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SECURED CLAIMS IN BANKRUPTCY: The Financing of Good and Bad Projects 2

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The Effect of Partial Priority on the Financing of Good Projects

Let us now consider the circumstances under which partial priority would prevent the financing of good projects that full priority would facilitate. Suppose that, under a rule of partial priority, borrower F is considering financing a project with a loan from creditor Cl. Suppose that the project would be value-increasing, but that borrower F and creditor Cl cannot capture enough of the gain under partial priority to make it worthwhile for them to pursue the project. Specifically, suppose that the project would generate a surplus of 100 but would confer a positive externality on nonadjusting creditors of 120 (and the nonadjusting creditors are unwilling to reduce the size of their claims in order to reduce the size of the externality). Thus, the project would make borrower F and creditor Cl worse off by 20 even though it would produce a net surplus of 100.
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Full priority would facilitate such a project if the additional transfer of expected bankruptcy value as a result of the project is at least 20. Suppose that the additional transfer of expected bankruptcy is 30. In that case, the project would make nonadjusting creditors better off by only 90, leaving 10 of surplus available to be shared between borrower F and creditor Cl. As a result, the two will have an incentive to pursue the project.
More generally, full priority would facilitate the financing of value-creating projects that would not go forward under partial priority whenever both of the following conditions obtain: (1) under partial priority, the value-creating project will confer a positive externality on nonadjusting creditors that is bigger than the surplus it would create (and the parties are unable to renegotiate to reduce this externality) and (2) under full priority, the positive externality is reduced sufficiently so that it becomes smaller than the surplus that would be created.

This post was written by , posted on February 20, 2015 Friday at 4:44 pm