Absolute Priority Rule Definition
The absolute priority rule, also known as “liquidation preference”, is a rule employed in financial analysis that specifies the order in which creditors and shareholders stand to be compensated in case the company undergoes liquidation. Absolute priority rule are brought into effect during corporate bankruptcies to arbitrate the distribution of assets amongst participants. Absolute priority rules typically prioritize a creditor’s claim over a shareholder’s claim. Furthermore, individuals facing liquidation of their own assets also come under the purview of this rule. However, secured claims are invariably prioritized over unsecured claims. In case liquidation involves the property of a deceased individual, the absolute priority rule mandates the settlement of all outstanding debts before liquidated assets are distributed to beneficiaries.
A Little More on What is the Absolute Priority
Section 1129(b)(2) of the U.S. Bankruptcy Code protects creditors’ interest by making it obligatory for liquidation plans to be non-partisan and non-discriminatory towards creditors. The absolute priority rule draws up the following hierarchy to fulfill the statute for fair and equitable treatment:
- The senior class of creditors is paid first and in full.
- Claims of junior creditors are fulfilled.
- Claims of equity holders are serviced.
However, there are certain arrangements that need to be made before creditors are compensated; these include setting aside funds for disbursing back pays, welfare benefits and tax claims.
In situations involving estates, estate resources are duly distributed. If these resources are deemed insufficient to recompense the debts, assets will need to be liquidated to fulfill the indemnification obligations. Also, the death of the owner of an estate will also result in the absolute priority rule being invoked.
There are instances when liquidation proceedings involve legal claims or disputes. In such cases, courts typically asseverate the absolute priority rule. For example, there are numerous cases that involve liaisons between groups of creditors and debtors who collectively attempt to preclude the distribution of liquidation paybacks to certain claimants. On such occasions, the usual court ordinance is that secured creditors must be paid first, followed by unsecured creditors, and then shareholders, provided there are sufficient assets to distribute. However, there might arise certain extraordinary circumstances that could force the courts to alter this hierarchy of recompense. There are also rare situations where secured creditors have consented to permuting this hierarchy.
There also exists a common law exception to the absolute priority rule. It is known as the New Value Exception, and is variously referred to as the New Value Doctrine and the New Value Corollary. The New Value Exception allows a shareholder to retain an equity interest in the business or receive a payment even when the claims of senior creditors remain unservices. The shareholder can invoke this exception by contributing money or providing money’s worth to the restructured firm.
The New Value Exception traces its roots to the Bankruptcy Act of 1898. However, this exception was not explicitly mentioned in the Bankruptcy Code of 1978, leading to confusion regarding the status quo of the exception in present times. Nevertheless, several courts have reiterated that the Bankruptcy Code does include the New Value Exception. Interestingly, the Supreme Court has refrained from ruling on whether or not the Bankruptcy Code includes the New Value Exception.
References for Absolute Priority Rule
Academic Research for Absolute Priority Rule
- Security pricing and deviations from the absolute priority rule in bankruptcy proceedings, Eberhart, A. C., Moore, W. T., & Roenfeldt, R. L. (1990). The Journal of Finance, 45(5), 1457-1469. The authors sample 30 filings under the 1978 Bankruptcy Reform Act and scrutinize claims that were eventually awarded to shareholders of firms in the process of reorganization. The authors conclude that shareholders received, on average, excess payments to the tune of 7.6 percent of the total compensation over and above what the absolute priority rule mandated.
- Bargaining after the fall and the contours of the absolute priority rule, Baird, D. G., & Jackson, T. H. (1988). The University of Chicago Law Review, 738-789. The authors outline the provisions of the absolute priority rule and scrutinize the role of stake bargainings in influencing the practice of bankruptcy as well as discussions of bankruptcy policy. In his paper, The Law and Language of Corporate Reorganizations, Walter Blum assesses the tension that arises between enforcing adherence to the pre-bankruptcy negotiations and the challenges posed by creditors and shareholders proposing changes to such prior negotiations. Baird and Jackson’s paper seeks to extend Walter’s Blum’s work in this regard.
- Absolute priority rule violations and risk incentives for financially distressed firms, Eberhart, A. C., & Senbet, L. W. (1993). Financial Management, 101-116. The authors scrutinize violations of the absolute priority rule and contend that since a typical bond covenant does not explicitly mandate strict adherence to the absolute priority rule at the time of issuance of debt, shareholders often resort to violations of this rule for personal gains. This is especially true when call or convertible provisions become redundant.
