Lender liability and large investors

We explore the optimal financial contract for a large investor with potential control over a firm's investment decisions. An optimal menu of claims resembles a U.S. version of lender liability doctrine - quitable subordination. This doctrine permits the court to subordinate a controlling investor`s claim in bankruptcy, but only under well-specified conditions. It allows a firm to strike an efficient balance between: (i) inducing the large investor to monitor, and (ii) limiting the influence costs that arise when claimants can challenge existing contracts. We provide a partial rationale for a financial system in which powerful creditors do not hold blended debt and equity claims. (C) 2001 Academic Press.