Washington University in St. Louis Washington University in St. Louis
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2018
Limited Liability Property Limited Liability Property
Danielle D'Onfro
Washington University in St. Louis School of Law
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D’ONFRO.39.4.5 (Do Not Delete)
1365
LIMITED LIABILITY PROPERTY
Danielle D’Onfro
†
This Article offers a theory of secured credit that aims to answer fundamental
questions that have long percolated in the bankruptcy and secured transactions
literatures. Are security interests property rights, contract rights, or something else?
Why do secured creditors enjoy a priority right that, in bankruptcy, requires them to
be paid in full before other debt holders recover anything? Should we care that
secured credit creates distributional unfairness when companies cannot pay their
debts?
This Article argues that security interests are best understood as a form of
“limited liability property.” Limited liability—the privilege of being legally shielded
from liability that would normally apply—has long been considered the
quintessential feature of equity interests. But limited liability is in fact a critical
feature of security interests as well. When examined closely, security interests enable
their holders to assert several privileges of ownership without bearing any of
ownership’s concomitant burdens.
In seeking to explain security interests, this Article offers a comprehensive
account of capital investment more generally, systematically examining the various
property-like interests held in corporate capital structures. Though critics have
bemoaned the inequity associated with the priority right in bankruptcy—a secured
debtholder can get all its assets back in the event of a bankruptcy while unsecured
creditors like unpaid employees get nothing—this priority right is an inevitable
consequence of recognizing security interests as a form of direct ownership. The real
problem lies in the scope of secured debt holders’ limited liability protections. While
equity holders enjoy limited liability, in return they are paid only after other claims
in the event of insolvency. Secured lenders, by contrast, collect first, and are thus
arguably overprotected. Understanding security interests as limited liability property,
†
Lecturer in Law, Washington University in St. Louis. For helpful conversations and
comments, I am grateful to Douglas Baird, Christopher Bradley, Kara Bruce, Tony Casey, Seth
Davis, Jared Ellias, Daniel Epps, Anne Fleming, Sally Henry, Steven Horowitz, Ted Janger,
Daniel Keating, Robert Lawless, Troy McKenzie, Ed Morrison, Lynn LoPucki, Ronald Mann,
Rory Van Loo, and Jay Westbrook. Many thanks to the American Bankruptcy Institute for
funding the Young Bankruptcy Scholars Works-in-Progress Workshop at which I received
invaluable comments. I am additionally indebted to John Goldberg, Henry Smith, and
Elizabeth Warren for early guidance and inspiration as I first began to develop these ideas.
D’ONFRO.39.4.5(Do Not Delete)
1366 CARDOZO LAW REVIEW [Vol. 39:1365
then, offers a more elegant way to understand capital investment at the theoretical
level while also helping us recognize when and where our system of secured debt may
need reform.
TABLE OF CONTENTS
INTRODUCTION .............................................................................................................. 1366
I. C
APITAL PROPERTY FROM RESIDUAL OWNERSHIP UP......................................... 1375
A. Equity .......................................................................................................... 1377
B. Unsecured Claims ...................................................................................... 1382
C. Secured Debt ............................................................................................... 1387
II. T
HE PROBLEM OF SECURED DEBT ......................................................................... 1392
A. Explaining Two Layers of Debt ................................................................ 1392
B. Making Sense of Priority ........................................................................... 1395
III. S
HARES AND SECURITY INTERESTS AS LIMITED LIABILITY PROPERTY ................ 1406
A. The First Principles of Limited Liability .................................................. 1407
B. A System for Not Paying Claims .............................................................. 1410
1. Judgment-Proofing ........................................................................ 1410
2. The Limits of Limited Liability .................................................... 1412
C. Applying Limited Liability to Security Interests ..................................... 1413
IV. S
QUARING LIMITED LIABILITY WITH PRIORITY ................................................... 1417
A. Locating the Problem ................................................................................. 1418
B. Bringing Coherence to Limited Liability Property ................................. 1421
C. Additional Implications ............................................................................ 1423
C
ONCLUSION................................................................................................................... 1426
I
NTRODUCTION
Ownership usually involves both benefits and burdens.
1
If you buy
a car, you control the car’s use and get to profit if its value rises. But you
also bear the risk that the car will turn out to be a lemon, and you will
face legal consequences if you ignore that burning smell and if it catches
fire in a parking deck. So too with any owned asset, however big or
1
Property scholars might describe this idea using a Hohfeldian framework, which
contrasts “powers” with “liabilities.” See, e.g., Joseph William Singer, The Legal Rights Debate in
Analytical Jurisprudence from Bentham to Hohfeld, 1982 W
IS. L. REV. 975, 986–87.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1367
small. If you own an oil pipeline directly, you can reap the profits
created by the crude oil that passes through. But if the pipe bursts, you
will be on the hook for the environmental cleanup—no matter how
large those costs might turn out to be.
2
In other words, to own
something is to be responsible for it.
Sometimes, though, the law allows owners to enjoy ownership’s
benefits without facing the burdens that ownership normally entails.
When it is available, limited liability permits an owner to profit from the
assets to which it attaches while shielding the owner from any liability
that asset creates. If, say, you own not the oil pipeline itself but instead
hold all the shares of a corporation that itself owns the pipeline, you
cannot be made to pay the costs of the cleanup out of your own
pocket—even if the corporation itself goes bankrupt.
3
This protection is
strong: No matter how grave the harm caused by the corporation, equity
holders cannot, absent extraordinary circumstances,
4
lose more than the
value of their equity interest and the attendant opportunity costs.
5
Although limited liability is usually thought of as the province of
equity investment, there is in fact another form of ownership
distinguished by limited liability—one that has long gone under-
recognized.
6
This Article argues that security interests, just like equity,
break the normal relationship between ownership rights and liability.
This argument begins with recognizing that security interests can only
be understood as property rights
7
: secured lenders (those who take a
2
As became clear in the Deepwater Horizon disaster, there are myriad possible claims and
claimants arising under state common law as well as state and federal environmental and
energy claims. See In re Oil Spill by the Oil Rig “Deepwater Horizon” in the Gulf of Mexico, 910
F. Supp. 2d 891, 900 (E.D. La. 2012), aff'd sub nom. In re Deepwater Horizon, 739 F.3d 790 (5th
Cir. 2014) (outlining the claims brought in the wake of the oil spill). The multitude of claims is
easily obscured by the mass settlements that occur after such disasters, especially since
government actors negotiating those settlements rarely pursue the true, full cost of cleanup.
3
See infra Section III.A.
4
These extraordinary circumstances must amount to some misuse of the corporate form
such that a court is willing to pierce the corporate veil and hold equity holders liable for the
actions of the company. See, e.g., PAH Litig. Tr. v. Water St. Healthcare Partners L.P. (In re
Physiotherapy Holdings, Inc.), No. 13-12965(KG), 2016 WL 3611831 (Bankr. D. Del. June 20,
2016) (attempting to hold shareholders liable following a failed buyout).
5
There have been efforts to use fraudulent transfer law to hold shareholders liable for
other parties’ losses. See Weisfelner v. Fund 1 (In re Lyondell Chem. Co.), 554 B.R. 655 (Bankr.
S.D.N.Y. 2016) (resolving a fraudulent transfer claim on safe harbor grounds after having
allowed it to proceed against former shareholders of a formerly public company that was taken
private in a leveraged buyout); PAH Litig. Tr., 2016 WL 3611831 (allowing fraudulent transfer
claims to proceed against shareholders).
6
Frank Easterbrook and Daniel R. Fischel observed that lenders enjoy limited liability. See
Frank Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U.
CHI. L.
REV. 89, 90, 93 (1985).
7
This Article does not endeavor to definitively answer the question of whether equity and
security interests are full-fledged property interests. For my argument, it is enough to say that
they both have many features of property rights that make them something more property-like
than the usual interests arising in contract or tort. Since these property-like features make them
D’ONFRO.39.4.5(Do Not Delete)
1368 CARDOZO LAW REVIEW [Vol. 39:1365
security interest
8
in a borrower’s assets as a condition of lending to the
borrower) enjoy a property claim over encumbered assets. For example,
a bank holding a mortgage claims to be a co-owner of that house such
that no other creditor of the borrower could take that house to satisfy its
claims without the bank’s consent.
9
This property claim is the sine qua
non of security interests because it alone explains their priority right—
the right to be paid ahead of all unsecured creditors—that distinguishes
security interests from other, riskier, forms of debt.
10
And yet, despite this property claim, secured lenders face almost
none of the liability that typically comes with ownership. They are
entitled to some or all of the value of the underlying assets while wholly
exempt from various forms of liability—negligent entrustment,
environmental remediation, and others—that normally attach to owned
resemble ownership, that is the word that I am using to describe these interests even if under
many theories of property these interests fail to qualify as property rights. That said, I take as
fundamentally correct the Restatement of Property’s position that an “owner” is “the person
who has one of more interests.” R
ESTATEMENT (FIRST) OF PROP. § 10 (AM. LAW INST. 1936).
This position potentially contradicts that of the U.C.C., which explains that “‘[s]ecurity interest’
does not include the special property interest of a buyer of goods . . . .” U.C.C. § 1-201(b)(35)
(A
M. LAW INST. 2001). Of course, acknowledging that taking a security interest does not
generate the same kind of property right as purchasing an asset says nothing about whether
security interests are a different kind of property. The better view is that our common law
system, with its system of estates and generally looser notions of ownership allows both
purchasers and security interest holders to be owners, albeit owners of a different scope of
rights. See Yun-chien Chang & Henry E. Smith, Structure and Style in Comparative Property
Law,
in COMPARATIVE LAW AND ECONOMICS 139 (Theodore Eisenberg & Giovanni B. Ramello
eds., 2016). Article 9, the state law that creates security interests in personal property,
unequivocally conceives of security interests as interests in property. U.C.C. § 9 (A
M. LAW INST.
2002). U.C.C. § 1-201(b)(35) defines “security interest” as “an interest in personal property or
fixtures which secures payment or performance of an obligation.”
8
Security interests are the property-like claims that borrowers give their lenders. U.C.C.
§ 1-201(b)(35) (“‘Security interest’ means an interest in personal property or fixtures which
secures payment or performance of an obligation.”). These claims entitle the borrower to
foreclose on a specific, identified asset of the borrower, called the collateral or encumbered
asset, if the borrower fails to adhere to the terms of the loan. U.C.C. § 9-609 (granting secured
creditors the right to take possession of collateral or render it inoperable “[a]fter default”);
U.C.C. 9-610(a) (“After default, a secured party may sell, lease, license, or otherwise dispose of
any or all of the collateral in its present condition or following any commercially reasonable
preparation or processing.”). This right to foreclose means that secured lenders have priority
over unsecured lenders in that they can take encumbered assets to satisfy their claims in full,
even when other creditors can only collect pari passu with other unsecured creditors and often
only at pennies on the dollar. To the extent that the collateral does not satisfy a secured
creditor’s claim, the secured creditor has an unsecured claim for the deficiency. 11 U.S.C.
§ 506(a)(1) (2012) (“An allowed claim of a creditor secured by a lien on property in which the
estate has an interest . . . is a secured claim to the extent of the value of such creditor’s interest
in the estate’s interest in such property . . . and is an unsecured claim to the extent that the
value of such creditor’s interest . . . is less than the amount of such allowed claim.”).
9
The loan documents govern the terms of this joint tenancy–like arrangement, much like
a prenuptial or joint-venture agreement governs the allocation of property rights in other joint
tenancies.
10
See infra Section II.B.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1369
property.
11
The only way to understand this state of affairs, I argue, is to
recognize security interests as a form of limited liability property: a right
to own an asset directly yet without sharing any of the liability burdens
normally associated with ownership.
Consider the following example: Andy owns Blackacre in fee
simple and leases it to ChemCo. If ChemCo infuses Blackacre with toxic
waste, even intentionally, and even against the terms of the lease it
signed with Andy, Andy is still liable for the cleanup merely because he
owns Blackacre. To be sure, he may have recourse against ChemCo, but
if ChemCo is insolvent, Andy must pay. And Andy must pay for the
cleanup even if it exceeds the value of Blackacre. If Andy spent all of his
money on the clean-up costs and in doing so failed to pay Therapist,
whom he frequented on account of the stress, Therapist would then
have an unsecured claim against Andy. Therapist could, after various
court proceedings and with the help of the sheriff, sell the newly cleaned
Blackacre to satisfy his claim.
If Andy had mortgaged Blackacre to Bank before ChemCo spilled
the oil, under traditional rules of lender liability, Bank would not be
liable for the clean-up costs as mere holder of a security interest. The
value of its collateral, Blackacre, would be reduced so it may lose money
as a result of the spill, but the Bank would not have to pay additional
funds for the cleanup. Its liability is limited. When Andy had restored
Blackacre, Bank’s collateral would be restored as well. Therapist,
however, would be out of luck since Bank’s security interest would have
to be satisfied before his claim could be paid from the proceeds of the
land. Bank would argue, and prevail, that its security interest in
Blackacre gives it a priority right over all other claims against Blackacre.
That is, Bank would argue that it is effectively a co-owner of Blackacre
and that Therapist cannot satisfy his claim against its portion of
Blackacre. This is true regardless of whether Andy files for bankruptcy
or somehow stays afloat. In this way, Bank, as secured lender, gets to be
an owner of Blackacre when it is beneficial to Bank, while at the same
time avoiding the burdens of ownership—here, the cleanup costs.
Modern brownfield cleanup laws shift some or all of the liability
that Andy faced onto Bank. While these reforms may reflect a desire for
deep pockets more than a desire for a rational system of property rights,
they effectively solve one of the most troubling aspects of secured
lending: squaring secured lenders’ priority right with their liability to
third parties. This Article will demonstrate that a more rational system
recognizes Bank as co-owner of Blackacre at all points in time. Taking
Bank’s property claim seriously means that its priority right should be as
absolute as that of any other joint tenant and its potential ownership
11
See infra Section III.B.
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1370 CARDOZO LAW REVIEW [Vol. 39:1365
liability will be the same as well. In other words, wherever Andy, as
owner, would face liability on account of his ownership, so too should his
secured lender.
This observation—that secured creditors enjoy limited liability like
equity holders—is not merely interesting for its own sake. Instead, it is
one key to unlocking the enduring mystery of security interests. It is not
an exaggeration to say that courts
12
and commentators
13
have struggled
to explain the concept of secured lending for more than four centuries.
The unanswered questions include: Are security interests property
rights, contract rights, or something else? Why do secured debt holders
enjoy a priority right that, in bankruptcy, requires them to be paid in
full before other debt holders recover anything? Should we care that
secured credit creates distributional unfairness when companies cannot
pay their debts?
14
This fundamental uncertainty has created a chorus of scholars
criticizing security interests.
15
The most common focal point of
criticism is secured lenders’ priority right, particularly in bankruptcy.
16
But this criticism of secured lending typically rests on concerns about
fairness,
17
distributional preferences,
18
arguments about “inefficiency,”
19
12
Twyne’s Case (1601) 76 Eng. Rep. 809 (barring the enforcement of security interests
where the borrower retained the collateral for fear of allowing borrowers to appear to be in
better financial health than they truly were).
13
See infra Section I.C.
14
That is, sophisticated parties who know of and plan for the risk of non-payment may
nevertheless be paid in full while innocent creditors, including involuntary creditors, may
receive little, if anything. See infra Section I.B.
15
See infra Section I.C.
16
See Edward J. Janger, The Logic and Limits of Liens, 2015 U. ILL. L. REV. 589 (arguing that
gaps in our system of perfecting liens prevents secured creditors from having a senior claim
over all of the value of a going concern); Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy
Case for the Priority of Secured Claims in Bankruptcy, 105 Y
ALE L.J. 857, 863 (1996) (arguing
that “a rule according full priority to secured claims in bankruptcy tends to reduce the
efficiency of the loan arrangement negotiated between a commercial borrower and a potentially
secured creditor”); C
OMMISSION TO STUDY THE REFORM OF CHAPTER 11, AM. BANKR. INST.,
2012–2014 FINAL REPORT AND RECOMMENDATIONS 207–08 (2014) (proposing that junior
creditors are entitled to receive the value of an option on the reorganized value of a firm from
senior secured creditors).
17
Concerns about fairness typically fall into two categories. Some believe that secured
creditors are bending the law and controlling creditors to receive more than they are owed. See
C
OMMISSION TO STUDY THE REFORM OF CHAPTER 11, supra note 16, at 207 (explaining that in
sales under Section 363, “valuation may occur during a trough in the debtor’s business cycle or
the economy as a whole, and relying on a valuation at such a time may result in a reallocation
of the reorganized firm’s future value in favor of senior stakeholders and away from junior
stakeholders in a manner that is subjectively unfair”). Others have argued that the ability of
secured creditors to deprive unsecured creditors of any satisfaction of their claim creates
unfairness. See Bebchuk & Fried, supra note 16; Lisa M. Bossetti & Mette H. Kurth, Professor
Elizabeth Warren’s Article 9 Carve-Out Proposal: A Strategic Analysis, 30 UCC
L.J. 3 (1997);
Elizabeth Warren, An Article 9 Set-Aside for Unsecured Creditors, 51 C
ONSUMER FIN. L.Q. REP.
323 (1997).
D’ONFRO.39.4.5 (Do Not Delete)
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or observations about historical practice.
20
These criticisms do not
identify what is uniquely wrong with security interests or explain how
these alleged distributional pathologies differ from those created by
other forms of private ownership. By identifying how secured lenders’
ownership claims intersect with their enjoyment of limited liability, this
Article finally articulates how secured lenders have a more favorable
bargain vis-à-vis third parties than is traditionally allowed in our private
law system.
Indeed, secured lenders get a more favorable bargain than equity
holders since they get the protection of limited liability without
subordinating their claims against the company’s assets to those of other
creditors. Normally, if a company becomes insolvent, equity holders are
paid last because their claims over the company’s assets are only indirect
claims against the residuary. By contrast, secured lenders are paid first
18
COMMISSION TO STUDY THE REFORM OF CHAPTER 11, supra note 16, at 67, 207–08
(proposing to limit adequate protection to the foreclosure value of collateral and proposing to
require certain senior secured creditors to pay the value of an option to junior creditors);
Michelle M. Harner, The Value of Soft Variables in Corporate Reorganizations, 2015 U.
ILL. L.
REV. 509, 519 (questioning whether liens can and should cover value generated by “soft” assets
such as synergies among assets, particular talents of the workforce, and relationships between
the company and third parties).
19
F.H. Buckley, The Bankruptcy Priority Puzzle, 72 VA. L. REV. 1393, 1395 (1986) (arguing
that efficiency explains the existence of secured credit); 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) (explaining that “[a]n economic
justification for secured credit has continued to elude legal scholars” and arguing that “secured
credit is a zero-sum transaction for the debtor”); James J. White, Efficiency Justifications for
Personal Property Security, 37 V
AND. L. REV. 473, 501-02 (1984) (arguing that secured credit is
efficient because it accommodates differing risk preferences); Alan Schwartz, Security Interests
and Bankruptcy Priorities: A Review of Current Theories, 10 J.
LEGAL STUD. 1, 33 (1981)
[hereinafter Schwartz, Security Interests and Bankruptcy Priorities] (surveying the economic
justifications for secured credit and concluding that “no convincing explanation for the
issuance of short-term secured debt exists”). But see Thomas H. Jackson & Anthony T.
Kronman, Secured Financing and Priorities Among Creditors, 88 Y
ALE L.J. 1143, 1149–57 (1979)
(arguing that the presence of secured credit facilitates lower borrowing costs); David Gray
Carlson, On the Efficiency of Secured Lending, 80 V
A. L. REV. 2179, 2180 (1994) (arguing that
security interests are efficient because “they reduce risk and thereby lower the cost of credit”).
See generally Richard L. Barnes, The Efficiency Justification for Secured Transactions: Foxes with
Soxes and Other Fanciful Stuff, 42 U.
KAN. L. REV. 13, 16 (1993) (questioning why it matters
that secured credit is or is not efficient).
20
See Douglas G. Baird, Priority Matters: Absolute Priority, Relative Priority, and the Costs
of Bankruptcy, 165 U.
PA. L. REV. 785 (2017) (arguing that strict adherence to absolute priority
is relatively recent); Melissa B. Jacoby & Edward J. Janger, Ice Cube Bonds: Allocating the Price
of Process in Chapter 11 Bankruptcy, 123 Y
ALE L.J. 862 (2014) (“Some critiques of Chapter 11,
and their attendant formulations of the baseline distribution to secured creditors, proceed from
an unduly romanticized account of creditors’ rights under state law.”); Douglas G. Baird &
Donald S. Bernstein, Absolute Priority, Valuation Uncertainty, and the Reorganization Bargain,
115 Y
ALE L.J. 1930 (2006) (explaining that relative priority has long coexisted with absolute
priority); see also Mark J. Roe & Frederick Tung, Breaking Bankruptcy Priority: How Rent-
Seeking Upends the Creditors’ Bargain, 99 V
A. L. REV. 1235 (2013) (arguing that deviations from
absolute priority upend the creditor’s bargain).
D’ONFRO.39.4.5(Do Not Delete)
1372 CARDOZO LAW REVIEW [Vol. 39:1365
precisely because they make a direct property claim over specific
assets.
21
And yet secured lenders enjoy an even stronger form of limited
liability than equity holders. Their liability is capped at their investment,
but only at the extent to which they are under-secured, if at all. That is,
they are doubly protected from the claims of third parties.
Whether from traditional limited liability or secured lending, this
reduction in liability has social costs. By encouraging investment
through limited liability, we accept that some claimants will go unpaid
even when there are affiliated parties with pockets deep enough to
satisfy the claims.
22
In theory, the benefit of the additional economic
activity outweighs the harm of limiting liability.
23
But there are plenty
who view this tradeoff as a bad deal for society, especially when
companies magnify their limited liability by layering subsidiaries into
numerous judgment-proof entities.
24
These critiques apply with even
greater force to secured lenders, whose ownership interests in collateral
allow them to remove the collateral from the assets available to
unsecured claimants while avoiding any of the liability that might be
attached to this collateral.
None of this is to say that there is anything inherently troubling
about limited liability in general or security interests in particular.
Indeed, there are reasons to believe that secured debt is a net positive for
the economy and is a key to our nation’s future innovation.
25
But the
problem is that we do not sufficiently understand what exactly secured
debt is at the theoretical level. Nor can we explain precisely what rights
it provides to its owners. Such a deeper understanding is critical before
we can even seriously evaluate whether secured debt is desirable.
In identifying security interests as limited liability property, this
Article offers a property-focused theory of secured debt, situating it
within a larger unified theory of capital investment generally. It argues
that security interests and equity interests are best understood together
as complementary forms of ownership, even if they are not necessarily
full-fledged property interests.
26
These ownership rights are united in
21
To be sure, secured lenders have lower potential returns or upside risk because the
comparatively lower risk associated with their investment commands lower interest rates.
22
See infra Section III.B.1.
23
See infra Section III.A.
