A Note on Absolute Priority Rule Violations, Credit Rationing, and Efficiency

Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest that these might arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely, raising the interest rate that firms must pay when borrowing. Both of these problems arise even when APR violations have no impact on the borrower’s incentive to undertake risk-shifting behavior.