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

However, if the total cost of credit is higher under partial priority than under full priority, it is only because involuntary creditors receive more in bankruptcy under partial priority. Presumably, we would prefer that tort and government claims are paid more in bankruptcy, even if this raises the total cost of credit. Put differently, few would argue that we should attempt to reduce the total cost of credit by making it more difficult for tort and government claims to be paid in bankruptcy.
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The Financing of Good and Bad Projects

In Section A, we explained why adoption of a partial priority rule need not reduce the availability of secured credit or increase the overall cost of credit. However, the aggregate amount and cost of credit in the economy is not as important as the uses to which the credit is put. If the effect of the availability of low-cost credit is to allow inefficient projects to go forward, while not facilitating the financing of good projects, than the availability of low-cost credit would clearly be undesirable. We now turn to the effect of the priority rule on the financing of different types of projects.

The Question

Let us now move to the central question: how does partial priority (relative to full priority) affect firms’ ability to undertake given projects? From the perspective of economic efficiency, we want firms to undertake all good projects (those that are value-increasing) and undertake no bad projects (those that are value-decreasing). If borrower F and creditor Cl would capture all of the benefits of a project and bear all of the costs, the two would have an incentive to finance and pursue a project if and only if it were value-creating. The problem is that, when there are nonadjusting creditors, borrower F and creditor Cl will not necessarily capture all of the benefits and bear all of the costs of a project. Some of the benefits and costs will accrue to nonadjusting creditors (unless there is further renegotiation). This can distort the agreement between borrower F and creditor Cl to finance a particular project, as we explain below.

This post was written by , posted on February 19, 2015 Thursday at 4:43 pm