Absolute Priority Rule Violations in Bankruptcy

by Stanley D. Longhofer of the Federal Reserve Bank of Cleveland, and
Charles T. Carlstrom of the Federal Reserve Bank of Cleveland

Q4 1995

Introduction: Any transaction involving a continuing relationship over time depends on a mechanism by which parties can commit themselves to some future behavior. This often involves writing con-tracts. In most cases, we depend on government to enforce these contracts through a court system. Indeed, one of government's most important roles in any economy is defining and enforcing private property rights. Since contracts are simply a means of transferring private property, the use of courts to enforce them has a certain logical appeal.

Loan agreements are one of the most common types of contracts in our economy. Lenders agree to invest in a business and the owners of that business agree to repay the loan, with interest, at some future date. If the borrower fails to repay the loan, his creditors may force him into bankruptcy and seize his assets. By definition, debt contracts require that creditors be paid before the firm's owners receive any value. In other words, creditors are assumed to have "priority" over a firm's equity holders.

This principle is known as the absolute priority rule (APR). Simply stated, this rule requires that the debtor receive no value from his assets until all of his creditors have been repaid in full. While this rule would seem quite simple to implement, it is routinely circumvented in practice. In fact, bankruptcy courts themselves play a major role in abrogating this feature of debt contracts. If private loan contracts are entered into voluntarily, why do courts allow (and even encourage) their terms to be violated on a regular basis? More important, what impact do these violations have on the cost of financial contracting and, hence, economic efficiency?

This article addresses these questions by analyzing the impact of APR violations on financial contracts. We begin in the next section by reviewing the magnitude of these violations and the frequency with which they occur. In section II, we develop a simple model to analyze the efficiency of APR violations. We complicate this model with several market frictions to show how the impact of these violations depends on which friction is present. Section proper role of bankruptcy law in enforcing these contracts. Section IV concludes.

Published in: Economic Review, Vol. 31, No. 4, (4th Quarter 1995), pp. 21-30.

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