Abstract

In principle, debt can bond a firm's management to diligence and wise investment of corporate assets. In practice, however, management can escape the ties of this bond through new capital infusion prior to financial collapse. When management pursues this tactic, insolvent corporations may enter bankruptcy too late, after an unnecessary economic decline. To address this problem, a beneficial modification of bankruptcy's voidable preference rules would permit a trustee to invalidate loan terms favorable to a creditor on any loan made while a debtor is insolvent if that loan is used to repay an earlier claim. This modification would deprive an insolvent firm of resources its managers can now use to stave off bankruptcy supervision. As a result of this modification, corporate bankruptcy would occur earlier in the financial distress of a firm, before managers could unduly dissipate the firm's value. The reasoning that supports this proposed modification, moreover, corrects sixty years of judicial error in the analysis of "earmarked loan" transactions.

Keywords

Loans, Preferential transactions (Bankruptcy), Bankruptcy transfer avoidance, Corporations -- Finance, Bankruptcy law, Debt financing, Priorities of claims and liens