The case against secured lending

IF~IuTTERWO RT H I~IE 1 N E M A N N

The Case Against Secured Lending* J O H N HUDSON

School of Social Sciences, University of Bath, Bath, England In this paper we argue that the secured loan exists because imperfect information allows a bargain that gives the firm cheaper credit and the lender a less risky loan. T h e costs of this are borne by unsecured creditors, who we argue are likely to be in part ignorant of the security. T h e consequences are that credit markets become distorted, failing firms are kept alive too long, and unsecured creditors face large losses. T h e case against the secured loan is, we believe, strong enough to warrant some reform in the system, some of the options for which are discussed. Introduction Secured lending is central to the working of financial systems across the world, yet it has generated very little analysis within the economics literature, and in the finance and legal literature there are few examples of a critical evaluation of its role. Part of the reason for the acceptance of secured lending may be the length of its history. Over 4000 years ago security was used by the Akkadians, where the debtor pledged his land and the members of his family. If payment was defaulted the lender not only gained the land, but the family as well. Some 2000 years later the Romans had a very sophisticated system of secured lending, which even included a floating charge over stock in trade. T h e r e is some confusion in the literature over the exact interpretation of some terms. We will follow the UK practice as set out by Samuels et al. (1090). A debenture is defined as a document issued by a company containing an acknowledgment of indebtedness that usually gives a charge on the company's .assets. When it does so it is a secured loan. T h e company agrees to pay the principal to the lender by some future date, and in each year up to repayment it will pay a stated rate of interest in return for use of the funds. In the United States the reverse is the case and a debenture signifies unsecured debt. In the UK the emphasis on secured lending and the protection to the secured lender is greater than in most other countries. This is because the banks grew from a tradition of a deposit protection service. T h e y have not built up a close relationship with industry that would give them the expertise to evaluate projects, and as a result have tended to fall back on secured lending. In other European countries such as Germany the emphasis on industrial banking (Edwards 1987) has led to a much closer relationship between industry and banks than in the UK. This has resulted in an understanding of the problems of industry and a technical expertise that has *1 would like to acknowledge the helpful comments of Geoff Simcox and two anonymous referees. International Review of Law and Economics 15:47-63, 1995 @ 1995 by Elsevier Science Inc. 655 Avenue of the Americas, New York, NY 10010

0144-8188/95/$10.00 SSDI 0144-8188(94)00003-D

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allowed Europeans to accept business that a British banker would traditionally regard as very risky. However, the use o f secured lending is by no means restricted to the UK. In a study of Canada, Wynant and Hatch (1991) have concluded that although secondary to the general prospects o f the business and cash flow, security was an essential requirement for virtually all loans, whereas in the United States nearly 70% o f all commercial and industrial loans are made on a secured basis (Berger and Udell 1990). It is a worldwide phenomenon. Despite its central position in the financial system there is some confusion about its advantages and hence its raison d'etre. According to Scott (1977), "Essentially when they sell secured debt stockholders are selling not only a promise of future repayment but the right to be first in the order of priority upon bankruptcy as well. This is a valuable right which stockholders themselves cannot exercise . . . . Since they cannot exercise it, it follows that it is optimal for them to sell it." On the other hand, Schwartz (1984) argued that "Secured creditors will charge lower interest rates because security reduces their risks, but unsecured creditors will raise their interest rates in response because security reduces the assets on which they can levy, and so increases their risks . . . . hence the firm makes no net gain from security." Being as issuing a security is not a cosfless operation, it will not be issued unless there is some compensating advantage. If Schwartz's argument is correct, all that remains are (i) lower monitoring costs, (ii) a signaling argument, and (iii) economies in evaluating future profit streams of potential borrowers. We shall examine these later, but, to anticipate that discussion, neither Schwartz nor we find them compelling enough to justify the widespread use o f secured lending. T h e answer to the puzzle, we believe, lies in the assumption that is implicit in most of the work on secured lending and which can be found in the passage from Schwartz cited above, that of perfect information. Unsecured creditors will only charge higher interest rates (or prices) if they are aware of the existence of the security. We will argue that this assumption is unlikely to be valid because of both information lags and search costs, which will leave some unsecured creditors unaware of the security's existence. Given this, all of the disadvantages from a secured loan, which we shall discuss below, will flow. Without this assumption, none of them will flow, but then again, in this case it is difficult to see why the secured loan is so prevalent. In the following sections we shall look at the disadvantages and then the economic and legal arguments in favor o f secured lending. We shall then discuss some alternatives to the present system of secured lending, before ending with a brief concluding section. The Case Against Secured Lending

In a recent paper Webb (1991) examined the working of the 1986 Insolvency Act in the UK. He was primarily concerned with the efficiency of that Act in ensuring that a company was liquidated at the right time, defined as the time when the expected value o f a company u n d e r continued trading is exceeded by the liquidation value o f the company. He gave an example of when the existence of two debenture holders would ensure that a company would be liquidated too early. At date t --- 1 the firm fails to make a total payment o f R1 to the two debenture holders, who agree that at date t = 2 the company will be worth V2 with probability P2 or L with probability (1 - P2), with V~ > L and L being the liquidation value of the business. Webb makes the

