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SECURED CLAIMS IN BANKRUPTCY: SECURITY INTERESTS UNDER FULL PRIORITY 2

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The problem of excessive use would not arise if incorporating a security interest into a loan arrangement always added value to the transaction (which, we are assuming for now, would go forward in any event).

There are, in fact, a number of ways in which the incorporation of a security interest into a loan contract can add value to such a transaction. Most of the ways in which incorporation of a security interest can add value are “priority-independent;” they do not depend on the security interest giving the creditor full priority over unsecured claims in bankruptcy, but rather depend on the rights the security interest gives the secured creditor against the borrower and other third parties (e.g., subsequent secured creditors, transferees, and non-ordinary course purchasers). For example, a security interest may enable the lender to prevent the borrower from selling the collateral to another party and inefficiently squandering the proceeds.

However, incorporating a security interest into a loan agreement can also give rise to various costs. Some of these costs are priority-independent, while others are priority-dependent, meaning that they arise only to the extent that secured claims are given priority over unsecured claims in bankruptcy. The priority-independent costs of including a security interest in a transaction that will go forward in any event include what we call “contracting costs”—the costs of creating the security interest; “enforcement costs”—the cost of monitoring the collateral; and “opportunity costs”—the potentially adverse effect of the security interest on the borrower’s investment and financing flexibility in the future.53 When the costs of incorporating a security interest into a loan arrangement would exceed the benefits, the incorporation of the security interest into the loan agreement would be value-wasting. In this situation, the problem of excessive use can arise.

This post was written by , posted on July 17, 2014 Thursday at 3:36 pm