INSOLVENCY LAW REFORM - World Banksiteresources.worldbank.org/GILD/Resources/InsolvencyLaw...Mike...

Mike Falke, Insolvency Law Reform in Transition Economies

1

INSOLVENCY LAW REFORM

IN

TRANSITION ECONOMIES

Doctoral Thesis

By

Mike Falke Knaack Str. 32 10405 Berlin

Germany [email protected]


2


3

Acknowledgements In writing this paper, I have been influenced by a number of people. Special thanks to the Legal Transition Team of the European Bank of Reconstruction and Development, London, where the idea of this paper was born. In particular, I wish to thank Joachim Menze, Craig Averch, David Berstein and Alexej Zverev. They have provided me with invaluable information, reading recommendations and up-to date legislation of many jurisdictions. Furthermore, I am deeply indebted to Prof. Stefan Breidenbach and his team from the Europa-Universität Viadrina, Frankfurt (Oder). Initial support I have also received from Manfred Balz, Deutsche Telekom AG, Gordon Johnson, Legal Department of World Bank and Prof. Philip Wood, Allen & Overy, London. I would like to mention and thank Lee Hirschman who contributed comprehensive and generous assistance on the language editing process. Last but not least, I am much obliged to Mafalda without her I would have not enjoyed that much the time while writing the thesis. Mike Falke Berlin, May 2003


4


5

Contents

BIBLIOGRAPHY ............................................................................................... 13

A. INTRODUCTION....................................................................................... 23

I. Relevance of the Topic .............................................................................. 24

II. Methodology............................................................................................... 25 1. General ...................................................................................................................... 25 2. Comparative element................................................................................................. 26 3. A legislator’s perspective .......................................................................................... 27

III. Expectations ............................................................................................... 28

IV. Scope of the paper...................................................................................... 29 1. Exclusions ................................................................................................................. 29 2. Inclusions .................................................................................................................. 29

V. Synopsis ...................................................................................................... 30

B. DEFINITIONS AND THEORETICAL FUNDAMENTALS .................... 35

I. The relevance of insolvency laws in a market economy ........................ 35 1. Definition and introductory remarks ......................................................................... 35

1.1. The asset sale or “liquidation” option ................................................................. 36 1.2. The structured bargaining or “rescue” option ..................................................... 37 1.3. Economical function of the process .................................................................... 37

2. Policy Choices........................................................................................................... 38 2.1. Reflection of prevailing principles and needs ..................................................... 38 2.2. Pro-debtor versus pro-creditor policies ............................................................... 39 2.3. Different interests and different perspectives...................................................... 40

2.3.1. Debtor and Creditor views ............................................................................... 40 2.3.2. Adding interests of community ........................................................................ 41

a. Community interest ...................................................................................... 41 b. Recognising interests of the community in transition economies................ 42

2.4. Unification approach to insolvency..................................................................... 43 3. General Objectives .................................................................................................... 44

3.1. Provide market conformity.................................................................................. 45 3.2. Maximising asset values...................................................................................... 45

3.2.1. General ............................................................................................................. 45 3.2.2. Necessity to protect the debtor assets............................................................... 46 3.2.3. Common provisions ......................................................................................... 47

3.3. Equitable treatment of similarly situated creditors (par creditium creditorum).. 48 3.3.1. General ............................................................................................................. 48 3.3.2. Treatment of different situated creditors .......................................................... 48 3.3.3. The treatment of similar situated creditors....................................................... 49 3.3.4. Classification of diverse creditors .................................................................... 49


6

3.3.5. Mechanisms promoting individual equality among unsecured creditors......... 50 3.4. Foster corporate discipline .................................................................................. 51 3.5. Exit mechanism................................................................................................... 52 3.6. Allocation of risk among the participants ........................................................... 52

3.6.1. General ............................................................................................................. 52 3.6.2. Recognition of the diversity among creditors .................................................. 52 3.6.3. Internalisation of costs ..................................................................................... 53

3.7. Encourage investment risk taking ....................................................................... 53 3.8. Increasing the availability and reducing the costs of credit ................................ 54

3.8.1. Availability of credit ........................................................................................ 54 3.8.2. Price of credit ................................................................................................... 54

3.9. Provide for certainty and predictability in commercial affairs ........................... 55 3.10. Protect economies from systemic risks ............................................................... 56 3.11. Support wider community interests..................................................................... 57

3.11.1. Methods to protect community interests .......................................................... 58 3.11.2. Examples .......................................................................................................... 59 3.11.3. Considering community interests..................................................................... 61 3.11.4. Criticism........................................................................................................... 63 3.11.5. Effects for transition economies....................................................................... 65

3.12. Provide for social balance ................................................................................... 66 3.13. Attract foreign investments ................................................................................. 67 3.14. Other frequently found objectives....................................................................... 68

4. Incentives and disincentives...................................................................................... 69

II. The relevance of insolvency laws in economies in transition ................ 71 1. The meaning of transition ......................................................................................... 71

1.1. General ................................................................................................................ 71 1.2. Key features of a market economy in respect to the transition process .............. 71 1.3. The scope of “transition economies” .................................................................. 73

2. The different characteristics and forms of economies in transition .......................... 75 2.1. Legal tradition ..................................................................................................... 75 2.2. Cultural attitude................................................................................................... 76 2.3. Level of knowledge among domestic participants.............................................. 77 2.4. Types of transition economies............................................................................. 78

2.4.1. Post-socialist transition economy..................................................................... 78 a. Regional division.......................................................................................... 78 b. Distance to market principles as criterion .................................................... 79 c. Pre-war situation as criterion........................................................................ 79 d. Common features of post-socialist countries ............................................... 80

2.4.2. Post-colonial transition economy ..................................................................... 80 2.4.3. Other types of transition economies................................................................. 81

3. Differing stages of economic development and their practical implications ............ 82 4. Historical causes that led to a increasing importance of insolvency......................... 82

4.1. 1980`s crisis......................................................................................................... 83 4.2. Collapse of the command economies.................................................................. 83 4.3. Asian crisis .......................................................................................................... 83 4.4. Pressure by the international lending community ............................................... 84

5. Policy choices and additional objectives in transition economies ............................ 85 5.1. Low number of filings......................................................................................... 85

5.1.1. General ............................................................................................................. 85


7

5.1.2. Reasons for the low number of filings ............................................................. 86 5.1.3. Alternatives to insolvency proceedings applied in transition economies ........ 88

5.2. State-owned enterprise insolvency...................................................................... 89 5.2.1. General ............................................................................................................. 89 5.2.2. Current situation of SOE’s in transition economies......................................... 89 5.2.3. Causes for this situation ................................................................................... 90 5.2.4. Insolvency-related aspects of SOE’s in transition economies ......................... 91

a. Debt relief and moral hazard........................................................................ 91 b. Downsizing the over-employment ............................................................... 91 c. Lack of markets to absorb assets.................................................................. 92 d. High number of technically insolvent SOE’s............................................... 92 e. Corporate governance structure of SOE’s.................................................... 93 f. Financial and operational deficiencies of SOE’s ......................................... 94 g. Legal and institutional frameworks in transition economies ....................... 95 h. Social assets.................................................................................................. 95 i. Size of the debt............................................................................................. 96

5.2.5. Elements and structures of the insolvency regime related to SOE’s................ 97 a. General ......................................................................................................... 97 b. Informal workout process............................................................................. 97 c. Developments in some transition economies ............................................... 98

(i) Programs in Eastern Europe.................................................................... 99 (ii) Programs in other parts of the world..................................................... 102 (iii) Programs derived from the aftermath of the Asian crisis...................... 104

6. Pro-debtor versus pro-creditor regimes and moral hazard ...................................... 105 6.1. General .............................................................................................................. 105 6.2. Indicators........................................................................................................... 105 6.3. Moral hazard ..................................................................................................... 107

6.3.1. Moral hazard and debt restructuring .............................................................. 107 6.3.2. Moral hazard and secured credit .................................................................... 107

7. Insolvency as tool for privatisation ......................................................................... 108 7.1. General .............................................................................................................. 108 7.2. Interrelation between privatisation and insolvency in transition economies .... 108

III. The Insolvency Regime and its interrelation with other legal and general societal elements.................................................................... 111

1. The Insolvency Regime: insolvency codes and the related legal framework ......... 111 1.1. General .............................................................................................................. 111 1.2. Enforcement procedures.................................................................................... 111 1.3. Recognition of security and security-like devices............................................. 112

2. The consistency of the insolvency law with underlying elements of the society ... 113

IV. The comparability of insolvency codes of developed countries with those of emerging economies .................................................................. 115

1. General .................................................................................................................... 115 2. Comparing different Western insolvency regimes.................................................. 115 3. Comparing Western insolvency regimes to those of transition economies ............ 115


8

C. LIQUIDATION, QUASI-LIQUIDATION, GOING-CONCERN-SALE, RESCUE, WORKOUTS, PRE-INSOLVENCY PROCEDURES AND THEIR INTERRELATIONSHIP.............................................................. 117

I. Definitions................................................................................................. 117 1. Liquidation .............................................................................................................. 117 2. Quasi-liquidation..................................................................................................... 117 3. Rescue ..................................................................................................................... 118

3.1. Modern rescue proceedings............................................................................... 118 3.1.1. Reflect commercial expectations ................................................................... 118 3.1.2. System of flexible rescue techniques ............................................................. 120 3.1.3. Reflect other affected interests....................................................................... 120 3.1.4. Examples ........................................................................................................ 121

a. Russian Bankruptcy Code (1998) .............................................................. 121 b. Polish Bankruptcy Law .............................................................................. 122

3.2. Informal workout............................................................................................... 122 3.2.1. General ........................................................................................................... 122 3.2.2. Elements of informal workouts ...................................................................... 122 3.2.3. Development of workouts .............................................................................. 123 3.2.4. Categories of informal workouts.................................................................... 124 3.2.5. Pre-insolvency proceedings............................................................................ 124 3.2.6. Structured informal rescue process ................................................................ 125

a. Reasons for the emergence of informal workout programs in Asia........... 125 b. Examples .................................................................................................... 126

(i) Indonesia – the Jakarta Initiative........................................................... 127 (ii) Korea ..................................................................................................... 128 (iii) Malaysia ................................................................................................ 129 (iv) Thailand................................................................................................. 131

c. General considerations when designing an institutional program ............. 132 (i) Common ground.................................................................................... 132 (ii) Elements and functions ......................................................................... 132 (iii) Obstacles ............................................................................................... 134

d. Applicability of such initiatives in other transition economies.................. 135

II. The relationship between liquidation and rescue proceedings ........... 137 1. Rate of success of rescue proceedings .................................................................... 137 2. Balancing in between liquidation and reorganisation ............................................. 139

2.1. Balancing the goals of liquidation and reorganisation ...................................... 139 2.2. Leverage function of efficient insolvency proceedings .................................... 140 2.3. Other considerations.......................................................................................... 140

3. Procedural and substantial common ground of liquidation and reorganisation ...... 141 4. Balancing between a going-concern-sale and formal reorganisation proceedings . 141 5. Abolishing reorganisation for extended liquidation proceedings ........................... 143 6. Examples ................................................................................................................. 143 7. Procedural approaches: unitary and semi-unitary proceedings............................... 145

7.1. General .............................................................................................................. 145 7.2. Characteristics and advantages.......................................................................... 145

III. The relationship between formal rescue and informal workout ........ 147 1. Advantages of informal workouts ........................................................................... 147


9

1.1. Costs .................................................................................................................. 147 1.2. Flexibility .......................................................................................................... 148 1.3. Private autonomy............................................................................................... 149 1.4. Acceptance ........................................................................................................ 149 1.5. International rescues.......................................................................................... 149

2. Preconditions, necessary to initiate informal workouts .......................................... 150 3. Functions of the underlying formal insolvency regime .......................................... 150

3.1. Leverage function.............................................................................................. 150 3.2. Recognition of pre–packed plans under the formal insolvency law ................. 151 3.3. Provision on external advisors .......................................................................... 152 3.4. Additional factors supporting workouts............................................................ 152

3.4.1. Exemption to file a petition during workout negotiations.............................. 152 3.4.2. Availability of adequate security.................................................................... 153 3.4.3. Retention of debtor management ................................................................... 153 3.4.4. Foreign exchange treatment ........................................................................... 153 3.4.5. Lender liability ............................................................................................... 154

4. Dilemmas of workouts and respective solutions..................................................... 154 4.1. Standstill............................................................................................................ 154 4.2. Outside and dissenting creditors ....................................................................... 155 4.3. Post-petition credit ............................................................................................ 156 4.4. Absence of other instruments ............................................................................ 156 4.5. Legal enforceability of the final workout agreement ........................................ 157

5. Minimizing obstacles of private workouts .............................................................. 157 5.1. Private workouts – ex ante and ex post agreements.......................................... 157

5.1.1. Ad hoc or ex-post agreements........................................................................ 157 a. Ex-ante agreements .................................................................................... 158 b. Punishment for non-compliance................................................................. 159

5.1.2. General obligation to participate in workouts ................................................ 160 5.1.3. Consequences for transition economies ......................................................... 161

5.2. Pre-packaged insolvency................................................................................... 161

IV. Statistics and the rate of success............................................................. 163 1. Value of statistics on insolvency proceedings – pros and cons............................... 163 2. Available statistics for some transition economies ................................................. 164

2.1. Asian jurisdictions............................................................................................. 164 2.2. Eastern European jurisdictions.......................................................................... 165

V. The model insolvency codes used as a basis for comparison............... 167 1. Russian Bankruptcy Code ....................................................................................... 167 2. Romanian Insolvency Code .................................................................................... 168 3. Polish Bankruptcy Code.......................................................................................... 169

D. ANALYSIS OF INSOLVENCY KEY ISSUES....................................... 171

I. General Principles ................................................................................... 171 1. The trigger criterion ................................................................................................ 171

1.1. Balance sheet test .............................................................................................. 171 1.2. Cash-flow test.................................................................................................... 172 1.3. Limitations on the scope of the cash-flow test .................................................. 173 1.4. Special types of claims...................................................................................... 174


10

1.5. Protection from abusing filings ......................................................................... 174 1.6. Specific features of rescue proceedings ............................................................ 175 1.7. Prospective insolvency...................................................................................... 176 1.8. Examples ........................................................................................................... 177

2. Scope of the law ...................................................................................................... 178 2.1. Companies and individuals ............................................................................... 178 2.2. All debtors or only merchants ........................................................................... 179 2.3. All companies.................................................................................................... 180

2.3.1. State-owned-enterprises (SOE’s) ................................................................... 180 2.3.2. Other companies............................................................................................. 183

3. Voluntary insolvency proceedings .......................................................................... 184

II. Commencing an Insolvency Case........................................................... 185 1. Limitations and thresholds for creditor filings........................................................ 185

1.1. No-asset-cases ................................................................................................... 185 1.2. Thresholds and other limitations ....................................................................... 186

2. Protection of creditors from abusive filings............................................................ 186 3. Waiting periods ....................................................................................................... 187 4. Who has a right to file a petition ............................................................................. 187

4.1. In liquidation ..................................................................................................... 187 4.1.1. Creditor filings ............................................................................................... 187 4.1.2. Debtor filing ................................................................................................... 188 4.1.3. Other possible petitioners............................................................................... 188

4.2. In reorganisation................................................................................................ 189 5. Duty of the management to file a petition............................................................... 189

5.1. Legal obligation................................................................................................. 189 5.2. Incentives .......................................................................................................... 190 5.3. Examples ........................................................................................................... 190

6. Pre-insolvency debtor protective proceedings & moratoria.................................... 192 6.1. General .............................................................................................................. 192 6.2. Examples ........................................................................................................... 193

7. Provisional Protective Measures ............................................................................. 193

III. Legal Effects of Commencing a Case .................................................... 195 1. Preliminary considerations...................................................................................... 195 2. Stay of any creditor action ...................................................................................... 195

2.1. General functions .............................................................................................. 195 2.2. Scope of the provision....................................................................................... 195 2.3. Effect on secured creditors ................................................................................ 196

3. Prohibition of the debtor to dispose assets .............................................................. 197 4. Estate over all of the debtors assets......................................................................... 198

4.1. Definition .......................................................................................................... 198 4.2. Scope ................................................................................................................. 199

5. Management of the debtor....................................................................................... 200 5.1. In liquidation ..................................................................................................... 200 5.2. In reorganisation................................................................................................ 200

5.2.1. Replacement by administrator........................................................................ 201 5.2.2. Debtor in possession....................................................................................... 201 5.2.3. Stay and supervision....................................................................................... 201 5.2.4. Ex-ante and ex-post view ............................................................................... 202


11

5.2.5. Unitary proceedings ....................................................................................... 203 5.3. Examples ........................................................................................................... 203

6. Recognition of title finance ..................................................................................... 204 7. Insolvency set-off rights and netting....................................................................... 206

7.1. Importance......................................................................................................... 206 7.2. Balancing the objectives.................................................................................... 207 7.3. General design features ..................................................................................... 207 7.4. Netting............................................................................................................... 208 7.5. Carve-outs ......................................................................................................... 208 7.6. Examples ........................................................................................................... 209

8. Contractual termination (“ipso facto”) clause......................................................... 210 8.1. Policy considerations......................................................................................... 210 8.2. Example............................................................................................................. 211

9. Right of the administrator to assume or reject pre-insolvency contracts ................ 211 9.1. General design features ..................................................................................... 212 9.2. Labour contracts................................................................................................ 212 9.3. Examples ........................................................................................................... 213

10. Avoiding Powers (actio pauliana) .......................................................................... 214 10.1. General .............................................................................................................. 214 10.2. Underlying policies ........................................................................................... 214 10.3. Design features.................................................................................................. 215

10.3.1. Liquidation and reorganisation....................................................................... 215 10.3.2. Objective and subjective criteria .................................................................... 215 10.3.3. Categories of preferences ............................................................................... 216 10.3.4. Mitigating preferences.................................................................................... 217 10.3.5. Inclusion of secured transactions ................................................................... 218

10.4. Experiences in transition economies ................................................................. 218 11. Management and shareholder liability .................................................................... 219

11.1. Corporate liability ............................................................................................. 219 11.2. Management liability......................................................................................... 219 11.3. Shareholder liability .......................................................................................... 221

12. Involvement and protection of secured creditors .................................................... 222 12.1. General .............................................................................................................. 222 12.2. Policy considerations......................................................................................... 222 12.3. Excluding secured creditors .............................................................................. 222 12.4. Including secured creditors ............................................................................... 223

12.4.1. Protecting the collateral.................................................................................. 224 12.4.2. Arguments for the inclusion and protection................................................... 225

12.5. Examples ........................................................................................................... 227

IV. Role of the Administrator ....................................................................... 231 1. Rights to propose and recommend an administrator ............................................... 231 2. Rights to dismiss and replace an administrator....................................................... 231 3. Interim administrator............................................................................................... 232 4. Rights, duties and liabilities of the administrator.................................................... 233 5. Standards and qualification requirements of the administrator............................... 234

V. Reorganisation Plan ................................................................................ 235 1. Provision of information ......................................................................................... 235 2. Who can propose a plan .......................................................................................... 235


12

3. Content of the plan .................................................................................................. 237 3.1. General .............................................................................................................. 237 3.2. Content of a plan ............................................................................................... 237 3.3. Debt to equity conversion ................................................................................. 238 3.4. Examples ........................................................................................................... 239

4. Considering diverse interests in the voting system ................................................. 241 4.1. General .............................................................................................................. 241 4.2. Voting system.................................................................................................... 241

4.2.1. Necessary majorities ...................................................................................... 241 4.2.2. Definition of value ......................................................................................... 242 4.2.3. Finality of the voting result ............................................................................ 242 4.2.4. Secured creditors in the voting process.......................................................... 243 4.2.5. Voting in classes............................................................................................. 244

5. Protection of impaired creditors.............................................................................. 246 6. Participation of foreign investors ............................................................................ 246

VI. Priorities and the Treatment of Secured Creditors ............................. 247 1. General remarks ...................................................................................................... 247 2. Priority ladder.......................................................................................................... 248

2.1. Secured creditors ............................................................................................... 248 2.1.1. First priority rule ............................................................................................ 248 2.1.2. Limitations on the first-priority-rule .............................................................. 249

a. Rationale for restrictions ............................................................................ 249 b. Four different scenarios.............................................................................. 250 c. Impact on transition economies.................................................................. 252 d. Interim result .............................................................................................. 253 e. Examples .................................................................................................... 254

2.2. Costs of administration...................................................................................... 258 2.3. Post-petition credit ............................................................................................ 260

2.3.1. General ........................................................................................................... 260 2.3.2. Protection of post-petition creditors............................................................... 260 2.3.3. Examples ........................................................................................................ 261

2.4. Wages, taxes and personal injury claims .......................................................... 262 2.4.1. General ........................................................................................................... 262 2.4.2. Employee salaries and benefits ...................................................................... 262 2.4.3. Tax and state budget claims ........................................................................... 263 2.4.4. Claims for personal injury.............................................................................. 265

3. Priority rules and possible substitutions or limitations ........................................... 266 3.1. General .............................................................................................................. 266 3.2. Devices .............................................................................................................. 267

3.2.1. Social security system .................................................................................... 267 3.2.2. Partial priority ................................................................................................ 268 3.2.3. Weighting of different types of privileges ..................................................... 268 3.2.4. Limitations on privileged claims.................................................................... 268

4. Preferential treatment of small and medium sized creditors ................................... 269 4.1. Priority for creditors irreparable injured by pro-rata treatment......................... 269 4.2. Implementation.................................................................................................. 270

5. Protection of foreign currency creditors.................................................................. 271

E. CONCLUDING REMARKS AND OUTLOOK ...................................... 273


13

Bibliography

Adler, Barry, “A World Without Debt”, 72 Washington University Law Quarterly, 811 (1994)

Aghion, Philippe, Hart, Oliver, Moore, John, “Improving Bankruptcy Procedure”, 72 Washington University Law Quarterly, 849 (1994)

Asian Development Bank, “Law and Development at the Asian Development Bank”, (1999 Edition), Special Report: Insolvency Law Reform in the Asian and Pacific Region (hereinafter cited as: ADB-Report 1999)

Asian Development Bank, “Law and Policy Reform at the Asian Development Bank”, (Volume April 2000), Insolvency Law Reform in the Asian and Pacific Region (hereinafter cited as: ADB-Report)

Baird, Douglas, “The Uneasy Case of Corporate Reorganisations”, 15 Journal of Legal Studies, 127 (1986) (hereinafter cited as: Baird-The Uneasy Case)

Baird, Douglas, Jackson, Thomas, “Corporate Reorganisation and the Treatment of Diverse Ownership Interests: A Comment on Adequate Protection of Secured Creditors in Bankruptcy”, 51 University of Chicago Law Review, 97 (1984) (hereinafter cited as: Baird/Jackson-Corporate Reorganisations)

Baird, Douglas, The Elements of Bankruptcy, (1992) Balfour, Michele, “A Privatisation Test: The Czech Republic, Slovakia and Poland”,

17 Fordham International Law Journal, 84 (1993) Balz, Manfred, “Insolvency Law Reform in the Russian Federation”, unpublished –

on file with the author (hereinafter cited as Balz-Russia) Balz, Manfred, “Market Conformity of Insolvency Proceedings, Policy Issues of the

German Insolvency Law Reform”, 23 Brooklyn Journal of International Law, 167 (1997), (hereinafter cited as: Balz-Market Conformity)

Balz, Manfred, “The European Convention on Insolvency Proceedings”, 70 American Bankruptcy Law Journal, 458 (1996)

Balz, Manfred, Die Ziele der Insolvenzordnung, Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 3

Balz, Manfred, Logik und Grenzen des Insolvenzrechts, ZIP 1988, 1438 (hereinafter cited as: Balz-Logik und Grenzen)

Balz, Manfred, Sanierung von Unternehmen und Unternehmensträgern, 1986 (hereinafter cited as: Balz-Sanierung)

Balz, Manfred, Schiffman, Henry, “Insolvency Law Reform For Economies in Transition – Comparative Law Perspective”, Butterworths Journal of International Banking and Financial Law, January 1996, 19, 27 (hereinafter cited as Balz, Schiffman)


14

Bebchuk, Lucian, “A New Approach to Corporate Reorganisations”, 101 Harvard Law Review, 775 (1988) (hereinafter cited as: Bebchuk-A New Approach)

Bebchuk, Lucian, Fried, Jesse, “The Uneasy Case for the Priority of Secured Claims in Bankruptcy”, 105 Yale Law Review, 857 (1996) (hereinafter cited as: Bebchuk-The Uneasy Case)

Berger, Klaus, Lösungsklauseln für den Insolvenzfall, in Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 375

Bickford, Pamela, Schiffman, Henry, “Bankruptcy Law Reform in Eastern Europe”, 28 The International Lawyer, 927 (1994) (hereinafter cited as: Bickford-Bankruptcy Law Reform)

Bloxham, Peter, “Russia’s New Bankruptcy Law”, Law in Transition Autumn 1998, European Bank for Reconstruction and Development, London 1998

Bosch, Ulrich, Differenz- und Finanztermingeschäfte nach der Insolvenzordnung, in Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 775

Bowers, James, “Rehabilitation, Redistribution or Dissipation: The Evidence for Choosing among Bankruptcy Hypotheses”, 72 Washington University Law Quarterly, 955 (1994)

Braucher, Jean, “Harmonising the Business Bankruptcy Systems of Developed and Developing Nations: Some Issues”, 17 New York Law School Journal of International and Comparative Law, 473 (1997)

Breidenbach, Stephan (Hrsg.), Handbuch Wirtschaft und Recht in Osteuropa Breidenbach, Stephan, Thesen zur Entwicklung des Mobiliarsicherheitenrechts in

Mittel- und Osteuropa, in Drobnig, Ulrich, Hopf, Klaus, Kötz, Hein, Mestmächer, Ernst-Joachim (Hrsg.), Systemtransformation in Mittel- und Osteuropa und ihre Folgen für Banken, Börsen und Kreditsicherheiten, Tübingen 1998, 357 (hereinafter cited as: Breidenbach-Thesen)

Brol, Jan, Das polnische Konkursrecht in der Praxis, Jahrbuch für Ostrecht, 1997 2. Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 305

Brooks, Sidney, “Russia’s Struggle with the Bankruptcy Law”, International Business Lawyer, 468 (1999)

Brown, David, Corporate Rescue, Insolvency Law in Practice, Chichester 1996 Bufford, Samuel, “Bankruptcy Law in Eastern European Countries Emerging from

Communism: The Special Legal and Economic Challenges”, 70 American Bankruptcy Law Journal, 459 (1996) (hereinafter cited as: Bufford-Bankruptcy Law)

Bufford, Samuel, “Romanian Bankruptcy Law: A Central European Example”, 17 New York Law School Journal of International and Comparative Law Review, 251 (1997) (hereinafter cited as: Bufford-Romanian Bankruptcy Law)


15

Bufford, Samuel, “What is Right about Bankruptcy Law and Wrong about its Critics”, 72 Washington University Law Quarterly, 829 (1994) (hereinafter cited as: Bufford-What is Right)

Buxbaum, Richard, Western Support of Law Reform and Codification Efforts of the Countries of the Former Socialist Bloc as Seen from the United States` Viewpoint, in Drobnig, Ulrich, Hopf, Klaus, Kötz, Hein, Mestmächer, Ernst-Joachim (Hrsg.), Systemtransformation in Mittel- und Osteuropa und ihre Folgen für Banken, Börsen und Kreditsicherheiten, Tübingen 1998, 53

Campbell, Dennis, International Corporate Insolvency Law, London 1992 Capatina, Octavian, Länderbericht Rumänien, Jahrbuch für Ostrecht, 1997 2.

Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 335 Carlson, “David, Bankruptcy Theory and the Creditors Bargaining”, 61 University of

Cincinnati Law Review, 453 (1992) Cohen, Steven, “The Tunnel at the End of the Light: Privatisation in Eastern Europe”,

7 Transnational Lawyer 7, 12-17 (1994) Dalhuisen, Jan Hendrik, Compositions in Bankruptcy, Leyden 1968 David, Sorin, Praktische Probleme des Konkursverfahrens in Rumänien, Jahrbuch für

Ostrecht, 1997 2. Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 365

Deloitte Touche Thomatsu Int., Restructuring and Bankruptcy in Central and Eastern Europe, London 1995, (unpublished – on file with the author)

Drukarczyk, Jochen, Schüler, Andreas, Zahlungsunfähigkeit, drohende Zahlungsunfähigkeit und die Überschuldung als Insolvenzauslöser, Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 57

Eckstein, Rosa, “Towards a Communitarian Theory of Responsibility: Bearing the Burden for the Unintended”, 45 University of Miami Law Review, 843 (1991)

Ehrlich, Craig, Lee, Jay, “Governance of Korea’s Chaebols: Role in Crisis, Coming Changes”, East Asian Executive Reports, March 15, 1998

Eidenmüller, Horst, Unternehmenssanierung zwischen Markt und Gesetz, Mechanismen der Unternehmensreorganisation und Kooperationspflichten im Reorganisationsrecht, Köln 1999

European Bank for Reconstruction and Development, “The meaning of transition”, Transition Report 1995, 3

European Bank for Reconstruction and Development, Nicholas Stern, “The transition in Eastern Europe and the former Soviet Union: some strategic lessons from the experience of 25 countries over six years”, Working Paper 18, April 1997 (hereinafter cited as: EBRD-Working Paper 18)


16

European Bank for Reconstruction and Development, Simon Commander, Mark Schankerman, “Enterprise Restructuring and Social Benefits”, Working Paper 22, April 1997 (hereinafter cited as: EBRD-Working Paper 22)

European Bank for Reconstruction and Development, Summary of Major Aspects of the Romanian Insolvency System, London April 2000 (on file with the author)

European Bank for Reconstruction and Development, Summary of Major Aspects of the Russian Insolvency System, London April 2000 (on file with the author)

Falke, Mike, “Community Interests: An Insolvency Objective in Transition Economies?”, Discussion Papers No. 01/02, Frankfurt Institute for Transformation Studies, hereinafter cited as: Falke-Community Interests)

Flaschen, Evan, Timothy Desieno, “The Development of Insolvency Law as Part of the Transition from a Centrally Planned to a Market Economy”, 26 International Lawyer, 667 (1992)

Flessner, Axel, Sanierung und Reorganisation, Insolvenzverfahren für Grossunternehmen in rechtsvergleichender und rechtspolitischer Untersuchung, Tübingen 1982 (hereinafter cited as: Flessner-Sanierung und Reorganisation)

Fletcher, Ian, The Law of Insolvency, 2nd edition, London 1996 Frost, Christopher, “Bankruptcy Redistributive Policies and the Limits of the Judicial

Process”, 74 North Carolina Law Review, 75 (1995) Garrity, James, Ramdhanie, Karen, “Korean Bankruptcy Law: The Heavy Duty

Hypothetical Applied”, 17 New York Law School Journal of International and Comparative Law Review, 267 (1997)

Gobert, Arne, Insolvenzrecht in Ungarn, Zeitschrift für Ostrecht und Rechtsvergleichung 1997, 265

Gottwald, Peter, Adolphsen, Jens, Die Rechtsstellung dinglich gesicherter Gläubiger in der Insolvenzordnung, in Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 805

Gray, Cheryl, “Evolving Legal Frameworks for Private Sector Development in Central and Eastern Europe”, 10-11, World Bank Discussion Papers No. 209, 1993

Gross, Karen, “Taking Community Interests into Account in Bankruptcy: An Essay”, 1994, 72 Washington University Law Quarterly, 1031 (hereinafter cited as: Gross-Community Interests)

Gross, Karen, Failure and Forgiveness – Rebalancing the Bankruptcy System, 1997, Yale University Press (hereinafter cited as: Gross-Failure and Forgiveness)

Guislain, Pierre, “Divestiture of State Enterprises”, 22, World Bank Technical Paper No. 186, 1992

Guitian, Manuel, “Fund Conditionality – Evolution of Principles and Practices”, International Monetary Fund, IMF Pamphlet Series, Washington, D.C. 1981


17

Gutbrod, Max, Vogel, Frank, Das neue russische Insolvenzgesetz – ausgewählte Aspekte, RIW 1999, 37

Habscheid, Edgar, Grenzüberschreitendes (internationales) Insolvenzrecht der Vereinigten Staaten von Amerika und der Bundesrepublik Deutschland, Berlin 1998

Hamer, Ronald, “Insolvency Law and Reform in the People’s Republic of China”, 64 Fordham Law Review, 2563 (1996)

Heidelberger Kommentar zur Insolvenzordnung, Heidelberg 1999 Henckel, Wolfram, Insolvenzanfechtung, in Kölner Schrift zur Insolvenzordnung,

Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 645 Hill, Jonathan, “Comparative Law, Law Reform and Legal Theory”, 9 Oxford

Journal of Legal Studies, 101 (1989) Institute for East-West Studies, “Enterprise Bankruptcy in Russia: Critical

Recommendations for Microeconomic Restructuring” (1993) International Monetary Fund, “Orderly and Effective Insolvency Procedures: Key

Issues”, Washington 1999, www.imf.org/external/pubs/ft/orderly/index.htm Jackson, Thomas, “Avoiding Powers in Bankruptcy”, 36 Stanford Law Review, 725

(1984) Jackson, Thomas, Bankruptcy, “Non-Bankruptcy Entitlements, and the Creditor’s

Bargain”, 91 Yale Law Journal, 857 (1982) (hereinafter cited as: Jackson-Bankruptcy)

Jackson, Thomas, The Logic and Limits of Bankruptcy Law, Cambridge, Mass., 1986 (hereinafter cited as: Jackson-Logic and Limits)

Jehn, Knaul, Das neue russische Insolvenzgesetz, Wirtschaft und Recht in Osteuropa 1998, 340, 376

Kilgus, Stefan, Yayang Setiadarma, Monika, Das neue indonesische Insolvenzrecht, RIW 1999, 47

Kim, Michael, “When Nonuse is Useful: Bankruptcy Law in Post-Communist Central and Eastern Europe”, 65 Fordham Law Review, 1043 (1996)

Lam, Joseph, Kan, Carmen, “Rules and Regulations on Insolvency in China”, Journal of International Banking Law 1999, 351

Landfermann, Hans-Georg, Allgemeine Wirkungen der Insolvenzeröffnung, in Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 127

Laurence, Robert, “The State of Hungarian Insolvency Law”, 17 New York Law School Journal of International and Comparative Law, 495 (1997)

Leif, Clark, “What Constitutes Success in Chapter 11? A Roundtable Discussion”, 2 American Bankruptcy Institute Law Review, 229 (1994)

Lichtblau, Karl, Privatisierungs- und Sanierungsarbeit der Treuhandanstalt, Köln 1993


18

Lowitzsch, Jens, Pacherowa, Paulina, Das novellierte polnische und slowakische Insolvenzrecht, Zeitschrift für Ostrecht und Rechtsvergleichung 1998, 211

Maus, Karl-Heinz, Der Insolvenzplan, Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 707

Paulus, Christoph, Der Internationale Währungsfond und das internationale Insolvenzrecht, IPrax 1999, 148 (hereinafter cited as: Paulus-Der Internationale Währungsfond)

Paulus, Christoph, Ein Spannungsfeld in der Praxis: Sanierung und Insolvenzanfechtung, Betriebs-Berater 2001, 425 (hereinafter cited as: Paulus-Ein Spannungsfeld)

Paulus, Christoph, Entwicklungslinien des Insolvenzrechts, KTS 2/2000, 239 (hereinafter cited as: Paulus-Entwicklungslinien)

Paulus, Christoph, Verbindungslinien des modernen Insolvenzrechts, ZIP 49/ 2000, 2189 (hereinafter cited as: Paulus-Verbindungslinien)

Paulus, Christoph, Zum Verhältnis von Aufrechnung und Insolvenzanfechtung, Zeitschrift für Wirtschaftsrecht, 1997, 569 (hereinafter cited as: Paulus-Aufrechnung und Insolvenzanfechtung)

Pfaff, D., Linsmeier, P., Das Insolvenzrechts Osteuropas (Polen, Rumänien, Russland, Slowenien, Tschechien, Ukraine, Ungarn), Wirtschaft und Recht in Osteuropa, 2/1998, 41

Popova, Valentina, Das Insolvenzverfahren nach bulgarischem Recht, Jahrbuch für Ostrecht, 1997 1. Halbband, 37

Prütting, Hanns, Allgemeine Verfahrensgrundsätze der Insolvenzordnung, in Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 183

Rajski, Jerzy, Privatisation in Poland, in: Privatisation in Central and Eastern Europe 35, 48, 1992

Ramasastry, Anita, “Central and Eastern Europe and the Commonwealth of Independent States – Bankruptcy Law Reform: Recent Studies of Trends and Developments”, Butterworths Journal of International Banking and Financial Law 1998, 195

Report of the Working Group on International Financial Crisis, October 1998, G-22-Report, www.imf.org/external/hp/g22/ifcrep.pdf

Riley, “Borrowing with Security in China”, 10 Journal of International Banking Law, 428 (1995)

Roggemann, Herwig, Funktionswandel des Eigentums in Ost und West – vergleichende Anmerkungen zur postsozialistischen Transformation in Ost- und Westeuropa, Zeitschrift für Ostrecht und Rechtsvergleichung, 1997, 189, 225


19

Scarberry, Mark, Klee, Kenneth, Newton, Grant, Nickles, Steve, Business Reorganization in Bankruptcy, Cases and Materials, St. Paul, Minnesota 1996

Schermer, Barry, “Response to Professor Gross: Taking the Interests of the Community into Account in Bankruptcy – A Modern-Day Tale of Belling the Cat”, 72 Washington University Law Quarterly, 1049 (1994)

Schiffman, Henry, “Model Provision For Commercial Bankruptcy Law For Economies in Transition”, Butterworths Journal of International Banking and Financial Law, March 1999, Special Supplement

Schwerdtner, Peter, Der Sozialplan im Eröffnungsverfahren und nach der Verfahrenseröffnung, Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 1127

Slawinski, Ilona, Geistlinger, Michael (Hrsg.), Probleme der Rechtsüberleitung in der Tschechischen Republik, Ungarn, Polen und der Slowakischen Republik, Bern 1997

Smid, Stefan, Das Insolvenzverfahren in den Beitrittsstaaten, Wirtschaft und Recht in Osteuropa, 2000, 393 (hereinafter cited as: Smid-Das Insolvenzverfahren)

Smid, Stefan, Die Haftung des Insolvenzverwalters in künftigen deutschen Insolvenzrecht – Kontinuität und Diskontinuität des Rechts der Haftung des Insolvenzverwalters, in Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 337 (hereinafter cited as: Smid-Haftung des Insolvenzverwalters)

Smith, Timothy John, “Hungary Irons out Insolvency Wrinkles”, 28 International Corp. L., 58 (1993)

Tabalujan, Benny, “Issues in Insolvency Law – Indonesia, International Briefings”, Butterworths Journal of International Banking and Financial Law 1998, 199

Taibi, Anthony, “Banking, Finance, and Economic Empowerment: Structural Economic Theory, Procedural Civil Rights and Substantive Racial Justice”, 107 Harvard Law Review, 1463 (1994)

Török, Gabor, Länderbericht Ungarn, Jahrbuch für Ostrecht, 1997 2. Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 377

Triantis, George, “The Careful Use of Comparative Law Data: The Case of Corporate Insolvency Systems”, 17 New York Law School Journal of International and Comparative Law Review, 193 (1997)

Trunk, Alexander, Internationales Insolvenzrecht – Systematische Darstellung des deutschen Rechts mit rechtsvergleichenden Zügen, Tübingen 1998

Trunk, Alexander, Stand und Probleme des Insolvenzrechts in Ost-, Mittelost- und Südosteuropa, Jahrbuch für Ostrecht, 1997 2. Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 233 (hereinafter cited as: Trunk-Stand und Probleme)


20

Uhlenbruck, Wilhelm, Das neue Insolvenzrecht, Insolvenzordnung und Einführungsgesetz nebst Materialien, Berlin 1994 (hereinafter cited as: Uhlenbruck-Neues Insolvenzrecht)

Uhlenbruck, Wilhelm, Die Rechtsstellung des vorläufigen Insolvenzverwalters, Kölner Schrift zur Insolvenzordnung, Hrsg. Arbeitskreis für Insolvenz- und Schiedsgerichtswesen e.V., Köln 1997, 240 (hereinafter cited as: Uhlenbruck-Rechtsstellung des vorläufigen Insolvenzverwalters)

Varanese, James, Westphal, Antje, “Debt-for-Equity: The Czech Republic’s Swapping for Survival Game”, 5 Survey of East European Laws, April 1994

Virgos, Miguel, “The 1995 European Community Convention on Insolvency Proceedings: an Insider’s View”, Forum Internationale, March 1998, No.25

Vitrjanskij, Vasilij, Anwendungspraxis und Verbesserungsbedürftigkeit des Russischen Insolvenzrechts, Jahrbuch für Ostrecht, 1997 2. Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 257 (hereinafter cited as: Vitrjanskij-Anwendungspraxis)

Vitrjanskij, Vasilij, Länderbericht der Russischen Förderation, Jahrbuch für Ostrecht, 1997 2. Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 247 (hereinafter cited as: Vitrjanskij-Länderbericht)

Warren, Elizabeth, “Bankruptcy Policy”, 54 University of Chicago Law Review, 775 (1987)

Warren, Elizabeth, “Bankruptcy Policymaking in an Imperfect World”, 92 Michigan Law Review 1993, 336 (hereinafter cited as: Warren-Bankruptcy Policymaking)

Warren, Elizabeth, Westbrook, Jay, The Law of Debtors and Creditors, 2nd edition 1991

White, Michelle, “Does Chapter 11 Save Economically Inefficient Firms?”, 72 Washington University Law Quarterly, 1319 (1994)

Will, R., Eigentumstransformation unter dem Grundgesetz, Antrittsvorlesung an der HU Berlin, 29.Juni 1995, Berliner Debatte: Initial, Heft 7/1996

Wiston, Kenny, “The Flavour of Indonesia’s new Bankruptcy Law – too hot or too plain in the UK?”, Insolvency Law & Practice 1999, 197

Wolfe, Marshall, Elusive Development, 1996 Wood, Philip, “Principles of International Insolvency”, 4 International Insolvency

Review 94, 109 (1995) (hereinafter cited as: Wood-Principles) Wood, Philip, Principles of International Insolvency, London 1995 (hereinafter cited

as: Wood-International Insolvency) World Bank, “Latin American Insolvency Systems: A Comparative Assessment”,

World Bank Technical Paper No. 433


21

World Bank, “Principles and Guidelines for Building Effective Insolvency Systems and Debtor-Creditor Regimes”, World Bank Insolvency Initiative, www1.worldbank.org/legal/insolvency_ini.html (hereinafter cited as: WB-Towards Principles)

World Bank, Building Effective Insolvency Systems, “Institutional Alternatives to Insolvency for Developing Countries”, Washington 1999 (hereinafter cited as: WB-Institutional Alternatives)

World Bank, Building Effective Insolvency Systems, “Rehabilitation”, Washington 1999 (hereinafter cited as: WB-Rehabilitation)

World Bank, Building Effective Insolvency Systems, “State-Owned Enterprise Insolvency: Treatment of Financial Distress”, Washington 1999 (hereinafter cited as: WB-SOE Insolvency)

World Bank, Building Effective Insolvency Systems, “The Economic Dimension”, Washington 1999 (hereinafter cited as: WB-Economic Dimensions)

World Bank, Building Effective Insolvency Systems, “The Legal Framework”, Washington 1999 (hereinafter cited as: WB-Legal Framework)

Zedler, Feliks, Länderbericht Polen, Jahrbuch für Ostrecht, 1997 2. Halbband, Themenband: Insolvenzrecht in Deutschland und Osteuropa, 287

Zuy, Eric, “Russia and the CIS – Recent Developments in Bankruptcy Law”, Butterworths Journal of International Banking and Financial Law 1998, 469

Zweigert, Konrad, Kötz, Hein, Einführung in die Rechtsvergleichung, 3nd edition, Tübingen 1996


22


23

A. Introduction Following the financial crisis in several emerging markets in 1997-98, there has been a broad international consensus on the need to strengthen the international financial architecture in several areas, all of which impact on insolvency systems: enhancing transparency and promoting standards or best practises; strengthening country policies, financial systems and institutional foundations; involving the private sector in crisis prevention and resolution; and strengthening and reforming international fora. Insolvency systems and their supporting institutions are of critical importance to enable countries to achieve the benefits and avoid the pitfalls of integration with the international financial system.1 During earlier periods of rapid growth, governments could afford to bail out failing businesses and banks continued to extend credit with implicit or explicit government encouragement, regardless of repayment risk. This widely applied policy led to over-indebtedness of whole parts of economies and endangered the financial system not only of the relevant country. In these expanding credit markets the significance of effective insolvency systems was little understood and largely ignored. With credit markets tightening and enterprises struggling to survive, and globalisation changing international competition, the challenge we face today is to reinvigorate insolvency systems to promote the restructuring of viable businesses and the efficient closure and transfer of assets of failed businesses.2 Development of universal, international approaches and policies for insolvency laws is the current subject of the World Bank Insolvency Initiative.3 The World Bank, along with other international financial institutions4 (IFI’s) and other organisations5, is committed to identify principles and guidelines for sound insolvency systems and related debtor-creditor regimes.

1 Paulus refers to insolvency law as the “constitution of commercial laws”, Paulus-Der Internationale Währungsfond, 148 2 IMF-Toward Principles, A 3 World Bank, Building Effective Insolvency Systems 4 See for example Asian Development Bank, Law and Policy Reform at the Asian Development Bank, Insolvency Law Reforms in the Asian and Pacific Region, Manila 2000 5 G 22, Report of the Working Group on International Financial Crisis, Washington 1998; International Bar Association, Committee J, Bankruptcy Legislation Subcommittee, Model Insolvency Law; United Nation Commission on International Trade Law (UNCITRAL), Report on UNCITRAL-INSOL-IBA Global Insolvency Colloquium (Vienna, 4-6 December 2000)


24

In this regard the legal department of the International Monetary Fund6 has recently published a paper on many of the general objectives and features of insolvency procedures. The European Bank for Reconstruction and Development is also working intensively on insolvency issues in several Central and Eastern European Countries. In addition to the work of those IFI’s, a great number and variety of scholars and practitioners are involved in relevant reform discussions and projects. The debate may focus on a national insolvency system or may cover a whole region or economic system. For example, the political change in many former socialist countries in the late 1980’s and early 1990’s towards a market-based economy required the creation or re-establishing of insolvency laws in many jurisdictions.7 Western countries have attempted, and still attempt8, to influence the political direction of transition economies by persuading these countries to adopt principles of their commercial laws without considering the incompatibilities between their legal systems. These developments have also influenced the reform process of many transition economies. On the other hand, several transition economies confidently developed their own insolvency regime and attempted to adjust it to their current needs. However, many of these attempts have revealed shortcomings and provide further impetus for the topic of this paper.

I. Relevance of the Topic The topic of this paper is not only of academic importance, but also has enormous practical relevance. The existence of a well-functioning insolvency regime contains an important economical dimension, particularly for economies in transition. In analysing these economical impacts it is helpful to distinguish between micro- and macroeconomic dimensions. The microeconomic dimensions deal with the simple situation of a market participant being unable to pay its debts. In Central and Eastern Europe, for example, where the prevailing

6 International Monetary Fund, Orderly and Effective Insolvency Procedures: Key Issues, Washington 1999; See also Paulus-Der Internationale Währungsfond, 148-152 7 See for an insight on the political background, Paulus- Der Internationale Währungsfond, 148 8 See for an overview on western assistance in legal reform projects: Buxbaum-Western Support of Law Reform and Codification Efforts of the Countries of the Former Socialist Bloc as Seen from the United States` Viewpoint, in Drobnig, Hopt, Kötz, Mestäcker, Systemtransformation, 53


25

command economies collapsed and were replaced by market-style economies, effective insolvency systems are required to take account of the large number of insolvent state-owned enterprises (hereinafter referred to as SOE’s). In macro-economic terms, by way of example, we can refer to the regional economic crisis that has recently affected many economies in Asia. This phenomenon exposed, amongst many other things, the inadequacy of corporate insolvency law regimes or their application in many of those economies. In times of rapid growth the significance of functioning insolvency systems was largely ignored because banks and other creditors could extend credit without repayment risk and governments could afford to bail out failing debtors. An effective and functioning insolvency regime represents an important mechanism in the prevention and resolution of a regional or even international (financial-) crisis. In addition, insolvency issues become more and more decisive in the ongoing globalisation of capital and financial markets. Transition economies, in this context commonly referred to as emerging markets, are in favour of many investors. The attraction of foreign capital is often crucial to the sustainable development of those countries. The insolvency regime provides the investor with predictability and transparency in order to allocate the risk of his investment decision. The absence of an effective insolvency regime will have an adverse impact on the future availability of credit and foreign capital. Although many transition economies have already addressed problems related to their insolvency regime, recent international discussion and the related surveys and observations show that this process will continue in the future. Other less developed countries will first emerge to a transition stage and subsequently deal with the reform of their insolvency regime in order to catch up with the development of other transition economies.

II. Methodology

1. General The intention when writing this paper was mainly to provide a broad overview of core issues that arise when reforming insolvency systems in transition economies. The author was aware of the choice to either discuss and observe isolated issues in depth, or rather review a wider range of issues in a more descriptive manner. The justification for a broader approach is obvious: Firstly, the many issues at stake. Secondly, the likely readers of the paper are not only academics but also lawyers, other


26

professionals, officials and policy makers actually involved in the reform process in transition economies – therefore it is useful to provide a broad overview of a variety of relevant problems. Thirdly, core issues are considerably variable among transition economies as transition economies vary considerably; what might be worth discussing in more depth in one country might be less relevant in another jurisdiction. Finally, the approach provided an avenue to keep the paper practical and more comprehensible.

2. Comparative element By reviewing the different problems of several transition economies on a comparative basis mainly with Germany and the US, the paper attempts to avoid a reflection of the national insolvency debate ongoing in those reference countries. In particular, the respective discussion in the US and Germany centres on several highly sophisticated issues that is only of limited significance for transition economies. As we will see in the following discussion the economical, social and political development of a country directly influences the demands on its insolvency law. Consequently, issues at stake in highly developed market economies may differ considerably from those of transition economies. However, offering some insights into this national debate is sometimes necessary since these, especially the US-Bankruptcy Code and the German Insolvency Code, have heavily influenced reform attempts in transition economies.9 Accordingly, some current developments and reform discussion in those jurisdictions might be of particular relevance for transition economies which have adopted the principles, institutions or structures of these systems. Therefore, the paper reviews relevant issues more extensively. On the other side, the paper refers to a variety of transition economies mainly in Central and Eastern Europe and Asia. However, a more detailed comparative analysis is provided for the insolvency legislation of the Russian Federation, Poland and Romania.10 The applied legislation is recent, mainly dated 1999-2000. However, one has to be aware that in the area of insolvency law there prevails a fast changing development, particularly in transition economies.