24
See Lynn M. LoPucki, The Essential Structure of Judgment Proofing, 51 STAN. L. REV. 147
(1998) [hereinafter LoPucki, The Essential Structure of Judgment Proofing].
25
I have historically been critical of efforts to tinker with the rights of secured creditors to
change distributional outcomes without first having a solid empirical or theoretical reason for
doing so beyond notions of fairness. See Allison Hester-Haddad & Danielle D’Onfro, Limiting
the Background Noise: Investor Motivation and Identity in Bankruptcy, 33 A
M. BANKR. INST. L.
REV. 38 (2014); Elliot Ganz & Danielle D’Onfro, Viewpoint: Two Years After Bankruptcy
Reform, Much Ado About Little, W
ALL ST. J. (Dec. 8, 2016), http://www.wsj.com/articles/
viewpoints-two-years-after-bankruptcy-reform-much-ado-about-little-1481211587.
26
Tellingly, security interests are sometimes called “indicia of ownership” (e.g., 42 U.S.C.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1373
part, because secured debt and equity investments both create interests
that have many features of property rights—the security interest and
equity interest, respectively—that are protected by limited liability.
This greater theoretical clarity can inform policy. There is growing
concern among legal commentators that powerful secured lenders
exercise significant control over borrowers
27
and that security interests
should therefore be reconsidered in various ways.
28
While there are
arguments to support some reform of the law governing security
interests—as I discuss later in the piece—any changes must proceed
from a clear vision of what secured debt is, and what role it plays in the
larger system of capital markets. This Article seeks to offer that vision.
The argument proceeds in four parts. Part I situates the problem
and lays the theoretical foundation for the Article’s thesis. There I define
§ 9601 (2012)) and courts review so-called “indicia of ownership” to determine whether a
transaction was intended to create a security interest (e.g., In re Kempker, 104 B.R. 196, 203
(Bankr. W.D. Mo. 1989)).
27
E.g., Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 STAN. L. REV.
751, 751–52 (2002) (arguing the old model of business reorganization is irrelevant because
sophisticated debt investors anticipate distress and leave no assets unencumbered); Douglas G.
Baird & Robert K. Rasmussen, Chapter 11 at Twilight, 56 S
TAN. L. REV. 673, 675–76 (2003)
(adding data to support their claim that creditor control has constrained the ability of
distressed companies to reorganize in bankruptcy); David A. Skeel Jr., The Past, Present and
Future of Debtor-in-Possession Financing, 25
CARDOZO L. REV. 1905, 1906 (2004) (arguing that
debtor-in-possession (DIP) lending, which is typically secured, is the most important
governance lever in Chapter 11); Douglas G. Baird & Robert K. Rasmussen, Private Debt and
the Missing Lever of Corporate Governance, 154
U. PA. L. REV. 1209, 1212 (2006) (“When a
business enters financial distress, the major decisions--whether the CEO should go, whether the
business should search for a suitor, whether the corporation should file for Chapter 11--require
the blessing of the banks.”); Kenneth M. Ayotte & Edward R. Morrison, Creditor Control and
Conflict in Chapter 11, 1
J. LEGAL ANALYSIS 511, 514 (2009) (finding that the presence of over-
secured creditors is correlated with asset sales in bankruptcy); Charles K. Whitehead, The
Evolution of Debt: Covenants, the Credit Market, and Corporate Governance, 34
J. CORP. L. 641,
669 (2009) (arguing that debt disciplines borrowers not only through control covenants but
also feedback provided by increasingly liquid private debt markets); Barry E. Adler, A
Reassessment of Bankruptcy Reorganization After Chrysler and General Motors, 18 A
M. BANKR.
INST. L. REV. 305 (2010) (criticizing courts’ willingness to honor creditors’ requests for less-
than-competitive fire-sales of assets); Stephen J. Lubben, The Board’s Duty to Keep Its Options
Open, 2015
U. ILL. L. REV. 817 (arguing that creditors’ apparent control in bankruptcy results
from problems of corporate governance and that regulating blanket liens is one solution to this
problem); see also Sarah Pei Woo, Regulatory Bankruptcy: How Bank Regulation Causes Fire
Sales, 99
GEO. L.J. 1615, 1632 (2010–2011) (finding that bank regulations incentivize bank
lenders “to liquidate debtors in sectors where banks face high concentrations--regardless of the
debtors' individual recovery values--in order to reduce unexpected losses and capital adequacy
requirements”).
28
E.g., Juliet M. Moringiello, When Does Some Federal Interest Require a Different Result?:
An Essay on the Use and Misuse of Butner v. United States, 2015 U.
ILL. L. REV. 657, 671–73
(arguing that, given the rise of secured credit, federal policy not state law should determine the
treatment of security interests in bankruptcy); Anthony J. Casey, The Creditor’s Bargain and
Option-Preservation Priority in Chapter 11, 78 U.
CHI. L. REV. 759, 762, 765 (2011) (arguing
that creditor control causes firms to waste assets and proposing “Option-Preservation Priority”
for unsecured creditors). See generally, C
OMMISSION TO STUDY THE REFORM OF CHAPTER 11,
supra note 16 (proposing several changes to the treatment of security interests in Chapter 11).
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the three main layers of capital and competing property interests in a
company. When viewed from the bottom up, we see that the competing
property-like interests all proceed from equity holders’ initial capital
investments in companies and their decision to interpose the corporate
form between themselves and their capital. From this view, secured
creditors’ priority rights appear to follow from their property rights, but
new anomalies emerge.
Part II returns to secured credit to more fully explore the
awkwardness of its priority right over other kinds of claims. For those
less familiar with lending, I provide additional background around why
secured and unsecured claims must coexist. I then summarize prior
efforts to theorize secured debt, as well as arguments aimed at prior
Article 9 and bankruptcy reform efforts.
Part III is the heart of the Article’s theoretical contribution. There,
I probe the most difficult aspects of security interests and find that they
arise from a misalignment of limited liability with claims of direct
ownership over corporate assets. I first explain the mechanics and
justifications of limited liability. Modern companies use limited liability
in elaborate judgment-proofing strategies to protect equity interests
higher in a web of related companies such that the norm is not to pay
downstream claims in full.
29
In other words, distributional justice has
never been the sole goal of our system of corporate law. Turning then to
security interests, I show that the security interest accomplishes the
equivalent of the elaborate judgment proofing regimes used to protect
equity holders. Viewed this way, the anomalous feature of security
interests is not their impact on downstream creditors per se, but rather
the scope of their limited liability. For limited liability purposes, secured
lenders enjoy the same scope of potential loss as equity holders—
liability bounded at their investment—notwithstanding their claim of
direct ownership over company assets.
30
29
LoPucki, The Essential Structure of Judgment Proofing, supra note 24, at 149 (“[A]ll, or
substantially all, judgment proofing has a single essential structure: a symbiotic relationship
between two or more entities, in which one of the entities generates disproportionately high
risks of liability and another owns a disproportionately high level of assets. Through the
contract that unites them, the two entities allocate between them the gains from judgment
proofing.”).
30
The exceptions here prove the rule. Typically, secured lenders’ only risk is that the value
of their collateral declines below the value of the debt. Lenders do face unlimited liability—that
is, liability measured by the harm and not by their investment—under a handful of statutes. For
example, if lenders foreclose on and then sell goods produced in violation of the Fair Labor
Standards Act. See Citicorp Indus. Credit v. Brock, 483 U.S. 27, 39 (1987). Creditors who
exercise excessive control over their borrowers risk having their claims subordinated and in
more serious cases, having the veil between borrower and lender pierced such that the lender
becomes liable for the borrower’s debts. See generally Margaret Hambrecht Douglas-Hamilton,
Creditor Liabilities Resulting from Improper Interference with a Management of a Financially
Troubled Debtor, 31 B
US. LAW. 343 (1975) (cataloging cases of lender liability).
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Part IV explores the practical implications of the Article’s new
theory of security interests. My normative proposal flows directly from
the Article’s theoretical insight: we should take security interests’ claims
of direct ownership of assets seriously and give them the liability that
follows from direct ownership. Secured lenders then would enjoy the
same limited liability that any company enjoys. They could recreate
their current allocation of liability through indemnification agreements.
But if so, such agreements should be enforceable through contract law
against contracting parties, not through property rules against innocent
third parties. This proposal, to be sure, would not eliminate the
distributional unfairness bemoaned by the secured transactions
literature. But a consequence of normalizing the privileges and liabilities
of security interest holders within our traditional framework of property
ownership is that some of these distributional fairness concerns might
be reduced. At the very least, we would have a more coherent way of
situating security interests in our systems of private property and
limited liability.
Part IV goes on to address three practical implications of this
proposal for debt markets. First, any changes that increase the potential
liability of lenders would certainly add costs and complexity to both
loan underwriting and servicing, which might reduce overall lending.
Second, shifting even the threat of liability to lenders might increase
monitoring of borrowers’ behavior and creditor influence in a
borrower’s business decisions. Where limited liability can tend to reduce
the incentive to monitor liability below socially desirable levels, creditor
involvement might restore it.
31
And third, since regulatory hurdles may
make lenders less able than borrowers to judgement-proof themselves,
shifting some liability to them might better align actual liability with the
goals of both our private law and regulatory systems. It is unclear how
these practical implications balance out. But in choosing to maintain the
status quo, we can understand that it is the awkwardness of according
secured lenders limited liability despite their direct ownership claims
that should lie at the root of their perceived unfairness, not the
institution of secured lending itself.
I.
CAPITAL PROPERTY FROM RESIDUAL OWNERSHIP UP
This Part provides a practical foundation for the theoretical and
normative arguments offered later in the Article.
32
Section A begins by
31
See generally Saul Levmore, Monitors and Freeriders in Commercial and Corporate
Settings, 92 Y
ALE L.J. 49 (1982) (explaining how creditors may act as monitors).
32
With bankruptcy, as with so many areas of the law, it is impossible to divine what the law
“is” from case law alone because there are so many exceptions, which may be driven by bad
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defining each layer of capital and previews the rights held at each level
in the basic corporate capital structure. Next, Section B explores prior
efforts to understand the layers of corporate capital structures generally
and security interests in particular.
Business entities have three main sources of capital: equity,
unsecured debt, and secured debt. Each layer, however, can contain
numerous subdivisions. These sources of capital each sit at a different
point in any asset’s so-called priority waterfall. A longstanding rule of
both the federal bankruptcy system
33
and state-law wind-up regimes
34
is
that claims against a company’s assets must be paid out according to the
absolute priority rule.
35
Priority refers to the order in which claims are
paid in the event that a company’s liabilities exceed its assets. This
structure is a waterfall because in the event of liquidation, both federal
36
and many state
37
laws require assets to be distributed according to the
facts, bad lawyering, bad judging, and any combination thereof. Because of the noise in the case
law, some discussion of the rights of secured lenders must proceed from an idealized vision of
how such lending occurs and is received in courts. See Robert E. Scott, The Truth About Secured
Financing, 82 C
ORNELL L. REV. 1436, 1440 (1997) [hereinafter Scott, The Truth About Secured
Financing] (“The simple truth is that we will not come to understand the nature and function
of secured credit in our economic system without both a sound theoretical foundation and a
thorough knowledge of how particular security devices function . . . .”).
33
See 11 U.S.C. § 1129(b) (2012) (explaining the requirements for confirming a plan of
reorganization); Case v. L.A. Lumber Prod. Co., 308 U.S. 106, 122–23 (1939) (holding that a
reorganization that did not accord full priority to senior interests failed and violated § 77B of
the Bankruptcy Act); Kansas City Terminal Ry. Co. v. Cent. Union Tr. Co. of N.Y., 271 U.S.
445, 455 (1926) (explaining that under early federal equity reorganizations, “to the extent of
their debts creditors are entitled to priority over stockholders against all the property of an
insolvent corporation”).
34
Indeed, in New York, money that would be distributed to a creditor must be paid instead
to the state comptroller as abandoned property if that creditor cannot be located. It cannot be
used to satisfy the claims of downstream creditors. See N.Y. B
US. CORP. LAW § 1005(c)
(McKinney 2003).
35
The absolute priority rule means that a secured creditor is entitled “to get [its] money or
at least the property” securing the debt. In re Murel Holding Corp., 75 F.2d 941, 942 (2d Cir.
1935); see also John D. Ayer, Rethinking Absolute Priority After Ahlers, 87 M
ICH. L. REV. 963
(1989) (tracing the development of the absolute priority rule along with its exceptions).
36
11 U.S.C. § 1129(b) (explaining the requirements for confirming a plan of
reorganization); see 11 U.S.C. § 507 (detailing the order in which unsecured claims must be
paid); see also Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 979 (2017) (“The Code also sets
forth a basic system of priority, which ordinarily determines the order in which the bankruptcy
court will distribute assets of the estate. Secured creditors are highest on the priority list, for
they must receive the proceeds of the collateral that secures their debts.”); Norwest Bank
Worthington v. Ahlers, 485 U.S. 197, 202 (1988) (“Under current law, no Chapter 11
reorganization plan can be confirmed over the creditors' legitimate objections . . . if it fails to
comply with the absolute priority rule.”); see also 4-507 C
OLLIER ON BANKR. ¶ 507.02[1] (16th
ed. 2017); 3 N
ORTON BANKRUPTCY LAW AND PRACTICE § 49:1 (3d ed. 2016). Some details of
this waterfall may be constitutionally required. See Ayer, supra note 35, at 979–93.
37
See N.Y. BUS. CORP. LAW § 1005(a)(3)(A) (requiring companies to distribute assets to
stakeholders “according to their respective rights”). But see Stephen J. Lubben, The Overstated
Absolute Priority Rule, 21 F
ORDHAM J. CORP. & FIN. L. 581, 584 (2016) (explaining that “[t]he
concepts behind the [absolute priority] rule inform many state laws, like prohibitions on
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1377
absolute priority rule, meaning that secured claims must be paid in full
before unsecured claims, which in turn must be paid in full before
equity claims can receive the residuary.
38
This absolute priority rule,
“the cornerstone of reorganization practice and theory,”
39
is the
backdrop against which all capital is raised and where all interests in
companies and their assets are proven.
40
This Part discusses the layers of capital from the bottom of the
priority waterfall up, which happens to be the natural order in which
claims against company assets attach after a company is formed. This
view makes clear exactly which rights a company has available to trade
with investors at each layer of its capital structure.
41
A. Equity
Every company begins with equity holders. What happens to
property when its owners decide to interpose a company between
themselves and said property? When investors initially organize a
company, the equity holders have the most senior claim against the
company’s assets because they are the only claims.
42
They are also the
residual owners of the company’s assets. As residual owners, if the going
concern dissolves, and all claims against the company were paid, they
would become the owner of any remaining assets.
43
While no equity
fraudulent transfers and restrictions on dividend [payments, but the rule itself] is absent from
any direct application in state corporate debt collection law . . . ”).
38
Secured claims are typically only secured up to the value of their collateral. If their total
claim exceeds the value of the collateral, the claim is typically bifurcated, with the portion
supported by capital sitting at the top of the priority waterfall and the unsupported portion
sitting pari passu with unsecured claims. 11 U.S.C. § 506(a).
39
Bruce A. Markell, Owners, Auctions, and Absolute Priority in Bankruptcy
Reorganizations, 44 S
TAN. L. REV. 69, 123 (1991); see also Roe & Tung, supra note 20, at 1236
(“Absolute priority is central to the structure of business reorganization and is, quite
appropriately, bankruptcy’s most important and famous rule.”). But see Lubben, supra note 37,
at 584 (“[C]hapter 11 will not work under the kind of rigid absolute priority rule many
academic commentators promote, and thus the rule would be certainly flouted.”); Edward H.
Levi & James W. Moore, Bankruptcy and Reorganization: A Survey of Changes III, 5 U.
CHI. L.
REV. 398, 408 (1938) (“The absolute theory of priority . . . is entirely unrealistic in the
reorganization of a large company.”).
40
It is hard to overstate bankruptcy’s importance for understanding property rights. After
all, the boundaries of rights are most relevant when they are being challenged. And nowhere are
property rights more regularly challenged than in bankruptcy where—by definition—there are
insufficient assets to satisfy all claims, and thus an inevitable clash of rights.
41
As will be made clear below, not all of these investors are voluntary. See infra Section I.B.
42
This status is temporary since modern law causes more senior claims, such as tax claims,
to attach almost immediately. See 31 U.S.C. § 3713 (2012) (giving priority to federal tax claims
for parties not in bankruptcy). Interposing the company between them and their assets changes
the equity holder’s property interests from one in a specific asset, to a general claim against the
residuary of a company.
43
See CIT Group Inc. v. Tyco Int’l Ltd. (In re CIT Group Inc.), 460 B.R. 633, 641 (Bankr.
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1378 CARDOZO LAW REVIEW [Vol. 39:1365
holder would have any claim over any particular remaining assets, as a
class, equity holders could liquidate or divvy up assets proportionately
to their ownership interests.
44
Equity—shares, membership interests, partnership interests—is the
classic ownership interest in a company. Equity holders own a fractional
interest in the company. In corporations, equity holders are entitled to
vote for the board of directors, which in turn chooses the management
of a company.
45
In smaller businesses, it is common for equity owners to
also manage the company; that is, for their share in the company to
appear to give them a possessory interest in the company. But
possession and quotidian control are not among equity’s inherent
rights.
46
Nevertheless, an equity interest represents a fractional
S.D.N.Y. 2011) (explaining that shareholders as residual owners are entitled “to share in profits
with no limitation”). For our purposes, I am discussing whichever class or classes of shares are
the true residual owners of a company. It is commonly the case that most large companies have
multiple classes of shares whose claims against the residuary have different priority. As will be
explained in this Section, the different rights among shareholders arise pursuant to the same
mechanisms as other property interests in this Section.
44
Morgan Ricks has recently argued that this property relinquishment—the process of
owners of capital forfeiting their direct claims against that capital in exchange for claims in a
company—is one of the essential roles of American organizational law. By taking a claim in the
residuary of a company in place of their interest in their capital, equity holders subordinate all
of their personal liabilities to claims of their company’s creditors. The process of
relinquishment then serves as a powerful commitment device that “eliminates the ability of co-
owners (and their successors/heirs) to defect with individual business . . . and, hence, going-
concern value.” Morgan Ricks, Organizational Law as Commitment Device, 70
VAND. L. REV.
1303, 1306 (2017).
45
In publicly-traded companies, this right to have the company run for the shareholders’
benefit continues to be an important check on the actions of the company and its managers
even as ownership becomes so diffuse that collective action problems all but eliminate any
individual shareholder’s ability to influence control of the company. When a company becomes
insolvent and the company is unable to satisfy its higher-priority obligations, equity is no
longer the residual owner of the company and therefore not entitled to have the company run
for its benefit. Instead, the fiduciary obligations of the managers (even if they are one and the
same people as the equity holders) shift to the creditors. See Quadrant Structured Prods Co. v.
Vertin, 115 A.3d 535 (Del. Ch. 2015) (explaining that the directors of a balance-sheet insolvent
company have a fiduciary duty to creditors); Royce de R. Barondes, Fiduciary Duties of Officers
and Directors of Distressed Corporations, 7 G
EO. MASON L. REV. 45, 63 (1998) (“The majority
rule, and the law in Delaware, is that, upon insolvency, a board’s duties are owed to the
creditors of the enterprise.”). For the purposes of this Article, I am relying on the traditional
“black box” model of corporations derived from the work of Adolf Berle and Gardiner Means.
See generally A
DOLF A. BERLE & GARDINER C. MEANS, THE MODERN CORPORATION AND
PRIVATE PROPERTY (1st ed. 1932). Many have improved on this model over the years to
recognize the realities of institutional investors and the like, but those realities do not change
shareholders’ formal rights, even if they do change shareholders’ ability to successfully exercise
those rights. See M
ARGARET M. BLAIR, OWNERSHIP AND CONTROL: RETHINKING CORPORATE
GOVERNANCE FOR THE TWENTY-FIRST CENTURY 21 (1995). The rights of equity holders in
other kinds of business associations are similar to those of stock owners.
46
The separation of ownership and control as a feature of corporate property theory has
been well studied over many decades. See Eugene F. Fama & Michael C. Jensen, Separation of
Ownership and Control, 26 J.L.
& ECON. 301 (1983); Michael C. Jensen & William H. Meckling,
Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J.
FIN.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1379
ownership interest
47
over the company and therefore a residuary
interest in,
48
or indirect ownership over, the company’s assets. Although
equity holders often cannot control the company’s management
directly,
49
management’s fiduciary obligations to the company constrain
their choices as to how to manage the company such that, in theory,
they should always be acting in the equity holders’ best interests. First
and foremost, the duty of care
50
and the duty of loyalty
51
ultimately
require board members and directors to operate companies for the
benefit of the equity holders. They have broad,
52
perhaps even overly
broad,
53
leeway to do so, but at the very least, they cannot engage in self-
dealing. That said, even where it seems easy to identify equity holders’
best interests, agency costs will often create a gap between those
interests and management’s actions.
54
ECON. 305 (1976); see also BERLE & MEANS, supra note 45.
47
The property rights at the core of this Article are those that determine the relationships
among different parties and “the sanctioned behavioral relations among men that arise from
the existence of things and pertain to their use.” Eirik G. Furubotn & Svetozar Pejovich,
Property Rights and Economic Theory: A Survey of Recent Literature, 10 J.
ECON. LITERATURE
1137, 1139 (1972).
48
To be sure, this is an idealized view of residual ownership. Commentators have long
observed that, given the amount of debt companies can issue, the true residual claimants are
somewhere in the class of unsecured bonds and trade creditors. See, e.g., B
LAIR, supra note 45,
at 26.
49
Control rights vary depending on the kind of business association and there are
exceptions that prove the rule. For example, shareholders in a co-op residential building
acquire the right to occupy, that is, posses, a particular apartment through the purchase of
shares in the cooperative company that nominally owns the building. See Jay Romano, When
the Owner of a Co-Op Dies, N.Y.
TIMES (Oct. 16, 2005), http://www.nytimes.com/2005/10/16/
realestate/when-the-owner-of-a-coop-dies.html (explaining co-op ownership). Thomas Merrill
has suggested that holders of common stock, like commercial paper and other “interests of the
modern capitalist state” may not be able to “exercise any managerial control over” their
property (i.e., the stock or commercial paper itself) because there “is nothing [there] to
manage.” Thomas W. Merrill, Property and the Right to Exclude, 77 N
EB. L. REV. 730, 750–51
(1998); see also Harold Demsetz, The Structure of Ownership and the Theory of the Firm, 26 J.L.
& ECON. 375, 375 (1983).
50
See, e.g., Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985) (explaining
that the duty of care provides that “corporate directors have a fiduciary duty to act in the best
interests of the corporation’s stockholders”).
51
See Leo E. Strine Jr. et al., Loyalty’s Core Demand: The Defining Role of Good Faith in
Corporation Law, 98 G
EO. L. REV. 629 (2009) (explaining that the duty of loyalty requires
directors to both abstain from conflicts of interest and, acting in good faith, to avoid unlawful
conduct); see also Melvin A. Eisenberg, The Duty of Good Faith in Corporate Law, 31 D
EL. J.
