Priority matters: absolute priority, relative priority, and the costs of bankruptcy.

• Author: Baird, Douglas G.

Chapter 11 of the Bankruptcy Code is organized around the absolute priority rule. This rule mandates the rank-ordering of claims. If one creditor has priority over another, this creditor must be paid in full before the junior creditor receives anything. Many have suggested various modifications to the absolute priority rule. The reasons vary and range from ensuring proper incentives to protecting nonadjusting creditors. The rule itself, however, remains the common starting place.

This Article uses relative priority, an entirely different priority system that flourished until the late 1930s, to show that using absolute priority even as a point of departure is suspect. Much of the complexity and virtually all of the stress points of modern Chapter 11 arise from the uneasy fit between its starting place (absolute instead of relative priority) and its procedure (negotiation in the shadow of a judicial valuation instead of a market sale). These forces are leading to the emergence of a hybrid system of priority that may be more efficient than one centered around absolute priority.

INTRODUCTION 786 I. ABSOLUTE AND RELATIVE PRIORITY 789 II. THE SALE PARADIGM 806 III. RELATIVE PRIORITY 812 IV. BARGAINING IN THE SHADOW OF ABSOLUTE PRIORITY 821 CONCLUSION 827 INTRODUCTION

The absolute priority rule is the organizing principle of the modern law of corporate reorganizations. (1) If one creditor has priority over another, this creditor needs to be paid in full before the other is entitled to receive anything. It does not matter whether payment takes the form of cash from a sale or new securities in a reorganization. Priority is absolute. By its nature, priority requires a rank-ordering of claims. Such is the conventional thinking about priorities in bankruptcy. (2)

This state of affairs, however, is very far from inevitable. An alternative conception of priority--relative priority--once flourished. (3) "Relative priority" was the central feature of the reorganization regime that reigned until New Deal reforms fundamentally changed the bankruptcy landscape. (4) This Article uses the relative-priority paradigm to illuminate structural weaknesses at the core of Chapter 11.

Traditional accounts of Chapter 11 take the combination of absolute priority and a nonmarket restructuring mechanism for granted, (5) but, as this Article shows, a reorganization regime that uses both is inherently unstable. Absolute priority is naturally suited for regimes in which the financially distressed firm is sold to the highest bidder. It is much less appropriate for a regime that puts a new capital structure in place without a market sale. Looking at Chapter 11 from this vantage point shows that much of the complexity and virtually all of the stress points of modern Chapter 11 arise from the uneasy fit between its priority regime (absolute instead of relative) and its procedure (negotiation in the shadow of a judicial valuation instead of a market sale).

In the absence of an actual sale, absolute priority requires some nonmarket valuation procedure. Such a valuation is costly and prone to error. (6) Chapter 11 attempts to minimize these costs by inducing the parties to bargain in the shadow of a judicial valuation, but this bargaining is itself expensive and hard to control. (7) Relative priority introduces some difficulties and weaknesses of its own, but not these. (8) Nineteenth century reorganization law was so successful because it coupled relative priority with its nonmarket valuation mechanism. (9)

Part I of this Article reviews the modern understanding of capital structures and the rationale for respecting priority rights in bankruptcy. Parts II and III examine absolute and relative priority, respectively, and show how the virtues of both priority schemes turn crucially on the presence or absence of a market sale.(10) Part IV shows that absolute priority is implemented only imperfectly in Chapter 11. Finally, the Article closes by suggesting that much of the modern commentary on reorganization law begins in the wrong place. Modern Chapter 11 might best be characterized as a hybrid system of absolute and relative priority, and such a system may be more efficient than one centered around absolute priority.

