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Absolute Priority Rule Violations and Risk Incentives for Financially Distressed Firms

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  • Allan C. Eberhart
  • Lemma W. Senbet
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    Abstract

    In a June 12, 1990 Wall Street Journal article entitled "Warning Flag: When a Firm's Stocks and Bonds Diverge," the stocks and bonds of companies such as Pan Am and TWA were cited as being clearly mispriced. How, the article asked, could Pan Am's stock be trading at $2.50 per share when its senior debt was only worth 30 to 40 cents on the dollar? A managing director of a mutual fund was quoted as stating the prices were "totally ridiculous," and he further remarked, "Either the bond is too cheap or the stock is too high." The article noted that, "At least in theory, if a company's creditors' can't be fully paid, its stock, which ranks lower among its financial obligations, is next to worthless." In other words, the absolute priority rule (APR) will be followed. The APR states that creditors should be fully compensated before shareholders receive any portion of the bankrupt firm's value.

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    Bibliographic Info

    Article provided by Financial Management Association in its journal Financial Management.

    Volume (Year): 22 (1993)
    Issue (Month): 3 (Fall)
    Pages:

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    Handle: RePEc:fma:fmanag:eberhardt93

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    Cited by:
    1. Lucian Arye Bebchuk, 2002. "Ex Ante Costs of Violating Absolute Priority in Bankruptcy," Journal of Finance, American Finance Association, vol. 57(1), pages 445-460, 02.
    2. Bertrand Chopard & Eric Langlais, 2009. "Défaut de paiement stratégique et loi sur les défaillances d’entreprises," EconomiX Working Papers 2009-10, University of Paris West - Nanterre la Défense, EconomiX.
    3. Régis Blazy & Bertrand Chopard & Agnès Fimayer & Jean-Daniel Guigou, 2007. "Financial versus Social Efficiency of Corporate Bankruptcy Law: the French Dilemma?," LSF Research Working Paper Series 07-02, Luxembourg School of Finance, University of Luxembourg.
    4. Stanley D. Longhofer, 1997. "Absolute priority rule violations, credit rationing, and efficiency," Working Paper 9710, Federal Reserve Bank of Cleveland.
    5. Longhofer, Stanley D., 1997. "Absolute Priority Rule Violations, Credit Rationing, and Efficiency," Journal of Financial Intermediation, Elsevier, vol. 6(3), pages 249-267, July.
    6. Bertrand Chopard, 2005. "« Ex post » vs « Ex ante » : le cas de l’économie du droit de la faillite," Revue d'Économie Financière, Programme National Persée, vol. 81(4), pages 291-303.
    7. Stanley D. Longhofer & Stephen R. Peters, 2000. "Protection for whom? creditor conflicts in bankruptcy," Working Paper 9909R, Federal Reserve Bank of Cleveland.
    8. Pyo, Unyong & Thompson, Howard E., 2007. "Bond prices in a debt priority structure with absolute priority rule deviation," The Quarterly Review of Economics and Finance, Elsevier, vol. 47(1), pages 113-134, March.
    9. Philippe Frouté, 2007. "Theoretical foundation for a debtor friendly bankruptcy law in favour of creditors," European Journal of Law and Economics, Springer, vol. 24(3), pages 201-214, December.
    10. Stanley D. Longhofer, 1994. "Bankruptcy rules and debt contracting: on the relative efficiency of absolute priority, proportionate priority, and first-come, first-served rules," Working Paper 9415, Federal Reserve Bank of Cleveland.
    11. Kenjiro Hori & Jorge Martin Ceron, 2014. "Agency Costs of Bail-in," Birkbeck Working Papers in Economics and Finance 1407, Birkbeck, Department of Economics, Mathematics & Statistics.
    12. Esty, Benjamin C., 1998. "The impact of contingent liability on commercial bank risk taking," Journal of Financial Economics, Elsevier, vol. 47(2), pages 189-218, February.
    13. Bertrand Chopard & Eric Langlais, 2009. "Défaut de paiement stratégique et loi sur les défaillances d’entreprises," Cahiers du CEREFIGE 0901, CEREFIGE (Centre Europeen de Recherche en Economie Financiere et Gestion des Entreprises), Universite de Lorraine, revised 2009.

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