Anthony J. Casey1Professor, The University of Chicago School of Law. & Joshua C. Macey2Assistant Professor, The University of Chicago School of Law. We wish to thank Ken Ayotte, Vince Buccola, Douglas Baird, Jared Ellias, Saul Levmore, Alan Schwartz, and David Skeel for helpful comments. We also thank Julian Gale, Silvia Moreno, and Leonor Suarez for excellent research assistance. The Richard Weil Faculty Research Fund and the Paul H. Leffmann Fund provided generous support.
Abstract: On June 11, 2020, the Hertz Corporation attempted to become the first corporate debtor to finance a bankruptcy proceeding by issuing new shares of common stock to the public. Though many thought Hertz’s equity was worthless, its stock was trading at a positive value on the secondary markets, and Hertz was attempting to tap into that market value. When the bankruptcy court blessed the plan, many observers responded with outrage on behalf of retail investors who, they argued, were being duped into a worthless investment. They suggested that the law should prevent retail investors from buying these shares. Ultimately, the Securities Exchange Commission signaled that it had similar concerns and effectively killed the proposal.
This Essay explores the questions raised by this incident. It argues that commentators were focused on the wrong bankruptcy problem. Contrary to the view of the commentators, Hertz’s bankruptcy does not show that retail investors require bankruptcy-specific protections. The Hertz maneuver does, however, highlight distortions created by bankruptcy law’s distribution rule, known as the absolute priority rule. That rule cuts off future opportunities for those holding equity (or junior claims) in a debtor firm and makes it difficult for stockholders and unsecured creditors to make long-term investments in the firm’s future value. From this perspective, existing proposals to alter bankruptcy’s priority rules begin to look like a form of investor protection that could facilitate investment in a firm’s long-term value.
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On June 11, 2020, the Hertz Corporation introduced a new strategy for bankruptcy financing. In a court motion, the company asked for permission to sell up to 246 million shares of authorized but unissued shares of its common stock for up to $1 billion.3Motion To Sell Shares Of Common Stock Of Debtor Hertz Global Holdings, Inc, In re Hertz Corp., Case 20-11218, Doc. 387 (June 11, 2020) [hereinafter Motion To Sell Shares] (PDF). While there is nothing inherently peculiar about a corporation selling stock, at the time of the request, Hertz was in bankruptcy.4Less than four weeks earlier, Hertz and several affiliated entities had initiated reorganization proceedings under Chapter 11 of the United States Bankruptcy Code. And there is something peculiar about a debtor in bankruptcy selling stock. Indeed, in its motion seeking authority to conduct the sale, Hertz cited no cases in which a debtor in bankruptcy had raised funds by selling unissued shares to the public.5The primary authority Hertz relied on to support its attempt to fund its bankruptcy through a stock issuance was a bankruptcy from the Northern District of Texas, in which the court—in a different context—held that unissued stock was not the property of the estate and therefore not subject to some of the Bankruptcy Code’s protections. See Motion To Sell Shares at 7 (citing Intramerican Oil & Minerals, Inc. v. Mid-America Petroleum, Inc. (In re Mid-America Petroleum, Inc.), 71 B.R. 140, 141 (Bankr. N.D. Tex. 1987)). And commentators speculated that this was likely the first time a large Chapter 11 debtor had tried to do so.6See Jeff Sommer, Hertz: And Now for Something Completely Worthless, NYTimes (June 17, 2020) (quoting a former SEC chief accountant as saying, “I can’t recall an incident where a company has made a stock filing this early after filing for bankruptcy.”);David Welch, Hertz Killing Share Sale Ends Unusual Bid To Fund Bankruptcy, Bloomberg (June 18, 2020) (“‘There is a reason this hasn’t been done before,’ said attorney Thomas J. Salerno, who represented owners of the Phoenix Coyotes hockey team when the NHL property was sold in bankruptcy. ‘How can you sell stock and then take the position later that you can’t pay all your creditors?’”); Limited Objection and Reservation of Rights of Gamco Investors, In re Hertz Corp., Case 20-11218, Doc. 406, ¶ 2 (June 12, 2020) (PDF) (“To be sure, the Motion seeks extraordinary and unique relief. The Debtors advance the Motion on the theory that proceeds from sales of unissued shares is a cost-effective, efficient and creative substitute for debtor-in-possession (‘DIP’) financing and base it on the premise that Hertz ‘shares have significant value.’”).
Some commentators responded to Hertz’s move with outrage, tweeting, for example, that “a company in bankruptcy just found idiots to buy their stock before it probably goes to ZERO.” Others marveled at Hertz’s boldness, observing that the maneuver “is incredibly creative and they get props for that.” But all of this was short-lived. While the bankruptcy court granted Hertz the authority to issue new shares, the Securities and Exchange Commission (SEC) was less sanguine. After reviewing the disclosures that Hertz planned to make to potential buyers, the SEC advised Hertz that it had comments on the disclosures and intended to review the supplement.7Hertz had filed—and the SEC approved—disclosures for a stock issuance before declaring bankruptcy. It is possible that Hertz did not need SEC approval to sell the new shares. However, it seems likely that the SEC was concerned about the adequacy of those disclosures now that Hertz was in bankruptcy, and that Hertz halted the stock issuance after receiving comments from the SEC because the company did not want to risk a protracted investigation. That effectively killed the scheme.8Hertz suspended its sale of up to $500 million in new shares after the SEC announced that it planned to review the sale. Hertz did, however, manage to raise $29 million by selling new stock before the SEC intervened.
The conventional expectation is that Hertz’s common stock has no value and will be wiped out in reorganization. Yet there was (and still is) significant market demand for these shares.9On August 18, Hertz was trading at $1.49 a share, and the stock has continued to trade at more than $1 a share into October. This presents several interesting questions. For example, why does bankruptcy wipe out equity value, and why would anyone want to buy worthless equity?10This issue is relevant in many bankruptcy disputes and is not limited to Hertz’s attempt to issue new stock in bankruptcy. There is an active market for equity of firms that have filed for bankruptcy. See Jared A. Ellias, Bankruptcy Claims Trading, 15 J. Emp. L. Studies 772, 799 (2018) (“The Chapter 11 equity sample contains trades of more than 38 billion shares issued by 135 firms on 36,323 trading days with an aggregate market value of approximately $335 million. Approximately 78% of observed trading days involve transactions with a price-per-share of less than $1.”). See also Luis Coelho, Kose John & Richard J. Taffler, Bankrupt Firms: Who’s Buying (SSRN). And, in light of the outrage, whether debtors should ever be able to raise funds through a public equity offering, and whether—and perhaps how—the law should step in to prevent such transactions.