9 See Bufford-What is Right, 829:”Although our Constitution and Bill of Rights traditionally have been our most important legal exports, Chapter 11 of our Bankruptcy Code has become the next most important in recent years. Bankruptcy reorganisation is an idea that is especially popular in Eastern Europe, including Russia.”; The German Insolvency Code influenced the reform for example in Bulgaria, Romania, Russia and Moldavia 10 For a more detailed introduction of the Russian, the Romanian and the Polish Code see C.V.


27

The paper is generally comparative in its approach – it discusses problems theoretically and then refers to relevant national insolvency laws to compare and analyse prevailing solutions. Thereby, it tries to make use of one of the main functions of comparative law, namely to inform domestic law reform by evaluating the experience of foreign systems.11 A comparative approach of insolvency issues is nothing new and one might wonder why it has become increasingly fashionable to analyse insolvency laws from a comparative perspective. Besides many other reasons, in the last decade insolvency law has become an efficient tool for economical development.12 This function, in turn, is from an overwhelming necessity to foster and stabilise social progress, particularly in transition economies. There, whole economies have to be reorganised and restructured, assets have to be distributed according to the new agenda and closely connected social, economical and political goals have to be met.

3. A legislator’s perspective The paper views the discussed issues from a potential legislator’s point of view, whereby the benefits and repercussions of respective policy decisions will be analysed in the context of the particular economical, social and political needs of the jurisdictions in question. In particular, the paper attempts to illustrate these issues by reference to case studies and the various advantages and shortcomings associated with different legislative approaches. The aim of the thesis is to discuss the policy objectives a potential legislator is facing in a country seeking to reform its insolvency regime and to offer guidelines that support good practise standards in the countries in question. In doing so, the paper does not intend to promote a unified approach to insolvency but rather to reflect the diversity of circumstances prevailing in different countries. Furthermore, the paper attempts to articulate a comprehensive statement concerning the various and competing goals that underlie the insolvency system, particularly in a transition economy. To illustrate those theoretical results, the thesis contains some statistical surveys with reference to certain key questions. For example, in certain model jurisdictions the number of initiated proceedings over a longer period of time will be assessed and statistically outlined.

11 Triantis-The Careful Use, 193 12 Trunk-Stand und Probleme, 233; Paulus refers to it as the Fluchtpunkt of the commercial law, see Paulus-Verbindungslinien, 2189


28

III. Expectations The author had several expectations when starting to work on this paper. Firstly, the author wanted to find out and prove that transition economies have, according to their prevailing situation, different needs and demands on their insolvency law. Consequently, the insolvency law of those countries needs to address several other goals than their Western counterparts. It is, for example, in those countries more important for the insolvency law to adjust shortcomings of the general social system than it is in modern market economies. Moreover, caused by an exorbitantly high share of financially distressed state-owned enterprises it might be justifiable to favour in general reorganisation over liquidation proceedings. Secondly, it was felt that this difference may decrease with the progressing economical and social development of those countries. In other words, a more highly developed transition economy may have an insolvency law more similar to those which are prevailing in Western market economies. Another fact which was anticipated related to similarities frequently found in many insolvency laws of transition economies. Certain elements or components of those laws may be conditioned by the transition status of those countries. Moreover, the author wanted to point out provisions which might be unnecessary under the current stage of these economies and which negatively affect the overall development towards a well-functioning market economy. A further concern of this paper was to demonstrate mechanisms in the insolvency law which are workable means to serve the needs of the transition process but, at the same time, do not extensively interfere with other, mainly creditor, rights. The paper intends, for example, to put forward methods to reduce the negative impact of extensive priority ladders. As a result, the author expects to identify several key elements that should form the basis of any insolvency regime. Furthermore, the outcome of the research is likely to identify certain issues which will be of more importance for transition economies than for developed countries and vice versa.


29

IV. Scope of the paper

1. Exclusions The scope of the paper is limited to a number of important issues. It mainly focuses on corporate insolvencies rather than insolvencies of natural persons. The project deals with general insolvency issues, but the main focus is on various rescue models and the related questions, they pose. Main concerns are thereby the relevant substantive issues even if procedural provisions may be similarly important. The paper does not include insolvency issues faced by national or local governments nor of banking and financial institutions. To further narrow the topic, the paper does not discuss the institutional and regulatory frameworks which need to supplement the legal framework of an insolvency regime. Neither does the thesis contain detailed comments on the important but comprehensive relationship between corporate governance and insolvency13 nor on the relationship of security and insolvency. It will, however, briefly refer to those issues where it becomes relevant in the context of the paper. It further excludes the important and highly topical debate on conflict of law issues in insolvency.14

2. Inclusions On the other hand, the thesis is not limited to formal or legislative insolvency proceedings but also analyses out-of-court workouts and similar techniques. In doing so it questions the relationship between formal proceedings and informal workouts and attempts to present mechanisms of the formal regime which may encourage or discourage participants in transition economies to make use of such informal rescue alternatives. Furthermore, the author is aware of the fact that the study of insolvency law cannot be addressed in isolation as insolvency law will normally both influence and be influenced by a large number of economic, legal, commercial, social and cultural considerations. It is therefore essential to reflect those very different issues throughout the entire paper. For example, are there any objectives to consider other than the pure economical outcome for the concerned creditor? In transition economies the problems of insolvent state-owned enterprises, for example, can play a critical role and might well affect social welfare or even political stability in the country concerned.

13 See therefore Paulus-Verbindungslinien, 2189-2191 14 See in relation to the UNCITRAL Model Law on Cross-border Insolvency, Paulus-Der Internationale Währungsfond, 148-152


30

V. Synopsis The paper is broadly divided into two parts. The first part is descriptive in nature and provides some essential definitions, theoretical foundations and a general contextual discussion on the topic. In its second part, the paper analyses, compares and discusses several key provisions which are regarded as being of outstanding importance for the insolvency regime in transition economies. The first part begins with a general discussion of the necessity of an insolvency law in a credit-based economy, the connected policy choices a legislator has to balance and refers subsequently to the general objectives of the insolvency regime. There, the paper will set the fundamental angles for discussion throughout the whole paper. The objectives of asset maximisation for creditors and the protection of community and other social aspects, for example, seem to be contrary and of divergent importance for Western and transition economies. Thereby, the different needs and prevailing circumstances are analysed and evaluated in order to make both positions more clearly understandable. In a further step, the relevance of insolvency laws for transition economies is examined more closely. In doing so the term transition economy is defined for the purpose of the paper and a discussion about the historical causes of the importance of insolvency law is included. It follows a study of characteristics of insolvency in transition economies. Here, the paper makes reference mainly to the low number of filings and the high number of insolvent state-owned enterprises dominating the insolvency process in many transition economies. Subsequently it follows some examples showing how several transition economies have reacted to these serious obstacles. These examples are mainly administrative quasi-liquidations enacted by several transition countries to cope with the exorbitant amount of heavily indebted and insolvent state-owned enterprises. The following subsections consider the frequently used labels of ‘pro-creditor’ and ‘pro-debtor’ regimes and also discuss the moral hazard aspect related to policy making in the area of insolvency law. The debate then turns to the relation between privatisation and insolvency law; a highly important field especially for economies in transition. The ongoing discussion leads to the analysis of the insolvency law and its interrelationship with other legal and social elements and raises the question of the need for a general consistency of the insolvency law with economical, social, political and other elements prevailing in the given society. Consequently, the question of its comparability of the insolvency regime of a Western market economy with the one of a transition economy becomes debatable.


31

A further part is dedicated to definitions of frequently used terms like liquidation, quasi-liquidation, going-concern-sale, rescue, workout, and pre-insolvency procedure. Main attention is thereby paid to rescues and informal workouts. When discussing informal workouts a more detailed analysis is drawn to several structured workout initiatives of some Asian countries. The underlying question is whether such alternative instruments may be of interest for other transition economies? The next subsection analyses the relationship between liquidation and rescue proceedings. In doing so, an initial question concerns their objectives and the general rate of success of rescue proceedings. In a further step, the discussion turns to the matter of how to balance the insolvency law in relation to liquidation and reorganisation. Under prevailing economical theories the insolvency law should deal with liquidation and reorganisation on an equal basis, without preferring one procedure to another. According to those theories the final outcome for creditors is supposed to be the only measure determining the applicable procedure. However, as pointed out in more detail, the theories cited might be insufficient to cope with the situation in transition economies. Within this context, the discussion refers to several substantial and procedural instruments which might be able to promote and stimulate rescue proceedings. Subsequently, the discussion turns to analyse the relationship between formal rescue proceedings and informal workouts. At the outset, advantages and disadvantages of workouts in comparison to formal rescues are examined. It then follows some remarks concerned with the instruments of the formal insolvency regime having the potential to promote and foster out-of-court workouts. However, beside several advantages, workouts are also characterised by their obstacles and shortcomings. The paper briefly discusses those shortcomings and then presents some solutions for the interested parties. A more detailed examination deals particularly with ex-ante and ex-post workout agreements and pre-packed insolvencies. The last subsection of the descriptive part is concerned with statistics in insolvency and its value for a macro- or microeconomic analysis of economies. Even when the offered statistics of insolvency proceedings of some transition economies are hardly complete, the paper attempts to draw some explanations from them. The second part attempts to analyse elements of the formal insolvency law which are supposed to be of special significance for transition economies. The first subsection evaluates some general principles and their impact on the transition process. Here, the paper deals with the right trigger criterion and the scope of the law.


32

Thereby, it questions whether and to what extend SOE’s should be subject to the formal insolvency regime. The next step leads to issues concerned with the commencement of proceedings. Here, we consider for example the necessity of limitations and thresholds for creditor filings, waiting periods and other protective measures. The author tries to identify the initial petitioner, questions whether the management of the debtor should have a duty to file for proceedings and, finally, analyses possible and necessary pre-insolvency debtor protective proceedings and provisional protective measures for the creditors. The next section is concerned with the legal effects of the commencement of proceedings. In doing so, the paper examines different stay provisions, the scope of the debtor estate, the shifting of execution powers to the administrator, the treatment of the debtor management, the recognition of title finance and set-off, executory contracts, preferences and avoidance rules, management and shareholder liabilities and, finally, the inclusion and protection of secured creditors. As becomes apparent from the number of issues covered, this section contains an extensive discussion on a great variety of subjects. Since it is impossible to list the great variety of subjects, dealt with in this section, one may refer only to one point, normally of significant importance to transition economies: Whether or not to generally include or exclude secured creditors from insolvency proceedings. This is a question of outstanding significance mainly but not only for the success of prospective rescue attempts. Internationally there are broadly two methods to deal with the issue: Some jurisdictions which exclude secured creditors with the consequence, that they may enforce their individual security interest during insolvency proceedings, thereby possibly limiting the chances for a successful rescue. Or jurisdictions which generally include secured creditors and thereby interfere with the contractual rights of them. The discussion attempts to offer some guidance and solution to this dilemma, especially when addressed to the unique situation of transition economies. The next subsection is mainly concerned with the role of the administrator and the reorganisation plan. Thereby, the paper analyses issues like the initial proposal for a reorganisation plan, the requirements on the content of a plan, the availability of debt to equity swaps and the voting system on a plan. This section concludes with a brief discussion on the protection of impaired creditors and the participation of foreign creditors. The last section discusses the priority system and the related treatment of secured creditors. In doing so, the first priority rule for secured credit is questioned and the applicability of a partial priority rule for certain circumstances is examined. Subsequently, several other creditor types and their respective ranking in the distribution process are analysed. Thereby, the paper distinguishes mainly between insolvency costs and post-petition credit, on one hand, and other frequently found priorities on the other.


33

Nevertheless, even if those other priorities are not in the favour of Western scholars and officials, they may have some significance for the transition period of the reviewed countries. Finally, the thesis concludes with a discussion on several alternative measures which may rebalance the negative impact of a strict and extensive priority system.


34


35

B. Definitions and theoretical fundamentals

I. The relevance of insolvency laws in a market economy

1. Definition and introductory remarks Organised societies have encountered the need to provide some system of rules and procedures for regulating the phenomenon of insolvency. In the classic sense, insolvency is a state of affairs under which a debtor is financially incapable of meeting all liabilities and obligations that are presently or potentially exigible, having regard to the assessed value of all species of assets which properly belong to the patrimony of that debtor. When a balance sheet is drawn up, measuring the amount of current and future liabilities against the value of the assets, the former exceed the latter with the consequence that the debtor’s net estate must be expressed in terms of a negative sum of money.15 Causes for this situation might be manifold and range from internal factors such as poor management, extended internal factors like product liability to external factors such as increasing competition or the overall economic situation of the country in question. As we will see in the forthcoming discussion, transition economies encounter different challenges due to the unique status of their economic, political and social development.16 The phenomenon of insolvency only ever emerges in a credit system, one of the characteristics of a market economy. If market participants could obtain goods and services only on a cash basis or for comparable equivalents as in traditional barter systems, there would be no debt and therefore no need for an insolvency system. As we will learn from the later17analysis, transition economies have in common that they are progressing towards market-based economies. Under a planned economy system, with mainly state-owned businesses and without private property rights and market rules, an insolvency system is widely unnecessary. In the absence of any insolvency system a creditor of the illiquid or over-indebted debtor would have only two options: he could seize available collateral if the credit was secured; or he could try to enforce his contractual repayment right via a judicial execution order with the prospect of selling parts of the debtor’s assets.

15 WB-Towards Principles, 1 16 See B.II. 17 See B.II.1.


36

This method of debt collection runs into difficulties when there are many unpaid creditors and the debtor’s assets do not cover existing liabilities.18 Following the rules of the market, creditors would start a “race to the court house door”19 in order to recover their claims from the remaining assets of the debtor. This would ultimately lead to a dismantling of the firm’s assets and a total loss of value for all creditors.20 The obvious need to coordinate and organise this collection process results in an insolvency system, existing in almost every jurisdiction.21 Consequently, most of the market-based economies in the world provide for liquidation proceedings. But they frequently22 have another statutory alternative to final liquidation.23 In other words, irrespective of the very different approaches to individual elements of insolvency procedure, one can group them into two categories: a formal or informal asset sale or cash auction on one hand and a structured bargaining on the other.24

1.1. The asset sale or “liquidation” option The asset-sale-option consists mainly of a piece-meal sale of the available assets or a sale of the enterprise as a going concern, depending on the expected outcome of the procedure.25 This approach is commonly justified by economic26 and legal theories. Economical theories require that an uncompetitive market participant unable to perform its obligations should be removed from the market place and the remaining assets distributed to a more efficient and productive use. Legal theory supplements this by maintaining that such a process can only function effectively if it is regarded as a collective process, balancing and considering the different interests involved. The combination of these theories has developed the liquidation process as the necessary basic component of a corporate insolvency law regime.27

18 See for a discussion on the common pool problem of insolvency: Baird-The Uneasy Case, 132; Baird, Jackson-Corporate Reorganisations, 107; Jackson-Logic and Limits, 10; Balz-Logik und Grenzen, 1438; Balz-Market Conformity, 171 19 Wood-International Insolvency 20 WB-Economic Dimensions, 1; Smid-Das Insolvenzverfahren, 393: The absence of a functioning insolvency system may even lead to civil war – as Albania experienced in 1997 after several gambling companies collapsed; The creditors bargaining model, developed by Baird and Jackson, views insolvency against the backdrop of non-insolvency debt collection rules, which would in the absence of a collective proceeding lead to a destructive race under execution laws and result in the value-destroying piecemeal liquidation of the business, See: Baird-The Uneasy Case, 133; Baird/Jackson-Corporate Reorganisations, 107 21 Baird/Jackson-Corporate Reorganisations, 105; WB-Legal Framework, 1 22 Wiston-The flavour, 200: The Indonesian Bankruptcy Code does not contain any provisions for a corporate rescue 23 WB-Legal Framework, 1 24 Aghion-Improving Bankruptcy, 855; Braucher-Harmonising the Business Bankruptcy, 477 25 WB-Economic Dimensions, 3; for a “pure” economic approach also: Baird/Jackson-Corporate Reorganisations, 109; Balz-Market Conformity, 168; Aghion-Improving Bankruptcy, 855 26 An economical theory of the law provides: Baird/Jackson-Corporate Reorganisations; Baird-The Uneasy Case; Jackson-Logic and Limits; Bebchuk-A New Approach; Balz-Logik und Grenzen; Aghion-Improving Bankruptcy 27 ADB-Report, 16


37

1.2. The structured bargaining or “rescue” option The usually more sophisticated structured bargaining is a process where creditors determine the future of the debtor enterprise according to a prescribed procedure. Creditors are typically divided into classes depending on their type of claim (secured, priority, unsecured, subordinated or equity). They bargain28 about the future of the debtor, determine a plan which can propose the liquidation or reorganisation of the debtor and vote on the plan. Usually a majority can bind dissenting creditors.29 Economical theory maintains also that not every player who fails should be immediately removed from the market. Failing debtors with the potential and the prospect of survival should be given a chance to reorganise their business accordingly. Legal theory requires a rescue law which provides for easy access to the process, protection for all involved, a structure for negotiations, a binding force of a majority vote and effective judicial or other supervision.30 Furthermore, an essential feature of both options is the stay of individual creditor action and their replacement by a collective debt collection process. All assets of the insolvent debtor belong to a pool (estate) which is available to pay creditor claims. Thereby creditors are paid pari-passu, i.e. pro rata, out of the assets according to the value of their claims. As we will see, the latter two propositions are the ideal, often eroded and outstripped by economical, social or political needs within a jurisdiction.31

1.3. Economical function of the process According to this, the basic function of insolvency law is perceived as the correction, through collective action, of the market failure caused by the large number of unrelated actors (claimants) and their asymmetric information about the state of the debtor’s affairs, about their respective behaviour and about the options for maximising the value of the insolvent’s estate.32 The role of the insolvency process is to organise the collective action in such a way that the value of the debtor’s assets will be maximised and that every one, ideally, will be better off than without such action. In other words, to collectivise and rationalise debt collection.33

28 For the terminology see: Jackson-Bankruptcy, 857 29 WB-Economic Dimensions, 3 30 ADB-Report, 17 31 Wood-Principles, 95 32 Balz-Market Conformity, 171; Balz-Sanierung, 35 33 Balz-Market Conformity, 171; Baird-The Uneasy Case, 131


38

However, as we will notice in the forthcoming discussion34, such a view is heavily creditor focused and may to some extent ignore the perspective from debtors and affected communities.35

2. Policy Choices Designing and redesigning an insolvency system, in today’s complex and rapidly changing commercial environment, is a process of making and balancing difficult policy choices. Even when several objectives collide with each other, the overall objective should be to form a coherent system in itself that is in line with the wider social goals of the legal and cultural system of which it is a part. The law should therefore reflect the value system which is currently regarded as providing the social consensus in that society.

2.1. Reflection of prevailing principles and needs As a starting point, the insolvency law should consider the different expectations of market participants in a commercial relationship. A creditor who extends credit on a voluntary basis should be aware of the risk of a potential inability to repay the debt by his debtor. On the other hand, the debtor should be in a position to know the rights and options, the creditor has in the case of non-repayment of the debts owned. What is therefore required is a clear, predictable and transparent insolvency process which enables both debtor and creditor to calculate the consequences in the event insolvency actually occurs. Beside the normal difficulties in a commercial relation, the insolvency law should be able to respond to abnormal or systemic disturbances of the credit system which threaten the entire credit system or even the whole economy.36 Any policy considerations will firstly require an assessment and analysis of the commercial and economic environment and the socio-legal context into which the insolvency law will be implanted. The outcome of this analysis gives answers to the needs of the society as a whole and the need of special interest groups, such as the commercial community, the fiscal agencies, the financial community etc and will determine the policy choices which should be implemented in the insolvency law. There can be no one perfect solution since countries vary significantly in their needs, as do their legal, economical, political and social conditions. By way of example, the questions whether the law should promote financial discipline by eradicating the inefficient and incompetent; whether it should encourage competitiveness and risk-taking; whether it should uphold commercial morality that persons should pay their

34 See B.I.2.3. and B.I.3.11. 35 Gross-Failure and Forgiveness, 138 36 WB-Towards Principles, 5


39

debts rather than support the concepts of rescue and debt relief, or if the insolvency law should pursue wider social purposes, such as the protection of employment or the attraction of capital investment are answered after having assessed the commercial, economical, social and other needs of the interested parties and the society as a whole.37 As it will become apparent in the later discussion38, transition economies particularly may utilize the insolvency system to correct overwhelming social needs of the society39. A function which is frequently criticised in modern market economies.40

2.2. Pro-debtor versus pro-creditor policies As explained in more detail in a subsequent section41, insolvency systems are often labelled as pro-debtor (debtor friendly) or pro-creditor (creditor friendly).42 There are several indicators in the law according to which a jurisdiction is assessed as being pro-debtor or pro-creditor. For example, an insolvency regime, favouring the principles of equity or pro rata sharing over a rescue policy and closely connected interference with several creditor rights is commonly seen as pro-creditor.43 Jurisdictions which prohibit or limit set-off rights of creditors in insolvency proceedings, are generally viewed as pro-debtor. However, the respective indicators are not always straightforward and frequently used in different ways. For instance, sometimes there is a provision, favouring the management of a debtor, understood as being pro-debtor, since management retains control of the company and the position to influence the future of the debtor. However, others view a provision as pro-debtor, which provides for the replacement of the debtor, primarily because the provision allows the enterprise to survive and the remaining employees to keep their jobs. Consequently, the concept of pro-debtor and pro-creditor jurisdictions, as frequently applied, is only an inaccurate and incomplete means to categorise insolvency regimes and is therefore not extensively used in this paper. Nevertheless, it might be beneficial to examine insolvency laws of transition economies under a pro-debtor or pro-creditor perspective since competing policy goals in transition economies may favour either creditors or debtors and should be balanced accordingly.

37 WB-Towards Principles, 8 38 See B.I.3.11/12. 39 Bufford-What is Right, 838; Smid-Das Insolvenzverfahren, 393 40 E.g. for the US see: Baird/Jackson-Corporate Reorganisations, 102; for Germany see: Balz-Market Conformity, 171 41 See B.II.6. 42 See Wood-International Insolvency, 4 43 WB-Towards Principles, 9


40

2.3. Different interests and different perspectives

2.3.1. Debtor and Creditor views

According to the respective attitude of the law, it might be seen from a more-debtor or from a more-creditor perspective. Legislators are charged with balancing the different interests of debtors and creditors. Oversimplified, a debtor may wish to escape the pain insolvency measures are able to impose. In economic terms, a debtor may mainly wish to protect its assets from the action of creditors, may wish to remain existing management and control over its activities, or may wish to continue the business without further creditor interference. A creditor, on the other hand, may wish to recover outstanding debts as soon as possible. However, reality is more complex and interests of debtors and creditors are more diverse.44 On the debtor side, there might be different interests between management and shareholders. On the creditors side, interests may be even more diverse. Secured creditors, for example, may be interested in the quick realisation of their collateral, unsecured finance creditors may be interested in the liquidation or realisation of the going concern value of the debtor and trade creditors may be more in favour of a continuing business relationship with the debtor.45 The employees commonly have similar views since the debtor may be the (only) source for their future income. Therefore, interests of those creditors may be closer to some debtor interests than to the concern of some other classes of creditors. The task for the legislator, hence, is to consider the perspectives of the different debtor and creditor views and thus balance the law accordingly.

44 See for the discussion on the different interests among participants in insolvency, Flessner-Sanierung und Reorganisation, 195 45 Baird/Jackson-Corporate Reorganisations, 106


41

2.3.2. Adding interests of community But insolvency affects not only debtors and creditors– a two dimensional approach to the problem is insufficient.46 There is yet another perspective to consider: the interests of community47. Community is not a self-defining term and therefore needs some elaboration. Although in some respects it may overlap with the interests of either debtors or creditors or both, it brings a markedly different perspective in the insolvency discussion.

a. Community interest

What community interests generally have in common is that they represent non-legal but societal accepted concerns of a certain community surrounding the debtor. Insolvency may touch on many communities, and these communities simultaneously co-exist, much like co-centric and interlocking circles. By way of example, one imagines a situation where the main employer of a town or region gets into financial difficulties.48 Firstly, there are several types of creditors which are usually recognised by the insolvency law in a prescribed manner. They might be employees, suppliers, lenders, or the fisc with valid legal claims. But there are, on the other hand, other parties with a valid “moral/ societal claim” on the debtor.49 People depending in that way on the performance or future existence of the debtor may be the family of creditors, the whole community of that town/ region since the insolvency of the debtor may diminish the tax base, in the case of knock-on insolvencies the creditors of the creditors of the debtor, customers which may depend on the supply of the products of the debtor or any other affected communities.50 One could possibly argue, that such non-legal claims do not matter in insolvency proceedings since the debtor would generally also have the right to close or relocate its business when he would have been solvent – without granting anybody a valid and enforceable right in the future existence of the debtor. That position might be right under a pure legal perspective. But it definitely falls short in a wider context. Bringing a humanistic element into the discussion of insolvency may provide a means to consider and balance broader society goals. As we see in the forthcoming discussion, this applies particularly in transition economies where societies traditionally depend and rely more intensively on social interrelations among participants rather than on legal claims.

46 Frost-Bankruptcy Redistributive Policies, 78 47 See Gross-Failure and Forgiveness, with instructive examples; Flessner-Sanierung und Reorganisation, 194 48 See B.I.3.11.2 49 See Frost-Bankruptcy Redistributive Policies, 79: Frost distinguishes between investors and non-investors 50 Gross-Failure and Forgiveness, 20


42

Others51 argue that particularly big businesses have developed to social and political centres, not only functioning as mere employer but also as “public institutions” within the society. The value they represent for the society cannot only be measured in economic terms. Stating only a few examples: they may provide a platform for communication and interconnection among people; may financially support varying cultural activities through sponsoring and other means; or may be accountable for education, training or elderly care of people. Those concerns have to be considered when shaping the insolvency regime and thus deciding about the treatment of these enterprises under financial distress.

b. Recognising interests of the community in transition economies

As mentioned before and discussed in more detail further on52, many western scholars53 criticise the employment of the insolvency law to promote social stability and other “non-insolvency policy goals” here summarised as interests of community. However, even though those critics may be valuable and, in their result, acceptable for modern and developed market economies54 they might be not correct for many transition economies. Contrary to many Western economies, where individualism dominates societal relations, the concept of and the philosophical orientation towards community is society rooted and well accepted in many transition economies. In the former communist states of Central and Eastern Europe, for example, have developed a strong belief in communities, deriving not only from the communist ideology but also from legal institutions as, for example, the provision of dominating public ownership rights. Other transition economies in Asia or Latin America may also be more reliant on family and similar community values. The most significant difference to Western societies is that transition societies function to a considerable decree on a non-legal interdependence among its inhabitants. Western societies, on the contrary, are broadly based on the rule of law and thereby function mainly through the reliance on legal rights and entitlements. Within Western societies predominates the conception of individualism which provides the individual with relative freedom supported by a great variety of legal entitlements. In that way, the legal entitlement has replaced moral and societal obligations.

51 Flessner-Sanierung und Reorganisation, 196 52 See B.I.3.11. 53 Baird-The Uneasy Case, 134; Baird/Jackson-Corporate Reorganisations, 102; Bebchuk-A New Approach, 776; Schermer-Response to Professor Gross, 1052; generally for the discussion under the US-Bankruptcy Code: Frost-Bankruptcy Redistributive Policies, 81-91 54 See Frost-Bankruptcy Redistributive Policies


43

However, even in Western societies community interests are currently integrated in the legal discussion55 in general and the insolvency debate56 in particular. Consequently, one should attempt to view insolvency issues in a three dimensional way, from debtors, creditors and respective community perspectives.57 In doing so, one should consider the existing interrelations between the three angles. What is good for debtors might be negative for some creditors. What is favourable for creditors might be the contrary for a community. A legislator has to analyse the different perspectives and interests and as a result balance them in the final policy decision. A related policy issue, which is discussed in more depth later, is the function of insolvency as an economic safety net.58 As learned from the history of the US-Bankruptcy Code and especially its reorganisation provisions, the insolvency process may be a necessary and appropriate tool to slow down economic downturn and particularly to protect viable businesses and thereby preserve employment.59 This function might be not necessary and in fashion in modern and well functioning Western economies but of essential importance to several economically struggling transition economies.60

2.3. Unification approach to insolvency When thinking about designing or re-designing an insolvency law one has to consider that the effectiveness of such a system should be measured on the capability to deal with insolvency problems prevalent in this jurisdiction rather than try to force the application of “international standards”61. Law, in order to fulfil its social function, has to respond to local needs, traditions and expectations. What is considered as essential in one jurisdiction may have a negative effect in another jurisdiction.62 But this truism applies in the case of (corporate) insolvency only to a certain degree since in this area of law, internationally, a similar and comparable environment exists. This common environment and related common functional coherences necessitate the need for similar solutions and outcomes63 even if the underlying systems are different.

55 Taibi-Banking and Finance, 1463; Eckstein-Towards a Communitarian Theory, 843 56 Gross-Failure and Forgiveness, 193-235; Frost-Bankruptcy Redistributive Policies, 81-91; Warren-Bankruptcy Policymaking, 354-361; Carlson-Bankruptcy Theory, 475-478; Flessner-Sanierung und Reorganisation, 185-196 57 Gross-Failure and Forgiveness, 19 58 Bufford-What is Right, 836 59 Bufford-What is Right, 837 60 Bufford-What is Right, 838 61 See for the standards developed by the IMF-Report, Paulus-Der Internationale Währungsfond, 149: Paulus sees the standards promoted by the IMF-Report as the “smallest common denominator” on a global perspective. 62 Triantis-The Careful Use, 195; Hill-Comparative Law, 108 63 Triantis-The Careful Use, 200


44

Companies with legal capacity are the major players in commerce. They depend on capital or debt funding, are exposed to competition and other market forces and engage in secured borrowing. They have numerous other commercial and non-commercial relations to employees, suppliers, equity-holders, tax authorities etc. This common environment requires to a certain extent similar rules and techniques in order to balance the different interests involved in an insolvency situation.64 It is also useful to consider what might be best described as economic expectations and commercial needs. Since all of the economies under review have dedicated themselves to a market-style economy, goals and expectations of the participants are similar. Insolvency law should enable those goals to be reached and provide mechanisms to support the expectations of business and other communities which depend on the outcome of the insolvency process.65

3. General Objectives There are several objectives of insolvency law frequently conflicting with each other. The policy maker has to balance the different objectives and bring them into line with the prevailing situation in the relevant jurisdiction. Prioritising one objective means in turn giving less weight for others. The policy decisions will and should finally reflect social consensus and expectations within the society. Objectives for liquidation and reorganisation may differ substantially since the two procedures might serve different interests and goals. However, main objectives apply to liquidation and to reorganisation as well. To illustrate the differences, it is sufficient to refer to them when discussing objectives of the insolvency regime in general, rather than having two chapters for objectives of liquidation and objectives of reorganisation.

64 WB-Rehabilitation, 8 65 ADB-Report, 25


45

3.1. Provide market conformity A rather economically rooted objective of the insolvency law calls for the establishment of a system which will provide market conformity66 for the relevant jurisdiction. In doing so, the law should recognise and uphold market rules and forces, respect rights and entitlements created outside insolvency, stimulate and foster negotiations among the various classes of claimants and, whenever necessary, promote efficient market exchange processes.67 Thereby, the law should avoid weakening or redistributing valuable pre-insolvency rights or entitlements such as title in movables sold under a reservation of title clause, set-off rights and security interests.68 Moreover, the law should evade extensive interference with pre-insolvency contracts and the introduction of unjustified priority rules.69 If the law does not provide for a market conformity it will be strategically misused by participants in order to reduce credit costs, to dispose of an extensive debt burden, to push competitors out of the market, or more generally, to follow targets which are not consistent with market rules.70

3.2. Maximising asset values

3.2.1. General

Asset maximisation is one of the key objectives of insolvency. The whole process should be designed to serve this objective. Economical theories suggest that a firm should be reorganised, sold for cash as going concern, or closed down and liquidated piece-meal according to which of these techniques generates the greatest total value.71 However, how to define what represents the greatest value and who should be in favour of it remains debatable.72 There are empirically based economic assumptions which argue that reorganisation or the sale of the debtor as going concern is likely to produce more value than ordinary

66 See generally: Balz-Market Conformity; Balz-Sanierung 67 Balz-Market Conformity, 173 68 Baird/Jackson-Corporate Reorganisations, 121: “It is the difference between the size of the slices and the size of the pie. Only the latter is a bankruptcy question.” 69 Baird/Jackson-Corporate Reorganisations, 110 70 Generally for the treatment of secured creditors: Baird/Jackson-Corporate Reorganisations, 116 71 WB-Economic Dimensions, 2; Baird/Jackson-Corporate Reorganisations, 109; Aghion-Improving Bankruptcy, 851; Balz-Sanierung, 24; see also the discussion at Flessner-Sanierung und Reorganisation, 185, with a critical analyse of the economical foundation of that theory by Buchanan, The Economics of Corporate Enterprise 72 See the discussion on „value“, C.II.2.1


46

liquidation.73 However, like any other empirical observation, these factual presumptions are subject to challenge. There are constellations where reorganisation or the sale as going concern is not feasible due to the lack of market capacity or for other reasons. Piecemeal liquidation on the other hand, might be able to produce some value.74

3.2.2. Necessity to protect the debtor assets

The collective nature of insolvency proceedings increases the value of the debtor assets for all creditors75 and reduces at the same time transaction costs in comparison to individual enforcement actions by creditors.76 The individual (non-insolvency) enforcement system is based on the priority principle: an early initiation of proceedings increases the chances of satisfaction. This approach may be justified as long as the debtor is able to repay all creditors from its assets. The situation changes when remaining assets are not sufficient to repay the total outstanding debt. A coordination of the varying creditor enforcement activities becomes necessary. Creditor equality requires a collective nature of proceedings and a balancing and coordinating of the competing creditor rights. Without the collective system, creditors in an insolvency situation would face the prisoner’s dilemma77, as known from game theory. The natural tension of creditors would be to enforce rights as early as possible in order to gain a higher return on their credit. This behaviour would negatively affect the value of the debtor assets and consequently decrease the value of returns available to creditors as a whole. They may, for example, seize assets essential for further revenues of the debtor, or seize bank accounts and thus extract cash funds necessary for ongoing supplies and other essential spending. Individual creditor enforcement actions may damage the asset pool of the debtor without giving this individual creditor any advantage over remaining creditors. Furthermore, collective proceedings reduce transaction costs; costs for the monitoring of the debtor and decrease the risk of a single creditor receiving nothing at all. Main purpose for the collectiveness of proceedings in insolvency is hence the maximisation of asset value available for repayment of outstanding debt.78

73 See Flessner-Sanierung und Reorganisation, 188 74 Warren-Bankruptcy Policymaking, 350 75 Jackson-Logic and Limits, Chapter 1 76 Warren-Bankruptcy Policymaking, 346 77 See: Eidenmüller-Unternehmenssanierung, 16; Paulus-Entwicklungslinien, 239; Balz-Logik und Grenzen, 1438; Balz-Market Conformity, 171 78 Eidenmüller-Unternehmenssanierung, 17; Balz-Logik und Grenzen, 1439; Jackson-Logic and Limits, 7-19


47

Another threat for the value of the asset pool is the separation of execution (Verfügung) and liability (Haftung), a common feature of entities with limited liability. Owners usually have the decision-making power and participate in the profits of the business. However, they do not bear the losses beyond their capital investment. That consequently may lead to strategic behaviour: when the initial investment is exhausted or tends to exhaust owners will be less reluctant to engage in more risky investments since they are playing with somebody else money. One function of the insolvency law should be to correct this result by, for example, shifting the execution powers upon the opening of proceedings to an independent administrator.79 Closely related to this is the function of insolvency law as corporate governance mechanism.80 Financial distress or insolvency is frequently a result of managerial failures81 – the insolvency law may provide a means to correct such faults through efficient reorganisation provisions or the compulsory removal of existing management. Also the shift of execution powers from the debtor and its respective management to creditors may strengthen corporate governance structures of the failing firm.82

3.2.3. Common provisions

Examples of common provisions that serve that objective are the automatic stay of creditor action upon commencement of proceedings; the appointment of an independent liquidator or administrator with broad powers (e.g. re-examination and termination of contracts); prohibition of the debtor to dispose assets; priority for post-petition credit and provisions that extend liability to management.83

79 Eidenmüller-Unternehmenssanierung, 24; see for a more detailed discussion on management of the debtor, D.III.5 80 Triatis-The Careful Use, 202; see more generally for the relation between insolvency law and corporate governance, Paulus-Verbindungslinien, 2189-2191 81 Triatis-The Careful Use, 203 82 Triatis-The Careful Use, 202 83 IMF-Report, 16


48

3.3. Equitable treatment of similarly situated creditors (par creditium creditorum)

3.3.1. General

As mentioned above, common element of all insolvency proceedings is their collective nature. Unlike the individual enforcement provisions the insolvency law is available for the situation where several creditors of one debtor remain unpaid. Rather than enforcing each claim by single actions, creditors are integrated in one process which provides for a more equitable treatment among similar situated creditors and prevents the “race to the court-house-door”. Thereby, equitable treatment does not require equal treatment – creditors with different bargaining power (e.g. secured creditors) and different risks and interests might be treated differently.84 According to the principle of market conformity85 the insolvency law should generally honour pre-insolvency entitlements existing outside insolvency.86 Otherwise, participants will use insolvency proceedings strategically to circumvent such entitlements and gain “windfall profits”.87 A prominent example provides the treatment of secured creditors.88 Those claimants have obtained a specific right to seize and sell the collateral under certain circumstances, which should be respected in insolvency proceedings. On the other hand, general unsecured creditors are normally situated similarly and the law should reflect this through equal treatment in insolvency.89

3.3.2. Treatment of different situated creditors

How to treat different creditor types in the insolvency process is commonly determined by the absolute priority rule. That is, the most senior creditors should be paid off before anything is given to the next class of creditors, and so on down the ladder with ordinary shareholders at the bottom.90 The justification for that rule is that its outcome corresponds with to what the parties have contracted for outside insolvency; that any interference with that rule may deter creditors to

84 Smid-Das Insolvenzverfahren, 393 85 See B.I.3.1 86 Baird/Jackson-Corporate Reorganisations, 98 87 Balz-Logik und Grenzen, 1439 88 See for secured credit: Baird/Jackson-Corporate Reorganisations, 98 89 See for the treatment of parties with different legal rights: Warren-Bankruptcy Policymaking, 353 90 See generally for the absolute priority rule as main principle of bankruptcy: Aghion-Improving Bankruptcy, 852; Balz-Market Conformity, 172


49

extend further credit and that this rule provides an efficient method to prevent strategic misuse of proceedings to gain windfall profits.91 Since financing and trade are done increasingly on an international scale, equitable treatment in that sense means also the non-discrimination of foreign creditors. Generally, they should in be able to expect the same protection and treatment as granted to domestic creditors.92 It is exemplary to refer to the stay-of-action-clause preventing creditors to enforce rights individually, outside the collective procedure of insolvency and provisions that regulate the priority of creditors in the case of asset distribution and voting provisions for a reorganisation plan.

3.3.3. The treatment of similar situated creditors

The equitable treatment of creditors is embodied through the basic concept that general creditors share assets or participate in payments on a pro rata basis. According to this principle, creditors share the available assets of the debtor corresponding to their individual portion of the debt. However, not surprisingly our complicated societies require for various reasons exceptions to this basic principle. These omissions are mainly justified by overwhelming economical, political or social needs.

3.3.4. Classification of diverse creditors

Having established that the insolvency law should generally distinguish between similar and different situated creditors one may consequently raise the question what elements may influence such a characterisation? Apparently, secured creditors can be identified as a separate and more senior creditor class. But what constitutes a class of general creditors which are supposed to be treated on an equal footing? According to the established terminology a general creditor could be an unsecured bank creditor, a supplier, an employee or a tort claimant. Additionally, according to the type of their credit (e.g. trade/finance, long-term/short-term or contractual/non-contractual), they may have very different claims related to its size. Treating them on an equal pro-rata basis leads to very different outcomes and effects: the bank creditor may not even “notice” its loss, also the supplier may be able to carry on and

91 Aghion-Improving Bankruptcy, 853 92 IMF-Report, 5


50

write off its losses. On the other hand, the failure of the debtor may have a more severe impact on employees and tort claimants. Depending on the amount owed, they may themselves financially struggle in the absence of other safety mechanisms. Equal treatment is not synonymous with equal outcome.93 Current insolvency regimes universally lack instruments and provisions to provide for a real equal treatment (equal outcome versus formal equality)94 among general creditors. They usually focus on an equal treatment (pro-rata sharing) of unsecured creditors but ignore the very different impact of this treatment among them. The only alley legislators have chosen to adjust the varying impacts of insolvency on unsecured creditors is to grant certain creditors a priority status above other unsecured creditors. As we see later95, such treatment is frequently criticised and may be contrary to other goals and objectives of insolvency. It differentiates between creditors on a general and formal basis and moves away from a system of individual equality. On the other hand, a decision which would reflect the outcome of insolvency for each individual creditor based on every single case is cost intense, unpredictable and impracticable.

3.3.5. Mechanisms promoting individual equality among unsecured creditors

We come back to this issue in the ongoing discussion and refer to several mechanisms which are more suitable to reach the goal of equality among diverse unsecured creditors. Such instruments are, for example, provisions which allow individual and small creditors to get paid upfront if they are in existential need of the payment96; provisions which provide for a weighting of unsecured creditor claims rather than strictly applying the absolute priority rule97; or rules, which grant priority to creditors, who are at existential risk when treated on a pro-rata basis with other unsecured creditors98.

93 Gross-Failure and Forgiveness, 176 94 Gross-Failure and Forgiveness, 144 95 See D.VI.3 96 Gross-Failure and Forgiveness, 164; See D.VI. 97 See D.VI.3.2.3. 98 See D.VI.4.


51

3.4. Foster corporate discipline Although management of corporations is limited in their liability and personal financial exposure, through the veil of incorporation accompanied by limited liability of the enterprise, the provisions of the insolvency law commonly enables the re-examination of transactions which took place prior to the commencement of insolvency proceedings. Not only may certain transactions be impeachable, but also is it possible that responsible individuals may be held to bear personal responsibility for a portion of the losses incurred by the company. The management involved may also be subject to criminal liability. These sanctions match with the advantages of limited liability of an incorporated enterprise and are necessary to foster corporate discipline in order to maintain public confidence in the credit culture in which companies operate.99 Under an ex-ante perspective, those provisions may promote sound business practises and hence avoid insolvencies. Thereby, prospective punishment should not only penalise management, but also equity holders in the way that they have their claims wiped-out.100 Furthermore, the disincentive for the management, namely to loose their position in the debtor enterprise when insolvency proceedings are commenced, may function as encouragement to more financial discipline. Another related effect of the insolvency regime in transition economies is that it fosters corporate governance structures in state-owned enterprises (SOE’s) by promoting concentrated outside ownership and outside finance. Rescue laws and rules entailed in insolvency regimes regularly provide for the conversion of debt to equity as one possible reorganisation technique, hence promoting a change from inside (state) to outside (various equity investors) ownership. Empirical research suggests that increasing outside ownership may improve corporate governance structures and, in this manner, indirectly foster profitability and efficiency of an enterprise. A similar effect derives from the implied change from inside (state) finance to outside (bank loans from independent national banks, foreign banks; bonds) finance. Outside investors are usually more concerned with their respective returns and fewer with other political or social implications.101

99 WB-Towards Principles, 4 100 WB-Economic Dimensions, 2 101 EBRD-Working paper 18, 21


52

3.5. Exit mechanism The insolvency law provides the insolvent debtor with exit mechanisms in order to liquidate and distribute the estate of the irretrievably insolvent debtor or to provide for a more balanced existence for the future.102 In this way, insolvency might rehabilitate the failed management and save human capital. This function may be of particular importance in transition economies103 where managerial and entrepreneurial resources are scarce commodities.104

3.6. Allocation of risk among the participants

3.6.1. General

Furthermore, the insolvency law should attempt to allocate the involved risk among the participants. According to pure economical terms every market-participant should bear the risk of a transaction or relation according to his economical interest in it. Owners or shareholders, who usually take the largest gains of a business should assume the greatest losses if it fails. Accordingly, insolvency laws should permit owners to retain their position in a post-insolvency business only if creditors collectively consent or the business is able to pay of all the creditors in full.105 Consequently, a creditor who extends credit to a debtor should have access to a mechanism to enforce its contractual or statutory rights. If there is more than one creditor, the insolvency law should also balance the risks among the different creditors.

3.6.2. Recognition of the diversity among creditors

However, abilities to assess the risk that a debtor will default and to allocate this risk vary considerably among the different parties. More sophisticated creditors, such as banks or big suppliers, may be more able to assess ex-ante the standing of the debtor then others. They usually have a greater bargaining power to negotiate pre-insolvency entitlements (security, guarantees) which will grant them preferential treatment in insolvency proceedings and, thus, increases the chances of

102 WB-Towards Principles, 4 103 See for the influence of the fresh-start-philosophy, deriving from the Chapter 11 US-Bankruptcy Code, on the insolvency reform of Central and Eastern European countries: Smid-Das Insolvenzverfahren, 394 104 Balz, Schiffman, 21 105 Warren-Bankruptcy Policymaking, 359


53

repayment. Lenders, for example, have possibilities to diversify their investment portfolios and thus reduce the impacts of the default of a single debtor. Other creditors, like tort claimants or employees, have no or only a limited prospect to assess the risk of a default of their debtors. Neither do they have the chance or bargaining power to improve their repayment chances in the insolvency of their debtor by negotiating a respective security interest. The insolvency law should consider the different situations of several creditor types and allocate risks accordingly.106

3.6.3. Internalisation of costs

Furthermore, the law should attempt to internalise costs of the default to debtor-creditor relations only. Costs or losses are born only in the debtor-creditor relation, as profits would be. Therefore, the law should avoid externalising or distributing the costs to participants not party of a debtor-creditor relation. Such a result may be reached by granting the public fisc a distributive priority in liquidation or reorganisation107 or in the attempt to make the insolvency system self-supporting, without substantial government subsidies.

3.7. Encourage investment risk taking The insolvency regime may also encourage investors to make more risky investment decisions, a economically necessary and desired behaviour not only in transition economies. In a market economy, risk taking enables the wheels of the economy to turn; individuals fend for themselves and do not become a drain on scarce societal resources; enterprises may increase their profits by taking higher risks and thus support wider societal goals.108 Start-ups and other businesses, especially, without existing credit standing are frequently in need of urgent funding. In transition economies, those entrepreneurial activities are fundamental to develop a still not or only marginal existing private sector. However, creditors usually tend to invest preferably in businesses with a good credit standing since risk assessment and allocation is much easier. Nevertheless, investors may finance also creditors with a lower credit rating since the profits of such a transaction might be considerably higher as an investment in a business with an excellent credit rating. However, what creditors expect as an essential pre-condition for their investment are predictable and easily enforceable rights in the case of insolvency of their debtors.

106 Warren-Bankruptcy Policymaking, 357 107 But see for a more detailed discussion on priorities for the fisc D.VI.2.4.3. 108 Gross-Failure and Forgiveness, 94


54

The applicable insolvency regime may reduce risks for investors by granting them rights in a transparent and predictable manner. By way of example, if the insolvency law respects expressively security or other pre-insolvency entitlements, creditors may be more willing to extend credit to less credible or assessable debtors. Furthermore, the availability of certain rescue instruments might increase the willingness of creditors to extend credit to enterprises less credit-worthy.109

3.8. Increasing the availability and reducing the costs of credit Developed economies depend on a high degree on the availability of credit whether in the form of capital or trade credit. The availability mainly depends on the willingness of prospective creditors to extend credit influenced by the legal environment which may or may not promote an extensive credit system. A lender expects effective legal procedures for the debt recovery in the event of default of its debtor and an insolvency regime which supports an efficient collective mechanism for the recovery of assets. In jurisdictions where such a system is not implemented or not efficient enough, credit is more difficult to attain.110

3.8.1. Availability of credit

The confidence of lenders and other creditors in the legal system of the debtor is a main criterion which influences the willingness to extent credit and the terms and conditions of the credit. Thereby, the prevailing insolvency law plays a major role since it governs the relation between the parties in the ultimate case of the debtor’s inability to repay outstanding debt. In this way the insolvency law provides a system that serves to facilitate the making of investment decisions.

3.8.2. Price of credit

A related obstacle in those countries with an insufficient insolvency system is the higher price of credit. Lenders unsurprisingly calculate the risk stemming from insufficient insolvency regulations and add high-risk premiums in insufficient systems accordingly. This in turn may affect the whole economy since high interest rates may hamper the general economic development.

