A dilution mechanism for valuing corporations in bankruptcy

Yale Law Journal

Volumn 111, Issue 1, 2001, Pages 83-149

  Adler, Barry E ^a   Ayres, Ian ^a  

^a NONE

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EID: 0041805432     PISSN: 00440094     EISSN: None     Source Type: Journal    
DOI: 10.2307/797516     Document Type: Article

References (158)

1. See infra Section III.B.
2. 526 U.S. 434 (1999).
3. See infra Sections III.A-B.
4. Douglas G. Baird, Revisiting Auctions in Chapter 11, 36 J.L. & ECON. 633 (1993).
5. Mark J. Roe, Bankruptcy and Debt: A New Model for Corporate Reorganization, 83 COLUM. L. REV. 527 (1983).
6. Lucian Arye Bebchuk, A New Approach to Corporate Reorganizations, 101 HARV. L. REV. 775 (1988).
7. See Barry E. Adler, Bankruptcy and Risk Allocation, 77 CORNELL L. REV. 439, 473-76 (1992). For a general description of debt's potential efficiency benefits, see, for example, Sanford J. Grossman & Oliver D. Hart, Corporate Financial Structure and Managerial Incentives, in THE ECONOMICS OF INFORMATION AND UNCERTAINTY 107 (John J. McCall ed., 1982); and Stephen A. Ross, The Determination of Financial Structure: The Incentive-Signalling Approach, 8 BELL J. ECON. 23 (1977).
8. See Barry E. Adler, Bankruptcy and Risk Allocation, 77 CORNELL L. REV. 439, 473-76 (1992). For a general description of debt's potential efficiency benefits, see, for example, Sanford J. Grossman & Oliver D. Hart, Corporate Financial Structure and Managerial Incentives, in THE ECONOMICS OF INFORMATION AND UNCERTAINTY 107 (John J. McCall ed., 1982); and Stephen A. Ross, The Determination of Financial Structure: The Incentive-Signalling Approach, 8 BELL J. ECON. 23 (1977).
9. See Barry E. Adler, Bankruptcy and Risk Allocation, 77 CORNELL L. REV. 439, 473-76 (1992). For a general description of debt's potential efficiency benefits, see, for example, Sanford J. Grossman & Oliver D. Hart, Corporate Financial Structure and Managerial Incentives, in THE ECONOMICS OF INFORMATION AND UNCERTAINTY 107 (John J. McCall ed., 1982); and Stephen A. Ross, The Determination of Financial Structure: The Incentive-Signalling Approach, 8 BELL J. ECON. 23 (1977).
10. See Alan Schwartz, A Theory of Loan Priorities, 18 J. LEGAL STUD. 209 (1989). For an explanation of why early debt is not always high priority, see Barry E. Adler, An Equity-Agency Solution to the Bankruptcy-Priority Puzzle, 22 J. LEGAL STUD. 73 (1993).
11. See Alan Schwartz, A Theory of Loan Priorities, 18 J. LEGAL STUD. 209 (1989). For an explanation of why early debt is not always high priority, see Barry E. Adler, An Equity-Agency Solution to the Bankruptcy-Priority Puzzle, 22 J. LEGAL STUD. 73 (1993).
12. A firm can, of course, be subject to obligations of nonconsensual creditors such as tort victims. These creditors cannot adjust their relationships with a firm to achieve optimal incentives. But the law can, in principle, award such creditors first priority and thus largely force consensual investors to internalize the costs imposed on those who cannot contract. Cf. Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 YALE L.J. 1879 (1991) (proposing that satisfaction of tort claims extend beyond priority against a debtor's assets to the shareholders' assets). That the law does not maximize tort-claim recovery is not relevant to our discussion here. Indeed, the prospect of nonconsensual creditors altogether is inapposite to our discussion of how consensual investors may arrange their priorities. Thus, we do not again refer to nonconsensual creditors. A reader who is interested in the relative importance of the claims filed in business bankruptcy cases should consult the Business Bankruptcy Project (principal investigators, Teresa Sullivan, Elizabeth Warren, and Jay Lawrence Westbrook), which has collected data on more than 3500 business cases from twenty-three judicial districts and has recorded detailed information on tens of thousands of the claims filed in those bankruptcies. For an overview of the research study, see Elizabeth Warren & Jay Lawrence Westbrook, Financial Characteristics of Businesses in Bankruptcy, 73 AM. BANKR. L.J. 499 (1999). Preliminary (but yet unpublished) results from this study reveal that claims based on contract substantially outnumber claims based on tort.
13. A firm can, of course, be subject to obligations of nonconsensual creditors such as tort victims. These creditors cannot adjust their relationships with a firm to achieve optimal incentives. But the law can, in principle, award such creditors first priority and thus largely force consensual investors to internalize the costs imposed on those who cannot contract. Cf. Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 YALE L.J. 1879 (1991) (proposing that satisfaction of tort claims extend beyond priority against a debtor's assets to the shareholders' assets). That the law does not maximize tort-claim recovery is not relevant to our discussion here. Indeed, the prospect of nonconsensual creditors altogether is inapposite to our discussion of how consensual investors may arrange their priorities. Thus, we do not again refer to nonconsensual creditors. A reader who is interested in the relative importance of the claims filed in business bankruptcy cases should consult the Business Bankruptcy Project (principal investigators, Teresa Sullivan, Elizabeth Warren, and Jay Lawrence Westbrook), which has collected data on more than 3500 business cases from twenty-three judicial districts and has recorded detailed information on tens of thousands of the claims filed in those bankruptcies. For an overview of the research study, see Elizabeth Warren & Jay Lawrence Westbrook, Financial Characteristics of Businesses in Bankruptcy, 73 AM. BANKR. L.J. 499 (1999). Preliminary (but yet unpublished) results from this study reveal that claims based on contract substantially outnumber claims based on tort.
14. This may justify the creation of a perverse incentive at work prior to insolvency. Adler, supra note 7, at 473-75 (describing the trade-off between pre-and post-insolvency investment incentives); see also Barry E. Adler, Finance's Theoretical Divide and the Proper Role of Insolvency Rules, 67 S. CAL. L. REV. 1107, 1111-31 (1994) (collecting references to the literature in support of such distribution); Paul Povel, Optimal "Soft" or "Tough" Bankruptcy Procedures, 15 J.L. ECON. & ORG. 659 (1999) (describing the same tradeoff); Alan Schwartz, A Contract Theory Approach to Business Bankruptcy, 107 YALE L.J. 1807 (1998) (describing and modeling the potential desirability of a distribution to equity from the assets of an insolvent firm).
15. This may justify the creation of a perverse incentive at work prior to insolvency. Adler, supra note 7, at 473-75 (describing the trade-off between pre-and post-insolvency investment incentives); see also Barry E. Adler, Finance's Theoretical Divide and the Proper Role of Insolvency Rules, 67 S. CAL. L. REV. 1107, 1111-31 (1994) (collecting references to the literature in support of such distribution); Paul Povel, Optimal "Soft" or "Tough" Bankruptcy Procedures, 15 J.L. ECON. & ORG. 659 (1999) (describing the same tradeoff); Alan Schwartz, A Contract Theory Approach to Business Bankruptcy, 107 YALE L.J. 1807 (1998) (describing and modeling the potential desirability of a distribution to equity from the assets of an insolvent firm).
