Insolvency of Significant Non-Financial Enterprises: What Can We Learn from Bank Failures and Bank Resolution?
by | posted in: Bankruptcy Reform, Bankruptcy Roundtable Updates, International and Comparative | 0

By Ilya Kokorin, Leiden Law School (The Netherlands)

Ilya Kokorin

The current economic downturn triggered by the spread of COVID-19 demonstrates that the role of insolvency law should not be restricted to resolving conflicts between private parties (i.e. creditors and debtors). Nevertheless, the very framework of insolvency law remains primarily: (i) microprudential – single entity focused and designed to protect individual debtors and their creditors, (ii) contractarian – implementing the idea of creditors’ bargain and solving coordination problems between creditors of a single entity, and (iii) reactive – centred around post-crisis liquidation of assets and allocation of proceeds among creditors. It may therefore be ill-fitted to serve the public interest in mitigating the negative externalities of large-scale (systemic) corporate debacles (e.g. Chrysler, GM, British Steel, Carillion) or handling the economy-wide instability experienced nowadays.

In contrast to corporate insolvency, in the aftermath of the global financial crisis of 2008 (GFC), bank resolution in the European Union (EU) and the USA went through fundamental changes that seek to preserve financial stability and ensure continuity of critical functions. Bank resolution has increasingly embraced the macroprudential vision, recognizing the need for an advanced preparation and a speedy intervention to ensure continuity of critical functions, preservation of financial stability and avoidance of bailouts. This vision has resulted in the specific proactive and reactive recovery and resolution strategies. In the recent paper Insolvency of Significant Non-Financial Enterprises: Lessons from Bank Failures and Bank Resolution, I explore whether the modern approaches to bank crises can be extended to non-financial enterprises. I discuss how insolvency law might help minimize social harm stemming from wide-ranging shocks and grand-scale business failures and suggest what we can learn from bank failures and bank resolution.

The failure of Carillion, once the UK’s second-largest construction company, has shown that the reactive approach to crisis resolution, centred around post-crisis intervention, posed significant risks not only for creditors but also for other stakeholders and communities at large. Carillion had around 43,000 workers, of whom 19,000 were based in the UK. It owed around GBP 2 billion to the extensive network of 30,000 suppliers, sub-contractors and other creditors and left the pension liability exceeding GBP 2.5 billion. Even though the signs of financial distress appeared long before Carillion filed for liquidation in January 2018, these warning signals were largely ignored. The failure of Carillion had substantial implications for the provision of public services, raising environmental, health and safety concerns. It ultimately led to a state intervention backed by taxpayers’ money. However, the actual economic and social cost of Carillion’s insolvency are hard to quantify. Financial distress of such a significant enterprise (significant non-financial enterprise or SNFE) required timely state intervention. Nevertheless, its multiple profit warnings came as a surprise to the Cabinet Office.

Insolvency of Carillion was characterized by the absence of timely reaction to prevent crisis escalation, a genuine threat of public disruption and a vast complexity determined by both the debtor’s organizational structure, consisting of more than 320 group members, and the nature of its activities. Many of the same features were observed in the failure of banks and banking groups during the GFC. As a response, both the EU (BRRD) and the USA (Title II of the Dodd-Frank Act) have embraced a proactive and precautionary approach focused on preparation and early response. In my paper, I use the case of Carillion to inquire whether selected bank recovery and resolution tools could have been adopted to prevent the collapse of Carillion, or to mitigate its negative consequences.

In particular, I analyse three such tools, namely: (i) intervention powers granted to state authorities for early (preventive) reaction to the escalation of financial problems before the actual insolvency, (ii) entity and group recovery and resolution planning, and (iii) administrative-led insolvency process. I conclude that while the first two mechanisms may prove beneficial, the last one is rather controversial. While an administrative-led process has certain advantages and prevails in bank resolution, it may be difficult and unnecessary to replicate or transpose to non-financial enterprises. Instead, a transparent court-supervised process with active involvement of creditors and debtors, as well as a limited and targeted engagement of public authorities on matters of public interest should be encouraged.

The full paper is available here.