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implicit assumption that L is constant over the two time periods, i.e., it represents the liquidation value in both time periods. Being as this will largely reflect the value o f the firm's assets, this may not be too great a simplification in the short run. In any case, in o r d e r to maintain consistency with Webb, it is an assumption that we too shall follow. In addition, V2 > D 2 + R1 > L, where D 2 is the face value of the loan plus interest at the end of period two. A proportion o~ = (Di~ + Ril)/(D2 + R1) o f B 1, where B1 = p2(D2 + R1) + (1 - p2)L, then accrues to debenture holder i and its complement to debenture holder j. T h e crux of the problem is that if either debenture holder puts in a receiver at date t = 1, he will then be certain of getting back D~ + R~ in its entirely. Hence there is an incentive to do so even though the expected value of the firm u n d e r continuation exceeds its liquidation value. T h e problem occurs because there is more than one debenture holder. However, it should be noted that when the debenture holders are secured by suitably drawn-up fixed charges the problem can be reduced. Neither debenture holder can liquidate assets that fall u n d e r the security of the other; hence, in the absence of synergy between the two (fixed charge) assets, there is not incentive to be "first in," apart perhaps from the less important one of being in charge of the firm during the first stages of the liquidation. Indeed, as we shall see later, this deterrent of the incentive to be first in in the event of a bankruptcy is one of the advantages of the secured loan as discussed in the literature. Webb touched upon a second case where there is just a single debenture holder and where there are also further unsecured creditors. T h e r e is now the reverse danger that the firm will be kept going too long. This can be simply illustrated with a further example. Let the notation be as before, but where U2 represents debts to unsecured creditors payable at the end of period 2, and let us further define V2 = f~ p(t~)t~d~ and p~ = f~ p(t~)d~, where p(t~) is the probability density function in period 2 relating to firm value 0. T h e firm should be wound up ifp2V 2 + (1 - p2)L < D2 + R1 + U2, i.e., the firm is insolvent, and V2 < L, i.e., the expected value of the firm in state 2 is less than its current liquidation value. For a firm with limited liability and where L < D 1 + RI + U1, there is no financial incentive for the shareholders to wind the company up, because their shareholding is then worthless. In this case, provided that there is some positive probability that the value of the firm at time 2 exceeds D2 + R1 + U9 (i.e. f~2+n~+v2 p(t~)d¢ > 0), they have an incentive to attempt to continue trading. T h e bank may agree to this, i.e., agree to waive immediate payment o f R1 in return for an increased payment (D*2) in period 2, provided D* 2 + R~ < L, i.e., this increased payment is less than the liquidation value of the firm, which represents an upper bound on the value of the security. This, for both the banks and the shareholders, will be a risk-free venture. T h e shareholders have nothing left to lose, whereas the bank's money is entirely covered by the liquidation value o f the firm. T h e risk is taken, unwittingly or otherwise, by the unsecured creditors. From one perspective a secured loan is the outcome of a bargain freely undertaken between two agents to the benefit of both. From this perspective there seems no need to set institutional constraints on the bargain. From a different perspective, however, it represents a bargain between two agents that in the event of bankruptcy one of these agents will be favored over all other creditors. These other creditors will not have been party to the bargain, they will initially be unaware of its existence, and they will only become aware o f it should they conduct a search on the firm granting the security. Thus, although the risk to the debenture holder is reduced, this is not a net

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gain to the economy, because the risk is merely transferred to other creditors. In addition, an element o f uncertainty that did not previously exist also faces these other creditors. All non-bank creditors will operate in an environment where they cannot be certain that the debtor's assets are not secured by a bank loan or to what extent they are secured, unless they continually search for up-to-date information. Even then delays in notification of the debenture may still lead them to remain in ignorance of its existence. T h e extent o f this risk can be illustrated with the use of figures taken from a recent issue of Stubbs Gazette (Dun and Bradstreet 1993) giving preliminary details on 52 insolvent firms. This is a weekly journal providing information on the more important insolvencies in England and Wales. T h e average assets o f these firms were £40,147 after allowance had been made for average preferential and secured debts. These amounted to £117,720 and £40,470, respectively. Total liabilities averaged £496,990 per firm. Hence total liabilities net of assets amounted to £456,843, some 11 times greater than the assets. Thus in total this represented £23.75m of debt not covered by assets reported in a single week. I f these figures were extrapolated to a gross annual total they would then equal £ 1235m. Thirty-one of these 52 firms had zero assets, and it is probable that many of them had previously been in receivership. Hence the above figure for secured debt is almost certainly an understatement. Some of these firms will already have been in receivership and their secured creditors paid either in full or to the full extent of the firm's assets. One of these companies had liabilities o f £4.2 million, of which the secured lender was owned £2.2 million. Another o f its creditors, a firm, was owed in excess of £ 100,000. Its assets after allowing for secured loans and debenture holders were nil. Hence this creditor would almost certainly have lost all of the £100,000 and, being a medium-sized firm, must also have been put in danger o f insolvency. Taking all 52 firms together there were some 272 creditors owed in excess of £10,000. Not all o f these were British firms; some were from abroad. T h e largest amount owed to any single creditor was £247,000; the assets of the insolvent firm in this case were nil. Unsecured creditors have responded to the problems created by the secured loan by resorting to devices like Reservation of title (ROT) in their own self-defense. Normally, goods supplied to a trader become his property as soon as he has obtained possession of them. I f the trader then becomes insolvent they are treated as part o f his assets and the supplier becomes an ordinary unsecured creditor. Reservation of title allows the supplier to retain ownership until certain conditions, such as full payment, are fulfilled. Reservation of title is especially common in Europe, particularly Germany, where it is termed Eigentumsvorbehalt. But it is also becoming common in the UK, particularly since a 1976 case, Aluminium Industrie B.V. v Romalpa Aluminium Ltd., drew attention to its potential. T h e contract between these two companies had inserted in it a complex clause that if goods sold to Romalpa were manufactured into other goods and then sold to third parties, the debts owned by these third parties to Romalpa should be transferred to Aluminium Industrie B.V., the original suppliers. When Romalpa became insolvent this right was upheld in court. Since then "Romalpa clauses" have become more and more common, but subsequent case law has cut back on their effectiveness by restricting them to clear reservation o f legal ownership. I f this is done the effect will be to give the seller a floating charge that must be registered as any other floating charge. However, reservation of tide is not a method of raising all unsecured creditors to the status of secured creditors. First, there are a large n u m b e r of cases where it is not applicable in practice, e.g., the

