, or a maximum allowable concentration of pollutants in a discharger's
water or air sample. To avoid the daunting task of explicitly modeling the bureaucratic and
legal process by which violators are prosecuted we adopt a simpler reduced form description
of the enforcement process. We assume that given 5 and q there is a probability that the
party will be successfully cited for violating the standard denoted by P(q,s,e) e [0,1], where
e is the effort the law enforcer supplies to monitor the party. We assume that this probability
is decreasing as the party supplies more care at a decreasing rate with Pq < 0, and Pqq > 0
whenever e> 0. A tightening of standards increases the citation probability, Ps > 0 for e >
0. Further P is increasing in the enforcer's effort, at a decreasing rate so
that Pe >0, Pee< 0. This implies that the burden of proof falls on the enforcer to
demonstrate that a violation has occurred. Finally, we assume that the sign
(Pes) = sign (~Peq) which means that an increase in standards or a decrease in care both
have the same qualitative effect on the enforcer's marginal returns from effort, Pe 6
As mentioned in the introduction, we distinguish between two cases describing how
5This specification of care benefits is made for simplicity and is not essential for the foregoing
analysis.
6A simple specification that satisfies our assumptions isP (q,s,e) = p{6,e) where 5 - s-q
measures the gap between the standard and the care provided, and p6,p55 >0. In the
context of pollution standards, 5 might measure the difference between acceptable and actual
effluent concentration in a water or air sample for example.

39
d/ds (P ) < 0,311 increase in standards affects the incentives for enforcers to monitor. In the
complements case dlds (Pe) >0, and an increase in standards increases the marginal returns
to monitoring. This might arise, for instance, if a party is cited whenever he is simultaneously
violating the law and he is being monitored by the enforcer. In that case a tightening of
standards will increase the probability that the party is in fact violating the law, which will
therefore increase the enforcer’s returns from monitoring. In the substitutes case, and a
tightening of standards reduces the marginal returns to monitoring. This situation arises ,for
example, if the enforcer knows whether a party has violated the law, but he must expend
effort to prove the violation has occurred. When standards are tightened violations of the law
are easier to demonstrate. Consequently, the enforcer’s expenditure of effort required to
prove a violation is reduced. 7
7 An example of a monitoring technology satisfying all the assumptions we have posited for
the substitutes case is
P(q,s,e) = -
where
i - Ufa)
f \ e)dX s > p(q)
o
0 s f(X\e) = B(e)e~B^x ,X > 0
B(e) = e/(\+e)
\i{q) = ln(l + q) ,q> 0
In this example, a agent exercises care q to produce a product with quality p (q). The
enforcer observes a signal of quality, a, given by
a = p (q) + X
Exerting greater effort allows the enforcer to observe quality with greater precision

40
If cited the party pays a fine, F > 0 for his offense. Consequently, the expected
penalty for a violation is given by P(q, s, e) = FP(q, s, e). Throughout most of our analysis
we assume that F is fixed, thus allowing us to focus on the setting of standards as the primary
tool for shaping compliance and enforcement behavior.8 Later in section 6 we examine the
implications of varying the level of the fines, as well as the extent to which fines and standards
are substitute instruments for law enforcement.
as reflected in the specification for /(A | e). One can easily verify that this
specification satisfies our assumptions for the substitutes case
A slight variation on the first example allows us to produce another
monitoring technology which satisfies all of our assumptions for the complements
case. Here we assume that
o = n(?) + {1 - exp [ - (A + g(»/B(e))]}
where
g(e) = -2 In
Then for s e
P(q,s,e) =
\ e + l)
(p(<7) + i-e«y*\ |i(<7) + l)
0
which satisfies the assumptions required for the complements case.
8This treatment of fines differs from the economics of crime literature, as exemplified by
Becker (1968), Stigler (1970), Polinsky and Shavell (1979), Malik (1990), Andreoni (1991)
and Mookerheijee and P'ng (1992, 1994), which typically treats variations in fines as a
primary enforcement tool. In reality the level of fines is set by the legislative branch, and the
ability to adjust statutory penalties is restricted as noted by Graetz et al (1986). Harrington
(1988) points out that the fines for violation of environmental standards are constrained to
be quite small.

41
Enforcement of the standard is delegated to a single agency, who supplies effort to monitor
potential offenders.9 There is a cost borne by the agency personnel of supplying effort given
by the function, D(e), which is strictly increasing and convex in effort with D y(0) = 0 . We
make the realistic assumption that it is not possible for public officials to commit the agency
to an enforcement policy or to know how diligently the agency enforces standards. Any
agency model is likely to be deficient in describing some aspects of bureaucratic behavior,
nonetheless we require some paradigm to proceed. We therefore assume that the agency
selects an enforcement strategy to maximize the expected sum of fines collected net of the
costs of enforcement effort.10'11
The interaction between the party and the enforcer is modeled as a game. The party
chooses care q(e;s), given the enforcer's effort and the standard where
q (e; s) = argmax {U(q, e, s)=-P (q, s,e)-C (q)}. The enforcer chooses effort e(q;s) given the
q
party's care decision and the standard, where
e ( °We are assuming that economies of scale in collecting and processing information dictate that
enforcement be centralized.
10This approach is also employed by Graetz et al (1986) in their analysis of tax compliance.
Our results do not change significantly if we assume more generally that the agency is
rewarded based on some increasing function of the fines collected. For instance, promotion
of agency personnel may be conditioned on their success at prosecuting violators.
“Alternatively, we might imagine that enforcement is undertaken by a private firm selected
by the government. The relative advantages of employing private versus public law
enforcement are discussed in Becker and Stigler (1974), Landes and Posner (1975) and
Polinsky (1980).

42
Tis a government transfer paid to the agency to insure it breaks even.12 A Nash equilibrium
to this game consists of a decision pair {q(s), e(s)} such that q(s) = q(e(s);s) and e(s) =
e(q(s);s). Below we demonstrate that such an equilibrium exists and that it is unique given
5.
We assume that the government's objective function , V = (Bq - T) + U + XII, is the
societal benefit of care net of government subsidies to the enforcer (Bq-T), plus the utility of
the party, U, plus the enforcer's profit, discounted by X < 1. The discounting of enforcer
profits derives from the fact that the government's primary constituency is the public at large,
including the care providing parties.13 In this case the government limits the agency’s profit
to zero. Rewriting V, the government’s problem [G-P] becomes
max V(s) - max B(q(s)) - C(q(s)) - D(e(s)) [G-P]
The government selects a standard 5 to maximize the net benefit of inducing a given level of
care, including the costs of enforcement given the Nash equilibrium behavior of the party and
the enforcer.
Analysis of the Simple Case
For a given standard, 5, the corresponding Nash equilibrium care level and
enforcement effort are characterized by
-Pg(q,e,s)-CXq) = 0 (3.1)
Pe(q,e,s)~D'(e) = 0 (3.2)
^Alternatively ,T is a tax which allows the government to collect excess revenues, when the
agency generates positive profits.
13In the symmetric information case of section 3 the government sets T = P-D, so that
II = 0, and the government's objective function simplifies to become Bq-C -D

43
Given e, and s, the party selects care to equate the marginal reduction in expected fines to the
marginal cost of care. The enforcer optimally responds to q and s by selecting effort to
equate the increase in expected fines to the marginal cost of effort. Given our assumptions
we have:
Proposition 3,1: A unique Nash equilibrium exists satisfying (3.1),(3.2)
The reaction functions for the party and the enforcer and the resulting Nash equilibrium for
the case of complements and substitutes are displayed respectively in Figures 3-1 and 3-2.
When the standard and enforcement effort are complements, an increase in care decreases the
probability of noncompliance which causes the enforcer to allocate less effort as indicated by
the negatively sloped reaction function e(q:s) in Figure 3-1. A decrease in enforcement effort
induces less care as reflected by the positive slope of the q(e:s) reaction function. By contrast
in the substitutes case, Figure 3-2 reveals that an increase in care induces greater effort from
the enforcer, whereas greater enforcement effort causes the party to be less careful.14
The Nash equilibrium characterized by (3.1) and (3.2) corresponds to a given
standard, 5. To investigate how the equilibrium behavior of the party and enforcer vary with
different standard levels we introduce the following assumption
Assumption 3.1: (dqlds)| > {dq (e (s),s)/ds) |
de-0 de(s)=0
Assumption 3.1 provides sufficient conditions for determining how enforcement effort varies
14This result arises because the marginal reduction in expected fines from increasing care is
decreased when enforcement effort is increased in the substitutes case.

44
with the tightness of the standards. To interpret this condition, note that
(dq(e (s),s)/ds) | measures the response of care to an increase in standards required for the
de(s)=0
enforcer to maintain a constant level of effort. The expression (dq/ds) | reflects the actual
de=0
change in care for an increase in standards undertaken by the party assuming enforcement
effort in unchanged. Assumption 1 requires that the actual change in care undertaken by the
party is insufficient to maintain the enforcement effort at a constant level. This simply implies
that a change in standards will induce a nonzero response from the enforcement agency.
Assumption 3.1 is satisfied for the example where P(q,e,s) = p(s-q,e)15.
The effect of tightening the standard on equilibrium care and enforcement is
characterized by:
Proposition 3,2: A tightening of standards always leads to greater care. Given Assumption
3.1, tighter standards lead to more enforcement effort in the complements case, and it leads
to less effort in the substitutes case.
According to Proposition 3.2, the party always increases care as standards tighten to partially
reduce the probability of being cited. Despite this increase in care, the opportunity for the
enforcer to find a violation increases with a tightening of standards. This leads to an increase
in effort when standards and effort are complements as the enforcer's marginal return from
effort increases. In contrast, when effort and standards are substitutes the enforcer reduces
effort since there is less need for monitoring to convict the party.
15 When
P(q,e,s)=P(s-q,e)=P(6,e), then (dq/ds)| = 1 >PJ(P66 + C") = (dq(e(s),s)/ds) i
de=0 de(s)=0

45
The government sets a standard to maximize the net benefits from care, including
enforcement costs. If enforcement were costless, it would be optimal to set standards to
induce care levels which equate the marginal benefit and marginal cost of care. This
prescription for setting standards will not be optimal, however, when enforcement is costly.
For suppose we begin with such a standard and assume that effort and standards are
complements. A small reduction in standards, will decrease care, but, there will be virtually
no effect on net benefits since the marginal benefits and marginal costs of care are
approximately equal. However, a small reduction in standards will cause enforcement effort
costs to decrease by a non negligible amount. Consequently a small reduction in standards
below the level which would cause the marginal benefits and costs of care to be equated, will
result in an increase in net surplus inclusive of compliance costs. A similar argument
establishes that when standards and enforcement effort are substitutes, it is optimal to increase
standards above the level which would induce the net benefit maximizing level of care. This
is the intuition underlying the following proposition. In that proposition we refer to q* as the
care level which maximizes the net benefits from care (excluding enforcement costs) and s(q*)
as the standard which induces q* in equilibrium.
Proposition 3.3: Let S be the solution to [GP]. In the complements case, s < £(<7*) and
B - C!(q(sj) > 0 as the optimal standard induces less than the net surplus maximizing level
of care. In the substitutes case, s > s(q*) and B - C '(q(s)) < 0 as the optimal standard
induces more than the net surplus maximizing level of care.
Proposition 3.3 shows how the enforcement monitoring technology influences the standards
for due care, as well as the care level provided in equilibrium. When standards and effort are

46
complements, then standards must be relaxed to prevent enforcers from being overzealous
in ensuring compliance. This could possibly explain why some safety and environmental
standards appear to be too lax from the view point of the general public. Landes and Posner
(1975) have similarly noted that it may be necessary to reduce violation fines to prevent over
investment by private enforcers.
The results for the substitutes case are perhaps more surprising. One's intuition might
suggest that when enforcement is costly this would add to the costs of inducing parties to take
care thus making it optimal to induce lower care. However in the substitutes case,
compliance costs are reduced by making it easier for enforcers to convict parties by tightening
the standards, but tighter standards induce the parties to supply greater care.
Privately Informed Enforcer
In this section we extend our basic model to consider instances in which the enforcer's
cost of effort is private knowledge. Such cases may arise when the cost of monitoring varies
by the diligence required to apprehend offenders, by the nature of the offense, or by the
characteristics of the parties. All of these attributes may be privately known by the
enforcement agency. Hidden information may present difficulties for the government, if it
operates under a fixed budget, and the agency claims its costs of enforcement are high. The
government must insure the agency staff are adequately compensated to insure their
participation, but it also must minimize the expenditures required to run the agency. We
focus here on how care standards are optimally set under these circumstances.16
i6To our knowledge the impact of privately informed enforcers on the design of optimal fines
and standards has not been analyzed in the literature.

47
Suppose that the cost of effort is given by D(e, 8) where 8 is a cost parameter known
privately by the enforcer, with the properties that D0 (e, 8), Deg(e,8) > 0 so that total cost
and marginal cost of enforcement are increasing in#17 The government is unaware of the
realization of 8, but it knows that 8 is distributed according to the density
/(0) > for0e [ 0,0 ].
We assume that the timing of the interaction between the government, the agency and
the party is: first, the agency observes 8. Second, the government offers the agency a menu
of contracts {T(8),s(8)}, where the dependence of the pair on 8, denotes that it is intended
for the agency of type 6. 18 T is a reimbursement paid by the government to the agency to
help cover its enforcement expenses. Third, the agency selects a preferred contract. The
contract choice is public knowledge and the parties update their beliefs about the type of the
enforcer based on the agency's contract choice. Fourth, simultaneously the parties choose
their level of care, and the agency selects enforcement effort. Finally the agency collects fines
from those parties found to be in violation of the standard.
Let n(07|0) denote the agency's expected profit who selects the contract
{T(07), s(07)} when their type is 0, where
n(0/|0) = P(g(5(0/),0/),e(5(0/),0),5(0/))-D(e(5(0/),0),0)-F((0/),
q(s(Q/),Q/) is the equilibrium care level for the standard 5(07) given that the enforcer has
chosen the contract intended for type 07. The enforcer's contract choice affects the parties'
beliefs about the enforcer which influences their choice of care. The equilibrium enforcement
17We continue to assume that D is increasing and strictly convex in e, and that/7g(O,0) = 0.
18That is, the menu is designed so that type 0 will choose {7(0),5(0)}

48
effort e(5’(0/),0) depends on the standard, as well as on 0 which is the enforcer's type.
The government's problem [GP-A] for this case is to choose {7(0), 5(0)} to
max Eq V(5(0), 0)) [GP-A]
where Ee is the expectation taken with respect to 0, and such that for all 08[0 ,0]: (i) the
agency breaks even, II (0) = II (010) > 0, (ii) the party picks the contract which is intended
for it, ü(0|0) > II(0/|0).
In what follows, we focus on the separating equilibria solution to [GP-A] in which
each type 0 is induced to select a separate contract.19 As a convenient benchmark for this
solution to [GP-A] consider the complete information case, analyzed in section 3, where the
government and the party know the agency's cost parameter, 0, at the time of contracting.
Let 5 * (0) be the standard which induces the party to choose the net benefit maximizing care,
q*, in equilibrium. Refer to s (0) as the optimal standard given the agency is known to be
of type, 0. We then have :
Proposition 3.4: In the separating solution to [GP-A] the optimal standard, s (0) satisfies
(i) 5(0) ¿ 5(0) < 5 *(0) for the complements case, and (ii) 5(0) > 5(0) > 5*(0) for the
substitutes case (with strict inequality for 0 > 0 in both cases) .
The presence of a privately informed agency causes a greater distortion in standards away
19Another possible policy for the government is to offer pooling or semi-pooling contracts in
which several different types of enforcers are induced to accept the same contract. In this
case, the enforcer's choice of a contract would not necessarily reveal his type. Such a policy
might be beneficial if it were less costly to enforce standards when the enforcer's type was
not known by the care providers. Deriving conditions under which pooling or separating
contracts are preferred seems quite difficult, and therefore determining the optimal form of
contract remains an open question. Although we focus on separating contracts in our
discussion, we demonstrate in the appendix that Proposition 3.4 also holds for the case of
pooling contracts

49
from 5 *(0), the level which induces the net benefit maximizing care. This arises because the
agency will try to overstate its costs to obtain a more favorable contract from the government.
In the case of complements the government reacts by reducing compliance standards which
decreases the enforcer's effort. This renders it less attractive for a low cost enforcer to claim
to be high cost, by reducing the number of effort units over which he can exercise his cost
advantage. As a result of the reduction in standards the party provides less care as
g(5(0)) < q(s(Q)) When effort and care are substitutes the government increases the standards, thus
reducing the incentives for the enforcer to monitor. Again this makes it less attractive for a
low cost enforcer to pretend to be high cost, because it reduces the number of effort units
over which he may exercise his cost advantage. This tightening of standards induces the party
to increase its care as c/(f (0)) > ?Cs(0)) > q*.
Heterogenous Parties
In this section we examine desired alterations in optimal standards when there is a
heterogenous population of parties varying according to their cost of taking care. Variations
in cost arise because the parties have access to different methods to reduce the harmful effects
of their behavior20. Further we assume that the parties are privately informed about their cost
of taking care. As in the previous cases we've studied, the government sets a uniform
standard which parties must adhere to. However, with a heterogenous population, the
20For instance, firms may differ according to the costs they incur to reduce pollution.

