On 28 March 2019, the European Parliament adopted a new directive on ‘preventive restructuring’, aiming to “increase[e] the efficiency of restructuring”. The Reform Directive1 specifies that a new procedure must be in place in all member countries by 2022. The introduction of the Directive was motivated by slow reform progress in member states, and is inspired by Chapter 11 of the US Bankruptcy Code. Reforming the insolvency system can serve several useful goals. It supports vigorous recovery from recessions (Gilson 2012) and limits creditor losses in insolvent companies, which is critical to developing and increasing creditor recovery (Becker and Josephson 2016, Bris et al. 2006). All this helps support healthy credit markets.
European insolvency systems today, which vary widely across member states, deliver much less than the Chapter 11 system in the US. Several European countries struggle with large numbers of insolvent or questionable firms (e.g. Andrews and Petroulakis 2019). The current rapid rate of technology-driven disruption means that more firms become insolvent (Becker and Ivashina 2019). For these reasons, insolvency reform in Europe offers great potential benefits.
The advantages of the US insolvency system
Chapter 11 of the US Bankruptcy Code, implemented by Congress in 1978, introduced the idea that bankrupt firms need not be liquidated. Instead, if a firm is worth more as a ‘going concern’ than if it is dissolved and all assets sold in pieces, the firms is restructured. Restructuring refers both to improving operations and to getting the firm towards a less levered capital structure. All claims get paid off or written down. Typically, secured debt is repaid in cash, junior debt exchanged for equity in the new capital structure, and pre-petition equity holders are wiped out. After first being introduced, the Chapter 11 system was slow and often resulted in violations of priority. Reforms introduced by Congress, as well as increasing sophistication by market participants, has improved the respect of priority and made outcomes more predictable (Bharath et al. 2010). The Chapter 11 system is capable of handling very large firms with complex multinational operations and large number of creditors with varied claims. Recent examples include American Airlines in 2011 and California’s largest utility, Pacific Gas and Electric Company, in 2019, which had suffered large losses from wildfires. Over time, the Chapter 11 system has become faster, and many cases now take less than a year. Specialised investors invest in the claims of insolvent firms and help restructure them (Jiang et al. 21012, Ivashina et al. 2016). Chapter 11 and the legal and financial expertise around it helped the US economy rebound quickly after the Global Crisis (Gilson 2012).
The important but flawed new EU directive
The current European effort to push insolvency law forward does get several things right. Figuring out all the ins and outs of a rational, efficient system may be too much for individual countries, especially the smaller ones, and it makes sense that this should be a union matter (bankruptcy is federal, not state, law in the US). Implementing uniform and consistent rules across Europe will increase predictability and fairness for firms which operate across borders. Improving formal in-court procedures reduces the need for out-of-court bargaining that unfairly favours some claimants like big banks (Becker and Josephson 2016). Introducing the possibility of cramming down a restructuring against the objection of some creditors increases the chance of success. All these are important steps forward.
Despite the progress, the new rules are unlikely to establish an effective European insolvency regime. First of all, restructuring will remain outside of bankruptcy. The term ‘pre-insolvency’ is used in the directive. This is an attempt to sidestep the need to harmonise complex and varied bankruptcy rules around Europe. Unfortunately, pre-insolvency restructuring is a little like a pre-pregnancy delivery. Pre-insolvent means solvent. If a firm is solvent, why restructure? In solvent firms, equity retains an interest – who is supposed to write down their claims when equity holders remain? Solvent firms in need of restructuring do not need a court and attempts at abuse are likely. Furthermore, bankruptcy and liquidation will be a constant threat. If a firm in restructuring would ever become insolvent, it would have to enter bankruptcy proceedings. Firms trying to restructure will end up being liquidated.
