The Logic and Limits of Liens
29 Pages Posted: 2 Nov 2017
Date Written: October 31, 2017
Thomas Jackson, in his iconic book, The Logic and Limits of Bankruptcy Law, seeks to establish both a distributional baseline for bankruptcy reorganizations and a normative set of limits for bankruptcy policy. Nonbankruptcy entitlements should establish both the distributional priorities and the distributional floor in a bankruptcy case. A number of normative prescriptions follow. Equity should not seek reorganization on the backs of the unsecured creditors. Bankruptcy-specific priorities should be avoided, to the extent possible to avoid “forum shopping” into bankruptcy (unless, of course, bankruptcy is a more efficient forum). Most importantly, however, the state law rights of secured creditors should be respected.
Since Jackson wrote, however, times have changed. Paradoxically, bankruptcy courts have become the preferred venue for realizing value on a secured creditors’ collateral, and Jackson’s rhetoric has allowed secured creditors to capture bankruptcy created value that is not necessarily allocated to them by the statute. Specifically, undersecured creditors argue that they have a blanket lien on all of the debtor’s assets and should have the power to determine their disposition.
This article first seeks to reestablish the Jacksonian balance by arguing that state law security schemes do not provide for the creation of blanket liens that capture enterprise value, but instead create asset specific security devices that are limited in scope, and are not calculated to maximize value.
It then seeks to establish three key points, and develop their implications. The points are (1) an ownership rule, (2) a realization rule, and (3) an equitable tracing—or “no moving up”—rule. The ownership rule is that baseline entitlements of a secured creditor in bankruptcy are established, as both a legal and a practical matter, by what could have actually been realized by that creditor outside of bankruptcy. The realization rule is that, unless the statute specifies (which it does in some cases), the baseline entitlement is valued as of the petition date. The equitable tracing rule recognizes the limits of the state law definition of proceeds and shows that equitable tracing principles operate to freeze the relative position of creditors on the date of the bankruptcy filing. This, in turn, limits the ability of secured creditors to use their property-based claims to “roll up” all of the bankruptcy-created value.
The article concludes by suggesting that a proper understanding of priority in bankruptcy requires attention not just to the priority of a secured creditor’s state law entitlement, but also its limits.
Keywords: Bankruptcy, Secured Credit, Article 9, UCC, Proceeds
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