50
government may grant higher cost parties immunity from the standard, if they pay a fix fee.21
This arrangement saves high cost parties the expense of meeting standards, while reducing
the enforcer’s monitoring costs.22
We model the heterogenous party population by assuming that an individual's cost of
care is given by C(q7 ¡j) , whereq is a privately observed cost parameter. Total and marginal
costs are increasing in q, with, Cu, Cqq > 0, for q > 0, 23 The density of parties of type q in
the population, which is normalized to one is given by g(/u) > 0 for We assume
the government offers parties the choice of either paying a fixed assessment, A to the
enforcer, which exempts them from being cited, or the choice of trying to meet the standards'.
Let q(s,q) = argmax (-P (e (s),q(s),s) - C(q,/a)), be party type /Ts optimal care to avoid
being fined. Given A, and q, type //s response is to pay A and avoid providing care if
(-P(q(s,/P)e(s),s) - C(q(s7/P)7[P)) < -A, otherwise the party provides care q(s,/j). Fora
given A, some subset of the highest cost individuals ¡iz (/¿, q] for q < q will elect to pay the
assessment, A. The cutoff type, ¡1 will just be indifferent between investing in care and
paying the assessment to avoid being cited.
The government's problem, for the case of heterogenous parties, [GP-P] is to choose
2’Alternatively, parties may self report their violations to the agency, where upon they are
assessed a fixed fee. as in Kaplow and Shavell (1994).
22In theory if the set of potential offenders was known by the government, a menu of different
standards and fines could be offered to separate out offenders by their cost of taking care.
This approach is employed by Mookherjee and P'ng(1994) in their analysis of marginal
deterrence of crime. Such fine tuning of standards is impractical however when the identity
of the offenders is unknown at the time standards are determined.
23We continue to assume that C is increasing and strictly convex in q with Cq(0,¿¿) =0

51
the assessment A to
max E„ < u {B The maximand in [GP-P] represents the expected net benefit of care minus the enforcement
costs taken over the population of parties investing in positive care levels. Those parties
> ¡jl who exempt themselves, contribute zero net benefits and impose zero enforcement
costs on society. The solution to [GP-P] is characterized in the following proposition. In that
proposition we refer to s as the optimal standard, and 5 * as the standard that maximizes
E„ Proposition 3,5: In the solution to [GP-P] (i) no parties are exempted from standards when
B is sufficiently large, (ii) when exemption occurs A < F, and jl satisfies
v(/¿) = Bq(s,jl) - C(q(s,jl),jl) - D' (F(jl)e(s))e(s) = 0 (iii) s < s*for the case of
complements, and (iv) s > s * for the case of substitutes.
Part (i) of Proposition 3.5 indicates that parties are exempted only if the benefits from taking
care are suff ciently small, otherwise even high cost care providers are induced to provide
care. Part (ii ) indicates when exemption arises that higher cost parties opt to pay the
assessment rather than risk paying a higher fine if they are cited. The assessment is set at a
level so that only those parties with a negative care contribution to social welfare , net of
marginal enforcement costs, v(/i), seek exemption. Parts (iii) and (iv) verify that the same
distortion in standards arises when parties are heterogenous as when they are homogenous.
When exemptions are possible, dishonest enforcers may also take bribes from parties
not wanting to provide care. To analyze this possibility, suppose for now that government
sanctioned exemptions are not offered, perhaps because the benefits from care are too large.

52
Imagine that the enforcer offers any party an exemption from being monitored if the party
pays the enforcer a bribe equal to Y. Assume also that such illegal activity goes unnoticed by
the government, and that agreements between parties and the enforcer are kept.24 Given the
standard, s, the enforcer's problem , [EP] is to set the level of the bribe, Y and enforcement
effort e(s) to
max E^¿{P(q(s,(¿),e,s)} - D(F^')e) - (1 -Ftf)) Y + T [EU]
where all parties // ] pay the bribe and type // is indifferent to paying the bribe and
investing in care. The solution to the enforcer's problem is characterized in,
Proposition 3.6: In the solution to [EP], (i) the enforcer always offers a bribe Y < F which
the higher cost parties aze (a¿7, M ] pay. (ü) Y satisfies
(1 - iV) - Y(d/j.//dY)f(pL1)) = - {P(q(s^),e(s),s) - D >(F(^)e(s))e(s))(d^ldY)f(^)
According to Proposition 6 the enforcer always offers a bribe which some non neglible subset
of the higher cost parties agree to pay for exempting themselves from being cited. The
optimal bribe, characterized by the equality in (ii) sets the enforcer's marginal revenue from
an increase in the bribe to the marginal increase in the collection of fines as more types invest
in care in response to an increase in the bribe.
Propositions 3.5 and 3.6 suggest that if illegal bribes cannot be detected, high cost
parties will always exempt themselves from fines by paying the enforcer a fee. In cases where
the benefits from care are large, the fee will be a bribe paid to the enforcer, as assessments for
exemptions will not be sanctioned by the government. In cases where the benefits from care
240ne rationale for why corrupt agents may trust one another to honor agreements is that
they may want to maintain a reputation for being reliable. See Tiróle (1992) for one approach
to modeling collusion between corrupt individuals.

53
are small, the fee may be a government sanctioned assessment, if A is less than Y.25
Setting Optimal Fines
To this point in our analysis we have assumed the level of fine for a violation, F, is
fixed exogenously. Here we investigate whether increases in F are welfare improving.
Becker (1968) first observed that larger fines deter parties from breaking the law and thus
reduce enforcement effort required to insure compliance. As we demonstrate, this argument
may fail to apply when the enforcer's effort supply depends on the probability that the party
is in compliance.26
Suppose the fine, F, is increased. This will cause the government to adjust its optimal
standard, s, and it will induce both the party and the enforcer to adjust their behavior. Let deldF
and dqldF represent respectively the rate of change in equilibrium enforcement effort and
care as F is increased. Then the increase in welfare from a change in F can be written as
dV/dF - (B-Cq)(dq/dF) -De(de/dF)
- {(B-Cq)/De - (de/dF)/(dq/dF)}De (dq/dF)
[ = | 0 as (delds)l(dqlds) |=J {deldF) I dqldF) (3-3)
where the first line of (3-3) follows from the Envelope Theorem, the second line follows from
25We conjecture that A will be less than Y for B sufficiently small, although we have so far
been unable to verify this.
“Several analyses have discovered reasons why maximal fines may be not be desired. Malik
(1990) demonstrates that increasing fines may increase agent's avoidance behavior, thus
leading to higher enforcement costs. Andreoni (1992) argues that juries are less apt to
convict offenders when fines are more severe, thus reducing the deterrence power of maximal
fines. Polinsky and Shavell (1979) argue that maximal fines are welfare decreasing in that
some offenses should not be deterred if marginal benefits of the crime exceed the marginal
costs. Stigler( 1970) and Mookherjee and P'ng (1994) show that fines should be varied
continuously in order to maintain marginal deterrence in enforcement.

54
the first by rearranging terms and the last line follows from the condition for setting optimal
standards, (dV/ds = 0)27
A necessary and sufficient condition for ordering (de/ds)/(dq/ds) and (de/dF)/(dq/d.F)
and thus determining whether increasing fines is welfare enhancing is given in
Proposition 3.7: (delds)l(dqlds) (de/dF)/(dq/dF) as d/ds {-PJPq) (="jo.
To interpret (3-3) note that under the optimal standard (de/ds)/(dq/ds) represents the rate at
which enforcement effort and care may vary while keeping total surplus constant. In the
complements case, too little care is allocated. An increase in F will induce the party to
provide more care, but it will also cause the enforcer to expend more effort. If the rate at
which extra effort expended for an increase in care is sufficiently small ( less than
(de/ds)/(dq/ds)) then increasing the fine will increase welfare. Otherwise increasing the fine
will reduce welfare, if it will induce too much enforcement effort to be expended. A similar
argument serves to confirm this intuition for the case of substitutes.
Proposition 3.7 provides necessary and sufficient conditions for an increase in the fine
to be welfare decreasing. It's easy to verify that in the substitutes case where Pes< 0,
that d/ds{-PJPq} < 0. This implies that a small increase in the violation fine is welfare
decreasing and it provides an interesting exception to Becker's argument for maximal fines.
The intuition supporting this finding is that in the substitutes case, the level of care induced
is excessive in order to limit enforcement effort, (see Proposition 3.3) An increase in the fine
reduces welfare, by causing parties to further increase care which also induces enforcers to
expend more effort.
27The optimal standard satisfies dV/ds = 0 or B-Cq)/De=(de/ds)/(dq/ds).

55
Conclusion
Our analysis offers one rationale for the divergence between the marginal benefits and
the marginal costs from taking care which often arise in practice. Pollution and safety
standards may either be set too loose or too stringent to discourage enforcers from exerting
excess effort. Whether standards are set too low or too high depends on the available
technology for identifying violators.
Our analysis also reveals the importance of setting standards, not only to influence
compliance, but also to shape the behavior of enforcers. In circumstances where penalties are
fixed, varying standards may be one of the few tools policy makers have to affect compliance
and reduce enforcement expenses. In instances where fines can be varied as well, it may be
counterproductive to set maximal fines which encourage overzealous law enforcement.

Figure 3-1
Complements Case: Pes>0

57
Figure 3-2
Complements Case: Pes<0

CHAPTER 4
MONITORING AND THE OPTIMAL MIX OF PUBLIC
AND PRIVATE DEBT CLAIMS
Introduction
Two of the most important functions of intermediated lending are that it facilitates
delegated monitoring and provides flexibility. The theory of finance suggests that diverse
groups of public lenders do not sufficiently monitor the firms to which they provide funds: It
points to free rider problems and inefficient monitoring technologies as contributing reasons.
In contrast, financial intermediaries are often assumed to have a unique advantage in
performing monitoring. Intermediaries can act as delegated monitors by monitoring and
controlling borrowers on behalf of other lenders, and in turn produce information1.
Moreover, conflicts of interests and legal restrictions render negotiations with dispersed
public lenders very costly, if not impossible. In contrast, concentrated lending by
intermediaries enables negotiations to occur at ease, and provides flexibility allowing
modifications of loan contracts as circumstances necessitate.
Despite the success in our understandings of intermediated lending, important
questions remain unanswered (or only partially answered): 1) Given intermediaries'
advantages in performing monitoring, what is their incentive to actually provide monitoring?
1 See Berlin and Loeys (1988), Campbell and Kracaw (1980) and Diamond (1984). Empirical
evidences based on loan announcement are documented in Billet, Flannery and Garfmkel
(1995), James (1987) and Lummer and McConnell (1989). Fama (1985) provides another
piece of evidence.
58

59
2) Casual observations of firms' capital structures reveal that they frequently borrow from
both intermediaries and public debt market. Given the advantages of intermediated lending,
why do firms demand public lending as well? 3) The notion that intermediaries act as
delegated monitors assumes that public debtors' incentives over monitoring are in accordance
with that of intermediaries'. Given that firms choose their debt structures, why do they desire
to align the two incentives? This paper provides some answers to these questions.
To analyze these issues, we employ the following model: A wealth constrained
manager must seek external financing to start a project, which lasts two periods and produces
cash flows only on the final date. The distribution of the final cash flow depends on the
interim states which are privately observed by the manager. The project provides positive
NPV only in the favorable state. There are two sources of external financing, public lending
and intermediated lending (private lending). Costly monitoring and costless interim
renegotiation are feasible only with intermediated lending. Besides being the residual claimant
of the cash flow from the project, the manager enjoys non-transferable private control rents,
provided the project is continued at interim. The existence of control rents is the source of
potential misalignment of preferences between the manager and the lenders over the interim
continuation decision: In pursuit of the control rents, the manager may prefer to continue the
project even if liquidation benefits the lenders. We assume that for lenders to break even,
interim liquidation in the unfavorable state must occur with positive probability and it must
strictly benefit the lenders.
To raise initial financing, the firm must assure lenders of an expected repayment equal
to the amount of fund lent. The divergence of preference, between lenders and the manager,

60
over the interim continuation decision implies that monitoring may be required to ensure
timely liquidation and initial financing. Our analysis is based on the observation that while
monitoring can facilitate initial financing by mitigating agency problems, it introduces
deadweight costs: l)There is a cost for expending monitoring effort; 2)Liquidation destroys
the manager’s control rent. Thus, in designing the optimal debt structure, the manager has
two goals: l)To credibly payout the cash flows so that the required level of monitoring for
initial financing is minimized; 2) To structure the private debt claim to induce the required
level of monitoring. The main result of this analysis is that in general the manager can not
achieve both of his two goals by relying entirely on private debt financing, and the optimal
debt structure is a mix of both public and private debt. To derive this result, we proceed in
several steps.
We first analyze the case in which the manager's private rent is sufficiently small. In
this case, liquidation in the unfavorable state generates positive surplus, and therefore is
efficient. We find that if the firm borrows long-term bank debt2, which requires a repayment
only after the cash flow from the project is realized, then in the unfavorable state the project
is liquidated through renegotiation independent of whether the bank is informed or not. The
need to borrow public debt arises because the bank’s debt claim must be renegotiated to
induce liquidation, so the division of surplus from liquidation can not be specified through ex
ante contracting. If the bank is the only lender, the firm can extract most of the surplus from
liquidation when it commands large bargaining power, and initial financing may become
2Henceforth, we will use the term "bank" to represent all types of institutions which can
provide similar functions in our model. These institutions may include insurance companies,
pension funds, etc.

