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Priority Contracts and Priority in Bankruptcy

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  • Alan Schwartz

    ()
    (Law School)

Abstract

Parties to lending agreements can create priority rankings in two ways: by securing a lender or by protecting the lender's debt with financial covenants. Protected debt turns into high priority debt because the early lender will permit covenant violations only if a later lender agrees to subordinate its claim. The Bankruptcy Code sustains both forms of priority by according secured debt senior status and by enforcing subordination agreements among creditors. The latter priority is not controversial but several recent reform proposals would reduce the secured lender's priority. This article argues that creditors who lend early in a firm's life are concerned about debt dilution, which can occur even when all of the borrower's later projects have positive values. It then shows that the equilibrium financial contract for private debt has strong borrowers protecting the early debt with financial covenants, and it suggests that weak borrowers protect the early debt with security. Thus security and financial covenants may be substitutes. "Covenant equilibria" are argued to be efficient. That these equilibria closely resemble "security equilibria," and that arguments for the inefficiency of the secured lender's priority are weak, both argue that the Bankruptcy Code's current respect for both forms of priority should continue. The article also argues that financial covenants should be made binding on later lenders whose advances would cause covenant violations.

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Bibliographic Info

Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm72.

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Date of creation: 15 May 1997
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Handle: RePEc:ysm:somwrk:ysm72

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Web page: http://icf.som.yale.edu/
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Cited by:
  1. Veld, Klaas T. van 't & Rausser, Gordon C. & Simon, Leo K, 2000. "Fitting the glass slipper: optimal capital structure in the face of liability," CUDARE Working Paper Series 917, University of California at Berkeley, Department of Agricultural and Resource Economics and Policy.
  2. Kenneth Ayotte & Patrick Bolton, 2011. "Optimal Property Rights in Financial Contracting," Review of Financial Studies, Society for Financial Studies, vol. 24(10), pages 3401-3433.
  3. Richard Hines & Jeremy Berkowitz, 1998. "Bankruptcy exemptions and the market for mortgage loans," Finance and Economics Discussion Series 1998-07, Board of Governors of the Federal Reserve System (U.S.).
  4. Stanley D. Longhofer & João A. C. Santos, 1999. "The importance of bank seniority for relationship lending," Proceedings 620, Federal Reserve Bank of Chicago.
  5. Kroszner, Randall S. & Strahan, Philip E., 2001. "Bankers on boards: *1: monitoring, conflicts of interest, and lender liability," Journal of Financial Economics, Elsevier, vol. 62(3), pages 415-452, December.
  6. Randall S. Kroszner & Philip E. Strahan, 1999. "Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability," NBER Working Papers 7319, National Bureau of Economic Research, Inc.
  7. Clas Bergström & Theodore Eisenberg & Stefan Sundgren, 2004. "On the Design of Efficient Priority Rules for Secured Creditors: Empirical Evidence from A Change in Law," European Journal of Law and Economics, Springer, vol. 18(3), pages 273-297, December.
  8. Richard Hynes & Jeremy Berkowitz, 1998. "Bankruptcy Exemptions and the Market for Mortgage Loans Journal of Law and Economic," Center for Financial Institutions Working Papers 98-17, Wharton School Center for Financial Institutions, University of Pennsylvania.
  9. Bolton, Patrick & Jeanne, Olivier, 2005. "Structuring and Restructuring Sovereign Debt: The Role of Seniority," CEPR Discussion Papers 4901, C.E.P.R. Discussion Papers.
  10. Stanley D. Longhofer & Stephen R. Peters, 2000. "Protection for whom? creditor conflicts in bankruptcy," Working Paper 9909R, Federal Reserve Bank of Cleveland.
  11. John Armour & Michael J Whincop, 2005. "The Proprietary Foundations of Corporate Law," ESRC Centre for Business Research - Working Papers wp299, ESRC Centre for Business Research.
  12. Nancy Huyghebaert & Linda Gucht & Cynthia Hulle, 2007. "The Choice between Bank Debt and Trace Credit in Business Start-ups," Small Business Economics, Springer, vol. 29(4), pages 435-452, December.

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