Bankruptcy & Bailouts; Subsidies & Stimulus: The Government Toolset for Responding to Market Distress
by | posted in: Bankruptcy, Bankruptcy Reform, Bankruptcy Roundtable Updates | 0

By Anthony J. Casey (The University of Chicago Law School)

Anthony J. Casey

In the spring of 2020, as the Covid-19 pandemic shut down economies around the world, pressure arose for governments to respond to the growing threat of pandemic-related market distress. In the United States, the initial proposals for government action varied in nature and focus. Some proposals targeted the financial system while others targeted small businesses and individuals. Others were intended to bail out large businesses and specific industries. Still other proposals took a more institutional focus. In the context of bankruptcy law, many imagined building up the bankruptcy system as a primary bulwark against a seemingly imminent wave of economic and financial distress.

With the exception of measures related to financial markets, the actual responses formed a chaotic mix of disconnected half-measures that neither stabilized the economy nor provided meaningful relief to those most affected. While that failure may be attributed in part to general government dysfunction and legislative gridlock, a large part of the problem arises from the lack of a clearly identified framework to guide government responses.

The main lesson here is that the appropriateness of tools deployed to alleviate a crisis depends on the nature of the specific problem at hand, and scattershot approaches are unlikely to work. As obvious as that principle may seem, it was largely ignored in 2020. Much of the confusion in the pandemic responses is attributable to using the wrong tools and implementing measures that lacked any clear purpose.

In particular, governments and commentators lost sight of two important distinctions in deciding how to act. The first is the distinction between tools appropriate for addressing economic distress and those appropriate for addressing financial distress. The second is the distinction between a systemic crisis where distress is spreading and an instance of firm-specific distress where the harm—though perhaps large—is contained.

These distinctions present four types of market distress: specific economic, systemic economic, specific financial, and systemic financial. Each type is distinct from the others, and for each there is a category of appropriate government responses (respectively): direct subsidies, general stimulus, bankruptcy proceedings, and financial bailouts. We thus have this matrix:

Systemic Specific
Economic General Stimulus Direct Subsidies
Financial Financial Bailouts Bankruptcy Proceedings

(Chapter 11)

 

The importance of understanding these classifications is most evident in the flawed proposals for pandemic-related fixes to bankruptcy law and in the lack of a centralized economic plan to support failing small businesses around the country.

In a new article, I lay out this framework for identifying the right tools for responding to different forms of market distress.  I describe the relationship between the category of tools and the type of distress. Having presented the framework, I then use it to closely examine the interaction between pandemic responses and bankruptcy law. This analysis is particularly important because efforts to understand the bankruptcy system’s role during the pandemic provide the starkest example of confused analysis of appropriate responses to systemic crises, and because a striking decline in bankruptcy filings in 2020 has puzzled many commentators.

The Italian Insolvency Law Reform
by | posted in: Bankruptcy Reform, Bankruptcy Roundtable Updates, International and Comparative | 0

By Andrea Zorzi (University of Florence)

Andrea Zorzi

On January 12, 2019, a new ‘Code of enterprise crisis and of insolvency’ was adopted in Italy.

The qualifying aspect of the new law is its emphasis on early intervention. The early warning system is based on enhanced internal monitoring and a ‘duty to scream’ imposed on public creditors, if the company is delinquent on VAT or social security contributions. All business entities must set up adequate ‘organisational, management and accounting’ systems that allow early detection of a crisis and timely dealing with it. The law also creates a public office that should help debtors to find an agreement with creditors or induce them to file for a proper reorganisation procedure.

There are incentives for debtors and directors who tackle the crisis early (and for auditors who take the appropriate steps). On the other hand, undue delay is addressed in various ways. Among them, a new presumption regarding the quantification of damages in case of directors’ trading after the moment when the company is deemed dissolved, that will make it easier for trustees to hold directors liable.

The reform also brings in updates on international jurisdiction, now entirely based on centre of main interest (COMI) (however, there is no general cooperation obligation with regard to cross-border insolvency), and a comprehensive set of rules on group crisis (seemingly compliant with the UNCITRAL principles).

Finally, the law makes relevant changes regarding two of the three available restructuring instruments, while there is nothing new with regard to the very peculiar reading of the absolute priority rule (APR) according to Italian insolvency law.

The law broadens the scope of the cramming down on dissenting creditors (subject to a 75% supermajority in the relevant class) in out-of-court, but court-confirmed debt restructuring agreements: once restricted to financial creditors only, they are now available with respect to all creditors. The confirmation of the plan, which envisages only intra-class cram down, is possible irrespective of compliance with any priority rule (absolute or relative), with the only backstop of a ‘best-interest test’, now based on a comparison with a liquidation scenario. This makes the Italian ‘scheme of arrangement’ a very flexible and effective tool (confirmation rates are also very high, in practice).

