D'Onfo on Property Rights and Secured Credit

Danielle D'Onfro (Washington University) has posted Limited Liability Property (Cardozo Law Review) on SSRN. Here's the abstract:

This Article offers a new theory of secured debt that aims to answer fundamental questions that have long puzzled bankruptcy scholars. 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? Because scholars have yet to provide a satisfactory account of security interests, these questions remain unanswered.

The 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, the Article offers a comprehensive account of capital investment more generally, systematically examining the various 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 make no such tradeoff, and are thus arguably over-protected. Understanding security interests as limited liability property, 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 needs reform.