21

Absolute Priority Rule

Violations in Bankruptcy
by Stanley D. Longhofer and
Charles T. Carlstrom
Stanley D. Longhofer and Charles
T. Carlstrom are economists at the
Federal Reserve Bank of Cleveland.
Introduction
Any transacti on i nvolvi ng a conti nui ng relati on-
shi p over ti me dependson a mechani sm by
whi ch parti escan commi t themselvesto some
future behavi or. Thi soften i nvolveswri ti ng con-
tracts. I n most cases, we depend on govern-
ment to enforce these contractsthrough a court
system. I ndeed, one of governmentsmost i m-
portant rolesi n any economy i sdefi ni ng and
enforci ng pri vate property ri ghts. Si nce contracts
are si mply a meansof transferri ng pri vate prop-
erty, the use of courtsto enforce them hasa
certai n logi cal appeal.
Loan agreementsare one of the most com-
mon typesof contractsi n our economy. Lenders
agree to i nvest i n a busi nessand the ownersof
that busi nessagree to repay the loan, wi th i nter-
est, at some future date. I f the borrower fai lsto
repay the loan, hi scredi torsmay force hi m i nto
bankruptcy and sei ze hi sassets. By defi ni ti on,
debt contractsrequi re that credi torsbe pai d
before the fi rmsownersrecei ve any value. I n
other words, credi torsare assumed to have
pri ori ty over a fi rmsequi ty holders.
Thi spri nci ple i sknown asthe absolute pri or-
i ty rule ( APR) . Si mply stated, thi srule requi res
that the debtor recei ve no value from hi sassets
unti l all of hi scredi torshave been repai d i n
full.
1
Whi le thi srule would seem qui te si mple
to i mplement, i t i srouti nely ci rcumvented i n
practi ce. I n fact, bankruptcy courtsthemselves
play a major role i n abrogati ng thi sfeature of
debt contracts. I f pri vate loan contractsare
entered i nto voluntari ly, why do courtsallow
( and even encourage) thei r termsto be vi olated
on a regular basi s?More i mportant, what i mpact
do these vi olati onshave on the cost of fi nanci al
contracti ng and, hence, economi c effi ci ency?
Thi sarti cle addressesthese questi onsby
analyzi ng the i mpact of APR vi olati onson
fi nanci al contracts. We begi n i n the next secti on
by revi ewi ng the magni tude of these vi olati ons
and the frequency wi th whi ch they occur. I n
secti on I I , we develop a si mple model to ana-
lyze the effi ci ency of APR vi olati ons. We com-
pli cate thi smodel wi th several market fri cti ons
to show how the i mpact of these vi olati ons
dependson whi ch fri cti on i spresent. Secti on
I I I di scussesthe modelsi mpli cati onsfor the
proper role of bankruptcy law i n enforci ng
these contracts. Secti on I V concludes.
I 1 The APR al so states that seni or credi tors shoul d be pai d before
j uni or credi tors. In thi s paper, we consi der onl y APR vi ol ati ons between the
borrower and a (si ngl e) l ender.
22
I. The Prevalence
of APR Violations
A growi ng body of empi ri cal evi dence supports
the conclusi on that APR vi olati onsare common-
place both i n Chapter 11 reorgani zati onsand i n
i nformal workouts. Usi ng di fferent samplesof
large corporati onswi th publi cly traded securi -
ti es, numerousresearchershave found that
equi ty holdersrecei ve value from fi nanci ally
di stressed fi rmsi n vi olati on of the APR i n nearly
75 percent of all reorgani zati ons.
2
Thi sappears
to be true whether one looksat pri vate, i nfor-
mal workouts, conventi onal reorgani zati ons, or
prepackaged bankruptci es i n whi ch the detai ls
of the reorgani zati on are negoti ated before the
bankruptcy peti ti on hasbeen fi led.
The frequency wi th whi ch APR vi olati ons
occur mi ght be mi sleadi ng i f the magni tude of
these devi ati onsasa percentage of the fi rms
value were relati vely small. I ndeed, some com-
mentatorshave suggested that value pai d to
equi ty i ssi mply a token to speed up the process
and hasli ttle economi c si gni fi cance: Sharehold-
erswere tossed a bone, crumbsoff the table, to
get the deal done...
3
Exi sti ng evi dence, how-
ever, suggeststhat thi si snot generally the case.
Esti matesof the magni tude of APR vi olati onsi n
favor of equi ty vary, but i n reorgani zati onsi n
whi ch such vi olati onsoccur, equi ty holders
appear to recei ve between 4 and 10 percent of
the fi rmsvalue.
4
And although the evi dence i s
limited, some have suggested that these devia-
tionsare larger for small firmswhose owners
I 2 See Franks and Torous (1989), LoPucki and Whi tford (1990),
