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SECURED CLAIMS IN BANKRUPTCY: Empirical Evidence That Security Interests Are Often Inefficient 2

However, the failure of a lender to incorporate a security interest into its loan arrangement with a borrower does not prove that a security interest would have been value-wasting because the creation of a security interest, even under a rule of priority, can, in principle, make nonadjusting creditors better off. Thus even under full priority a borrower and lender contemplating the use of a value-increasing security interest in their loan arrangement might choose not to incorporate the security interest into the loan arrangement because they do not capture enough of the benefits to make it worthwhile read only.

Negative Pledge Clauses
The widespread use of negative pledge covenants—provisions in loan agreements that severely restrict the borrower’s ability to incur secured debt—provides evidence that the creation of a security interest can often make unsecured creditors worse off. Unsecured creditors would not seek these provisions if these provisions did not make them better off. These provisions would not make unsecured lenders better off unless the creation of the security interests prohibited by the provisions would make them worse off. Thus the existence of these provisions indicates that the creation of security interests can make unsecured creditors worse off.

The fact that borrowers agree to these provisions provides additional information. Negative pledge covenants impose a substantial cost on borrowers by preventing borrowers from collateralizing loans in the future (in order to get cheaper financing, or perhaps in order to get any financing). The fact that a borrower agrees to such a covenant thus indicates not only that the creation of a security interest prohibited by the covenant would make the lender worse off, but also that the creation of the security interests would hurt the lender more than it would help the borrower. In other words, the provision increases the size of the pie that the two parties can share.

This post was written by , posted on August 18, 2014 Monday at 3:53 pm