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HeinOnline --- 80 Va. L. Rev. 1887 (1994)

THE UNSECURED CREDITOR'S BARGAIN

Lynn M. LoPucki*

[D Joes it make any sense to award everything to a secured party who stands idly by while a doomed enterprise goes down the slippery slope into bankruptcy?

-Grant Gilmore1

INTRODUcrION •••.•••..•••••••••••••••••••••••••••••••.•••.••• 1888 1. THE SECURED CREDITOR'S BARGAIN ••••.•••••••••••• 1892

A. Involuntary Creditors .............................. 1896 1. Leaving Involuntary Creditors Subordinate to

Secured Creditors .............................. 1903 2. Elevating Involuntary Creditors Through

Universal Insurance ............................ 1906 3. Elevating Involuntary Creditors to Priority

over Secured Creditors ......................... 1907 B. Uninformed Creditors .. ............................ 1916 C. Can Security Be Proven Efficient? ................. 1920

II. THE UNSECURED CREDITOR'S BARGAIN ••••••••••••.• 1924 A. Asset-Based Unsecured Lending ................... 1924 B. Cash-Flow-Based Unsecured Lending .............. 1931

1. LoPucki's Formulation of Bowers' Law: Security Tends To Expand to the Liquidation Value of the Collateral ......................... 1931

* William R. Orthwein Professor of Law, Washington University in St. Louis. I express my appreciation to Barry Adler, Susan Block-Lieb, Jim Bowers, David Carlson, Kate Heidt, Dan Keating, Steve Knippenberg, Ronald Mann, Bob Rasmussen, Paul Shupack, Harry Sigman, Barbara Jo Smith, Bob Thompson, Jay Westbrook, Bill Whitford, Jim White, and participants in the University of Virginia School of Law's Conference on "Revision of Article 9 of the Uniform Commercial Code" for their comments on earlier drafts of this manuscript, to Bob Thompson for supplying unpublished data from his empirical study of corporate veil piercing, to Steven L. Schwarcz for his insights into unsecured lending by large financial institutions, to Bob Wirengard for his insights into unsecured lending by sophisticated trade creditors, and to Barbara Jo Smith for assistance with research.

1 Grant Gilmore, The Good Faith Purchase Idea and the Uniform Commercial Code: Confessions of a Repentant Draftsman, 15 Ga. L. Rev. 605, 627 (1981).

1887


1888 Virginia Law Review [Vol. 80:1887

2. Cash-Flow Surfing in a Fully Encumbered World .......................................... 1938

3. The Legal-Theoretical Implications of Cash-Flow Surfing ................................... 1941

C. Justifying the Subordination of Unsecured Creditors: Three Bad Theories and One Not So Bad ................................................ 1947 1. The Presumption That Everyone Knows the

Law ...... ...................................... 1949 2. The Property Theory ........................... 1952 3. The Economic Theory ......................... 1954 4. The Implied Contract Theory .................. 1958

III. CONCLUSION ........................................... 1963

INTRODUCfION

E CONOMICS is called the dismal science2 for good reason. For most of its inhabitants, this world is a cruel place.3 A principal

role of economists seems to be to explain why things cannot be better. Most appear to enjoy this work and to regard harsh economic realities much as personal injury lawyers regard severe injuries.

The institution of security has a similarly bad reputation. Its most persistent image i,s that of families forced from home or farm through forec1osure.4 Most noneconomists wish that things could

2 The term "dismal science" was coined by Thomas Carlyle. Thomas Carlyle, The Nigger Question, in 6 Critical and Miscellaneous Essays, 169, 177 (London, Chapman & Hall 1869). The context is worth repeating:

Id.

And the Social Science,-not a "gay science," but a rueful,-which finds the secret of this Universe in "supply and demand," and reduces the duty of human governors to that of letting men alone, is also wonderful. Not a "gay science," I should say, like some we have heard of; no, a dreary, desolate, and indeed quite abject and distressing one; what we might call, by way of eminence, the dismal science.

3 See generally the New York Post. 4 For example, John Steinbeck wrote:

A man can hold land if he can just eat and pay taxes; he can do that. Yes, he can do that until his crops fail one day and he has to borrow money from

the bank. But-you see, a bank or a company can't do that, because those creatures don't

breathe air, don't eat side-meat. They breathe profits; they eat the interest on money.

John Steinbeck, The Grapes of Wrath 43 (1939).


1994] Unsecured Creditor's Bargain 1889

be different. We are rooting for the underdog, which means we are rooting against security. But even as we dislike that harsh institution, we respect it. The debtor agreed to it expressly and the unsecured creditors did so implicitly. How could it be unfair?

When the newly minted discipline of Law and Economics met the institution of secured credit in the late 1970s, they fell in love. Law and Economics needed cruelty to explain, and secured credit had something of a gold mine. The seminal article, written by Professors Thomas Jackson and Anthony Kronman and published in the Yale Law Journal in 1979, purports to justify security as an institution by proving it to be economically efficient.s When an institution is "efficient," any change in it will reduce aggregate wealth, something that nobody with any sense wants to do.6 As bad as an efficient institution might seem to the layperson, tinkering with it, the economist has opined, can only make things worse. Ah, to be exquisitely cruel but at the same time efficient-what more could an economist ask of an institution?

Popular discussions of security quickly deteriorate into melodrama. For example, Amy Wallace reported on one woman's plight as follows:

The men lifted the ailing, 56-year-old grandmother onto a tarp and carried herkicking and screaming-out to an alley .... And that's where she sat, a bottle of oxygen at her side, as ... the president of Otwin Investments ... took a quick look around the house that is now his and then padlocked the door.

Amy Wallace, In Debt and Out of a Home, L.A. Times, Mar. 19, 1993, at B3. So, sometimes, do scholarly discussions of security, as when Professors Harris and

Mooney argue that the "good name" of secured transactions "should be cleared." Steven L. Harris & Charles W. Mooney, Jr., A Property-Based Theory of Security Interests: Taking Debtors' Choices Seriously, 80 Va. L. Rev. 2021, 2037 (1994).

5 Thomas H. Jackson & Anthony T. Kronman, Secured Financing and Priorities Among Creditors, 88 Yale L.J. 1143 (1979) (suggesting that monitoring savings justify secured finance). Jackson and Kronman do not use the word "efficient," but their proof is essentially that and others have so described it. See, e.g., Homer Kripke, Law and Economics: Measuring the Economic Efficiency of Commercial Law in a Vacuum of Fact, 133 U. Pa. L. Rev. 929, 930 (1985) (stating that Jackson and Kronman "conclude that taking security is economically efficient").

6 Nicholas Kaldor and J.R: Hicks are credited with the idea that when maximizing wealth necessitates the goring of somebody's ox, society can, if it wants to, replace the ox with the newly created wealth and stilI have some left over. J.R. Hicks, The Foundations of Welfare Economics, 49 Econ. J. 696, 706 (1939); Nicholas Kaldor, Welfare Propositions of Economics and Interpersonal Comparisons of Utility, 49 Econ. J. 549,550-51 (1939). Here I must admit that I agree with the economists. More is better. For a contrary view, see Less is More: The Art of Voluntary Poverty (Goldian VandenBroeck ed., 1978).



The Jackson and Kronman article became the foundation for a debate that has become known as the "puzzle of secured debt." The debate has smoldered in the academic literature like a coal mine fire for fifteen years7 and gives no indication of burning out any time soon. Its persistence is all the more remarkable in that none of the debaters has yet questioned whether the institution of security is justified, good, or even in need of significant change.8

In the early years of the debate, two leading "Law and Law"9 scholars argued in separate articles that the Law and Economics scholars had come to the right result-that security was good-but for the wrong reasons.10 Among themselves, the Law and Economics scholars debated not whether security was efficient, but

7 See Barry E. Adler, An Equity-Agency Solution to the Bankruptcy-Priority Puzzle, 22 J. Legal Stud. 73 (1993); Richard L. Barnes, The Efficiency Justification for Secured Transactions: Foxes with Soxes and Other Fanciful Stuff, 42 Kan. L. Rev. 13 (1993); James w. Bowers, Whither What Hits the Fan?: Murphy's Law, Bankruptcy Theory, and the Elementary Economics of Loss Distribution, 26 Ga. L. Rev. 27, 57-68 (1991); F.H. Buckley, The Bankruptcy Priority Puzzle, 72 Va. L. Rev. 1393 (1986); Saul Levmore, Monitors and Freeriders in Commercial and Corporate Settings, 92 Yale L.J. 49 (1982); Randal C. Picker, Security Interests, Misbehavior, and Common Pools, 59 U. Chi. L. Rev. 645 (1992); Alan Schwartz, The Continuing Puzzle of Secured Debt, 37 Vand. L. Rev. 1051 (1984) [hereinafter Schwartz, The Continuing Puzzle]; Alan Schwartz, Security Interests and Bankruptcy Priorities: A Review of Current Theories, 10 J. Legal Stud. 1 (1981) [hereinafter Schwartz, Security Interests]; Robert E. Scott, A Relational Theory of Secured Financing, 86 Colum. L. Rev. 901 (1986); Paul M. Shupack, Solving the Puzzle of Secured Transactions, 41 Rutgers L. Rev. 1067, 1118 (1989); George G. Triantis, Secured Debt Under Conditions of Imperfect Information, 21 J. Legal Stud. 225 (1992); James J. White, Efficiency Justifications for Personal Property Security, 37 Vand. L. Rev. 473 (1984).

8 I considered whether Alan Schwartz had questioned the inherent goodness of security and concluded that he had not. Although Schwartz explored many of the arguments against security and attached arguments for it, he did not subscribe to any of them. He did recommend giving priority over secured creditors to a financial institution that makes the first loan to a debtor. His proposal in that regard amounts to little more than excusing the financial institution-a secured creditor in sheep's clothing-from filing a financing statement. See Alan Schwartz, A Theory of Loan Priorities, 18 J. Legal Stud. 209, 218-22 (1989).

9 As Law and Economics theorists came to dominate the field of debtor-creditor relations, their natural predators, the empiricists, began to multiply. Traditional scholars, always known for their good sense of humor, began referring to themselves as "Law and Law." I first heard the term in a conversation with Peter Alces, Charles Tabb, and Margaret Howard in San Antonio in 1992. All seemed fully accustomed to it, indicating additional history with which I am not familiar.

10 Kripke, supra note 5, at 930; White, supra note 7, at 508.



whether the other scholars had proven it SOl1 or had proven it so for all of the applicable reasons.12 This Article will demonstrate that all of these scholars have been wrong. Security tends to misallocate resources by imposing on unsecured creditors a bargain to which many, if not most, of them have given no meaningful consent. It is an institution in need of basic reform.

Part I of this Article briefly retraces the origins of the debate, focusing on two explanations for the widespread use of security that had been identified in earlier writings but not thoroughly explored. The first is that security enables secured creditors and debtors to extract a subsidy from those who involuntarily become unsecured creditors. I conclude that such a subsidy exists and argue that the appropriate remedy is to give involuntary creditors priority over secured creditors. The second is that the deceptive nature of security enables secured creditors and debtors to extract a similar subsidy from relatively uninformed unsecured creditors who predictably miscalculate their likelihoods of recovery. The remainder of Part I conducts a brief search for the essence of the secured creditor's bargain and concludes that none exists. Part II argues that voluntary unsecured credit is of two principal types. The first, "asset-based" unsecured lending, takes place between sophisticated lenders and borrowers, producing no systemic problems of significance. The second type of unsecured lending, which I refer to as "cash-flow surfing," occurs in the virtual absence of unencumbered assets or income. An understanding of the context in which cash-flow surfing occurs leads to a reconceptualization of the unsecured creditor's bargain. That reconceptualization demonstrates the need for basic reforms in the Article 9 filing system and the rules and procedures for determining the content of the unsecured creditor's bargain in specific cases. The Article ends with a proposal that the content of the unsecured creditor's bargain be determined not wholesale by the rigid con-

11 Schwartz, for example, has written three articles, each arguing or asserting that other scholars had not proven security efficient. Schwartz, The Continuing Puzzle, supra note 7, at 1051-52; Schwartz, Security Interests, supra note 7, at 29; Schwartz, supra note 8, at 243-47.

12 See, e.g., Picker, supra note 7, at 650 (listing several functions of security not yet acknowledged in the puzzle debate).



ceptions of priority in Article 9, but on a case-by-case basis, applying basic rules of contract law.

I. THE SECURED CREDITOR'S BARGAIN

Jackson and Kronman presented two arguments for the efficiency of secured debt, both grounded in contract. First, the unsecured creditors seemingly disadvantaged by security in fact voluntarily contracted for their roles:

It is a fair assumption ... that these other creditors will be aware of [the additional risk from being unsecured] and will insist on a premium for lending on an unsecured basis, will demand collateral (or some other form of protection) to secure their own claims, or will search for another borrower whose enterprise is less riskyP

That they contracted for a status subordinate to other creditors, rather than paying the premium required to induce the debtor to provide security, demonstrated that the subordinate status was actually better. Second, even "if the law denied debtors the power to prefer some creditors over others through a system of security agreements, a similar network of priority relationships could be expected to emerge by consensual arrangement between creditors."14 That creditors themselves would contract for these priorities "supplement[ed] and reinforc[ed]" Jackson and Kronman's first argument and suggested "why secured credit is such a widespread phenomenon." 15 In other words, the secured credit

13 Jackson & Kronman, supra note 5, at 1147-48 (footnote omitted). Other scholars have accepted the idea that reductions in the cost of financing achieved by giving priority to some creditors will be offset by increases in the cost of the debtor's other financing. See, e.g., Schwartz, supra note 8, at 210 ("Any [proposal by an initial financer for priority] would "elevate the first financer's rank at the expense of potential later creditors, whose priority status necessarily would be lowered; actual later creditors then would exact compensation for their worsened status in the interest rate they charge."); Robert E. Scott, Error and Rationality In Individual Decisionmaking: An Essay on the Relationship Between Cognitive Illusions and the Management of Choices, 59 S. Cal. L. Rev. 329, 351 (1986) ("Viewed from a supply side perspective, secured credit is a zero-sum transaction for the debtor. Any reduction in the debtor's credit bill caused by offering security to one creditor is offset by a corresponding increase in the cost of unsecured credit."). This zerosum hypothesis is incorrect. See David G. Carlson, On the Efficiency of Secured Lending, 80 Va. L. Rev. 2179 (1994) (demonstrating that the zero-sum hypothesis is incorrect in the simplest case where the debtor finances with only a single secured creditor).

14 Jackson & Kronman, supra note 5, at 1157 (emphasis added). 15 Id. at 1158.



arrangement was better for everyone involved-debtor, preferred creditor, and subordinated creditor. The proof was that those apparently disadvantaged by security knowingly and voluntarily agreed to it and it flourished.

Jackson and Kronman's reasoning was based on two false16

assumptions. First, they assumed that unsecured creditors agree to subordinate status when in fact a substantial number of unsecured creditors are creditors such as tort victims whose unsecured status is imposed on them against their willP Second, Jackson and Kronman assumed that voluntary creditors contract for unsecured status with a full awareness of the consequences when in fact they contract under varying levels of coercion with varying levels of awareness.1S In the ensuing debate, the falsity of these assumptions did not go unnoticed.19 But neither were their implications developed.

In an article published in the Journal of Legal Studies in 1981, Alan Schwartz argued that it is impossible to prove that security is efficient without first understanding how it reduces social costS.20 He tested several economic theories to see if they might account for the pattern of secured and unsecured debt he thought he saw. None did, and he pronounced the efficiency of secured debt to be unproven.21 Schwartz' article took the debate in a new and ulti-

16 The word may seem to harsh to some. The use of assumptions that are known not to accord with reality is customary and accepted in economic modeling because with realistic assumptions, the economic models become unmanageably complex. Economists derive conclusions based on unrealistic assumptions, and then attempt to transfer those conclusions from the world in which the model operates to the world in which we live. I have argued elsewhere that (1) "false" is an appropriate description of those assumptions; and (2) conclusions can be transferred only by loose analogy, with the result that they prove nothing and at best suggest what theories might be tested through realistic models. See Lynn M. LoPucki, Strange Visions in a Strange World: A Reply to Professors Bradley and Rosenzweig, 91 Mich. L. Rev. 79, 106-10 (1992).

17 See infra notes 38-42 and accompanying text. 18 See, e.g., Schwartz, Security Interests, supra note 7, at 30-31: James H. Scott, Jr.,

Bankruptcy, Secured Debt, and Optimal Capital Structure: Reply, 34 J. Fin. 253, 254 & n.2, 256 (1979).

19 See supra note 18; infra notes 38-42, 112 and accompanying text. 20 See Schwartz, Security Interests, supra note 7, at 7 ("Firms issue and creditors buy

secured debt when the private gains from doing so exceed the costs. An efficiency explanation of secured debt must show when this is so and also that the social gains from security exceed the social costs.").

21 See supra note 11.



mately unsuccessful direction. Even though his theories could not explain the pattern of secured and unsecured debt, other scholars thought that theirs would.22 Like Cinderella's sisters, they began offering their own theories in the hope that they would fit the glass slipper.23 Because no one really believed that security might be unjustified, the focus was on what Dean Robert Scott called the benign theories24-the good things that secured debt does that might also explain why debtors and their creditors agree to it in some circumstances, but not in others. To explain secured debt, scholars advanced theories that its existence reduces the total cost to creditors of monitoring the debtor,25 ensures that necessary monitoring will occur,26 reduces the risk of asset substitution,27

22 For a brief history of the puzzle debate, see Shupack, supra note 7, at 1073-83. 23 The glass slipper in this analogy is, of course, the actual pattern of secured and

unsecured debt. In the Cinderella story, the Prince had the slipper and the sisters had to fit their feet into it. But in the debate over the puzzle of secured debt, each debater can control, for purposes of his or her own article at least, the shape of the slipper. The debater does that by asserting the pattern of secured and unsecured debt that the debater seeks to explain. Under the rules by which the debate has been conducted, evidence that the pattern asserted is the pattern that actually exists has been considered unnecessary by both the writers and the journals in which they have published. See, e.g., Schwartz, The Continuing Puzzle, supra note 7, at 1059 (stating that "[the facts disconfirm the prediction] that debtors always will secure all of their debt until they run out of assets to offer" but providing no supporting authority); id. at 1061 (discounting White's explanation for the efficiency of secured debt, which relies on recent U.C.c. changes, because "the pattern of secured lending seems not to have changed materiaIly in the last two decades" but providing no supporting authority); id. at 1068 (stating that "[r]etailers that borrow, for example, seemingly are secured more frequently than manufacturers that borrow," but again providing no supporting authority). Professor F.R. Buckley states that two predictions "fly in the face of the reality that banks, the most typical secured creditors, are generally long term creditors" but provides no authority. Buckley, supra note 7, at 1444. Buckley's "reality" in fact flies in the face of data published by the Federal Reserve, which shows that only about 8% of lending by commercial banks is long term. See Fed. Reserve Bull., Aug. 1993, at A76 tbl. 4.23 (listing amounts for the week of May 3-7,1993). Robert Scott is correct in stating that "the existing literature fails to assemble and evaluate even the most rudimentary data on patterns of secured and unsecured lending." Scott, supra note 7, at 912. Given the ground rules under which the puzzle debate has been conducted, the likelihood that a particular debater who is looking for a fit will find one is considerably better than the chances of Cinderella's sisters.

24 See Scott, supra note 7, at 901 ("What purposes, whether benign or malignant, does security serve?").

25 Jackson & Kronman, supra note 5, at 1149-61. 26 Levmore, supra note 7, at 55-57. 27 Schwartz, Security Interests, supra note 7, at 11.



makes more credit available,28 lowers the costs of screening firms to determine their creditworthiness and anticipated bankruptcy value,29 prevents the debtor from wasting the assets in reorganization,30 and gives creditors the opportunity to sort themselves out by their levels of vulnerability to loss.31

They found it much more difficult to explain the existence of unsecured debt, but eventually came up with the following explanations: (1) transaction costs are higher for entering into a secured credit contract, and sometimes the benefits of security are not worth it;32 (2) the existence of unsecured debt serves to bond management to the interests of equity holders;33 and (3) unsecured creditors are less vulnerable to loss than their competitors and accordingly lack the incentive to outbid them for secured status.34

Two promising malignant explanations for the existence of secured debt were commonly noticed but rarely explored.35 Security might have flourished because it facilitates the exploitation of involuntary36 creditors or of voluntary creditors who failed to react to security.37 Probably the reason for the lack of interest in these explanations is that both the Law and Economics scholars and the Law and Law scholars knew where they wanted to get to-secured

28 Kripke, supra note 5, at 941. 29 Buckley, supra note 7, at 1469. 30 White, supra note 7, at 487-89. 31 See Bowers, supra note 7, at 56-67. 32 Scott, supra note 7, at 937-38. 33 See Adler, supra note 7, at 74-75. 34 See Bowers, supra note 7, at 66. 35 Only one of the puzzle scholars, Professor Shupack, chose to pursue either as a

solution to the puzzle. His work in this regard has not been given the recognition it deserves. I discuss his ideas principally infra at notes 93-95 and accompanying text.

36 I will use the more descriptive "involuntary" rather than the more common "nonconsensual" to describe creditors who were made such without their consent and "voluntary" rather than "consensual" for their opposite. I believe that this usage originated with Professor Elizabeth Warren. See Elizabeth Warren, Bankruptcy Policymaking in an Imperfect World, 92 Mich. L. Rev. 336, 354 (1993) (referring to "involuntary creditors, such as tort victims and environmental cleanup funds").

37 Schwartz, Security Interests, supra note 7, at 30-31. Although Schwartz noticed the tendency for such redistributions to occur and considered these redistributions undesirable, he still found the case against security unconvincing and did not support any change. Instead, he set forth an agenda for research and suggested that things ought to remain the same until someone completed the agenda. Id. at 34-37. Shupack also noticed the tendency for such redistributions to occur and considered them undesirable but argued that existing law has countervailing provisions. See Shupack, supra note 7, at 1118-21.



credit is good-and these two explanations seemed to point in the wrong direction.

A. Involuntary Creditors

The few data available suggest that a substantial portion of all unsecured creditors do not consent to their status in any meaningful sense. They become creditors only by the wrongful acts of their debtors. For example, Professors Teresa Sullivan, Elizabeth Warren, and Jay Westbrook found that twenty-three percent of the unsecured debt of persons filing bankruptcy under Chapters 7 and 13 of the Bankruptcy Code was owed to what the researchers called "reluctant creditors."38 By that they meant that those creditors were not in the business of extending credit and did not seek credit relationships.39 In the cases studied by Sullivan, Warren, and Westbrook, the debtors were principally consumers and their reluctant creditors were (1) tort victims, (2) former spouses and children with unpaid support orders, (3) government agencies, (4) educationallending agencies, (5) health care providers, (6) tax authorities, (7) landlords, and (8) utilities.40

Corresponding data with regard to business debtors do not exist. But on the basis of the data that are available, I would speculate that money owed to reluctant creditors constitutes an even larger portion of the debt of financially distressed companies.41 In the

38 Teresa A. SuIlivan, Elizabeth Warren & Jay L. Westbrook, As We Forgive Our Debtors 18, 294 (1989). Not all of these "reluctant" creditors should be regarded as involuntary for purposes of the argument I make here. See infra note 42 for the argument that government is a voluntary creditor. But neither is it appropriate to treat them as voluntary merely because their relationship with the debtor was voluntary. A spouse claiming support claims on the basis of a voluntary relationship but may not have actually contemplated a credit relationship at the time of his or her dealing with the debtor. Reluctant creditors are perhaps best seen as occupying places along a continuum from voluntary to involuntary.

