In principle the answer to this collision of interests is an equitable sharing of misery. Many corporate insolvency systems provide for equal creditor treatment of similarly situated creditors, including similarly situated foreign and domestic creditors. Without a strong reason to depart from this principle, like creditors should be satisfied equally. This principle would call, for example, for treating all bondholders equally. A subnational insolvency framework also provides guidance on the priority of settling competing creditor claims.

The economic literature on bankruptcy asserts that absolute priority rule (APR) is optimal, since it provides the right incentives for lending ex ante (White 2005). If lenders are repaid in the exact order of their lending, implying that no lender can jump the queue, then costs of additional lending are fully internalized and reflected in pricing. In other words, there is no risk of debt dilution, since the effect of the marginal dollar lent on the debtor’s payment capacity is fully incorporated in the costs of lending.

Yet in practice, no country has adopted a pure absolute priority rule. The reason is twofold. Although the APR rule might be efficient ex post, it need not be efficient ex ante. The rule may have a deterrent effect on new lending, _even_ when such lending is desirable. Debtor-in-possession financing in US corporate bankruptcy law addresses this concern. Contrary to the APR rule, priority is given to new financing once the debtor is under bankruptcy protection. The convincing rationale is to allow refinancing in financial distress.

Second, distributing the pool of available assets in bankruptcy is never about efficiency alone. The distributional impacts loom large. The APR is only one possible policy choice. Many other configurations of priority are possible. Which one is most appropriate for the insolvency of subnational entities will depend, first, on the distributional judgment of the society concerned and, second, on the effect of a chosen priority structure on the capital market and its impact of new financing during a liquidity crunch. It is also important to allow sufficient flexibility within a general priority framework.

In the absence of a binding priority structure, the defaulting borrower may choose the order in which to satisfy creditors. A subnational insolvency framework eliminates this source of arbitrariness by providing guidance on the priority of creditor claims. Yet the devil is in the details of “equitable priority structure”. This notion will differ across countries, reflecting society’s distributional judgments over sharing the insolvent’s dwindling pie of assets.<sup>63</sup> The U.S. approach in Chapter 9 gives first priority to secured

> 63 In German corporate bankruptcy, for example, wages, taxes and arrears to suppliers are in a first class, with shareholders in the second. In Japan, it is administrative claim holders, taxes, and workers’ salary for three months prior to commencement of bankruptcy, other claim holders and finally shareholders. In China the order is secured debt, bankruptcy expenses, staff wages and insurance, followed by taxes, unsecured debt and shareholders. The priority structure of US corporate bankruptcy places secured creditors first and unsecured creditors second. In the second class, the debt adjustment plan determines the order of repayment. Restructuring practice tends to give high priority to bondholders in the second class. We are grateful to Darshini Manraj from Doing Business, World Bank Group for sharing the information.

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