By Mark J. Roe (Harvard Law School) & Michael Simkovic (USC Gould School of Law)
Bankruptcy reformers advocate substituting relative priority for the prevailing absolute priority standard to promote a more consensual restructuring process. In deciding who does and does not get paid when there is not enough value to pay all creditors, bankruptcy’s prevailing absolute priority rule lines creditors up in rank-order, compensating highest ranking creditors in full before lower-ranking creditors get anything. By contrast, relative priority would account for the possibility that the firm could recover and become more valuable after the bankruptcy. Relative priority would compensate lower-ranking creditors for that chance of the debtor turning around, thereby reducing both their incentive to delay and seniors’ incentive to rush.
Relative priority has these and other potential advantages, but we here show that it would also introduce valuation difficulties. Valuation difficulties are important because under either priority rule, the parties always have some Coasean incentive to come to a deal that maximizes the total value of the firm, and then assess how the rule would split that value; indeed, we show that the absolute priority conflict structure that relative priority seeks to mitigate could readily re-emerge under relative priority.
Absolute priority requires point-estimate valuations of the enterprise, like valuing equity of a non-indebted enterprise. But relative priority would require judges, parties, and outside investors to make complex valuations needing additional information, because relative priority valuation requires that decisionmakers assess the chances of multiple future outcomes with substantial precision. Worse, the increased valuation uncertainty from relative priority’s added complexity would discourage quick settlement and full-firm sales. Indeed, in many instances relative priority would recreate the bargaining problems afflicting absolute priority. Relative priority would, moreover, work poorly with today’s population of large business bankruptcies, which increasingly are private firms, for which we show relative priority valuation would be particularly difficult. Today, financial professionals generally do not trade and offer for sale similar financial instruments: stock options requiring substantially similar valuation analyses exist for stable public firms, but rarely for distressed firms.
True, relative priority has other advantages over absolute priority. These advantages, however, must outweigh the costs we identify here: namely that relative priority entails greater valuation uncertainty for the parties, the courts, and outside investors, leads to more valuation conflict than absolute priority, and, in this dimension, would increase bankruptcy’s cost.
The article is forthcoming: Mark J. Roe & Michael Simkovic, Absolute Priority, Relative Priority, and Valuation Uncertainty in Bankruptcy, 173 U. Pa. L. Rev. __ (2025). Click here to read the full article.