FIN.22:5.1 - A larger total recovery can still leave a creditor worse off

Consider a separate constructed debtor with two old claims against one pool: a senior claim of 60, a junior claim of 40 and residual equity. The applicable exit treatment is stipulated: net sale proceeds of 70 are available now after every cost and other claim. Senior receives 60, junior 10 and equity zero. This priority is part of the case, not a jurisdictional rule.

A proposed turnaround followed by sale needs 10 immediately for the necessary transition work. A new lender actually offers 10 net, repayable as 11 in one year ahead of both old claims under a priority that all required parties would have to accept. The dated operating plan is otherwise funded throughout the year. At year end, realizable proceeds after ordinary operating payments and tax but before final process costs and the interim claim are 120 or 80, each with supported probability one half. Final process cost is 8 in either state. These proceeds include the benefits of the initial transition spending; that spending is funded by the 10 advance and is not deducted a second time at sale.

After process cost and interim repayment, the pool for old claims is 101 in the high state and 61 in the low state. Applying the original priority gives:

For this illustration only, all expected recovery streams have a qualified 5% one-year valuation rate, including a stipulated zero premium for their remaining risk. Their total present value is 81/1.05 = 77.14, exceeding the immediate exit’s 70. But the senior creditor’s present value is 60/1.05 = 57.14, below its exit recovery 60. Junior receives value 19.52 and equity 0.48. The higher total does not establish senior consent.

Allocating the average pool 81 as if certain would give senior 60, junior 21 and equity zero. That loses the actual high-state residual and overstates junior expected payment by 0.50. The order of calculation therefore changes a participant’s result.

One proposed amendment increases the senior allowed year-end claim to 65 while keeping its priority. It receives 65 in the high state and all 61 in the low state, with expected payment 63 and present value 60. Junior receives 36 or zero, with expected payment 18 and value 17.14; equity receives zero. The senior now matches its financial exit value on these grounds, and junior remains above 10. This describes a possible allocation for negotiation, not a right to compel agreement. Different claim-specific risk prices or participation interests can change that judgement.

If the only obtainable interim offer instead requires repayment 20 for the same advance of 10, the pool for old claims falls to 92 or 52. Its expected present value becomes 72/1.05 = 68.57, below the exit’s 70. The operating improvement has not changed, but its financing price reverses the aggregate financial preference. If no one supplies the initial 10 at all, the continuation route fails earlier, regardless of its modeled year-end value.