This Essay explores these questions. It argues that commentators have focused on the wrong bankruptcy problem. Contrary to the conventional wisdom, Hertz’s bankruptcy does not show that retail investors require bankruptcy-specific protections. If unsophisticated retail investors need to be protected from making uninformed investments, that is the case both inside and outside of bankruptcy. Hertz’s bankruptcy does, however, highlight distortions created by the absolute priority rule. By collapsing all future possibilities into a present value that is distributed based on priority, the absolute priority rule arguably redistributes value from stockholders to creditors. And, by giving senior investors significant control rights, the absolute priority rule reduces the likelihood that junior creditors and shareholders will provide new financing to a debtor in bankruptcy even if those investors place the highest value on the firm. The real bankruptcy problem, then, is not that retail investors are incapable of making informed bets, but that bankruptcy law makes it difficult for stockholders and unsecured creditors to make long-term bets about a company’s future value. From this perspective, relative priority begins to look like a form of investor protection that facilitates investment in a firm’s long-term value.11As discussed in Part IV, relative priority protects both sophisticated and unsophisticated investors. Relative priority protects sophisticated investors because it reduces the administrative costs of negotiating to protect junior investors’ option, and it protects unsophisticated investors because it makes bankruptcy’s default rules more closely approximate the expectations of naïve investors.
I. Hertz’s Bankruptcy
Until Hertz attempted to fund its bankruptcy through a stock issuance, its bankruptcy was remarkable only for its size.12As of October 5, it was the largest firm in terms of asset value to file bankruptcy in 2020. While the COVID-19 pandemic was the immediate cause of Hertz’s distress, the company was by certainly not in the clear before the pandemic. Hertz was facing new competition from ride-hailing companies such as Lyft and Uber, and like many debtors, the firm was functioning under a highly leveraged capital structure. Starting when it was acquired by a group of private equity funds in 2005, Hertz’s leverage continued to grow as it borrowed heavily to fund an acquisition of Dollar Thrifty and update its fleet of vehicles. Over the past few years, its debt to capital ratio had consistently hovered above 90 percent.13Debt-to-capital ratio is debt divided by the sum of debt and shareholder’s equity. A 90-percent debt-to-capital ratio means that Hertz was highly leveraged and less able to weather an economic downturn. By the time it filed for bankruptcy protection, the company had disclosed approximately $19 billion in debt obligations.14Declaration of Jamere Jackson in Support of Debtors’ Petitions and Requests for First Day Relief, In re Hertz Corp., Case 20-11218, Doc. 28 (May 24, 2020) [hereinafter Jackson Declaration] (PDF).
Then the pandemic pushed Hertz into insolvency. Reduced travel had an outsized impact on Hertz’s business. As people stopped flying, they stopped using Hertz’s airport rental car services. In a bankruptcy filing, the company stated that its revenue for April 2020 was 73 percent lower than its revenue for April 2019.
In addition to reducing demand for Hertz rental cars, the pandemic also caused Hertz’s costs to increase. Most of Hertz’s debt—approximately $15 billion at the time of Hertz’s bankruptcy filing—was raised through asset-backed securities programs (ABS).15Hertz’s ABS programs raise funds when an issuer, which is a special purpose entity (SPE) that is a Hertz wholly owned subsidiary, sells bonds in the ABS market. Generally, the issuer loans the proceeds of the Notes to a second special purpose entity. That second entity uses the money raised from the ABS issuance to purchase vehicles. The vehicle owner leases the vehicles to Hertz’s rental car businesses and uses the payments it receives from Hertz’s rental car business to repay the issuer. The issuer, in turn, uses those funds to pay the principal and interest to holders of the ABS Notes. The ABS Notes are secured by the vehicles the Hertz vehicle owner purchases with the money raised through the issuance. See Jackson Declaration at 43–46. Under the ABS program, Hertz was required to make monthly payments for any reduction in the market value of the cars in its fleet with that market value calculated in part by reference to used car price indices. The initial economic shutdown in March and April led to a brief but large reduction in used car sales. This in turn depressed the reported prices for used cars. According to Hertz, because of this drop in the price indices, it had “to pay an additional approximately $135 million into its U.S. rental fleet ABS Program in April in order to maintain access to funding at existing levels, with even greater amounts projected in the months to come.”16See Jackson Declaration at 8. It is worth noting that reported used car prices have since recovered and indeed experienced significant increases compared even to pre-pandemic levels. Despite terminating over 14,000 employees, the company could not pay its debt obligations. In late April 2020, Hertz failed to pay nearly $400 million it owed to its ABS facility. A few weeks later, the company filed for bankruptcy protection.
II. Hertz’s Equity Financing
After Hertz filed for bankruptcy, its bonds traded at a significant discount, suggesting that creditors were concerned that they would not be paid back in full. Hertz’s equity, however, told a different story. On May 26, 2020—the first trading day after Hertz filed for bankruptcy protection—Hertz shares traded as low as $0.40 per share.17See Debtors’ Emergency Motion for Authority to Enter into a Sale Agreement at 9, In re Hertz Corp., Case 20-11218, Doc. 387 (Jun. 11, 2020) [hereinafter Motion to Enter Sale Agreement] (PDF). Over the next two weeks, Hertz’s stock price rose nine hundred percent to a peak of $5.53 per share.
This rally was unusual.18But not unique. Whiting Petroleum and JCPenney also saw their shares more than double after entering Chapter 11. As a formal matter, bankruptcy law requires the distribution of assets based on priority.19In reality, things are more complicated. Uncertainty, frictions, and settlements often result in bankruptcy outcomes that deviate from the absolute priority rule. See Frederick Tung, Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate Governance, 57 UCLA L. Rev. 115, 134 (2009); Mark J. Roe, Bankruptcy and Debt: A New Model of Corporate Reorganization, 83 Colum. L. Rev. 527, 542–43 (1983); Lucian Ayre Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 Yale L.J. 857 (1996); Lucian Ayre Bebchuk & Jesse M. Fried, A New Approach To Valuing Secured Claims in Bankruptcy, 114 Harv. L. Rev. 2388 (2001). Secured creditors are paid first. Unsecured creditors are paid next. Stockholders have the last claim on the company’s assets and receive nothing if secured and unsecured creditors are not fully repaid. Since Hertz filed for bankruptcy after failing to pay $400 million in debt, there was certainly some reason to think that Hertz might have been balance sheet insolvent. That is, the value of its liabilities exceeded the value of its assets. At the same time, since Hertz’s bankruptcy was apparently triggered only when $135 million came due unexpectedly, there is perhaps reason to think that Hertz was balance sheet solvent and simply faced cash flow problems.20As discussed below, the distinction between these two forms of distress is important. We will use the term “insolvency” to refer to balance sheet insolvency.
