9 - Bargaining after the fall and the contours of the absolute priority rule

Summary

The absolute priority rule provides that in a reorganization senior owners are paid in full before junior owners are paid anything. When a firm owes more than its assets are worth, the shareholders receive nothing unless the creditors consent. Under the 1978 Bankruptcy Code, consent can be given through a classwide vote of creditors. A single uncompromising creditor's objection is not sufficient to prevent the participation of shareholders. Nevertheless, the absolute priority rule and its rhetoric stand in distinct contrast to the distrust of market mechanisms and ex ante bargains that pervades both the practice of bankruptcy and discussions of bankruptcy policy. Walter Blum's classic essay, “The Law and Language of Corporate Reorganizations,” takes as its theme this tension between the need for respecting the prebankruptcy bargain and the harshness of vindicating that bargain after the fact. Recognition of that tension permeates much of what he has written since. The insights contained in his work establish the common ground upon which all modern bankruptcy scholars stand.

The dispute in Case v. Los Angeles Lumber Products and the other opinions that gave rise to much of Walter Blum's work, however, developed only after the absolute priority rule was well into middle age. These cases all involved battles between a creditor or group of creditors on the one hand and shareholders on the other. In its infancy, the absolute priority rule involved not two parties but three. In this chapter, we make an effort to extend Walter Blum's work.