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SECURED CLAIMS IN BANKRUPTCY: Nonadjusting Creditors and the Use of Inefficient Security Interests 2

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The fact that the security interest would transfer $10 from nonadjusting creditors to the borrower may, in turn, affect the borrower’s decision whether to grant creditor Cl a security interest. Suppose, for example, that the creation of the security interest would give rise to an efficiency cost of $15 and provide an efficiency benefit of $10 (excluding the transfer of $10 from nonadjusting creditors) and that the borrower and creditor Cl would bear all of the efficiency costs and capture all of the efficiency benefits.

Such a security interest would be value-wasting. If all of the creditors were adjusting, the borrower and creditor Cl would not have an incentive to adopt the security interest because, without the transfer, the security interest would impose a net cost of $5. However, if the effect is to transfer $10 from nonadjusting creditors, the borrower and creditor Cl will have an incentive to adopt the security interest. The reason is that the apparent benefit to the borrower and creditor Cl of adopting it appears to be $20 (rather than $10), an amount greater than the cost of $15 (or, equivalently, the apparent cost is now only $5, less than the benefit of $15).

Before proceeding, we would like to emphasize two important points. First, we are not arguing that incorporation of a security interest into a loan transaction (that will go forward in any event) will always have the effect of transferring value from nonadjusting creditors. The creation of a security interest giving the secured creditor bankruptcy priority will, everything else equal, transfer value from nonadjusting creditors by reducing their fractional share of the bankruptcy pie.

But, as we have emphasized, the incorporation of such a security interest into a loan agreement will also affect unsecured creditors in two other ways: (1) by affecting the probability that the borrower will fail and (2) by affecting the amount of assets that will be available in the event of bankruptcy. Depending on the circumstances, the use of a particular security could either increase or decrease the probability of failure, and either increase or decrease the amount of assets that will be available to creditors as a group.86 Thus the use of a security interest under full priority in connection with a loan transaction that will go forward in any event will make unsecured creditors better off overall, if the subordination effect is outweighed by the other two effects.

This post was written by , posted on August 6, 2014 Wednesday at 3:47 pm