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SECURED CLAIMS IN BANKRUPTCY: Reduced Use of Covenants 5

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Under the rule of full priority, however, the borrower may give the creditor a security interest that protects the value of the creditor’s loan from the dilutory effect of tort claims. Consequently, if the creditor is given a security interest, it may not charge a higher interest rate even if the borrower fails to take precautions, and there are more tort claims against the borrower. Because the borrower will not face the prospect of paying the creditor a higher interest rate if more tort claims against it are likely, the borrower will have less incentive to invest in precautions if it knows that it can grant the creditor a security interest.

With respect to this particular efficiency cost of foil priority, Harris and Mooney argue that tort liability generally has litde to no effect on the borrower’s behavior. Therefore, the borrower’s ability to reduce the effect of tort liability by issuing security interests under the rule of foil priority should not, they argue, have much effect on the borrower’s decisions whether to take precautions or to refrain from activities likely to generate tort claims.

We do not share the view that tort liability has little effect on firm behavior, for there is substantial evidence that tort liability does affect firm behavior. For example, firms invest in precautions that have the effect of reducing their expected tort liability. Firms would not incur such expenses if they were indifferent to their expected tort liability.
Harris and Mooney argue in the alternative that even if tort liability does affect firm behavior, firms’ ability to reduce the cost of tort liability by issuing secured debt under a rule of foil priority is likely to have only a minimal effect on tort liability and therefore on firm behavior. Whether foil priority has a small or large effect on tort liability is, of course, an empirical question to which we currently do not have an answer.

Nevertheless, it is worth emphasizing that even if foil priority has only a limited effect on expected tort liability, and therefore on firm behavior, partial priority may still yield substantial benefits in terms of reducing expected tort liability. For example, a slight increase in expected tort liability might cause firms to adopt, at little expense, additional precautions that have a substantial effect on the amount of expected harm.

This post was written by , posted on September 3, 2014 Wednesday at 4:23 pm