Absolute Priority Rule Violations, Credit Rationing, and Efficiency
by Stanley D. Longhofer of the Federal Reserve Bank of Cleveland
Abstract: Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely to occur, thereby making debt financing more costly. Together, these results support the view that APR violations create an impediment to efficient financial contracting.
Published in: Journal of Financial Intermediation, Vol. 6, No. 3, (July 1997), pp. 249-267.