16. This may justify the creation of a perverse incentive at work prior to insolvency. Adler, supra note 7, at 473-75 (describing the trade-off between pre-and post-insolvency investment incentives); see also Barry E. Adler, Finance's Theoretical Divide and the Proper Role of Insolvency Rules, 67 S. CAL. L. REV. 1107, 1111-31 (1994) (collecting references to the literature in support of such distribution); Paul Povel, Optimal "Soft" or "Tough" Bankruptcy Procedures, 15 J.L. ECON. & ORG. 659 (1999) (describing the same tradeoff); Alan Schwartz, A Contract Theory Approach to Business Bankruptcy, 107 YALE L.J. 1807 (1998) (describing and modeling the potential desirability of a distribution to equity from the assets of an insolvent firm).
17. See Douglas G. Baird & Robert K. Rasmussen, Priority Rights, Control Rights, and the Conceptual Foundations of Corporate Reorganizations, 87 VA. L. REV. (forthcoming 2001).
18. See Adler, supra note 10, at 1111-31 (showing that purportedly desirable distributions accomplished through deviation from absolute priority could be replicated through contracts among investors). See generally LUCIAN ARYE BEBCHUK, USING OPTIONS TO DIVIDE VALUE IN CORPORATE BANKRUPTCY 9 (Nat'l Bureau of Econ. Research, Working Paper No. 7614, 2000) (modeling an option approach to a flexible distribution scheme), available at http://papers.nber.org/papers/W7614.
19. There is a live debate about the circumstances under which investors can so choose and adjust. Compare Lucian Arye Bebchuk & Jessie M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 YALE L.J. 857 (1996), with Barry E. Adler, Secured Credit Contracts, in THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 405 (Peter Newman ed., 1998). We do not enter this debate here and, for simplicity, assume that all investors can do what at least many can, which is control the terms of finance.
20. There is a live debate about the circumstances under which investors can so choose and adjust. Compare Lucian Arye Bebchuk & Jessie M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 YALE L.J. 857 (1996), with Barry E. Adler, Secured Credit Contracts, in THE NEW PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 405 (Peter Newman ed., 1998). We do not enter this debate here and, for simplicity, assume that all investors can do what at least many can, which is control the terms of finance.
21. Moreover, there is reason to believe that any such error, even of an unbiased judge, would not itself be unbiased. See infra note 27 and accompanying text.
22. E.g., Phillippe Aghion et al., The Economics of Bankruptcy Reform, 8 J.L. ECON. & ORG. 523 (1992);
23. Baird, supra note 4; Douglas G. Baird, The Uneasy Case for Corporate Reorganizations, 15 J. LEGAL STUD. 127 (1986);
24. E.g., Phillippe Aghion et al., The Economics of Bankruptcy Reform, 8 J.L. ECON. & ORG. 523 (1992); Bebchuk, supra note 6; Roe, supra note 5; cf. Barry E. Adler, Financial and Political Theories of American Corporate Bankruptcy, 45 STAN. L. REV. 311 (1993) [hereinafter Adler, Financial and Political Theories] (exploring one such approach); Bebchuk, supra note 6; Roe, supra note 5; cf. Barry E. Adler, Financial and Political Theories of American Corporate Bankruptcy, 45 STAN. L. REV. 311 (1993) [hereinafter Adler, Financial and Political Theories] (exploring one such approach); Barry E. Adler, A Theory of Corporate Insolvency, 72 N.Y.U. L. REV. 343 (1997) [hereinafter Adler, Corporate Insolvency] (describing ex ante insolvency approaches that dispense with ex post valuation altogether).
25. E.g., Phillippe Aghion et al., The Economics of Bankruptcy Reform, 8 J.L. ECON. & ORG. 523 (1992); Baird, supra note 4; Douglas G. Baird, The Uneasy Case for Corporate Reorganizations, 15 J. LEGAL STUD. 127 (1986); Barry E. Adler, A Theory of Corporate Insolvency, 72 N.Y.U. L. REV. 343 (1997) [hereinafter Adler, Corporate Insolvency] (describing ex ante insolvency approaches that dispense with ex post valuation altogether). Barry E. Adler, A Theory of Corporate Insolvency, 72 N.Y.U. L. REV. 343 (1997) [hereinafter Adler, Corporate Insolvency] (describing ex ante insolvency approaches that dispense with ex post valuation altogether).
26. 526 U.S. 434 (1999).
27. 11 U.S.C. § 1129(b)(2)(B)(ii) (1994).
28. LaSalle, 526 U.S. at 442-43.
29. Id. at 457-58 (footnote and citations omitted); see also Norwest Bank Worthington v. Ahlers. 485 U.S. 197, 207 (1988) ("[T]he Code provides that it is up to the creditors - and not the courts - to accept or reject a reorganization plan which fails to provide them adequate protection or fails to honor the absolute priority rule.").
30. In LaSalle, the Court simply assumes that absolute priority is the appropriate standard because the Bankruptcy Code incorporates this standard. The Court therefore does not address the ex ante benefits of absolute priority discussed above in Section II.A. Independent of those benefits, given absolute priority, a market valuation is important because judicial error can otherwise lead to inefficient investment ex post. For example, a debtor's pre-bankruptcy shareholders might attempt to convince a court both that the debtor is solvent and that the debtor should continue in business even if in fact the firm is both insolvent and more valuable in piecemeal liquidation. Old equity will receive a share of the debtor's value only if the court can be so misled, as the cash prices received at a piecemeal liquidation sale will clearly reveal the debtor's true solvency state. See Barry E. Adler, The Emergence of Markets in Chapter 11: A Small Step on North LaSalle Street, 8 SUP. CT. ECON. REV. 1, 9-20 (2000).
31. Although estimates vary, it is well established that judicial valuations in cramdown, or settlements in prospect of the cramdown process, yield violations of absolute priority. The direct and indirect costs - e.g., professional fees and distraction of management - imposed by the reorganization process, moreover, can exceed the costs of an open market sale of assets similar to those being valued, as the direct costs alone of the former are comparable to the costs of the latter. For a standard analysis of both absolute priority violations and the direct costs of bankruptcy reorganization, see Lawrence A. Weiss, Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims, 27 J. FIN. ECON. 285 (1990).
32. For a caution about overstated indirect costs, however, see GREGOR ANDRADE & STEVEN N. KAPLAN, HOW COSTLY Is FINANCIAL (NOT ECONOMIC) DISTRESS?: EVIDENCE FROM HIGHLY LEVERAGED TRANSACTIONS THAT BECAME DISTRESSED 3-4 (Nat'l Bureau of Econ. Research, Working Paper No. 6145, 1997), available at http://www.nber.org/papers/w6145. See generally Adler, Corporate Insolvency, supra note 15 (collecting sources on the theory and empirical evidence of absolute priority violations and the costs of reorganization).
