The Paradox of Priority
Financial Managment, Vol 32, No. 1, pp. 69-81, 2003
Posted: 17 Feb 2003
The ubiquity of bank seniority is now a widely accepted fact in the academic literature. At the same time, trade creditors are sometimes granted a purchase money security interest in the materials or equipment they provide the firm. These two conflicting facts present a puzzle: Why would banks willingly give up a valuable priority claim on the firm, but only with respect to a subset of the firm's assets? We propose a resolution to this paradox of priority by arguing that trade creditors are better able to liquidate the materials they supply to a firm. When trade creditors have a security interest in these assets, their claims are state-contingent, and therefore dependent on the value of the assets pledged as collateral. Surprisingly, this ability of trade creditors to more efficiently liquidate the materials they supply to a firm also makes it desirable to subordinate the non-collateralized portion of their claims. Doing so increases the face value of a trade creditor's claim for a given level of borrowing, thereby increasing the "liquidation bang" from each trade credit buck. This combined priority structure maximizes social welfare by reducing the firm's overall cost of funding.
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