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

The Problem

We are now ready to consider how full priority and the presence of nonadjusting creditors affects the incentives of borrowers and creditors contemplating the use of a security interest in connection with a loan transaction that will proceed whether or not a security interest is used. Recall that the steps in the analysis are as follows: (1) under full priority, the use of a security interest can effect a transfer of bankruptcy value from nonadjusting creditors; (2) this transfer of value acts as a subsidy for the use of a security interest, by reducing the apparent cost (or increasing the apparent benefit) to the borrower and the secured creditor of using a security interest; and (3) this “subsidy” can lead to the use of inefficient security interests. Below, we provide a simple example to illustrate these points.

To begin, suppose that a borrower and creditor Cl are contemplating incorporating a security interest into their loan arrangement. Under full priority, one effect of incorporating a security interest is that, everything else equal, in the event of bankruptcy, creditor Cl will receive more than it would without the security interest, and other creditors will receive less. Everything else equal, creditor Cl should therefore be willing to charge the borrower a lower interest rate.

To the extent these other creditors are adjusting, the borrower will be required to “pay” for transferring the bankruptcy value from these creditors to creditor Cl through a higher interest rate charged by these other creditors. But at least some of the borrower’s creditors will be nonadjusting. Suppose that the effect of incorporating the security interest under a rule of full priority is to transfer an expected value of $10 from these nonadjusting creditors.

The presence of nonadjusting creditors means that, by creating a security interest in favor of creditor Cl, the borrower can “sell” $10 of expected bankruptcy value to creditor Cl in exchange for a lower interest rate without “paying” for the transfer through higher interest rates to nonadjusting creditors. The transfer of $10 in expected bankruptcy value to creditor Cl should, everything else equal, cause creditor Cl to reduce the interest it charges the borrower by the same amount—$10. From the borrower’s point of view, this transfer reduces the apparent cost of creating the security interest by $10 (or, equivalently, increases the apparent benefit of creating the security interest by $10).

This post was written by , posted on August 4, 2014 Monday at 3:46 pm