Wei ss (1990), Eberhart, Moore, and Roenfel dt (1990), and Betker (1995).
I 3 Quoted i n Wei ss (1990), p. 294.
I 4 See Eberhart, Moore, and Roenfel dt (1990), Franks and Torous
(1994), Tashj i an, Lease, and McConnel l (1996), and Betker (1995). Franks
and Torous note that the l arger devi ati ons found by Eberhart, Moore, and
Roenfel dt may be a consequence of the l atters ol der sampl e of di stressed
fi rms: Wi th the growth i n the market for di stressed debt securi ti es and the
greater i nvol vement of i nsti tuti onal i nvestors such as vul ture funds,
debthol ders may have i ncreased thei r bargai ni ng power at the expense of
equi ty hol ders (Franks and Torous [ 1994] , p. 364).
T A B L E 1
Empirical Research
on APR Violations
Article Data Dates Frequency Magnitude
Franksand Torous( 1989) 30 fi rmswi th publi cly traded 197084 66.67%
debt fi li ng for bankruptcy
LoPucki and Whi tford 43 fi rmswi th more than 197988 48.84%
( 1990) $100 mi lli on i n assetsand
at least one publi cly traded
securi ty under Chapter 11
Eberhart, Moore, and 30 fi rmswi th publi cly traded 197986 76.67% 7.57%
Roenfeldt ( 1990) stock under Chapter 11
Wei ss( 1990) 37 NY SE and AMEX fi rms 198086 72.97%
under Chapter 11
Franksand Torous( 1994) 82 fi rmswi th publi cly traded 198390 9.51% workouts
debt under Chapter 11 or an 2.28% Chapter 11
i nformal workout
Tashji an, Lease, and 48 fi rmswi th a publi cly traded 198093 72.92% 1.59%
McConnell ( 1996) securi ty or more than $95 mi lli on
i n assets, reorgani zi ng wi th a
prepackaged bankruptcy
Betker ( 1995) 75 fi rmswi th publi cly traded 198290 72.00% 2.86%
securi ti esunder Chapter 11
SO URCE: Authors revi ew of the li terature.
23
also manage the company.
5
Table 1 summarizes
recent empirical research on APR violations.
O ne major caveat should be kept i n mi nd
when consi deri ng these fi ndi ngs: All the stud-
i esof bankruptcy resoluti on ci ted here have
focused on fi rmswi th publi cly traded stock
and/or debt.
6
However, such fi rmscompri se
only a small subset of those fi li ng for Chapter 11
bankruptcy or i ni ti ati ng out-of-court debt work-
outs. Asa result, the number of fi rmsi ncluded
i n these studi esaverageslessthan 50. I n con-
trast, there were over 176,000 Chapter 11 cases
fi led nati onwi de i n the fi rst 10 yearsafter the
new Bankruptcy Code wasi mplemented i n
1979 ( Flynn [1989]) . Even after eli mi nati ng
si ngle-asset real estate partnershi psand house
fi li ngsto focuson what mi ght reasonably be
consi dered true busi ness reorgani zati ons,
these studi eshave depressi ngly small and
bi ased samplesof average reorgani zati ons.
7
I ndeed, bankruptcy judge Li sa Fenni ng notes
that only fi ve out of more than 600 Chapter 11
caseson her docket i nvolve publi cly traded
compani es.
8
Clearly, we must be cauti ousand
avoi d overi nterpreti ng these empi ri cal studi es.
II. APR Violations
and Efficiency
Many have argued that APR vi olati onsoccur be-
cause they are pri vately opti mal for bankruptcy
parti ci pants. I f stri ct adherence to the APR cre-
atesperverse i nvestment i ncenti vesonce the
fi rm i si n bankruptcy, i t may be pri vately opti -
mal ( ex post) for everyone i nvolved to abrogate
such rulesand renegoti ate thei r contracts.
9
Under thi svi ew, APR vi olati ons both i nsi de
Chapter 11 and i n out-of-court workouts are
a desi rable consequence of renegoti ati on be-
tween the fi rm and i tscredi tors; APR vi olati ons
are essenti ally payoffsby lendersto encourage
the fi rmsshareholdersto make good i nvest-
ment deci si onsonce the fi rm i si n fi nanci al di s-
tress. Unfortunately, thi svi ew fai lsto take i nto
account how such behavi or affectsex ante effi -
ci ency through the termsof the ori gi nal fi nan-
ci al contract, whi ch i sulti mately the only way to
evaluate the effi ci ency of APR vi olati onsfully.
To focuson thi sproblem, we develop a si m-
ple model of fi nanci al contracti ng. Consi der an
entrepreneur who wantsto open a fi rm and i n-
vest i n a project, but needsto borrow I dollars
from an outsi de i nvestor to do so. I n return for
thi sloan, the entrepreneur agreesto repay hi s
lender R dollarsfrom hi sfi rmsfuture profi t.
For ease of exposi ti on, we wi ll often refer to
Rasthe i nterest rate.
10
O f course, the fi rms
profi t i snot guaranteed. Let x denote the fi rms
reali zed profi t, whi ch can take valueson the
i nterval [