61
infeasible. Unlike the bank lender, however, public debtors can free ride on the benefit of
negotiations without making concessions of their claims in liquidation. By equating public
debtors’ claims in liquidation to the surplus generated, the firm can credibly pay out the
surplus and enable initial financing without monitoring.
When the private rent is sufficiently large, the manager never desires to liquidate the
project. Feasibility of initial financing requires involuntary liquidation in the unfavorable state.
Therefore, the firm's initial borrowing must include bank debt requiring a repayment when the
interim state is realized. Such a debt claim confers the interim control rights upon the bank,
allowing it to force liquidation. Given the control rights, the bank can benefit from better
information which enables it to timely liquidate the project in the unfavorable state. Thus, the
bank’s desire to maximize the value of the control rights motivates it to monitor.
When the manager raises initial financing only from a bank, we find that the optimal
bank debt requires repayments both at interim and on the final date. Moreover, the size of
the final repayment depends on the relative bargaining power between the manager and the
bank lender. When the manager commands larger bargaining power, initial financing requires
that the final repayment be sufficiently large. If the final repayment is small, the bank never
forgives the interim repayment and the project can only be continued through renegotiation.
When the manager commands large bargaining power, he can extract most of the surplus
from continuation, and initial financing becomes infeasible. Increasing the promised final
repayment increases the bank’s expected payoff. This follows because if renegotiation breaks
down, the bank can choose between its payoff in liquidation and its payoff when it forgives
the interim repayment and allow the project to continue. Increasing the promised final

62
repayment raises the bank’s reservation level, and therefore increases its expected payoff from
continuation. When the bank commands large bargaining power, initial financing is always
ensured. In this case, the manager desires to control the bank’s benefit from being informed
in order to reduce the costs associated with monitoring. We show that there exists a bank
debt claim so that the bank’s payoff, when it is informed of the favorable state, is equal to the
promised interim repayment. By optimally setting this repayment, the firm can reduce the
amount of bank monitoring.
In general, however, it is strictly suboptimal for the firm to raise initial financing only
form a bank. To minimize the level of monitoring required by initial financing, the manager
desires to maximize the bank’s benefit per unit of monitoring effort. On the other hand, to
induce the minimum level of monitoring, the manager must structure the bank’s debt claim
to control its benefit from monitoring. Thus, when the project is financed only by a bank, the
manager’s two goals are in conflict with each other.
In addition to bank debt, the firm can raise initial financing by also borrowing public
debt. We consider the two cases in which the firm borrows either long-term or short-term
public debt. In both cases, we find that by financing the project with a mix of public and bank
debt, the firm can separate its two goals in designing the optimal debt structure: It can
regulate the bank’s incentive to monitor without interfering its desire to minimize the required
level of monitoring for initial financing. To minimize the required level of monitoring, the
manager desires to maximize the lenders’ (the bank’s and the public lenders’) total expected
payoff when the bank is uninformed. If the project is financed by a mix of public and private
debt claims, then, for any fixed payoff scheme for the bank, the manager can maximize this

63
payoffby paying out cash flow form the project to the public debtors. Furthermore, by giving
the public debtors a share of the proceeds from the liquidation, the manager can control the
bank’s benefit from monitoring, so that the desired level of monitoring is induced.
In comparing the optimal mix of bank debt and long-term public debt and that of bank
debt and short-term public debt, we find that the former strictly dominates the latter. With
short-term debt claims, the public lenders are repaid in full whenever the project is refinanced
and allowed to continue by the bank. In this case, the public lenders can never strictly benefit
from timely liquidation in the unfavorable state, which arises only when the bank is informed.
In contrast, with long-term debt claim, the public lenders’ payoff is state contingent and they
can benefit from timely liquidation. Thus, long-term public debt claim allows the firm to align
the public debtors’ incentive over monitoring with that of the bank’s, so that the debtors’ total
marginal benefit from monitoring is maximized, further reducing the required level of
monitoring for initial financing. When the project is financed by the optimal mix, the bank
acts as a delegated monitor.
There is an extensive literature on optimal debt structures. Our analysis is most closely
related to that of Hart and Moore (1991). We share similar premises that managers design
debt structures to credibly assure the lenders of their repayments. The main difference
between the two is that Hart and Moore assume that there is no asymmetric information and
renegotiation is frictionless. Therefore, there are no differences between public lending and
bank lending in their analysis. Our analysis is also related to those by Rajan (1992), Park
(1994), and Rajan and Winton (1995). Rajan (1992) analyzes the bank hold-up problem.
He argues that firms can use public debt to mitigate the distortion in managers’ incentives to

64
expend effort caused by banks’ opportunism. Both Park (1994) and Rajan and Winton (1995)
demonstrate that optimal enforcement of debt covenant can provide banks with incentive to
monitor. Our analysis, on the other hand, is based entirely on the distribution of cash flows.
Diamond (1991, 1993) investigates how firms having private information choose their debt
structures. In our analysis, prior information is symmetric among agents.
The rest of the paper is organized as follows. In section I, we outline our model. In
section II, we consider the case in which the manager's private rent is sufficiently small. In
section II, we analyze the bank's incentive to monitor and derive the optimal bank debt. In
section IV, we derive the optimal mix. Section V presents empirical evidence and section VI
concludes.
Elements of The Model
There are three dates, t=0,l,2. There is an indivisible project which requires an initial
investment of I0 at t=0. The project returns a stochastic cash flow of r at t=2 distributed over
the compact support [0,X], The distribution of r is denoted as F(r 10) and depends on the
interim state 0e{0H,0L}. F(r|0n) strictly dominates F(r 10^ according to first-order stochastic
dominance. If the project is terminated at t=l, the firm’s assets can be liquidated at L terminal value of the assets at t=2 is zero. The parameters satisfy
Assumption 4,0: f'rdF(r \ Qh)>Iq>L> fxrdF(r | 0¿). (4-1)
Jo Jo
Assumption 4,1: L Assumption 4.0 indicates that the project provides positive NPV in the favorable state while
liquidation yields more cash flow in the unfavorable state. Assumption 4.1 says that, at t=l,

65
continuing the project is more profitable than liquidation when the belief about the occurrence
of the two states coincides with the prior. It implies that without additional information
lender(s) perceives continuation as more profitable than liquidation. To ascertain the
profitability of liquidation, lender(s) must acquire additional information.
The manager, having no wealth of his own, must seek external financing. There are
two types of lenders—banks and public lenders. Unlike public lenders, a bank lender can have
access to a costly monitoring technology which generates an interim signal correlated with
the realized state. We assume that only the bank lender who lent at t=0 can observe a signal
at t=l3. The bank’s signal is, however, not verifiable, and therefore can not be contracted
upon. By expending effort ee[0,l], the banker can observe the realized interim state with
probability e and remain uninformed with probability 1-e4. Expending effort e costs the bank
i|i(e). We assume i|/'(e)>0, ijr"(e)>0 and i)/(e=0)=0. At t=0, there is competitive supply of
public and bank financing. The prevailing interest rate is normalized to zero. This implies
that, ex ante, lenders are willing to provide financing if the expected returns from their claims
equal the amount lent. At t=l, the supply of public financing remains perfectly competitive.
The only type of contract between the firm and its lenders is the standard debt contract which
specifies a repayment schedule and contains a covenant. Following the incomplete contract
approach, we assume that the interim decisions are not contractible. Therefore, the interim
3This is consistent with most of the empirical findings. See Billett, Flannery and Garfinkel
(1995), James (1987), Lummer and McConnell (1991).
^Formally, this corresponds to the information structure in which the signal space consists of
three elements, {sH,sL,cf>}. The correlations between the signals and the interim states are
f(sH|0H)=e^(4)l®H)=l_eJ f(siJ0L)=e and f( uninformative, and the signal sH (sL) perfectly reveals the state 0H (0L).

66
continuation decision can not be explicitly constrained by the covenant, and the party who has
the interim control rights can unilaterally decide on the actions to be taken5. All agents are
assumed to be risk neutral.
At t=0, the manager attempts to raise the capital needed to start the project. Apart
from being the residual claimant of the t=2 cash flow, the manager enjoys a non-transferable
and state-contingent private control rent C(0), with C(0h)>C(0l), provided that the project
is continued to t=26. The private control rent is the source of potential misalignment of
incentives, between the manager and its lenders, over the interim continuation decision. To
raise initial financing, the manager must credibly assure lenders of an expected repayment
equal to the funds they initially provide. We assume that the return from the project also
satisfies the following condition.
Assumption 4.2: vffj'XrdF{r | 0^)+vlL>I0>Eq[ JXrdF(r 10)]. (4-3)
Assumption 4.2 indicates that the t=0 expected cash flow is less than the initial investment if
the project is always continued to t=2; It exceeds the initial investment if the project is only
continued in state 0H. For lenders to break even, liquidation in state 0L must occur with
strictly positive probability and it must strictly benefit the lenders. To simplify our notations,
we introduce the following definition.
5This arises either when an informed bank’s signal is not verifiable or if the costs of describing
interim actions are prohibitively high.
6The control rent may not be actual monetary benefit for the manager. In our analysis, it
merely serves as a measure of the divergence of preference, between lenders and the manager,
over the interim continuation decision. For further discussions, see Aghion and Bolton (1991).
Hart and Moore (1991) endogenize the control rent by giving the manager some bargaining
power through his ability to quit.

67
x
Definition 4.1: r(0)= hdF(r\Q), 0e{0H,0L}. (4-4)
o
The information structure is specified as follows. At t=0, information is symmetric
among all agents, with common prior of the favorable and the unfavorable state being vH and
vL respectively. The manager can costlessly observe the interim state and the signal acquired
by the bank. Thus, at t=l, the manager knows whether the bank is informed or not. On the
other hand, public debtors observe neither the realized state nor the signal acquired by the
bank.
If the project is financed at t=0, the firm and the bank can costlessly renegotiate at
t=l. Renegotiations occur either because there are needs to modify the terms of the bank loan
or because the firm needs to request additional financing. The renegotiation process is
specified as follows. We assume that both the bank and the firm can initiate renegotiation. In
bargaining over a new contract, the firm can, with probability A, make a take-it-or-leave-it
offer which the bank can accept or reject; With probability 1-X, the bank can make a take-it-
or-leave-it offer which the firm can accept or reject. Thus, A is a measure of the firm's
bargaining power7. In the event that renegotiation breaks down, two possibilities arise: l)If
the firm has short-term bank debt outstanding, then the bank can either force liquidation or
forgive the short-term repayment and allow the project to continue (if possible)8; 2) If the firm
7There are many factors which can affect the size of A. For example, the bank's reputational
concerns, the length of the firm-bank relationship, and the firms' accessibility to alternative
sources of capital, can all affect the relative bargaining power.
8Since this assumption will turn out to be rather important for our analysis, we provide some
justifications. First, banks are not prohibited by law from forgiving repayments due. Second,
as is easily seen , if the bank only holds short-term debt claim, it will not forgive the t=l
repayment if renegotiation breaks down. However, when it holds both short-term and long¬
term claims, it may choose to forgive the t=l repayment in the interest of capturing a larger

68
only has long-term debt obligation(s) outstanding, the existing contract(s) stands. On the
other hand, we assume that it is impossible for the firm to renegotiate with the existing public
debtholders9. The firm can, however, raise financing from the interim competitive capital
market, in which case the firm makes a take-it-or-leave-it offer to investors10.
As a preliminary analysis, we demonstrate the existence of demand for bank debt.
Suppose the firm tries to raise initial financing by only borrowing public debt. With public
lenders, monitoring and interim renegotiation are both infeasible. Without monitoring, public
lenders can not acquire additional information about the realized state, and, by assumption
4.1, they will not choose to liquidate the project. Since renegotiation is infeasible, the firm
will never choose to liquidate the project. Thus, the project is always continued, and by
assumption 4.2 public debtors will not finance the project. To raise initial financing , the
firm’s initial borrowing must include bank debt.
When the firm’s initial borrowing includes bank debt, the lender’s (or lenders’) t=0
expected payoff can be written as
t=2 payoff. This is similar to a debt restructuring except that the latter is usually furnished
under a new contract. The difference arises because in the present setting, financial distress
occurs with certainty. Therefore, the result of a t=l restructuring is partially reflected in the
ex ante contract. Finally, this assumption accords our definition of the interim control rights
to that of Grossman and Hart (1986). According to these authors, the party who has the
control rights can unilaterally decide on the course of action in the absence of negotiation.
In our model, the there are two possible interim actions—continuation and liquidation. By
allowing the bank to forgive the t=l repayment, short-term bank debt claim confers the
control rights on the bank in the sense of Grossman and Hart (1986)
9This assumption may be justified by the presence of free rider problem in exchange offers.
See Gertner and Scharfstein (1994).
10We assume that lenders in the capital market are sufficiently diverse so that the firm can
make the offer to investors other than the existing ones.

69
(1 -e)Ru+eR-m=Ru+e(R-Ru)-W\ (4'5)
where R¡ and R„ are the lender’s (or lenders’) payoff when the bank is informed and uninformed
respectively, and e is the bank’s monitoring effort. To raise initial financing, the expected
payoff, in (4-5), must be at least as large as the initial investment, I0. The analysis in this
paper is based on the observation that there are deadweight costs associated with
monitoring11: 1) There is a cost i)/(e) for expending monitoring effort e; And 2) as a result of
monitoring, the project must be liquidated when the bank is informed of the unfavorable state.
Liquidation destroys the manager’s private rent, which may exceed the liquidation value of
the assets (see the discussion in section III). Thus, the manager desires to minimize the level
of monitoring required by initial financing. To minimize the required level of monitoring, the
manager must maximize the lender’s (or lenders’) payoff when the bank is uninformed, R^,
and, when positive level of monitoring is required by initial financing, the lender’s (or
lenders’) marginal benefit of monitoring, R, -R^. Furthermore, he must structure the bank’s
debt claim to induce the minimum level of monitoring.
The Mix of Long-Term Public and Bank Debt Claims
The manager raises initial financing by borrowing from a bank and public lenders. In
return, he promises a t=2 repayment s2 to the bank and t2 to public lenders. The bank's and
the firm's expected payoff in state 0 is denoted as R,,(s2,t210) and Rf(s2,t210) respectively12.
11 We assume throughout the paper that all rents extracted by the lenders in excess to the
initial funds lend are prepaid. Thus, the manager’s objective is to maximize the total t=0
expected surplus, while ensuring initial financing.
12Both of the payoffs incorporate any contractual specifications which may affect them,
including, for example, the relative seniority between the public and bank debt claims.

70
The mix also specifies the payoffs to the bank and to the public debtors in liquidation, denoted
as Lj and Lp{ respectively. In analyzing the mixes of long-term debt claims, we make
Assumption 4.3: CL Assumption 4.3 implies that liquidation in state 0L generates positive surplus, and hence is
efficient. Since the manager can not renegotiate with the public lenders, it falls on the bank
to bribe the manager and induce liquidation. Consider the interim renegotiation when the
bank is informed. In this case, the firm and the bank negotiate under symmetric information
and the their total payoff is maximized14. If the project is continued, the firm’s and the bank’s
individual rationality conditions imply that the existing contract will not be replaced. If the
project is liquidated, the total cash flow available to the firm and the bank is Thus,
negotiation leads to liquidation in state 0L if and only if
L'bi [K/V, 10i) f 0J +Q] â–  (4-7)
Condition (4-7) indicates that it is individually rational for the bank to bribe the manager and
induce liquidation in state 0L. When the bank is uninformed, the analysis is more involved and
I3If CL>L-r(0L), then the project can not be financed by a mix of long-term debt. This follows
because the manager can always continue the project without raising additional financing at
t=l. To induce liquidation in state 0L, lenders must offer the manager a bribe of at least CL.
This leaves the lenders (both the bank lender and the public debtors) with a t=0 expected
payoff no greater than
vHr(0H)+vL[L-CL] By assumption 4.2, this is smaller than the initial investment I0. Therefore lenders will refuse
to provide initial financing.
14In general, when one of the parties in the negotiation is wealth constrained, symmetric
information is not sufficient to ensure the optimality of bilateral bargaining. In the present
case, monetary transfer is from the bank, who is not subject to wealth constraint, to the
manager, and therefore optimality is ensured.

71
is relegated to the appendix. We summarize the result in the following lemma.
Lemma 4,1: If the bank is uninformed, then in the unique equilibrium of interim negotiation15:
i)If s2 and t2 satisfy (4-7) and
L'b-[Rp2,I21 10)], (4-8)
then the project is liquidated in state 0L and continued in state 0H, independent of who makes
the offer;
ii)For all s2 and t2 which do not satisfy (4-7) or (4-8), the project is either always liquidated
or always continued when the firm makes an offer.
In the following, we focus on debt structures which satisfy conditions (4-7) and (4-8).
Condition (4-8) indicates that when the firm makes an offer in state 0H, continuing the project
returns it a larger payoff than that in liquidation. It ensures that the project is always
continued in the favorable state. In (4-8), the bank's payoff in continuation is its expected
return, reflecting that the bank is uninformed. If the debt structure satisfies conditions (4-7)
and (4-8), then, independent of the bank’s information, the equilibrium for the interim
negotiation is separating: The project is liquidated in state 0L and continued in state 0H. The
manager desires to maximize the total surplus while ensuring initial financing. Given the
above liquidation policy, the total surplus is independent of the promised repayments to the
debtholders. Thus, to ensure initial financing, the manager desires to maximize the lenders'
15It is well known that negotiation under asymmetric information generally leads to multiple
equilibria when the informed party can also propose offers. Throughout this analysis, we
require that the equilibrium satisfy the divinity criterion of Banks and Sobel (1987).