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supply o f perishable goods to a hotel or restaurant and consumer creditors. Second, the legal niceties that surround the correct specification of a reservation o f title are still a very difficult area, and this, coupled with problems of whether the goods can be identified as the supplier's goods at all, presents severe problems to a supplier wishing to protect himself by using reservation of tide. Receivers and liquidators o f insolvent companies devote considerable resources to fighting ROT clauses, which often go to court, thus potentially imposing upon the supplier further costs. In addition, the petition and appointment of an administrator u n d e r sl0 of the Insolvency Act of 1986 prevents the owner of the goods from repossessing them, except with the leave o f the court. In many respects R O T clauses are a poor man's secured loan. T h e y are intended to serve much the same purpose, but their efficiency in this respect is limited. However, because they are a form of secured loan any reforms made to secured lending would have to be accompanied by similar reforms to ROT clauses. Such clauses are disliked by banks because they make j u d g m e n t of a firm's financial position considerably more difficult and have led to banks reducing their volume of lending (Cork 1982, para. 1601). T h e growth of ROT clauses has increased the incentive for banks to obtain security, particularly in the form of a fixed charge. Hence we have a self-reinforcing problem. ROT clauses grew partly in response to secured lending, but their growth reinforces the bank's tendency to lend on a secured basis. A further problem arising from secured lending centers around the optimal allocation o f credit. T h e credit market should work to ensure that on the marginal loan the benefit just equals the cost. We will call projects that satisfy this criteria "viable" projects. T h e benefit, as we define it, is the difference between the present value o f the firm with the loan and without the loan, where the former ignores any loan repayment. In the case of an investment project this is simply the return on that project. However, if the loan is necessary to the firm's survival by easing, for example, a cash flow problem then the return on the loan is the expected value of the company in period 2 less its current liquidation value, i.e., p~ V2 + (1 - p ~ ) L - L = p 2 ( V 2 - L ) . If credit is allocated in this way and the market for credit clears, then there should be no unsatisfied viable projects. Under a system whereby the banks lend solely on the basis of security and no other consideration credit will be allocated so that on the marginal loan the principal plus interest is just covered by the available security. T o an extent the two sets of borrowers will overlap. Many of the potential borrowers who satisfy one criterion will also satisfy the other. But the two sets will not exactly coincide, and herein lies a potential welfare loss. First, there will be some potential borrowers with viable projects who do not obtain credit because they do not have sufficient security to offer the bank. These projects will not then be funded, but ones with a smaller expected return will be funded. This represents a net loss to the economy. This is, of course, an extreme case. In reality banks are highly unlikely to lend solely on the basis o f security in all cases. But, to the extent that this is a factor in their decision the above conclusions still apply. Problems also arise because of the bank's role as principal whistle blower, calling to a halt the activities of failing firms at the optimal time, as defined by Webb. This role, which was not been widely discussed within the literature, stems from the position of the bank as supplier of short-term finance--the one commodity that can be used to simultaneously satisfy all other creditors. In addition, from an informational perspective the bank is in a particularly advantageous position to perform this role for

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the benefit o f itself, other creditors, and the economy as a whole. This is reflected in recent developments in financial economics where the view is gaining ground that banks are in a unique position to gather information on firm credit worthiness (Lummer and McConnel 1989; Fama 1985; Black, 1975). T h e basis for this view is that the banks have access to private information about their customers, which is denied other creditors, because of a possibly long and continuous business relationship. However, in the circumstances of a secured loan there will be no incentive for the bank to use this knowledge optimally and will tend to keep failing firms in existence for too long, as suggested by Webb.

An Example Before proceeding to look at the economic and legal arguments in favor o f secured lending, we shall briefly illustrate the arguments we have made so far with the simple example shown in Table 1. T h e figures in parentheses that follow are the values used in calculating this table. T h e example is in the context of a one-period situation where the firm will obtain receipts of Vs (£3.5m) if the state termed "successful" occurs and Vu (£1.5m) if it does not, where both these values include the liquidation value of the firm, L, which equals £1m. T h e probability p of the former state occurring varies as shown in column one. T h e gross present value (pv s + (1 - p) Vu) of the firm (excluding any debt to bank or trade creditors) is shown in column 2. T h e bank is being asked to give the firm a loan which at a risk-free rate o f interest would result in it being paid B (£1m) at the end o f the period. Credit totaling U (£1m) is simultaneously being sought from trade creditors. This is also inclusive of a risk-free interest charge. Thus the face value of the amount eventually paid to creditors may exceed these amounts once they have been adjusted to take account of risk. Initially we assume imperfect information, which in this context means that the existence of the secured loan is unknown to these other creditors. If the bank lends on a secured TABLE 1. Example o f loan options u n d e r varying probabilities o f success