109 Warren-Bankruptcy Policymaking, 357 110 WB-Towards Principles, 47


55

Observers suggest that efficient insolvency regimes, which fully recognise secured transactions, may decrease interest rates up to the factor of fifty percent and may raise the ratio of debt/income more than eight-fold. At the same time, the size of the loans available and the term length will increase respectively.111

3.9. Provide for certainty and predictability in commercial affairs However the policy choices of the legislator towards a more debtor or creditor friendly regime are, however the risk allocation elements in the law are designed, a more important issue is the predictability of the system as a whole since participants can take measures against higher risks (pricing, guarantees, insurance) but there are no instruments available against an unpredictable system.112 A lack of predictability does not only increase the costs of credit, it even jeopardises the general availability of credit. The objective of predictability collides with other objectives. For example, the objective of asset maximisation requires the interference with pre-insolvency transactions of the debtor which prejudice a creditor.113 On the other hand, a wide reaching right to re-examine transactions disturbs the commercial predictability and stability. To balance both objectives in the particular example, the law should exempt transactions made in good faith and for value or transactions performed in an ordinary course of business from re-examination rights of the administrator. Closely related with that is the objective of transparency. The participants in an insolvency procedure should obtain easy access to information necessary for them. Creditors, for example, should have easy access to the books, accounts and balance sheets of the debtor as soon as proceedings are commenced. The debtor should have a corresponding obligation to provide for such information.114

111 ADB-Report, 90 112 IMF-Report, 4 113 See B.I.3.2. 114 IMF-Report, 5


56

3.10. Protect economies from systemic risks Particularly in transition economies usually exist a considerable amount of debt owed among associated state and private enterprises. That is due to the conglomerate structure prevalent in many transition economies. SOE’s but also private enterprises are commonly organised as groups covering frequently whole industry sectors and very different activities. Financing functions within the group results thus in an extensive amount of debt and credit among enterprises of a group or conglomerate.115 Conglomerates of enterprises are also a common feature of some Asian jurisdictions.116 Powerful families or other influential interest groups own or control important parts of the national economy. Cross-guarantees, cross lending and cross shareholding among the members of a group may increase the systemic risk deriving from the insolvency of one member company. Within the South Korean “chaebols”, for example, funds were siphoned from profitable companies to support failing businesses. As we have learned from South Korea in the Asian crisis, a general financial distress in a region or industry sector may affect an economy more where such interrelations among enterprises are prevalent.117 Strong insolvency regimes provide the predictable legal framework that is essential for addressing the financial difficulties of troubled firms before the accumulated financial difficulties of the corporate sector spill over and contribute to an economy-wide payments crisis.118 Consequently, well-functioning insolvency systems are essential to the orderly resolution of payments crises, particularly when corporate indebtedness, including external indebtedness, is a major source of strain on a country’s macroeconomic stability.119 By facilitating the rapid workout of a corporate debt crises and the quick restoration of a financially stable corporate sector, strong regimes help to limit contractions in economic output and to ensure the rapid return of economic growth. One provision that supports that objective usually contained in modern insolvency codes to reduce the systemic risk of insolvencies is the provision for set-offs of mutual debt and credit between market participants.120

115 Harmer-Chinese Bankruptcy Reform, 2582 116 ADB-Report 1999, 20: for example in Japan, Korea and Thailand 117 Ehrlich-Governance of Korea’s Chaebols, 23: In 1997 one fourth of the top 30 chaebols in South Korea filed for bankruptcy. 118 Bufford-What is Right, 836: Bufford speaks from insolvency law as an economical safety net for the national economy. 119 G22-Report, 14 120 Harmer-Chinese Bankruptcy Reform, 2582; see also the discussion on set-off provisions and close-out-netting, D.III.7.


57

Nevertheless, the general insolvency regime may not always prove sufficient to deal with systemic problems in an economy. Particularly the banking and financial sector in transition economies is frequently exaggerated affected by non-performing loan portfolios, and massive un-hedged foreign currency debt that was made worse by deep currency devaluations. In order to deal with and to prevent the systemic effects of those crisis` governments of some transition economies have initiated special informal workout programs to supplement the general insolvency regime.121

3.11. Support wider community interests122 A objective, frequently ignored or underestimated in the ongoing discussion123 of insolvency is concerned with the impact of insolvency laws on communities which are not directly legally connected with the struggling debtor. Since those issues seem to be of significant relevance to the here in more detail examined transition economies, the paper intends to look at the related questions in more depth. Basically, the insolvency regime is concerned with parties having formal legal rights and entitlements. It organises and structures the conflict between the debtor and several types of creditors. As described by the well-accepted creditors bargaining model124, insolvency law is mainly charged with the debt collection process under the common pool situation. However, the business failure of a debtor may also impact on parties who are not creditors and who have no formal legal rights to the assets of the debtor business.125 This impact might be of particular weight in transition economies, since there enterprises are often accountable for a varying degree of social functions.126 Therefore, the final economical outcome for creditors should be not the only means when considering insolvency precepts and policies. A pure economical analysis focused solely on the debtor/creditor relationship is fraught with problems. Community interests must also be considered and rebalanced in a modern insolvency law.127

121 ADB-Report 1999, 12; see for a more detailed discussion on those programs, C.I.3.2.6. 122 See for a definition of community interests, B.I.2.3.2. 123 Neither the respective paper of the IMF (IMF-Report) nor the study of the World Bank (WB-Towards Principle) mentioned the issue expressly 124 See generally for the creditors bargaining model: Baird/Jackson-Corporate Reorganisations, 100; Jackson-Bankruptcy, 857 125 See B.I.2.3.2. 126 See also B.II.5.1.2.d.viii. 127 Averch-Lien Stripping, 79


58

3.11.1. Methods to protect community interests128 The protection an insolvency regime can give to parties without formal legal rights is usually derivative in nature and limited in scope. Their interests are commonly only indirectly considered, mainly through provisions that forestall liquidation to permit the business to remain in operation and to reorganise, instead if being shut down by a few anxious creditors.129 Communities or other affected non-insolvency parties have frequently no substantive rights under the respective insolvency code.130 Often, the mere existence of reorganisation provisions may have a redistributive effect from creditors to shareholders, managers, employees and other related communities. The delays, along with the reorganisation process lead frequently to a shift of wealth from creditors to other (non-investor) communities.131 A similar result could be also reached by provisions which limit or extend rights and obligations of participants in insolvency when these are contrary or consistent with “public interests or public policy”.132 By way of example, the court may only confirm a reorganisation plan when its outcome is in the interest of the public or with other words in the interest of community.133 An good example provides the Polish Bankruptcy Code134, where the court may refuse to approve an arrangement, when it conflicts with decency or public order. However, it might be problematic to grant the necessary wide discretions to courts and other participants in order to determine “public policy or order” in a highly sensitive field as insolvency. That is of particular importance in transition economies, where the judiciary and other official participants are frequently un-experienced in insolvency issues and economical-based decision-making. Another technique to recognise potential community interests would be a general clause granting the court wide discretionary powers to consider such interests and to balance them with the interests of other participants, namely the debtors and creditors. But similarly as

128 Falke-Community Interests, 12 129 Warren-Bankruptcy Policymaking, 354 130 Frost-Bankruptcy Redistributive Policies, 101 131 Frost-Bankruptcy Redistributive Policies, 93 132 Gross-Failure and Forgiveness, 219 133 E.g. the railroad reorganisation provisions of Chapter 11 of the US-Bankruptcy Code (US-Bankruptcy Code §§ 1161-74 134 Polish Bankruptcy Code, Art.191 (3)


59

with “public-policy clauses” such provisions may create non-uniformity and unpredictability among participants.135 Moreover, community interests could be acknowledged in the insolvency plan confirmation process. The law could compel the court to consider and balance not only debtor and creditors interest but also community interest before confirming a proposed reorganisation plan.136 But that again requires economical-based wide-reaching decision-making from the involved authorities. Another way to consider interests of particular vulnerable claimants directly through the legislative process would be the explicit granting of distributive priorities for such claims. This important issue will be discussed in more detail at a later point.137 Likewise, the law could consider the varying interests in the insolvency process by granting the different interest groups participation rights.138 Several insolvency laws follow this path when granting employee representatives139, representatives of councils or local governments respective participation rights.

3.11.2. Examples

A practical example for the legislative implementation of community matters offers the Russian Bankruptcy Code (1998) in its Chapter VIII §2, dealing with the insolvency of town-forming organisations. According to these provisions, town-forming organisations are legal entities which employ half of the population of a region or town or a minimum of 5000 employees.140 As already discussed141, such dominating industries are a common feature of transition economies and one of their major impediments. Those SOE’s have usually wide-reaching social responsibilities and functions, with the consequence that their piecemeal liquidation can result in a social downturn combined with the deterioration of the living conditions of the local community. The Russian legislator has responded to this dilemma in its new bankruptcy code and consequently included provisions which deal explicitly with the situation of those industries.

135 Gross-Failure and Forgiveness, 227 136 Gross-Failure and Forgiveness, 228 137 See D.VI. 138 Flessner-Sanierung und Reorganisation, 197 139 The Hungarian Bankruptcy Code, Section 8 (1), for example, grants trade unions and employee councils (employee delegates) a information right prior to the filing of the bankruptcy petition 140 Russian-Bankruptcy Code (1998), Article 132 141 See B.II.5.1.2.d.viii.


60

In the case of the insolvency of a town-forming organisation the affected body of local self-government obtains a formal right to participate in the case.142 Other authorities, such as federal executive bodies or executive bodies of the corresponding constituent region of the Russian Federation, may be allowed to participate by the respective Arbitration Court.143 On request of one of these authorities or on its own discretion the court may order the institution of external administration even if the creditor committee voted for liquidation of the debtor.144 To protect the creditor interests in such a case, the respective governmental body has to furnish a guarantee for the obligations of the debtor.145 Additionally, the body of local self-government may apply for an extension of the external administration.146 Moreover, the Russian Federation, a constituent region of the Russian Federation, or a municipality, represented by their authorised bodies, have at any time the right to settle with all creditors of the debtor.147 If the sale of the enterprise is necessary, shall that be done under a competition with the conditions that the enterprise is sold as a single property complex148 and retains at least 70 percent of the employees working at the enterprise at the time of its sale.149 Another example presents the Bulgarian Commercial Code150 granting the consideration of the interests of employees explicitly a priority objective in bankruptcy proceedings. These provisions offer a good example how transition economies react to their unique problems and thereby are contrary to widespread Western insolvency theories and policies. The decision whether to liquidate or reorganise is determined not only by the expected outcome for creditors but also by the interests of the affected communities. At the same time creditor interests are protected by a mandatory guarantee from part taking governmental bodies. The legislator has attempted to consider affected community interests at one hand and to preserve creditors valid claims on the other hand. Furthermore, the attempt to protect community interests corresponds with a more profound economic reality: the parties with formal legal rights never internalise the full costs of a business failure. Hence, any measures to avoid rapid liquidations helps as well to offset the losses imposed on parties to whom the costs have been externalised.151 142 Russian-Bankruptcy Code (1998), Article 133 (1) 143 Russian-Bankruptcy Code (1998), Article 133 (2) 144 Russian-Bankruptcy Code (1998), Article 134 (1) 145 Russian-Bankruptcy Code (1998), Article 134 (1) 146 Russian-Bankruptcy Code (1998), Article 135 (1) 147 Russian-Bankruptcy Code (1998), Article 136 (1) 148 Russian-Bankruptcy Code (1998), Article 138 (1) 149 Russian-Bankruptcy Code (1998), Article 137 (1) 150 Bulgarian Commercial Code, Art.607 (2)


61

Consequently, insolvency laws should endeavour to minimise losses to the general public when a business fails and to force parties dealing with the failing debtor to bear the burden of the failure. The benefits of such a policy are obvious. If creditors have the opportunity to externalise losses significantly, they will be less cautious when making their credit decision or monitoring the debtor to assure repayment. Conversely, if lenders know that they must bear a reasonable bulk of the losses, they are more likely to develop appropriate levels of investigation and monitoring ex- ante. In that way, the insolvency law will avoid or reduce moral hazard.152

3.11.3. Considering community interests

That leads consequently to the question: what constitutes a right or interest that is worth being protected or supported in an insolvency scenario or what forms a community?153 Generally, insolvency laws protecting not only contractual rights but also other legal entitlements as, for example, tort claims, unjust enrichment or administrative obligations. However, all these claims can be normally characterised as legal claims, also recognised and enforceable under the relevant (individual) compulsory execution regime. Nevertheless, the underlying situation in insolvency and in an individual enforcement situation might be quite different. If a creditor tries to enforce a valid claim against a debtor he may or may not succeed with its action with the consequence that the debtor has to pay or has not to pay. Affected from the outcome of such an individual action are usually only the two parties of the underlying obligation. As mentioned before, in an insolvency scenario are not only the debtor and all formal creditors involved, but also other parties with a unique interest in the future existence of the debtor. That in turn raises the question, whether the insolvency law should generally consider similar interests and rights as the individual enforcement system or rather go beyond it? What are the criteria determining whether a non-legal interest is worth being protected in insolvency? Social interrelation among people is not only defined by legal rights but on a variety of levels. Generally, any interconnectedness has value and is worth being protected; even it cannot be measured in economic terms.154 What is necessary is a shift away from right-based thinking towards responsibility-based thinking.155

151 Warren-Bankruptcy Policymaking, 356 152 Warren-Bankruptcy Policymaking, 361 153 See also the previous discussion, B.I.2.3.2. 154 Gross-Failure and Forgiveness, 195 155 Gross-Failure and Forgiveness, 210


62

People are usually interconnected with, and integrated in, very different communities. There are communities which are closer, as the family for example, and others which are further remote, as the inhabitants of a city or a region. The workplace represents another frequently close community. For a business, the shareholders form a community as the suppliers and the neighbours in the commercial district or the whole local population do. The amount of communities may be uncountable as the variety of human interaction. Consequently, every insolvency case affects varying communities.156 However, for a workable insolvency system, designed to function in a market economy, not all communities and their respective interests can be considered. In order to take rights and interests into account the respective community should have a nexus to the insolvent debtor, should be palpably injured by the insolvency and the injury should be redressable. Thereby, the community interest in question can take a variety of forms; the injury does not need to be economic but cannot be solely conjectural or hypothetical.157 As a consequence, insolvency law should protect and support wider community interests. It may protect the economy from mass unemployment, may stabilise social welfare, may protect interests and rights of local creditors (e.g. trade creditors), preserve markets for suppliers, encourage private sector development and give failing debtors a second chance.158 These features are of significant importance in transition economies159 since other protective devices for these interests (e.g. social safety systems) are often not, or only insufficiently, available. However, one should consider that any unnecessary interference with market rules by instruments of the insolvency law should be avoided. Nevertheless, it might be necessary to support the transition process by such intervention where the appropriate market-conform techniques and institutions have not been established yet. Insolvency laws provide an opportunity to deal with social problems immediately, not in the sense of creating a global long-term solution but in terms of resolving an actual situation.160 This view may make policy decisions in transition economies more understandable. Throughout the paper we will frequently come back to these questions and mainly ask what weighting those wider community objectives should receive when balancing different policy choices in transition economies. 156 Gross-Failure and Forgiveness, 197 157 Gross-Failure and Forgiveness, 212 158 Flessner-Sanierung und Reorganisation, 196 159 Bufford-What is Right, 838 160 Gross-Failure and Forgiveness, 249


63

3.11.4. Criticism On the contrary, some commentators161 believe that the welfare of communities, the continuity of existing businesses and the preservation of human dignity should not be considered in the insolvency process. But the inability to measure those impacts in strict and immediate monetary units does not consequently mean that those considerations should be excluded but rather that the prevailing neoclassical economic approach to insolvency is too narrow.162 However, it does not mean that interests of community are necessarily always non-economic nor are they, per se, economically inefficient.163 Neither are community interests always consistent with the interests of the debtor – recognising and considering community interests indicates only a different approach to the problem and adds another, independent value to the balancing process.164 Advocates of the creditor value-maximisation theory165 argue further that the inclusion of non-investor or non-insolvency interests in the process may provide incentives that cause over- or under-utilisation of insolvency proceedings. That would reduce the economical outcome for creditors and shifts thus the burden unjustifiably to investors.166 Moreover, critics put forward that any judicial interference with legal entitlements by non-legal entitlements or moral/ societal obligations may create politicised court decisions and would step on the toes of elected legislators who are usually charged with developing public policy by identifying and responding to the interests of the public.167 The judicial process might be the inappropriate means to implement social policy considerations.168 Furthermore, one has to admit that under market conditions some firms will always fail, and postponing the inevitable or keeping marginal firms alive may do more harm than good.169 Keeping a firm in one town from closing, for example, can have the indirect effect of keeping a new one in another town from opening.170

161 See, e.g., Schermer-Response to Professor Gross, 1049; Baird/Jackson-Corporate Reorganisations, 102; in its consequences also (but only for the US Bankruptcy System): Frost-Bankruptcy Redistributive Policies, 138 162 Gross-Failure and Forgiveness, 88; Gross-Community Interests, 1046 163 Gross-Community Interests, 1033 164 See the discussion on a three dimensional approach to insolvency, B.I.2.3.2. 165 See the discussion on the objective of value maximisation, B.I.3.2. 166 Frost-Bankruptcy Redistributive Policies, 89 167 Schermer-Response to Professor Gross, 1052; Frost-Bankruptcy Redistributive Policies, 123 168 Frost-Bankruptcy Redistributive Policies, 123 169 White-Does Chapter 11, 1339 170 Baird/Jackson-Corporate Reorganisations, 102


64

Additionally, insolvency-related problems as along going unemployment, knock-on insolvencies and other social hardship are not unique insolvency problems. The insolvency law should not be the place to implement a policy that society does not enforce outside of insolvency. Social reform should be brought about through broad changes in policy by changing the respective substantive law rather than through ad hoc modifications of rights in insolvency.171 A redistributive effect and thereby a protection of communities or other non-investors affected from insolvency could be reached through progressive taxation and a respective design of social welfare systems.172 Moreover, it appears unclear who should bear the costs of the redistributive effects created by a protective insolvency regime. Any redistribution from creditors to communities or non-investors will affect a shift of wealth from creditors to the communities since costs are not externalised.173 The capital providers will finally not bear the costs but price the new risk and further distribute it. Consequently, that will lead to increasing costs of capital and may negatively affect economical developments.174 Competitors of the debtor may be negatively affected when the debtor enterprise is artificially kept in business in order to protect respective employee or community interests. Such debtor enterprises have a comparative advantage over their competitors since their operations are directly or indirectly subsidised and capital providers are forced to extend further credit below market terms.175 Additionally, one has to admit that the insolvency process may not have the institutional capacity to extensively deal with non-insolvency interests and is generally not designed to achieve redistributive goals.176

171 Baird/Jackson-Corporate Reorganisations, 103 172 Frost-Bankruptcy Redistributive Policies, 136 173 Frost-Bankruptcy Redistributive Policies, 113 174 Frost-Bankruptcy Redistributive Policies, 115 175 Frost-Bankruptcy Redistributive Policies, 120 176 Baird/Jackson-Corporate Reorganisations, 101; Frost-Bankruptcy Redistributive Policies, 91


65

3.11.5. Effects for transition economies As we have seen, there exist valuable arguments to generally minimise the impact of community interests as well as convincing policy goals to consider those interests in formal insolvency proceedings. However, we have to acknowledge that the discussion reflected above is mainly lead by scholars from the US177 and some other highly developed countries. The proponents as well as the critics base their arguments on the legal and social environment of their home jurisdictions. Since this paper is primarily applicable to the situation in transition economies, it will not enter a respective discussion focusing on the relevance of the topic for highly-developed market economies but rather consider a conclusion for transition economies. In doing so, one should not adequately apply the above-mentioned pros and cons for the transition process. As mentioned before, and will in more detail later, circumstances in transition economies may greatly vary from situations prevalent in highly developed market economies. Including some measures to protect affected communities may, at least for the limited period of the transition process, be a legitimate instrument to reach varying social goals in a society. Considering community interests in transition economies by means of the insolvency law is historically not unprecedented – insolvency policy was always dominated by economical developments. In the 1930`s in the US, for example, a pro-reorganisation approach to insolvency policy towards the prioritisation of enterprise reorganisation prevailed out of the fear of mass unemployment and economical downfall. Insolvency policy in general and the relation between liquidation and reorganisation in particular, has always been dependent on the prevailing economical situation. In times of economical downturns insolvency policy concentrated on the promotion of enterprise reorganisation going along with the protection from mass-unemployment and general social disorder, whilst in times of a boom more liquidation-favoured policies prevailed.178 Applying similar measures to contemporary transition economies may justify a more intense recognition of community interests and general social matters in the insolvency regime. Furthermore, such a result may be the only solution available to deal with varying problems on a short-term basis. As mentioned before, legislative remedies to the underlying social hardship in transition economies are far away or at least insufficient to cope with the dimension of existing problems.

177 See for example the excellent article by Frost-Bankruptcy Redistributive Policies focused only on the situation under the US-Bankruptcy Code 178 Flessner-Sanierung und Reorganisation, 192


66

3.12. Provide for social balance A closely related problem questions whether the insolvency law should reflect social needs of participants of the process. Usually under a market economy concept, insolvency is adjusted mainly to economical theories.179 Market forces are dominating the respective outcome and any interference resulting in the redistribution of wealth should be avoided.180 As we have seen, asset maximisation becomes the central goal of the process.181 Nevertheless, the insolvency process is able to serve other social goals prevalent in the respective society. That might be less crucial in developed market economies since there exist other institutional settings or regulations to protect and support social stability but may be of essential importance in some transition economies. As explained later, a dominating aspect of transition economies is that they are turning towards market economies without having yet established certain instruments or institutions to protect social elements and provide for respective safeguards in the society. Since insolvency frequently affects those social elements, the insolvency regime in transition economies is often used to balance social and economical stability. Such a policy may conflict with basic economical theories of the market by having redistributive effects, but might be an indispensable instrument to provide for immediate social and economical stability in the transition process.182 By way of example, many transition economies give employees or tort claimants a high distributive priority in the liquidation process. That may be criticisable under a developed market economy with a well developed and functioning safety system for redundant workers but might be essential in a transition economy currently without or only with an insufficient safety net. Other insolvency laws are biased towards reorganisation of the struggling debtor. Such a policy is contrary to the asset maximisation policy, favoured by many scholars in developed market economies.183 However, if particularly transition economies would apply solely these economical standards to determine whether a failing debtor has to be reorganised or liquidated, whole parts of these economies would have been liquidated. A further consideration in this context should be drawn to the risk that the insolvency process is exclusively (mis-) used by large and economically significant creditors to recover their outstanding claims. They usually have powerful lobbies to actually influence the insolvency 179 See for example the theory of the creditors bargaining model, B.I.1. 180 WB-Economic Dimensions, 2 181 See for the objective of asset maximisation, B.I.3.2. 182 Bufford-What is Right, 838; see also the discussion before 183 See for example Balz-Sanierung, 24


67

system and may have valid arguments in favour of their priority treatment. However, when thinking about these issues one should always keep in mind the not solely economical importance of small-scale creditors and individual creditors. As mentioned earlier, one should add to the pure economical perspective also a social or human dimension.184 Insolvency law, and within its application especially reorganisation provisions, can be also seen as creating an economical safety net by protecting viable businesses, preserving jobs and protecting communities and giving debtors an opportunity to wait out an economic downturn, thereby avoiding a catastrophic destruction of economic values. Particularly, insolvency reorganisation prevents secured creditors in weak economies from collectively precipitating a downward spiral leading to a total economic collapse.185

3.13. Attract foreign investments For many foreign investors a workable and predictable insolvency regime is a pre-condition for any positive investment decision in emerging markets. The formal insolvency law becomes a “tranquilliser” for foreign creditors, even if it is rarely used. The mere existence of an efficient insolvency law gives foreign investors more security and predictability when extending credit to a debtor in a transition economy.186 The foreign investments, on the other hand, are very important for emerging economies in order to develop their economy. Domestic resources on operational and financial investments are frequently insufficient to encourage a rapid economical development of transition economies. Foreign investment becomes a key figure to provide the necessary funds. However, a legislator in a transition economy always has to carefully balance diverse policy goals which are frequently contrary to each other. As we have seen, a respective policy maker may be tended to institutionalise the insolvency law to prevent mass unemployment and social disorder and therefore needs to interfere with existing creditor rights. Apparently, such a policy may negatively impact on creditors in general and foreign creditors in particular.

184 Gross-Failure and Forgiveness, 103 185 Bufford-What is Right, 838; see also the discussion in the previous section on community interests 186 For Hungary see: Gobert-Insolvenzrecht in Ungarn, 265; Creditor protection and the protection of foreign investments are the main features relevant for many Western advisers.


68

3.14. Other frequently found objectives Furthermore, there exist a varying number on other goals and functions an insolvency law is able support. As a final result, the law may promote the voluntary re-allocation of assets from inefficient and destructive to more efficient and productive market participants with a positive result for the whole society. Insolvency laws usually improve the amount of information available to investors regarding the recovery of capital invested in an enterprise that fails. With this information creditors are able to accurately determine when the value of assets deteriorates and accurately compute credit agreement terms such as collateral requirements and interest rates.187 By eliminating the uncompetitive market participant, the insolvency process fosters the competition among market players. In balancing the rights among participants of an insolvency case, the law may protect impaired and minority creditors as well as debtors. In doing so, it may provide for commercial stability and order.188 A feature what remains important, particularly in transition economies, is its function as a tool to support a contribution of the private sector to the resolution of a financial crisis. Mainly through rescue procedures the private sector might be forced to contribute to a country’s financial crisis. Particularly, when SOE’s are governed by the general insolvency law and restructured by a reorganisation plan – also dissenting creditors are bound by the majority vote and have to contribute in the way the plan prescribes – thereby limiting the public costs of reorganisation and limiting moral hazard.189 This list is not intended as being conclusive and certainly it might be possible to add further objectives and goals insolvency law may accomplish. However, the list above meant to reflect objectives and goals with a crucial relevance to the scope of the paper.

187 Kim-When Nonuse is Useful, 1052 188 ADB-Report, 26 189 IMF-Report, 6


69

4. Incentives and disincentives The behaviour of the participants in insolvency proceedings will significantly be influenced by the incentive structure of the law. The incentive structure derives from the insolvency law itself, from other relevant laws and regulations and, basically, from human and business behaviour. One can broadly distinguish between debtor and creditor incentives. Incentives and disincentives are frequently used in the law to stimulate a desired behaviour by considering the natural tension of actors in a determined situation. Experiences suggest that participants will usually opt for instruments, tools or proceedings provided by the insolvency law when they expect any advantage from it and, on the other hand, will refuse to act in a certain manner when they may fear disadvantages from it. The incentive structure becomes apparent throughout the whole insolvency law and it will be referred to it in this paper at the relevant point. Examples Debtors, for example, may initiate proceedings at an early point and thereby increasing chances for a desired reorganisation of their affairs when the law imposes an early stay on creditor actions, provides pre-insolvency measures or rules that the debtor management may remain generally their positions in a subsequent reorganisation process. Creditors, on the other hand, might be influenced in their behaviour in proceedings by the speed and the costs of the process, by their ability to actively influence procedures or by the validity and enforceability of collateral. 190 Moreover, incentives apply not only after insolvency has occurred (from an ex-post perspective) but also in a pre-insolvency situation (ex-ante perspective). Thereby, incentives may encourage a worthwhile conduct of the participants prior to insolvency. The penalising of management failures, for example, will encourage more responsible and efficient management decisions.191

190 Deloitte-Restructuring, 14 191 Eidenmüller-Unternehmenssanierung, 27; Aghion-Improving Bankruptcy, 852


70


71

II. The relevance of insolvency laws in economies in transition

1. The meaning of transition

1.1. General The term “transition economies” is frequently used to refer to the countries of Central and Eastern Europe after the fall of the communist or socialist regimes in the end of the 1980’s. Thereby, transition means the status of those countries during the evolution from a command economy to a market-based economy.192 This movement is usually characterised by the changing and creating of institutions, particularly private enterprises; changes in the role of the state, thereby, the creation of fundamentally different governmental institutions; and the promotion of private-owned enterprises, markets and independent financial institutions. The transformation process in Central and Eastern European countries was and still is a fundamental socio-economical change, mainly based on the creation and promotion of private property rights.193 Thereby, property rights are the essential and most basic elements of any type of market-based economy and define fundamental terms like interest, money and credit but also value, price, profit and market.194 However, the starting point of the transition process may vary from country to country. A transition in that sense is not a simple, linear, one-dimensional progression to a “standard” market economy.

1.2. Key features of a market economy in respect to the transition process Nevertheless, there exist some key features which are basic and essential for the functioning of a market economy. As mentioned before, the existence of private property rights might be the most basic element of a market economy.195 A market economy is driven by the profit seeking of the owners of privately owned enterprises. Therefore, the privatisation of SOE’s became a central element of the transition process, not only in the countries of Central and Eastern Europe.

192 Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 211 193 Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 211; Roggemann-Funktionswandel des Eigentums, 189; Will-Eigentumstransformation 194 Roggemann-Funktionswandel des Eigentums, 225 195 Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 211


72

A further essential component of a market economy is the necessity of markets as the key arena in which enterprises and households interact. Well functioning markets are trading platforms, a source for the exchange of information and, above all, the main creators of competition. Moreover, financial institutions are central players in a market economy. They are responsible for the allocation of resources over time, for the distribution and assessment of risks, for payment mechanisms, and for the enforcement of financial discipline. They are typically the main capital investors and have therefore a strong influence on the productive enterprise sector. Thereby, it is highly important that financial institutions are free from extensive governmental interference in order to be able to make independent investment decisions based on economically sound risk assessments. On the other hand, they are the main capital suppliers; their failure to provide the market with needed capital may negatively affect the macro economic situation of the whole economy. Banks and other financial institutions in transition economies frequently carry a heavy burden of non-performing loans on their balance sheets. The “cleaning up” of those balance sheets becomes a key task in the early transition stage. The state in a market economy, on the other hand, is not eliminated but is charged with relatively distinctive tasks as in other economical systems. Instead directing output and resources, as typical in a command economy, the role of the state is to set, supervise and enforce the basic market principles and rules; provide for certain goods, services and facilities and ensure a varying range of rights and guarantees. The level of governmental involvement in market decisions varies widely among developed market economies and may be more intense in transition economies. Furthermore, the state must resist the temptation and incentives to interfere and protect on behalf of special interests. That may be particularly difficult since the state under other systems was frequently overloaded with responsibilities and the corresponding rights to interfere. Many of those functions and obligations rest in a market economy with independent and self-sustainable or self-regulatory institutions and organisations. The building up of such an institutional infrastructure may take a reasonable period of time and therefore may be a significant obstacle in the transition period. The task of redefining and creating a strong but limited state is fundamental to the transition process.196

196 EBRD-Working paper 18, 20


73

1.3. The scope of “transition economies” According to these observations it might be possible to use the term “transition economy” also in a wider context, covering a wider range of countries than only the jurisdictions in Central and Eastern Europe. Firstly, there are countries outside of Central and Eastern Europe, emerging from a socialist-type command economy towards a market-based economy.197 Moreover, it might be justifiable to categorise several other types of economies as being in transition as well.198 One has only to remember the key elements forming a market economy and the typical facets of the economical, social and political transition process. Economies which attempt to change their basic constitutional elements towards market-style fundamentals undertake a transition in a wider sense. Their origin could be in a post-colonial situation, in a heavily regulated Asian-style economy, in a Latin American post-dictatorship or even in a somehow economically less-developed country in Africa. Another more historical example, which provides for the contrary transition, is the economical and political process followed the Bolshevik revolution in 1917 in Russia. The new rulers initiated a transformation from a market-based to a command economy, including a change from private ownership to public or collective ownership rights (nationalisation). Similar developments took place in other socialist or communist countries.199 However, contemporary transition economies are usually characterised by one or more of the following features. In transition economies commonly prevails a strong governmental interference in markets and related activities of participants. They have frequently developed a system of weak private-ownership rights which is complemented by some form of extensive public or state ownership rights. Additionally, domestic markets are regularly shielded from international competition combined with a low level of competition among national participants. Finally, transition economies habitually lack the institutional infrastructure essential to support a market economy.

197 The most important example therefore provide surely the reform efforts of the Peoples Republic of China, see generally: Harmer- Chinese Bankruptcy Reform, Lam-Rules and Regulations; but also for example Vietnam 198 Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 211 199 EBRD-Working paper 18, 3


74

Consequently, the mere economical stage of development does not provide a valid criterion to identify a transition economy. According to the above-mentioned criteria, a country may be highly developed but in a phase of a transition in order to apply more market-based structures and principles. A good example therefore is provided by the recent developments in South Korea. Before the Asian crisis, South Korea was the eleventh largest economy in the world, the world’s third largest automobile exporter and one of the largest steel producer and shipbuilder.200 Nevertheless, the Korean economy was heavily affected by structures and elements incompatible with principles of a well-functioning market economy.201 After a serious decline of economical development in the Asian crisis the Korean government realised and recognised the shortcomings and failures and proposed extensive changes in their economical and institutional environment. Currently, South Korea is in a transition process to more market-based principles and structures and thus became temporarily a transition economy. Because of the similarities of the transition process of the Central and Eastern European countries (transition economies in a closer sense) and other types of economies (transition economies in a wider sense) towards more market-based structures and elements, the paper will cover and regard all of those countries as transition economies. Nevertheless, the main focus remains with several economies in Central and Eastern Europe and only additionally it will be referred to other transition economies. Nevertheless, a certain degree of development and progress is a usual and necessary feature of every economy. Also advanced market economies continue to develop their economical and legal structures and institutions in order to keep pace with economical needs and requirements. To distinguish between a mere further development of an already market-based economy and true challenges towards a market economy remains a difficult task. For the purposes of this paper it might be sufficient to grade an economy as in transition when the prevailing state of affairs does not comply with basic market rules and attempted or initiated reforms do exceed the usually expected development in a comparable economy.

200 Ehrlich-Governance of Korea’s Chaebols, 9 201 Ehrlich-Governance of Korea’s Chaebols, 9: E.g. extensive cross-guaranteeing among members of Chaebols, government-directed lending, close ties among government, banks and the Chaebols, weak corporate governance structures, insufficient debt-equity ratios, extensive short-term borrowing for long-term investments


75

2. The different characteristics and forms of economies in transition The subsequent discussion refers to characteristic features commonly found in transition economies which should influence the examination but especially the reforming process of the insolvency laws of those countries. The consideration and transformation of these characteristics in the reform process may become a key indicator for the success of the mission.

2.1. Legal tradition When comparing any sort of laws on an international scale one has to consider the sources from which particular laws have derived. Among over 300 jurisdictions worldwide we may be able to group them broadly into 8 legal families.202 For our purposes it may be even sufficient to concentrate on the common law tradition on one hand and the civil law tradition on the other hand. The distinction might be necessary since legal theories, instruments and mechanisms can significantly vary between those two legal families. In English-based common law countries, for example, corporate insolvency law is mainly contained in corporate or company legislation.203 In countries like India, Malaysia or Hong Kong, which have derived from the English common law system, the corporate insolvency law is contained in the companies act or similar laws and often have never been substantially reformed nor revised since their adoption many decades ago. Civil law jurisdictions usually provide for separate statutes both on liquidation and reorganisation.204 The jurisdictions of Central and Eastern Europe are mainly influenced by Continental European civil law countries like Germany, Austria, France or Italy. This is frequently reflected in their respective insolvency codes.205 What is questionable is, whether both systems differ in the application of insolvency law, despite of the different legal theories, instruments and mechanisms. Evidence suggests that there is no difference or, at least, none of any substance.206

202 Zweigert, Kötz-Rechtsvergleichung, 73 203 See for the historic division between personal and corporate insolvency under English law: Fletcher-Law of Insolvency, 10 204 ADB-Report, 18 205 Trunk-Stand und Probleme, 236 206 ADB-Report, 75


76

2.2. Cultural attitude Not really a characteristic feature only for transition economies is its cultural or commercial attitude towards insolvency proceedings or, more generally, towards any confrontational legal process. However, it might be of some advantage to consider such circumstances when studying or reforming an insolvency system. In some Asian jurisdictions, for example, prevails the position among individuals in general, and business people, in particular to prefer non-confrontational negotiations to formal and confrontational legal proceedings.207 Public litigation is often seen as breach of trust or breach of the business relationship.208 In this way, insolvency is not viewed solely from the perspective of law but, like most other legal issues, viewed within its social and cultural context. Such an approach is essential when reforming the insolvency regime and may be one of the reasons for the success of the structured informal insolvency initiatives recently set up in some Asian countries.209 Other countries, such as the former communist countries of Central and Eastern Europe, may face an aversion against the legal system and its institutions due to former misuse of the system by the communist government or the communist party or are reluctant to adopt Western or capitalist cultural norms or policies, as represented by the very basic principle of insolvency. On the other hand, people in transition economies may have had negative experiences with the executive branch under dictatorship or communist repression. Government officials from those periods might be still in office or have shifted to other influential positions. Consequently, the necessity for an independent judiciary with wide-reaching powers in those countries is enormous.210 Additionally, jurisdictions may have a different cultural believe towards a financial failure of a market participant and its consequences. Cultural beliefs about human nature and property rights influence how a particular society wants to treat creditors and insolvent debtors. The culture helps to explain why in certain societies some creditors and/or debtors are considered

207 Garrity-Korean Bankruptcy Law, 270 208 ADB-Report, 79 209 ADB-Report, 74; see for more details on some Asian debt restructuring initiatives, C.I.3.2.6. 210 Bufford-Romanian Bankruptcy Law, 256: that might be a historical reason why the Romanian syndic judge in insolvency proceeding has thus wide-reaching powers and the process is mainly court-driven.


77

more deserving than others. These beliefs may justify the redistributive effects that the consideration of cultural values imposes on other interests.211

2.3. Level of knowledge among domestic participants Another relevant characteristic of transition economies is the prevalent lack of knowledge and experience of the participants involved in the insolvency process. The insufficient level of knowledge and experiences is thereby not only commonly apparent in the judiciary and related professions (e.g. administrators)212 but also among the commercial and banking community and other supporting professions. However, the insolvency law, which is supposed to function in such an environment, should be designed to limit the impact of those shortcomings. Generally, if knowledge and expertise is not sufficiently available a more structured process for insolvency and workouts has to be considered. The discretion and freedom for creative participation, frequently granted to participants to reach several objectives, may have to be replaced by a more formal and structured process, providing participants with guidance and support. Additionally, the law should be drafted as easily and understandably as possible. Example One of the current obstacles of the insolvency regime in Russia is that there has been little experience with, knowledge about or tradition in, property, business and commercial law. The recent changes and developments in Russia’s commercial law regime are faced with resistance, antipathy and resentments among many participants. The 2000 judges of the new Russian Commercial Court, dealing exclusively with insolvency issues, are equipped with inadequate resources and are generally assisted by insufficient and poorly trained staff.213

211 Averch-Lien Stripping, 91; Gross-Failure and Forgiveness, 91 212 Brooks-Russia’s Struggle, 469: in Russia the number and quality of available trustees is completely inadequate. 213 Brooks-Russia’s Struggle, 469


78

2.4. Types of transition economies

2.4.1. Post-socialist transition economy

As mentioned before, the paper mainly focuses on jurisdictions from Central and Eastern Europe. What these jurisdictions have in common is that they emerged from a communist or socialist regime mainly dominated by the former Union of Soviet Socialist Republics (USSR). However, even with this common background are they quite different and might be therefore divided broadly into 4 groups.

a. Regional division

The first group214 consists of countries west of the former USSR which were never formally part of the USSR but came under Russian domination after the 2nd World War. In all of those countries the socialist governments were abolished in 1989. A second group215 consists of countries that were part of the USSR since its foundation in 1922, and which gained their independence in 1991, shortly after the aborted military coup in Moscow. The third group216 are countries that were formally part of the USSR after its occupation in 2nd WW. These countries gained their independence in 1989217 or after the military coup in 1991.218 To the last group belong the countries of the Balkan region which are Albania and the successor states of former Yugoslavia.219 Generally, these countries have a quite different and unique historical development in comparison to the countries of group 1-3. Yugoslavia, for example, was under a socialist or communist government but not dominated by the USSR. Albania, on the other hand, closed itself to the East as well as to the West for decades and is currently centuries behind in development. After the changes in the whole of Europe, Yugoslavia fell into an ethnic war from which effects it is still suffering.220 Because of the unique situation in the Balkan region, it will be only a secondary focus of this paper.

214 Poland, Czech Republic, Slovakia, Hungary, Romania, Bulgaria 215 Ukraine, Belarus, Russia 216 Baltic Republics: Latvia, Lithuania, Estonia; Moldova 217 Baltic Republics 218 Moldova 219 Slovenia, Croatia, Serbia, Macedonia and Bosnia-Herzegovina 220 Bufford-Bankruptcy Law, 461


79

b. Distance to market principles as criterion It might be even possible and appropriate to further distinguish among the different jurisdictions emerging from a socio-economic collectivism. Some countries221 in Central and Eastern Europe for example, controlled the quantity of production with fixed prices and markets, evincing little regard for reforms to increase overall productive efficiency. Other socialist countries222 made some attempts to allow a few market-economy concepts to guide economic decisions.

c. Pre-war situation as criterion

Additionally, we may differentiate between economies that already had some experience with a market-style economy prior to the 2nd WW and on the contrary, transition economies, which did not have such experiences. In several Central European Countries223 western-style legal system and market economies already existed prior to World War II. In most of those countries substantial parts of the legal system remained intact but were simply not used during the communist era. For our purposes, a great advantage was that insolvency and other commercial laws have existed already and did not need to be newly drafted. However, those pre-war laws were not used and amended for almost half a century and thus were in urgent need of substantial changes and amendments in order to cope with the challenges of the modern commercial and business reality. As we see in the forthcoming discussion, Poland, for example, is still using its Bankruptcy Law which was promulgated as presidential order in 1934 but was recently amended many times.224 Other countries, mainly states of the former USSR, did not have that tradition and consequently commercial, especially insolvency laws, had to be newly drafted and enacted.225

221 E.g. Romania, Bulgaria 222 E.g. Hungary, former Yugoslavia 223 E.g. Poland, Hungary, Romania 224 Bickford-Bankruptcy Law Reform, 928 225 Bufford-Bankruptcy Law, 477


80

d. Common features of post-socialist countries However, for our purposes the common features of those countries are of more importance. All of them were economically ruled by a type of planned economy. Characteristic measures of a planned economy are that production requirements were determined annually by the government; that costs and revenues were determined pursuant to a central plan; that production assets are owned by the state or government as “public property”; that no competition among enterprises was existing and market-shares were determined by plan; that those economies had only limited access to “world markets” due to the lack of freely convertible currency; that enterprises were generally agents of the governments without independence and their own decision making competence; that in order to avoid unemployment, the workforce was kept too high without consideration for efficiency; and finally, enterprises were usually charged with a variety of social functions. However, the two characteristics prevalent in those economies most important for the purpose of this paper are the absence of insolvencies and unemployment.

2.4.2. Post-colonial transition economy

Another type of transition economies is formed by countries, formerly dominated and governed by colonial powers. These countries226 usually have a number of features in common and may be therefore grouped under one heading. Typically, the colonial powers have imposed their administrative and legal system on their colonies without adjusting the structures to the cultural, traditional, economical or social needs and realities existing in these countries. Frequently, they even exported their commercial laws including insolvency and company legislation. Experiences with those imported insolvency laws have been quite different, but they were generally not often used by local businesses. Consequently, the colonial powers and the successor governments of the independent colonies have been paying little attention to the development and adjustment of those laws. After independence from its colonial powers, many of those former colonies have turned or turning towards the development of market-based economies. Generally, basic legal structures did exist but were outdated and therefore insufficient to cope with the challenges of a modern market economy. The reform of basic commercial laws became an important issue on those government’s agenda.

226 Typical former colonies in that sense are mainly found in Asia, Latin America and Africa


81

2.4.3. Other types of transition economies As mentioned above, one may think on several other situations, where an economy tends to open itself to market-based principles. It could be conceivable, for example, that a heavily regulated Asian-style economy is in the need of reforming the economy in general and the insolvency law regime in particular. Furthermore, some economically less-developed economies may still function without (workable) insolvency law. As soon as their development reach a certain stage they need to adjust their insolvency regime to the new requirements or, as the case may be, establish such a system. Nevertheless, the different types of economies in transition discussed are not necessarily separately assigned to particularly one jurisdiction. Several types may somehow apply to one economy and may therefore overlap respectively.


82

3. Differing stages of economic development and their practical implications As a matter of fact, there exist a varying degree of economical developments among emerging or transition economies. Some of them belong economically to the highest developed countries in the world227, others have advanced their economy successfully in the last few years and are almost on the way to a developed country228 whilst other nations are still struggling with the establishment of basic market concepts. However, the stage of economic development is in direct relation to the demands on the prevailing insolvency regime. Especially the different phases of the transition process may require respective response from the insolvency law. Right at the beginning of the transition course, for example, it might be necessary to protect failing SOE’s from liquidation and associated plant closures. It might be a central policy to prevent mass unemployment, along going mass poverty or even social unrest. Under this aspect, the insolvency law may be a mechanism for social stability. Additionally in this early transition stage, the insolvency regime might become an important tool to reorganize the state-owned sector and thereby adjust the structure of the economy to market principles. One the other hand, a country’s insolvency system should be viewed as part of its law and policy of economic development, but this does not necessarily mean that a country’s stage of economical development is or should be the only or predominant concern when designing the corporate insolvency system.229 Policy decisions regarding the insolvency law should be made in harmony with the prevailing political, social, historical, cultural and economical realities in that society.230

4. Historical causes that led to a increasing importance of insolvency Historically, insolvency law rarely attracted the increased interest of governments, the commercial community or even legal and other scholars. It is thus quite remarkable that insolvency and related issues in the last decade draw extensively on the attention of those people on a regional, national and even global scale. As mentioned earlier231, several organisations, financial institutions and scholars have been dealing with insolvency-related problems and impacts associated on economic growth and development.

227 E.g. South Korea, see B.II.1.3 228 E.g. the 12 new member countries of the EU 229 Braucher-Harmonising the Business Bankruptcy, 473 230 Braucher-Harmonising the Business Bankruptcy, 475 231 See for example the papers by the World Bank (WB-Towards Principles) and the IMF (IMF-Report)


83

Several, largely unrelated factors contributed to this unexpected and unique prominence.232

4.1. 1980`s crisis The first reason was the economic recession that affected many of the higher developed countries in the 1980’s. After an economic boom, stock and property values declined sharply and economical growth came to a halt. As many companies had borrowed extensively during the boom years, the crash resulted in widespread corporate insolvencies. Insolvency and particularly rescue regimes at this time were largely inefficient and difficult to apply. The lack of workable rescue mechanisms in those countries affected by the crisis produced extensive efforts to introduce modern and efficient formal rescue regimes and informal workout techniques.233

4.2. Collapse of the command economies Another important factor was the collapse of command economies around the world in 1989/90 and the beginning of the transformation of those countries towards market-oriented economies. The introduction of efficient insolvency regimes was and still is an important issue on those government’s agenda to take account of insolvent state-owned enterprises234, to reorganise and restructure the economy as a whole and to foster financial discipline. Pre-existing insolvency laws had to be reformed and up-dated or new insolvency laws drafted and enacted. This process is still going on; especially countries in Eastern Europe are still concerned with the reform and amendment of their insolvency laws.235

4.3. Asian crisis A third cause was the regional economic and financial crisis in 1997/98 having affected many countries in Asia and to a lesser extent the financial crisis in Russia 1998. This exposed, amongst many other things, the inadequacy of insolvency regimes or their application and implementation in many of those countries. After years of economical and financial growth many countries in the region were unable to accept or consider any economical backdrop and therefore largely ignored the importance and the need of efficient insolvency laws. Insolvency laws in the countries concerned were mainly outdated and widely not used.236 Many insolvency laws in the region were imported from colonial powers

232 See for a reasoning for the growing popularity of issues on international insolvency, Paulus-Der Internationale Währungsfond, 148-149; Paulus-Verbindungslinien, 2189-2195 233 ADB-Report, 10 234 See for the amount of insolvent SOE’s in some transition economy, B.II.5.1.2.b. 235 ADB-Report, 11 236 ADB-Report, 11


84

or other overseas jurisdictions more than hundred years ago and had never been reviewed. Available statistics237 indicate that there had been no cases of corporate insolvency at all. As a conclusion one could say that jurisdictions generally tend to ignore insolvency issues when they do not need them, as in the case of economical prosperity (insolvency is not an issue on the political agenda) and in a command system (insolvency does not exist, since corporations are mainly state-owned or “public property” and competition is non- existing). As evidenced in the Asian crisis, the consequences of such behaviour can be fatal. These lessons have impressed upon governments the importance and the need to introduce efficient insolvency systems and to maintain them under constant review even in times of prosperity and economical growth. Example Indonesia, for example, was severely affected by the financial crisis in Asia. Between mid-1997 and February 1998, the Rupiah lost about 80% of its value against the US-Dollar. One major consequence of the devastating currency devaluation was that it raised the prospect of large-scale insolvencies throughout Indonesia. Observers suggest that at the start at 1998 more than 80% of Indonesians enterprises were technically insolvent and the private sector debt mounted by US$ 80 billion.238

4.4. Pressure by the international lending community As a reaction of those developments, the international lending community, principally lead by the World Bank and the International Monetary Fund, have strongly pushed transition economies for insolvency reform. The IMF, for example, made insolvency frequently subject to its principle of Conditionality239 and required substantial changes in the insolvency regime of countries applying for financial assistance.240 Examples For example, in 1994, the IMF imposed a requirement of legal reform on Romania in four areas as a condition of qualifying for further IMF lending, of which one was insolvency law.

237 See C.IV.2.1 238 See for some general facts on the situation and the insolvency system of Indonesia: Tabalujan-Indonesia, 199 239 For a overview of lending practice of the IMF in general and its Conditionality in particular see: Guitian-Fund Conditionality, 1-47 240 See Paulus-Der Internationale Währungsfond, 148-149


85

Romania immediately scheduled insolvency law as a priority for revision in order to receive further funds needed for the development of a market economy.241 Guidelines of the IMF influenced also the reform process of the Bulgarian Commercial Code.242 Similar proposals to modernise and reform the existing insolvency regime were made to the Indonesian government by the IMF243, other international financial institutions244 and foreign investors in general in the aftermath of the Asian crisis in 1998.245

5. Policy choices and additional objectives in transition economies In addition to the aforementioned general insolvency objectives, several may be added in the case of a transition economy. However, some of the previously mentioned objectives might be of primary importance for the transition stage. As mentioned earlier, employing the insolvency law as an instrument to balance community interests, to provide social stability, prevent economies from systemic risk or to attract foreign capital is already a characteristic feature of the transition process. Nevertheless, in the subsequent section we discuss the characteristic conditions, necessities and respective objectives in more depth. In doing this, we contrast the existing situation in transition economies with the situation in modern market economies and may deduce the respective consequences from any differences for the purpose of this paper.

5.1. Low number of filings

5.1.1. General

As a matter of fact, existing insolvency laws in transition economies were and are often not or only rarely used.246 The number of filings and especially the number of concluded proceedings lacks considerably behind comparable statistics available from Western developed market economies.247

241 Bufford-Bankruptcy Law, 464 242 Popova-Bulgarisches Insolvenzrecht, 38: The Bulgarian Insolvency Law is part of the Commercial Code, Part IV Bulgarian Commercial Code 243 Indonesia – Memorandum of Economic and Financial Policies, 15.1.1998, Article 25 244 A main influence came from the technical assistance by the Asian Development Bank. 245 Kilgus – Das neue indonesische Insolvenzrecht, 47 246 For a general overview on statistics and filing numbers of insolvency see also C.IV. 247 Gross-Failure and Forgiveness: In the calendar year 1997, a time of relative economic prosperity, rose bankruptcy filings in the US to 1.4 million (96% individuals, 4% businesses); see for statistics of some transition economies C.IV.


