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SECURED CLAIMS IN BANKRUPTCY: ON THE DESIGN OF PARTIAL-PRIORITY RULES

Funding of Marginal Activities

So far we have discussed three efficiency costs of foil priority: (1) in loan transactions that will go through in any event, foil priority may cause a borrower to incorporate a security interest into the arrangement even though it is value-wasting; (2) in loan transactions that will use a security interest regardless of the priority rule in bankruptcy, foil priority may undesirably reduce the secured creditor’s incentive to monitor the borrower; and (3) the prospect of borrowing on a secured basis under foil priority may cause a firm to undesirably reduce its investment in precautions or to undesirably engage in more activity likely to give rise to tort liability website.

The fourth efficiency cost of foil priority is that it may facilitate loan transactions that enable the borrower to fund inefficient investments. The intuition here is simple: when there are nonadjusting creditors, the creation of a security interest giving a lender full priority creates a subsidy not only for the use of the security interest in the arrangement, but also for the transaction itself. Thus, a transaction that would not go forward without such a subsidy might go forward with such a subsidy. We will defer further discussion of this efficiency cost of full priority until Part VI, where we discuss the effect of partial priority on the financing of good and bad projects.

ON THE DESIGN OF PARTIAL-PRIORITY RULES

We have seen that full priority can produce significant efficiency costs. However, it would not be desirable to adopt a rule of partial priority if either (a) the efficiency costs of such a rule would be even larger; or (b) such a rule could not be effectively implemented. Before considering these issues (as we do in Parts VI and VII), it is necessary to explain how partial priority might be implemented. Therefore, this Part presents and discusses three possible partial priority rules.

We first restate the two partial-priority rules we put forward and analyzed in The Uneasy Case (the “fixed-fraction priority rule” and the “adjustable-priority rule”). We then introduce a third possible rule (the “consensual priority rule”).

This post was written by , posted on September 5, 2014 Friday at 4:24 pm