The Future of Reorganization Procedures in the Era of Pre-insolvency Law

Abstract

Several countries and regions around the world, including Singapore, the United Kingdom, and the European Union, are amending their restructuring framework to implement a pre-insolvency mechanism that includes most of the features that exist in the US Chapter 11 reorganization procedure. However, unlike what happens in the United States, where unsuccessful reorganizations lead to Chapter 7 liquidations, companies using this ‘de facto Chapter 11’ (DFCH11) are still allowed to use formal reorganization procedures. This article argues that, while the rise of the DFCH11 is not necessarily undesirable provided that various protections are put in place, jurisdictions implementing this restructuring tool need to adapt their formal insolvency framework to this new era of ‘pre-insolvency law’. Otherwise, some inefficiencies can be created from the lack of coordination between insolvency and pre-insolvency law, since non-viable firms as well as viable businesses managed by the wrong people can opportunistically delay the commencement of a liquidation procedure even when it is the most desirable outcome for society.

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Notes

  1. 1.

    Countries and regions implementing these pre-insolvency mechanisms include Singapore, the United Kingdom and the European Union. For an analysis of the insolvency reforms in Singapore, see McCormack and Wan (2018); Wee (2017). For the European Union, see De Weijs (2018); Eidenmüller (2017). For a general overview of the insolvency reforms planned in the United Kingdom, see Payne (2018).

  2. 2.

    This article will use the term ‘pre-insolvency proceedings’ to refer to procedures usually characterized by two aspects. First, debtors are not yet formally insolvent. Second, debtors enjoy certain restructuring tools available in insolvency proceedings. For an analysis of the definition, goals and features of pre-insolvency proceedings, see Tollenaar (2019), pp 38–98, 188–250. See also Garrido (2012), pp 2–6; Eidenmüller (2016b); Wessels and Madaus (2017), pp 183–190.

  3. 3.

    The concept and rationale of these features or restructuring tools existing in a US Chapter 11 reorganization procedure will be analyzed in Sect. 2.2.

  4. 4.

    In the United States, the appointment of an examiner or trustee in reorganization procedures occurs in very rare cases. These cases usually involve situations of fraud, dishonesty or gross mismanagement. See Lipson (2010).

  5. 5.

    For the purpose of this article, ‘insolvency proceedings’ and ‘bankruptcy procedures’, as well as ‘insolvency law’ and ‘bankruptcy law’, will be used as synonyms.

  6. 6.

    The expression ‘opportunistic filing for reorganization’ used in this article will refer to any situation in which a debtor, even in good faith, files for reorganization when it should not do so, usually because the company is not viable or the creditors do not trust the shareholders/managers. A filing in good faith might take place for several reasons, including the founder’s failure to recognize that the company is no longer viable. Filings in bad faith usually include those where the company’s founders or controlling shareholders know that the company is no longer viable but they seek to reach a reorganization agreement because they know that, in a hypothetical scenario of liquidation, they would not get any value out of the corporation while in reorganization they might still get something. Other opportunistic filings, even if they are not strictly in bad faith but just a result of a negligent behavior of the managers, include those associated with filings for reorganization when the managers do not analyze the viability of the company and, assuming that the company is economically viable even if it is not, they file for reorganization. For the purpose of this article, all these types of filings will be considered ‘opportunistic filings’, since they all can opportunistically favor the founders/controlling shareholders at the expense of the creditors and, if so, other stakeholders.

  7. 7.

    The concept of insolvency differs across jurisdictions. In general, there are two main concepts of insolvency: (i) balance-sheet insolvency, whenever a debtor’s liabilities exceed the value of the company’s assets; and (ii) cash-flow insolvency, whenever a debtor is unable to pay its debts as they fall due. For a detailed analysis of these concepts, see Goode (2011), pp 109–147. Likewise, some jurisdictions, such as Germany and Spain, have also introduced the concept of ‘imminent insolvency’ to refer to those situations in which, even though a debtor is still able to pay its debts, it will probably be unable to do so at some point in the near future (see, for example, Art. 2.3 of the Spanish Act and Art. 18 of the German Insolvency Act). For the purpose of this article, insolvency will be generally understood as inability to pay debts.