86

Reasons for that might be manifold and much has been written about it. Nevertheless, counselling, advice and assistance of western scholars and officials is often based on a western understanding of a functioning market economy. It was commonly assumed that insolvency laws in transition economies would serve the same function as they do in the West: the restructuring of markets through asset-allocation. Thus asset re-allocation through insolvency laws would maximise market efficiency.248

5.1.2. Reasons for the low number of filings

Beside different privatisation approaches249, which may strongly influence the use of the insolvency regime, some other reasons are causal for the low number of filings in transition economies. Firstly, the fear of mass-insolvencies through the unlimited application of insolvency theories and already existing laws has prevented legislators to adopt Western-style insolvency laws or stopped market participants, (e.g. SOE management) to apply such existing provisions.250 The state was and often still is the owner or at least in control of significant key industries including the banking sector giving him the position to control the application of the insolvency law. Mass insolvencies cause mass-unemployment since labour markets in transition economies are usually not in the condition to absorb redundant employees on a large scale.251 Governments even have feared social unrest and the political fallout possibly resulting from the closing of insolvent enterprises.252 Furthermore, the outright liquidation of technically insolvent SOE’s may lead to a decline of respective asset values down to 20-30%.253 In addition, the insolvency infrastructure254 was and often is not on an equal level with Western jurisdictions. However, as important the issue is, the paper deals not further with it. Moreover, decision makers in transition economies did and do not understand the concept of enterprise insolvency. The principle of market failure is often unknown and insolvency

248 Kim-When Nonuse is Useful, 1048 249 See for the relation between privatisation and insolvency: B.II.7. 250 Trunk-Stand und Probleme, 238 251 The 1992 amendment of the Hungarian Bankruptcy, for example, and the along going mass-liquidations caused an increase in unemployment from 3%-11%. 252 Kim-When Nonuse is Useful, 1066 253 Lowitzsch/Pacherowa-Das novellierte polnische und slowakische Insolvenzrecht, 212 254 Including: specialized insolvency courts with experienced and well trained judges, experienced and skilled administrators, trustees, liquidators, bailiffs, lawyers, accountants and bankers, well functioning markets to absorb assets stemming from liquidation or reorganisation; functioning capital markets to channel investments as precondition for successful reorganisations


87

proceedings are frequently seen as something negative. Additionally, concepts of insolvency are frequently understood as Western cultural norms and policies that transition economies are habitually unwilling to embrace.255 Furthermore, prevailing experiences with insolvencies have often been not very promising without any worth mentioning positive outcome for debtors, creditors and other participants. Occasionally, the governments of many transition economies stepped in and bailed out failing enterprises. The moral hazard thereby produced was contrary to the general objectives mentioned above and did increase the general disbelief in the insolvency law.256 Another obstacle, due to shortcomings of several insolvency laws and not limited to transition economies, is the fact that directors and managers often fear the loss of control of the enterprise, what frequently negatively affects the willingness to voluntarily commence formal insolvency proceedings.257 Severe inflation258, as experienced frequently in transition economies, has a number of impacts influencing the application of the insolvency law. For example, substantial inflation reduces the value of assets that are carried on balance sheets at historic costs, unless an inflation adjustment is made. High inflation levels render it difficult to reach agreements on rescue plans since opinions about values of assets may vary considerably among participants. Another significant factor, which is reflected in the low level of filings, is creditor passivity259: creditors rarely act aggressively to collect the debts owing to them. That is especially true for state-owned enterprises. When nobody enforces its claims by using the judiciary, nobody is motivated to initiate insolvency proceedings since protection against individual debt collection efforts is not needed.260 Furthermore, the prospects for general unsecured creditors to recover even a part of the outstanding debt are usually very small.261 To initiate proceedings, the filing debtor has to advance the often not insignificant filing fee and frequently prove the insolvent status of the debtor. Creditors make often an economical based decision, balance the possible outcome of insolvency proceedings with the connected risks and efforts and may refuse to file a petition.262

255 See for the here as cultural attitude referred to phenomenon: B.II.2.2. 256 Kim-When Nonuse is Useful, 1067; for a discussion on moral hazard see: B.II.6.3. 257 ADB-1999 Report, 16 258 Bufford, for example, estimates that the (hyper-) inflation in Ukraine in 1993 was 4735 percent, see Bufford-Bankruptcy Law, 471 259 For Poland: Brol-Das polnische Konkursrecht, 307; for Romania: David-Praktische Probleme, 368 260 Bufford-Bankruptcy Law, 474 261 David-Praktische Probleme, 369 262 Brol-Das polnische Konkursrecht, 307


88

An additional feature which frequently occurs in transition economies is a severe drop in asset values and poor debt recovery prospects because of general macro economical setbacks. One consequence is that creditors and debtors alike tend to adopt a general “wait and see” attitude and postpone individual enforcement and collective remedial actions.263

5.1.3. Alternatives to insolvency proceedings applied in transition economies

The common view that the low level of insolvency proceedings is a warning sign of macroeconomic problems may not be true in transition economies. To avoid the impacts of insolvency proceedings governments of transition economies have frequently turned to various debt-restructuring devices which may result in similar effects normally reached through the insolvency process. The techniques and methods264 applied vary considerably among jurisdictions but are mainly concerned with the restructuring of the heavy debt burden carried forward by lenders and other creditors. Firstly, governments set up public entities which acquire bad loans and other debts. These governmental agencies are often equipped with special powers to negotiate with and to a varying degree restructure debtor enterprises.265 Furthermore, some governments have channelled financing and other support to selected entities, thereby preparing these enterprises for privatisation and for a competitive market environment. Under this approach insolvency law purposely was circumvented and whole industry sectors were exempted from the insolvency regime to achieve financial stability and ensure social stabilisation.266 Especially SOE’s with a high number of employees, SOE’s in certain key industries and those with prospects of reasonable revenues were dealt with in this way. Other transition economies have transferred ownership rights of certain SOE’s to a governmental restructuring agency which has been carrying out the necessary restructuring measures as precondition for a subsequent privatisation or a more profitable existence as SOE.267

263 ADB-1999 Report, 11 264 See for a brief introduction of several examples: B.II.5.2.5.b./c. 265 Kim-When Nonuse is Useful, 1069 266 Trunk-Stand und Probleme, 238 267 Kim-When Nonuse is Useful, 1070


89

Again other countries exempted particular enterprises completely from the scope of the general insolvency law and tried to deal with those financially distressed companies outside insolvency.268 As mentioned earlier269, particularly in Asian jurisdictions, informal workouts are preferred to formal insolvency proceedings. This cultural attitude is reflected in the insolvency statistics in those countries.270

5.2. State-owned enterprise insolvency

5.2.1. General

Another specific issue of insolvencies in transition economies is the financial distress of the relatively high number of state-owned enterprises. A SOE is an economic entity that is state or government owned or controlled by the government. A government is able to control a SOE when it may influence effectively and directly management decisions of that enterprise. There are several ways how this control might happen, for example, through a majority stake of the government or respective statutory powers. The common problems of SOE’s are not unique to transition economies since SOE’s exist also in developed economies. But there are several aspects related to insolvencies and financial problems of SOE’s which are unique to transition economies.

5.2.2. Current situation of SOE’s in transition economies

In emerging economies, even after privatising parts of the state-owned sector, the largest enterprises remain state owned and are often the largest employers and loss-makers. They are still directly or indirectly subsidised by the state or the state-owned banking institutions271. Statistics and estimations suggest that a substantial share of SOE’s in transition economies are or has been assessed as technically insolvent either after a balance sheet or liquidity test.272 268 Trunk-Stand und Probleme, 238; for Romania see: Romanian Insolvency Code Art.129, 130 and for the Romanian “administrative” liquidation: David-Praktische Probleme, 366, Emergency Ordinance of the Romanian Government No. 10/1997 269 See B.II.2.1. 270 See C.IV. 271 WB-SOE Insolvency, 2


90

Furthermore, SOE’s in transition economies are frequently mainly indebted to the government, a state-owned bank or another governmental agency.273 In some transition economies274 these debts cannot be worked out since governments are prohibited by statute from compromising debt: only a court order may allow them to reduce, forgive or postpone the debts. Thus, a formal reorganisation procedure may be the only way to restructure businesses in the typical case where a substantial portion of the debt is owned to government enterprises.

5.2.3. Causes for this situation

At the outset one has to admit that the current financial and operational situation of many SOE’s in transition economies is the result of certain historical and/ or political developments. In the countries of Eastern Europe, for example, SOE’s used to have a constant market share without competition, constant income streams and relative freedom from market forces since economies were planned and the existing business shared among SOE’s of one country or within the member states of the Council for Mutual Economical Assistance (CMEA). After the political and economical turn275 these economies have opened themselves to a market-style economy. Overnight SOE’s had to compete with market-experienced companies from other parts of the world. Accordingly, those countries lost markets and clients and were hardly in the position to restructure their business nor successfully tap new markets. Additionally, they eliminated or reduced price control and trade barriers what lead to a further increasing of competition. Payment mechanisms switched suddenly to hard currency, with prices moving towards world levels. Crucial supplies became unavailable or unaffordable. Workforces have become bloated because businesses operated as bureaucracies, where there were no incentives for efficiency.

272 75%-90% of SOE’s in Romania are technically insolvent, WB-SOE Insolvency, 11; 70-80% of Russia’s enterprises are insolvent and unprofitable, Brooks-Russia’s Struggle, 468; 25% of Hungarian, 45% of Polish and some 90% of Ukrainian enterprise are technically insolvent, Bufford-Bankruptcy Law, 469 273 Bufford-What is Right, 843: In Romania, for example, 70% of the debt of the state-owned sector is owed to the government. 274 E.g. Romania, See: Bufford-Romanian Bankruptcy Law, 254 275 At the historic CMEA meeting in Sofia in January 1990 the member countries decided that trade should be conducted in hard currency and based on world market prices, Nicolas Stern, EBRD Working Paper 18, April 1997


91

In addition, there has been for many years a lack of capital and operational investment, and equipment and facilities are frequently obsolete or in disrepair.276

5.2.4. Insolvency-related aspects of SOE’s in transition economies

There are a variety of circumstances regarding SOE’s which have to be considered when a legislator in a transition economy may wish to reform its insolvency regime.

a. Debt relief and moral hazard

Firstly, in the situation where the state is owner, lender and largest creditor, a restructuring effort might become difficult. If the state as a lender forgives debt of its equity holdings it may expose the financial system to prudential risk. This applies particularly in transition economies where SOE’s are often abnormally over-indebted and financially distressed. Contrary to many developed countries in transition economies SOE’s are major employers and form a substantial percentage of GDP. On the other hand, a debt relief, how ever designed, might be essential to transform the SOE to a more productive and efficient enterprise. Another effect that is closely related to the former is the potential for moral hazard. When the government decides to bail out failing SOE’s there is no incentive for other borrowers to repay their debts since they expect to receive a similar treatment as the SOE’s bailed out.

b. Downsizing the over-employment

A further macro-economic and social concern relates to the problem of unemployment. Since SOE’s in transition economies are traditionally top heavy on the labour side, downsizing might be necessary to bring expenses in line with revenues. That requires a well performing social safety net since labour markets in transition economies are frequently not able to absorb the great number of redundant workers. But a respective social safety net in those countries is often not existing or weak and incapable to cope with the increasing amount of benefit seekers. Of course, a solution to these difficulties may lie outside the application of an insolvency law and may be only resolved in the long term by the provision of a comprehensive social security system.277 Nevertheless, policy makers in transition economies

276 Bufford-Bankruptcy Law, 469 277 Harmer-Chinese Bankruptcy Reform, 2582


92

have frequently attempted to correct deficiencies of their respective systems and, at the same time, providing for social stability through instruments available under the insolvency law. Furthermore, mass lay-offs may even provoke social upheaval278 and will most certainly lead to political disfavour among voters.

c. Lack of markets to absorb assets

According to a well-accepted objective of insolvency279, an enterprise without the prospect of viability has to be liquidated and the remaining assets transferred to a more efficient use. Thereby, liquidation should not been favoured over reorganisation and vice versa. But markets in transition economies are frequently not capable to absorb more assets stemming from liquidation proceedings. The effect is that assets either languish in liquidation procedures in the never-ending hunt for buyers who will pay a fair market price, or they are sold at a percentage of their real value. If markets are not capable of absorbing liquidated assets to reasonable market prices, liquidation becomes a destroyer of asset values with a possible severe impact on the whole economy. But even where market capacity exists tight credit and weak capital markets may place the assets out of reach of local buyers. The only available buyers might be foreign investors, but many governments of transition economies resist a foreign “take over” of their former SOE’s or remaining assets for political and policy reasons.280 Another consequence of the absence of markets in transition economies is that it makes it nearly impossible to value assets in order to determine whether a plan of reorganisation should be confirmed.281

d. High number of technically insolvent SOE’s

Furthermore, because of the enormous amount of corporate insolvencies in transition economies, a mass liquidation of insolvent businesses is neither economically nor politically desirable. In many transition countries the entire liquidation of the insolvent enterprises would result in the virtual disappearance of the economy altogether. Restructuring is the only feasible alternative that can be considered for a substantial portion of the larger business entities.282 Consequently, policy makers in transition economies may tend to prefer reorganising a SOE instead of liquidating it, even when a pure economical analysis would suggest the latter.

278 As recently experienced in Indonesia and Romania, WB-SOE Insolvency, 7 279 See for an economical approach to insolvency the “creditors bargaining model”, See B.I.1. 280 WB-Towards Principles, 95; WB-SOE Insolvency, 2 281 Bufford-Bankruptcy Law, 470 282 For the situation in Poland see: Brol-Das polnische Konkursrecht, 313


93

e. Corporate governance structure of SOE’s

Conflicting interests of the state, frequently found in transition economies, make the decision-making process of SOE’s more difficult. Acting in the best interest of the equity holder, means acting against its creditor interests. Acting as a creditor, means acting not for the advantage of the SOE and other creditors. Acting for the interests of the work force, may mean ignoring needs and the economical reality of the SOE. Decisions are often more influenced by political than commercial realities. Any decision towards restructuring or privatisation of the financially distressed SOE reduces the influence and power of the decision-making politician. It seems to many bureaucrats less painful to rollover due debts or to extend further credit or government subsidies than undergo a disliked financial and operational restructuring. Decision-making in SOE insolvency proceedings regularly entails extensive government involvement. It is often impossible for an enterprise to submit to insolvency or to file for certain other measures unless the enterprise has been cleared or licensed to do so by a number of government department and agencies.283 Corporate government structures are often ineffective since there is no clear separation between equity holders, management and creditors. Additionally, the state interferes in management decisions on a day-to-day basis. Furthermore, decision-making directors or other officers might be representatives of the government or other individuals with no expertise regarding the business and management of the SOE. Moreover, the immediate costs of an efficient restructuring process (debt write-offs, employee redundancies) are often much higher than to afford further subsidies or extend credit. Officials tend to focus on immediate costs and gains, while the benefits of the restructuring are realised over the long term.284

283 A serious problem in the PRC, See Harmer-Chinese Bankruptcy Reform, 2578 284 WB-Towards Principles, 97; WB-SOE Insolvency, 4


94

f. Financial and operational deficiencies of SOE’s Many transition countries` financial systems are weakly regulated, poorly supervised and under-capitalised. This is often combined with ineffective lending practises, poor credit rating and risk management techniques for distressed enterprises. Restructuring the distressed SOE’s requires in many cases debt relief or rescheduling, debt to equity conversions and cost-reducing measures. The weak financial systems are often not capable to handle debt write-offs and rescheduling on the scale necessary to address the dimension of the problem. Additionally, underdeveloped capital markets, often prevalent in emerging economies, hamper the possibility to raise new capital to meet ongoing operational and debt service costs. Traditional “financing” of the needs of SOE’s originally came from the government in the form of direct lending. According to the economic plan (often with a 5 years duration) state-owned banks were extending subsidised credit to SOE’s. The terms of the loans lacked usually any market basis, were done without risk assessment and other credit control measures. This lending practise was continued after subjecting economies to market-based rules. However, consequences were dreadful: debt levels of SOE’s have increased remarkably and the balance sheets of lending institutions revealed a high level of non-performing loans. Often, these lending banks will not voluntarily participate in insolvency proceedings nor initiate them. The final liquidation of a debtor will prove the un-recoverability of a loan and negatively affect the banks balance sheet and thereby might have directly an effect on the credit rating of the bank. But also reorganisations are not in favour of these institutions since they usually end with substantial debt write-offs.285 SOE’s in developing countries are often not only financially distressed; they suffer also from operational deficits. Business strategies are obsolete; technologies have to be upgraded; management is ineffective and costs are too high; marketing, research and development does not exist; price structures for products are artificial and disconnected from economical factors and real costs. Restructuring this may require enormous financial input and hence is frequently politically undesirable. Applying, for example, market prices to many goods may result in an undesired increase of price levels formerly subsidised by the government.

285 Harmer-Chinese Bankruptcy Reform, 2580


95

g. Legal and institutional frameworks in transition economies Perhaps the strongest external factor that affects not only SOE’s is the widespread ineffective legal and institutional framework in transition economies. By way of example, contractual rights are often poorly defined and hardly enforceable and available security rights are limited or even not existing.286 Consequently, lenders and creditors in general have little protection and therefore less incentive to deal with SOE’s. That in turn makes it difficult for SOE’s to obtain credit to reasonable prices since creditors will ultimately add high risk premiums to their credit. Finally, the existing institutional framework frequently lacks skilled and trained professionals to handle the amount and variety of insolvencies among SOE’s. Especially the judiciary is, qualitatively and quantitatively, often not able to cope with the range of problems accompanied with SOE insolvencies.

h. Social assets

Furthermore, SOE’s are frequently burdened with “social assets” like medical clinics, kindergartens, schools or elderly care centres287 that are critical and invaluable to the local community. In exchange, SOE’s are often directly or indirectly subsidised by the government. In order to successfully reorganises their business, they would have to abandon those social engagements. However, local governments which are according to a western understanding responsible for such facilities, are frequently not able to afford and to maintain these necessary services. However, in a liquidation scenario, those welfare facilities would belong to the assets of the debtor enterprise and consequently distributed to the creditors accordingly. Such an outcome may be neither favoured by workers and other inhabitants, depending on those services, nor by the government, somehow responsible for those basic facilities. In the Peoples Republic of China, for example, it has been provided on a trial basis that certain welfare facilities shall not be included as part of the assets available to creditors for distribution in liquidation proceedings. Additionally, these facilities were taken over and managed by the government where the insolvent enterprise is located.288

286 See for obstacles on the availability of security in transition economies: Breidenbach-Thesen, in Drobnig (Hrsg.) Systemtransformation, 357 287 EBRD-Working Paper 22 288 Lam-Rules and Regulations, 356


96

Similarly exempts the Russian Bankruptcy Code289 the social housing fund, children’s pre-school institutions and other facilities of public infrastructure from the estate of a debtor enterprise. If a debtor, who his currently maintaining such facilities becomes insolvent, the respective facilities shall be transferred to and maintained and operated by the respective municipality without further conditions.290 In other transition economies, those social facilities were divested directly to municipals or local governments.291 Even more complicated is the situation in areas with an extreme high concentration of employment. Especially the planned-economy-doctrine gave rise to “one-company-towns or areas”292, where one SOE is the main provider of employment, social benefits, housing and infrastructure. Liquidation or restructuring of such enterprises requires the consideration of a wide range of issues. However, this problem should be addressed explicitly in the respective insolvency law with provisions for a general arrangement of this impediment.293 As a general policy consideration, transition economies should attempt to transfer those financial and operational responsibilities from SOE’s to municipals, local or central governments. Moreover, some transition countries have shifted the burden for the social welfare of workers to state and collective enterprises. The government has neither responsibilities nor sufficient resources to provide social support for redundant workers, pensioners or to cover work related injuries, permanent disability or general medical care. Those SOE’s are therefore regularly heavily indebted and frequently not able to finance the increasing numbers of redundant workers. Under these circumstances, unemployment and lack of funding to provide for retrenched and retired workers, and a multitude of other social services threaten social order.294

i. Size of the debt

Another obstacle is the sheer size of the debt burden of many SOE’s. Due to the above-mentioned reasons many SOE’s have accumulated unmanageable debt levels during the early years of the transition process.

289 Russian Bankruptcy Code, Art.104 (4) 290 Russian Bankruptcy Code, Art.104 (5) 291 EBRD-Working Paper 22 292 EBRD-Working Paper 22, 16 293 See for a more detailed discussion on the problem, B.I.3.11.2. 294 Harmer-Chinese Bankruptcy Reform, 2565


97

There is a need for appropriate mechanisms to write off these accumulated liabilities, write down assets and allow the enterprises to go forward with a clean balance sheet.295

5.2.5. Elements and structures of the insolvency regime related to SOE’s

a. General

Generally, SOE’s in transition countries may have a valid chance to be returned to viability or restructured if they undergo financial restructuring through debt forgiveness, rescheduling or perhaps debt-equity conversions and a operational restructuring concerned mainly with cost-performance ratios, efficient management and technologies. Such a restructuring process contains some typical macro-economic implications that go along with insolvencies of SOE’s in transition economies. However, most important for the success of a rescue and reorganisation regime in transition economies is that the policy maker considers the prevalent issues carefully and designs a insolvency regime that reflects those specific issues and balances the varying policy goals accordingly.

b. Informal workout process

Since judicial capacity and expertise varies considerably among transition economies, attention should be paid to informal workouts with no court involvement on a day-to-day basis. Additionally, informal workouts are frequently more flexible, with less negative stigma and cheaper than formal insolvency proceedings.296 To lever participants to workout their debt and financial difficulties privately, an underlying and supportive statutory mechanism has to be designed. Viable SOE’s are more likely to be restructured if they are subject to financial discipline. Financial discipline requires internal incentives as well as external incentives.297 Internal incentives to financial discipline are, for example, when management and owners receive benefits according to performance criteria; external incentives are, for example, when market forces and legal structures pose serious consequences for certain behaviour (breach, fraud). Workouts are more likely to occur where creditors have strong enforceable rights and actively participate in the process. Such rights must be reflected in the laws pertaining both security and enforcement rights. 295 Deloitte-Restructuring, 6 296 See for a more detailed discussion on informal workouts C.I.3.2.


98

Furthermore, the decision-making process should be transferred to independent and neutral parties away from any governmental intervention, except where such intervention is truly neutral and necessary. That can be reached through a compulsory or voluntary replacement of existing management by outside directors in the restructuring process. At least the existing management should, when it stays in office, be accompanied by outside directors which have a majority on board decisions. These outside directors should be complemented by independent and neutral advisers which should be held independently accountable. Additionally, dissenting minority creditors should be prevented from upsetting out-of-court negotiations by sanction standstill agreements by statutory mechanism. One possibility would be to recognise pre-packed plans under the formal reorganisation regime.298 In designing the general system, emphasis should be on operational reorganisation since pure financial restructuring might give a wrong impression of the viability of the SOE and comes to short to make the enterprise viable for the future. Generally speaking, SOE’s should be within the scope of the general insolvency regime.299 Experiences in transition economies have revealed that a quick and decisive procedure might be necessary to cope with the systemic effects of financially distressed SOE’s. Therefore fast-track procedures or pre-packed plans might be useful and supportive. As a result, the institutional capacity has to be built up including a well-trained judiciary. However, SOE’s without relation to non-state participants (state is owner, and solely creditor) may be exempted from the general insolvency law. These enterprises may better be dealt with under an entirely separated administrative law even though it may contain some aspects of insolvency procedure.

c. Developments in some transition economies300

In the absence of a strong workout culture301, as frequently prevalent in transition economies, informal or formal procedures and guidelines might be encouraging the parties to negotiate. For that reason, several jurisdictions in transition economies302 have developed some kind of a structured informal workout procedure outside the scope of the general insolvency law. Characteristics vary considerably among jurisdictions and cannot be discussed extensively within the scope of this paper. However, we may consider some of them and by doing so briefly discuss their features and contents.

297 See for a brief discussion on the incentive structure of the insolvency law: B.I.4. 298 See also the discussion on pre-packed or pre-negotiated reorganisation plans, C.III.5.2 299 See also the discussion on the scope of the formal insolvency law, D.I.2.3. 300 See for more WB-SOE Insolvency, 7 301 Workout culture=attitudes and expectations of companies and other creditors toward out-of-court workouts 302 E.g. see the non-exhaustive list at Deloitte-Restructuring, 18 for Central and Eastern Europe


99

(i) Programs in Eastern Europe In Eastern Europe, for example, one can broadly distinguish among three different types of programs.303 All of them provide for the establishment of a state body or agency acquiring the debts of the relevant SOE’s. The agency starts then negotiating and thus restructuring the SOE debtors. Some of those programs provide just for bank recapitalisation. Two approaches to the problem of recapitalisation to deal with bad loans may be identified: “carve-out” and “workout”.304 Under “carve-outs” a central institution (“hospital bank”) acquires bad loans and tries to workout the loans with the borrowers and thus allowing them the opportunity for restructuring. Under “workouts” the lending institution itself attempts to deal with the non-performing loans while carrying on its business. Other programs set up a restructuring agency which scrutinises the viability of the SOE and decides consequently whether the SOE is to liquidate or to restructure. Ownership of the SOE’s is normally not transferred to the agency. Again other programs even disclaim the establishment of such an agency and provide just for procedural guidelines (by way of statutory instruments) under which the negotiations with banks and other creditors shall take place.305 Those programs were seen as a practical temporary solution to address the needs of the vast amount of illiquid SOE’s. In many of these Eastern European jurisdictions such programs have already expired after having had a more or less successful live. Analysing the rate of success of those programs may be difficult since types and shades of them vary considerable. However, generally one can say that programs which provide for a transfer of ownership to the restructuring agency and programs containing easy understandable but detailed provisions were more successful than other programs.306

303 See Deloitte-Restructuring, 18 304 EBRD-Working paper 18, 18 305 Deloitte-Restructuring, 18 306 Deloitte-Restructuring, 19


100

Polish FREB One program to reorganise SOE’s is the Polish Law on Financial Restructuring of Enterprises and Banks promulgated 3rd February 1993 (“FREB”).307 When the law was enacted in 1993, many SOE’s were performing badly in Poland and often unable to repay loans extended by mainly 7 state-owned banks. Figures suggest that approximately 30-40% of bank loans made to commercial borrowers were troubled or in default. However, for several reasons, those banks were not instituting insolvency measures as provided by the existing Bankruptcy and Arrangement Act. To deal with this situation, the government enacted FREB. The intended objectives of the law were mainly to rescue SOE-borrower with a perspective of viability, to closedown insolvent SOE-borrower with no realistic chance of independent existence, a speeding-up of the privatisation process of the state sector, the essential re-capitalisation of state-owned banks and more generally, the strengthening of Poland’s financial sector. The FREB authorises state-owned banks to conduct out-of-court reorganisation proceedings on behalf of all creditors with failing SOE-borrowers. Thereby the banks have wide discretions, for example, to reschedule capital/ interest payments; to negotiate debt write-offs or to negotiate debt/ equity swaps. The FREB also created a framework for the disposal and trading of bad debts. Retrospectively, the FREB has been quite successful with more than 500 commenced conciliation programs involving SOE’s.308

German Treuhandanstalt309

Furthermore, one might refer to the special legislation enacted in 1990 in reunified Germany to deal with the former East German state sector, containing almost all medium and large enterprises of the region. Most of those SOE’s were burdened with the impediments mentioned above. In order to encourage private ownership rights in the economy and to reorganise the operational inefficient and financially distressed public sector, a powerful administrative body (Treuhandanstalt) was established. The task of this agency was to restructure SOE’s and either to sell (privatise), merge, conglomerate, or liquidate them in cases where restructuring and privatisation did not appear possible. Therefore the Treuhandanstalt applied mainly administrative measures and did rarely refer to judicial resources. 307 Zedler-Länderbericht Polen, 290 308 Deloitte-Restructuring, 26; Brol-Das polnische Konkursrecht, 314


101

The restructuring and privatisation process begun with the corporatisation of the SOE: the Treuhandanstalt became the sole shareholder and installed a supervisory board and the legal ownership of assets was transferred to the newly established company. Subsequently, the Treuhandanstalt commenced a temporary financial restructuring, including a short-term moratorium and new loans guaranteed by the Treuhandanstalt. At the same time, balance sheets were rewritten according to international accounting standards and business plans were drawn up. In order to recapitalise the SOE’s, the Treuhandanstalt did not inject new capital but assumed liability for the existing debt. The operational restructuring process contained measures like the breakdown of groups with different production units in separate companies (spin-off) and the sale of excess or unused assets. Along going with the restructuring, a downsizing of considerable parts of the excess workforces, characteristic of the state enterprise system of the former East Germany, became necessary. Among other things, this reduction required intensive job creation programs. After this process some 14,500 enterprises have been privatised, either through partial privatisation of a going concern business (50%), outright sale (30%), or partial sale. For enterprises that could not immediately be restructured and privatised, different restructuring techniques were applied. Where privatisation was projected as possible solution in the long term, a holding company was established and several enterprises were grouped under the holding. An independent manager was supervising the financial and operational restructuring process. Another method was the so-called “administrative liquidation” which provided for a gradual and orderly disposal of assets of the affected SOE and a “consultative bargaining” process with creditors to reduce their claims. However, in contrast to normal liquidation the proceeds were much higher. In this process, debts, whether reduced or not, had to be paid in full. This was, in effect, a state administrative process, without doubt costly for the state but arguably providing in the long term some social and economic benefits and a better result than outright formal liquidation. Furthermore, formal liquidation through the judicial process was applied. This appears to have been a “last resort” option in the East German experiment.310 However, only 10-15% of the liquidated SOE’s in former East Germany went through formal liquidation proceedings and the rest were dealt with in the administrative process. The administrative liquidation provided for several advantages: the business activities could continue until the enterprise or respective assets were sold; a reduced workforce could be maintained; the Treuhandanstalt was able to manage the asset and, subsequently, a better micro and macro economic control was possible.

309 See for a brief overview on the German privatisation agency: Lichtblau-Privatisierungs- und Sanierungsarbeit der Treuhandanstalt 310 Harmer-Chinese Bankruptcy Reform, 2585


102

However, disadvantageous on this method was that it caused higher costs since the government had the obligation to further debt service and the maintenance of the assets until its sale or transfer.

A final observation should be made to effects of this privatisation or restructuring technique on the employment situation in the former state sector. In 1991, there were approximately some three million employees in state enterprises that were engaged in some form of restructuring or liquidation. At the end of 1994, approximately fifty percent of them were enjoying continued employment in now privatised companies; about seventeen percent were unemployed; about twenty-seven percent had been retired; and the remaining six percent were employed in temporary labour schemes.311 Another example offers the new privatisation law in Romania which provides for more flexible workout and restructuring procedures and incorporated an independent liquidation scheme for state owned enterprises.312

(ii) Programs in other parts of the world

However, these quasi-liquidations and administrative approaches were not only means of the transition process of Eastern or Central Europe but were also applied in other parts of the world.

The Indian Sick Industrial Act 1985

Another example for a more administrative approach to financial and operational difficulties in the industrial sector presents the Indian Sick Industrial Act 1985. After serious economical problems in several industries the Indian legislator enacted special legislation to deal with mainly private enterprises. However, the law was 1991 amended and extended to SOE’s. Under the law a Board for Industrial and Financial Reconstruction was established and equipped with wide-reaching administrative powers. Enterprises with financial difficulties313 were referred to the Board, an investigation was started and, finally, a decision about prospects of the enterprise made. Once an enterprise is subject to such proceedings, a moratorium or stay takes effect preventing civil proceedings or other action from being taken

311 Harmer-Chinese Bankruptcy Reform, 2587 312 WB-SOE Insolvency, 11 313 A “sick” industrial enterprise is defined under the Act as one that has incurred losses in consecutive years and whose assets to liability ratio is below a nominal standard of 1:1.


103

against the debtor or its assets except with the consent of the board.314 The Board is required to conduct an inquiry into the financial position of the debtor and determine whether the company might, within a reasonable period of time, recover; whether a scheme of rehabilitation should be proposed or whether it should be liquidated. The board may compel liquidation by requiring that the relevant court grants an order to that effect under the relevant insolvency law. The Board was particularly successful in rehabilitating SOE’s. That result is mainly due to the establishment of a special fund in 1992, helped by a $300 million loan from the World Bank to assist with the problems of redundant employees in these enterprises. The fund has been used to promote early retirement and retraining schemes among the redundant and displaced workers from affected SOE’s. However, beside this success, critics suggest that this legislation was very much conforming to a somewhat interventionist economic approach of the Indian government at this time. Frequently, the Act as “branch” of the Indian insolvency law was labelled as being very much “pro debtor”. Often, the result has been the write-off of government investment and/or loan funding in the SOE to enable it to a fresh start.315

Philippines Presidential Decree 902A

Another example is the Presidential Decree 902A of the Philippines of 1976. A rescue procedure known as “suspension of payments” under the insolvency law of the Philippines was transferred under the jurisdiction of the Securities and Exchange Commission. In addition, an alternative to suspension of payments was introduced. This procedure is commonly referred to as ‘rehabilitation’. It enables a corporation whose assets do not exceed its liabilities to apply to the SEC for the appointment of a rehabilitation receiver and/or management committee and then to develop a rehabilitation plan. In effect, a company files a petition, a provisional suspension order is granted, creditors are notified of the petition and the Commission may then appoint a management committee and rehabilitation receiver. Once such an appointment is made, an automatic stay or suspension takes effect. The provisions of the decree relating to a stay or suspension of actions against the corporation or its property admit of no exceptions and may even operate so as to require all creditors (secured and unsecured) to be treated the same. Control of the enterprise passes from the management to the appointed management committee or the receiver. The receiver may propose a reorganisation plan. If such a proposal is not made or if the Commission refuses to do so, the Commission may order the liquidation of the corporation. A further

314 ADB-1999 Report, 25 315 Harmer-Chinese Bankruptcy Reform, 2583


104

approval of a respective creditor body is not essential – the ultimate decision is that of the Commission, from which there is no appeal to a court. This process has shifted what was once a judicial process into a quasi-judicial process, since jurisdiction was transferred from the courts to the Commission. A state agency assumes the power to decide over the future perspectives of enterprises. Furthermore, it is remarkable that formal creditor involvement is not required. The Commission may accept a reorganisation proposal which is contrary to the interests of the creditors. Although the rehabilitation process has operated with some apparent success there has been a clear need to provide greater transparency, predictability and fairness in the procedure. On January 15, 2000, the SEC’s newly enacted Rules of Procedure on Corporate Recovery took effect. These provisions contain, amongst others, a set of rules governing the qualifications of persons who may be appointed as a receiver or liquidator; the creation of classes of secured and unsecured creditors; detailed time periods for various parts of the procedure; a clear statement of the functions and duties of a receiver under the rehabilitation process; the creation, functions and duties of a management committee comprised of secured and unsecured creditors and representatives of the debtor; and rules governing the liquidation of a corporation in the event that rehabilitation is not feasible. The SEC will continue to administer the rehabilitation process, thus cementing the shift from what was once a judicial function into a quasi-judicial or administrative process. This development is unique in the region.316

(iii) Programs derived from the aftermath of the Asian crisis

As mentioned before, the Asian crisis has revealed in several countries shortcomings of their insolvency law and, more importantly, a heavy debt burden on state-owned and private enterprises coming along with a high number of defaulting loans. This situation is economically comparable with the situation prevalent in many transition economies in Eastern Europe and other parts of the world. Consequently, legislators in those countries have developed varying informal or administrative techniques to deal with the insolvency or financial difficulty of defaulting debtors. A review of some of these programs will follow at a later point in this paper.317

316 ADB-Report, 23 317 See for a discussion on the Asian initiatives, C.I.3.2.6.


105

6. Pro-debtor versus pro-creditor regimes and moral hazard

6.1. General As mentioned before318, insolvency regimes are often regarded as being either pro-creditor or pro-debtor. 319 Usually a pro-creditor regime concentrates on the protection of the varying interests of creditors (e.g. by allowing security and set-off) since a pro-debtor regime is more protective of debtors (e.g. by increasing the assets available for distribution). Even though these labels are frequently used and widespread, one may have difficulties in applying them.320

6.2. Indicators There are certain indicators in the law according to which it is often assessed as pro-debtor or pro-creditor. Depending, for example, how the law balance policies of pro-rata sharing and rescue321, how it treats set-off rights and title finance agreements, how it acknowledges a director liability, how it interferes with contracts of the debtor322, whether it provides for an extensive range of distribution priorities to unsecured creditors, how it protects post-petition credit, or if it provides for the replacement of the debtor management in liquidation and rescue proceedings, jurisdictions are divided in being rather debtor or creditor friendly. Some observers323 even categorise jurisdictions within a scale as more creditor- or debtor friendly. The English-based jurisdictions are usually accepted as extreme creditor friendly while France and other French-based jurisdictions are commonly known as extreme pro-debtor. A similar division does not exist comprehensively yet among transition economies and one might be interested in a respective outcome. Does the status of a jurisdiction as pro-debtor or pro-creditor depend on the degree of its economical, political or social development? Is there a correlation between economic performance and bankruptcy bias? According to a research of Wood324, there is not a necessary interdependence between the level of development of a jurisdiction and its characterisation as pro-debtor or pro-creditor.

318 See the discussion above, B.I.2.2. 319 See at al: Wood-Principles, 97 320 See respective arguments and examples at B.I.2.2. 321 WB-Towards Principles, 9 322 Wood-Principles, 97 323 Wood-Principles, 98 324 Wood-Principles, 100


106

Others325 describe insolvency regimes as either stricter or more liberal. They argue that the drafting of the insolvency laws and their implementation reflect social policies a nation wants to promote. If an economy needs or wants to attract (Western foreign) investments, the insolvency law should be strict. The term “strictness” thereby means that the process should be driven by creditors, focus on the interests of creditors, should be predictable and transparent by forcing liquidations and thereby enabling creditors to quickly retrieve the assets of financially troubled businesses. If a country, on the other hand, wishes to promote domestic stability and job security among employees, the insolvency regime should be more liberal. Features of a liberal insolvency law are, for example, the possibility for the debtor to abandon or postpone payment and the encouragement of reorganisation instead of liquidation. A reorganisation gives the debtor time to restructure financing and operation in order to return to efficiency and profitability. However, the latter approach does not provide the investor with predictability or clear information about the debtor enterprise, and thus discourages investment. One has to consider that those two different types of insolvency regimes represent extreme poles, hardly found in that pureness in reality. Particularly transition economies frequently tend to promote both objectives equally: the attraction of investments in order to develop and foster market economy structures and the promotion of social stability, a factor urgently needed in transition economies to compensate shortcomings in economical and social development. Because transition economies have experienced varying historical and socio-economic legacies, they are at varying levels of market economy development. In response to their unique development levels, transition economies make different policy choices towards a stricter or a more liberal insolvency regime. But not only socio-economical factors determine the decision towards stricter or more liberal insolvency laws, also political considerations often influence the legislative approach to insolvency. Some countries, for example, fear a Western dominance through economical influence and therefore restrict foreign investment accordingly. These restrictions are usually also reflected in the insolvency laws. However, more important for the purpose of characterising the law as debtor or creditor friendly is less the existing legal framework but more the effective implementation process and the institutional capacity. A pro-debtor law that is applied effectively and consistently will engender greater confidence in financial markets than a pro-creditor law that is unpredictable and hardly enforceable.326 325 Kim-When Nonuse is useful, 1053


107

6.3. Moral hazard The insolvency law should strike a balance between the rights and obligations of both the creditors and the debtor in order to prevent tactical conduct of participants. If the law fails to provide for such a balance, the behaviour of the favoured party will generate moral hazard. If, for example, credible sanctions do not exist in order to penalize the debtor’s wrongful management, it will be difficult to uphold proper standards of financial discipline. At the opposite extreme, if the law confers an unduly favourable position upon certain groups of creditors, a similar form of moral hazard is generated with regard to the manner in which creditors may approach any material questions bearing upon the provision of credit and the management of risk, with potentially adverse consequences both for the debtor and for the other, less-favoured, creditors concerned.327

6.3.1. Moral hazard and debt restructuring

As mentioned before, many transition countries have initiated special recapitalisation or reorganisation programs to reorganise their state-owned financial and real sector and to reduce the heavy debt burden usually prevalent among their SOE’s. However, the bailing out of SOE’s outside the general insolvency law by the government may increase moral hazard among other SOE’s, not eligible for governmental debt restructuring programs and consequently the creditors of SOE’s, which are supposed to be bailed out. Therefore, it is necessary that the government or the respective legislator clearly set out the conditions of the debt restructuring programs. Furthermore, the government should clearly signal that the program is only of temporary duration and that those rescue packages will not be readily available again.328

6.3.2. Moral hazard and secured credit

A closely related issue, discussed in more depth somewhere else329, is the approach of the insolvency regime towards security. The only reliance on collateral by creditors may create moral hazard. Under economical theory creditors should primarily rely on a cash-flow analysis and only secondary on the available security interests. Particularly in emerging

326 IMF-Report, 2 327 WB-Towards Principles, 3 328 EBRD-Working paper 18, 25 329 See the discussion if secured creditors should be included in proceedings, D.III.12.


108

markets, value for collateral may collapse unexpected and income streams of the debtor become the only source for repayment.330

7. Insolvency as tool for privatisation

7.1. General Privatisation of a reasonable part of the state sector was and still is a pre-condition for a successful transition to a market-based economy.331 Nevertheless, the privatisation process is of particular importance for post-socialist economies, since there all or most of the existing assets and means of production have belonged to the state.332 Insolvency techniques have been and are frequently used as tool for privatisation. The insolvency process provides for a clear and transparent result regarding claims and liabilities of the SOE – a condition for every private investor. Once insolvency proceedings are concluded, either as a reorganisation or as liquidation proceedings, the remaining debtor enterprise or solely the assets are released from further obligations and liabilities. The investor is now able to acquire the assets free from hidden liabilities – one of the main obstacles in the privatisation process. In liquidation, the assets of an insolvent SOE will be privatised piece-meal or sold as going concern and transferred to the private sector for more productive uses.333 In reorganisation procedures334, a plan will frequently provide for a change in equity335 which is often followed by a transfer of ownership rights from the state to the private sector.336

7.2. Interrelation between privatisation and insolvency in transition economies Privatisation is a most basic precondition for the development of market economies in transition countries. That is not only a truism for many states in Eastern Europe, where productive assets mainly vested with the government (“public or state property”) but also for other transition economies, where usually the stake of governmental ownership is considerable high or the government has the right and position to interfere excessively with private ownership rights.

330 ADB-Report, 90 331 Roggemann-Funktionswandel des Eigentums, 232; See also the discussion above, B.II.1. 332 See B.II.2.4.1 333 Balz, Schiffman, 20 334 See for the relation between reorganisation and privatisation in transition economies: Smid-Das Insolvenzverfahren, 394 335 See for more details on debt to equity swaps, D.III.5.3.3. 336 Balz, Schiffman, 20


109

Under the socialist system, productive units were usually state bodies or agencies without legal personality. In order to privatise them, in a first step they had to be transformed into legal entities which are subject to civil and commercial laws in general and to the insolvency law in particular. After this so-called corporatisation process several privatisation measures were applied. One of the techniques employed has been liquidation and reorganisation procedures under the general insolvency law. The established state-owned companies were transferred to a specific state-property agency. This governmental agency had special statutory authorities to reorganise and restructure the SOE’s. After the reorganisation process the SOE’s were either sold as going concern or liquidated and assets or shares sold to the private sector. Privatisation by this means occurred frequently in Poland, Hungary and Ukraine337 and as mentioned above, in East Germany.338 The Polish legislator even exempts certain state-owned enterprises from the bankruptcy process339 but at the same time make them subject to the composition law. Consequently, these companies could not be liquidated piecemeal but restructured under the respective composition provisions.340 Among the very different approaches to privatisation applied in transition economies one may roughly divide them into the “speed” and the “gradual” paradigm.341 Since there is a close correlation between privatisation and insolvency issues in transition economies, each paradigm, along with other factors, engendered different models of insolvency laws. The “speed” paradigm, as practised in the Czech Republic through their voucher program, promotes the rapid transfer of state-owned assets to private hands. Generally, SOE’s were transformed to legal entities and immediately transferred to the private sector. They were neither restructured nor liquidated during the privatisation process. For that reason, the insolvency law had to be more liberal during this process and fully applicable only after the mass privatisation had finished. The Czech Republic’s relaxed approach to insolvency directly correlated to the speed paradigm of privatisation. The “gradual” paradigm, as practised in Hungary, stands in direct opposition to the “speed” paradigm and correspondingly has influenced the prevailing insolvency laws. Over simplistically, this approach provided for a restructuring or liquidation of the relevant SOE before transferring it to private ownership. The respective government agency applied 337 Bufford-Bankruptcy Law, 467 338 See B.II.5.1.2.e. 339 Polish Bankruptcy Code, Art.3 340 Smid-Das Insolvenzverfahren, 394 341 These termini were suggested from Kim-When Nonuse is Useful, 1054


110

restructuring or liquidation measures in order to return the SOE in a valuable entity or, if not feasible, extracted valuable assets for privatisation. Therefore, a more aggressive insolvency regime was needed. The relevant changes in the 1992 reform of Hungary’s insolvency law342 contained many features of a stricter insolvency law.343 Hence, in transition economies the selected privatisation approach may directly influence the prevailing insolvency regime towards a stricter or more liberal nature.344

342 See D.II.5.3. 343 Kim-When Nonuse is Useful, 1055 344 Kim-When Nonuse is Useful, 1062


111

III. The Insolvency Regime and its interrelation with other legal and general societal elements

1. The Insolvency Regime: insolvency codes and the related legal framework

1.1. General

Generally, the respective insolvency code is the key provision for a jurisdictions insolvency regime. The insolvency regime consists of a network of provisions contained in a great variety of general legislation and other laws. Provisions related to insolvency issues can be frequently found, for example, in civil procedure and enforcement rules, criminal law, security law, company legislation, employment protection and social security law, law on foreign investments and many others. Nevertheless, the insolvency code should contain all central provisions of the insolvency regime and only locate provisions in other laws when their connection is closer to those respective laws. Particularly in transition economies, the code should explicitly refer to other relevant legislation when insolvency-relevant provisions are located outside the code. A further related issue deals with the interconnectedness of the insolvency law with other related provisions. Even a perfectly designed insolvency law may have no effect and thus remain unused when other interconnected provisions do not support objectives of the insolvency law.

1.2. Enforcement procedures Frequently, insolvent debtors are reluctant to submit themselves to a form of insolvency administration (formal or informal, liquidation or rescue). But also some creditors are frequently unwilling to apply the insolvency law since they do not have to fear individual enforcement actions by other creditors due to a weak individual enforcement regime outside insolvency. To overcome that and to put some pressure on the unwilling debtor345, creditors should have the opportunity to easily pursue their individual enforcement rights. If the pursuit of those rights is restricted or delayed there will be no or at least less pressure on the insolvent debtor to voluntarily participate in the insolvency process and no need for creditors to initiate insolvency proceedings.

345 We may refer to this function in the ongoing discussion as leverage function.


112

If creditors can easily seize assets of the debtor by individual legal remedy, debtor and creditors will be more willing to participate in insolvency proceedings.346 A similar leverage function exists between liquidation and rescue proceedings.347 Only when the underlying liquidation regime is efficient and easily accessible may the debtor and dissenting creditors be willing to participate in rescue negotiations and proceedings. When they do not have to fear prospective piece-meal liquidation of the debtor, they will be tempted to delay and distort reorganisation proceedings.

1.3. Recognition of security and security-like devices Similarly, the law on security should provide for an easy and quick enforcement of security interests.348 The efficiency of the security enforcement system is a key factor for parties in determining whether to pursue informal or formal workouts.349 The absence or the weaknesses of such an enforcement regime means that there is neither pressure on the insolvent debtor to participate in any insolvency proceedings in a wider sense nor have unsecured creditors to fear that some secured creditors will seize key assets of the debtor. A further related question is whether the insolvency law will effectively modify other substantive laws. By way of example, will it supersede labour laws that afford employees special protection?350 Insolvency reform is often ineffective without parallel reform of other commercial laws. It is therefore important to identify and remove legal impediments to reorganisation, such as tax penalties on debt forgiveness, obstacles to debt-equity swaps, restrictions on the transfer of creditors’ rights, restrictions on foreign ownership and limitations on the rights of equity owners created by poor and inadequately enforced regimes for corporate governance.351 Along going with the reform of its insolvency law a transition economy should improve provisions on accounting and accounting standards and particularly consider imposing a professional liability on accountants and the introduction and the strict enforcement of international recognised accounting standards (GAAP). Furthermore, a transition economy should advance existing standards on corporate governance structures by requiring outside management in insolvency proceedings of SOE’s and at the same time reducing governmental influence on management decisions.

346 ADB-Report, 76 347 See for a more detailed discussion, C.II.2.2. 348 See therefore: Breidenbach-Thesen, in Drobnig (Hrsg.) Systemtransformation, 357 349 ADB-Report, 92 350 IMF-Report, 8 351 G22-Report, 15


113

2. The consistency of the insolvency law with underlying elements of the society The insolvency law must be complementary to and compatible with the legal system of the society in which it is rooted. The law should maintain a philosophical consistency between the insolvency law and other laws in order to reinforce the goals and values to which they are committed. As mentioned before, many different parts of the general law are in direct or indirect relation to the insolvency law including, for example, property laws, contract and commercial law, the law dealing with mortgages and other types of security, as well as tax and inheritance laws, employment and social security regimes, and even family and matrimonial law questions. Furthermore, this consistency should be not only maintained in a closer legal context but also in a wider sense of any societal elements. The insolvency law should be able to respond to the absence of institutions, instruments and other elements necessary for a functioning market economy. In transition economies, in particular, the insolvency law has to reflect the relevant transition stage, respond to related problems and thereby support the transition process. Generally, the transition process is characterised by the absence or underperformance of essential components of a market economy. Thereby, countries in transition towards a market-based economy starting their transition process by implementing basic market-rules and establishing more fundamental market institutions. Experiences reveal that those countries need much longer for more painful reforms and transformations of the economy and society. Consequently, transition economies have, to a certain degree, established some market principles and institutions, but lack others. The insolvency law is frequently used as one instrument to rebalance these deficiencies. This may often conflict with Western insolvency policy and the economical analysis of insolvency law.352 However, using the insolvency law to protect certain groups in the society or to reach some other legitimate societal goals may be the only immediately available solution in a transition economy. By way of example, according to Western economists, legal scholars and other officials, secured creditors should have the highest priority in the distribution process in case of liquidation, ranking ahead of employees and other affected parties.353 That seems to be fully

352 See for more details; B.I.3.11.4 353 See for a discussion on the protection of secured creditors (first-priority-rule) and their ranking in the distribution process: D.VI.2.1.


