Some credit analysts place less emphasis on collateral compared to covenants and business risk. Explain why

Question

What will be an ideal response?

Answer 1

Some analysts place less emphasis on collateral compared to covenants and business risk due the observation that bankruptcy often only allows secured creditors to receive part of their claim in terms of assets pledged by a borrower to secure a loan. Thus, the both covenants found in the indenture and also the business risk (under which the company operates) takes on added significance. More details are given below.

A corporate debt obligation can be secured or unsecured. In the case of the liquidation of a corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. In contrast, seldom do the absolute priority rules hold in a reorganization. What is typically observed in such cases is that the corporation's unsecured creditors may receive distributions for the entire amount of their claim and common stockholders may receive some distribution, while secured creditors may receive only a portion of their claim. Secured creditors are willing to allow distribution to unsecured creditors and common stockholders in order to obtain approval for the plan of reorganization, a plan that requires approval of all parties.

The question is then, what does a "secured position" mean in the case of a reorganization if the absolute priority rule is not followed in a reorganization? The claim position of a secured creditor is important in terms of the negotiation process. However, because absolute priority is not followed and the final distribution in a reorganization depends on the bargaining ability of the parties, some analysts place less emphasis on collateral compared to covenants and business risk.