CORP. L. 1 (2006) (distinguishing the duty of good faith from the duty of care and the duty of
loyalty).
52
See, e.g., Treadway Cos. v. Care Corp., 638 F.2d 357, 382 (2d Cir. 1980) (“Under the
business judgment rule, directors are presumed to have acted properly and in good faith, and
are called to account for their actions only when they are shown to have engaged in self-dealing
or fraud, or to have acted in bad faith.”).
53
See Douglas G. Baird & M. Todd Henderson, Other People’s Money, 60 STAN. L. REV.
1309, 1323 (2008) (criticizing the business judgment rule).
54
There is a rich literature describing all the ways in which our separation of ownership
and management incentivizes managers to operate companies for their own benefit rather than
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1380 CARDOZO LAW REVIEW [Vol. 39:1365
The law also polices overreach by creditors who would either
attempt to exercise too much control over the company
55
or to drain out
more than their fair share of assets, thereby usurping equity holder’s
indirect control rights and right to have the company operated for their
benefit.
56
As residual owners, equity holders initially have all of the upside
risk as the residuary grows with the company’s success. That is, there is
no limit on how much they can profit if the company is a runaway
success. Of course, the value of the residuary can shrink as well, but the
notion that higher returns come with downside risk is hardly novel.
57
The downside risk is significant, because equity owners’ property rights
are the first to yield when a company becomes insolvent.
58
And when
there is nothing left after paying creditors—as is normally the case—this
interest is wiped out
59
along with the company (through liquidation or
acquisition).
60
Equity holders’ downside risk is, however, limited: it is capped at
the price at which they acquired and maintained their interest, plus any
additional capital contributions that they made pursuant to that
for the benefit of the shareholders. See generally John Armour et al., Agency Problems, Legal
Strategies, and Enforcement (ECGI Working Paper Series in Law 2009) (surveying the
disconnect between equity holders’ rights and management’s incentives).
55
See Margaret Hambrecht Douglas-Hamilton, Creditor Liabilities Resulting from Improper
Interference with the Management of a Financially Troubled Debtor, 31 B
US. L. 343 (1975).
56
Fraudulent transfer law allows courts to undo certain transfers for which the debtor
received less than “reasonably equivalent value” 11 U.S.C. § 548(a)(1)(B)(i) (2012). Similarly,
courts occasionally recharacterize debt as equity if the capital contribution has various
attributes of an equity contribution but attempts to masquerade as a debt transaction to gain
priority over prior equity holders. See, e.g., Bayer Corp. v. MascoTech, Inc. (In re Autostyle
Plastics, Inc.), 269 F.3d 726, 748 (6th Cir. 2001) (recharacterizing alleged debt as a capital
contribution).
57
In theory, well-functioning markets require higher rates of return as the risk of loss
increases. See Robert E. Scott, A Relational Theory of Secured Financing, 86 C
OLUM. L. REV.
901, 955 (1986) [hereinafter Scott, A Relational Theory of Secured Financing]; Easterbrook &
Fischel, supra note 6, at 91.
58
See Jensen & Meckling, supra note 46, at 340 (explaining how equity holders lose their
claims to their firms when the claims against a firm exceed its market value).
59
Some commentators have argued recently that equity interests should be more difficult
to extinguish through bankruptcy. Instead, they propose that equity holders receive an option
on the upside risk of a reorganized company—that is, on a company that emerges from
bankruptcy as a going concern rather than liquidating. See Casey, supra note 28 (arguing that
unsecured creditors are entitled to an option on the value of a going concern and proposing
that senior creditors buy out unsecured creditors’ option when selling or foreclosing on a firm);
AMERICAN BANKRUPTCY INSTITUTE, COMMISSION TO STUDY THE REFORM OF CHAPTER 11 207–
24 (2014) (proposing that fulcrum creditors receive the value of an option equal to the
redemption price of the reorganized company even when more senior creditors are not paid in
full).
60
Or rather, it should disappear when a company is either liquidated or recapitalized,
meaning that former debt holders receive equity interests in exchange for their higher-priority
claims against the reorganized going concern.
D’ONFRO.39.4.5 (Do Not Delete)
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interest.
61
Even if creditors are owed far more than the assets of the
company, and even if the equity holders have deep pockets, they are not
liable beyond the value they have put into the company. That is the
benefit of limited liability.
Picturing equity holders as participants in a tenancy in common
makes their property right all the clearer. Like tenants in common who
own a piece of real property, they can act as a group—typically by
voting—to use, change, or sell their property. As with co-tenants, equity
holders may have a fiduciary obligation to each other that provides the
outer limits on their rights to use and dispose of the co-tenancy’s
assets.
62
They are fundamentally co-owners of the corporation.
When parties become equity holders by investing their capital in a
company,
63
they are purchasing a spot in this co-tenancy-like entity that
entitles them to: (1) the residuary of the company; (2) a pro-rata share
of any dividends; and, usually, (3) a vote for the directors or managers of
the company whose actions will determine the residuary and other
distributions.
64
The directors and managers, through this delegated
authority, then control future company actions that can and do impact
the value of the equity holder’s claim against the company.
65
In this way,
when managers and directors create rights to the company’s assets that
are senior to the equity interests, they do so with the consent and
authority of equity holders. Individual equity holders may disagree with
individual actions, but they consented to live with the choices of their
managers and directors when they traded their capital for an interest in
the company.
Equity holders have two paths for bringing additional capital into
their company: they invite in additional equity holders or delegate to
management the right to create senior claims against company assets.
Some of these senior claims are the unavoidable consequences of doing
61
This is the core of limited liability. Shareholders can lose their investment, but they are
not, absent highly unusual circumstances, responsible for other losses incurred or caused by the
company in which they invest. See Lynn M. LoPucki, The Death of Liability, 106 Y
ALE L.J. 1, 38
(1996) [hereinafter LoPucki, The Death of Liability].
62
In closely held corporations, shareholders have fiduciary duties to each other that
shareholders in publicly-traded corporations do not have. These duties to each other generally
prohibit conflicts of interest that might lead to strategic behavior that would negatively impact
the other shareholders. That said, even in large, public corporations, certain strategic behavior
may lead to liability among shareholders. See, e.g., Rexford Rand Corp. v. Ancel, 58 F.3d 1215,
1219 (7th Cir. 1995) (“Generally, imposing a fiduciary duty on shareholders in a close
corporation shields minority shareholders from oppressive conduct by the majority.”).
63
This discussion presumes that the company in question has only one layer of equity. If
there are preferred shares or other equity interests that have a preference right over the
common stock, those interests proceed from the common stock.
64
Whether that right to vote is meaningful is subject to debate. See Frank H. Easterbrook &
Daniel R. Fischel, Voting in Corporate Law, 26
J.L. & ECON. 395, 395-97 (1983) (explaining
disagreement in the literature about shareholder voting rights).
65
Easterbrook & Fischel, supra note 6, at 94.
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business—utility bills, salaries, tax obligations, and so on. If the
company wants a more significant infusion of capital, it must either
issue equity interests or issue debt. With unsecured debt, a company is
selling a claim against the residuary of the company. With secured debt,
it is selling specific company assets that then no longer comprise the
residuary. Both kinds of debt can be understood as equity holders,
through management, temporarily alienating their interests in the hope
of achieving better investment returns. External sources of law may
limit the condition of sales,
66
but it is rare for law to render any
particular property right inalienable.
67
B. Unsecured Claims
Moving up the priority waterfall, the next most senior class of
capital is unsecured debt.
68
Unsecured debt includes not only
commercial unsecured debt and credit cards but also all unfilled
contractual obligations and potential judgment creditors. These
claimants can be suppliers who do not require immediate payment,
employees who have accrued paid leave, contract counterparties, and
tort claimants, among other possibilities.
69
Unsecured debt is unique
among the layers of capital in that it is often given involuntarily when
claims are not paid upon accrual.
When a company incurs unsecured claims, equity holders, through
management, temporarily alienate some of their claims over the
residuary of the company by creating a right to the company’s assets
that has priority over their claim. That is, if the company were to cease
doing business, its unsecured claims would be paid before equity
66
For example, fraudulent transfer and fraudulent conveyance laws tend to limit sales for
other than reasonably equivalent value. E.g., M
O. ANN. STAT. § 428.029(1) (West 2017). (“A
transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim
arose before the transfer was made or the obligation was incurred if the debtor made the
transfer or incurred the obligation without receiving a reasonably equivalent value in exchange
for the transfer or obligation and the debtor was insolvent at that time or the debtor became
insolvent as a result of the transfer or obligation.”).
67
As Thomas Merrill observed, “[i]t takes some special conveyance or legislation to defeat
the expectation that the right to exclude entails a right to transfer.” Merrill, supra note 49, at
743.
68
For the purposes of this Article, I am lumping bonds and loans together and focusing
instead on whether the obligation is secured or unsecured. While there remain some differences
between the bond and loan markets, the two forms of debt are economic equivalents, primarily
distinguished by their regulatory obligations. See Elisabeth de Fontenay, Do the Securities Laws
Matter? The Rise of the Leveraged Loan Market, 39 J.
CORP. L. 725 (2014) (cataloging the
convergence of the bond and leveraged loan markets).
69
In a bankruptcy, these groups would all begin as unsecured creditors. 11 U.S.C. § 506
(2012) (claims are unsecured unless they meet the statutory requirements for being treated as
secured claims).
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holders received any distribution of assets.
70
As mentioned above, there
are many sources of unsecured claims, some voluntary, some not; some
intentional, some not.
71
But the effect on the capital structure of a company is the same
whether it issues unsecured bonds, delays payments to vendors, or
injures someone in tort.
72
From the perspective of equity, the company
is ideally increasing the value of its equity interest by selling a priority
claim against the general pool of assets that would otherwise comprise
its residuary.
73
As a company does business, it puts its capital, which
would otherwise comprise equity holders’ residuary, at risk in the hopes
that the risk returns a profit.
But what kind of interest does the unsecured lender have in the
company? Is it a property right? If it is, it must be the same kind of
property right created by contracts and unliquidated liability generally.
74
Upon close analysis, it is difficult to fit unsecured debt into our
traditional conception of property. Instead, through contract, they
acquire a non-specific interest in the company’s assets that is supported
70
Equity holders may receive compensation ahead of unsecured claims if the equity
interests are being extinguished through a sale or merger that intends to preserve unsecured
claims. The effect of the wind-up on the original company may be the same, and indeed, the
sale or merger may decrease the chances that unsecured claimants will be able to satisfy their
claim, but the key difference between a dissolution and a sale is that there is a successor entity
to assume the unsecured claims, which in turn permits distributions to equity to occur.
71
See supra Section I.B.
72
To be sure, there can be incredible variation and stratification within a pool of unsecured
claims. Lawmakers may give wage and tax obligations priority over other unsecured claims. For
example, 11 U.S.C. § 507, sets priorities among unsecured claims based on lawmakers’ policy
preferences rather than any rights stemming from contractual or property rights. For example,
under § 507, domestic support and tax obligations must receive priority over other unsecured
claims, even if those unsecured claims purport to be “senior” themselves or otherwise prohibit
the company from incurring senior claims. In this way, any stratification within the pool of
unsecured claims does not reflect any stratification of property rights within that pool of claims.
11 U.S.C. § 507.
73
See Rene Stulz & Herb Johnson, An Analysis of Secured Debt, 14 J. FIN. ECON. 501, 502
(1985) (explaining that some profitable projects will only be possible if the firm can finance it
with secured debt).
74
Olivia A. Radin, Rights as Property, 104 COLUM. L. REV. 1315, 1336–37 (2004)
(explaining that “[t]o the extent that an abrogated right is a traditional common law right, such
as a tort right, these cases indicate that the court will protect it as a property interest. If the right
is not clearly established or conflicts with the constitutional allocation of power, then the courts
are unlikely to treat those rights as property for due process purposes”); see, e.g., Landgraf v.
USI Film Prods., 511 U.S. 244, 271 (1994) (“The largest category of cases in which we have
applied the presumption against statutory retroactivity has involved new provisions affecting
contractual or property rights, matters in which predictability and stability are of prime
importance.”); Preveslin v. Derby & Ansonia Developing Co., 151 A. 518, 522 (Conn. 1930)
(“The defendant’s right of defense . . . was a property right which vested in the defendant and
for whose protection against legislative invasion in the form of a validating act or otherwise it
could rely . . . upon the Fourteenth Amendment of the Federal Constitution.”); N.Y. Cent. R.R.
Co. v. White, 243 U.S. 188, 198 (1917) (explaining that unaccrued liabilities are subject to
change, for “[n]o person has a vested interest in any rule of law, entitling him to insist that it
shall remain unchanged for his benefit”).
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by the residual value of the company as a whole.
75
Their interest does
not become a property right against a company’s assets unless and until
it is reduced to a lien through the judgment process.
76
For example,
courts
77
and commentators
78
often insist that property ownership
includes the right to exclude. But, as explained above, unsecured claims
are rights to be paid from a general pool of a company’s assets. There
are literally no limits on how many claims against those assets can exist,
nor does an unsecured creditor have an inherent right to limit whether,
how, or to what extent a company incurs additional unsecured claims.
79
For this reason, unsecured claims, unlike equity, do not resemble a
kind of common property.
80
Although the company may claim that it
75
See generally James Steven Rogers, The Impairment of Secured Creditors’ Rights in
Reorganization: A Study of the Relationship Between the Fifth Amendment and the Bankruptcy
Clause, 96 H
ARV. L. REV. 973 (1983). In Louisville Joint Stock Land Bank v. Radford, the
Supreme Court held that for the purposes of the Fifth Amendment, secured creditors had a
compensable property right in the collateral while unsecured creditors had an uncompensable
contract claim against the debtor, but gave no explanation for this distinction. Louisville Joint
Stock Land Bank v. Radford, 295 U.S. 555, 588–89 (1935).
76
That is, unless we extend the definition of property to include all contractual rights. See
generally Thomas W. Merrill & Henry E. Smith, The Property/Contract Interface, 101 C
OLUM.
L. REV. 773 (2001) (exploring the line between in personam contract rights and in rem property
rights).
77
Int’l News Serv. v. Associated Press, 248 U.S. 215, 246 (1918) (Holmes, J., concurring)
(“Property depends upon exclusion by law from interference . . . .”); Kaiser Aetna v. United
States, 444 U.S. 164, 176 (1979) (explaining that “one of the most essential sticks in the bundle
of rights that are commonly characterized as property . . . ” is “the right to exclude others”);
Dolan v. City of Tigard, 512 U.S. 374, 384 (1994) (same); United States v. Craft, 535 U.S. 274,
283 (2002) (same); Philip Morris v. Reilly, 312 F.3d 24, 51 (1st Cir. 2002) (explaining that the
value of a property right “is inextricably tied to both the demand of others for access and the
legal enforceability of the owner’s right to exclude” such that government action impairing the
right to exclude requires just compensation).
78
1 WILLIAM BLACKSTONE, COMMENTARIES ON THE LAWS OF ENGLAND 2 (1753) (defining
property as “that sole and despotic dominion which one man claims and exercises over the
external things of the world, in total exclusion of the right of any other individual in the
universe”); Merrill, supra note 49, at 730 (arguing “that the right to exclude others is more than
just ‘one of the most essential[’] constituents of property[—]it is the sine qua non” (emphasis
added)); Henry E. Smith, Exclusion Versus Governance: Two Strategies for Delineating Property
Rights, 31 J.
LEGAL STUD. 453, 485 (2002) (arguing that “exclusion is often the first low-cost
(but low-precision) cut at defining and defending a resource”). But see James Y. Stern,
Property’s Constitution, 101 C
ALIF. L. REV. 277, 302 (2013) (arguing that exclusivity, not
exclusion, is the core of property because “[a] right to control is most complete and most
meaningful when it is not shared with others . . . ”); R
ESTATEMENT (FIRST) OF PROP. § 10 (AM.
LAW INST. 1936) (“The word ‘owner,’ as it is used in this Restatement, means the person who
has one or more interests.”).
79
Sophisticated unsecured creditors can bargain for this right to exclude through the
covenants governing their loan, but there is no presumption that such a right exists on its own.
Still, the limitations of covenants illustrate how unsecured claims fail as property claims.
Notably, a covenant not to create senior interests does not actually prevent the creation of
senior interests. It only creates an event of default if the lender in fact creates a senior interest.
Carl S. Bjerre, Secured Transactions Inside Out: Negative Pledge Covenants Property and
Perfection, 84 C
ORNELL L. REV. 305, 308 (1999).
80
See Merrill, supra note 49, at 750 (discussing the right to exclude as applied to common
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controls who is or is not a member of the community of unsecured
claims holders, its control is always thwarted by involuntary creditors.
Short of going out of business, there is nothing that a company can do
to protect its unsecured creditors from having their ranks diluted by tort
claims. Even ceasing to operate is not enough to limit the class of
unsecured creditors since there will always be recurring obligations to
the state for the privilege of existing as a company.
81
The continued
existence of the company necessarily means that the class of potential
unsecured creditors remains open.
If they are property, unsecured claims significantly differ from
more familiar forms of property in that they are not tied to a specific
asset; there is no in rem right.
82
Defending or dissolving the entire
framework of our common law system is a project for another day.
83
For
now, it is enough to say that unsecured claims are not, on their own,
property, even if the underlying contractual and tort claims are
sometimes construed as property rights.
A better way to conceive of unsecured claims is as priority rights
over the claims of equity holders against the assets of a company. There
can be no unfairness when, in a wind-up or reorganization, unsecured
claims receive distributions ahead of equity because equity holders
chose to incur exactly this risk when they invested in a company capable
of incurring such liabilities. This is true even when the liability comes
from an unexpected tort claim—the possibility of incurring such claims
is part of the risk that equity holders assume in exchange for their
unlimited upside risk in their claim against the residuary.
But this priority right has a cost. As compared to equity holders—
whose upside risk is theoretically infinite—unsecured creditors’ upside
has a ceiling, that which is defined in their contract or claim. Their
profit is the extent to which the interest and fees that they collect
exceeds the time-value of money over the term of the loan.
84
property).
81
For example, there are regular filing fees for maintaining any company forms. Likewise,
there are tax filing obligations even when no taxable income has accrued. Failure to comply
with these obligations typically results in fees and fines that themselves become unsecured
claims.
82
Merrill & Smith, supra note 76, at 834 (“The security interest gives the lender two rights
that an unsecured lender does not have. First, the lender has what is called a ‘property right’ or
‘repossessory right,’ which means that upon default the lender can seize the collateral without
having to resort to judicial process.”).
83
It is possible that both contractual rights and tort claims are best conceived of as flavors
of personal property. Such an open framework might harmonize some of the strange
jurisprudence around the Takings Clause. But it might also throw our entire system of
bankruptcy into constitutional crisis if relieving a going concern of its debt overhang means
extinguishing property rights that are otherwise constitutionally protected from interference.
See Thomas C. Grey, The Disintegration of Property, 22 N
OMOS 69, 74–75 (1980) (arguing that
reducing property into a limitless set of rights denies any conceptual coherence).
84
Some lenders may be able to increase their profit considerably through the amend and
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Unsecured debt, although it primes equity holders’ claims against a
company’s assets, presents a much lower risk to equity’s interest than
secured debt, or even the issuance of additional equity interests.
Unsecured claimants have no claim over a specific asset of the company.
If a company must sell its possessions to service those claims, it can elect
to sell possessions that are not critical to its long-term health, if it has
any such assets. By preserving those assets that are critical for its
business, the company has a chance to continue as a going concern and
dig itself out of debt—thus preserving the equity holder’s upside risk by
staying in business.
Unsecured debt also poses less of a threat to equity interests
because unsecured creditors have a strong incentive to negotiate a
compromise with a struggling debtor. Without any claim against a
specific asset, unsecured creditors’ expected recovery given default may
be quite low as they must share a limited pool of unencumbered assets
with all of the other unsecured claimants.
85
Moreover, whether in
bankruptcy or in the state court system, the process for liquidating an
unsecured claim is both time intensive and subject to waste.
86
The
borrower can drag out the process, spending its limited assets down as it
does so, to effectively hold its unsecured creditors hostage.
Unsecured lenders can protect themselves to some extent with
covenants.
87
With covenants, the company trades some of its rights to
self-control to the lender in exchange for more favorable terms or for
credit that would be otherwise unavailable.
88
From equity’s perspective,
covenants represent a further delegation of control over their capital. If
equity holders dislike the path the company is on, they can use their
voting rights to try to instill debt-averse directors or managers in the
future,
89
but their only way to avoid the impact of any covenants is to
sell their equity interests and invest elsewhere.
extend process. This occurs when the borrower is unable to make a payment on the loan and
renegotiates the terms in lieu of default. Lenders typically collect handsome fees with each
round of this process. See Andrew G. Herr, Joyce M. Bernasek & William Corcoran, “Amend
and Extends” Emerge as New Trend in U.S. Loan Markets, L
EXOLOGY (July 7, 2009), https://
www.lexology.com/library/detail.aspx?g=f39ec24a-917c-40c9-8161-720ef292a205.
85
Moreover, even if there is no secured debt in a company’s capital structure, other laws
may give certain other unsecured claims distributional priority over another claimant,
notwithstanding contractual provisions to the contrary. See, e.g., 11 U.S.C. § 507 (2012)
(explaining priorities).
86
See Jacoby & Janger, supra note 20, at 872–73 (criticizing state court liquidation options);
Ronald J. Mann, Strategy and Force in the Liquidation of Secured Debt, 96 M
ICH. L. REV. 159,
164 (1997) [hereinafter Mann, Strategy and Force] (finding the view among loan officers that “a
decision to repossess collateral and liquidate was tantamount to accepting a loss on the loan”).
87
Whitehead, supra note 27, at 651.
88
Henry Hansmann & Reinier Kraakman, Hands-Tying Contracts: Book Publishing,
Venture Capital Financing, and Secured Debt, 8 J.L.
ECON. & ORG. 628, 649 (1992).
89
Of course, the weight of any one equity holder’s vote will vary with the number of
outstanding equity interests. A small shareholder in a large company has almost no chance of
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When unsecured creditors are the fulcrum creditor, a handful of
state laws work together to protect unsecured creditors’ residual
interests in the borrowers’ property. Most notably, fraudulent transfer
law and restrictions on dividends ensure that borrowers do not siphon
assets away from creditors without replacing them with something else
of value.
90
Nevertheless, unsecured claims are extremely vulnerable to
non-payment. Because they can accrue through tort and other
unplanned means, existing lenders cannot use contract to bar borrowers
from taking on new, unsecured liabilities. To protect themselves,
commercial unsecured creditors contract with the company for certain
promises and, oftentimes, control rights, in exchange for their capital. If
the company breaches these promises, the lender must look to
contractual remedies. Lacking any direct property interest in the
company’s assets, they have no inherent right to self-help. This lack of
any direct property interest also means that the unsecured debt can be
wiped out in bankruptcy if there are insufficient assets to satisfy it before
the debtor receives a discharge.
