A Dilution Mechanism for Valuing Corporations in Bankruptcy

Abstract

Issues of corporate finance become most critical when a firm encounters financial distress. In this case, there may be insufficient assets to go around, and the question of valuation comes to the fore. Valuation is central to the resolution of distress because distributions consistent with the hierarchy of investor priority (called "absolute priority") depend on the amount available to distribute. A firm with little value may belong entirely to its most senior creditors, while a firm with much value may belong in part to its junior creditors, or perhaps even its shareholders. Not surprisingly, therefore, valuation is the most hotly contested and debated topic in the realm of corporate bankruptcy law. In this Article, we enter this debate with a new "dilution" approach for valuation. The dilution approach begins with the issuance of some new shares to investors at a particular level of priority, and then, to the extent that absolute priority requires, "dilutes" the value of those shares with the issuance of additional shares, or new claims against the firm, to investors at a different level of priority. This process, which is implemented through a stylized auction at a fixed price, not quantity, harnesses information available among a corporation's investors and the capital market as a whole in order to implement better the absolute priority rule.