72
(the sum of the bank's and the public debtor's profit) expected payoff16. The following
proposition characterizes the optimal solution.
Proposition 4.1: At optimal, s2+t2=X and
Ll=Rb(sv12\Q^Cv (4-9)
The project is liquidated in state 0L and continued in state 0H, and the bank does not monitor.
In the optimal solution, the bank’s monitoring effort is zero. Equation (4-5) implies
that the lenders’ t=0 expected payoff consists of only Ru Since the total promised repayment
to the lenders, s^t^ equals the maximum profit from the project, they acquire the entire cash
flow from the project in state 0H. To induce liquidation in state 0L, however, the bank must
offer the manager a bribe CL. The lenders'—the bank and the public lenders—1=0 expected
profit is
VV<0tf)+vJZ-CJ. (4-10)
Thus, if the payoff, in (4-10), exceeds the initial investment, I0, project can be financed by a
mix of long-term public and bank debt.
The optimal solution has the following two properties. First, since the continuation
decision is independent of the bank’s information, there is no need for monitoring. There are
two reasons why the interim equilibrium is separating even when the bank is uninformed:
l)Since the manager’s control rent is sufficiently small, he can recoup the loss of private rent
when the project is liquidated; 2)Since the manager has the interim control rights, he is not
harmed by revealing the unfavorable state.
16From part ii) of lemma 4.1, debt structures which do not satisfy (4-6) or (4-7) reduces both
the total surplus and the contractible cash flow. Consequently, they are suboptimal.

73
Next, consider condition (4-9) in proposition 4.1. The left hand side of the equality
is the total payoff to the bank and the firm when the project is liquidated in state 0L . The right
hand side is their total payoff if the project is continued. Condition (4-9) indicates that the
bank and the firm do not strictly benefit from liquidation; The public debtors extract the entire
surplus from liquidation. As has been pointed out previously, the manager desires to
maximize the t=0 expected payoff to the lenders. Since the bank’s debt claim is not
renegotiated when the project is continued, the firm can credibly pay out the profit from
continuation through ex ante contracting. However, when the project is liquidated, the bank’s
debt claim must be renegotiated. If the bank is the only lender, the division of the surplus
from liquidation can not be specified through ex ante contracting. Instead, it is divided
according to the relative bargaining power. When the manager commands large bargaining
power, he can extract most of the surplus from liquidation. The bank’s benefit from
liquidation diminishes and, by assumption 4.2, it may refuse to provide initial financing.
Unlike the bank lender, however, public debtors can free ride on the benefit of the negotiation
between the bank and the firm without making concessions of their claims in liquidation.
Thus, by borrowing a mix of bank debt and public debt, the firm can credibly pay out the
surplus generated from liquidation to the public lenders. The optimal debt structure
maximizes debtors’ total payoff when the bank is uninformed, R^, and initial financing is
ensured without the firm incurring any cost of monitoring. This provides an explanation why
the firm may desire to diversify its borrowing17.
17Raja (1992) argues that bank's opportunism may cause public debt to be more desirable than
bank debt. Our finding extends Raja's result in three aspects: 1) It indicates that a mixed debt
structure can be desirable; 2) Diversified borrowing also arises when the firm commands large

74
Optimal Bank Debt
When the manager’s control rent becomes large, that is, when the divergence of
preference between the manger and the lenders is large, liquidation through interim
renegotiation is no longer feasible. Therefore, the firm can not finance the project by using
a mix of long-term public and bank debt. Specifically, we will assume the following in the
ensuing analysis.
Assumption 4,4: Cl>L. (4-11)
In this case, feasibility of initial financing requires involuntary liquidation. This implies that
the firm’s initial borrowing must include short-term debt. A short-term debt claim transfers
the t=l control rights to the lender when the manager can not make a repayment. Given the
control rights, the lender can force liquidation without having to bribe the manager.
By assumption 4.1, without additional information lenders’ consider continuation as
more profitable than liquidation, and the firm can always continue the project by promising
a sufficiently large t=2 repayment. Since initial financing requires that the project be
liquidated in the unfavorable state with strictly positive probability, the firm must structure
the debt claim to induce monitoring by the bank lender. To find the minimum level of
monitoring required by initial financing, notice that the maximum value for R,,, the lender’s
(or lenders’) expected payoff when the bank is uninformed, is E0[r(0)] and the maximum
value for R^, the lender’s (or lenders’) expected payoff when the bank is uninformed, is
vhf(0h)+vlL- The minimum level of monitoring required by initial financing, e*, is then
bargaining power; 3)Diversified borrowing may be desirable even in the absence of moral
hazard problem.

75
defined by
£e[r(0)]+V *[L-r(Qj\-M¡(e >/0. (4-12)
In the ensuing analysis, we make
Assumption 4.5: dty(e ) de*
To interpret assumption 4.5, suppose that the firm can structure the debt claims so that both
and R¡ attain their maximum values. The right hand side of (4-13) is the lender’s (or
lenders’) total marginal benefit of monitoring which must (weakly) exceed the bank’s
marginal benefit from monitoring. Assumption 4.5 ensures that it is feasible for the firm to
both minimize and induce the amount of monitoring required by initial financing.
In this section, we assume that, ex ante, the firm only borrows from a bank. At t=l,
however, it can acquire additional financing from the market and/or by negotiating with the
bank. Besides motivating the analysis in the next section, this section derives the optimal debt
structure for a firm which initially does not have access to the public debt market.
Short-Term Bank Debt
The manager raises initial financing by borrowing from a bank and promises to repay
st at t=l. In the discussion of short-term bank debt, we assume that the firm does not raise
financing from the interim market. To continue the project, the manager must renegotiate
with the bank. If the renegotiation breaks down, the project will be liquidated and the bank
gets L while the manager gets nothing. These are the bank’s and the firm’s reservation levels
in the renegotiation. Consider the renegotiation when the bank is informed. In state 0H, when

76
the bank makes an offer, it can demand the entire return from the project by proposing a
continuation contract s2b=X18. When the firm makes an offer, it promises a t=2 repayment
which returns the bank an expected payoff equal to its reservation level, L. In state 0L, the
project must be liquidated. When the bank is uninformed, the analysis is slightly more
complicated and is relegated to the appendix. The result is summarized in the following
lemma.
Lemma 4,2: When the bank is uninformed, there is a unique equilibrium in the interim
renegotiation. In this equilibrium, the project is always continued and
i) the firm proposes the pooling continuation contract s/ which yields the bank an expected
return equal to its reservation level L;
ii)the bank proposes the pooling continuation contract s2b=X.
The intuition for lemma 4.2 is quite simple. With short-term debt claim, the bank can
unilaterally decide to terminate the project. If the manager’s offer is state contingent, the
bank can infer each realized state. It will refuse the offer indicating the unfavorable state and
terminate the project. The manager thus offers the same contract in both states, and the
feasibility of continuation follows from assumption 1. When the bank makes an offer, it can
demand the entire t=2 cash flow by proposing a continuation contract s2b=X. Alternatively,
18In the negotiation between the firm and the bank, the parties can reach a new contract which
specifies a t=T repayment to the bank. The project is then liquidated and the bank is paid
according to the new contract. Such a contract is termed a liquidation contract.
Alternatively, the parties can reach a new contract which specifies a t=2 repayment. The
project is then allowed to continue. Such a contract is termed a continuation contract.
Throughout the paper, offers with subscript 1 indicate t=l repayments and correspond to
liquidation contracts. Offers with subscript 2 indicate t=2 repayments and correspond to
continuation contracts. All offers are described in terms of the payments to the bank.

77
the bank can offer a menu of contracts which screens out the unfavorable state and induce
liquidation. However, the manager will reveal the unfavorable state only if he is bribed, at
least, his private rent CL. By assumption 4.3, this is infeasible. Part ii) of lemma 4.2 then
follows.
It follows from the above discussion that the bank's t=0 expected profit and
monitoring effort are
PfoMl-A)£eW6)]+Ai+e(l-A)vi[I-r(0I)]-.K 7feí=(l -Á)v,[¿-K0t)] (4-15)
Equation (4-14) indicates that the bank’s profit is independent of the manager's private rent.
This follows because the short-term debt claim transfers the interim control rights to the bank,
allowing it to force liquidation without bribing the manager. However, the bank’s expected
payoff depends on its bargaining power, 1-A. At t=l, the bank acquires the control of the
firm’s assets. To continue the project, the manager must purchase the assets back from the
bank through renegotiation19. The expected price he must pay increases with the bank’s
bargaining power. Consequently, the bank’s expected payoff increases with its bargaining
power.
Equation (4-15) indicates that the bank’s marginal profit of monitoring is positive and
is increasing in the bank’s bargain power, 1 -A. When the bank only holds long-term debt
claim, its marginal profit of monitoring is zero because it can not act upon better information
19 Hart and Moore (1989, 1995) show that the need to purchase control rights from the
debtors can serve to discipline the manager by forcing him to pay out excess cash, thereby
mitigating the free cash flow problem suggested by Jensen (1986).

78
without the control rights. Given the control rights, however, the bank can benefit from
better information which allows it to timely liquidate the project in the unfavorable state.
Thus, maximizing the value of the control rights motivates the bank to monitor20.
To assess the feasibility and desirability of short-term bank debt financing, let A* be
defined as Pb°(A*)=I0. From assumption 4.5, 0 equality. If the firm’s bargaining power is sufficiently large, so that A>A*, short-term bank
debt financing is infeasible. In this case, the manager can repossess the assets at a small
average price, whenever the project is allowed to continue. He extracts most of the surplus
from continuation, and the bank can not recoup the initial fund lent. On the other hand, if the
firm’s bargaining power is sufficiently small, so that A feasible. However, except when A*=0, the monitoring effort induced strictly exceeds the
minimum level of monitoring e*. This follows because when the firm raises initial financing
by using only bank debt, the bank acquires the entire benefit from monitoring and the
monitoring effort supplied exceeds e*. Thus, the firm’s desire to minimize the required level
of monitoring through maximizing the marginal benefit of monitoring, and its desire to induce
the minimum level of monitoring through controlling the bank’s benefit from monitoring are
in conflict with each other.
Bank Debt Requiring Both Short-Term and Long-Term Repayments
The manager raises initial financing by borrowing from a bank. In return, he promises
to repay s^O at t=l and S2 at t-2. At t=l, the manager can finance the repayment, ^ , by
20Park(1995), Raja and Winton (1995) show that an alternative way to confer control right
upon the bank is to combine covenant with long term bank loan.

79
raising funds from the public debt market and/or by negotiating with the bank. To raise
financing from the market, the manager makes a take-it-or-leave-it offer to investors. This
offer consists of the amount of money the manager intends to borrow and, in exchange, the
debt claim. Since the public debt market remains competitive at t=l, this debt claim is
determined by investors’ individual rationality conditions. It follows that at interim the
manager’s strategic decision involves choosing the amount of financing to be raised from the
market. For simplicity, we assume that the firm’s offer is observable by the bank, while public
lenders do not observe the outcome of the negotiation between the firm and the bank. The
timing of the interim game is specified as follows. First, the firm decides whether or not to
raise financing from the market, and the amount of financing to be raised. After acquiring the
fund, the firm makes a repayment to the bank21. If the bank is not fully repaid, then the
manager must still negotiate with the bank. The following lemma summarizes the manager’s
equilibrium strategy.
Lemma 4.3: In the interim equilibrium induced by the optimal bank debt,
i)if L>Rb(s21 0h) and the firm raises financing from the interim market, then its equilibrium
offers must be separating;
ii) if L Part i) of lemma 4.3 indicates that if the firm raises financing from the interim market,
its equilibrium offers must be separating: Its offer when the bank is informed of the favorable
21Here, we make two assumptions. First, we assume that in equilibrium the firm will not make
an offer to investors if the offer will be rejected. This assumption will hold if there is flotation
costs in issuing public debt. Second, we assume that the manager can carry the funds to t=2,
but he can not divert the money to gain private benefit.

80
state must be different from that when the bank is uninformed. This follows from the
following two reasons. First, it is strictly suboptimal for the firm to renegotiate with the bank
after it has made a repayment, because borrowing from public lenders reduces the total
surplus over which the firm and the bank bargain. The firm is strictly better off directly
negotiate with the bank without making a repayment. Thus, if the firm raises financing from
the interim market, it will borrow a sufficient amount so that after the repayment the bank will
forgive the residual t=l repayment. On the other hand, since the firm is the residual claimant
of the t=2 cash flow, it also desires to minimize the promised t=2 repayment to public lenders,
and therefore the amount of financing to be raised. These two considerations suggest that the
firm desires to raise an amount of financing from the market so that after the repayment, the
bank is just willing to forgive the residual t=l repayment and allow the project to continue.
Second, the t=2 claim specified in the initial contract is more valuable to the bank when it is
informed of the favorable state than when it is uninformed. Therefore, it will allow the project
to continue with a smaller repayment in the former case. These two reasons suggest that the
interim equilibrium must be separating. Note that this feature of the equilibrium indicates that
at interim the market can perfectly infer the bank’s information. In other words, the bank’s
information is transmitted to the market22.
Part ii) of lemma 4.3 indicates that when the promised t=2 repayment is sufficiently
22The bank’s decision to forgive the t=l residual repayment can also be interpreted as that the
bank automatically provides refinancing in an amount equal to the residual repayment due.
According to this interpretation, for a fixed t=2 repayment, the bank provides a larger
amount of refinancing when it is informed of favorable state. In other words, the bank
charges a lower interest for the interim refinancing when it is informed of the favorable state.
Thus, in equilibrium investors revise their belief upward when the bank charges a lower
interest for refinancing.

81
large, the manager never desires to raise financing from the interim market. To see this, note
that, if the negotiation breaks down when the bank is informed of the state 0H, it can get a
payoff L by liquidating the firm or a payoff Rb(s210H) by forgiving Sj and allowing the project
to continue. If L fails. Therefore, if the manager does not raise financing from the market and forces the
negotiation to break down23, the bank will not liquidate the project. Anticipating that
continuation is ensured without making a repayment, the manager will not raise financing
from the interim market. When the bank is uninformed, the same reasoning indicates that the
manager will not raise interim financing from the market if L the case when
WW0)]^-^!0*). (4-16)
Since Ee[Rb(s210)] repayment when it is uninformed. However, in the interim equilibrium induced by the
optimal bank debt claim, the firm will not raise financing from the market. To see this, notice
that an increase in the bank’s payoff, when it is uninformed, reduces its marginal benefit from
monitoring without decreasing its t=0 expected payoff. Thus, to minimize the required level
of monitoring, the manager desires to structure the debt claim to constraint himself from
raising financing from the market when the bank is uninformed24. Consequently, in the
equilibrium induced by the optimal bank debt claim, the manager does not raise financing from
BThe manager can force the negotiation to break down by, for example, rejecting any of the
bank’s offer and offer a t=2 repayment of zero.
24This can be easily ensured by setting a sufficiently large t=l repayment senior.