C. Secured Debt
At the top of the priority waterfall sits secured debt.
91
Secured debt
refers to a loan where, in addition to a promise to repay the principal
and interest, the borrower gives the lender an interest in collateral. This
interest then entitles the lender to foreclose on the collateral if the
borrower fails to satisfy the terms of the loan. Secured creditors must
satisfy certain formalities to perfect their security interest. It is only once
they perfect their lien that their claim against the collateral is fixed in
place.
92
Before then, the debt is effectively unsecured. Subsequent
implementing change through its vote.
90
See Robert Charles Clark, The Duties of the Corporate Debtor to Its Creditors, 90 HARV. L.
REV. 505 (1977) (explaining limitations on borrowing); see also 11 U.S.C. § 548(a)(1)(B)(i)
(“The trustee may avoid any transfer received less than a reasonably equivalent value in
exchange for such transfer or obligation . . . .”).
91
There are a few exceptions to the rule that secured lenders are at the top of the priority
waterfall. These largely arise when municipalities place their own claims against the borrower
in the first position notwithstanding the presence of earlier secured claims. For example, in
many places in the United States, liens arising from unpaid taxes can prime existing liens and
become the most senior security interests against property. In re Ecology Paper Prods. Co., 17
B.R. 281, 282 (Bankr. D. Ariz. 1982). Similarly, mechanics’ liens commonly prime preexisting
senior secured interests without the consent of those preexisting senior secured lenders. See
Church Bros. Body Serv., Inc. v. Merchs. Nat’l Bank & Tr. Co., 559 N.E.2d 328, 331 (Ind. Ct.
Appl. 1990) (explaining when mechanic’s liens have priority over other liens).
92
See generally Ronald J. Mann, First Shall Be Last: A Contextual Argument for Abandoning
Temporal Rules of Lien Priority, 75 T
EX. L. REV. 11 (1996) [hereinafter Mann, First Shall Be
Last] (explaining and criticizing regimes for protecting security interests).
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creditors could leap in with a prior lien
93
and, if the borrower were to
file for bankruptcy, the trustee could defeat the lien altogether.
94
Although the particular steps for perfecting a lien depend on the
jurisdiction and kind of collateral encumbered, the typical first step is a
public filing of some kind. One common recording requirement is that
the borrower and the collateral must be clearly identified so that third
parties who would do business with the borrower can discover that its
assets are already encumbered. Even though searching for perfection
filings can be expensive and imperfect, they are universally treated as
sufficient notice to the world that the encumbrance exists.
95
This filing
requirement is closely related to the filing system for recording
ownership of real property. Indeed, liens against real property and
fixtures are typically recorded alongside deeds and transfers.
When a company issues secured debt, it again creates a claim that
has priority over the equity holders’ claim against the residuary in
exchange for capital. Secured debt differs from other investments
because rather than being supported by the residuary of the company,
the debt is supported by collateral comprised of specific assets.
96
From
the perspective of equity, the creation of secured debt looks a lot like the
sale of the encumbered asset. To the extent that they are encumbered,
these encumbered assets are removed from the residuary of the
company when the secured lender perfects its lien.
97
Depending on the
terms of the loan, the company may still be able to possess and use the
asset while it is encumbered, but perfection may require that the lender
assume control
98
or even possession of the collateral.
99
The company
then slowly repurchases the assets from the lender as it makes payments
93
Both liens could be perfected against the same property, but the first creditor to make the
requisite filing usually has complete priority over liens in subsequent filings unless the first filer
had notice of the second filer’s lien at the time it made its filing. N.Y.
REAL PROP. LAW § 291
(McKinney 2003). Other states do not even require the second creditor to complete their filing
first to have priority. M
O. ANN. STAT. § 443.035 (West 2000). And Delaware, Louisiana, and
North Carolina do not even ask whether the second lender knew about the first lender’s lien,
relying entirely on the order in which lenders complete the requisite formalities to determine
priority. D
EL. CODE ANN tit. 25 § 153 (West 2014); LA. CIV. CODE ANN. art. 1839 (1985); N.C.
G
EN. STAT. ANN. § 47-18 (West 2005).
94
See 11 U.S.C. § 544 (2012) (allowing bankruptcy trustees to avoid unperfected liens). If a
trustee successfully avoids a lien, the debt enters the general class of unsecured debt.
95
This notice to the world feature is important because the security interest creates a
property interest that is good against the world.
96
Melissa B. Jacoby & Edward J. Janger, Tracing Equity: Realizing and Allocating Value in
Chapter 11 (Brooklyn Law Sch. Legal Studies Research Papers, Research Paper No. 537, 2017)
[hereinafter Jacoby & Janger, Tracing Equity].
97
See Merrill & Smith, supra note 76, at 835.
98
For example, to perfect a security interest in money held in a bank account, the lender
must have control over that account. Control is typically established through a deposit account
control agreement, which may restrict the borrower’s ability to access funds in the account.
99
For example, security interests in shares are perfected by taking possession of the share
certificates.
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and this repurchased portion then supports the claims of unsecured
lenders and equity holders.
The key feature here is that while an asset is encumbered, the
company no longer has sole ownership over it. Rather, the company co-
owns it with the secured creditor in proportion to the extent to which
the value of the lien matches the value of the encumbered asset. If the
lien exceeds the value of the asset, one can legitimately wonder whether
the borrower owns it so much as merely has a right to use it. This dual-
ownership complicates a secured lender’s upside risk. In theory, and like
unsecured debt, the upside risk is the price of the debt given in the
contract. In practice, if the borrower defaults, the secured lender can
foreclose on its collateral—use a credit-bid to prevail in the auction—
and take over the borrower’s interest in the collateral. If that interest
includes unlimited upside risk, the secured lender gets that unlimited
upside risk.
Even if security interests are somehow not full-fledged property
rights, they only work in our private law framework if we recognize and
focus on their property-like features. Otherwise, they are merely
contracts to involuntarily subordinate the rights of other creditors.
100
Property rights, by contrast, regularly subordinate the rights of third
parties. For example, if a company sells an asset outright, unsecured
creditors are potentially worse off post-sale because the asset is no
longer available for creditors to levy against and the cash may be freely
spent. But, absent covenants prohibiting the sale of assets, the unsecured
creditor has no right to stop or undo the sale because the borrower
never had an obligation to preserve specific assets for paying their
claims.
101
Instead, unsecured creditors facing a sale of assets can look
only to fraudulent transfer and preference law if the sale occurred when
the borrower was unable to pay its claims.
102
Normally, parties cannot contract to directly harm a third party
without incurring liability to that third party.
103
Dave and Emily cannot
contract for Emily to break her contract with Fran without Fran
accruing the right to seek damages from one or both of them either in
contract
104
or in tort.
105
This is not to say that courts only enforce
100
See Jackson & Kronman, supra note 19, at 1147 (“The idea that all creditors should be
treated equally, regardless of the private arrangements they may have made with their debtor,
has played an important role in the evolution of the federal bankruptcy system. Reported case
law is replete with references to the bankruptcy ‘principle’ that ‘equality is equity.’”).
101
See Douglas G. Baird & Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper
Domain Symposium on Bankruptcy, 38 V
AND. L. REV. 829, 836 (1985).
102
Id. at 830.
103
Lynn LoPucki described security agreements succinctly as an “agreement between A and
B that C take nothing.” Lynn M. LoPucki, The Unsecured Creditor's Bargain, 80 V
A. L. REV.
1887, 1899 (1994) [hereinafter LoPucki, The Unsecured Creditor’s Bargain].
104
Decolator, Cohen & DiPrisco, L.L.P. v. Lysaght, Lysaght & Kramer, P.C., 756 N.Y.S.2d
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1390 CARDOZO LAW REVIEW [Vol. 39:1365
victimless contracts. Buyer may contract with Supplier to be the
exclusive distributor of its widgets in a particular city. If Retailer can no
longer buy those widgets, or must pay more to acquire them, then the
contract between Buyer and Supplier likely harmed Retailer. As much as
Retailer might dislike this arrangement, Retailer will only have recourse
if it has an agreement with Supplier that is now breached or if the
agreement between Buyer and Retailer triggers antitrust or unfair
competition concerns. That is, since the harm of the exclusivity contract
is not specifically targeted at Retailer, its rights must either lie in its own
contractual claim, or because there is a specific public policy—for
example, antitrust—that the contract between Buyer and Supplier
violates.
Outside of security interests, borrowers generally cannot
subordinate one creditor to another without the consent of the
subordinated lender.
106
Imagine that a borrower has two unsecured
loans, but one of them purportedly requires the borrower to pay that
debt before making any other debt payments. If the borrower makes all
the payments, this provision offends no one. Of course, this kind of
provision is aimed at the times when the borrower lacks the cash-flow to
make its payments as they come due. If and when the borrower skipped
payments to the involuntarily subordinated lender, provided that other
conditions are met, that lender could file an involuntary bankruptcy
petition against the borrower.
107
No bankruptcy court would respect a
loan provision unilaterally claiming priority over other debt, absent the
full formalities of a security interest.
108
Unsecured lenders must rely on
147, 150 (N.Y. App. Div. 2003) (“It is well settled that in order to have standing to challenge a
contract, a nonparty to the contract must either suffer direct harm flowing from the contract or
be a third-party beneficiary thereof.” (citation omitted)).
105
For example, the tort of intentional interference with business advantage “permits
recovery for interference with business relationships or expectations even in the absence of a
legally binding agreement or where the expectations of the parties are only the subject of an
unenforceable contract.” Smith v. Superior Court of L.A., 198 Cal. Rptr. 829, 836 (Cal. Ct. App.
2d 1984). The elements of intentional interference with business advantage are:
(1) An economic relationship between the plaintiff and some third person containing
the probability of future economic benefit to the plaintiff; (2) knowledge by the
defendant of the existence of the relationship; (3) intentional acts on the part of
defendant designed to disrupt the relationship; (4) disruption of the relationship; and
(5) damages proximately caused by the acts of defendant.
Id.
106
Hideki Kanda, Debtholders and Equityholders, 21 J. LEGAL STUD. 431, 436–37 (1992).
(explaining the absence of “preferred debt”).
107
11 U.S.C. § 303 (2012).
108
See William E. Hogan, Unperfected Security Interests and the “Floating Lien”, 44 TEX. L.
REV. 713, 713–14 (1966). Moreover, even if the loan did claim to be a secured loan, the
bankruptcy trustee could seek to boot the debt back into the pool of unsecured debt unless each
and every perfection formality was met. See 11 U.S.C. § 544 (granting trustees power to avoid
unperfected security interests).
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contract—specifically inter-creditor agreements—to effectuate different
priority rights. Without an inter-creditor agreement, if the borrower
makes payments to one lender while withholding payments to the other,
the unpaid lender may recover some of those payments in a preference
action.
109
If security interests are merely contractual rights, there is little to
distinguish them from the unenforceable unilateral priority clause in the
contract above. Borrowers can create security interests without the
consent of other creditors. But once created, borrowers cannot
subsequently subordinate the rights of a secured creditor without its
consent. Unlike with unsecured debt, the presumption with secured
debt is not that it is paid pari-passu, but rather that it is paid in the order
in which it was perfected.
110
While the line between contractual rights
and property rights is increasingly vague, this perfection process, and
the rights that it triggers, are undeniably property-like.
The role of secured debt in capital structures has shifted
considerably in recent decades as it has become the dominant form of
small business lending.
111
The changing role of secured credit is due to
both changes in the laws facilitating its creation and changes in
sentiments towards secured debt.
112
Notwithstanding these changes, the
core has been mostly stable: the contract between the lender and the
borrower defines the lender’s expected upside risk,
113
which comprises
interest and fees defined in the loan agreement. In exchange for a lower
interest rate, the borrower gives the lender a security interest, which is a
claim against specific assets of the borrower. When certain conditions
occur—typically nonpayment or failure to cure a material default—the
109
11 U.S.C. § 547(b) (permitting the bankruptcy trustee to avoid transfers to creditors
made within ninety days of bankruptcy that would otherwise allow that creditor to recover
more than it would recover under the absolute priority rule).
110
See Alan Schwartz, A Theory of Loan Priorities, 18 J. LEGAL STUD. 209, 209 (1989); Mann,
First Shall Be Last, supra note 92.
111
See, e.g., Mark Jenkins & David C. Smith, Creditor Conflict and the Efficiency of
Corporate Reorganization (2014) (unpublished paper), https://ssrn.com/abstract=2463700
(“Secured debt represented less than 45% of the debt of Moody’s-rated firms filing for
bankruptcy in 1991; by 2012, secured debt accounted for more than 70 percent of the debt of
Moody’s-rated bankruptcy filers.”).
112
See infra Section II.B.
113
A lender’s upside risk is typically capped at its expected interest and fees less any
underwriting and servicing costs and the relevant time-value of the money lent. In rare cases,
secured lenders may prefer to foreclose on an asset instead of being paid back in full. See
Hester-Haddad & D’Onfro, supra note 25 (discussing loan-to-own strategies). In these so-
called loan-to-own cases, the lenders are trying to circumvent their capped upside risk and, by
stepping into their shoes of equity holders, obtain equity’s unlimited upside risk. See In re Free
Lance-Star Publ’g Co., 512 B.R. 798, 806 (Bankr. E.D. Va. 2014) (explaining a creditor’s loan-
to-own strategy). Certain kinds of convertible debt similarly allow secured lenders to trade their
secured position for better upside risk by converting their claim to equity. See Michelle M.
Harner, Activist Distressed Debtholders: The New Barbarians at the Gate?, 89 W
ASH. U. L. REV.
155, 165–69 (2011) (cataloguing loan-to-own strategies).
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security interest entitles the lender to liquidate the encumbered assets to
satisfy its claim, thereby giving it a distributional priority over
unsecured claims up to the value of its collateral. For example, an auto
lender who takes a security interest in a vehicle can repossess that
vehicle if the borrower defaults on the loan. As Judge Learned Hand
long ago put it, a security interest entitles a lender “to get [its] money or
at least the property” securing the debt.
114
Since a secured creditor’s interest is in identifiable assets, it
typically travels with that asset, or the proceeds of that asset, until the
value of the asset is itself destroyed.
115
For example, a lien on a personal
property becomes moot if the property is destroyed in a fire although
the underlying debt may remain valid as unsecured debt. If the property
were sold out of state without the lender’s consent, the lien would
remain attached but the lender would have to take certain steps to
maintain perfection.
116
The key feature is that the security interest is, at
least in part, an in rem right unlike other claims against the company.
117
II.
THE PROBLEM OF SECURED DEBT
A. Explaining Two Layers of Debt
Understanding why both equity and debt exist is comparatively
simple. As discussed above, equity holds the upside risk in any venture.
As entrepreneurs seek equity investments, they must sell part of their
own stake in the company or dilute their interest by issuing additional
shares, unless the company is sufficiently sophisticated to justify
multiple classes of equity.
118
Entrepreneurs who need cash but who wish
to maintain control and to avoid reducing their upside risk can avoid
diluting their control by choosing debt.
119
114
In re Murel Holding Corp., 75 F.2d 941, 942 (2d Cir. 1935).
115
See generally Jacoby & Janger, Tracing Equity, supra note 96 (explaining how security
interests attach to assets and the limits of asserting security interests against the proceeds of the
original collateral).
116
U.C.C. § 9-316(a)(3) (AM. LAW INST. 2012).
117
Merrill & Smith, supra note 76, at 833–43.
118
Companies that have raised capital beyond the initial investors or have begun issuing
stock options to employees typically have both preferred shares and common shares. Preferred
shares typically pay a regular dividend that must be paid before any dividends can be paid on
the common shares. If the company were to liquidate, preferred stock may have priority over
common stock. In most cases, preferred shares are non-voting shares, making them effectively
like unsecured debt, but without a cap on the value that must be repaid. To protect existing
shareholders, corporate law typically requires companies to issue new equity at the fair market
value of existing equity. Kanda, supra note 106, at 434.
119
Many companies never even get to this choice. Their only option is secured debt because
they are insufficiently creditworthy to borrow unsecured or have not sufficiently proven their
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The more puzzling question is why we need both secured and
unsecured debt.
120
Modigliani and Miller famously posited that if
bankruptcy costs are zero and tax policies are neutral, capital structure
should not influence firm value and therefore firms should not
rationally prefer one form of financing over another.
121
Of course,
bankruptcy costs are not zero, and tax policies are neither neutral nor
consistent between firms. Nor are firms consistently rational actors in
the face of these costs. Companies and investors have idiosyncratic
preferences just as the people that comprise them do. Accordingly, the
choice between secured and unsecured debt can likely be explained by
lenders’ varying preferences for risk and control.
Any loan, whether it backs a business venture or helps purchase a
house, entails some risk that the borrower will not repay in full. Lenders
have three levers for manipulating their exposure to that risk: collateral,
covenants, and price. Collateral, as shown above, helps lenders reduce
their downside risk by raising their expected recovery given default.
122
Recovery given default is the value that the lender expects to receive
should the borrower default on the loan. It typically reflects the value of
the collateral, the priority of the liens, as well as macroeconomic
conditions such as the overall default rate.
123
Unsurprisingly, companies
whose balance sheets reveal cash-flow risks or whose industries are
either very competitive or in secular decline get shut out of the
unsecured debt markets.
124
idea to attract venture capital. See Steven L. Schwarcz, The Easy Case for the Priority of Secured
Claims in Bankruptcy, 47 D
UKE L.J. 425, 447–48 (1997).
120
The fact that most companies have a mixed capital structure has perplexed
commentators for some time. See Scott, The Truth About Secured Financing, supra note 32, at
1437 (lamenting that nineteen years into the debate about the social value of secured credit,
there was still no theory of finance explaining why firms sometimes issue secured debt); see also
White, supra note 19; Schwartz, Security Interests and Bankruptcy Priorities, supra note 19, at 1
(arguing that the variety of debt and equity instruments is relatively poorly understood).
121
Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance and the
Theory of Investment, 48 A
M. ECON. REV. 261, 268–71 (1958).
122
That said, given the transaction costs associated with selling collateral, and the risk that a
court could find a lien to be invalid or unperfected, few if any lenders rely exclusively on
expected recovery given default when deciding to lend. Scott, A Relational Theory of Secured
Financing, supra note 57, at 944–45. While recovery given default may not have driven lending
decisions in earlier generations, id., for non-investment grade companies (that is, those with a
real risk of default), it currently is a key driver of company’s credit ratings and in turn, the cost
of their debt. L
OAN SYNDICATIONS & TRADING ASS’N, THE TROUBLE WITH UNNEEDED
BANKRUPTCY REFORM: THE LSTA’S RESPONSE TO THE ABI CHAPTER 11 COMMISSION REPORT
28 (2015) (studying a sample of 855 issuers rated BB- through B by Standard & Poor’s and
showing that companies with a lower expected recovery given default paid more for their debt).
123
See Edward I. Altman, Default Recovery Rates and LGD in Credit Risk Modeling and
Practice: An Updated Review of the Literature and Empirical Evidence (2006) (unpublished
paper), https://pdfs.semanticscholar.org/f079/20544cb9d2ba1daf21fbfa5419bff48ade5d.pdf
(reviewing credit risk modeling).
124
Before the development of sophisticated valuation techniques, most lending was secured
since lenders lacked the tools needed to accurately and efficiently assess the risk in a potential
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These companies prove their creditworthiness by offering
collateral. Collateral protects lenders by decreasing the borrowers’
ability to acquire additional debt payable from the same pool of assets.
125
If the gilded age of Silicon Valley has shown us anything, it is that
emerging or growth companies can consume enormous sums of capital
before becoming profitable. Collateral is one of the only ways that
investors can ensure their priority in the company’s capital structure
and protect against dilution.
126
While bringing in secured debt that
primes the original unsecured lender may be a breach of the original
loan agreement, that breach will not undo the new lender’s security
interest in the collateral. The original lender’s only recourse would be
against the borrower, who incidentally now has fewer assets against
which the original lender can execute its claim.
The second lever, covenants, allows lenders to control negotiated
aspects of the borrower’s behavior, ostensibly to prevent the borrower
from intentionally increasing its risk. For example, covenants often bar
borrowers from entering into bet-the-company joint ventures without
lender consent. Covenants can also ensure that the lender is the first to
know—and therefore in the best position to negotiate its exit—if the
borrower’s risk profile has changed.
127
The most common covenants are
measures of the borrower’s financial health.
128
These covenants allow
the lender to declare an event of default, and therefore accelerate its
debt, before the company becomes otherwise insolvent. The mere threat
of acceleration typically forces the borrower to negotiate an amendment
or release with the lender. In turn, the lender typically increases the
borrower’s balance sheet. See Scott, A Relational Theory of Secured Financing , supra note 57, at
940–41, 943 (explaining that newer and smaller firms “cannot offer prospective lenders proof of
capable management or a solid base of existing assets . . . ” such as manufacturing equipment, a
form of collateral that firms were more likely to possess to offer lenders to obtain financing);
Ronald J. Mann, Explaining the Pattern of Secured Credit, 110 H
ARV. L. REV. 625, 668–74
(1997) (exploring why stronger companies rarely choose secured debt while weaker companies
often choose it).
125
See Scott, A Relational Theory of Secured Financing, supra note 57, at 944–45.
126
Investors can contract for these rights, but any remedy for a violation is going to lie in
contract, not against the subsequent investor, especially if the subsequent investor made its
investment in good faith. Bjerre, supra note 79, at 315.
127
For example, covenants can require the borrower to comply with “all laws, rules,
regulations and orders of any Governmental Authority applicable to it or its property” and
notify the lender if it breaches the covenant such that the lender may know of the borrower’s
regulatory compliance failures before the applicable regulator does. See M
ICHARL BELLUCI &
JERMONE MCCLUSKY, THE LSTA’S COMPLETE CREDIT AGREEMENT GUIDE 344–54 (2017).
128
Common financial covenants require the borrower to maintain revenue not less than a
designated percentage of total indebtedness or to maintain a minimum amount of liquidity. See
id. at 312–27. The riskier the loan and the tighter the credit market, the more onerous these
covenants will be. See Richard Barley, Heard on the Street: Shining a Light on Covenants, W
ALL
ST. J. (July 21, 2014), https://www.wsj.com/articles/heard-on-the-street-shining-a-light-on-
covenants-1405938538.
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price of the loan.
129
And if renegotiation fails, acceleration gives the
lender a larger claim against the borrower in bankruptcy.
130
The price of capital is the most visible lever by which lenders
control their risk. As their expected recovery given default decreases,
they must charge more in interest and fees to make up the shortfall.
Borrowers who do not expect to default can offer collateral to buy down
the price of the loan. It is thus no surprise that a majority of small
businesses use secured credit. One survey of about 500,000 small
businesses found that sixty-two percent had secured debt.
131
From the
perspective of a borrower with no intention of defaulting, collateral and
covenants can seem like free ways to reduce their cost of capital or to
gain access to capital altogether.
