Publication Date

2006

Publication Title

Yale Law Journal

Abstract

In a Chapter 11 reorganization, senior creditors can insist on being paid in full before anyone junior to them receives anything. In practice, however, departures from "absolute priority" treatment 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 permissive judges. In this Essay, we suggest a different force is at work. Deviations from absolute priority are inevitable even in a world completely committed to respecting priority as long as the value of the reorganized enterprise is 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 in large corporate reorganizations. Even when rational and well-informed senior investors expect the absolute priority rule to be strictly enforced, they must take into account the uncertainty associated with any valuation. The possibility of an unexpectedly high appraisal may sometimes 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 always lead to absolute priority outcomes. A coherent account of reorganization outcomes must take into account the junior investors' right to insist on an appraisal the result of which is uncertain. This uncertainty may by itself give that right option value. The most sensible path for reform is one that seeks to minimize this valuation uncertainty.

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