In the 1980's, corporations and individuals took on unprecedented levels of debt. By the 1990-1991 recession, several consequences of this high leverage were being felt--troubled debt restructurings, defaults, and bankruptcies. Because of these problems, significant academic attention has been paid to the causes and costs of financial distress, the effect of financial distress on operating performance, and the efficacy of Chapter 11 of the U.S. Bankruptcy Code in resolving financial distress. This dissertation provides theoretical models that give insight into these issues.; The second chapter, "The Capital Structure Holdout Problem: Why Firms in Financial Distress Remain Overleveraged," considers the capital structures that result from outside of Chapter 11 debt restructurings. I demonstrate that debt restructuring leads to a highly leveraged capital structure--what I call the capital structure holdout problem. No creditor will lower her debt level past a certain point because other creditors take advantage of the debt reduction by not lowering their debt levels. This problem is different from the free-rider problem which arises when no creditor believes that she is pivotal to the success of the offer. Even when the free-rider problem is solved, the capital structure holdout problem remains. These results are consistent with the empirical literature which suggests that firms experiencing financial distress remain highly leveraged after the resolution of financial distress and are likely to experience distress again.; The third chapter, "Efficient and Equitable Division of Value in Chapter 11 Bankruptcy," examines the pattern of violations of absolute priority in Chapter 11 bankruptcy. A cooperative game theoretic model of bargaining inside of Chapter 11 is used to address this issue when there are more than two relevant players (debtholders and equityholders). In an N-player framework with or without equity as a class of claimants, I demonstrate that there will, in general, be violations of absolute priority as an outgrowth of notions of fairness employed by the courts. I characterize when violations of absolute priority will occur, when they will will not occur, and when they will be small. I also show that, in some cases, there will be incentives to delay reaching agreement inside of Chapter 11 which is consistent with the stylized fact that Chapter 11 proceedings can be quite lengthy.; The fourth chapter, "Optimal Capital Structure and Efficient Reorganization with Inefficient Consequences," considers the capital structures that result from inside of Chapter 11 reorganizations. I derive the optimal capital structure for a firm with many creditors that may default on its debt. Current U.S. bankruptcy law (Chapter 11) leads to efficient reorganization/ liquidation decisions in the case where the firm defaults. The cost of this efficiency however is that the outcomes of the bankruptcy process lead to inefficient capital structures. This tradeoff occurs in several alternative bankruptcy mechanisms. I present a mechanism that overcomes it.
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