132
All of the variation in debt contracts described above are driven by
contracts. The company, theoretically for the benefit of the equity
holders, contracts with lenders for capital. Through contract it can trade
away future income (price), control (covenants), and property rights
(collateral). The key takeaway about the relationship between secured
versus unsecured debt is that the secured lender receives a property-like
interest not received by the unsecured lender. This property-like
interest, in turn, makes the loan a different animal both for theoretical
and constitutional purposes.
B. Making Sense of Priority
While it is easy to explain why lenders, and sometimes even
borrowers, like secured credit, it is far more difficult to explain why
secured credit should enjoy the priority right that makes it so attractive.
As Lynn LoPucki puts it, “[s]ecurity is an agreement between A and B
that C take nothing.”
133
If security interests were merely contractual
129
For many non-investment-grade borrowers, amend-and-extend is how they do business
until the terms of their debt become too unbearable or the lender determines that the risk is
unacceptable at any price. See David Henry, The Time Bomb in Corporate Debt, B
US. WEEK
(July 15, 2009) (describing how the now-defunct Blockbuster bought itself more time by
extending its debt).
130
In re General Growth Props., No. 9-11977, 2011 WL 2974305, at *4–5 (Bankr. S.D.N.Y.
July 20, 2011).
131
See ALAN SCHWARTZ & ROBERT E. SCOTT, COMMERCIAL TRANSACTIONS: PRINCIPLES
AND
POLICIES 547 (2d ed. 1991).
132
This is especially true when there is a “flight to safety” among investors. In such times, it
is common to see previously creditworthy companies unable to find attractive capital and for
terms of the capital they can raise to become increasingly burdensome as the overall economic
outlook sinks, even when there are no other changes in the fundamental business of the
company. See Min Zeng & Nick Timiraos, Nervous Investors Flee to Treasurys, W
ALL ST. J. (Jan.
6, 2015), https://www.wsj.com/articles/u-s-government-bonds-continue-to-strengthen-
1420552119.
133
LoPucki, The Unsecured Creditor’s Bargain, supra note 103, at 1899.
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rights, they might be less puzzling. Usual limitations on contract could
dictate whether, if at all, we enforced security agreements against
various downstream creditors. After all, normally, we do not let two
people agree with each other to deprive a third person of their property.
But security interests have too many attributes of property interests to
fit comfortably within a contractual framework.
The challenge of situating security interests into our understanding
of property is longstanding. This is in part because defining “property”
and then determining what it means for something to be “property” is a
massive intellectual problem with centuries of its own literature. The
one constant in the history of security interests is that they have always
faced skepticism as to whether, and to what extent, they should exist.
134
It remains difficult to explain why larger and more sophisticated parties
claim enormous portions of the assets of a failed enterprise, leaving its
smaller vendors, and other creditors such as workers and tort victims,
with little if anything. There can be little surprise then, that secured
lenders have always been dogged by the perception that they take more
than their fair share.
135
To many, the priority right violates principles of
distributional justice.
One reaction to this perceived unfairness was to view security
interests as a form of theft. The “secret lien” consumes the assets of a
party that still appeared healthy to potential business partners, leaving
unsecured creditors with enormous claims against an insolvent
company. America inherited a wary view of secured credit from
England where non-possessory interests in property were often deemed
fraudulent.
136
In 1601, the canonical Twyne’s Case held that,
notwithstanding value given, a creditor could not claim to be a bona fide
purchaser of collateral if the “seller” retained possession of the
collateral.
137
Early American courts were similarly concerned that the
invisibility of liens made them ideal vehicles for fraud against debtors’
business partners or prospective purchasers of the collateral.
138
Indeed,
some of the earliest equitable rights available to debtors—such as the
134
Some of this skepticism arises from simple revulsion at the terms of early security
interests. From the Sumerians to more recently than we might hope, borrowers pledged their
own freedom and that of their family along with their real and personal property. See D
AVID
GRAEBER, DEBT: THE FIRST 5,000 YEARS 85, 127–30 (2011) (tracing the history of human
bondage as collateral and currency). That a farmer’s children should be sold into slavery when
rain fails to fall hardly leads to feelings that the system is right and good.
135
See BRUCE H. MANN, REPUBLIC OF DEBTORS: BANKRUPTCY IN THE AGE OF AMERICAN
INDEPENDENCE (2009).
136
To be sure, out of necessity, security interests were more broadly accepted in the early
America than in England, except to the extent that debt itself was seen as contrary to Christian
values. Id. at
56.
137
Twyne’s Case (1601) 76 Eng. Rep. 809.
138
See Clow v. Woods, 5 Serg. & Rawle 275, 279, 283 (Pa. 1819) (invalidating a lien for being
a “secret matter”); First Benedict v. Ratner, 268 U.S. 353, 359 (1925) (same).
D’ONFRO.39.4.5 (Do Not Delete)
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right of redemption
139
—are meant to balance the power of secured
creditors.
140
Beginning in the 1970s, as Article 9 of the Uniform Commercial
Code and the Bankruptcy Code stood on the verge of reform, new
normative theories of security interests emerged as commentators
grappled with the apparent conflict between our normal modes of
analyzing property and our desire for some semblance of distributional
fairness.
141
At one level, this view is driven not by ideologically charged
premises but by the relatively controversial view that innocent parties
not be forced to bear unexpected losses.
142
The property rights of secured creditors have remained unclear in
part because Article 9,
143
which governs the creation of security interests
in most personal property, has undergone several rounds of reform
since the 1950s.
144
Where there had previously been uncertainty whether
139
The right of redemption allows the former owners of property to repurchase the property
within a certain window following a foreclosure sale. See Peugh v. Davis, 96 U.S. 332, 337
(1877) (explaining equity of redemption).
140
Fears of sanctioning fraud also led early courts to adopt an intricate matrix of formal
requirements for the perfection of liens. Secured lending remains one of the few areas of
modern U.S. law that both requires a myriad of non-intuitive formalities and then requires
strict compliance with them. See Official Comm. of Unsecured Creditors of Motors Liquidation
Co. v. JP Morgan Chase Bank, N.A. (In re Motors Liquidation Co.), 777 F.3d 100 (2d Cir. 2015)
(holding that a mistake made by a paralegal at Mayer Brown while preparing the UCC
financing statements made JP Morgan’s $1.5 billion dollar lien on General Motor’s assets
unsecured even though both parties at the time expected the loan to be secured and there was
no claim that any party had relied on the loan being unsecured); see also Douglas Baird &
Thomas Jackson, Information, Uncertainty, and the Transfer of Property, 13 J.
LEGAL STUD. 299,
300–01 (1984) (explaining that legal rules around property transfer must balance protecting
owners against protecting would-be owners).
141
See generally Schwartz, Security Interests and Bankruptcy Priorities, supra note 19
(collecting commentaries).
142
See, e.g., Grant Gilmore, The Good Faith Purchase Idea and the Uniform Commercial
Code: Confessions of a Repentant Draftsman, 15 G
A. L. REV. 605, 612 (1980) (“In a society that
recognizes property as something more than theft, you do not go around lightly destroying
property rights; you must have a compelling reason for awarding A’s property to C. Even in a
contract-oriented law, you do not go around lightly telling people who have been tricked,
cheated, and defrauded that they must nevertheless pay up in full . . . .”).
143
Merrill & Smith, supra note 76, at 833–43 (explaining that part of the difficulty of
defining the property rights of security interest arises because they are clearly also contractual
interests).
144
These changes quickly influenced secured lending the world over and did so right as
corporate finance became a global endeavor. Article 9’s global influence is difficult to overstate.
It was adopted with modifications as the Canadian Personal Property Security Acts and reforms
to secured lending worldwide have tended to bring those laws closer to American secured
lending. R.M. Goode, Is the Law Too Favourable to Secured Creditors?, 8 C
AN. BUS. L.J. 53, 54
(1984); see also Padma Kadiyala, Impact of Bankruptcy Law Reform on Capital Markets in
Brazil, 8 I
NV. MGMT. & FIN. INNOVATIONS 31, 32 (2011) (explaining the impact of bankruptcy
reform in Brazil); Tomas Richter, Reorganizing Czech Businesses: A Bankruptcy Law Reform
Under a Recession Stress-Test, 20 I
NT’L INSOLVENCY REV. 245, 247–48 (2011) (tracing the Czech
Republic’s efforts to base its insolvency laws on Chapter 11); Steven J. Arsenault, The
Westernization of Chinese Bankruptcy: An Examination of China’s New Corporate Bankruptcy
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1398 CARDOZO LAW REVIEW [Vol. 39:1365
any particular lien would survive judicial scrutiny, Article 9 made a bevy
of commercially necessary, but heretofore uncertain, security interests
“safe” and “judge-proof.”
145
In doing so, it reduced the risk in secured
debt meaning that lenders could satisfy their expected recovery given
default needs at lower interest rates. Although Article 9 generally
expanded secured lending, it initially enjoyed support from unsecured
creditors who had often found themselves at the wrong end of what felt
like a secret lien.
146
The main criticism of Article 9 was that it was a
“sell-out to the vested interests at the expense of the public interest”
insofar as it repealed many of the statutorily and judicially promulgated
limitations on secured lending.
147
The newfound certainty for secured lenders created by Article 9
marked the path away from asset-based lending towards all-assets
lending.
148
The logical consequence of this expansion is the practice of
lending to a holding company and taking a security interest in the
equity of the operating company, which is presumably where both the
value and the substance of a corporation lies. In the event of default, the
lender can foreclose on the equity of the operating company and
become the owner of the going concern.
149
As the scope of the secured lenders’ property rights began to
resemble the scope of equity holders’ rights, it became less clear why
secured credit should benefit from the absolute priority rule in the event
of liquidation.
150
This view that secured lenders should not be able to
Law Through the Lens of the UNICTRAl Legislative Guide to Insolvency Law, 27 PENN ST. INT’L
L. REV. 45, 57 (2008) (surveying China’s modernization of its bankruptcy laws).
145
Grant Gilmore, The Secured Transactions Article of the Commercial Code, 16 LAW &
CONTEMP. PROBS. 27, 30 (1951).
146
Id.
147
Id. at 34.
148
It accomplished this by allowing companies to easily encumber after-acquired property
that would otherwise not have been covered by an earlier-in-term security interests. This shift
allowed companies with revolving inventory to use that inventory as collateral. U.C.C. § 9-
204(a) (A
M. LAW INST. 2012) (security agreement may provide that obligations are to be
secured by after-acquired collateral); § 9-204(c) (obligations covered by security agreement may
include future advances).
149
But see Anthony J. Casey, The New Corporate Web: Tailored Entity Partitions and
Creditors Selective Enforcement, 124 Y
ALE L.J. 2680, 2719–20 (2014) (explaining that security
interests do not always work to permit creditors to foreclose on a project-by-project or entity-
by-entity basis in a world in which cross-liability provisions are common).
150
Scholars have fiercely debated whether there is a good theoretical justification for
security interests’ priority privilege under Article 9 and bankruptcy law. See Paul M. Shupack,
Solving the Puzzle of Secured Transactions, 41 R
UTGERS L. REV. 1067 (1988); Buckley, supra
note 19; Scott, A Relational Theory of Secured Financing, supra note 57; Thomas H. Jackson &
Alan Schwartz, Vacuum of Fact or Vacuous Theory: A Reply to Professor Kripke, 133 U.
PA. L.
REV. 987 (1985); Homer Kripke, Law and Economics: Measuring the Economic Efficiency of
Commercial Law in a Vacuum of Fact, 133 U.
PA. L. REV. 929 (1985); Alan Schwartz, The
Continuing Puzzle of Secured Debt, 37 V
AND. L. REV. 1051 (1984); Schwartz, Security Interests
and Bankruptcy Priorities, supra note 19; White, supra note 19. Indeed, concerns that security
interests were becoming less about funding specific acquisitions and more about gaining an
D’ONFRO.39.4.5 (Do Not Delete)
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capture all the proceeds of foreclosure, especially when the scope of the
underlying security interest is broad, reflects skepticism towards
security interests as property rights. Nevertheless, Article 9 facilitated an
explosion in secured lending, and with it, an explosion in companies
entering bankruptcy with few unencumbered assets.
151
Article 9 also simplified the processes by which secured lenders
exercised their rights in the event of default.
152
It eliminated the public
auction requirement and allowed foreclosing lenders to sell their
collateral almost immediately where previously there were waiting
periods that inevitably gave borrowers room to negotiate.
153
A new
standard—“commercial reasonableness”—replaced the rules that had
previously given borrowers leverage to challenge liens.
154
This simplified
foreclosure process made it clearer that borrowers only tenuously
owned their encumbered assets.
advantage over less sophisticated parties dogged even the principal draftsman of Article 9. As
Grant Gilmore explained:
Considerations of policy and common sense suggest that there must be a limiting
point somewhere. Borrowers should not be encouraged or allowed to hypothecate all
that they may ever own in the indefinite future in favor of a creditor who is willing to
make a risky loan now . . . . And ways should be found to penalize a lender who, after
allowing his borrower to pile up an intolerable weight of debt, then claims all the
assets of the insolvent estate, leaving nothing to satisfy other claims.
G
RANT GILMORE, SECURITY INTERESTS IN PERSONAL PROPERTY § 7.12 at 248–49 (1965)
(footnotes omitted).
151
White, supra note 19; see also LoPucki, The Death of Liability, supra note 61 (explaining
how the percentage of liquidations in which there was a distribution to unsecured creditors fell
from twenty percent in 1976—a number that already reflected some of the impact of Article 9—
to five percent in 1992).
152
Modern bankruptcy practice has almost entirely replaced state-law foreclosure for going
concerns. As a result, these changes now largely impact the backdrop against which companies
negotiate, rather than actual foreclosure practice. One of the effects is that without cases, state
foreclosure law has not had the opportunity to develop around modern secured lending
practices, therefore it is the theoretical projection of what would happen under state law that
governs practice, rather than actual state law. This development has many detractors who view
secured lending practice as having gotten ahead of both state foreclosure law and Article 9 itself
in recognizing blanket liens and other forms of total lender control over going concerns. Janger,
supra note 16 (arguing that our current perfection regimes do not allow for truly blanket liens);
Michelle M. Harner, The Value of Soft Variables in Corporate Reorganizations, 2015 U.
ILL. L.
REV. 509, 512–13 (arguing that the things that create an entity’s going concern surplus are not
traditionally things that can be encumbered).
153
Gilmore, supra note 145, at 35. There is always the threat that borrowers facing
foreclosure will elect to destroy the collateral to spite the lender who would otherwise repossess
it. The longer the period between foreclosure becoming obvious and the change in possession
occurring, the more time the borrower has in which to destroy the collateral. See Michael M.
Phillips, Buyers’ Revenge: Trash the House After Foreclosure, W
ALL ST. J. (Mar. 28, 2008),
https://www.wsj.com/articles/SB120665586676569881.
154
There was considerable hesitation around treating commercial and consumer credit
alike, especially with respect to foreclosures, but ultimately the desire for a consistent and broad
foundation for secured lending prevailed. Gilmore, supra note 145, at 45.
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Borrowers’ tenuous ownership over their encumbered assets is best
illustrated by the fine line between sales or leases and security
interests.
155
One way to think of a security interest is as a sale to the
lender under which the seller has the right to repurchase its interest in
the collateral from the lender within a certain period of time. This
resemblance is so strong that teasing out the line between security
interests, which are subject to perfection requirements and cram-down
in bankruptcy, and so-called “true sales,”
156
which render assets
bankruptcy-remote, continues to vex courts.
157
Indeed, this close
relationship between sales and security interests is so pervasive in the
common imagination that people often say that the bank “owns” their
house if it is merely mortgaged. Many security interests are outwardly
indistinguishable from sales, particularly when the lender perfects its
security interest by taking possession of the collateral.
158
Not long after the adoption of Article 9, Congress took up the
process of modernizing federal bankruptcy law,
159
making it more
transparent, predictable, and creditor-friendly.
160
The importance of
bankruptcy to understanding security interests cannot be overstated.
Bankruptcy is the proving ground for security interests.
161
After all,
when there is only one party making a claim against an asset there is
155
See Steven L. Harris & Charles W. Mooney Jr., When Is a Dog’s Tail Not a Leg?: A
Property-Based Methodology for Distinguishing Sales of Receivables from Security Interests That
Secure an Obligation, 82 U.
CIN. L. REV. 1029, 1040–43 (2014) (criticizing the multi-factored
tests used to identify security interests for the uncertainty that they create in the market).
156
In complex securitization deals, issuers and lenders alike will turn to law firms for formal
opinions of counsel that the contemplated asset transfers are “true sales” and not secret liens.
See generally Jonathan M. Barnett, Certification Drag: The Opinion Puzzle and Other
Transactional Curiosities, 33 J.
CORP. L. 95 (2007) (explaining the role of legal opinions in
complex transactions).
157
See, e.g., In re Commercial Loan Corp., 316 B.R. 690, 700 (Bankr. N.D. Ill. 2004)
(“Whether to deem a transaction a sale or a loan when a financial asset[—]a right to
payment[—]has changed hands is an old legal problem for which there has never been an easy
solution.”).
158
The more familiar situation has the seller, or borrower, retaining possession of its
collateral, but there are significant examples to the contrary. Consider cash collateral. Typically,
bank lenders require that cash collateral be kept in an account over which they have control at
their office. See U.C.C. § 9-312 (A
M. LAW INST. 2012) (requiring lenders to have control over
and possession of cash in order to have a perfected security interest). Similarly, pawn shops
usually take possession of the collateral against which they are lending.
159
Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549 (1978).
160
The Bankruptcy Reform Act of 1978 created the modern Bankruptcy Code. Most notably
for our purposes, it created Chapter 11, making it easier for businesses to file and maintain
control over their reorganization. Under the prior Bankruptcy Act, companies could
voluntarily file for bankruptcy protection, but the Securities and Exchange Commission then
oversaw the administration of the process and trustees were required in the largest cases. See
Emmet McCaffery, Corporate Reorganization Under the Chandler Bankruptcy Act, 26 C
ALIF. L.
REV. 643 (1938). Enabling debtors to remain in possession of their business and making the
process more transparent also made it more appealing and filings increased.
161
See Steven L. Harris & Charles W. Mooney, The Article 9 Study Committee Report: Strong
Signals and Hard Choices, 29 I
DAHO L. REV. 561, 563 (1993).
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2018] LIMITED LIABILITY PROPERTY 1401
little dispute about who owns it (or at least, owns its value). Bankruptcy
makes stark the zero-sum game of capital structures. This reform
reinvigorated the debate around the nature of security interests.
Commentators tended to fall into two main camps. On the one
hand were those who took a property-based view of security interests.
This camp includes the Reporters for the Permanent Editorial Board of
the Article 9 Study Committee, Stephen L. Harris and Thomas W.
Mooney.
162
Harris and Mooney were the first to offer an explanation of
security interests that used the “well-accepted rights of property
owners” to use and alienate their property as a point of departure.
163
They fault both the debate about whether security interests are efficient
and the parallel debate about whether security interests are a
distributional evil for using the ambient skepticism about security
interests as the baseline for their analyses.
164
Instead, Harris and Mooney propose that classic vanilla property
ownership should be the baseline.
165
Beginning with Svetozar Pejovich’s
four elements of property ownership—(i) the right to use; (ii) the right
to capture benefits; (iii) the right to change; and (iv) the right to transfer
the first three rights for a price—they embrace the broader property
literature that theorizes that private property is essential both to liberty
and to efficiency by encouraging resources to be allocated to those who
value them most.
166
All of the benefits of private property arise from an
owner’s ability to alienate that property more or less as they see fit.
167
For this reason, property theory generally validates owners’ decisions to
alienate their property, even if doing so may reduce the pot against
which creditors can recover.
168
Indeed, solvent owners can alienate their
property in a number of ways that may harm future creditors, including
162
See Steven L. Harris & Charles W. Mooney, A Property-Based Theory of Security Interests:
Taking Debtors’ Choices Seriously, 80 V
A. L. REV. 2021, 2047–66 (1994) [hereinafter Harris &
Mooney, Security Interests].
163
Id. at 2047–53.
164
Id. at 2037. They dub the two main bodies of scholarship about security interests the
Efficiency Literature and Sympathetic Legal Studies. The former, as the name suggests, is
concerned primarily with whether security interests are efficient relative to other methods of
raising capital. See id. at 2042–45. The latter is primarily concerned with the relatively large
share of debtors’ assets that secured credit is able to claim in bankruptcy. Id. at 2045–46.
165
Id. at 2052.
166
Id. at 2048–49; see also SVETOZAR PEJOVICH, THE ECONOMICS OF PROPERTY RIGHTS:
TOWARDS A THEORY OF COMPARATIVE SYSTEMS (1990). Harris and Mooney are among the
first, if not the first, debt and bankruptcy scholars to look to the classic property literature as
the source of their theory of security interests. They draw on the familiar sources of Milton
Friedman’s Capitalism and Freedom, Hume, Margaret Radin’s Property and Personhood, and
the chestnuts of the law and economics literature such as Charles J. Goetz, Law and Economics
(1984) and R.H. Coase, The Problem of Social Cost, 3
J.L. & ECON 1 (1960).
167
Harris & Mooney, Security Interests, supra note 162, at 2048–49.
168
Id. at 2037–41.
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choosing to pay some claims but not others.
169
The main check on this
practice has always been preference and fraudulent transfer law,
170
which is a far from perfect remedy. Legislative proposals to ban asset
sales by leveraged but solvent companies have never been on the table,
yet security interests face persistent skepticism.
171
Finding no reason
that security interests are inherently different from other forms of
property, they conclude that “the law should honor the transfer or
retention of security interests on the same normative grounds on which
it respects the alienation of property generally.”
172
Harris and Mooney had a significant victory with the 1990s
revisions to Article 9, which ushered in a second revolution in liens.
Harris and Mooney took it as their “first principle” that Article 9 should
facilitate secured lending, believing that “the transfer of an effective
security interest ought to be as easy, inexpensive, and reliable as
possible.”
173
The revised Article 9 more or less removed any concerns
about the validity of blanket liens,
174
while protecting security interests
from avoidance actions brought by a bankruptcy trustee.
175
The revised
Article 9 implicitly endorsed the property view of security interests and
expanded their scope accordingly.
Opposing the Harris-Mooney view were many commentators who
questioned the efficiency and fairness of security interests.
176
Few of
those participating in the debate around Article 9 staked out an
explicitly anti-property view of secured credit, but their normative
169
Id. at 2037. Choosing among creditors is the norm in business. Companies may agree to
prepay certain suppliers, perhaps for a discount, but use their clout to demand that others
accept quarterly, or even less frequent, payment. These delayed payments are often low-
interest, if not interest-free loans allowing companies to use the cash that would have paid the
supplier on other ventures.
170
Id. at 2054.
171
Lurking in the scholarship that Harris and Mooney dub the “Efficiency Literature and
Sympathetic Legal Studies” is the idea that unless someone can prove that security interests are
a net positive to society, the law should not recognize them. Id. at 2044.
