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SECURED CLAIMS IN BANKRUPTCY: Reduced Use of Covenants 2

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In a perfect world in which the terms of other creditors’ arrangements fully reflect the consequences to them of all of the elements of the arrangements into which the borrower enters, the two parties would have an incentive to adopt any covenant that is efficient because they would capture all of the resulting benefits. In our world, however, nonadjusting creditors would capture part of the benefits and bear none of the costs of any covenants which the creditor and the borrower negotiate. Consequently, even if the set of covenants were efficient when considering its total benefits, it would not be privately beneficial for the borrower and creditor to adopt if the cost to the borrower outweighed the benefits accruing to the creditor (and any other adjusting creditors).

Although this problem—that a borrower and creditor will have an insufficient incentive to adopt efficient covenants—is generally true whenever there are creditors whose claims do not fully reflect the agreement between the borrower and creditor, the problem becomes even more severe if the two parties adopt a security interest under the rule of full priority. In such a case, the creditor’s risk of loss will be reduced and, therefore, the benefit to the creditor of an additional set of covenants will be even smaller. Source The creditor is thus even less likely under a rule of full priority to adopt a covenant that is highly efficient.

Reduction in Monitoring
We have just seen that, in the presence of nonadjusting creditors, full priority may cause a borrower and a creditor to forego the use of desirable covenants even if they use an otherwise value-creating security interest in the arrangement. However, even if full priority has no effect on the use of covenants in the arrangement, full priority will inefficiently reduce the creditor’s enforcement of its loan contract with the borrower. In particular, full priority will give the creditor less incentive to enforce any loan contract covenants with the borrower or to force the borrower into bankruptcy when it would be socially desirable for the borrower to liquidate or reorganize.

This post was written by , posted on August 28, 2014 Thursday at 3:59 pm