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The Technology of Creditor Protection

Contract is the primary means through which creditors control a firm’s debt– equity conflict. There is an irony here, however. Actions that may render a debtor insolvent are the events against which creditors contract. Yet when a breach of contract yields a debtor’s insolvency, the debtor cannot fully satisfy its creditors. Thus, a general creditor’s contractual remedy against a debtor cannot be fully effective, and anticipation of this shortcoming may increase a debtor’s cost of capital. A solution to this conundrum, proposed here, would permit creditors and debtors to contract for creditor remedies against third parties—other creditors, shareholders, and corporate affiliates—who may have benefitted from a debtor’s breach, provided that the creditor gave actual or constructive notice of its right to seek such remedies. This solution would offer creditors protection akin to that now afforded contractually through secured credit and now afforded by legal rule through the laws of voidable preference and fraudulent conveyance. Because the proposed protection would be contractually based, it could be tailored to the needs of individual firms and could thus improve, and to some extent obviate the need for, the protections now provided by law.

Note: Marcel Kahan would like to thank the Milton and Miriam Handler Foundation for financial support.