172
Id. at 2051.
173
Id. at 2021.
174
To the extent that there remain serious difficulties in creating blanket liens, those arise
from the gaps in our three main systems for perfecting liens: U.C.C. filings, real estate filings,
and intellectual property filings. See generally Janger, supra note 16 (cataloging the technical
difficulties of creating blanket liens).
175
See G. Ray Warner, The Anti-Bankruptcy Act: Revised Article 9 and Bankruptcy, 9 AM.
BANKR. INST. L. REV. 3, 18 (2001) (arguing that the drafters of Article 9 exceeded the proper
bounds of uniform law drafters when they proposed changes that “enhance[d] the priority
rights of secured creditors” despite the lack of consensus about whether secured credit is
efficient or a social good). But see G. Ray Warner, Is Revised UCC Article 9 an Anti-Bankruptcy
Act? Yes, 28 O
KLA. CITY U. L. REV. 537 (2003) (arguing that the Article 9 revision process was
agenda-driven); Alvin C. Harrell, Security Interests in Deposit Accounts: A Unique Relationship
Between the UCC and Other Law, 23 U.C.C.
L.J. 153 (1990) (defending Article 9).
176
See Jay Lawrence Westbrook, The Control of Wealth in Bankruptcy, 82 TEX. L. REV. 795,
838 (2004) (tracing the literature arguing against the efficiency of secured credit).
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1403
preferences are functionally incompatible with appreciating security
interests as property rights. This disconnect is most apparent in
proposals to limit the priority of security interests.
177
Professors
Bebchuk and Fried separated the underlying property rights from the
remedies traditionally associated with those rights.
178
Bebchuk and Fried
divided secured creditors’ rights into a “repossessory right”—the right
to seize the collateral more quickly than if unsecured—and a “priority
right”—the right to levy against particular collateral before any other
creditors.
179
They then argue in favor of limiting creditors’ priority
rights since, in light of creditors who cannot bargain for their relative
security, according absolute priority tends to encourage inefficient and
potentially harmful use of security interests.
180
While Professors
Bebchuk and Fried find that their partial priority proposal is “consistent
with fundamental principles of contract law,”
181
they cannot say the
same for the fundamental principles of property law. A property right is
a right against the world.
182
By definition, it cannot depend on the
identity of third-party claimants irrespective of those claimants’ own
property rights.
Similarly, the wave of carve-out proposals beginning with Elizabeth
Warren’s seminal work subordinated concerns about formal legal
interests to concerns about distributional fairness.
183
Carve-out
proponents questioned whether the reach of security interests should
extend so far as to allow borrowers to lend against all of their property,
leaving few, if any, unencumbered assets for unsecured claimants.
184
Even if a security interest unequivocally reached all of an asset’s value,
Warren and others found this security interest to be such an affront to
distributional equity that it should be cut short so that there would be
something leftover for others.
185
Her proposal mandated a twenty
percent carve-out in the enforceability of security interests so that there
177
See, e.g., Bebchuk & Fried, supra note 16, at 861; Bossetti & Kurth, supra note 17.
178
See Bebchuk & Fried, supra note 16, at 861.
179
Id.
180
Id. at 895–97.
181
Id. at 866.
182
See James Y. Stern, The Essential Structure of Property Law, 115 MICH. L. REV. 1167,
1179–80 (2017).
183
Warren, supra note 17.
184
Id. Some early case law suggested that a cushion should remain available for unsecured
claims. See, e.g., Benedict v. Ratner, 268 U.S. 353 (1925); Zartman v. First Nat’l Bank of
Waterloo, 82 N.E. 127 (N.Y. 1907) (refusing to enforce a blanket lien that purported to cover
after-acquired property). Article 9 explicitly overturned these cases. See U.C.C. § 9-205, cmt. 2
(A
M. LAW INST. 2012).
185
Warren, supra note 17, at 323 (proposing a twenty percent carve-out in Article 9).
Others proposed limiting the carve-out to cases in which there was insolvency and unsecured
creditors, which would typically be, but need not be in bankruptcy. Lynn M. LoPucki, Should
the Secured Credit Carve Out Apply Only in Bankruptcy? A Systems/Strategic Analysis, 82
C
ORNELL L. REV. 1483 n.11 (1997).
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1404 CARDOZO LAW REVIEW [Vol. 39:1365
would always be something left for judgment lien creditors.
186
These
proposals sought to “assure[] that trade creditors, tort victims,
employees, and other unsecured creditors who also contribute to the life
of a business will have some access to the assets of that business if it is
unable or refuses to pay its debts.”
187
Many carve-out proponents appear to reject the notion that
security interests are property rights in the collateral, although they do
not always say so explicitly.
188
At best, these commentators treat security
interests differently than other forms of private property, which are
generally alienable even when doing so creates distributional injustice,
unless that injustice is so grave as to run afoul of fraudulent transfer law.
For example, companies can sell all of their assets then enter leasing
arrangements without triggering widespread moral opprobrium. It is
unclear why encumbering assets should be any different.
Recently, several commentators have reopened the debate about
the role of priority at a more fundamental level. Stephen J. Lubben has
argued that the role of absolute priority has been widely overstated.
189
He explains that the rule only got its name in a 1936 article and then as
only “one possible bankruptcy rule, which the Supreme Court had
occasionally seemed to endorse in corporate reorganization cases going
back to the middle Nineteenth Century.”
190
Instead, he argues that
priorities are much more flexible in our system of reorganization and
that reorganization often requires senior creditors to yield some of their
priority to continue the debtor’s quotidian operations.
191
Similarly,
Douglas Baird recently argued that, in part, in light of its weak pedigree,
the absolute priority rule is the wrong point of departure for
understanding competing claims against a company’s assets in
bankruptcy.
192
186
Warren, supra note 17, at 323.
187
Id.
188
Elizabeth Warren argued that, when faced with an insolvent entity, claims should be
settled by a bankruptcy judge with broad equity to do what is right to preserve the company as
a going concern. Id. at 326. As Douglas Baird noted, the implicit assumption in Warren’s
proposal is that, contrary to the dominant wisdom in corporate law scholarship, there is a link
“between who has rights to the assets of a firm and how those assets are used.” Douglas G.
Baird, Loss Distribution, Forum Shopping, and Bankruptcy: A Reply to Warren, 54 U.
CHI. L.
REV. 815, 819–20, 819 n.5, 820 n.6 (1987) (describing how Warren’s view conflicts with
Modigliani and Miller’s hypothesis that “owners of a firm (but for agency costs) share the same
goals”).
189
Lubben, supra note 37, at 581–85 (explaining that the absolute priority rule is only
relevant at Chapter 11 plan confirmation, at which point it has already been breached several
times).
190
Id. at 586.
191
Id. at 605.
192
See Douglas G. Baird, Priority Matters: Absolute Priority, Relative Priority, and the Costs
of Bankruptcy, 165 U.
PA. L. REV 785 (2017).
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2018] LIMITED LIABILITY PROPERTY 1405
But neither the alleged newness of the rule nor its uneven
application necessarily mean that priority is not one of the core rights of
secured creditors. After all, security interests are largely creatures of
state statutory law.
193
When those statutes were passed is largely
irrelevant. Similarly, that bankruptcy courts do not always respect
secured creditors’ priority rights may be evidence that the court or the
Federal Bankruptcy Code under protects those state-created rights. It
cannot prove that those rights do not exist. And finally, unsecured
interests could be subject to alternative priority rules notwithstanding
secured lenders’ rights to first priority in the event of insolvency.
194
Theory aside, one constant in the history of security interests in the
United States is that whatever legal rights a lender may have, politics
periodically renders them unenforceable,
195
especially with respect to
consumers. But political unenforceability does not change the
underlying property rights.
196
If anything, it makes the need to
understand them more urgent.
197
193
The three most significant sources of security interests are Article 9, real property
mortgage recordation laws, and the various motor vehicle registration laws, all of which are
state laws.
194
For example, 11 U.S.C. § 507 (2012) sets out the order in which unsecured creditors are
paid based on the nature of the debt.
195
Deviations from the absolute priority rule tend to occur on a one-off basis, responding to
particular crisis—real or perceived—in a particular industry. For example, secured creditors of
an insurance company could find themselves competing with a regulator with a strong
incentive to ensure that policyholders are paid in full. Mark G. Peters, Issues for Secured
Creditors in Insurance Insolvency, L
AW360 (Nov. 17, 2010, 3:36 PM), http://www.law360.com/
articles/206753/issues-for-secured-creditors-in-insurance-insolvency.
196
In more recent times, the federal government has more or less forced lenders to
compromise their enforcement rights by enacting mortgage modification programs and other
forms of borrower relief. The largest of these programs, HAMP, was voluntary for lenders
although the government-backed entities insuring many mortgages required participation for
the loans it insured. While both the government and the effected lenders may act as if such
programs are mandatory, their legality is actually an open question, but not one that any lender
would ever ask a court to answer due to reputational concerns and the need to preserve, to the
extent possible, friendly relations with its regulators. Such programs are dubious because if we
take security interests seriously as property and as property arising under state law, the federal
government cannot retroactively force lenders to give some of that property away by modifying
the face value of the loan. To be sure, the federal government may force lenders to do any
number of things as a condition of receiving other benefits, but it cannot require lenders to
destroy its property without an opportunity to be compensated for that property (as is the case
when a company divests parts of its business to satisfy antitrust concerns). Louisville Joint
Stock Land Bank v. Radford, 295 U.S. 555, 589–90, 601–02 (1935) (holding that Congress
violates the Fifth Amendment when it retroactively takes creditors’ “substantive rights in
specific property”).
197
This urgency is especially acute given the current calls to reform the Bankruptcy Code.
See generally C
OMMISSION TO STUDY THE REFORM OF CHAPTER 11, supra note 16 (proposing
various reforms).
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1406 CARDOZO LAW REVIEW [Vol. 39:1365
III. SHARES AND SECURITY INTERESTS AS LIMITED LIABILITY
PROPERTY
We have seen above that equity interest and security interest are
both property-like rights. While neither is as theoretically pristine as fee
simple ownership, in both, the rights holders own a non-exclusive
interest in a company’s assets that is good against the world. Equity
holders own the residuary. Secured creditors own the collateral up to the
value of their security interest.
But traditional notions of ownership come with risk and
responsibility not seen in either equity interests or security interests.
Normally, owners are responsible for harm that their possessions or
property may cause. For example, real property owners are liable both
to guests and even to certain trespassers for certain dangers on their
property.
198
The measure of their liability is the harm.
199
It is possible,
even likely, that their liability as owners can and will exceed the value of
their property.
200
Modern corporate, insolvency, and secured transactions law has
created two enormous exceptions to the general rule that property
owners are liable for the harm caused by their property. The first
exception, explained in Section A below, is the familiar form of limited
liability enjoyed by equity holders in most modern companies. Section B
then examines how insolvency rules amplify limited liability such that
judgment proofing becomes an effective strategy for enjoying the upside
risks of ownership while firmly capping the downside risks.
198
See, e.g., Ruocco v. United Advertising Corp., 119 A. 48, 50 (Conn. 1922) (“[A]n owner of
property abutting on a highway rests under an obligation to use reasonable care to keep his
premises in such condition as not to endanger travelers in their lawful use of the highway; and
that if it fails to do so, and thereby renders the highway unsafe for travel, he makes himself
liable, although the consequent injury is received upon his own land and not on the highway.”);
Humphrey v. Glenn, 167 S.W.3d 680, 684 (Mo. 2005) (explaining that Missouri has adopted an
exception to the “no duty” rule, instead making property owners liable to known trespassers for
concealed hazards that the owner creates or maintains); R
ESTATEMENT (SECOND) OF TORTS
§ 335 (AM. LAW INST. 1979) (same). Because the presumption that property owners are liable to
those injured on their property is so strong, legislatures have passed statutes immunizing
property owners from ownership liability to encourage them to allow the public on their lands.
See, e.g., C
AL. CIV. CODE § 846 (West 2015); Klein v. United States, 235 P.3d 42, 51 (Cal. 2010)
(explaining that section 846 was meant to “encourage owners who might otherwise fear liability
to grant access to their property.” (citations omitted)).
199
See City of Shawnee v. Cheek, 137 P. 724, 736 (Okla. 1913).
200
The most dramatic example of this phenomenon is environmental liability. A grungy lot
in an industrial neighborhood may have very little value on the market, but its owner may
nevertheless be liable for millions of dollars of clean-up costs. That the property would never
sell for that much money does not limit the liability. Similarly, the owner of an old, high-
mileage Honda is as liable as a Mercedes owner for damages caused by that vehicle. See Maturo
v. Comm’r of Dep’t of Envtl. Prot., No. CV910313753S, 2008 Conn. Super. LEXIS 763, at *81–
82, *85–87 (Mar. 19, 2008) (holding that an environmental abatement order that exceeds the
value of the affected property is a valid exercise of the police power and therefore not a taking).
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1407
The second exception to the rule that property owners are liable for
the harm caused by their property belongs to security interests. Section
C below will show that secured creditors enjoy the limited liability of
equity holders but have the added benefit of a distributional priority
over other claimants since they have a distinct property interest in their
collateral, as opposed to a property interest in the company. That is,
while they enjoy many features of “ownership” over their collateral, they
do not bear the responsibilities that traditionally come with ownership.
And indeed, their limited liability is even stronger than that of equity
holders, as claimants injured by the collateral can never make claims
against the assets of the lender generally.
A. The First Principles of Limited Liability
Liability is the primary means by which private law regulates the
actions of both natural persons and corporate persons.
201
While a
limited set of wrongs create rights to specific performance,
disgorgement, or other more property-like remedies, a majority of
claims reduce to liabilities.
202
Liability then has been broadly justified by
the incentives that it creates to internalize risk and prevent harm to
others.
203
Limited liability, as the name suggests, sets a hard cap on the
liability that a person can incur. In its most basic form, limited liability
protects a company’s equity holders from being personally responsible
for liabilities that the company may incur. Not all business
organizations enjoy limited liability, but many of the most common
forms do, namely corporations, limited liability companies, and, to a
certain extent, limited partnerships.
204
In these kinds of companies, the
equity holders cannot lose more than the capital they contributed in
exchange for equity interest. In a large public company, limited liability
201
See LoPucki, The Death of Liability, supra note 61, at 3–4.
202
As Calabresi and Melamed famously observed, liability rules and property rules are two
ways to protect entitlements. See Guido Calabresi & Douglas Melamed, Property Rules, Liability
Rules, and Inalienability: One View of the Cathedral, 85 H
ARV. L. REV. 1089, 1092–93 (1972).
203
GUIDO CALABRESI, THE COSTS OF ACCIDENTS: A LEGAL AND ECONOMIC ANALYSIS 69–73
(1970); R
ICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 139, 143 (2d ed. 1977).
204
The limited partners of a limited liability partnership enjoy limited liability while the
general partner faces unlimited liability. U
NIF. LTD. P’SHIP ACT § 404(a), § 303 (NAT’L
CONFERENCE OF COMM’RS ON UNIF. STATE LAWS 2001). In regular partnerships, the partners
are all personally responsible for the partnership’s liabilities. Such partnerships have become
the exception precisely because limited liability is such a valuable protection. Jones Day is
famous among current “BigLaw” firms for remaining a true partnership while most others
became limited liability partnerships or other liability-protecting entities. See The Value of a
True Partnership,
JONES DAY, http://www.jonesday.com/atruepartnership (last visited Feb. 1,
2018).
D’ONFRO.39.4.5(Do Not Delete)
1408 CARDOZO LAW REVIEW [Vol. 39:1365
caps shareholders’ liability at the purchase price of their shares. In a
smaller company, the cap may grow over time if, as a condition for
remaining an equity holder, the equity holder must contribute
additional capital. Regardless of the corporate form, the protection
remains the same: creditors are entitled to claims against the assets of
the company but not against the assets of the owners of the company
unless they can pierce the corporate veil.
For entrepreneurs and businesses alike, the appeal is obvious:
equity investments have unknowable upside risk but a cabined and
known downside risk.
205
Without limited liability, GM’s shareholders
would be personally liable for the damages caused by its faulty ignition
switches, and Exxon’s shareholders would likely still be making
payments to clean oil out of Prince William Sound.
Indeed, it is rare for equity holders to lose anything beyond their
principal investment,
206
even if they have already recovered more than
that investment in dividends and other distributions to shareholders.
207
Since limited liability became available for almost any enterprise,
unlimited liability has largely become a relic.
208
205
See Phillip I. Blumberg, Limited Liability and Corporate Groups, 11 J. CORP. L. 573, 616
(1986) (explaining that limited liability changes the risk calculation for entering into a business
venture).
206
And, of course, opportunity costs.
207
The exceptions to this rule typically involve preference actions or fraudulent transfer
claims arising from bankruptcy proceedings and typically involve the claim that the debtor
corporation was transferring money away from its creditors to its equity holders while
insolvent. Even then, the action sounds in disgorgement rather than typical liability. Equity
holders typically cannot be made to turn over more than they received, regardless of the harm
caused. Easterbrook & Fischel, supra note 6, at 90.
208
Corporate limited liability dates to at least the Romans but spent much of its early life as
a privilege for the well connected. As recently as the colonial era, shareholders investing in
companies incurred unlimited personal liability for the company’s debts. In the age of debtors’
prisons and limited, if any, access to personal bankruptcy protection, the stakes for investing
were very high. Unsurprisingly, once limited liability was introduced, capital flooded in as
investing became a much less risky endeavor. Jurisdictions competing for capital quickly
introduced limited liability to prevent investors from going elsewhere. See The Key to Industrial
Capitalism: Limited Liability, E
CONOMIST (Dec. 23, 1999), http://www.economist.com/node/
347323. In the United States, with the rise of the limited liability company in the second half of
the twentieth century, smaller businesses could enjoy limited liability without the
administrative (and tax) burdens of incorporating or using the specialized limited partnership
forms that many states had promulgated. Limited liability companies (LLCs) have in effect
become a catch-all, enabling businesses that previously were excluded from limited liability
protection to enjoy it. Germany pioneered the limited liability company model when it allowed
the creation of Gesellschaft mit beschränkter Haftung (GmbH) in 1892. Much of Europe and
South America quickly adopted similar laws. The United States, however, did not see its first
LLCs until Wyoming passed its Limited Liability Companies Act in 1977. W
YO. STAT. ANN.
§ 17-15-103 (West 1977). Just twenty years later, in 1997, all fifty states recognized LLCs, the
National Conference of Commissioners on Uniform State Laws had promulgated its Uniform
Limited Liability Company Act, and the Internal Revenue Service issued guidance officially
allowing LLCs to choose their tax status. 26 C.F.R. § 301.7701–3 (1997). For corporate lawyers,
it is almost certainly malpractice to fail to advise clients to take on the shield of limited liability
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1409
There is a hard truth to limited liability: to the same extent that
limited liability exists to protect entrepreneurs from personally ruinous
claims, it limits the rights of claimants—aggrieved contracting parties,
tort victims—to realize corrective justice.
209
Limited liability is about
cutting off the private law remedies at a legal boundary rather than
plumbing the depths of causality and responsibility. These private law
remedies are about transferring resources that “simultaneously
represent the plaintiff’s wrongful injury and the defendant’s wrongful
act . . . ” from the defendant to the plaintiff.
210
Limited liability cuts these
remedies off at the corporate form notwithstanding the seeming
absurdity of insisting either that the corporation rather than some
natural persons committed the wrong or that a deeper-pocketed parent
company bears no responsibility for the harm.
The impact of limited liability can be multiplied by layering limited
liability entities within a single conglomerate.
211
For example, a
consumer products company may put each of its brands in a separate
subsidiary under a single parent company. If one subsidiary produces a
toxic product that injures consumers and incurs liability beyond its
means, the injured consumers cannot look to the assets of the other
subsidiaries to satisfy their judgment. The parent may, for reputational
or other concerns, elect to move sufficient funds into the troubled
subsidiary to satisfy the claim, but it need not. It could elect to put the
troubled subsidiary into bankruptcy and force the injured consumers to
accept a small fraction of their judgment.
The consequence of limited liability is, of course, that companies,
especially smaller companies, may pay far less than the true value of
their liabilities, except to the extent that they are insured.
212
It does not
given the low barriers to entry. For most endeavors, regardless of the potential contract, tort, or
environmental risk, obtaining limited liability protection is as simple as filing a two-page form
with the relevant secretary of state and paying a fee of less than $500.
209
I am envisioning an explicitly Aristotelian notion of corrective justice in which the
relationship between the victim and the malefactor is central. See A
RISTOTLE, 5 NICOMACHEAN
ETHICS ch. 4 (349 B.C.).
210
ERNEST J. WEINRIB, THE IDEA OF PRIVATE LAW 56 (rev. ed. 2012).
211
LoPucki, The Essential Structure of Judgment Proofing, supra note 24, at 151. But see
James J. White, Corporate Judgment Proofing: A Response to Lynn LoPucki’s the Death of
Liability, 107
YALE L.J. 1363 (1998) [hereinafter White, Corporate Judgment Proofing] (showing
that few large companies had made themselves judgment proof by the mid 1990s); Alan
Schwartz, Products Liability, Corporate Structure, and Bankruptcy: Toxic Substances and the
Remote Risk Relationship, 14 J.
LEGAL STUD. 689, 690 (1985) [hereinafter Schwartz, Products
Liability, Corporate Structure, and Bankruptcy] (cataloging bankruptcy companies that planned
on managing future tort risks through operating subsidiaries).
212
This theoretical gap between what a company can actually pay and the harm that it may
create is the source of the moral hazard problem that has drawn many commentators. See
Easterbrook & Fischel, supra note 6, at 103–04; Henry Hansmann & Reinier Kraakman, Toward
Unlimited Shareholder Liability for Corporate Torts, 100 Y
ALE L.J. 1879, 1881 (1991); Schwartz,
Products Liability, Corporate Structure, and Bankruptcy, supra note 211, at 690.
D’ONFRO.39.4.5(Do Not Delete)
1410 CARDOZO LAW REVIEW [Vol. 39:1365
matter that a company may have enriched other companies or
individuals, who now could satisfy its liabilities. It seems as though the
tradeoff between limited liability enabling entrepreneurship and
enabling unfairness is inescapable.
B. A System for Not Paying Claims
1. Judgment-Proofing
Given the ubiquity of limited liability,
213
our legal system’s reliance
on liability can make its goals appear more performative than
practical.
214
As explained above, limited liability typically cabins liability
to the operating company, which may or may not have any meaningful
assets of its own.
215
Limited liability reduces the chances that any given
plaintiff will receive a full recovery. The reasons are twofold. First, while
liability rules are relatively easy to enforce in court, they only generate
judgments, which are much more difficult to enforce. In an ideal world,
once the plaintiff wins a judgment for damages, the defendant satisfies
that judgment by making payment in full to the plaintiff. This ideal
hardly reflects what happens when plaintiffs receive judgments. Putting
aside the issues of delay and the time-value of money—all of which are
eminently relevant given that the appeals process can take years—the
process of collecting a judgment not paid voluntarily is a lawsuit unto
itself. If the defendant does not voluntarily pay in full, enforcing the
judgment requires separate proceedings, often in different courts, to
levy against assets, garnish wages, or otherwise compel payment. These
transaction costs are only sometimes recoverable.
