A dilution mechanism for valuing corporations in bankruptcy

This Article proposes a new mechanism for valuing firms in bankruptcy. Unde r the "senior dilution" mechanism, a court would dilute the reorganized sto ck issued to senior claimants by issuing additional shares to junior claima nts until there was no excess demand for the stock at a price that would im plement absolute priority. A "junior dilution" mechanism could also be impl emented to provide a market test for proposed reorganization plans of junio r claimants by having a court issue additional debt to senior claimants unt il there was no excess supply of the debt at a price that would implement a bsolute priority. We show that these mechanisms harness the private informa tion of the claimants and of third parties to produce distributions consist ent with absolute priority. Dilution mechanisms can be superior to other in formation-harnessing devices (such as an option or auction approach) becaus e they (1) are less susceptible to the problem of junior illiquidity l than an option approach proposed by Lucian Bebchuk; (2) are less susceptible to the problem of market manipulation and may better allocate control premia than a partial float proposal by Mark Roe; and (3) may produce fewer transa ction costs than a full auction approach proposed by Douglas Baird. Moreove r, as a response to the Supreme Court's recent admonishment in LaSalle that bankruptcy courts employ market tests more often when creditors dissent to a reorganization plan, the junior dilution mechanism provides a uniquely w orkable solution within the current statutory framework.