The Uneasy Case for the Priority of Secured Claims in Bankruptcy: Further Thoughts and A Reply to Critics

Bebchuk, Lucian Arye; Fried, Jesse M.

doi:10.2139/ssrn.55559

Cited by 7 publications

(9 citation statements)

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“…First, one criticism of secured debt is that well-secured creditors, with low incentives to monitor, allow economically distressed firms to unduly delay filing for bankruptcy (e.g., Bebchuk andFried, 1997:1317). Owners have nothing to lose by continuing operations and the secured creditor will not press for bankruptcy as long as its loan is secured by the firm's liquidation value.…”

Section: The Relation Between Secured Debt Priority and Delayed Bankrmentioning

confidence: 99%

“…Firms for which full priority is suboptimal will grant partial priority, or borrow on an unsecured basis and include negative pledge covenants in their loan contracts. In fact, use of negative pledge covenants, said to be widespread (Bebchuk and Fried, 1997) indicates that firms frequently find that the costs of secured debt exceed the benefits. A partial priority rule would eliminate the option to grant full priority when it reduces the debtor's cost of capital.…”

Section: Implications For Priority Proposalsmentioning

confidence: 99%

“…Some scholars argue that full priority for secured debt creates perverse incentives that delay liquidation of unviable firms (e.g., Webb, 1991;Hudson, 1995) and reduce secured creditors' incentives to obtain high bids in bankruptcy liquidation sales (Bebchuk and Fried, 1996;Schwartz, 1981). But others argue that partial priority for secured debt would (1) harm business activity by reducing the credit supply (Harris and Mooney, 1997;Klee, 1997), (2) undermine freedom of contract (Bebchuk and Fried, 1997), (3) increase the administrative costs of bankruptcy (Baird, 1997), or (4) otherwise reduce efficiency (Hill, 2002;Schwartz, 1997).…”

Section: Introductionmentioning

confidence: 99%

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On the Design of Efficient Priority Rules for Secured Creditors: Empirical Evidence from A Change in Law

2004

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This article assesses the effect of a reduction in secured creditor priority on distributions and administrative costs in liquidating bankruptcy cases by reporting the first empirical study of the effect of a priority change. Priority reform had redistributive effects in liquidating bankruptcy. As expected, average payments to general unsecured creditors were significantly higher after the reform than before the reform and payments to secured creditors decreased. Reform did not increase the size of the pie to be distributed in bankruptcy. Nor did it increase the direct costs of bankruptcy.

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Section: The Relation Between Secured Debt Priority and Delayed Bankrmentioning

confidence: 99%

Section: Implications For Priority Proposalsmentioning

confidence: 99%

Section: Introductionmentioning

confidence: 99%

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On the Design of Efficient Priority Rules for Secured Creditors: Empirical Evidence from A Change in Law

2004

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“…More generally, large corporations have an incentive to spin off their most hazardous activities into separate units with limited financial assets. 4 Indeed, between 1967 and 1980 to the outsourcing of risky activities by large corporations to small firms. 5 Large companies can also issue secured debt based on their physical assets, and then use the cash received to buy back equity or pay dividends to existing shareholders (LoPucki, 1996).…”

Section: Introductionmentioning

confidence: 99%

Strategic Judgment Proofing

Che

Spier

2008

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A liquidity-constrained entrepreneur needs to raise capital to finance a business activity that may cause injuries to third parties -the tort victims. Taking the level of borrowing as fixed, the entrepreneur finances the activity with senior (secured) debt in order to shield assets from the tort victims in bankruptcy. Interestingly, senior debt serves the interests of society more broadly: it creates better incentives for the entrepreneur to take precautions than either junior debt or outside equity. Unfortunately, the entrepreneur will raise a socially excessive amount of senior debt. Giving tort victims priority over senior debtholders in bankruptcy prevents over-leveraging but leads to suboptimal incentives. Lender liability exacerbates the incentive problem even further. A Limited Seniority Rule, where the firm may issue senior debt up to an exogenous limit after which any further borrowing is treated as junior to the tort claim, dominates these alternatives. Shareholder liability, mandatory liability insurance and punitive damages are also discussed.

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“…In the corporate finance context, Bebchuk and Fried (1996, 1997) have argued that raising the priority of tort victims in bankruptcy and subordinating debt claims will give the debtholders a strong incentive to monitor the borrower ex post , improving the firm's precautions 10 . Bebchuk and Fried did not anticipate the negative effect of subordination on incentives identified here, however.…”

Section: Introductionmentioning

confidence: 99%

Strategic judgment proofing

Che

Spier

2008

The RAND J of Economics

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A liquidity-constrained entrepreneur needs to raise capital to finance a business activity that may cause injuries to third parties -the tort victims. Taking the level of borrowing as fixed, the entrepreneur finances the activity with senior debt in order to shield assets from the tort victims in bankruptcy. Interestingly, senior debt serves the interests of society more broadly: it creates better incentives for the entrepreneur to take precautions than either junior debt or outside equity. Unfortunately, the entrepreneur will raise a socially excessive amount of senior debt, reducing his incentives for care and generating wasteful spending. Giving tort victims priority over senior debtholders in bankruptcy prevents over-leveraging but leads to suboptimal incentives. Lender liability exacerbates the incentive problem even further. A Limited Subordination Rule, where the firm may issue senior debt up to an exogenous limit after which any further borrowing is treated as junior to the tort claim, dominates these alternatives. Mandatory liability insurance and punitive damages are also discussed.

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The Uneasy Case for the Priority of Secured Claims in Bankruptcy: Further Thoughts and A Reply to Critics

Abstract: The Easy Case for the Priority of Secured Claims in Bankruptcy, 47 Duoe LJ. (forthcoming Dec. 1997). Because Schwarcz's article will be finalized only after publication of this Symposium issue, we must defer a full response to some future occasion.

Cited by 7 publications

References 1 publication

On the Design of Efficient Priority Rules for Secured Creditors: Empirical Evidence from A Change in Law

On the Design of Efficient Priority Rules for Secured Creditors: Empirical Evidence from A Change in Law

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