Capital Structure , Priority Rules , and the Settlement of Civil Claims

Capital structure affects the bargaining position of a firm in the settlement of civil litigation when the civil judgment may cause the firm to become insolvent. We analyze this pretrial bargaining game under different bankruptcy priority rules. A leveraged capital structure can benefit the firm’s shareholders for two reasons. Most obviously, if the civil plaintiff will not receive top priority in bankruptcy, debt may serve to directly dilute the value of the civil claim. A more subtle effect, however, arises because the cost of a large civil judgment may be borne by the debtholders in bankruptcy. This can make the shareholders into tougher bargainers by narrowing the settlement range. This latter effect implies that even unsecured debt may be used strategically to dilute the value of civil claims, even when the civil plaintiff is given priority in bankruptcy. Welfare and legal implications are discussed. © 1998 by Elsevier Science Inc.