  8. 8.

    In some jurisdictions, such as the United States, companies are not required to prove a situation of ‘insolvency’. However, in the absence of a collective action problem and other similar ‘bankruptcy problems’, the court may dismiss the case. A situation of insolvency (or even imminent insolvency) usually involves collective action problems. Therefore, there is a potential role for bankruptcy law in these situations. For some authors, solving the collective action problems generated in a situation of financial distress is one of the primary roles of insolvency law. See Jackson (1986), pp 1–19.

  9. 9.

    In some countries, the role of bankruptcy courts can be played by some administrative bodies with judicial powers. For the purpose of this article, these administrative bodies in charge of overseeing insolvency proceedings are also included in the concept of ‘bankruptcy courts’.

  10. 10.

    Outside of bankruptcy, debt contracts can only be modified by all creditors. In a formal reorganization procedure, however, this unanimity rule is no longer required.

  11. 11.

    This moratorium, as it is called in the United Kingdom and Singapore, or ‘automatic stay’, as it is referred to in the United States, has been classified as the primary features of insolvency proceedings, since it protects the debtor’s assets against the enforcement actions potentially initiated by the creditors. See Squire (2016), p 13.

  12. 12.

    For a more in-depth analysis of the concept and features of insolvency proceedings, see Eidenmüller (2016b). For an analysis of the differences between ‘informal’ and ‘formal’ insolvency mechanisms, see Garrido (2012), pp 2–6. It should be noted that the appointment of a trustee is not required in some insolvency jurisdictions adopting a debtor in possession, as is the case of the United States. Under the US Bankruptcy Code, the debtor remains in possession during a Chapter 11 reorganization procedure. Only in Chapter 7 liquidations, as well as in exceptional cases in Chapter 11, a trustee is appointed to manage the procedure.

  13. 13.

    This type of ‘enhanced scheme of arrangement’ can be found in Singapore, where the debtor enjoys most of the benefits existing in a Chapter 11 reorganization procedure (e.g., moratorium, cross-class cramdown, DIP financing, no appointment of supervisors/trustees), but the procedure is conducted through a scheme of arrangement. In Spain, another restructuring tool exists. However, the procedure is not formally structured as a scheme of arrangement, and the debtor does not enjoy some of the ‘insolvency tools’ available under the ‘enhanced scheme of arrangement’ that exist in Singapore. Therefore, while both procedures can be classified under the broad concept of DFCH11 used in this article, there will be different levels of intensity of DFCH11, depending on the number of insolvency tools existing in these restructuring procedures. For this purpose, the Singapore scheme of arrangement would be a strong form of DFCH11 while the Spanish pre-insolvency mechanism is a low-medium form of DFCH11. For an analysis of the Singapore enhanced scheme, see McCormack and Wan (2018); Wee (2017). For an analysis of the pre-insolvency framework in Spain, see Tirado (2018). See also Gurrea-Martínez (2020).

  14. 14.

    Some authors distinguish five types of insolvency proceedings depending on both the level of regulatory intervention and the severity of the debtor’s financial troubles. These procedures include: (i) informal or out-of-court proceedings (workouts); (ii) enhanced restructuring; (iii) a hybrid procedure; (iv) formal reorganizations; and (v) formal insolvency. See Garrido (2012), pp 2–6. For the distinction between ‘insolvency law’ and ‘pre-insolvency law’, as well as ‘insolvency law’ and ‘restructuring law’, see Paterson (2015); Madaus (2018); Tollenaar (2019), pp 8–80, 188–250.

  15. 15.

    For a general overview of the different models of ‘insolvency governance’, see Eidenmüller (2016a), pp 14–16.

  16. 16.