33. To confirm a plan over dissent, the plan must satisfy a number of conditions. First, if there is an impaired class of claims under the plan, at least one impaired class of claims must accept the plan as a class. 11 U.S.C. § 1129(a)(10). As a general matter, an impaired class of claims is one that the plan would not reinstate on the claims' original terms. Id. § 1124. Note that "impairment" is a term of art. A class of claims is impaired whether or not the plan proponents, or a bankruptcy judge for that matter, determines that the holders will be fully compensated for their claims. Class approval is also defined by the Bankruptcy Code. In general, a class of claims accepts the plan whenever the plan is accepted by creditors within the class who hold at least two-thirds in amount and more than one-half in number of the claims in that class. Thus, taken together, while an individual creditor may be unable to block a reorganization plan, any creditor with more than a one-third stake in a class of claims in an impaired class can block the plan, regardless of any judicial valuation, unless another impaired class accepts the plan. There are other hurdles, even if a plan garners the acceptance of an impaired class but not of all creditors or all classes. If a dissenter is in a class of claims or interests that as a class accepts the plan, a court must be satisfied that the dissenter will receive property under the plan worth at least as much as it would have received in a liquidation. Id. § 1129(a)(7)(B). If a dissenter is in a class of claims or interests that as a class fails to accept the plan, a court must be satisfied that the dissenter will receive property under the plan worth an amount equal to full satisfaction of its claim or an amount equal to its by-class ratable portion of the residual interest in the value of the firm after higher priority claims or interests are satisfied in full. Id. § 1129(b)(1)-(2). As a matter of bankruptcy parlance, this last condition alone is referred to as the absolute priority rule. Despite these creditor protections within the Bankruptcy Code (those described here as well as others that are not relevant), often the only one that bites is the absolute priority rule. If plan proponents are creative, and they often are, a plan can be proposed that includes a friendly impaired class, one that will approve the plan despite objection from another impaired class. (To satisfy § 1129(a)(10), the friendly class need not have the same priority as the dissenter class.) Similarly, the rights of an individual dissenter within an accepting class may prove no obstacle even to an otherwise objectionable plan if the debtor's piecemeal value - the hypothetical benchmark under § 1129(a)(7) - is low compared to the debtor's going-concern value. Only a class - not an individual within a class - may insist on absolute priority to the full extent of the debtor's going-concern value.
34. We assume here and hereafter that negotiation costs are positive and significant despite the theoretical prospect of a unique equilibrium bargain that would be reached instantaneously and would thus be costless. See Ariel Rubinstein, Perfect Equilibrium in a Bargaining Model, 50 ECONOMETRICA 97 (1982) (hypothesizing such a unique bargaining solution). When information is asymmetric, which may be common, the instantaneous Rubinstein solution will not obtain, even by the terms of the Rubinstein model itself. Moreover, the Rubinstein solution is controversial even where information is perfectly symmetric.
35. See Robert Sugden, Rational Bargaining, in FOUNDATIONS OF DECISION THEORY 294, 308 (Michael Bacharach & Susan Hurley eds., 1991) (noting that the Rubinstein analysis can "show us what the uniquely rational solution to a bargaining game would be, were such a solution to exist. But we still have no proof that a uniquely rational solution exists."):
36. We assume here and hereafter that negotiation costs are positive and significant despite the theoretical prospect of a unique equilibrium bargain that would be reached instantaneously and would thus be costless. See Ariel Rubinstein, Perfect Equilibrium in a Bargaining Model, 50 ECONOMETRICA 97 (1982) (hypothesizing such a unique bargaining solution). When information is asymmetric, which may be common, the instantaneous Rubinstein solution will not obtain, even by the terms of the Rubinstein model itself. Moreover, the Rubinstein solution is controversial even where information is perfectly symmetric. cf. ALAN SCHWARTZ & JOEL WATSON, ECONOMIC AND LEGAL ASPECTS OF COSTLY RECONTRACTING (Yale Law Sch., Law & Econ. Working Paper No. 242, 2000) (describing potential benefits to costly contracting), available at http://papers.ssrn.com/paper.taf?abstract_id=224444. Theory aside, it is commonly believed that negotiation among constituents to an insolvent firm is costly. See supra note 21. cf. ALAN SCHWARTZ & JOEL WATSON, ECONOMIC AND LEGAL ASPECTS OF COSTLY RECONTRACTING (Yale Law Sch., Law & Econ. Working Paper No. 242, 2000) (describing potential benefits to costly contracting), available at http://papers.ssrn.com/paper.taf?abstract_id=224444. Theory aside, it is commonly believed that negotiation among constituents to an insolvent firm is costly. See supra note 21.
37. See infra Part VI (discussing the alternatives to bankruptcy reorganization).
38. See supra note 21. Note, moreover, that juniors' option to propose a reorganization plan, an option codified in 11 U.S.C. § 1121, can allow juniors to benefit systematically even from unbiased but variable judicial valuations. See Barry E. Adler, A Simple Game-Theoretic Solution to the Tension Between Cramdown and Holdup in Corporate Reorganization (Feb. 9, 2000) (unpublished manuscript, on file with author).
39. On the other hand, some analysts, particularly practitioners, believe that senior creditors, specifically secured creditors, take advantage of the reorganization process at the expense of juniors. See Samuel L. Bufford, What Is Right About Bankruptcy Law and Wrong About Its Critics, 72 WASH. U. L.Q. 829, 842 (1994). Suffice it to say here that there is reason to believe that the distribution of potential outcomes in each case is something other than unbiased results with absolute priority at its mean.
40. Bufford, supra note 25, at 841-42.
41. Id. at 836-38.
42. Id. at 843.
43. Id. at 846.
44. Id.
45. Id. at 842.
46. Robert M. Daines & Jon D. Hanson, The Corporate Law Paradox: The Case for Restructuring Corporate Law, 102 YALE L.J. 577, 622-24 (1992)
47. (reviewing FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW (1991)).
48. Id. at 622.
49. For a discussion of what equilibrium damages would be under a naive topping-off mechanism, see infra note 36 and accompanying text.
50. Cf. Janet Cooper Alexander, The Value of Bad News in Securities Class Actions, 41 UCLA L. REV. 1421, 1435 (1994) (discussing a similar circularity problem with regard to inferring damage from the price movement at the time of a corporate fraud).
51. A/2. In this equilibrium, the stock price would not move when Gates paid the damage amount because the market would have already capitalized both the award and the actual injury. It may be interesting to note that compensation for more than half of the plaintiffs injury could be accomplished by setting the plaintiffs recovery as a multiple of the difference between the pre-tort stock price and the post-tort stock price. For example, if that multiple were two, the judicially determined award would compensate the plaintiff corporation for two-thirds of its injury after a fall in the stock price that was equal to one-third of that injury. Indeed, as the multiplier increased, the undercompensation would approach zero. However, as the multiplier increases, the predicted drop in stock price also decreases, and the mechanism could become intolerably noisy -subject to market fluctuations unrelated to the tort injury - well before undercompensation became trivial.
52. It probably would be useful to use a beta-adjusted stock price. If the general stock market had gone up 10% since the tort and if the rival's stock had a beta of 1.2, then (ignoring dividends for the moment) Gates should be required to pay in money until the rival's stock price exceeds 112% of its price just before the tort was inflicted. See Daines & Hanson, supra note 32, at 624 n.219.