- Pricing the risk of recovery in default with absolute priority rule violation, Unal, H., Madan, D., & Güntay, L. (2003). Journal of Banking & Finance, 27(6), 1001-1025. The authors present an independent strategy to hypothesize the risk-neutral density of recovery rates implicated by debt security prices of a company. Their strategy does not account for the simulation of default arrival rates and explicitly permits violations of the absolute priority rule. This paper introduces the concept of adjusted relative spread as a new statistic to weigh risk-neutral recovery information in debt prices.
- The Absolute Priority Rule and the Firm’s Investment Policy, Schwartz, A. (1994). Wash. ULQ, 72, 1213. This paper hypothesizes that it is not possible for bankruptcy laws to determine management or investor behavior prior to bankruptcy. Subsequently, scholars have initiated a new research program to scrutinize the influence of bankruptcy laws on the endeavors of the involved parties to settle disputes following the declaration of bankruptcy.
- Absolute priority rule violations in bankruptcy, Longhofer, S. D., & Carlstrom, C. T. (1995). Economic Review-Federal Reserve Bank of Cleveland, 31, 21-30. This paper seeks to answer the following questions pertaining to absolute priority rule violations during bankruptcy: Given that private loan contracts are voluntary processes, why is it so easy to violate their terms even under the purview of courts? What is the fiscal impact of such violations on the cost of economic efficiency? The authors seek to answer these questions by scrutinizing the effect of absolute priority rule violations on financial contracts. They then gauge the extent of such violations and their frequency of occurrence. Subsequently, a model is developed to investigate the efficacy of absolute priority rule violations.
- Bankruptcy, absolute priority, and the pricing of risky debt claims, Warner, J. B. (1977). Journal of Financial Economics, 4(3), 239-276. This paper highlights the presence of several exceptions to the absolute priority rule. It then proceeds to scrutinize the risk and return attributes of claims registered in courts against companies during bankruptcy proceedings. The paper concludes that there are inherent risks involved in such financial claims. Furthermore, the equity-backed security markets tend to manipulate prices of risky debt claims to include not only the risk attributes but also the anticipation of a deviation from the absolute priority rule.
- The New Value Exception to the Absolute Priority Rule: Is Ahlers the Begining of the End, Powlen, D. M., & Wuhrman, A. H. (1988). Com. LJ, 93, 303. According to the absolute priority rule, during a bankruptcy-enforced reorganization, it is obligatory for creditors to receive payment of their claims in the stipulated pecking order. Moreover, creditors also need to be reimbursed in full before assets are distributed among shareholders. However, the formulation of the New Value Exception to the APR in 1939, bestowed upon equity holders the right to retain all or part of their interests during a debtor reorganization enforced by a bankruptcy. This was explicitly mentioned in Chapter 11 of the Bankruptcy Code.
- The Truth About the New Value Exception to Bankruptcy’s Absolute Priority Rule, Carlson, D. G., & Williams, J. F. (1999). Cardozo L. Rev., 21, 1303. The introduction of the New Value Exception to the absolute priority rule in 1939 resulted in junior parties receiving new equity participations from reorganized bankrupt firms in exchange for the payment of new value. However, the Supreme Court of the United States reversed the confirmation of a new value plan, while at the same time vindicating the existence of the New Value Exception.
- Absolute priority, valuation uncertainty, and the reorganization bargain, Baird, D. G., & Bernstein, D. S. (2005). Yale LJ, 115, 1930. Baird and Bernstein discuss aspects of the absolute priority rule and discuss its lapses. They contend that such lapses creep up from certain uncertainties as well as forbearing judges that allow well-placed insiders to exploit valuation procedures to their own advantage. Furthermore, reorganization bargains often offer contingent interests in the reorganized business to out-of-the-money junior investors.
- The Absolute Priority Doctrine in Corporate Reorganizations, Blum, W. J., & Kaplan, S. A. (1974). The University of Chicago Law Review, 651-684. Blum and Kaplan assert that the absolute priority rule has given rise to formidable levels of dissent among parties who have consistently demanded that modifications be made to the rule. The authors seek to explain this development by tracing the roots of the absolute priority rule to equity receivership reorganizations. They also contend that the structure of the rule itself has been a major bone of contention since its implementation.