Absolute Priority, Valuation Uncertainty, and the Reorganization Bargain

Abstract

In a Chapter 11 reorganization, senior creditors are entitled to insist upon being paid in full before anyone junior to them receives anything. In practice, however, departures from such “absolute priority” are commonplace. Explaining these deviations has been a central preoccupation of reorganization scholars for decades. By the standard law-andeconomics account, deviations from absolute priority arise because well-positioned insiders take advantage of cumbersome procedures and inept judges. In this paper, we suggest that a far simpler and more benign force dominates bargaining in reorganization cases. “Deviations” from absolute priority are inevitable even in a world completely committed to respecting priority as long as asset values are uncertain. Uncertainty accompanies any valuation procedure. Bargaining in corporate reorganizations takes place in the shadow of this uncertainty, and standard models of litigation and settlement show that valuation uncertainty alone can explain many of the departures from absolute priority we see in large corporate reorganizations. Even where rational and well-informed senior investors expect the absolute priority rule to be strictly enforced, they must account for the uncertainty associated with any valuation. The possibility of an unexpectedly high appraisal will cause them to offer apparently out-of-the-money junior investors contingent interests in the reorganized business. The debate over absolute priority, the central principle of modern corporate reorganization law, has been misdirected for decades. It has failed to recognize that a substantive rule of absolute priority does not lead to an absolute priority outcome. A coherent account of absolute priority must incorporate relative priority. It must take account of the option value implicit in the junior investors’ right to insist on an appraisal. This paper offers an explanation for one of the most important and persistent puzzles in corporate reorganizations. In a Chapter 11 reorganization, senior creditors are, in principle, entitled to insist upon “absolute priority.” They have a right to be paid in full before junior investors receive anything. This “fixed principle” has been the foundation of our corporate reorganization laws for decades. In practice, however, departures from ab-