Rethinking Priority: The Dawn of the Relative Priority Rule and a New ‘Best Interest of Creditors’ Test in the European Union
by | posted in: Bankruptcy Roundtable Updates, Cramdown and Priority, International and Comparative, Priority | 0

By Axel Krohn (Martin-Luther-University Halle-Wittenberg, Germany)

Axel Krohn

The European Directive on restructuring and insolvency (“Directive”), which came into force in July 2019, has triggered a series of interesting debates. The possibility for EU Member States to subject the cram-down from Article 11 to a “relative priority rule” (“EU RPR”) when implementing the Directive into national law has proven to be particularly controversial.

Despite a confusing conceptual overlap with approaches presented in the U.S., the European interpretation of “relative priority” breaks new ground. The rule stipulates that, under a restructuring plan, dissenting voting classes have to be treated merely more favorably than any junior class. Although the Directive allows national lawmakers to refrain from the EU RPR and introduce a familiar “absolute priority rule” (“APR”)—that is, that a dissenting class of creditors must be paid in full before junior parties may receive any distributions—the EU RPR has already found supporters in various jurisdictions and should therefore be thoroughly examined.

This article identifies one aspect of the cram-down that has received little attention to date. In addition to the EU RPR, the European legislature has introduced a new “best interest of creditors” test (“EU BIT”), which does not—as in 11 U.S.C. § 1129(a)(7)(ii)—use the value that a party could expect in a hypothetical liquidation as a comparator, but refers to the “next-best-alternative scenario.” Although the concept of combining the EU RPR and the EU BIT is coherent in theory and may even eliminate some misconceptions about the EU RPR, the interaction of the two cram-down elements is likely to raise problems in practice.

First, this article discusses the concepts of the two priority rules and traces the motives of the European legislature for introducing the EU RPR.

Three aspects in particular appear to have motivated the legislature in drawing up the rule. For one, the legislature wished to create more flexibility in plan negotiations and thus respond in particular to special needs in the restructuring of smaller businesses. The rule may bring advantages, especially when it is reasonable to enable existing shareholders to participate in the continued business by means of an equity interest. Second, with regard to some Member States, the desire has arisen to create an instrument to overcome structural blocking positions of certain preferential (priority) creditors, in particular tax authorities. Finally, there is a trend in Europe which sees in the Directive a procedure that enables a structured contractual renegotiation of debts and detaches itself from the “traditional laws of insolvency law,” including the APR.

This article then deals with the new EU BIT and examines its interaction with the EU RPR.

It is worth noting that the EU BIT plays a much more important role in an EU RPR cram-down than under an APR. By moving away from the traditional liquidation benchmark and instead linking to the “next-best-alternative scenario,” the test protects precisely the value that can be achieved from the perspective of a creditor outside insolvency without cooperating with other parties. The then remaining reorganization surplus, which is subject to the EU RPR, is that fraction of the going concern surplus which can only be achieved through the combined efforts of all parties involved, but which creditors cannot claim in an individual case of enforcement.

Despite this harmonious interaction in theory, doubts may be expressed as to whether the combination of the EU RPR and the EU BIT would work in practice. The new focus on the hypothetical next-best-alternative scenario value will likely lead to an additional stress point in plan negotiations. The EU RPR, which does not itself contain a clear guideline for the distribution of the remaining surplus, is then to be applied between two unclear values, namely the hypothetical next-best-alternative value and the presumed reorganization value. It is reasonable to assume that the resulting distributional uncertainty will cause new hold-up potential and render it difficult to realize consensual plans, especially in larger restructuring cases. Also, it seems likely that unsophisticated junior creditors will face difficulties in defending their rights adequately in view of the potentially unclear next-best-alternative scenario value, and that others will try to use this to their advantage in complex negotiations.

The full article is available here.

Repo Markets Across the Atlantic: Similar but Unalike
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, International and Comparative | 0

By Songjiwen Wu (University of Heidelberg) and Hossein Nabilou (Universite du Luxembourg – Faculty of Law, Economics and Finance)

The vulnerabilities in the wholesale funding and in particular short-term (overnight) repurchase agreement (repo) markets were significant sources of systemic risk in the Global Financial Crisis. Numerous studies have investigated the role of repos in the crisis, but only a few scholars have explored why the European repo markets have weathered the crisis better than their US counterparts. With a focus on the underlying legal and structural features of repo markets across the Atlantic, our paper sets out to explain such a different outcome. In doing so, it sketches the key differences in the EU and the US repos by focusing on three main aspects of repo markets that are pivotal to highlighting potential vulnerabilities. First, it highlights the differences in the legal framework governing repos, such as legal construction of repo contracts, special bankruptcy treatment—the reform of which has been a key controversial issue across the Atlantic—and legal treatment of the reuse of collateral. Second, it discusses the composition, structure, and organization of the repo markets, such as differences in the composition of repo participants, maturity of repos, and the composition of the underlying collateral in repo contracts. Finally, it investigates the differences in the issues related to the market infrastructure of repo markets such as differences in the clearing and collateral management stages. The findings of our paper suggest that multiple legal and regulatory divergences, which could still pose challenges to the short-term funding markets, exist in repo markets across the Atlantic.

