On Deviating from Absolute Priority: The Case of Tort Claims and Active Creditors
- 1 Faculty of Business, Athabasca University, Athabasca, Canada
Abstract
The impact of deviating from absolute priority rule, a basic tenet of bankruptcy law that accords secured creditors a privileged position in bankruptcy distribution, has long been at the centre of research on bankruptcy. This paper develops a model of a firm that can cause an accident and then claim bankruptcy to investigate the ex ante effects of elevating tort claims a head of creditors. In the model, the firm (or its manager) controls an unobservable care (or effort) decision. The creditor not only provides the requisite capital, but also exercises control over the firm by virtue of its significant cash flow rights. Together managerial care and creditor control determine the distribution of the tortious harm. We find that according tort claims a privileged position relative to creditors leads to a shift away from managerial care and towards more creditor control. As a consequence, subordinating secured creditor has an ambiguous effect on the expected social welfare .
- Meckling, W.H. (1977) Financial Markets, Default, and Bankruptcy: The Role of the State. Law & Contemporay Problems, 13, 30-31.
- Couwenberg, O. and Lubben, S.J. (2013) Solving Creditor Problems in the Twilight Zone: Superfluous Law and Inadequate Private Solutions. International Review of Law and Economics, 34, 61-76.
- Elson, C.M. and Rasmussen, R.K. (2003) Switching Priorities: Elevating the Status of Tort Claims in Bankruptcy in Pursuit of Optimal Deterrence. Harvard Law Review, 116, 2541-2564. https://doi.org/10.2307/1342770
- Fisher, T.C.G., Martel, J. and Gavious, I. (2016) Tax Claims, Government Priority, Absolute Priority and the Resolution of Financial Distress. International Review of Law and Economics, 48, 50-58.
- Berkovitch, E., Israel, R. and Zender, J.F. (1997) An Optimal Bankruptcy Law and Firm Specific Investments. European Economic Review, 41, 487-497.
- Berkovitch, E., Israel, R. and Zender, J.F. (1998) The Design of Bankruptcy Law: A Case for Management Bias in Bankruptcy Reorganizations. Journal of Financial and Quantitative Analysis, 33, 441-464.
- Heinkel, R. and Zechner, J. (1993) Financial Distress and Optimal Capital Structure Adjustments. Journal of Economics & Management Strategy, 2, 531-565.
- Kalay, A. and Zender, J.F. (1997) Bankruptcy, Warrants, and State-Contingent Changes in the Ownership of Control. Journal of Financial Intermediation, 6, 347-379.
- Berkovitch, E. and Israel, R. (1998) The Bankruptcy Decision and Debt Contract Renegotiations. European Finance Review, 2, 1-27.
- Berkovitch, E. and Israel, R. (1999) Optimal Bankruptcy Law across Different Economic Systems. The Review of Financial Studies, 12, 347-377.
- Longhofer, S.D. (1997) Absolute Priority Rule Violations, Credit Rationing, and Efficiency. Journal of Financial Intermediation, 6, 249-267.
- Adler, B.E. (1992) Bankruptcy and Risk Allocation. Cornell Law Review, 77, 439-489.
- Schwartz, A. (1997) Contracting about Bankruptcy. Journal of Law, Economics, & Organization, 13, 127-146. https://doi.org/10.1093/oxfordjournals.jleo.a023376
- Bebchuk, L.A. (2002) Ex Ante Costs of Violating Absolute Priority in Bankruptcy. The Journal of Finance, 57, 445-460. https://doi.org/10.1111/1540-6261.00427
- Nini, G., Smith, D.C. and Sufi, A. (2012) Creditor Control Rights, Corporate Governance, and Firm Value. Review of Financial Studies, 25, 1713-1761. https://doi.org/10.1093/rfs/hhs007