53. Imagine, for example, that Gates tortiously destroys 10% of his rival's business worth $1,000,000 prior to the injury and that the proposed remedy is for Gates to pour money into the rival firm until the rival's shares reach a trading price above $100 per share. Now assume that shortly after the remedy is announced, the value of the rival's assets unaffected by the tort decline in value by $200,000. If no other changes take place, and the shareholders do not withhold their shares strategically, Gates will pay a total of $300,000 in damages before the share price exceeds $100 even though he caused only $100,000 of injury. Conversely, if the rival's unaffected assets appreciated, rather than depreciated, by $200,000, Gates might then pay no damages before the share price exceeds $100, but if each event is equally likely his expected liability would be excessive as (0.5)($300,000) + (0.5)($0) = $150,000, an amount greater than the $100,000 injury.
54. Carving out separately traded rights represents another way of solving the circularity problem. Under a "carve-out" solution, shareholders of the target corporation, or shareholders of the rival corporation in the Microsoft example, would be given separately tradeable rights that would receive the proceeds of any litigation payment. Carving out separately tradeable rights destroys the circularity problem because the price of the stock itself would no longer reflect the expected value of litigation. As a result, to continue with the Microsoft illustration, the share price of the Gates rival would immediately fall to $90. This fall of $10 would at once establish the value of the tradeable compensation rights at that amount. Carve-out rights are increasingly being seen in real-world transactions. For example, in the 1994 battle for Paramount, Viacom gained its ultimate advantage over rival bidder QVC by including in its bid a so-called contingent value right. Stephen Fraidin & Jon D. Hanson, Toward Unlocking Lockups, 103 YALE L.J. 1739, 1833 n.372 (1994).
55. For a description of the device employed by Viacom, and how it came to be, see John Cassidy, Paramount Victory Leaves Viacom Exposed, TIMES (London), Feb. 20, 1994, § 3, at 5;
56. Carving out separately traded rights represents another way of solving the circularity problem. Under a "carve-out" solution, shareholders of the target corporation, or shareholders of the rival corporation in the Microsoft example, would be given separately tradeable rights that would receive the proceeds of any litigation payment. Carving out separately tradeable rights destroys the circularity problem because the price of the stock itself would no longer reflect the expected value of litigation. As a result, to continue with the Microsoft illustration, the share price of the Gates rival would immediately fall to $90. This fall of $10 would at once establish the value of the tradeable compensation rights at that amount. Carve-out rights are increasingly being seen in real-world transactions. For example, in the 1994 battle for Paramount, Viacom gained its ultimate advantage over rival bidder QVC by including in its bid a so-called contingent value right. Stephen Fraidin & Jon D. Hanson, Toward Unlocking Lockups, 103 YALE L.J. 1739, 1833 n.372 (1994). and John Greenwald, The Deal That Forced Dilier To Fold, TIME, Feb. 28, 1994, at 50. As with the passivity pill, a would-be management team promised to compensate shareholders if the future share price was less than a certain amount. But instead of being structured so that payments would be made to the corporation until the stock price exceeded a particular amount, the contingent value rights were carved out and obligated the payor to pay the simple shortfall between the stock price and the guaranteed amount (within certain limits). Litigation carve-outs are also being traded with regard to some claims by savings and loan institutions (S&Ls) regarding the federal government's potential liability under United States v. Winstar Corp., 518 U.S. 839 (1996). In Winstar, the United States Supreme Court found that the federal government, by enacting the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), Pub. L. No. 101-73, 103 Stat. 183 (codified in scattered sections of 42 U.S.C.), had breached certain contracts with S&Ls that had agreed to take over failing S&L counterparts and remanded the case for a consideration of damages. Winstar, 518 U.S. at 910. There are now over 100 Winstar-related cases. In the first case calculating damages for a single bank, the court awarded damages of more than $900 million. Glendale Fed. Bank, FSB v. United States, 43 Fed. Cl. 390, 410 (1999). The substantial size of potential damages has led some plaintiffs to spin off their claims against the government as separate assets. and John Greenwald, The Deal That Forced Dilier To Fold, TIME, Feb. 28, 1994, at 50. As with the passivity pill, a would-be management team promised to compensate shareholders if the future share price was less than a certain amount. But instead of being structured so that payments would be made to the corporation until the stock price exceeded a particular amount, the contingent value rights were carved out and obligated the payor to pay the simple shortfall between the stock price and the guaranteed amount (within certain limits). Litigation carve-outs are also being traded with regard to some claims by savings and loan institutions (S&Ls) regarding the federal government's potential liability under United States v. Winstar Corp., 518 U.S. 839 (1996). In Winstar, the United States Supreme Court found that the federal government, by enacting the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), Pub. L. No. 101-73, 103 Stat. 183 (codified in scattered sections of 42 U.S.C.), had breached certain contracts with S&Ls that had agreed to take over failing S&L counterparts and remanded the case for a consideration of damages. Winstar, 518 U.S. at 910. There are now over 100 Winstar-related cases. In the first case calculating damages for a single bank, the court awarded damages of more than $900 million. Glendale Fed. Bank, FSB v. United States, 43 Fed. Cl. 390, 410 (1999). The substantial size of potential damages has led some plaintiffs to spin off their claims against the government as separate assets. See Leonard Bierman et al., On the Wealth Effects of the Supervisory Goodwill Controversy, 22 J. FIN. RES. 69, 71 (1999).
57. Carving out separately traded rights represents another way of solving the circularity problem. Under a "carve-out" solution, shareholders of the target corporation, or shareholders of the rival corporation in the Microsoft example, would be given separately tradeable rights that would receive the proceeds of any litigation payment. Carving out separately tradeable rights destroys the circularity problem because the price of the stock itself would no longer reflect the expected value of litigation. As a result, to continue with the Microsoft illustration, the share price of the Gates rival would immediately fall to $90. This fall of $10 would at once establish the value of the tradeable compensation rights at that amount. Carve-out rights are increasingly being seen in real-world transactions. For example, in the 1994 battle for Paramount, Viacom gained its ultimate advantage over rival bidder QVC by including in its bid a so-called contingent value right. Stephen Fraidin & Jon D. Hanson, Toward Unlocking Lockups, 103 YALE L.J. 1739, 1833 n.372 (1994). For a description of the device employed by Viacom, and how it came to be, see John Cassidy, Paramount Victory Leaves Viacom Exposed, TIMES (London), Feb. 20, 1994, § 3, at 5; See Leonard Bierman et al., On the Wealth Effects of the Supervisory Goodwill Controversy, 22 J. FIN. RES. 69, 71 (1999). See Leonard Bierman et al., On the Wealth Effects of the Supervisory Goodwill Controversy, 22 J. FIN. RES. 69, 71 (1999).
58. We note that the Article is awash with liquid metaphors. Cf. Samuel Issacharoff & Pamela S. Karlan, The Hydraulics of Campaign Finance Reform, 77 TEX. L. REV. 1705, 1705 (1999).
