A dilution mechanism for valuing corporations in bankruptcy.

• Author: Adler, Barry E.

This Article proposes a new mechanism for valuing firms in bankruptcy. Under the "senior dilution" mechanism, a court would dilute the reorganized stock issued to senior claimants by issuing additional shares to junior claimants until there was no excess demand for the stock at a price that would implement absolute priority. A "junior dilution" mechanism could also be implemented to provide a market test for proposed reorganization plans of junior claimants by having a court issue additional debt to senior claimants until there was no excess supply of the debt at a price that would implement absolute priority. We show that these mechanisms harness the private information of the claimants and of third parties to produce distributions consistent with absolute priority. Dilution mechanisms can be superior to other information-harnessing devices (such as an option or auction approach) because they (1) are less susceptible to the problem of junior illiquidity than an option approach proposed by Lucian Bebchuk; (2) are less susceptible to the problem of market manipulation and may better allocate control premia than a partial float proposal by Mark Roe; and (3) may produce fewer transaction costs than a full auction approach proposed by Douglas Baird. Moreover, as a response to the Supreme Court's recent admonishment in LaSalle that bankruptcy courts employ market tests more often when creditors dissent to a reorganization plan, the junior dilution mechanism provides a uniquely workable solution within the current statutory framework.

1. INTRODUCTION

   Issues of corporate finance become most critical when a firm encounters financial distress. In this case, there may be insufficient assets to go around, and the question of valuation comes to the fore. Valuation is central to the resolution of distress because distributions consistent with the hierarchy of investor priority (called "absolute priority") depend on the amount available to distribute. A firm with little value may belong entirely to its most senior creditors, while a firm with much value may belong in part to its junior creditors, or perhaps even its shareholders. Not surprisingly, therefore, valuation is the most hotly contested and debated topic in the realm of corporate bankruptcy law. In this Article, we enter this debate with a new "dilution" approach for valuation. The dilution approach begins with the issuance of some new shares to investors at a particular level of priority, and then, to the extent that absolute priority requires, "dilutes" the value of those shares with the issuance of additional shares, or new claims against the firm, to investors at a different level of priority. This process, which is implemented through a stylized auction at a fixed price, not quantity, harnesses information available among a corporation's investors and the capital market as a whole in order to implement better the absolute priority rule.

   Under what we call a "senior dilution" mechanism, a court would dilute the reorganized stock issued to senior claimants by issuing additional shares to junior claimants until there was no excess demand for the senior claimants' stock at a fixed price that would implement absolute priority. For example, imagine a firm with two priority classes of unsecured claimants--senior and junior. At the time of bankruptcy, each is nominally owed $100. Under our senior dilution mechanism, a court would issue 100 shares in the reorganized firm to senior claimants but would potentially dilute the value of the seniors' claims by issuing dilution shares to juniors until there was greater supply of seniors' stock than demand at a fixed price of $1 per share. If the reorganized firm is worth less than $100, there would never be excess demand for senior claimants' stock: Junior claimants or third parties would not want to spend $1 to purchase stock worth less than $1. Consequently, no dilution shares would be issued to juniors. If, however, the reorganized firm were worth more than $100, then junior and third-party bidders would have an incentive to offer to buy senior shares until the amount of dilution was sufficient to implement absolute priority. While we leave until later a detailed discussion of the implementation of this fixed-price auction (through a court's solicitation of bidding schedules), (1) the big idea is that senior dilution harnesses the claimants' (and third party bidders') private information to implement absolute priority. When the reorganized firm is worth less than the amount of the senior debt, the senior claimants come away owning all the firm. When the reorganized firm is worth more than the senior debt, the senior claimants come away with assets worth the amount of their debt with the residual going to junior claimants.

   The dilution approach, moreover, is not merely a new entry in an academic debate. In the recently decided Bank of America National Trust & Savings Ass'n v. 203 North LaSalle Street Partnership, (2) the Supreme Court expressed its dissatisfaction with judicial valuations that allocate interests in corporate debtors over the objection of a class of creditors who argue for a different valuation and thus a different allocation. The Court observed that, when possible within the confines of the bankruptcy reorganization process, bankruptcy judges would do well to resolve valuation disputes through a market mechanism. The difficulty is that traditional market mechanisms do not lend themselves to current American bankruptcy law, which may yield a reorganization plan approved by some but not all classes of creditors. For such a plan, only the noncash property to be received by the dissenters requires valuation, and an auction of that property might or might not yield a price equivalent to the dissenters' priority entitlement. The plan could be scrapped if the auction did not yield the right price, but this would lead proponents to propose a new plan with a different distribution to the dissenters. The result could be a wasteful series of failed plans and attempted sales, perhaps without any successful plan at the end of the process, as it could prove impossible for the proponents to satisfy the dissenters' entitlement consistent with the arrangement made among the other classes.

   The dilution approach we propose here solves this problem of an uncertain auction price because, as noted above and explained more fully below, (3) the dilution mechanism is, in essence, a "fixed-price" auction. To address the claims of a class that dissents from a reorganization plan, we propose a "junior" version of our dilution mechanism. For this version of the mechanism, a price can be fixed at the level of the dissenters' entitlement, and a low-bid auction can be held with bids in the currency of a piece of the debtor to be purchased for that fixed price. The greater the piece required to yield the fixed price, the more diluted the junior's residual interest. When the proponents' reorganization plan can satisfy the dissenters' entitlement, the fixed-price auction will set the distribution accurately. When the plan cannot satisfy the entitlement, the auction will reveal that fact. There is never a need for multiple plans or auctions. The dilution mechanism, moreover, unlike other market alternatives to judicial valuation, can be employed by the bankruptcy court only when needed to settle a valuation dispute. Absent such a dispute, or until the point of such a dispute, the bankruptcy process can proceed as under current practice. Thus, the dilution mechanism, with its fixed price rather than fixed quantity, is uniquely suitable to provide a market test within current American bankruptcy law. Given the Supreme Court's opinion in LaSalle, this is an opportune moment to propose such a mechanism.

   We proceed in steps to build an argument for our dilution mechanism. Part II explains the importance of the absolute priority rule and discusses the relative merits of market as opposed to judicial determination of absolute priority. Part III then explains the fundamentals of our dilution mechanism with an illustration of "senior dilution." Part IV extends the model and includes a description of how the dilution mechanism can mitigate difficulties that arise in any market process when the market in question includes few participants, not all of whom have liquid assets.

   Part V shows how American bankruptcy courts could use our dilution mechanism under current law to obtain the benefits of market valuation while preserving the merits of judicially supervised corporate reorganization. This could be accomplished through a "junior dilution" version of our dilution idea. Under this junior dilution mechanism, junior claims would be diluted by giving seniors more claims to the reorganized firm's cash flow until there was no excess supply of senior debt at a fixed price that implements absolute priority. For example, a court might raise the proposed interest rate on senior debt under a proposed reorganization plan until the demand for such debt (from juniors or third parties) was at least as great as the seniors' offers to sell the debt at absolute priority par value. Raising the interest rate would dilute the value of the residual interest left for the junior claims. As with our senior dilution mechanism, we will show that junior dilution is likely to continue until the junior and senior claimants receive their absolute priority just deserts.

   Part VI then compares the various implementations of our dilution mechanisms to its three primary market-harnessing competitors: Douglas Baird's auction proposal, (4) Mark Roe's partial-float proposal, (5) and Lucian Bebchuk's option proposal. (6) We devote particular attention to the Bebchuk proposal, which most resembles ours, and which forms a foundation for the dilution mechanism. Our mechanism and the option approach offer similar advantages over mechanisms based on a full or partial auction of...