114

consistent with basic principles of a social market economy where unpaid employees can rely on an existing social system stepping in when the employee remains unpaid in the insolvency of its employer. However, such social components do frequently not (yet) or only inadequately exist in transition economies, nor are there any private protection provisions available nor have average employees the capability to cover essential expenses from their savings or other resources. Insolvency would for the affected employees necessarily lead to social hardship, increasing poverty and even social unrest. Added to the amount of threatening mass-insolvencies that may represent a serious problem for many transition economies. To avoid those undesired effects, some of those jurisdictions have granted unpaid employees or other debtors in need a priority higher than that of secured creditors. Under a Western perspective, that seems to be contrary to elementary principles of insolvency354 and related economical analysis.

354 E.g. the well-accepted principle of market conformity requires a treatment of different creditors in insolvency, which exactly reflects the situation (bargaining power) of those creditors outside insolvency; see for a general overview: Balz-Market Conformity, 169


115

IV. The comparability of insolvency codes of developed countries with those of emerging economies

1. General

Criticisms from Western insolvency practitioners, legal scholars or bankers are often unfounded, considering that their comparative studies are frequently based upon very different footings.355 When one compares different insolvency regimes, especially western regimes, with those of transition economies, one should try to include in respective opinions and analyses not only the unconnected insolvency codes but also all other legal, political and social elements prevalent in the jurisdictions under revision. But there are also general difficulties in comparing insolvency regimes of different jurisdictions. This is due to different operative legal system traditions, the inheritance of insolvency laws from different systems356, the influence of cultural attitudes357, customs or traditions, differences in political and economic policies and practical and pragmatic factors.358

2. Comparing different Western insolvency regimes Even between jurisdictions, here referred to as “Western”, may exist considerable differences in their insolvency policies and related provisions. By way of example, the US, the French and German insolvency regimes may significantly differ in many substantive issues. Those laws functioning in a different economical, political and social environment, are based on different legal tradition and custom and may support different policies. Comparison among such jurisdictions becomes a difficult undertaking and one always runs the risk of comparing two elements which are not comparable without careful consideration of their wider context.

3. Comparing Western insolvency regimes to those of transition economies However, even more complex appears the task to compare insolvency regimes of Western jurisdictions with those of transition economies. Such a comparison may even lack the common market principles and a common market environment359 functioning among

355 A good example offers the discussion on the low number of filings for insolvency in transition economies, B.II.5.1.1. 356 See B.II.2.1. 357 See B.II.2.2. 358 ADB-Report, 25 359 See B.I.2.


116

Western jurisdictions as a basic, defining fundamental needs, interests and rights of the participants. The general difference for the position of the insolvency law in a transition economy and an Western developed market economy is that, first, the insolvency law is needed to establish a functioning market economy whilst in the latter case the insolvency law is regulating a well-functioning market economy.360 Therefore, this paper should not be viewed as a pure comparative work, but rather as an attempt to refer to different legal systems when discussing a certain legal issue and at the same time, trying to examine and contrast the differences of the underlying systems. Nevertheless, dealing with insolvency through a web of economics-based laws is certainly a Herculean task. The addition of cultural and human factors makes it that much more difficult to formulate “fair” insolvency laws. As mentioned before, approaching this mission in transition economies adds further complexities. Nonetheless, fair insolvency laws are a necessity for a smoothly operating and performing market economy.361 However, this paper is supposed to refer to insolvency issues that might be from particular relevance for transition economies, thereby pointing out the varying policy choices a potential legislator in those countries is facing and at the same time considering and reviewing certain typical policy decisions prevalent in transition economies without bias. Finally should be added that the non-existence of certain provisions may not inevitably imply that the insolvency law under revision is insufficient in those points. Jurisdictions may have developed devices in order to achieve the desired economical or social outcome or they may have simply no need for a certain provision.362

360 Lowitzsch/Pacherova, Das novellierte polnische und slowakische Insolvenzrecht, 212 361 Averch-Lien Stripping, 93 362 See B.II.5.1.1.


117

C. Liquidation, Quasi-Liquidation, Going-Concern-Sale, Rescue, Workouts, pre-insolvency procedures and their interrelationship

I. Definitions Under the heading of insolvency have developed on a comparative perspective several different forms of proceedings dealing with financial difficulties of legal and natural persons.

1. Liquidation363 Liquidation might be best described as the formal insolvency process, which results in an immediate cessation of the business activities of an insolvent debtor, the sale of the debtors’ assets and the distribution of the proceeds to the creditors according to their stake in the debt. Liquidation represents within an insolvency regime the ultimate remedy against an intractable insolvent debtor.

2. Quasi-liquidation A phenomenon, mainly applied in transition economies, is the so-called quasi-liquidation process.364 Countries especially in the transition from a command economy towards a market-style economy had and have to deal with a great amount of insolvent or financially distressed state-owned enterprises. Some of those countries have combined features of a traditional liquidation with administrative procedures in order to restructure their SOE sector.365

363 See also the discussion on the liquidation option, B.I.1.1. 364 See for details and examples B.II.5.1.2.e. 365 WB-Rehabilitation, 11; see for example: the Romanian “administrative” liquidation: David-Praktische Probleme, 366, Emergency Ordinance of the Romanian Government No. 10/1997


118

3. Rescue366 The term “rescue” is not easy to define since it is vastly different applied in many jurisdictions. Responding to economic and commercial needs and expectations many countries367 have recently reformed and reshaped their laws governing rescue-type procedures. The traditional rescue models include voluntary compositions368; preventative compositions; moratoriums; judicial management and creditor compositions. These older versions were not much used since they prescribed high thresholds on entry and other requirements. The recent changes in many jurisdictions introduced rescue laws with easier access and without other unnecessary restrictions369 and follow thereby to a varying degree the proceedings prescribed by Chapter 11 of the US Bankruptcy Code.

3.1. Modern rescue proceedings These modern rescue laws include, among other provisions, a voluntary or compulsory submission of the debtor to proceedings, the automatic and mandatory stay or suspension of actions and proceedings against the property of the debtor affecting all creditors for a limited period; the continuation of the business of the debtor enterprise by the existing management, an independent manager or trustee or a combination of both; the formulation of a plan which proposes the manner in which creditors, shareholders and the debtor corporation (as legal person) will be treated; the consideration of and voting on acceptance of the plan by creditors and the judicial sanction of an accepted plan and its implementation.370

3.1.1. Reflect commercial expectations

Thereby, modern rescue laws tend to address a variety of commercial expectations related to the objectives of rescue. For example, an early, quick and easy access to the process before it is too late; the comprehensive protection of the involved participants; the creation of a environment which promotes the negotiation of a rescue plan and which enables a majority of creditors to bind a minorities through a democratic voting system and the possibility for judicial review and supervision. 366 See also the discussion on the structured bargaining or rescue option, See also B.I.1.2. ; See for a definition of rescue also Brown-Corporate Rescue, 1 367 E.g. Germany, Russia, Romania, Bulgaria 368 E.g. Zedler-Länderbericht Polen, 290: The Polish Composition Law (1934) 369 These developments derive mainly from the Chapter 11 proceedings of the US-Bankruptcy Code and have a significant influence on insolvency reform in transition economies. See: Smid-Das Insolvenzverfahren, 394


119

Only a few jurisdiction refer to it as “rescue”; the other jurisdiction use a variety of terms, such as “reorganisation”, “rehabilitation”, “restructuring”, “arrangement”, “administration”, “composition” or “reconciliation”. The common goal of the different rescue proceedings is to obtain a better economic result by administrating and reorganising the affairs of the insolvent debtor than by liquidating him. By this means, rescue does not necessarily imply that the debtor enterprise will been “saved” nor will the original participants, like creditors and owners, be after the process in the same legal and economical position as prior to the rescue proceedings.371 The development of rescue policies reflects the widely accepted goal of insolvency law in contemporary times to maximise the value of the assets of the debtor.372 The efficient reorganisation of an enterprise or the sale as going concern can turn a greater economic outcome to the creditors than a mere piece-meal sale of the assets of the debtor.373 This view reveals an additional dimension when considering the ongoing change of means of production on a global scale.374 The commercial world is currently facing an evolution from a dominating productive to a service industry combined with a change of existing assets. More and more are enterprises based on and equipped with intangible assets as for example intellectual property rights, good will or know how. The market value of such assets depends more than traditional means of production and underlying assets375 on available markets and its connection to its owners. A liquidation of those assets may not generate any value whilst a reorganisation of the respective enterprise and the remaining of the assets with its original owners may enable a satisfaction of the creditors in a reasonable short period of time. Furthermore, the procedural aspects of rescue proceedings should provide for an efficient system to reach the various objectives of insolvency by recognising the different interests of the participants. The overwhelming considerations of the rescue should be the increase of income streams by the reduction of external debt.

370 ADB-1999 Report, 10 371 Balz-Sanierung, 20 372 See also the subsequent discussion on assets maximisation as the key objective of the insolvency process, B.I.3.2. 373 Flessner-Sanierung und Reorganisation, 188, suggests that reorganisation or the sale as going concern is likely to produce more value than ordinary liquidation. 374 See on this issue, Paulus-Entwicklungslinien, 247; Paulus-Verbindungslinien, 2192 375 Such assets are commonly real property, movables and claims


120

3.1.2. System of flexible rescue techniques In order to gain a better economic result as from liquidation the rescue law should provide for a flexible system containing, among other methods, the liquidation or sale of parts or units of the debtor enterprise, even if they are income generating; the cease of the debtor enterprise; the cancellation of owner “equity” rights and the provision of debt-equity swaps376; the removal and replacement of the debtor management; the debt reduction by creditors (“haircuts”) or debt rescheduling (extended length of the loan, extended period to repay, deferral of payment of interest) and the change of the identity of creditors. In order to reach the goals and objectives of rescue, the law should not intensely intrude in proscribing the nature or form of the plan. The law should leave it to the market place to determine what is the appropriate commercial solution. However, conceivable limitations on that rule may be, for example, that preferences or priorities established prior to the insolvency and hypothetically maintained in a liquidation process are recognised and reflected in the plan or that the outcome of the plan may not be less beneficial to creditors than a hypothetical liquidation would be.377 However, in transition economies with only rudimentary experiences in reorganisation and the absence of a rescue culture378 it might be useful to list some available rescue and financing techniques in the law.379

3.1.3. Reflect other affected interests

As mentioned at an earlier point380, especially in transition economies, it may be also essential for the insolvency law in general and the rescue proceedings in particular to address other interests, affected by the consequences of insolvency. A successful reorganisation law, for example, might be able to protect from mass unemployment, preserve markets for suppliers and the like; encourage growth of the private sector and the development of an entrepreneurial class; prevent a cascade of knock-on insolvencies with consequences for the whole economy; prevent shortcomings of necessary

376 Measures providing for the fundamental reordering of company’s balance sheet (frequently through a conversion of debt to equity) are also called balance sheet restructuring. 377 ADB-Report, 44 378 WB-Towards Principles, 81: Rescue culture=attitudes and expectations of companies and creditors toward corporate reorganisation 379 See D.V.3.3. on debt-equity conversion and similar measures; See for example: Russian Bankruptcy Code, Art.85; Bulgarian Commercial Code, Art.700 380 See the previous discussion at B.I.3.11/12.


121

supplies (e.g. food, water, electricity, gas); or simply give debtors a second chance and thereby save human capital. However, whether to address those issues in the respective rescue regime is a policy decision of a legislator and depends certainly on the stage of development of the individual jurisdiction.

3.1.4. Examples Many transition economies have recently reformed their insolvency laws what usually included the introduction of modern rescue provisions.

a. Russian Bankruptcy Code (1998)

The Russian legislator, for example, introduced with the 1998 Bankruptcy law a more modern rescue regime381 and abolished at the same time the old composition proceedings382. The old Russian composition proceedings contained several provisions which were contrary to the afore mentioned standards of modern rescue proceedings. Secured and privileged creditors, for example, were not involved and have not been affected by proceedings, even when it would be in their interest to rehabilitate the debtor. Only restructuring of enterprise debt was provided for in a composition. A composition could not restructure equity. Orderly liquidation (sale of all or parts of the going concern of the debtor enterprise) was not an option. There was no possibility of a liquidation plan. The Code required a minimum dividend of 35% of claims as threshold limit for composition proceedings. Even where it would have been in the interest of creditors to receive a smaller dividend (because they would fare worse in a liquidation) a composition was not permitted. A non-cash compensation for creditors was not possible (for instance, a swap of debt for equity). Furthermore, the Russian Code (1992) did not provide for a stay of an ongoing liquidation when a feasible plan was admitted by the court.383 As we will see in the subsequent discussion, the new Russian Bankruptcy Code (1998) did remove most of those obstacles by introducing more rescue-friendly provisions.

381 “Amicable Settlement”, Russian Bankruptcy Code, Art.120-130 382 Russian Bankruptcy Code (1992), Art.39-43 383 Balz-Russia, 43


122

b. Polish Bankruptcy Law The Polish insolvency law, contrary to the developments in Russia, provides still for the composition law initially enacted in 1934. The law is outdated and can hardly cope with the challenges of a modern market economy. The Polish legislator and respective other authorities have proposed extensive reform to overcome those obstacles by enacting a modern law dealing with liquidation and reorganisation proceedings.384

3.2. Informal workout

3.2.1. General

To this category should be added informal workout proceedings which have also been accorded the status of a rescue method. The informal workout process is normally applied outside of, and sometimes due to the absence of a formal statutory rescue regime.385 However, since the informal process provides a valuable supplement to the insolvency regime particularly for transition economies, the paper will consider it more extensively. It essentially involves bringing debtor and creditors (at least, the main creditors) together. It is up to the debtor and /or one or more of the main (bank) creditors to initiate the workout process. The informal practice follows similar objectives as formal rescue proceedings reached through a privately negotiated agreement with similar contents as the reorganisation plan.

3.2.2. Elements of informal workouts

Initial function of the informal workout process is the creation of a forum in which debtor and creditors can come together for the purpose of exploring and negotiating an arrangement in order to deal with the financial difficulty or insolvency of the debtor. This forum is not only for the benefit of the debtor and its creditors, but also for the creditors, between themselves. Most commonly regulate those informal provisions the appointment of a "lead" creditor to provide leadership, organization, management and administration. The lead creditors is usually accompanied by a selected committee which represents the participating creditors (commonly referred to as "steering" committee) to assist the lead creditor and to act as a provisional sounding board toward proposals for the corporate debtor. Creditors and debtor agree commonly on a "standstill" arrangement to suspend adverse actions by both creditors and the debtor during a defined, preferably short, time period. The

384 Zedler-Länderbericht Polen, 290 385 WB-Towards Principles, 62


123

standstill agreement can be compared to the "moratorium" or stay of actions and proceedings which has become an important feature of formal rescue proceedings. In essence, the ‘participants’ in the proposed workout (the creditors) agree not to improve their position relative to each other. The debtor agrees not to change its position other than in the normal conduct of its business. A further element provides for the gathering and provision of complete and accurate information regarding the corporate debtor, including its business activities, current trading position, general financial position and assets and liabilities. This functions as equivalent to the statutory requirement for the supply of similar material frequently found in most of the formal rescue regimes.386 The key element of an informal workout is a contractual agreement among creditors and the debtor and contains usually a varying degree of reorganisation and restructuring techniques. It is usually accompanied by several other provisions necessary to protect a number of interests of the participants involved. Those contractual arrangements are regularly similar to provisions available under the formal insolvency law. However, a more detailed discussion of common provisions and the advantages and disadvantages of the informal process in comparison to formal proceedings follows at a later point.387

3.2.3. Development of workouts

The concept emerged some ten years ago in the USA and England mainly encouraged and applied in a non-official capacity by the Bank of England and leading American and English commercial banks.388 There are several explanations for the development of informal workouts. Firstly, the commercial and financial world was in need for a more flexible approach to insolvency issues. The formal rescue regimes could frequently not provide for the flexibility available under informal workouts. Workout techniques enable, for example, for a very early response not provided for in formal rescue laws. The ability to react at an early point to financial difficulties of debtors may tremendously increase chances for a successful rescue and a full recovery of the outstanding credit. Additionally, private workouts are confidential and hence do not damage the reputation of a debtor.

386 ADB-Report, 54 387 Subsection C.III. provides for a comparison of formal rescue and informal workout. 388 Eidenmüller-Unternehmenssanierung, 236: The so-called London Approach contains mainly the following elements: (1) creditor banks provide further liquidity during financial difficulties of the debtor, (2) information should be distributed among the creditor banks, (3) creditor banks shall try to negotiate a consensus about the future of the debtor; Brown-Corporate Rescue, 9


124

Later, informal approaches were applied to restructure the heavily indebted state-owned sector in transition economies and to workout an extensive debt burden of banks and commercial borrowers in the aftermath of financial crises.

3.2.4. Categories of informal workouts

Informal workouts may take very different forms and developments. The paper attempts to analyse and categories some of those features. Nevertheless, main attention is paid to the structured informal approach that emerged in the aftermath of the financial crisis in several Asian countries. The reason therefore is that this technique is deemed to be of enormous value for the future development of insolvency law in transition economies.

3.2.5. Pre-insolvency proceedings

Some countries have adopted so-called “pre-insolvency” procedures which are, in fact, a hybrid of informal out-of-court reorganisation and formal reorganisation procedures. Chapter 11 of the US-Bankruptcy Code, for example, allows the court to approve a reorganisation plan even though the support required from creditors as a condition for court approval under this chapter was obtained through a vote that occurred before the actual commencement of the formal rehabilitation proceedings. Other countries have adopted a so-called pre-negotiated plan, where negotiations among creditors take place prior to the commencement of formal rescue proceedings.389 Such a “pre-packed” insolvency process is designed to minimise costs and delays associated with formal rescue procedures while, at the same time, providing a means by which a reorganisation plan can be approved absent unanimous support of all creditors and in this way overcome a main obstacle of informal workouts.390 From a debtor’s perspective, it provides certainty with respect to its retention of control of the enterprise and minimises the disruption of business. However, a significant restraint of those procedures is the fact that it generally does not provide the debtor with any protection during negotiations.

389 IMF-Report, 60 390 IMF-Report, 12


125

3.2.6. Structured informal rescue process Responding to the recent financial crisis in Asia, some Asian jurisdictions391 have successfully introduced a more structured informal rescue process.392 These approaches are considered as interesting for the purpose of this paper as they might be applicable for transition economies in general. The recent developments in the area experienced several distinctive types of those institutional programs. They are government initiatives intending to accelerate the pace of corporate debt restructuring by promoting informal workouts as a viable alternative to judicial insolvency. The different types vary from a mere educational function towards restructuring negotiations393 over formal procedural rules and guidelines394 to active government participation in the informal restructuring process.395

a. Reasons for the emergence of informal workout programs in Asia

In order to assess the applicability of those informal approaches to transition economies in other regions, one has to analyse the common and distinctive features which have provided the ground for the introduction of those procedures in the relevant Asian countries. Firstly, the commercial culture of many Asian economies appears to be more conditioned towards non-confrontational dispute resolution by negotiation and mediation and not the employment of formal legal proceedings. This might have been an important factor to promote successfully structured informal procedures which became well accepted among the commercial community and other participants.396 However, as mentioned before397, also participants of other transition economies may have an aversion against a formal legal process. Additionally, there might be reasons for every economically based deciding market participant to prefer informal over formal proceedings.398 In Indonesia, for example, the insolvency regime was between 1986 and 1994 used only in 13 cases, of which nine involved individuals. These figures are even more demonstrative, if

391 ADB-Report, 57: Indonesia, Korea, Malaysia and Thailand 392 WB-Rehabilitation, 28; WB-Towards Principles, 79, ADB-Report, 57 393 e.g. the Jakarta Initiative in Indonesia 394 e.g. the CDRAC program in Thailand is designed to create procedural regularity 395 e.g. the Korean approach may belong to this category 396 ADB-Report, 57 397 See the discussion at B.II.2.2. 398 The negative stigma connected with formal proceedings may influence participants to choose more informal rescue means, see also C.III.1.1.


126

one considers the current population of Indonesia from some 200 million and the related amount of enterprises existing in Indonesia.399 Furthermore, many Asian jurisdictions had only inadequate legal systems with particular shortcomings in their insolvency and debtor-creditor regimes. Since their insolvency laws were rarely used, they had neither the institutional infrastructure nor a sufficient amount of skilled and experienced professionals. Especially under the threat of a systemic crisis, those jurisdictions did lack the capacity of the whole legal system necessary to deal with the enormous amount of insolvent or financially struggling companies. A further problem came from the extensive systemic debt problem of the banking sector. Banks were carrying huge amounts of bad loans on their balance sheets which could hardly have been restructured in an efficient manner under the available formal insolvency regimes.400 An immediate solution was necessary since otherwise the financial system and the whole economy would have been seriously jeopardized.

b. Examples

Characteristic for those structured informal approaches is that they are frequently managed through an agency that operates in a semi-official capacity to promote and sometimes supervise workouts. The initiatives in those countries were originally introduced to primarily deal with the financially distressed banking and finance sector in the aftermath of the Asian crisis. It was only as a by-product extended and applied to the general corporate sector in those countries. Statistical evidence401 in those countries reveals that the informal process is clearly the area of the greatest development and success in corporate insolvency and has so far worked reasonably well.402

399 Tabalujan-Indonesia, 200 400 ADB-Report, 62 401 See for statistics on the Asian initiatives, C.IV.2.1. 402 ADB-Report, 57


127

(i) Indonesia – the Jakarta Initiative403 The Indonesian Jakarta initiative is a workout process largely modelled on the “London approach” in terms of process and methodology. It is facilitated by the Jakarta Initiative Task Force, a governmental agency appointed by the President. Its main functions are to assist in negotiations, refer cases of “public interest” to the courts under the insolvency law, speed up the process and ease the approval procedure for the implementation of reorganisation plans by providing a forum for expedited “one stop approval”. In that way, the out-of-court process shall complement the formal insolvency law and support the bank and commercial sector restructuring process. The Jakarta Initiative generally establishes only a voluntary framework, which the government expects creditors and debtors to follow as a matter of enlightened self-interest. However, in circumstances where a debtor is not cooperating within this framework, the principles recognise the authority of the public prosecutor under the formal insolvency law to initiate formal insolvency proceedings against a company for reasons of public interest. The provisions on general workout principles are the main item of the four-point government program. There, the initiative offers guidelines for prospective debtors and their creditors. The program promotes a desired behaviour of the participants and lays down best practise standards in the informal workout process. It covers such important concerns as standstill agreements, interim financing, and provisions on information, reorganisation proposals and the possibility to have a “pre-negotiated” plan in the courts imposed on dissenting creditors according to the rules of the formal insolvency law.404 The Jakarta Initiative does not involve government decision making with respect to substantive restructuring issues.405 Neither the Task Force nor the Corporate Restructuring Advisory Committee406 may “dictate the terms of a restructuring plan”. However, the Indonesian Bank Restructuring Agency (IBRA) has been granted so-called “Article 17” powers to liquidate companies under certain circumstances. The experiences of the Jakarta Initiative are rather negative in comparison with other initiatives in the region: the progress is slower than anticipated and only a few cases have 403 ADB-1999 Report, 48, Appendix 1 404 ADB-1999 Report, 37, Appendix 1,THE JAKARTA INITIATIVE, 1.Adoption of Principles 405 WB-Institutional Alternatives, 6 406 ADB-1999 Report, 37, Appendix 1,THE JAKARTA INITIATIVE, 4.Corporate Restructuring Advisory Committee and Public Participants: The Task Force shall designate a Corporate Restructuring Advisory


128

been concluded successfully.407 There are several reasons which may have been accountable for this result. Firstly, debtors and creditors are generally reluctant to recognise losses. The newly reformed insolvency law is only ineffectively applied. It is, for example, difficult for creditors to switch to formal proceedings (liquidation) and hence less motivation for corporate debtors to participate in the voluntary informal workout. Furthermore, the local capacity to deal with the complexity of the financial and operational reorganisations is insufficient. And finally, the Bank-Restructuring Agency (IBRA) is not provided with enough leverage functions on corporate debtors as its more successful Malaysian counterpart. 408

(ii) Korea

Korea follows a different path. It has established a “Company Restructuring Committee” to act as a facilitator. Several main commercial banks have signed an inter-bank agreement409 which allows that one bank (of the agreement) may impose proceedings in respect of one of its debtors with effect for the other signing banks. The other banks are bound by this agreement and may not enforce rights individually against the respective debtor contrary to the agreement. The Korean approach is thus more in the nature of a formal ex-ante agreement410 among certain banks to workout the debt of one of its debtors. And, additionally, there is a greater degree of government involvement in substantive restructuring matters. This method has the advantage that it brings forward the point when creditors agree to a certain negotiation procedure. The inter-bank agreement is not negotiated under an ex-post perspective when a respective debtor is already insolvent but from an ex-ante standpoint for the case of the future insolvency of any of their debtors.411 Furthermore, the inter-bank agreement binds the member banks to a certain degree and thereby increases speed and chances of the attempted workout.

Committee which shall be comprised of a selected representative group of domestic and foreign banks, Indonesian companies and bondholders. 407 ADB-Report, 72: In Indonesia 350 cases had come under the Jakarta Initiative debt-restructuring program. These included some 250 medium to large-scale companies. However, there was not much other public information available concerning these cases. The percentage of that number that resulted in the adoption of rescue or reorganization plans was quite small. 408 ADB-Report, 58 409 ADB-1999 Report, 64, Appendix 3, “Financial Institution Agreement for Promotion of Company Restructuring” 410 See generally for ex-ante agreements, C.III.5.1. 411 See for a more general discussion on the possibility of private ex-ante and ex-post creditor agreements, C.III.5.


129

The Korean experience with this procedure is positive with a considerable number of successful workouts in which a variety of restructuring and refinancing techniques were employed.412 However, there are still some concerns with the effect and practicability of the approach. The inter-bank agreement as a mere contractual arrangement only binds participating banks – other creditors can enforce their rights individually.413 But also participating banks can legally effective enforce their claims individually. However, the Company Restructuring Committee may in this case impose penalties on those creditor banks which are in breach of the inter-bank agreement.414 Another frequently emerging problem are disputes regarding the continuity of management.415

(iii) Malaysia

Malaysia has developed a two-tiered system. Firstly, there is the CDRC informal corporate debtor process. This process is operated through a Steering Committee and hosted by the central bank. The committee and a permanent administrative Secretariat promotes and administrates negotiations among debtors and creditors. The process is only open to large entities with large-scale debt. Additionally, the Malaysian government set up a statutory corporation known as “Danharta”416. It is vested with wide extra-judicial powers to deal with distressed banks and other financial institutions. It has focused on the acquisition and management of non-performing loans (NPL’s) in the banking sector. Danharta usually acquires a NPL from a bank and has than wide powers to deal with the corporate debtor: it can either negotiate an informal workout with other creditors; participate in informal and formal rescue proceedings; appoint management or special administrators of the failing debtor; enforce available security

412 ADB-Report, 72: In Korea about 80 companies had entered the structured workout process. A high percentage of these had reached agreement on workout plans. A lot of attention had, however, been directed at restructuring the top 5 Chaebols and the next largest group of Chaebols (known as the ‘6-64’). This, plus the fact that many of the subsidiaries or affiliates of these big Chaebols are dependant on their restructuring plans, had tended to distract needed informal workout attention to smaller and medium sized insolvent companies. This may, in part, explain the relatively small numbers. 413 But see for a possible obligation of creditors to participate in workouts, C.III.5.1.2. 414 ADB-1999 Report, 64, Appendix 3, “Financial Institution Agreement for Promotion of Company Restructuring”, Chapter V, Art.20 415 ADB-Report, 58 416 The Pengurusan Danharta Nasional Berhad (Danharta) Act was enacted in 1998


130

rights; or propose/approve a reorganisation plan. Thereby a one-year moratorium takes automatically effect.417 After the administrator has proposed a reorganisation plan, the government board may approve or veto the plan. If it is approved, a meeting of creditors must be convened to seek a majority vote in favour of the plan. If the creditors accept the plan, it becomes binding and it is then implemented under the direction of the special administrator.418 The extra-judicial powers enable “Danharta” to exert considerable leverage on both the debtor corporation and other creditors. This is possibly a better example of a special (administrative) insolvency process. It is instructive that it is done through an administrative body. It also enables an insolvent enterprise to be forced into possible rescue or liquidation.419 Experiences suggest that the “Danharta” process has been associated with a number of successful informal and formal rescues.420 This may be attributed to either the use of its extraordinary powers or the possibility that those powers may be employed.421 However, there are still concerns on the CDRC initiative. Firstly, the process does not cover small/medium but only large sized debtors. For a successful impact on the whole economy, it would be necessary that the procedure cover also small and medium sized debtors. Secondly, under the CDRC initiative it may remain difficult for debtors to receive new money. And thirdly, it seems to be troublesome to include secured creditors in the process.422

417 WB-Rehabilitation, 29 418 ADB-1999 Report, 25 419 ADB-1999 Report, 25 420 ADB-Report, 72: In Malaysia some 63 companies had been involved in the CDRC debt restructuring process. These included quite high profile listed public companies. The more enforcement driven Danharta process had resulted in the review of some 1780 corporate cases in the debt settlement/recovery process. Some of these had sought restructuring arrangements through the CDRC. There are others to which special managers had been appointed through the extra judicial powers exercised by Danharta. 421 WB-Rehabilitation, 29 422 ADB-Report, 59


131

(iv) Thailand423 Again different is the approach introduced in Thailand. Under the auspices of CDRAC424 a standard form “Inter-Creditor” and a form “Debtor-Creditor” was developed. The first provides for the basic conditions between different creditors in an informal workout (inter-creditor agreement) and is binding and final for those creditors who have signed the agreement. This ex-ante agreement among creditors is comparable with the afore mentioned approach developed in Korea. The latter, on the other hand, is proposed by a debtor seeking to invoke informal workout proceedings. Parties of the agreement are the debtor and creditors that have executed the inter-creditor agreement. The debtor-creditor agreement has to be approved by the CDRAC. The agreement contains necessary substantial and procedural rules that are essential for a successful workout. The CDRAC process has been reasonably successful even if it is only applied to financial sector creditors and to reasonably complex restructurings.425 However, some 46% of corporate debtors under the guidance of CDRAC have preferred to negotiate simpler reorganisation agreements and thus refused to sign the creditor-debtor agreement.

In some cases the standard agreements were used to negotiate and impose “pre-packaged” plans. Therefore the agreements were signed after a workout proposal was negotiated and subsequently referred to formal rescue proceedings under the insolvency law. The pre-packaged plans agreed under the CDRAC process become the reorganisation plan after a sufficient majority has voted in favour of the plan and are then binding for all creditors.426

If parties fail to follow the agreed restructuring process, the CDRAC may impose specified penalties among those parties.427

423 See ADB-Report 1999, 49, Appendix 2, Framework for Corporate Debt Restructuring in Thailand 424 For Corporate Debt Restructuring Advisory Committee 425 ADB-Report, 72: In Thailand more than 700 corporations had sought the assistance of the CDRAC debt restructuring process. Approximately one-half had progressed to the point of putting a standard form of debtor/creditor agreement in place and some 52 of that number had reached agreed restructuring plans with their creditors. 426 ADB-Report, 60 427 WB-Institutional Alternatives, 7


132

c. General considerations when designing an institutional program

(i) Common ground

Common to all emerging economies is their great necessity for informal debt restructuring procedures. That is due to inadequate legal systems, shortcomings of the relevant laws, lack of skilled and experienced professionals and lack of capacity of the legal system when a systemic crisis is affecting parts or the whole economy.

(ii) Elements and functions

Since local professionals are not trained and inexperienced in negotiating debt restructuring plans, it might be difficult for them to distinguish the commercially reasonable compromise that would lead to an agreement. This situation makes negotiations unnecessary time consuming, disorganised and confrontational. The institutional program should serve the participants with guidance and structure. Another problem derives from the different business cultures among the players. Debtors in transition economies may have a very different understanding from debt restructuring than their international lenders. Rescue cultures may vary from developing country to developing country and may even differ among international lenders. To overcome these obstacles, institutional programs should set initial starting positions for negotiations.428 Those designing an institutional program should determine the goals of the program. Beside the general goal of fostering the path of the restructuring process there are several other competing policy objectives to balance. An institutional program will be better accepted if it contains more recognised commercial principles whilst a more custom-tailored approach needs more governmental support when initiating, negotiating and implementing the program. A good example offers the “London Approach”429. The “London Approach” reflects accepted commercial standards and provides for the free dissemination of information and a negotiation process involving all parties including a “standstill period”. Another important issue is the degree to which the government should be involved in the institutional restructuring process. As mentioned above, some institutional programs are not

428 WB-Institutional Alternatives, 1-4 429 See C.I.3.2.5.


133

intending governmental participation at all430, whilst other examples on the other extreme, provide for a comprehensive government involvement431. In deciding the issue one should consider the current and historical relation between government and private sector.432 In countries with a history of corruption and abuse of governmental powers (like Indonesia), a substantive participation of the government should be minimised. However, if the program shall provide for a substantial governmental participation, the powers of the government in the process should be drawn up precisely. If the program does not contain direct government involvement, it might provide for substantive guidance through mediation, where an experienced and trained mediator can bridge cultural differences and communication problems. Another function of a governmental program may be to support debtor management which is in transition economies frequently not sufficient trained and experienced to cope with the challenges of the transition process nor to handle the reorganisation independently. Governmental support can reach from actual interference in management decisions through a governmental agency to the offering of educational programs for managers and directors of the troubled company. Furthermore, the program should spell out whether the refusal to participate or the participation in an unsatisfactory manner by one party should be punished. Therefore the specific circumstances in the country and the need to force parties to comply with available rules has to be assessed. In reviewing the different initiatives introduced above, one has to recognise that several programs lever creditors as well as debtors to participate in the workout and may even punish a respective refusal.433 The program has to determine the rigidity or flexibility of the procedural rules contained. Depending on the restructuring experience prevalent in the jurisdiction and among the program staff, the institutional program should balance between procedural flexibility to include different restructuring techniques and practises to achieve case-by-case flexibility and the necessary procedural rigidity to achieve predictability and guidance. As set forth earlier, it might be frequently necessary to restructure both the real and financial sector, since operational and financial deficits are interdependent. As a result of bank

430 E.g. Indonesia 431 E.g. Korea 432 See also the discussion on cultural attitude, B.II.2.2. 433 E.g. the Korean, the Malaysian Danharta and the Thai CDRAC program; but see also the discussion about a general obligation of creditors to participate in an informal workout, C.III.5.1.2.


134

takeover and recapitalisation programs, government asset management units hold considerable portfolios434 of non-performing loans and other positions. To lever non-performing debtors and to extract a higher return, these asset management units are frequently equipped with extra-judicial powers435 not available to other creditors. By threatening to exercise these powers, the government asset management unit can certainly recover more than other creditors. On the other hand, this higher recovery might affect the value of the remaining assets and hence jeopardize the restructuring process. The government should therefore balance the goals of short-term recovery by immediate cash settlements and long-term recovery by successful restructuring. Unless short-term liquidity is an overriding issue, governments are better advised to encourage long-term corporate recovery, since long-term recovery preserves employment, maximises tax revenues and increases the value of government’s distressed debt portfolio on the secondary market.

(iii) Obstacles

However, there are several obstacles to an informal workout also relevant when designing an institutional program. Firstly, informal procedures also rely on a legal framework that can accommodate the plan/ agreement by allowing a wide range of financing and security techniques, such as debt-equity swaps, debt relief and the taking of collateral. Secondly, it is crucial for the success of the institutional program that the underlying insolvency law provides for sufficient sanction to lever debtors and creditors to participate. The best-drafted institutional program may be highly inefficient, when not backed by a solid legal framework in general and a well functioning formal insolvency law in particular. It might be essential for the parties involved to engage independent advisors. Frequently, parties are not prepared to invest in the respective fees and costs of such professionals. As a lever instrument, the formal insolvency law should also provide for a compulsory engagement of advisors. Thirdly, it is often difficult to get a satisfying creditor agreement on the provision of new money.

434 The Indonesian Bank Restructuring Agency was in 1999 dealing with a portfolio of over IDR 155 Trillion 435 WB-Institutional Alternatives, 4: IBRA has been granted extra-judicial powers to liquidate companies under certain circumstances


135

b. Applicability of such initiatives in other transition economies One of the objectives of this paper was to analyse the recent developments of informal workout procedures in some Asian jurisdictions with a perspective consideration; whether such techniques would be generally applicable in other transition economies as well? As mentioned before436, many jurisdictions in Eastern Europe have implemented debt-restructuring programs to restructure the heavy debt burden of their state sector. To assess the applicability of the Asian initiatives, we may first compare them with the informal workout programs available in certain Eastern European transition economies.

(i) Common ground

As mentioned above, one common feature of transition economies in general is an enormous need for informal debt restructuring procedures. This necessity is generally due to inadequate legal systems; shortcomings of the relevant laws; lack of skilled and experienced professionals; and lack of capacity of the legal system when a systemic crisis is affecting parts or the whole economy. The cultural attitude towards informal workouts dominates in Asian jurisdictions437 but may exist somehow also in other transition economies.438 On the other hand, jurisdictions in Eastern Europe are mainly concerned to restructure their state-owned sector and at the same time dealing mainly with SOE creditors. The Asian programs, on the contrary, are not limited to state-owned enterprise restructurings.

(ii) Structure of the programs – common and different elements

The approaches have several similarities and some significant differences. Both systems provide as a basic function for some procedural and substantial guidance in the workout process. Furthermore, the respective programs frequently entail the set up of a governmental agency which is charged with the implementation and promotion of the informal workout process. Generally, this agency is equipped with some extra-judicial powers. Different is the type of participants involved. In Eastern European jurisdictions are debtors and creditors frequently SOE’s whilst in Asia the process affects mainly private enterprises.

436 See B.II.5.1.2.e. 437 See the discussion on cultural attitude of Asian jurisdictions, B.II.2.2. 438 See the discussion on cultural attitude of post-socialist and other economies, B.II.2.2.


136

The Eastern European process enormously limits participation rights of creditors whilst Asian programs try to hold up rights of the creditors involved. Some Eastern European programs439 provide for the transfer of assets440 and ownership rights of the SOE to the respective restructuring agency. Asian initiatives, on the other hand, frequently attempt to apply a voluntary contractual approach by facilitating ex-ante inter-creditor agreements.

(iii) Conclusion

The general features and corner stones of both approaches are similar. They both attempt to overcome similar obstacles prevailing under their current state of affairs. The basic idea behind them is to promote the informal workout process since it provides several advantages to otherwise applicable formal proceedings. Generally, the here-introduced different techniques might be available to other transition economies as well. However, one has to be careful to exempt certain types of enterprises from the general application of the formal insolvency process.441 Furthermore, it is important to adjust the informal program exactly to the needs and prevailing conditions of the respective jurisdiction. A positive development, provided for in the Asian initiatives, is the facilitation of ex-ante creditor agreements. Similar methods might be also applicable in other transition economies but require an underlying efficient legal framework.

439 E.g. the Development Fund in Slovenia 440 However, the Danharta initiative in Malaysia does also provide for the acquisition of NPL’s by Danharta 441 See also the discussion on the scope of the formal insolvency law, D.I.2.3.


137

II. The relationship between liquidation and rescue proceedings Most of the jurisdictions reviewed have both a liquidation law and a rescue-type procedure designed to save the business rather than to terminate it.

1. Rate of success of rescue proceedings Statistics reveal that the rate of success of rescue proceedings is generally low, ranging from some 25% to 7%.442 Considering these figures one must recognise the almost insuperable difficulty of measuring what means “success” in this context.443 Some consider it as success when returns to creditors flow in a short term. For others success means that the business of the debtor is preserved, even when management or ownership changes, again different opinions believe that success indicates the maintaining of jobs for employees, even it can affect the viability of the debtor in the long run. Finally, few observers regard a reorganisation already as success when solely a plan is confirmed and other formal insolvency requirements are satisfied.444 To answer this question, policymakers should bear in mind to set the boundaries of the mission of insolvency law. If the goal of insolvency law is simply to keep lots of companies in business, formal rescue proceedings may have failed to reach this objective. If the system supports also some other goals, however, the presented data may support that the system is successful. Furthermore, one should consider that also the formal liquidation process, the alternative outcome after a failed rescue attempt, provides several advantages to the participants and the public as a whole. It, for example, can maximise asset value445 through collective proceedings and certain powers of the liquidator, can consider and enforce the principle of par creditium creditorum446 in the distribution process and may also serve wider community interests.447 According to the above mentioned statistics, up to 90% of insolvency proceedings end up in liquidation. Yet, statistics may be misleading. They regularly fail to capture the fact that larger companies with a greater impact on economy and society are more likely to be reorganised. Moreover, the failure of rehabilitation may often be due to the inadequate design and application of the rescue regime, and the conversion of reorganisation into liquidation may reflect the fact that

442 Gross-Failure and Forgiveness, 5: Approximately 20% of Chapter 11 business reorganisations are confirmed in the US. 443 WB-Legal Framework, 5; for Chapter 11: Leif-Success in Chapter 11, 229 444 Gross-Failure and Forgiveness, 120 445 See the discussion on the objective of asset value maximisation, B.I.3.2. 446 See the discussion on the objective of equitable treatment of similarly situated creditors, B.I.3.3. 447 See the discussion on the objective of community interests, B.I.3.11.


138

an enterprise with no chance of reorganisation has abused the reorganisation procedure solely as a means of forestalling or delaying liquidation.448 In Germany for instance, before the recent change of it insolvency law, less than one percent of all court-supervised insolvencies ended in a confirmed concordat; an agreement between debtor and creditors.449 Also Chapter 11 of the US-Bankruptcy Code is frequently criticised because of its low rate of success.450 Observers451 estimate that four out of five chapter 11 bankruptcy cases fail prior a reorganisation plan can be confirmed. Among these confirmed cases, some thirty percent provide for the liquidation of the business. By these estimations, only about ten percent of cases initiated under chapter 11 result in a reorganised business.452 However, all commentators do not share this view and some guess that the real success rate in Chapter 11 cases is in the range of 40%.453 Furthermore, observers suggest that under the US-Bankruptcy Code approximately 30% of insolvency filings are specifically intended as reorganisation cases.454 However, there also exist examples of how legislators have adjusted an existing relation between liquidation and reorganisation when the economy was in need of a higher share of reorganised businesses. The later in more detailed discussed changes of the Hungarian Bankruptcy Law in 1992455, for example, caused a relation between liquidation and reorganisation filings in 1992 of 9.900 (liquidation) to 4.400 (reorganisation).456 However, the Hungarian Bankruptcy Code did not provide for a modern and efficient reorganisation law, with the consequence, that most of the reorganisation filings did not lead to a reorganised business.

448 IMF-Report, 12; Baird/Jackson-Corporate Reorganisations, 125 449 Balz, Schiffman, 20 450 Generally: Baird-The Uneasy Case; Bowers-Bankruptcy Hypotheses; Aghion-Improving Bankruptcy; Baird/Jackson-Corporate Reorganisations; see on strategic behaviour also Warren-Bankruptcy Policymaking, 348 451 Warren-Bankruptcy Policymaking, 373; Bowers-Bankruptcy Hypotheses, 964 452 Warren-Bankruptcy Policymaking, 373; Bowers-Bankruptcy Hypotheses, 964 453 Bufford-What is Right, 833 454 Bufford-What is Right, 835 455 See D.II.5. 456 Bickford-Bankruptcy Law Reform, 940


139

2. Balancing in between liquidation and reorganisation How to balance the competing goals and outcomes of liquidation and rescue is a fundamental policy decision for an early stage of the transition process.

2.1. Balancing the goals of liquidation and reorganisation As stated earlier457 there is a widely recognised view not only among economists that the decision whether to liquidate the failing enterprise piece-meal, through a sale as going concern or to reorganise should be determined by the prospective value of the outcome of the procedure chosen.458 However, questionable is what representatives of this opinion understand under the term “value”.459 Value could mean the ultimate economical outcome for the creditors or investors involved.460 In a wider sense, value could also mean the benefits for all parties involved, covering even long-term benefits without being necessarily mere monetary. In this context, one may raise the question of whether insolvency law should have a redistributive character, in other words whether it should recognise pre-insolvency entitlements461 and distribute the debtor’s assets accordingly or ignore them and distribute assets according to another schedule?462 As mentioned more extensively in a discussion above463, particular in transition economies, there may exist good reasons to consider in the insolvency law some additional concerns than those prescribed by pure economical insolvency theories.464 By way of example, some hardly avoidable aspects of outright liquidations may have severe consequences on workers, local markets, suppliers and social welfare in general. However, available measures to rebalance such effects should be generally limited to the transition period and are subject to the respective legislators policy decision depending on the 457 See B.I.3.2. 458 WB-Economic Dimensions, 2; Baird/Jackson-Corporate Reorganisations, 109; Aghion-Improving Bankruptcy, 851; Balz-Sanierung, 24; see also the discussion at Flessner-Sanierung und Reorganisation, 185, with a critical analyse of the economical foundation of that theory by Buchanan, The Economics of Corporate Enterprise 459 Frost-Bankruptcy Redistributive Policies, 81: “Contemporary bankruptcy commentary, while diverse, can be divided roughly into two camps. One group of commentators sees bankruptcy as a device narrowly designed to maximise creditor returns while another group sees the process as an opportunity to address the vast range of social problems caused by business failure.” 460 So at least representatives of a pure economical approach to insolvency 461 Balz-Sanierung, 20 considers the recognition of pre-insolvency entitlements as the main tool to provide for market conformity – the ultimate goal of insolvency law 462 See Bowers-Bankruptcy Hypotheses, 964 463 See for community interests B.I.3.11. 464 Brown-Corporate Rescue, 875 justifies a preferential treatment of rescue policies in the transition phase and expects a shift to more creditor-focused rights as soon as market structures have developed.


140

actual prevailing situation in a respective jurisdiction. Nevertheless, it might be valuable for a transition economy in doing so to structural favour reorganisation over liquidation proceedings in their insolvency laws.

2.2. Leverage function of efficient insolvency proceedings As mentioned before, the prospect of forcing efficient liquidation upon an insolvent debtor provides a very important incentive for the possible initiation of rescue proceedings465. The prospective liquidation combined with the termination of the debtor and the sale of assets overshadows the negotiations between the parties involved and will encourage debtor and creditors to consider rescue-type proceedings. Therefore it is necessary that the liquidation is easy accessible, efficient, quick and with a reasonable prospect of success.

2.3. Other considerations An insolvency regime should carefully balance the advantages of near-term debt collection through piecemeal liquidation and of maintaining the debtor as a going concern through reorganisation. In doing so, a regime should seek to avoid abrupt disruption of the debtor business through liquidations (often the preference of secured creditors) and should seek to maximise going-concern value (often the preference of unsecured creditors). Increasing creditor bargaining power may lead to premature liquidations. On the other hand, increasing debtor bargaining power may incur costs and delays, and may negatively affect the costs and availability of credit to the whole economy.466 Additionally, experiences suggest that the values of the debtor enterprise might fall cataclysmic in a fireside liquidation sale.467 As mentioned in this paper, the underlying situation in a transition economy might be considerably different from the situation in a developed market economy. One feature already referred to is the frequent inability of markets in transition economies to absorb further assets stemming from widespread liquidations.468

465 See C.II.2.2.; also WB-Rehabilitation, 10 466 G22-Report, 44 467 Wood-Principles, 118 468 See B.II.5.1.2.d.iii.


141

3. Procedural and substantial common ground of liquidation and reorganisation Although liquidation and reorganisation procedures are quite distinctive with partially different objectives, there are certain linkages and overlaps between them, both as a matter of procedure and in terms of the substantive issues they address. As stated above, the decision whether to choose liquidation or a rescue procedure is frequently made according to the perspective of the viability of the debtor enterprise. Right at the outset of the proceedings such a decision is hardly to make since it needs scrutiny of the economical and financial affairs of the debtor. Therefore unitary or semi-unitary proceedings469 should be in place allowing an unproblematic switch or conversion from liquidation to reorganisation proceedings without further delays and costs.470 With respect to the substantive issues that these procedures address, there is also considerable overlap. This is due to the fact that there is no clear dividing line between liquidation and reorganisation. How is the sale of the debtor enterprise as going concern to qualify? Is it liquidation because the veil of the incorporated debtor is terminated and the assets are now owned by a different legal person or is it rather a reorganisation because the business of the debtor continues its activities and employment is preserved?471 If, as in most cases472, the sale of an enterprise as a going concern is considered as a liquidation proceeding, the continuation of the enterprise becomes just as critical as under a rehabilitation procedure, which means that similar safeguards with respect to the stay on creditor actions and the treatment of contracts may be required.473

4. Balancing between a going-concern-sale and formal reorganisation proceedings When one considers the sale of the debtor enterprise as going concern and a formal reorganisation as mechanisms with similar objectives, namely asset maximisation on one hand and the continuation of the business on the other hand, it might be essential to balance both techniques in the insolvency law. The sale as going concern is over-simplified a change of legal ownership without imposing other rescue mechanisms on the debtor enterprise. Creditors are paid out of the proceeds of the sale and the enterprise continues its existence under different ownership. Reorganisation, on the other hand, does not necessarily require a change in legal ownership, but will usually influence the position of the shareholders/owners in some way. However, the 469 See for a discussion on unitary and semi-unitary proceedings, C.II.7. 470 IMF-Report, 13 471 Baird-The Uneasy Case, 145 472 Baird-The Uneasy Case, 144: Chapter 7 of the US Bankruptcy Code (the liquidation chapter), for example, permits going concern liquidations; Polish Bankruptcy Code, Art.113 explicitly prefers the going concern sale to a piecemeal liquidation


142

factual ownership in reorganisation shifts from the shareholders to the creditors. After initiating reorganisation proceedings, the former owners/ shareholders turn their execution and decision making powers to the administrator, who represents and protects creditor interests, or to creditors directly. Generally, creditors will favour the respective process promising the highest return on the outstanding debt. Empirical research suggests that prices of the going concern value of troubled enterprises usually lack considerable market values due to time pressure in decision-making and respective deficiencies of information about the debtor enterprise but provide a higher asset value than liquidation does.474 On the other hand, the reorganisation value of the debtor enterprise is solely determined by the creditors: reorganisation therefore may be best described as the sale of the going concern to the participating creditors.475 Owners and shareholders will be usually more in favour of a reorganisation since it might keep them to some degree in their shareholder position and offers the solely chance to recover their investment in the long run. Similarly, management prefers presumably the alternative with the highest chance to keep their position in the company. As mentioned somewhere else476, reorganisation provisions usually provide for the remaining of the existing management. Contrary, in the case of a sale of the debtor enterprise as going concern, the management is usually replaced by new directors and officers from the new owner. Therefore, management will consequently have a preference for reorganisation instead for the sale as going concern. Consequently, one can say that in the case the law promotes unilaterally the sale as going concern, it will presumably discourage management or owners from initiating insolvency proceedings at an early stage due to a lack of incentives combined with such a decision.477 Hence, the insolvency law should avoid any structural bias of going-concern-sale over formal reorganisation measures.