x,

x]. Let f ( x) be the probabi li ty that

any gi ven x i sreali zed ( that i s, i tsprobabi li ty
densi ty functi on) and, asi sstandard, let F( x) be
the associ ated di stri buti on functi on. To model
APR vi olati ons, let represent the fracti on of
the fi rmsprofi t retai ned by the entrepreneur i n
bankruptcy.
The entrepreneur wi ll default whenever do-
i ng so gi veshi m a hi gher return ( that i s, when-
ever x R< x) . Defi ne x

= R/( 1 ) asthe
cri ti cal level of profi t below whi ch default
occurs. The entrepreneursexpected return
from hi sbusi ness, E, i sthen:
( 1) E =

x
xf (x) dx+
x

( x R) f ( x) dx.
When bankruptcy occurs, the entrepreneur
recei vesonly fracti on of the fi rmsprofi t x;
by wei ghti ng thi sby f ( x) and i ntegrati ng over
all levelsof profi t for whi ch default occurs, we
obtai n the fi rst term i n E. O n the other hand,
when the fi rmsprofi t exceedsx

, the entrepre-
neur usesi t to repay hi sloan and keepsthe
rest. Wei ghti ng thi sby f ( x) and i ntegrati ng over
all x > x

gi vesusthe second term i n E.

I n a competi ti ve lendi ng market, the equi li b-
ri um i nterest rate, R*, i sset to ensure that the
lender i sjust wi lli ng to make the loan:
11
( 2) L =

x*

x
( 1 ) xf ( x) dx +

x*
R*f (x) dx I = 0.
Asabove, the fi rst term i n thi sexpressi on
representsthe lendersexpected return when
I 5 See LoPucki (1983) and LoPucki and Whi tford (1990).
I 6 LoPucki (1983) i s an excepti on.
I 7 House fi l i ngs are Chapter 11 fi l i ngs by i ndi vi dual s whose home
mortgages exceed the Chapter 13 debt l i mi t. The 1994 changes to the
Bankruptcy Code shoul d make such fi l i ngs l ess common.
I 8 Fenni ng (1993).
I 9 See Bul ow and Shoven (1978), Whi te (1980, 1983), Gertner and
Scharfstei n (1991), and Berkovi tch and Israel (1991) for model s that pro-
mote thi s i dea.
I 10 Techni cal l y, R i s the face val ue of the debt and i s equal to
(1 + r ) I , where r i s the nomi nal i nterest rate on the l oan.
I 11 Implicit in this specification is the assumption that the competi-
tive return on riskless assets is 1, so that the lenders cost of funds is only I.
24
default occurs, and i sthe fi rmsprofi t i n these
statesmi nusthe APR vi olati on. The second
term i n L followsfrom the fact that the lender
i ssi mply pai d R* i n all nondefault states.
I n thi ssi mple model, APR vi olati onshave no
i mpact on the fi rmscost of fi nanci ng. Whi le i t i s
true that once the fi rm i si n bankruptcy the en-
trepreneur i sbetter off wi th large APR vi ola-
ti ons, these gai nsare enti rely offset by i ncreases
i n the i nterest rate the fi rm i sforced to pay. To
see thi s, we substi tute the equi li bri um soluti on
for R i nto ( 1) to get
( 3) E =

x
xf (x) dx I .
The fact that doesnot appear i n thi sex-
pressi on showsusthat the fi rmsprofi t i sunaf-
fected by the si ze of the APR vi olati on.
12
I n thi ssi mple model, the magni tude of APR
vi olati onshasno i mpact on the cost of the i ni -
ti al fi nanci al contract. O f course, thi sanalysi s
i gnoresmany of the problemsthat plague real-
world fi nanci al contracti ng. Throughout the rest
of thi ssecti on, we extend thi smodel wi th sev-
eral standard compli cati onsand show how the
effect of APR vi olati onsdependson whi ch
problem i spresent.
Costly Bankruptcy
One of the most basi c problemsi n fi nanci al
contracti ng i sthe fact that bankruptcy i scostly.
Let c denote the cost pai d by the lender when-
ever he forcesthe entrepreneur i nto bankruptcy
( for si mpli ci ty, assume c < x

) .
13
Asbefore, the
equi li bri um i nterest rate, R*, must be set to en-
sure that the lender earnsa competi ti ve return:
( 4) L =

x*

x
[ ( 1 ) x c] f ( x) dx
+

x*
R*f (x) dx I = 0.
I n the appendi x, we veri fy that, asbefore, i n-
creasesi n the magni tude of the APR vi olati on
make default more li kely ( that i s, dx */d > 0) .
Substi tuti ng ( 4) i nto the entrepreneurs
expected profi t ( 1) , we get
( 5) E =

x
xf (x) dx I cF( x *) .
Thi sexpressi on demonstrateshow APR vi ola-
ti onsaffect the termsof the loan agreement.
Si nce x

