Secured Credit, Control Rights and Options
19 Pages Posted: 14 Jul 2004
Changes in bankruptcy practice require a reexamination of the incentives of secured lenders. Traditionally, such lenders were viewed as favoring liquidating distressed businesses, even when such liquidation would be inefficient. Through devices such as revolving credit facilities, senior lenders have extensive control over the operations of financially troubled companies before a bankruptcy petition is filed. This control provides the lender with two options. One is a real option on the continued operation of the business. The lender can exercise this option to sell the enterprise in whole or in part or to revamp operations. A second is a financial option. Through the use of a prearranged bankruptcy, the secured lender can effectively convert its debt into equity while extinguishing the interests of equity holders. The secured lender can exercise both options, changing the course of the firm's operations and converting its debt claim into an equity interest. When the rights of the senior lender are viewed as a set of options, one cannot conclude on an a priori basis that the senior is overly favorable toward liquidation.
Keywords: Bankruptcy, secured lenders
JEL Classification: G0, K0
Suggested Citation: Suggested Citation