A Theory of Capital Structure with Strategic Defaults and Priority Violations ∗ Hans K. Hvide and Tore Leite † October 31, 2003 Abstract We reformulate the classic CSV model of financial contracting from Townsend (1979) and Gale & Hellwig (1985) to tackle criticisms raised against it voiced by Hart (1995), such as lack of optimal behavior at the repayment stage and an inability to allow for outside equity. As a result, we obtain a theory of capital structure that accommodates empirical regularities such as bankruptcies, strategic defaults of debt obligations, and violations of absolute priority rules as parts of the equilibrium description. Keywords: Cash Diversion, Costly State Verification, Outside Equity, Financial Contracts. 1 Introduction Financial contracts typically do not specify repayments to investors as a detailed function of all payoff relevant variables. For example, debt contracts normally do not specify ∗ For valuable comments and suggestions, thanks to Mike Burkhart, Piero Gottardi, Michel Habib, Eirik G. Kristiansen, Pierre Mella-Barral, Espen Moen, Trond Olsen, Fausto Panunzi, Kristian Rydquist, Leif K. Sandal, Suresh Sundaresan, and seminar audiences at Bocconi, London School of Economics (FMG), Norges Bank (Central Bank of Norway), Norwegian School of Economics and Business, Norwegian School of Management, Stockholm School of Economics, and Tel-Aviv University. † Both authors: Department of Finance, Norwegian School of Economics and Business, Helleveien 30, 5045 Bergen, Norway. Email: hans.hvide@nhh.no, tore.leite@nhh.no. 1