Academic journal article Fordham Journal of Corporate & Financial Law

The Overstated Absolute Priority Rule

Academic journal article Fordham Journal of Corporate & Financial Law

The Overstated Absolute Priority Rule

Article excerpt

Introduction

The absolute priority rule describes the basic order of payment in corporate bankruptcy: 1 secured creditors get paid first, unsecured creditors get paid next, and only then do shareholders get paid, if at all.2 3 The rule has obtained a kind of unassailable, near scriptural status in the corporate reorganization literature.1 As one august group of scholars has bluntly argued, "a good bankruptcy procedure should preserve absolute priority."4 Another concludes, "simple rules that honor absolute priority are likely the best response."5 And two well-known authors recently wrote that the "Bankruptcy Code's core principle is that distribution conforms to predetermined statutory and contractual priorities."6

The most strident statements of the absolute priority rule come from those who are not bankruptcy experts. For example, Jonathan Macey and a co-author recently declared that "[t]he bankruptcy process is meant to follow standard rules in which the proceeds of unencumbered assets are distributed to creditors according to a strict priority schedule, governed by the nature of each creditor's claim."7 A similar notion can be seen in many of Richard Epstein's writings during the Chrysler bankruptcy case.8

The affection for the rule comes from a simple argument.9 Namely, supporters argue that the rule reduces the cost of debt capital because lenders can properly calculate their expected return on any loan at the time the loan is made.10 If lenders know that they will have to share value upon insolvency, they will charge more for their loans up front.11

In chapter 11, under federal law, the absolute priority rule only comes into play at plan confirmation, and then only when the plan is rejected by some class.13 It seems strange that a rule that might never be invoked, in a bankruptcy that might never happen, could have a big role in credit pricing. Moreover, by the time the rule appears at the end of a chapter 11 case, it has already been breached so often that its entrance no longer matters.13 Indeed, sensible corporate reorganization requires frequent departures from absolute priority.14

There are several difficulties with the debt pricing argument-and whether shareholders might want to incur this extra cost is never considered15-but this paper focuses on two more basic problems with it. First, there is no absolute priority rule of the kind described in the literature under current law. It is not clear that there ever has been such a rule. 16 And even if there were, adopting such a rule would be inconsistent with chapter 11, or any other sensible system of reorganization.17 That is, chapter 11 will not work under the kind of rigid absolute priority rule many academic commentators promote, and thus the rule would be certainly flouted.

The claim that the rule does not exist will take many by surprise. But consider the basic fact that there is no state law forum in which to vindicate the rule,18 and under chapter 11 of the Federal Bankruptcy Code, the rule only applies when there is a contested plan.19

The concepts behind the rule inform many state laws, like prohibitions on fraudulent transfers and restrictions on dividend payments,20 but the rule itself is absent from any direct application in state corporate debt collection law.21 Secured creditors worry about the priority of their liens relative to other secured creditors, and creditors of all sorts worry about the debtor leaking assets. But absolute priority is only relevant when a firm's entire capital structure becomes due and payable at a single instant. That does not happen under state law.

Instead, state law is primarily focused on providing a mechanism whereby unsecured creditors can obtain a judgment, and thus become secured creditors. Once creditors undergo that transformation, the issue of priority is determined by the order in which the creditor obtained its lien.22 Thus, while the absolute priority rule focuses on the entire capital structure, priority under state law has no such concern because all creditors eventually become secured creditors by force of law if they seek payment. …

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