On Deviating from Absolute Priority: The Case of Tort Claims and Active Creditors

Abstract

The impact of deviating from absolute priority rule, a basic tenet of bankruptcy law that accords secured creditors a privileged position in bankruptcy distribution, has long been at the centre of research on bankruptcy. This paper develops a model of a firm that can cause an accident and then claim bankruptcy to investigate the ex ante effects of elevating tort claims a head of creditors. In the model, the firm (or its manager) controls an unobservable care (or effort) decision. The creditor not only provides the requisite capital, but also exercises control over the firm by virtue of its significant cash flow rights. Together managerial care and creditor control determine the distribution of the tortious harm. We find that according tort claims a privileged position relative to creditors leads to a shift away from managerial care and towards more creditor control. As a consequence, subordinating secured creditor has an ambiguous effect on the expected social welfare.