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The rest of this Part provides a detailed analysis of the problem of excessive use. Section A reintroduces the concept of “nonadjusting” creditors—creditors that cannot or do not adjust the size of their claims against a borrower to reflect the borrower’s arrangements with other creditors, including arrangements creating a security interest that subordinates the nonadjusting creditors’ claims. Section В then explains why the existence of such creditors can lead to the excessive use of security interests. In Section C, we explain why the empirical data shows that the use of a security interest would often be value-wasting.

A. The Concept of “Nonadjusting” Creditors

In The Uneasy Case, we introduced the concept of “nonadjusting” creditors. A “nonadjusting” creditor is a creditor that, for one reason or another, cannot or does not adjust the terms of its loan to reflect the effect on its loan of all the arrangements the borrower enters into with other creditors, including the creation of security interests which, under full priority, completely subordinate the nonadjusting creditors’ claim in bankruptcy.56 Because this concept is critical for understanding the problems of full priority, we want to make clear the identities of these creditors.
Before proceeding, we wish to emphasize the following. Our point is not that some nonadjusting creditors are “victimized” by priority. As we will see, some nonadjusting creditors will lose out under priority and others will not. Our point is simply this: the existence of nonadjusting creditors means that, at the moment a borrower is considering creating a security interest giving a lender priority in the underlying collateral, the borrower knows that the interest rate charged by nonadjusting creditors will be the same whether or not the borrower incorporates the security interest into the loan arrangement. This means that the borrower is able to “sell” the nonadjusting creditors’ share of bankruptcy value to a secured creditor in exchange for a lower interest rate, without paying any additional interest to the nonadjusting creditors. As we explained in The Uneasy Case, the ability to sell nonadjusting creditors’ share of bankruptcy value (whether those nonadjusting creditors are large banks, small trade suppliers, or tort creditors) creates a “subsidy” for the use of security interests and can cause a borrower, under full priority, to incorporate a security interest into its loan arrangements even though the security interest is value-wasting.

This post was written by , posted on July 19, 2014 Saturday at 3:37 pm