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B. Is Full Priority Required by Freedom of Contract Principles?

Many share the sentiment, which was also expressed during the Symposium, that freedom of contract principles require a rule of full priority. To illustrate this view, suppose that creditor Cl offers borrower a choice between (1) an unsecured loan to borrower in exchange for interest payments totalling $15 (plus repayment of principal) and (2) a secured loan in exchange for interest payments of only $10 (plus repayment of principal) that, if the borrower becomes insolvent, gives creditor Cl a larger fraction of the borrower’s assets (and creditor C2, borrower’s other creditor, a smaller fraction). The freedom of contract argument asserts that borrower and creditor Cl should be free to choose either arrangement (1) or arrangement (2).

In general, if an arrangement would have no detrimental effect on third parties, freedom of contract principles would suggest permitting borrower and creditor Cl to enter into the arrangement if they so choose. However, freedom of contract arguments are not applicable when the arrangement contemplated by borrower and creditor Cl is at the expense of another party. In this case, since arrangement (2) is at the expense of creditor C2, freedom of contract does not require that borrower and creditor Cl be permitted to enter that arrangement.
To be sure, it might be argued that arrangement (2) only appears to be at the expense of creditor C2. According to this argument, while arrangement (2) reduces creditor C2’s fractional share of the borrower’s bankruptcy assets ex post, relative to arrangement (1), arrangement (2) could actually make creditor C2 better off than arrangement (1) ex ante by lowering the borrower’s interest burden, thereby reducing the probability that the borrower will go bankrupt in the first instance.29 But the fact that arrangement (2) could, in theory, benefit creditor C2 ex ante (relative to arrangement (1)) does not mean that freedom of contracts require that the borrower and creditor Cl be permitted to enter into that arrangement.

This post was written by , posted on July 5, 2014 Saturday at 3:28 pm