Probability of success

Gross present value of firm (£m)

Return to bank with no security (£m)

0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1

2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6

0.975 0.95 0.925 0.90 0.875 0.85 0.825 0.80 0.775

Risk-adjnsted bank loan (£m) imperfect inf

Risk-adjnsted bank loan (£m) perfect inf

Debt repaid to unsecured creditors in bankruptcy (£m)

1.03 1.06 1.09 1.14 1.19 1.25 1.33 1.45 1.63

1.03 1.06 1.11 1.17 1.25 1.38 1.58 2.00 3.25

0.741 0.731 0.721 0.711 0.700 0.689 0.678 0.667 0.654

Liquidation value of the firm = £1m; value of debt to bank = £1m; value of non-bank trade credit = £1m; value of firm's receipts of successful = £2.5m; value of firm's receipts if unsuccessful = £0.5m. The return to the unsecured creditor in the event of bankruptcy with the bank taking a secured loan equals £1.5m - £1.0m = £0.5m.

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basis then it will always make the loan because it is exactly covered by the value of the security on the firm's assets (i.e., the liquidation value o f £1 m). T h e expected return from the bank lending on an unsecured basis, with no risk-related adjustment to the rate of interest, Bp + (1 - p) V~B/(B + U), is shown in column three. However, the bank does have the opportunity to adjust the interest rate so that the expected value of the loan is always at B. T h e repayment value of the loan adjusted in this m a n n e r is shown in column four. It is the amount X that satisfies the equation B = pX + (1 - p)V,~/(X + U), and the table values were found by iteration. X comprises the principal, the risk-free interest rate adjustment, and a further interest adjustment for risk. T h e bank will make this loan provided X ~< Vs. In Table 1 this is always the case. Column five shows the risk-adjusted repayment value of the loan necessary to yield the bank an expected payment of B with perfect information. It is the value Z that satisfies the formula B = pZ + Vu(l - p)Z/(Z + U*), where U* is the riskadjusted payment value of trade credit. Being as there is perfect information, and that in our example U = B, the trade creditor will demand the same return as the bank; thus the business will only continue if 2Z ~< Vs. T h e critical value for p is that at which pVs + (1 - p)Vu = B + U. Values o f p below this will result in creditors' attempting to compensate for the risk of bankruptcy with payments in the event of success which exceed the revenue to the firm when successful. Clearly, this will not be possible. In the example in column 5 this critical value is 0.25. A lower probability of success will see the firm fail to continue. Column 6 shows the maximum amount available (Vu - X) for repayment to imperfectly informed unsecured creditors in a bankruptcy when the bank makes a risk-adjusted loan. It declines as the probability of success declines, and the risk-adjusted repayment value of the loan to the bank shown in column 4 increases. T h e r e are several points to note arising from this table. First, it is always profitable for the bank to make an unsecured loan provided (i) the probability of success is greater than zero, (ii) the principal plus risk-free interest payment is less than the gross expected value of the firm, (iii) the principal plus risk-free interest payment plus risk-related interest payment is less than the value of the firm if successful, and (iv) there is imperfect information. Second, the imperfectly informed unsecured creditor is always better off in the case of a risk-adjusted unsecured loan compared with a secured loan. T h e rationale for this is that only some of the bank's extra expected revenue comes out of the firm's assets in a bankruptcy; the remainder comes out of the firm's profits if successful. Thus even though the potential sdll exists for a bank to take advantage of informational asymmetries, the unsecured creditor is always better off with an interest-adjusted loan than with a secured loan. T h e final point to note is that the bank will only be able to lend without security to a firm whose gross present value is less than its proposed debt to bank and trade creditors provided there are informational asymmetries. In the absence of these, all creditors will be attempting to cover themselves against bankruptcy to an extent that the firm's assets cannot meet. Creditors will realize this and the firm will not continue. T h u s with perfect information, the problem highlighted by Webb of secured lenders keeping ailing firms alive too long will not arise.

The Economic Case for Secured Lending Secured lending has been justified on both legal and economic grounds. T h e economic arguments center around the possibility that secured lending increases eco-