82
the market. The project is then continued through negotiation.
Before describing the optimal bank debt, we explain figure 4-1. In the figure, s2u is
the promised t=2 repayment which returns the bank, when it is uninformed, an expected
payoff equal to the liquidation value of the assets, L. If the firm’s promised t=2 repayment
exceeds s/, the uninformed bank will forgive the t=l repayment if renegotiation breaks down.
Otherwise, it will choose to liquidate the project. Similar interpretation applies to s2H when
the bank is informed of the favorable state. Since s2u(A)>s2u, the uninformed bank will
forgive the t=l repayment if the promised t=2 repayment is equal to s2u(A). The expected
payoff it will receive is the same as that when the project is continued through renegotiation.
Similar interpretation applies to s2H(A) when the bank is informed of the state 0H. From the
figure, it is clear that s2u(A=l)=s2u and s2H(A.=T)=s2H.
Consider first the case when the manager has large bargaining power so that A>A*,
and financing by short-term bank debt is infeasible. We denote the bank’s expected payoff,
in state 0, from a promised t=2 repayment x as R,,(x| ©h). As will soon become clear, we only
need to focus on structures in which L repayment in the initial contract. The following proposition characterizes the optimal bank
debt when the firm commands large bargaining power.
Proposition 4.2: i)If in the optimal bank debt s2>s2u, then s^X and the t=0 bank’s
expected payoff is Pb°(A=l), where Pb°(A) is defined in (4-14);
ii)If in the optimal bank debt s2H(A) monitoring effort are
Ai+(l-A)£,[/iiWe)]+e(s2)v1(l-A)[I-iis(JS'|0i)^(s2)]-i|,(<.(j2)). (4-17)

d^(e(Sr))
A -v¿(i -x)[i-«^¡
ae(s2)
83
(4-18)
A(s2) is continuous and strictly increasing in s2 with A(s2=s2H(A))=0.
From fig. 4-1, if s2>s2u, the bank will forgive the t=l repayment both when it is
informed of the favorable state and when it is uninformed. Therefore, its expected payoff in
continuation is completely specified by the initial contract. Clearly, the bank’s t=0 expected
payoff is increasing in s2. Its monitoring effort, however, is decreasing in %. This follows
because the bank’s payoff in continuation is independent of its information when the favorable
state is realized. In the unfavorable state, the bank’s loss of profit from allowing the project
to continue decreases with s2. Thus, the benefit from timely liquidation diminishes and the
bank’s monitoring effort decreases as s2 increases. Since the manager desires to minimize
monitoring as long as he can raise initial financing, he chooses to set s2 at its maximum. In
this case, the bank acquires all the cash flow from the project when it is continued.
Comparing with the case of short-term debt claim, the bank is effectively assuming full interim
bargaining power, and initial financing becomes feasible.
Debt claim described in part ii) of proposition 4.2 becomes optimal when s2H(A) and A is just above A*. Under these conditions, the bank’s t=0 expected payoff from a short¬
term claim is just below the required initial investment. Thus, with a slight increase in the
bank’s expected payoff initial financing becomes feasible. If s2H(A) the bank’s expected payoff by promising a t=2 repayment s2, so that s2H(A) fig.4-1, comparing with the short-term claim, this contract returns the bank a higher
payoff when it is informed of state 0H; When the bank is uninformed, it returns the
bank the same payoff. By continuously increasing s2 over the interval [s2H(A),s2u),

84
both the bank’s t=0 expected payoff and its monitoring effort are continuously increased.
When initial financing only requires a small increase in the bank’s t=0 expected payoff, the
contract in part ii) of proposition 4.2 becomes optimal, because while ensuring initial
financing it reduces the amount of monitoring.
Consider next the case when the bank has large bargaining power, so that X this case, financing by short-term bank debt is undesirable because of the bank’s oversupply
of monitoring. The following proposition characterizes the optimal bank debt claim.
Proposition 4.3: With the optimal debt claim, the bank’s t=0 expected payoff equals the initial
investment I0. At interim, when the bank is uninformed, its payoff is the same as that with
short-term claim. This outcome can be implemented by a repayment schedule in which the
t=l promised repayment is senior and the t=2 repayment is arbitrarily small. In the interim
equilibrium induced by this structure, the firm seeks financing from the interim market only
when the bank is informed of the state 0H.
Form part ii) of lemma 4.3, the firm can not increase the total surplus for the bank and
itself by raising financing from the interim market, because the firm is fairly priced by the
market. It follows that, independent of whether the firm raises financing from the market or
not, the uninformed bank’s payoff can not exceed that with short-term claim. To induce the
desired level of monitoring, the firm must reduce the bank’s payoff when it is informed of the
favorable state. This, as is indicated by proposition 4.3, can be implemented by a senior, and
“almost” short-term, bank debt claim. As is shown in the appendix, in the interim equilibrium,
the firm raises financing from the market when the bank is informed of the favorable state, so
that after the repayment the bank is just indifferent between liquidating the firm and forgiving

85
the residual short-term repayment. Thus, when the bank is informed of the favorable state,
its payoff is equal to the promised t=l repayment. By optimally setting the value of this
repayment, the firm can induce the desired level of monitoring.
The discussion in this section indicates that, in general, the firm prefers to borrow
bank debt requiring repayments both at interim and on the final date. Such a repayment
schedule gives the firm more latitude in achieving its two goals in designing the optimal debt
structure. Optimal bank debt generates two types of outcome. In the first instance, as
indicated by part I) of proposition 4.2, both the bank’s payoff when it is uninformed, and
its marginal benefit from monitoring, Rj, are maximized. Therefore, the required level of
monitoring for initial financing is minimized. However, the firm can not further adjust the
level of monitoring induced and there is an over supply of monitoring effort. In the second
instance, as indicated in part ii) of proposition 4.2 and proposition 4.3, the firm can adjust
the level of monitoring supplied, but neither Ru nor B is maximized. Consequently, the
amount of monitoring required by initial financing is not minimized. Thus, if the firm raises
initial financing by only borrowing from a bank, it can not simultaneously achieve both of its
two goals.
The Optimal Mix
The analysis in the previous section assumes that the manager raises initial financing
only from a bank. Returning to the discussion of the optimal mix, we will analyze in this
section the two cases in which the firm acquires initial financing by borrowing, in addition to
bank debt, either short-term or long-term public debt. For ease of exposition, however, we
will assume away interim market. A complete analysis, which takes into considerations of the

86
interim public debt market, proceeds in the same way as in the previous section.
Mixed structure with bank debt and long-term public debt
The firm raises initial financing by borrowing from a bank and public lenders. In
return, it promises the bank a repayment s:>0 at t=l and S2 at t=2, and the public lenders a
repayment t2 at t=2. The bank’s and the public lenders’ payoff in state 0 from the promised
t=2 repayments S2 and t2 are denoted as Rb(s2,t210) and Rp(s2,t210)25 . In addition, the mixed
structure specifies the bank’s and the public lenders’ payoffs in liquidation. We denote the
bank's payoff in liquidation as Lb. Lengthy but straightforward calculations provide the
following result.
Lemma 4.4: In the optimal mix, Lb Lemma 4.4 implies that at interim the bank will forgive the t=l repayment both when
it is informed of the favorable state and when it is uninformed. Thus, the bank's monitoring
effort and the debtor's total t=0 expected profit (the bank's and the public debtors') are
^=vJV*»(V2|0l)]. (4-19)
(1 -e)Ee[Rb(s2,t21 Q)+Rp(s2,t2 | 0)] +e[\H(Rb(s2,t21QH) +Rp(s2,t2 | QH)) +vlL]-i|/(e).(4-20)
Equations (4-19) and (4-20) imply the following. First, a comparison between (4-5) and (4-
20) indicates that both R¡, the creditors’ payoff when the bank is informed, anc), R, the
creditors’ payoff when the bank is uninformed, depend only on the sum s2+t2. Second, the
debtors’ marginal benefit from timely liquidation, or from monitoring, can be written as
25Again, these payoffs incorporate any contractual specifications which may affect them,
including, for example, the relative seniority between the public and bank debt claims.

87
vL[Lb ~Rb(s2,t210¿)] +v¿[Z -Lb -Rp(s2,t2 [ 0¿)]- (4-21)
Equation (4-21) reveals that, in contrast to the case when the firm raises initial financing only
from a bank, the debtors’ total marginal benefit of monitoring is no longer the same as the
bank’s marginal benefit from monitoring. The public debt claim breaks this linkage, allowing
the manager to separate the tasks of maximizing the lenders’ total benefit of monitoring and
inducing the bank to supply the desired level of monitoring. To minimize the required level
of monitoring, the manager desires to maximize the sum s2+t2. Inducing the desired level of
monitoring requires that the manager optimally distribute the benefit of monitoring between
the bank and the public lenders. The next proposition characterizes the optimal mix.
Proposition 4.4: In the optimal mix,
i)s2+t2=X;
ii)The bank’s monitoring effort is e*;
iii)L-Lb-Rp(s2,t210L)>O;
iv)In the optimal mix, if the payoffs in liquidation are determined by seniority then the public
debt claim t2 is senior to the t=2 bank debt claim s2.
Part i) and ii) of proposition 4.4 indicates that with the optimal mix of claims, the firm
can both minimize and induce the required level of monitoring for initial financing. The public
debt claim plays two roles. First, for any fixed payoff scheme for the bank, and so for any
fixed level of monitoring, it allows the firm to minimize the required amount of financing by
paying out the entire cash flow from the project. Second, by giving the public debtors a share
of the proceeds from liquidation, the firm can control the bank’s benefit from timely
liquidation, and therefore the monitoring effort supplied. Thus, with two debt instruments,

88
the firm can regulate the bank's incentive to monitor without interfering its desire to minimize
the required level of monitoring for initial financing.
Part ii) of proposition 4.4 asserts that when the project is financed by the optimal mix,
the public lenders benefit from the bank's monitoring. Therefore, their incentive over
monitoring, is aligned with that of the bank's. To see this, notice that the change in the
debtors’ t=0 expected payoff, under a small change in the bank’s monitoring effort, is
SeiZ-V^Cs^iej]. (4-22)
If the public lenders’ marginal benefit is negative, then a decrease in the bank’s monitoring
effort increases debtor’s t=0 expected payoff. It follows that the firm is strictly better off
reducing the the amount of monitoring. Consequently, at optimal, the public lenders’ benefit
of monitoring must be positive. In fact, the firm prefers to maximize the public lenders’ share
of the benefit of monitoring, provided the bank supplies the level of monitoring required by
initial financing. This follows because while allocating the benefit to the bank can equally
increase the debtors’ total benefit from monitoring, the firm must incur an increased cost from
the increased monitoring by the bank. By allocating this benefit to the public lenders, the firm
can increase the debtors’ total benefit of monitoring without incurring any additional cost.
Thus, when the project is financed by the optimal mix, the bank acts as a delegated monitor.
The reason for part iii) of proposition 4.4 is simple. Lemma 4.4 implies that the
promised t=2 repayment to the bank must be strictly larger than its payoff in liquidation.
When Sj is senior to t2, the bank’s payoff in liquidation must be strictly larger than Lb, if L^L.
It follows that when S2 is senior, the bank’s payoff in liquidation is L. Thus, the bank acquires
all the proceeds from liquidation, and the manager can not optimally allocate the marginal

89
benefit of monitoring between the bank and public lenders. Such a mix is therefore
suboptimal.
Finally, notice that, in order for the firm to align the public lenders7 and the bank’s
incentive over monitoring and maximize the debtors’ total benefit of monitoring, the public
debtors' payoff must be state contingent, so that they can benefit from timely liquidation. As
we shall see, this is precisely the reason why long-term public debt is strictly preferred to
short-term public debt by the firm.
Mixed structure with bank debt and short-term public debt
The firm raises initial financing by borrowing from both a bank and public lenders.
In return, it promises to repay the bank Sj>0 at t=l and s2 at t=2, and the public lenders tx at
t=l. In addition, the mixed structure defines the payoff in liquidation. We denote the bank's
payoff in liquidation as Lb.
At t=l, the firm must renegotiate with the bank. The analysis of the renegotiation is
similar to that when the firm only borrows from the bank. The only difference is that the
bank's reservation level is increased by tl9 because at interim the bank must invest an
additional tt to finance the firm’s repayment to the public debtors. A complete analysis,
however, is not necessary for comparing a mixed structure with short-term public debt and
the optimal mix with long-term public debt. We first present the result, followed by an
explanation.
Proposition 4,5: A mixed structure with short-term public debt is strictly dominated by the
optimal mix with long-term public debt.
Like a long-term debt claim, a short-term public debt claim also allows the firm to

90
maximize the debtors’ payoff when the bank is uninformed, and adjust the level of monitoring
induced. By increasing tb the firm pledges to pay out more t=2 profit from the project to the
bank. This profit is ultimately paid to the public debtors. In addition, by giving the public
debtors a share of the proceeds from liquidation, the firm can control the bank’s supply of
monitoring. Despite the similarities, there is a crucial difference between the short-term and
long-term public debt claim. The payoff to the public debtors with long-term claims is state
contingent, so that they can benefit from the bank's monitoring. In contrast, the payoff to
public lenders with short-term claims is decision dependent. They are fully repaid whenever
the project is continued, and they can not benefit from timely liquidations26. Therefore, the
lenders' total marginal benefit of monitoring is not maximized. It follows that short-term
public debt is strictly dominated by its long-term counterpart in the mixed structures.
Empirical Implications
In this section, we list some of the empirical implications of our analysis.
Regulation
Form the discussion in section 3, when agency problems are not sever, i.e. when CL
is small, firms can rely entirely on long term debt. For firms with less discretion over future
investment decisions, the agency problems are likely to be small. We would expect that those
firms rely more on long-term debt financing. Managers in regulated firms typically have more
constrained decision sets comparing to those for managers in the unregulated firms. Our
analysis suggests that regulation should increase the average maturity of debt. Barclay and
26In fact, it can be easily shown that in the optimal mix with short-term public debt, the public
lenders’ marginal benefit of monitoring is zero.

91
Smith (1995) find that regulation increases the proportion of the long-term debt by 6.6
percentage points.
Firm size
The analysis in section 4 indicates that debt maturity is intimately related to the
relative bargaining power between firms and their banks. Our analysis suggests that firms with
large bargaining power over their private lenders must rely more on long-term borrowing.
This can effectively enhance the bank's bargaining power and enable initial financing. Taking
firm size as a proxy for firms' relative bargaining power, our analysis implies that as firm size
increases the maturity of private debt increases. In practice, small firms tend to rely more on
short-term bank loans. On the other hand, medium size firms frequently seek financing
through private placement, which are usually long-term. Our analysis squares well with this
empirical regularity.
Our analysis in section 4 indicates that firms which do not have access to the public
debt market may suffer from over-monitoring. Excessive monitoring arises either because a
firm can not raise capital from interim public debt market or it can not borrow long-term
public debt. It follows that the cost of monitoring is likely to be higher for small firms. This
implies that the interest rate of private debt to small firms should, on average, be higher than
that to larger firms.
Riskiness
Consider two firms with projects which have the same t=0 expected return and t=l
liquidation value, but differ in their riskiness. Equation (4-21) implies that the firm with the

92
riskier project demands less monitoring, because the benefit of monitoring increases with the
riskiness of the project. It follows that firms with riskier project will finance their project with
less bank debt and more public debt. This provides an explanation for the recent empirical
finding by Houston and James (1995). In this study, they find that firms with more growth
opportunities rely less on bank loan if they borrow only from a single bank. In contrast, for
firms with multiple banking relationships, the proportion of bank financing increases. When
a firm borrows from a single bank, the bank captures all the benefit from monitoring and it
will supply a high level of monitoring. If the firm maintains multiple banking relationships,
the benefit of monitoring is shared among the banks and monitoring supplied is lowered. In
effect, multiple bank lending creates a quasi-public debt market. Since the cash flows of
growth firms are likely to be more volatile than those of more matured firms, our analysis
suggests that the change in the proportion of bank debt arises because riskier firms demand
less monitoring.
Conclusion
This paper analyzes how firms can optimally design debt structures to facilitate initial
financing at minimum costs. Our analysis provides some answers to the questions raised in
the introductory section. First, to induce a bank to monitor, it must be given the interim
control rights. Given the control rights, the bank can benefit from better information, which
allows it to timely liquidate the project in the unfavorable state. The bank’s incentive to
maximize the value of the control rights motivates it to monitor. Second, the need to
diversify a firm’s borrowing arises both when the manager’s private rent is sufficiently small,
so that in the unfavorable state the project can always be liquidated through renegotiation,

93
and when the manager’s private rent is sufficiently large, so that initial financing requires
involuntary liquidation. In the first instance, the private debt claim must be renegotiated to
allow liquidation. If the firm only borrows from a bank, the division of the surplus from
liquidation can not be specified through ex ante contracting. Borrowing public debt allows
the firm to credibly pay out the surplus generated from liquidation and facilitate initial
financing without incurring any cost of monitoring. In the second instance, the bank must be
allocated the interim control rights, so that it can force liquidation without bribing the
manager. The control rights also induces monitoring, allowing the bank to ascertain the
profitability of liquidation. To minimize the costs associated with monitoring, however, the
manager desires to minimize the amount of monitoring required by initial financing.
Furthermore, the firm must structure the bank’s debt claim to induce the minimum level of
monitoring. To minimize the required level of monitoring, the manager desires to maximize
the creditors benefit per unit of monitoring effort. To induce the desired level of monitoring,
the manager must control the bank’s benefit from monitoring. If the firm raises initial
financing only from a bank, then the bank acquires all the benefit from monitoring and the
manager’s two goals are in conflict with each other. Borrowing public debt allows the firm
to minimize the required level of monitoring and control the bank’s incentive to monitoring
through optimally allocating the benefit of monitoring between the bank and the public
lenders. Third, the need to control the bank’s benefit from monitoring requires that the public
lenders be given a share of the benefit from monitoring. Thus, when the project is financed
by the optimal mix of long-term public debt and bank debt, the manager prefers to align their
incentives over monitoring. The bank thus acts as a delegated monitor.

