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A. Full Priority is Inconsistent with the General Principle Against Nonconsensual Subordination

Because most firms entering bankruptcy are insolvent, there is generally insufficient value to pay every claim in full. An important purpose of the bankruptcy system is to determine the proper distribution of that value. Under the bankruptcy systems of the United States and many other countries, pro rata sharing is the general rule. That is, any assets that remain after secured claims are paid in full are divided pro rata among those with unsecured claims. In the absence of secured claims, all of the assets of the bankruptcy estate are distributed on a pro rata basis.

A fundamental principle of bankruptcy law is that—once a statutorily created scheme for allocating a bankrupt debtor’s assets among its creditors is in place, the borrower may not circumvent that scheme by transferring one creditor’s bankruptcy allocation to another party without the former’s consent. That is, a borrower may not favor one creditor at the expense of another. For example, unsecured creditor Cl may not contract with the borrower for its claim to have priority in bankruptcy over that of another unsecured creditor C2. The law also does not allow a borrower to contract with unsecured creditor Cl to provide it with preferential payments on the eve of bankruptcy. Were the borrower to contract with creditor Cl for priority over creditor C2 in bankruptcy, or for preferential payments outside of bankruptcy, the contract would be completely disregarded if the borrower ever entered bankruptcy. Indeed, the only way for creditor Cl to subordinate creditor C2’s claim is by negotiating a subordination agreement with creditor C2 under which creditor C2 promises to pay creditor Cl as much of what creditor C2 receives in bankruptcy as is necessary to make creditor Cl whole. Such arrangements are often observed. Presumably, the creditor consenting to subordination receives a higher interest rate from the borrower or compensation directly from the subordinating creditor.

This post was written by , posted on June 29, 2014 Sunday at 3:25 pm