    Most jurisdictions around the world provide a moratorium, special rules to approve a plan without the consent of all the creditors, and new rules for executory contracts and post-petition financing. Nevertheless, the US Chapter 11 differs significantly from other reorganization regimes in at least three aspects. First, unlike most jurisdictions around the world, which only provide an intra-class cramdown (that is, the possibility of imposing the plan on dissenting creditors within the same class), the US Chapter 11 provides a powerful cross-class cramdown that only requires the approval of a single class of creditors to impose the plan on other classes, provided that other conditions are met (e.g., the absolute priority rule and the fact that the plan cannot discriminate unfairly). Second, while many jurisdictions around the world only give preferential treatment to post-petition lenders, the US Chapter 11 provides a system that, under certain circumstances, may provide this preferential treatment of altering pre-existing creditors’ rights. Finally, unlike most formal reorganization procedures around the world, the US Chapter 11 does not impose the appointment of a supervisor or trustee to oversee the insolvency proceeding.

  17. 17.

    For an analysis of the insolvency reforms in Singapore, see McCormack and Wan (2018); Wee (2017). For a study of pre-insolvency proceedings in Europe, see Stanghellini et al. (2018). Analysing the European Directive 2019/1023 on Preventing Restructuring Frameworks [2019] OJ L 172/18, see McCormack (2017); Eidenmüller (2017). For a general overview of the insolvency reforms taking place in the United Kingdom, see Payne (2018).

  18. 18.

    These tools have been included in the new pre-insolvency frameworks implemented in Singapore and the European Union. In the United Kingdom, although the new restructuring tool will probably include a moratorium, it is not clear whether it will finally include the non-enforceability of ipso facto clauses. See supra n. 17.

  19. 19.

    The use of a moratorium is provided in most insolvency jurisdictions around the world, since it is probably the most important insolvency tool to preserve value. In the absence of a moratorium, creditors would be incentivized to start a ‘race to collect’ that may end up destroying going concern value in addition to increasing collection costs for the creditors. See Jackson (1986), pp 16–17. The restriction of ipso facto clauses, however, while it is relatively extended internationally, it is more controversial. More about these clauses will be discussed in Sect. 2.2.6.

  20. 20.

    The concept, rationale and feature of these provisions will be analyzed in Sects. 2.2.4 and 2.2.3, respectively.

  21. 21.

    In the United Kingdom, however, the new restructuring tool will likely require the appointment of an insolvency practitioner to oversee the reorganization process.

  22. 22.

    The appointment of a supervisor (usually in charge of overseeing the debtor) or, depending on the jurisdiction, an administrator/trustee (generally replacing the management team) has been the general rule in most reorganization procedures around the world, including those that exist in the United Kingdom, Singapore, and the European Union.

  23. 23.

    The distinction between ‘insolvency’ and ‘pre-insolvency’ law is becoming more unclear in this new era of ‘pre-insolvency law’. As some authors have mentioned, if any bankruptcy expert from the United States looks at the features of the new pre-insolvency framework in Europe, he or she would probably think that it is a formal reorganization procedure. See Eidenmüller (2017).

  24. 24.

    Williamson (1975).

  25. 25.

    In the United Kingdom, however, this is not a primary issue due to the existence of a developed regulatory framework for insolvency practitioners that, among other aspects, include a licensing regime. See https://www.gov.uk/government/collections/insolvency-practitioner-regulation.

  26. 26.

    These practices have led the legislator in both jurisdictions to change the system for the appointment of trustees. In Colombia, a system of automatized appointment based on an algorithm has been put in place. In Spain, the legislator has decided to implement a system of randomly assigned trustees among those included in a list of people meeting certain requirements. However, both jurisdictions still allow, in some exceptional cases, the appointment of the trustee at the discretion of the court. These exceptional appointments usually take place in complex bankruptcy cases. Therefore, the conflicts of interest that the legislator sought to solve might not really disappear, since the bankruptcy court will still have the ability to choose the trustee in complex and large bankruptcy cases, which are usually those with higher fees potentially earned by the insolvency practitioner.

  27. 27.

