Strategy and Force in the Liquidation of Secured Debt

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This article provides an empirical and theoretical study of the processes for the liquidation of secured debt. The empirical portion of the study includes an empirical base of 74 profiles of distressed secured loans randomly selected from the portfolios of three lenders (one finance company, one bank, and one insurance company). Those profiles include information on such topics as how the lenders decide which loans to terminate, what happens to the debtors after the lender decides to terminate the relationships, how successful the lenders are in obtaining repayment, and how much the process of termination costs. The theoretical portion of the study builds on the base of empirical evidence in two ways. The first part of the theoretical discussion presents a model of the economics of distressed debt. I argue that debtors are surprisingly capable of protecting themselves even in the face of demands for payment from their lenders, relying on the substantial incidence in my profiles of transactions where the debtors either refinanced their loans or paid them off with cash flow generated from continued operations or sale of the underlying collateral. As a related point, I argue that extremely poor results lenders face in cases where they foreclose rebut the concerns of some academics about the ability of lenders to use foreclosure to capture valuable assets from their borrowers. The second part of the theoretical discussion addresses broader questions about the connection between the market for distressed debt and the larger market for the initial issuance of debt. First, based on the very low frequency of liquidation and the poor results that lenders obtain on liquidation, I argue that the principal reasons that lenders take collateral are the strategic advantages it gives them; the enhancement of their power to liquidate collateral by force is of so little value that it cannot plausibly be viewed as a general justification for those transactions. Accordingly, legal reforms of the secured-credit system should focus more on the serious policy issues raised by those strategic advantages than on perceived difficulties in obtaining a reliable right to liquidate. I close by addressing the long-standing concern that rules hindering creditors' collection efforts will affect the willingness of lenders to issue new loans. My evidence of the low frequency of business failure and bankruptcy strongly suggests that the concern is for the most part unfounded.