Magazine article Business Credit

Is Absolute Priority the Rule?

Magazine article Business Credit

Is Absolute Priority the Rule?

Article excerpt

Many creditors argue that Chapter 11 favors debtors (usually represented by the management of the bankrupt firm) at the expense of creditors. Debtors are given rights under Chapter 11 that they would not have outside of bankruptcy, increasing their negotiating leverage and resulting in violations of the Absolute Priority Rule. The Absolute Priority Rule states that the claims of senior creditors must be fully satisfied before a more junior claimant may receive consideration.

The management of the bankrupt firm has a fiduciary responsibility to protect and enhance shareholders' wealth, therefore, any plan proposed by the debtor will include some consideration for shareholders. If debtors (i.e., management) do have more negotiating leverage under Chapter 11, it would follow that plans proposing violations of priority may be accepted. Recent studies show that violations of absolute priority are actually the rule and are a result of the terms dictated by Chapter 11. Why is this the case?

Strict adherence to the Absolute Priority Rule is not the goal of Chapter 11. The process was designed to provide an efficient plan of reorganization for those firms that are worth more as going concerns than the liquidation value of their assets. An efficient reorganization enhances the firm's value and benefits all parties concerned.

In order for any negotiation process to be successful, it must also provide incentives for the parties to negotiate. Chapter 11 provides incentives for both debtors and creditors. Creditors are guaranteed to receive at least the same level of consideration in a reorganization that they would have received through liquidation, while debtors are given rights unavailable outside of the Chapter 11 process. Providing incentives to both parties to enter Chapter 11 allows the code to address its primary goal--a negotiated reorganization. Both debtors and creditors must focus their efforts on devising a negotiation strategy that results in an optimal settlement.

VIOLATING THE RULE

The Absolute Priority Rule originated as the method by which claims are satisfied in a liquidation under Chapter 7. Under Chapter 11, absolute priority is violated when a claimholder receives a stake in the securities of the reorganized firm, (or the proceeds of a liquidation) before more senior claims have been satisfied. Violations occur as a result of the negotiation process. The claimants agree to a plan that violates priority when it is in their best interest to do so, given the framework of Chapter 11 and the specific factors relating to the bankruptcy case.

In a surprising majority of Chapter 11 cases, absolute priority is violated. Weiss (1990) completed a study of 37 New York and American Stock Exchange firms that filed for bankruptcy between November 1979 and December 1986, and found that the priority of claims was violated in 29 cases. The breakdown in priority of claims was found to occur primarily among the unsecured creditors and between the unsecured creditors and the equity holders.

These findings are also supported by a study completed by Franks and Torous (1990) which found that out of a sample of 29 firms, 21 exhibited deviations from absolute priority.

This study also suggests that unsecured creditors receive only a small fraction of what secured creditors obtain and that there are large deviations from absolute priority. Violations of priority appear to be the result of the rights granted to debtors under the Chapter 11 process, including the debtor's ability to delay bankruptcy proceedings and increase the direct and indirect cost incurred by the firm, therefore reducing the value available to creditors.

SOURCES OF VIOLATIONS OF PRIORITY

Violations of priority have a number of potential sources, some of which are discussed by Baird and Jackson (1988) in their paper in the University of Chicago Law Review. The most obvious explanation is that deviations are the result of the bargaining power of the debtor granted by the bankruptcy code. …

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