    The advantages and disadvantages of the debtor in possession, as well as some regulatory proposals to improve the transparency, effectiveness and efficiency of the existing models for the appointment of trustees can be found in Gurrea-Martínez (2018a), pp 135–145.

  28. 28.

    This problem can be avoided or significantly reduced if, as it happens in the United States, a trustee or examiner can be appointed in cases of fraud, dishonesty, incompetence or mismanagement. See 11 USC § 1104. See also supra n. 4.

  29. 29.

    Jensen and Meckling (1976).

  30. 30.

    Armour et al. (2017), pp 109–114.

  31. 31.

    McCormack and Wan (2018); Gurrea-Martínez (2020).

  32. 32.

    La Porta et al. (1998); La Porta et al. (1999); Claessens et al. (1999); Barca and Becht (2002); Enriques and Volpin (2007); Yeh et al. (2007); Masulis et al. (2011); Aminadav and Papaioannou (2016); Franks and Mayer (2017).

  33. 33.

    Other aspects to take into account when deciding about the governance system of insolvency proceedings may include the sophistication of the industry of insolvency practitioners, the regulatory framework of directors’ duties and liability, and the quality and efficiency of the institutions in charge of enforcing those duties.

  34. 34.

    See supra n. 30.

  35. 35.

    This problem, generally known as ‘asset substitution’, relies on the intuition that the shareholders, once they have lost everything, may have incentives to pursue very risky investments (or ask the managers to do so) even if these projects have a negative net present value but in case of success yield very high returns. Thus, if the project succeeds, the shareholders can still recover part of their investments. Nevertheless, if the project fails (as will likely be the case in these types of risky projects), the shareholders will lose nothing since they will be protected through limited liability. Therefore, all the losses will be borne by the creditors. See Jensen and Meckling (1976); Davies (2006); Armour et al. (2017), pp 111–112; Eisdorfer (2008). Showing that this asset substitution (or ‘risk shifting’) problem might not actually occur, however, see Gilje (2016); Hernández et al. (2014); Eckbo and Thorburn (2003).

  36. 36.

    In practice, however, a monitor or scheme manager is often appointed, since this can be beneficial for the success of a corporate reorganization due to the level of credibility and expertise potentially added to the restructuring process.

  37. 37.

    For a summary of the proposed reform in the United Kingdom, see https://www.r3.org.uk/index.cfm?page=1949&element=32517&refpage=1865.

  38. 38.

    La Porta et al. (1998); La Porta et al. (1999).

  39. 39.

    This is one of the reasons that may make a DIP more desirable in the United States than in other jurisdictions where companies have more concentrated ownership structures. See supra n. 38. Arguing that the United States may have more concentrated corporate ownership structures than it is generally assumed, however, see Holderness (2009).

  40. 40.

    Lobbies have often influenced the design of business laws. For instance, in the context of takeovers, it has been argued that the powerful lobby of managers in the US and the power of institutional investors in the UK have made the regulatory framework of takeovers very director-friendly and shareholder-friendly, respectively, in the US and the UK. See Armour and Skeel (2007). Similarly, arguing that the families controlling most European corporations may have influenced the design of takeover law in Europe, see Ventoruzzo (2008). Therefore, since the associations of insolvency practitioners are larger and more established in the United Kingdom, this lobby is probably more powerful than in Singapore or many European countries.

  41. 41.

    For a review of the costs of bankruptcy, see Warner (1977), showing that the direct costs of bankruptcy were 3–4% of the pre-bankruptcy market value of the total assets in large firms. These figures are relatively consistent with Weiss (1990). However, in Andrade and Kaplan (1998), the authors show that the costs of financial distress represent 10–20% of the market value of the firm. These costs, however, seem to be higher in the United Kingdom, at least for small firms. See Franks and Sussman (2005), reporting that insolvency liquidations subtract 20–40% of the company’s proceeds in the context of small and medium-sized enterprises.

  42. 42.

