Strategy and force in the liquidation of secured debt.

• Author: Mann, Ronald J.

The question of why parties use secured debt is one of the most fundamental questions in commercial finance. The commonplace answer focuses on force: A grant of collateral to a lender enhances the lender's ability to collect its debt by enhancing the lender's ability to take possession of the collateral by force and sell it to satisfy the debt. That perspective draws considerable support from the design of the major legal institutions that support secured debt: Article 9 of the Uniform Commercial Code and the less uniform state laws regarding real estate mortgages.

Both of those institutions are designed solely to support the liquidation process. Each has four major elements: statutory rules describing the actions a borrower and lender must take to create a lien or security interest in a particular asset, statutory and contractual rules describing the occurrences that entitle the lender to take possession of the collateral, statutory and contractual regulations of the mechanics by which the lender can sell the collateral, and statutory rules allocating priority among various claimants to the asset or its proceeds.(1) All of those rules reflect an implicit assumption that the central focus of the transaction is the ability of the lender to liquidate the collateral. Legal and contractual institutions foster that ability both by enhancing the practicability of reliable and cost-effective liquidation and by tempering the potential for inequities in the process of liquidation.

The most general problem with that arrangement is that forced liquidation has little to do with the system as it actually operates. In practice, the important element is not force, but strategy. The most important effects arise from the capacity of a grant of collateral to influence the actions the parties take short of forced liquidation of collateral. Although that perspective is contrarian, it is not entirely novel. Bob Scott suggested the limited i-importance of forced liquidation in a passing comment more than a decade ago.(2) More recently, my anecdotal research has presented a general explanation of the reasons for the use of secured credit in which there is little place for forced liquidation.(3) Rather, I have argued that the most important justifications for the use of collateral are its indirect effects: enhancing the credibility of limits on future borrowing and repairing the loan-induced incentives of the borrower toward excessive risk.(4)

But neither Bob Scott nor I has done anything to explore the perception that liquidation is relatively unimportant in the practice of secured debt. Liquidation certainly occurs: a trip to the steps of any county courthouse in Texas on the first Tuesday of any month will prove that.(5) But we know little or nothing about just how frequently it does occur. More fundamentally, if it is relatively infrequent -- as I have argued in my prior work -- why? Given the existence of valuable collateral, why would any competent lender faced with a borrower that is unwilling or unable to pay refrain from taking the collateral and selling it?

Those questions raise a related point that is just as central to the academic discourse on debtor-creditor relations: if liquidation is a marginal element of the practice of secured credit, just how important is bankruptcy to the system for disposing of failed businesses? The recent academic literature on debtor-creditor issues has expended considerable effort to analyze the ex ante effects of bankruptcy on the credit market. In that literature, the basic question is how various rules for the treatment of businesses in bankruptcy affect two aspects of the world before bankruptcy. First, at the time the loan is issued the decisions of borrowers and lenders might be affected by the possibility that a later bankruptcy would alter the borrower's obligation to repay the loan.(6) Second, during a period of distress the decisions of borrowers and their lenders might be affected by the way the loan would be treated in a potential bankruptcy proceeding.(7) But those questions have less direct significance if the ordinary process for the liquidation of distressed loans proceeds without recourse to bankruptcy.

Surprisingly, no substantial empirical research has investigated those questions. A number of widely recognized studies by legal academics have investigated the last part of the credit process -- what happens when firms enter bankruptcy.(8) Similarly, a number of finance scholars have studied the characteristics of loans that go into default.(9) But there has been no general study of the crucial period in the middle, when loans have fallen into distress but the business has not yet failed completely.(10)

To fill that gap, I undertook a series of three case studies designed to provide a picture of what actually happens when secured loans to businesses(11) fall into distress. Each case study was designed to collect as random a group as practicable of problem secured loans in the portfolio of an institutional lender and to study what happened to those loans. To enhance the admittedly limited robustness of the study, I conducted case studies at three separate kinds of lenders: an insurance company, a bank, and a commercial-finance company.(12) At each lender I reviewed files covering between twenty-one and twenty-eight problem loans.(13) For each loan, I reviewed all of the files that the lender was able to retrieve and interviewed one or more loan officers responsible for dealing with the loan during its time of distress. I then completed a standardized profile consisting of about twenty questions regarding the initial lending transaction, the event that caused the loan to be identified as a problem loan, how the lender responded to the distress, and what ultimately happened to the collateral and to the lender's investment.(14) To put the problem loans in context, I also conducted general exit interviews with each of the loan officers designed to collect information about the lender's general lending practices.

Although my work does not involve anything approaching a random sample of all distressed loans, the profiles do provide a rich picture of secured credit in action, with information of far more general interest than the specific questions that motivated the study. On those questions, however, the profiles reveal a world in which the occurrence of liquidation is surprisingly rare. The pursuit of collateral was rare not only in the smaller loans typical of the finance-company study but also in the somewhat larger bank loans and even in the much larger loans I examined at the insurance company. Officers at all three institutions exhibited a firm predisposition to treat repossession of collateral as a last resort, to be pursued only when all else fails.

More importantly for theoretical purposes, the profiles provide a persuasive and coherent explanation for the limited significance of liquidation. The answer has two parts -- the relatively high transaction costs of liquidation and the relatively effective alternative ways for debtors to repay their loans -- but the effect is much more pervasive than I anticipated. At bottom, all three case studies indicate a consistent belief by loan officers that a decision to repossess collateral and liquidate was tantamount to accepting a loss on the loan. Those officers generally believed that they could not hope to liquidate collateral at a value that would be sufficient to pay off the nominal loan balance and, more importantly, to cover the costs of repossession and liquidation, including the risks of litigation associated with any adversarial response.

Moreover, the substantive results of my profiles offer strong reasons for accepting the perspective of those loan officers. Most important is the direct results those lenders received from liquidation. Although all three of those lenders are highly sophisticated entities that use careful underwriting standards designed to ensure that collateral is adequate to protect their investments, not a single one of my profiles involved a liquidation of collateral in which the lender recovered the entire balance of its loan. Indeed, even though the overwhelming majority of the profiles revealed full payment of the loans -- particularly at the bank and finance company(15) -- not a single one of the cases of full payment involved repossession or foreclosure. Rather, full payment almost invariably came either from continued operations of the distressed business, often for months or years during which the loan continued in a serious state of default; from a sale by the debtor of all or part of the underlying collateral; or from a successful refinancing, where another lender paid off the loan I was studying. Taken together, those results provide evidence of a relatively thick and well-functioning market in which distressed debtors have a real ability to obtain funds to protect their business assets even while their lending relationship is in the process of termination. Those results are particularly valuable given the general assumption of previous scholarship that distressed debtors face pervasive liquidity problems.(16)

My analysis proceeds in two steps. Part I presents the empirical part of my study -- the data from the three case studies. For each lender, I outline the types of transactions in which it engages, the mechanisms the lender uses for identifying problem loans, the way in which it responds to problem loans, and the ultimate outcomes those responses produce.

Part II assesses two separate theoretical implications of my evidence. The first part of the theoretical discussion addresses the direct implications of my evidence for the economics of distressed debt. In particular, I show how the mechanisms evidenced in my case studies generally allow debtors to protect any equity they have in assets that they have given as collateral. From that perspective, the poor prices at...