Asymmetric Information, Choice of Workout Under Financial Distress, and Absolute Priority Violations

We study the reorganization of a financially distressed firm when public debt-holders are uninformed about future profitability of its projects. With large expected NPV of the continuation project, exchange offers restructure the public debt. Low NPV results in liquidation. For intermediate ranges of NPV, the bank refinances the short-term public debt. We show that the signaling requirements of exchange offers imply additional equity to the firm's shareholders in violation of the Absolute Priority Rule. Our analysis derives testable hypothesis relating the nature of workouts and the magnitude of APR violations to observables such as the short term public debt.