A Dilution Mechanism for Valuing Corporations in Bankruptcy

Abstract:     
This article proposes a new mechanism for valuing firms in bankruptcy. Under the mechanism, a court would dilute the reorganized stock issued to senior claimants by issuing additional shares to junior claimants until there was no excess demand for the stock at a price that would implement absolute priority. This mechanism could also be adapted so that a court would issue additional debt to senior claimants until there was no excess supply of the debt at a price that would implement absolute priority. We show that the mechanism harnesses the private information of the claimants and of third parties to produce distributions consistent with absolute priority. The dilution mechanism can be superior to other information-harnessing devices (such as an option or auction approach) because it (i) is less susceptible to the problem of junior illiquidity than an option approach proposed by Lucian Bebchuk; (ii) is less susceptible to the problem of market manipulation and may better allocate control premia than a partial float proposal by Mark Roe; and (iii) may produce fewer transaction costs than a full auction approach proposed by Douglas Baird. Moreover, as a response to the Supreme Court's recent admonishment in LaSalle Street that bankruptcy courts employ market tests more often when creditors dissent to a reorganization plan, the dilution mechanism provides a uniquely workable solution within the current statutory framework.

Working Paper Series