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Ex Ante Costs of Violating Absolute Priority in Bankruptcy

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  • Bebchuk, Lucian Arye

Abstract

A basic question for the design of bankruptcy law concerns whether value should be divided in accordance with absolute priority. Research done in the past decade has suggested that deviations from absolute priority have beneficial ex ante effects. In contrast, this Paper shows that ex post deviations from absolute priority also have negative effects on ex ante decisions taken by shareholders. Such deviations aggravate the moral hazard problem with respect to project choice increasing the equityholders' incentive to favour risky projects as well as with respect to borrowing and dividend decisions.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2914.

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Date of creation: Aug 2001
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Handle: RePEc:cpr:ceprdp:2914

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Keywords: absolute priority; asset dilution; bankruptcy; chapter 11; claim dilution; corporate reorganizations; moral hazard; workouts;

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References

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  1. Berkovitch, Elazar & Israel, Ronen & Zender, Jaime F., 1997. "Optimal bankruptcy law and firm-specific investments," European Economic Review, Elsevier, vol. 41(3-5), pages 487-497, April.
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  7. Heinkel, Robert & Zechner, Josef, 1993. "Financial Distress and Optimal Capital Structure Adjustments," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 2(4), pages 531-65, Winter.
  8. Matthew Rhodes-Kropf & S. Viswanathan, 2000. "Corporate Reorganizations and Non-Cash Auctions," Journal of Finance, American Finance Association, vol. 55(4), pages 1807-1854, 08.
  9. David M. Cutler & Lawrence H. Summers, 1987. "The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil Litigation," NBER Working Papers 2418, National Bureau of Economic Research, Inc.
  10. Povel, Paul, 1999. "Optimal "Soft" or "Tough" Bankruptcy Procedures," Journal of Law, Economics and Organization, Oxford University Press, vol. 15(3), pages 659-84, October.
  11. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  12. Lucian Arye Bebchuk, 2000. "Using Options to Divide Value in Corporate Bankruptcy," NBER Working Papers 7614, National Bureau of Economic Research, Inc.
  13. Franks, Julian R. & Torous, Walter N., 1994. "A comparison of financial recontracting in distressed exchanges and chapter 11 reorganizations," Journal of Financial Economics, Elsevier, vol. 35(3), pages 349-370, June.
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  15. Giammarino, Ronald M, 1989. "The Resolution of Financial Distress," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 25-47.
  16. Lucian Arye Bebchuk, 1998. "Chapter 11," NBER Working Papers 6473, National Bureau of Economic Research, Inc.
  17. Michael C. Jensen, 1991. "Corporate Control And The Politics Of Finance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(2), pages 13-34.
  18. Gilson, Stuart C. & John, Kose & Lang, Larry H. P., 1990. "Troubled debt restructurings*1: An empirical study of private reorganization of firms in default," Journal of Financial Economics, Elsevier, vol. 27(2), pages 315-353, October.
  19. Lucian Arye Bebchuk & Howard F. Chang, 1991. "Bargaining and the Division of Value in Corporate Reorganization," NBER Technical Working Papers 0097, National Bureau of Economic Research, Inc.
  20. Bhattacharyya, Sugato & Singh, Rajdeep, 1999. "The resolution of bankruptcy by auction: allocating the residual right of design," Journal of Financial Economics, Elsevier, vol. 54(3), pages 269-294, December.
  21. Allan C. Eberhart & Lemma W. Senbet, 1993. "Absolute Priority Rule Violations and Risk Incentives for Financially Distressed Firms," Financial Management, Financial Management Association, vol. 22(3), Fall.
  22. Smith, Clifford Jr. & Warner, Jerold B., 1979. "On financial contracting : An analysis of bond covenants," Journal of Financial Economics, Elsevier, vol. 7(2), pages 117-161, June.
  23. White, Michelle J, 1989. "The Corporate Bankruptcy Decision," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 129-51, Spring.
  24. Berkovitch, Elazar & Israel, Ronen, 1999. "Optimal Bankruptcy Laws across Different Economic Systems," Review of Financial Studies, Society for Financial Studies, vol. 12(2), pages 347-77.
  25. Weiss, Lawrence A., 1990. "Bankruptcy resolution: Direct costs and violation of priority of claims," Journal of Financial Economics, Elsevier, vol. 27(2), pages 285-314, October.
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