    In the US, a plan is deemed to be approved by a class of creditors if at least a majority in number and 2/3 in value vote in favor of the plan. In Singapore and the United Kingdom, the approval of a plan under a scheme of arrangement requires a higher majority (a majority in number and at least 75% in value). For an excellent analysis of the scheme of arrangement, with particular focus on the regulation in the United Kingdom but providing an overview of this tool in other jurisdictions, see Payne (2014). For the scheme of arrangement in Singapore after the 2017 insolvency reform, see McCormack and Wan (2018); Wee (2017).

  43. 43.

    See 11 USC § 1129(b)(1).

  44. 44.

    Baird (2010), p 71.

  45. 45.

    See 11 USC § 1129(a)(7).

  46. 46.

    Analyzing the concept of Pareto improvements, see Varian (2010), p 15. For the concept of efficiency, and how it is used in law, see Posner (2011), pp 17–20; Mokal (2003).

  47. 47.

    Casey (2020).

  48. 48.

    An underinvestment problem occurs whenever a valuable project cannot be pursued due to the lack of finance. See Myers and Majluf (1984). By contrast, the concept of ‘overinvestment’ refers to those situations in which projects with a negative net present value, that should not be pursued, are being financed. See Brealey et al. (2011), p 291.

  49. 49.

    Triantis (1992).

  50. 50.

    For an analysis of the rationale and regulation of DIP financing in the United States, see Triantis (1992); Triantis (1993); Skeel (2004); Squire (2016), pp 235–260; Adler et al. (2007), pp 475–520; Triantis (2017).

  51. 51.

    See 11 USC § 364(c)(d). Similar provisions can be found in the new restructuring framework that exists in Singapore.

  52. 52.

    In the United Kingdom, it has been argued that, due to the current availability of debt finance for viable businesses facing financial trouble, a new regime for DIP financing might not be needed. In fact, it can even do more than good since the implementation of a regime of rescue financing including the possibility of altering the order of priority can increase borrowing costs for firms. See https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/578524/Summary_of_responses_26-10-16_Redacted.pdf, p 11.

  53. 53.

    See supra n. 50. In Singapore, see section 211E(9) of the Companies Act.

  54. 54.

    Varian (2010), p 15. About these concepts of efficiency, and why the concept of Kaldor-Hicks efficiency is more commonly used in practice than the concept of Pareto efficiency, see Posner (2011), pp 17–20; Mokal (2003).

  55. 55.

    This article uses the terms ‘moratorium’ and ‘automatic stay’ as synonyms.

  56. 56.

    Squire (2016), p 13.

  57. 57.

    In general, this automatic stay applies to both unsecured creditors and secured creditors, even though the stay on secured creditors is usually subject to special rules.

  58. 58.

    Some of the first countries to adopt a moratorium outside of formal insolvency proceedings were Singapore and Spain. Nowadays, this moratorium has been proposed for a new restructuring tool in the United Kingdom, as well as for the pre-insolvency mechanism established in the European Directive on Preventing Restructuring Frameworks.

  59. 59.

    For a definition of ipso facto clauses, see Collett (2010).

  60. 60.

    Other common triggering events include a mere situation of financial distress. See supra n. 59.

  61. 61.

    Jurisdictions that have recently adopted the restriction of ipso facto clauses in their pre-insolvency or restructuring framework include Singapore and the European Union.

  62. 62.

    These countries include, for example, Australia, the United States and Spain.

  63. 63.

    For a comparison between pre-insolvency proceedings and the US Chapter 11, see Madaus (2018). For an analysis of the features of pre-insolvency procedures from a positive and normative perspective, and comparing these procedures with the US Chapter 11 procedure, see also Tollenaar (2019).

  64. 64.

    In fact, even unsuccessful workouts may prevent debtors from filing for Chapter 11 as a second shot to reorganize a company. See In Re Colonial Ford, Inc, 24 B.R. 1014 (1982).

  65. 65.

    Summarizing the debate, see Tajti (2018); Gurrea-Martínez (2020).

  66. 66.

    Tajti (2018); Gurrea-Martínez (2020).