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nomic welfare as the gains to firms and secured creditors outweigh the costs to unsecured creditors. These gains relate to lower monitoring costs and the use of secured debt as a signal. The need to monitor firms arises for several reasons. Firms may borrow money for a specific project but use the proceeds for a riskier project. Being as the interest rate reflects the degree of risk, this riskier project will be financed at too low an interest rate, from the creditor's perspective. Monitoring is likely to be expensive, and a security can be viewed as a device to reduce costs. The creditor need only monitor to ensure that the assets subject to the security are not wasted. Since asset substitution is an important aspect of behaving more riskily, security reduces the risk of debtor misbehavior, not just for the secured creditor, but for all creditors. Schwartz (1981, 1984) argued that the applicability of this case was limited because few firms will behave in such a way because of the loss of goodwill and reputation that would permanently hamper their future business. Hence any monitoring gains that exist seem likely to be small. In addition, it ignores the problem that no general health check is being applied to the firm. The debenture holder merely keeps surveillance on the assets that form his security. Thus other creditors will still need to monitor the position of the firm as best they can. In addition, they will either need to continuously incur search costs to find out whether the firm has issued a debenture or operate in an environment of uncertainty. This will also be the case for another form of debtor misbehavior where the bank finances a profitable investment, but the firm subsequently issues further debt to finance additional bad investments, which potentially adversely affect the bank's return. The existence of secured (or senior) debt again reduces the need for the bank to monitor the firm, but other creditors still need to do so. In addition, Schwartz's arguments seem equally valid in this case. Picker (1992) has extended the monitoring argument to encompass possible creditor misbehavior. The analysis centers around the common pool problem in bankruptcy. Without rules of precedence a creditor may seize assets and sell them piecemeal even if a sole owner would keep them together. If no single creditor enjoyed priority there would be an incentive for all creditors to expend resources monitoring both the debtor and other creditors. However, this resolution of the common pool problem has been achieved by letting one creditor take precedence in the event of bankruptcy. In addition, there is no incentive for a bank operating through a receiver to ensure that the disposal of the firm is efficient as long as the value of the loan is fully recovered. The signaling case rests on the argument that a firm that is willing to restrict its courses of action by taking a secured loan is "signaling" that in its view its prospects justify these potential constraints. Schwartz, although finding the approach promising, rejected it on two grounds. First, the security interest may not provide a sufficiently clear signal. Second, even granting the signaling argument, it still has to be demonstrated that the gains outweigh the social costs of secured lending, which is difficult because of the problems with empirically testing signaling hypotheses effectively. There are other problems in addition to these. Firms take credit for two reasons: first, to finance a capital expansion program, and second, to help with short-term cash flow problems. The signaling advantages would appear to relate mostly to the former. Firms, willing to encumber themselves with a security for short-term finances, may be those with secure prospects, but they may equally include firms with very insecure prospects who have little alternative but to take finance on any terms. The empirical evidence too is against the signaling hypothesis.

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Studies by Orgler (1970), Hester (1979), and most recently Berger and Udell (1990) have concluded that secured loans tend to be associated with riskier, rather than less risky borrowers. Clearly, if the signaling hypothesis were valid the reverse would be the case. There is also the argument that banks need not incur the costs involved in a possible difficult evaluation of the firm's future profit stream, but merely have to assess the resale value of the security. The problem with this argument is that if the bank is to allocate credit efficiently and if it is to perform its potential role of closing down failing firms at the optimal time, then it has to evaluate future profit streams. Thus, we can see that the advantages of secured lending to the bank comprise the reduced cost of loans because (i) lending should not be such a risky operation to the bank, (ii) lower search costs are incurred in evaluating future profit streams, and (iii) secured lending lowers monitoring costs. To the extent that these arguments are valid this should result in more projects being financed, to the advantage of the economy. However, for this to constitute an economic case for secured lending these gains would need to outweigh the costs. In particular, it needs to be borne in mind that although the banks may finance more projects this financing will not be so well targeted.

The Legal Case for Secured Lending In legal terms the justification for the priority of the secured over the unsecured creditor has been based upon the three principles of bargain, value, and notice (Goode 1983). The fundamental one is the first. The secured creditor is entitled to look to the debtor's assets outside bankruptcy and in preference to other creditors because he bargained for that right. Other creditors could have done so but chose not to. The concept of value is that the security should confer some added value on the firm and not just be in recognition of past debts. Notice requires that the agreement is filed with the appropriate authorities. Of these three principles that of bargain is crucial; the remaining two elaborate on the conditions by which a security can be made, but the ethical basis for it is based on the freedom to bargain. There is some validity to this argument. However, for it to be completely satisfactory it is also necessary that all of the potential participants to the bargain have equal power. It should be a bargain between equals. If they do not, if some of the potential participants to the bargain are more powerful than the others, then the ethical basis behind the bargaining argument loses much of its force. In fact, it would appear that not all parties are in an equal position to bargain for the privileges a secured loan endows, as is suggested by the fact that ordinary trade creditors rarely take out such a security. If all parties to a potential bargain were equally able to take out a security then we would expect such securities to be randomly distributed across all types of creditor. This is not, in fact, the case, as can again be illustrated by figures taken from the issue of Stubbs Gazette already referred to, this time relating to details of insolvent firms where a receiver has been appointed. There were 116 such firms, of which 104 were appointed by banks, finance houses, or building societies. Sixty-three of the banks were clearing banks, 25 were other high street bankers, and eight were foreign banks. Of the remainder three were from firms in liquidation and two from an insurance company. This leaves just seven from firms or individuals who were not themselves bankrupt. These figures strongly suggest an asymmetry in bargaining power that puts the