59. But it would also be at least theoretically possible to use a carve-out mechanism for valuing firms in bankruptcy. Imagine again that senior claimants represent that the reorganized firm is worth less than their outstanding debt, while juniors claim the firm is worth more than the outstanding senior debt. Under a carve-out mechanism, senior creditors would be given 100% of the new stock in the reorganized firm. More generally, senior claimants would be given the initial choice of how to divide the stock in the reorganized firm. For example, if senior creditors (who were owed $100) represented that the reorganized firm would be worth $120, they would be given five-sixths of the new stock and junior claimants would be given the remaining one-sixth. Senior claimants would then have a separately tradeable duty to pay junior claimants for any amount by which the total value of their stock exceeded $100 when the stock was initially traded. That is, senior claimants would receive an independent obligation (a potential liability, not an asset) to pay junior claimants any amount by which the total reorganized stock value exceeded $100 as soon as the reorganized stock initially traded. Given the high volatility that sometimes accompanies the initial trading of a new security, see Royce de R. Barondes, Adequacy of Disclosure of Restrictions on Flipping IPO Securities, 74 TUL. L. REV. 883, 884 (2000), it might be prudent to have the carve-out liability amount turn on the stock price that prevails after a few days of trading.
60. As in the Microsoft illustration above, one might worry about market manipulation. Imagine, for example, that even though the reorganized firm is worth $150, the senior claimants have chosen to take all of the stock in the reorganized firm and the independent compensation liability. Senior claimants would have an incentive to depress the price of the reorganized firm's stock when it goes public so as to limit the amount of compensation they have to pay junior claimants. But to lower the stock price, they will have to stand ready to sell stock to all comers who demand stock at an artificially depressed price. Junior claimants can protect themselves from such shenanigans by making firm offers to buy at depressed prices. Conversely, senior claimants can protect themselves from junior claimants' strategic incentive to inflate the initial stock price artificially by simply offering to sell all of their shares at the inflated price. As in the Microsoft illustration, manipulation would be more difficult the more homogeneous (and the more vigilant) the investors. The risk of manipulation aside, the initial stock price should be the amount at which supply equals demand - and so the carve-out method (like the fixed-priced auction method) gauges the price that fully compensates junior claimants. While bankruptcy carve-outs are of theoretical interest, we focus on the dilution implementation, because it does not suffer from risk of manipulation, presents fewer difficulties than carve-outs in assuring that individual liability obligations of senior claimants would in fact be paid, and does not require an overhaul of current bankruptcy law. The mechanism could require that senior claimants post a bond in the amount of the liability before they could trade the associated shares. But such a mechanism could prove cumbersome and, in essence, a tax on liquidity. For a general discussion of the difficulty of implementing a regime of personal liability associated with publicly traded shares, see Janet Cooper Alexander, Unlimited Shareholder Liability Through a Procedural Lens, 106 HARV. L. REV. 387 (1992).
61. As noted in the Introduction, the process that can best accomplish an integration with current bankruptcy law is a "junior dilution" mechanism, through which junior claims are diluted until absolute priority is achieved. Rather than describe junior dilution now, however, we take a slightly simpler course and first describe the essentially identical, but inverted, "senior dilution" mechanism, through which senior claims are diluted until absolute priority is achieved. (The relative simplicity of senior dilution stems from the ease with which the process terminates when the junior claims are entitled to nothing. Senior dilution, moreover, is easier to compare with other market-based proposals discussed later in this Article.) A full explanation of junior dilution follows in Part V.
62. The assumption that the capital structure of the reorganized firm will be all stock is merely for the ease of illustration. In practice, the new capital structure could have any combination of debt or equity as would be efficient. Shares of the company to be divided among the holders of pre-bankruptcy claims or interests would simply be vertical-priority shares of the new capital structure. So, for example, in a firm that emerged from bankruptcy with $100 in debt and 100 equity shares, a pre-bankruptcy creditor entitled to 10% of the debtor would receive $10 in debt and 10 equity shares. See infra note 51.
63. Bidding schedules are also submitted as part of share auctions. See Robert Wilson, Auctions of Shares, 93 Q.J. ECON. 675, 680 (1979).
64. When junior claimants are illiquid, however, we show that they may offer to buy more shares as the amount of dilution increases, because pledging prospective dilution shares may relax the liquidity constraint. See infra Section IV.C.
65. We later discuss the possibility of third parties offering to "sell short" shares in the reorganized firm. See infra Subsection IV.A.3.
66. If supply is greater than demand at the equilibrium level of dilution, a proportionate amount of all offers to sell would be executed. Details of the market clearing are discussed below in Section III.C.
67. Even if the juniors submitted a bidding schedule with the maximum offer to buy (100 shares) when dilution was nil, the court would find that supply was equal to or less than demand without dilution and, hence, under the mechanism would issue zero shares free of charge to the junior claimants and would execute the 100 shares initially issued to the seniors to the juniors at $1 per share.
68. Of course, junior claimants will be able to buy only if they have sufficient liquidity. When junior claimants are liquidity-constrained, dilution mechanisms may produce equilibria that do not comport with absolute priority. We show, however, that there are several factors that work to ameliorate the problem of junior illiquidity. See infra Section IV.C.
69. In this respect, the mechanism also resembles devices used by shareholders in small businesses who need to resolve deadlocked situations. For example, a shareholder agreement could allow one shareholder to pick a price and the other to buy or sell at that price. For a more general account of information-forcing valuation mechanisms, see Saul Levmore, Self-Assessed Valuation Systems for Tort and Other Law, 68 VA. L. REV. 771 (1982) (describing self-enforcing valuation schemes in other contexts).
70. Without loss of generality, one might alternatively assume any mixture of debt and equity instruments. In that case, instead of distributing common stock in the reorganized firm, the court would distribute pro-rata combinations of separately tradeable securities. For example, if it were determined that the firm would be more valuable with 50% common stock, 30% preferred stock, and 20% bonds, then instead of issuing, for example, 10% of the equity to Junior, the court would issue to Junior 10% of each type of security (10% of the stock, 10% of the preferred shares, and 10% of the bonds). See supra note 43; see also Bebchuk, supra note 6, at 781-82 (discussing a similar example). It is possible that the value of the firm will turn not only on the mixture of security types that are issued but also on the identities of owners of particular security types. HENRY HANSMANN, THE OWNERSHIP OF ENTERPRISE 68 (1996). We will return to this issue in Part VI as we discuss the relative advantages and disadvantages of different market-harnessing devices.
71. J. This does not represent a significant shortcoming for our mechanism, however, as it is often relatively simple to value assets in isolation, while it is difficult to value assets grouped as part of a going concern. See Adler, supra note 7, at 446-47; see also Bebchuk, supra note 6 (proposing the use of options to value corporations in bankruptcy). While our mechanism offers no mitigation of a small problem (collateral valuation), it does contribute substantially to the solution of a larger one (firm valuation). Moreover, our mechanism could be modified, or, more accurately, appended to alternative means of determining the value of collateral. For example, Adler proposes that a debtor undergoing reorganization might be empowered to make a take-it-or-leave-it offer for collateral that the debtor hoped to obtain. Adler, supra note 25. If that offer were accepted, the debtor's promise to pay the purchase price could become a priority obligation of the reorganized debtor. The dilution mechanism could then be applied between the equity class and the junior claims class or between junior and senior claims classes if different plenary priorities of claims remained after disposition of the collateral. Similarly, Bebchuk and Fried propose that a debtor undergoing reorganization issue nonrecourse notes against the debtor's collateral, with the proceeds to the secured creditors, and with the debtor to redeem the notes in exchange for the collateral. Lucian Arye Bebchuk & Jesse M. Fried, A New Approach to Valuing Secured Claims in Bankruptcy, 114 HARV. L. REV. 2386 (2001). The dilution mechanism could proceed from that point in the same manner as it would after the collateral valuation process that Adler proposes. In either case, the new obligations owed to the holders of secured claims would take their own priority class, above all unsecured obligations. As described in Subsection IV.A.2, the dilution mechanism can function with any number of priority classes.