Commentators have suggested that unsophisticated retail investors—in particular, retail investors who used the Robinhood trading platform—were behind Hertz’s rally. Robinhood gives retail investors easy access to financial markets. It has no trading fees or sales minimums, and it uses game-like features to nudge users into making more trades.21These include, for example, a leaderboard that ranks stocks from most popular to least popular, a social component that encourages users to invite friends, and pushes notifications that encourage users to use the app more frequently. The app has become immensely popular and counts millions of users. And there is evidence that Robinhood traders had an appetite for Hertz stock. While nearly 43,000 Robinhood accounts owned shares of Hertz prior to the firm’s bankruptcy filing, that number skyrocketed to 171,000 by June 2020. Of course, this fact alone does not prove that the trade was irrational. And, although Hertz shares declined since reaching a peak of $5.53 per share, as of October 5, the company’s common stock has continued to trade at more than double its May 26 low.22There is also evidence that Hertz shareholders continue to respond to developments that affect the company’s long-term prospects. See Daniel Miller, Why Hertz Declined Another 6% Wednesday, Motley Fool (Sept. 30, 2020) (noting that Hertz shares declined after executives left the company).
In any event, because someone in the market was willing to buy Hertz stock, the company saw an opportunity to finance its bankruptcy through a stock issuance. While this move was apparently unprecedented,23Lynn Turner, former chief accountant of the SEC, told the Wall Street Journal that he “can’t recall an incident where a company has made a stock filing this early after filing for bankruptcy.” it may have been a sensible response to the market’s appetite for Hertz common stock. As Hertz explained in a bankruptcy filing, “[t]he sale would also allow the Debtors to raise capital on terms superior to any debtor-in-possession financing. The stock issuance would not impose restrictive covenants on the Debtors and would be junior to claims of the Debtors’ creditors.”24Motion to Enter Sale Agreement at 9. In other words, the stock issuance would not require Hertz to comply with the onerous conditions that usually accompany DIP financing. Moreover, “the issuance of the shares would impose no payment or repayment obligations on the Debtors.”25Id. Hertz still had to pay investment bankers and lawyers involved in the stock issuance. It simply would not have been under any obligation to repay stockholders. Hertz, in short, had a rare opportunity to receive what it saw as “free” money.26Of course, there is no such thing as free money. Conventional DIP financers usually charge interest to compensate for the loan and demand priority over other claims, making a DIP loan one of the safest investments a bank can make. See B. Espen Eckbo, Kai Li & Wei Want, Rent Extraction by Super-Priority Lenders, working paper available here (noting that DIP loans are “almost risk-free”). The cost of interest and priority is born by the other creditors. DIP financers also bargain for significant control rights.The debtor in possession and its managers are the ones who most directly bear the cost of giving up control. With the Hertz maneuver, there was no interest payment and there was no grant of control rights. To be sure, though, someone is bearing the cost here. The question is who. The answer depends on the pricing of the stock. In well-functioning markets, the price paid for the new equity should be low to reflect its low priority position and high risk. This implicit cost of financing would be borne by the existing equity holders whose interests would be diluted. It is not surprising then that the only objection to the offering came from a group of equity holders seeking adequate protection against dilution. See Limited Objection and Reservation of Rights of Gamco Investors, In re Hertz Corp., Doc. 406, ¶ 3 (PDF). If critics were correct, however, and markets were not functioning well and the stock was worthless, then the new investors were bearing the entire cost of the financing, which was indeed “free” to Hertz and its stakeholders. For that reason, Hertz told the bankruptcy court, not unreasonably, that the stock issuance was “an exercise of the Debtors’ sound business judgment.”
In its disclosures to potential buyers, Hertz was explicit that shareholders should not expect to be repaid, warning seven times in an SEC filing that its reorganization “may cause the stock to decrease in value or become worthless.” Hertz further explained that any shareholder recovery “would require a significant and rapid and currently unanticipated improvement in business conditions to pre-COVID-19 or close to pre-COVID-19 levels.” The company also noted that its shares would likely be delisted from the major stock exchanges, which would “impair our stockholders’ ability to buy and sell our common stock.”
On Friday, June 12, the bankruptcy court authorized Hertz to sell up to $1 billion in new shares.27See Order Granting Debtors’ Emergency Motion for Authority To Enter Into A Sale Agreement, In re Hertz Corp., Case 20-11218, Doc. 417 (June 12, 2020). If the buying frenzy that caused Hertz shares to rise after the firm filed for bankruptcy caused a commotion, the company’s decision to issue new shares incited an uproar among financial analysts. A common refrain was that the bankruptcy judge should never have allowed the company to issue stock, and that doing so risked taking advantage of retail investors who did not realize that they were giving money to Hertz creditors with little, if any, chance of recovery. For example, prominent bankruptcy scholar Professor Jared Ellias told the Wall Street Journal that “this is retail investors setting money on fire.”28Professor Elias further tweeted “To me, it is clear that this transaction was beneath the dignity of what we expect of a firm availing itself of the privileges of Chapter 11.” Another columnist chastised the bankruptcy judge for refusing to “do the right thing” by not “put[ting] a stop to Hertz’s cynical move.”
In the end, Hertz’s attempt to finance its bankruptcy through a stock issuance was short-lived. Although the bankruptcy court sanctioned Hertz’s stock issuance, less than a week after the bankruptcy court approved the maneuver, Hertz announced that it had decided to suspend the stock issuance in response to SEC comments.
III. A Bankrupt Firm’s Equity May Have Value
Hertz’s brief flirtation with a stock issuance in bankruptcy raises the question of when shares of a bankrupt firm have value, and whether bankruptcy judges should allow such issuances or intervene to protect prospective retail investors. Despite commentators’ forceful critiques of Hertz’s attempted stock issuance, there are certainly situations in which a bankrupt firm’s equity has value, but it can be difficult to distinguish informed bets about the future value of a firm from uninformed speculation.
A. Firm Has Net Value
First, a firm’s equity may have value in bankruptcy if—as occasionally happens—that firm’s assets turn out to be worth more than its liabilities such that the bankruptcy plan can fully repay all creditors. Under current bankruptcy law, shareholders can expect to receive compensation if there is residual value that can be used to pay them after all the creditors are repaid. This might occur if the firm unexpectedly discovers value, or if the bankruptcy filing was driven by cash flow rather than balance sheet insolvency problems. These situations occur infrequently, but they are not unheard of.