216
And this collection
213
Easterbrook & Fischel, supra note 6, at 90.
214
Lynn LoPucki probably described it best when he said that discussions over who should
be liable for what were tantamount to debating “the arrangement of the deck chairs on the
Titanic.” See LoPucki, The Death of Liability, supra note 61, at 4.
215
Supra Section III.A.
216
The American rule typically militates that each party pay its own costs even in collection
actions. See Hardt v. Reliance Standard Life Ins. Co., 560 U.S. 242, 252–53 (2010) (“Our basic
point of reference when considering the award of attorney’s fees is the bedrock principle known
as the ‘American Rule’: Each litigant pays his own attorney’s fees, win or lose, unless a statute or
contract provides otherwise.” (citations omitted)). There is one enormous, but accidental,
exception in the consumer debt market, which has arisen because consumer contracts typically
require that consumers pay collection costs, and even when they do not, consumers regularly
default on collections claims in small claims court, meaning that they forfeit their right to
object to paying for these transaction costs. See, e.g., Security Instruments,
FANNIE MAE , https://
www.fanniemae.com/singlefamily/security-instruments (last visited Mar. 1, 2018) (requiring
borrowers to “pay all . . . expenses [incurred] in enforcing this Security Instrument, including,
for example, reasonable attorneys’ fees, property inspection and valuation fees, and other fees
incurred for the purpose of protecting Lender’s interest in the Property and rights under this
Security Instrument”); Markell, supra note 39, at 123.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1411
procedure assumes that the defendant has assets or income useful for
satisfying the debt.
217
Second, defendants of all stripes are routinely judgment-proof,
meaning that they have no assets against which an award for damages
can be enforced.
218
Companies use several mechanisms to render
themselves judgment-proof, each aimed at ensuring that the operating
company—that is, the entity facing customers and therefore the entity
most likely to incur liability—has limited assets.
219
The parent acts as a
holding company for the subsidiaries. The intermediate subsidiaries do
not typically own any hard assets. Finally, the operating company enters
agreements with the intermediate subsidiaries to rent the assets or
obtain services from them. The operating company then uses these
assets or services to support what the layperson might consider the
business of the company. As a result, the entity doing business typically
owes much of its revenue to other subsidiaries or the parent itself. Its
cash flows up the corporate structure almost as fast as it comes in. At the
same time, it owns few, if any, of the trappings of its business. Should a
customer prevail in a lawsuit and attempt to collect a judgment against
the operating company, there may be a small amount of cash against
which the customer could satisfy the judgment, but little else.
It might be wishful thinking to imagine that an operating company
even has a small amount of cash available to satisfy judgments. Professor
Lynn LoPucki identified several legal structures in addition to limited
liability that work together to render even seemingly profitable
companies completely judgment-proof: secured credit, national
sovereignty, and third-party ownership of property.
220
All of this is to
say that the norm in corporate liability is that there are few if any assets
available to satisfy unsecured claimants. That is, while a court may hold
a judgment-proof entity liable in an action, the practical effect for the
plaintiff is often as if no liability existed.
221
To be sure, the liability may
impose other costs on the defendant—it may cause reputational harm or
217
Individual defendants may have assets, typically the family home and certain retirement
accounts, which are statutorily exempt from levy by creditors absent a finding of fraud or other
malfeasance on the part of the debtor. See Law v. Siegel, 134 S. Ct. 1188, 1196 (2014)
(explaining California’s exemption laws and the extraordinary remedy of surcharging the
exempt property).
218
Steven Shavell, The Judgment Proof Problem, 6 INT’L REV. L. & ECON. 45, 45 (1986).
219
LoPucki, The Essential Structure of Judgment Proofing, supra note 24, at 151.
220
LoPucki, The Death of Liability, supra note 61, at 4. In LoPucki’s framework, a debtor is
judgment-proof when its secured debt exceeds the liquidation value of its assets. Id. at 14.
221
The exception here is that a plaintiff unable to satisfy a judgment may be able to drag the
responsible entity into an involuntary bankruptcy proceeding. See 11 U.S.C. § 303 (2012). That
said, involuntary petitions are exceedingly rare precisely because few entities have sufficient
unencumbered assets to make such a filing worthwhile. Susan Block-Lieb, Why Creditors File
So Few Involuntary Petitions and Why the Number Is Not Too Small, 57 B
ROOK. L. REV. 803,
844 (1991).
D’ONFRO.39.4.5(Do Not Delete)
1412 CARDOZO LAW REVIEW [Vol. 39:1365
even cause an event of default under a commercial credit agreement
222
—
but these consequences do not flow from the defendant’s liability to the
plaintiff.
In this way, judgment-proofing is a strategic choice aimed at
maximizing the effects of limited liability.
223
The first layer of limited
liability ensures that the entrepreneurs behind any endeavor would not
lose their shirts. Subsequent layers protect the company itself.
The net effect of layered limited liability is that there is nothing left
over for the very same parties that Professors Bebchuk and Fried
identify as non-adjusting creditors.
224
Individuals and even smaller, less-
savvy businesses may not perceive the layers of limited liability—if they
are even familiar with the concept of limited liability itself—and as a
result, may interact with these entities expecting that they will be made
whole if one of the entities harms them. They may perceive deep pockets
where there are none. Some of these interactions may be voluntary, but
the majority will be involuntary—just consider how many commercial
vehicles drive by you on any given day.
225
Although the injustices are
obvious, as a society we have decided that the economic benefits
outweigh these injustices. And so, the ideal of our liability system has
become the exception rather than the rule thanks to limited liability.
2. The Limits of Limited Liability
Limited liability and, to a lesser extent, judgment-proofing do have
an important, yet difficult to access, safety valve in veil piercing. That is,
courts can disregard one or several layers of corporate structuring to
hold parent companies and even shareholders liable for the actions of
limited liability entities.
226
In this way, courts can recreate unlimited
liability.
Although there are a couple of different theories available to courts
for piercing the corporate veil,
227
the common thread is that one of the
upstream parties—the parent company or shareholders—itself failed to
222
See White, Corporate Judgment Proofing, supra note 211, at 1384 (explaining that “the
indirect costs of damage to one's reputation in the business community” are sufficiently
“onerous” to prevent businesses from becoming strategically insolvent in the face of liability).
223
Easterbrook & Fischel, supra note 6, at 117.
224
Bebchuk & Fried, supra note 16, at 891.
225
There are parallel examples of non-adjusting claimants with each of the structures of
judgment-proofing identified by Professor LoPucki. See generally LoPucki, The Essential
Structure of Judgment Proofing, supra note 24 (explaining how judgment-proofing impacts
innocent third parties).
226
See generally Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76
C
ORNELL L. REV. 1036 (1991) (explaining when veil-piercing occurs).
227
See Mobil Oil Corp. v. Linear Films, Inc., 718 F. Supp. 260, 271 (D. Del. 1989) (describing
the difference between pure agency theory and alter ego theory).
D’ONFRO.39.4.5 (Do Not Delete)
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observe the separateness of the corporate entities so much so that to
allow it the benefit of limited liability would be to allow it to commit
something just shy of actual fraud.
228
Somehow, the upstream party
must have exercised such dominion and control over the defendant
entity that the court cannot recognize even the pretense of
separateness.
229
But these are high bars. Certainly, a corporate parent
can set the agenda for its subsidiaries. It can even create the subsidiaries
for the explicit purpose of containing potential liability. It can have
continuous branding throughout its lines of business, even if they are
technically under the purview of separate entities. Even if the MBAs at
the helm of the parent company know that most consumers do not
perceive the separateness of its companies, that alone is not enough to
justify piercing the corporate veil. While courts will not endorse
outright fraud to guarantee the smooth functioning of business, the line
is not terribly far from fraud.
230
C. Applying Limited Liability to Security Interests
It is hopefully now clear that the effect of a company creating
security interests in its assets is hardly different from it selling the
collateral then leasing it back, a common judgment-proofing tactic.
Why then are sales morally neutral economic transactions while security
interests are the continued focus of hostility?
Some of the wrath seems misplaced. For most unsecured creditors,
judgment-proofing has the same effect on their recoveries against
insolvent companies as security interests.
231
It makes no more sense to
require a carve-out for unsecured creditors than it does to require
purchasers to assume some liability to a seller’s creditors in the event of
default. Especially if management is wasteful with the proceeds of the
228
See Trs. of Nat’l Elevator Indus. Pension, Health Benefit & Educ. Funds v. Lutyk, 332
F.3d 188, 194 (3d Cir. 2003) (affirming the requirement of injustice or fundamental unfairness
in defendant’s use of the corporate form, but rejecting efforts to require proof of actual fraud);
Am. Bell, Inc. v. Fed’n of Tel. Workers of Pa., 736 F.2d 879, 886 (3d Cir. 1984) (“In addition to
gross undercapitalization, these factors are failure to observe corporate formalities,
nonpayment of dividends, the insolvency of the debtor corporation, siphoning of funds from
the debtor corporation by the dominant stockholder, non-functioning of other officers or
directors, absence of corporate records, and the fact that the corporation is merely a facade for
the operations of the dominant stockholder . . . .”).
229
Mobil Oil Corp., 718 F. Supp. at 271.
230
Teller v. Clear Serv. Co., 173 N.Y.S.2d 183, 187–88, 190 (N.Y. Sup. Ct. 1958) (explaining
that dividing the assets of a large taxi conglomerate among numerous small companies allows
“the true owners of most of the large fleets of taxicabs [to use] a corporate device to defraud the
public”).
231
LoPucki, The Essential Structure of Judgment Proofing, supra note 24, at 153.
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1414 CARDOZO LAW REVIEW [Vol. 39:1365
sale, the result will be the same: there are fewer hard assets post-sale
against which creditors can satisfy their judgment.
If the seller of an asset then leases it back from the purchaser—as is
often the case with machinery, photocopiers, and such—a sale can
conceal this lack of assets from other, less sophisticated creditors much
in the same way that a security interest does. To be sure, sophisticated
parties find out about sale/leaseback transactions by doing their own
diligence before contracting with companies.
232
Similarly, the
partitioning of assets into distinct, judgment-proof subsidiaries is
sometimes invisible to unsophisticated counterparties.
233
Consider the case of a taxi mogul. Over the years, a very successful
taxi mogul might amass a fleet of dozens of taxis and, if in a city like
New York, an equal number of taxi medallions (i.e., permits to operate a
cab). His assets are the cars, the medallions, and maybe some basic
office supplies. If he held all these assets in a single company and if one
of his drivers injured a pedestrian, the pedestrian could collect a
judgment against those assets generally. The pedestrian nevertheless
may not be able to collect the full judgment and be made whole since
the vehicles and medallions could be encumbered, but there might be
little pieces of equity scattered throughout the company against which
the pedestrian could collect. But this is not how taxi companies operate.
Instead, the taxi mogul can separate his cars and medallions into a
myriad of small companies.
234
Typically, both the vehicle and the
medallion are encumbered.
235
As a result, accident victims must sue not
a large, successful taxi operation but a very small company with no
assets available for unsecured claimants. As one New York court
explained, “the state and the city are unwitting accomplices of a
legalized racket to avoid liability for payment for the negligent maiming
232
Sale-leaseback transactions involving land will generate records of ownership just as
security interests are recorded. See In re OMNE Partners II, 67 B.R. 793, 796 (Bankr. D.N.H.
1986) (explaining that with the recorded deed, there was “[n]o misleading of creditors dealing
with the debtor”). Since there is no need to record any kind of “deed” with the purchase of
personal property, sale-leaseback transactions may indeed be less visible to the public than a
properly recorded security interest. That said, before entering a material contract, sophisticated
businesses require their counterparties to disclose their other material agreements so that they
can evaluate the true solvency of their counterparties. And in a commercial debt contract, the
borrower would almost certainly have to represent and warrant that there were no material
agreements other than those disclosed, and then covenant not to enter new material agreements
without the consent of, or at least notifying, the lender.
233
Teller, 173 N.Y.S.2d at 187–88, 190.
234
See Christopher Drew & Andy Newman, Taxi Owners Deftly Dodge Claims of Accident
Victims, N.Y.
TIMES (May 24, 1998), http://www.nytimes.com/1998/05/24/nyregion/taxi-
owners-deftly-dodge-claims-of-accident-victims.html#story-continues-1 (explaining this
elaborate judgement-proofing regime and its consequences in detail).
235
Id.
D’ONFRO.39.4.5 (Do Not Delete)
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and killing by taxicabs.”
236
This is a well-oiled system for not paying
claims.
This system may be less effective at cutting off liability if the
medallions and vehicles were sold outright to a holding company rather
than encumbered. When an asset is sold outright, even if it is leased
back to the original owner, the new owner of that asset becomes liable
for certain harms caused by that asset. There are various tort actions,
notably negligent entrustment, that our squashed pedestrian could bring
against the holding company as owner of a taxi.
237
Indeed, the victim
would have two potential sources of recovery: the operating company
that leased the vehicle and the holding company that owned the vehicle.
To be sure, the victim suing the vehicle owner does not have a direct
claim against the vehicle owner for her injuries. Nevertheless, she was
supposed to be protected by one more safeguard—the duty of property
owners to exercise reasonable care over their property—and if that
failed, would have one more source of recovery.
Similarly, if a pedestrian was maimed by leased equipment while
passing a construction site, he may be able to claim against the
equipment owner for any defect that caused his injury
238
or for negligent
entrustment if the operator was unqualified to be using the equipment.
Depending on his line of business, he might be happy to learn that the
equipment was leased since the equipment supplier might have much
deeper pockets than the construction company. The pedestrian would
have access to these deeper pockets because he could claim against the
assets of the lessor generally.
239
Limited liability would prevent him
from claiming against the owners of the equipment rental companies or
related companies. But, critically, the value of his claim would not be
236
Teller, 173 N.Y.S.2d at 190.
237
See, e.g., Tellez v. Saban, 933 P.2d 1233, 1239 (Ariz. Ct. App. 1996) (holding that a rental
car company could be held liable for negligent entrustment when it failed to ensure that drivers
were properly licensed). Indeed some states have even codified negligent entrustment into their
vehicular codes as one means to force vehicle owners to be responsible for their property. See,
e.g., C
AL. VEH. CODE § 17150 (West 2017).
238
8A AM. JUR. 2D Bailments § 103 (2015).
If the property which is the subject of a bailment for hire is of such nature that its use
threatens serious danger to others unless it is in good condition, there is a positive
duty on the part of the bailor to take reasonable care to ascertain its condition by
inspection. Furthermore, the bailor’s duty to exercise reasonable care to see that the
bailed property is safe and suitable for its known intended use may, in the case of
property that is a dangerous instrumentality if improperly used, require the bailor to
warn the bailee of the dangers inherent in improper operation, and to make inquiry
as to the bailee’s ability to operate it.
Id.
239
Of course, the lessor could partially control its liability by engaging in the same
judgment-proofing tactics discussed in Section III.B, supra.
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limited by the rental company’s relationship with the construction
company.
240
The opposite is generally true when it comes to security interests.
241
If our pedestrian friend is maimed by the construction company’s
encumbered equipment while passing a construction site, his primary
recourse is against the construction company unless he has a products
liability claim against the crane manufacturer. Given the six figure–plus
prices of heavy equipment, the construction company may only have a
smattering of personal property—hammers, wrenches, scrap lumber,
etc.—along with a small amount of cash to count among its
unencumbered assets. The company may have sufficient insurance to
make the pedestrian whole, but it may not. And if it does not, it is
reasonably likely that the company will be unable to satisfy the
pedestrian’s claim in full. At this point, the pedestrian would have a
choice among unattractive options. He could accept a settlement of less
than he is owed and bear some of the cost of his own injury
notwithstanding his blamelessness. Or, he could obtain a judgment and
levy it against the construction company, liquidating its odds and ends
into whatever cash he can get. Of course, the company would almost
certainly file for bankruptcy protection before it let this happen. And in
bankruptcy, the pedestrian would again have to accept a fraction of his
claim along with the company’s other unsecured creditors.
At no point could the pedestrian access the value of the company’s
encumbered equipment. The construction company may “own” that
equipment, but, on account of the security interest, the lender also
“owns” it. In bankruptcy, the lender could foreclose on it thereby
defeating the company’s ownership interest entirely or the company
could keep it, subject to the security interest, and use it when it emerges
as a reorganized company post-bankruptcy. Because the secured lender
owns the collateral, it is not available to satisfy the pedestrian’s claims,
240
Accord Smith v. Clark Equip. Co., 483 N.E.2d 1006, 1008 (Ill. App. Ct. 1985) (estate of
deceased victim brought personal injury claims against a forklift manufacturer and the
company that rented the forklift to the victim’s employer). A rental agreement between the
owner of heavy equipment and a construction company would almost certainly require the
construction company to indemnify and hold harmless the rental company, but such provisions
would not prevent the pedestrian from claiming against the rental company. The two
companies would have to sort out ultimate liability amongst themselves. And if the
construction company proved to have insufficient assets to cover the claim, the rental company
would be left with the liability. In many ways, this arrangement is as it should be. The
pedestrian is unable to vet the solvency or even safety performance of construction companies
that he passes, but a rental company is capable of such vetting and monitoring, even if it
strategically chooses not to vet or monitor its counterparties. Since the rental company can vet
and monitor both its own equipment and the equipment operators, it does not seem inherently
unfair for it to bear some of the liability when its equipment injures an innocent third party,
who lacked such vetting and monitoring capabilities.
241
A key exception here are the so-called “hot goods” provisions of the Fair Labor Standards
Act. See Citicorp Indus. Credit v. Brock, 483 U.S. 27, 39 (1987).
D’ONFRO.39.4.5 (Do Not Delete)
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but somehow the secured lender’s ownership does not include any
responsibility for harm caused by its collateral.
Indeed, under our current regime, the scope of the secured lender’s
responsibility is that of the borrower company.
242
Although the property
that caused the harm effectively has two owners—the lender and the
borrower—legally, it is as if only one entity, the borrower, participated
in that harm. While it may be true that the secured lender’s contribution
of capital technically enabled the corporate venture to cause the injury,
limited liability shields them from such liability to incentivize future
investments. The only thing at stake for a lender is its collateral.
But of course, the collateral is not really at stake because the
secured lender’s property right does not include any of the usual
responsibility for property-related wrongs. The only risk faced by the
collateral is the chance that it could be destroyed as a result of whatever
the underlying wrong is (for example, if an encumbered vehicle is
“totaled” in an accident in which that vehicle also causes other
damage).
243
Herein lies the unfairness.
244
Secured creditors receive the
privilege of priority that a third-party owner would receive, but, because
they enjoy the company’s limited liability, this ownership does not
expose them to the kinds of direct liability that a typical asset owner
would face.
IV.
SQUARING LIMITED LIABILITY WITH PRIORITY
The previous Part focused on the similarities between the two
flavors of limited liability property—security interests and equity
interests. There, I discussed the economic justifications for what appears
to be a fundamentally unfair system in which the norm is not to pay
claims in full as they are due. This Part will delve deeper into security
interests as limited liability property. Section A will look closely at
security interests’ distributional priority over judgment creditors, a
feature which magnifies the fundamental unfairness of not paying
certain junior claims. Having identified how priority amplifies the
effects of limited liability, Section B will then propose that if we take
242
Easterbrook & Fischel, supra note 6, at 89–90.
243
This destruction could be physical. For example, a piece of encumbered equipment could
be so damaged as to retain value only as scrap. In the environmental context, encumbered land
could become so polluted that no lender would ever foreclose on it since becoming the fee
simple owner of the property would make the lender liable for the clean-up costs. In this case,
the collateral literally has negative value to the lender. The more complicated form of
destruction is reputational. Then a brand or the trappings of a brand serve as collateral,
whatever wrong causes the financial distress that makes the collateral relevant may
simultaneously drive down the value of that collateral.
244
See infra Part IV.
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1418 CARDOZO LAW REVIEW [Vol. 39:1365
secured creditors’ justification for their priority right seriously—that
they have a property interest in the collateral—that alone tends to dial
back the scope of their limited liability since ownership carries both
burdens and benefits. This normative proposal is not without costs and
complications, which are addressed in Section C.
A. Locating the Problem
As an initial matter, we should identify what exactly is “unfair”
about secured credit. There has been considerable criticism that because
of a proliferation of secured credit, the recoveries of unsecured creditors
have declined in recent decades.
245
But it is not clear that limited
recoveries for unsecured creditors is inherently unfair or socially costly.
For example, consider sophisticated unsecured lenders.
246
Many receive
pennies on the dollar in bankruptcy, but—to put it bluntly—this is
exactly what they signed up for.
247
That a secured creditor might prime
their claim is part of, arguably even the main source of, the risk that
entitles unsecured lenders to the higher interest rate than that paid to
secured lenders.
Next, there are commercial creditors who are not traditional
lenders. These are vendors who do not require companies to prepay for
their goods and services.
248
During the period between when they
245
Such concerns have been around for quite some time. See Gilmore, supra note 142. But
they continue to inspire calls for broad-scale bankruptcy reform. See C
OMMISSION TO STUDY
THE
REFORM OF CHAPTER 11, supra note 16. Some of the perception that secured creditors are
driving down recoveries by unsecured creditors is wholly misplaced. Most notably, the safe
harbors found in section 546(e) have given a myriad of transactions the super-priority status
traditionally reserved for secured creditors by protecting them from recovery by the bankruptcy
trustee. See Kandarp Srinivasan, The Securitization Flash Flood (Aug. 25, 2017) (unpublished
paper), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2814717. Again here, the
argument is that we need to tolerate the apparent unfairness of paying wall street in full but not
paying unsecured claimants in full—even when their property rights would otherwise entitle
them to payment pari passu—to preserve the smooth functioning of wall street. Steven L.
Schwarcz & Ori Sharon, Derivatives and Collateral: Balancing Remedies and Systemic Risk, 2015
U.
ILL. L. REV. 699, 700; Steven L. Schwarcz & Ori Sharon, The Bankruptcy-Law Safe Harbor for
Derivatives: A Path-Dependence Analysis, 71 W
ASH. & LEE L. REV. 1715 (2014). To the extent
that we, as a society decide that one group deserves “more” and another “less” in the face of
limited resources, it perhaps makes sense to look to the section 546(e) safe harbors and other
provisions that redistribute wealth rather than attacking the foundational property rights on
which our capitalist society was built.
246
Indeed, because of the risks inherent to being an unsecured creditor, only the largest
companies can borrow on an unsecured basis. See Bebchuk & Fried, supra note 16, at 4–5.
(rounding up studies that indicate only a small portion of loans are unsecured and that these go
to large, stable companies).
247
See LoPucki, The Unsecured Creditor’s Bargain, supra note 103.
