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.).

Bankruptcy’s Quiet Revolution

posted in: Cramdown and Priority | 0

Douglas G. Baird, University of Chicago School of Law


Over the last few years, reorganization practice has undergone a massive change. A new device—the restructuring support agreement—has transformed Chapter 11 negotiations. This puts reorganization law at a crossroads. Chapter 11’s commitment to a nonmarket restructuring with a rigid priority system requires bankruptcy judges to police bargaining in bankruptcy, but the Bankruptcy Code gives relatively little explicit guidance about how they should do this policing.

In the past, the debtor initiated multiple rounds of negotiations in which everyone participated. Each party would push back against the claims of the other, and a consensus eventually emerged that left things roughly in equipoise. This has now changed. Instead of bargaining in which everyone participates, there is now a sequence of two-party bargains, beginning with the key players.

Changing the structure of negotiations in this fashion would not matter much if there were not much to bargain over. If bankruptcy’s substantive rules allowed for little variation in what each party received or if the debtor had an incentive to limit what each creditor group received, changing the rules would not change outcomes. But neither is the case, at least not any more.

Priority rights in bankruptcy are sufficiently uncertain that there are a broad range of confirmable plans in any case, each with radically different distributional consequences for the various creditor groups. And modern debtors are interested in a speedy and successful exit from Chapter 11. They are relatively indifferent to how rights in the firm are divided among competing creditors.

These changes have become manifest only in the last few years, and there is little wisdom about how the bankruptcy judge should respond. This essay suggests that long-established principles inform how bankruptcy judges should go about this task. In assessing whether a plan is “fair and equitable” and whether it has been filed in “good faith,” judges should focus not on how the plan apportions rights in the reorganized firm, but whether the process that has led to the plan ensures that everyone’s cards are on the table.

In particular, judges should ensure that restructuring support agreements do not interfere with the flow of information to the judge. Negotiations that lead to a confirmable plan should be problematic to the extent, but only to the extent, that they keep the judge in the dark and limit her ability to ensure that the plan complies with the terms of the Bankruptcy Code.

Click here to view the full article.

Bankruptcy Step Zero

Authors: Douglas G. Baird and Anthony J. Casey

In RadLAX Gateway Hotel, LLC v Amalgamated Bank, the Supreme Court’s statutory interpretation focuses on an emerging theme of its bankruptcy jurisprudence: the proper domain of the bankruptcy judge. While one might expect the Court to approach that question of domain as it has for administrative agencies, that is not the approach taken. This article explores the Court’s approach to bankruptcy’s domain. In doing so, we connect three principal strands of the Court’s bankruptcy jurisprudence. The first strand, embodied in Butner v United States, centers on the idea that the bankruptcy forum must vindicate nonbankruptcy rights. The second, most recently addressed in Stern v Marshall, focuses on the limits of bankruptcy judges in deciding and issuing final judgment on the issues before them. Bankruptcy judges must limit themselves to deciding issues central to the administration of the bankruptcy process. RadLAX is the continuation of a third strand that makes it plain that the Court reads ambiguous provisions of the Bankruptcy Code to narrow the range of decisions over which the bankruptcy judge may exercise her discretion — at least when the exercise of that discretion might impact nonbankruptcy rights. The resulting bankruptcy jurisprudence is in stark contrast with the Court’s approach in administrative law. This paper attempts to make sense of this state of affairs and connect it with the realities of bankruptcy practice today.

The article is available here on SSRN.