The example of American Airlines is instructive. American Airlines filed for bankruptcy on November 29, 2011. The company had lost more than $10 billion in the decade leading up to its bankruptcy filing. It filed for bankruptcy to restructure its debt and renegotiate employee wages. At one point, the company’s stock fell to $0.20 a share. However, its shares soared after US Airways submitted a takeover bid. As the Wall Street Journal observed, “one of the best investments of the past couple of years was a bankrupt airline.” After the merger closed, the holders of pre-bankruptcy equity received a stake in the new company worth about $11 billion.29And shares of new American Airlines continued to surge years after the merger.
The American Airlines bankruptcy provides an example of a situation where the equity’s value is realized before a formal reorganization wipes out the prepetition shareholders. And that payout can be substantial. The decision to consolidate American Airlines and U.S. Air was a “bonanza for investors who gambled on AMR [American] stock as bankruptcy-related cost cutting, merger synergies and an overall improvement in the airline industry boosted Americans prospects.”30Note, though, that American Airlines’ shareholders were able to recover only because the takeover bid was submitted during—not after—the bankruptcy. It is therefore also an example in which an event with an unlikely, but high potential payout, occurs before the bankruptcy shuts out shareholders. But even firms with net value depend on certain events happening during the bankruptcy for shareholders to realize that value. In this way, many cases are examples of both cases. We discuss the second case in more detail in the next subsection.
Stockholders can also recover in a bankruptcy if a firm faces temporary liquidity issues but is actually balance sheet solvent. Consider, for example, the General Growth Properties’ bankruptcy, which provided a forum in which to restructure the debt of a highly leveraged but otherwise healthy company. General Growth was a large real-estate company and the second largest shopping mall operator in the United States. When it filed for Chapter 11 bankruptcy protection in April 2009, its filing marked the largest ever real estate bankruptcy.
In the decade leading up to the 2008 financial crisis, General Growth had engaged in a highly aggressive acquisition spree, which it funded primarily by issuing new debt. The company had little cash on hand, and the 2008 financial crisis made it difficult for the company to pay or refinance its debt obligations. The bankruptcy process provided breathing room for it to restructure its obligations and in the end all claimants—including equity—recovered substantial value. The firm’s bankruptcy triggered a bidding war that ultimately provided a massive payout to certain shareholders. Analysts estimated that Bill Ackman’s Pershing Square Capital, which had acquired a twenty-five percent stake in General Growth before the firm filed for bankruptcy, made a 256 percent return on its investment.
These are not the only examples where a company’s prepetition shareholders received a meaningful stake in the postpetition company.31The examples we discuss in this paper show that there are reasons to think that equity actually does have value. There are other reasons that shareholders of a bankrupt firm may be able to recover. For example, a large literature has argued that shareholders are often compensated in order to prevent shareholders from exercising their option to delay reorganization. See, e.g. Brian L. Betker, Management’s Incentives, Equity’s Bargaining Power and Deviations from Absolute Priority in Chapter 11, 68 J. Bus. 161 (1995). An influential, though dated, study found that a majority of large bankruptcies resulted in some recovery for shareholders. And more recent work has found that the number of reorganizations that deviate from absolute priority and compensate shareholders has declined over time, but that stockholders continue to recover in a nontrivial number of cases.32Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis 511, 513 (2009) (“[F]ew reorganization plans (at most 12 percent) deviate from the absolute priority rule by distributing value to equity holders even though creditors have not been paid in full. In at least 82 percent of the cases, equity holders received nothing.”). A more recent study found that pre-bankruptcy equity receives value in approximately fourteen percent of Chapter 11 cases. See Jared Ellias, @jared_ellias, Twitter (Jun. 15, 2020, 4:25 PM CT). There is also evidence that shareholders hire counsel to represent them in a nontrivial number of cases, and that this practice constrains managerialism. See Jared A. Ellias, Do Activist Investors Constrain Managerial Moral Hazard in Chapter 11?: Evidence from Junior Activist Investing, 8 J. Leg. Analysis 493 (2016).
B. Low Probability of High Payout
Second, a bankrupt company’s stock may trade at positive value even when it is balance sheet insolvent if there is a small chance of a large payout in the near future that could pay off all creditors and provide value to equity.33The decline of lengthy Chapter 11 reorganizations has caused the length of this window to contract and therefore compressed the time frame in which option value can be realized under the absolute priority rule. See Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 J. Legal Analysis 511, 517 (2009) (finding reduced reliance on lengthy reorganizations and increased use of sales); William W. Bratton & Adam J. Levitin, The New Bond Workouts, 166 U. Pa. L. Rev. 1597, 1642–46 (2018) (arguing that creditor concentration has facilitated restructuring support agreements and other out-of-court workouts). One could imagine, for example, that there is a very low probability that a COVID-19 vaccine is ready for distribution sooner than anticipated, that the government will choose to bail Hertz out, or that Hertz will suddenly become the object of a bidding war. If any of those events occurs, Hertz will suddenly be able to pay its creditors in full.
This possibility creates tension between stakeholders. The equity holders want to wait as long as possible to see if the low probability event materializes. At the same time, the secured creditors may rationally expect that a drawn-out bankruptcy will cause the company’s assets to lose additional value. That expectation can cause those creditors to prefer a course of action the wraps things up and allows them to cash out quickly.
A simple example illustrates this phenomenon. Imagine a firm has one project and two investors. One investor receives a debt instrument with a blanket lien on all the project’s assets. The other investor receives equity. The creditor is entitled to $1,000 and the shareholder will receive whatever remains. After the project gets started, it becomes clear that it has a five percent chance of success. If the project is successful, it will be worth $100,000. If it fails, it will be worth $0. The expected value of the project is therefore $5,000. At this point, the project’s debt will trade at a significant discount. Creditors have a ninety-five percent chance of being wiped out, and a five percent chance of recovering their $1,000 investment. The debt is therefore worth $50—just one-twentieth its face value. Equity, by contrast, is worth significantly more than the debt. Although equity will be wiped out ninety-five percent of the time, in the unlikely event that the project succeeds, equity will receive $99,000. In this case, the equity has an expected value of $4,950—nearly one hundred times more than the debt.
