The importance of deviations from the absolute priority rule in Chapter 11 bankruptcy proceedings

Financial Management (Financial Management Association), Winter, 1998 by Allan C. Eberhart, Lawrence A. Weiss

Frequent departures from the absolute priority rule (APR) in Chapter 11 bankruptcy proceedings have been of great interest to finance researchers over the past several years. Since the publication of Franks and Torous (1989), Eberhart, Moore, and Roenfeldt (1990), and Weiss (1990) (collectively called the priority papers), many theoretical and empirical papers have explored the implications of departures from the APR.

Recently, Beranek, Boehmer, and Smith (1996, hereafter BBS) criticize the priority papers for providing a misleading interpretation of the APR. First, they claim that the priority papers do not inform readers that Chapter 11 allows for violations of the APR. Second, they criticize the priority papers for failing to explain why APR violations are important. In the last part of their paper, BBS propose a new APR definition and present some empirical evidence to support their views.

The purpose of this paper is to answer the BBS criticisms and correct any confusions in the literature about APR violations, especially those created by the BBS paper. This paper proceeds as follows: Section I explains the importance of APR violations and documents how the priority papers clearly note that Chapter 11 allows for APR violations. In Section II, we demonstrate the validity of the priority papers' definitions of the APR and the problems with the new definition provided by BBS. Section III uncovers problems with the BBS empirical section. Our summary and conclusions are presented in Section IV.

I. Deviations from the APR

BBS criticize the APR definition in the priority papers. Listed below are the definitions from each priority paper.

Eberhart, Moore, and Roenfeldt (1990 p. 1457) define the APR:

The absolute priority rule (hereafter APR) states that a bankrupt firm's value is to be distributed to suppliers of capital such that senior creditors are fully satisfied before any distributions are made to junior creditors, and junior creditors are paid in full before common shareholders.

Franks and Torous (1989, p.748) define the APR:

Absolute priority denies any claimholder a stake in the securities of the reorganized firm, until more senior claims have been fully satisfied.

Weiss (1990, p. 286) defines the APR:

Priority of claims is violated when senior claimants are not fully satisfied before junior claimants receive any payment.

BBS call these definitions the "laymen's" APR and argue (p. 102): "...the laymen's APR is not current bankruptcy law." As will be fully discussed in Section II, the APR definition used by the priority papers is an important underlying assumption in many seminal finance articles and documenting violations of this rule is a key point of the priority papers. Moreover, as discussed below, the priority papers do provide a clear explanation of the Bankruptcy Code's allowance of APR violations.

BBS claim the priority papers mislead readers by failing to explain the law properly (p. 103):

Note the omission of any references to the power of claimants to waive priority rights and compromise their claims.

All three priority papers, however, clearly note that creditors may waive their priority rights.(2) Franks and Torous (1989) argue that departures from the APR occur because Chapter 11 gives shareholders a right to delay the reorganization process; therefore, creditors agree to violate the APR to resolve the bankruptcy faster. Eberhart, Moore, and Roenfeldt (1990) devote an entire section of their paper (Section III.B) to testing the Franks and Torous explanation for why creditors waive their priority rights, and they find some support for this explanation. Moreover, in the first part of their paper, Eberhart, Moore, and Roenfeldt clearly state (p. 1458 italics added): "Reorganization of the corporation is governed by Chapter 11 of this Act, and this chapter does not generally require that the APR be followed." Weiss (1990, p. 290) not only states that "the Code allows priority of claims to be violated" but describes how the voting process allows violations and explicitly discusses claimants waiving their rights. BBS acknowledge the quotation on page 1458 from Eberhart, Moore, and Roenfeldt shown above (albeit in a footnote) and - in another footnote - that Franks and Torous point out that creditors may waive their priority rights. BBS then argue (p. 105) that the priority papers merely imply that creditors may waive their rights but as we show above, the priority papers clearly state it.

The priority papers do not contain a lengthy discussion of the Bankruptcy Code because it is not their focus. They do, however, refer the reader to several different articles for additional details on the Bankruptcy Code and explain why creditors may waive their priority rights.

With their title, statements,(3) and underlying tone, BBS argue that deviations from the APR definition proposed in the priority papers are unimportant. This argument, however, fails to recognize that the APR-as defined by the priority papers - is explicitly or implicitly assumed in many seminal finance models. For instance, Black and Scholes (1973) show that equity can be viewed as a call option on the underlying firm value. In this analogy, bankruptcy occurs when the firm value is below the debt's face value at maturity and the stock finishes out-of-the-money. The APR is followed because shareholders receive nothing when the bondholders have not been fully paid.