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SECURED CLAIMS IN BANKRUPTCY: The Financing of Good and Bad Projects 3

The Effect of Partial Priority on the Financing of Bad Projects

Next, consider the circumstances under which partial priority would prevent the financing of bad projects that full priority would facilitate.163 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-decreasing, and that borrower F and creditor Cl would not transfer enough bankruptcy value from nonadjusting creditors to make it worthwhile for them to pursue the project. Specifically, suppose that the project would generate a loss of 100 and would make borrower F and creditor Cl worse off by 20.
Full priority would facilitate such a project if the additional transfer of expected bankruptcy value is at least 20. Suppose that the additional transfer of expected bankruptcy is 30. In that case, the project would make nonadjusting creditors worse off by 110, leaving 10 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 will facilitate the financing of value-decreasing projects that would not go forward under partial priority whenever both of the following conditions occur: (1) under partial priority, the value-reducing project will not transfer sufficient value from nonadjusting creditors to make it worthwhile and (2) under full priority, sufficient value is transferred from nonadjusting creditors so that it makes the project worthwhile.

Assessing the Overall Effect of Partial Priority on Financing
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One cannot determine the overall effect of partial priority on the financing of good and bad projects on a priori theoretical grounds. The net effect may also depend on the extent of the reduction in priority. For example, on the margin, reducing priority from 100% to 90% may create a desirable net effect, but moving from 90% to 80% may create an undesirable net effect. Therefore, we would need evidence to make the determination as to what level of priority yields the optimal mix of projects.

This post was written by , posted on March 22, 2015 Sunday at 4:46 pm