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SECURED CLAIMS IN BANKRUPTCY: Reduced Use of Covenants 4

Thus, even if the creditor and borrower did not include any covenants in the loan agreement other than a default clause, the rule of full priority, by tending to insulate the creditor from the effects of the borrower’s collapse, does not provide the creditor with the proper incentive to terminate its.

As we saw, full priority may affect a borrower’s behavior following a loan transaction, if the effect of full priority is to cause the creditor to fail to incorporate various covenants into the arrangement or enforce those that are incorporated. However, the borrower’s ability to give the creditor a security interest that subordinates the claims of nonadjusting creditors may affect the borrower’s behavior even before the creditor and the borrower negotiate their loan contract.

Consider the case where the borrower must decide, prior to contracting with the creditor, whether to take certain precautions that will make its products safer and reduce the number of ftiture tort claims against the borrower. The borrower knows that when the creditor and the borrower later negotiate their loan contract, the creditor will take expected tort claims into account in setting its interest rate. If the creditor is unsecured, the creditor will charge the borrower a higher interest rate, to the extent it anticipates that future tort claims will reduce the value of its loan by diluting the creditor’s share of the borrower’s bankruptcy assets.

By adjusting its interest rate to take into account the expected number of tort claims, the creditor will force the borrower to internalize more of the costs of the tort claims that are likely to arise if it fails to take these precautions. If the creditor is expected to be unsecured, the prospect of paying a higher interest rate to the creditor will increase the incentive for the borrower to take the precautions in the first place.

This post was written by , posted on September 1, 2014 Monday at 4:22 pm