* i ncreaseswi th , larger APR vi olati ons

make bankruptcy occur more frequently. Asa
result, the added expected bankruptcy costs,
cF ( x

*) , lower the entrepreneursex ante

expected return.
I n thi senvi ronment, APR vi olati onsmay cre-
ate an addi ti onal problem. Although the lenders
expected return i sgenerally i ncreasi ng i n the i n-
terest rate, eventually the added expected bank-
ruptcy costsassoci ated wi th hi gher i nterest rates
outwei gh thei r benefi ts; that i s, L wi ll eventually
be decreasi ng i n R. Wi lli amson ( 1986) shows
that thi seffect can lead to credi t rati oni ng, si nce
changesi n the i nterest rate may be i nsuffi ci ent
to clear the loan market.
I ncreasesi n the magni tude of APR vi olati ons
have the same i mpact: By reduci ng the lenders
payoff i n default statesand i ncreasi ng the prob-
abi li ty that bankruptcy wi ll occur, a poi nt
comesat whi ch the lender can no longer be
compensated for addi ti onal vi olati onsof the
APR through i ncreasesi n the i nterest rate. I n
other words, APR vi olati onsexacerbate credi t-
rati oni ng problems.
Thus, when bankruptcy i scostly, there are
strong reasonsto avoi d APR vi olati ons. Fi rst,
these vi olati onsrai se the i nterest rate the entre-
preneur must pay, i ncreasi ng the chance that
default and i tscorrespondi ng costs wi ll
occur. Furthermore, vi olati onsmake credi t
rati oni ng more li kely, thereby li mi ti ng the
entrepreneursi nvestment opportuni ti es. Why,
then, do they occur wi th such frequency?We
next turn to one possi ble reason.
Asymmetric
Liquidation
Value
The model presented above assumesthat the
fi rm had no capi tal assetsonce the project was
completed or, alternati vely, that the fi rm had no
goi ng-concern value. But much of the justi fi -
cati on for a reorgani zati on procedure deri ves
from the beli ef that many fi rmsi n fi nanci al di s-
tressare i n fact economi cally vi able and should
be reorgani zed rather than li qui dated.
14
To focuson thi si dea, we return to our ori gi -
nal model ( i n whi ch bankruptcy i scostless) and
si mpli fy i t by assumi ng that only two levelsof
I 12 On the other hand, APR vi ol ati ons can l ead to credi t- rati oni ng
probl ems, even i n thi s si mpl e model , si nce they make defaul t occur more
frequentl y. We di scuss thi s probl em i n the subsecti on that fol l ows.
I 13 Thi s, then, i s the costl y state veri fi cati on envi ronment devel oped
by Townsend (1979) and Gal e and Hel l wi g (1985).
I 14 Harri s and Ravi v (1993) devel op a model based on thi s i ssue
and come to si mi l ar concl usi ons.
25
profi t are possi ble. I n good statesof the world,
whi ch occur wi th probabi li ty , the entrepre-
neursbusi nessearnsxH. I n contrast, when
busi nessi sbad, the fi rm earnsonly xL; thi soc-
curswi th probabi li ty ( 1 ) . Furthermore,
assume that when busi nessi sgood the entre-
preneur can repay hi sdebt, but i n bad stateshe
cannot; that i s, xH > R> xL.
I n addi ti on to i tsprofi t, x, the fi rm hascapi -
tal assetsworth A once i tsproject i scompleted;
these can be thought of asthe value of the
fi rmsexpected future profi t. I f thi svalue i sthe
same regardlessof who ownsthe fi rm, our
resultsremai n unchanged: APR vi olati onshave
no i mpact on the termsof the fi nanci al con-
tract. O n the other hand, i f the fi rmsassetsare
worth more i n the handsof the entrepreneur,
there wi ll be an i ncenti ve to modi fy the fi nan-
ci al contract to allow hi m to retai n control of
the fi rm even after fi li ng for bankruptcy.
Let represent the fracti on of the fi rms
assets( and hence future profi t) retai ned by the
entrepreneur duri ng bankruptcy. I n thi scase,
the entrepreneursexpected profi t
15
i s
( 6) E = ( 1 ) ( xL + A) + ( xH R + A) .
Let be the fracti on of the fi rmsongoi ng
value that i slost by transferri ng these assetsto
the lender. O nce agai n, the equi li bri um i nterest
rate must be set to guarantee the lender a com-
peti ti ve return:
( 7) L = ( 1 ) [( 1 ) xL + ( 1 ) A]
+ R* I = 0.
Substi tuti ng thi si nto the entrepreneurs
expected profi t gi vesus
( 8) E = ( 1 ) ( xL + A) + ( xH + A)
+ ( 1 ) ( 1 ) ( 1) A I .
Asbefore, i t i si rrelevant whether the entre-
preneur i sallowed to keep some of the profi t
( the si ze of ) when the fi rm defaults; the i nter-
est rate adjustsso asto keep the entrepreneurs
expected return unchanged. Li kewi se, when
= 1 and the fi rmscapi tal assetshave the same
value regardlessof who controlsthem, the si ze
of doesnot matter; that i s, APR vi olati ons
i nvolvi ng the fi rmscapi tal assetsare i rrelevant.
I n thi scase, we are back to our ori gi nal model.
Noti ce, however, that the same i snot true
when i slessthan one. Di fferenti ati ng ( 8)
wi th respect to gi vesus
( 9)
d
d