39 SuIlivan et aI., supra note 38, at 294. 40 Id. at 294-98. 41 Many debtors have substantial involuntary liabilities. For example, in our empirical

study of the 43 largest reorganizations of the 1980s, Professor Whitford and I found that for two of the companies (5% of the popUlation we studied), more than two-thirds of the unsecured debt was involuntary. (The companies were Manville Corporation, with well in excess of $2 billion in asbestos personal injury claims alone, In re Johns-Manville Corp., 36 B.R. 743, 746 (Bankr. S.D.N.Y. 1984), and Smith International, which had a $205 million judgment against it for patent infringement.) Similar cases not included in our study were Texaco, Inc. ($11.1 billion tort judgment), see Texaco, Inc., 1985 Annual Report 29 n.16



business cases, the categories of reluctant creditors include (1) product liability claimants; (2) victims of business torts, ranging from negligence to intentional interference with contractual relations; (3) victims of antitrust violations, unfair competition, and patent, trademark and copyright infringement; (4) environmental agencies that perform clean-ups; (5) taxing authorities;42 (6) creditors who became such through the debtor's fraud, including securities fraud; (7) government agencies, such as the Pension Benefit Guarantee Corporation; and (8) utility companies. Regardless of where one draws the line among these creditors, involuntary unsecured credit clearly exists in substantial amounts.

The ability to victimize involuntary creditors may in significant part explain "why secured credit is such a widespread phenomenon."43 Simply by entering into a security agreement, the debtor and a favored creditor can expropriate for themselves value that,

(1986), and A.H. Robins ($2.5 billion in tort claims), see In re A.H. Robins, 88 B.R. 742, 747 (E.D. Va. 1988), aff'd, 880 F.2d 694 (4th Cir.), cert. denied, 493 U.S. 959 (1989).

Other companies in our study with substantial "reluctant unsecured debt" included Baldwin-United (the insurance regulators of various states were major creditors), Braniff (ticket holders), Charter Company (possible veil piercing of a subsidiary, IPC, to hold Charter Company liable for the infamous dioxin contamination of Times Beach, Missouri), and McLouth Steel Corporation (Pension Benefit Guarantee Corporation). In at least 7 more of these 43 companies, management had fraudulently concealed the financial problems of the company in the period before bankruptcy, casting doubt on whether any of their unsecured creditors should be considered to have consented to the status they were given. Four of the cases resulted in criminal indictments; three others resulted in charges by the Securities Exchange Commission ("SEC"). See Lynn M. LoPucki & William C. Whitford, Corporate Governance in the Bankruptcy Reorganization of Large, Publicly Held Companies, 141 U. Pa. L. Rev. 669,738 & nn.226-27 (1993). Thus, in nearly a third of the cases we studied, substantial portions of the unsecured debt were held by creditors who had not meaningfully agreed to their status as such.

42 Government and its agencies arguably do not belong on this list. They are voluntary creditors in that they voluntarily engage in the programs that cause them to become unsecured creditors. They could deem themselves secured creditors or, if they chose to remain unsecured, could adjust the rate of interest as necessary to react to the increased risk resulting from their debtors' grants of security.

I find this argument unconvincing because governments do not in fact appear to act as profit maximizers in their extensions of credit. Although governments realize that they inevitably will extend credit, they do not seek to do so. Even though governments can, and sometimes do, charge rates of interest that reflect their assessment of the risk on each extension of credit, they more often charge the same rate of interest to all borrowers, regardless of the riskiness of the extension. For example, the Internal Revenue Service charges all delinquent taxpayers the same rates of interest. In doing so, it is not behaving like the voluntary creditors of economic theory.

43 See supra note 15 and accompanying text.



absent the agreement, would go to involuntary creditors.44 To take the simplest example, assume that Debtor has assets of $100 and debt of $100 owed to a creditor ("C"). Debtor then inflicts a tortious injury of $100 on a victim ("T"). Debtor becomes liable for the tort, but does not gain from it, so that Debtor has assets of $100 and debt of $200. Debtor is then liquidated. If the debt to C is unsecured, C and T each receive distributions of $50. If the debt to C is secured, C receives $100, and T receives nothing. Because C collects $100 with security and only $50 without it, Debtor's cost of borrowing from C likely will be lower if the loan is secured. The cost saving thus achieved is not offset by higher costs of borrowing from T, because T had no opportunity to bargain.45 Professor David Leebron refers to the phenomenon described here as the "extemalization of tort risk. "46

Any debtor who either has, or expects in the future to have, involuntary unsecured creditors will find economic advantage in "selling" secured status to its voluntary creditors. The use of an allequity capital structure exposes the shareholders of the tortfeasors to liability to the extent of the capital they contributed to the enterprise. Critics have argued that such a structure is already too generous to the shareholders of the tortfeasor.47 When unsecured debt is introduced into the capital structure of a potential tortfeasor, the shareholder's real exposure48 to tort liability declines further.49 When all assets, including the future income stream of the tortfeasor, are encumbered to their full value, the company's real exposure to tort liability can be almost eliminated.50 Because of

44 See David W. Leebron, Limited Liability, Tort Victims, and Creditors, 91 Colum. L. Rev. 1565, 1646-49 (1991) (noting that granting security "will remove assets from potential tort claimants for the benefit of creditors").

45 For similar illustrations, see id. at 1639-40. 46 Id. at 1648. 47 Id. at 1646-49; see also Henry Hansmann & Reinier Kraakman, Toward Unlimited

Shareholder Liability for Corporate Torts, 100 Yale L.J. 1879, 1920 (1991) (arguing that limited liability prevents tort law from determining the appropriate allocation of costs among stakeholders in a corporation).

48 By "real exposure," I mean only exposure to tort liability that the debtor can be made to pay. Tort liability that the debtor can defeat through insolvency or bankruptcy will not have a deterrent effect.

49 See supra notes 44-45 and accompanying text. 50 Real exposure to tort liability can be reduced, but never entirely eliminated, by this

method. Even when secured debt exceeds the entire liquidation value of the company, tort



this "expropriation effect" of secured debt on involuntary unsecured creditors, debtors will tend to issue secured debt to reduce their real exposure to tort liability.51

The tort example illustrates the fundamental nature of security. It is not, as Jackson and Kronman present it, a contract among debtor, secured creditor, and unsecured creditor. Only the debtor need sign; the "consent" of the unsecured creditor is implied in the best case and a blatant fiction in the worst. Security is an agreement between A and B that C take nothing.52

Law and Economics relies heavily on consent to prove the inherent justice of the way things are.53 When the analysis requires the consent of a party to some aspect of social organization, but that party clearly did not give it, the standard economic move is to argue that the party would have agreed to that aspect ex ante, by which they mean before the party knew what role it would have in society.54

creditors may retain substantial leverage to negotiate settlements. Those settlements will be paid from the collateral of secured creditors. See infra text accompanying notes 191-200.

51 This point was noted in Buckley, supra note 7, at 1417 ("A firm known by its claimants to face large potential tort liability ... could strategically issue secured debt, thereby subordinating tort creditors and making its cost of credit lower than that of an equivalent-risk firm whose creditors are predominantly consensual.").

52 I am not the first to notice this fact. See, e.g., Jackson & Kronman, supra note 5, at 1147 ("At first blush, it may seem unfair that a debtor should be allowed to make a private contract with one creditor that demotes the claims of other creditors from an initial position of parity to one of subordination."). Some may think I put the case too strongly because the contract between A and B merely subordinates C's claim rather than prevents C from recovering. The only importance of subordination, however, is in the situation in which the subordinate claims will not be paid in full. Thus, if subordination does anything, it prevents full recovery by the subordinate party.

S3 See infra notes 247-48 and accompanying text. S4 For examples of such ex ante analyses in the context of whether secured credit is

beneficial to involuntary creditors, see, e.g., Leebron, supra note 44, at 1646-47 (concluding that tort claimants generally would not agree ex ante to secured credit); Shupack, supra note 7, at 1099-1102 (examining the potential harm of secured credit to tort claimants by analyzing whether they would agree ex ante to secured credit). Baird and Jackson sought to bind tort creditors through the use of a similar argument:

"Nonconsensual" creditors, be they tort or tax, would not necessarily want different limits of restraint than would consensual creditors. Indeed, in many respects, their interests in controlling the debtor are identical. As a result, the limits that consensual creditors would impose on investments by a debtor also largely will protect nonconsensual claimants because of the congruence in their interests.



Even assuming there is some validity to this method of analysis,55 it is not likely to save the institution of security. A tort award typically means more to the tort victim than to the defendant who is to pay it.56 If we do not know whether we will be tortfeasor or tort victim in the world under consideration, other things being equal, I think that most of us would opt for the tort judgment to be paid. The arguments likely to change our minds about that are all variations of the same one: The system in which the tort judgment would be paid would have higher transaction costs and therefore would be less efficient than the system in which it would not be paid. Unfortunately for the economists, they have no set of tools for comparing transaction costs in two systems. To make such a comparison, they are relegated to the methods of ordinary law professors. They must begin by asserting that the current system, which subordinates the tort creditor, works smoothly, then explain why the proposed system without that subordination will cause big problems, and close with the assertion that surely the transaction costs in the former are less than the transaction costs in the latter.

Defenders of the status quo may be tempted to substitute the consent of legislatures for the consent of tort creditors in the argument justifying secured debt. The defenders would assert that the various legislatures set the aggregate level of tort liability with full knowledge of the difficulties tort creditors face in trying to collect. Legislatures, by not enacting rules limiting tort liability, allowed overly generous liability to give tort victims the leverage to extract reasonable compensation. The conclusion of this argument is that suddenly to render nearly all tort judgments collectible by giving

Douglas G. Baird & Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829, 835 n.20 (1985).

55 I find it difficult to understand how the "party," stripped of its role in the societal organization under consideration, is any different from the average law professor in policy mode but equipped with the Golden Rule rather than Rawlsian methodology. Both sit back in their armchairs and try to imagine what kind of social organization will have the most appeal to those subject to it. To interpose the hypothetical party with no self-identity between the law professor and the proposed societal organization adds nothing.

56 Bowers has noted that some creditors value a dollar of recovery more than others. He puts the observation to a very different use, however, arguing that it justifies security. His model, like that of Schwartz, assumes that all creditors are voluntary and thus does not reach the issues I discuss here. See Bowers, supra note 7, at 57-68.


.'


them priority over the claims of secured creditors would result in higher levels of compensation than legislators ever intended.57

These arguments fail for at least two reasons. First, the idea that the victims of torts should be fully compensated is today grounded in economic theory,58 not in the command of the legislature. That is, full compensation of tort victims ensures that tortfeasors cannot externalize costs attributable to their operations.59 That in tum ensures an appropriate allocation of resources. If a legislature decided that there should be less than full compensation, the legislature would simply be wrong.60 Second, legislative intent on an issue such as this one is largely fictitious. What the legislatures have actually decided is that those who can pay their tort victims should do so-to the full extent of their wealth. In all likelihood, no legislators have ever actually decided that firms should be able to limit or substantially to eliminate their real exposure to tort liability by using secured debt in their capital structures.

As I have previously noted, many of the models used to justify security are based on the assumption that all creditors consent to their roles.61 Those who create the models know that involuntary debt exists. That they create them anyway suggests their belief in a two-stage approach to the puzzle of secured debt. In the first stage, these theorists justify security as a voluntary and therefore efficient relationship. In the second stage, which they tend not to

57 Thompson notes use of this "runaway tort damages" argument in the debate over limited liability. Robert B. Thompson, Unpacking Limited Liability: Direct and Vicarious Liability of Corporate Participants for Torts of the Enterprise, 47 Vand. L. Rev. 1, 23 (1994).

S8 See Guido Calabresi, The Costs of Accidents: A Legal and Economic Analysis 69-70 (1970); A. Mitchell Polinsky, An Introduction to Law and Economics 86-88, 91-93 (1983); George J. Stigler, The Theory of Price 110-12 (3d ed. 1966); Kathryn R. Heidt, Cleaning Up Your Act: Efficiency Considerations in the Battle for the Debtor's Assets in Toxic Waste Bankruptcies, 40 Rutgers L. Rev. 819, 832-35 (1988); Christopher M.E. Painter, Note, Tort Creditor Priority in the Secured Credit System: Asbestos TImes, the Worst of TImes, 36 Stan. L. Rev. 1045, 1056-66 (1984).

59 See Calabresi, supra note 58, at 70,73-74. 60 See James Boyd & Daniel E. Ingberman, Noncompensatory Damages and Potential

Insolvency, 23 J. Legal Stud. 895, 896 (1994) ("Standard analyses conclude that [full] compensatory damages are optimal unless enforcement is imperfect.").

61 See supra notes 53-54 and accompanying text.



address in their writings, the involuntary creditors will be added to the model, with whatever priority is appropriate.62

When these theorists do reach the second stage, they face a choice among three alternatives: (1) leave the involuntary creditors where they are now-subordinate to the secured creditors; (2) attempt to ensure payment of the involuntary debt through insurance; or (3) give the involuntary creditors priority over secured creditors.63 I conclude that the third solution would produce the best allocation of resources and should be adopted. In discussing the economic effects of each of these alternatives, I will assume that transaction costs are small.64

62 This argument is made most explicitly in Robert K. Rasmussen, Debtor's Choice: A Menu Approach to Corporate Bankruptcy, 71 Tex. L. Rev. 51, 67 (1992) ("[O]nce policymakers decide the optimal treatment of nonconsensual creditors, this treatment should be unalterable by any debt contract."). Rasmussen returned to the subject later to endorse priority for tort creditors on the basis of a Rawlsian analysis. See infra note 88. Schwartz has also developed a theory of priorities based on the assumption that all creditors are contract creditors and then, late in the article, fitted a single class of tort claimants, product liability plaintiffs, into the scheme. Schwartz, supra note 8, at 257-59. Schwartz proposes to subordinate the product liability plaintiffs to substantial, earlier loans, even if the earlier lenders are unsecured. Id. at 257, 260. He defends his solution by asserting that it will make no difference because (he assumes) nearly all tort liability is covered by insurance. Id. at 259. His assumption is incorrect. See infra note 81.

Bowers explicitly declines to resolve the difficult issue of the priority appropriate to tort creditors. See James W. Bowers, Groping and Coping in the Shadow of Murphy's Law: Bankruptcy Theory and the Elementary Economics of Failure, 88 Mich. L. Rev. 2097, 2140 n.l00 (1990) ("Like other writers before me, I ignore the substantial difficulties involved in resolving potential conflicts of interest by contract for creditors like tort victims and tax collectors, whose claims arise nonconsensually." (citation omitted)).

Shupack is a notable exception; he addresses the plight of the tort creditors directly. Shupack, supra note 7, at 1099-1102, 1111-18. Unfortunately, he reaches the wrong conclusion, deciding that economics cannot provide an answer to whether tort creditors should have priority over secured creditors. Id. at 1117.

63 Other solutions may be possible. See, e.g., Lucian Bebchuk & Jesse Fried, The Uneasy Case for Providing Secured Creditors with Absolute Priority in Bankruptcy 37-42 (Nov. 24, 1993) (unpublished manuscript, on file with the Virginia Law Review Association) (examining alternative systems in which (1) involuntary creditors have priority equal to secured creditors and (2) secured creditors have priority for only 80% of their claims). Neither of the solutions considered by Bebchuk and Fried seems sufficiently promising to warrant consideration here.

64 The reason for not testing under the traditional assumptions of perfect markets and zero transaction costs is that those assumptions are nonsensical. As the Coase Theorem demonstrates, under conditions of perfect markets and zero transaction costs, every proposed scheme of rules and entitlements works equally well. See LoPucki, supra note 16, at 106-10. To test a theory assuming a pattern of relatively low but realistically achievable transaction costs may provide useful information. If the assumptions are


1994] Unsecured Creditor's Bargain

1. Leaving Involuntary Creditors Subordinate to Secured Creditors

1903

Assume that the legislature ratifies the status quo, leaving the involuntary creditors subordinate to secured creditors and equal in priority with voluntary unsecured creditors. As the transaction costs of secured financing fall, the use of security as a means of shifting tort risk back to the victims will tend to expand.65 There is no apparent reason why this incentive would not eventually render security ubiquitous and reduce tort recoveries to a fraction of tort liability.66 To freeze out their involuntary creditors, firms would have to incur secured debt to the liquidation value of their assets and be willing to go through some kind of liquidation if the involuntary creditors refused to settle. But, as I discuss in Part II.B.1, most small firms already have secured debt in excess of their liquidation values.67 Chapter 11 provides a vehicle for a liquidation that can discharge unsecured creditors even while the owner-managers retain contro1.68 If tort recoveries pose a significant threat to a firm that is not already judgment proof, the firm can solve the problem in two easy steps. First, the firm can convert substantially all of its equity into debt through a refinancing, a leveraged buyout, or a stock repurchase. Second, the firm can grant security sufficient to exceed the liquidation value of its assets. That the resulting firm might have only a small net worth will not hamper its ability to do business; the firm's shareholders can provide whatever

accurate, such a test may show us how the appropriateness of the theory will change as, over time, actual transaction costs approach those assumed.

65 F.R. Buckley and James Scott both argue that debtors have incentives to reduce their exposure to tort liability by issuing secured debt. Buckley, supra note 7, at 1417; James R. Scott, Jr., Bankruptcy, Secured Debt, and Optimal Capital Structure, 32 J. Fin. 1,2 (1977) ("By the issuance of secured debt, the firm can increase the value of its securities by reducing the amount available to pay legal damages in the event that the firm should go bankrupt."). As the cost of obtaining secured financing decreases, it becomes easier for the debtor to take advantage of this means for transferring wealth from its unsecured creditors to its shareholders.

66 There may be benefits inherent in the use of equity as part of the capital structure that could offset or entirely overcome the advantage of security examined here. The difficulty that finance scholars have had in demonstrating them and thereby defeating the Modigliani-Miller Theorem, however, suggests that these benefits are minimal.

67 See infra note 172 and accompanying text. 68 Lynn M. LoPucki, Strategies for Creditors in Bankruptcy Proceedings § 11.11.2, at

642-45 (2d ed. 1991).


1904 Virginia Law Review . [Vol. 80:1887

guarantees are necessary to induce third parties to deal with the firm-without offering the involuntary creditors equivalent protection.69

If such strategies were employed brashly enough, they might cause a court to disregard the corporate entity and hold the shareholders of the firm liable for the firm's torts or to determine one of the transfers to have been fraudulent. But practically speaking, neither of these doctrines provides a meaningful check on the debtor's strategy. The corporate law doctrine that permits disregard of a corporate entity appears to be applied principally in contract cases; courts rarely disregard a corporate entity for the benefit of tort creditors?O The mere fact that security interests exceed the liquidation value of a company's assets, rendering the company judgment proof, is not grounds for disregard; if it were, most corporate entities would be vulnerable to disregard already. The disregard doctrine seems to be reserved for cases in which the effort to freeze out the tort creditors is virtually the sole purpose for the corporate structure employed. The doctrine probably has never been applied in favor of tort creditors against an initially adequately capitalized corporation that sank into insolvency and continued to operate in that condition.71

Theoretically, any transfer of property is fraudulent and avoidable if made with the "actual intent to hinder, delay, or defraud" present or future creditors.72 A d~btor that announced that it would be following LoPucki's two-step program for defeating its

69 The use of guarantees would be manageable even in the case of a public company with numerous investors. The investors would own shares in a holding company that held most of the equity of the corporate group and that guaranteed the contract debts of the operating company.

70 In an empirical study of veil piercing in nearly 1600 reported cases, Professor Robert Thompson found that only 14% of the cases arose in tort settings. Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76 Cornell L. Rev. 1036, 1058 & tbl. 9 (1991). Among the 226 tort cases, undercapitalization was mentioned in only 12. The court pierced the veil in only nine of the undercapitalization cases. Id. at 1066 n.149; Memorandum from Robert B. Thompson, Professor of Law, Washington University, to Lynn M. LoPucki (Sept. 17, 1993) [hereinafter Thompson-LoPucki Memorandum] (on file with the Virginia Law Review Association).

71 In his study, Professor Thompson separately tabulated undercapitalization cases in which the firm initially had been capitalized, but had become undercapitalized (either intentionally or unintentionally) at a later date. There were 19 such cases, none of which was a tort case. Thompson-LoPucki Memorandum, supra note 70.

72 Unif. Fraudulent Transfer Act § 4(a)(1), 7A U.L.A. 652 (1984) ("UFTA").



involuntary creditors73 might have a difficult time defending the transaction against later attack.74 But debtors who merely stumbled into such capital structures or were swept into them by the invisible hand,75 and thus had no wrongful intent, should have nothing to fear. The specific provisions of fraudulent transfer law most directly applicable to the two-step process described above seem to approve of it.16

Our current system, in which secured creditors have priority over involuntary creditors, appears to work only because transaction costs77 and reputational concems78 prevent many firms from adopting an all-secured-debt capital structure and liquidating when necessary to defeat the claims of involuntary creditors. Although current law allows a judgment-proof debtor to slough off its unsecured creditors as often as necessary,79 it remains costly and disreputable to do so. Scholars who favor the current, secured-first system ought to be uneasy about the equilibrium toward which this

73 See supra text accompanying notes 65-69. 74 But see Baird & Jackson, supra note 54 (arguing that fraudulent conveyance law

should not reach leveraged buyouts, because to extend it so would prevent voluntary creditors from opting out of its coverage).

75 Market forces propel companies in the direction of an all-secured-debt capital structure. To the extent that capital structures include unsecured debt or equity, the firm's real exposure to tort liability is higher, putting it dt a competitive disadvantage. In a world where transaction costs are large, numerous other factors will impact on the firm's decisions regarding its capital structure, and the factor discussed here may show up as only a weak tendency. But as transaction costs are reduced and competition increases, firms must seize whatever advantages are available to them.

76 Probably the most directly applicable provision of the UFfA is § 4(a)(2)(i). That section renders fraudulent any transfer made "without receiving a reasonably equivalent value in exchange" if the debtor "was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small." UFfA § 4(a) (2) (i), 7 A V.L.A. 652 (1984). Granting security for an antecedent debt will never run afoul of this provision because § 3(a) of the Act provides that "[v]alue is given ... if ... an antecedent debt is secured." Id. § 3(a), 7A V.L.A. at 650. That is, to grant security to a creditor is merely to prefer that creditor. The UFfA does not disapprove the making of a preference to a person other than an insider unless it is made with actual fraudulent intent. See id. § 5(b), 7A V.L.A. at 657.

