Ex Ante Costs of Violating Absolute Priority in Bankruptcy

Authors

  • Lucian Arye Bebchuk

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    • William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance, Harvard Law School; Research Associate, National Bureau of Economic Research. An earlier version of this paper, entitled, “The Effects of Chapter 11 and Debt Renegotiation on Ex Ante Corporate Decisions,” was circulated as Discussion Paper No. 104, Program in Law and Economics, Harvard Law School. For their comments, I am grateful to Howard Chang, Milton Harris, Oliver Hart, Christine Jolls, Marcel Kahan, Louis Kaplow, Reinier Kraakman, Steve Shavell, Lars Stole, Rene Stulz, Michelle White, three anonymous referees, and participants in workshops at Chicago, Harvard, Michigan, and Tel Aviv for their helpful comments; and to the National Science Foundation and the Harvard John M. Olin Center for Law, Economics, and Business for their financial support.

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 favor risky projects-as well as with respect to borrowing and dividend decisions.

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