Absolute Priority Rule and Option Theory

Abstract

Using the language of options, this paper shows how variance in judicial valuation under an unbiased judge may work to the disadvantage of the junior class in Chapter 11 reorganizations. Given liquidity constraints and information barriers, the parties to bankruptcy cases choose Chapter 11 to propose plans to distribute securities of the reorganized debtor instead of cash. In this context, we identify three effects from the valuation variance - the floor, the ceiling, and the feasibility effects - two of which favor the senior class. Our analysis puts in doubt the conventional wisdom (Baird & Bernstein 2006) of a systematic bias of valuation variance in favor of the junior class in Chapter 11 reorganizations. The framework we offer may also enable us to further examine the efficiency of absolute priority.