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SECURED CLAIMS IN BANKRUPTCY: PRELIMINARY OBSERVATIONS AND INITIAL INTUITIONS 6

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To see why this is the case, consider two other arrangements that have the same ex ante and ex post effects on creditor C2 as arrangement (2) but which are legally unenforceable.
First, suppose that creditor Cl offers the borrower an unsecured loan under the same terms as arrangement (1) except that borrower need pay only $10 in interest payments if it accepts the following provision: should the borrower go bankrupt, creditor Cl would have an option to buy its bankruptcy assets up to the value of the balance on the loan, at a strike price of $0. Should the option be exercised, it would be at the expense of creditor C2. Most people would agree that freedom of contract does not require observation of such a provision, and in fact, the law does not permit such an arrangement.

Second, suppose that creditor Cl offers the borrower an unsecured loan under the same terms as arrangement (1) except that the borrower need pay only $10 in interest payments if the borrower agrees that should it file for bankruptcy it must first pay creditor Cl in full, effectively reducing the pro rata amount available to creditor C2. Again, most people would agree that freedom of contract does not require the law to enforce such an arrangement, and in fact, such an arrangement is legally unenforceable.
It is easy to see that the option and preference arrangements have the same ex ante effect on creditor C2 as the creation of a security interest under full priority. Each of the arrangements could benefit creditor C2 ex ante relative to an ordinary unsecured loan by reducing the probability of the borrower’s bankruptcy. But we do not consider the option and preference arrangements required by freedom of contract principles. If these arrangements are not mandated by freedom of contract, then freedom of contract does not require that the borrower and creditor Cl be permitted to enter into an almost identical arrangement through the creation of a security interest giving creditor Cl full priority in the borrower’s bankruptcy assets.

This post was written by , posted on July 7, 2014 Monday at 3:29 pm