473 IMF-Report, 14 474 Bowers-Bankruptcy Hypotheses, 959 475 Jackson, Logic and Limits, 212 476 See D.III.5. 477 See Eidenmüller-Unternehmenssanierung, 34


143

5. Abolishing reorganisation for extended liquidation proceedings Some authors478, however, do even call for the total abolishment of reorganisation proceedings in favour of extended liquidation proceedings (by increasing the going concern value during liquidation proceedings). They argue that the negotiation process in reorganisation proceedings does negatively affect the asset value (negotiations causes costs, delays and may be misused strategically by certain groups).479 They opt for the replacement of reorganisation by the going concern sale since going concern value is determined by market forces rather than by debtor-creditor negotiations.480 According to those observations, markets are the only efficient institutions to deal with financial distressed companies and any interference by court-supervised reorganisation proceedings destroys wealth.481 However, as we have seen in the preceding discussion, markets are far from being perfect and provide, in the case of a going-concern-sale, only for a reduced asset value due to several reasons. The negative impact of the markets or their absence may be from particular importance in transition economies. As mentioned before482, one characteristic feature of the insolvency process in transition economies is that markets are frequently not able to absorb further assets. The bargaining and negotiating commonly along going with reorganisation proceedings remains so a necessary feature for a successful insolvency process.

6. Examples On a comparative perspective, jurisdictions are balancing this field of tension quite differently. Some countries483 clearly favour reorganisation to a final liquidation and even allow liquidation proceedings only to start when a reorganisation attempt has failed or is not possible or feasible. Others484 treat the two procedures more equal and give creditors powers to drive proceedings according to their expectations. Moreover, some jurisdictions clearly prejudice liquidations over rescue proceedings in imposing high thresholds on rescue attempts.485 478 For the abolishment or amendment of Chapter 11 of the US-Bankruptcy Code generally: Jackson-Logic and Limits, 218; Baird-The Uneasy Case, 136; Baird/Jackson-Corporate Reorganisations, 125; Bowers- Bankruptcy Hypotheses, 976; disapproving: Bufford-What is Right, 829 479 See et al: Baird/Jackson-Corporate Reorganisations, 125 480 Balz-Logik und Grenzen, 1442 481 Bowers-Bankruptcy Hypotheses, 977; disapproving: Bufford-What is Right, 846 482 See for more details B.II.5.1.2.d.iii. 483 See for example: Hungarian Bankruptcy Law, Preamble, which only permits a liquidation of the debtor when a reorganisation is not possible; Georgian Bankruptcy Code, Art.1, 2 (3), which rules liquidation of a debtor inadmissible as long as a sanction (reorganisation) is not attempted 484 The new German Insolvency Code, for example, is theoretically neither biased towards liquidation nor towards the reorganisation of a debtor and follows thereby the principle of market conformity


144

An interesting legislative reaction to the redundancy of employees connected with insolvencies provided the Polish Bankruptcy Code.486 The Code promotes the sale of the debtor enterprise as going concern or single asset complex and gives participants several incentives to favour such an option. Firstly, it exempts the acquirer of the enterprise from further liability for pre-transaction obligations of the debtor enterprise.487 Furthermore, the acquirer enters into the labour contracts with the employees of the debtor enterprise with the effect that the jobs of the employees of the debtor are saved. Nevertheless, there are possibilities for the acquirer to reduce the workforce accordingly.488 Under chapter 11 of the US-Bankruptcy Code reorganisation proceedings became a common and widespread financing instrument for the crisis management of solvent enterprises. Those enterprises are misusing the procedural and substantive advantages of the reorganisation proceedings to reschedule payments, to reduce their debt burden or they follow other strategic targets.489 The German insolvency code prior to its reform did grant reorganisation a position of a special objective of the process and thus gave a preference to reorganisation over liquidation. However, that was changed with the reform and the preferential treatment of reorganisations was abolished. Now, liquidation, the sale as going concern and reorganisation as procedural options are treated equally and only the creditor meeting has the right to choose the proceedings490 and hence provides for a competition among the different types of asset realisation. None of the forms (piecemeal liquidation, sale as going concern, liquidation and reorganisation by a plan) is preferred to another; the expected outcome for the creditors is the only relevant motive.491

485 Such obstacles are characteristic for traditional composition laws 486 Polish Bankruptcy Code, Art.113; Brol-Das polnische Konkursrecht, 312 487 The liability of the legal successor, commonly found in many jurisdictions, is a main impediment to reorganization proceedings. The German law, for example, abolished for the same reason the respective provision in the German Civil Code. (§419) 488 Brol-Das polnische Konkursrecht, 312 489 Balz-Logik und Grenzen, 1438; Jackson-Logic and Limits, 218; Baird/Jackson-Corporate Reorganisations, 125 490 Balz-Logik und Grenzen, 1440; German Insolvency Code, § 157; see also German Insolvency Code, §1; to the general and special objectives of the German Insolvency Code see: Prütting-Allgemeine Verfahrensgrundsätze, 183 491 Balz-Logik und Grenzen, 1443


145

7. Procedural approaches: unitary and semi-unitary proceedings

7.1. General Aside from the fundamental importance of the general relationship between liquidation and rescue, also the procedural approach to the two insolvency tools is crucial. Cases in the real commercial world are seldom of pure liquidation or rescue nature. Many of them are somewhere in between, the assessment of the state of affairs of the debtor is difficult and long lasting. In jurisdictions with a separate liquidation and rescue law, the petitioner or the court has to decide at this early stage if the case belongs to liquidation or to a rescue-type of proceeding. To overcome this obstacle and many related problems, many jurisdictions have introduced so called unitary or semi-unitary proceedings. In transition economies, recent examples are Romania492, Bulgaria493, Russia494, Indonesia, Korea and the Philippines.495

7.2. Characteristics and advantages There are still some jurisdictions496 where a conversion from rescue proceedings to liquidation and vice versa is not provided for, with the consequence that the process has to be initiated again once proceedings within one action have failed or faltered. The most common case is where a rescue attempt has failed and due to the absence of a respective provision, the ultimate liquidation proceedings have to start from the beginning. Such non-unitary proceedings are frequently more expensive, time-consuming, ineffective, difficult to handle and put reorganisation proceedings at a disadvantage. Unitary proceedings provide for one “entry” regardless of the categorization of the insolvency case as liquidation or rescue.497 The law commences insolvency proceedings which are similar for both liquidation and rescue until a decision is made whether the debtor shall be liquidated or rescued. A semi-unitary proceeding provides for two different openings as liquidation or rescue, but with the prospect of conversion from one to the other to be initiated by the debtor, the administrator, the court or even the creditors.

492 For Romania see: Capatina-Länderbericht Rumänien, 359 493 Balz, Schiffman, 22; Popova-Bulgarisches Insolvenzrecht, 38 494 EBRD-Summary of the Russian System, 6 495 For Korea, Indonesia and the Philippines see: ADB-Report, 30 496 ADB-Report, 30: e.g. India, Malaysia, Thailand 497 EBRD-Summary of the Russian System, 6: Bankruptcy liquidation and external administration are commenced in a unitary way – with the commencement of a voluntary or involuntary filing under the Russian Bankruptcy Code (1998); nevertheless may the petitioner have the right to file for reorganisation or liquidation proceedings: see for example: Romanian Insolvency Code, Art.26 (1)(f)


146

A unitary or semi-unitary approach offers the parties involved the necessary amount of flexibility, choice and freedom and saves them unnecessary confusion, expenses and time waste.498 The philosophy, underlying such a unitary structure of the insolvency process, is that the classical elements of liquidation (e.g. stay of creditor action, estate over assets of debtor and the right to re-examine and assume/reject pre-insolvency contracts of the debtor by the administrator) should apply to any collective proceedings once insolvency is established and creditor interests and their equal treatment are jeopardised. Furthermore, unitary proceedings reduce the improper strategic misuse of petitions for an individual proceeding in order to harass or lever other participants. For example, a debtor may file for reorganisation proceedings in order to reduce its debt burden and thus defraud creditors. Under unitary proceedings, there would be the risk for the debtor that proceedings are automatically converted into liquidation proceedings when the reorganisation criteria are not met.499 A good example is the Romanian Insolvency Code500 providing explicitly for the immediate conversion of reorganisation proceedings to liquidation proceedings under the relevant circumstances.

498 WB-Towards Principles, 11 499 Balz, Schiffman, 24; IMF-Report, 49 500 See the key provision in the Romanian Insolvency Code, Art.77


147

III. The relationship between formal rescue and informal workout After having discussed the relationship between formal reorganisation and liquidation, it might be worth considering the same for formal reorganisation and informal workout, particularly in the unique context of transition economies. Formal rescue procedures are embodied in a formal statutory regime whilst informal workouts are frequently501 not governed by special procedural rules. Informal workout techniques have developed over a reasonable period of time and are mainly encouraged by the financial markets.

1. Advantages of informal workouts Workouts have considerable advantages502 to formal rescue proceedings. They are often more flexible, cheaper, involve only sophisticated creditors with less publicity and speculation, carry less “stigma”503 and provide in this way a better environment for market-oriented negotiations.

1.1. Costs Empirical research of respective US cases suggests that informal workouts may take a considerable shorter period of time then comparable formal Chapter 11 proceedings.504 A similar situation exists under the German insolvency code. The length of the process directly influences the overall costs of the proceedings. Informal “workouts” are usually confidential between the debtor and its main (sophisticated) creditors and have therefore not the negative effect on the debtor’s business as commonly reported from formal insolvency proceedings.505 By way of example, if a manufacturing company goes into formal reorganisation proceedings, it will be usually announced to the public. Consequently, customers will become sceptical whether the debtor is still able to perform contracts; to keep quality and safety standards; provide after sales service; or comply

501 However, they might be embodied as guidelines or procedural instructions in more structured workout programs, see for example the Asian workout initiatives, C.I.3.2.6. 502 See generally also Brown-Corporate Rescue, 11 503 See for the shame, deriving from bankruptcy proceedings as a societal phenomenon, Paulus-Entwicklungslinien, 240 504 Eidenmüller-Unternehmenssanierung, 332: the average duration of informal workouts is 18 month, comparable Chapter 11 proceedings last 30 month up to 4 years 505 Bowers-Bankruptcy Hypotheses: Empirical research in the US suggests that in Chapter 11 proceedings companies loose approximately 30 % of their relative market value within 5 days of the filing date; Bufford-What is Right, 840: However, that may be only true for companies listed or publicly traded companies.


148

with quality and performance warranties. Suppliers will refuse to extend further trade credit with the effect that the debtor must pay in cash upfront. Banks are not willing to advance new money without an absolute assurance of repayment. As a logical result, the business becomes even more difficult and expensive. These fatal consequences can be avoided if the restructuring is private and confidential.506

1.2. Flexibility Furthermore, informal workouts allow a very early response to financial difficulties of debtors by banks and other financial institutions normally not available under the formal rescue laws. Well-established and applied informal workout techniques may avoid the actual insolvency of enterprises since they deal with the problem upfront and often before it is too late. Mainly banks and other financial institutions apply sophisticated credit control techniques which enable them to realise and react to financial difficulties of respective debtors at a very early time. In addition, the commencement of formal insolvency proceedings may spark off ipso facto clauses507, entitling parties to cancel contracts, franchises, distributorship, agency agreements, leases, intellectual property licenses and concessions. The commencement of negotiations to a mere informal workout may not have this effect, unless there are other contractual grounds for cancellation, e.g. cross-default clauses.508 Moreover, once formal insolvency proceedings are commenced, it is usually not possible for creditors to take security for existing debt.509 But in the case of an informal workout, creditors can, and commonly do, take security and cross guarantees for their existing debt and hope to outlive the suspect period.510 Additionally, informal workouts offer more flexibility to deal with the management of the debtor. The workout agreement may provide for the replacement of the existing management, for the remaining of it or for the temporary employment of external crisis management. Formal proceedings are usually more stiff and do not provide for the frequently necessary flexibility.511

506 Wood-Principles, 116 507 See for details the discussion on ipso facto clauses under formal insolvency proceedings, D.III.8. 508 Wood-Principles, 122 509 Such a transaction is typically treated as preference with respective avoidance powers of the administrator, see for example: German Insolvency Code, § 135; Romanian Insolvency Code, Art.45 (1)(e); Polish Bankruptcy Code, Art.54 § 2; US-Bankruptcy Code, § 547; See also the discussion on D.VI.2.1.2.a. 510 Wood-Principles, 121 511 Eidenmüller-Unternehmenssanierung, 340; See also the treatment of management under formal proceedings, D.III.5.


149

1.3. Private autonomy Generally, one can say that the informal process enables results which may be not available under the formal rescue regime. Informal proceedings are not governed by predetermined rules and provisions and therefore provide the participants with more freedom in designing the process and the substance of the reorganisation. The main instrument of informal proceedings is the private agreement and therefore generally only governed by the law of contract. By the way of example, in many formal rescue regimes of transition economies exist obstacles on debt to equity conversions.512 The informal workouts provide an instrument to circumvent these obstacles and overcome existing restrictions in the formal process.

1.4. Acceptance Since main creditors have usually consented to the proposed workout agreement, it may provide for a higher acceptance than a reorganisation plan imposed against the will of a certain percentage of participants.

1.5. International rescues A further legitimacy of informal rescues derives from problems of formal insolvency proceedings with financial difficulties or insolvencies of multinational companies.513 Frequently, the formal insolvency regimes of many countries are not suitable to deal efficiently with the varying problems arising in the case of the insolvency of multinational companies. Multinational companies are usually structured as groups, consisting of several legal entities incorporated in different countries. The formal insolvency process would require proceedings against each legal entity while an informal workout may embrace the whole group as one economic unit.514 Consequently, dealing with the restructuring of the whole group in one process may reduce costs and provide more efficient solutions. Even existing proposals for a unification of international aspects of formal insolvency law515 do promote the concept of “secondary” proceedings in the case where assets or production units are in different countries.516 512 See D.V.3.4. 513 Eidenmüller-Unternehmenssanierung, 923 514 Eidenmüller-Unternehmenssanierung, 925 515 UNCITRAL Model Law on Cross-Border Insolvency, 1997; European Convention on Insolvency Proceedings, 1995


150

2. Preconditions, necessary to initiate informal workouts However, not every insolvency case is suitable for an informal workout. Several preconditions should be present. Firstly, the debtor should own a significant amount of money to a number of banks/ financial institutions and should be generally unable to service this debt. Secondly, debtor and main creditors should be generally consenting to negotiate about the situation. Thirdly, the prevailing legal system should provide for sophisticated refinancing, security and other commercial techniques linked with the sanction that the process could easily swift to formal insolvency proceedings if the negotiations fail. Finally, there should be a prospect that the workout may provide a greater benefit for creditors than the immediate resort to formal proceedings.

3. Functions of the underlying formal insolvency regime

3.1. Leverage function The informal workout is a voluntary procedure since creditors have generally no obligation to negotiate with defaulting debtors.517 For the success of the informal proceedings it is essential that an efficient formal insolvency regime is in place in order to “lever” creditors to consent to the informal process since the outcome in the formal proceeding might be economically less attractive. Therefore, it is necessary that the formal process is easy and quick accessible. The underlying formal proceedings function thus as a “bargaining” factor in the commencement and progression of an informal workout. The availability of this sanction may influence the corporate debtor and its creditors alike. There will frequently be situations where debtors are not interested to negotiate with certain creditors, or other creditors which rather enforce their claims individually than being involved in a collective bargaining process. If a corporate debtor refuses or is reluctant to participate in an informal process, it will almost certainly lead either to individual debt or security enforcement action or the application of the formal insolvency procedures with usually more rigid sanctions than agreed in the informal workout and which the debtor will not be able to delay or defeat.

516 Virgos-Convention on Insolvency Proceedings, 33 517 But see the following discussion on creditor obligations to cooperate, C.III.5.1.2.


151

A similar situation applies to dissenting creditors: they may find that they are subject to a formal insolvency process which effectively prevents them from enforcing their individual rights and may not offer the most optimal solution for maximising value of their claims.518 The formal insolvency law thus can be viewed as creating a baseline: it enables the affected parties in distressed situations to negotiate out-of-court restructurings because each party can assess whether the consensual treatment of its position is better than the expected outcome of formal insolvency proceedings. Indeed, in a jurisdiction with clear insolvency rules and procedures which are uniformly and transparently applied and enforced, the majority of debtor-creditor financial issues should be resolved through bargaining and consensus, not through litigation in the courts.519

3.2. Recognition of pre–packed plans under the formal insolvency law A second important function of an efficient formal insolvency regime in that respect is the fact that it may enable participants to impose a pre-negotiated reorganisation plan520 among dissenting or unwilling creditors. Frequently in informal workout negotiations some creditors may refuse to participate in the negotiations at all or to consent to a proposed reorganisation plan. One of the main shortcomings of the informal process is that its result, the final restructuring agreement, is a private contract among the parties and non-binding for creditors not party to it. To overcome this, participants need to have the opportunity to pre-negotiate a plan in a manner that it will receive the necessary majority consent under the formal insolvency law and then imposing it among dissenting creditors by getting approval in the courts under the formal insolvency law. The formal insolvency regime should generally consider that function and provide for the respective mode.

518 ADB-Report, 55; ADB-Report 1999, 29 519 Averch-Lien Stripping, 89 520 See for more details about pre-negotiated and –packed plans, C.III.5.2.


152

3.3. Provision on external advisors In order to successfully carry out an informal workout, it may be essential to engage advisers from various disciplines (legal, accounting, finance and business reorganisation) what may make the process more expensive. Particularly debtors are usually reluctant to consult and engage outside professionals since they fear the costs, the surrender of control and other consequences. To overcome this reluctance, the underlying formal insolvency procedure should also provide for the participation of outside advisers since it reduces the chance for the debtor to opt for a less interfering alternative.521

3.4. Additional factors supporting workouts Irrespective those already mentioned, there are some further factors influencing the decision process of participants towards workout or formal insolvency proceedings.

3.4.1. Exemption to file a petition during workout negotiations

Usually, informal workouts are attempted before the respective insolvency criteria are reached. In those cases, the rescue plan may provide for measures to urgently restore the solvency or generally improve the financial situation of the debtor. More difficult is the situation, where an informal rescue is attempted when the debtor is already insolvent since debtors or their respective management are frequently522 obliged to file for formal proceedings as soon as the debtor becomes insolvent. In order to promote workouts, the formal insolvency law should exempt the management generally form such an obligation while being in informal workout negotiations. A possible mode would be to set a short time limit523, within which the debtor management has to file for insolvency after the debtor enterprise became insolvent. Within this limited period the debtor management may have the chance to negotiate, informally, emergency rescue measures without being exposed to personal or criminal liabilities. However, on the other hand, one could also argue that the threat of personal liability of the debtor management functions as an incentive to initiate informal workouts at a very early stage – before the enterprise becomes actually insolvent. Closely related is the fact that a wide reaching personal liability of directors, when incurring debts while insolvent, might minimise chances of informal workouts. A similar exemption 521 ADB-Report, 55 522 See for the obligation of management to file for insolvency, D.II.5.


153

for such an extensive personal liability during workout negotiations should be considered in the formal insolvency law.

3.4.2. Availability of adequate security

Another provision in the formal insolvency law influencing the attitude of creditors towards workouts regards the validity of security agreements especially for pre-insolvency debt. Insolvency laws which are ruling out any security interest granted after the debtor has reached the respective insolvency criteria or within a long suspect period disadvantage workouts. Hence, if creditors are able to take valuable security, they will be more willing to agree on rescheduling, debt relief and other rescue techniques.

3.4.3. Retention of debtor management

As mentioned before, the treatment of management in formal proceedings may have varying effects on the behaviour and attitude of debtors.524 Since management may naturally fear any loss of control, they will most probably favour the process providing them with the most autonomy. Private workouts are not limited to a prescribed treatment for management and are therefore generally a preferred option for a debtor. However, if also the formal reorganisation law provides for the unlimited continuation of management control, an important incentive for the initiation of workouts might be lost.525

3.4.4. Foreign exchange treatment

A further influential factor regards the compulsory conversion of foreign exchange and related depreciation risks in formal insolvency proceedings. As mentioned in this paper526, in formal proceedings claims in foreign currency are commonly converted into local currency and thereby frequently exposed to considerable depreciation risks. A workout agreement, on the contrary, is commonly based on the currency of the underlying credit agreement and so not exposed to depreciation risk in weak currency markets. 527

523 The German company law, for example, provides for a 3 weeks period, § 64 German GmbHG, § 92 German AktG; See for other examples D.II.5.3. 524 See C.II.4. 525 See also for a discussion of several options of the treatment of management in formal rescue proceedings, D.III.5. 526 See for the treatment of foreign currency claims also: D.VI.5. 527 Wood-Principles, 124


154

3.4.5. Lender liability On the other hand, creditors participating in informal workout negotiations may be exposed to extended lender liability when the final workout agreement provides them with extensive powers to effectively influence management decisions of the debtor. 528

4. Dilemmas of workouts and respective solutions But beside obvious advantages, the informal workout process has also some considerable obstacles and shortcomings in comparison to formal rescue proceedings. That derives from its nature as pure private agreement (instead of having the quality of a binding juridical decision) which normally requires unanimity among participating creditors.

4.1. Standstill Firstly, there is no statutory stay on creditor action after negotiations have started. Part taking creditors solve the problem through negotiation of a standstill agreement for a defined period. The standstill agreement may be compared with the stay of actions and proceedings generally available under the formal insolvency regime but with the main difference that the stay in the formal proceedings is automatically triggered by law or imposed by the court whilst in a workout it is privately agreed among the participants. The standstill agreement usually contains provisions prohibiting the participating creditors to enforce unitarily any rights and disallow the debtor to change its position other than in the normal conduct of its business. A similar setback exists with secured creditors. Secured creditors are regularly not interested in reorganisation proceedings since it may not increase the value of their collateral. They may not need to reorganise the debtor in order to recover the extended credit - they solely seize and sale their collateral. Those encumbered assets, on the other hand, might be necessary for a successful reorganisation attempt of the debtor. However, not every secured creditor is fully secured and may therefore recover the whole outstanding credit only through a successful rescue. Furthermore, in transition economies exist frequently serious difficulties to find a market for assets529 which may affect also the secured creditor trying to sell his collateral. Commonly, the inter-creditor rescue agreement extends the stay to collateral but on the other hand provides the secured creditors with sufficient protection.530

528 Eidenmüller-Unternehmenssanierung, 371 529 See also B.II.5.1.2.d.iii. 530 Eidenmüller-Unternehmenssanierung, 356


155

4.2. Outside and dissenting creditors Furthermore, it remains difficult or undesirable to force creditors to participate in the process. Often small claim creditors (outside creditors) have no expertise or interest to negotiate with the debtor and to participate in the process. The participation of all of those creditors in the negotiations would probably cause delays and render the process inefficient and more expensive. Regularly bondholders, disaffected trade creditors, counter parties to large burdensome contracts or shareholders have different opinions about the reorganisation of the debtor’s financial and operational affairs and refuse consequently to take part in the workout process (dissenting creditors). But even though they do not participate in the informal workout they cannot be ignored. Some of them may be essential for the business of the debtor. They might be suppliers of necessary goods or services or might even participate in crucial parts of the production process of the debtor corporation. In such a case it might be commercially of advantage for the remaining major creditors to pay the debts of these dissentient or not interested creditors in full. The involvement of only sophisticated creditors makes the whole process less complicated and confrontational, avoids unnecessary delays and is consequently less expensive. Some bank creditors may also be not willing to participate in the workout or to renegotiate or reschedule the terms of the loan agreement. These creditors may sell the debt to professional debt traders which become creditors and may engage in the workout. This, however, can produce a cultural clash because bank creditors and distressed debt traders come from different backgrounds and exhibit different approaches toward debt recovery.531 Other lenders may tend to refuse their participation in order to shift the financial burden of the rescue strategically to the remaining creditors.532 As discussed before, another solution would be to agree on a reorganisation plan among the major (bank) creditors and then use the plan as a basis for a formal reorganisation process which would be binding on all creditors when the necessary majority has consented to the plan. (“Pre-packaged” plan)533

531 ADB-Report, 56 532 Eidenmüller-Unternehmenssanierung, 346 533 ADB-Report, 56; See also for pre-packed or pre-negotiated plans, C.III.5.2.


156

4.3. Post-petition credit The problem of post-petition credit is frequently another difficulty. Lenders and creditors in general will be highly reluctant to extend further credit or even maintain existing credit lines with an insolvent company. What is needed in this situation is a guarantee or a kind of security for repayment of the new money. As there is no statutory rule which grants post-petition credit a super-priority as in formal proceedings and the possibly existing rule in formal rescue (it often not even exists)534 might not be extendable to the informal process, creditors have to negotiate an “inter-creditor” agreement granting new funds a super-priority ahead of pre-insolvency entitlements among the participating creditors. However, if the rescue attempt fails and the debtor is liquidated, there might be a problem concerning the treatment of a claim for the repayment of that new money in the formal liquidation proceedings. Unless it was secured it will be an ordinary unsecured claim. As discussed earlier, many rescue laws grant to post-petition credit a super priority to accommodate the similar problem in formal proceedings. It is doubtful if such provisions would extend to cover informal workout arrangements with the consequence of recognition in final liquidation proceedings.535 However, it would be useful to pursue the possibility of extending a respective statutory protection available under the formal reorganisation regime to the informal process.536 A closely related question is concerned with the recognition, application and enforcement of contractual subrogation arrangements among creditors in formal insolvency proceedings. One technique to promote post-petition money in workouts is the consensual subrogation of creditor claims which do not grant new money. To foster the availability of new money, the formal insolvency law should fully recognise the contractual subrogation among creditors in the case of subsequent formal proceedings.537

4.4. Absence of other instruments Furthermore, the informal workout process does not provide for preferences, avoidance rules and other advantageous mechanisms usually available under the formal regime. Moreover, insolvency laws ease often the possibility to terminate employment538, lease and other long-

534 ADB-Report, 36 535 ADB-Report, 57 536 ADB-Report, 62 537 ADB-1999 Report, 31 538 E.g. Indonesian Bankruptcy Code (1998), Article 39: employment contracts may be terminated after the commencement of insolvency proceedings with six weeks notice.


157

term contracts, mechanisms often essential for a successful rescue. Those instruments are not always available under informal workouts. The only chance to reach similar outcomes as in formal proceedings would be a respective contractual agreement among creditors. However, such an agreement will be not sufficient to effectively interfere with rights of third persons (e.g. employees). As there is also no stay on other creditor action, like security enforcement, set-off and repossessions of leased or sold assets, the creditors should in the private workout agreement consent not to exercise these rights.539

4.5. Legal enforceability of the final workout agreement Finally, the so reached restructuring or workout agreement is legally not binding. In order to bind a dissenting minority, all creditors have to submit to an agreement that contractually binds them to the majority decision.540 As mentioned before, formal rescue proceedings should be able to accommodate a negotiated informal agreement as “pre-packaged” plan with the legal and economical consequences of a formal reorganisation plan.541

5. Minimizing obstacles of private workouts In recognising the overwhelming advantages of private workout arrangements, it might be useful to consider how one could improve their general efficiency and rate of success.

5.1. Private workouts – ex ante542 and ex post agreements Generally, the underlying legal framework should support both ex ante and ex post workout agreements.

5.1.1. Ad hoc or ex-post agreements

The term workout refers usually to a situation where creditors negotiate the treatment of a debtor after the insolvency or financial difficulty has occurred (Ad hoc agreements). They examine the state of affairs from an ex-post perspective and attempt to negotiate an acceptable agreement for the reorganisation of the failing debtor. As mentioned above, this 539 Wood-Principles, 122 540 WB-Towards Principles, 75 541 WB-Rehabilitation, 28


158

procedure might be complicated since negotiations can be blocked or delayed by dissenting creditors or because of the absence of procedural or substantial negotiation rules coupled with respective inexperience of participants. Therefore, it may be beneficial for participants to have some sort of agreement established prior to the occurrence of insolvency or financial difficulty of the debtor.

a. Ex-ante agreements

The parties could simply negotiate their own private insolvency regime which shall govern the underlying debtor-creditor relation in the case the debtor becomes unable to service the debt. However, reality is more complicated and such private solutions for the insolvency of the debtor, negotiated prior to the actual insolvency, are exceptional. The main reason is probably the high level of transaction costs543 deriving from the great variety of creditors and the frequent exchange of assets and creditors or simply the ability of the parties.544 Those ex-ante agreements may be only available for bank creditors and some trade creditors, but not for tort claimants or bondholders. Bank creditors have usually the best position to reach an ex-ante agreement about a potential insolvency situation with their debtors. The size of the finance debt is usually reasonable and banks focus frequently on long-term commitments.545 Trade creditors have frequently long-term commitments but the size of the debt may vary extremely. Transaction cost may be to high for small-claim trade creditors. For non-contractual claimants, like tort claimants there exists no opportunity to negotiate any ex-ante solution – they have to rely on the formal insolvency law or may participate in informal ex-post negotiations. Another obstacle of ex-ante agreements is the fact that they may lead to negative effects on debtor behaviour by producing moral hazard. If the debtor knows he will be rescued, he may lower his managerial and operational efforts for efficiency.546 However, the following methods for ex-ante insolvency agreements are theoretically conceivable and practically applied. 542 Eidenmüller-Unternehmenssanierung, 123, 179 543 Aghion-Improving Bankruptcy, 851 544 Bufford-What is Right, 842 545 Bufford-What is Right, 842: What may lead to a situation where the insolvency system is needed to protect insolvent debtors from secured creditors since those lenders write their own remedies, including the right to foreclose on their security upon default and the right to collect lawyer fees from the debtor.


159

Firstly, creditor banks may include rescue-supportive provisions (covenants) in their syndicated loan agreements containing basic rules and treatment of the debtor in insolvency. Such provisions may cover issues like the exchange of information among the banks, the extension of further money or the rescheduling of credits. Another option would be to negotiate a more general agreement (inter-creditor agreement) among creditor banks which governs the relation to all of their (prospectively) insolvent debtors. Such an agreement could provide for fundamental procedural and substantial rules applicable in the insolvency of a debtor of one of the singing creditor banks.

b. Punishment for non-compliance

It remains debatable whether such an agreement should have a binding legal effect on the signing parties. In other words, should member banks be forced to follow the rules of this agreement? Practise in Western jurisdiction shows that this might be not necessary. The above-mentioned London Approach547 represents this kind of ex-ante inter-creditor agreement on basic rules but is not legally enforceable. Banks are expected to follow the rules of the London Approach but are not penalised if they do not. However, this situation might be different in transition economies. Creditor banks may be less experienced with private workouts and therefore may tend more rapidly to resist economically reasonable workout proposals. Therefore, in transition economies it is justifiable to impose penalties on signing creditor banks which refuse to follow the rules of the agreement. However, this may in turn reduce the number of participating banks since the enforceability may considerably limit the flexibility of participating banks. As discussed at an earlier point548, several jurisdictions have implemented the method in structured informal workout programs. According to these programs, banks are obliged to participate and might be punished for any breach of the agreement.

546 Eidenmüller-Unternehmenssanierung, 252 547 See for the development and elements of the “London Approach”, C.I.3.2.3. 548 See for details on the programs of Thailand and Korea, C.I.3.2.6.b.ii/iv.


160

5.1.2. General obligation to participate in workouts However, beside those considerations it might be worth raising the question whether creditors to a workout are generally obliged to participate in negotiations and, to a certain extend, to confirm a workout agreement?549 As mentioned above, one of the main obstacles of out-of-court workouts are creditors which strategically try to hamper and delay such negotiations. Firstly, one has to analyse the legal relation among different creditors in their relationship to the debtor. As mentioned somewhere else in the paper550, interests of creditors are on one hand focused on the maximisation of their individual debt recovery, but on the other hand do all creditors share a common interest in the maximisation of the total debt recovery. The situation is therefore comparable with a partnership – even when a real partnership among creditors does not exist.551 From this interdependence may derive some duties to cooperate in the workout process. These possible duties can be manifold, but are mainly a general obligation to attend meetings and negotiations, a general standstill obligation as long as a real chance of out-of-court reorganisation exists and the obligation not to reclaim collateral or other essential assets. Bank creditors have furthermore the obligation to extend fully secured short-term credit (temporary bridging loan for the reorganisation process); to maintain existing credit lines and to accept debt restructuring agreements and other proposed reorganisation measures. (long-term credit) However, any leverage to assist in a workout against the will of the respective creditor means a violation of the principle of private autonomy and reduces the flexibility and predictability for creditors. Therefore several conditions have to be prevalent to establish such an obligation. Firstly, a reorganisation of the distressed debtor must seem feasible and attainable after a first investigation of the financial and operational situation of the debtor. Secondly, the proposed reorganisation measures, to which the creditors are supposed to participate or consent, should be suitable and necessary to reach the recovery of the debtors` affairs. Thirdly, such means should be reasonable for the affected creditors. That in turn means, for example, that the principle of pari-passu among creditors in respect to their portion of the outstanding debt is

549 See generally to this question under German law: Eidenmüller-Unternehmenssanierung, Chapter VI., 551 550 See B.I.1. 551 Eidenmüller-Unternehmenssanierung, 668


161

considered and that the obliged creditors are treated not worse than in formal reorganisation proceedings.552 The enforceability of such obligations is another difficulty and might be treated differently among jurisdictions. Generally both performance and compensation are conceivable.

5.1.3. Consequences for transition economies

As outlined before, the informal workout process is of significant importance especially for the situation prevalent in transition economies. Nevertheless, conditions prevailing in those countries are usually not perfect to initiate and carry out private out-of-court workouts. One method to improve the workout environment in transition economies could be the statutory or similar legal embodiment of the above mentioned creditor obligations. However, detailed rules and provisions may depend on the prevailing circumstances in a respective jurisdiction and shall be not subject to further examination. Since such provisions may interfere with the interests of varying types of creditors, the drafter of such provisions should be sensitive to the possible consequences of the legally binding embodiment of those creditor obligations.

5.2. Pre-packaged insolvency553 Pre-packaged insolvencies have developed in the US and are there an frequently used instrument to supplement informal workouts. The basic idea of a pre-packaged insolvency plan combines the advantages of informal and formal rescue proceedings. The reorganisation plan is negotiated outside formal insolvency proceedings – that saves costs and time and gives participants more flexibility. The negotiated agreement is then as a reorganisation proposal referred to the court which makes the agreement as reorganisation proposal legally binding on dissenting creditors and imposes an automatic stay on any creditor action. However, beside those advantages, such a course of action may also result in the loss of some advantages of the informal workout process. The pre-packaged plan may increase costs, cause further delay and will reveal the financial difficulties of the debtor to the public. Nevertheless, the pure existence of a pre-packaged insolvency may lever dissenting creditors to participate in the workout negotiations and therefore increase the chances of a respective success.

552 Eidenmüller-Unternehmenssanierung, 912 553 See already C.I.3.2.5.


162

An even more advanced form is the so-called “pre-voted prepack”, where even the formal voting on the reorganisation plan is done outside and prior to the “commencement” of formal proceedings. In order to facilitate this strategy and to make use of the mentioned advantages the law should generally recognise pre-packaged plans. Therefore it is necessary that the petitioners have the right to submit the reorganisation proposal at the time of the filing of the petition. Furthermore, the law should generally recognise a voting result on the reorganisation agreement as valid voting on the reorganisation plan reached outside formal proceedings.554

554 Eidenmüller-Unternehmenssanierung, 437


163

IV. Statistics and the rate of success

As mentioned on several occasions before555, measuring the success of insolvency proceedings is a difficult and highly uncertain undertaking.

1. Value of statistics on insolvency proceedings – pros and cons On one hand, one could possibly argue that statistical surveys are an important instrument to assess the extent of application of insolvency laws. Information regarding the number and type of cases should be readily available in every jurisdiction since it provides an important macro-economic statistic and can be a valuable indicator of trends in the economic system. Empirical evidence has shown that social progress takes a toll in the form of insolvencies.556 Furthermore, statistics on insolvency may provide for our purposes some guidance for the need to further reform the prevailing insolvency regime. As it seems to be very difficult to measure the success of an insolvency regime and its impact on complex macro-economic relations, statistic may be a major (or even only) tool to do so. On the other hand, the economic effect of insolvency proceedings is not easily to measure. There is hardly any evidence to find that the rate of growth, prosperity, employment or monetary stability is directly related in a straightforward way to the legal and institutional set-up used for dealing with business insolvencies. Quite obviously, the effectiveness of insolvency regimes cannot be measured by the number of proceedings initiated. Less obviously, the number of successful reorganisations as against liquidations in insolvency would not be an intelligent success indicator, either. As mentioned before557, liquidation proceedings are not necessarily an economic ill and a “destroyer” of wealth. Even the viability of a reorganised business may not be a valid measure since it may show only the results of governmental interference or subsidies, social inertia or other factors. Furthermore, one has to admit that statistics on insolvency, when then available, show commonly only half of the truth – it reveals number and type of filings but does not say anything about failed negotiations on a rescue, the impact of the insolvency on third parties or respective communities or the long-term success or failure of a agreed reorganisation plan. Additionally, one should be aware that such statistics may only reflect formal insolvency proceedings and not informally negotiated workout agreements.

555 See for example the discussion on the success of reorganisation proceedings, C.II.1. 556 Averch-Lien Stripping, 93: One empirical study suggests that 50 percent of all new business formations in the US fail. 557 See therefore the discussion on the low number of insolvency filings in some transition economies, B.II.5.1.1.


164

However, the economic analysis of law and schools of institutional economics have yielded a number of quite reliable and precise precepts for the efficient structuring of the insolvency process. Among economists it is hardly debatable that the goal of legislative decision making on insolvency is not to produce x% reorganisations or y% liquidations, but rather establish a structure which allows for efficient decision making in individual cases and which minimises losses to claimants and negative repercussions on the non-insolvent economic environment.558 A statistical reflection of those interrelations might be difficult if not impossible.

2. Available statistics for some transition economies In the here examined transition economies, such statistics are either barely sufficient, outdated or almost non-existent. Nevertheless the paper attempts to reflect some figures on relevant issues.

2.1. Asian jurisdictions The Asian Development Bank provided a reasonable source with reliable figures on recent informal workout initiatives and corresponding figures for formal proceedings of several Asian countries. 559 Jurisdiction Cases/period Liquidation/period Formal rescue/period Structured workout/period Indonesia 0 prior 1998 Indonesia 19 after 1998 13 in 1999 6 in 1999 350 cases under the Jakarta

Initiative Philippines 89 last 16

years 89 last 16 years

Philippines 0 in 1999 11 in 1999 Thailand 32 in 1999 24 in1999 8 in 1999 700 cases under CDRAC Korea 160 in 1999 80 cases Malaysia 20 in 1999 63 cases under CDRC; 1780

cases under Danharta

In addition, some Asian countries have experienced increasing activities in the form of “private” workouts. Reliable figures were not available.

558 Balz-Market Conformity, 169 559 ADB-Report, 71


165

In evaluating those figures, two conclusions might be possible. Firstly, the jurisdictions under examination are characterised by extreme low numbers of formal insolvency proceedings.560 As mentioned before, that might be due to a cultural aversion to public insolvency proceedings but also to a possible lack in their general insolvency regime. Secondly, the number of proceedings commenced under the mentioned debt restructuring programs reveal that there is a necessity for efficient insolvency measures. A related conclusion suggests that informal proceedings in those countries might be generally more successful than a formal process.

2.2. Eastern European jurisdictions Even more incomplete are statistics available from some Eastern European transition economies. In Poland, insolvency filings increased extremely from 149 in 1990 to 5278 in 1996.561 In the Russian Federation, insolvency proceedings increased from 100 in 1993 to 2618 in 1996.562 However, after the enactment of the new Russian Bankruptcy Code (1998) the number of filings has sharply risen up to some 9000 in 1998.563 In Hungary, in 1996 there were 3074 liquidation and 55 reorganisation filings.564 In the Czech Republic, the number of filings increased from 1098 in 1993 to 2996 in 1996. One conclusion, drawing from the evaluation of these figures, is that there is an increasing tendency to apply the insolvency regime in those countries. That might be due to the growing familiarity of market participants with insolvency instruments but also the growing impact of market principles among those economies. However, numbers lack still extremely behind comparable figures of some Western economies565 and may therefore been expected to further increase over the next few years.

560 Especially, when comparing with the number of filings in developed Western economies, see for example: Gross-Failure and Forgiveness: In the calendar year 1997 rose bankruptcy filings in the US to 1.4 million (96% individuals, 4% businesses). 561 Brol-Das polnische Konkursrecht, 307 562 Trunk-Stand und Probleme, 238 563 Brooks-Russia’s Struggle, 473: 9000 petitions were filed in 1998 564 Török-Länderbericht Ungarn, 396 565 In the US, for example, rose bankruptcy filings in 1997 to 1.4 million (96% individuals, 4% businesses); in Germany, filings for insolvency proceedings were in 1998 at an level of 27.828 (only business insolvencies – the old German Bankruptcy Code did not provide for the insolvency of individuals) but increased in 1999 with the introduction of the German Insolvency Code considerably, See Statistisches Bundesamt Deutschland: http://www.statistik-bund.de/basis/d/insol/insoltab1.htm, 12.2.2001


166

As far as the Russian experience is concerned, one has to admit, that the removal of obstacles and shortcomings566 with the new law has considerably influenced the willingness of participants to commence formal insolvency procedures. To the elements which are supposed to have been decisive for that development will be referred throughout the subsequent analytical discussions on general insolvency standards. Another example567, related to statistical issues, was the amendment of the Hungarian Bankruptcy Code in 1991. As will be discussed later, the respective figures show how a legislator may cause a tremendous increase in the number of filings by changing respective elements in the law.

566 See therefore our discussion on D.I.3.1.4.a. 567 See D.II.5.3.


167

V. The model insolvency codes used as a basis for comparison

1. Russian Bankruptcy Code The new Russian Bankruptcy Code (1998)568 contains some important challenges in comparison to the old law.569 The subsequent discussions may refer to some of those innovations in more detail. However, some of them should be briefly mentioned at this point. Firstly, the new law does now provide for different types of insolvency procedures. The composition570 was, after frequent criticism571, replaced and extended by an external administration572 and amicable settlement.573 Thereby many of the obstacles of the old composition procedure were abolished and substituted by more modern provisions known from other rescue laws. However, several shortcomings of the old law are still apparent in the new code. External administration as reorganisation option, for example, may be only initiated by the creditors and not by the debtor.574 Under the old Bankruptcy Code (1992)575 formal bankruptcy or insolvency proceedings have been rare. There are probably a number of reasons why companies, courts and other participants were reluctant to utilise fully the insolvency procedures afforded under that law. Certainly, with unemployment rising, it is difficult to liquidate large enterprises, especially when they are the main or only employer in a region, responsible also for the social and cultural infrastructure. Furthermore, the Russian government is currently struggling with providing funds for the unemployment benefit of redundant workers.576 However, a major factor has been certainly shortcomings and mistakes in the old bankruptcy law. The old law appeared to be flawed and wholly ineffective.577

568 Russian Federation Federal Law on Insolvency (Bankruptcy), FZ-6, adopted by the State Duma December 10, 1997, approved by the Council of Federation December 24, 1997, which became effective as of March 1, 1998. 569 See: Vitrjanskij-Länderbericht, 247; generally also: Balz-Russia, Gutbrodt-Das neue Russische Insolvenzgesetz 570 Russian Bankruptcy Code (1992), Art.39-43 571 Balz-Russia, 43 572 Russian Bankruptcy Code, Art.68-96 573 Russian Bankruptcy Code (1998), Art.120-130 574 Russian Bankruptcy Code (1998), Art.68 (1) 575 Russian Federation Federal Law on Insolvency of Enterprises, 1992 576 Zuy-Russia and the CIS, 469 577 Brooks-Russia’s Struggle, 468


168

The new Bankruptcy Code was mainly drafted by Russian legal scholars, legislators and judicial officials and is largely based on a mix of insolvency codes and principles from Western Europe, the US and Canada.578 As mentioned before, the new Bankruptcy Code is far more often used then its predecessor. But certainly, that are many fewer than necessary to help restructure and jump-start Russia’s industry and the economy as a whole.579 Generally, one may say that the insolvency process under the new Bankruptcy Code is mainly court driven.580

2. Romanian Insolvency Code Secondly, the paper attempts to consider more in detail the Romanian Insolvency Code (1995).581 The Romanian Code is frequently described as one of the best-drafted insolvency laws in Central and Eastern Europe.582 The Romanian law is comprehensive and has the frame work necessary to either bring about the liquidation of a failed enterprise or the flexibility to permit a reorganisation. It is balanced in its approach to debtor and creditor rights and responsibilities. The law does place enormous responsibilities on the judges who become the central figures in driving a case.583 The Romanian Insolvency Code is civil law based and has been mainly influenced by French and Italian law.584

578 Brooks-Russia’s Struggle, 468 579 Brooks-Russia’s Struggle, 473 580 EBRD-Summary of the Russian System, 5 581 Law No. 64/1995 on the procedure of judicial reorganization and bankruptcy, published in the Official Monitor, Part I, no. 130 on June 29, 1995, modified by Government Ordinance No. 38/1996 (Modified Art. 17 and Art. 97), published in the Official Monitor of Romania, No. 204, on August 30, 1996, modified and completed by the provisions of Government Emergency Ordinance No. 58/1997, published in the Official Monitor of Romania, Part I, No. 265, on October 3, 1997, and amended by Law No. 99/1999, Title IV, published in Official Monitor of Romania, Part. I, No. 236, on May 27, 1999, which has subsequently been renumbered; see: Capatina-Länderbericht Rumänien, 335 582 See for example Bufford-Romanian Bankruptcy Law, 251 583 EBRD-Summary of the Romanian System, 1 584 EBRD-Summary of the Romanian System, 1


169

3. Polish Bankruptcy Code A third national insolvency legislation which will be more closely under study is the Polish Bankruptcy Code.585 The Polish bankruptcy law586 is mainly divided into two pieces of legislation: a Composition Act and a Bankruptcy Act. Both laws were enacted in 1934 and not repealed under the communist system. Poland therefore had, after the political and economical changes of 1989/90, not to enact a new insolvency law but only to adjust the existing law to the challenges of the current situation of Poland’s society. However, as we will see, the present situation of Poland’s insolvency law is characterised by frequent flaws and loopholes and one might wonder if it would have been not better to abolish the existing law and to introduce new legislation.587

585 Regulation of the President of the Republic of Poland of 24 October, 1934 Bankruptcy Law, last amendment considered: Dziennik Ustaw 1998 No. 117, item 756 586 See: Zedler-Länderbericht Polen, 287; Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 211 587 For a wide-reaching reform of Poland’s insolvency law with reference to respective governmental activities see: Zedler-Länderbericht Polen, 290


170


171

C. Analysis of insolvency key issues The following chapter aims to address the key issues which have to be considered when designing or redesigning the formal insolvency regime in transition economies. These issues are by no means exclusive nor are they comprehensive but aim to reflect important questions which have to be discussed in order to implement policy choices and practices when reforming the insolvency system in a transition economy. Neither intends the discussion to repeat the detailed debate of some issues ongoing in several Western jurisdictions.

I. General Principles

1. The trigger criterion

The definition of insolvency or the trigger criterion is a key feature in any insolvency law. If the trigger is pulled to early, the initiated proceedings may have tragic effects for the debtor who is trying to save his business. On the other hand, if the trigger is pulled too late, the rights of creditors may be impaired because the assets of the debtor may have depleted before creditors were allowed to initiate insolvency proceedings.588 Another general aspect any insolvency law should consider is the clearness and preciseness, especially of the definition of insolvency. Market participants should be in the position to realise at an early stage and without further in-depth investigations when a business enterprise has become insolvent. Therefore, the used definition of insolvency should be as simple and easy understandable as possible.