E
=( 1 ) ( 1 ) A > 0;
si nce these assetsare worth lessto the lender
than they are to the entrepreneur, APR vi ola-
ti onsof thi ssort are benefi ci al.
Why are both and necessary to analyze
the i mpact of APR vi olati onsi n thi senvi ron-
ment?The i ntui ti on i sclear: APR vi olati onsare
benefi ci al only when they are appli ed to A,
si nce thi si sthe only part of the fi rmsvalue
that i sworth more i n the handsof the entre-
preneur. I f allowi ng the lender to keep some
of x
L
hasany detri mental i mpact ( such as
costly bankruptcy) , the desi rabi li ty of di sti n-
gui shi ng between these two typesof APR vi o-
lati onsi sobvi ous.
O ne mi ght wonder whether there i sa practi -
cal di sti ncti on between x
L
and A. For large,
publi cly traded fi rms, thi sdi sti ncti on may be
i rrelevant. After all, the goi ng-concern value of
Johnson & Johnson i sli kely to be unaffected by
the i denti ty of i tsstockholders( that i s, thei r i s
equal to one) . O n the other hand, fi rmsthat are
owned and managed by an entrepreneur who
bri ngsspeci ali zed ski llsto hi scompany are
li kely to have small s. I n thi scase, i t mi ght be
reasonable to allow the entrepreneur to keep
control of hi sfi rm after bankruptcy, but all of
the fi rmsli qui d assetsshould be transferred to
i tscredi tors.
Risk Shifting
Perhapsthe most common problem i n fi nanci al
contracti ng i sthe borrowersi ncenti ve to under-
take acti onsthat affect the ri ski nessof hi sbusi -
ness.
16
Suppose that, by exerti ng effort, the
entrepreneur can affect the li keli hood that the
fi rm wi ll be successful. I f the entrepreneur
workshard, the fi rm wi ll earn x
H
wi th proba-
bi li ty
1
; wi thout effort, i t wi ll earn x
H
wi th
probabi li ty
2
<
1
. I n addi ti on, assume that the
amount of effort requi red ( or alternati vely, the
cost of thi seffort) i snot di scovered unti l after
the loan i smade; let e represent the effort ulti -
mately requi red. Fi nally, suppose that the lender
cannot observe whether effort i sexerted.
After learni ng the effort requi red, the entre-
preneursexpected return from the good
project i s( 1
1
) x
L
+
1
( x
H
R) e, whi le
hi sexpected return from the bad project i s
( 1
2
) x
L
+
2
( x
H
R) . Ulti mately, whether
I 15 Thi s expressi on i s anal ogous to equati on (1); note that we have
assumed onl y two possi bl e states of the worl d.
I 16 Bebchuk (1991) devel ops a di fferent model of ri sk shi fti ng and
comes to si mi l ar concl usi ons. See al so Innes (1990).
26
the entrepreneur choosesto undertake the
good project ( that i s, exert effort) wi ll depend
on how much effort i srequi red. He wi ll select
the good project aslong ashi sreali zed e i sless
than e*, where
( 10) e* = ( 1 2) ( xH R xL) .
I n what follows, i t wi ll be useful to know
how often the entrepreneur wi ll select the
good project, whi ch requi resusto know the
di stri buti on of e. Assume for si mpli ci ty that
ei sdi stri buted uni formly on the i nterval [0,1].
I n thi scase, the probabi li ty that the entrepre-
neur wi ll choose the good project ( that i s, that
e < e*) i ssi mply e*.
The lender, knowi ng that the entrepreneur
wi ll choose the good project wi th probabi li ty e*
and the bad project wi th probabi li ty 1 e*, wi ll
demand an i nterest rate that guaranteeshi m
zero expected profi t:
( 11) L = [e*( 1 1) + ( 1 e*) ( 1 2) ]( 1 ) xL
+ [e*1 + ( 1 e*) 2]R* I = 0.
Before he takesthe loan, the entrepreneurs
expected return i ssi mply hi sexpected profi t
from each of the projects, wei ghted by the
probabi li ty that he wi ll choose each, mi nushi s
expected effort condi ti onal on the good project
bei ng chosen:
( 12) E = ( 1 e*) [2( xH R) + ( 1 2) xL]
+ e*[1( xH R) + ( 1 1) xL]
e
2
*
2

