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SECURED CLAIMS IN BANKRUPTCY: Use of Security Interests Under Full Priority 2

Next consider borrowers as a class. To the extent that adjusting and sophisticated nonadjusting creditors charge higher interest rates to reflect the risk of loss due to the creation of value-wasting security interests, borrowers’ profits are reduced. Link Note that sophisticated nonadjusting creditors will charge a higher interest rate to any borrower that could potentially create value-wasting security interests subordinating their claims.

If in the end, all borrowers do create value-wasting security interests, then each borrower will ultimately bear the cost through higher interest rates that would otherwise be imposed on adjusting and sophisticated nonadjusting creditors. However, if some borrowers create security interests and others do not, and nonadjusting creditors are unable to distinguish between these two types of borrowers, then both types of borrowers will pay higher interest rates for unsecured credit even though one type will create value-wasting security interests and the other will not. In essence, the higher interest rates paid by borrowers that do not create value-wasting security interests will subsidize the use of value-wasting security interests by other borrowers. This cross-subsidization effect means that borrowers creating security interests do not necessarily internalize the full cost of the security interests they create.


In Part Ш, we examined one efficiency cost of full priority: in loan transactions that would go through whether or not the parties use a security interest, full priority may cause the borrower to create a security interest even though it does not add value to the transaction.

This Part further develops and defends our claim that full priority produces at least three other efficiency costs: (1) in a loan transaction in which the parties will use a security interest whether or not secured claims receive full priority in bankruptcy, according full priority to secured claims may undesirably reduce the secured creditor’s monitoring of the borrower; (2) the possibility of borrowing later on a secured basis under full priority may cause a borrower to make inefficient decisions with respect to potential tort liability; and (3) when a loan transaction will not go through unless the lender is given a security interest providing it with full priority in the underlying collateral, full priority may permit the financing of undesirable activities.

This post was written by , posted on August 24, 2014 Sunday at 3:57 pm