Beyond Stakeholder Options in Bankruptcy

Much of the debate in bankruptcy scholarship today centers on the extent to which the law protects stakeholder options. In a new paper, “Beyond Options,” we argue that this focus is misplaced. Protecting options is neither necessary nor sufficient for advancing the goal of a well-functioning bankruptcy system. What is needed is a regime that cashes out the rights of junior stakeholders with minimal judicial involvement.

Modern bankruptcy scholarship adopts an options-based perspective, seeing options embedded in every layer of the firm’s capital structure and examining ways that current law redistributes value across stakeholders by modifying, creating, or destroying options. For example, because confirming a bankruptcy plan takes time and asset values are volatile, the value of the bankruptcy estate can change substantially between filing and plan confirmation. For junior stakeholders, this volatility creates a payoff profile identical to the payoffs from a call option. As with any option, the longer the time until the option expires (the delay from filing to confirmation), the greater the option value. Moreover, the firm’s value at confirmation is determined by a judge, not the market. The greater the variance in judicial valuation, the greater the option value created by a process that relies on that valuation.

These insights have prompted recent reevaluation of the absolute priority rule (APR), which forbids payouts of any kind to junior creditors when senior creditors have not been paid in full. Because the APR causes the expiration of all junior-creditor options, for example, it creates an incentive for junior creditors to agitate for a lengthier bankruptcy proceeding, especially a reorganization, which exposes the parties to greater judicial variance. For the same reason, the APR induces secured creditors to push for quick sales, even at fire-sale prices.

Recent scholarship has therefore advocated reforms that unwind these adverse effects. For example, scholars have advocated a return to “relative priority,” requiring senior lenders to buy out the options of junior lenders when seniors advocate a quick sale, or at least to compensate the junior lenders for the value of those options. The primary goal of a relative priority regime is to preserve, as much as possible, the options held by creditors outside bankruptcy. A bankruptcy filing would no longer represent a common expiration date for options. Instead, junior creditors and investors would retain options allowing them to capture future appreciation in firm value, if the debtor is reorganized. If the debtor is instead sold off, they might (depending on the specific proposal) retain the right to compensation for the value of these options, which are extinguished by the sale.

These proposals make sense if our primary concern is the APR and its degrading effect on the options of junior creditors. This concern, we argue here, is too narrow. It ignores the many other options that are altered by bankruptcy proceedings. For example, valuable real options held by senior creditors are impaired both by the bankruptcy code’s automatic stay and its lien stripping rules. Equally important, the focus on junior creditors’ options exalts options for options sake without considering whether or not protecting those options is necessary for advancing the goals of a well-functioning bankruptcy system.

To illustrate our general point, we develop an “automatic bankruptcy procedure” that gives senior creditors an option to restructure the firm’s debt or sell its assets at any time after a default, with or without a bankruptcy filing. If the option is exercised, the senior creditor must choose between two types of restructurings. One is to sell the firm’s assets free and clear of all interests but allow junior creditors and equity holders to demand an appraisal, which guarantees that they receive no less than they would have received from the going-concern value in a reorganization. Alternatively, the senior creditor can sell the firm subject to warrant-like instruments that are distributed to all creditors and equity holders who are not paid in full on the sale date. These instruments ensure that these junior stakeholders benefit from future appreciation in the value of the assets. The warrants would have a strike price equal to the face value of the senior claims and an expiration date set at somewhere around five or 10 years after the restructuring date.

Our proposal can be seen as an effort to design a formalized restructuring procedure that borrows from traditional state law governing corporate-control transactions. We show that this procedure minimizes core problems of current law—fire sales that harm junior stakeholders, delay that harms senior lenders, and the uncertainties generated by judicial valuation, which are exploited by all parties.

This post comes to us from Professor Anthony J. Casey of the University of Chicago Law School and Edward R. Morrison of Columbia Law School. It is based on their recent article, “Beyond Options,” which is available here.