When the expected payout of such an event is high, it can be better to buy stock than debt, since stock enjoys a claim on the company’s residual value. Bankruptcy, however, compresses the time frame within which an event that would allow equity to receive the full upside of its position can occur. And that time period runs out when the bankruptcy process is complete. Essentially, the confirmation of a plan of reorganization is a moment that collapses all future possibilities to a present value to be distributed in order of priority.34Douglas G. Baird & Robert K. Rasmussen, Control Rights, Priority Rights, and the Conceptual Foundations of Corporate Reorganizations, 87 Va. L. Rev. 921, 936 (2001); Melissa B. Jacoby & Edward J. Janger, Ice Cube Bonds: Allocating the Price of Process in Chapter 11 Bankruptcy, 123 Yale. L.J. 862 (2013); Melissa B. Jacoby & Edward J. Janger, Tracing Equity: Realizing and Allocating Value in Chapter 11, 96 Tex. L. Rev. 673 (2018). At that point, equity is stuck with whatever value is left over after creditors are repaid in full.35One way to preserve stockholders’ option value is to give stockholders of the old firm warrants in the new company. Stock warrants give the holder of the warrant a right to buy the company’s stock at a specified price. Stock warrants and stock options work in similar ways. A stock option is a contract between two people that gives the holder the right, but not the obligation, to purchase stock at a specified date and at a specified price. When an investor exercises a warrant, by contrast, the shares that fulfill the obligation are issued by the company. When stockholders of the old firm receive warrants in the new firm, they have an opportunity to purchase shares of the reorganized company at a low price if the reorganized firm’s stock turns out to have significant value. In this way, warrants could allow stockholders of the old firm to retain the option value of the old firm. In order to accurately preserve the option value, careful attention must be paid to setting the price at which the warrant could be exercised and the date on which it expires. As a practical matter, this means that low probability events with high payouts for equity are less likely once a firm has entered bankruptcy because the payout for equity must occur before the bankruptcy is complete.36As a result of bankruptcy law, stockholders’ option value is a function of time. In bankruptcy, equity will only receive the benefit of the option value of a high-payout event occurs before the end of the bankruptcy. Outside of bankruptcy, stockholders presumably have a longer time horizon, but if liquidity problems prevent a firm from honoring its debt obligations, even the prospect of bankruptcy can give creditors holdup power that allows them to demand a premium from equity in order to refrain from forcing a reckoning in which the creditors might be paid before the shareholders. For example, while an unexpected bidding war or government bailout could cause the firm’s value to increase rapidly, it must occur or at least become imminent before the case closes in order to benefit equity holders. These situations may be infrequent, but they are not impossible.37The American Airlines example above presents an example. Before the merger was imminent, it was possible that any residual value would not be realized before the firm emerged from bankruptcy. Still, that possibility was still worth betting on, and once the merger became a reality, the firm had actual net value.
Finally, equity can also receive compensation in a bankruptcy proceeding if there is uncertainty about a firm’s value. PG&E’s recent bankruptcy might be an example in which uncertainty results in a settlement that compensates equity. Throughout PG&E’s bankruptcy, PG&E’s common stock traded well above zero and, at one point, reached nearly $14 a share. Some investors questioned the company’s decision to file for bankruptcy. For example, Blue Mountain Capital Management, which owned 0.8 percent of PG&E and was one of the company’s twenty-five largest shareholders, wrote that “PG&E is solvent” and the firm’s decision to file for bankruptcy was therefore an “abdication of its [fiduciary] duty to its shareholders.”
Although PG&E’s board and the bankruptcy court decided to go forward with the reorganization, PG&E’s shareholders were not wiped out when PG&E reorganized. Instead, PG&E repaid all of its creditors and reserved $1.25 billion of its $5.75 billion post-reorganization stock issuance to investors who owned stock as of June 19, 2020. Perhaps, as with American Airlines, the company was solvent. Or perhaps the possibility that the company was solvent, and the associated threat of a protracted bankruptcy process (or the threat of litigation), contributed to a settlement that preserved substantial value for stockholders.
Because PG&E’s bankruptcy was triggered by wildfire liability, and because there was some uncertainty about the magnitude of the company’s obligations to wildfire victims, stakeholders could reasonably adopt different views about PG&E’s financial health. Moreover, the company itself benefited from resolving its wildfire liability quickly and thereby ensuring that protracted litigation did not hang over the firm’s head for years. In providing a relatively sizable compensation to PG&E’s shareholders, PG&E satisfied shareholders who might otherwise have objected to the reorganization plan. In that way, the firm avoided the need for a complicated and costly valuation or cramdown.
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These are the general scenarios where the equity might have value and it would be rational for an investor to buy shares. Of course, every transaction involves a seller as well as a buyer. And the seller must think that selling is rational. In the end, the main reason to buy shares in a bankrupt company is to make a bet that the sellers who think the stock is worth less (or worthless) are wrong. But that is true of almost all stock trades. Trades occur when parties have asymmetric expectations or asymmetric tolerance for risk. In such circumstances, it is not clear that a bankruptcy judge or anyone else will be able to definitively distinguish between trades that reflect reasonable bets on valuation or low probability events from trades that reflect a basic misunderstanding of financial markets.
In Hertz’s case, there was at least some possibility that the firm had residual value that could be realized before a reorganization wiped out the firm’s stockholders. The most obvious possibility is that Hertz stock offered investors an opportunity to bet that the pandemic would end quickly and this would lead to a rapid recovery of Hertz’s business. Moreover, because Hertz is highly invested in the used car market, an increase in the price of used cars might increase the value of Hertz’s assets. Finally, the pandemic has reduced demand for taxis, ride-hailing companies, air travel, and public transportation. If people substitute private rental car travel for these other modes of transport, it may create new demand. These are the most obvious among various scenarios where a bet on equity would pay off. That possibility makes it at least arguable that these investors were acting rationally and not engaging in rampant speculation.38Ironically, the argument against the Hertz’s offering might actually be stronger if the equity has value. In that case, it would have diluted and therefore reduced the value of existing Hertz shares. See Limited Objection and Reservation of Rights of Gamco Investors, In re Hertz Corp., Case 20-11218, Doc. 406, ¶ 3 (June 12, 2020) (PDF) (arguing that if the stock issuance does not protect existing shareholders, “then the Sale Agreement is objectionable because it effectively provides DIP financing at the expense of current equity holders who will suffer massive dilution”). This problem might be mitigated by offering existing shareholders a right of first refusal before issuing the stock.
Assigning a definitive value to Hertz is even more imprecise in the current volatile economic environment. Between February 19 and March 23, the S&P 500 lost a third of its value dropping from a then-record high of 3,386.15 to 2,237.40. In the months since then, the American economy has seen record unemployment and a record 32.9 percent drop in GDP in the second quarter. And yet, the S&P has since hit a record high close of 3,580.84 on September 2 and of this writing (October 5) sits at 3,408.56. This is all to say that with the current market volatility, one should not be too confident in declaring someone else’s predictions about low probability valuation events irrational.