The full article is available here.

For previous Roundtable posts on repo markets, see Ganduri, “Repo Regret?“, and Morrison, Roe & Sontchi, “Rolling Back the Repo Safe Harbors“.

Bankruptcy Forum Shopping in Europe
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Reform, Bankruptcy Roundtable Updates | 0

By Wolf-Georg Ringe (University of Hamburg – Institute of Law & Economics; University of Oxford – Faculty of Law).

Over the past several years, European firms have been active in cross-border arbitrage to benefit from a more favorable bankruptcy regime. The European Insolvency Regulation (EIR), an instrument determining the competent courts and the applicable law in EU cross-border insolvency proceedings, has long sought to curb such efforts. A major reform which came into force in 2017 has the specific objective of further restricting abusive versions of forum shopping, in particular by introducing a three-month “suspension period” for forum shopping activities carried out shortly before the debtor files for insolvency.

In a recent article, I demonstrate that these efforts fail to achieve a satisfactory response to forum shopping. The key element of the reform, the suspension period, is both over-inclusive and under-inclusive in its scope of application and may, at best, be entirely without effect. The new rule will also create significant uncertainty and undermine effective ways of business restructuring.

Meanwhile, the reform does not address new variants of forum shopping, such as the use of the British “scheme of arrangement” by continental European firms. Such “procedural” forum shopping may be effected entirely without any physical relocation, as it does not come within the scope of application of the EIR.

The laudable goal of the EIR to improve the pricing of risks in cross-border insolvencies is jeopardized where the rules on jurisdiction are unclear or uncertain. The 2017 reform is a missed opportunity to improve the system by attaching substantive bankruptcy law and jurisdiction to a company’s registered office as the only clear and predictable connecting factor. Instead, the reform introduces new riddles and inconsistencies. Such steps will blur rather than improve the pricing of insolvency risk and thereby ultimately drive up the cost of capital.

The full article is available here.

The Impact of Brexit on Debt Restructuring and Insolvency Practice
by | posted in: Bankruptcy Administration and Jurisdiction, International and Comparative | 0

By Manuel Penades and Michael Schillig (King’s College London – The Dickson Poon School of Law).

With its flexible restructuring framework and experienced courts, England has become the foremost restructuring destination in Europe. A restructuring typically combines a scheme of arrangement with a pre-pack administration. Under the former, lenders exchange their debt for equity or new debt in a new corporate holding structure; the latter facilitates the transfer of the business to this new holding structure. The effectiveness of these restructuring measures in all EU Member States is currently guaranteed by the combined effect of the European Insolvency Regulation (EIR), the Judgments Regulation (Brussels Ibis), and the Regulation on the law applicable to contractual obligations (Rome I).

This regime currently ensures the availability of English-law pre-pack administration and other insolvency procedures to many EU debtors. The EIR ties exclusive jurisdiction and applicable insolvency law to the debtor’s Centre of Main Interests (COMI). Insolvency measures issued by the opening court are automatically recognised and enforced throughout the EU. Subject to a COMI transfer to England, any debtor can benefit from English insolvency and restructuring mechanisms (including pre-pack administration) and their automatic EU-wide effect.

Post-Brexit, the EIR will cease to apply in the UK and insolvencies opened therein will lose their automatic EU effect. English domestic law alone will be insufficient to achieve this result. Only a new international instrument, probably in the form of a convention, could maintain the effectiveness of the current practice.

By contrast, schemes of arrangement are not covered by the EIR and their enforceability across the EU is currently ensured by Brussels Ibis and/or Rome I. The UK will be able to retain the Rome I regime through a unilateral instrument, but not the Brussels Ibis, which requires reciprocity, like the EIR.

Given that schemes and insolvency procedures are usually combined, absent new international instruments, Brexit is likely to result in significant uncertainty and disruption for European restructuring practice.

The article is available here.