Regarding judicial composition with creditors (concordato preventivo), the law confirms the controversial requirement (introduced in 2015) that a minimum 20% payment of unsecured creditors is ensured when a liquidation plan is proposed, and adds the requirement of some form of ‘external’ financial input. By contrast, there is no such a threshold when the business is due to continue under the plan: however, ‘business continuation’ is now defined more narrowly than in the past – it is such only if creditors are paid mainly out of proceeds of the ongoing business, rather than from asset sales, or, under a statutory definition, if the continued business employs at least one-half of the previous workforce. This requirement may exceedingly restrict access to reorganisation or transfer wealth from creditors to employees.

As mentioned, the APR conundrum – the matter is domain of case law – is not solved by the new law. While the discussion regarding APR among creditors is confined mainly to what constitutes ‘new value’ (thus evading the APR waterfall), APR still seems not to apply to equity holders, in case of business continuation.

Finally, the new law introduces very minor tweaks to ‘plain’ insolvent liquidation proceedings, solving some interpretive issues but without an innovative approach, and makes the ‘certified reorganisation plan’, an out-of-court restructuring framework, somewhat more stable in case things don’t work out and the debtor ends up insolvent.

Certain new measures are already in force, but the whole new Code will come into force on 15 August 2020. It should be noted that the new law fully applies – as the law it supersedes – only to enterprises with less than 200 employees. Enterprises exceeding that threshold are deemed ‘large’ and, while being able to access ordinary restructuring tools, if insolvent they are subject to ‘extraordinary administration’, a special going-concern liquidation regime that provides for broad discretion for governmental authorities and the pursuit of business continuity even at the expenses of creditors’ rights.

The paper offers a comprehensive review of the main features of the new law, setting it in the context of the current Italian insolvency law framework.

The full article is available here.

For previous Roundtable posts on Relative and Absolute Priority Default Rules in EU, see Jonathan Seymour and Steven L. Schwarcz, Corporate Restructuring under Relative and Absolute Priority Default Rules: A Comparative Assessment.

A Functional Law and Economics Analysis of the Restructuring Directive from a French Law Perspective
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Cramdown and Priority, International and Comparative, Legislation | 0

Vasile Rotaru (Droit & Croissance / The Rules for Growth Institute)

From a functional law and economics perspective, the recent European restructuring directive (the ‘Directive’) brings both welcome innovations and multiple pitfalls. Its final text bears the traces of the divergent objectives and inspirations of its drafters. In a recent paper, I attempt to provide a thorough analysis of the different hidden ‘models’ and important measures of the Directive, as well as its unfortunate oversights.

The first part of the paper lays the theoretical foundations of the subsequent analysis. It has long been argued that insolvency law should pursue two objectives: (i) facilitating debtor’s ex ante access to finance; and (ii) ensuring an efficient ex post distribution of resources in the economy, by restructuring economically viable companies with bad capital structures and swiftly liquidating companies with an unsustainable business. Together, the two should result in wealth maximization, the default (but by no means only) criterion for assessing business law’s merits.

The paper takes a ‘functional’ approach, which is fueled by a deep skepticism towards any extensive cost-benefit analysis. It suggests that the ex ante focus should be on ensuring that a suitable epistemic framework is in place when the decision as to the redistribution of resources has to be taken. This implies incentivizing decision-makers to reliably reveal their preferences and bear the costs of their actions while diminishing coordination failures and potential conflicts of interests. Starting with this intuition, I attempt to reformulate the classical creditors’ bargain theory, underlining that so called ‘preventive’ proceedings are no exception.

In the second part of the paper, I rely on this theoretical framework to provide a critical analysis of the main measures of the Directive. I show that the apparent complexity of its final text (the contemplated proceedings could potentially take more than 70 forms) is owed to its drafters pursuing divergent objectives: economic efficiency or short-term preservation of businesses and jobs at all costs, with an unfortunate bias in favor of the latter (especially concerning SMEs).

Moreover, two coherent formal ‘models’ of proceedings are offered. The first is a unitary, public proceeding, with a potential general moratorium for up to four months. The second is a two-step proceeding—partially inspired by the current French model—that would start with an amicable phase devoid of wide publicity and would be accompanied by individual moratoria granted on a casuistic basis where they seem justified. The second, short and public ‘closing’ phase would be triggered in the specific circumstances where the restructuring plan has to be forced upon dissenting stakeholders. Once a decision has been made as to the objectives and formal model, most of the subsequent transposition options follow.

The Directive implies a devolution of decision-making powers to classes of affected stakeholders, although the court preserves a far too important role. Indeed, stakeholders are in the best position to identify and exploit any restructuring gain. It remains to be seen which criteria will be used to ensure that the interests of members of a class are aligned and no abusive behavior takes place. Where a plan is not approved by all classes of stakeholders, the Directive provides for a cross-class cram-down, where a majority of classes or at least one class of stakeholders who are ‘in the money’ must approve the plan. The latter option could potentially lead to abuses and uncertainties, given the meagre experience of European practitioners with valuations as a going concern. The cram-down can involve a debt-equity swap imposed both on shareholders, who should be treated as any other class of stakeholders and dissenting creditors. This possibility is not trivial, as it forces creditors to continue financing the business, and should be duly justified.

