Corporate Finance, Incomplete Contracts, and Corporate Control Patrick Boltony Columbia University This version: June 27, 2013 Abstract This essay in celebration of Grossman and Hart (1986) (GH) discusses how the introduction of incomplete contracts has fundamentally changed economists’perspec- tives on corporate finance and control. Before GH, the dominant theory in corporate finance was the tradeoff theory pitting the tax advantages of debt (relative to equity) against bankruptcy costs. After GH, this theory has been enriched by the introduc- tion of control considerations and investor protection issues. This essay assesses how our understanding of corporate finance has been improved as a result and where the incomplete contracts perspective has not yet been successfully applied. I am grateful to two anonymous referees and the editor (Al Klevorick) for very helpful comments. yColumbia University, 804 Uris Hall, 3022 Broadway, New York, NY 10027, e-mail:
[email protected], http://www0.gsb.columbia.edu/faculty/pbolton This is a pre-copyedited, author-produced PDF of an article accepted for publication in the Journal of Law, Economics, and Organization following peer review. The version of record: Bolton, Patrick. "Corporate Finance, Incomplete Contracts, and Corporate Control." Journal of Law, Economics, and Organization 30, suppl 1 (May 2014): i64-i81, is available online at < http://dx.doi.org/10.1093/jleo/ ewt010 >. It is a great pleasure to write this essay in celebration of Sandy Grossman’sand Oliver Hart’s classic 1986 article “The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration”. To appreciate the importance and novelty of their contribution it is helpful to put it into context of their earlier research and the state of economic theory at the time.