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SECURED CLAIMS IN BANKRUPTCY: Voluntary Creditors with Small Claims

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Involuntary creditors—tort creditors and government agencies—are not able to adjust the size of their claims against a borrower when it creates a security interest in favor of another creditor, because their claims are fixed by law. But the fact that a creditor voluntarily contracts with a firm does not necessarily make that creditor adjusting with respect to a particular security interest which the firm has created.

Many of a firm’s voluntary creditors are customers, employees, and trade creditors that have relatively small claims against the firm. Even though these creditors can, in principle, take the existence of a security interest into account in contracting with the firm, the small size of their claims will generally make it rational for them not to do so. Even trade suppliers, which are more commercially sophisticated than employees and customers, are believed to have neither the time nor the expertise to evaluate individual firm risk. Indeed, trade creditors generally charge uniform interest rates to all customers that are allowed to purchase on credit, indicating that those creditors do not set the interest rate to take into account the particular risk of loss associated with lending to that customer.

The failure of creditors with small claims to take into account a borrower’s arrangements with other creditors does not imply that these creditors are systematically undercompensated for bearing the risk that other creditors of the borrower will have priority claims in bankruptcy. Experienced trade creditors probably set terms that compensate them for the average risk of loss they face in lending to all of their customers. However, whether or not these creditors are adequately compensated for their risk of loss is not relevant to our analysis.

The point is simply that, when deciding whether to create a security interest giving a lender priority in the underlying collateral, the borrower knows that the decision will not affect the interest rate charged by creditors with small claims. Thus, a borrower creating such a security interest can obtain a lower interest rate by selling the bankruptcy value to which these creditors would otherwise be entitled by creating a security interest under full priority.

This post was written by , posted on July 27, 2014 Sunday at 3:42 pm