72. This two-player model would not change if there were only one class of debt and the court could not verify that the firm was insolvent. In that case, the mechanism modeled would divide value between a creditor and an equity shareholder. We chose to describe the debtor as demonstrably insolvent merely because it may be convenient for some to think of a debtor in bankruptcy as insolvent. When we expand the model in Subsection IV.A.2 to cover multiple priority classes, it should become apparent that nothing turns on this assumption.
73. For now, we assume that Junior has sufficient dollars to place in escrow when submitting its bidding schedule to ensure that the court can automatically execute its conditional offers. Cf. Robert H. Gertner & Geoffrey P. Miller, Settlement Escrows, 24 J. LEGAL STUD. 87, 91 (1995) (discussing an analogous mechanism of self-executing offers). Below we discuss the important issue of whether Junior has sufficient liquidity to buy. See infra Section IV.C.
74. S].
75. AP, because at this amount of dilution it would be buying or selling stock that is intrinsically worth $1 per share.
76. Simply put, a "Nash equilibrium" exists at a position in which no player in a game has an incentive to change her strategy given the strategies of the other players.
77. S for all D. As discussed below, see infra text accompanying note 59, this alternative equilibrium also implements the absolute priority rule.
78. S shares. FIGURE 2. SET OF NASH EQUILIBRIA UNDER THE DILUTION MECHANISM (figure presented)
79. In some games, the stability of an equilibrium turns crucially on the rationality of each player being common knowledge. See Ian Ayres & Barry J. Nalebuff. Common Knowledge as a Barrier to Negotiation, 44 UCLA L. REV. 1631, 1640 (1997).
80. For an example of a disequilibrium that occurs from strategies that are not dominated, consider a game in which A and B get to divide $1 but only if each simultaneously submits the same distribution scheme. Otherwise, neither gets anything. A and B might each claim $0.90 in the hope that the other will anticipate its greed and claim only $0.10.
81. S by offering short sales of shares. In thin markets, however, it is unlikely that short sales would be feasible.
82. S, B(D*)] in which the offers to purchase are fulfilled on a pro-rata basis when B* < B(D*). Offers to sell by multiple seniors are also fulfilled on a pro-rata basis when S(D*) > B*.
83. 21 and Junior would be able to sell and buy some number of shares arbitrarily close to their indifference point of D = 20.
84. See infra text accompanying note 73.
85. See infra Section IV.C.
86. Instead, we could have as easily defined a senior class of creditors, a junior class of creditors, and an equity class. See supra note 53.
87. Under current practice, bankruptcy reorganization may bypass an intermediate class of creditor claims or equity interests while awarding property to more senior and more junior classes, all arguably consistent with absolute priority. Imagine, for example, that a debtor subject to $100 in senior debt and $100 in junior debt is worth $100 if reorganized with the participation of pre-bankruptcy shareholders, who are also managers with specialized human capital, but worth only $50 without such participation. A consensual reorganization plan might provide the senior creditor an interest worth $80, the junior creditor an interest worth $5 (to obtain the junior's consent), and the shareholders an interest worth $15. This plan might seem a breach of absolute priority because the junior claims are not paid in full while shareholders receive property under the plan (indeed, more than the junior creditor). In fact, however, the plan represents a compromise among the classes of claims and interests, primarily between the senior creditor, who is entitled to the entire value of the firm absent the shareholders' participation, and the shareholders, who are not obligated to participate. The Bankruptcy Code permits the confirmation of such a plan as part of the bankruptcy reorganization process. 11 U.S.C. § 1129 (1994); see also supra note 22 (describing the process). The dilution mechanism we propose in this Article makes no provision for such an arrangement among the classes. Under our mechanism, the shareholders would not expect to receive any continuing interest in the reorganized debtor unless both the senior creditor and the junior creditor are paid in full, an event that will not occur in this example. But this is not necessarily a shortcoming of our mechanism. Current bankruptcy reorganization combines a structured negotiation process among classes, as illustrated in the prior paragraph, with a valuation device when such negotiation fails. Our dilution mechanism is meant as a substitute for the latter only. Indeed, the plan described in the prior paragraph can be confirmed in current practice only if the junior creditor consents to the shareholders' continuing interest. With such consent, no judicial valuation is necessary, and the dilution mechanism similarly would be unnecessary. Absent such consent, moreover, either current bankruptcy practice (to the extent it honors absolute priority) or the dilution mechanism would operate to award the entire interest in the debtor to the senior creditor. In either case, the senior creditor might be able to strike a subsequent side deal with the former shareholders for their continuing participation. (The results would be similar if the debtor were worth less than the amount of the senior claim without shareholder participation but between the amount of the senior claim and the total debt obligation with shareholder participation.) Part V further discusses how a dilution mechanism can substitute narrowly for the judicial valuation component of current bankruptcy reorganization practice.
88. S). Short sale offers when there are multiple sellers might be undertaken for strategic reasons, but because of free-riding, short sales are more likely to represent sincere beliefs about the relative value of the firm.
89. This self-protection attribute of the dilution mechanism is also an attribute of Bebchuk's option approach and was originally (and insightfully) formulated by Bebchuk. See Bebchuk, supra note 6, at 788-97. Eric Talley pointed out that this self-protection attribute might need to be modified in circumstances where one claimant's valuation might be affected by its beliefs about other claimants' valuations. For example, if a junior and a senior claimant's valuations are imperfectly - but positively - correlated, then the junior claimant's willingness to buy might be a function of the senior claimant's willingness to sell. If the players under the dilution mechanism have to submit bidding schedules simultaneously, a junior may, because of the "winner's curse" effect, shade down its demand. But of course, just as the junior may be less willing to buy if the senior is willing to sell, the senior may be less willing to sell if the junior is willing to buy, and the senior will similarly adjust its bidding schedule. Just as winner's curse corrections under standard auction assumptions yield sale prices that are an unbiased estimate of underlying value, we believe it plausible to assume that the dilution process would yield results that are an unbiased estimate of absolute priority.
90. S, which proves that for any level of dilution, a junior claimant only needs to offer to buy its proportionate share of the senior shares in order to protect itself. Moreover, the dilution mechanism could both permit each junior to bid for more than its prorata share and require continuous bidding schedules that could be arbitrarily steep. This combination would permit juniors who value the debtor's shares more than others to purchase more of those shares. See supra note 64.
91. J), then nonstrategic bidding would induce (1) the senior claimant to offer to sell nothing until D = 40, and (2) the junior claimant to offer to buy all of the senior shares until D = 20. Such nonstrategic bidding would be favorable to the senior, with D* = 20 and B* = 0. But a junior claimant knowing (or even having imperfect information) that the senior claimant had a higher valuation might be tempted to increase its offers to buy for 20 < D < 40, in hopes of inflating the equilibrium amount of D toward 40 (and the senior claimant, foreseeing this, might inflate its offers to sell in hopes of keeping the equilibrium amount of D down toward 20). When the senior claimant values the firm more than the junior claimant, there is a kind of surplus value over which the parties can haggle, because by the junior claimant's lights its absolute priority share of the firm is smaller than the amount it is due by the senior claimant's lights. But as stressed in the text, there cannot be an equilibrium at which any claimant accepts a lower expected payoff than the amount consistent with absolute priority that it could have assured itself by unilateral action.
