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We have just seen that involuntary creditors cannot adjust and that voluntary creditors with small claims generally do not adjust to the security interests created by a borrower (although some voluntary creditors with small claims may charge an interest rate that compensates them ex ante for the risk of subordination in bankruptcy). In contrast, voluntary creditors with larger claims may find it worthwhile to adjust the interest rate they charge to take into account the existence of a security interest which, in the event of bankruptcy, would give the secured creditor priority over their claims. However, a sophisticated unsecured creditor with a large claim can adjust only to security interests which the parties have already created. Thus even voluntary creditors with large claims will be nonadjusting with respect to later created security interests.

Again, the point is not that the voluntary creditor is “hurt” by the subsequent creation of a security interest giving the other creditor priority; the voluntary creditor with a large claim would be expected to take into account the possibility of the subsequent creation of a security interest in setting its interest rate. The point is that, when the borrower is deciding whether or not to create a security interest in favor of a lender, it knows that the decision will not affect the interest rate charged by pre-existing unsecured creditors lending at fixed rates.

One might ask why a voluntary creditor with a large claim would ever allow itself to become a nonadjusting creditor. That is, why would the creditor fail to simply require that the borrower covenant not to grant security interests during the term of the loan? Indeed, as discussed below, institutional creditors frequently negotiate a negative pledge covenant restricting their borrowers’ ability to issue secured debt. The question then is why sophisticated creditors do not always use such covenants when extending a large amount of credit to a borrower. We can offer three reasons for this phenomenon.

First, a negative pledge covenant may be inefficiently broad. Consider the case of an unsecured creditor lending to a borrower that anticipates issuing both efficient and inefficient security interests. If (a) the aggregate efficiency loss from preventing the creation of efficient security interests would be greater than the aggregate efficiency benefit from preventing the creation of inefficient security interests; and (b) the creditor and the borrower would bear all of the costs and enjoy all of the benefits of a negative pledge covenant, then the parties will not find it worthwhile to negotiate a negative pledge clause, even though the borrower may later create an inefficient security interest subordinating the unsecured lender’s claim.

This post was written by , posted on July 29, 2014 Tuesday at 3:43 pm