The Creditors' Bargain and Option-Preservation Priority in Chapter 11

Corporate reorganization under Chapter 11 of the Bankruptcy Code is built on the foundation of the absolute priority rule, which requires that senior creditors be paid in full before any value can be distributed to junior creditors. The standard law and economics understanding is that absolute priority follows inevitably from the “creditors' bargain” model. That model tells us that the optimal system of reorganization must respect nonbankruptcy contract rights while maximizing the expected value of assets in bankruptcy. The conventional wisdom is that absolute priority fits this bill as the singular way of protecting creditors' nonbankruptcy contract rights. But what if this conventional wisdom is incorrect? A closer look at the structure of corporate debt suggests that it is. Junior creditors issue debt supported by the residual value of the debtor firm. The repayment of that debt is contingent on the future value of the firm: the junior creditors receive any future value that exceeds the face value of the senior debt. It is well recognized that this right is the equivalent of a call option on the firm's assets. And yet Chapter 11 destroys the value of that call option by collapsing all future possibilities to present-day value. Thus, absolute priority eliminates the nonbankruptcy contract rights of junior creditors and creates new rights in going-concern value for senior creditors. This Article examines the potential of an alternative priority mechanism that protects both the junior creditors' call-option value and the senior creditors' nonbankruptcy contract rights. This mechanism — which I call Option-Preservation Priority — is shown to protect the nonbankruptcy contract rights of all creditors and maximize the expected value of assets in bankruptcy