92. See supra text accompanying note 65.
93. This modification would most likely be implemented together with the earlier-discussed requirement of submitting continuous bidding schedules. See supra note 64. Requiring continuity would prevent a strategic bidder from avoiding equal bidding amounts by submitting idiosyncratic and discontinuous bids for higher dilution levels.
94. As explained in the next Subsection, free-riding by multiple senior claimants may restrict their ability to make strategic offers to sell some of their shares when the dilution amount is low.
95. See supra note 64.
96. Both players offering to sell all their shares when D = 0 would not be a Nash equilibrium because neither of the players' bids would be pivotal. If one senior claimant believed that the other was going to offer all fifty of its shares, the first senior claimant would do better to reduce its offer to zero.
97. Any mixed strategy equilibrium would be dominated by a pure strategy equilibrium. We therefore ignore mixed strategies.
98. Constraining the equilibrium level of dilution to discontinuous amounts reduces the players' strategy space to a two-dimensional vector (instead of a continuous function of the dilution amount). This assumption is somewhat analogous to baseball arbitration in which the disputants submit discontinuous alternative offers, and the arbitrator picks one or the other. As in baseball, arbitration that gives the court a dichotomous and discontinuous choice may further serve to discipline the senior claimants' bidding. See Amy Farmer & Paul Pecorino, Bargaining with Informative Offers: An Analysis of Final-Offer Arbitration, 27 J. LEGAL STUD. 415, 415-16 (1998). But as noted above, see supra note 64, discontinuous bidding schedules may have the detriment of undermining the self-protection benefit when claimants have heterogeneous valuations.
99. The junior claimant on average will have $50 to bid when D = 0. It will thus buy on average fifty shares worth $2 per share for a price of $1 per share - earning an expected value of $50 (= 50 × ($2 - $1)). The senior claimants must then on average earn the residual value of the firm, $150 (= $200 - $50).
100. 2 = 0.
101. The beneficial effects of senior free-riding are, however, contingent on the senior claimants being sufficiently numerous. In many bankruptcies, the claims of at least some senior classes will be relatively concentrated in the
102. For this to be an equilibrium, the junior claimants' bidding schedules would have to offer to buy a positive number of shares (say, forty) for all levels of dilution less than twenty.
103. Senior claimants might effectively acquiesce in junior control under alternative mechanisms by accepting nonvoting shares or debt claims in the reorganized firm.
104. The senior claimants end up owning sixty percent of a firm worth $110 as well as $40 earned by selling some of their initial shares (0.6 × $110 + $40 = $106); the junior claimants end up owning forty percent of a firm worth $110, but had to pay $40 for these shares (0.4 × $110 - $40 = $4).
105. The senior claimants end up owning half the shares in a firm worth $150 and receive an additional $40 for selling some of their initial shares, providing them with $115 (= $75 + $40). The junior claimants end up owning half the shares in a firm worth $150, but had to pay $40 for this privilege, providing them with $35 (= $75 - $40).
106. See supra text accompanying notes 16-19.
107. Under bankruptcy law, a secured claim would become a senior claim for our purposes based on judicial valuation of collateral under section 506(a) of the Bankruptcy Code, 11 U.S.C. § 506(a) (1994), a relatively simple process as compared with the valuation of a going concern. See supra note 51.
108. Of course, if the reorganized firm is worth less than the amount owed to senior claimants, no interest rate may be high enough to provide seniors payment in full.
109. Section 1129(b) contains additional requirements for confirmation, none of which are particularly relevant to this discussion. 11 U.S.C. § 1129(b) (1994).
110. 85 B.R. 160 (Bankr. M.D. Fla. 1988).
111. Id. at 162.
112. See supra notes 25-31 and accompanying text.
113. We use the term "junior interest" here because, in this Part, we introduce the use of a dilution mechanism that includes equity holders. In our above discussion of senior dilution, we limited our examples to senior and junior creditor classes, and thus referred to "junior claims." In bankruptcy parlance, a "claim" refers to a debt obligation, while an "interest" refers to a shareholder's rights. Nomenclature aside, however, the distinction is unimportant, and either senior or junior dilution works with classes of claims or interests. Thus, throughout this Article, in our discussion of either junior or senior dilution, the reader may treat "junior claims" and "junior interests" as interchangeable.
114. See Baird & Rasmussen, supra note 11.
115. See 11 U.S.C. § 105(a) (1994) ("The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.").
116. A fixed-price auction could also be implemented by varying other aspects of the bonds auctioned. For example, bidders might be asked how many bonds they would want to buy or sell at $100 apiece when the amount of assets securing the bonds was varied.
117. More formally, under a junior dilution model, the court after aggregating the bidding schedules would confirm the plan with an equilibrium rate of interest I* equaling: I* = arg min B(I) ≥ S(I) I and simultaneously would execute the sale of S(I*) debt securities from seniors to juniors.
118. AP. In any case, the real world fact of heterogeneous value estimations makes precise ties that yield utter indifference as unlikely as balancing a pea on the edge of a knife.
119. Even when the reorganized firm is worth more than the senior's absolute priority claim, there might not be an interest rate at which supply equals demand. For example, if excess leverage creates large agency costs, see Stuart C. Gilson et al., Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default, in BANKRUPTCY AND DISTRESSED RESTRUCTURINGS 77 (Edward I. Altman ed., 1993);
120. Joseph E. Stiglitz & Andrew Weiss, Credit Rationing in Markets with Imperfect Information, 71 AM. ECON. REV. 393, 393-94 (1981), then it is possible that a senior dilution mechanism of an all-equity firm would indicate that the firm was worth more than the senior's claim, while a junior dilution mechanism would fail to find a noninfinite level of dilution. But this problem is limited by the size of the agency costs, which in turn is limited by the amount of debt in a proposed reorganization.
121. (0.5 × $75 + 0.5 × $225) = $150. For this calculation and those that follow we ignore, for simplicity, both the passage of time and the role of investor risk aversion. No important result would change were we to relax these assumptions.
122. (0.5 × $75 + 0.5 × $125) = $100.
123. (0.5 × $75 + 0.5 × $105) = $90.
124. This description is somewhat impressionistic. For a more precise account, see supra note 22 and accompanying text.
125. This is not to say that the dilution mechanism could not work with multiple priority classes. It could. See supra Subsection IV.A.2. Although one could modify the junior dilution mechanism to address multiple priority classes, outside the context of current bankruptcy reorganization practice, discussed in the text, there would be no need to do so, as, freed from current practice, one could simply deploy senior dilution.
126. AP), and then to reduce their supply to zero. If the seniors perform on this agreement, the equilibrium interest rate is likely to be twice the absolute priority amount. But free-riding is now a real risk. Each senior should worry that the other will chisel on the collusive agreement by reducing its offer to sell at a lower interest rate. The senior who fails to chisel ends up selling all of its bonds at par and thus makes no excessive interest. As before, free-riding among a relatively small number of senior claimants might undermine the strategic incentive to inflate the aggregate supply schedule.
