We characterize an optimal financial contract when the firm’s realized cashflow isunobservable to the investor and the firm’s collateral can only be liquidated partiallyby resorting to the services of a costly third party. An optimal contract may exhibita piecewise structure and vary with the liquidation cost and the firm’s actual liquidityshortage. Partial liquidation and wholesale transfers of collateral can coexist in anoptimal contract. In contrast to part of the literature, the incentive-compatibilityconstraint incorporates the firm’s limited liability, and may be slack at the optimum.Allowing the firm to overcome an ex-post liquidity shortage by borrowing surreptitiouslyfrom a third party may reduce the firm’s ex-ante expected utility.
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