Agency Costs and Deviations from the Absolute Priority Rule in Bankruptcy Reorganization

A theoretical model examines real investment decisions during bankruptcy reorganization and the closing distribution of property rights over capital structure to creditors and equityholders. Estate value is uncertain. Risky real investment levels in firm technology are endogenous and subject to financing constraints with interest rates sensitive to the probability of default and expected creditor recovery. The model demonstrates that firms inefficiently overinvest in continuing operations during reorganization. Deadweight losses are exacerbated by possible interim (DIP) financing legislatively senior to preexisting debts. The model also explains why deviations from the absolute priority rule occur, i.e. why old equity typically shares in the distribution according to the plan of reorganization despite creditors recovering less than their contractual claims. Liquidation in toto is found to be efficient in contrast to reorganization.