I am once again writing about bankruptcy and applying economic theory. Let us once again imagine a x1-x2 graph where we are comparing the recoveries of different tranches in bankruptcy. Once again, there is a minimum requirement of 2/3 voting for the Plan of Reorganization to pass. Imagine (for simplification) that there are only 3 voting classes. Parties A and B are aligned close to each other (or in the same location) and have a utility maximum location of a high x1 value and low x2 value. Conversely, there is party C with a high x2 value and low x1. A and B outnumber C and have the requisite 2/3 vote to pass a favorable outcome for them.
So there's a stable equilibrium right? Yes, but not where you think. Party C does not like to get bageled (lose all their money), so they're willing to fight, and fight a bit they do. They send A and B an ugly pre-cursor to a lawsuit and claim they will appeal with the US Circuits on some highly suspect grounds. At this point, C will not win any of these, but A and B also lose: they pay heafty legal fees to fight this. A and B don't like this, and offer a deal (trade creates value): they will give C a recovery rate above zero but less than their potential legal fees for C to leave them alone. The threat of bleeding legal fees creates an interesting arbitration opportunity here.
Because the same players play the same game of bankruptcy, they have become sophisticated and anticipate this. The "winning" parties offer this in the original P.O.R. instead of a post-hoc transfer. They call this a "tip": they're offering C some cash! How kind! C calls this a "death trap": if they don't accept this POR, they will later be offered a different POR where their recovery is 0. They are trapped with two losing options, of which they have to pick the least bad one. This equilibrium is unique because it is inside the triangle ABC, and this is made possible by the cost of legal fees from dissenting voters and the foresight by the involved parties.
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