Absolute Priority, Relative Priority, and Valuation Uncertainty in Bankruptcy

Bankruptcy reformers advocate substituting relative priority for the prevailing absolute priority standard to promote a more consensual restructuring process. In deciding who does and does not get paid when there is not enough value to pay all creditors, bankruptcy’s prevailing absolute priority rule lines creditors up in rankorder, compensating highest ranking creditors in full before lower-ranking creditors get anything. By contrast, relative priority would account for the possibility that the firm could recover and become more valuable after the bankruptcy. Relative priority would compensate lower-ranking creditors for that chance of the debtor turning around, thereby reducing both their incentive to delay and seniors’ incentive to rush. Relative priority could have these and other potential advantages, but we show here that it would also introduce valuation difficulties. Valuation difficulties are important because under both priority rules the parties have the Coasean incentive to come to a deal that maximizes the total value of the firm, and then split that maximized value; indeed, we show that the absolute priority conflict structure that relative priority seeks to mitigate could readily reemerge under relative priority. A more difficult valuation could make both a deal among the parties and judicial resolution harder. Absolute priority requires point-estimate valuations of the enterprise, like valuing equity of a non-indebted enterprise. But relative priority would require judges, parties, and outside investors to make complex valuations needing additional information, as relative priority valuation requires that decisionmakers assess the chances of multiple future outcomes with more precision than absolute priority needs. Worse, the increased valuation uncertainty from relative priority’s added complexity would discourage full-firm sales. Indeed, relative priority could recreate the bargaining problems afflicting absolute priority. Relative priority would, moreover, work poorly with today’s population of large business bankruptcies, which increasingly is made up of private firms, for which we show relative priority valuation would be particularly difficult. Today, financial professionals generally do not trade or offer for sale similar financial instruments: stock options requiring substantially similar valuation analyses exist for stable public firms, but rarely for distressed firms. True, relative priority could have other advantages over absolute priority. These advantages, however, must outweigh the costs we identify here: namely, that relative priority entails greater valuation uncertainty for the parties, the courts, and outside investors, leads to more valuation conflict than absolute priority, and, in this dimension, would increase bankruptcy’s cost.