Tax Claims, Absolute Priority and the Resolution of Financial Distress

Abstract

Abstract We propose a formal model which captures the ability of financially distressed firmsto extract rents from soft-touch creditors in order to buy time before filing for re-organization. Essentially, we show how an insolvent firm may delay filing for reor-ganization by using unpaid tax claims as short-term cash, behavior we refer to as‘claims substitution’. We show how this type of behavior depends on a number ofparameters such as the enforcement of absolute priority and the repayment rate oftax (soft-touch) and unsecured claims. From a welfare perspective, we show thatclaims substitution can either be efficient or inefficient. (JEL G33, G38, K22) I The authors would like to thank Regis Blazy and participants at the 31st Annual Conference ofthe French Finance Association (Aix-Marseille), the World Finance Conference (Venice) and the 2ndInternational Meeting in Law and Economics (Pantheon-Assas). Fisher would like to acknowledge thefinancial support of the Australian Research Council grant DP0663477.