The uneasy case for the priority of secured claims in bankruptcy.

• Author: Bebchuk, Lucian Arye

CONTENTS

1. INTRODUCTION 859

2. TOWARD RECONSIDERATION OF THE PRIORITY OF

   SECURED CLAIMS IN BANKRUPTCY 867

   A. The General Prohibition Against Nonconsensual

   Subordination 868

   B. Value Transfer and Efficiency 870

   C. Would Adopting a Partial-Priority Rule Be a

   Radical Change? 871

3. THE PRIORITY-INDEPENDENT VALUE OF SECURITY INTERESTS 872

   A. The Problem of Borrower Misbehavior 873

   B. The Priority-Independent Benefits of Security Interests 875

   C. The Priority-Independent Costs of Security Interests 877

   D. The Relative Value of Covenants 878

4. THE INCENTIVE TO USE SECURITY INTERESTS

   UNDER FULL PRIORITY 880

   A. The Loan Contract Between Firm and Creditor 880

   B. The Easy Case for Full Priority in a World with Perfectly

   Adjusting Creditors 881

   C. The Presence of Nonadjusting Creditors 882

   1. Private Involuntary Creditors 882

   2. Government Tax and Regulatory Claims 884

   3. Voluntary Creditors with Small Claims 885

   4. Prior Voluntary Creditors 887

   D. Full Priority and the Decision to Create a Security Interest 891

5. EFFICIENCY COSTS OF FULL PRIORITY 895

   A. The Use of Inefficient Security Interests 896

   B. Distorted Choice Between Security Interests and Covenants 897

   C. Distorted Investment and Precaution Decisions 898

   D. Suboptimal Use of Covenants 900

   E. Suboptimal Enforcement Efforts 902

6. POSSIBLE ALTERNATIVES To FULL PRIORITY 904

   A. The Adjustable-Priority Rule 905

   B. The Fixed-Fraction Priority Rule 909

   C. The Existing Erosion of Priority 911

7. THE COST AND EFFECTIVENESS OF A PARTIAL-PRIORITY RULE 913

   A. The Efficiency Costs of Partial Priority 913

   1. Increased Information-acquisition Costs 914

   2. Increased Cost of Coordinating Monitoring

      Efforts Among Creditors 915

   3. Reduced Financing for Desirable Activities 917

      B. Some Relevant Empirical Evidence 921

      C. Enforcement of Partial Priority 923

   1. "Opting Out" of Bankruptcy 924

   2. Using Lease Arrangements to Evade Partial Priority 926

8. FURTHER CONSIDERATIONS CONCERNING THE DESIRABILITY OF

   PARTIAL PRIORITY 929

   A. Learning from the Past Behavior of U. S. Firms 929

   B. Leaving the Priority Rule to Private Ordering 930

   C. Fairness and Bargain Considerations 931

   D. Freedom of Contract Concerns 932

9. CONCLUSION 934

1. INTRODUCTION

   This Article challenges the desirability of a fundamental and longstanding feature of bankruptcy law: the principle that a secured creditor is entitled to receive the entire amount of its secured claim--the portion of its bankruptcy claim that is fully backed by collateral--before any unsecured claims are paid.(1) There is a widespread consensus among legal scholars and economists that the rule of according full priority to secured claims is desirable because it promotes economic efficiency. The analysis we offer demonstrates that, contrary to this conventional view, the efficiency case for full priority is at best problematic. We find that according full priority to secured claims leads to distortions in the arrangements negotiated between commercial borrowers and their creditors, which in turn generate a number of inefficiencies. Our analysis indicates that these inefficiencies could be reduced or eliminated by according only partial priority to secured claims, and that a rule of partial priority therefore may well be superior to the rule of full priority from the perspective of efficiency. Accordingly, the Article offers two rules of partial priority that should be considered as possible alternatives to the rule of full priority.

