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There is a commonly held view, expressed by some participants at the Symposium, that full priority is required by freedom of contract and property rights considerations. Indeed, many people think of a “security interest” as a device that, by definition, gives the secured lender full priority in the collateral over the claims of all third parties, including unsecured creditors. To people accustomed to this way of thinking, the notion of a rule that gives secured creditors only partial priority over the claims of unsecured creditors in bankruptcy may initially appear puzzling. Therefore, we wish to start our analysis by offering a set of intuitive reasons why the issue of priority should be approached with an open mind.

A “security interest” is simply a legal arrangement that gives the borrower, the lender, and third parties certain rights that are specified by law. And although historically those rights in the United States have generally included the secured lender’s right to full priority in the underlying collateral, we explain below that there is no legal principle that requires that secured lenders have full priority over unsecured creditors’ claims in bankruptcy. Nor is full priority required by economic considerations: in practice, secured creditors in the United States already do not have full priority in bankruptcy, and many other countries have adopted rules that explicitly give secured creditors only partial priority in bankruptcy. Indeed, the next two Parts explain why it might be economically desirable to deny secured creditors full priority in their collateral in bankruptcy.
Section A explains that, notwithstanding its long history, full priority is actually inconsistent with an important general principle of commercial law: that a borrower may not subordinate one creditor’s claim to that of another without the consent of the subordinated creditor. Section В explains why full priority is not required by freedom of contract. Section С explains in turn why full priority is not required by property rights considerations. Section D points out that our system is already one of de facto partial priority, which has two important implications. First, adopting a formal rule of partial priority would not necessarily be such a radical change. Second, claims that the existing system works well actually support the case for partial priority, not full priority. Section E summarizes the arguments for why the issue of priority should be approached with an open mind.

This post was written by , posted on June 27, 2014 Friday at 3:24 pm