My new paper, Secured Credit and Effective Entity Priority addresses a puzzle in bankruptcy and secured transactions law regarding the scope of security interests. Under existing law, security interests are granted in specific items of property and the priority that those interests provide extends only to the value of the asset, and not to the value of the debtor itself. Notwithstanding this legal construct, secured creditors and their lawyers routinely claim that the priority accorded their blanket liens extends to the entire value of the debtor as measured by the discounted value of the debtor’s future cash flows. Secured creditors contend that this entity based priority allows them to lend based on the entire cash flow of the debtor and not just individual assets. Only rarely have these claims been directly addressed by the courts but they are made frequently and influence the negotiations that occur during the bankruptcy process.
My article attempts to provide a systematic doctrinal argument in favor of what I call ‘effective entity priority.’ Effective entity priority results in a waterfall distribution in reorganization cases under which all of the enterprise value of the debtor is allocated to the holder of the priority until that holder’s claim is fully satisfied. Remaining value is then allocated to the next creditor group in line. This type of priority eliminates the need to allocate the value of the reorganized debtor to secured and unsecured claimants, and thereby results in enhanced returns for the secured creditor and substantial control over the reorganization process.
The doctrinal basis for effective entity priority is difficult to sustain given the asset-based character of secured lending. The bankruptcy code cuts off the effect of a secured creditor’s after acquired property clause, fixing the secured creditor’s priority claim to collateral that exists at the date of the petition and to the post-petition proceeds of that collateral. As several commentators have noted, the effect of this treatment is to eliminate the secured creditor’s claim to the going concern value of the debtor that is preserved by the bankruptcy process. That value, instead, is allocated to general creditors.
The article suggests that if a secured creditor creates a broad enough claim to the pre-bankruptcy assets of the debtor that priority can extend to the entire value of the entity, even after the bankruptcy case has commenced. The argument is premised on the notion that such a broad secured claim creates a closed system in which all the post-petition assets relate, and can be traced, to pre-bankruptcy collateral. Under this argument, the secured creditor’s priority may extend to the value of the entity itself, rather than the value of specific assets within the entity. In short, if the secured creditor is entitled to everything at the start of the bankruptcy case, it should be entitled to everything at the end of the case.
Such a closed system is difficult to maintain, however. Where collateral is combined with unencumbered assets to generate income post-bankruptcy, that income no longer relates specifically to the prebankruptcy security interest, and the secured creditor’s claim that its interest in proceeds captures that income is thereby defeated. The article considers several ways that the closed system might develop leaks that eliminate the secured creditor’s effective entity priority. Although several commentators assert that contributions of labor and other non-lienable assets preclude a claim to the value of the entity, the article argues that, to the extent they are paid for a secured creditor’s collateral, even these contributions should not defeat the secured creditors effective entity priority claim.
Although the doctrinal claim is a plausible one, the article notes that it can be difficult to maintain under the facts of particular cases. Thus, the article suggests that changes to the Bankruptcy Code and the Uniform Commercial Code that recognize true entity priority may provide clarity and efficiency to the bankruptcy process. Entity priority makes possible loans secured by the entire future cash flow of the debtor – rather than just the value of specific assets – perhaps expanding the availability of credit. While entity priority might have distributional consequences for unsecured creditors, those consequences already exist under the current asset-based priority structure, and the article suggests that those consequences could be addressed under an entity priority structure in a way that is substantially more certain and effective than under existing law.
Christopher W. Frost is the Everett H. Metcalf Professor at the University of Kentucky, College of Law.