Australia is one of the last G20 countries to review its insolvency laws following the GFC. This article looks at what is happening on the reform front in Europe and the US.
Australia is not alone in considering reforms to encourage restructuring rather than liquidation in circumstances where businesses are facing financial difficulty. Both the United States and the European Union are considering reforms to their restructuring frameworks to encourage early intervention and turnarounds rather than break-ups and value destruction, through the traditional process of court-controlled liquidation.
Discussed below are the study of the American Bankruptcy Institute (ABI) into the reform of the Chapter 11 restructuring provisions and the European Commission's recommendation to EU member states to adopt a similar, debtor-in-possession (DiP) style restructuring framework.
The experience in both the United States and Europe shows that while developing frameworks is an essential first step to reform, this must be matched with continued engagement by government to progress these policy platforms into law.
United States - ABI’s Reform Commission
In keeping with the nation’s entrepreneurial ethos, the United States has one of the most flexible formal restructuring schemes through reorganisation under Chapter 11 of the United States Bankruptcy Code. Unlike voluntary administration or similar formal “corporate rescue” provisions in other jurisdictions, Chapter 11 grants the business under reorganisation a stay from enforcement of debts and claims arising prior to entry into Chapter 11 and does not require an independent practitioner to take control of the business. Instead, the management of the business can retain control of the business as a DiP and can then reorganise the business under a formal plan approved by its creditors.
While Chapter 11 is often referenced as a model for insolvency reform world-wide, it is not without its critics within the United States. Some perceive that Chapter 11 is expensive and inefficient, thereby discouraging companies facing financial distress from utilising it. Its provisions have changed little since its introduction in 1978, while business operations and the financial structures which underpin them have become radically more complex. Chapter 11 was drafted in an era where businesses were less leveraged, held more physical as opposed to intangible assets (such as intellectual property) and were simpler in their organisation and operation.
In this context, in 2009 the US’ peak body for insolvency, the ABI formed a commission of 22 of the nation's leading insolvency professionals and began investigating reforms to Chapter 11. In December 2014, after extensive industry, government and stakeholder consultation, the ABI released the Final Report of the Commission to Study the Reform of Chapter 11 (Chapter 11 Report). Key reforms proposed in the Chapter 11 Report included:
- prohibitions on pre-reorganisation lenders who provide additional finance to the DiP from using the process to unfairly convert their existing debts into priority post-Chapter 11 debt;
- restrictions on sales of all or substantially all of a debtor's assets shortly after entry into Chapter 11;
- the ability for equity owners to participate in reorganisation plans where creditors are not paid in full, provided they contribute new value to the business;
- enhancing the ability for reorganisations to "cramdown" impaired creditors. A creditor whose rights who will be impaired by a reorganisation has the right to vote on it, and under the current provisions of Chapter 11, at least one class of impaired creditors must approve a reorganisation to allow objecting impaired creditors to be bound. This requirement often produces significant litigation and "gamesmanship" to attempt to establish or abolish an impaired class of creditors which will support the reorganisation. The Chapter 11 Final Report, while conscious of maintaining the rights of impaired creditors, suggested a removal of the requirement of approval of a class of impaired creditors; and
- narrowing the scope of financial contracts exempted from the automatic stay and the ipso facto provisions, which prevent termination merely on the grounds of entry into Chapter 11. The logic behind these exemptions is to promote financial market stability and liquidity. However, the Chapter 11 Report noted that these provisions have developed to protect from the automatic stay a number of types of financial contracts, including physical supply contracts, repurchase agreements, and certain transactions in connection with leveraged buyouts, which have minimal connection to the markets the exemptions were intended to protect. Therefore, the Chapter 11 Report recommends narrowing these exemptions.
The US Congress is yet to substantially engage with the ABI’s recommendations in the Chapter 11 Report.
Europe - a slowly developing framework for recovery
European states, historically, do not share the United States’ flexible attitude to business failure and recovery. With insolvency laws heavily focused on liquidation, there was traditionally little scope for a turnaround or other business rescue within a formal legal framework. However, in the 21st century, a number of European states and the EU have concluded that the lack of a formal restructuring framework risks value destruction and misses opportunities to rescue troubled, but viable businesses.
In 12 March 2014, the European Commission adopted “A New Approach to Business Failure and Insolvency”, a recommendation to encourage European states to:
…to put in place a framework that enables the efficient restructuring of viable enterprises in financial difficulty and give honest entrepreneurs a second chance, thereby promoting entrepreneurship, investment and employment and contributing to reducing the obstacles to the smooth functioning of the internal market.
In their analysis of the recommendation in their paper, Restructuring the European Business Enterprise, Professors Horst Eidenmuller and Kristin van Zwieten (Oxford Faculty of Law) identified six core principles of the new systems proposed by the recommendation.
1. Early recourse - a business in financial distress should have access to a restructuring procedure, even if they are yet to become insolvent;
2. Minimal court involvement - a formal court process should not be required to initiate a restructuring procedure, reducing the costs of the procedure and also allowing an environment where restructuring negotiations can occur with putting all creditors on immediate notice;
3. Debtor-in-possession - allowing the debtor to keep control of the day-to-day operations of their business, which encourages early entry into the restructuring procedure by managers and ensures business continuity, reducing costs compared to an external manager being appointed.
4. Access to a court-ordered stay of enforcement - debtors should be able to apply to a court to seek stays of enforcement action by creditors, including secured creditors. This prevents the dismantling of a business during restructuring negotiations and helps balance the power of secured creditors, unsecured creditors and debtors during these negotiations.
5. Ability to bind dissenting creditors to a restructuring plan - if a majority of creditors agree to a restructuring plan, there should be an expedited court process to allow dissenting creditors to be bound and the restructure to proceed. The recommendation suggests creditors be grouped into classes - at a minimum, secured and unsecured creditors should be treated separately for obtaining approval.
6. Protection for new finance - parties that provide new finance to debtors negotiating a restructuring should have protection from avoidance rules which could see the finance obligations set aside, encouraging the continuing supply of finance to business undertaking a restructure.
The similarities between the European Commission's recommendations and Chapter 11 are clear. However, it is obvious from the ABI's work that a mere wholesale adoption of Chapter 11 would fail to reflect the complex nature of business and business failure in the 21st century. In their implementation of the recommendations, EU states would be well advised to consider the ABI's work on the reform of Chapter 11.
On 30 September 2015, the European Commission released an evaluation of states’ implementation of the recommendations. There has been little progress to implement the recommendations - those states in compliance already had compliant restructuring schemes, while a significant number of states without the restructuring schemes have made no progress in introducing one.
Positively, the Commission did note where reforms had taken place, impacts in an increased take-up of restructuring has occurred, however as a whole the position in the EU is inconsistent between states, creating legal uncertainty and increasing costs for investors.