   In a secured transaction, the borrower gives the creditor a security interest in specified property of the borrower that, if the borrower defaults, permits the creditor to take possession of the property in partial or full satisfaction of the debt.(2) The practice of taking a security interest in a borrower's property, which has ancient origins,(3) continues to be widespread: Although there is no comprehensive source of information on secured commercial lending, the available data suggest that a substantial percentage of total U.S. business debt is secured.(4) In the United States, large, publicly traded firms tend not to borrow on a secured basis.(5) Thus, most commercial secured debt in the United States is issued by small and medium-sized companies.(6)

   Under state laws governing transactions in personal and real property, a security interest in favor of a lender becomes effective when credit is extended and certain procedural requirements are met.(7) Unless the parties agree otherwise, the secured lender generally retains all of the baseline rights of an unsecured creditor with respect to the borrower. That is, if the borrower defaults on the terms of the loan agreement, the secured lender may seek to reduce its claim to judgment, and then instruct an agent of the court to enforce the judgment against any of the debtor's property. As a secured creditor, the lender also enjoys two additional rights: a "repossessory right" and a state-law "priority right."(8) In the event of default, the "repossessory right" gives the lender a qualified right to take possession of the assets covered by the security interest without resorting to judicial process.(9) The state-law "priority right' gives the lender a right to these assets that is generally superior to the rights of other claimants, including purchasers, transferees, and other creditors.(10) The state-law "priority right" is typically established when the lender "perfects" its security interest, either by taking possession of the assets or by filing a financing statement in the appropriate public registries.(11) The secured creditor can fully exercise both its "repossessory right" and its state-law "priority right" only outside of bankruptcy.

   Our focus, however, is on the rights of the secured creditor when an insolvent debtor enters bankruptcy.(12) Once the debtor enters bankruptcy, bankruptcy law "stays" the secured creditor from exercising its "repossessory right" to take possession of the collateral covered by the security interest.(13) The secured creditor's state-law "priority right" in the collateral is also suspended. To compensate the secured creditor for the loss of its "priority right," bankruptcy law requires generally that, by the end of the proceeding, the creditor receive an amount equal to its secured claim.(14) In practice, however, the compensation actually received by secured creditors is sometimes less than the value of their secured claims at the beginning of the bankruptcy process.(15)

   Even though secured creditors do not always receive the full value of their secured claims in bankruptcy, they still retain a substantial advantage over general unsecured creditors, which have a claim to only those assets that remain after secured claims and the claims of certain priority unsecured creditors are paid or provided for.(16) The effect of this priority scheme on the allocation of bankruptcy value among creditors is significant. If, as is usually the case, the business debtor is immediately or eventually liquidated,(17) general unsecured creditors can expect to receive only a few cents on the dollar.(18) Even in the relatively few cases where a business debtor successfully reorganizes under Chapter 11,(19) the mean recovery by general unsecured creditors is typically only 20[cts.] to 30[cts.] on the dollar.(20)

   The principle of according full priority to secured claims in bankruptcy is firmly established in the law.(21) And although some commentators have questioned the fairness of permitting a debtor to encumber its assets in favor of secured creditors at the expense of unsecured creditors,(22) the predominant view of those who have examined full priority from an economic approach is that it is desirable to respect the state-law "priority right" of secured creditors to the greatest extent possible in bankruptcy.(23) It is this view-sometimes described as the "creditors' bargain" theory(24)--that we challenge in this Article.(25)

   We will show that a rule according full priority to secured claims in bankruptcy tends to reduce the efficiency of the loan arrangement negotiated between a commercial borrower and a potentially secured creditor. That is, full priority tends to reduce the total value captured by the borrower, the potentially secured creditor, and all other parties affected by the arrangement, which we assume to be the borrower's other creditors.(26)

   Our analysis does suggest that the loan arrangement between a commercial borrower and a potentially secured creditor under the rule of full priority would be efficient in a hypothetical world in which the use of a security interest does not have distributional consequences for the borrower's other creditors. Assume that when a security interest is created, the amount owed to all other creditors changes in such a way as to offset the impact of the transaction on them, including the effect on them of permitting the recipient of the security interest to have a secured claim with full priority in bankruptcy. Under these circumstances, the creation of a security interest under full priority would never impose a negative externality on the other creditors, and a security interest could not, therefore, be used to divert value from these creditors. Consequently, a security interest would be chosen only if it were efficient. In this hypothetical world, efficiency would thus require giving full priority to the secured claim in the event of bankruptcy.

   In the real world, however, the creation of a security interest under the rule of full priority has distributional consequences. In particular, under the rule of full priority, the creation of a security interest diverts value from creditors that do not "adjust" the size of their claims to take into account the effect of the loan transaction that creates the security interest, including the fact that any security interest given to the secured creditor subordinates their unsecured claims.

   A firm will have many such "nonadjusting" creditors. The size of the...