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banks in a stronger position than other creditors. This may arise for several reasons. First there is the informational asymmetry we have already referred to; the firm's bank is in a unique position to be able to determine its financial position when a security becomes a wise precaution and to monitor the firm once the debenture has been given. Second, there are economies of scale. Banks are very large financial institutions that can employ specialists to advise upon and draw up the legal arrangements relating to secured lending. Those unsecured creditors, who are suppliers to the firm, are frequendy far too small to countenance employing such specialists. Third, trade creditors are not in the position of providing medium-term credit. T h e y expect to be paid within a few weeks, or at most months, of the final delivery of the goods or services. T h e transactions, as Scott (1977) has emphasized, may take place frequendy, but they are separate transactions; credit it not continuously outstanding, and each transaction would require separate debentures. T h e bank, on the other hand, is providing credit continuously over a medium-term period for which a single debenture is sufficient. Similar comments apply to unsecured creditors who are consumers. Thus, because of the nature of their loan, the banks have more to gain from a security and face lower set-up and monitoring costs. It is not surprising, therefore, that they are in a stronger bargaining position than other creditors. From an ethical standpoint, this is unsatisfactory if the banks always, or nearly always, reap the benefits of their stronger bargaining position. It might be argued that unequal bargaining power generally affects the distribution of assets rather than leads to inefficiency. However, in this case there is an incentive for the firm to attempt to continue if its net assets are currently nonpositive, when immediate closure would secure the owners nothing. As long as there is some non-zero probability o f positive net worth in the future, then it is in the interests o f the firm to attempt to bargain with the bank to allow the firm to continue by offering the bank, at the expense o f other creditors, a greater piece of the cake, not just a share, in the future. In most cases the effect o f this will be a smaller cake in t + 1 than at time t, and this is the basis of the inefficiency argument. Given no restrictions on the bargaining process, there would be an incentive for the bank to bargain with other creditors for shares of the bigger cake that immediate closure would bring. But they are restricted from doing so because there is an u p p e r bound on what the bank can claim from today's cake, set by the amount and terms of their loan to the firm. Thus the law in determining this and in predetermining the shares in the event of i,~solvency restricts the bargaining process in such a way that inefficient outcomes are possible. T h e logic behind notice is that after filing the security other creditors can theoretically become aware o f its existence. It is an essential prerequisite for information about the secured loan to be transmitted to other creditors. However, no guarantee can be made that all creditors will become aware of it, and for them to do so will involve them in informational search costs. T h e individual creditor can, for a fee, find out directly from the Registrar of Companies whether there is a mortgage on firm's assets. Alternatively, he can use one o f several firms specializing in this activity. But because a security may be granted at any time these search costs need to be constantly incurred. T h e y will only be incurred if the expected gains exceed these search costs. This will not always be the case for all creditors, and thus an area o f uncertainty will exist. T h e approach to notice differs between countries. In the United States if a security agreement is concluded for new value but filing is deferred until a date within 90

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days of the filing of a petition for bankruptcy, the transfer by way of the security is considered from the date when the security is perfected by filing, not from the time of attachment. This has the consequence of treating the security as being given for past value and thus is impeachable as a preference by unsecured creditors. As is generally the case the English approach is weaker. A registrable charge is void if not registered within 20 days. But the court has the power to extend the period for registration, and this is almost always given unless the firm has begun insolvency proceedings. Thus the English law frequently fails to protect the unsecured creditor against the late filing of a security, and imperfect information will inevitably result from these information lags. To a layman the term "new value" implies that the firm obtains assets additional to the ones it previously had. We shall later refer to this as "genuine new value." In practice the situation falls far short of this, particularly in the UK. In England if a bank grants a customer an unsecured overdraft, which upon reaching a value of £50,000 is secured by a charge on the debtor's assets, this is seen as giving past value and is thus vulnerable in the event of insolvency. However, if money is then paid into the account and new drawings are honored, this is viewed as converting past value into new value even though the overdraft never rises above £50,000. The security is then unimpeachable. A further problem is raised by the after acquired property clause by which a security interest could be made to attach by virtue of the debtor's acquisition of the asset without any need for a new act of transfer. This implies that when the debtor acquires the asset, the security is regarded as having being attached from the date of the security agreement. Moreover, even assets falling in after the liquidation has commenced fall into the after acquired clause. It should be noted that this retrospective value can greatly exceed the original value, because each asset subsequently coming in under the after acquired clause is deemed to have been given for new value. Thus an original advance of £100 can end up securing assets of £1 million. Alternatives to the Present System

Abolishing Secured Lending In this section we shall look at alternatives to the present system. First, there is the obvious step of removing the legal basis for secured lending altogether. The concept rests on dubious legal and economic foundations. Abolishing secured lending would put all creditors on an equal footing with respect to the post-bankruptcy distribution of assets. It would remove the advantage secured creditors enjoy and possibly, although this is a different argument, the privileges preferential creditors enjoy. We have already seen that the banks will still allow a troubled firm to continue. Reverting to the notation and example used by Webb, this will happen provided there is some compensatory payment R~ that can be made which satisfies the following inequalities: DI + Rl D1 + Rl + R2 Dt + Rl + Ul L < Dl + Rl + R2 + U2 [p2v~ + (1 - p2)L]

(1)

The decision to lend at all at the beginning of period 1 will depend upon the existence of a risk-adjusted rate of interest, R 1, which gives the risk-neutral bank an equivalent, or better, return to a riskless loan (D1 + R*O:

