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SECURED CLAIMS IN BANKRUPTCY: Nonadjusting Creditors and the Use of Inefficient Security Interests 3

But by the same reasoning, unsecured creditors may be in an even worse position after the creation of a security interest than if the only effect of the security interest is to reduce their fractional share of the borrower’s bankruptcy assets. In particular, and as we explain in the next Part, under full priority the incorporation of a security interest not only subordinates the claims of unsecured creditors, but also, by reducing the incentive of the secured creditor to monitor the borrower, it may increase the probability of failure and reduce the amount of assets that are available to pay all claims in the event of default.

That is, the incorporation of a security interest into a loan agreement may make unsecured creditors worse off in not one, but three ways: (1) by increasing the probability of the borrower’s failure; (2) by reducing the amount of assets that will be available to all creditors in the event the borrower fails; and (3) by reducing unsecured creditors’ fractional share of these assets.

The second point to be emphasized is that a particular security interest’s potential, under foil priority, to transfer value from nonadjusting creditors does not mean that the borrower and a potentially secured creditor would always have an incentive to use the security interest.

The borrower and the potentially secured creditors would have an incentive to use a security interest if the efficiency benefits they capture from the security interest, plus the (expected) transfer of value from nonadjusting creditors, is greater than the efficiency costs they will bear from the use of the security interest. Thus the fact that a security interest under foil priority can transfer value from nonadjusting creditors does not imply that lenders and borrowers would always use security interests in their loan arrangements. payday loan help

This post was written by , posted on August 8, 2014 Friday at 3:48 pm