127. Indeed, the leveraging effect is even stronger at low levels of dilution with junior dilution than with the previously analyzed senior dilution depicted in Figures 3-4, supra Subsection IV.C.2. In the extreme, under a mechanism of junior dilution in which the juniors propose a reorganization plan with a zero interest rate, the juniors have for low levels of dilution (I close to zero) claims to almost all of the firm's assets (cash flow) to pledge as collateral for bank loans. Therefore, the leveraging effect is strongest at low levels of dilution (low I) under junior dilution, while the previous analysis suggested that the leveraging effect would be strongest at high levels of dilution (high D) under a senior dilution mechanism.
128. There may be no appropriate market test for a cramdown when neither plan proponents nor third parties can provide liquidity. See Adler, supra note 20, at 20.
129. A traditional auction of new debt with a fixed interest rate proposed by the plan proponents and a reservation price of $100 would not work as well as the fixed-price auction mechanism suggested here. Needless delay could result in a process that rejected a reorganization plan whenever an auction price of proposed compensation proved less than dissenting creditors' claims. Such a shortfall might be the result of insufficient value in the debtor, or it might be the result of a miscalculation by plan proponents. Thus the shortfall might or might not be eliminated by a subsequent auction of an enhanced compensation package. Rather than a process of repeated trial and error, a fixed-price auction with variable interest rates, as proposed here, allows for expedited results.
130. But see supra note 52 (discussing issues of collateral valuation).
131. See supra notes 21-23.
132. See supra note 52 (describing alternatives to judicial valuation of collateral).
133. Baird, supra note 4; Baird, supra note 15.
134. Roe, supra note 5.
135. Bebchuk, supra note 6; see also Aghion et al., supra note 15 (incorporating Bebchuk's options approach into a broader reorganization framework).
136. See supra notes 25-31 and accompanying text.
137. Douglas G. Baird, Bankruptcy's Uncontested Axioms, 108 YALE L.J. 573, 593 (1998).
138. Remember that in the junior dilution mechanism, third parties potentially offer to buy the debt of senior claimants if the interest rate on the debt exceeds the absolute priority inducing rate.
139. One might question whether the juniors' transaction costs of borrowing would be substantial in a thick market where, by hypothesis, information about the debtor is available to third parties. We do not contend that such costs would be as great as in a thin market, where borrower and lender might be locked in a bilateral negotiation. But even thick markets vary in their degrees of thickness, and information is never entirely free. Under our junior dilution mechanism, the market needs to value only a piece of the debtor - a debt obligation in our illustrations. In an auction of the entire debtor, the market (including any lender to the junior interest) would have to evaluate the entire firm. It may be less expensive to evaluate a fixed debt obligation than to evaluate the entire firm. Cf. Stewart C. Myers, The Capital Structure Puzzle, 39 J. FIN. RES. 575, 581-85 (1984) (describing the "pecking-order" theory of corporate finance).
140. Such manipulation would likely be fraudulent under both state and federal law. As the positive rate of crime attests, however, legal prohibitions do not deter all undesirable activity.
141. A principal function of debt is to prevent diversion of cash flow by those in control of a firm. See, e.g., Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AM. ECON. REV. 323, 324 (1986) (propounding the "control hypothesis" of debt creation).
142. This problem could be remedied if the slice were large enough to constitute control, but then, as discussed above, the bankruptcy court would lack the flexibility to concentrate control in the pre-bankruptcy juniors, as might be efficient.
143. Note that where external markets are viable, the control premium will reside somewhere within the junior interest even if that interest is atomized and no junior can afford to bid for any of the debt issued to the seniors.
144. AP, a court or other administrator of Roe's proposal could only guess at this value. (Establishment of an arbitrarily high interest rate in an attempt to capture the firm's entire value in the debt would not, in practice, solve the valuation problem, as such a firm would almost certainly emerge from bankruptcy with an unstable capital structure that would require further reorganization and a repetition of the same issue.) In other words, Roe's mechanism could reliably incorporate debt as a solution to the control-premium problem only if one already knew the answer to the question the mechanism is designed to address.
145. More generally, the dilution mechanism, like the Baird and Bebchuk proposals, gives a purchaser the incentive to account in a bid decision for the debtor's entire value, whether from a controlling or minority interest. The Roe proposal, in contrast, could establish an equilibrium valuation for the firm that excluded a portion of the value that purchasers of the slice sold would not expect to realize.
146. See supra Section III.C.
147. See supra Section IV.C.
148. While Bebchuk's mechanism does not allow juniors to leverage the value of dilution shares to ameliorate their potential illiquidity, either Bebchuk's or our mechanisms might send credible signals of value to lenders from the action of less liquidity-constrained actors. For example, Eric Talley pointed out to us that a claimant with intermediate priority might be able to signal the value of its claim by pointing to the willingness of less senior claimants to buy at particular levels of dilution.
149. We illustrated an example of this possibility in Figure 4, supra Subsection IV.C.2.
150. Cf. supra Section VI.A (discussing the possibility of this extra negotiation expense).
151. See supra text accompanying note 19.
152. The possibility that markets are imperfect, combined with the imperfection in negotiation and litigation under current reorganization law, leaves room for the possibility that investors would prefer to forgo any sort of valuation in the face of a debtor's financial distress, preferring instead to rely on ex ante predictions about, and agreements on the disposition of, a troubled firm's value. See Adler, Corporate Insolvency, supra note 15;
153. Adler, Financial and Political Theories, supra note 15;
154. The possibility that markets are imperfect, combined with the imperfection in negotiation and litigation under current reorganization law, leaves room for the possibility that investors would prefer to forgo any sort of valuation in the face of a debtor's financial distress, preferring instead to rely on ex ante predictions about, and agreements on the disposition of, a troubled firm's value. See Adler, Corporate Insolvency, supra note 15; cf. Michael C. Jensen, Takeovers: Their Causes and Consequences, J. ECON. PERSPECTIVES, Winter 1988, at 21, 31-32 (recommending a uniformly divided capital structure to avoid conflicts over valuation in the event of financial distress); Schwartz, supra note 8, at 237-41 (describing renegotiation-proof ex ante contracts). We confine ourselves here, however, to a comparison among ex post approaches, leaving for another day a comparison between ex ante and ex post insolvency regimes. cf. Michael C. Jensen, Takeovers: Their Causes and Consequences, J. ECON. PERSPECTIVES, Winter 1988, at 21, 31-32 (recommending a uniformly divided capital structure to avoid conflicts over valuation in the event of financial distress); Schwartz, supra note 8, at 237-41 (describing renegotiation-proof ex ante contracts). We confine ourselves here, however, to a comparison among ex post approaches, leaving for another day a comparison between ex ante and ex post insolvency regimes.
155. Bank of Am. Nat'l Trust & Sav. Ass'n v. 203 N. LaSalle St. P'ship, 526 U.S. 434 (1999).
156. See, e.g., Lynn M. LoPucki & William C. Whitford, Bargaining over Equity's Share in the Bankruptcy Reorganization of Large, Publicly Held Companies, 139 U. PA. L. REV. 125, 140-43 (1990).
157. See supra note 25.
158. N. Pac. Ry. Co. v. Boyd, 228 U.S. 482 (1913).