77 A firm must be willing to liquidate in order to nUllify its tort liability by means of an all-secured-debt capital structure. The transaction costs of liquidation may exceed the benefit to be gained by escaping tort liability.

78 If large firms blatantly and routinely adopted all-secured-debt capital structures and thereby nullified their tort liability, the public would be outraged.

79 LoPucki, supra note 68, § 11.11.2, at 642-45.



system tends to move. so It is an equilibrium in which tort liability will be almost entirely defeated.

2. Elevating Involuntary Creditors Through Universal Insurance

A second possibility for dealing with the priority clash between involuntary unsecured creditors and secured creditors would be to convert the involuntary claims from a potential liability to a current expense through mandatory insurance. That is, if all involuntary liability were insured by responsible insurers, victims could be assured of full recoveries, secured creditors could be assured of their first position, and the priority of involuntary debt would not matter.

As our legal system currently operates, substantial amounts of tort liability are uninsured.S! It will do no good to require that debtors insure against it. Much of the liability remaining uninsured

80 Equilibrium probably would be an all-secured-debt capital structure because real tort exposure would be zero. Any change in that capital structure would increase real tort exposure. Reputational concerns would tend to disappear in the intense competition of a world where transaction costs are small.

S1 For example, when it filed for reorganization, the Johns-Manville Corporation had over $2 billion in asbestos-related personal injury claims, In re Johns-Manville Corp., 36 B.R. 743, 746 (Bankr. S.D.N.Y. 1984), but it had insurance coverage of only approximately $700 million, In re Johns-Manville Corp., 68 B.R. 618, 621 (Bankr. S.D.N.Y. 1986), aff'd in part and rev'd in part, 78 B.R. 407 (S.D.N.Y. 1987), aff'd, 843 F.2d 636 (2d Cir. 1988). Texaco had negligible insurance against the $11.1 billion Pennzoil judgment. See Texaco, Inc., supra note 41, at 29 n.16 (stating that the Pennzoil judgment is a contingent liability and not mentioning any insurance); Michael A Hiltzik, Texaco Considers Filing Chapter 11 Petition by Monday, L.A Times, Apr. 10, 1987, § 4, at 1 (noting Texaco's efforts to avoid pledging company assets as security for the judgment and mentioning no insurance coverage). The Pennzoil judgment was based on a theory of tortious interference with contractual relations. See Thomas Petzinger, Jr., Oil and Honor: The Texaco-Pennzoil Wars 391-93 (1987). AH. Robins had $2.475 billion in personal injury claims, but effectively had only $600 million in insurance. See In re AH. Robins, Inc., 88 B.R. 742, 743-44, 747 (E.D. Va. 1988), aff'd, 880 F.2d 694 (4th Cir.), cert. denied, 493 U.S. 959 (1989). Amatex Corporation had tort liability "conservatively estimated" at $20 million, "well over the combined total of the debtor's assets and insurance coverage [of $9 million]." In re Amatex Corp., 755 F.2d 1034, 1035 & n.1 (3d Cir. 1985). For another example, see Andrew Blum, Keene Truce Announced. But Will it Hold?, Nat'l L.J., July 11, 1994, at A10 (noting Keene Corporation's operation in Chapter 11 with over $600 million in asbestos liability but making no mention of insurance coverage).

Insurance policies issued today generally contain pollution exclusion clauses, leaving the debtor without coverage for most damage to the environment. See, e.g., Smith v. Hughes Aircraft Co., 10 F.3d 1448, 1451 & n.1, 1453 (9th Cir.), superseded, 22 F.3d 1432 (9th Cir. 1993); United States Fidelity & Guar. Co. v. Morrison Grain Co., 999 F.2d 489, 491-93 (10th Cir. 1993); see also E. Joshua Rosenkranz, Note, The Pollution Exclusion Clause



is uninsurable because it arises from "reactive risk"-that is, risk that the insured has some ability to contro1.82 Insuring against this kind of risk reduces the incentives for the insured to control the risk and thereby increases the risk. For example, companies that can insure against their own knowing and deliberate dumping of toxic waste will be more likely to engage in such dumping. Even with unintentional torts, insurance leaves insureds with less than optimal incentives to avoid committing tortS.83 Although both these problems could be alleviated by pricing insurance coverage based on estimates of the risks actually generated, this solution would be complex84 and incomplete.85 Tort liability performs an important deterrent function in American society; its elimination through mandatory, universal insurance would be a drastic solution to the problems caused by secured credit.

3. Elevating Involuntary Creditors to Priority over Secured Creditors

In a few areas of the American legal system, involuntary creditors already have priority over secured creditors.86 In recent years,

Through the Looking Glass, 74 Geo. L.J. 1237 (1986) (discussing pollution exclusion clauses).

82 See Mark R. Greene, James S. Trieschmann & Sandra G. Gustavson, Risk and Insurance 48-49 (8th ed. 1992) (outlining the broad categories of risk that are and are not insurable). For concise descriptions of the problem of moral hazard in the insurance context, see Daniel Keating, Pension Insurance, Bankruptcy and Moral Hazard, 1991 Wis. L. Rev. 65, 67-68; Painter, supra note 58, at 1071-73 ("Since insurance fails both to compensate victims and to reduce the number of accidents, it cannot provide a basis for improving the lot of tort victims disadvantaged by the current priority system.").

83 See Keating, supra note 82, at 67-68. 84 Merit and credibility rating are employed to determine premiums for many kinds of

insurance, but such systems are generally difficult to implement. See, e.g., Greene et aI., supra note 82, at 354-57 (describing complexity of merit rating in automobile liability insurance).

85 Pricing coverage based on past claims would not take account of the endgame problem. Debtors who generated high tort risk while in financial difficulty would pay for those risks only if they survived, remained in business, and continued to pay premiums.

86 For example, maritime torts and seamen's wages have long had priority over preferred ship mortgages. 46 U.S.C. §§ 31,301(5),31,322,31,326 (1988) (stating that claims for damage arising out of a maritime tort are preferred maritime liens and have priority over preferred ship mortgages); see All Alaskan Seafoods v. MN Sea Producer, 882 F.2d 425,428 (9th Cir. 1989) (holding that "[p]referred maritime liens," including those arising out of tort claims, had priority over preferred ship mortgage liens under Ship Mortgage Act of 1920).



several scholars writing on subjects other than the puzzle of secured debt have concluded on one basis or another that involuntary tort creditors87 should have priority over secured creditors generally.s8 In addition, several scholars writing on the puzzle of secured debt have acknowledged the plausibility of the arguments, even though they have backed away from what must have seemed in the context of that debate a startling conclusion.89 The direction of scholarship in this area is now unmistakable. We are on the brink of recognizing that the priority of secured creditors over truly involuntary creditors is indefensible.

To reach the conclusion that involuntary creditors should have priority over secured creditors on efficiency grounds, we need only assume that the economy operates more efficiently when involun-

87 Some "tort" creditors arguably should be treated as voluntary creditors. For example, some products liability plaintiffs contract to purchase the product that injures them. Theoretically, at least, ~hey could bargain at the time they purchase the product for any tort claim that might arise from its use to be a secured claim against assets of the seller. That they do not could be interpreted as "consent" to their unsecured status.

88 Barry E. Adler, Financial and Political Theories of American Corporate Bankruptcy, 45 Stan. L. Rev. 311, 340 (1993) ("Ideally, nonconsensual claimants would have highest priority in any sort of firm."); Leebron, supra note 44, at 1650 ("In order to limit the externalities, and hence the inefficiencies, created by the limitation of liability, tort claimants should be given priority over both secured and unsecured financial creditors."); Mark J. Roe, Commentary on "On the Nature of Bankruptcy": Bankruptcy, Priority, and Economics, 75 Va. L. Rev. 219, 227 (1989) ("A rule of priority for nonbargain creditors seems efficient."); Painter, supra note 58, at 1081 ("Tort-claim superpriority over secured creditors is, therefore, the most efficient and equitable solution.").

On his second consideration of the issue, Professor Robert Rasmussen again clearly expressed the argument for tort priority. Re concluded that a Rawlsian legislature applying the difference principle would consider tort priority the correct solution. In the same article, however, Rasmussen disassociated himself from the difference principle, leaving it unclear where he stands on the issue of whether tort creditors should have priority over secured creditors. Robert K. Rasmussen, An Essay on Optimal Bankruptcy Rules and Social Justice, 1994 U. Ill. L. Rev. 1, 33 (1994) (noting that a Rawlsian analysis leads to the conclusion that tort creditors should have priority over secured creditors in bankruptcy). Rasmussen states that "[t]o the extent that a firm knows that it will not have to fully compensate its future tort victims, it has too little incentive to take care to prevent accidents in the first instance." Id. at 32.

89 Paul Shupack put together all of the elements of the argument for a tort-first system but then raised factual questions that he thought "cast further doubt on whether tort claimants would necessarily want the superpriority that has occasionally been proposed for them," Shupack, supra note 7, at 1117 & n.123. I respond to his factual questions infra at notes 93-101 and accompanying text. F.R. Buckley apparently declined to propose priority for tort creditors only because the problem would be better addressed by disregarding the corporate form. Buckley, supra note 7, at 1418-19.



tary creditors are paid than when they are not.90 To understand why this is so, assume that a debtor has two creditors, one involuntary and one secured, and that the debtor's wealth is sufficient to pay either, but not -both of them. If we view the competition between these two creditors ex post-that is, after both have extended credit-it appears not to matter which is paid. The aggregate loss to the economy is the same.

But if we view the competition ex ante, from the perspective of the two creditors before they extend credit, the superiority of the rule granting priority to involuntary creditors becomes apparent. In a world where involuntary creditors have priority, the secured creditor who can anticipate the priority contest can react to it by declining to extend credit beyond the debtor's ability to pay.91 On the facts assumed in the preceding paragraph, the secured creditor would not extend any credit, the involuntary creditor would be paid, and the aggregate loss to the economy would be zero.

In a world where secured creditors have priority, both these creditors would extend credit. The involuntary creditor would extend credit because it has no choice. The secured creditor would extend credit for the simple reason that it would be repaid.92

90 It is widely accepted among economists that to ensure appropriate levels of production, both the costs of producing a product and the costs of accidents resulting from it must be internalized by the producer and reflected in the price of the product. See supra note 58 and accompanying text. That will occur only to the extent that the legal system holds the producer liable for the costs of accidents and actually compels payment. If the legal system cannot compel a producer to pay because the producer has no unencumbered assets, the producer will not suffer the costs of the accidents and therefore will not pass those costs along in the price of its product.

91 Professor Kathryn Heidt has made essentially this observation with respect to the competition between environmental cleanup liability and secured lending. See Heidt, supra note 58, at 851 ("The creditor has notice of the rule and can tailor its actions as it sees fit."). In another article, Heidt has argued that secured creditors should be liable for environmental cleanup costs on a corrective justice theory. Kathryn R. Heidt, Corrective Justice from Aristotle to Second Order Liability: Who Should Pay When the Culpable Cannot?,47 Wash. & Lee L. Rev. 347, 358-65 (1990).

92 Some secured creditors do exhibit concern that the debtor be able to pay its tort creditors by requiring that the debtor purchase liability insurance as a condition of the secured loan. Cf. James W. Bowers & B.C. Hart, General Liability Insurance, in The Business Insurance Handbook 182, 187 (Gray Castle, Robert F. Cushman & Peter R. Kensicki eds., 1981) (noting that contractors often purchase liability insurance for their owner-customers). The acquisition of such insurance, however, is inadequate to cause the debtor to internalize the full tort risk the debtor creates because the coverage will be limited. Were this not so, the relative priority between involuntary creditors and secured



Because the debtor's wealth is assumed sufficient to pay only one creditor, the involuntary creditor would not be paid. Except to the extent, if any, that the debtor derived benefit from inflicting loss on the involuntary creditor, the involuntary creditor's loss would be an aggregate loss to the economy.

In a very thoughtful, well-written article, Professor Paul Shupack makes a variant of this argument. He, notes that in a world where tort creditors had priority over secured creditors, secured creditors would condition their loans on the debtor's payment of a premium sufficient to compensate the secured creditors for their additional risk.93 He concludes, as I have, that the secured creditor would suffer no loss.94

He asserts, however, that the tort creditors would not necessarily be better off in the world where they had priority. His argument is one that others have made less formally, to justify the preferred status of secured creditors. It is that in the world where secured debt comes first and tort creditors take only what is left, entrepreneurs can borrow more money, there is more economic activity, society is wealthier, and perhaps even the tort creditors themselves are better off.95

To understand why neither tort creditors nor the economy as a whole is better off under current law than it would be in a tort-first regime, consider the following proof:

W = the wealth created by economic activity that would occur in a world where tort debt comes first; A = the wealth created by activity that would not occur in a world where tort debt comes first but would occur in a world where secured debt comes first; and

creditors would be of no importance because tort claims would always be paid by insurance.

93 Shupack, supra note 7, at 1100-0l. 94 Id. 95 Shupack writes:

One would think that a tort claimant would, all other things being equal, prefer to assert a claim against a wealthier firm, which is less likely to be insolvent and unable to pay the tort claim, than a poorer firm, which, even if it had granted no security interests, would be unable to pay at all.

Id. at 1112.



T = the tort loss that would not occur in a world where tort debt comes first but would occur in a world where secured debt comes first.

I assert that:

W:2:W+A-T

The left side of this inequality is total wealth in the tort-first world; the right side is total wealth in the secured-first world. The right side of the inequality can be greater only if A is greater than Tthat is, as Shupack asserts, the added activity A is greater than the tort loss resulting from the activity T. For A to be greater than T for the economy as a whole, A must be greater than T for at least some person in the economy. That is, there must be some person who would increase his or her wealth through expanded economic activity in the secured-first world over what it would have been in the tort-first world and whose increased wealth is greater than the expanded tort liability that results from the expanded economic activity. The existence of many such people seems unlikely. They would all be people who could have expanded their activity in the tort-first world, paid the tort liability with their added wealth, and had some left over.96

The existence of substantial numbers of such people becomes possible if we add an assumption of risk aversion to the model. That is, there may be a person ("P") with a project likely to generate slightly more wealth than tort liability. P's source of capital ("S") is unwilling to make the loan in a tort-first world because even though the probable outcome is profit and repayment, S must risk scenarios in which torts occur and there is no repayment. In a secured-first world, S might be willing to make the loan because the tort risk to S has been eliminated.

96 Even in a tort-first world where information is imperfect, it remains true that for economic activity to be higher than in a secured-first world, there must be people who could expand their economic activity, pay the tort debt, and have money left over. The misjudgments resulting from imperfect information may result in too much secured lending or too little. It is only the assumption of risk aversion that leads Professors Shupack and Block-Lieb to expect it will be too little. Id. at 1116 & n.121; Susan Block-Lieb, The Unsecured Creditor's Bargain: A Reply, 80 Va. L. Rev. 1989, 2006-07 (1994). But if, as I argue below, the secured creditors' risks are fully insurable, risk aversion no longer has an effect. The cost of the insurance will discourage some economic activity, but, for the reasons I set forth in the discussion of that insurance, the cost should be minimal.



Even the assumption of the existence of risk -averse lenders does not save Shupack's argument. As I am about to show, "secured creditor insurance" can transform S's tort risk into a fixed premium, which S can require its debtor to pay in advance. To the extent that the premium is for actual tort risk, its payment ensures the internalization of tort risk. To the extent it is for the transaction costs of insurance, it can be viewed as a deadweight on the economy. But any such deadweight would be small and, in any event, far less than the insurance deadweight under a system of mandatory, universal insurance.

The secured creditor insurance that I contemplate would be similar in nature to mortgagee title insurance. It would not insure the debtor against all or any part of the debtor's tort liability.97 Instead, it would insure the secured creditor against losses from subordination of the security interest to tort claims. The policy would provide no protection to the debtor. To the contrary, if the insurer paid a secured creditor's claim, the insurer would be subrogated to the rights of the secured creditor against the debtor.98

Secured creditor insurance combined with a rule giving involuntary creditors priority over secured creditors has three advantages over universal tort insurance as a solution to the tort priority problem. First, risk that is reactive when the debtor is the insured would not be reactive when the secured creditor is the insured.99 Second, secured creditor insurance would not have to be

97 Much of that liability will be uninsurable or insurable only at excessive cost because it is reactive risk. See supra notes 82-85 and accompanying text.

98 This is how mortgagee title insurance works. D. Barlow Burke, Jr., describes such insurance as follows:

[W]hen the mortgagee is insured and under the mortgage covenants has the right to payoff liens that arise and prevent the insured [mortgagee] from attaining first-lien status ... [,] the insurer can payoff the superior lienor and be subrogated against the mortgagor, unless the mortgagor is also an insured of the insurer seeking subrogated rights.

D. Barlow Burke, Jr., Law of TItle Insurance 356-57 (1986). 99 To illustrate, consider the risk that the debtor will intentionally infringe on the patent

of a competitor. This risk is reactive in the sense that if the debtor has insurance that protects it against liability for the infringement, the debtor's incentives not to infringe are greatly reduced. If the policy merely insures the secured creditor against loss because of the debtor's infringement and subrogates the paying insurer to the secured creditor's rights against the debtor, the debtor's incentives not to infringe are hardly reduced at all. If the debtor infringes, the insurer will pay the secured creditor and then sue the debtor on the secured debt. See supra note 98 (describing mortgagee title insurance).



mandatory, because the tort victims would not have to depend on it for their recoveries; they could look to the collateral. Secured creditors could have the option to insure or assume the risk.lOO

Third, the insurance would be limited to the amount of the secured debt, so the potential loss insured against would be both lower and more predictable than the debtor's entire potential tort liability.101

In his commentary, Professor Steve Knippenberg notes that giving involuntary creditors priority over secured creditors may compel secured creditors "to become managers with or close monitors of" their borrowers.102 He would instead allow lenders to focus narrowly on being repaid, and leave debtors to worry about the tort liability.103 The difficulty with such a division of labor is that there is no reliable way to bring it about. When a debtor operates with substantial equity in a tort-first system, the secured creditor's risk is minimal and its incentive to monitor small. As the amount of equity the debtor has in the business declines, the secured creditor's risk and incentive to monitor increase. That is as it should be. Unless the secured creditor's incentive to monitor increases as the debtor's decreases, the total level of monitoring will be inappropriately low. In our current, secured-first system, the secured creditor's incentive to monitor does not increase as the debtor's equity and incentive to monitor decrease. Predictably, once the debtor is insolvent, neither the debtor nor the secured creditor has significant incentives to monitor. This point is illustrated each time the fully encumbered truck of an insolvent toxic waste disposal company hits the road.

The tort-first regime that I propose is grounded in the premise that whoever supplies the capital that enables a business to operate should be legally responsible for its torts, at least to the extent of the supplier's investment. Whether the capitalist should control

100 That secured creditors have the option of self-insuring will give them greater leverage in bargaining with the insurer over the cost of insurance. In a system that attempts to solve the tort problem through universal insurance, the debtors who must purchase the insurance have no option, and as a result can be expected to pay more.

101 In a system that attempts to solve the tort problem through universal insurance, the debtor must purchase insurance that has no maximum limit. Such insurance is rare, which suggests that it might be extremely expensive.

102 Steve Knippenberg, The Unsecured Creditor's Bargain: An Essay in Reply, Reprisal, or Support?, 80 Va. L. Rev. 1967, 1981 (1994).

103 Id.



that liability by monitoring, involving itself in management, lending only to those whom it trusts, or delegating the task to an insurance company is left to the capitalist to decide. But if civil liability is to provide the necessary incentives to hold tort risk to economically optimal levels, the liability must be placed on participants who have something to lose.

Professor James J. White has argued with some persuasiveness that any effort to give tort creditors priority over secured creditors would not succeed.104 Debtors and would-be secured creditors would invent substitutes for security that would effectively ensure that when a debtor's wealth was insufficient to pay both tort creditor and financer, the financer would be paid.los To illustrate, assume that the legislature has enacted a law granting tort creditors priority over secured creditors. A debtor owns a factory and wants to mortgage it in such a manner that the mortgagee would be paid even if the debtor could not pay the future liability claims arising out of the factory's operation. The debtor might accomplish that by setting up two corporations. One would own the factory and incur the mortgage debt. It would lease the factory to the other. The other would conduct the business, sell the products, and bear the resulting liability. If the court recognized the separate identities of the two corporations, the device would be a near-perfect substitute for security.106

This illustration demonstrates the relationship between the priority of secured credit and corporate limited liability as devices for externalizing tort liability. They are alternative means by which

104 See White, supra note 7, at 502-08. Even if White is correct, and we have security because we cannot rid ourselves of it, at least we know it is a blight, not the savior it has been portrayed to be in the literature.

105 Id. 106 This scheme would not offend UFfA § 4(a)(2) because the debtor would make sure

that the operating company received reasonably equivalent value for anything it transferred. See supra note 76. Such a scheme withstood attack in NLRB v. Fullerton Transfer & Storage, 910 F.2d 331 (6th Cir. 1990). In that case a debtor divided its operations among three corporations-one to hire the truck drivers, one to own the trucks, and one to own the real estate. Id. at 333. The court held that an NLRB back-pay order obtained against the corporation that hired the drivers could not be enforced against the corporations that owned the trucks and real estate. Id. at 335, 342.

Leebron also suggests debtor use of finance subsidiaries as a means of insulating assets against tort liability when the debtor is unable to use security for that purpose. See Leebron, supra note 44, at 1647-48.



business owners can, with varying degrees of difficulty and uncertainty, accomplish the same economically undesirable thing. Perhaps both must be reformed for reform of either to be completely effective. But the space allotted to me here does not permit full consideration of the persuasive arguments made by others for the reform of corporate limited liability.lo7

Even without major reform directed at corporate limited liability, I am more optimistic than Professor White that the legal system could ferret out and invalidate the security substitutes that debtors and their creditors would invent. Although a complete response to White is beyond the scope of this Article, the scheme of Article 9 already requires that courts distinguish transactions in the nature of security from those that are not/os and the high regard in which Article 9 is held generally suggests it has done so passably.

In her commentary on this Article, Professor Susan Block-Lieb argues that the abolition of corporate limited liability should be considered as an alternative to subordination of secured debt as a solution to the problems I discuss here.109 I see no reason to choose between the two reforms. Unlimited liability is an incomplete solution; it would leave the involuntary creditor without remedy in the common cases where all shareholders are judgment proof or the debtor is unincorporated. Involuntary creditor priority is an incomplete solution as well; it would leave the involuntary creditor without remedy in the case where tort damages exceed the value of an incorporated debtor's assets. The two reforms together would seem best to serve the goal of minimizing the externalization of tort liability.