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Dl + R t <~pl(Dl + R1) +

(1 - pl)L(D1 + RI) D1 + RI + UI

for L < Dl + Rl + U1

(2)

where R* is the risk-free market rate of interest. The feasible set for R may not only have a lower bound of R*, but possibly an upper bound set by the norms, which image-conscious high-street banks will seek not to trespass beyond. However, it is of course possible, even probable, that if such norms exist they would change once secured lending was no longer possible. Thus the opportunity would still exist for banks to profitably lend to firms whose net present value is negative, provided they have an informational advantage over at least some other creditors. But, as we have seen, this is not a damaging to the position of these other creditors in the event of a bankruptcy as lending on a secured basis. There are potential problems with this option, as indeed there is with any move intended to restrict the banks' freedom of action, in that they might seek to circumvent restrictions on secured lending. For example, firms could "sell" fixed assets to the banks, which could then lease back the assets to the company with the option to buy back the assets for a very low price when the lease terminates. Black (1975) has argued that this could be arranged so that for tax purposes the company would own the assets. But in the case of bankruptcy the firm would only have an option to buy the equipment at some time in the future, conditional on having met all the legal requirements. To an extent this has happened in the United States, where the bankruptcy laws, even before Chapter 11, limited debenture holders' abilities to realize their security. As a consequence, as Scott (1977) has pointed out, there has been a growth in financial leasing. However, there is also evidence from Hudson (1992) that the introduction of Chapter 11, with the further restrictions this imposes on debenture holders' freedom of action, has led to a reduction in the average liability of bankrupt firms--a clear indication that banks may have been less willing to keep failing firms alive on the basis of their security alone. To prevent the growth of financial leasing following changes to the law surrounding secured lending, restrictions would have to be placed on banks' abilities to "buy" assets from client firms. Improving the Flow of Information Central to our analysis of secured debt is the information set unsecured creditors have concerning the debtor, particularly with respect to the existence of any secured loans. We have argued that if this information set is perfect, many of the problems that we have associated with secured lending would be greatly diminished and perhaps would disappear altogether. However, given such perfect information the rationale for secured lending would be greatly reduced, and we believe that the practice would quickly decline. Proposals to increase the flow of information should therefore be uncontroversial. If perfect information already exists, then no extra information is generated and none of the parties to the bargain can be adversely affected. If, however, information is not perfect, then the harmful impact of secured lending that we have outlined follows. One possibility is to oblige firms to identify on any contract with any creditor any security that is currently operative. It might also want to list the circumstances surrounding this security, i.e., whether it is for genuine new value or whether it is to provide current working capital. This would then provide all creditors with the information that in theory they are supposed to have already and with which the market would function so much more efficiently.

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Adopting Other Countries' Practices One could also resolve some of the problems with the after acquired clause by following US practice, of treating assets falling within an after acquired clause as transferred not at the date of the security agreement but at the date o f acquisition by the debtor. T h e r e is also the option of making the banks accountable if they keep an insolvent firm alive, as in French law. In France a debtor who is unable to pay his debts and with a view to delaying the onset of bankruptcy proceedings borrows greatly in excess of his ability to pay, commits a breach of bankruptcy law. In addition, the creditor who knowingly assists in this breach is also guilty of complicity, thus incurring a civil liability to subsequent creditors who were led to do business with the bankrupt to their detriment.

Variations on the 10% Fund T h e 10% Fund was one of the recommendations of the Cork Report (1982), which never became translated into law. In essence, the proposal concerned the compulsory surrender of part of the security, in the case of the Cork Report 10%, to create a fund for unsecured creditors. It was simply designed to ensure that a guaranteed minimum would be left for unsecured creditors, subject to the limitation that they would not receive a greater percentage of their debts than the holder of the floadng charge. T h e damage done to the secured lender would be limited by the fact that he would be aware when making the advance that the security would be worth only 90% of its value and hence presumably limit the value of the loan accordingly. T h e figure of 10% is an arbitrary one, presumably arrived at as a sum that does not gready dent the secured lender's scope for lending, but at the same time leaves a "reasonable" amount available to unsecured creditors. However, it is by no means sacrosanct and does not rule out alternatives. One possibility is that it could be introduced in stages. So for example, during a trial period of five years it could be set at 10% and at the end o f this period revised either upward or downward for a further five years in light of the experience gained during the trial period. In this way it would be hoped that the level would iterate toward an optimal level. In theory this could be 100%, in which case we are, in the long run, back with the solution where secured and unsecured creditors are treated on an equal footing.

No Inside Secured Lending Most of the problems with secured lending come from "inside secured lending," i.e., the granting of a security on assets pertaining to the firm. A security on the owner of the firm's house does not lead to depletion of the firm's assets to the detriment of unsecured creditors in the event of bankruptcy. Nor does it affect the priority of other creditors in the event of bankruptcy. Indeed, being as the loan is now secured on assets outside the firm, it may even improve, in the short term at least, the position of unsecured creditors. At the same time many of the supposedly beneficial effects of the secured loan system are retained. Capital will still be available to would-be entrepreneurs who are willing to stake their house in much the same way as it is today. Similarly, if an existing firm gets into trouble the owners will still be able to borrow on the basis o f such security. Thus this system would leave assets available to unsecured creditors, although, in a world of informational asymmetry, it might still lead

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firms to be kept alive by the banks past the optimal date, but the costs would be borne to a considerable extent by the owners o f the firm, rather than the unsecured creditors.

Restricting Inside Loans to "New Capital Value" This would allow secured lenders to take an inside security interest provided it was for the creation o f genuine new value, e.g., the purchase of new machines or buildings, with this new value being the basis for the security. It would not be possible, however, to secure short-term working capital or to cover loans intended to tide firms over cash flow problems. This would then prevent a bank from keeping firms alive on a respiratory system that when removed leads to their demise, at the expense of unsecured creditors. Again, such firms might still be kept going by the bank, but only if equation (1) were satisfied. Thus this would lead to a split system; banks could obtain security for genuine purposes o f expansion through firms buying new capital, but they would not be able to obtain security to help overcome current financial problems. Decisions o f this nature would have to be made on the basis o f an evaluation o f profits suitably adjusted for risk.

