If liability on a firm’s contingent debt is especially likely to be triggered when the firm is insolvent, the contract that creates the debt transfers wealth from the firm’s creditors to its shareholders. A firm therefore has incentive to engage in correlation-seeking — that is, to incur contingent debts that correlate, or that through asset purchases can be made to correlate, with the firm’s insolvency risk. The consequence is an overuse of contingent debt that destroys social wealth through overinvestment, higher borrowing costs, financial distress, and potential systemic risk. Correlation-seeking is especially pernicious because, unlike other forms of shareholder opportunism such as asset substitution, it can reduce risk to shareholders even as it increases shareholder returns.
AT: It's long been known that a firm close to bankruptcy has an incentive to gamble because if the gamble pays off the shareholders prosper and if the gamble fails then the shareholders are no worse off (since the firm was already close to bankruptcy). But gambles like this add to shareholder value primarily by transferring wealth from the creditors who bear the downside risk without any hope of upside gain.
Squire shows how this idea is magnified when we add contingent debt and correlated asset returns. A contingent debt is one that must be paid only in certain states. If the shareholders take on contingent debt and at the same time buy assets with low or negative payoffs in the same set of states then the shareholders can focus the downside risk into the states in which they are bankrupt anyway - thus focusing the downside risk onto unsecured creditors. (the rest here)
[a commenter adds: As firms get closer to insolvency, managers and directors become exponentially more sensitive to risk of personal liability and thus much more conservative. Further, creditors' monitoring increases exponentially as said risk rises (gambles always need a counterparty and they disappear in insolvency situations). The gambles by large firms occur more during times of complacency. -- MR, as so often, indispensable for supposedly unfun things]