Secured debt, bankruptcy, and the creditors' bargain model

Abstract

Explaining the economic efficiency of secured debt is rather difficult. Some scholars put this question into the basket of unresolved puzzles of the theory of finance.’ Many authors argue that prebankruptcy entitlements should be fully respected by bankruptcy law, since creditors in a fictitious collective decision under the veil of ignorance would have agreed to such ruling and that it could therefore be judged as welfare-increasing. But we also find the opposing view, arguing that prebankruptcy entitlements should not be respected fully in bankruptcy proceedings. The purpose of this article is to explore different arguments purporting that secured debt is an efficiency-increasing device. Part II presents the creditor’s bargain model, arguing that collateral-based security agreements should be fully respected in bankruptcy proceedings, and an alternative position in favor of impairing priorities in bankruptcy proceedings. Part III presents debt financing as a principal-agent problem and the resulting problems of debtor misbehavior. A possible response of debtors is secured debt. While it is convincing that secured debt is advantageous if the analysis is restricted to a debtor and secured creditors, it is unclear if secured debt is advantageous when its effects on unsecured creditors are taken into account. Different approaches to this question are discussed in Part IV. Part V points to a problem created by priorities in reorganization.