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The philosophy of insolvency rescues

 

10 March 2009

This is the fourth in a series of articles written by Philip Wood, Allen & Overy's Special Global Counsel, on the financial crisis and the global slowdown from a legal perspective.  

The current financial crisis is likely to bring in its train a re-examination of corporate rescue statutes as a way of protecting the economy and it is worth reviewing where we have got to on this topic internationally.

Insolvency does not mean insolvency proceedings. By far the great majority of financial problems are resolved by a private restructuring outside the courts, known as work-outs. Nobody knows the proportion of work-outs to judicial rescues or liquidations internationally, but there is no question that they are the preferred course for both debtors and creditors if at all possible.

Work-outs avoid the trauma of formal insolvency proceedings which cause credit to dry up and which deter new business. They avoid a loss of control by both management and creditors to a court or administrator. They avoid the forcible stays on creditor rights (which may include, depending on the jurisdiction, stays on set-off, taking and enforcing security and contract terminations). They keep the group together. They avoid the examination of management, greater public scrutiny and the delays, formality, cost and tactical litigation typical of court proceedings. Security for old and new money to support the company is easier to take.

Also, whatever you call the insolvency proceeding in most countries, it inevitably sparks off termination clauses in leases and contracts and any resulting close-outs and cancellations. Formal proceedings are generally a last resort. 

On the other hand, they might be unavoidable. This will be the case if there are hold-out creditors who will not agree to a work-out, or there are desperate junior creditors who do not realise they have lost everything, or disgruntled shareholders who have a veto, e.g. against a debt-equity conversion or a large disposal, or the issues are too complex to be worked out before the company runs out of money. There can be just too many conflicts – between creditors in laddered tranches, or creditors with credit protection, or labour unions or pension trustees with blocking rights.

Of course the decision may be taken out of the hands of creditors and management by reason of rules imposing personal liability on directors if they deepen the insolvency by not stopping early enough or by reason of rules imposing a duty on them to file once the company is insolvent. See Letter No. 3.

Liquidation is the stroke of midnight for everybody, the final guillotine. It is very rare for liquidation to have advantages over judicial rescues or work-outs.

Some jurisdictions have half-way houses between judicial rescues and private work-outs. These include  official umpires (France), and "voluntary" codes of conduct for work-outs, prompted by the authorities. These were based on the "London Approach" initiated in the 1970s and are found in Indonesia, Turkey, Hong Kong, Japan, Thailand and elsewhere. They are official arm-twisting, soft law.

It was rather late during the Roman Empire that the Romans concluded that a composition could be a better way of getting paid than enslaving or imprisoning the debtor. Much later, judicial compositions were enacted in 19th century Europe but were little used, apart from the 1870 English corporate scheme of arrangement. The Great Depression accelerated judicial rescues around the world but it was only in the last quarter of the 20th century that the judicial rescue really took off, including the celebrated Chapter 11 of the U.S. Bankruptcy Code of 1978.

The proliferation is shown by the map: Corporate insolvency rescue statutes . This displays in red the countries which have a modern corporate rescue statute, i.e. a statute with low entry criteria, with stays on creditor attachments and liquidation petitions, and with creditor voting on a plan.

Since the map was drawn, in September 2007, there have been quite a few changes or proposed changes. For example, Greece has a new rescue statute, Hong Kong is considering re-introducing a rescue statute after an aborted attempt a few years ago, and so are the Netherlands. But Luxembourg is one of the few advanced countries which remains unconvinced. Luxembourg has the highest per capita income in the world.

It will be seen that practically the whole world outside sub-Saharan Africa and the Middle East has a judicial rescue statute. In the Middle East bankruptcy statutes are somewhat thin, probably because of the Sharia objection to interest.

Nevertheless, these rescue statutes vary enormously in terms of their impact on creditors. They differ especially on such  matters as the stay on security enforcement, on set-off and on contract cancellations, the degree of creditor control (as opposed to control by management or the court), incentives imposed on directors to petition, the application of preference rules, the ability to novate contracts (available in the U.S. and France) and the method of voting on plans.