94
Finally, we point out some of the limitations of our analysis. First, our analysis ignore
the separation of control and ownership: The manager is also the owner of the firm. Strictly
speaking, our analysis only applies to small firms in which the agency problems associated
with the separation of ownership and control is not sever. Second, our analysis assumes that
the intertemporal distribution of the return of the project is fixed. This ignores those cases
in which the manager may have discretional choice over the intertemporal distribution of cash
flows. Thus, our analysis can not address the problem of how financing by mixed debt
structure affects the manager’s investment horizon. These issues await future studies.

95
Figure 4-1

CHAPTER 5
CONCLUSIONS
This dissertation has explored three issues in financial economics and law, ranging
from optimal compensation schemes for investment advisors to firm’s optimal debt
structures. The emphasis of this study has been to apply information economics to examine
problems the solutions to which depend critically on the allocations of information among
agents.
The main findings of this study can be summarized as follows. First, in designing
compensation schemes for investment advisors, I show that both the advisors’ technologies
of information collection and agents’ priors are crucial in determining the structures of
compensation schemes. The optimal payment scheme rewards the advisor more richly for
correctly predicting an outcome, if expending effort best enhances his ability to predict that
outcome. When the advisor's information is not publicly observable, I find that the need to
induce an advisor to expend effort generally interferes with the need to elicit truthful
revelation. Second, in setting optimal legal standards, I find that some divergence between
the marginal benefits and marginal costs of providing care by potential violators of the
standards are needed to control the costs of enforcement. Furthermore, it is found that
setting maximal fines may be welfare reducing. Third, in choosing optimal debt structures,
I show that firms in general prefer to borrow from both public and private lenders. Through
96

97
monitoring the firm to which they provide funds, private lenders can produce information.
In addition, in the optimal debt structure, firms desire to align the public lenders incentive
over monitoring with that of private lenders, and so private lenders act as delegated
monitors.
While providing interesting findings, this study also reveals that there are important
issues that require further analyses. In designing optimal compensation schemes for
investment advisors, I have focused on a setting in which there is only one investor and one
advisor. Moreover, I have restricted the analysis to a one-period setting. In a fuller analysis,
it would be interesting to analyze cases in which one or more of these assumptions are
violated. In deriving optimal debt structures, I have ignored agency problems associated
with the separation of ownership and control. In addition, in a richer model, one must also
relax the assumption that a firm initially borrows only from a single bank. It is also
important to examine cases in which firms raise external capital to finance multiple projects.
I plan to explore these issues in the future.

APPENDIX A
PROOFS OF THE MAIN RESUETS IN CHAPTER 2
Proof of Proposition 2.1.
The proof of the equivalence between [I-P] and [I-P7] relies on the following two
observations. First, the only difference between [I-P] and [I-P/] is in replacing constraints
(2-5) and (2-6), in [I-P], by constraints (2-9) and (2-10), in [I-P']. Thus, if it can be shown
that a payment scheme satisfies (2-5) and (2-6) iff it satisfies (2-9) and (2-10), i.e, (2-5) and
(2-6) are equivalent to (2-9) and (2-10), the equivalence between the two formulations is
then established. Second, a payment scheme satisfies (2-5) and (2-6) iff {0,(xH,xL)} is a
Nash equilibrium strategy for the advisor. Thus, if it can be shown that a payment scheme
satisfies (2-9) and (2-10) iff [0, (xH,xL)} is a Nash equilibrium strategy for the advisor, the
equivalence between constraints (2-5),(2-6) and constraints (2-9) and (2-10) is then
established. It then follows from the first observation, [I-P] and [I-P'] are equivalent. The
following proof shows that a payment scheme satisfies (2-9) and (2-10) iff {0, (xH,xL)} is
a Nash equilibrium.
Necessity: If compensation scheme (w(x,r): xe{xH,xL} re{rH,rL} }
satisfies constraints (2-9) and (2-10), then for any strategy [0', (x¡,Xj)}
L(xi,xj10')-C(0')< Maxe.[L(xi,xj10')-C(0')]=II(xi,xj) By (2-10), II(xh,xl)=L(xh,xl|0)-C(0). Thus {0, (xh,Xl)} is a Nash equilibrium strategy.
Sufficiency: if {0, (xH,xL)} is a Nash equilibrium strategy, then
98

99
L(xh,xl| 0')-C(0')^L(xh,xl| 0)-C(0) V0'
Hence, 0eArgmax0<[L(xH,xL|0')-C(0')]. Further, for any strategy {,0^ (x,x)},
Xi.XjSÍXH^},
L(x,,Xj 10')-C(0') implies II(xi,xj)=Maxe.[L(xi,xj|0/)-C(0,)] thus a Nash equilibrium strategy iff the payment scheme satisfies constraints (2-9) and
(2-10). It follows from the discussion above that formulations [I-P] and [ I-P'] are
equivalent.
Proof of Lemma 2.2.
1 Straightforward.
2) i) Since the payment scheme satisfies constraint (2-10), we have
n(xH,xL)=L(xH,xL|0)-C(0). n(xH,xL)>II(xH,xH) implies
OtiJ VA(w(xvrL)) - VA{w(xwrL))] > (1 -0)tt/7[VA(w(xH,r¡})) - VA(w{x,/„))] +C(0) (A. 1)
and n(xH,xL)>n(xL,xL) implies
®KH\VA{w{xwrH))-VA(w(xL,rH))]>(1 -0)7t J VA(w(x£,r¿))-VA{w(xH,rL))\ +C(0) (A.2)
(A.l)x(l-0(e))+(A.2)x0(e) followed by simple rearrangement provides
^H[VA(w(xHrH))-VA(w(xL,rH))](20-l)>C(0)
0>l/2 implies w(xHrH)>(wL,rH). Similar derivation provides w(xuxI)>w(xH,xL).
2) ii) For any 0'e[l/2,l), part i) implies L(xl,xh|0') is strictly decreasing in 0',
and the result follows.

100
Proof of Lemma 2.3.
I))Being risk neutral, the investor will invest W0 in the risky asset if E[r | x,0] >R and zero
amount otherwise. Simple calculation provides that E[r|xH,0]>R and E[r|xH,0] any 0> 1/2. As will be shown, the equilibrium accuracy 0rp>1/2. Thus A(xl)=0 and
A(xh)=W0.
Following Grossman and Hart (1983), the solution can be derived by first solving
for the optimal compensation scheme implementing a given level of accuracy 0, and then
optimize over 0 in the second step. The solution to the first step will easily follow once
we establish the following two facts.
Fact 1: Let f(x) be a function with f(x)>0 and f'(x)<0. If af(x1)+(l-a)f(x2)=af(y1)+(l-
a)f(y2) where x1>y1>y2>x2 and ae(0,l), then ax1+(l-a)x2>ay1+(l-a)y2.
To show this, let be(0,l) be such that axI+(l-a)x2=by1+(l-b)y2. The existence of
b is obvious. Define two random variables X,Z, with density functions
gx(X=X!)=a,gx(X=x2)=l-a and gz(Z=yj)=b, gz(Z=y2)=l-b. X and Z differ by a single
mean preserving spread (MPS). It follows that af(x1)+(l-a)f(x2) (Rothschild and Stiglitz (1970)). Thus b>a and ax1+(l-a)x2=by,+(l-b)y2>ay1+(l-a)y2.
Fact 2: lime,+1C'(0)=+°°
This is shown as follows: if lime_+„C(e) is finite , then p=supeC(e) is finite. Thus
for Ve>0 3e s.t C(e)>p-e. Since C(e) is strictly convex, thus CXe^-CXe) >(e1-e)C'(e), for
Ve¡>e. Choose ej s.t e1-e=e/C'(e). Then Cfo )>C(e)+e>p which forms a contradiction.
Thus lime_.+„C(e)=lim0JlC(0)=«. Use of strict convexity <0-- implies
C'(0) 2

101
lime.1C,(0)=+~.
The optimization problem corresponding to the first step is the following.
MÍnw(y)Ex,£W(xS) | 6]
s.t — L(V¿|0)=C/(0)
dQ
w(x,r)ii0 xebcjjXjj reirL,rH}
We have replaced constraint (2-16) in the reduced problem by its first order
condition and have dropped the individual rationality constraint. The validity follows from
the concavity of L(xh,xl|0)-C(0) and that the limited liability constraint guarantees
individual rationality be satisfied. Since
Er[w(xH,r)|0]=0[7iHw(xH,rH)+7tLw(xL,rL)]+(l-0)[7tHw(xL,rH)+TtLw(xH,rL)]
and L(xh,xl| 0)=[%VA(w(xH,rH))+7iLVA(w(xL,rO)H7tHVA(w(xL,rH))+7tLVA(w(xH,rL))
dv
It follows from fact 1, for given 7tHVA(w(xH,rH))+TCLVA(w(xL,rL), t%w(xH, rH)+7tLw(xL,rL) is
minimized at w(xH,rH))=w(xL,rL). Similarly, nHw(xL,rH)-t-7iLw(xH,rL) is minimized
at w(xL,rH)=w(xH,rL) for a given TrHVA(w(xL,rH))+7tLVA(w(xH,rL)). Thus, at optimal,
Er[w(x,r)|0]=0w(xH,rH)+(l-0)w(xH,rL)
7- L(xh,xl| 0)=VA(w(xH,rH))-VA(w(xH,rL))=C'(0)
d
The limited liability constraint for w(xH,rL) must bind. If otherwise, a simultaneous
decrease in w(xH,rH) and w(xH,rL) while leaving VA(w(xH,rH))-VA(w(xH,rL)) unchanged will
result in a decrease in Er[w(x,r) 10]. We conclude that the optimal compensation scheme

102
implementing a given Q>Vi must be such that w(xH,rH))=w(xL,rI)=h(C(0)) and
w(xL,rH)=w(xH,rL)=01.
ii) In the second step, the investor optimize over 0 using the payment scheme derived in step
one, i.e Max96[1/21)[0p-0h(C(0))]. Fact 2 implies, in optimizing over 0, we can restrict the
range of 0 to [1/2,M] M<1. The existence of 0RP follows from the continuity of [0p~
0h(C'(0))] in 0. The first order derivative of [0P-0h(C'(0))] with respect to 0 is strictly
positive at 0=1/2. This implies 0RP> 1/2. To show 0RP <0^, notice C(0=1/2)=O and C"(0)>O
imply C(0)<(0- 1/2)C,(0)O imply C'(0)<(0-
1/2)C"(0)<0C"(0). Thus
~^\Qh(C ;(0))] =h(C ;(0)) +0C"{Q)h '(C /(0))>4[/i(C(0))]
dv do
Recall, 0RP and 0FB satisfy
^[«a0))]|».6ra=P=^[0*(c'(e))]|e,9if>^[A(a0))]ie.e„
The monotonicity of h(C(0)) in 0 implies 0rp<0fb
Proof of Lemma 2.4.2.
From lemma 2.4.1, the optimization problem can be simplified as follows.
Mmw(..jQ \ -Knw{xH,rH) +nLh(
71,
]}
%^(w(^^))^[(1-e)C/(0)+a0),0C'/(0)-C(0)]
'At 0=1/2, w(x,r)=0 V x,r. In this case, no contracting occurs.

103
â– KLVA(w(xL,ri))=C 7(0) - KHVA(w(xH,rH))
It can be easily verified that the objective function in the simplified problem is strictly
convex. The strict convexity of C(0) implies the closed interval constraining
^HVA(w(xH,rH)) is nonempty. The continuity of the objective function in w(xH,rH) and the
continuity of h implies the solution to the reduced problem exists. Straightforward
calculation indicates the first order derivative evaluated at the right end of the interval is
strictly negative if and only if 0<0°H. Strict convexity of the objective function implies that
the constraints are not binding and the first order condition is sufficient if 0>0°H. The first
order condition provides w(xH,rH))=w(xL,rL)=h(C'(0)). Strict convexity also implies the
objective function reaches minimum at -n;HVA(w(xH,rH))=0C'(0)-C(0) when 0<0°H.
Proof of Proposition 2.2,
If 0RP>0°H, then 0PH<1. Lemma 2.4.2 implies that the objective function is [0P-
0h(C(0))] for 0>0°H and is 0{P-['n:Hh(a1(0)/TcH)+h(a2(0)/7TL)TCL]} for 0<0°H. The strict
convexity of h implies TCHh(a,(0)/KH)+h(a2(0)/7i:L)7iL>h(C,(0)). It follows
Max06[I,e“][P0~0(V(—)+*zA(—)] 2’ Kh TIl 2’
= MaxQeKl)[$Q-Qh(C'{m
Thus 0sb=®rp-
If 0°h>0rp, lemma 2.4.2 indicates that the objective function is [0P-0h(C'(0))l if
. <3>(0) 0>0°H and is [p0-0(/z(—i—-)KH+KLh{-^—))] for0<0°H. [0p-0h(C(0))] is strictly
TU r t TC J

104
concave in 0. 0RP<0°H implies — [0p-0/z(C/(0))]|e=eo dQ H
a,(0) a,(0) , ,
[pe-e^-L-^ +7t *(^_))]| 0 = m-Qh(c'm]\^do > [0p—0/z(c;(0))]
for any 0>0°H. Thus, 0SB must be the solution to the problem
„ _ «,(0) a2(0)
Max i o. [ d-6(h(^-)TiH+-KLh(.^—))]2.
2H 71H 71L
Furthermore, the first order derivatives of the objective function evaluated at 0=1/2 and
0=0°H are strictly positive and negative respectively. Thus 1/2<0SB<0°H.
Proof of Proposition 2.3.
If 0°H is smaller than 1, then both of optimization problems in proposition 2.2
involves optimizing continuous functions over compact sets. The solution spaces of the two
problems are thus compact subsets of real line, and a maximum exists in either case.
If either 0°H is 1, then fact 2 in the proof of lemma 2.3 can be used to restrict the
range of 0 to a compact set in the optimization problem proposition 2.2. The previous
argument can again be applied to yield a compact solution space which contains a maximum.
Proof of Proposition 2.5.
(i)This follows directly from part i) of proposition 2.2.
(ii)If 0rp<0°h and 0sb 2If 0H°=1, the range of the 0 is open on the right. In this case, fact 2 in the proof of lemma 2.3
can be used to show the existence of the solution.

