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Circumvention Through Alternative Forms of Financing

The Severity of the General Problem

As symposium participants and others have pointed out, there are many arrangements that accomplish a result similar to a secured loan but which would receive more favorable treatment in bankruptcy under a formal partial priority rule. Borrowers and creditors facing a rule of partial priority may seek to avoid its effects by using such arrangements. Although there are many ways to accomplish a result similar to a secured loan, all of the arrangements have one thing in common: they put the ownership in the assets that would have served as collateral for a secured loan in the hands of another (perhaps related) party, in an attempt to make those assets unavailable to the borrower’s unsecured creditors in bankruptcy.

In our view, the problem of circumvention through the use of economically similar but legally different arrangements would not be as severe as others believe. Application of a rule resembling a partial priority rule to arrangements similar to secured credit, but that would otherwise remain outside its reach, could substantially reduce circumvention. In general, courts pay attention to substance over form. For example, if the parties characterize an arrangement as a lease, but it is in fact economically equivalent to a secured loan, a bankruptcy court will treat it as a secured loan.
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Thus, two parties that would otherwise have used a secured loan could avoid a partial priority rule only by using an arrangement that is substantially, economically different from a secured loan. However, using an economically different arrangement will often impose costs on the parties that a secured loan would not impose. Parties would bear these whether or not either party enters bankruptcy. In contrast, a partial priority rule will impose costs on the parties only if one of the parties enters bankruptcy. Thus, the expected cost of partial priority would have to be quite high (or the cost of substituting an alternative arrangement would have to be quite low) for the use of alternatives to secured loans to be worthwhile.
We now turn to briefly examine specific types of alternative financing arrangements: (1) the use of leases rather than secured loans; (2) the use of subsidiary financing; and (3) the use of “special purpose” or “bankruptcy-remote” vehicles to isolate liquid assets (typically receivables from creditors in bankruptcy).

This post was written by , posted on March 25, 2015 Wednesday at 4:50 pm