ABSOLUTE PRIORITY RULE VIOLATIONS AND RISK INCENTIVES FOR FINANCIALLY DISTRESSED FIRMS

The role of financial contracting in resolving agency conflicts between creditors and shareholders has been extensively investigated in the finance literature.1 The purpose of financial contracting is to create a self-enforcing mechanism for the alignment of conflicting interests of securityholders so that shareholaers make decisions to maximize firm value. With rational financial markets, shareholders are forced to absorb any costs that result fi-om unresolved agency conflicts. Hence, it is in dieir interest to seek contracts - explicit or implicit - diat reduce, or even eliminate, agency conflicts. Conversion or call provisions included in the bond indenture are two well-known examples of the use of explicit financial contracting to mitigate agency conflicts. These provisions are particularly effective in diminishing the incentive for shareholders to shift the firm's assets into high-risk projects. Convertibles mitigate the incentive because equityholders are forced to share the residual payoff with converting bondholders in the event of a large payoff. Call provisions reduce the incentive through a decrease in the underlying bond value (in response to a risk shift) thereby diminishing the value of the call provision held by shareholders. These traditional methods of controlling risk-shifting lose their effectiveness, however, as the firm approaches financial distress, because the probability of a conversion or call approaches zero. The purpose of this paper is to investigate, in a contingent claims framework, the role of absolute priority rule (APR) violations in reducing agency conflicts between bondholders and shareholders. In particular, we demonstrate that departures from the APR are effective in controlling the risk-shifting incentive of financially distressed firms. The APR states that creditors must be fully compensated before shareholders receive any portion of the bankrupt firm's value.2 Betker [10], Eberhart, Moore, and Roenfeldt [25], Franks and Torous [28], [29], LoPucki and Whitford [49], and Weiss [60] demonstrate that this rule is enforced in only about 25% of corporate bankruptcy cases. There is also strong evidence that the capital market anticipates departures from the APR (e.g., Betker [11], Eberhart, Moore, and Roenfeldt [25], Eberhart and Sweeney [26], and Wamer [59]). The possibility of a departure from the APR is an implicit feature of the bond contract (implicit because this feature is not explicitly mentioned in the bond covenant at the time of debt issuance) that allows for equity participation on the lower tail of the firm's cash flow distribution. Moreover, because deviations from the APR also occur in informal bankruptcies/workouts (Franks and Torous [29]), these implicit contracts are not dependent on enforcement by the bankruptcy court. As with explicit financial contracting, APR violations have the attractive feature of self-enforcement. Further, they are most effective when the more traditional methods are least effective; as the probability of a conversion or call approaches zero with a worsening of the firm's financial condition, a deviation from die APR becomes the dominant force in reducing risk-shifting. Thus, an APR violation complements die traditional methods of controlling the risk incentive by serving as an ''insumnce'' policy against their failure when the firm is financially distressed. 3,4 The first section discusses the risk-shifting problem and the means of combating the problem. Section II presents the valuation effects of a conversion provision and an APR violation in a contingent claims framework. The impact of convertibles and departures from the APR on die risk incentive are shown in Section III. Section IV concludes with a summary.