"Absolute Priority, Valuation Uncertainty, and
BY: DOUGLAS G. BAIRD
University of Chicago Law School
DONALD S. BERNSTEIN
Davis Polk & Wardwell
Document: Available from the SSRN Electronic Paper
Paper ID: U Chicago Law & Economics, Olin Working
Paper No. 259
Date: September 2005
Contact: DOUGLAS G. BAIRD
Postal: University of Chicago Law School
1111 E. 60th St.
Chicago, IL 60637 UNITED STATES
Co-Auth: DONALD S. BERNSTEIN
Postal: Davis Polk & Wardwell
450 Lexington Ave.
New York, NY 10017 UNITED STATES
In a Chapter 11 reorganization, senior creditors are
insist upon being paid in full before anyone junior
receives anything. In practice, however, departures
"absolute priority" are commonplace. Explaining
has been a central preoccupation of reorganization scholars
decades. By the standard law-and-economics account,
from absolute priority arise because well positioned
take advantage of cumbersome procedures and inept judges.
this paper, we suggest that a far simpler and more benign
dominates bargaining in reorganization cases.
"Deviations" from absolute priority are
inevitable even in a
world completely committed to respecting priority as
asset values are uncertain. Uncertainty accompanies
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
absolute priority we see in large corporate reorganizations.
Even where rational and well informed senior investors
the absolute priority rule to be strictly enforced,
account for the uncertainty associated with any valuation.
possibility of an unexpectedly high appraisal will cause
offer apparently out-of-the-money junior investors contingent
interests in the reorganized business.
The debate over absolute priority, the central principle
modern corporate reorganization law, has been misdirected
decades. It has failed to recognize that a substantive
absolute priority does not lead to an absolute priority
A coherent account of absolute priority must incorporate
relative priority. It must take account of the option
implicit in the junior investors' right to insist on