Debtor Priority and Options in Bankruptcy: A Policy Intervention

Abstract

The priority structure of debt claims against business entities is a key feature of corporate finance. The American Bankruptcy Institute’s Commission to Study Reform of Chapter 11 recently recommended that U.S. bankruptcy law grant junior, out-of-the-money creditors a distribution in the reorganization or sale of the debtor. The distribution would reflect the possibility that the value of the debtor enterprise would increase in the three years following bankruptcy. This proposed priority reallocation in favor of junior creditors was at least partly inspired by a series of legal academic articles published over the past fifteen years. In this article, we first review the insights of earlier foundational scholarship regarding the benefits of hierarchical debt contracts and then critique the more recent articles that advocate for deviations from absolute priority, including through an extension of the implicit option held by junior creditors. We suggest that the parties themselves can contract for such adjustments under the limited circumstances in which this would be desirable.

Keywords: bankruptcy, corporate reorganization, corporate finance, debt priority

JEL Classification: G33; K22