Cornell Law Review Volume 84 Article 1 Issue 2 January 1999 Secured Transactions Inside Out: Negative Pledge Covenants Property and Perfection Carl S. Bjerre Follow this and additional works at: http://scholarship.law.cornell.edu/clr Part of the Law Commons Recommended Citation Carl S. Bjerre, Secured Transactions Inside Out: Negative Pledge Covenants Property and Perfection , 84 Cornell L. Rev. 305 (1999) Available at: http://scholarship.law.cornell.edu/clr/vol84/iss2/1 This Article is brought to you for free and open access by the Journals at Scholarship@Cornell Law: A Digital Repository. It has been accepted for inclusion in Cornell Law Review by an authorized administrator of Scholarship@Cornell Law: A Digital Repository. For more information, please contact [email protected]. SECURED TRANSACTIONS INSIDE OUT: NEGATIVE PLEDGE COVENANTS, PROPERTY AND PERFECTION Carl S. Bjerret INTRODUCTION ................................................. 306 I. A CR TQUE OF CuRRENT NEGATIVE PLEDGE COVENANT DoCTRINE ............................................... 308 A. Some Basics and a Challenge ....................... 308 1. Secured and Unsecured Debt ....................... 309 2. Function and Dysfunction of the Negative Pledge Covenant ........................................ 311 3. The Needlessly Excluded Middle .................... 313 B. The Negative Pledge Covenant as Mere Contract ... 315 C. Unpredictable Exceptions to the Mere Contract V iew ................................................ 318 1. Equitable Lien ................................... 319 2. Injunction ....................................... 328 3. Liability for Tortious Interference with Contract...... 329 D. Third-Party Notice as a Crucial Element of Both Negative Pledge Law and Article 9 .................. 331 1. Secured Party Versus Lien Creditor ................. 333 2. Secured Party Versus Secured Party ................. 335 3. Negative Pledgee Versus Subsequent Secured Party: Current Law ..................................... 335 4. Negative Pledgee Versus Subsequent Secured Party: This Article's Proposal ............................ 337 E. By the Way, Why Don't All Lenders Just Take Security? A Glance at the Dynamics of Negative Pledge Debt ........................................ 338 1. The Secured/UnsecuredDecision ................... 340 2. The Negative Pledge Covenant Decision ............. 343 II. THE PROPOSAL Up CLOSE: THREE BIATERAL RELATIONSHIPS .......................................... 344 t Assistant Professor, University of Oregon School of Law. B., University of Califor- nia at Berkeley; J.D., Cornell Law School. For valuable comments and conversations, I thank Andrea Coles-Bjerre, Jesse Fried, MarkJohnson, Ken Kettering, Lynn LoPucki, Ron- ald Mann, Tom Plank, Alan Schwartz, and Paul Shupack, as well as several friends on the faculty of the University of Oregon School of Law. I also remain grateful for the insights and generosity of the late Barry Zaretsky. For financial assistance, I thank theJames 0. and Alfred T. Goodwin Senior Faculty Fellowship and theJames C. Dezendorf Charitable Trust. CORNELL LAW REVIEW [Vol. 84:305 A. Negative Pledgee Versus Secured Party ............. 347 1. Priority Without Property? ......................... 349 2. Interlude: Property as a Radially Structured Category ......................................... 353 3. Enforcing the New Priority Rule .................... 364 B. Secured Party Versus Subsequently Executing Creditor ............................................ 369 C. Executing Creditor Versus Negative Pledgee ........ 371 1. In General: A Conservative Result .................. 371 2. A Narrow Exception .............................. 372 D. Trustee in Bankruptcy Versus Negative Pledgee ..... 374 III. THE PROPOSAL COMPARED TO STRUCTURAL ALTERNATIVES .............................................376 A. Voiding of Subsequent Security Interests ............ 376 B. Contractual Waiver and Subordination ............. 378 C. Automatic Priority for Lead Financers .............. 380 IV. RAMIFICATIONS: TIHE WORLD IN A GRAIN OF SAND ........ 384 A. Traditional Principles at the Heart of a Radical Proposal ............................................ 384 B. Further Leveling of the Playing Field ............... 385 C. Efficiency and Reduced Debtor Cross- Subsidization ....................................... 386 D. A Fresh View of the Debate over Secured Transactions ........................................ 389 CONCLUSION ...................................................... 