248
Law firms are a classic example. While they may require a retainer to cover some of their
costs, it is common for companies entering bankruptcy to list the firms that helped try to keep
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1419
provide their good or service and when they are paid, they have
effectively lent the value of that good or service to the company. These
parties traditionally do not typically conduct the kind of extensive due
diligence that lenders do during their underwriting process. As a result,
they arguably know less about the fiscal health and risks facing their
clients.
249
Is it unfair when they are underpaid in bankruptcy? Yes and
no. Larger companies could do more diligence or require payment on
shorter schedules, i.e., within thirty days rather than ninety days. They
could also build penalty features into their contract so that their claim
grows over time, thereby increasing their pro rata claim on any
unencumbered assets. Others could structure their transactions to fall
into one of the special categories entitled to administrative expense
priority so that they would be paid ahead of general unsecured
creditors.
250
And others could structure their transactions to ensure that
they would become secured creditors having taken a purchase money
security interest in their goods.
251
And finally, these vendors could raise
their prices to cover the risk that they will not collect their contracts in
full. In sum, many of the traditional unsecured lenders have paths to
protect their status, and if they do not it may be because they took the
strategic risk of proceeding unsecured, perhaps hoping to make up any
losses on volume or market share. For these companies, it is hard to
argue that declining unsecured creditor recoveries represent any
significant unfairness.
Small companies, however, present a more sympathetic case.
252
They may lack any realistic ability to improve their priority, or even to
demand payment on a tighter schedule, but their transactions are still
fundamentally voluntary. Perhaps the best that can be said is that the
owners of these companies could pursue other vocations if they cannot
stomach the risks of entrepreneurship.
253
them out of bankruptcy among their unsecured creditors. See In re Adam Furniture Indus., 158
B.R. 291, 296 (Bankr. S.D. Ga. 1993).
249
Some, however, arguably know more about their clients than distant commercial lenders
since they are on the ground with the borrower and may gain early insight into geographic or
niche-specific risks.
250
Although not guaranteed, they could structure their relationship with the borrower so
that they receive payments, even on the eve of bankruptcy “in the ordinary course” of business
or as a critical vendor such that they would receive special treatment in the first-day orders and
have defenses against preference actions. See 11 U.S.C. 363(c)(1) (2012). But see In re Kmart
Corp., 359 F.3d 866 (7th Cir. 2004) (holding that a bankruptcy court lacked authority to bypass
usual priority rules with a critical vendor order).
251
Purchase money security interests are priority liens given to lenders who finance the
purchase of an asset against that asset. U.C.C. § 9-103 (A
M. LAW INST. 2012).
252
Indeed, many of these small companies may hardly be companies at all but rather
individuals’ sole proprietorships.
253
This is, of course, easier said than done. Still, I hesitate before any suggestion that we
create special recovery rules for small business creditors since our system of easy incorporation
makes remaining a nominally small business easy. Just consider the taxi cab companies
D’ONFRO.39.4.5(Do Not Delete)
1420 CARDOZO LAW REVIEW [Vol. 39:1365
But even this argument is not available for truly involuntary
creditors. Involuntary creditors cannot satisfy their claims when a
bankrupt company has no unencumbered assets. They may bear the
costs of an injury that is no fault of their own. In many cases, this sense
of unfairness may be magnified since, for all intents and purposes, it
may appear to the casual observer that there is a party that both can and
should shoulder the costs instead.
This unfairness, however, is not a unique feature of security
interests but rather of capital property and its limited liability more
generally. Specifically, it is the ability of limited liability to create
judgment-proof entities that nonetheless have the capital to operate that
creates the potential for this unfairness. Consider the taxi cab company
above. From the view of the injured rider, the outcome is the same if the
cars and medallions are divvyed up into several judgment-proof
companies or if all the assets sit in a single company but are covered by a
blanket lien. If companies owned in fee simple the capital they needed to
operate, there would be more assets available to satisfy the claims of
involuntary claimants. But, security interests or not, that is not how
business organization law works in this country.
Of course, it is an open empirical question whether tort claimants
and other unsecured creditors would be better off if the law discouraged
judgment-proofing and security interests since there might be less
investment, less innovation, and less entrepreneurship as a result.
254
The
arguments in favor of tolerating judgment-proofing in the corporate
structure context have always been that it encourages economic activity
and therefore promotes overall flourishing.
255
These are the same
arguments used to defend security interests.
256
discussed in Section III.C, supra. Each taxi could be its own company, which is about as small a
business as they come, yet the ultimate owner of a web of such companies might be a large,
sophisticated taxi conglomerate.
254
The closest that we can get to conducting such a study is to compare the United States to
other jurisdictions that permit fewer security interests, that do not adhere to our absolute
priority rule in bankruptcy, or that do not offer companies the same limited liability protections
found in the United States. Such a project is beyond the scope and aspirations of this Article.
However, it is worth noting that as countries modernize their lending, insolvency, and
corporate laws to encourage growth, the trend is to make laws more like those in the United
States, not less.
255
See supra Section III.B.1.
256
See generally Thomas H. Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the
Creditors’ Bargain, 91 Y
ALE L.J. 857 (1982) (advocating for the efficiency of preserving of non-
bankruptcy rights in bankruptcy).
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1421
B. Bringing Coherence to Limited Liability Property
One way to mitigate some of this unfairness while at the same time
making the priority rights held by secured lenders more coherent is to
treat security interests more like the property rights that they claim to
be.
257
Our current system allows secured lenders to peel certain
privileges of property ownership off of the responsibilities that normally
accompany those property interests.
Moreover, property rights are claims against the world, not claims
against the rights of other individuals. It is odd, then, that security
interests functionally convert certain in rem aspects of the property
right—notably ownership-based liability—into in personam obligations
belonging to the borrower.
258
This conversion happens because secured
lenders do not incur any ownership-based liability as long as their
interest is technically a security interest—that is, before a foreclosure
sale has occurred—even when it would be nearly impossible for the
borrower to relieve the asset of the encumbrance.
259
The borrowers
retain all of the responsibility for the property, even when they no
longer have the right to use the property for their own benefit since,
facing insolvency, their fiduciary obligations have shifted from equity
holders to debt holders.
260
Since secured lenders’ priority right depends on security interests
being at least property-like interests, a better system would be to
condition secured lenders’ priority right on assuming ownership-based
liability. That is, where owners of property face liability by virtue of their
257
We can treat security interests like property interests for liability purposes even if they
are not ultimately true property under prevailing theories of property. See Thomas W. Merrill
& Henry E. Smith, Optimal Standardization in the Law of Property: The Numerus Clausus
Principle, 110 Y
ALE L.J. 1 (2000) (excluding security interests from true property interests). But
see Yun-chien Chang & Henry E. Smith, Structure and Style in Comparative Property Law, in
C
OMPARATIVE LAW AND ECONOMICS 24–28 (Giovanni Battista Romello & Theodore Eisenberg
eds., 2014) (arguing that because they entail a right to exclude, act in rem, and run with the
collateral, “a mortgage is a property right” even if it lacks certain characteristics of other
property rights).
258
See generally Merrill & Smith, supra note 76 (describing how to be a hybrid of in rem and
in personam rights).
259
To be sure, an ex machina infusion of cash could allow the borrower to buy off the
security interest, but there are many cases in which the odds of a company regaining the
financial health needed to do so are virtually zero. Consider a manufacturing outfit that has
incurred significant environmental liability on its land. No solvent company will want to
acquire the manufacturer if the environmental liability exceeds the expected value of the going
concern. And due to concerns that the manufacturer will worsen the pollution problem, state
and federal regulators may prevent it from conducting business as usual in an effort to operate
its way into solvency. Lacking the cash to do the clean-up itself and to re-tool its operations to
be cleaner, it has no path, even through bankruptcy, to de-leverage its assets.
260
Laura Lin, Shift of Fiduciary Duty Upon Corporate Insolvency: Proper Scope of Directors’
Duty to Creditors, 46 V
AND. L. REV. 1485, 1499–1500 (1993).
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1422 CARDOZO LAW REVIEW [Vol. 39:1365
ownership alone, so too should holders of security interests. The scope
of this liability is narrow—primarily consisting of real property–based
liability
261
and negligent entrustment. Critically, other metrics of
creditor behavior—notably, control—would be irrelevant to
determining whether the creditor should bear liability. Despite the
limited scope, this change would go a long way towards making the in
rem rights of security interest holders make sense as in rem rights.
Secured lenders would hold both the privileges and liabilities of their in
rem claims.
Such a system would also be more coherent with the system of
capital property described in Part I above. There, I described how equity
holders receive limited liability in exchange for forfeiting direct control
over their capital.
262
Since they no longer control their capital, they do
not personally assume any responsibility for the proceeds of their
capital. One of the ways in which equity holders have given up control
over their capital is by delegating to the company the ability to give
other claimants a priority claim over the assets of the company in the
hope that such claims will ultimately increase their residuary. When the
company issues unsecured debt, it accepts another class of capital whose
value is supported by the residuary of the company. Companies have a
contractual obligation to repay unsecured debt, but their ability to do so
depends on the health of the company as a whole. Unsecured claimants
can only look to the unencumbered assets of a company for assurance
that they will be able to satisfy their claims should the company fail to
make its contractual payments.
But when a company issues secured debt, it accepts another class of
capital whose value is supported by the assets to which the security
interest attaches. The security interest then removes that asset from the
pool of assets supporting all junior claims. Whereas the ownership
interests held by equity and the claims held by unsecured creditors are
rights to the proceeds of a pool of assets, secured creditors have a direct
claim on particular assets. But while they take ownership of the asset
from the company such that the asset no longer supports general claims
against the company, they leave the claims generated by that asset with
the company.
Such a split between ownership and ultimate liability fits with our
permissive system of contracting. Borrowers could easily indemnify
secured lenders for any liability arising out of their security interest. But
261
I am conceiving of real property liability as liability that belongs to the owner of real
property by virtue of his ownership. The largest category of such liability is undoubtedly
environmental liability for which owners face strict liability under various regulatory regimes.
262
Instead of owning any company assets, equity holders own the residuary of a company,
which is merely a pro rata share of the proceeds remaining once any assets are sold to satisfy
prior claims.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1423
such indemnification claims would necessarily be unsecured claims
supported by the residuary.
263
This split makes little sense in a system of
property rights where one of the core distinctions between property
rights and contract rights is their enforceability against third parties. For
this reason, certain structures such as priority and subordination, that
are desirable options in contracts, are not necessarily desirable options
when enforced through property rules.
Making secured lenders liable for certain ownership-based claims
would force secured lenders to look to their own limited liability to
manage risk rather than enjoying the limited liability of equity holders
while claiming to have a property interest in the company assets that is
distinct from equity’s interest in the residuary. To be sure, secured
lenders could use corporate law to achieve a nearly identical degree of
judgment-proofing as they can under the present system, but the
mechanism by which claims went unpaid would be more coherent.
Moreover, the same reputational and political forces that already
motivate conglomerates to satisfy their subsidiaries’ liabilities
264
might
come to bear on secured lenders if they formally owned that liability.
265
C. Additional Implications
Of course, any revisions to our system to take more seriously
secured lenders’ direct ownership claims would cause significant
headaches—perhaps even chaos—in the loan industry. The most
immediate effect of which would almost certainly be reduced overall
secured lending. The main change for secured lenders would be an
increase in their risk when taking security interests. Where previously
263
Loan documents could also use a mechanism like cross-collateralization to support any
indemnity claims with the original collateral. Such a system would be inferior in the eyes of
secured creditors since it would only be effective if they were over-secured by at least the
amount of the indemnity claim and if a bankruptcy court would recognize the addition to the
secured claim. If the addition occurred post-petition, the automatic stay found in 11 U.S.C.
§ 362 (2012) would likely prevent the secured creditor from tucking its indemnity claim under
the existing security interest.
264
For example, after the Deepwater Horizon oil spill killed eleven workers and pumped
millions of barrels of oil into the Gulf of Mexico, the relevant subsidiaries parent companies, BP
Corporation North America Inc. and BP P.L.C. guaranteed the global settlement reached by the
Department of Justice, five states, and BP. U.S. and Five Gulf States Reach Historic Settlement
with BP to Resolve Civil Lawsuit Over Deepwater Horizon Oil Spill, U.S.
DEP’T JUST. (Oct. 5,
2015), https://www.justice.gov/opa/pr/us-and-five-gulf-states-reach-historic-settlement-bp-
resolve-civil-lawsuit-over-deepwater.
265
For example, if the Dakota Access Pipeline is built with secured financing from
subsidiaries of Bank of America and Wells Fargo, and it then causes an environmental disaster,
even though the cost of the clean-up may exceed the value of the lending subsidiaries, one can
imagine that the reputational harm that Bank of America and Wells Fargo would suffer if they
let those subsidiaries become insolvent while posting large profits elsewhere, might inspire
them to pay claims beyond their technical liability.
D’ONFRO.39.4.5(Do Not Delete)
1424 CARDOZO LAW REVIEW [Vol. 39:1365
they could hold security interests with virtually no added liability, they
now would face ownership-related liability.
266
This risk would cause
their expected returns to dip, even on loans to otherwise very credit-
worthy companies. Underwriting costs would rise as diligence into
potential ownership liability claims become essential. In turn, there may
be convergence in the pricing of secured and unsecured debt. And in
high-risk industries—such as those prone to environmental liability—
secured debt could become costlier than unsecured debt making it an
unattractive option for borrowers and lenders alike.
It is also possible that full recognition of the property claims
inherent to secured lending would make true blanket liens less
appealing.
267
For example, if a creditor asserts a lien on all of the firm’s
value instead of against particular assets, perhaps there is a point at
which the lender becomes liable for all of the firm’s actions. That is,
perhaps the secured lender’s liability would match the scope of equity’s
liability but lack the protection of limited liability.
There would also be added administrative costs, particularly with
widely held leveraged loans. Under the proposed system, a plaintiff
could sue the holders of debt,
268
who may be numerous and constantly
in flux. Lenders would have to have a system in place for participating in
ownership liability suits in a coordinated way. One could imagine this
becoming the responsibility of the collateral agent or indenture trustee.
For widely traded debt, plaintiffs might have little choice but to sue
defendants as a class.
269
Since the liability would be ownership-based,
some of it would not depend on when the holder purchased the security
interest.
270
Purchasers of debt on secondary markets might find deeper
diligence needed before they can comfortably purchase debt. Debt in
high-risk industries might become less tradeable on secondary markets.
Large issuances could become more difficult as participating banks
266
Current law does impose additional liability on secured lenders who use their status to
exercise too much control over a company. See Daniel R. Fischel, The Economics of Lender
Liability, 99 Y
ALE L.J. 131, 131–40 (1989) (explaining lender misbehavior). This risk is not
something that must necessarily be priced into a loan since the lender can choose to avoid it
completely by not exercising an impermissible level of control over the borrower.
267
It is unlikely that secured creditors can actually take a security interest in all of a
company’s going concern value since security depends on having identifiable assets as
collateral. See Jacoby & Janger, Tracing Equity, supra note 96.
268
There are various ways such liability could work, each yielding subtly different results.
For example, lenders could be joint and severally liable or subject only to pro rata liability.
269
Such defendant classes are rare now, but unwieldly and burdensome on courts when they
do arise. For example, the fraudulent transfer litigation arising from Lyondell Chemical’s 2009
bankruptcy was still pending nearly a decade later having been through various appeals and
other costly hurdles. Voluntary Petition (Chapter 11), In re Lyondell Chem. Co., 543 B.R. 127
(Bankr. S.D.N.Y. 2016) (No. 09-BK-10023).
270
Claims about the condition of property may not depend on the time of purchase since
they function almost like strict liability claims. However, claims such as negligent entrustment
may depend on who held the debt when the wrong occurred.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1425
worry about holding significant and indeterminate risks on their
balance sheets.
271
Diligence over the life of the loan would also become more
essential for the protection of lenders. In addition to their usual
servicing costs,
272
secured lenders would have potentially significant
monitoring costs as they would need to inspect not only the value of
their collateral but also whether that collateral may cause them
additional trouble. These costs could make secured lending more
expensive or even unavailable in difficult-to-monitor industries.
273
For
example, it could become difficult to impossible to get secured financing
to build gas stations, auto body shops, and dry cleaners because of the
risk that some deep corner of soil would become an environmental
liability.
274
At the same time, the cost of complying with covenants could
increase for borrowers as lenders may require additional audited
reporting or inspections.
These added costs, though significant, might nonetheless prove to
be net positives for society. Lenders’ diligence might sufficiently reduce
liability-producing incidents, especially those that optimally should
never occur. Consider how the incentives to maintain an oil pipeline
might change if the secured lender whose collateral includes the pipeline
could instantly become liable in the event of a leak versus a
conglomerate that holds the pipeline in a judgment-proof subsidiary.
While lenders themselves could use some judgment-proofing strategies
to minimize their exposure, the mere threat of litigation should make
them somewhat more sensitive to risks,
275
especially those risks that are
easily avoided.
276
This might be particularly true since the borrower, not
271
The norm in large-scale leverage finance is for a small coalition of banks to fund a
leveraged loan then for those banks to quickly diversify their holdings by selling portions of
their loan on secondary markets or through securitization. In January 2017 alone, there was
nearly $57 billion dollars of debt traded over the secondary markets. IQ17 Secondary Trading
Volume: Trade Activity Spikes to a Record $178.7 Billion, L
OAN SYNDICATIONS & TRADING
ASS’N (April 24, 2017), https://www.lsta.org/news-and-resources/news/1q17-secondary-
trading-volume-trade-activity-spikes-to-a-record-1787-billion.
272
Namely, payment processing, covenant monitoring, and collateral monitoring.
273
Monitoring only makes sense if the cost of monitoring is less than the higher interest the
debtor would have to pay in its absence. Otherwise, both parties benefit from agreeing not to
monitor. See Jackson & Kronman, supra note 19, at 1150 (in which case the lender may prefer
to lend on an unsecured basis, if at all).
274
Such businesses may find themselves shut out of capital markets if they are not
creditworthy enough for even very expensive unsecured debt.
275
Modern banking regulations may make it more difficult for lenders to use the most
aggressive judgment-proofing strategies. See, e.g., Regulatory Capital Rules, 78 Fed. Reg. 55,340,
55,343–344 (2013) (imposing capital requirements on FDIC-insured banks).
276
For example, secured lenders could condition the loan on receiving regular independent
inspection reports.
D’ONFRO.39.4.5(Do Not Delete)
1426 CARDOZO LAW REVIEW [Vol. 39:1365
the lender, could be made responsible for the cost of mitigating the risk
under the terms of the loan agreement.
277
Moreover, there are reasons to believe that lenders may be better at
monitoring risks than borrowers.
278
While they may lack the insider’s
view of the borrower itself, large-scale lenders may have a whole-
industry view that affords it considerable expertise both about risks and
about best practices. A lender with a reputation to protect may also be a
more diligent monitor than an anonymous company that can easily
rebrand and move on if the unthinkable happens.
279
While these consequences are certainly negatives for the lending
industry, they could better align actual, collectible liability with the
idealized liability rules of our private law and regulatory system. That is,
shifting some ownership liability to secured lenders may help undo our
system for not paying claims. In any event, however, we can only
evaluate this proposal by first understanding the awkward fit between
secured lenders’ direct ownership claim—and therefore their priority
right—and limited liability.
C
ONCLUSION
Security interests have many features of a one-sided property right
that gives holders many of the privileges of ownership without any of
the liability that ownership normally entails. They are a kind of limited
liability property—a direct ownership interest in company assets that
cannot be liable for more than the existing value of that ownership
interest. This disconnect between direct ownership and liability helps
277
To control their liability, lenders may have to shoulder the cost of some repairs should
borrowers refuse to make them, but they could structure their loan agreements so that such
refusal is a material default or even capitalize the costs of repairs into their security interest.
Unless the borrower were truly insolvent and had no hope or intention of reorganizing, its
desire to maintain a positive relationship with lenders would further incentivize it not to force
the lender to make repairs itself. After all, the borrower’s long-term fiscal viability likely
depends on it having regular access to lenders.
278
But duplicative monitoring obligations can also lead to under monitoring or inefficient
over monitoring. See Levmore, supra note 31, at 50 (exploring the problem of freeriding
monitors and arguing that that “the freeriding problem is solved if unique monitoring tasks can
be assigned to secured creditors”); see also Schwartz, Security Interests and Bankruptcy
Priorities, supra note 19, at 12 (explaining that the sanction of lost good will reduces the need
for monitoring).
279
Even very large companies that are not consumer-facing rebrand as a strategy for
burying stains on their reputation—to cease to be household names when they never wanted to
be household names. Consider for example how Blackwater, a defense contractor known for
abuses in Iraq, became Academi, a defense contractor that no one has ever heard of and whose
creative use of vowels suggests a benign Silicon Valley–based education venture. See Ben
Makuch, The Company Formerly Known as Blackwater Is Training Canadian Soldiers, V
ICE
(Apr. 9, 2015, 4:31 PM), https://www.vice.com/en_us/article/3bj85y/the-company-formerly-
known-as-blackwater-is-training-canadian-soldiers-296.
D’ONFRO.39.4.5 (Do Not Delete)
2018] LIMITED LIABILITY PROPERTY 1427
fuel the perception that secured lending imposes undue costs and risks
on downstream claims. These costs and risks are not unique to security
interests, but instead are the products of our systems of property and
limited liability. We are mostly comfortable with the costs of private
property and limited liability because we believe that they are net
positives for society. While secured lending merges the externalities of
both systems into a particularly potent force, it is quite possible that
secured lending as it currently exists is also a net positive for society.
After all, it has proven to be an incredibly effective tool for financing
small businesses, homeownership, and countless other trappings of the
American dream, downstream concerns notwithstanding. It could well
be that the benefits of secured credit vastly outweigh its costs.
280
But we
cannot begin to answer that question—or even begin to see why it needs
to be asked—until we understand security interests for what they are:
limited liability property.
280
Ultimately, these concerns reduce to an empirical question: would taking secured
lenders’ property rights seriously by affording them liability along with privileges of ownership
produce a more optimal level of liability? Knowing the answer to this question would
dramatically improve our ability to design an efficient system of property and property-like
rights. But of course, we would first have to know what a more optimal level of liability is. If the
limited liability literature teaches us anything, it is that knowing the optimal level of liability is a
fabulously difficult question. See A. Mitchell Polinsky & Steven Shavell, Punitive Damages: An
Economic Analysis, 111
HARV. L. REV. 869, 877–97 (1998) (describing the problem of setting
optimal liability). At some point, the answer may boil down to one’s view of the relationship
between fairness, welfare, and even redistribution. See Louis Kaplow & Steven Shavell, Fairness
Versus Welfare, 114
HARV. L. REV. 961, 966 (2001) (arguing that fairness should not be an
independent criterion for evaluating policies); Jeremy Waldron, Locating Distribution, 32
J.
LEGAL STUD. 277, 298–99 (2003) (championing distributive convictions as valid
notwithstanding the lack of a complete theory in which to situate them).