1.1. Balance sheet test One can identify two common commencement criteria. The classical approach, the “balance sheet” test, where a company is insolvent when its total liabilities exceed the fair market value of the total assets589, suffers from certain practical limitations, in that it is seldom possible for parties other than the debtor to ascertain the true state of affairs before it has become a settled and irreversible fact. Furthermore, the “balance sheet” approach might be an inadequate measure for insolvency, as domestic accounting standards and valuation techniques may lack accuracy and give rise to distorted values that do not reflect fair market

588 Bickford-Bankruptcy Law Reform, 932 589 WB-Towards Principles, 12; See also the definition in the German Insolvency Code, § 19 (2)


172

values.590 This is a common obstacle especially in transition economies where GAAP or comparable standards are often not applied. The “balance sheet” test requires surveys of qualified accounting and valuation experts, a process that makes this approach more costly and time-consuming or even impossible where such experts do not or only rarely exist.591 As mentioned elsewhere, inflation and currency depreciation are common impediments in transition economies. They make it more difficult to value assets on the balance sheet – an essential pre-condition for the application of the balance sheet test. Drawing on the experiences of the application of the “balance sheet” test as trigger criterion in many jurisdictions592, it might be doubtful if it can serve as a useful additional standard to determine whether a company should be subject to insolvency proceedings.593 Especially in economies where low debt-equity ratios are frequently found, the test might force viable companies in insolvency proceedings. A low debt-equity ratio is not itself unsound and a company might work well as long as it is able to attract further capital inflows. Under a rigid over-indebtedness standard (balance sheet test), all of such enterprises would be insolvent.594 By way of example, the German legislature suspended the “balance sheet” standard completely for formerly East German enterprises while they were owned by the privatisation agency (Treuhandanstalt), so long as they would have adjusted their debt/equity ratio to standards prevailing in a western-style market economy. The underlying policy was that viable enterprises should not be forced out of operation only because they were carrying forward a heavy debt burden from their times as SOE in a planned economy. The privatisation agency was usually able to provide operational cash funds on a day-to-day basis but it frequently could not solve over-indebtedness problems immediately.595

1.2. Cash-flow test Another test of insolvency enables the unpaid creditor to initiate insolvency proceedings on the basis of being able to provide evidence of certain kinds of conduct or default by the debtor. This is mainly the case when the debtor fails to pay a debt that is due and undisputed, and of which payment has been requested in writing (and without current prospect of being

590 WB-Towards Principles, 12 591 For problems of the valuation process see: Drukarczyk-Zahlungsunfähigkeit, 76 592 But see for Bulgaria: Popova-Bulgarisches Insolvenzrecht, 45: The author is for a retention and even extension of the balance-sheet test or over-indebtedness as independent commencement criteria. Main argument is the protection of creditors. 593 See: Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 213 594 Balz, Schiffman, 23 595 Balz-Russia, 16


173

able to do so).596 Although such conduct is commonly known as indicator of the debtor’s insolvency, it might only reflect a temporary phase of illiquidity. In modern commercial relations, where market participants often have to accept ever-thinner profits or even losses to become competitive, the concept of illiquidity has to be considered carefully. In the systemically distressed markets especially in transition economies, where illiquidity has often become the norm, the use of the “cash-flow” test as trigger criterion requires cautious consideration.597

1.3. Limitations on the scope of the cash-flow test To overcome the obstacle, some systems598 have added to the cash-flow test a prognostic element as to the debtor’s capacity to resume payment within a reasonable period. Other jurisdictions599 require a fixed period of non-payment by the debtor as additional condition to the general cash-flow test. However, a waiting period of several months600 is certainly not conducive to financial discipline and does not promote the objectives of insolvency.601 During such a waiting period, assets of the debtor enterprise may be dissipated and creditor rights impaired. On the other hand, the “cash-flow” test enables a timely commencement of the proceedings and has thus the beneficial effect of reducing losses born by the creditors and thereby increases the chances of a successful rescue. Another advantage of such an early initiation is that debtors will adopt a more responsible approach to management affairs and will improve their paying habits, a common problem especially in transition economies.602

596 IMF-Report, 17; WB-Towards Principles, 2 597 WB-Towards Principles, 2 598 Balz-Russia, 15: the French and the German system; For the German Insolvency Code, Art.17 “Not only temporary”, see Drukarczyk-Zahlungsunfähigkeit, 66, Heidelberger-Kommentar, § 17, 18, 42 ;Polish Bankruptcy Code, Art.2: A short-term suspension of debt payment due to temporary difficulties shall not be deemed to be a ground for a declaration of bankruptcy, critical to the Polish provision because of its lack of predictability: Lowitzsch/Pcherova-Das novellierte polnische und slowakische Insolvenzrecht, 214; Popova-Bulgarisches Insolvenzrecht, 41: a similar provision provides the Bulgarian Commercial Code, Art.631, which refuses the commencement of proceedings in the case of a temporary illiquidity; 599 E.g.: Romanian Bankruptcy Code, Art. 29 (1) requires a waiting period of at least 30 days; Russian Bankruptcy Code, Art.3 (2) requires a 3 month waiting period; Croatian Bankruptcy Code, Art.4 (3) requires a 30 days waiting period 600 Russian Bankruptcy Code, Art.3 (2) requires a 3 month waiting period 601 Balz, Schiffman, 23; Balz-Russia, 15 602 WB-Towards Principles, 2


174

1.4. Special types of claims Furthermore, attention should be drawn to some special types of claims. It is, for example, generally accepted that debt which is disputed by the debtor in good faith should not be considered in the proceedings.603 Moreover, contingent claims (claims where the amount becomes fixed and/or the obligation to pay only arises upon the occurrence of some subsequent event), future claims (claims arising after the commencement of proceedings but which relate to an event occurring before commencement of proceedings – e.g. environmental claims discovered after commencement of proceedings) and claims in foreign currency – after depreciation604 require careful consideration when drafting the insolvency code. A related issue is how to assess/ verify the validity and the amount of a claim. The law should avoid to have every claim scrutinised/ verified by the court. It should rather presume the validity of claims unless challenged by those with an incentive to do so, such as the debtor, the administrator, or another creditor.605 In this way, the rare judicial resources in transition economies are only utilised when their expertise is really needed.606

1.5. Protection from abusing filings When a decision has to be made to design the commencement criteria for insolvency proceedings, additional attention should be paid to a potential abuse of proceedings.607 Debtors can use insolvency proceedings as a shield against their creditors in order to avoid payment of their obligations and creditors can use the process in order to drive other market participants out of the business. If owners or managers are allowed to (re) purchase assets from the estate, they may try to stay in control, but extinguish pre-insolvency debt, and thus misuse proceedings to reduce their debt burden.608 To avoid these negative effects in the case of a creditor filing, a legislator should consider the implementation of threshold determinations regarding the minimum total amount of claims609 or the requirement of a joint action by several creditors.610

603 Balz, Schiffman, 24; e.g. US Bankruptcy Code § 303 (3) (h) (1); See for the Bulgarian Commercial Code, Art.608 (2): Popova-Bulgarisches Insolvenzrecht, 41; Romanian Insolvency Code, Art.29 (2) exempts well-founded refusal to pay by the debtor, which are made in good faith 604 Deloitte-Restructuring, 10 605 See for example: Romanian Insolvency Code, Art.88 (4): All the claims registered at the clerk’s office at the tribunal shall be deemed valid and correct, as long as the debtor, the liquidator, or another creditor does not contest them. 606 Deloitte-Restructuring, 10 607 WB-Towards Principles, 13 608 Balz, Schiffman, 24 609 Russian Bankruptcy Code, Art.5 (2): for legal entities: 500 times the minimum monthly wage (Zuy-Russia and the CIS, 469: currently approximately US$5)


175

Some laws611 require good faith of the debtor for proceedings to be opened or make creditors filing in bad faith subject to liability. More generally, other jurisdictions require a legitimate interest in the opening of insolvency proceedings from any petitioner.612 This criterion may be invoked, e.g. if a fully secured creditor triggers a proceeding instead of seeking a sale of his collateral.613 As mentioned earlier, another instrument to limit the actual application of the cash-flow test is the employment of a negative-future-outlook clause614. According to this clause, insolvency proceedings may be only commenced when (1) the debtor has not satisfied its creditors and (2) chances that he will satisfy them in the near future are little. Others615 clearly distinguish between a cessation of payment and the inability to pay outstanding debt. The cessation of payment is thereby only the factual non-payment of amounts due, whilst the inability to pay describes a situation where the debtor lacks resources in its cash flow to repay outstanding debt. Generally, insolvency proceedings should be only commenced in the latter case. However, several jurisdictions616 assume the debtors inability to pay in the case of its cessation of payment. Furthermore, a legislator might penalise false declarations by creditors or debtors when they are made with the intention to abuse the process.617 On the other hand, when the filing debtor does not meet the applicable insolvency standard, the relevant court or tribunal should declare that the debtor is no longer subject to insolvency proceedings.

1.6. Specific features of rescue proceedings The law should encourage financially troubled enterprises to voluntarily submit to a rescue process. Therefore entry requirements should be low, inexpensive and quick in the case of a debtor filing. It should be sufficient in such a case that the debtor, represented through its board of directors, declares himself insolvent or in financial difficulties. The law should not require a further proof of this state of affairs.

610 US Bankruptcy Code, section 303 (b), minimum 3 creditors, at least $ 5.000,00 in value; Philippines: minimum of 3 creditors; Czech Bankruptcy an Composition Act, section 1 (2): minimum of two creditors 611 E g US-Bankruptcy Code, § 303(i)(2) 612 Balz, Schiffman, 24 613 Balz-Russia, 18 614 German Insolvency Code, § 17 615 See for discussion of this problem regarding the Bulgarian provisions – Bulgarian Commercial Code, Art.608 (3) – Popova-Bulgarisches Insolvenzrecht, 43 616 E.g. Bulgarian Commercial Code, Art.608 (3)(2), German Insolvency Code, § 17 (2) 617 See for the Slovakian Bankruptcy Code: Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 214


176

1.7. Prospective insolvency In order to enhance the chances to successfully rescue troubled enterprises, the process should be also open for companies which are not yet formally insolvent but in a financial situation that will certainly result in a state of insolvency when external support will be not available.618 The prospective insolvency of a debtor should function as an additional trigger criterion of insolvency proceedings but only as petition right for the debtor. Thereby, the debtor should have the right but no obligation to file for proceedings as soon as it becomes presumable that he will not be able to service its outstanding debt in the near future.619 The demands on the criteria should be not too high620 and the debtor should have some discretion in determining its liquidity status since otherwise the positive effects of this additional criterion may be diminished. One of the main issues of the German insolvency reform621 was to start proceedings generally at an earlier point to enhance chances for a rescue of the debtor or to protect assets of the debtor for a later liquidation. As a result, one of the innovations of the new German Insolvency Code was the introduction of a third trigger criterion in the case of threaten or prospective illiquidity.622 For a creditor filing apply the principal commencement criteria – with the only difference that the filing creditor should prove the insolvency – normally by showing the non-payment of a debt due and requested.623

618 IMF-Report, 45; See for example: Hungarian Bankruptcy Code, section 3 (1)(b) “…or presumably will not be able to settle its debt (debts) on the due date”, illiquidity is defined in section 27 of the Hungarian Bankruptcy Code; Russian Bankruptcy Code, Art.7 (2) “A debtor has the right to apply to an Arbitration Court with a debtor’s petition in anticipation of bankruptcy provided that circumstances clearly indicate that the debtor will be unable to perform monetary obligations…” 619 See for the German provision, German Insolvency Code, § 18, Drukarczyk-Zahlungsunfähigkeit, 69; Heidelberger-Kommentar, § 18 620 Drukarczyk-Zahlungsunfähigkeit, 69: A 50% presumption should be sufficient to trigger proceedings 621 See Drukarczyk-Zahlungsunfähigkeit, 69 622 German Insolvency Code, Art.18; since this additional criterion does not impose on the debtor the obligation to file for formal proceedings, the debtor management may decide if a formal process or a workout provides the best prospect for a rescue, see also Uhlenbruck-Neues Insolvenzrecht, 38 623 WB-Towards Principles, 66; see for example: Russian Bankruptcy Code, Art.35 (2)


177

1.8. Examples Thailand, for example, provides only for the balance sheet test as trigger to reorganisation. This entry criterion is far too high to encourage reorganisations and is reflected in its statistics of filings for reorganisations.624 Indonesia, even after its recent amendments of its bankruptcy code625, does not provide for a clear criterion or concept of insolvency. A debtor might be declared insolvent when he has failed to pay a debt due and payable either by its own petition or upon petition of one or more of its creditors.626 The new Russian Bankruptcy Code (1998)627 provides clearly for a cash-flow test and abolishes thus the ultimate recourse to the balance sheet of the debtor additionally required under the old Russian Code (1992).628 The requirement of the balance-sheet test in the old Code was a major obstacle to the applicability of the insolvency law.629 Beside the non-payment (illiquidity/ cash-flow test) it had additionally to be established that the liabilities of the debtor succeed its available assets (over-indebtedness/ balance sheet test). The existing accounting standards and their application did factually prevent or impede any creditor filing for insolvency. In addition, one has to take into account that the individual enforcement of rights in Russia is still a difficult and long-lasting process with uncertain outcome. Under the old regime debtors had a good chance to escape their creditors. The Russian experience shows also how important a functioning underlying individual enforcement system as leverage mechanism is. Nevertheless, the Russian Code (1998) does employ a waiting period of 3 month.630 Generally, a fixed waiting period may considerably reduce the chances for a successful rescue and even negatively affect the asset value in liquidation proceedings. However, as long as the Russian judiciary and related professions lack the expertise and capacity to make economical decisions, like a prediction about the future ability of a company to pay its bills, the employment of a limited fixed waiting period may be justified and thus increase transparency and predictability of the insolvency regime.631 One may wonder if the duration

624 ADB-Report, 33, 71: even after the Asian crisis with great impact on the Thai economy occurred in 1999 only 8 reorganisation cases under the formal reorganisation law. 625 Government Regulation in Lieu of Law No1 of 1998 concerning amendments to the Faillissements-Verordening or Regulations concerning Bankruptcy of 1905, 22nd April 1998; See: Wiston-The flavour, 197 626 Section 1 of the Indonesian Bankruptcy Code 1998; Wiston-The flavour, 197 627 Russian Bankruptcy Code (1998), Article 3(2) – for legal entities, Article 3(1) remains the additional balance sheet test (over-indebtedness) for natural persons (citizen) 628 Vitrjanskij-Länderbericht, 247 629 Vitrjanskij-Anwendungspraxis, 259 630 Russian Bankruptcy Code (1998), Article 3 (1)(2) 631 Gutbrod-Das neue russische Insolvenzgesetz, 38


178

of the waiting period of 3 months could be shortened with the effect of a reduction of the depreciation of asset values until the opening of the proceedings. The Romanian Code provides for two tests: firstly, a debtor who can no longer service its outstanding debt may file for insolvency proceedings632; secondly, any creditor who has a debt, liquid and due, may file a petition against a debtor who, for at least 30 days, has stopped payment.633 The Polish Bankruptcy Code provides as general insolvency criterion for the cessation of payment634 by the debtor but allows additionally a balance sheet test if the debtor is a legal person.635 However, a short-term suspension of payments shall not give creditors a right to petition for bankruptcy proceedings.636

2. Scope of the law

2.1. Companies and individuals As mentioned earlier, the paper deals only with corporate insolvencies and not with financial problems or illiquidity of individuals. Since issues of corporate and individual insolvency may differ considerably, the law should clearly distinguish between the two. However, experiences from several transition economies637 suggest that forms of companies without limited liability are frequently used for a wide range of business activities. That may be due to difficulties with the incorporation of companies; high stamp duties and incorporation fees, a slow incorporation process and a general lack of knowledge of advantages and availability of a limited liability status or even the lack of the initial capital, required to set up a company with limited liability. Therefore, the law should decide under which branch of the insolvency law (personal or corporate) should been dealt with individual business activities. Since owners are facing personal liability, the law should deal with such cases under the personal insolvency regime.638 Nevertheless, it remains the unique feature of transition economies, where substantially more businesses are not incorporated with limited liability status. It is therefore important that the law addresses these problems at the outset and deals with it accordingly.

632 Romanian Insolvency Code, Art.25 633 Romanian Insolvency Code, Art.29 634 Polish Bankruptcy Code, Art.1 §1 635 Polish Bankruptcy Code, Art.1 §2 636 Polish Bankruptcy Code, Art.2 637 Bickford, Bankruptcy Law Reform, 938:”In Eastern European countries, many businesses are in the form of unincorporated single proprietorships.” 638 ADB-Report, 26


179

A final debt relief for insolvent individuals, as only recently introduced in several developed jurisdictions639, should be introduced in order to protect human resources, encourage entrepreneurship and to provide for a second chance. The Russian Bankruptcy Code (1998) introduced in Russia, for the first time, the institute of final debt relief for citizens640 and for individual entrepreneurs.641 Also the Romanian Insolvency Code deals with the insolvency642 and the respective debt relief643 of individuals but only if they are “tradesmen”. A further and more detailed study of this issue might be necessary but cannot be done within the scope of this paper.

2.2. All debtors or only merchants On a comparative basis, there exist mainly two systems in respect of the personal scope of the insolvency law. The system deriving from the Germanic law family644 and also applied by US-law645 includes as debtors all persons (natural and legal) within the scope of insolvency but usually provides for separate chapters for companies and individuals in the relevant code. Those jurisdictions understand insolvency law as a branch of civil procedure, more precisely, of the law of debt enforcement. Consequently, all debtors, private or commercial alike, are generally subject to insolvency proceedings. However, experiences from those jurisdictions suggest that insolvency proceedings of private individuals remain rare.646 That might change currently, since the scale of consumer credit has increased and insolvency laws have been reformed towards easier access along with the introduction of a final debt relief of insolvent individuals.647

639 E.g. the reform of the German Insolvency Code, adopted 1999, German Insolvency Code, § 286 640 Russian Insolvency Code, Articles 152-163 641 Russian Insolvency Code, Articles 164-166, see also: Gutbrod-Das neue russische Insolvenzrecht, 41; Vitrjanskij-Anwendungspraxis, 266 642 Romanian Insolvency Code, Art.1 643 Romanian Insolvency Code, Art.123 644 German Insolvency Code, § 11 (1); See for an assessment of this fact in the new German Insolvency Code, Paulus-Entwicklungslinien, 244 645 US-Bankruptcy Code, § 109 646 See for the negative experiences of the German Code after the introduction of consumer insolvency proceedings, §§ 304ff German Insolvency Code, Paulus-Entwicklungslinien, 244-246 647 Balz-Russia, 13


180

Other jurisdictions648 mainly inspired by the French Napoleonic Code de Commerce view insolvency as part of commercial law. Those jurisdictions restrict their insolvency law only to merchants and persons engaged in commercial or entrepreneurial activities.649 Some countries even include their insolvency proceedings in the commercial code.650 In these systems non-commercial debtors are generally not subject to a collective debt collection procedure or to collective reorganisation proceedings.

2.3. All companies The determination which entities should be subject to the general insolvency law as debtors is an important question having significant implications for the economy. To the extent that a country excludes certain entities, these entities will neither be subject to the discipline imposed by an effective insolvency regime nor be able to take advantage of the protections it offers.

2.3.1. State-owned-enterprises (SOE’s)

However, particularly transition economies651 might have good reasons to exempt special regulated entities or certain types of SOE’s from the scope of the general insolvency law and deal with them by special insolvency process.652 What should be avoided is the entire exemption of legal entities from any kind of insolvency regime.653 When SOE’s are generally within the scope of the general insolvency law, the policy makers in transition economies will face a difficult situation in applying the insolvency regime to the

648 Romanian Insolvency Code, Art.1 “; Polish Bankruptcy Code, Art.1 §1 “entrepreneur”; the Russian Code did previously only deal with commercial debtors but was extended to citizen with the 1998 Code, see: Russian Bankruptcy Code (1998), Art.1 (4) 649 Balz-Russia, 13 650 Bulgaria: Insolvency Proceedings are Part IV of the Commercial Code, see for Bulgaria: Popova-Bulgarisches Insolvenzrecht, 41; Bulgarian Commercial Code, Art.608 (1): Insolvency Proceedings are only applicable to commercial transactions; before Romania 1995 (Law No.64) introduced its new Insolvency Code, bankruptcy was dealt with in the Romanian Commercial Code, see: Romanian Insolvency Code, Art.131 (2) 651 Deloitte-Restructuring, 14: Lithuania, for example, excludes “Special Purpose” SOE’s by statute from insolvency proceedings; Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 212: exempted are under the Polish Bankruptcy Code, Art.3 sec.2, for example, the State enterprise Polish Railways ("Polskie Koleje Pañstwowe"), the State enterprise Airports ("Porty Lotnicze”) and State public utility enterprise Polish Post "Poczta Polska", on the other hand, the Polish legislator did them not exempt from the Composition Code in order to make them subject to composition proceedings in the privatisation process, see: Smid-Das Insolvenzverfahren, 394; Bulgarian Commercial Code, Art.612 (1) exempts public enterprise merchants exercising a state monopoly 652 See for the quasi-liquidation or administrative-liquidation process, frequently applied to restructure SOE’s, B.II.5.1.2.e. 653 IMF-Report, 16


181

private and state sector alike. Viable SOE’s frequently need a softer approach to insolvency since otherwise they will be often damaged by formal insolvency proceedings. Furthermore, their dominance and social function in transition economies requires a more careful treatment when applying the general insolvency law. On the other hand, this soft application disadvantages the private sector and may impede its development. Simply extending the soft approach to the private sector carries its own risks: if private businesses are not constrained by the normal application of insolvency laws then there is a risk of financial indiscipline which will harm private sector development as a whole through reduced confidence in credit.654 Consequently, those reasons may justify an exemption of SOE’s from the scope of the general insolvency law for the transition period and consequently deal with them under a special regime outside the formal insolvency law. The insolvency regime of the Peoples Republic of China655, for example, submits SOE’s generally to the insolvency law but provides for extensive government involvement and several exemptions for SOE’s. By way of example, SOE’s engaged in some key industries, utility enterprises and companies of national importance may be exempted from the general insolvency law and the relevant governmental agency or department provides financial assistance or other means to assist in repaying or restructuring the debts and reorganising the business operations. Moreover, a company which obtains a guarantee and repays its debts within 6 month of the petition is not declared insolvent.656 Also the Romanian Insolvency Code offers the possibility to exempt state companies657 and “regies autonomes”658 from the scope of the general insolvency law. The legislator provides a special restructuring procedure for those enterprises.659 These special procedures are mainly for the transition process and will be abandoned as soon as the transition period has finished.660 The Russian Bankruptcy Code also exempts “public enterprises” generally from its scope.661 However, it remains unclear what the term means exactly and one may assume that this exemption applies only to a limited amount of SOE’s which have limits on their ability to alienate assets.662

654 Deloitte-Restructuring, 20 655 Lam-Rules and Regulations, 355 656 Lam-Rules and Regulations, 355 657 Romanian Insolvency Code, Art.129 658 Romanian Insolvency Code, Art.130, i.e. defence industry and some utilities 659 See: David-Praktische Probleme, 365; Capatina-Länderbericht Rumänien, 338 660 Capatina-Länderbericht Rumänien, 338 661 Russian Bankruptcy Code (1998), Art.1 (2) 662 A similar view expressed Craig Averch, EBRD on a respective question on 31th January 2001


182

On the other hand, exempting SOE’s from the scope of the insolvency law (directly or indirectly) and bailing them out in financial difficulties gives them a competitive advantage over the private sector which may disturb the free market balance between private and public participants.663 Including SOE’s in the scope of the general insolvency law has the advantage of both subjecting the enterprise to the discipline of the market place and sending clear signal that government financial support will not be unlimited.664 As mentioned earlier in this paper665, in transition economies some 70-90% of enterprises may be technically insolvent. In order to restructure this enormous amount of loss-making enterprises, many transition economies have promulgated special restructuring programs666 for SOE’s and have at same time exempted eligible enterprises from the scope of the general insolvency law. Those programs were often designed and funded by several IFI’s.667 Nevertheless, formal rescue process should generally apply to all kind of companies, private or state-owned.668 Government or state ownership of an enterprise should not in itself provide a basis for excluding an enterprise generally from the coverage of the formal insolvency law.669 However, the problem of insolvent state-owned enterprises might be best dealt with for a limited transition period by a special rescue regime governing the unique situation of those enterprises.670 Thereby, the SOE restructuring program should foster financial and operational discipline and provide for similar measures as the general insolvency law does.671 Nevertheless, where both the owner of a debtor enterprise and all, or substantially all, creditors are state-entities, formal insolvency procedures may be not needed to solve liquidity or operational problems of the respective entity. Moreover, the law may exclude SOE’s which do not have limited liability since in these cases the equity holder, namely the state, is liable for all debts.672 A Similar situation exists where the government has extended a type of guarantee with respect to all liabilities of a certain SOE.673

663 Bufford-Bankruptcy Law, 473; Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 212 664 IMF-Report, 16 665 See B.II.1.2. 666 See B.II.5.1.2.e. 667 Deloitte-Restructuring, 14 668 The Hungarian Bankruptcy Code, Section 3 (1)(a) includes explicitly SOE’s, public enterprises and cooperatives but also trusts and private companies. 669 IMF-Report, 17 670 WB-Towards Principles, 65; Harmer-Chinese Bankruptcy Reform, 2583 671 See B.II.5.1.2.e. 672 Balz, Schiffman, 20 673 See for example, Czech Bankruptcy and Composition Act, section 1a


183

Nonetheless, there exist opinions among transition economies that a SOE (even with own legal personality) is an agency or branch of the state and the government therefore is obligated to ensure that all debts and liabilities of a state enterprise are met in full. Hence, a state enterprise could not, and should not, become insolvent. However, SOE’s in most of the transition economies have increasingly exposed themselves to the competition of the market economy and their respective rules. They should therefore become subject to the same market rules and forces as other market participants.674 Within the state sector, where debtor and creditors are usually the state or its enterprises, it might be more efficient to apply informal liquidation and restructuring techniques rather than use the formal insolvency regime. The (East) German privatisation agency (Treuhandanstalt), for example, used court administered insolvency proceedings only in about 15% of all state enterprise liquidations and liquidated the load of the SOE’s in an administrative process.675 Similarly, the Romanian government enacted 1997 a law, according to which SOE’s can be liquidated in an administrative process.676 However, experiences in transition economies also suggest, that the commencement of proceedings against SOE’s is often delayed by necessary additional formalities, consents and approvals. Such requirements aggravate the chances of a successful rescue of the failing SOE and are contrary to the objectives of insolvency.677

2.3.2. Other companies

Furthermore, it may be necessary to exclude certain types of companies, engaged in special business activities from the scope of the general insolvency law. By way of example, insolvency issues of banks and other financial institutions are regularly governed by special insolvency legislation or a separate chapter in the “general” insolvency code. Other examples depend on the special need and structure of the economy of the jurisdiction in question and might reach from agriculture businesses678 over town-forming enterprises679 to other utilities.

674 Harmer-Chinese Bankruptcy Reform, 2574 675 See also the prior discussion on the German Treuhandanstalt, B.II.5.2.5.c.i. 676 See for the Romanian “administrative” liquidation: David-Praktische Probleme, 366, Emergency Ordinance of the Romanian Government No. 10/1997 677 Deloitte-Restructuring, 14 678 Russian Bankruptcy Code, Chapter VIII §3; Republic of Lithuania Law on the Provisional Procedure of Bankruptcy for Enterprises Processing Agriculture Products 679 Russian Bankruptcy Code, Chapter VIII §2


184

Whether or not a debtor is owned by foreigners should not be a criterion for determining jurisdiction over insolvency proceedings. However, international insolvencies raise a number of complex questions and cannot be discussed at this point.

3. Voluntary insolvency proceedings One of the main practical impediments of the insolvency process in transition economies is the general scarcity of judicial resources in those jurisdictions.680 To ease the judiciary from their workload and thus to enable the insolvency system to work more efficiently the law should provide procedures which avoid a necessary involvement of the courts on a day-to-day basis in as many cases as possible.681 The voluntary liquidation, as known mainly in common law countries, might be therefore a good example. The insolvent debtor is liquidated without extensive court involvement after a shareholder resolution682 or respective creditor consent.683 The English winding-up procedure under the Companies Act, for example, requires an extra-ordinary shareholder resolution (75%) and a court order to commence the voluntary proceedings and determines the status of insolvency – consent of every shareholder or of the creditors is not necessary. However, to protect creditor rights, any creditor has the right to petition for cause to the court and obtain a conversion into a compulsory winding-up which is in fact a formal insolvency procedure.684 However, in order to promote such voluntary proceedings the law should either require management to initiate respective proceedings or provide incentives to do so.685 Similarly functions the “Debtor’s voluntary application for recognition as bankrupt” under the Russian Bankruptcy Code.686 The main difference of the Russian code is that it requires the consent of all creditors to start proceedings. This requirement may limit the desired easing role of the voluntary process.687

680 See also the discussion on B.II.2.3. 681 Balz, Schiffman, 22 682 English winding-up of companies under the Companies Act; see generally Fletcher-Law of Insolvency, Section B, 485ff 683 Voluntary liquidation under the Russian Bankruptcy Code (1998), Art.181 (3) 684 Fletcher-Law of Insolvency, 485 685 See also the discussion on the duty of management to file for a petition, D.II.5. 686 Russian Bankruptcy Code (1998), Art.181-184 687 Balz-Russia, 11


185

II. Commencing an Insolvency Case

1. Limitations and thresholds for creditor filings

1.1. No-asset-cases Proceedings are generally not commenced when the debtor enterprise has insufficient assets to fund remuneration of the trustee and court costs.688 Several cases were reported in transition economies where debtors have been stripping assets prior to the commencement of proceedings until remaining assets were insufficient to fund costs of the insolvency process. Applying the “no-asset-rule”, the court did not commence proceedings for such enterprises and the fraudulent debtor was protected from any investigations in his transactions and transfers prior to the opening.689 However, some jurisdictions have tried to hamper such fraudulent actions by funding the minimum costs of proceedings with the consequence that proceedings may not be rejected because of the insufficiency of the remaining debtor assets.690 Romania, for example, set up a liquidation fund which shall be used in the case that a debtor’s assets are not sufficient to cover the costs for the insolvency proceedings.691 The liquidation fund is stuffed by a percentage of fees, charged by the office of the trade registry.692 In the case of an insolvent SOE a similar responsibility lasts with the State Ownership Fund.693 The Polish Code694 generally applies the “no-asset-rule” but provides for proceedings against insolvent SOE’s695 even when they are not able to afford the costs of proceedings.

688 See for example: Polish Bankruptcy Code, Art.13, 218 689 Smid-Das Insolvenzverfahren, 396: The insolvency law should provide for a simplified procedure in the case that remaining assets may not be sufficient to cover the costs for the ordinary proceeding; See for example, Croatian Bankruptcy Code, Art.300, provides for Bankruptcy Proceedings against Assets of Small Value according to which several rules of the general Bankruptcy Code are not applicable (no creditor committee, no court tribunal – only a single judge) 690 Deloitte-Restructuring, 14 691 Romanian Insolvency Code, Art.4 (3) 692 Romanian Insolvency Code, Art.4 (4) 693 Romanian Insolvency Code, Art.4 (5) 694 Polish Bankruptcy Code, Art.13, 218 695 Polish Bankruptcy Code, Art.218 §2


186

1.2. Thresholds and other limitations As mentioned before696, the law may establish a minimum amount for the outstanding debt to be considered in proceedings697 or may require a petition from more than one creditor.698 Such requirements are expected to prevent abusive filings by creditors and thereby limiting the scope of the cash-flow test. In transition economies such practises are frequently found and respective measures to protect debtors may be useful.699 The Russian Code700 requires from a corporate creditor for acceptance of its petition that the corporate debtor owes him at least 500 times the minimum monthly wage established by law701. The Polish Code702 requires that filing creditors show the verisimilitude of the debt due to him.

2. Protection of creditors from abusive filings Debtors, on the other hand, may use protective measures of the insolvency proceeding to avoid or delay paying their creditors.703 The law may therefore sanction abusive filings in the case of fictitious insolvency and grant the affected creditor respective damages.704

696 See D.I.1.3. 697 See D.I.1.5 698 See for example: US Bankruptcy Code, section 303 (b), minimum 3 creditors, at least $ 5.000,00 in value; Philippines: minimum of 3 creditors; Czech Bankruptcy an Composition Act, section 1 (2): minimum of two creditors 699 Balz, Schiffman, 24 700 Russian Bankruptcy Code, Art.5 (2), 29 (2) 701 On 7 April 2000 the State Duma adopted the Law “On the Minimum Monthly Wage.” which was previously rejected by the Federation Council in December 1999 and a conciliatory commission was formed to review it. The Law has now been adopted in the version proposed by the conciliatory commission. The Law provides for an increase of the minimum monthly wage from 83,49 roubles to 132 roubles beginning 1 June 2000/ to 280 roubles from 1 October 2000/ and 300 roubles from 1 January 2001. The Council of the Federation rejected the draft on 19 April 2000. First deputy Minister of Finance A. Kudrin stressed that the government did not object to the growth of the minimum wage rate from 83 to 132 roubles monthly, but that the further growth of the minimum wages up to 280 and than 300 roubles monthly was unreal as the budget did not provide for the sums necessary for this purpose. 702 Polish Bankruptcy Code, Art.9 §4 703 See D.I.1.5. 704 See for example: Russian Bankruptcy Code, Art.10 (1)


187

3. Waiting periods There are mainly two models in determining the status of insolvency of a debtor. The first model, mainly applied in transition economies, prescribes a certain waiting period of non-payment in order to allow the opening of insolvency proceedings.705 Other countries706 do not specify a certain period in the law but rather grant the court a wider discretion when deciding if the debtor is insolvent. Generally, a fixed period of non-payment may not necessarily indicate the insolvency of a debtor. However, in transition economies it might be necessary to apply a more formal approach to initiation and commencement criteria since courts and other involved professionals are often not able to determine if the debtor is insolvent and the situation is not only temporary.

4. Who has a right to file a petition707

4.1. In liquidation Although insolvency laws give usually the debtor and the creditor a right to initiate proceedings, they may require different commencement criteria for debtor and creditor filings.

4.1.1. Creditor filings

When a creditor files a petition to commence proceedings, he should prove the debtor’s insolvency. Even so he can provide evidence for the non-payment of his claim, it might be difficult for him to prove the general illiquidity of the debtor. To overcome this barrier, it is important that the law avoids placing an unreasonably heavy evidentiary burden on creditors. Laws differ in the way they address this problem. Some require petitions filed by a number of creditors.708 In other cases, upon the filing by a single creditor, the debtor is required to submit information that will enable the court to determine debtor’s ability to pay in general.709 705 Bufford-Romanian Bankruptcy Law, 252: Art. 29 (1) Romanian Bankruptcy Code requires a waiting period of at least 30 days; Russian Bankruptcy Code, Art.3 (2) requires a 3 month waiting period; Croatian Bankruptcy Code, Art.4 (3) requires a 30 days waiting period; Hungarian Bankruptcy Code, sec.27 (2)(a) requires a period of non-payment of at least 60 days 706 See for example, German Insolvency Code, § 17 (2); Bulgarian Commercial Code, Art.608; Polish Bankruptcy Code, Art.1 707 See also D.I.1. 708 See also D.I.1.5 709 Lowitzsch/Pacherowa-Das novellierte polnische und slowakische Insolvenzrecht, 214: The law should clearly spell out if the filing of only one creditor is sufficient for the commencement of proceedings.


188

Thereby, most laws assume generally that a debtor is unable to pay its debts when he has ceased making payments as they become due.710 The Romanian law goes another way.711 A debtor is deemed unable to fulfil its obligations when a creditor has filed for insolvency and thus asserted the cessation of payments by the debtor and the debtor has not contested within a time limit of 5 days. The insolvency law should in this respect avoid further barriers on creditor filings, particularly it should evade limitations or even preclusions of filings of foreign creditors since this would affect the ability to attract the necessary foreign investments and the access to international capital markets.

4.1.2. Debtor filing

Similar criteria apply in the case of a debtor filing, with the difference that in such cases the insolvency of the debtor can be assumed since debtor filings for liquidation are usually a last resort after other measures have failed.712 Thailand, as a negative example, prohibits debtor filings for liquidation and provides a high threshold (asset/ liability) test for all other filings.713

4.1.3. Other possible petitioners

In addition, primarily in transition economies, a governmental agency may be given the authority to initiate liquidation proceedings against insolvent debtors. Usually the public prosecutor714 or a regulatory/ governmental agency715 would have this authority when an enterprise is insolvent and/or the insolvency process is in the “national or public interest”. This could be particularly relevant on the state-owned sector, where incentives for creditors to initiate proceedings are often rare; creditors may be reluctant for some reasons to file for insolvency proceedings; or there is a general unfamiliarity with new insolvency legislation among market participants.

710 Popova-Bulgarisches Insolvenzrecht, 42; for example: Bulgarian Commercial Code, Art.608 (3)(2), German Insolvency Code, § 17 (2) 711 Romanian Insolvency Code, Art.31 (3)(7) 712 See for example, Slovakian Bankruptcy and Arrangement with Creditors Act, Art.4 (2) 713 ADB-Report, 33 714 Russian Bankruptcy Code, Art.6 (1), Art.40; Indonesian Insolvency Code (1998), Article 1 (1) 715 Russian Bankruptcy Code, Art.6 (2): other state bodies authorised by federal law for example: tax authorities, pension-, medical-, and social insurance and employment funds; Romanian Bankruptcy Code, Art.24, 29 (3) the regional Chamber of Commerce and Industry may also file a petition against the debtor, see for Romania: Capatina-Länderbericht Rumänien, 341


189

The interpretation of terms like “national or public interest” might be problematic since it may involve wide reaching political, social or economical judgements. To mitigate the risk of abuse, the law should clearly define when such a case occurs and should avoid granting judiciary or government wide discretions in defining it.716

4.2. In reorganisation While it is almost undisputed and common standard717 that the debtor may initiate reorganisation proceedings, there are fewer consensuses as to whether such proceedings may be commenced by creditors. However, most reorganisation laws allow creditors to file a petition or to propose a plan for reorganisation since creditors are frequently the main beneficiaries of those proceedings.718

5. Duty of the management to file a petition Another issue that arises in the context of a debtor-initiated process is whether the insolvency law should actually impose a duty upon a debtor to initiate proceedings at a certain stage of its financial difficulties.719 That there is a necessity to do so is almost undisputed since an early opening of proceedings will protect remaining assets of the debtor against asset striping and thus increases the chances for a possible reorganisation. Nevertheless, there are generally two ways to force management to initiate proceedings at an early stage.

5.1. Legal obligation Firstly, the law can impose personal liability in the form of civil liability or even criminal liability on directors and officers of the debtor enterprise that fail to file a petition after the debtor enterprise became insolvent.720 The disadvantage of the inclusion of such rules is that they may discourage management to attempt an out-of-court restructuring agreement, out of the fear that any delay in commencing formal proceedings may result in personal liability.721

716 IMF-Report, 20 717 The Chinese insolvency law prohibits debtor petition for reorganisation, Insolvency Law of the Peoples Republic of China, Art.17; Lam – Rules and Regulations, 356 718 IMF-Report, 44 719 Drukarczyk-Zahlungsunfähigkeit, 76 720 E.g. Slovakian Bankruptcy Code, § 66g, within 60 days after insolvency; Bulgarian Commercial Code, Art.626 (1), within 15 days after insolvency, Croatian Bankruptcy Code, Art.4 (7) within 21 days after insolvency; Czech Bankruptcy and Composition Act, Section 4a without undue delay; the German Insolvency Code does not requires from the debtor management to file a petition, but such a requirement may be stipulated in special legislation, see for example, GmbHG (for limited liability companies) § 64 within 3 weeks after insolvency 721 See also the discussion on informal workouts, C.I.3.2.


190

Therefore, it is desirable that the law rules-out any penalised obligation of the management to initiate formal proceedings for the time of honest and promising out-of-court negotiations between the debtor and his creditors. Furthermore, the management of an enterprise is usually considered as agent of the company and of the respective owners/ shareholders and not of creditors. Consequently, management should be not obliged to act for creditors – they are responsible to monitor the extended credit by themselves. However, on the other hand, one could argue that particularly in transition economies creditors are usually not provided with the necessary experiences and skills, nor are the necessary information and other means for an appropriate credit assessment always available. Leaving creditors in those countries self-responsible for their claims may even cause more macro-economical problems.

5.2. Incentives Another tool to stimulate early initiation by debtors is the implementation of rules which give management certain incentives if they start proceedings at an early stage.722 The law could, for example, provide for the remaining of the management as long as reorganisation procedures are attempted.723 Furthermore, the law could grant the debtor management an initial right to propose a rescue plan724, what may also increase the chances for them to stay in office and additionally enhance the chances for the plan to be successfully implemented.725 More generally, one could say that rules which promote the reorganisation of the debtor enterprise may serve as incentive for the management to initiate proceedings at an early stage since those provisions increase the chance for them to stay in office.726 However, the implementation of this issue varies considerably even among transition economies.

5.3. Examples The Russian legislator, for example, introduced in the new Bankruptcy Code (1998) the obligation of the debtor management to file for insolvency within one month after the occurrence of the insolvency727 linked with a possible civil and criminal liability.728 The Polish Bankruptcy Code729 requires from the insolvent debtor to file a petition within fourteen days after the debtor enterprise became insolvent and grants compensation for creditors in the case of non-fulfilment.730 722 IMF-Report, 19 723 See for example: Romanian Insolvency Code, Art.71 724 See Drukarczyk-Zahlungsunfähigkeit, 76 725 See D.V.2. 726 Eidenmüller-Unternehmenssanierung, 35 727 Russian Bankruptcy Code, Art.8; Vitrjanskij-Länderbericht, 252


191

The Romanian Code, on the other hand, does not oblige the debtor to file a petition when he becomes unable to pay outstanding debts.731 Other examples reveal that the introduction of such an obligation in jurisdictions which did not have it before may increase the number of filings considerably. Hungary732, for example, introduced with their 1992 bankruptcy law reform733 provisions where the debtor management had to file for bankruptcy proceedings (reorganisation) when they had debts more than 90 days overdue. Simultaneously, the Hungarian legislator automatically granted filing enterprises a payment moratorium of 90 days, during which they may have attempted to draw a plan of reorganisation and obtain subsequent creditor approval. However, the number of debtor filings increased immediately from a few hundred a year before to more than 4000 in 1992.734 Having pushed all these enterprises into insolvency, the Hungarian law did not provide them with an efficient reorganisation procedure. Most significantly 100% creditor agreement was required when the plan proposed some kind of debt write-offs. The few plans that could have been negotiated were largely cosmetic in nature, promising contributions that proved to be incapable of fulfilment. If proposed plans were not confirmed by all creditors, the liquidation of the debtor was started. However, another consequence of those changes in the Hungarian law were that the unemployment rate in Hungary rose from 1% in 1991 to around 11% during 1992 and by the end of 1992 some 20% of the Hungarian economy was involved in formal insolvency proceedings.735 In order to decrease the number of filings and to prevent further mass insolvencies, Hungary amended its Bankruptcy law in 1993736 again to “soften the quasi-automatic triggering of insolvency proceedings and the liquidation bias”.737 Additionally, a proposed reorganisation plan could now be confirmed from creditors representing two third of the outstanding debt.738

728 Russian Bankruptcy Code, Art.9 729 Polish Bankruptcy Code, Art.5 730 Polish Bankruptcy Code, Art.17 731 Capatina-Länderbericht Rumänien, 341 732 see: Török-Länderbericht Ungarn, 378 733 Hungarian Bankruptcy Code (1991), § 9, Law No. LV/1992, LXVIII/1992 734 Deloitte-Restructuring, 27 735 Deloitte-Restructuring, 27 736 Law No. LXXXI/1993 737 Kim-When Nonuse is Useful, 1065; Török-Länderbericht Ungarn, 381 738 Török-Länderbericht Ungarn, 382


192

6. Pre-insolvency debtor protective proceedings and moratoria

6.1. General In general terms, pre-insolvency debtor protective proceedings are measures a debtor can initiate to obtain a breathing space and to reorganise his financial and operational affairs before his actual insolvency. The available means vary among jurisdictions, but go mainly along with some form of moratorium, in other words, the stay of creditor actions for a limited period.739 If debtor protective proceedings (moratorium, external administration) should be needed under the present state of a transition economy, it would be wise to trigger them not by strict insolvency criteria but rather by another more soft criterion such as “economic difficulty” which usually precedes insolvency proper. In this case, only the debtor should have a right to trigger such proceedings.740 A failure of such proceedings should not entail the automatic liquidation of the debtor enterprise.741 Pre-insolvency protective measures should be designed in a similar manner as regular insolvency proceedings. A stay of creditor action, for example, should have the same scope as in formal insolvency proceedings including all unsecured and secured pre-insolvency debts.742 However, pre-insolvency protective proceedings do usually not allow the debtor or its administrator to reject executory contracts.743 Moratoria are normally limited in time and are supposed to give the troubled debtor a short breathing space to reorganise its business and to prevent threatening actual insolvency. It lasts commonly from 5 weeks (1982 Austrian preliminary procedure) up to 2 years (Italian “amministrazione controllata”).

739 IMF-Report, 18 740 Balz, Schiffman, 22 741 Balz, Schiffman, 23 742 Balz, Schiffman, 25; See also D.III.2.3. 743 Balz, Schiffman, 66


193

6.2. Examples The Hungarian Bankruptcy Code provides for a moratorium for 90 days in the case that the debtor will be presumably not able to settle its debts and two thirds of the creditors confirm the requested moratorium.744 The Indonesian Bankruptcy Code (1998) provides for a moratorium for up to 270 days745 with a stay on unsecured claims but not on secured and maintenance claims nor on set-off rights. The debtor management retains the execution powers but is supervised by the court and an administrator.746 During the moratorium, the debtor may negotiate reorganisation measures with its unsecured creditors. After a respective filing of the debtor, the court has to impose the moratorium even when an insolvency petition was filed before.747 This provision is seen as a main obstacle in the Indonesian insolvency regime and functions as a workable means for debtors to postpone and delay insolvency proceedings.748 That result is even reinforced by the absence of effective sanctions for the misuse of the provision. Nevertheless, the court will automatically commence formal liquidation proceedings if the moratorium expires without reorganisation agreement.749 The Czech Bankruptcy and Composition Act750 provides for a “protection period” for the debtor in the case of a creditor filing for up to three months. However, the situation here is slightly different as the debtor has reached the state of insolvency already but attempts to reorganise its affairs and return to liquidity during the protection period.

7. Provisional Protective Measures The commencement effects of insolvency procedures normally come into effect with the granting of an insolvency order by the court.751 There might be a considerable time-gap between filing of the petition and the final court decision opening proceedings since the court has to scrutinise the financial and economical status of the debtor what may take considerable time in countries with a limited judiciary or other supporting professionals. During this time, the debtor may be tempted to transfer assets out of the business, as creditors may be tempted to take remedial legal actions against the debtor in order to pre-empt the effect of any stay that will be imposed when the court makes a positive determination. For

744 Hungarian Bankruptcy Code, sec.11, sec.9 (4) 745 Indonesian Bankruptcy Code (1998), Article 212 746 Indonesian Bankruptcy Code (1998), Article 214 (2) 747 Indonesian Bankruptcy Code (1998), Article 217 (6) 748 Kilgus-Das neue indonesische Insolvenzrecht, 52 749 Indonesian Bankruptcy Code (1998), Article 217 A 750 Czech Bankruptcy and Composition Act, Section 5a 751 IMF-Report, 22


194

this reason, an insolvency law should contain provisions for interim protective measures to protect the estate before the opening of the proceedings.752 Generally, the court may impose such measures at its own discretion or upon request. Such measures may include appointing a preliminary liquidator/ administrator753, prohibiting the debtor from disposing assets, except in the usual course of business, sequestering some or all off the debtor’s assets, and suspending enforcement of security interest against the debtor.754 Since these are provisional protective measures, that are provided prior to a judicial determination asserting that the commencement criteria have been met, the court may request a petitioning creditor to provide evidence that the measure is necessary and, in some cases, may require even a bond.755 Russian law (1992), for example, had no special rules on provisional measures for the time between a petition and the opening of proceedings. That could cause problems when considerable time did pass before proceedings could be opened.756 The new Bankruptcy Code (1998)757 gave the Arbitration Court wide discretion to impose provisional measures to protect claims of creditors. Additionally, the new Code introduced the Observation procedure.758 This procedure aims mainly to protect the assets of the debtor enterprise until a decision about the petition is reached.759

752 See generally Smid-Das Insolvenzverfahren, 395 753 See D.IV.3. 754 See for Poland: Zedler-Länderbericht Polen, 299, Polish Bankruptcy Code, Art.12 provides the court with the power to grant an interim order to protect the assets of the debtor for the time until a decision about the petition is made; for Romania: Capatina-Länderbericht Rümänien, 344; Bulgarian Commercial Code, Art.629a the court may at a request by a creditor or ex-officio appoint a temporary assignee, order the stay on actions of other creditors and several other protective measures; Slovakian Bankruptcy and Arrangement with Creditors Act, §4b (1)(a), 9a, the debtor is not allowed to dispose assets and the court may on request appoint a preliminary receiver; Croatian Bankruptcy Code, Art.44, the bankruptcy tribunal may appoint an interim trustee, prohibit the disposal of assets by the debtor or order a stay of any enforcement actions against the debtor; See also for the German Insolvency Code, § 21, which provide for similar measures: Uhlenbruck-Rechtsstellung des vorläufigen Insolvenzverwalters, 240 755 IMF-Report, 23 756 Balz-Russia, 21 757 Russian Bankruptcy Code, Art.44 758 Russian Bankruptcy Code (1998), Chapter IV. 759 Vitrjanskij-Anwendungspraxis, 261; EBRD-Summary of the Russian System, 8: Other than in respect of certain payments to existing participants of the debtor, there is no automatic stay on the payment of the debtor's debts during observation proceedings, but recovery of those debts against the debtor under court order or the performance of any recovery by creditors is suspended for the period of the observation proceedings.


195

III. Legal Effects of Commencing a Case

1. Preliminary considerations A decision about the legal effects of the commencement of insolvency proceedings requires a cautious balancing of competing policies – sanctity of contract, pari-passu treatment of creditors, maximising of asset values and the rescue of viable enterprises have to be brought in line with existing overall objectives prevailing in this jurisdiction.

2. Stay of any creditor action

2.1. General functions Once a debtor files for insolvency, the sole concern of many creditors will be the immediate individual enforcement of their claims against the troubled debtor. Such a strategic behaviour would end in a “run to the courthouse door”760 in order to enforce their different individual claims. As mentioned earlier761, main aim of an insolvency law is the transformation from an individual to a collective process. The automatic stay of any individual creditor action, execution or enforcement measure is a key function to reach that objective. 762 A second function of the automatic stay is that it provides the debtor with the frequently necessary breathing space to reorganise and restructure its financial and operational state of affairs without extensive creditor interference.

