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SECURED CLAIMS IN BANKRUPTCY: Excessive Use Can Occur Without Involuntary Creditors

The presence of nonadjusting creditors can lead to the use of value-wasting security interests, whether or not nonadjusting creditors are hurt. To show that value-wasting security interests might be used under foil priority, even though no involuntary nonadjusting creditors are hurt, suppose that, in the example above, all of the nonadjusting creditors are voluntary.

Suppose, for example, that all of the nonadjusting creditors are large unsecured lenders that have lent at fixed interest rates before the borrower faces the decision of whether to create a security interest as part of its loan arrangement with creditor Cl that will have the effect of, among other things, increasing the expected value of creditor Cl’s bankruptcy claim by $10, and reducing that of the nonadjusting creditors’ bankruptcy claims by the same amount Here.

In principle, the creditors extending large loans to the borrower before the borrower enters into a transaction with creditor Cl can compensate themselves ex ante, via a higher interest rate, for the possibility that, when the borrower and creditor Cl negotiate their loan arrangement, the borrower will create a security interest that, everything else equal, reduces the expected value of their bankruptcy claims by $10.

So while the incorporation of a security interest into the loan arrangement with creditor Cl will, at that time, make these nonadjusting creditors worse off than if a security interest is not incorporated into the loan arrangement, they will not be worse off than they would have been in a world where there is no priority because they will have been compensated for the risk of subordination by a higher interest rate. At the same time, because the terms will be set at a fixed amount that will not be adjusted whether or not creditor Cl gets a security interest, there will still be a subsidy in favor of using a security interest, and this subsidy could lead to the use of a security interest even if it reduces the total value of the transaction.

This post was written by , posted on August 10, 2014 Sunday at 3:49 pm