Abolishing the Floating Charge A floating charge is a device now virtually unique to British law that gives the debenture holder security over present and future assets. It is commonly given over the whole o f the undertaking of the borrowing company. But the company remains free to deal with and dispose of these assets without consulting the holder of the charge. Upon a certain event set out in the deed constituting the charge or the appointment o f a receiver or the winding up o f the company, the charge is said to "crystalize," and these assets become indistinguishable from a fixed charge. This allows the value o f the security to cover all of the firm's value, whereas a fixed charge would be limited to assets that would be expected to stay u n d e r the company's control. Hence a floating charge can relate to work in hand, stocks of raw materials, finished products, etc. T h e floating charge both gives the debenture holder much greater security and at the same time leaves a still smaller proportion of assets available for distribution amongst unsecured creditors. Not surprisingly, it is not universally popular. T h e nub o f the problem is summarised in Cork: It enables a company, apparently in possession of assets of great value, to obtain credit from suppliers and others, and to continue to trade on borrowed money, while the semblance of wealth on the strength of which such credit is obtained is falsified by the existence of the charge which is capable of being enforced at any moment . . . . The matter for wonder is that such a device should ever have been invented by a Court of Equity. It is not easy to discern on what principle of equity the holder of a floating charge should obtain security over goods for which his money has not paid, in priority to the unpaid supplier of the good. (Cork, paras. 105-107) Various people have expressed reservations about the concept. In 1906, the Loreburn Committee suggested some modifications, which led to some changes, although a minority o f the Committee favored outright abolition. T h e Cork Committee too

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suggested some changes, but found the floating charge too useful to abolish. They felt that it had become so fundamental a part of the financial structure on which the commercial and industrial system of the United Kingdom rests that abolition could not be contemplated. This argument is a little difficult to understand. Are we to suppose that the British credit markets could not function without the assistance of a floating charge? If so, one must question how other countries have managed to survive without it. Casual empiricism would suggest that commerce and industry in Britain have not fared notably better than in other countries such as Germany, the United States, Japan, France, etc., none of which make use of the floating charge. Given the clear inequity of the basic concept and the enhanced potential for the misallocation of credit and resources it gives rise to, one clearly needs greater justification for its continued existence than can be found in the Cork Report. If the floating charge were abolished a parallel reform of the implementation of insolvency proceedings, possibly along the lines suggested by Aghion et al. (1991), might need to be considered. It should also be emphasized that the right of a floating charge holder to appoint a receiver is often seen as a good thing (Cork 1982, para. 495), because a receiver with the power to run the whole company may be able to restore the company, or a significant part of it, to profitability. Conclusions Since the nineteenth century there has been a great increase in the extent to which commerce and industry are financed by commercial lenders who provide finance by way of secured loans (Cork 1982, para. 17). This has had the effect of divorcing the risk taker from the decision maker, and this combined with the growth of limited liability and the increase in the burden of the preferential debts in recent years has effectively made the risk taker the unsecured creditor. The divorce of risk taking from financial reward in the credit market lies at the heart of the problem. Provided the banks act in a profit-maximizing manner, they will inevitably be led into making loans that from the point of view of the economy as a whole cannot be justified and that result in a misallocation of resources. The transfer of the risk of making loans away from the debenture holder to other economic agents, is particularly undesirable because the unsecured creditor may be less suited to this task than the banks. They are frequently small and less able to survive a loss than a bank, which is typically a very large concern. In addition to this transfer of risk an additional area of uncertainty is created concerning the possible existence of a secured loan, and search costs are imposed upon firms who try and reduce this uncertainty. We have examined the arguments in favor of secured lending, both legal and economic, and have found them unproven. They depend crucially upon the assumption of perfect knowledge. But because such knowledge is costly to acquire, it cannot be perfect and informational lags will exacerbate the problem. In the face of these arguments the onus surely rests on those who argue for the continuance of a system that "has brought the law of insolvency into disrepute" (Cork 1982, para. 1480) to prove its advantages more clearly than has been done hitherto. If this cannot be done then the process of reform should begin. This conclusion and indeed the spirit of the whole paper runs contrary to a well-established tradition in economics that freedom to contract leads to an efficient allocation, unless some parties to the transaction are not at the bargaining table (Coase 1937; Williamson 1985). However, in recent years it has been argued (Casson

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1991, 1994) that transaction cost theory has paid insufficient attention to the role of information costs in decision making. Information costs in this context are the costs of using information in decision making. T h e y are related to the quantity of information that is collected. Transaction costs, by contrast, are concerned primarily with the quality o f information. T h e y are the costs of ensuring that people do not supply wrong information in order to mislead other people (Casson 1994). Thus, in a world of b o u n d e d rationality where information is not free, it may be rational for optimizing agents to choose to stay ignorant of certain information that is costly to acquire. Hence, although secured loans and floating charges have been in existence for at least a h u n d r e d years and their potential existence must be known by most economic agents, their existence in any specific case is information that is costly to acquire, and hence many agents may rationally choose not to acquire it. This should not be interpreted as a free---and hence globally optimal--choice. It is free given the informational costs and hence the constrained optimization problem they face. This p a p e r has concerned itself with the potential benefits f r o m either reducing these information costs or reducing the need for them.

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