Costly State Verification and Multiple Investors: The Role of Seniority

Many f inancial c laims specify f ixed maximum payments , varying seniori ty , and absolute priori ty for more senior investors . These features are motivated in a model where a f irm’s manager contracts with several investors and f irm output can only be verif ied privately at a cost . Debtl ike contracts of varying seniori ty generally dominate symmetric contracts, and, when investors are risk neutral, it is optimal to use debtl ike contracts where more senior claims have absolute priority over more junior claims. In addition to motivating severalfeatures of debt and preferred stock, the model offers an explanation for structures used in leveraged buyouts, assetbacked s ecur i t i za t i ons , and r e insurance contracts .