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SECURED CLAIMS IN BANKRUPTCY: Empirical Evidence That Security Interests Are Often Inefficient 3

If the lender and the borrower were the only parties affected by the arrangement, the existence of a negative pledge covenant would suggest that the covenant is efficient, and, therefore that the creation of the security interests prohibited by it would be inefficient.

However, the two parties do not capture all of the net benefit created by the provision, as some of the benefit flows to nonadjusting unsecured creditors. For example, the provision ensures that unsecured creditors’ loans are not subordinated during the term of the negative pledge lender’s loan. Therefore, such restrictions mean that the negative pledge lender’s share of the net benefits derived from not creating the security interest is greater than the entire cost borne by the borrower’s owners.

In other words, the provision is so efficient (or, equivalently, the creation of the security interests would be so inefficient) that even though the negotiating creditor cannot capture all of the benefits from the provision, the two parties still find it worthwhile to include the provision in the loan agreement.

Of course, the fact that negative pledge clauses, when value-creating, confer a benefit on other creditors means that there are many times when they are not used by unsecured lenders even though they would be efficient. There are also many times that negative pledge clauses are not used because the lender takes a security interest that is less efficient, but more privately beneficial because of the resulting transfer of value. Thus the widespread use of negative pledge clauses understates the extent to which the creation of security interests would be inefficient.

This post was written by , posted on August 20, 2014 Wednesday at 3:55 pm