IV. What is the Role of a Bankruptcy Court?
The criticisms of the bankruptcy court’s decision to allow the Hertz maneuver are based on the idea that bankruptcy law should do more to protect retail investors from engaging in bad trades. The arguments in favor of this view are weak. Even setting aside difficulties in identifying bad trades and other general questions about the optimal levels of protection for retail investors, there remains a flaw with regard to domain.39We have bracketed the threshold matter of whether it is desirable to give retail investors additional protections at all. This is a complicated question turning on a complicated assessment of feasibility and costs and benefits. See R. David McLean, Tianyu Zhang & Mengxin Zhao, Why Does Law Matter? Investor Protections and Its Effects on Investment, Finance, and Growth, 67 J. Fin. 313 (2011). However sympathetic one is to investor protection, it is not a problem that calls for a bankruptcy-specific solution.
A. The Limits of Bankruptcy Law
A fundamental characteristic of bankruptcy law is its limited scope. Protections and entitlements that exist only when a firm is in bankruptcy pose a real risk of distorting behavior and interfering with nonbankruptcy rules. This problem is well recognized and has been described as “troublesome forum shopping.” When the rules change at the moment of filing, interested parties—and here that would include potential investors—have incentives to expend resources to either trigger or prevent that filing depending on whether the bankruptcy rules favor them or not, or to otherwise change their behavior.
If certain capital-raising opportunities are cut off when a bankruptcy is filed, a firm may delay filing, accelerate equity offerings, seek out less favorable avenues for capital, or conceal information about its financial condition. Creditors seeking control or ownership may engage in activities intended to nudge the firm into bankruptcy to push out equity, old and new. And potential investors may simply move their money to riskier investments with less publicly available information.
The fundamental point is that bankruptcy law should be directed at bankruptcy problems. There is some debate about what falls under that label.40See Douglas G. Baird, Anthony J. Casey, & Randal C. Picker, The Bankruptcy Partition, 166 U. Pa. L. Rev 1675 (2018); cf. Anthony J. Casey, Chapter 11’s Renegotiation Framework and the Purpose of Corporate Bankruptcy, Colum. L. Rev. (forthcoming 2021) (arguing that bankruptcy should solve the problem of incomplete contracting but not alter nonbankruptcy entitlements); Douglas G. Baird, Priority Matters: Absolute Priority, Relative Priority, and the Costs of Bankruptcy, 165 U. Pa. L. Rev. 786 (2017); Vincent S.J . Buccola, Bankruptcy’s Cathedral: Property Rules, Liability Rules, and Distress, 114 Nw. L. Rev. 705 (2019) (arguing that the only justifiable purpose of modern corporate bankruptcy law is to administrative costs prevent parties from (a) toggling from a property rule to a liability rule in distress, and (b) a liability rule is efficient in distress but not in the ordinary course of business); Barry E. Adler, Financial and Political Theories of American Corporate Bankruptcy, 45 Stan. L. Rev. 311, 323–33 (1993); Barry E. Adler, Priority in Going-Concern Surplus, 2015 U. Ill. L. Rev. 811, 813 (describing how priority protects against “the debtor’s pursuit of excessive risk that might be financed by subsequent loans from other creditors”); Anthony J. Casey & Edward R. Morrison, Beyond Options, in Handbook on Corporate Bankruptcy (B. Adler ed., forthcoming 2017), available here; Barry E. Adler & Ian Ayres, A Dilution Mechanism for Valuing Corporations in Bankruptcy, 111 Yale L.J. 83, 88–90, 96–100 (2001) (proposing a novel valuation mechanism while defending the absolute priority rule). But even under the broadest definition of bankruptcy’s purpose, protecting an investor who has no prepetition relationship with the debtor is not a bankruptcy purpose.41Those who adhere to the traditional Butner principle would argue that this is an unnecessary distortion of non-bankruptcy entitlements. Those taking a broader view—as one of us does—would argue that the investor has no relationship-specific investment or incomplete contract with the debtor to protect. At the same time, this protection does create a bankruptcy problem because it blocks a firm in in bankruptcy from accessing a source of financing that is available to firms outside of bankruptcy.
B. Retail Investor Protections
Moreover, imposing a bar on equity offerings in bankruptcy does little to protect retail investors. While investing in bankrupt companies is risky, prohibiting a debtor from issuing new stock does not stop retail investors from buying shares of the debtor in the secondary market. And there are ample examples of retail investors doing just that. To be sure, even after the Hertz maneuver was killed, old equity holders were free—and continue to this day—to sell shares on the secondary market. And while newly issued shares might in some cases provide valuable financing to a viable business,42It is of course possible that they are providing financing to a failing business. these secondary transactions create little or no social value. They just shift risk from one party to another.
Nor does the prohibition stop retail investors from gambling on shares of risky firms that have not yet filed. Tragic stories of retail investor losses are not limited to the bankruptcy world. While the New York Times and the Wall Street Journal have published profiles about the Robinhood app in which they documented numerous stories in which retail investors have suffered extreme losses—including the tragic story of a college student who took his life after suffering more than $700,000 of losses—not one of these stories involved investments in bankrupt firms.43To be sure, some of these stories ended with the firm in bankruptcy. But none of them started with the issuance of shares from a debtor in bankruptcy.
While these transactions are troubling, right now there is no federal policy protecting retail investors in these situations.44The SEC has historically acted primarily as a disclosure agency, but it has occasionally adopted rules to provide stronger protections for retail investors. The SEC is primarily a disclosure agency and does not have authority to ban a public offering simply because it thinks something is a bad investment. In fact, the SEC even permits speculative investments in “blank check companies” that have “no specific business plan or purpose.” Those investments are at least as risky as investments in a firm in bankruptcy, especially when one considers the instances—though few—where stocks of bankrupt companies have in fact offered large returns. Like bankruptcy judges, the SEC will struggle to distinguish between informed speculation and irrational exuberance. And even if the demand for Hertz’s equity issuance was a clear example of retail investor irrationality, it was only one of many. It is not clear why the SEC should intervene here when the issuer is in bankruptcy but stand quiet in other cases where retail investors stand to lose everything.45Given the furor that surrounded Hertz’s stock issuance, one might wonder if the SEC was reacting to media outrage. If the SEC wants to protect retail investors from purchasing worthless securities, it should develop a rule that defines how the SEC will determine that there is a low probability payout, and the SEC should intervene in a manner that actually protects retail investors. Here, because retail investors could still purchase Hertz shares that had already been issued, the SEC’s intervention did not even succeed in preventing retail investors from purchasing Hertz stock.
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As a final note, one should reflect on the different actions taken by the two government actors in this episode. The SEC and the bankruptcy court are unusual entities. Much has been written about how and whether their particular structures fit within the constitutional structure of the federal government, and about the proper scope of their jurisdiction. As an independent agency, the SEC doesn’t fit neatly within the executive branch. And decades of litigation have failed to resolve exactly where bankruptcy courts—as non–Article III courts—fit and what powers they have.
