Priority Matters

posted in: Cramdown and Priority | 0

By Douglas G. Baird, University of Chicago Law School

Chapter 11 of the Bankruptcy Code is organized around the absolute priority rule. This rule mandates the rank-ordering of claims. If one creditor has priority over another, this creditor must be paid in full before the junior creditor receives anything. Many have suggested various modifications to the absolute priority rule. The reasons vary and range from ensuring proper incentives to protecting nonadjusting creditors. The rule itself, however, remains the common starting place.

This paper uses relative priority, an entirely different priority system that flourished until the late 1930s, to show that using absolute priority even as a point of departure is suspect when firms are being reorganized. The essential difference between absolute and relative priority is the effect of bankruptcy on the exercise date of the call-option component of the junior investment instrument. Under absolute priority, the bankruptcy accelerates the exercise date; a regime of relative priority leaves it untouched.

Absolute priority is naturally suited for regimes in which the financially distressed firm is sold to the highest bidder. It is much less appropriate for a regime that puts a new capital structure in place without a market sale. In the absence of an actual sale, absolute priority requires some nonmarket valuation procedure. Such a valuation is costly and prone to error.

Chapter 11 attempts to minimize these costs by inducing the parties to bargain in the shadow of a judicial valuation, but rules are needed to police the strategic behavior that arises from the ability of parties to exploit information they have, but the judge does not.

Once one decides in favor of a reorganization rather than a market sale, the commitment to absolute priority is suspect. Instead of trying to find a bankruptcy mechanism that best vindicates the absolute priority rule, one is likely better off trying to identify the priority rule that minimizes the costs of bankruptcy itself. Asking which priority rule is most likely to lead to a successful plan at reasonable cost is a better point of departure than a debate over which priority rule provides the best set of ex ante incentives.

Looking at Chapter 11 from this perspective shows that much of the complexity and virtually all of the stress points of modern Chapter 11 arise from the uneasy fit between its priority regime (absolute instead of relative) and its procedure (negotiation in the shadow of a judicial valuation instead of a market sale). These forces are leading to the emergence of a hybrid system of priority that may be more efficient than one centered around absolute priority.

Read the full article here (forthcoming 165 U. Pa. L. Rev.).