A dilution mechanism for valuing corporations in bankruptcy

This Article proposes a new mechanism for valuing firms in bankruptcy. Under the "senior dilution" mechanism, a court would dilute the reorganized stock issued to senior claimants by issuing additional shares to junior claimants until there was no excess demand for the stock at a price that would implement absolute priority. A "junior dilution" mechanism could also be implemented to provide a market test for proposed reorganization plans of junior claimants by having a court issue additional debt to senior claimants until there was no excess supply of the debt at a price that would implement absolute priority. We show that these mechanisms harness the private information of the claimants and of third parties to produce distributions consistent with absolute priority. Dilution mechanisms can be superior to other information-harnessing devices (such as an option or auction approach) because they (1) are less susceptible to the problem of junior illiquidity l than an option approach proposed by Lucian Bebchuk; (2) are less susceptible to the problem of market manipulation and may better allocate control premia than a partial float proposal by Mark Roe; and (3) may produce fewer transaction costs than a full auction approach proposed by Douglas Baird. Moreover, as a response to the Supreme Court's recent admonishment in LaSalle that bankruptcy courts employ market tests more often when creditors dissent to a reorganization plan, the junior dilution mechanism provides a uniquely workable solution within the current statutory framework.