One of the key recommended principles of the American Bankruptcy Institute’s (ABI) proposed reform of the US bankruptcy procedure is to grant a redemption option to junior creditors. This option would essentially allow them to exit the bankruptcy process at virtually no cost. The ABI justifies the reform by pointing out that financially distressed corporations have been relying less and less on Chapter 11, often preferring faster and less-costly out-of-court restructuring. Under the proposed change, a junior creditor is entitled to a share of the ongoing company, called the redemption option value, even if a senior creditor is not paid in full. This is an important departure from the Absolute Priority Rule (APR). Specifically, the junior creditor's share is ‘the value of a hypothetical option to purchase the entire firm with an exercise price equal to the redemption price [...] and a duration equal to the redemption period’ (American Bankruptcy Institute, 2014, p. 209). More precisely, the junior creditor would be offered the value of a hypothetical option on the firm's assets, with a three-year maturity starting from the plan petition date. The goal of the proposed reform is to accelerate the resolution of financial distress, thereby reducing the costs of Chapter 11, by providing junior creditors with an exit strategy. Aside from its benefits, the ABI reform could potentially disadvantage senior creditors by limiting their rights to be paid in full before junior creditors, and could also disadvantage junior creditors by limiting their ability to veto an organization plan and delay the reorganization process.
In our paper, we study the potential consequences of the redemption option by relying on a game-theoretic, contingent-claims model of the financially distressed firm. Following Annabi, Breton & François, we analyze Chapter 11 negotiations as a non-cooperative game played between three classes of claimants (equity holders, senior and junior creditors). Our model is then adapted to the situation where the redemption option reform is implemented: as the distressed firm files for bankruptcy, junior creditors are offered the redemption option value and exit the negotiation game, while equity holders and senior creditors bargain over the remaining value of the firm.
Our main findings are the following. As expected, the redemption option reduces the duration of the bankruptcy procedure and the total bankruptcy costs. However, it results in an increase in the risk of liquidation, as senior creditors and equity holders are left in a more difficult position to negotiate a reorganization agreement. While the overall fairness of the bankruptcy procedure is slightly improved, the ABI reform operates a shift in APR violations: those at the expense of senior creditors become the most frequent. As a matter of fact, the redemption option, as it is currently designed, appears to be too generous a compensation for junior creditors, who are paid in full in most scenarios. Our policy recommendation is twofold. First, the redemption option should not be systematically offered to junior creditors, but only when its wealth transfers are reasonable and its welfare impact is positive. According to our model, these conditions are met when the weight of junior debt in the bankrupt firm's total debt is low. Second, the design of the redemption option should be revised to lower its value. Our numerical simulations indicate that reducing the option maturity is not enough. A solution could consist in reducing the moneyness of the option by increasing its exercise price. We conclude that it may be advisable to revise the design of the redemption option and to offer it on a case-by-case basis.
Amira Annabi is Assistant Professor of Finance at Manhattan College.
Michèle Breton is Professor of Management Science at HEC Montreal.
Pascal François is Professor of Finance at HEC Montreal.