For those who worry that such entities will invariably expand beyond their intended jurisdiction, the bankruptcy judge’s decision to refrain from exercising her power to regulate the actions of prospective investors with no prior relationship with the debtor should be refreshing. The SEC’s exercise of its authority to effectively ban one specific public offering simply because the commissioners thought it was a bad investment is a different story.
V. Relative Priority as Investor Protection
While the Hertz maneuver does not, as some suggest, pose a new bankruptcy problem that calls for a ban on equity offerings, it does highlight a few important and strange features (or bugs) of bankruptcy law process. The Hertz maneuver would have allowed investors to bet on option value. As noted, the option at play here is very limited because the confirmation of a bankruptcy plan collapses future possibilities to present value. Thus, the time horizon that buyers are betting on is a short one. The option value must play out before plan confirmation. It is not enough to have a 5 percent chance of a $1,000 valuation in the future. That ship needs to come in before the plan is confirmed.
But this doesn’t have to be the case. As many scholars have noted, a coherent bankruptcy system could exist with “relative priority.” Unlike absolute priority, relative priority allows junior investors to recover their option value even if senior creditors are not paid in full. Junior investors can recover that value as a payout in the bankruptcy proceeding, a stake in the reorganized firm, or a warrant that allows them to buy shares of the reorganized firm at a predetermined exercise price at a future date.46See Jonathan M. Seymour & Steven L. Schwarcz, Corporate Restructuring Under Relative and Absolute Priority Default Rules: A Comparative Assessment, 2021 U. Ill. L. Rev. (forthcoming). Warrants preserve option value, but they do so only if equity is willing to inject new funds into the recapitalized firms. One can therefore understand them to be a compromise between equity and other stakeholders in which the other stakeholders’ priority interest gives them a sort of holdup power over equity. Relative priority does not fully resolve this issue. Even absent absolute priority, firms would still be permitted to reorganize through a 363 sale that, like absolute priority rule, brings about a day of reckoning. More aggressive judicial valuation or increased use of warrants might mitigate, albeit only imperfectly, this distortion. Anthony Casey, The Creditors’ Bargain and Option-Preservation Priority in Chapter 11, 78 U. Chi. L. Rev. 759, 773–75 (2011).
Scholars who advocate for such a system have focused primarily on two things. First, some argue that relative priority is necessary to preserve nonbankruptcy entitlements. Under this view, the day of reckoning created by a bankruptcy filing is problematic because it transfers option value from junior to senior stakeholders. Recall the example in Part II, where the senior claim had an expected value of $5047It expected to receive $1,000 with a 5 percent probability and $0 with a 95 percent probability. and the junior claim (equity in that example) had an expected value of $4,950.48It expected to receive $99,000 with a 5 percent probability and $0 with a 95 percent probability. Those are the values that exist in the absence of bankruptcy’s day of reckoning. But under current bankruptcy law, because the senior creditor is paid first based on today’s value of the firm, the senior creditor receives the face value of the debt—$1,000—before the junior investor receives anything. Thus, if the firm is correctly valued at $5,000, the junior investor receives $4,000 and the senior creditor receives $1,000 even though their investments are respectively worth $4,950 and $50 outside of bankruptcy.49One can question whether the nonbankruptcy entitlements are relevant or even ascertainable here. For an extended discussion, see Anthony J. Casey & Edward R. Morrison, Beyond Options, in Handbook on Corporate Bankruptcy, available here; Anthony Casey, The Creditors’ Bargain and Option-Preservation Priority in Chapter 11, 78 U. Chi. L. Rev. 759, 773–75 (2011);Douglas G. Baird & Robert K. Rasmussen, Control Rights, Priority Rights, and the Conceptual Foundations of Corporate Reorganizations, 87 Va. L. Rev. 921, 939 (2001); Douglas G. Baird, Priority Matters: Absolute Priority, Relative Priority, and the Costs of Bankruptcy165 U. Pa. L. Rev. 785 (2017); Alan Schwartz, A Normative Theory of Business Bankruptcy, 91 Va. L. Rev. 1199, 1257 (2005); Lucian A. Bebchuk, A New Approach to Corporate Reorganizations, 101 Harv. L. Rev. 775, 785–87 (1988).
Second, some argue that absolute priority distorts the incentives of those in control of the bankruptcy process. The trend in large bankruptcies over the last thirty years has been toward senior creditor control.50Kenneth Ayotte & David A. Skeel, Jr., Bankruptcy Law as a Liquidity Provider, 80 U. Chi. L. Rev. 1557, 1579–85 (2013); Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 Stan. L. Rev. 751 (2002); Douglas G. Baird & Robert K. Rasmussen, Chapter 11 at Twilight, 56 Stan. L. Rev. 674 (2002); Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. Pa. L. Rev. 1209 (2006). In a world with absolute priority, those creditors recover first and only up to a capped amount. The result is that those creditors bear much of the downside of a risky project but get little of the upside. As such, they have an incentive to prefer a sure thing over waiting. Indeed, there is evidence that this incentive leads them to push for “fire sales” at discount to actual value. Why spend time and money marketing a firm when every marginal dollar goes to someone else? The flip side is that in the cases where junior investors gain control, they have an incentive to block a quick sale even when it would maximize value. In short, all creditors are inclined to focus on their own distributions, often at the cost of destroying value for the estate.
The debate over Hertz maneuver, however, reveals an additional concern about the absolute priority: namely, how absolute priority interacts with investor protection. The noteworthy aspect here is not that Hertz’s equity was worthless, but that it could have been worth a lot more! If new investors are willing to buy $1 billion in junior securities to bet on the small possibility that Hertz can fully recover before a plan of reorganization is confirmed, that implies they would be willing to invest much more to bet on the possibility that Hertz could recover sometime in the more distant future.
The absolute priority rule blocks that bet or, to be more precise, it shifts ownership of that bet to one class of creditors. The only way a new investor can invest in the long-term option value of the firm is to buy out the fulcrum class of creditors—that is, the one class of partially in-the-money stakeholders. That fulcrum position is defined by the absolute priority rule. Take a firm with three layers of debt—first lien, second lien, and unsecured. If only the first lien lender is paid in full, then the second lien lender is the fulcrum lender and owns the long-term option. If the first and second lien lenders are paid in full, then the option belongs to the unsecured creditors. The fulcrum investors are the only stakeholders who benefit from any long-term option value that exists in bankruptcy.51In this way, the absolute priority rule cuts off—or at least increases the costs of—certain financing options for a debtor in bankruptcy. If a firm’s value lies in an uncertain but potentially highly valuable future payout, equity may offer an attractive form of financing—but only so long as the equity is not wiped out in bankruptcy.
