Costly State Verification and Multiple Investors: The Role of Seniority Andrew Winton Northwestern University Many financial claims specify fixed maximum payments, varying seniority, and absolute pri- ority for more senior investors. These features are motivated in a model where a firm’s man- ager contracts with several investors and firm output can only be verified privately at a cost. Debt-like contracts of varying seniority gener- ally dominate symmetric contracts, and, when in- vestors are risk neutral, it is optimal to use debt- like contracts where more senior claims have absolute priority over more junior claims. In ad- dition to motivating severalfeatures of debt and preferred stock, the model offers an explanation for structures used in leveraged buyouts, asset- backed securitizations, and reinsurance con- tracts. Although firms issue many different financial claims, three features are quite common. Many of these claims have contractually fixed maximum payments, debt and preferred stock being, obvious examples. Claims often vary in their degree of seniority, which spec- ifies who is first entitled to full payment. Moreover, the contractual order of payments typically follows This article originally formed Chapter 2 of my Ph.D. dissertation at the Uni- versity of Pennsylvania, where my work was supported by a Unisys Fellow- ship. Earlier versions were entitled “Costly State Verification and Multiple Investors: The Role of Subordination.” I would like to thank Franklin Allen, Mike Fishman, Gary Gorton, Joe Haubrich, Ronen Israel, Rich Kihlstrom, Jonathan Paul, John Persons, Tony Santomero, Chester Spatt (the editor), and the University of Michigan for their advice and comments. Of course, I am responsible for any remaining errors. Address correspondence to An- drew Winton, KGSM/Finance, 2001 Sheridan Road, Evanston, IL 60208. The Review of Financial Studies Spring 1995 Vol. 8, No. 1, pp. 91-123 © 1995 The Review of Financial Studies 0893-9454/95/$1.50