If a company were to go bust, how would its limited assets repay its sundry liabilities? Would those who happen to be at the right place at the right time walk away with what remains leaving others in the lurch? The absolute priority rule (APR) lends order to what happens when a company liquidates.
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The APR, also known as the “liquidation principle," is the theoretical standard use to resolve financial contracts when a debtor becomes insolvent. This rule states that a debtor receives no value from his or her assets until his or her creditors are repaid in full. It establishes the order of payouts and stipulates that repayment of creditors takes precedence over shareholders. It is based on the Wall Street order that a bond is senior to preferred stock, which is senior to common stock.
APR stipulates using available assets to repay debts to creditors first with shareholders dividing whatever assets remain after that. Similarly, repayments of outstanding debts take precedence when disposing the estate of a deceased person with the beneficiaries dividing what remains after clearing debts.
The rule establishes seniority for making payouts from liquidated assets with senior creditors or those who lend money first paid first, followed by the next in line and so on, before moving to the shareholders in the same order. If a business were to go bankrupt, this rule would apply and payment of dues would take place in the following order:
Employers (for wages due)
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On the face of it, APR is straightforward and easy to implement. On reorganization, the company draws up a list of creditors and other parties to whom it owes money in the specified order and appropriates the assets accordingly. On liquidation, the bankruptcy court steps in to oversee liquidation of all assets, evaluate creditor claims and determine the payment each creditor receives.
However, actual implementation of APR raises several challenges. The process may range from weeks to years depending on the size and nature of the assets available for liquidation, the nature of the debtors, and the complexity of the debt agreements that may make determining the order of seniority or preference difficult. Very often, a class of stakeholders may challenge the list or order, thus leading to lawsuits.
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APR is one key rule that regulates corporate behavior. It provides a degree of protection to creditors when the company declares bankruptcy, becomes insolvent, or the sole proprietor dies. Creditors eventually recover at least a portion of their money, if not the full amount.
Without APR, unscrupulous companies can declare bankruptcy and walk away with the assets, leaving creditors in the lurch, or disburse whatever assets they have to creditors or others at their whims and fancies without any order or fair play. With APR, all stakeholders including creditors, suppliers, employees, shareholders and others have a fair and predetermined chance of receiving their investments if the company goes bust.
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With the prospect of APR looming in the face of a company in distress, the promoters lose their motivation to take risks and make a turnaround. Since APR reserves the first rights of remaining assets to bondholders and creditors rather than shareholders, shareholders would prefer to cut their losses and take what remains of the assets rather than take risks, which may put whatever little asset they may otherwise get in risk. For companies that are deep in dept, such risks would only contribute to repaying debtors and could still not be enough to accrue anything for shareholders, which further deters them away from taking any action.
The APR prevents retention of an equity interest by owners following restructuring if stockholders are junior to the interests of the unsecured creditors. Individuals and companies filing bankruptcies under Chapter 11 for reorganization or Chapter 13 for readjustment of debts need to file a plan about how they propose to allocate remaining assets. APR applies only when a class of similarly situated creditors do not agree to the plan proposals.
For approval of such plans:
The dissenting creditors needs to be paid in full.
No one with claims junior to the claims of the dissenting creditor may retain anything under the plan
One solution to this imbroglio is “give ups" by senior classes of creditors whereby such creditors give away their rights to a junior class such as shareholders. This is, however, controversial and a subject of many lawsuits.
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The challenges of implementation and the disadvantageous terms to shareholders or company holders prompt companies to routinely circumvent the Absolute Priority Rule. Studies by Betker (1995), Franks and Torous (1991), and LoPucki and Whitford (1990) show that stockholders of publicly traded companies that reorganize receive value about 75 percent of the time even when their creditors do not receive the full value of their claims. Selling or pledging the land or machinery and siphoning the cash when it becomes obvious that the company will have to file for bankruptcy are routines way company owners can circumvent APR.
APR is an issue of corporate governance ethics. Successful implementation requires an active regulatory watchdog.
Longhofer, Stanley D. & Carlstrom, Charles T, Federal Reserve Bank of Cleveland. "Absolute Priority Rule Violations in Bankruptcy ." Retrieved from http://webs.wichita.edu/longhofer/Vita/aprrev.pdf on August 17, 2011.
Jones Day. "Application of the Absolute Priority Rule to Pre-Chapter 11 Plan Settlements: In Search of the Meaning of “Fair and Equitable” Retrieved from http://www.jonesday.com/newsknowledge/publicationdetail.aspx?publication=4313 on August 17, 2011.