Unfortunately, the contemplated protections of stakeholders’ interests are somewhat underwhelming. For instance, instead of ensuring that all stakeholders share the restructuring gain in accordance with their respective ranks in the capital structure, the Directive provides for a confusing and dangerous ‘relative’ priority rule, which will likely render the negotiations unpredictable, or, alternatively, for an incomplete ‘absolute’ priority rule. Moreover, no protection is provided against debtor’s potentially abusive behavior before the opening of proceedings.

Finally, the paper offers some insights into the expected impact of its transposition into French law. In particular, its last part suggests that any transposition needs to aim at increasing the transparency and predictability of restructuring proceedings in order to foster secondary debt markets, and therefore to ensure that impatient creditors can easily be replaced by those interested in the restructuring gain.

The full article is available here.

The Rise and Fall of Regulatory Competition in Corporate Insolvency Law in the European Union
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, International and Comparative | 0

By Horst Eidenmüller (University of Oxford; European Corporate Governance Institute – ECGI)

In a recent paper, I discuss the rise and fall of regulatory competition in corporate insolvency law in the European Union. The rise is closely associated with the European Insolvency Regulation (EIR, 2002), and it is well-documented. The United Kingdom (UK) has emerged as the ‘market leader’, especially for corporate restructurings. The fall is about to happen, triggered by a combination of factors: the recasting of the EIR (2017), the European Restructuring Directive (ERD, 2019) and, most importantly, Brexit (2019). The UK will lose its dominant market position. I present evidence to support this hypothesis.

Regulatory competition in European corporate insolvency law happened by accident: it was the unwelcome consequence of the entering into force of the EIR in 2002. The EIR was designed to eliminate forum shopping and to harmonize Member States’ jurisdiction and conflicts rules for international insolvencies. However, in practice, it did not achieve this end. The Regulation’s test for main insolvency proceedings, a company’s ‘Centre of Main Interests’, can be manipulated. Forum shopping became almost a signature feature of the EIR, and the UK emerged as the ‘market leader’ for corporate restructurings in the European Union (EU). The available data clearly confirms this assessment. The popularity of the UK as a restructuring venue also stems from the attractiveness of the Scheme of Arrangement—a procedure that is not within the scope of the EIR. Under the applicable European rules, restructuring decisions taken by courts in one Member State must be automatically recognized in all other Member States.

The regulatory landscape for corporate insolvency law in the EU is changing. The EIR was recast in 2017, the EU passed the ERD in 2019, seeking to harmonize Member States’ pre-insolvency restructuring regimes so that local businesses get local access to restructuring processes, and the UK will probably leave the EU in 2019.

I argue that the recast EIR will not significantly affect forum shopping and regulatory competition in corporate restructurings. However, the ERD will have such an effect, i.e. it will significantly reduce forum shopping and regulatory competition in corporate restructurings. This is because the ERD mandates that Member States implement certain key features of pre-insolvency restructuring regimes by 2021, effectively ruling out radical legal innovations departing from the new European standard. Unfortunately, the ERD is a ‘defective product’: it mandates inefficient procedures and should be repealed.

Most importantly, Brexit will eliminate the dominant competitor in the European restructuring market, i.e. the UK. This is because Member States will no longer be forced to automatically recognize decisions taken in UK restructuring proceedings. It appears that the restructuring market already anticipates this effect: one can observe a decline of the popularity of the Scheme of Arrangement in cross-border cases from 2016 onwards. I present evidence in the form of hand-collected data on cross-border Schemes of Arrangement to support this hypothesis.

The full article is available here.

Insider Trading: Are Insolvent Firms Different?
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Insider Status | 0

By Andrew Verstein (Wake Forest University School of Law)

Are insolvent firms different from solvent firms with respect to insider trading law and policy? One difference is the level of regulation of trading in the residual claims of the firm. In solvent firms, the residual claims are equity securities, and equity securities are subject to the full ambit of trading restrictions. In insolvent firms, non-equity claims are typically residual claims that are subject to less stringent regulation precisely because they are not equity and they may not even be securities. As a result, insider trading regulations apply with lesser force to the most economically significant and informationally-sensitive interests in an insolvent company. Insolvency is therefore deregulatory.

While insolvency deregulates, it also expands the reach of other aspects of federal insider trading law. That is because bankruptcy law creates new roles and new duties. Since insider trading law hinges on duties, these new relationships expand the coverage of insider trading restrictions.

I consider these tradeoffs in a forthcoming article, and I offer two tentative conclusions.  

First, we should not rush to close the “loopholes” in insider trading law that open with regards to the residual claims. Deregulating insider trading is a Faustian bargain—greater price accuracy at the risk of lesser liquidity, fairness, and managerial integrity—but we should be more willing to accept the bargain with respect to insolvent firms than solvent ones.

Second, we should be solicitous of efforts to shield members of creditors’ committees from extensive insider trading regulation because these creditors occupy a position without analogue in the solvent firm: they both receive and contribute material, nonpublic information. Traditional insider trading law theory may not have the resources to manage a two-way flow of information, requiring new and accommodating thought.

The full article is available here.