Merely putting involuntary creditors first might alone produce most of the benefits sought by advocates of unlimited corporate liability. Secured creditors already commonly require individual guarantees from the owners of their corporate borrowers. In effect, they contract for a selective unlimited corporate liability in which they are the only beneficiaries. In a tort-first world, those secured creditors could be counted on to expand those guarantees to include the secured creditor's losses from tort priority. The

107 See, e.g., Leebron, supra note 44. 108 See v.c.c. § 9-102 cmt. 1 ("[T]his article applies regardless of the form of the

transaction or the name by which the parties may have christened it."). 109 Block-Lieb, supra note 96, at 1994-97.



effect would be to expand the beneficiaries of consensual unlimited corporate liability to include the tort creditors.

Giving involuntary creditors priority over secured creditors would drastically change the American legal system. The change would eliminate the currently valid "tort objection"110 to Jackson and Kronman's argument for the efficiency of secured credit.Ill It would not, however, make their argument sound. As I discuss in the next Section, there are many "voluntary" unsecured creditors whose consent to the secured status of others is mostly a figment of legal and economic imaginations. They too stand in the way of the "consent" argument for the efficiency of secured credit.

B. Uninformed Creditors

A grant of security exploits not only creditors who are forced into unsecured status but also creditors who accept unsecured status on the basis of an underestimation of the risk. Scholars have noted the potential for such underestimation to redistribute wealth from the unsecured creditor to the debtor and secured creditor.l12

But none has yet advocated a change in the law to remedy the problem. Schwartz, for example, declined to advocate a change because he doubted that very many unsecured creditors were "incompetent,"113 and he saw the harm from their victimization as "slight. "114 As a lawyer practicing commercial and bankruptcy law in a small city for eight years, I came to the opposite conclusion. A substantial proportion of the unsecured creditors who showed up on bankruptcy schedules were not creditors who had knowingly assumed the risk of the debtor's business. They were creditors who, had they known the true state of the law and the debtor's finances when they made the fatal decision to extend credit (or not to withdraw from an extension already made), would have decided differently.11s

IlO See supra notes 17, 38-42 and accompanying text. 111 See Jackson & Kronman, supra note 5. 112 See, e.g., Scott, supra note 7, at 908. 113 Schwartz, Security Interests, supra note 7, at 36. 114 Id. at 35. llS See, e.g., Chicago Limousine Servo v. Hartigan Cadillac, 548 N.E.2d 386 (Ill. App. Ct.

1989), rev'd on other grounds, 564 N.E.2d 797 (Ill. 1990), in which a buyer of limousines rescinded the transactions solely as an accommodation to the dealer from which the buyer purchased. The dealer, who was already in default to its secured creditor, refunded the



Article 9 is highly complex, unintuitive, and notoriously deceptive. In order to protect secured creditors, it rejects what are, for anyone other than an expert in Article 9, basic principles of justice. Three examples will illustrate the magnitude of this departure. First, Article 9 employs generally what is often referred to as a "pure race" filing system.116 That is, the first creditor to file or perfect its security interest has priority, even if that creditor lends with full knowledge that a competing creditor has made advances against the collateral but failed in some technical respect to perfect propedy.117 Second, Article 9 ignores the common expectation that a seller can recover the property it sells if the buyer does not

purchase price in the form of bad checks and took title to the cars. Id. at 388. Consistent with its characterization of the rescission as a sale back to the dealer, the appeals court held the buyer to be merely an unsecured creditor. Chicago Limousine, 548 N.E.2d. at 391-93. The Supreme Court of Illinois reversed and remanded, but it was able to reach that result only by determining that the rescission was not a sale back to the dealer. Chicago Limousine, 564 N.E.2d at 801-03. Thus, the case continues to stand for the proposition that a seller who is defrauded with bad checks loses to the defrauder's secured creditor. Chicago Limousine, 548 N.E.2d. at 394.

The owner-managers of failing businesses are under tremendous pressures to defraud and mislead creditors and customers. To illustrate the extent of the problem, Whitford and I found that in 4 of the 43 cases we studied (9%), the CEOs were indicted for fraud against creditors. In several others, the SEC brought administrative charges for such fraud. See LoPucki & Whitford, supra note 41, at 675, 738 & nn. 226-27.

116 James J. White & Robert S. Summers, Uniform Commercial Code § 24-4, at 1132 (3d ed. 1988) (referring to U.C.C. § 9-312(5) as a "pure race" statute). Professor Carlson correctly points out that Article 9 is not a pure race system in all respects, but he acknowledges that "law professors are practically unanimous in believing that Article 9 condones a race priority wherein knowledgeable lenders can defeat prior unknowledgeable lenders," David G. Carlson, Rationality, Accident, and Priority Under Article 9 of the Uniform Commercial Code, 71 Minn. L. Rev. 207, 210 (1986), and that "[i]n two circumstances ... [Article 9 rules] effectively legalize theft from lenders who have not attempted to perfect their security interests," id. at 209. Pure race recording statutes are generally held in low regard in the real estate world because of the unfairness they engender. See, e.g., John E. Cribbet & Corwin W. Johnson, Principles of the Law of Property 312 (3d ed. 1989) ("When certainty and fairness conflict nearly all states have opted for the latter value and this probably accounts for the unpopularity of the pure race model.").

117 The United States Court of Appeals for the Eighth Circuit has stated: [T]he fact that [the junior creditor] was aware of [the senior creditor's] onceperfected security interest does not render harmless [the senior creditor's] failure to file a proper continuation statement. "[S]ince the purpose of statutory filing requirements is, in most instances, to resolve notice disputes consistently and predictably by reference to constructive or statutory notice alone ... consideration of a junior creditor's actual notice of a now lapsed prior filing by a competing senior creditor" is precluded.



pay for it. us Article 9 instead gives priority to the buyer's secured creditor even if the buyer obtained the property through fraud and the secured creditor made no advances against the propertyy9 At least some courts consider it legitimate for secured creditors who have already decided to call their loans to wait deliberately for their debtor to obtain additional property from uninformed suppliers so that the secured creditors can then claim it as collateral.12o Statutes apparently giving sellers the right to reclaim what they sell are trumped by Article 9 provisions to the contrary.121 As a result,

In re Hilyard Drilling Co., 840 F.2d 596, 600 (8th Cir. 1988) (quoting Botswick-Braun Co. v. Owens, 634 F. Supp. 839, 841 (E.D. Wis. 1986)); see also In re Reisinger, 146 B.R. 649, 653 (M.D. Pa. 1992) ("Given that the purpose of the financing statement is to give other creditors at least constructive notice of the prior interest, an 'actual knowledge' provision would seem logical, but we can not supplement the plain words of the statute." (quoting Consumer Prod. Safety Comm'n v. GTE Sylvania, 447 U.S. 102, 108 (1980))).

118 For example, Louisiana recognizes a variant of the French vendor's lien, under which the seller of chattels prevails over the buyer's secured creditor with respect to any portion of the purchase price that remains unpaid as long as the buyer retains possession of the property. See La. Civ. Code Ann. art. 3227 (West 1952); Scott v. Reed, 524 So. 2d 756, 758-59 (La. Ct. App. 1988).

119 See, e.g., In re Samuels & Co., 526 F.2d 1238, 1241-42 (5th Cir.), cert. denied, 429 U.S. 834 (1976); Chicago Limousine, 548 N.E.2d at 393-94. Many applications of the rule are highly counterintuitive. For example, most of the standard agreements between authors and publishers provide for assignment of the publishing rights to the publisher in return for the publisher's agreement to pay royalties as books are sold. Many of the contracts specifically provide that in the event of bankruptcy, the publishing rights revert to the authors, and most authors probably think of themselves as the owners of their works to the extent of their royalty rights. Article 9, however, treats them as unsecured creditors. The publishers reassign the publishing rights to secured lenders as collateral. If the secured lenders foreclose, they will have the right to publish the book or, if it has been published, to continue selling it, without paying any royalties. See, e.g., Cynthia Crossen, Stein & Day Authors End Up Getting Nothing from Publisher'S Bankruptcy, Wall St. J., Sept. 19, 1988, at 40.

120 See In re M. Paolella & Sons, 161 B.R. 107 (E.D. Pa. 1993). Not only did the secured creditor in that case wait for "a propitious time ... relative to [unsecured creditors]," id. at 120, but the secured creditor even deliberately misrepresented facts to an inquiring unsecured creditor, id. at 121. The court apparently concluded that the unsecured creditor would have sold to the debtor even if it had been told the truth, and on that basis held that the unsecured creditor had not reasonably relied on the misrepresentation. Id.

121 For example, U.C.C. § 2-702 gives selling creditors the right to reclaim goods shipped to an insolvent buyer, but the right turns out to be subject to the rights of the buyer's secured creditors. See In re Pester Refining, 964 F.2d 842, 844-45 (8th Cir. 1992) ..

Ironically, Congress has in other contexts declared the Article 9 floating lien on inventory to be "a burden on and obstruction to commerce" and "contrary to the public interest." 7 U.S.C. § 196(a) (1988) (commerce in livestock); see also 7 U.S.C. § 49ge(c)(1) (1988) (commerce in perishable agricultural commodities). In those two contexts, Congress has imposed a trust in favor of the unsecured sellers that gives the sellers priority



secured creditors who are short of collateral can, and sometimes do, encourage their debtors to buy more collateral from guileless suppliers and wait for it to arrive before calling their loans. 122 Third, the drafters of Article 9 attempted to abolish the equitable doctrines by which courts have traditionally protected unsecured creditors against the harshest effects of security.l23

The small businesses and consumers I observed struggling with the concept of security were at the lowest level of sophistication. They could not afford lawyers for many transactions, and the lawyers they could afford were often themselves struggling to understand Article 9. Many more businesses operate and much more credit is extended at their level of sophistication than at the virtually perfect levels of sophistication assumed in economic modeling. A realistic economic model would not ignore these creditors.

The Law and Economics theorists with whom I discussed my ignorance hypothesis almost uniformly asserted that those who did not understand the system as well as others ought to lose their investments. Some regarded the redistribution from the less to the better informed as a market process that improved the allocation of resources. These views seem to me to confuse the nonproductive competition to master unnecessarily complex laws with the productive competition to render better products and services less expensively.124

over the floating lien of the buyer's secured creditor. 7 v.s.c. §§ 196(b), (c), 49ge(c)(2), (3) (1988 & Supp. V 1994).

122 See Paolella, 161 B.R. at 120-21 (holding that a secured creditor's conduct in "embarking on a policy to gamer additional information so as to exercise its contractual right not to lend at a propitious time ... relative to [unsecured suppliers]" was insufficient to warrant equitable subordination of secured creditor's claim in bankruptcy); Ninth Dist. Prod. Credit Ass'n v. Ed Duggan, Inc., 821 P.2d 788 (Colo. 1991) (holding that a secured creditor can be liable to an unsecured creditor under a theory of unjust enrichment only if the secured creditor directly induced the unsecured creditor to lend), discussed infra at notes 257-70 and accompanying text.

123 See V.C.C. § 9-203 cmt. 5. 124 Professor Knippenberg takes a different tack, asserting in essence that those ignorant

of the nuances of Article 9 and the contents of security agreements should bear the costs of their own education. Knippenberg, supra note 102, at 1985. I am concerned less with who bears the costs than with how much those costs will be. Implicit in my proposal of an implied contract regime is an empirically verifiable assumption that the economic costs of communication between secured creditors and unsecured creditors will be less than the economic costs of ignorance and the treachery it invites.



Although Schwartz recognized that relatively uninformed people could fall victim to the institution of security, he did not see their victimization as an integral part of the institution.l25 He argued that "markets can work well in the face of substantial numbers of uninformed persons."126 His point, however, depends on his assumption that there are prevailing "market" rates of exchange and that the current rates are made known to the uninformed and the informed alike, enabling the uninformed to freeride by emulating the informed. The assumption is not generally true of the markets for unsecured credit. Both the decision to grant credit and the terms of credit ordinarily are private, making emulation difficult.127

C. Can Security Be Proven Efficient?

Most of the puzzle articles seem to assume that secured credit is efficient and seek only to explain why secured credit or unsecured credit occurs in the particular places where it does. In Sections A and B, I have demonstrated the existence of a "subsidy" to the institution of security,128 paid by involuntary and uninformed creditors. That subsidy mayor may not account for the prevalence of

Professor Knippenberg points out that contracting parties do not ordinarily have the duty to disclose facts to one another and asserts that I would impose such a duty on the secured creditor. Id. at 1983. Not so. Secured creditors would continue to have the option to disclose or not. But the contents of the agreement implied between secured creditor and unsecured creditor would, under the rule I propose, be a function of what was in fact disclosed. That is the rule applicable to implied contracts generally. See John D. Calamari & Joseph M. Perillo, The Law of Contracts § 2-2, at 27 (3d ed. 1987) ("[A] party's intention will be held to be what a reasonable man in the position of the other party would conclude his manifestation to mean."). It is, as the dissent in Duggan eloquently points out, the Article 9 regime that departs from the general rules of contract. See Duggan, 821 P.2d at 801-04 (Vollack, J., dissenting); infra text accompanying note 268.

125 Schwartz, Security Interests, supra note 7, at 34. 126 Id. at 36. 127 See infra notes 251-54 and accompanying text. 128 Others have recognized the possibility that such a subsidy exists. See Shupack, supra

note 7, at 1111 ("Security interests not only provide the mechanism for efficiency gains, but also provide a means by which wealth is transferred from involuntary or ignorant creditors to secured voluntary creditors."). Buckley attempted to justify the subsidy as the market premium appropriately exacted by secured creditors to "compensate them for the cost of determining the firm's bankruptcy value." Buckley, supra note 7, at 1424. His argument fails to justify the premium to secured creditors because they perform no information function for the benefit of uninformed unsecured creditors. It is the informed unsecured creditors who do so.



security. But, as with anything that is subsidized, there will tend to be more of it than is economically efficient.

Who captures these subsidies, and what are their likely effects on contracting among debtors and creditors? Although secured loans are made largely by firms in regulated industries, in recent years there has been competition to lend money. That competition may have prevented secured creditors from capturing any substantial part of the subsidies.129 If so, their customers have borrowed at costs below those that would prevail in an efficient market. Too many secured loans will have been made for the simple reason that the institution of security enables the lenders to recover even their bad loans in full.130 It will be difficult to prove security efficient because, in all probability, it is not.

There is a second reason why security is unlikely ever to be proven efficient. Security offers the user some combination of three features, which I will refer to as priority, encumbrance, and remedy.l31 None of the three is present in every arrangement that qualifies as security; any of the three features can be present in arrangements that are not security. Because security does not always have the same features, it is highly unlikely always to have an attribute such as "efficiency."132

An arrangement can lack any of these characteristics and still be "security." Under current law, a mortgage lacks priority in that it may be displaced by subsequently assessed property taxes. This

129 Even when secured creditors manage to bilk trade creditors out of a little more collateral in the dying days of the debtor's business, the advantage thus gained is not necessarily a profit to the secured creditor. In a competitive market, the secured creditor who can bilk must do so and pass the benefits along to its customers. The proceeds of whatever bilking can likely be accomplished will be taken into account in setting the price of secured credit, and will be passed along to the borrower in the form of lower interest rates.

130 By a bad loan I mean a loan to a debtor with a business that had a high probability of failing and that did in fact later fail, whereupon the debtor did not pay all of its creditors. One might argue that the secured creditor's loan was "good," because it was repaid. But if, for example, the secured loan enabled the debtor to establish a business that generated tort liability it could not pay, the secured loan was "bad" for the economy as a whole.

131 Priority is the right to satisfaction out of the collateral in a particular order. Encumbrance is the inability of the debtor to convey inconsistent rights to others. A third characteristic, that of a relatively quick and easy remedy, is also associated with security.

132 Professor Triantis has made much the same point I make here. See Triantis, supra note 7, at 257 ("Most of the effects of secured debt may be reproduced by other contractual terms in debt contracts.").



lack is of relatively little importance because property taxes are comparatively small and predictable as to amount. The secured creditor can retain its priority by paying the property taxes and adding the amount of that payment to the secured debt. But we easily can imagine systems in which debts such as tort liabilities, environmental liabilities, or employment taxes also could displace the priority of the secured creditor.133 The resulting mortgage still would be "security" even though the mortgagee might have no meaningful way to gauge in advance what its priority would be. Nor is encumbrance a universal characteristic of security. We do not hesitate to classify the typical Article 9 inventory loan as "secured," even though buyers in the ordinary course of business usually take free of the secured party's interest.134 Finally, the secured creditors' remedies under Article 9 are notoriously quick and easy,135 but the secured creditor's remedies under real estate law are in many states slower and more difficult than the remedies of unsecured creditors.136

Other arrangements that we do not call security perform the same functions and therefore offer the same advantages as security. One does not need security to achieve priority; subordination agreements may serve just as well. If the intent is priority as to only a particular asset, this priority can be achieved by isolating the

133 Some such systems already exist. Under U.S. admiralty law, tort debts and seamen's wages both have priority over preferred ship mortgages. See supra note 86. In Canada, the Crown's claims for payroll taxes that the debtor was required to withhold have priority over the claims of a secured creditor. Income Tax Act, R.S.C., ch. 1, § 224(1.2) (Supp. V 1992) (Can.).

134 The rule applies whether or not the secured party receives the proceeds of sale. See U.C.C. § 9-307(1).

135 See, e.g., Del's Big Saver Foods v. Carpenter Cook, 603 F. Supp. 1071, 1072 (W.D. Wis. 1985) (describing how, in a single day, the secured creditor properly filed a replevin action, obtained issuance of a corresponding writ, and obtained possession of the debtor's business), aff'd, 795 F.2d 1344 (7th Cir. 1986). Things do not always proceed so smoothly in a replevin. The court may require a bond in an amount that the plaintiff will find difficult to furnish, the debtor may remove the collateral from the jurisdiction, or the court may be slow in hearing the case.

136 See, e.g., Wis. Stat. Ann. § 846.10(2) (West Supp. 1990) ("No sale involving a one-to 4-family residence that is owner-occupied at the commencement of the foreclosure action ... may be held until the expiration of 12 months from the date when judgment is entered, except a sale under s. 846.101 or 846.102."); Wis. Stat. Ann. § 846.101 (West 1977 & Supp. 1990) (allowing a foreclosure sale involving an owner-occupied one-to-four-family residence six or more months after foreclosure if the mortgagee waives its right to a deficiency judgment after the foreclosure sale).



asset in a separate corporation. As will be shown below, in some circumstances negative covenants combined with credit reporting can make it impossible for debtors to transfer property that is not collatera1.137 The practical effect may be no different than if the debtors granted security.138 The legislature can make quick, easy remedies available without tying them to security. For example, California gives unsecured creditors of a business debtor an attachment remedy substantially as quick and easy139 as the secured creditor's remedy of replevin. Because security has no unique aspects, it is hard to imagine how one ever could prove "security" more efficient than some cobbled-together set of alternatives.14o

That security has not been shown to be either efficient or otherwise economically beneficial is important. For more than two generations, security has been regarded by policymakers as an unmitigated good. Article 9's drafters have repeatedly sought to expand both the use of secured credit and the rights of secured creditors.141 Further expansions of the protection afforded secured creditors are proposed as part of the current round of revisions to Article 9.142 Once we realize that expanding the rights of secured creditors is not necessarily good for the economy, we should be ready to examine their mirror image-the rights of unsecured creditors-with new eyes.

137 See infra Part II.A. 133 Grant Gilmore probably first noted the lien-like nature of the negative covenant.

See 2 Grant Gilmore, Security Interests in Personal Property § 38.1, at 999 (1965) ("[T]he beneficiary of [a negative covenant] will argue, when things go wrong, that he ought to be treated as if he were secured: that he has, if not a true lien, something 'like' or 'in the nature of' a lien .... ").

139 See Cal. Civ. Proc. Code § 483.010 (West 1979 & Supp. 1994). 140 Most commentators have chosen to compare a system with security to a system in

which all debt is unsecured and contracted for without covenants. The resulting arguments attribute all of the advantages of contracting to the institution of security.

141 See Gilmore, supra note 1, at 625. 142 See Permanent Editorial Bd. for the Uniform Commercial Code, PEB Study Group

Uniform Commercial Code Article 9: Report (Dec. 1, 1992). Examples include recommendations to (1) give secured creditors who file rather than take possession of negotiable instruments priority over lien creditors, including the trustee in bankruptcy, id. at 152-55; and (2) extend the period during which a creditor secured by a motor vehicle remains perfected after the vehicle is removed from the state, id. at 86; and (3) create a 10-day "safe harbor" regarding the requirement of "reasonable notification" of a secured creditor's sale of collateral, id. at 231.



II. THE UNSECURED CREDITOR'S BARGAIN

Many unsecured creditors are sufficiently sophisticated that their extensions of credit cannot be explained as mere mistakes. In this Part, I examine unsecured lending by sophisticated lenders and conclude that it is of two types: (1) "asset-based" unsecured lending, which is functionally indistinguishable from secured lending; and (2) "cash-flow surfing," which is accomplished by making small, short-term extensions of credit against cash flow, usually in the complete absence of liquidation value. The latter kind of lending has not yet been recognized in legal theory. It suggests that an unmet need exists for extenders of unsecured credit to have access to the terms of the security agreements to which they are subordinate as well as access to the intentions of the secured parties under those agreements with respect to the calling of the loans.143

A. Asset-Based Unsecured Lending

Currently prevailing theory conceptualizes unsecured debt as a priority in the debtor's assets.144 Certainly some unsecured creditors do look to the debtor's assets as the basis for their extensions of credit. In a study of the bankruptcy reorganizations of large, publicly held companies during the 1980s, Professor William Whitford and I found that many of those companies issued little or no secured debt, even as they approached bankruptcy reorganiza-

143 See Douglas G. Baird, Notice Filing and the Problem of Ostensible Ownership, 12 J. Legal Stud. 53, 55 (1983) (arguing that the Article 9 filing system provides "virtually no assistance to unsecured creditors").

144 That is, the legal rights of the unsecured creditor are seen as rights to any value remaining after the debtor's assets have been liquidated and those with higher priority have been paid. See, e.g., Harris & Mooney, supra note 4, at 2059 ("[J]udicial lien creditors are 'nonreliance' parties who have bargained for the right to enforce a judgment against whatever property the debtor may have on hand at the time."); Schwartz, Security Interests, supra note 7. at 8 & n.25 (describing hypothetical in which unsecured creditors compete for assets in liquidation and concluding that "creditors may often anticipate bankruptcy-style liquidations when calculating risks of default").



tion.145 Liquidation of those companies, even in bankruptcy, would yield substantial recoveries for unsecured creditors.146

This kind of unsecured lending is done by banks, insurance companies, and other financial institutions.147 That some 55% of all lending by commercial banks is unsecured148 demonstrates that this kind of unsecured lending not only exists, but is common. The borrowers who receive asset-based unsecured loans tend to be the largest, financially strongest companies.149

145 For example, at the time it filed for bankruptcy reorganization, the Johns-Manville Corporation had assets of $2.2 billion, see Lynn M. LoPucki & William C. Whitford, Patterns in the Bankruptcy Reorganization of Large, Publicly Held Companies, 78 Cornell L. Rev. 597, 614 (1993), and secured debt of approximately $40 million, see Lynn M. LoPucki & William C. Whitford, Narrative Data Paragraphs Sorted by Subject: NSF Bankruptcy Project § 15 (Sept. 3, 1991) (unpublished manuscript, on file with the Virginia Law Review Association) [hereinafter LoPucki & Whitford, Narrative Data Paragraphs]. If, however, there is an out-of-court debt restructuring after the debtor is in financial distress, the bank lenders are likely to become secured. See Stuart C. Gilson, Bankruptcy, Boards, Banks, and Blockholders, 27 J. Fin. Econ. 355, 367 tbl. 4 (1990) (stating that 72.5% of 40 privately restructured bank lending agreements contained a grant of "increased security interest in firm's assets").