The chart below shows some of the differences. This chart is broken down into three panels comprising common law, Roman-Germanic and Napoleonic groups of illustrative jurisdictions. It will be seen that, although these groups are more or less true to their original inspiration, there is nevertheless significant fragmentation within the groups.

When Chapter 11 was first drafted, it was considered extremely debtor-protective, a creature of the 1970s. That is still more or less true compared to the models in, say, Britain, China, Japan and Germany. Nevertheless there are other versions which are even more debtor-protective, at least on paper, such as France, Spain and Kazakhstan.

One of the great conundrums is why the rate of take-up of judicial reorganisations is quite high in the U.S., but very low in France – around 7 per cent, at least before the recent introduction of the French safeguard procedure.  The answer probably has to do firstly with the fact that in the U.S. public bondholders cannot be bound to a change in the terms of payment by majority vote (apart from a minor exception for interest) since this is contrary to the Trustee Indenture Act of 1939. Apart from various other inefficient strategies, binding dissentient minority bondholders can only be done by a Chapter 11 plan.

Further, in France there are three other factors – both creditors and management lose control to the all-powerful court, the stays are very adverse to creditors, and directors are often made personally liable if there are insolvency proceedings (not so in the U.S.). So in France, both banks and management are discouraged from entering a proceeding. That may not be a wrong result.  But in France the reluctance of the participants is countered by a director duty to file on a continuing cessation of payments. In any event, the idea that the U.S. has a bold entrepreneurial culture which is not present in France and which is symptomised by a positive American enjoyment of going into Chapter 11 is probably just another piece of myth-making. For example, the big U.S. car companies are hardly showing enthusiasm for filing.

The overall approach to judicial organisations involves complex policy judgements. The argument is not whether they are useful – it is considered that they are. The argument is how draconian the impact on creditor rights and transactions generally should be. Reorganisations must, as a minimum, impose a stay on creditor executions and on liquidation petitions. So the issue is whether those limited stays are enough or whether the law should be more intrusive, e.g. by the imposition of more dramatic stays on security enforcement, on the repossession of title finance assets, on set-off and on contract cancellations, and by the conferring of a forced priority on new money subordinating existing creditors without their consent.

Any significant erosion of creditor rights increases transaction disruption, unpredictability and international legal complexity. It can lead to protectionism and international collisions. Some judicial rescue statutes were intended not to maximise creditor returns but to redistribute on insolvency by effectively using bank and bondholder money to pay out other favoured creditors, such as employees and trade suppliers. Others were attempts by the retreating state to continue to micromanage the economy via the puppetry of the legal regime. In the end, somebody loses, somebody is demoted. On insolvency , there is no free lunch.

Until now, reorganisations have not been mainstream in many advanced jurisdictions outside the U.S., except in mega cases where often they are used as a slow motion liquidation with a quick sale of viable assets followed by a groaning winding-up of the rest over many long years. In some countries, reorganisations seem to be used in less than 10 per cent of the cases compared to liquidation. This must point to a very high proportion of work-outs.

One leaves aside corporate receiverships in English-based jurisdictions. Those are basically the enforcement of a universal security interests by a possessory manager appointed by the secured creditor followed usually by a private sale – a highly successful device in practice. These universal security interests are much less common for the commanding heights of the economy – public companies.

On the whole, it seems that creditors favour work-outs if they are achievable and prefer not to involve the court. That is also very obviously the view of management. This is the minimalist approach that the court is needed only as a fall-back where it is necessary to bind hold-out creditors, e.g. by a pre-packaging. A pre-packaging is a pre-negotiated private plan forced through by a judicial plan if minority creditors do not agree.

In other words, restructurings are carried out, not by the law but in the shadow of the law. The law is used as a menacing force to induce agreement and consensus. It is the dark bulk lurking behind the curtain, axe in hand. That is as it should be. The idea that court involvement should be positively encouraged by the law in priority to private work-outs, e.g. by forcing directors into proceedings or by imposing the more dramatic creditor stays, could be the least efficient approach and the least welcome to creditors and corporates.

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