.
Substi tuti ng R* i nto thi sexpressi on gi vesus:
( 13) E = e*( 1 2) ( xH xL) + 2 xH
+ ( 1 2) xL

e
2
*
2

I.
Asi n our ori gi nal problem, hasno di rect
effect on the entrepreneursex ante expected
return; the i nterest rate si mply adjuststo ensure
that the lender makesa competi ti ve return. O n
the other hand, such APR vi olati onsdo have an
i ndi rect effect through thei r i mpact on the
probabi li ty that the entrepreneur wi ll exert
effort and choose the good project. Di fferenti at-
i ng ( 13) wi th respect to yi elds
( 14)

d
d

d
d
e

[( 1 2) ( xH xL) e*]
=

d
d
e

( 1 2) [R ( 1 ) xL].
Now, R > ( 1 ) x
L
by assumpti on. I n the
appendi x, we demonstrate that de*/d 0,
that i s, that the presence of large APR vi olati ons
makesthe entrepreneur lessli kely to choose
the good project.
17
Combi ni ng these results
showsthat the entrepreneursexpected profi t i s
decreasi ng i n . Hence, when ri sk shi fti ng i sa
problem, APR vi olati onsare ex ante i neffi ci ent.
The i ntui ti on behi nd thi si sstrai ghtforward.
Asbefore, the di rect benefi t to the entrepreneur
of recei vi ng compensati on when the fi rm fai ls
i sexactly offset by the hi gher i nterest rate he
must pay.
18
O n the other hand, APR vi olati ons
reduce the entrepreneursi ncenti ve to under-
take the good project. Why i sthi sthe case?
Si nce effort i scostly for the entrepreneur, he
would li ke to avoi d i t whenever possi ble. Nev-
ertheless, he i swi lli ng to exert some effort,
si nce doi ng so makesi t more li kely that the
fi rm wi ll be successful, reapi ng hi m a hi gher
return. The presence of these vi olati ons, how-
ever, reducesthe pai n of bankruptcy and hence
the relati ve benefi tsof thi seffort. After all, why
should the entrepreneur work hard i f he can be
assured of a si zable payoff even when hi sbusi -
nessbombs?Asa result, the entrepreneur
exertslesseffort than he would i f there were
no APR vi olati ons.
III. Policy Implications
The resultsof the last secti on suggest that an
opti mal bankruptcy i nsti tuti on would allow
debtorsand credi torsto deci de ex ante
whether APR vi olati onswi ll occur. I n other
words, the parti esto the loan agreement should
be allowed to wri te a contract that speci fi es
under what condi ti onsAPR vi olati onswi ll and
wi ll not occur.
Although the desi rabi li ty of such a system
mi ght seem obvi ous, current bankruptcy law
doesnot enforce agreementsli ke these. O nce a
fi rm entersbankruptcy, i t must follow the rules
and proceduresset out i n the Bankruptcy
Code, and no one i sallowed to forfei t hi s
future ri ght to fi le for bankruptcy when he
si gnsa loan agreement. Thi smi ght not be a
problem i f i t werent for the fact that current
bankruptcy law strongly encouragesAPR vi ola-
ti ons, regardlessof whether they are effi ci ent.
I 17 For smal l , d e* / d may be zero; i n thi s range, the payments
that the entrepreneur recei ves i n bankruptcy are not l arge enough to di s-
courage hi m from choosi ng the good proj ect, regardl ess of the l evel of
effort requi red.
I 18 Once agai n, however, a credi t- rati oni ng probl em i s possi bl e.
27
Several featuresof the code make thi strue.
Fi rst, the debtor retai nscontrol of the fi rm
throughout the process, except i n extraordi nary
ci rcumstances. Second, the debtor i sallowed to
obtai n debtor-i n-possessi on fi nanci ng to con-
ti nue operati on of the busi ness; thi sfi nanci ng i s
automati cally gi ven pri ori ty over all of the
fi rmsunsecured clai ms. Thi rd, the debtor i s
granted 120 daysto propose a plan of reorgani -
zati on; duri ng thi sti me, no other parti esmay
propose alternati ve plans.
19
Fi nally, i f the
debtorsreorgani zati on plan i snot approved by
i tscredi tors, i t may attempt to enforce a cram-
down, getti ng the judge to i mpose the plan
agai nst the credi tors wi shes.
20
Each of these
factorsgi vesthe debtor leverage i n the reorga-
ni zati on, i ncreasi ng the li keli hood ( and magni -
tude) of APR vi olati ons.
Although one mi ght appeal to asymmetri c
li qui dati on valuesasa justi fi cati on for APR vi o-
lati ons, a formal bankruptcy procedure that
mandates them seemsunwarranted, especi ally
i n li ght of other problemsthat make APR vi ola-
ti onsi neffi ci ent. After all, nothi ng preventsthe
fi rm and i tscredi torsfrom wri ti ng a loan agree-
ment that would keep the fi rmscapi tal assets
i n the entrepreneurshands, even i n default.
Thi spoi ntsout an addi ti onal compli cati on
that must be present to justi fy a speci al bank-
ruptcy law: i ncomplete contracti ng. I f the future
value of the firmscapital assetsisuncertain, and
the entrepreneur and the lender cannot agree
on a way to measure i tsvalue, some outsi de
arbi ter may be useful. Whi le bankruptcy courts
can certainly fill thisrole, the implicit assumption
that the contract parti ci pantscannot desi gnate
such an arbi ter i n thei r agreement seemsex-
treme. O n the other hand, bankruptcy law may
be able to provi de a useful baseli ne to reduce
the costsof contracti ng on i mprobable events.
Potenti al confli ctsamong di fferent credi tors
mi ght provi de another justi fi cati on for bank-
ruptcy laws.
21
I n thei r rush to retri eve some
value from a fi nanci ally di stressed fi rm, the
theory goes, lendersmay i nadvertently reduce
the total value of the fi rmsassetsthat are avai l-
able for di stri buti on. Thi smi ght happen i f the
fi rmsassetsare worth more undi vi ded, but
