Control Rights, Priority Rights, and the Conceptual Foundations of Corporate Reorganizations

Modern Chapter 11 places control decisions in the hands of the bankruptcy judge and insists on rigid adherence to absolute priority in all cases. In both respects, modern Chapter 11 departs sharply from the equity receivership. The equity receivership governed the reorganization of railroads and other large firms in the 19th Century, and it was fashioned in a way that strongly suggests that it vindicated the creditors' bargain. This paper suggests that, when a speedy auction of the firm is not possible, these twin principles of the equity receivership continue to make sense. When the managers and shareholders cannot be easily separated, control rights should lie in the hands of someone whose loyalties are aligned with the creditors, but the reorganization itself should not affect the value of the managers' equity interest. To use the language of the equity receivership, the "relative priority" of their interests should be preserved. The focus of modern scholarship on the absolute priority rule neglects the question of who controls the assets during the reorganization. It also fails to take account of the role that existing manager/shareholders will play in firms that possess going concern value and cannot be resold in the market. In this environment, the absolute priority rule triggers costly renegotiations that may yield no off-setting advantages over the relative priority rule.