391 INTRODUCTION Lowly tools, when put to a new use, can accomplish great things. When Archimedes mounted an ordinary wooden bar on a fulcrum, he created a new device called a lever, with which we can move masses.' The potential for similarly surprising results inheres in one lowly tool of unsecured lenders: the negative pledge covenant, by which a borrower promises its lender that it will not grant security interests to other lenders. These covenants are common in unsecured loan agreements because they address one of the most fundamental con- cerns of the unsecured lender: that the borrower's assets will become unavailable to repay the loan, because the borrower will have both granted a security interest in those assets to a second lender and dissi- pated the proceeds of the second loan. Unfortunately, negative pledge covenants' prohibition of such conduct may be of little practi- cal comfort, because as a general matter they are enforceable only 1 His boast, "Give me where to stand, and I will move the earth," dramatizes the surprising power that such a simple device can have. 8 PAPPus OF ALEXANDRIA, prop. 10, § 11, quoted in BARTLErr's DICTIONARY OF QUOTATIONS 83 (16th ed. 1992). 1999] SECURED TRANSACTIONS 1NS1DE OUT 307 against the borrower, and not against third parties who take security interests in violation of the covenant. Hence, when a borrower breaches a negative pledge covenant, the negative pledgee 2 generally has only a cause of action against a party whose assets are, by hypothe- 3 sis, already encumbered. This Article explores the possibility of alleviating this problem. It proposes making negative pledge covenants enforceable against sub- sequently perfecting secured parties, provided that the negative pledgee satisfies certain third-party notice concerns in the manner currently required for security interests by Article 9 of the Uniform Commercial Code. In short, it proposes making negative pledge cove- nants perfectible, without altering negative pledgees' characteristic vulnerability to other unsecured creditors. This fairly simple change in the law would generate a number of extraordinary results, both practical and theoretical. On a practical level, this change would bring new vitality to a very common device, making negative pledge covenants much more effec- tive, and reducing uncertainty on the part of both secured and un- secured lenders. It would integrate protection for negative pledgees into the statutory pattern of Article 9, thereby obviating the need for much of the costly, judge-made doctrine relied upon today. It would enrich the range of possible outcomes of bargaining between borrow- ers and lenders, which in turn would have several salutary effects: (1) increasing party autonomy, (2) furthering borrowers' ability to alien- ate their property, and (3) increasing transactional efficiency by en- abling some borrowers to save interest costs without harm to third parties. In sum, the proposal may encourage the market to recognize negative pledge debt as a new and distinct mezzanine, located midway between current law's poles of secured and unsecured debt. The proposal also offers theoretical insights that are at least as important as the practical effects. In effect, it turns Article 9 inside 2 "Negative pledgee" is the standard term used to refer to the promisee of a negative pledge covenant. 3 Why, then, do lenders use negative pledge covenants at all? This and related natu- ral questions are addressed infra in Part I.E. As a preliminary matter, it is important to note that most debtors do not breach their negative pledge covenants, and that presuma- bly only a minority of the debtors who do breach dissipate, on a problematically quick basis, the proceeds of the resulting secured loan. See infra text accompanying note 16 (noting that breach of a negative pledge covenant typically triggers acceleration of the original debt); infra notes 281-82 and accompanying text (noting a variety of other forces that bolster the effectiveness of negative pledge covenants). For these reasons, negative pledge lending is widespread under current law and, for the most part, functions well. This Article's purpose is not to urge any legislative reform, but rather to explore what a certain complex of ideas can reveal about current law and about commercial law in gen- eral. For that reason, though I refer throughout this piece to a "proposal," I use that word in its relatively neutral sense, as a simple means of referring to the principal subject of discussion. 308 CORNELL LAW REVIEW [Vol. 84:305 out, using a statute that is often considered the nemesis of unsecured creditors as a tool to help them. In the process, the proposal invites us to look deeply into Article 9's structure and into the nature of un- secured debt itself. It also invites us to explore the nature of property rights, revealing the concept as a relatively flexible linguistic construct that should not automatically exclude lenders without security inter- ests. It offers