Absolute Priority Rule Violations and Risk Incentives for Financially Distressed Firms

In a June 12, 1990 Wall Street Journal article entitled "Warning Flag: When a Firm's Stocks and Bonds Diverge," the stocks and bonds of companies such as Pan Am and TWA were cited as being clearly mispriced. How, the article asked, could Pan Am's stock be trading at $2.50 per share when its senior debt was only worth 30 to 40 cents on the dollar? A managing director of a mutual fund was quoted as stating the prices were "totally ridiculous," and he further remarked, "Either the bond is too cheap or the stock is too high." The article noted that, "At least in theory, if a company's creditors' can't be fully paid, its stock, which ranks lower among its financial obligations, is next to worthless." In other words, the absolute priority rule (APR) will be followed. The APR states that creditors should be fully compensated before shareholders receive any portion of the bankrupt firm's value.