Another problem is that the new system does not respect priority among creditors. In Chapter 11, a class of creditors cannot be paid unless more senior classes of creditors have been paid in full. Such ‘absolute priority’ makes financial contracts meaningful and payoffs predictable. If you have collateral for your loan but I do not, you will be paid first.2 The EU proposal replaces the sensible concept of absolute priority with the new concept of ‘relative priority’. This simply states that recovery has to be at least as high for a class of creditors as for all claims junior to that class. If a class of junior creditors receives recovery of 40 cents on the dollar, a more senior class may receive 41 cents. In other words, large losses may be imposed on senior creditors while junior creditors receive payments. Under relative priority, it will therefore be possible to impose large losses on senior lenders while junior creditors, or even shareholders, get paid. This effectively dismantles financial priority. Under these rules, there is little point to secured debt or seniority in general. The implications could be disruptive for credit markets and for firms’ ability to fund themselves.
Next round
The Reform Directive is a step in the right direction. For a truly effective insolvency regime, which steps remain? First, the restructuring procedure would have to be incorporated into bankruptcy law, for which insolvency is the trigger. Courts should be directed into restructuring or liquidation based on value maximisation. Second, to respect private contracts and support a healthy credit market, the system should respect priority: no losses on any creditors unless equity is wiped out, and so on. Such a system would then be able to handle larger insolvencies with complex balance sheets. Third, managing this kind of process is challenging, and a system of specialised courts may be needed. There are only six bankruptcy courts in the US, and two of these (Delaware and the Southern District of New York) handle 71% of large bankruptcies.4 Perhaps a new system of European bankruptcy courts, at least for corporate cases, would be appropriate.
With these additional reforms, Europe could achieve the corporate revitalisation, deep credit markets, and support for employment, productivity growth, and faster recoveries produced by Chapter 11.
References
Andrews, D and F Petroulakis (2019), “Breaking the shackles: Zombie firms, weak banks and depressed restructuring in Europe”, ECB working paper 2240.
Baird, D (2017), “Priority matters: Absolute priority, relative priority, and the costs of bankruptcy”, University of Pennsylvania Law Review 165(4): 785-829.
Becker, B and V Ivashina (2019), “Disruption and credit markets”, CEPR Discussion Paper 13508.
Becker, B and J Josephson (2016), “Insolvency resolution and the missing high-yield bond markets”, Review of Financial Studies 29(10), 2814-2849.
Bharath, S T, V Panchapagesan and I M Werner (2010), “The changing nature of Chapter 11”, working paper.
Bris, A, I Welch and N Zhu (2006), “The costs of bankruptcy: Chapter 7 liquidation versus Chapter 11 reorganization”, Journal of Finance 61(3): 1253-1303.
Gilson, S C (2012), “Coming through in a crisis: How Chapter 11 and the debt restructuring industry are helping to revive the U.S. economy”, Journal of Applied Corporate Finance 24(4): 23-35.
Ivashina, V, B Iverson and D C Smith (2016), “The ownership and trading of debt claims in Chapter 11 restructurings”, Journal of Financial Economics 119(2): 316-355.
Jiang, W, K Li and W Wang (2012), “Hedge funds and Chapter 11”, Journal of Finance 67: 513-559.
Endnotes
[1] The full title is “Increasing the efficiency of restructuring, insolvency and discharge procedures”; see http://www.europarl.europa.eu/doceo/document/TA-8-2019-0321_EN.html.
[2] In Chapter 11, priority is not followed religiously. Baird (2017) points out situations when absolute priority may be too strict, for example when firm value is very uncertain. Baird highlights how Chapter 11 outcomes sometimes allocate value to junior creditors (e.g. in the form of post-reorganisation warrants) to compensate for lost option value. This happens within a system with very strong protection for creditors (for example, all creditors must get at least as much as they would have in a liquidation), and the Restructuring Directive is unlikely to work the same way.
[3] Refers to the 134 Chapter 11 cases with above $1 billion in liabilities, filed between 2000 and 2018. For those above $10 billion, the share is 97%. Calculated using data from bankruptcydata.com.