146 Among the 43 reorganizations of large, publicly held companies that Professor Whitford and I studied, the liquidation of Baldwin-United yielded 54 cents on the dollar for unsecured creditors. That distribution totaled $239 million, over $100 million of which was paid in cash within three years after confirmation. Similarly, the liquidation of White Motors yielded 61 cents on the dollar for unsecured creditors. That distribution totaled $174 million, over $100 million of which was paid in cash within six months after confirmation. In at least five cases in which the debtor did not liquidate, the liquidation value of the assets exceeded the secured debt by a sufficient amount that it was clear beyond argument that unsecured creditors would have substantial recoveries in liquidation. See Lynn M. LoPucki & William C. Whitford, Bargaining Over Equity's Share in the Bankruptcy Reorganization of Large, Publicly Held Companies, 139 U. Pa. L. Rev. 125, 171-72 (1990) (quoting disclosure statements on projected recoveries in liquidation and explaining the context in which the projections were made).

147 For a different, but not inconsistent, description of negative covenant lending, see Schwartz, supra note 8, at 216-18.

148 This estimate is based on data on the terms of lending at commercial banks as reported by the Federal Reserve System. For the week of May 3-7,1993,42.7% of $41.2 billion in short-term loans were secured while 64.7% of $3.7 billion in long-term loans were secured. Fed. Reserve Bull., supra note 23, at A76 tbl. 4.23. But see Allen N. Berger & Gregory F. Udell, Collateral, Loan Quality, and Bank Risk, 25 J. Monetary Econ. 21. 21 (1990) (reporting that "nearly 70% of all commercial and industrial loans are currently made on a secured basis" but providing no citation). Even if Berger and Udell are correct, the amount of unsecured bank lending remains substantial.

149 See Berger & Udell, supra note 148, at 23 ("Overall, the data strongly suggests that collateral is associated on average with riskier borrowers, riskier loans, and riskier banks .... "); see also T.H. Donaldson, Credit Risk and Exposure in Securitization and Transactions 76 (1989) ("It is not always true that a borrower who has to give security is a



In the context in which it occurs, this unsecured lending to larger companies functions in much the same way as secured lending to smaller companies. That is, it assures the lender that in the event of nonpayment, the lender will have priority in the debtor's assets. In secured lending, the assurance results from the grant of a security interest. In the "asset-based" unsecured lending described here, the assurance results from the combination of (1) negative covenants against competing debts and priorities and (2) active monitoring to prevent competing debts from arising.

The relatively unimportant difference between secured lending and asset-based unsecured lending is in formal legal effect. A perfected security interest or mortgage prevents later lenders from acquiring equal or superior priority.1S0 A negative covenant alone does not. A debtor's grant of a security interest to a later lender in violation of the negative covenant still might confer priority.1S1 It will be a default under the negative covenant, however, and probably will lead promptly to acceleration of the unsecured loan.

In the case of a large company, the likelihood that a later lender will attempt to obtain priority over a negative covenant unsecured lender is small. The custom among lenders to such companies is to obtain representations, warranties, and often a legal opinion as well, that the security interest it is taking does not violate the

weak credit, but it is true most of the time."). That loans should be unsecured when they are to the largest, financially strongest firms is not particularly startling. But it does dispatch the "signaling" theory from the economic literature, which Schwartz describes as predicting that loans will be secured when they are to the companies least likely to fail because, by their willingness to give security, those firms are signaling their economic strength. See Schwartz, supra note 8, at 245-47 (expressing doubts about one of the premises of signaling theory).

150 By this statement I mean only that, if a creditor ("Sl") perfects a security interest in property owned by a debtor ("D") and thereafter another creditor ("S2") perfects a security interest in the same property, S1's security interest has priority.

151 To continue with the example from the preceding footnote, assume that Sl does not obtain a security interest in the property, but does obtain D's promise not to grant a security interest to anyone else. If S2 then obtains a security interest in the property, S2 has priority over S1. See Equitable Trust Co. v. Imbesi, 412 A.2d 96 (Md. 1980) (holding that even though the debtor breached a covenant not to encumber by granting a mortgage, the mortgagee had priority in the property); 2 Gilmore, supra note 138, § 38.5; Schwartz, supra note 8, at 209-10. But see Thomas C. Mitchell, The Negative Pledge Clause and the Classification of Financing Devices, 60 Am. Bankr. L.J. 153,168-72 (1986) (acknowledging the power of a debtor to transfer title in violation of a negative pledge clause but arguing for the availability of injunctive relief to prevent such transfers).



debtor's covenants to others. Knowingly to lend in violation of a negative covenant might even subject the lender to liability for tortious interference.

Where the grant of security is not to a new lender but to an existing lender that initially made its advances on an unsecured basis, the grant would be vulnerable to preference avoidance if the debtor then filed for bankruptcy within ninety days of its recording.1s2 Professor Whitford and I found that large companies seldom granted such security interests before they entered bankruptcy reorganization and that when they did, the creditors remaining unsecured did in fact file involuntary bankruptcy petitions within the ninety-day period so that they could attack the security interests as preferences.1s3

Negative covenant lenders also rely on the fact that their debtors must maintain access to credit markets. Contrary to the image popular in scholarly literature,ls4 many large companies borrow from several sources at the same time. ISS At any given time, one or more of these "credit facilities" are likely to be up for a renewal or renegotiation. The debtor will be able to renew or renegotiate successfully only if its other credit facilities are in good standing. The negative covenant lender's declaration of default may quickly put

152 That is, if the debtor first granted a security interest in a portion of its assets to a creditor for previously unsecured debt and then filed for bankruptcy within 90 days, the grant would be avoidable as a preference. See 11 u.s.c. § 547(b) (1988). If the debtor granted a security interest in a portion of its assets to secure a new loan, the creditor with the negative pledge could declare a default and immediately proceed against the proceeds of the new loan.

153 In 28 of the 42 cases (67%) in which the debtor had bank debt, the primary banks were wholly or substantially unsecured as bankruptcy approached. The banks demanded security in at least 20 of the 28 cases (71 %). The debtor refused to grant the security in 10 of the 20 cases (50%). In five of the 10 cases in which security was granted shortly before bankruptcy, the bankruptcy case was filed within the 90-day preference period and the grant was attacked. LoPucki & Whitford, Narrative Data Paragraphs, supra note 145, § 15. In a separate study of out-of-court arrangements, Professor Gilson found security was granted in 72.5% of the cases. Gilson, supra note 145, at 367 tbl. 4. Putting the results of these studies together, it would appear that companies are more likely to grant security when they avoid bankruptcy.

154 See, e.g., Scott, supra note 7, at 949 ("The standard commercial finance security agreement, for example, states that the lender will act as the borrower's 'sale source of financing.' ").

155 Telephone Interview with Steven L. Schwarcz, Attorney with Kaye, Scholer, Fierman, Hays & Handler, New York City (Sept. 21, 1993). Mr. Schwarcz's practice centers on the kinds of lending to large companies described here.



the debtor into a financial crisis from which it cannot recover. If the debtor does not respond to this leverage, the negative covenant lender can, and likely Will,IS6 petition the debtor into involuntary bankruptcy. In any event, the negative covenant lender will act quickly, before the assets it looks to for satisfaction can be dissipated. For a negative covenant lender with such extensive leverage also to take security may be overkill.

When one considers all these effects together, one can see that the negative covenant lender to a large company is in roughly the same relationship to the debtor's assets as is the secured lender to a small company's assets.157 In neither relationship can the debtor dissipate its assets or effectively commit them to others. Because a negative covenant lender can, and often does, rely on the debtor's assets as a source of repayment, I will refer to its bargain as the "asset-based" unsecured creditor's bargain.

With respect to two other threats, negative covenants are less effective protection for a lender than security. The first of these threats is from tort and other involuntary claims. Such claims can come into existence suddenly and in large amounts. ISS Because they do not add to the debtor's estate but do share pro rata with the negative covenant lender in the estate, they dilute the negative covenant lender's expectancy. The thesis I present in the first Part of this Article-that grants of security can be a means of defeating

156 See Lynn M. LoPucki & William C. Whitford, Venue Choice and Forum Shopping in the Bankruptcy Reorganization of Large, Publicly Held Companies, 1991 Wis. L. Rev. 11, 12,26 n.54 (finding that 14% (6 of 43) of the bankruptcy reorganizations of large, publicly held companies were initiated by creditor petition).

157 Negative covenants are not widely used in lending to smaller companies. One reason for this may be that smaller companies are more often able to obtain loans that violate a negative covenant. The lenders who make such loans to smaller companies typically do so as an accommodation; they are friends, relatives, and business associates of the debtors. Another reason may be that small companies return to the credit markets less frequently, making it more likely that they can continue to operate until creditors exercise possessory legal remedies such as replevin or execution. Negative covenants and credit reporting would be less of a threat. Yet another explanation may be that the effectiveness of negative covenants depends upon the parties' advance agreement on what limitations of action are appropriate to the particular debtor's situation. This customization may require time and expense not justified in the case of a smaller company.

158 For example, Texaco was in good financial health until it unexpectedly suffered a tort judgment in the amount of $11.1 billion. See Final Cumulative Index, Moody's Bond Survey, Dec. 1985, at 45 (showing ratings of Texaco's commercial paper slipping from Prime-1 to Not Prime during the year the Pennzoil judgment was entered).



present or future tort liability-suggests that when the threat of such claims is significant for a large company, the company and its lenders will switch from negative covenant financing to secured financing.159 The second threat that affects the negative covenant lender more severely than the secured lender is the risk that the debtor's assets will be consumed in unprofitable operations under the protection of the bankruptcy court. In bankruptcy, the debtor generally may use, and thus possibly consume, the secured creditor's collateral only if it provides the secured creditor with adequate protection against loss.160 The debtor may use and possibly consume the unsecured lender's expectancy without providing such protection.161 The prevention of such use and consumption may be an important function of security.162

159 For example, in 1980, the institutional lenders to Chrysler Financial converted their unsecured negative covenant loans to secured loans to gain priority over the claims of the government's Pension Benefit Guarantee Corporation. See Robert B. Reich & John D. Donahue, New Deals: The Chrysler Revival and the American System 174, 180 (1985).

160 11 U.S.C. § 363(e) (1988); see also 11 U.S.C. § 363 (c) (2) (1988) (requiring the bankruptcy trustee to obtain authorization from the court or from all entities with an interest in the collateral before using cash collateral).

161 Unsecured creditors are not entitled to adequate protection. See, e.g., In re Pioneer Commercial Funding Corp., 114 B.R. 45, 48 (Bankr. S.D.N.Y. 1990) ("[T)he concepts of adequate protection of an interest in property and the existence of an equity interest in property do not apply to unsecured claims."); In re Steffens Farm Supply, 35 B.R. 73, 75 (Bankr. N.D. Iowa 1983) ("As the Plaintiff has no charge or lien against any collateral, there is no 'interest in property' entitled to adequate protection.").

Professor Whitford and I have proposed that the beneficiaries of risk taking during reorganization be required to compensate those on whom the risks are imposed by transferring to those harmed by the risk taking part of the beneficiaries' interests in the company. LoPucki & Whitford, supra note 41, at 788-96; Lynn M. LoPucki & William C. Whitford, Compensating Unsecured Creditors for Extraordinary Reorganization Risks, 72 Wash. U. L.Q. (forthcoming 1994). Adoption of this proposal would give unsecured lenders, including negative covenant lenders, protection roughly parallel to that given secured lenders. See, e.g., In re Paradise Boat Leasing Corp., 5 B.R. 822, 825 (D.V.I. 1980) (holding that the secured creditor was entitled to protection against the risk that debtor's sole asset, a yacht, would be lost at sea).

162 Professor White noted that bankruptcy "is not just a competition between the secured and unsecured prebankruptcy creditors." White, supra note 7, at 482. Indeed,

a large percentage of all business bankruptcies that start out as Chapter 11 reorganizations prove to be unsuccessful and conclude either as Chapter 7 or Chapter 11 liquidations. . . . Without exception, one can assume that the unsuccessful reorganization attempt will have dissipated some of the assets that might otherwise have been distributed to creditors ....

Id. at 488-89 (footnote omitted).



Despite these weaknesses, the asset-based unsecured creditor's bargain makes sense. A creditor can safely lend unsecured against the debtor's assets, relying on their liquidation value as well as the debtor's cash flow. Although the debtor retains the power to sell or encumber the unsecured creditor's expectancy, it gives up the right to do so and with it the practical ability to do so. When the debtor does anything to impair the unsecured creditor's expectancy, the unsecured creditor begins its withdrawal from the lending relationship. Because the companies and the assets involved are large, they cannot be dissipated overnight. Thus, the negative covenant lender will have a reasonable likelihood of being able to complete that withdrawal before the impairment exhausts the unsecured creditor's cushion of equity. In this context, the unsecured creditor's bargain is not unlike the secured creditor's bargain: it is essentially a bargain for satisfaction from the debtor's assets.

That the most sophisticated lenders and borrowers eschew security ought to bother commentators who consider security efficient. Literature addressing the puzzle of secured debt provides us with numerous and often convincing explanations why secured debt is more "efficient" than unsecured debt. Most of those explanations lead to the conclusion that lending from the most sophisticated financial institutions to equally sophisticated debtors should be secured. Instead, those lenders and borrowers forgo security, and with it an apparently substantial windfall in the form of priority over involuntary and uninformed unsecured creditors. Presumably, the institution of asset-based unsecurity must offer something even more valuable.

My suspicion is that large companies pay higher rates of interest to borrow unsecured and that they do so in order to retain leverage in dealing with their lenders in the event of financial difficulty. By borrowing unsecured, the managers may be sacrificing the best interests of their companies to render their own positions less precarious.163 If their company gets in trouble, they can count on at

163 Thompson finds an important parallel in the tendency of managers to cause their companies to insure against various kinds of liability that the companies otherwise might be able to externalize through financial failure. He speculates that the managers eschew the advantage to their companies in order to protect their firm-specific human capital. Thompson, supra note 57, at 37.



least one debt restructuring in which the banks go from unsecured to secured statusl64 before the bankruptcy in which they almost certainly will be removed from office.165

B. Cash-Flow-Based Unsecured Lending

Most unsecured credit is extended in circumstances very different from those described in the previous Section. Either the value of the debtor's property is fully encumbered before the extension or the creditor has every reason to expect that it will be encumbered before the value is liquidated.166 The debtor does not execute a negative covenant, the unsecured creditor is not in a position to monitor the debtor's assets, and the assets are small enough that they can be dissipated easily and quickly.167 These unsecured creditors have no reasonable expectation of a substantial recovery in liquidation.168 In this more common context, the explanation of the unsecured creditor's bargain as a claim against liquidation value169 is absurd.

1. LoPucki's Formulation of Bowers' Law: Security Tends To Expand to the Liquidation Value of the Collateral

The express intention of the drafters of Article 9 of the Uniform Commercial Code has been to expand the amount of credit available to debtors by making it easier and less expensive to take

It remains possible that managers who pay a premium to borrow unsecured are serving the best interests of their equity investors. The conventional explanation would be that the managers serve their equity investors by preventing the bankers from seizing control of the business in the event of a temporary default. Adler, however, sees the use of unsecured credit as having precisely the opposite effect. He argues that the equity investors demand the use of unsecured credit because they themselves are unable to control management and creditors who lend unsecured will do so. See Adler, supra note 7, at 75.

164 See Gilson, supra note 145, at 367 tbl. 4. 165 See Stuart C. Gilson, Management Thrnover and Financial Distress, 25 J. Fin. Econ.

241, 247 tbl. 3 (1989) (reporting that in one study of financially distressed firms, 40% of senior managers remain in office for more than two years when the company avoids bankruptcy through debt restructuring but that only 29% remain in office when the company does not avoid bankruptcy); LoPucki & Whitford, supra note 41, at 723-37 (reporting high turnover rates for managers in companies filing for bankruptcy reorganization).

166 See infra Part I1.B.!. 167 That is, this kind of lending predominates in small businesses. 168 See infra note 172 and accompanying text. 169 See supra note 144 and accompanying text.



securityPO The drafters also have sought to legitimize the use of virtually every kind of asset as collateraU71 Once the law authorized the encumbrance of nearly all assets, many kinds of debtors encumbered them. Except among the largest firms, it is a rare debtor that, at the time of liquidation, has assets not encumbered beyond their liquidation value.l72 As every bankruptcy practi-

170 See u.c.c. § 9-101 cmt.; Gilmore, supra note 1, at 620; Shupack, supra note 7, at 1083-84.

171 For example, the official commentary to § 9-204 states: The widespread nineteenth century prejudice against the floating charge was

based on a feeling, often inarticulate in the opinions, that a commercial borrower should not be allowed to encumber all his assets present and future, and that for the protection not only of the borrower but of his other creditors a cushion of free assets should be preserved. That inarticulate premise has much to recommend it. This Article decisively rejects it not on the ground that it was wrong in policy but on the ground that it was not effective.

U.C.C. § 9-204 cmt. 2; see Gilmore, supra note 1, at 625-27. 172 See, e.g., Vern Countryman, Code Security Interests in Bankruptcy, 75 Com. L.J.

269,269 (1970) ("[M]any practitioners and bankruptcy referees tell me ... more and more bankruptcy cases emerge with every scrap of the bankrupt's property covered by some sort of a Code security interest. ... That means, of course, that nothing will be distributed to any unsecured creditor, with or without priority."). Countryman's perceptions are borne out in the statistics on distributions to unsecured creditors in straight bankruptcy cases. A recent study by the United States General Accounting Office found that "[o]f the 1.2 million Chapter 7 bankruptcy cases closed in statistical years 1991 and 1992, about 5 percent (56,994) generated some receipts for distribution to professionals and creditors." U.S. Gen. Accounting Office, Pub. No. GGD-94-173, Bankruptcy Administration: Case Receipts Paid to Creditors and Professionals 1-2 (1994) (Report to the Chairman, Subcommittee on Economic and Commercial Law, Committee on the Judiciary, House of Representatives). General unsecured creditors received payments in only 58.3% of the 56,994 cases, which is about 2.8% of Chapter 7 cases. Id. at 38. Thus, unsecured creditors received no payments whatsoever in 97.2% of Chapter 7 cases. Professor Skeel has commented that "general creditors depend upon current payment, not payment in bankruptcy, and bankruptcy results do not disappoint this expectation." David A. Skeel, Jr., Markets, Courts, and the Brave New World of Bankruptcy Theory, 1993 Wis. L. Rev. 465, 511 n.165.

In cases under the reorganization provisions of the Bankruptcy Code, debtors often promise substantial payments to unsecured creditors. See, e.g., Lynn M. LoPucki, The Debtor in Full Control-Systems Failure Under Chapter 11 of the Bankruptcy Code?, 57 Am. Bankr. L.J. 247, 266-67 (1983) (noting that debtors proposed full payment to unsecured creditors in 9 of 19 cases where debtors proposed operating plans). The large bulk of these payments, however, will be made not from liquidation value, but from continuation of the debtor's business. Only in the largest reorganization cases do debtors have unencumbered assets sufficient to support substantial dividends to unsecured creditors on liquidation, and usually, unsecured creditors cannot count on even that. See Dana Milbank, Banks Agree to $1.7 Billion Rescue of Failed Canary Wharf Office Project, Wall St. J., Sept. 13, 1993, at A12 (quoting the administrator of one of the largest



tioner knows, security tends to expand to the liquidation value of the collateral as a debtor sinks into financial distress.173

To explain this expansion requires only the assumptions that debtors prefer to avoid bankruptcy for as long as possible and that their unsecured creditors come after them seriatim.174 Begin by imagining such a debtor sinking into financial distress with assets encumbered to less than their liquidation value. The existence of this unencumbered property gives unsecured creditors an incentive to press for collection. When the first of the attacking unsecured creditors are in a position to execute against the debtor's assets,175 it will be in the interests of a debtor that wants to stay in business to offer them security in return for forbearance. The probable alternatives to the agreement for security and forbearance are execution or bankruptcy. It likely will be in the interests of the attacking unsecured creditors to choose security and forbearance. In bankruptcy, the attacking unsecured creditors will be treated the

bankruptcy reorganizations ever as saying that the rejection of the proposed plan would lead to liquidation "under which unsecured creditors would get nothing").

173 Thinking that I would be the first to introduce this well-known fact into legal scholarship, I provisionally claimed credit in a draft of this Article and suggested that it be referred to as "LoPucki's Law." I was, however, forced to modify my claim when my attention was directed to the following passage:

Given the power to liquidate and distribute a portion of their estate, [debtors] are not likely to remain passive in the face of losses but instead are likely to exercise the power they bargained for. Left in their bankruptcy estates will be the encumbered assets which they had no power to liquidate and distribute, but those assets will benefit the secured parties and not the general creditors. . . . [E]xcept in the occasional accidental case, [bankruptcy law] is never likely to produce anything but empty bankruptcy estates.

Bowers, supra note 62, at 2140-41. Alas, my scaled-down claim can be only to the particular formulation of the law that appears in the text.

Bowers would attribute the ubiquity of security to the "efficiency" of voluntary as opposed to involuntary liquidation. Id. I would attribute it more broadly, not only to some of the efficiencies he notes, but also to the probably inefficient desire of debtors to favor friends and relatives, particularly when it can be done at the expense of hostile or unimportant holders of unsecured claims.

174 The strategic analysis I present here does not require Bowers' assumption that the first creditors to come after the debtor will be the most vulnerable. They may in fact be those best informed. Hence, the process I describe should not be presumed efficient.

175 An unsecured creditor generally must obtain a judgment before it will be entitled to a coercive collection remedy such as execution. If the debtor does not resist, getting the judgment may take only a month or two; if the debtor does resist, it may take many months or even years. See LoPucki, supra note 68, § 2.14.



same as everyone else;176 security, like execution, offers them at least the hope of preferred statusp7 The debtor's offer of security is preferable to the attacking creditors' right to execute because, to achieve and retain preferred status, not only must the attackers execute successfully, but also the debtor must remain outside bankruptcy for ninety days thereafter.178 Execution is likely to throw the debtor into bankruptcy immediately and result in avoidance of the lien, whereas security is notp9 Thus the grant of security in return for forbearance is the best course for both sides. As long as the debtor continues to have unencumbered collateral, this process will repeat with successive waves of unsecured creditors. Only when the liquidation value of the debtor's property is fully encumbered will it break down.18o Until then, the debtor will continue to grant security and succeed in avoiding bankruptcy.

