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"Absolute Priority, Valuation Uncertainty, and
the Reorganization
Bargain"
BY: DOUGLAS G. BAIRD
University of Chicago Law School
DONALD S. BERNSTEIN
Davis Polk & Wardwell
Document: Available from the SSRN Electronic Paper
Collection:
http://papers.ssrn.com/paper.taf?abstract_id=813085
Paper ID: U Chicago Law & Economics, Olin Working
Paper No. 259
Date: September 2005
Contact: DOUGLAS G. BAIRD
Email: Mailto:douglas_baird@law.uchicago.edu
Postal: University of Chicago Law School
1111 E. 60th St.
Chicago, IL 60637 UNITED STATES
Phone: 773-702-9571
Fax: 773-702-0730
Co-Auth: DONALD S. BERNSTEIN
Email: Mailto:bernstn@dpw.com
Postal: Davis Polk & Wardwell
450 Lexington Ave.
New York, NY 10017 UNITED STATES
ABSTRACT:
In a Chapter 11 reorganization, senior creditors are
entitled to
insist upon being paid in full before anyone junior
to them
receives anything. In practice, however, departures
from such
"absolute priority" are commonplace. Explaining
these deviations
has been a central preoccupation of reorganization scholars
for
decades. By the standard law-and-economics account,
deviations
from absolute priority arise because well positioned
insiders
take advantage of cumbersome procedures and inept judges.
In
this paper, we suggest that a far simpler and more benign
force
dominates bargaining in reorganization cases.
"Deviations" from absolute priority are
inevitable even in a
world completely committed to respecting priority as
long as
asset values are uncertain. Uncertainty accompanies
any
valuation procedure. Bargaining in corporate reorganizations
takes place in the shadow of this uncertainty, and standard
models of litigation and settlement show that valuation
uncertainty alone can explain many of the departures
from
absolute priority we see in large corporate reorganizations.
Even where rational and well informed senior investors
expect
the absolute priority rule to be strictly enforced,
they must
account for the uncertainty associated with any valuation.
The
possibility of an unexpectedly high appraisal will cause
them to
offer apparently out-of-the-money junior investors contingent
interests in the reorganized business.
The debate over absolute priority, the central principle
of
modern corporate reorganization law, has been misdirected
for
decades. It has failed to recognize that a substantive
rule of
absolute priority does not lead to an absolute priority
outcome.
A coherent account of absolute priority must incorporate
relative priority. It must take account of the option
value
implicit in the junior investors' right to insist on
an
appraisal. |
5.6.2 Business valuation in corporate appraisal 