In this way, the Hertz maneuver illustrates the extent to which the absolute priority rule distorts debtor financing. A bankruptcy system should encourage the investors who place the highest value on the firm to invest in it. Sometimes they will want to invest in the whole firm or a senior tranche of debt, but other times they will want to invest in the firm’s option value. At best, the absolute priority rule gives senior stakeholders a holdup right when it comes to investments in option value. To realize option value, junior investors must buy out senior stakeholders who already exercise significant control and a potential veto power over the plan process. At worst, absolute priority itself blocks the investments from junior stakeholders who might inject capital in the firm to preserve their option value.52One might try to solve this problem without jettisoning absolute priority by providing junior stakeholders an automatic right to exercise their option during the bankruptcy. Absolute priority with these options still collapses all future possibility to a present-day value, but it does guarantee junior stakeholders the right to buy the option at that value.
This might all be fine. After all, markets should price these rules into the ex-ante cost of capital.53This point is well-rehearsed in the bankruptcy-priority literature. See Kenneth Ayotte & David A. Skeel, Jr., Bankruptcy Law as Liquidity Provider, 80 U. Chi. L. Rev. 1557, 1565 (2013); Alan Schwartz, A Contract Theory Approach to Business Bankruptcy, 107 Yale L. J. 1807, 1808 (1998); Alan Schwartz, Bankruptcy Workouts and Debt Contracts, 36 J. L. & Econ. 595, 630–31 (1993); Douglas G. Baird & Robert K. Rasmussen, Antibankruptcy, 119 Yale L.J. 648, 653 (2010) (explaining that coordination problems can occur even with low transactions costs because of an “empty core problem”). This may not be true for involuntary and nonadjusting creditors. All contractual creditors may benefit from excluding tort victims and environmental claimants. For an extended discussion of that issue, see Joshua C. Macey & Jackson Salovaara, Bankruptcy as Bailout: Coal Company Insolvency and the Erosion of Federal Law, 71 Stan. L. Rev. 879 (2019). But if we accept the claim that retail investors buying shares of the bankrupt Hertz are naïve to the fact that bankruptcy law wipes out their long-term option value, shouldn’t we also assume that all retail investors—especially those who bought shares long before the filing—could be naïve to that fact? Indeed, when retail investors buy shares of Hertz two years before bankruptcy, it seems less likely that they are rationally pricing for the impact of the absolute priority than an investor who buys those shares on a day when they can open up the Wall Street Journal to a headline calling the shares “Potentially Worthless.”
And yet the law does nothing to protect the first set of investors. This presents a new angle to the priority debate—perhaps relative priority is actually a form of investor protection. If Hertz shows that unsophisticated investors do not understand that current bankruptcy law makes it very likely that they will be wiped out at the end of the reorganization, then a relative priority rule more closely conforms with naïve investors’ expectations about how the bankruptcy process works. And if this is true, then bankruptcy law should be reformed to match those investors’ expectations.54This is a classic point about default rules. If sophisticated parties understand the rules and unsophisticated parties always believe the rule is X, the default rule should be X.
Sophisticated investors, too, could benefit from relative priority. In theory, sophisticated investors shouldn’t care about priority as they will be aware of and can easily price in any rule. Junior investors will respond to absolute priority simply by demanding additional interest or larger dividends, and senior creditors would respond to relative priority in a similar manner. In practice, however, absolute priority can change more than prices. Because the rule is mandatory and makes it difficult for junior investors to protect any option value when a firm nears insolvency, all investment in distressed option value will take a senior form regardless of price. Thus, an investor who wants to invest in option value will alter the structure of its investment, especially when a firm is in or is likely to enter bankruptcy.
A relative priority rule, by contrast, more closely conforms to the financial rights that creditors enjoy when the debtor is outside of bankruptcy. With relative priority, junior investors enjoy option value both inside and outside of bankruptcy. Thus, under a relative priority rule, an investor in option value is not forced to take a senior a position. Nor is that investor forced to take a junior position to invest in option value. A senior creditor wanting to purchase option value in bankruptcy could enter into financing arrangements such as a debt-to-equity swap to bundle the option value with a senior loan.
The point is that with relative priority it is easy for the parties to choose who—junior or senior creditors—can invest in the option value. With absolute priority unbundling the option value from the senior debt is not so easy. Perhaps a junior investor wanting to invest in the option value of a distressed firm could negotiate for a highly bespoke financial instrument to prevent the distortion. But this might require complicated transactions between all creditors. The costs involved in drafting and negotiating such an instrument may deter prospective investors who would otherwise buy stock or junior debt altogether. This would harm all stakeholders by cutting off an investment source when a firm becomes distressed. It would be simpler and less costly if bankruptcy law just allowed junior investors to retain their option value rather than redistributing it to senior creditors. Unlike absolute priority, relative priority does just that, protecting retail investors and their investments in option across the board—for those buying shares inside bankruptcy and those buying shares outside of bankruptcy.
Hertz is very likely a firm with going concern value and significant long-term prospects. It has also been devastated by the combination of excessive leverage and bad timing. That timing places it as a debtor in one of the most uncertain and volatile times for distressed debt. The equity markets that fueled the Hertz maneuver may be explainable in large part by irrational retail investing. But part of the story may be that volatility dramatically increases option value, short- and long-term.
The Hertz maneuver reveals not that people shouldn’t be investing in option value, but rather that by forcing a reckoning, bankruptcy’s absolute priority rule makes it difficult for equity to retain its option value even when there would otherwise be plausible reasons to invest in or continue to hold equity. Hertz’s attempt to issue new equity caused an uproar because analysts recognized that equity should expect to be wiped out once Hertz emerged from bankruptcy. That may be true, but it is also possible that Hertz’s equity had even more value than the so-called irrational trades implied, and that the bankruptcy law was transferring all that value to the firm’s creditors.
It is a bit odd for federal law to transform old equity into a security with no option value while at the same time preventing new investors from buying that very same security. After all, it is the law’s own destruction of option value to which critics point as evidence that new investors need the law’s protection. A more coherent approach would look at the bigger picture and consider more deeply how priority rules interact with the investor expectations across the board.
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Anthony J. Casey is Professor at the University of Chicago Law School. Joshua C. Macey is Assistant Professor at the University of Chicago Law School. The authors thank Ken Ayotte, Vince Buccola, Douglas Baird, Jared Ellias, Saul Levmore, Alan Schwartz, and David Skeel for helpful comments. They also thank Julian Gale, Silvia Moreno, and Leonor Suarez for excellent research assistance. The Richard Weil Faculty Research Fund and the Paul H. Leffmann Fund provided generous support.
Featured photo credit to Don O’Brien.
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