176 See generally Susan Block-Lieb, Why Creditors File So Few Involuntary Petitions and Why the Number Is Not Too Small, 57 Brook. L. Rev. 803 (1991) (explaining why so few creditors file involuntary bankruptcy petitions).

177 These strategies are discussed at greater length in LoPucki, supra note 68, § 2.16.3, at 120-24.

178 The attacking secured creditors will receive their security "on account of an antecedent debt," making it probably avoidable as a preference in a bankruptcy case filed within 90 days of the grant. See 11 U.S.C. § 547(b) (1988).

179 Over 98% of business bankruptcies are filed by debtors; involuntary bankruptcies are relatively rare. See, e.g., Administrative Office of the U.S. Courts, Tables of Bankruptcy Statistics (1988) (unpublished data, on file with the Administrative Office of the U.S. Courts) (reporting that only 243 of 18,279 (1.3%) of Chapter 11 cases for the 12 months ending September 30,1988 were filed by creditors). Because execution interferes with the debtor's use of the property, it gives the debtor an incentive to file. A security interest, on the other hand, will not interfere with the debtor's use. Also, levy under a writ of execution often is only the first step in a collection campaign; the debtor may file bankruptcy to shield itself against further steps. By contrast, a security agreement usually is a settlement that marks the end of a collection campaign.

180 Once the debtor exhausts its unencumbered property through the grant of security interests, later creditors should choose execution or bankruptcy over security. Although the debtor still should be willing to grant them security in return for forbearance, they should not accept it because the security would be virtually worthless. See 11 U.S.C. § 506(a), (d) (1988) (stating that security interests are voidable to the extent they are for debts the aggregate amount of which is in excess of the value of the collateral). Although execution, levy, and sale probably would not result in a bid sufficient to enable these creditors to collect anything directly, seizure of the debtor's assets by the sheriff may well prompt the debtor to offer a settlement. Another possible strategy for the later unsecured creditors would be to force the debtor into bankruptcy and then seek avoidance of the secured interests given other creditors in the preceding 90 days. More sophisticated strategies for the later creditors might enable them to gain a share of the earlier creditors'



It should be apparent that no interest rate could compensate for the risk in a world in which unsecured creditors could look only to liquidation value but liquidation value was always fully encumbered.lSl In fact, small business debtors rarely have unencumbered assets, and unsecured creditors rarely recover from unencumbered assets. To make sense of the extension of credit on an unsecured basis in this environment, one must assume that the creditor is looking to something other than liquidation values.

The implausibility of an asset-based explanation of most unsecured lending is perhaps best illustrated in the context of a common form of leveraged buyout. Assume that a debtor has assets worth 60 in liquidation and 100 in continued operation. The debtor owes 30 of unsecured debt to creditors who did not obtain negative covenants and who do not monitor. The stock of the debtor is worth 70. If the debtor's estate were liquidated from this position, the unsecured creditors would be paid in full. Assume instead that the firm undergoes a leveraged buyout. A secured creditor loans 60 to the debtor, and the debtor pays that money to the current shareholders as a dividend. The purchaser of the company pays the current shareholders an additional 10 for their shares, leaving the company with secured debt of 60, unsecured debt of 30, and stock worth 10. If the business fails now and the debtor's estate is liquidated, the unsecured creditors will recover nothing.

Some Law and Economics scholars attempt to explain such scenarios by asserting that the unsecured creditors extracted a higher rate of interest (or at least should have) in anticipation of their loss of priority.lS2 Such explanations may be plausible with regard to

security by threatening to force the debtor into bankruptcy and then settling. See LoPucki, supra note 68, § 2.16.4.

181 Law and Economics scholars commonly assert that all risks can be dealt with by increasing the rate of interest. E.g., Levmore, supra note 7, at 51 ("From the creditor's perspective, fears of debtor misbehavior, that is, that the debtor will break promises made to the creditor, can be allayed by a sufficiently high interest rate."). Shupack has demonstrated the fallacy of this proposition. When the risk of loss is high, the interest rates necessary to compensate the creditor are far above customary and legal levels. Creditors don't charge higher rates; they refuse to lend. See Shupack, supra note 7, at 1095-98.

182 James Scott makes the argument that "unprotected creditors build in their (certain) expectation that secured debt will be issued, [so] they will not be exploited by the issuance of secured debt." Scott, supra note 18, at 258. Adler makes essentially the same argument:



long-term unsecured debt such as corporation bonds. But among trade creditors, even the sophisticated do not charge interest rates that anticipate the debtor's grant of security. They extend shortterm credit and monitor V.c.c. filings through credit reports to discover the grant of security when it comes. When it does, they expect to reassess and, if necessary, renegotiate the terms upon which they are extending credit. Their rights on liquidation are the farthest things from their minds.

I conclude that no theory based on priority in liquidation can explain the most common extensions of unsecured credit-extensions without asset monitoring and without negative covenants-to debtors whose assets already may be encumbered beyond their liquidation values. The large bulk of unsecured credit is not extended on the basis of priority in liquidation values of assets.183

Some scholars have attempted to explain unsecured debt as a claim against income.l84 That is closer to the truth, but not quite there. The problem is that debtors' incomes generally are either not available to creditors at all or as fully encumbered as other

[A]n unsecured creditor faces the risk ... that the firm will subsequently offer unencumbered property as collateral for another's loan .... And, since a subsequent disposition of a security or other interest in property generally provides the purchaser of that interest a claim with priority over an earlier unsecured creditor, the unsecured creditor charges an interest rate that does not fully reflect the value of unencumbered property as property available for repayment. Thus, in a world that permits secured credit, until a firm pledges all possible property as security for its loans, that firm pays more than it must in total interest if it borrows on an unsecured basis.

Adler, supra note 7, at 83-84. 183 See supra note 172 and accompanying text. 184 For example, Schwartz has written:

[W]hen the question concerns priorities among unsecured creditors, the analysis above may be persuasive because all such creditors look primarily to the debtor's general earning power for repayment, not to its possession of specific unliened assets. Hence, unsecured creditors are concerned only that a portion of the debtor's income stream has not been dedicated to earlier lenders. A secured lender, in contrast, looks to repayment out of the debtor's assets and so wants these assets to be unencumbered when it lends.

Schwartz, supra note 8, at 221 (emphasis added); see also Robert E. Scott, Rethinking the Regulation of Coercive Creditor Remedies, 89 Colum. L. Rev. 730, 744-45 (1989) (speaking of income as "committed to repayment" and of "assign[ing] a portion of that future income to Creditor[s],,).



assets. Because they cannot be encumbered,185 the wages of individual debtors might appear available to unsecured creditors through garnishment. But an individual debtor whose only unencumbered asset is his or her future income is also a likely candidate for bankruptcy. Bankruptcy frees the debtor's future income from the claims of all creditors to give the debtor a "fresh start."186

Corporate debtors, particularly those with small businesses, can, and frequently do, encumber their future incomes, rendering them unavailable to unsecured creditors. Although there is no such thing as a security interest in future income, a debtor can achieve the functional equivalent by granting a security interest in all of its assets, including accounts receivable. The secured creditor need only file a single financing statement to have priority over unsecured creditors in all manifestations of income.187 As a result, most unsecured creditors can reach their debtor's income only through repeated levies on cash, a technique that is unlikely to result in the seizure of much cash.188

185 Debtors can assign wages, but such assignments are generally ineffective. See, e.g., In re Miranda Soto, 667 F.2d 235, 237 (1st Cir. 1981) (holding that "the assignment of future wages as security for a present debt does not constitute a lien within the meaning of the Bankruptcy Code," with the result that such assignments are dischargeable in bankruptcy); see also Unif. Consumer Credit Code § 3.305 (1974) (prohibiting assignments of wages in consumer credit transactions).

186 A debtor's earnings after the date of the filing of the bankruptcy case are property of the debtor and not "property ofthe estate" available to pay claims. 11 U.S.C. §§ 541(a)(6), 726(a) (1988). In cases under Chapter 7, the debtor keeps future earnings as part of his or her "fresh start." Some courts may restrain debtors from filing under Chapter 7 to compel them to devote some of their postfiling income to unsecured creditors in Chapter 13. See, e.g., In re Walton, 866 F.2d 981 (8th Cir. 1989); see also 11 U.S.c. § 707(b) (1988) (permitting dismissal of cases that are a "substantial abuse" of Chapter 7). Few courts effectively police Chapter 7 filings, so, generally speaking, debtors who wish to keep their postfiling earnings from prefiling creditors can do so.

187 The secured creditor's prefiled interest has priority regardless of when the collateral comes into existence or the unsecured creditors' liens attach. See, e.g., Texas Oil & Gas Corp. v. United States, 466 F.2d 1040, 1048 (5th Cir. 1972) (holding that secured creditor has priority under U.C.C. § 9-301 when security interest and judgment lien are perfected simultaneously in after-acquired property), cert. denied, 410 U.S. 929 (1973).

ISS Relatively little cash will be available in a troubled business. Once the debtor realizes the vulnerability of that cash to levy, the debtor can reduce both the amount of cash and its vulnerability. See, e.g., Vitale v. Hotel Cal., 446 A.2d 880 (N.J. Super. Ct. Law Div.) (allowing an unsecured judgment creditor who was having difficulty collecting to make successive levies on the cash receipts of a punk rock bar), aff'd, 455 A.2d 508 (N.J. Super. Ct. App. Div. 1982). Many debtors have no cash receipts because they operate



Nor can unsecured creditors reach the debtor's assets or cash flow by forcing the debtor into bankruptcy. Once a debtor is in bankruptcy, the reach of an Article 9 security interest will be limited.189 But these limits fall far short of any kind of "carve out" of a significant portion of future income for unsecured creditors. The funds freed from the Article 9 security interest tend to be consumed in administration of the bankruptcy case. Expenses of administration can be charged against the secured creditor's collateral only to the extent of the benefit to the holder of the security interest.190 In or out of bankruptcy, the ability of secured creditors effectively to encumber assets and cash flow is sufficiently effective that it is not useful to think of unsecured creditors as lending in reliance on either.

2. Cash-Flow Surfing in a Fully Encumbered World

How then, do creditors who lend unsecured expect to recover? The answer is that they expect to be paid in the ordinary course of business from the secured creditor's collateral, particularly the debtor's usually fully encumbered bank account.191 As the debtor's cash flow enters the business, the secured creditor's floating lien attaches instantly. The cash flow goes into the bank account and quickly emerges in the form of checks to unsecured

under blocked account or "lock box" arrangements with their secured financers. See infra note 191.

189 For example, the court may order on the basis of the "equities" that the secured creditor's interest in proceeds be limited. 11 U.S.C. § 552(b) (1988). An undersecured creditor's claim will remain fixed in amount over the course of the proceeding, thereby liberating the "use value" of the collateral. See United Sav. Ass'n v. TImbers of Inwood Forest Assocs., 484 U.S. 365 (1988).

190 11 U.S.C. § 506(c) (1988). 191 This point is clearest when the lending relationship is by means of a "blocked

account." The debtor deposits collections from accounts receivable into a bank account under the control of the secured creditor. The deposits are considered payments on the secured loan. The debtor pays its unsecured creditors with funds from the same account released by the secured creditor for that specific use. For an example of this arrangement, see K.M.C. Co. v. Irving Trust Co., 757 F.2d 752, 759 (6th Cir. 1985). Under a similar arrangement known as a "lock box" account, debtors are directed to send payment of their accounts to a post office box that, unknown to the debtors, is under the control of the bank. The bank then makes the funds available to the debtor to pay unsecured creditorsso long as it chooses to do so. For examples of cases involving "lock box" accounts, see Bel-Bel In1'l v. Barnett Bank, 158 B.R. 252 (S.D. Fla. 1993); Western Nat'l Bank v. U.S., 812 F. Supp. 703 (W.D. Tex.), aff'd, 8 F.3d 253 (5th Cir. 1993); McCormack v. First Westroads Bank, 473 N.W.2d 102 (Neb. 1991).



creditors. When the unsecured creditors receive the funds represented by those checks, with the consent of the secured creditor or at least without knowledge that the payment is in violation of the interest of the secured creditor, the unsecured creditors take free of the security interest.192 Thus formal legal priorities are blurred in the actual operation of the system193 and the unsecured creditor lends against a cash flow that the secured creditor can interrupt at its whim.194

This does not necessarily mean that the unsecured creditor lacks the ability to force payment. The unsecured creditor has in most states the somewhat precarious right to levy on fully encumbered collateral.195 At least if the sheriff is cooperative, the levy interferes with the continued operation of the debtor's business, providing sufficient leverage to extract a settlement.196 The right is precarious for two reasons. First, the unsecured creditor cannot collect anything by levying on and selling already fully encumbered collateral. The security interest survives the sale and entitIes its holder to foreclose against the buyer. When the debtor has no equity in the collateral, knowledgeable bidders will pay no more than nominal amounts at the execution sale and that will be all the unsecured creditor can collect.197 Second, a body of poorly devel-

192 See, e.g., 1.1. Case Credit Corp. v. First Nat'l Bank, 991 F.2d 1272 (7th Cir. 1993) (allowing a creditor paid from proceeds of secured creditor's commingled collateral to prevail over the secured creditor).

193 See Lynn M. LoPucki, A General Theory of the Dynamics of the State Remedies! Bankruptcy System, 1982 Wis. L. Rev. 311, 344.

194 A substantial portion of all loans is payable "on demand." See, e.g., Fed. Reserve Bull., Nov. 1993, at A76 tbl. 4.23 (showing that $16.1 billion of the $48.2 billion of commercial bank lending during the week of August 2-6,1993, was on demand). Article 9 contemplates that demand loans may be called "at any time with or without reason." U.C.c. § 1-208 cmt.; see also Kham & Nate's Shoes No. Tho v. First Bank, 908 F.2d 1351, 1356 (7th Cir. 1990) ("[W]e are not willing to embrace a rule that requires participants in commercial transactions not only to keep their contracts but also do 'more ... .' ").

195 U.C.C. § 9-311 & cmt. 1 (describing the purpose of the section as "[t]o make clear that in all security transactions under this Article, the debtor has an interest (whether legal title or an equity) which . .. his creditors can reach") (emphasis added).

196 The fact that the levy may interfere with the debtor's business operations makes this a dangerous remedy to employ. See Grocers Supply Co. v. Intercity Inv. Properties, 795 S.W.2d 225, 227 (Tex. Ct. App. 1990) (holding the levying unsecured creditor liable to the secured creditor for damages).

197 See Lynn M. LoPucki & Elizabeth Warren, Secured Credit: A Systems Approach 594-97,607 (forthcoming 1995) [hereinafter LoPucki & Warren, Secured Credit] (problem 26.3); Lynn M. LoPucki & Elizabeth Warren, Teacher's Manual for Secured Credit: A


1940 Virginia Law Review [VoL 80:1887

oped legal doctrine gives the secured creditor whose own debt is in default the right to recover the collateral from the sheriff who executed on behalf of the unsecured creditor and thereby prevent the sale, even when the value of the collateral may exceed the amount of the secured creditor's interest in it.198 This doctrine is poorly developed in that it does not address the crucial issue whether the secured creditor can claim possession only to foreclose or whether it can claim possession in order to return the collateral to the debtor for continued use in the business.199 If it can do only the former, unsecured creditors generally have a coercive collection remedy against businesses in financial distress. They can send the sheriff to seize key assets of the business, and the debtor can continue in operation only by paying them or coming to terms with them. If the secured creditor can claim possession from the sheriff to enable the debtor to continue in business, unsecured creditors are without a coercive collection remedy even in the absence of bankruptcy.z°o Friendly secured creditors can shelter their debtors from execution. That this issue remains largely unresolved suggests that the existence of a coercive collection remedy may not be central to the unsecured creditor's bargain.

With that in mind, I propose an alternative conception of the unsecured creditor's bargain that depends neither on a priority against liquidation value nor on the existence of a coercive collec-

Systems Approach (forthcoming 1995) [hereinafter LoPucki & Warren, Teacher's Manual] (problem 26.3).

198 See, e.g., Grocers Supply, 795 S.W.2d at 227 (holding an unsecured judgment creditor liable for seizure of collateral under a writ of execution); First Nat'l Bank v. Sheriff of Milwaukee County, 149 N.W.2d 548 (Wis. 1967) (holding that the secured party was not entitled to replevy collateral from the sheriff only because the debt to the secured party was not in default).

199 In one case, the court sided with the unsecured creditor, noting that the bank cannot refuse to exercise its rights under the security agreement, thereby maintaining [the debtor] as a going concern, while it impairs the status of other creditors by preventing them from exercising valid liens. Allowing [the bank] to do so would fly in the face of all Article 9, which is premised on the debtor's ability to exercise rights in the property.

Frierson v. United Farm Agency, 868 F.2d 302, 305 (8th Cir. 1989) (citing U.C.C. § 9-311). 200 Whether unsecured creditors have a coercive collection remedy differs from

jurisdiction to jurisdiction. In Florida, where I practiced for eight years, sheriffs routinely take possession of encumbered property pursuant to unsecured creditors' writs of execution. In Wisconsin, sheriffs rarely do so. Interviews with Wisconsin lawyers convinced me that the difference is not so much a difference in law as in legal culture.



tion right. The unsecured creditor expects to be repaid as the result of a combination of nonlegal pressures on the debtor. In short, if the debtor does not seasonably pay its unsecured creditors, that fact will be transmitted through credit reporting and other information channels to the debtor's secured creditors, employees, suppliers, customers and other trading partners. If the reports get bad enough, others will refuse to deal and the debtor will be unable to remain in business. In this conception, unsecured debt is likely to be short term and restricted to amounts that are small in relation to the creditor's portfolio.201 The unsecured creditor monitors the debtor through credit reports and other sources of information and evaluates the risk that the business will be discontinued. The unsecured credit will be short term because the extender's recourse, in the event it deems the risk too great, is to withdraw. The unsecured creditor will have the leverage to withdraw only so long as the debtor continues to value its reputation for payment. If the business closes, it is usually a foregone conclusion that the unsecured debt will not be repaid.202

3. The Legal-Theoretical Implications of Cash-Flow Surfing

Reconceptualizing the unsecured creditor's bargain as cash-flow surfing has several interesting implications. First, it explains why even sophisticated creditors are willing to lend unsecured. They lend because they believe that the debtor has both the ability and the motivation to repay its short-term debt. They do not insist on security, because the debtor has none to offer. The debtor's property is already encumbered beyond its liquidation value.

Why doesn't the unsecured creditor take a security interest anyway? Even a security interest in personal property not backed by collateral value would work an improvement in the creditor's remedy.203 As Professors James White and Homer Kripke have

201 In Dean Robert Scott's tenns, each due date or renewal date for the extension of credit would be an "adjustment choice[ ]" in a long·term relationship. See Robert E. Scott, Conflict and Cooperation in Long-Tenn Contracts, 75 Cal. L. Rev. 2005, 2039 (1987).

202 See Douglas G. Baird, Security Interests Reconsidered, 80 Va. L. Rev. 2249, 2256, 2263 (1994) ("[T]rade creditors know that they will be paid only if the finn survives as an ongoing concern .... [T]rade creditors typically receive nothing if the firm liquidates.").

203 Instead of having to obtain a judgment before effecting a remedy as an unsecured creditor, as a secured creditor it would be entitled to a prejudgment writ of replevin. See, e.g., Del's Big Saver Foods v. Carpenter Cook, 603 F. Supp. 1071 (W.D. Wis. 1985)



pointed out, the necessary direct costs of taking such an interest are triviapo4 They are large enough to prevent my colleague from taking security when he loans me ten dollars to buy lunch, but not large enough to prevent a supplier from taking security when it sells merchandise to the debtor as part of a continuing relationship. The immediate reason most debtors do not grant security to their suppliers is that their contracts with their secured lenders prohibit it?05 As to why the creditor with the first security interest should contract to prohibit another creditor taking a virtually worthless206 second, I can only speculate. That creditor may fear that if there are multiple liens, priorities may become uncertain. It may want to force the debtor to maintain an equity in the business or merely to prevent the debtor from taking on too much debt. It may rely on the debt limitation to provide it with an earlier warning of the debtor's financial difficulties. It may intend that the debtor breach the contract, be in default, and thus be more easily controlled. It may prohibit other liens as a means of simplifying the physical monitoring of tangible collaterapo7 It may prohibit them specifi-

(holding constitutional a replevin procedure that enabled secured creditor to file suit, obtain a writ of replevin, and dispossess debtor of the business that served as collateralall in a single day and without prior notice to the debtor), aff'd, 795 F.2d 1344 (7th Cir. 1986).

204 Kripke, supra note 5, at 959; White, supra note 7, at 490. Professor Schwartz asserts that the costs of taking security are significant. See Schwartz, Security Interests, supra note 7, at 12 ("Security interests are expensive, however, and seem substitutes only for the high cost version of monitoring-that is, policing for preventive purposes."). There is much disagreement on the point, principally because writers disagree as to what should count as costs. For example, Shupack argues that when the creditor's costs of acquiring the necessary information are taken into account, the cost of extending unsecured credit may exceed the cost of extending secured credit. See Shupack, supra note 7, at 1091-92.

205 See, e.g., Richard E. Speidel, Robert S. Summers & James J. White, Commercial Law: Teaching Materials 86-94 (4th ed. 1987) (containing a sample inventory security agreement that prohibits other liens).

206 The default rules under Article 9 contemplate only first security interests in collateral. Unless the first and second lenders agree otherwise, the first lender can render a second lender unsecured in bankruptcy simply by making additional advances to the debtor. Even though the first lender makes the advances with full knowledge that they will render the second lender unsecured, the additional advances have priority over the second lender's interest. U.C.C. § 9-312(5), (7). The advances can push the second lender's interest above the value of the collateral and an ensuing bankruptcy can then render it unsecured. See 11 U.S.C. § 506(a) (1988).

207 That is, if there are no other security interests in property of the debtor, the secured creditor arguably is warranted in assuming that whatever fits the creditor's description of collateral and is in the debtor's possession is its collateral. The assumption is not



cally to bar competing creditors from the more effective remedies of secured creditors208 or to prevent risk alteration.209 Whatever the reason, the first lender's desire to bar other liens seems to have overpowered the unsecured creditor's desire for a subordinate and in some ways worthless security interest.

A second important implication of my reconceptualization of the unsecured creditor's bargain is that the unsecured creditor is dependent on credit reporting. The unsecured creditor does not monitor assets with a clipboard and a list of serial numbers. It monitors the vital signs of the debtor's business from a Dun & Bradstreet report.210 A credit report showing that the debtor has granted security, at least if the grant is in favor of an already existing creditor, signals not the debtor's financial strength, but its slide toward bankruptcy.211 Sometimes the poor financial health of a business will be visible on the premises in the form of low inventories or poor maintenance. But just as often it will not. The premises will look the same with a security interest on them as without. The sophisticated unsecured creditor will learn of the

necessarily warranted, because property in the debtor's possession may be owned by a third party.

