Document Type

Article

Publication Date

1986

Center/Program

Center for Contract and Economic Organization

Center/Program

Program in the Law and Economics of Capital Markets

Abstract

Despite advances in finance theory, secured debt remains a puzzle. As a consequence, the justification for the current legal regulation of secured financing is similarly unclear. What purposes, whether benign or malignant, does security serve? And what explains the peculiar system of priorities established by Article 9 of the Uniform Commercial Code? These are particularly urgent questions for students of commercial law because legally created priorities among creditors are an apparent aberration. In most legal regimes, equal treatment of those similarly situated is an important normative goal. Indeed, much of federal bankruptcy law seems to reflect a conception of business failure as a common disaster. As with a flood or an earthquake, when unanticipated disaster strikes all victims are treated equally. Yet personal property security is a discriminatory financing device, one that offers certain creditors preferential treatment in any distribution of the debtor's assets.

The conventional justification for such preferential treatment is that security increases the aggregate amount of credit available to de-serving debtors. Under this conception, creditors demand security for certain debts as a way of reducing unacceptably high risks of default. Without security, it is argued, such high risk debtors would be denied access to credit markets altogether. Developments in modem finance theory, however, have exposed an apparent fallacy underlying this conventional wisdom. The benefits to secured creditors from taking security are offset by the increased costs to unsecured creditors who face a corresponding reduction in the pool of assets available to them upon default. Alan Schwartz has shown that, given certain assumptions, secured credit is a zero sum game in which gains to some creditors are achievable only by inflicting losses on others. Furthermore, since setting up security arrangements is costly, the debtor's total credit bill – consisting of both secured and unsecured credit charges – maybe greater under a regime of secured credit than in a world where security is prohibited.

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