105
is
n d mr , ai(0), ,,a2(0),nll
P=-—{0[7T//i( )+7lLh( )]}|e=,
dQ
7T
H
Tlr
'SB
The strict convexity of h implies
a,(0) aJQ)
[”»*(—)+^(—)lle.e„ >h(C (0))
H
The condition h (â– )>0 implies
—[ )+V*( )] Ie.e * C"{Q)h (0 +(1 -0) ), 0=0
— — SB — —
dQ 7i
H
â– K,
n
H
7Ir
SB
>C//(0)h,(C(0)
i e=ec
The second inequality follows from the assumption 0SB<7tH. Thus
4(0*(C'(0))|el. =P=-Í|0[’ih'1(—)+n¿A(—)])|e-e >4r<0''(c'(0))
dQ
dQ
7T
H
71,
dQ
0=0,
Since —(0/z(C 7(0)) is strictly increasing in 0, we conclude 0SB<0RP.
dQ
Proof of Proposition 2,6.
I)Since the expected total payoff from the investment is increasing in 0 and that the agent
does not earn any rents under the first best solution, Lemma 4 implies PFB>PRP.
To compare PSB with PRP, we consider the following three cases.
Case 1. 0RP>0°H, Proposition 2.2 implies PSB=PRP,
Case 2. 0°H>0RP. The profit for the investor is

106
a,(0) a9(0)
P0-0(7t^(-!—))]|e=ew<[p0-0Ma1(0)+fl2(0))]
71
H
7U r
e=0c
= [p d-Qh(c'm]\ .
SB
When the signal is observable, the investor derives a profit [p0-0/z(C/(0))]|e=e^ . Since
0RP solves AfecgtpO-O/iiC^©))] , we have
[pO-O^C'iOfflle^ >m-Qh(C'm)\e=dsB .
The investor derives a strictly smaller profit in the second best case than that in the reduced
problem, i.e PSB ii)For fixed p, define tihc by [0 -—L e =7iu , where 0RP is the optimal accuracy level
^RP
in the reduced problem. Following Proposition 2.2, the investor's profit is a constant Ps for
7iH<7tHc, i.e 0°H<0RP. For 7ih>tihc, the optimal payment scheme is given by Proposition 2.2.
a,(0) a2(0)
Let s(0,nH)= P0-©[rc^i )+7iLh{ )] , then the investor's profit is the following
71
H
71,
expression
"*) •
where 0h°(tth) *s defined as in Definition 2.1.
Consider two priors tch1 and tth2, such that 7i Hc<7i ^<71 H2. By
definition, Oh^TCh^Qh^h2)- Further it is easily seen that V0<0h°(tih1).
Thus, if Pa(7rH2)>Pa(7rH1), then s(0,tth2) must be maximized at some point 0 ^uch that
0hW)<02*0h°(%2)- Since 0RP<0H°(7TH2), it follows that —j(0,7t^)|e=e , 2.<0 . Thus
dQ - H>

107
02<0H°(7rH2). Now, define prior tth3 by
B_aei]
C'(0)
0=02-71://
It follows that
Since s(02,TiH2)=Pa(TrH2) and Pa(7tH3)>s(02,7tH3), we have Pa(7iH3)>Pa(7rH2)>Pa(V). We can
continue to apply the procedure and construct the sequence {7THn, n=2,-,+°°} with
TCHls7lHn+1<'rtHn- Thus, the sequence must converge to From the procedure of
constructing the sequence, Pa(7i:Hn)=s(0Ho(7iHn+1),7T:Hn). From Definition 2.1, 0H°(%) is
continuous in 7th. The continuity of the function s(0,nH) implies that
limn_Pa(7iHn) =s(0Ho(7tH'),V)-
Since it follows that 0h°(ti:h,)>0rp- It follows from this inequality that P/tth')>
s^hVO^h^P^h1)- Let sCQ,^) be maximized at 0O, i.e Pa(7i:H,)=s(0o,7i:H'). Then, Pa(7iH')>
Pa(7tH(n))>s(0o,7iH(n)) implies limn_JPa(7i:H(n))=Pa(7T:H'). This then forms a contradiction.
Thus, we conclude that Pa(7iH2)
APPENDIX B
PROOFS OF THE MAIN RESULTS IN CHAPTER 3
Proof of Proposition 3.1
The assumptions on P (q,e,s) and on C (q) andD (e) suffice to insure U(<7,e,s)is strictly
concave in q and II (q,e,s) is strictly concave in e. If we further require that q,e < p < «
then by Theorem 3.1 of Friedman (1990), a pure strategy Nash equilibrium exists. The
conditions on P(q,e,s), C(q) and D(e) further insure that the Nash equilibrium is interior (with
e,q > 0) and that it is characterized by the first order conditions (3-1) and (3-2) in the text.
Finally, uniqueness of equilibrium follows by verifying that the reaction function of the party
and of the enforcer are continuous and have slopes of opposite signs indicating a unique
equilibrium at the single point of intersection.
Proof of Proposition 3.2
Totally differentiating eqs. (3.1) and (3.2) in the text with respect to s yields the following:
(-P -c
99 99
-P )
qe
dq/ds
( P )
qs
P
V 9e
P -D
ee ee)
v delds
-P
\ esJ
Cramer’s rule applied to (C.l) implies:
108

109
dq _ Pqs (P ee ^ee) P qeP e
ds A
> 0
(B.2)
— = + ÍÜ > o as P > 0
ds A < qe <
(B 3)
where A = - (Pqq + Cqq) (Pee - Dee) + Pqe > 0. The sign of dq/ds follows immediately
from our assumptions about P and D. To verify the sign of de/ds, rewrite (B.3) so that
de
[Pse
P }
qs
1 ^ + C<*) Pqe
ds
K
(P + C )
v qq qq’ \
1 A
¡dq
dq(e(s),s)
1 (Pqq + Cqq) Pqe
[¿¿S' ¡
ds
J A
de=0
N '
II
-0
(B.4)
^ 0 as Pne ^ 0 <=>• P 5 0
qe se >
by Assumption 3.1.
Proof of Proposition 3.3
The optimal standard .?satisfies
~ = (B - C )— - D — 0
ds q ds e ds
(B.5)
Solving for (B - Cq) from (B.5) yields

B - C =
D —
e ds
dq
ds
It follows from (B.6) and Proposition 3.2 that
5-Cj 0 as — J 0
9 < dsK
P„ J 0
se
no
(B.6)
(B.7)
Finally, since C < 0 , and q is increasing in 5, it follows from (B.7) that
s~ J s * as Pse 2 0
(B.8)
Proof of Proposition 3,4
First we provide necessary and sufficient conditions for satisfying the conditions (i) and (ii)
of [GP-A] in the text. Applying routine arguments (see Guesnerie and Laffont (1984)) one
can readily show that the schedules { 7(0), 5(0)} are differentiable almost everywhere, and
that the effort level induced, e(5(07), 0) must be non-increasing in 07 where 07 = 0. Further,
n'(0) = n, (0' | a), ^ * n2(0'|0), (b.9)
I dO I
07=0 07=0
= ~Dq (c(j(0),0),0)
where the second line of (B.9) follows from the Envelope Theorem. SinceII(0) is
decreasing, part (i) is insured provided
II (0) = 0
(BIO)

Ill
Combining (B.9) - (B.10), parts (i) and (ii) of [GP-A] are satisfied provided,
e
n(0) = f - Dq (e(s(Q),Q),Q)dQ (B.ll)
6
Substituting for II (0)from (C. 11) into [GP-A], integrating by parts and rearranging terms
yields
max E„ F(s(e\d) = max£e ¡B (•) - C(?(-)) - £>(«(•),8) - (1 - A) £>„ (e(-),0))
<0) í(0) l A0)J
wherewe have deleted the arguments of q(-) and e(-) for notational convenience. Rewriting V (s(0),0)
in terms of F(5(0),0) = B (•) - C (#(•)) - D (e(-),0) and recognizing that Z)0is implicitly
a function of 5(0) and 0 we have
V (s(6),0) = V (a(0),0) - (1 - 1) D„ (s(0),0) (B.12)
/(O)
Assuming a separating solution to [GP-A], Let
5 (0) = argmax V (5(0),0)
s(0)
5 (0) = argmax V (5(0), 0)
*(0)
Then, employing standard revealed preference arguments for all 0 e [0,0]
V (5(0),0) > F(s(0),0) (B. 13)
F (x(0),0) a V (s(0),0) (B. 14)
with strict inequality for 0 > 0. Adding (B. 13 ) and (B. 14) and simplifying yields

112
(1 - X)[Z)e(j(0),0) - Z)e(5(0),0)] * 0
This implies, since 1 - X > 0 that
(B.15)
f(0) as
d
ds(6)
Dq (5(0),0)
(BAG)
But
d
ds( A>(s(6),e) - A.,
de
ds
s
(B-17)
where the second line of (B. 17) follows from Proposition 3.2. Collecting (B. 16) and (B. 17)
we have
5(0) < 5(0) < 5* for Psq > 0
(B.18)
5(0) > 5(0) > 5* for Psq < 0
(B.19)
with strict inequality for 0 > 0, thus proving Proposition 3.4.
Proof of Proposition 3.5
The solution to [GP-P] as posed in the text is characterized by the first order conditions
£. . A [B - C/?(M,n)] W¿)
V *
D' (F(AMj))
de
ds
= 0
ds
(B.20)

113
P(£) 5 ~ Cfo(ÍW) - D'(F(P)e(s))e(s) > 0 (= if A < p) (B.21)
where (B.20) and (B.21) correspond respectively to the maximization of [GP-P] with respect
to s and p. The Nash equilibrium care and enforcement levels, q(p.,s) and e(s) are
characterized by
-Pq(qM,e(s),s) - Cq(g(\i,s),]i) = 0; p < p (B.22)
Pe{qM,e(s\s) - D' (F(fí)e (s)) F(¡i) = 0 (B.23)
First we prove parts (iii) and (iv) of the Proposition. Differentiating (B.22) and (B.23) totally
w.r.t. s yields:
' dq
- FnP
' de
- P - c
f d£
K dS>
qe
, ds,
qs qq
\ d$)
p < p
(B.24)
+ P.
' de'
\ ds >
+ P.
D‘F{Ál¿) '0
(B.25)
Combining (B.24) and (B.25) one obtains
where
de _ A
ds B
(B.26)
A = -E
-P.
qs
H s n
P +C
qq qq
P
e
p~
p
eq
qe\
(B.27)

114
B = E..
M ^ 1 P + C
99 99
^ + P ( - D'Ftfi) < 0
It follows from Assumption 3.1 and (B.26) - (B.28) that
de
^ 0 as P 't 0
\ qe <-*
>
ds" ^ qs<
In addition (B.24) and (B.25) also imply that
dq (M) =
ds
qe
‘ de}
\ ds ¡
+ P
qs
^99 + C9?)
> 0
(B.28)
(B.29)
(B.30)
where the inequality follows from (B.29). Substituting (B.29) and (B.30) into the first order
condition for s, (B.23) allows one to verify parts (iii) and (iv) of Proposition 3.5.
To verify part (i), notice that for B sufficiently large V(p) is strictly positive for all
p, as both terms C(q (£,s), ji) and D '(■) e(s) in (B.21) are bounded above since q (p,s) and e(s)
are bounded, while the term B q{\i,s) is arbitrarily large. Hence, p = p and no party types
are exempted when the marginal benefits of care are sufficiently large.
To verify part (ii), notice that for a type which decides to exempt himself
-A > min (-p(q,e(s),s) - C(q,¡i)) > -F (B.31)
9
or A < F. This completes the proof of Proposition 3.5.
Proof of Proposition 3.6
Given s, the first order condition for Y in the solution to the enforcer’s problem, [EP] stated
in the text is

(P(g(m'¿),e(s)¿) ~ D'(F(¡i)e(s))e(s) -
( = í/V < P)
Notice that when g7 = g
( \
d\í
\~dY)
+ (1 -F(g7)) > 0
(B.32)
Y = P (q (\a,s),e (s\s) + C(g(g,s),g) (B.33)
Substituting for this value of Y in (B.32) reveals that g7 = g can not be a solution to [EP],
Therefore, g7 < g.
Rearranging (B.32) and noting that it holds with equality yields the expression
appearing in Proposition 3.6. Finally, the result that Y < F follows from noting that
- F > min (~p(q,e(s),s) - C (q, g)) > -F (B.34)
q
for all g < g.
Proof of Proposition 3.7
According to eq (3-3) in the text
dV > delds > deldF
— = 0 as =
dF < dq/ds < dq/dF
rT., . r delds * deldF . ,
The expressions for and are given by
dqlds dq/dF
de/da = (K + pet) (Pqe ~ pee A(?) â–  a = SF (B 35)
dq/da (p2 - p A f + (P2 - P A ) (X + P )
v qe ee q' V qe ± ee q/ V a eq/
where

116
P
A = --JL A > 0
s pi
r eq
A = P -C >0
q qq qq
(B.37)
(B.38)
It is easy to demonstrate that the RHS of (B.35) is increasing in Aa so that
de/ds '
dqlds <
de/dF
dqtdF
>
<
( P \
_ e
y
\ i)
>
= 0
<
(B.39)
where one can easily verify the last equivalence in (B.39).

APPENDIX C
PROOFS OF THE MAIN RESULTS IN CHAPTER 4
Proof of Lemma 4.1.
Assuming that the bank is uninformed, consider first that the firm makes offers. Let
the equilibrium offer be G(0i), i=H,L. G(0) is the offer made by the firm in state 0. Consider
first separating equilibriums with G(0[L)*G(0L).
Case S. 1. Project is liquidated at 0H and continued at 0L.
In this case, G^h) represents a t=l repayment to the bank and corresponds to a
liquidation contract; G(0L) represents a t=2 repayment to the bank and is a continuation
contract. In state 0L, the firm's and the bank's individual rationality conditions requires that
Rf(G(0Iit2|0L)iI«!st2|0L)>
RbfGiej.t, | | ej. (c.i)
Since Rf(x,t210L) is continuously decreasing in x, thus G(0H) increasing in x, thus G(0L)>s2. Together, they imply G(0f)=%. In state Q,, the firm’s individual
rationality requires
W-cWíR^iea+c,.. (c.2)
In addition, incentive compatibility requires that the firm, in state 0L will not choose to
liquidate the project by proposing the liquidation contract G(0H), i.e.
Rfetiieo+cLiLl'-G,(eH). (c.3)
117

118
Together, (C.2) and (C.3) imply
R/MjI 6L)+CL>Ll'-G(0H)>Rl(S2,t2| 6h)+C„. (C 4)
But, R/s^IQh^R/s^IOl) and C(0H)>C(0L) imply that such a separating equilibrium is
infeasible.
Case S.2 Project is liquidated in state 0L and continued in state 0H.
In this case, G(0H) represents a t=2 repayment to the bank and corresponds to a
continuation contract; G(0L) represents a t=l repayment to the bank and corresponds to a
liquidation contract. Again, individual rationality conditions for the firm and the bank imply
G(0h)=s2. In state 0L, the liquidation contract must satisfy the following constraints,
W-G^R^iej+c,.,
G(0L)^Rb(S2>t2 I ®l)>
Rf(s2,t2|0H)+CH>Lb{-G(0L). (C.5)
The first two constraints are the firm's and the bank's individual rationality conditions. The
last constraint is the incentive compatibility constraint which ensures that the firm, in state 0H,
will prefer to continue than to liquidate the project. G(0L) satisfying these constraints exists
if
(C.6)
If this inequality holds, separating equilibrium exits and
G(0L)=Max{Rb(s2,t21 10H)+CH ]}â–  (C.7)
Consider next pooling equilibrium with G(0H)=G(0L).
Case P.l. Renegotiation leads to liquidation in both states.
In this case, both G(0H) and G(0L) are liquidation contracts and in equilibrium they

119
must be the same. We denote them by GL. The individual rationality constraints for the firm and
the bank are
Eb‘GL>Rf(s2,t21 0h)+C¡ j,
GL>Ee[Rb(s2,t2|0)].
(C.8)
Gl satisfying these constraints exits if
Lbi^Rf(s2,t21 0h)+Ch +Ee[Rb(s2,t210)].
(C.9)
If (C.9) holds, the manager proposes GL =E0[Rb(s2,t210)].
Case P.2. Renegotiation leads to continuation in both interim states.
In this case, both G(0¡L) and G(0l) are continuation contracts and in equilibrium they
must be the same. We denote them by Gc. Again, individual rationality constraints require
Gc=s2. The outcomes of this equilibrium is the same as that without interim renegotiation.
We establish the uniqueness in two steps.
Step 1: If (A.9) holds then the pooling equilibrium P.l is the unique equilibrium.
In this case, both the separating equilibrium S.2 and the pooling equilibrium P.2 are
feasible. We show, however, divinity criterion upsets these two equilibriums. Let G/ be a
liquidation contract satisfying
lV-[RXs2,t21 0h)+Ch]>G1 '>E9[Rb(s2,t210)]. (C. 10)
In the equilibrium S.2, G/ is strictly preferred by the firm in both states. By divinity, bank's
conjecture about the states, when faced with the offer G/ , is the same as the prior. Since
Gi'>E6[Rb(s2,t,|0)], the bank will accept such an offer. This upsets the separating equilibrium.
Same reasoning indicates that divinity criterion also upsets the pooling equilibrium P.2.
Step 2: If (C.6) holds and