203 Professor Schwartz proposes yet another explanation. "Initial secured parties say they regulate later security to avoid being pressured by junior lienors to foreclose when the debtor is in difficulty. Rather, the seniors want the power themselves to decide whether the debtor should be allowed to continue in business or not." Schwartz, supra note 8, at 217. This explanation does not seem convincing. Unsecured creditors can pressure initial secured parties to foreclose. If the secured parties do not, the unsecured creditors can levy, thereby becoming junior lienors. The seniors' only remedy is to foreclose. Thus the explanation is in essence that they demand the right to foreclose sooner in order to avoid being pressured to foreclose later.

209 See Hideki Kanda & Saul Levmore, Explaining Creditor Priorities, 80 Va. L. Rev. 2103, 2108-11 (1994).

210 See Charles W. Mooney, Jr., The Mystery and Myth of "Ostensible Ownership" and Article 9 Filing: A Critique of Proposals To Extend Filing Requirements to Leases, 39 Ala. L. Rev. 683, 762 n.301 (1988) ("For example, standard Business Information Reports issued by Dun & Bradstreet Inc. always include information on public filings, including Article 9 filngs, against the debtor covered by the report. This information provides important signals to existing and prospective unsecured trade creditors .... "); David M. Phillips, Secured Credit and Bankruptcy: A Call for the Federalization of Personal Property Security Law, L & Contemp. Probs., Spring 1987, at 53, 79 ("Trade creditors do rely upon firms in the business of assessing credit risk such as Dun and Bradstreet. And, indeed, these credit institutions do search filing systems, and their dicoveries are among the important data transmitted to trade creditors in their credit ratings of various debtors.").

211 See supra notes 172-80 and accompanying text.



security interest not through a U.c.c. search but through credit reporting. It will consider the grant of security it discovers, along with other information about the debtor's business, in deciding when to withdraw from the lending relationship.

The recognition that unsecured creditors depend heavily on credit reporting highlights one of the important ways in which the seemingly neutral scheme of Article 9 discriminates against unsecured creditors. Article 9 creates and mandates participation in an elaborate filing system designed to serve the information needs of secured creditors. That is, Article 9 requires the inclusion of the kinds of information needed by secured creditors, but it does not require the kinds of information needed by unsecured creditors.212

In at least one instance, Article 9's failure to provide for the information needs of unsecured creditors inflicts so obvious and egregious an injury that it cannot be ascribed to mere negligence on the part of the drafters of Article 9. My reference is to Article 9's treatment of execution sales by subordinate lien creditors. The successful bidder at an execution sale takes subject to prior security interests.213 Without knowing the amounts of those interests, a prospective bidder cannot even estimate the amount it should bid. Yet Article 9 does not include either lien creditors or bidders as persons entitled to discover the amount that the debtor owes to its secured creditor.214 Moreover, Article 9 blocks the drafters of the execution laws from solving the problem by requiring such discovery.215 Article 9 expressly permits the prior secured lender to

212 See Baird, supra note 143, at 55. For example, unsecured creditors typically want to know the amount of the earlier secured creditor's line of credit and the amount currently drawn against the line. To require that secured creditors make such information available would require a different kind of filing system, but that is precisely my point.

213 The scheme of most execution statutes is the same as the scheme of U.C.C. § 9-504(4). Sale "discharges the [lien] under which it is made and any security interest or lien subordinate thereto." Id. Senior liens survive the sale.

214 U.C.C. § 9-208 is the only provision of Article 9 that compels secured creditors to disclose information beyond the skeletal facts that appear in the financing statement. The comment explains, "This section gives the right to demand disclosure only to the debtor, who will typically request a statement in connection with negotiations with subsequent creditors and purchasers .... " U.C.C. § 9-208 cmt. 2. The only other categories of persons referred to in the comment are "casual inquirer[s]" and "competitor[s]." Id.

215 Given that the same legislature enacts both the execution laws and Article 9, some readers might question my assignment of blame to the Article 9 drafters. But to regard



increase the amount owing under its security interest through the likely date of the execution sale, even if the secured lender knows that an unsecured creditor has levied and a sale is pending.216 As a result, bidders could not rely on any disclosure the secured creditor was compelled to make under the execution laws.217 Only a statute that reverses the U.c.c. rule regarding the priority of advances made after execution would solve the problem.218 Article 9's dysfunctional rule regarding the priority of secured creditors' future advances renders it impossible to design a functional system for unsecured creditors' execution and sale.

The third important implication of my reconceptualization of the. unsecured creditor's bargain is that it shows the futility of trying to reproduce the unsecured creditors' state law entitlements in bankruptcy. The impetus for trying comes from the highly influential work of Professors Douglas Baird and Thomas Jackson. At the time they wrote on the subject, Baird and Jackson conceived of unsecured credit as merely a claim against assets, the entitlement to whatever value remained after provisions had been made for full payment to secured creditors. They thought that a bankruptcy system that protected only the "substantive" "rights against assets" of unsecured creditors would give unsecured creditors in bankruptcy all that they were entitled to under nonbankruptcy law.219 Baird

both sets of laws as made by the same group is to ignore the reality of the state legislative process. Except with regard to a few points raised by organized interest groups, legislatures accept Article 9 as it is handed to them by the American Law Institute and the National Conference of Commissioners on Uniform State Laws.

216 See U.C.C. § 9-301(4) (subordinating the execution lien to advances made by a prior secured party, provided that the advances are made within 45 days after the execution lien comes into existence). In most states, the execution lien comes into existence upon levy and the execution sale is held within 45 days of that time. Consequently, in a typical situation, the secured party could make a secret advance while execution sale bidding was in process and the buyer at the sale would take subject to the security interest in an amount that included the secret advance.

217 See LoPucki & Warren, Secured Credit, supra note 197, at 660-61 (problems 29.3, 29.4); LoPucki & Warren, Teacher's Manual, supra note 197 (problems 29.3, 29.4).

218 In some cases, a debtor might disclose the amount owing against the collateral in the hopes of encouraging bidding at the sale. In my experience, that seldom happens. For strategic reasons, many debtors do not want to encourage bidding at the sale. Their disclosures would not be very credible anyway.

219 Douglas G. Baird & Thomas H. Jackson, Corporate Reorganizations and the Treatment of Diverse Ownership Interests: A Comment on Adequate Protection of Secured Creditors in Bankruptcy, 51 U. Chi. L. Rev. 97, 103 (1984).



and Jackson's purpose in seeking to reproduce nonbankruptcy entitlements in bankruptcy was to eliminate artificial incentives for shifting cases from nonbankruptcy to bankruptcy forums, that is, forum shopping.220

With an understanding of the cash-flow surfer's bargain, the fallacy in Baird and Jackson's argument becomes apparent. Under nonbankruptcy law, cash-flow surfers have no substantive rights of any significance.221 They rely on procedural rights, such as the right to execute, and extralegal pressures. Through its automatic stay, bankruptcy deprives the unsecured creditors of both.222 If Baird and Jackson were to succeed in eliminating the rights of unsecured creditors that are unique to bankruptcy, unsecured creditors-whose leverage is considerable as long as the business continues to operate outside bankruptcy-would in bankruptcy have no leverage at all. The change would increase the artificial incentives secured creditors already have to forum shop.223 To neutralize those incentives, one would give cash-flow surfers leverage while their debtor operates in bankruptcy that is comparable in magnitude to the leverage they have while their debtor operates outside bankruptcy.

The unsecured creditors' loss of power when the case moves to bankruptcy is not merely temporary. Through bankruptcy procedure, skilled lawyers for the debtor and the secured creditor can

220 See id. Baird later returned to the issue, for the most part repeating the assertion that nonbankruptcy priorities should apply in bankruptcy even though the procedures of bankruptcy are different. Douglas G. Baird, Loss Distribution, Forum Shopping, and Bankruptcy: A Reply to Warren, 54 U. Chi. L. Rev. 815, 822-28 (1987).

221 I ignore the right of cash-flow surfers to take what is left over after secured creditors have been paid in full because that right is worthless and was recognized as such when the bargain was struck.

222 See 11 U.S.C. § 362(a) (1988). 223 Some may find surprising my assertion that secured creditors have substantial

incentives to move cases into bankruptcy. The bankruptcy forum purports to exist principally for the benefit of unsecured rather than secured creditors. See, e.g., In re Lundborg, 110 B.R. 106, 109 (Bankr. D. Conn. 1990) ("A trustee is the fiduciary of all of the creditors of a bankruptcy estate, but owes a primary duty to unsecured creditors."). But which interests bankruptcy serves in a particular case depends on the situation. For a catalogue of the benefits to secured creditors from bankruptcy, see LoPucki, supra note 68, § 3.3. Outside of bankruptcy, unsecured creditors can use procedural ploys and extralegal pressure to compete with secured creditors for their collateral. In bankruptcy, the court prevents such creditors from doing so, essentially conceptualizing their bargain as nothing more than a very low priority in assets.



"wash" the assets of claims in excess of their liquidation value through the mechanism of a bargain sale of the business to the old owner for a price equal to the liquidation value of the collateral.224

Although the bargain transfer scheme is older than the bankruptcy laws that continue to permit it,225 the inefficiency and stigma associated with it formerly confined its use to a few unusual cases. As bankruptcy has become more efficient and increasingly routine, it has become more and more apparent that a bankruptcy scheme that enforces the priorities of nonbankruptcy law without its procedures is not the unsecured creditor's remedy, but its nemesis.

C. Justifying the Subordination of Unsecured Creditors: Three Bad Theories and One Not So Bad

For several decades, scholars have treated expanded credit as patently desirable and security as the preferred mechanism for expanding it. In Part I of this Article, I demonstrated that security is merely a set of collection rights,226 the exalted227 status of which never has been justified and probably never can be. That does not mean that we should rush to abolish it, however. Security is so ingrained in the legal and popular culture that it may not be worth uprooting. Parties are free to contract out of most aspects of security. Only the aspects of security that are deceptive, misleading, or involuntary are harmful. It is to those aspects that the movement for reform should be directed.

In this Section, I propose, in general terms, two preliminary steps in that reform. The first is to employ familiar standards of contract law, as the Colorado Court of Appeals did in the recent case of Ninth District Production Credit Ass'n v. Ed Duggan, Inc. ,228 to determine whether and to what extent a particular security agreement should bind a particular unsecured creditor. Specifically, I propose that a security agreement should bind an unsecured credi-

224 I describe the bargain transfer scheme at length in LoPucki, supra note 68, § 11.11.2. 225 See Theodore Eisenberg, Baseline Problems in Assessing Chapter 11, 43 U. Toronto

L.J. 633, 636-48 (1993) (discussing equity receiverships). 226 See LoPucki & Warren, Secured Credit, supra note 197, at 1; supra notes 131-40 and

accompanying text. 227 Barkley Clark, The Law of Secured Transactions Under the Uniform Commercial

Code 'lI 1.02[3] (rev. ed. 1993) ("The position of the secured party with a properly perfected security interest is an exalted one.").

228 795 P.2d 1347 (Colo. Ct. App. 1990), rev'd, 821 P.2d 788 (Colo. 1991).


1948 Virginia Law Review [VoL 80:1887

tor only if and to the extent that a reasonable person in the position of the unsecured creditor would have expected to be bound at the time that person extended credit?29 The unsecured creditor's bargain should be an express or implied agreement in fact. The second step should be to modernize the Article 9 filing system to serve the needs of all who are to be bound by the terms of the security agreement.

Under current law, the security agreement binds the parties, purchasers of the collateral, and creditors, including unsecured creditors, "[e]xcept as otherwise provided by [the U.C.C.]."230 That is, absent a specific provision of Article 9 to the contrary, any security agreement, no matter how bizarre, unreasonable, or unexpected, will bind unsecured creditors, whether they extend credit before or after the security agreement is made. Thus, under current law, unsecured creditors can be bound to security agreements the existence of which they cannot discover, even through reasonable diligence.231 They can be bound to terms that are manifestly unreasonable, even if the debtor misrepresents or fraudulently conceals those terms from them.232

229 This would bring Article 9 into accord with both the general rules of contract, see Calamari & Perillo, supra note 124, § 2-2, at 27 ("[A] party's intention will be held to be what a reasonable man in the position of the other party would conclude his manifestation to mean."), and the bankruptcy rules regarding a secured creditor's accrual of postpetition interest and attorney's fees, see 11 U.S.C. § 506(b) (1988) (allowing recovery of postpetition interest and attorney's fees only to the extent "reasonable"); In re Terry Ltd. Partnership, 27 F.3d 241 (7th Cir. 1994) (reviewing the reasonableness of the default rate of interest provided in a secured creditor's contract).

230 U.C.C. § 9-20l. 231 For example, they can be bound to security interests that are perfected without filing.

See U.C.C. § 9-302(1). For a discussion of interests that are effective even though they cannot be discovered through reasonable diligence, see LoPucki & Warren, Secured Credit, supra note 197, at 429-53. For a discussion of the difficulty of discovering those that are filed, see Lynn M. LoPucki, Computerization of the Article 9 Filing System: Thoughts on Building the Electronic Highway, Law & Contemp. Probs., Summer 1992, at 5, 6 ("Many kinds of filings are effective even though they are, as a practical matter, impossible for searchers to discover .... ").

232 See, e.g., Consolidated Foods Corp. v. Pearson, 178 N.W.2d 223 (Minn. 1970). In that case, the debtor's principals were held personally liable for fraudulently concealing the fact that the assets of the corporation were encumbered. Id. at 225. The secured creditor was not a defendant and the case does not even mention what efforts the secured creditor had made to alert prospective unsecured creditors to the true situation. The case illustrates that if a secured creditor's lien is technically perfected, the reasonableness of the secured creditor's actions cannot, under current law, be an issue. The secured creditor wins.



The bases on which defenders of the current law justify these startling propositions are essentially three: (1) the adage that everyone is presumed to know the law, (2) the concept that a grant of security is a conveyance of property, and (3) economic theory that views secured and unsecured creditors as competitors in a market for the extension of credit. All three justifications are seriously flawed.

1. The Presumption That Everyone Knows the Law

The adage that everyone is presumed to know the law appears to have originated with William Blackstone.233 Few, if any, assert that the adage is true. Rather, it survives as an acknowledged fiction, justified on grounds of necessity:

If the presumption of universal knowledge [of the law] is to be justified, it can't be because it's true. People don't know the law. Why do we pretend that they do? We pretend chiefly because we think that we couldn't run a legal system without this pretense. If we could enforce only laws that people knew, the law would become totally subjective. Each person would be subject only to those laws that were in her head. In the United States, we would have 250 million different legal systems.234

Every unsecured creditor is presumed to know the provisions of Article 9. The direct result is to render unsecured creditors subject to the provisions of Article 9, whether they anticipate its existence or not. One of those provisions, V.C.c. section 9-201, makes any lawful provision in a security agreement entered into between a debtor and a secured creditor effective against all unsecured creditors. Thus, the indirect result of presuming that everyone knows the law is to provide justification for implying into every agreement between a debtor and an unsecured creditor the terms of a security agreement that the unsecured creditor has not even the right to see.235 The essence of the justification is that, because the unsecured creditor is presumed to know that various terms legally can be included in a security agreement, the unsecured creditor

233 4 William Blackstone, Commentaries *27 ("[A] mistake in point of law, which every person of discretion not only may but is bound and presumed to know, is in criminal cases no sort of defence.").

234 James Lindgren, The Lawyer's Fallacy, 68 Chi.-Kent L. Rev. 109, 112 (1992). 235 See supra note 212 and accompanying text.



should have anticipated that they might be. To illustrate this indirect effect of the presumption, assume Debtor grants a security interest in its business in favor of Secured. Later, Secured calls the loan without advance notice or reason, interrupting the cash flow upon which the unsecured creditors were surfing. The business fails, Debtor files bankruptcy, and a trustee is appointed to represent the unsecured creditors. Whether the unsecured creditors acting through the trustee have a cause of action against Secured probably depends on the terms of the agreement between Debtor and Secured. If Debtor agreed that the loan was payable "on demand," Debtor waived its right to question the reasonableness of the call236 and effectively foreclosed the unsecured creditors from doing so later. Thus an indirect effect of the presumption that every unsecured creditor knows Article 9 is that rights of the unsecured creditor are determined by the agreement between the debtor and the secured creditor, including agreements entered into after the unsecured creditor'S extension of credit.

Binding each person to only the laws in that person's head is not the only alternative to presuming that everyone knows every application of Article 9. The intermediate ground is to bind them only to that which is reasonable for them to have known or anticipated. That standard would give secured creditors the incentive to communicate unexpected terms that they wish to impose on unsecured creditors without imposing on them the obligation to communicate all terms in every case. If the secured creditors did not communicate the unexpected terms, they would not be binding. Unsecured creditors would have an incentive to be open to communication because once the secured creditor took reasonable steps to communicate particular terms, the terms would be binding regardless of whether the unsecured creditor actually learned of them. In the regime I propose, important terms buried in a long security agreement might not be considered "communicated" even if the security agreement was recorded in the public records. Terms not even discussed between the parties might be considered communicated if

236 See u.c.c. § 1-208 cmt. (stating that section requiring good faith in accelerating payment "has no application to demand instruments or obligations whose very nature permits call at any time with or without reason").



they were what both parties expected.237 Terms could also be communicated off the record. In some situations, the amount in issue would be too small to justify the expense of communication between secured and unsecured creditors. In such situations, the lack of communication would not indicate that either side had acted unreasonably, and implied contract doctrine would be indeterminate. That is, the facts would not support the inference that either side had agreed to the other's terms, and the rule would provide no basis for decision. To specify an appropriate basis for resolving such situations is beyond the scope of this Article, but there is no reason to believe that resolution of this detail would affect the workability of the overall system.

Communication from a secured creditor to voluntary unsecured creditors cannot take place in "real time" because secured creditors have no reliable way of knowing who might be contemplating an extension of credit to their debtor.238 To reach unsecured creditors before they make advances, secured creditors would have to make a public deposit of the information in what would amount to a filing system. For the Article 9 filing system to serve that need, important changes would be necessary. The system would have to implement modem technology so that its transparency and ease of use would approach that of a good computer bulletin board.239 Messages would have to be electronically transferrable. Permissive filing would have to be expanded to include a variety of information currently available from off-record sources.z40 Most importantly, the system would have to meet the needs of cash-flow surfers for information on matters such as the default status of the loan, the remaining balance available under a line of credit, and the secured creditors' intentions with regard to calling the loan. For such a system to work, it would not be necessary for all voluntary unsecured creditors to conduct searches. Probably most would continue to rely on credit reporting agencies that search for the

237 The essential difference between this proposed rule and current law is that the proposed rule would make the expectations of parties an empirical fact to be proven at trial by the party who would rely on it. Current law proclaims and enforces what the parties are supposed to expect without regard to their actual expectations.

238 See LoPucki & Warren, Secured Credit, supra note 197, at 367-68. 239 See LoPucki, supra note 231, at 15-31. 240 See id. at 31-36.



relevant information, extract it, and forward it to the unsecured creditors.

2. The Property Theory

The prevailing legal theory as to the terms of the unsecured creditor's bargain starts from the premise that security is property.241 When a debtor conveys a security interest in its automobile, it conveys the value of the automobile to the extent of the debt. An unsecured creditor cannot reach that value after the granting of the security interest for the simple reason that the debtor no longer owns it. If the amount of the debt for which the debtor grants security exceeds the value of the collateral, the effect on the unsecured creditor is almost the same as if the debtor had sold the car.

The property theory may seem innocuous as applied in the example of the automobile. But it seems less so when the property conveyed is property that the debtor does not yet own but expects to purchase on unsecured credit or is a procedural right under the security agreement such as the right to call the loan at any time for any reason satisfactory to the secured creditor.242 If the right to call the loan is "property" that the debtor conveyed to the secured party before the unsecured creditor came on the scene, it is difficult to see what objection the unsecured creditor can have to the later enforcement of this right.

The bargain in Jackson and Kronman's economic model was a three-party bargain. Although the unsecured creditor's agreement was inferred disingenuously from the circumstances, it was nonetheless considered necessary. The property theory dispenses with even the pretense of unsecured creditor agreement. Instead, the unsecured creditor is treated as having bought from someone other than the owner. The debtor had nothing it could convey to the unsecured creditors because it had already conveyed everything to

241 See Bowers, supra note 7, at 59 n.85 ("The Bankruptcy Code does not accord a priority to secured lenders. It simply refuses to distribute other people's property to the creditors of the debtor but instead distributes property to those who own it."); Harris & Mooney, supra note 4, at 2052 ("Because security interests are property, any general theory of the law of secured transactions must emanate from theories of property law.").

242 At least some courts will enforce such an agreement. See, e.g., Kham & Nate's Shoes No. Two v. First Bank, 908 F.2d 1351 (7th Cir. 1990).



the secured creditor. To illustrate the extreme nature of the property theory, under it a newborn baby with a malpractice claim against the delivering physician would be bound by the physician's previous grant of all the physician's assets to the bank as security for a loan?43 That the baby did not, and could not, contract for subordinate status is irrelevant. The baby's rights, if any, will be under the law of fraudulent conveyances.

Because the unsecured creditor's consent and expectations are irrelevant under the property theory, the secured creditor has no incentive to communicate the nature of its interest to the unsecured creditor except through the minimum filing required by law. The secured creditor actually has an incentive to avoid contact with the unsecured creditor; contact can result in liability?44

The property theory is constructed on the premise that a debtor has the right to convey all or any part of its property. It follows from this premise that a debtor can convey a security interest while retaining ownership of the collateral. The property theory stumbles because the premise is incorrect. There is no general rule giving an owner of property the right to divide and convey its property in any way the owner sees fit. Some ways are deceptive and therefore not permitted.

The concept of a self-settled spendthrift trust provides an example closely analogous to a security interest. To see the analogy, consider the argument of a solvent debtor who seeks to self-settle a spendthrift trust. The debtor regards its wealth as consisting of two sets of rights. One set permits the debtor to own and use the property and to sell it for cash. The other set permits the debtor to commit the property prospectively to the payment of creditors. By

243 See V.C.C. § 9-201 (stating that "a security agreement is effective according to its terms").

244 The Colorado Supreme Court stated: Where a secured creditor does not itself initiate or encourage the transaction that creates the unsecured obligation giving rise to the unjust enrichment claim, retention of any benefit realized by the secured creditor without compensating the supplier is not unjust ....

. . . A secured creditor can protect itself from unjust enrichment claims by remaining uninvolved.

