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

In Section A, we explained that there are four classes of nonadjusting creditors that cannot or do not adjust the size of their claims against the borrower to take into account the borrower’s arrangements with other creditors, including the use of security interests that, under full priority, would have the effect of reducing the expected value of the nonadjusting creditors’ bankruptcy claims.

In Section B, we explained why the existence of these creditors could cause a borrower to incorporate a security interest into a loan arrangement even though the security interest would not add value to the arrangement. In Section C, we presented evidence that the use of security interests would, in fact, often be value-wasting. In this Section, we identify the parties that ultimately bear the efficiency costs associated with the creation of value-wasting security interests. As explained below, the cost is spread among many different parties, including borrowers.

Perhaps the easiest way to identify the parties hurt by the creation of value-wasting security interests is first to identify the two types of parties that, in aggregate, are not hurt. The two groups that do not bear the efficiency cost associated with the use of value-wasting security interests are (1) adjusting creditors and (2) nonadjusting creditors that set an interest rate that, on average, compensates them for the risk of loss they face in extending credit including trade suppliers, commercial lenders, and others. Every other party affected is hurt, in one way or another, by the creation of value-wasting security interests.

Consider first involuntary nonadjusting creditors such as tort creditors and the government. Unlike other groups that might, in theory, be able to charge a price that compensates them for the increased risk of loss due to the use of a value-wasting security interest, involuntary creditors cannot. These nonadjusting creditors thus bear part of the costs arising from the use of value-wasting security interests.105 Certain voluntary nonadjusting creditors that do not always deal with the borrower on terms that reflect then-expected risk of loss due to the borrower’s use of a value-wasting security interest and that cannot diversify the risk, for example, the borrower’s employees and customers, might also bear part of the cost. guaranteed payday loan

This post was written by , posted on August 22, 2014 Friday at 3:56 pm