9th Symposium on
Finance, Banking, and Insurance
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Sanjay Banerji |
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Faculty of
Management |
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Several
empirical studies have established that violations from
the Absolute Priority Rule (APR) occur almost as a rule
rather than exceptions. This paper examines why do
creditors voluntarily waive their status as senior
claimants when a firm exercises its option to default. We
analyze violations of APR and its implications on
efficiency of investment in a set -up where various claim
holders engage in explicit private work outs. By
combining the financial contracting theory with real
options approach in the context of agency cost framework,
we find that (1) violations of APR take place because it
is optimal for creditors to pay an extra price (in
addition to unpaid debt) for the put option sold by them
to the stock holders. We show that paying such an
additional price acts as an incentive for stock holders
to invest more so that it reduces the likelihood of
bankruptcy in a world of asymmetric information. Such a
price is equivalent to conceding a part of the equity
stake to original share holders. Hence, APR violations
emerge endogeneously where creditors voluntarily quit
their right of a senior status. (2) We also show that
such a price, when optimally chosen, has two components:
(a) efficiency gains (b) incentive costs. (3) If
incentive constraints are not binding, APR violations
always maximizes the value of the firm and hence is
efficient. On the other hand, inefficiency arises
whenever such constraints are binding so that the optimal
strike price of the put option reflects the incentive
costs as well as gains in efficiency. (4) The incentive
costs are also endogenous and it varies negatively with
respect to initial cash flow and expected productivity of
firm’s investment opportunities. |
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* This is a thoroughly revised version of an earlier draft circulated while the author was visiting Boston University. In preparing this draft, I have benefited from discussion with numerous colleagues. In particular, I would like to thank Douglas Gale and Dilip Mookherjee for extensive discussion and helpful comments. My special thanks go to Sris Chatterjee and Phil O’conor for insightful comments on the paper. Also, I have received valuable comments from seminar participants at Concordia University, University of Connecticut, Erasmas University at Rotterdam, Indian Statistical Institute at New Delhi, McGill University and State University of New York at Buffalo and York University. Errors are mine. |
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