Ninth Dist. Prod. Credit As3'n v. Ed Duggan, Inc., 821 P.2d 788, 797-98 (Colo. 1991) (footnote omitted).



self-settling a spendthrift trust of the property, the debtor seeks to retain the first set of rights while alienating the second set by transferring them to the trustee. If the transfer were successful, future creditors could not levy on the property because the debtor no longer owned the right to commit (that is, lose) the property to them. The law does not permit self-settling of spendthrift trusts because the conveyance would leave the debtor in a condition likely to deceive its future creditors.245

From the standpoint of an injured third party, a grant of security has essentially the same effect as a self-settled spendthrift trust. The grant of security leaves the debtor with use and ownership of the property, but without the ability to commit the property to unsecured creditors. A grant of security, like a self-settled spendthrift trust, is likely to deceive the debtor's future creditors.246

3. The Economic Theory

Jackson and Kronman's explanation of the economic basis of secured financing illustrates two important conventions employed in economic theory. The first is the inference that persons who extend credit to a debtor have agreed to whatever consequences the law attaches. The second is the assumption that those persons contract with perfect information. Thus, Jackson and Kronman attempt to explain the apparent unfairness of permitting a debtor "to make a private contract with one creditor that demotes the

245 George Bogert states: [A] property owner may not create a spendthrift trust in his own favor .... To hold otherwise would be to give unexampled opportunity to unscrupulous persons to shelter their property before engaging in speculative business enterprises, to mislead creditors into thinking that the settlor stilI owned the property since he appeared to be receiving its income, and thereby to work a gross fraud on creditors who might place reliance on the former prosperity and financial stability of the debtor. In some cases there would be an actual intent to defraud or hinder creditors but it would be secret and could not be proved.

George T. Bogert, Trusts § 40, at 155-56 (6th ed.1987). All of these reasons seem to apply equally to the grant of a security interest.

246 In response to this analogy, defenders of security typically assert that the security interest is different because the secured creditor lent money to the debtor in exchange for it. By focusing on the equities applicable to the secured creditor, this response misses the point that spendthrift trusts and security interests are equally likely to deceive persons who later deal with the debtor. Altering security to make it less deceptive would not harm secured creditors; they would still have the choice whether to lend. The policy should focus on protecting those who lack the opportunity to protect themselves.



claims of other creditors" and that "increases the riskiness of other creditors) claims"247 by asserting that "these other creditors will be aware of this risk and will insist on a premium for lending on an unsecured basis."248 Jackson and Kronman do not mean that all unsecured creditors will be aware of the risk and charge the premium. Nor do they mean that only those who are aware of the risk and charge the premium should be bound to the contract. They are simply following a convention of economics that permits the modeler to charge all participants in a market with knowledge that only some have.

There are at least two explanations for this convention. The first) which I have already discussed, is a belief that under otherwise perfect market conditions) the market will reach the same efficient market price even though some participants are ignorant.249

As I have already pointed out, this argument is based on the further assumption that the uninformed can freeride on the informed, an assumption that is not true of most markets for unsecured credit.250

The second explanation for the convention is the common economic assumption that markets "learn."251 That is, if uninformed unsecured creditors underestimate the risks, they will underprice unsecured credit and suffer losses. Either they will discover their mistake and adjust or they will go bankrupt and be replaced by participants who charge sufficiently high rates. Over the long run, the market will approach an equilibrium in which even those who have no idea why they are doing it will charge sufficiently high

247 Jackson & Kronman, supra note 5, at 1147. 248 Id. at 1148. Essentially the same argument is made by Schwartz, supra note 8, at 210,

and by Buckley, supra note 7, at 1397 (acknowledging that this version of the irrelevance proposition holds only on the assumption of perfect markets).

249 See, e.g., Schwartz, Security Interests, supra note 7, at 36 ("[M]arkets can work well in the face of substantial numbers of uninformed persons.").

250 See supra notes 126-27 and accompanying text. 251 See, e.g., Buckley, supra note 7, at 1410-11 ("In time, no doubt, [unsecured creditors]

learned the painful lesson, and a new equilibrium was reached."); Schwartz, Security Interests, supra note 7, at 7 (assuming as part of a model that creditors "can learn of and react to the existence of security"). But see Shupack, supra note 7, at 1084-85 ("Once one realizes that ignorant creditors exist who, by definition, will not adjust their claims in response to the new market created by Article 9's transactional efficiencies, the vee can be seen as having a dark side.").



rates.252 To the extent that they are accurate in their assumptions, either of these theories warrants attributing to all market participants knowledge that few or none may actually have.

Real markets do not necessarily learn253 or reach the equilibrium price that perfect markets would reach. The nature of the markets for unsecured credit make market failures particularly likely. Each borrower represents a unique risk, requires separate assessment, and is therefore a separate market. The problem facing a trade creditor, for example, is not what interest rate to charge, but to whom to extend credit and in what amounts. In doing so, the creditor is deciding what markets to enter. Such micromarkets are likely to move very slowly toward their equilibriums and the circumstances that determine the equilibriums are highly likely to change before the markets reach those equilibriums. A sophisticated repeat player in these markets should be able to balance the possibilities of underestimating and overestimating the risks of loss in the aggregate. But the markets for unsecured credit are dispersed and constantly in the process of assimilating newcomers. At any given time, there will be a substantial number of players who are unsophisticated. The argument I present here was perhaps best expressed by P.T. Barnum when he said that "there's a sucker born every minute." With a constant flow of new suckers, and poor information flows, there is no a priori reason why the markets for unsecured credit cannot persistently underestimate the risk, resulting in a permanent subsidy to borrowers.254

A story, which I call the "Parable of the Pit," illustrates the limits on market learning. A town (the secured creditor) persuades the legislature to permit it to dig a large pit (Article 9) in the middle of a nearby state highway (commerce) without posting any warning

252 Buckley, for example, essentially makes this argument. Buckley, supra note 7, at 141O-1l.

253 Consider the example of a vending machine that takes in money but does not deliver the goods. If the location of the machine is sufficiently remote from the offices of those who accept complaints about it and users of the machine do not discuss it among themselves, then no complaints may be made and the machine can turn profits indefinitely.

254 It is no answer to say, as one of my economically inclined colleagues has, that if such a subsidy exists the trade creditors ought to become borrowers and take advantage of it. To reap the "benefits" of this subsidy, one must borrow money, lose it in a bad business, and fail to repay it. The subsidy is not part of a phenomenon in which wealth is transferred, it is part of one in which wealth is destroyed.



signs. On the morning after the pit is dug, cars begin falling into the pit. The occupants (unsecured creditors) are killed and the town takes their valuables as a source of revenue. The story is reported in newspapers, the public is outraged, and legal scholars begin to debate the "efficiency" of the pit. The economists assert that the pit is not a problem because (1) the public will learn not to use the highway where the pit is located and (2) members of the public who do continue to use the highway should suffer the consequences because without consequences there is no incentive to learn. Through media coverage and coffee break conversation, the public becomes intensely aware of the pit's existence. The flow of cars into the pit slows to a trickle, now consisting mostly of people whose level of social awareness is low and people who actually know of the pit but have a brief memory lapse. A prominent Yale professor of Law and Economics opposes the expenditures necessary to post warning signs because not many people are "incompetent" enough to fall in the pit and that the harm from their victimization is "slight." Eventually the flow stabilizes, the town derives a modest but steady subsidy from it, and the difference between the public ( the market) learning and all members of the public (all participants in the market) learning becomes apparent. Market learning fails to eliminate the subsidy.

Because imperfect markets that are assumed to be perfect can generate such subsidies without acknowledging them, the economic justification for security is dangerous. The theory with which I would replace it does not assume that unsecured credit is granted at appropriate rates. Instead my theory attempts to ensure that unsecured credit is. It does so by creating incentives for actual communication between secured and unsecured creditors.

Without such communication, a knowledgeable unsecured creditor may be able to protect itself by charging a risk premium when it extends credit. But the risk still exists and its existence constitutes an inefficiency in the system.25S If an effective communication sys-

255 The fact that an unsecured lender ("C") charges enough for credit in the aggregate does not in itself ensure efficiency. To illustrate, assume that, as between two possible debtors ("Dl" and "D2"), Dl is a better credit risk than D2 but that C must extend credit to both on .the same terms because C lacks the information to distinguish between them. Regardless of the price of the credit, either Dl will get credit at an inappropriately high



tern forces the secured creditor to make disclosure, the risk may be eliminated. There will be fewer bad extensions of credit.

Whether the communication will eliminate enough bad extensions to be worth the cost is an empirical question. But, based on casual observations of bankruptcy schedules over the past twentythree years, I expect that the answer will be yes. It is my impression that a very large proportion of the losses suffered by unsecured creditors in bankruptcy are not the result of known risks gone bad but the result of extensions of credit made in ignorance of information that would have been supplied through a better information system.256

In her commentary, Professor Block-Lieb advocates disclosure of at least some of the kinds of information that cash-flow surfers need. She proposes, however, that disclosure of the information be mandatory and in categories fixed by law. That system, I fear, would lead to overdisclosure in many cases and underdisclosure in others. The rule of reason that I propose encourages secured creditors to estimate whether the benefits from particular kinds of disclosure will exceed the costs and to act on their estimates.

4. The Implied Contract Theory

Aside from its treatment of involuntary creditors, the principal difficulty with the law of secured transactions and the practices that have arisen under it is that they are deceptive. Repeat players may be able to cope with the deception by increasing the price of credit or restricting its availability. But casual extenders of credit can be expected systematically to underestimate the risks, extend too much credit on terms too favorable to debtors, and thereby misallocate resources. In perfect markets, ignorant extenders of credit can simply follow the market in their decisions as to pricing and

rate or D2 will get credit at an inappropriately low one. There will be either too little credit available to Dl or too much to D2.

256 That is, if one examined the schedules filed by bankrupt debtors, one would find a substantial number of creditors who extended credit at a time when no rational person who was aware of the facts would have done so. To illustrate, there is usually a period of time, ranging from a few days to several months, between the time when a debtor decides to file bankruptcy and the time when the debtor actually does so. During that period, a debtor often is able to continue to obtain credit, because those extending it are unaware of the debtor's decision to file.



availability of credit. But in real markets, deceptive rules and practices inevitably and predictably generate victims.

Each of the three theories previously discussed provides a basis for the trier of fact to ignore the reasonableness of the conduct of those who deceive or are deceived through the institution of security. Implied contract theory takes the opposite approach. It invites the voluntary unsecured creditor to prove that its expectations about security were reasonable for a person in its position. In anticipation of that proof, secured creditors should attempt to make known ex ante the true nature and extent of their claims to priority. If, for example, they intend to claim the right to afteracquired property against which they have made no advances, they presumably will say so in terms that the suppliers of that property will understand. Voluntary unsecured creditors will be encouraged to seek information, both by its greater availability and by the threat that their failure to listen might later be used as evidence against them. Both sides will have an incentive to prove their reasonableness and, in anticipation of doing so, will tend to become more reasonable.

Although the implied contract theory I propose here was ultimately rejected by the Supreme Court of Colorado in Ninth District Production Credit Ass'n v. Ed Duggan, Inc. ,257 that case illustrates some of its implications. The Ninth District Production Credit Association ("PCA") held a security interest in all of the assets of a cattle feedlot business owned by the debtor.258 PCA collected the debtor's revenues and paid its expenses with sight drafts.259 While PCA was deciding whether to call the loan or allow the debtor to pursue an opportunity to sell the business, PCA authorized the debtor in writing to continue to buy corn on credit from Duggan, an unsecured feed supplier, and feed it to cattle subject to PCA's security interest.26o PCA communicated this authorization only to the debtor, but the debtor disclosed it to Duggan. On the basis of the authorization, Duggan sold corn to the debtor over a period of several months. Eventually, PCA called the loan,

257 821 P.2d 788 (Colo. 1991). 25S Id. at 790. 259 Id. at 790-91. 260 Id. at 792-93.



sold the cattle for its own benefit, and refused to pay Duggan for the corn.261

The trial court instructed the jury that it should find for Duggan if Duggan proved that (1) it delivered the com "with the reasonable expectation" that PCA would pay, (2) the delivery "conferred a benefit" on PCA, (3) PCA appreciated the benefit, and (4) PCA accepted it "under such circumstances that it would be inequitable" for PCA to retain it without paying for it.262 The jury found in favor of Duggan, the trial court entered judgment on the verdict, and the Court of Appeals affirmed.263 A narrow majority of the Supreme Court of Colorado saw a "tension" between this theory of unjust enrichment and the priority system established by Article 9.264 They resolved it by reversing and remanding with the instruction that PCA could only be held liable if they "initiate [ d] or encourage[d]" the transaction with Duggan (which PCA apparently did not).265 Three dissenting judges would have let Duggan's judgment stand on the basis of the jury's verdict that there was an implied contract for payment between PCA and Duggan.266

The dissent in Duggan found an appropriate answer to the argument that by lending unsecured Duggan agreed to subordinate status. The answer was that Duggan should not be held to have agreed unless a reasonable person in Duggan's position would have thought that was the deal. The question of what Duggan agreed to was one of fact, to be decided by the jury, based on an examination of the circumstances in which the particular parties acted.267 Duggan could not have been paid unless PCA signed the sight draft. To anyone not an expert and true believer in Article 9, PCA's authorization to the debtor to buy feed was at least ambiguous. One interpretation would be that PCA authorized its debtor to offer Duggan a deal that only a fool would accept-Duggan should feed PCA's collateral and PCA should later decide whether it wished to pay for the feed-and Duggan foolishly accepted the

261 rd. 262 Id. at 799. 263 Id. at 790. 264 Id. at 793. 265 Id. at 80l. 266 Id. at 803 (Vollack, J., dissenting). 267 See id. (Vollack, J., dissenting).



deaJ.268 Under the other interpretation, a secured creditor's authorization to buy collateral for the secured creditor'S benefit implies that the secured creditor will pay for the benefit it receives.

Were it open to juries to accept the second, more commonsense interpretation of the unsecured creditor's bargain, secured creditors who did not wish to pay for what they receive269 would have to make their propositions clear. On the facts of Duggan, it would no

268 Some might argue that such deals are the essence of secured credit; the spider (the secured creditor) spins the web and the flies (the debtors and unsecured creditors) decide whether to come into it. My seeming flight of literary imagination here actually is inspired by a full page advertisement placed by Continental Bank in the Wall Street Journal. The most prominent feature of the ad is a large, burping spider. The headline reads: "Shortly after mating, the black widow spider eats her mate. Sadly, many business banking relationships don't last much longer." The remainder of the text elaborates:

Business banking, it seems, has long taken its cues from nature. You know, survival of the fittest. Natural selection. Cannibalism.

Okay, wait a second. That last thing may occur in nature, but at Contine~tal Bank, we prefer to share the future with our partners for a period of time that's just a wee bit shy of forever ....

So, to untangle the complexity of business banking, we encourage our customers to feed off us. (A sort of financial symbiosis, if you will.) And with all we have to offer, they're in for a long, satisfying feast. ...

. . . Through it all, our customers deal with relationship managers who are above reacting on instincts alone. Instead, they study, analyze and view each problem from every conceivable angle before using the tools needed to get the job done ....

. . . Who knows, to start things off, maybe we could have you ... uh ... that is ... join you for lunch.

Wall St. J., Apr. 4, 1991, at C24. At the time this ad ran, Continental probably still held the record for the largest lender

liability verdict in history, $105 million. The action was for the bank's failure to honor loan commitments to the developer of the Port BougainvilIe project in North Key Largo, Florida. See Martha Middleton, Lost Loan Results in $105M Award, Nat'l L.J., May 18, 1987, at II.

Continental's ad is clearly designed to persuade prospective borrowers that Continental is a trustworthy "partner" that will not eat them for lunch. The lender liability verdict indicates that Continental had recently eaten one of its borrowers for lunch. My point here is that in a modern, fast-moving marketplace, reputation may be more usefully thought of as a commodity that is bought and sold than as an economic control on behavior.

269 Defenders of PCA might dispute whether PCA is getting Duggan's feed without paying for it. They might argue that by making secured advances in a legal system that gives secured creditors the right to after-acquired property, PCA paid for Duggan's feed in advance, perhaps by an advance made even before Duggan sold it to their common debtor. I suspect that if the Duggans of the world were advised that this theory was operating in a particular case, they would be considerably less willing to supply the corn.



longer be enough for the secured creditor to avoid contact with the sucker from whom they hoped to get free corn. Before authorizing the purchase of corn, the secured lender would have to decide whether it wanted the corn badly enough to pay for it.

The implied contract theory invites judges and juries, as the triers of fact, to consider what the parties actually knew and thought about the role of security in their deaJ.270 Few would question the reasonableness of security when the contract between secured and unsecured creditor is express and explicit. The reasonableness of security comes into question when the secured creditor does not communicate the nature and extent of its claims, the agreement of the unsecured creditor is implied, and the terms sought to be imposed are not those that reasonably should have been expected.

In his commentary, Professor White seems to concede that Article 9 does not treat unsecured creditors equitably,271 but he provoc-

270 That juries might serve as the triers of fact is the aspect of the implied contract theory that supporters of Article 9 find most threatening and abhorrent. Professor Block-Lieb acknowledges the unfairness of the current regime, but proposes to substitute "unconscionability" for my implied contract theory's "reasonableness." Block-Lieb, supra note 96, at 2018. I suspect it is not the change in standard that motivates her proposal, but rather the fact that "unconscionability" is a question of law, to be decided by the court rather than a jury. Apparently as a result of the jury proposal, Professor Knippenberg regards my "Bargain in Fact" as "perhaps more disruptive of present conceptions of secured credit than [granting tort creditors priority over secured creditors]." See Knippenberg, supra note 102, at 1983. Tho of the practitioners who have written about Duggan expressed concern about the involvement of juries. See Craig M. Tighe, The Unjust Enrichment Doctrine: An Expanded Definition Threatens the Rights of Secured Lenders, 25 UCC L.J. 203, 204.-05 (1993); Steven O. Weise, U.C.C. Article 9-Personal Property Secured Transactions, 46 Bus. Law. 1711, 1752 (1991). These supporters of Article 9 share a common conviction that juries will not be able to understand the supposedly complex relationship between secured creditor and unsecured creditor.

But why not? Juries routinely decide commercial cases far more complex than the typical dispute between secured and unsecured creditor. I know of no serious movement to remove them from that role. I suspect that the convictions of these commentators are grounded in the fear that juries, stumbling onto the Article 9 scene without preconceptions, will lack reverence for it and be unwilling to tolerate "the disadvantage of the system's occasional inequities" when necessary to promote the "value of a predictable system of priorities." Duggan, 821 P.2d at 797. The view I present here is that the goal of economic efficiency would be better served by not tolerating the inequities. By not tolerating them, we would encourage an information flow that would give unsecured as weII as secured creditors the benefit of "a predictable system of priorities."

271 James J. White, Work and Play in Revising Article 9, 80 Va. L. Rev. 2089, 2098 (1994) ("Even a barbarian finds it hard to argue that the debtor's last doIIar should go to the secured creditor, not to the tort claimant to purchase medical treatment.").



atively attempts to frame our choice as one between equity and certainty.272 It is not clear to me, however, that Article 9's departure from the general rules of contract in fact leads to greater certainty. The attempt to impose "stem" but inequitable rules through tens of thousands of independent judges throughout the United States leads not to certainty, but to volatility. Equitable claims continue to be asserted and perhaps honored or compromised, despite the apparent rigidity of the rules. Secured creditors probably could achieve greater certainty under the regime I propose simply by making their bargain with the unsecured creditors painfully express. Even juries will hold parties to bargains they in fact made.

III. CONCLUSION

Article 9 artificially and unjustifiably advantages the institution of security over unsecurity. It holds involuntary unsecured creditors to an entirely fictitious bargain. It holds voluntary unsecured creditors to the terms of security agreements to which they did not in fact agree and to which they do not even have access. The terms of those agreements are binding regardless of how unreasonable they may be. This bizarre scheme subsidizes the institution of security, causing more secured lending than is optimal.

With regard to involuntary unsecured creditors, the solution is becoming increasingly obvious to legal scholars. The priority of secured creditors over involuntary unsecured creditors cannot be justified by any coherent theory and should be abolished. Involuntary creditors should have priority over voluntary creditors, whether secured or unsecured.

To describe the voluntary unsecured creditor's bargain, I began by distinguishing two very different kinds of unsecured lending. The first, which I have referred to as "asset-based" unsecured lending, is characteristic of loans from large and powerful lenders to large and powerful borrowers. The arrangement effectively bars

272 White states: Even though each of the claims put forward by the unsecured creditors standing

alone can be defended, and even though each has a melodic appeal to equity, most should be rejected. Article 9's strength has been its stern rejection of equity; it has rightly chosen certainty over equity as the true way.

Id. at 2096.



the debtor from granting security and gives the unsecured creditors nearly all of the advantages of security. The second, which I refer to as "cash-flow surfing" is more common. Sophisticated cash-flow surfers extend credit in relatively small amounts for relatively short periods of time. They expect to be paid ahead of secured creditors, from the secured creditors' collateral, so long as the debtor's business survives. If the debtor's business fails, most do not expect to be paid at all.

Because it was designed to serve only the information needs of secured creditors, the Article 9 filing system fails to supply the basic information that cash-flow surfers need. The principal categories of omitted information are information on the default status of the loan, the balance remaining available under a line of credit, and the secured creditor's intentions with regard to calling the loan. All are highly time sensitive. Instead of guaranteeing access to these kinds of information, Article 9 goes to the opposite extreme, insulating secured creditors against liability that they otherwise would incur under general principles of contract law. The secured creditor can permit and encourage the debtor to induce cash-flow surfers to furnish additional collateral by misleading them, defrauding them, and feigning to pay them with worthless checks. So long as the secured creditor avoids direct contact with the cash-flow surfer, whatever property the debtor can gather by these means, the secured creditor can keep?73

In this Article, I have proposed two mechanisms for serving the information needs of cash-flow surfing unsecured creditors. First, the law should cease to bind unsecured creditors to the terms of agreements to which they are not parties and do not have access. Instead, cash-flow surfers should be presumed to know or assume only what reasonable persons similarly situated would in fact know or assume. What that is should be determined by a judge or jury as the trier of fact.

Under the scheme I propose, secured creditors who sought to bind unsecured creditors to a subordinate position would have to take whatever steps were reasonable to communicate their inten-

273 See, e.g., In re Samuels & Co., 526 F.2d 1238 (5th Cir.), cert. denied, 429 U.S. 834 (1976); In re M. Paolella & Sons, 161 B.R. 107 (E.D. Pa. 1993); Chicago Limousine Servo V.

Hartigan Cadillac, 548 N.E.2d 386 (III. Ct. App. 1989), rev'd on other grounds, 564 N.E.2d 797 (III. 1990); supra notes 119-22 and accompanying text.



tions to those unsecured creditors. To facilitate that communication, I have proposed that the Article 9 filing system be redesigned to serve the information needs of all who are to be bound by the secured creditor'S bargain. Legal theory should take its cue from architecture and highway design. Those disciplines assiduously avoid assuming that the users of buildings and roads know what they in fact do not. Instead, the designers seek to supply ignorant users with the information the users need, when and where they need it. When particular kinds of accidents are predictable, they do not blame the drivers and wait for the market to learn; they redesign the road. If we create systems to supply the information relevant to the unsecured creditor's bargain through easily accessible media, unsecured creditors will have powerful incentives to listen to the information and act on it. Once they do, the unsecured creditor's bargain will cease to be a figment of the legal and economic imagination and will become a bargain in fact.

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