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SECURED CLAIMS IN BANKRUPTCY: Prior Voluntary Creditors 2

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Second, even when a negative pledge covenant would not be too broad, the unsecured lender and the borrower may not use it if they cannot capture enough of the benefits that would be generated by the covenant. In particular, to the extent that the borrower has other (nonadjusting) unsecured creditors, some of the benefits of the arrangement will be captured by these other creditors.

In that case, the borrower and the unsecured creditor contemplating the use of a negative pledge covenant may not adopt it even if it would create value.
Third, even if a negative pledge covenant (a) would create value and (b) would (if enforceable) privately benefit the borrower and the unsecured lender, the parties may not use it if—as is often the case—the lender believes that such a provision would be difficult to enforce. Under current law, the claim of an unsecured creditor that has bargained for a negative pledge covenant is subordinated by a security interest created in violation of a negative pledge covenant. In many cases, the lender would have difficulty both preventing the borrower from creating such a security interest and then determining that such a security interest had been created.

A negative pledge covenant is not the only method that an unsecured creditor could use to ensure that it does not become nonadjusting with respect to a subsequently created security interest. For example, sophisticated unsecured creditors could build an adjustment mechanism into their contracts with borrowers which allows them to reset the interest rate if the borrower subsequently creates a security interest.

Unlike a negative pledge covenant, an adjustment mechanism negotiated between an unsecured lender and a borrower does not prevent the borrower from creating a value-creating security interest: it merely increases the cost of doing so. As long as the cost is not so high that it precludes the creation of the security interest, the adjustment mechanism, unlike a negative pledge covenant, would not be overbroad. Nor would such a mechanism confer a benefit on any other creditors. Thus, the parties are more likely to adopt an efficient adjustment mechanism than a negative pledge covenant.

This post was written by , posted on July 31, 2014 Thursday at 3:44 pm