Absolute priority, valuation uncertainty, and the reorganization bargain.

• Author: Baird, Douglas G.

ESSAY CONTENTS I. ABSOLUTE PRIORITY IN THEORY AND IN PRACTICE II. MODERN BUSINESS REORGANIZATION PRACTICE III. BARGAINING IN THE FACE OF VALUATION UNCERTAINTY A. The "Forced Sale" Model B. The Appraisal Model C. The Impact of "Appraisal Variance" D. Negotiating in the Face of Appraisal Variance: Postponing the Day of Reckoning IV. USING OPTIONS TO SETTLE VALUATION ISSUES IN REORGANIZATIONS V. APPRAISALS: THE WEAK LINK IN ABSOLUTE PRIORITY This Essay 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. (1) In practice, however, departures from absolute priority are commonplace. (2) Senior creditors regularly allow those junior to them to participate in recoveries even when the senior creditors may not be paid in full. Explaining this gap between law and practice has been a central preoccupation of reorganization scholars since the 1920s.

To most observers, these persistent deviations from absolute priority suggest that something is seriously amiss. Conventional accounts, particularly in the law-and-economics literature, are replete with finger-pointing. Bankruptcy judges are biased, incompetent, or in any event powerless to protect the priority of senior investors. Old managers, the representatives of the shareholders, "use their power to run their businesses and to control reorganization agendas to capture portions of the value that creditors are legally entitled to receive." (3) Junior creditors invoke expensive and timeconsuming procedures merely to extract a payout exceeding their entitlements.

These explanations, however accurate they may once have been, are not adequate to capture the dynamics of corporate reorganizations today. The typical modern bankruptcy judge is committed to respecting legal priorities and does not hesitate to entertain the sale of a business as an alternative to reorganizing. (4) She is far less likely to allow junior investors to play for time or otherwise manipulate the process. Old managers frequently are replaced (often before the Chapter 11 case even begins) with turnaround specialists whose loyalties, if any, are with the senior creditors. Old equityholders, far from controlling the process, typically are wiped out. The contest is most often among seasoned investors (banks, hedge funds, and other institutional investors) who hold debt at different levels of the debtor's capital structure. None of them enjoys special sympathy from the judge. Bankruptcy judges make every effort to prevent those who are out of the money, or indeed anyone else, from derailing the reorganization process. Compared to ordinary federal litigation, reorganization cases today move with surprising speed.

The Chapter 11 case of Conseco Corporation offers a good example of how the standard account fails to offer an adequate explanation of deviations from the absolute priority rule in modern reorganization practice. Conseco, one of the largest Chapter 11 debtors in history, was a successful insurance holding company when it made a multibillion dollar purchase of a mobile home financing company. The mobile home business turned out to be worth only a fraction of what Conseco paid for it, and Conseco, after having been successful for so long, proved insolvent. Conseco's founder (as well as his replacement as CEO) was removed before the Chapter 11 case even began. The negotiations were between the senior banks and the bondholders junior to them. Equityholders did not play any material role. (5) Neither creditor group had information the other did not. Neither had any special power over the business or how its affairs were run.

Conseco's senior bank debt amounted to approximately $2.04 billion. (6) In the bargaining over a plan of reorganization, the senior banks agreed to accept notes in the amount of $1.3 billion and callable, convertible preferred stock with a liquidation preference equal to the balance of their claims. (7) The bondholder classes, all of which were junior to the banks, divided among themselves substantially all of the common stock of the reorganized company. (8) At the time of these negotiations, it was suggested in the press that Conseco was not worth enough to pay even the bank debt in full. (9) By the standard law-and-economics account, a well-functioning reorganization process should have left junior investors with little or no distributions under a plan of reorganization. In this light, the substantial distributions received by Conseco's bondholders seem highly suspect. They appear to represent a deviation from absolute priority that the conventional model would attribute to the bondholders' ability to delay or otherwise manipulate the reorganization process.

Conseco's bondholders, however, had minimal ability to delay or manipulate the process. Insurance regulators were ready to appoint receivers for Conseco's insurance subsidiaries to protect policyholders if the companies were not speedily restructured. (10) The appointment of receivers would have meant that the profitable insurance subsidiaries would cease to write new policies and would shut down. The going-concern value of the enterprise would have been lost. This left little opportunity for junior investors to delay the day of reckoning.

The Conseco example captures a dynamic often seen in large corporate reorganizations. Sophisticated senior investors with clear entitlements to priority treatment, facing an impartial bankruptcy judge who holds a tight leash on the process, regularly agree to plans of reorganization that provide for distributions to apparently out-of-the-money junior investors, typically in the form of a residual stub of equity or warrants. (11) If these outcomes are not driven by junior investors' control of the process, as the standard account would have it, something else must be at work.

We believe the standard account ignores something that is quite important and straightforward: Applying the absolute priority rule in the context of a corporate reorganization requires the enterprise to be valued. Uncertainties accompany any valuation procedure. These uncertainties affect bargaining over reorganization distributions in ways that can readily be predicted from the standard models of litigation and settlement, and they regularly drive negotiated outcomes in many large corporate reorganization cases.

In this Essay, we show that the uncertainty inherent in valuing a large corporation in financial distress creates a bargaining dynamic that accounts for many of the puzzling departures from absolute priority that the standard model cannot explain. "Deviations" from absolute priority often are nothing of the kind. They are instead the natural product of bargaining in a system that is committed to respecting priority, but must do so in a world in which priorities are enforced through a valuation process the outcome of which is uncertain.

Critics of Chapter 11 assume that a substantive right to enjoy absolute priority should lead to outcomes that reflect absolute priority. Those participating in this debate have, however, been looking for greater conformity with the absolute priority rule than they should expect to see in a system that relies on judicial appraisal for enforcement of the rule. The need to rely on appraisal as an enforcement mechanism has predictable consequences. Senior creditors who bargain in the shadow of the threat of appraisal will sometimes agree to something less than an absolute priority outcome even if their entitlement to priority treatment is unambiguous and the valuation process is unbiased. The presence of valuation uncertainty can, by itself, give option value to the claims of junior creditors even when they are, in expectation, out of the money.

The available evidence suggests that valuations made by modern bankruptcy judges, though unbiased, are subject to substantial variance. (12) This should not be surprising. In Chapter 11, a single, nonexpert judge is expected to value the reorganizing business on the basis of the testimony of experts who, far from being impartial, are advocates for competing points of view. If reorganization law should facilitate absolute priority outcomes (as we believe it should) and if it already takes close to maximum advantage of markets (as we believe it does), reform should focus on its appraisal mechanism and the challenge of minimizing the variance associated with its valuations.

In Part I of this Essay, we review the absolute priority rule and the standard explanations for deviations from it offered in the law-and-economics literature. We suggest why these explanations do not adequately account for actual outcomes in reorganizations involving large, publicly traded businesses. In Part II, we describe the context in which a large business typically is reorganized in Chapter 11 today. In Parts III and IV, we lay out the bargaining dynamics created by valuation uncertainty and explain how those dynamics account for many of the deviations from absolute priority commonly seen in large reorganization cases. In Part V, we connect our observations to the longstanding debate in corporate reorganization law over the optimal distribution rule--the choice between relative and absolute priority--a debate that was joined by two legal scholars, James Bonbright and Milton Bergerman, in 1928 (13) and that has been raging ever since.

1. ABSOLUTE PRIORITY IN THEORY AND IN PRACTICE

   A single engine drives law-and-economics accounts of corporate reorganization: The reorganization of an insolvent enterprise is the equivalent of a going-concern sale of the business to its creditors in exchange for their claims. (14) The business...