wordpress-themes.org wordpress themes wordpress themes

SECURED CLAIMS IN BANKRUPTCY: Prior Voluntary Creditors 3

Although sophisticated creditors with large claims might find such mechanisms worthwhile in principle, adjustment mechanisms are generally considered to be impractical. Given that the appropriate adjustment factor for each security interest would depend on numerous parameters—such as the likelihood of the borrower’s insolvency—that would be realized only at the time the security interest is created, it would be extremely difficult to specify the appropriate schedule of interest rate adjustments in advance.

Moreover, such a contractual provision—like a negative pledge covenant—might be difficult to enforce against smaller companies that can easily conceal a financing transaction and that may lack the funds to pay the adjustment once the transaction is discovered. Thus, even if an appropriate adjustment schedule could be specified in advance at no cost, there might be situations in which a sophisticated creditor would not reduce the interest rate it charged a borrower in exchange for an adjustment mechanism.

In any event, even if some prior sophisticated creditors with sufficiently large claims did adopt such an interest rate adjustment mechanism, other prior creditors would be nonadjusting with respect to the creation of subsequent security interests by the borrower. Thus the borrower would still have an incentive—albeit a reduced one—to create security interests in order to transfer value from nonadjusting creditors.

We again want to emphasize that, while prior voluntary creditors might not be able to adjust to the creation of a security interest by the borrower, we are not assuming that they are exploited by the borrower. In fact, we are willing to assume that prior creditors anticipate the risk that subsequent security interests will subordinate their claims in bankruptcy and charge accordingly.

The only assumption on which our analysis depends is that the terms negotiated by almost all prior creditors, however set, are fixed by the time the borrower and a potentially secured creditor negotiate their loan transaction. Thus when the borrower and the potentially secured creditor shape their arrangement, the use of a security interest giving the creditor a secured claim with full priority—compared to an arrangement without such a security interest—can make the borrower better off by allowing it to “sell” to the creditor bankruptcy value that would otherwise be enjoyed by these prior nonadjusting creditors.

This post was written by , posted on August 2, 2014 Saturday at 3:45 pm