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SECURED CLAIMS IN BANKRUPTCY: Reduced Use of Covenants 3

In discussing full priority’s effect on the use of covenants in loan arrangements, we abstracted from the level of the creditor’s enforcement efforts—the activities the creditor undertakes to ascertain that the borrower is complying with its contractual commitments. However, a borrower’s incentive to comply with the covenants it has issued may depend on the extent of the creditor’s enforcement efforts. That is, the less the creditor monitors the borrower’s compliance with these commitments, the less likely it is to detect a breach. Hence, it will be more likely that the borrower will find the expected cost of breach to be less than the expected benefit of breach, and therefore will violate the covenants. To the extent the covenants bar the borrower from engaging in inefficient activities, the level of the creditor’s enforcement efforts will therefore have efficiency implications.

Even in the absence of priority, the creditor will engage in less than the optimal amount of enforcement activity because some of the benefit of this activity will flow to other creditors, yet it (and the borrower) will bear all of the costs. However, the creditor will have even less of an incentive to engage in enforcement activities to the extent that a security interest giving the creditor’s claim full priority in bankruptcy protects the creditor from risk of loss, just as it will have less incentive to adopt even highly efficient covenants.

As a result, the borrower may be more likely to violate a covenant and act inefficiently under a rule of full priority if the creditor has a security interest. Thus, even if full priority does not lead to the creditor’s and borrower’s adoption of fewer covenants, it may well degrade the effectiveness of the covenants they do adopt and lead to efficiency problems by reducing the creditor’s incentive to monitor the borrower’s compliance with those covenants.

Under the rule of full priority, a secured creditor that is well protected by collateral does not have sufficient incentive to call a default (or cut off funding) when the borrower’s owners attempt to continue operating inefficiendy to avoid losing the business. Because in many cases a borrower’s unsecured creditors will neither have the information nor the sophistication to force the borrower into bankruptcy,116 there will be an efficiency loss until the secured creditor forces the borrower to cease operating. low interest payday loans

This post was written by , posted on August 30, 2014 Saturday at 4:00 pm