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 repayments as a detailed function of the financial state of the firm, but rather puts some easily describable liability on the firm’s cash flow through a fixed repayment obligation. One focal approach in the literature that attempts to model this feature of financial contracts is the Costly State Verification (CSV) approach. The core of this approach is that, upon the date of repayment, inside investors have superior information to the outside investors about the profitability of the firm, and therefore may try to divert cash from outside investors by underreporting the true cash-flow. Of course, this may in turn create an ex-ante governance problem in that external investors may be reluctant to finance the firm.

The weapon outside investors can use to mitigate the cash diversion problem is to partially or fully verify the true profitability of the firm, by e.g. demanding an audit, declaring bankruptcy, or even discharge management and take control of the operations of the firm. Such a leveling of information can only take place at a certain cost of verification. Celebrated papers by Townsend (1979) and Gale & Hellwig (1985) derive debt contracts as optimal under such circumstances, i.e., contracts which promises a fixed repayment, and where the creditor verifies whenever the offered repayment falls below the promised repayment.

In spite of its elegance, the classroom CSV model suffers from some shortcomings. First, as pointed out by Hart (1995) and others, the debt contract derived under CSV relies on a commitment on the part of the lender to verify whenever the debt is not repaid in full, even if accepting a concession would be better for the lender, since verification is costly. As such, the equilibrium supporting the "optimal contract" may involve non-Nash strategies to be played by the creditor in default states, and perhaps equally importantly implies that the model cannot accommodate strategic defaults of debt obligations by the borrower. Second, as also pointed out by Hart (1995), while in practice debt typically coexists with equity as a financial claim on the firm, the standard CSV model is unable to explain the use of outside quity, and hence unable to account for capital structures with both debt and outside equity on the balance sheet.

The motivation of the present paper is to recast the CSV model in response to these criticisms. For debt contracts, we require sequential rationality and allow for stochastic verification at the repayment stage. In other words, verification occurs only if it is an optimal strategy given the repayment offer by the borrower, and the verification strategy may be stochastic. This allows us to solve for an equilibrium where the manager offers the lender a debt repayment that depends on the true cash-flow of the firm, and the lender monitors with a probability that is increasing in the magnitude of the default. This lenience on part of the lender implies that there can be strategic defaults of debt repayments in equilibrium, in that the borrower defaults on his debt obligation even though he has sufficient cash on hand to avoid a default.

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