  67. 67.

    See supra n. 65.

  68. 68.

    For an analysis of this institution, see Gurrea-Martínez (2018b).

  69. 69.

    See Art. 172 and 172 bis of the Spanish Insolvency Act.

  70. 70.

    Analyzing the relative use of bankruptcy procedures around the world, see Claessens and Klapper (2005). Pointing out that Chinese bankruptcy procedures have been misused, see Liu and Wei (2017). For an analysis of the reasons and implications of the low usage of bankruptcy procedures in Spain, see Celentani et al. (2010); García-Posada and Mora-Sanguinetti (2014); Gurrea-Martínez (2020).

  71. 71.

    Some authors include the concepts of ‘insolvency law’ and ‘restructuring law’ as part of the general concept of the ‘law of corporate distress’. See Paterson (2015). For a distinction between ‘insolvency law’ and ‘restructuring law’, see also Madaus (2018).

  72. 72.

    For an analysis of the role and functions played by this institution, see http://www.superir.gob.cl/.

  73. 73.

    For the concept and applications of 'nudges', see Sunstein and Thaler (2008).

  74. 74.

    Emphasizing that the new pre-insolvency framework established in the European Directive on Preventing Restructuring Frameworks can affect a variety of stakeholders and the use of formal insolvency proceedings can provide a higher level of protection to these stakeholders, see Eidenmüller (2017).

  75. 75.

    See Eidenmüller and Van Zwieten (2015). Emphasizing that the rise of ‘pre-insolvency law’, at least as it has been proposed in the European Directive on Preventing Restructuring Frameworks, may create a refuge for non-viable debtors, and this scenario may increase financial costs for firms, see Eidenmüller (2017).

  76. 76.

    See supra n. 41.

  77. 77.

    Actually, the debtor will even have an additional shot if, before using the formal restructuring frameworks, the company has tried to reach a workout.

  78. 78.

    For a general overview of the valuation methods in bankruptcy, see Ayotte and Morrison (2019). Even though the value of a firm as a going concern can be a very subjective value, it can still provide a useful valuation to have in mind. This valuation should be compared with the value of the firm in a hypothetical orderly piecemeal liquidation. See In Re Crowthers McCall Pattern, Inc., 120 B.R. 279. Thus, the value of the firm in its current use will be ultimately compared with the value of the firm under one of the worse scenarios, which is a piecemeal liquidation. For a general analysis of the valuation of companies in financial distress, see Gilson et al. (2000); Crystal and Mokal (2006); Ayotte and Morrison (2019); Tollenaar (2019), pp 99–113.

  79. 79.

    For an analysis of the concept of viability, and why non-viable (or economically distressed) firms should be liquidated and viable companies just facing a problem of financial distress should be reorganized, see White (1989); White (1994b); Baird (1997), pp 9–10; Armour (2001), p 4; Schwartz (2005). In my opinion, even though, for simplicity and familiarity, it is more common to distinguish between viable and non-viable firms, it is more precise to speak about ‘economically efficient firms’ and ‘economically inefficient firms’. After all, insolvency law should make sure that the assets are efficiently allocated. Therefore, the concept of ‘viable firms’ used in insolvency law should be understood as what some economists have called ‘economically efficient firms’. See White (1994a).

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Acknowledgements

For valuable comments and discussions, I would like to thank Stephen Bull, Richard Squire, an anonymous referee, and the participants of various events where I had the opportunity to present a preliminary version of this paper, including the 2019 Annual Conferences of INSOL International and INSOL Europe held in Singapore and Copenhagen, respectively. For excellent research assistance, I would like to thank Samuel Loh and Ken Teo Chuanzhong. All errors are mine.

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Gurrea-Martínez, A. The Future of Reorganization Procedures in the Era of Pre-insolvency Law. Eur Bus Org Law Rev (2020). https://doi.org/10.1007/s40804-020-00191-y

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Keywords

  • Pre-insolvency law
  • Restructuring
  • Reorganization
  • Chapter 11
  • DFCH11