i ndi vi dual credi torshave li enson speci fi c
assets. Worse yet, thi srush mi ght cause fi nan-
ci ally vi able fi rmsto be li qui dated. Setti ng asi de
the questi on of why the fi rm and i tscredi tors
cannot foresee these problemsand wri te thei r
contractsso asto prevent them, thi srati onale
for bankruptcy law doesnot necessari ly man-
date that i t vi olate contractual pri ori ti esthat are
determi ned ex ante.
Nonetheless, many fi rmsmay feel that the
fact-fi ndi ng and medi ati on servi cesprovi ded by
a formal bankruptcy i nsti tuti on provi de a cost-
effecti ve way of wri ti ng fi nanci al contracts. Si m-
i larly, confli ctsamong credi torsmay be suffi -
ci ently severe to justi fy the use of such an
i nsti tuti on. Asa result, one would be overzeal-
ousi n recommendi ng total repeal of the Bank-
ruptcy Code.
I t i sclear, however, that any bankruptcy pro-
cedure should merely provi de an opti onal start-
i ng poi nt for pri vate contracts. I f everyone i n-
volved fi ndsi t conveni ent to use thi si nsti tuti on,
they may. But i f they fi nd the procedure unnec-
essari ly restri cti ve, they should have the oppor-
tuni ty, when they wri te thei r fi nanci al contract,
to opt out of i t enti rely. That i s, the parti esto
the loan agreement should be allowed to deci de
up front, when they wri te thei r agreement,
whether a formal bankruptcy procedure wi ll
be used i n the event of fi nanci al di stress.
O n the one hand, small entrepreneuri al
fi rmswi th hi ghly uncertai n marketsand prod-
uctsmay fi nd Chapter 11 protecti on benefi ci al.
Asdi scussed above, Chapter 11 gi vesequi ty
substanti al bargai ni ng power i n the renegoti a-
ti on process. Si nce these fi rmsare more li kely
to benefi t from the abi li ty to recontract when
new i nformati on i savai lable, and thei r man-
agersare more li kely to possessspeci al ski lls
that affect the fi rmsgoi ng-concern value, thi s
added bargai ni ng power and the resulti ng vi o-
lati onsi n the APR are more li kely to be benefi -
ci al. Fi rmsi n thi ssi tuati on would typi cally
i nclude the ri ght to seek Chapter 11 protecti on
i n thei r debt contracts.
I n contrast, fi rmsthat have greater opportu-
ni ti esto adjust thei r acti vi ti esto the detri ment
of thei r credi torswould generally choose to opt
out of thi sprotecti on. Formally forfei ti ng thei r
ri ght to Chapter 11 protecti on would clearly
si gnal thei r credi torsof thei r i ntenti on to avoi d
hi gh-ri sk projects. Li kewi se, large, publi cly
I 19 Thi s excl usi vi ty peri od i s often extended i ndefi ni tel y (Franks and
Torous [ 1989] and LoPucki and Whi tford [ 1990] ).
I 20 Cram- downs are rather uncommon, and are al l owed onl y i n
cases i n whi ch al l di ssenti ng credi tors recei ve at l east what they are due
under the APR when the fi rm i s l i qui dated. A cram- down may nonethel ess
i mpose an APR vi ol ati on i f the fi rm woul d be worth more i f i t conti nued
than i f i t were l i qui dated, or i f the face val ue of the securi ti es offered to di s-
senti ng credi tors i s substanti al l y above thei r true market val ue. Further-
more, the threat of a cram- down, whi ch i s costl y to fi ght, may cause some
credi tors to accept l ower payouts than they mi ght otherwi se.
I 21 See Jackson (1986) for a compl ete di scussi on of thi s argument.
28
traded fi rmswhose goi ng-concern value i s
unaffected by thei r ownershi p would benefi t
from such an opti on.
IV. Conclusion
Thi spaper hasdemonstrated how the effi ci ency
of APR vi olati onsdependson the nature of the
contracti ng problem present. When the fi rms
future profi t wi ll be hi gher i f i t i scontrolled by
the entrepreneur, i t makessense for hi m to re-
tai n the fi rmscapi tal assets i f not i tspast
profi ts after bankruptcy. O n the other hand,
APR vi olati onsof any sort have the detri mental
effect of rai si ng i nterest rates, thereby i ncreas-
i ng expected bankruptcy costsand worseni ng
credi t-rati oni ng problems. Furthermore, APR
vi olati onscan reduce the entrepreneursi n-
centi ve to work hard i n order to ensure hi s
fi rmsprofi tabi li ty.
The di versi ty of these i mpli cati onssuggests
that an opti mal bankruptcy law would allow
fi rmsand thei r credi torsto deci de ex ante
whether ( and what type of) APR vi olati onswi ll
occur i n the event of fi nanci al di stress. Whi le
such deci si onscould reasonably be left to pri -
vate contracts, a formal bankruptcy law may be
desi rable for other reasons. I f thi slaw de facto
encouragesAPR vi olati ons, i t i sclear that i t
should also i nclude an opt-out provi si on that
allowspri vate agentsto determi ne whether i ts
structure wi ll be benefi ci al to them. Thi si snot
allowed under current U.S. bankruptcy law.
I n such a world, we mi ght expect owner-
operatorsof small fi rmsto i nclude APR vi ola-
ti onsi n thei r contracts, si nce these fi rmsare the
most li kely to lose value from transferri ng thei r
capi tal assets. I n contrast, the value of large,
publi cly traded compani esi slessli kely to be
affected by thei r ownershi p, and we would
therefore expect such compani esto avoi d APR
vi olati onsof any type, aswould fi rmsof any
si ze whose profi t streamsare easi ly affected by
manageri al effort.
Appendix
In thi sappendi x, we prove some of the more
techni cal resultsrequi red i n the text. The fi rst i s
the fact that, i n the model wi th costly bank-
ruptcy,