1. ABSOLUTE AND RELATIVE PRIORITY

   When a firm has value as a going concern, the investors as a group are better off if it remains intact even when it is in financial distress and not able to pay all of its bills. Nevertheless, each individual investor may find it in her self-interest to try to recover what she is owed without paying attention to the consequences for everyone else. These efforts can tear the firm apart. The investors are too dispersed to reach an agreement that would put a stop to a destructive race to the assets and give them time to negotiate a realignment of their rights against the firm. The law of corporate reorganizations overcomes this collective action problem. It enables investors to put a new capital structure in place and, at the same time, respect the nonbankruptcy bargain among the investors. (11)

   The simplest way to keep the firm intact is to sell it free and clear of all existing liabilities to a third party. (12) The new owner can impose a new capital structure that fits the circumstances in which the firm finds itself, and the proceeds of the sale can be divided among the existing investors. But a sale is not always possible. The market may be illiquid. The most likely purchasers of the firm may be other businesses in the same industry. When a firm is distressed, these other firms may be distressed as well and may not have the resources to take part in an auction. When those who value the firm the most are not able to bid, the auction will not yield what the firm is worth. (13)

   Even if the industry is flourishing or the potential buyers lie outside the industry, there is another problem that limits the ability to sell the firm: the private information problem. (14) By the time a distressed firm is sold, the investors have organized themselves. They have hired experts and spent time reviewing and assessing the quality of the managers and their plans for the business going forward. As a result, they may know much more about the value of the business than any potential buyer. Buyers may therefore fear that the existing investors want to sell the firm because things are worse than they appear. The existing investors possess private information. Buyers of firms are like buyers of used cars. They are not willing to pay top dollar because of the risk that the firm is being sold only because the current owners know it is going to fail and want to rid themselves of a lemon. (15)

   The illiquidity of the market and the existence of private information explain why investors as a group may be better off in a bankruptcy regime that provides for a change in the capital structure rather than a sale to a third party. The new debt and equity can be parceled out to the existing investors in return for their old stakes in the firm. Instead of an actual sale, there is a virtual one. This is the common justification for reorganization regimes such as nineteenth century equity receiverships and modern Chapter 11 reorganizations. (16)

   In every reorganization regime, there needs to be some rule that dictates how the rights of the old investors are recognized. It might seem that junior creditors should receive nothing when there is not enough value to pay the senior investors in full. Absolute priority among investors should be respected. Matters are not so obvious, however, when the reorganization leaves the senior investor with a stake in the firm.

   Outside of bankruptcy, senior creditors facing a debtor in default sometimes prefer to maintain their stake in the firm rather than insist on a sale to a third party. They choose to waive their right to declare a default and repossess collateral. (17) When they do this, however, they must allow junior creditors to remain in place. (18) Outside of bankruptcy, they cannot simultaneously keep their stake in the ongoing business and eliminate those junior to them in the capital structure. By analogy, when a firm is reorganized, it may make sense to create a new capital structure that also keeps everyone in the picture. Such a capital structure can solve the problems that arise from the firm's current financial condition (doing away with such things as the obligation to pay dividends and interest as well as stripping junior investors of voting or other control rights), yet still recognize the junior investors' right to any excess that remains when, at some time in the future, all the accounts are ultimately squared. This is the essence of relative priority.

   An artificial example can highlight the difference between absolute and relative priority. Imagine a firm has only one project and two investors. At the outset, they agree that one will be entitled to $150 when the project is completed and the other will be entitled to whatever remains. Their lawyers implement this deal by giving one investor a debt instrument and equity to the other. (19) Time passes, and it becomes clear that the project will either yield $200 or $0 with equal probability. At this point, a government regulation unexpectedly requires the firm to eliminate all debt in its capital structure in order for the project to move forward. (20) A market sale is not in the collective interest of the two investors. No outsider is willing to pay anything close to the firm's expected value.

   Because the two investors can realize value from their investment only by putting a new capital structure in place, it is in their joint interest to do so. How should the securities in the reorganized firm be divided between the senior and the junior investor? Upon what allocation rule would the parties have agreed had they thought about the need for such a restructuring at the time of their original investment? (21)

   There are two...