120
Lb{-[Rf(s2,t210L)+CL ]^[R^t, 10)], (C. 11)
then the separating equilibrium S.2 is the unique equilibrium.
In this case, pooling equilibrium P. 1 is clearly infeasible. Suppose the equilibrium is
the pooling equilibrium P.2. Let G,' be a liquidation contract which satisfies
Rf(s2,t2 ] Qnj+C^Lh'-Gj >Rf(s2,t210L)+CL,
0/^(8,,t2|0L). (C.12)
If such a contract G,' exists, the manager will deviate and offer the liquidation contract G¡'
in state 0L. By the divinity criterion and (C.12), the bank will accept such offer. This then
upsets the proposed pooling equilibrium P.2. G/ satisfying the two constraints exits if (C.6)
holds.
When the bank makes an offer, it offers a menu (F(0H),F(0L)}, where F(0,) is the
contract intended for the firm in state 0¡, i=H,L. From the above analysis, a menu, which
induces liquidation in state 0H and continuation in state 0L, can not be incentive compatible.
If the menu induces continuation in both state, then the bank’s and the firm’s individual
rationality conditions imply that F(0H)=F(0L)=s2. This is the same outcome as that without
renegotiation. If the menu induces liquidation in both states, the firm’s incentive compatibility
condition requires that F(0H)-F(0L)=FL. The firm’s individual rationality condition requires
F^R/s^l Oj^+Ch. Thus the bank will choose to offer FL=Rf(s2,t210H)+CH. Finally, the bank
can offer a menu which induces liquidation in state 0L and continuation in state Qj . The
firm’s individual rationality condition requires that F(0H)=s2. The contract F(0L) must satisfy
the incentive compatibility condition and the individual rationality condition for the firm,
FfejiRfetjieo+o,

121
^f(S2^2 I ^h)+Ch>F(0l).
(C.13)
F(0l) satisfying (C.13) exits if the condition (C.6) holds, in which case the bank will propose
F(0L)=Rf(s2,t2|0L)+CL.
(C.14)
It is easily seen that when conditions (C.6) and (C. 11) hold, the bank will propose the menu
which induces liquidation in state 0L and continuation in state 0H.
Proof of Lemma 4.2.
Consider first the manager makes the offer. If the manager offers a separating
contract, the bank can perfectly infer the realized state. Since L>r(0L), the bank will refuse
the offer indicating the state 0L and liquidate the firm. Thus the equilibrium must be pooling.
By assumption 4.1, the firm can offer a continuation contract s/, in both states, such that
(C. 15)
This contract satisfies the bank's individual rationality constraint and will be accepted by
bank. The project is always continued.
Consider next the bank makes the offer. The uninformed bank offers a menu
{G(0h),G(0l)}. Assuming first that the menu is separating, i.e. G(Qi)^G(^). It is easily
seen that a separating menu which induces continuation in state 0L and liquidation in state 0H
can not be incentive compatible. Focusing on the opposite case, the incentive compatibility
constraints are
cH+(x ('•-G(e„))dF(/-|e„)>¿-G(0i),
J G(Qh)
(C 16)

122
L-G(8l)íCl+ f (r-G(QM))dF(r 10L). (C.17)
J G(Oh)
The first inequality ensures, in state 0H, the firm will choose the contract G(0H) rather than
G(0l). The second ensures, at 0L, the firm chooses the contract G(0L). Combining the two
constraints provides
(r-G(0H))dF(/-|0i,)>¿-G(0i)2Ci+f (r-G(QH))dF(r\fSJ. (C.18)
By assumption 4.3, (C.18) can not be satisfied. It follows that the bank proposes a pooling
menu, i.e.G(0H)=G(0L) . By assumption 4.1, the bank proposes a pooling contract
demanding the entire t=2 cash flow, i.e. s2l-X.
Proof of Proposition 4.3
Since we only need to show existence, we prove the proposition by constructing such
a repayment schedule. We require (sj*^*) satisfy the following conditions.
Condition 1: (1 - X) JA rdF(r | 0;/) +XL>s[>( 1 -X)EejXrdF(r \ 0) +XL . (C. 19)
Condition 2: s¡ =(Z)'w(0ií)+^)- rí-(6")+Í2F(r|0//)¿/r (C.20)
â– I o
fDMHr\e )dr (C.21)
J 0
where and s^-I^O^KL.
Condition 3: st* is senior with seniority protected. S2* is junior and allows the firm to issue
additional public debt up to Dm’(0H).
From assumption 4.1, sx* and S2* satisfying the conditions exist. We claim that, in the

123
unique equilibrium, the firm raises Im'(0H) by issuing public debt with face value and
senior to s^when the bank is informed of the favorable state; When the bank is uninformed,
the project is continued through renegotiation. The project is liquidated when the bank is
informed of the state 0L. We prove this claim in two steps.
Step 1: The firm will not raise Tm'(0H) from the market except when the bank is informed of
the state 0H.
Consider first the case when the bank is uninformed. Suppose the firm deviates and
issues the senior public debt with face value Dm'(0H), then
fM |6)dr] . (C.22)
J D‘JQh) j D‘ (d„)
'Dm(®H)+S2 ]
The right hand side of (C.22) is the bank's expected profit from the promised t=2 repayment,
s2*, if the project is continued. The left hand side is no greater than the bank's payoff if the
project is liquidated after the repayment Im‘(0H)- Thus, when the bank is uninformed, it will
not forgive s^-I^On). The firm must still negotiate with the bank for the additional
financing. The firm is strictly better off acquiring the entire additional financing through
negotiating with the bank. Suppose, the firm raises Imu such that s,*-Imu is the same as the
bank's expected payoff in continuation. Then, the bank will forgive s^-I^ and allow the
project to continue. The firm's profit is
!xrdF(r\Q)-(S]-0-fm. (C.23)
J 0
By condition 1, one can easily see that the firm is strictly better off negotiating with the bank
Thus, when the bank is uninformed, the firm never raises capital from the market.

124
Consider next the case when the bank is informed of the state 0L. If the firm raises
C(0H), then
(C.24)
Thus, the bank will not forgive s,*. Since s¡ *>L>S! ’“-VCSIhX d is clear that the bank will
liquidate the firm. Consequently, the firm will not raise Im‘(0H) >n this case. Thus, if the firm
attempts to raise capital from the market, it will make an offer other than Im'(0H). It follows
then the market will know the realization of 0L. Since s^AL, by assumption 0, the project
must be liquidated when the bank is informed of the state 0L.
Step 2. We show that the unique equilibrium strategy for the firm in state 0H and with the
bank informed is to raise senior debt {^'(Qh^DJ^h)} from the market.
If the firm raises ^'(Qh) and repay the bank, the bank's payoff in liquidation is $ *-
Im'(0¡L) and is the same as its payoff if the project is continued under the exiting contract. Thus
the bank will forgive s^-IJ^n). The firm's profit in this case is
fArdF(r|0„)-[S;-/„(0„)]-4(8ff)
4 0
(C.25)
Alternatively, the firm can acquire financing by only negotiate with the bank and get
'xrdF(r\Qff)-L].
(C.26)
o
From condition 1, the firm strictly prefers to raise Im'(0H) from the market

REFERENCES
Aghion, P., and P. Bolton, (1992), “ An Incomplete Contracts Approach to Financial
Contracting,” Review of Economic Studies 59, 473-494.
Andreoni, I, (1991, “Reasonable Doubt and the Optimal Magnitude of Fines: Should the
Penalty Fit the Crime?” Rand Journal of Economics 22(3), 385-95.
Banks, Jeffrey., and J. Sobel, (1987), “Equilibrium Selection in Signaling Games,”
Econometrica 55, 647-661.
Barclay, M., and C. Smith, JR., (1995), “The Maturity Structure of Corporate Debt,” Journal
of Finance 50, 609-631.
Baron, D., and D. Besanko, (1984), “Regulation, Asymmetric Information and Auditing”,
Rand Journal of Economics, 15(4),. 447-470.
Baron,D., and R. Myerson, (1982), "Regulating a Monopolist with Unknown Costs",
Econometrica 50,911-930
Becker, G.S., (1968), “Crime and Punishment: An Economic Approach”, Journal of
Political Economy 76, 169-217.
Becker, G., (1983), “A Theory of Competition Among Pressure Groups for Political
Influence”, Quarterly Journal of Economics 98, 371-400.
Becker, G.S., and G.J. Stigler, (1974), “Law Enforcement, Malfeasance, and the
Compensation of Enforcers”, Journal of Legal Studies 3, 1-18.
Berlin, M., and J. Loeys, (1988), “Bond Covenants and Delegated Monitoring”, Journal of
Finance 43, 397-412.
Bhattacharya, S., and P, Pfleiderer, (1985), "Delegated Portfolio Management", Journal of
Economic Theory 36, 1-25.
Billett, M., M. Flannery, and J. Garfmkel, (1995), “The Effect of Lender Identity on a
Borrowing Firm’s Equity Return”, Journal of Finance 50, 699-718.
125

126
Border, K. C. and J. Sobel, (1987), “Samurai Accounting: A Theory of Auditing and
Plunder”, Rev. Econ. Studies 54, 525-40.
Campbell, T., and W. Kracaw, (1980), “Information Production, Market Signaling and The
Theory of Financial Intermediation,” Journal of Finance 35, 863-882.
Dewatripont, M., and J. Tiróle, (1995), "Advocates", Université de Toulouse Working Paper.
Diamond,D., (1984), “Financial Intermediation and Delegated Monitoring,” Review of
Economic Studies 51, 393-414.
Diamond, D , (1991), “Monitoring and Reputation: The Choice Between Bank Loans and
Directly Placed Debt,” Journal of Political Economy 99, 688-721.
Diamond, D., (1993), “Seniority and Maturity of Debt Contracts,” Journal of Financial
Economics 33, 341-368.
Fama, E., (1985), “What is Different About Banks?” Journal of Monetary Economics 15, 29-
39.
Gertner, R., and D. Scharfstein, (1991), “A Theory of Workouts and The Effects of
Reorganization Law,” Journal of Finance 46, 1189-1222.
Gertner, R., R. Gibbons and D. Scharfstein, (1988), “Simultaneous Signaling to The Capital
and Product Market,” Rand Journal of Economics 19, 173-190.
Graetz, M., (1986). “ The Tax Compliance Game: Toward an Interactive Theory of Law
Enforcement.” Journal of Law Economics and Organization 2, 1-322.
Grossman, S., and O, Hart, (1983), "An Analysis of the Principal-Agent Problem",
Econometrica 51, 7-46.
Grossman, S., and O.Hart, (1986), “The Cost and Benefits of Ownership: A Theory of
Vertical and Lateral Integration,” Journal of Political Economy 94, 691-719.
Harrington, W., (1988). “ Enforcement Leverage when Penalties are Restricted.” Journal
of Public Economics 37, 29-53.
Hart, O., and J, Moore, (1989), “Default and Renegotiation,” London School of Business
Working Paper.
Hart, O., and J, Moore, (1994), “A Theory of Debt Based on The Inalienability of Human
Capital,” Quarterly Journal of Economics 86, 841-879.

127
Houston, J., and C. James, (1995), “Information Monopoly and the Mix of Private and Public
Debt Claims,” University of Florida Working Paper.
James, C., (1987), “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial
Economics 19, 217-235.
Jensen, M., (1986), “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,”
American Economic Review 76, 323-329.
Kaplow, L. and S. Shavell (1994). “Optimal Law Enforcement with Self-Reporting of
Behavior,” Journal of Political Economy 102, 583-605.
Kilhstrom, R., (1986), "Optimal Contracts for Security Analysts and Portfolio Managers",
Wharton School Working Paper.
Laffont, J., and J, Tiróle (1986), "Using Cost Observation to Regulate Firms", Journal of
Political Economy 94,614-641.
Laffont, J.J. and J. Tiróle (1990). “The Politics of Government Decision Making: Regulatory
Institutions”, Journal of Law, Economics, and Organization 6, 1-32.
Laffont, J.J., and J. Tiróle (1991). “The Politics of Government Decision Making: A Theory
of Regulatory Capture”, Quarterly Journal of Economics 106, 1089-1127.
Landes, W., and R. Posner (1975). “The Private Enforcement of the Law”, Journal of Legal
Studies 1, 1-46.
Lummer, S., and J. McConnell, (1989), “Further Evidence on the Bank Lending Process
and the Capital Market Responses to Bank Loan Agreement”, Journal of Financial
Economics 25, 99-122.
Malik, A., (1990), “Avoidance, Screening and Optimum Enforcement,” Rand Journal of
Economics 21, 341-353.
Mookherjee, D., P., I, (1994). “Marginal Deterrence in Enforcement of Law.” Journal of
Political Economy 102, 1039-1066.
Mookherjee, D., and I. Png (1992). “Monitoring vis-a-vis Investigation in Enforcement of
Law,” American Economic Review 83, 556-65.
Myerson, R., (1979)," Incentive Compatibility and the Bargaining Problem", Econometrica
47, 61-74

128
Park, C., (1994), “Monitoring and Debt Seniority Structure,” University of Chicago Working
Paper.
Polinsky, M., (1980). “Private vs. Public Enforcement of Fines,” Journal of Legal Studies
9, 105-27.
Polinsky, M., and S. Shavell (1979). “The Optimal Tradeoff between the Probability and
Magnitude of Fine,.” American Economic Review 880-91.
Raja, R., (1992), “ Insiders and Outsiders: The Choice Between Informed and Arm’s-Length
Debt,” Journal of Finance 47, 1367-1400.
Rajan,R., and A. Winton, (1995), “Covenants and Collateral as Incentives to Monitor,”
Journal of Finance 50, 1113-1146.
Rothschild, M., and J. Stiglitz, (1970), " Increasing Risk: I. A Definition", Journal of
Economic Theory 2, 225-243
Stigler, George J., (1970), “The Optimum Enforcement of Laws.” Journal of Political
Economy 78, 526-36.
Stoughton, N., (1993), " Moral Hazard and Portfolio Management Problem", Journal of
Finance 48, 2009-2028
Tiróle, J., (1986), “Hierarchies and Bureaucracies: on the Role of Collusion in Organization”,
Journal of Law, Economics, and Organization 2, 181-214.
Tiróle, J., (1992), “Collusion and the Theory of Organizations.” Document De Travail, 1-61.

BIOGRAPHICAL SKETCH
Wei-Lin Liu received a bachelor’s degree in physics in 1989 from Flinders
University of South Australia, and a master’s degree in physics in 1991 from Virginia Tech.
He entered the graduate program in finance in 1993.
129

I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a
dissertation for the degree of Doctor of Philosophy
U/&*/¿/ / • 3^1
David T. Brown, Chair
Associate Professor of Finance,
Insurance, and Real Estate
I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a
dissertation for the degree of Doctor of Philosophy
Tracy R. Lewis, Cochair
James W. Walter Eminent Scholar
in Entrepreneurship and Economics
I certily that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a
dissertation for the degree of Doctor of Philosophy
UhIJ
Joel Houston
Associate Professor of Finance,
Insurance, and Real Estate
I certily that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a
dissertation for the degree of Doctor of Philosophy
jp.
Michael Ryngaert
Associate Professor of Finance,
Insurance, and Real Estate

I certify that I have read this study and that in my opinion it conforms to acceptable
standards of scholarly presentation and is fully adequate, in scope and quality, as a
dissertation for the degree of Doctor of Philosophy
Steven Slusky
Professor of Economics
This dissertation was submitted to the Graduate Faculty of the Department of
Finance, Insurance, and Real Estate in the College of Business Administration and the
Graduate School and was accepted as partial fulfillment of the requirements for the degree
of Doctor of Philosophy.
August 1997
>ean, Graduate School