x* i si ncreasi ng i n . Totally di fferenti at-

i ng ( 4) showsthat
( 15)
d
d
x

.
The numerator of thi sexpressi on i sclearly pos-
i ti ve, asi sthe denomi nator whenever
( 16)
1
c

<
.
Longhofer ( 1995) showsthat whenever thi s
condi ti on doesnot hold, no lendi ng occursi n
equi li bri um. That i s, when c or i stoo large,
credi t rati oni ng results.
The second fact we must prove i sthat
de*/d 0 i n the model wi th ri sk shi fti ng.
Solvi ng ( 11) for R*, substi tuti ng i nto ( 10) , and
si mpli fyi ng showsthat e* i sdefi ned by
( 17) e*
2
2 e*1 0 0,
where 0 = I 2xH ( 1 2) xL + xL,

1 = 2 ( 1 2)
2
( xH xL) , and
2 = ( 1 2) .
Although two rootswi ll solve thi sequati on,
di fferenti ati on of ( 13) wi th respect to e* shows
that the larger root wi ll alwaysbe the one cho-
sen i n equi li bri um. Usi ng the quadrati c formula
to solve for e*, i t i sstrai ghtforward to veri fy that
( 18) xL ( 1
2
420)

,
whi ch must be nonposi ti ve whenever a real
soluti on for e* exi sts.
I t i sworth aski ng what happenswhen the
opti mal e*, asgi ven by the quadrati c formula,
i sgreater than one. Thi swould i mply that the
entrepreneur wi ll alwayschoose the good proj-
ect, regardlessof the level of effort ulti mately
requi red. I n thi scase, small APR vi olati onswi ll
have no i mpact on the fi rmsex ante profi t.
Larger vi olati ons, however, wi ll sti ll reduce the
chance that the entrepreneur wi ll choose the
good project.
de*

d
1 F ( x*)

f ( x*)
x *[1 F( x*) ]
x

x
*
xf(x) dx
( 1 ) [1 F( x*) ] cf( x*)
29
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