Berkeley Program in Law and Economics

This paper offers an explanation for one of the most important and persis-tent puzzles in corporate reorganizations. In a Chapter 11 reorganization, senior creditors are, in principle, entitled to insist upon “absolute priority.” They have a right to be paid in full before junior investors receive anything. In practice, how-ever, departures from absolute priority are commonplace. Senior creditors regu-larly allow those junior to them to participate even when they may not be paid in full. Explaining this gap between theory and practice has been a central preoccu-pation of reorganization scholars since the 1920s. Conventional accounts point to the unwillingness of judges to fully recognize the rights of senior creditors and the ability of those junior to them to game the system to their advantage. In this paper, we suggest that these accounts are inadequate in the context of the reor-ganization of large businesses today. Something more is at work.