Academic journal article Texas International Law Journal

Harmonizing the Law Governing Secured Credit: The Next Frontier

Academic journal article Texas International Law Journal

Harmonizing the Law Governing Secured Credit: The Next Frontier

Article excerpt

NEIL B. COHEN^

I. INTRODUCTION: THE RELEVANCE OF SECURED CREDIT

It is certainly an honor for this paper to be included among those prepared for this august symposium, but I feel a duty to explain the presence of this article. What, after all, does secured credit have to do with international insolvency law?

The answer, both legally and economically, is "quite a bit." From a legal perspective, the interactions between the secured credit and insolvency systems are obvious. In the United States, for example, bankruptcy law refers to other bodies of law, including secured credit law, in the course of determining the rights of parties asserting claims in bankruptcy.' In addition, rights created under the aegis of secured credit law are sometimes vulnerable in bankruptcy; for this reason, bankruptcy law is often considered the "acid test" of any security interest. Yet the economic links between the systems are even closer than the legal links.

A. The Need for Credit Enhancement

The economic links between insolvency and secured transactions are simple, flowing from a desire to facilitate mutually profitable credit transactions. In virtually all extensions of credit, there is a fundamental economic reason-generation of profits-to seek or extend credit. To the borrower, a potential extension of credit will be seen as profitable if the borrower anticipates a greater return on the loaned funds than it will pay in interest. Obviously, the interest rate to be charged in the transaction plays the major role in determining whether the transaction will be seen as profitable. For the creditor, a transaction may generate profits in two different ways. The profits flowing to the seller that are generated by an extension of credit may be direct, derived from interest charges in excess of the creditor's time value of the money, or indirect, such as when the credit finances profitable sales (that might not otherwise have occurred) of the creditor's products or services to buyers. Obviously, many transactions generate profits for creditors both indirectly and directly-enabling a profitable sale that may not otherwise have taken place and making a separate profit from the interest charged to the customer.

In any case, individual extensions of credit are profitable for creditors only when the debtors' obligations are fulfilled, and an aggregate of credit extensions is profitable only if the profits from the successful transactions2 are greater than the losses from those in which the debtor does not fully repay the credit. While in some cases a debtor's failure to fulfill his or her obligations is due to dishonesty or unwillingness to pay, much more often the failure springs directly from inability to perform. Inability to fulfill one's financial obligations, of course, is part of the classic definition of insolvency.3 Thus, the risk of debtor insolvency is a major (perhaps the major) determinant of whether a credit transaction will be seen as profitable for the creditor.

Given the major impact on the creditor's profit or loss associated with a debtor's insolvency, it is not surprising that if a creditor believes that the risk of nonpayment associated with a particular proposed extension of credit is too high, that extension of credit will likely not take place. This is the case because nonpayment would not only make that transaction unprofitable, but would also more than offset gains from many other transactions in which the debtors fully pay their debts.4 Similarly, a creditor considering engaging in a particular class of credit extensions will not do so if the risk associated with individual extensions within that class exceeds a certain threshold. Even if the chance that any one debtor will default is relatively low, a small number of projected defaults will yield a negative expected value for the entire class. It might seem that this problem could be ameliorated for the creditor by simply raising the interest rate so that the profits from the successful transactions are high enough to outweigh the losses from the unsuccessful transactions. …

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