Priority Contracts and Priority in Bankruptcy

Taxes, bankruptcy costs, transactions costs, adverse selection, and agency conflicts have all been advocated as major explanations for the corporate use of debt financing. These ideas have often been synthesized into the trade-off theory and the pecking order theory of leverage. These theories and the related evidence are reviewed in this survey. A number of important empirical stylized facts are identified. To understand the evidence, it is important to recognize the differences among private firms, small public firms and large public firms. Private firms seem to use retained earnings and bank debt heavily. Small public firms make active use of equity financing. Large public firms primarily use retained earnings and corporate bonds. The available evidence can be interpreted in several ways. Direct transaction costs and indirect bankruptcy costs appear to play important roles in a firm's choice of debt. The relative importance of the other factors remains open to debate. No currently available model appears capable of simultaneously accounting for all of the stylized facts.

SSRN Electronic Journal, 2000

We present a model that shows how interactions between creditor groups in bankruptcy can affect the debt issuance decisions of firms. In particular, we suggest that deviations from APR should be priced and can affect the issuing decisions of junior and senior debt. Our model suggests that once firms issue debt with one level of seniority, they may have an incentive to alternate, and subsequent issues may have a different seniority level. When we introduce explicit costs of conflict in our model, we find that as these costs increase, firms will tend to stay with one class of debt. The empirical implications of our model are consistent with the tendency of firms to alternate the seniority of debt issues, and with the somewhat surprising fact that some firms issue debt at one seniority level only, and quite a few of them never issue any senior debt.

Journal of Finance, 1979

THIS PAPER ARGUES THAT THE issuance of secured debt' can increase the total value of a firm, even in the absence of corporate taxes. To this author's knowledge this constitutes the first rigorous explanation of the widespread use of secured debt contracts? The paper also presents and utilizes a mathematically tractible multiperiod firm valuation model derived under the assumption that bankruptcy is possible. Finally the results provide several plausible conjectures about the effect of bankruptcy law on the private advantages of secured debt relative to financial leases. Previous studies [12, 6, 9, 14, 171 have shown that in taxless, frictionless markets where there is no possibility that the firm will go bankrupt, changes in its debt-equity ratio will not alter the total market value of its debt plus its equity. Even if bankruptcy can occur, Stiglitz [17] has shown that the irrelevance of debt policy will follow if the individual investor is permitted to purchase equity on

2002

The paper extends the contingent valuation framework of Black and Cox (1976) to value subordinated debt by explicitly incorporating bankruptcy costs in the model. I show that subordinated debt prices have "value added" relative to equity. In fact, the joint use of equity and subordinated debt prices can provide information on magnitude of expected bankruptcy costs. Knowing the magnitude of expected bankruptcy costs is necessary for calculating variables underlying policy objectives. In particular, it is illustrated that the value of expected liability of a deposit insurer would be underestimates if the bankruptcy costs were not taken into account.

Under U.S. Bankruptcy Code, equity holders can restructure different debt classes at a time. Recognizing this allows us to endogenize, in continuous time, not only the restructuring threshold but also the restructuring order of senior and junior classes. Unlike previous studies, sequential restructuring explains absolute priority violation (APV) not just among debt and equity but also among debt classes. The extent of APV leads to positive credit spreads even if senior creditors are fully secured and virtually immune to default risk. Moreover, sequential restructuring can lead to reversals in the credit spreads. We provide sufficient conditions for avoiding reversals.

2016

their comments on earlier drafts. 2 Depending on the jurisdiction, there are different understandings of the meaning of 'insolvency law'. This paper adopts the English version of the notion. Therefore, the term 'insolvency law' is used to refer to corporate practice, while the term 'bankruptcy law' is relegated to cases dealing to individuals. Occasionally, in direct quotations from other authors, this distinction may not be respected. 3 EC Communication "Towards the Completion of the Banking Union" Com (2015) 587. 4 "Five Presidents' Report" on "Completing Europe's Economic and Monetary Union", 22 June 2015. 5 Reference is made to the lack of an efficient distressed debt market, and to the small number of private and public asset management companies (AMCs).

Financial Management, 2003

The ubiquity of bank seniority is now a widely accepted fact in the academic literature. At the same time, trade creditors are sometimes granted a purchase money security interest in the materials or equipment they provide the firm. These two conflicting facts present a puzzle: Why would banks willingly give up a valuable priority claim on the firm, but only with respect to a subset of the firm's assets? We propose a resolution to this paradox of priority by arguing that trade creditors are better able to liquidate the materials they supply to a firm. When trade creditors have a security interest in these assets, their claims are state-contingent, and therefore dependent on the value of the assets pledged as collateral. Surprisingly, this ability of trade creditors to more efficiently liquidate the materials they supply to a firm also makes it desirable to subordinate the non-collateralized portion of their claims. Doing so increases the face value of a trade creditor's claim for a given level of borrowing, thereby increasing the "liquidation bang" from each trade credit buck. This combined priority structure maximizes social welfare by reducing the firm's overall cost of funding.

rapport nr.: Working Papers in Economics, 2001

The paper analyzes the mandatory subordinated debt proposals in banking. It theoretically investigates the role of subordinated debt as a buffer against losses for the deposit insurer, and its role in providing direct and indirect market discipline. The incorporation of bankruptcy cost in the framework of the analysis provides some new evidence to the potential role of subordinated debt. The extent of market discipline of subordinated debt critically depends on its relative magnitude to senior debt and the bankruptcy costs. Under specified conditions, the subordinated debt prices are found to provide additional information about the value of bank assets relative to equity prices. The issues of the credibility of the proposed subordinated debt schemes are also discussed. The results indicate the critical role of regulator's judgment in interpreting and acting upon the information from the subordinated debt prices.

Law and contemporary problems, 2018

According to the Oxford Dictionary, "equality" is the state of being equal. 1 This simple definition has been subject to an extensive debate. From the legal point of view, it is even an indeterminate concept. It requires a major creative effort by the interpreter, that is, the judge, when deciding whether a particular rule or situation can produce a damaging or undermining effect. 2 The equality principle has been historically undetermined because the valuation of aspects used to distinguish people or give preferential treatment have changed over time. This article examines whether, in our increasingly complex and interconnected financial world, the risk of a systemic economic collapse should justify changing fundamental concepts of commercial law such as the relative ranking and remedies of secured and unsecured creditors. For example, should systemically important secured parties have greater remedies against collateral, in order to protect themselves, than other secured parties? Should systemically important debtors have greater immunities against foreclosure than other debtors? In an attempt to answer these two main questions, this article analyzes two systemically important types of entities in distress. First, it analyzes the bankruptcy reorganizations of Chrysler LLC and General Motors Corporation, which were seen as systemically important corporations because their failure posed a significant risk to financial market stability. 3 As such, they received official financial assistance. In connection with