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Our analysis would apply even if all nonadjusting creditors received an interest rate that compensated them, on an expected value basis, for the increased risk of loss associated with the possibility of subordination. For example, our analysis would apply even in a world where the only nonadjusting creditors are sophisticated financial institutions that charge interest rates fully compensating them for the additional risk of loss associated with subordination. The fact that in the real world many nonadjusting creditors are not compensated for the possibility of subordination is completely irrelevant for purposes of our analysis.

Involuntary Creditors

The classic example of a nonadjusting creditor is a party that has been injured by the borrower and that is unable to recover fully from the borrower’s insurance.60 Although uninsured tort claims do not often surface in bankruptcy, those that do turn up can be substantial.61 Because the claims are fixed by a court without regard to the borrower’s financial structure, the claims of these tort creditors cannot be adjusted to reflect the existence of a security interest.

The size of the tort claims will therefore neither take into account the extent to which the borrower has already encumbered its assets, nor will be subject to adjustment if the borrower subsequently subordinates the tort claims by issuing a security interest. Thus, in considering whether to create a security interest in a loan transaction, a borrower can “sell” some of what involuntary creditors would receive in bankruptcy by creating a security interest giving the secured lender priority.

This post was written by , posted on July 21, 2014 Monday at 3:38 pm