Center for Contract and Economic Organization
The Charles Evans Gerber Transactional Studies Center
The question of why parties use secured debt is one of the most fundamental questions in commercial finance. The commonplace answer focuses on force: A grant of collateral to a lender enhances the lender's ability to collect its debt by enhancing the lender's ability to take possession of the collateral by force and sell it to satisfy the debt. That perspective draws considerable support from the design of the major legal institutions that support secured debt: Article 9 of the Uniform Commercial Code and the less uniform state laws regarding real estate mortgages.
Both of those institutions are designed solely to support the liquidation process. Each has four major elements: statutory rules describing the actions a borrower and lender must take to create a lien or security interest in a particular asset, statutory and contractual rules describing the occurrences that entitle the lender to take possession of the collateral, statutory and contractual regulations of the mechanics by which the lender can sell the collateral, and statutory rules allocating priority among various claimants to the asset or its proceeds. All of those rules reflect an implicit assumption that the central focus of the transaction is the ability of the lender to liquidate the collateral. Legal and contractual institutions foster that ability both by enhancing the practicability of reliable and cost-effective liquidation and by tempering the potential for inequities in the process of liquidation.
The most general problem with that arrangement is that forced liquidation has little to do with the system as it actually operates. In practice, the important element is not force, but strategy. The most important effects arise from the capacity of a grant of collateral to influence the actions the parties take short of forced liquidation of collateral. Although that perspective is contrarian, it is not entirely novel. Bob Scott suggested the limited importance of forced liquidation in a passing comment more than a decade ago. More recently, my anecdotal research has presented a general explanation of the reasons for the use of secured credit in which there is little place for forced liquidation. Rather, I have argued that the most important justifications for the use of collateral are its indirect effects: enhancing the credibility of limits on future borrowing and repairing the loan-induced incentives of the borrower toward excessive risk.
But neither Bob Scott nor I has done anything to explore the perception that liquidation is relatively unimportant in the practice of secured debt. Liquidation certainly occurs: a trip to the steps of any county courthouse in Texas on the first Tuesday of any month will prove that.5 But we know little or nothing about just how frequently it does occur. More fundamentally, if it is relatively infrequent – as I have argued in my prior work – why? Given the existence of valuable collateral, why would any competent lender faced with a borrower that is unwilling or unable to pay refrain from taking the collateral and selling it?
Ronald J. Mann,
Strategy and Force in the Liquidation of Secured Debt,
Mich. L. Rev.
Available at: https://scholarship.law.columbia.edu/faculty_scholarship/458