2.2. Scope of the provision The stay should be wide and all embracing and should generally affect any kind of creditor, secured or unsecured.763 A stay on all claims against the estate generally promotes higher sales values for the debtor business where it enables the enterprise to be sold as going concern. However, an action intending to determine the validity or amount of a claim may be allowed to proceed. But it might be doubtful if there should be such an action outside insolvency

760 Wood-International Insolvency, Chapter I 761 See B.I.1. 762 See as example for stay provisions: Polish Bankruptcy Code Art.63; Romanian Insolvency Code, Art.35; Hungarian Bankruptcy Code, Section 38; Russian Bankruptcy Code, Art.57; Czech Bankruptcy and Composition Act, Section 14c; Bulgarian Commercial Code, Art.637, 638 763 IMF-Report, 25


196

proceedings since the insolvency judge might be suitable and competent to decide also on issues of the validity and the amount of claims.764 Furthermore, in order to rebalance creditor interests, the stay or suspension should be of limited specified duration and should be not extended without court order.765 Generally, the automatic stay should be effective from the time of the filing of the petition766, not from the time of the opening of insolvency procedures767; or the court should have at least discretion to grant immediately a stay following a request by a participant or ex-officio.768 As mentioned before, between the filing of the petition and the opening decision will be a time gap, where authorities and other interested parties scrutinise the situation of the debtor, the qualification of claims, the status of payments etc, in order to assess the actual situation of the debtor. In more difficult cases, this time gap can last for a considerable period.769 During that time, the assets of the debtor should be protect from any creditor action in order to retain asset value for a possible rescue or to maintain the pari-passu principle towards all creditors of the debtor in subsequent proceedings.770 However, in the case of a creditor filing, an automatic stay or suspension might be not necessary until the application has been heard and determined, but a stay should be capable of being applied, on an interim basis, if circumstances can be shown to warrant it.771

2.3. Effect on secured creditors772 A critical issue is whether secured creditors are subject to a stay. If not, they may be able to undermine the proceedings by selling assets they hold as collateral that are vital to the debtor’s business.773 Some mechanism should be put in place that will assure secured creditors that their rights will not be impaired by a stay.774

764 Bickford-Bankruptcy Law Reform, 937 765 ADB-Report, 35 766 US-Bankruptcy Code, §362(a) 767 WB-SOE insolvency, 10; this is not the case under the Slovak system, but also the Romanian Insolvency Code, Art.35, the Polish Bankruptcy Code, Art.63, the Czech Bankruptcy and Composition Act, Section 14(1), the Hungarian Bankruptcy Code, Section 38, provide generally for a stay only at the time of the granting of the order by the court. Nevertheless, they may provide for provisional protective measures 768 See for example, Russian Bankruptcy Code, Art.44, or Chapter IV, which provides for observation proceedings, Art.57 (1) provides that actions against the debtor enterprise may be suspended by the arbitration court on request of a creditor; or the Czech Bankruptcy and Composition Act, Section 5d (b), which gives the court the power to grant a protection period for up to three month on request by the debtor with the effect of a stay on execution measures. 769 That was frequently experienced in transition economies due to lacks in the institutional capacity, the skills and qualifications of the judiciary and other related professions and the amount of information available. 770 WB-Towards Principles, 15 771 ADB-Report, 35; not the case in Indonesia, Malaysia and Thailand 772 See for a more detailed discussion, D.III.12. 773 Zedler-Länderbericht Polen, 301: The Polish Bankruptcy Code did extend the stay originally not to secured creditors but was respectively amended in 1997; Polish Bankruptcy Code, Chapter VI. 774 G22-Report, 45


197

Following the objectives of rescue, the stay should be on secured and unsecured creditors alike when a rescue is attempted. The rationale for this is that rescue attempts will fail unless the essential assets and component parts of the debtor business are maintained. However, where it is clear that the corporate debtor will be liquidated piecemeal this rationale is no longer relevant and the stay should affect only unsecured creditors. Nevertheless, one may recall the discussion on unitary proceedings775 and thereby notice that in the case of proposed unitary proceedings an initial decision according the type of proceedings is not necessary. Therefore, in unitary proceedings secured creditors should be generally subject to a stay until a decision about the type of proceedings is made. Under the Russian Bankruptcy Code776 the initiation of external administration will trigger a moratorium on the satisfaction of most creditors' claims, other than wages, copyright royalties, alimony and those for personal injury. The moratorium does not affect obligations of the debtor accrued after the commencement of external administration. In the case of bankruptcy liquidation, a stay on creditor actions, executions and seizures takes effect.777

3. Prohibition of the debtor to dispose assets But not only the debtor has to be protected from individual actions by his creditors – creditor interests also require protective measures against activities of the debtor. As mentioned before, as soon as a petition is filed or even before, the debtor may be tempted to deprive assets belonging to the debtor enterprise. To prevent such behaviour a provision is needed according to which the debtor is prohibited to dispose assets of the estate in order to maximise value for the creditors.778 In liquidation procedures, that is usually reached through the mandatory appointment of an independent liquidator. The liquidator assumes the whole power of disposal of assets remaining to the estate of the debtor while the debtor is divested of all rights to manage and operate the business.779 That includes the right to initiate and defend legal actions on behalf of the estate and the right to receive all payments directed to the debtor.780

775 See C.II.7. 776 Russian Bankruptcy Code, Art.70 777 Russian Bankruptcy Code, Art.98 778 See for example: Polish Bankruptcy Code, Art.20; Hungarian Bankruptcy Code, Section 34; Romanian Insolvency Code, Art.78; the Russian Bankruptcy Code, Art.58 considerably limits the execution powers of the remaining management in the observation phase – until a decision is made if to reorganise or liquidate the debtor. 779 See for example: Romanian Insolvency Code, Art.78, 23


198

In reorganisation proceedings, where it may be desirable to retain management in office781, the debtor may keep the right to dispose assets in the normal course of business which is normally supervised by the administrator.782 However, a frequently overlooked question is, what should happen when the debtor management, after loosing the power of disposal, contracts with a third party or disposes assets to a third party which is in good faith and not informed about the pending insolvency proceedings of the debtor?783 The general statement that such a contract is invalid784 becomes debatable with respect to the good faith of the third party.785 Nevertheless, the contract should be invalid when the opening decision was publicised (e.g. in the companies register) even when the contracting party had positively no knowledge of the pending insolvency proceedings.786

4. Estate over all of the debtors assets

4.1. Definition The term “estate” is only familiar to legal systems, where the concepts of trust and divided ownership are recognised, hence, mainly to jurisdictions with a common law tradition. In such countries legal title is transferred to a trustee whilst beneficial ownership vests with the creditors which are eligible to receive the proceeds of the assets of the estate following liquidation. In other legal systems787, legal title continues to be retained by the debtor with certain restrictions to use its proprietary powers.788

780 IMF-Report, 23 781 See D.III.5. 782 See for example: Romanian Insolvency Code, Art.71; Bulgarian Commercial Code, Art.635 783 Trunk-Stand und Probleme, 243 784 For example the Polish Bankruptcy Code, Art.24 renders such transactions invalid and grants the counter-party only a right to reclaim its performance made. 785 E.g. German Insolvency Code, § 81 (1) protects the good faith of the contracting party in the case of immovable property 786 Vitrjanskij-Länderbericht, 253: That seems to be not the case under Russian insolvency law; the Czech Bankruptcy and Composition Act, Section 14(1)(a) rules such transactions generally ineffective against creditors of the debtor but grants the counter-party a right to withdraw only, if he was unaware of the bankruptcy order issued prior to the transaction. 787 Under the Civil Law System, ownership rights remain with the debtor and only execution powers may shift to an appointed administrator, see for example for the German Insolvency Code, Heidelberger-Kommentar, § 80, 3 788 IMF-Report, 21


199

4.2. Scope To promote policies of equity and rehabilitation, the insolvency administration should include as many as possible legal, equitable and beneficial interests of the debtor in property. Generally speaking, pro-debtor jurisdictions tend to cover a wider range of interests than pro-creditor jurisdictions. In pro-creditor systems secured creditors and property holders “in rem” may be excluded from the insolvency estate with the effect that rehabilitation efforts will be more difficult.789 As a general rule, the assets of the estate should normally include the entire property rights of the debtor as of the date the insolvency proceedings begin, plus the assets acquired by the liquidator or administrator after that date.790 Assets of third parties, which are in the debtor’s possession when the proceedings are commenced, should be normally excluded from the available estate. The treatment of title finance agreements is relevant in this context but will be discussed in more detail under a separate heading.791 Collateral should be generally belong to the estate, but might be excluded in liquidation proceedings where it is not considered as key asset (e.g. cash collateral, securities collateral), necessary to maximise the value when selling the debtor business as going concern.792 Some insolvency laws of transition economies793 exempt certain social obligations of the debtor from the estate. That might be necessary in the present stage of these economies, but should be abolished as soon as possible since it may seriously damage other creditors. The new and the old Russian Bankruptcy Code offers a illustrative example. In the 1992 law, security was expressively exempted and did not form a part of the estate in liquidation proceedings.794 After frequent criticism795 this was changed with the new Bankruptcy Code (1998)796 now including collateral in the estate.

789 WB-Towards Principles, 14 790 See for example: Russian Bankruptcy Code, Art.103; Czech Bankruptcy and Composition Act, Section 6; Polish Bankruptcy Code, Art.20; Bulgarian Commercial Code, Art.614; Hungarian Bankruptcy Code, Section 4; Slovakian Bankruptcy Code, §6 791 See D.III.6. 792 See for a more detailed discussion, D.III.12. 793 See for example: Polish Bankruptcy Code, Art.22 exempting property assigned as aid for the bankrupt's employees and their families 794 Balz-Russia, 26: Russian Bankruptcy Code (1992), Art.26 (4) 795 See: Balz-Russia, 25 796 Russian Bankruptcy Code (1998), Art.103, 104


200

5. Management of the debtor The treatment of the debtor management in insolvency proceedings is a key concern since it may significantly influence the attitude of directors and officers towards insolvency – an essential pre-condition for a successful process.

5.1. In liquidation In the case of liquidation procedures, the management of the debtor should be replaced by an independent administrator. The debtor and its management may in this situation not have any incentive for prudential management and investment since they can usually not expect any return from their initial investment, nor can they expect to retain their position within the debtor company. They start playing with someone else’s money as soon as liabilities of the debtor company exceed remaining assets.797 However, in cases, where the sale of the debtor as a going concern is desirable and feasible, the debtor should have some control of the business activities until it is sold, even it is procedurally treated as liquidation.

5.2. In reorganisation There are roughly three approaches to this question in rescue-type proceedings. Firstly, the existing management retains complete control798; secondly, the management is completely replaced by an administrator799; and thirdly, a combination of the two, where existing management retains control on a day to day basis supervised by an independent administrator responsible for wide reaching management decisions.800

797 Baird-The Uneasy Case, 131 798 Chapter 11 of the US-Bankruptcy Code provides for a “debtor in possession”, US-Bankruptcy Code, section 1101 (1) 799 ADB-Report, 33: Thailand; Aghion-Improving Bankruptcy, 857: U.K. Administration provides an external administrator (who is an insolvency practitioner) to run the company during reorganisation proceedings; Vitrjanskij-Anwendungspraxis, 262: in the case of an external administration under the Russian Bankruptcy Code, Chapter V., acquirers an external administrator the right to run the business of the debtor whilst the debtor management is suspended. 800 WB-Towards Principles, 16; see for example: Romanian Insolvency Code, Art.71; Bulgarian Commercial Code, Art.635; also German Insolvency Code, § 260


201

5.2.1. Replacement by administrator The complete removal of management can damage the business of the debtor since the management has the necessary expertise and familiarity with it. Moreover, this approach may discourage management to file early for reorganisation.801

5.2.2. Debtor in possession

The first alternative, whereby the debtor retains full control of the business, is followed by Chapter 11 of the US Bankruptcy Code802, commonly known as the “debtor in possession” concept.803 This approach has several disadvantages. Firstly, it may delay liquidation proceedings, since debtors have too many tempting incentives to file for reorganisation even if there is no real chance to have the debtor reorganised. Furthermore, creditors and other interested parties might not have enough confidence in the existing management to let them stay in office independently. And finally, management may act in this situation irresponsibly or even fraudulently.804 On the other hand, taking into consideration the scarcity of professional resources in transition economies, the “debtor-in-possession” method may provide some advantage for those jurisdictions.

5.2.3. Stay and supervision

Consequently, the third approach is to favour, as it strikes a balance between the two extremes and provides for a “power-sharing” arrangement between the debtor and the administrator. The law should provide the decision-making authority (court or administrator) with comprehensive discretion to design the respective agreement in order to reflect the necessity of any individual case.

801 See B.I.4. 802 US-Bankruptcy Code, section 1101 (1), the debtor stays usually in full control of its activities and is only supervised by a United States Trustee (government official) without appointment of an administrator (under the US Bankruptcy Code called trustee). A trustee might be appointed if there is cause for it or it is in the interest of creditors, shareholders or the estate (section 1104 (a)). The debtor in possession has almost all of the rights a trustee would have (section 1107(a), 1108); see also Business Reorganisations, 78, 209 803 The Croatian Bankruptcy Code, Art.266 provides for a method, which is called “debtor in possession” as well. However, characteristic provisions make it more comparable with the option, which provides for the remaining of the management connected with the supervision by the administrator 804 IMF-Report, 48


202

In doing so, the court may take into consideration, whether a debtor or a creditor has filed for reorganisation. In a case of a debtor filing, the debtor may stay in full possession805 while in the case of a creditor filing management may give up wide reaching powers.806 This approach reduces the risk of abuse of the proceedings to delay an ultimate liquidation and it also serves as safeguard for participating creditors. Only in cases, where the debtor demonstrates gross mismanagement or has acted fraudulently or improperly, the court should have the right to replace the management of the debtor entirely by an independent administrator.807

5.2.4. Ex-ante and ex-post view

One mechanism to encourage reorganisation to liquidation proceedings is a provision providing for the removal of management in liquidation and its supervised stay in reorganisation proceedings. Especially in economies with a considerable cultural aversion to complete loss of control808, the design of that provision may become a key role for the willingness of debtors to initiate voluntarily reorganisation proceedings. Viewing the situation from an ex-ante perspective, to promote efficient management, the debtor should be replaced upon the initiation of insolvency proceedings. The threat of loosing power, position and reputation may force management to apply more diligent management practises during the non-insolvent existence of the debtor enterprise. Viewing the situation from an ex-post perspective, after insolvency has occurred, the remaining of management may be necessary or desired to increase going concern value or the outcome of reorganisation efforts. The incentives are contrary809, depending if one views situations from an ex-ante or ex-post perspective. Solve the conflict may be difficult and requires careful policy decisions by the respective legislator. A solution could be to generally remain management in rescue

805 Romanian Insolvency Code, Art.71:”If the debtor declares – according to Art. 26 par. (1) letter f) – his intention to reorganize his activity and the plan of reorganization is confirmed – according to Art. 68 – by the syndic judge, he can manage his activity and administrate his assets, under the supervision of the administrator…” 806 ADB-Report, 33 807 IMF-Report, 48 808 ADB-Report, 34, 84: e.g. Thailand 809 Aghion-Improving Bankruptcy, 854


203

proceedings but replace them by an administrator or outside management if a case of wrongful trading or gross mismanagement becomes apparent.810

5.2.5. Unitary proceedings

As mentioned before811, in unitary proceedings, one does not distinguish procedurally whether reorganisation or liquidation is strived for by the petitioner until a respective decision is made by the court. In order to facilitate the advantages of unitary proceedings in this respect, it should not distinguish between prospective rescue and liquidation proceedings and the role of the debtor management should be not automatically determined by the prospective outcome of the proceedings.812 Otherwise, the debtor will be induced to choose proceedings strategically and to forestall creditor filings. The debtor may remain in control under the supervision of an independent administrator813 when the debtor has filed for insolvency and in the case of a creditor petition, possibly with the creditors consent. The creditor committee may at any time request the appointment of an administrator. The debtor in control may reject executory contracts but only the administrator may avoid transactions.814

5.3. Examples The Russian Code (1998)815 provides as an alternative to liquidation for external administration, which is in fact the replacement of the existing management with an external administrator. However, major transactions where the obligations incurred by the external administrator exceed 20% of the aggregate amount of the claims of the creditors, or such with "interested" persons816, can only be incurred by the external administrator with the consent of the creditors' committee or the creditors' meeting.817 The ultimate goal of these provisions is to improve the chances of a successful rescue of a debtor enterprise. The

810 Eidenmüller-Unternehmenssanierung, 30 811 See C.II.7 812 A good example provides the German Insolvency Code, which does generally deprive management of their execution powers (§ 80) but provides for a plan for liquidation, going-concern-sale or reorganisation, where the debtor may manage the debtors business under the supervision of the administrator (§ 260) 813 See for example: Bulgarian Commercial Code, Art.635 814 Balz, Schiffman, 66 815 Russian Bankruptcy Code (1998), Chapter V (Articles 68-97) 816 See for a definition: Russian Bankruptcy Code, Art.18 817 Russian Bankruptcy Code, Art.76


204

process is mainly creditor driven and has the common components of reorganisation proceedings.818 The Romanian Insolvency Code gives the debtor at the outset of proceedings the opportunity to declare if he intents to reorganise its affairs.819 If his intention is to reorganise and such an undertaking is confirmed by the relevant syndic judge, the debtor management may stay in office supervised by an administrator.820 Otherwise, the debtor management is replaced entirely by an administrator or liquidator, as the case may be.821 The syndic judge needs, for the selling of important assets of the debtor such as lands, factories or major equipment, the prior agreement of a minimum of two thirds of the creditors’ assembly.822 According to the respective provision in the Polish Bankruptcy Code823, the existing management is at the opening of bankruptcy proceedings replaced by an administrator, who administers the estate and conducts its liquidation. The Polish law does not provide for modern rescue proceedings but only for arrangement or composition provisions which do not open a separate process.824

6. Recognition of title finance In a modern credit-based market economy, the different techniques of title finance are often used as an alternative to security, having a similar economic effect as security. In title finance, the financier retains title or ownership of the asset. A retention of title clause, by way of example, is typically found in the commercial agreement between buyer and seller, and provides that the seller transfers ownership of the good only after he has received payment in full. Under the heading title finance exist many different techniques like hire purchase, finance lease, retention of title, factoring, sale and lease back, sale and repurchase, etc. These techniques often have the advantage not being regulated by strict pledge laws whilst they have a similar effect as security.825 818 Gutbrod-Das neue russische Insolvenzgesetz, 38 819 Romanian Insolvency Code, Art.26 (1)(f) 820 Romanian Insolvency Code, Art.71 (1) 821 Romanian Insolvency Code, Art.78 822 Romanian Insolvency Code, Art.84 (3); a similar provision provides the Polish Bankruptcy Code, Art.131, which requires approval of the committee of creditors for certain transactions of the official receiver 823 Polish Bankruptcy Code, Art.90 824 See C.I.3.1.


205

In the situation where a buyer becomes insolvent after having acquired possession of the asset but has not yet paid the good in full the question arises whether this asset belongs to the estate of the insolvent buyer, with the consequence that the administrator may sell or use it for the reorganisation process? In countries where title financing is of considerable economical necessity and importance, it may be appropriate to respect the creditor’s legal title in the asset and allow it to be separated from the estate. Other countries may choose to re-characterise these agreements as security arrangements, in which case the title-holder would be subject to the same restrictions as a secured creditor.826 Obviously, the former alternative supports the predictability of commercial affairs and the availability of credit in an economy in general while the later policy fosters asset-maximisation and the chances of a successful reorganisation of the debtor. However a respective policy decision might be, the law should clearly spell out the treatment of title finance arrangement in insolvency proceedings. In transition economies, security devices as title finance arrangements are of significant importance due to a lack of the availability of universal security.827 Therefore, the treatment of title finance in insolvency is of great importance for those economies. Under this perspective, it might be justifiable to exclude title financing from insolvency proceedings. Examples Under Polish law828, for example, the contractual reservation of title by the vendor shall be upheld in the case of the insolvency of the purchaser if the reservation is effective towards creditors under the provisions of the Polish civil law. The Croatian Bankruptcy Code829 treats those creditors differently who are in favour of a retention of title clause. According to the relevant provision, the bankruptcy trustee shall have the right either to assume the contract (creditors receive priority payment for post-petition credit830 but loose the right to reclaim the good) or to reject it (right to reclaim the good). The Croatian rule is a clear choice towards an asset maximisation policy.

825 WB-Towards Principles, 20: usually complicated registration proceedings and other formalities as common for pledges are not essential for the effectiveness of title financing 826 IMF-Report, 22 827 Transition economies are characterised by the general absence of efficient security laws, particularly for movables, See Breidenbach-Thesen, in Drobnig (Hrsg.) Systemtransformation, 357 828 Polish Bankruptcy Code, Art.42 829 Croatian Bankruptcy Code, Art.114 (2) 830 Croatian Bankruptcy Code, Art.114 (2), 110, 205 (1) 1


206

The German law831 gives the administrator the right to choose whether to pay and to acquire title over the assets or to reject and return the asset to the original seller. However, the administrator may, in the case that he has decided to reject the title finance agreement, return the assets only after the relevant consideration period.832

7. Insolvency set-off rights and netting

7.1. Importance The set-off right in insolvency is a major issue and any insolvency law should explicitly deal with the question. There is a great deal of diversity among insolvency laws on a worldwide perspective. English-based jurisdictions generally restrict set-off rights between solvent parties but make it compulsory on insolvency.833 Many jurisdictions allow set-offs inside and outside insolvency proceedings.834 Again other jurisdictions allow set-offs during solvency of the parties, but restrict it when one party becomes insolvent.835 The first two approaches are more creditor-friendly, because the creditor in the case of insolvency of the debtor is in substance “secured”. Therefore, set-off can properly be treated much as a contractual security interest in “cash collateral”.836 The latter approach is more debtor-friendly, because in the case of insolvency, the debtor (its administrator) can request payment in full while the creditor has only a claim against the estate as unsecured creditor. Some jurisdictions837 traditionally following the latter path, have recognised the problem and the necessity of set-offs on insolvency and introduced statutes governing the right of set-off and netting in financial and other related transactions. Since claims are a major form of property, not only in financial markets, and since creditors are often also the debtors of the same counter party, the law of set-offs is important in financial and business matters. In mutual trading transactions, the issue may arise between two parties which maintain a series of contracts in between them.838 A classical example where the set-off right becomes important, is the situation, where the creditor is a bank having extended a loan to a now insolvent debtor who maintains a deposit 831 German Insolvency Code, §§ 107 (2), 103 832 German Insolvency Code, § 107 (2) 833 Wood-Principles, 129, e.g. England, Ireland, Canada, Australia, Hong Kong and Malaysia; for England see: Fletcher-Law of Insolvency, 272, English Insolvency Act 1994, section 323 834 See for the German law before the German Insolvency Code (1999) Flessner-Sanierung und Reorganisation, 212; Paulus-Aufrechnung und Insolvenzanfechtung, 569; German Insolvency Code, § 94 835 See for example: US-Bankruptcy Code, §362(a)(7); Czech Bankruptcy and Composition Act, Section 14(1)(i) 836 Balz-Russia, 25 837 E.g. France, Luxembourg


207

with the lending bank. Should the creditor in this situation have the right to set-off the repayment claim against the deposit of the debtor?

7.2. Balancing the objectives Finding the right approach to the problem may again require a careful balancing of the competing objectives of the insolvency law. Arguments against a set-off right after the opening of proceedings are, for example, that the right to set-off violates the pari-passu principle among creditors since unsecured creditors with a set-off right gets paid in full, that the set-off reduces the value of the debtors assets and thus inhibits a rescue and, finally, that the set-off functions like an unpublicised security interest, causing assets to disappear.839 On the other hand, one may argue in favour of a set-off, that it might be unfair that the debtor should be allowed to insist on payment in full, but is not paying itself. A set-off is fundamental in financial markets and payment systems to mitigate systemic risk. Furthermore, set-off rights reduce fundamentally the risk of knock-on insolvencies, the exposure, the cost of credit and the transaction costs840. Finally, set-off rights are particularly beneficial to the banking sector and, because of the credit creation role of banks, are considered as of general benefit to the whole economy.841

7.3. General design features The design of set-off provisions interacts with a number of other issues, especially with avoidance rules842, if the transaction to which the debtor is obliged took place in a suspect period and with the treatment of “ipso facto” clauses843, which are frequently contained in commercial or financial agreements.844 In designing set-off rights the law should explicitly spell out, if set-off rights are allowed for pre- and post-commencement transactions and for counter-claims which are at the time of commencement not due and payable.845

838 Wood-Principles, 128 839 WB-Towards Principles, 25; Wood-Principles, 129 840 WB-Towards Principles, 25; Wood-Principles, 129 841 IMF-Report, 35 842 See D.III.10; See also for a detailed discussion on the interrelation between set-off rights and avoidance rules, Paulus-Aufrechnung und Insolvenzanfechtung, 569 843 See D.III.8. 844 IMF-Report, 35 845 See for example German Insolvency Code, § 95


208

In jurisdictions restricting insolvency set-offs846, the general principle is that the reciprocal claims must satisfy the conditions of the solvent set-off rules, prior to the relevant insolvency date, e.g. in the case of independent set-off both claims must be mutual, liquidated, matured and legally payable prior to the opening of proceedings. If these requirements are not fulfilled, there can be no set off and the creditor must pay the cross claim into the estate and has only a (unsecured) claim against the estate. By way of example, if a bank owes a deposit maturing after the opening date and is owed a term loan accelerated before the insolvency date, set-off is restricted with the consequence that the bank must pay in the deposit but has only a unsecured claim against the estate.847

7.4. Netting Netting differs from set-off in the way that it can appear as set-off of non-fungibles (securities) – “settlement netting” or requires a cancellation of contracts by the solvent counter-party before setting-off the counterclaims – “close-out netting”.848 Closeout netting provisions are used frequently in master agreements849 and govern a great number of mutual short-term financial relations (swaps, derivatives). To enable closeout netting, the insolvency law should provide for the right to terminate contracts by the solvent party and the right to set off its claims against (immature) counterclaims of the insolvent party.850

7.5. Carve-outs Many jurisdictions which do not allow termination and set-off under their general insolvency regime have introduced carve-outs, which allow termination and set-off for certain financial contracts since this contracts are considered as an increasingly important component of the global financial market and in this way vital for their economy.851 As important those regulations may be, one should not forget that carve-outs do complicate the overall system and reduce transparency. Other exceptions upon insolvency in those countries are a possible current account set-off and a transaction set-off.852 A current account set-off after the opening of proceedings is justified with the rationale that debits and credits are only one account, eligible for

846 Wood-Principles, 130: mainly Franco-Latin jurisdictions, e.g. France, Spain, Belgium, Argentina and Brazil 847 Wood-Principles, 130 848 WB-Towards Principles, 25; see for the German provision on close-out netting: Berger-Lösungsklauseln, 393; Bosch-Finanztermingeschäfte, 775 849 E.g. ISDA Master Agreement 850 See for example German Insolvency Code, § 104; similar Croatian Bankruptcy Code, Art.111 851 IMF-Report, 36; WB-Towards Principles, 26 852 Wood-Principles, 131: e.g. France, Luxembourg and Bahrain


209

compensation on termination of the bank-customer relationship on insolvency. A transaction set-off allows the set-off of mutual claims, arising from the same transaction after the insolvency date.853

7.6. Examples The position on insolvency set-off in jurisdictions of the former Soviet empire appears unclear. It is believed, that the new insolvency laws of Russia, Belarus, Kazakhstan and the Ukraine do not mention insolvency set-off.854 The Polish law855 generally allows set-offs where claim and counterclaim existed prior to the opening of proceedings even if payment of one of them were not due. However, it does not permit set-offs of post-petition claims and claims that have arisen within a year preceding the declaration of bankruptcy.856 The Croatian Bankruptcy Code857 and the Hungarian Bankruptcy Code858 similarly permit the set-off by creditors when the respective set-off was possible under general law prior to the opening of insolvency proceedings. However, Croatian law provides to this general rule several exceptions and prohibits the set-off, for example, if the claim has been ceded to the creditor by another creditor after the commencement of proceedings or within 6 month prior to the opening and in the knowledge of the insolvency of the debtor. The Bulgarian Commercial Code859 provides a comprehensive provision on insolvency set-off rights. The law allows a creditor set-off generally when both claims have been mutual, due, payable and of the same type prior to the opening of proceedings. However, according to this provision a set-off shall be also legitimate in cases where only the opening decision effected that claims became due or of the same type. US law forbids the set-off against a counterclaim of the estate after the commencement of proceedings, which effectively secures liquidity for the estate in the critical first weeks of proceedings.860

853 Wood-Principles, 131 854 Wood-Principles, 130 855 Polish Bankruptcy Code, Art.34 856 Polish Bankruptcy Code, Art.35 857 Croatian Bankruptcy Code, Art.103 858 Hungarian Bankruptcy Code, Section 38(3) 859 Bulgarian Commercial Code, Art.645 (1) 860 Balz-Russia, 24: US Bankruptcy Code, § 362(a)(7)


210

German law861 generally permits a set-off, even for claims which became due or mutual after the commencement of proceedings. Furthermore, the German Insolvency Code862 allows explicitly the set-off of mutual claims in different currencies when they are freely convertible. However, the German Code863 prohibits set-offs when the creditor has acquired its claim after the opening of proceedings. The Indonesian Bankruptcy Code (1998)864 allows creditors the set-off against claims of the estate when the set-off situation existed prior to the commencement of proceedings and the creditor was in good faith. The 90 days grace period as for security interests applies not for the set-off and makes it therefore an attractive security device.865

8. Contractual termination (“ipso facto”) clause Many contracts contain a clause where one party may terminate the contract when the other party enters into insolvency proceedings. The question is whether the insolvency law should honour such a clause or overwrite it with the consequence that usually only the administrator has a right to terminate not yet fully performed pre-insolvency contracts?

8.1. Policy considerations In rescue proceedings, predominantly, exist a need to dishonour the clause, since for a successful reorganisation it is essential that the business of the debtor can be maintained and all parties participate in the reorganisation process. As mentioned elsewhere, a similar necessity may exist when a sale of the debtor enterprise as a going concern is attempted.866 On the other hand, there are also arguments in favour to uphold such a clause in order to comply with the principle of the sanctity of contract. In liquidation proceedings, such a clause should be honoured, since it is not the aim of liquidation to carry on with the business of the insolvent debtor, even when the aim of liquidation might be the sale of the enterprise as going concern. In rescue proceedings, one can argue, the disregard of the clause enables the insolvent debtor to “cherry-pick” profitable contracts but cancel others. Furthermore, the other party cannot be forced to continue the business with a different legal person against its expressed will.867 861 German Insolvency Code, §§ 94, 95; see also Landfermann-Allgemeine Wirkungen, 145 862 German Insolvency Code, § 95 (2) 863 German Insolvency Code, § 96 864 Indonesian Bankruptcy Code (1998), Articles 52-54 865 Kilgus-Das neue indonesische Insolvenzrecht, 50 866 WB-Towards Principles, 24


211

However, when the law overwrites such a clause and gives the administrator the right to continue with the contract even against objections of the counter party, it should grant any claims arising after commencement of insolvency a priority status.868 Many commercial contracts contain a non-assignment clause where, in our case, a debtor would be not allowed to assign a commercially valuable contract to a third party in order to enhance the value of the estate. Some insolvency laws even overwrite this clause with the consequence that a debtor may effect assignment even against objections of the counter party.869

8.2. Example In the reform process of the German insolvency law870 existed considerable debate on this issue. But a provision, which would generally ignore ipso facto clauses, was finally not implemented.

9. Right of the administrator to assume or reject pre-insolvency contracts Most insolvency laws871 allow the administrator of an insolvent debtor either to continue or abandon pre-insolvency contracts, which are not yet fully performed by both the debtor and the creditor. Contracts which have been executed completely by either party may not be rejected under these rules; but they may be subject to avoidance rules if they are intrinsically unfair and within the relevant suspect period.872 The underlying policy is asset value maximisation: the administrator shall be able to convert onerous performance obligation into monetary claims.873

867 WB-Towards Principles, 24 868 IMF-Report, 32 869 IMF-Report, 33 870 See for a brief reflection: Heidelberger-Kommentar, § 119, 3; Berger-Lösungsklauseln, 375 871 E.g. US Bankruptcy Code, § 365; German InsO, § 103; Romanian Insolvency Code, Art.51; Russian Bankruptcy Code, Art.77, 101 (3); Polish Bankruptcy Code, Art.39; Bulgarian Commercial Code, Art.644; Czech Bankruptcy and Composition Act, Section 14(2) 872 Balz-Russia, 30 873 WB-Legal Framework, 9


212

9.1. General design features These rights should vest with the administrator in liquidation proceedings as well as in reorganisation proceedings. Arguably, it is the reorganisation context where these provisions are needed most, as this is precisely where such a tool is indispensable to rearrange and maximise ongoing business activities.874 In the case that the administrator terminates a contract, the counter party is released from its obligation to (further) performance and becomes an unsecured creditor with a claim equal to the amount of damages caused by the termination. The administrator may decide to continue with the contract, because the terms and conditions are more valuable than its termination, or the object of the contract is essential for the (remaining) business of the debtor. In order to protect affected creditors, the liquidator/ administrator should have a statutory obligation to inform them within a specified period about his decision875 and in the case of a continuation, cost of performance and possible damages should be given a priority status as administrative expenses.876 The right to interfere with such contracts has often to be weighted against other competing social and political interests, particular in the case of labour and lease contracts.877 Moreover, any right to interfere with under performed contracts will undermine commercial predictability and stability.878

9.2. Labour contracts It is debatable whether labour contracts should be subject to this regime? One can argue, that labour costs are in most of the businesses a major factor and reducing them would make an enterprise more valuable and would consequently enhance the chances for a successful rescue. On the other hand, as mentioned earlier, particularly transition economies have serious problems to fund and protect redundant employees since labour markets are usually dried up and efficient social safety nets are not always in place yet.

874 EBRD-Summary of the Romanian System, 11: Under the law prior to the 1999 amendments of the Romanian Insolvency Code, contract renunciation and annulment provisions were only applicable to cases of liquidation, and were not at all applicable to reorganisations. 875 E.g. 3 month period of the Russian Bankruptcy Code, Art.77 (1); 30 days under the Romanian Insolvency Code, Art.51 (2); Polish Bankruptcy Code, Art.39 §2 does provide for the general obligation to do so but respective time limit is decided by the judge-commissioner 876 IMF-Report, 32; e.g. Polish Bankruptcy Code, Art.204 §1 (2) 877 Trunk-Stand und Probleme, 243 878 IMF-Report, 31


213

Furthermore, relaxing the employment protection laws in the case of insolvency (liquidation/reorganisation) may create a way to circumvent the existing labour protection laws.879 To avoid this effect, the law should provide tools that protect from such evasions. Conceivable would be penalising any wrong or incomplete declarations made by the management of the debtor in order to gain advantages of relaxing labour law under insolvency provisions. Long-term executory contracts, such as leases or labour contracts, may be cancelled for the future only and with certain minimum notice periods irrespective of the agreed duration.880 Some laws require that certain utilities and other monopoly suppliers must continue to supply goods and services, even when the underlying contracts are cancelled or amounts due in the past have not been paid.881

9.3. Examples The Russian legislative changes in 1998 also contained rules on the right to reject executory contracts. The old Bankruptcy Code (1992)882 provided only for such rights in liquidation and was extended also to non-executory contracts which confuses the issue with the problem of avoidance of unfair acts of the debtor. The new law883 established the right for the administrator to reject such contracts also in external administration; it applies to executory contracts only and provides the counter party with a claim for damages when the administrator rejects a contract.884 Thereby, the administrator has to make his decision within 3 month after the institution of external administration.885 A similar right has the bankruptcy liquidator in bankruptcy liquidation proceedings.886 The Polish law allows the administrator to terminate existing labour contracts and the thus redundant employees acquire a claim of compensation against the social security body.887

879 IMF-Report, 33 880 E.g. Romanian Insolvency Code, Art.51 (5): Labour or lease contracts can be terminated only with compliance with the legal period of notification; Croatian Bankruptcy Code, Art.120 (3), employment contracts can be terminated by the trustee with a notice period of one month 881 US-Bankruptcy Code, § 366; Romanian Insolvency Code, Art.64 (1) 882 Russian Bankruptcy Code (1992), Art.21, 51 883 Russian Bankruptcy Code, Art.77 884 Russian Bankruptcy Code, Art.77 (3), Though the counter party will have a claim for compensation for actual damages suffered as a result of the disclaimer of the contract, it falls under the moratorium during external administration, Russian Bankruptcy Code, Art.74 (3), 70 (3), See also D.II.6. 885 Balz-Russia, 29 886 Russian Bankruptcy Code, Art.101 (3) 887 Zedler-Länderbericht Polen, 302; Brol-Das polnische Konkursrecht, 313: Up to 3 month of the pre-insolvency wage claims of employees are paid out of “Fond for guaranteed employee work”, See D.VI.3.


214

10. Avoiding powers (actio pauliana)

10.1. General The laws in most jurisdictions888 provide for the re-examination of certain transactions which took place prior to the commencement of insolvency with the possibility to recapture such transactions under certain circumstances. One may roughly group those avoiding powers of the administrator or the court889 into the following categories: (1) avoiding preferential transfers and payments; (2) avoidance of fraudulent and intentional prejudicial transfers; and (3) the avoidance of insider dealing.

10.2. Underlying policies The policies which support an extensive net of provisions on preferences or avoiding powers are manifold. Firstly, existing preferences may influence the behaviour of the debtor or its management ex-ante, by preventing them from fraudulent acting or acting generally to the disadvantage of other creditors. Moreover, these rules may discourage individual creditors to harass the debtor to pay them off in full before others, since such transaction may be void or avoidable under the respective preference rules. Additionally, preference rules are efficient tools to maximise the asset value of the estate and thereby providing for an equitable treatment of similar situated creditors and thus supporting the pari-passu principle. Finally, avoidance rules are able to encourage the debtor to proper business practices in pre-insolvency situations. However, there are also several reasons and objectives to mitigate the scope of preference rules. As any interference with private contracts, extensive avoidance rules may conflict with predictability and certainty, indispensable in commercial transactions and contractual relations.890

888 See for example: German Insolvency Code, § 129 see for the German law generally: Henckel-Insolvenzanfechtung, 645, Paulus-Ein Spannungsfeld, 425; Russian Bankruptcy Code, Art.78; Polish Bankruptcy Code, Title II, Chapter V; Romanian Insolvency Code, Art.44-50; US-Bankruptcy Code, section 547, See generally for US-Bankruptcy Law: Jackson-Avoiding Powers 889 See Russian Bankruptcy Code, Art.78: the arbitration court avoids relevant transactions upon a petition from the external administrator; usually, the administrator has an initial right to file for avoidance to the court; see also: Polish Bankruptcy Code, Art.57, Romanian Insolvency Code, Art.44-46; 890 Wood-Principles, 136


215

Furthermore, extensive preference laws discourage the debtor from trading out its debts with the consequence that management tends to close business early and thereby increasing the insolvency risk and reducing the chances for a successful rescue.891 A possible out-of-court restructuring of the debtor may be hampered when certain creditors have the potential power to re-examine informal reorganisation agreements or for rescue purposes given security after an informal rescue attempt has failed and formal proceedings are opened.892

10.3. Design features

10.3.1. Liquidation and reorganisation

Traditional continental insolvency laws consider avoidance rules as an exclusive issue of liquidation proceedings. This approach is generally seen as being beneficial for debtors. More modern codes893 view reorganisation as a value maximising technique in the interest of creditors, with the consequence that they include in provisions on reorganisation avoidance rules as well.894 Russian law, for example, introduced with its new Bankruptcy Code (1998)895 avoidance rules for external administration, while it had only similar rules for compulsory liquidation in its old Bankruptcy Code (1992)896.

10.3.2. Objective and subjective criteria

In designing avoidance rules there exist, internationally, two common approaches. Firstly, those rules can be of more general and objective nature. For example, a prescribed type of transaction took place within the specified suspect period. The second approach is more case-related and subjective. Was the debtor insolvent when the transaction took place and did the counter party know of the insolvency? Generally, objective criteria provide for more simplicity and predictability. But on the other hand, overwhelming policies and goals may make it necessary to consider the parties intention when designing the rules. For example, while a perfectly legitimate and useful

891 See for the relation of avoiding powers and rescue under the new German Insolvency Code, Paulus-Ein Spannungsfeld, 425-430 892 See generally on the problem under current German insolvency law: Paulus-Ein Spannungsfeld, 426 893 E.g. the Romanian Code, Art.43, see for avoiding powers under the Romanian Code: Capatina-Länderbericht Rumänien, 346; EBRD-Summary of the Romanian System, 10: avoidance rules were previously limited to liquidation proceedings only but extended explicitly to reorganisation proceedings by the 1999 amendments. 894 Balz-Russia, 28 895 Russian Bankruptcy Code, Art.78 896 Russian Bankruptcy Code (1992), Art.28


216

transaction that falls within the suspect period may be void or fraudulent, preferential transactions and transfers that happen to fall outside this period, may be upheld.897 The law should try to include and combine both approaches, considering the fact that subjective elements and intention is difficult to prove and might become an obstacle in a formal process like insolvency.898 To circumvent this, it would be advisable to include presumption rules899 or rules providing for the change of the burden of proof.900

10.3.3. Categories of preferences901

Generally, the law should cover all transactions and omissions that objectively harm creditors, that are intended to harm creditors and gratuitous acts. Insider dealings should be subject to a stricter avoidance regime than dealings at arm’s-length. One may categorise avoidance rules into several groups which are commonly found in many jurisdictions. Firstly, intentionally prejudicial and fraudulent transfers902 by the debtor in the knowledge of both parties form such a group and are frequently automatically void or avoidable even without suspect period. Moreover, gifts903, undervalued transactions and transaction with inadequate consideration904 may create a category, whereby the parties intent to defraud is regularly presumed. These provisions usually provide for a medium-term suspect period and require sometimes, that the debtor upon the transfer was insolvent or near insolvency. Another group of preference rules may contain any voluntary transfer or transaction within a shorter suspect period which give preferential treatment to a creditor905, who is not entitled to and/or the debtor not obliged to, e.g. early payments when not due or voluntary grant of security for pre-existing debt.906

897 IMF-Report, 29 898 For the Polish experiences and the respective amendments in 1997 see: Lowitzsch/Pacherova-Das novellierte polnische uns slowakische Insolvenzrecht, 215 899 See for example for the German Insolvency Code, § 133 900 Brol-Das polnische Konkursrecht, 310: With the 1997 amendments to the Polish Bankruptcy Code introduced the Polish legislator provisions according to which it is assumed, that a creditor, which received preferential treatment after the debtor became insolvent, knew from the insolvency, Polish Bankruptcy Code, Art.54 §2, Polish Civil Code Art.27 § 14, see also: Lowitzsch/Pacherova-Das novellierte polnische uns slowakische Insolvenzrecht, 215 901 See for a general discussion: Wood-Principles, 137 902 German InsO, § 133, 10 years; Romanian Insolvency Code, Art.44, 3 years 903 German InsO, § 134, 4 years; Romanian Insolvency Code, Art.45 (1)(a), 3 years; Polish Bankruptcy Code, Art.54 § 1, 1 year 904 Romanian Insolvency Code, Art.45 (1)(b), 3 years 905 Russian Bankruptcy Code, Art.78 (3), 6 month 906 Romanian Insolvency Code, Art.45 (1)(c), 3 years; Polish Bankruptcy Code, Art.54 §2, two month


217

General preferences, with prejudicial transfers within a brief suspect period in a time when the debtor was already insolvent or near insolvency, may form another category of avoidance provisions. Thereby, it is often presumed that the debtor was already insolvent when he made the transfer. Other laws providing for avoidance powers explicitly when the debtor grants security within a certain suspect period. 907 Finally, most of the insolvency laws apply stricter preference rules for transactions with insiders908 or other with the debtor connected persons and presume that the transfer to insider gives preferential treatment. Thereby, they either presume bad faith or knowledge of the acquirer or they extend the duration of the relevant suspect periods.

10.3.4. Mitigating preferences

As mentioned before, there are convincing reasons to mitigate preference rules and to exempt certain transactions from their regime. Therefore, the law should generally uphold transactions made as general preferences without intention by the debtor and without knowledge of the insolvency by the creditor.909 Furthermore, avoidance rules should exempt transactions performed in an ordinary course of business and for mutual exchange of values.910 Another element to govern the impact of preferences is the length of suspect period.911 General preferences should be void or avoidable only within a brief suspect period, whilst fraudulent transfers or insider dealing should be capable of being recaptured for a much longer period. Finally, transactions could be either void automatically or only avoidable on discretion of the administrator or the court. However, especially in transition economies should certain transactions be void automatically912 and a mandatory court involvement should be reduced to a minimum.913

907 IMF-Report, 29; German InsO, § 135 (1) 10 years, Romanian Insolvency Code, Art.45 (1)(e), 120 days; Polish Bankruptcy Code, Art.54 § 2, two month 908 Romanian Insolvency Code, Art.45 (2), Art.46, 1 year; Russian Bankruptcy Code, Art.78 (2), no limitation; Polish Bankruptcy Code, Art.55, six month 909 Wiston-The flavour, 199: The Indonesian Bankruptcy Law does not exempt transactions made in good faith and for valuable consideration 910 See for example Romanian Insolvency Code, Art.47 911 WB-Towards Principles, 27; WB-Legal Framework, 15 912 E.g. the Polish Bankruptcy Code, Art.54, 55, rules gratuitous acts, the granting of security and transactions concluded by insider dealing automatically void. 913 Balz, Schiffman, 66


218

10.3.5. Inclusion of secured transactions Secured transactions should not be exempted from avoidance rules with the justification that it might negatively influence the decision of creditors to extend credit. Examples reveal that in jurisdictions with extensive avoidance powers for secured transactions, lenders and creditors in general do still extend secured credit. The data shows that the US, a country far from being a secured creditor` paradise, has about the lowest interest rates and that creditors continue to lend. Moreover, seventy percent of the credit in the US is nevertheless secured.914

10.4. Experiences in transition economies However, experiences in transition economies suggest that preference rules and the related avoidance powers are rarely used. This might be due to unclear definitions in the laws regarding the circumstances which allow a transaction to be avoided, or the inadequate books and records of the debtor, often not sufficient to put the administrator in a position to re-examine suspicious transactions. 915 Another reason is the complexity of cases in these countries and the burden of proof, provided for by many insolvency laws in transition economies. These laws frequently require the administrator or the court to prove subjective criteria, such as intention or knowledge of the counter-party of the debtor’s transaction. As mentioned earlier, to overcome this obstacle, transition economies should use more objective criteria, supplemented by presumption rules and provisions which modify the burden of proof. Another characteristic feature of transition economies is the continuing dominance of insiders in decision-making and control, in privatised as well as state firms.916 Therefore, attention should be paid to insider provisions917, which should be also extended to companies or persons who dominate the debtor formally (transfers within a group, transfers to directors, officers, majority shareholders) or informally (transfers to companies which are not legally connected to the debtor but have a very strong informal relation to the debtor, transfers to family or close friends of directors, officers or majority shareholders).918 One of the major concerns in contemporary Russia related to insolvency issues is not only the increasing criminality of creditors, but also managers, officers and directors of

914 ADB-Report, 94 915 Deloitte-Restructuring, 9 916 EBRD-Working Paper 22, 4 917 An interesting example provides the Russian Bankruptcy Code, Art.78 (4), which states, that the withdrawal of a shareholder from participation and the connected payoff of the value of such shares shall be avoidable within 6 month of the acceptance of a petition by the arbitration court. 918 A comprehensive list on potential insiders provides the Croatian Bankruptcy Code, Art.136; or Slovakian Bankruptcy Code, §15


219

enterprises. They often serve themselves, friends and families, and their own future economic well being, in complete disregard of creditors rights and others interest. This often takes the form of “fraudulent transfers”, “preferential transfers”, “asset stripping” or pilfering the company’s bank account.919 A system was needed to monitor, prosecute and punish those activities and to review and set-aside unfair transfers and transactions. The new Russian Bankruptcy Code920 has extended “preference rules” to external administration. However, one might wonder if the new rules are sufficient to cope with the problem effectively.921 The rules on preferences of the Russian Code are kept very general, without specifying the different facts and circumstances of preferences. Moreover, the code failed to adjust different suspect periods to the different situations of preferential treatment.

11. Management and shareholder liability

11.1. Corporate liability Under the general law, liability for debts is only incurred by the company as a legal person. Under this classical scheme owners are liable upon insolvency only up to the amount unpaid on their shares. The “veil of incorporation”922 provides that the management act as agent of the legal person with an instrument that protects them from personal liability and fosters in this way commercial activity by reducing the personal risk for the participating players.923 On the other hand, the legal personality of companies is an instrument which can be abused by the non- or limited liable individuals behind the company with legal personality.

11.2. Management liability There are strong arguments to supersede this principle in the case of wrongful trading924 or acting by the directors or other responsible officers of an insolvent company.925 Firstly, the principle of fairness towards the creditors of an insolvent debtor requires for personal liability in such a case. Furthermore, the ability to challenge such transactions and

919 Brooks-Russia’s Struggle, 469 920 See Russian Bankruptcy Code, Art.78 921 See also the discussion on management liability, D.III.11. 922 See therefore also Wood-Principles, 132 923 Nevertheless has limited liability already been contractually curtailed outside the insolvency context. Lenders and other creditors, for example, require directors and other corporate officers (many of whom are shareholders as well) frequently to guarantee the debt of the company, what may lead to a personal liability in insolvency and thereby promote financial and operational discipline. 924 Wrongful trading is to define as incurring debts when there is no reasonable prospect of paying them, WB-Legal Framework, 15 925 E.g. Romanian Insolvency Code, Art.124, see Capatina-Länderbericht Rumänien, 352; a similar approach follows the Russian Bankruptcy Code, Art.10 (2) by extending liability to directors or other influential persons in the case that the insolvency was caused through the fault of them.


220

activities may increase the value of the available assets and thus foster the overwhelming insolvency objective of assets maximisation. Another related point is that personal liability of the management stops them doing business before it is too late and encourages to apply earlier for bankruptcy proceedings. Moreover, the lifting of limited liability in certain cases may protect some other societal goals. The company, for example, commonly pays over social security contributions directly to the respective body. This is, in essence, employee’s money. If a company is financially troubled, there is a risk that it will use this money for its own benefit. To prevent such behaviour and to protect the financial supply of the respective bodies, laws usually penalises the wilful non-payment of social security contribution by personal or even criminal liability. The opposing opinion suggests that an early stoppage of business activities prevents the company from trading out their difficulties or carrying out a private workout, and may instead force them into formal insolvency proceedings with the possible consequence of a sharp decline in asset values. By way of example, if one imposes a sanctioned obligation on the debtor management to file for insolvency immediately when insolvency occurs, the debtor will stop doing business early and remaining assets will be protected from further dilution. But on the other hand, such a policy will discourage the commencement and negotiations of desired private workouts since directors run the risk of personal liability if they do not file for formal insolvency proceedings. Generally, directors become liable because they are responsible for conducting the business and are entrusted with its proper management in the interests of shareholders and creditors. According to the prevailing corporate governance system in the respective jurisdiction directors are subject to ordinary agency duties towards their principles and other affected parties.926 Jurisdictions handle this problem in different ways. The possible sanctions are pure personal liability, criminal liability and the disqualification from being concerned in the management for a prescribed period or even no liability and consequences for the responsible management at all.927 Thereby, one may consider distinguishing possible sanctions in liquidation and rescue proceedings, in order to incentive rescue efforts of the management of the debtor.928 Whereby in liquidation a strict system of liabilities and other sanctions should prevail, it may be less rigid in proposed reorganisation proceedings.

926 Wood-Principles, 134 927 WB-Towards Principles, 10; but nevertheless are criminal activities usually sanctioned under the criminal law 928 WB-Rehabilitation, 25


221

Furthermore, it might be worth mentioning that statutory protection against such activities should be not only remediable for shareholders of a company, but also for other affected parties such as investors, employees and other creditors.929 As mentioned before, fraudulent trading is a common phenomenon of transition economies and needs therefore special attention in the policy making and law drafting process. Reasons for that might be manifold but may be primarily to seek in the absence or weaknesses of the rule of law, shortcomings in the regulatory and supervisory process and a generally prevailing confusion in the transition phase. The Romanian Insolvency Code930, for example, offers a comprehensive list on director or management liability. It covers fraudulent trading for their own interest or in the interests of a third party, continuation of the business that was leading to the companies insolvency, fictitious bookkeeping and increasing of liabilities and preferential payments to single creditors at the disadvantage of the other creditors and so on.

11.3. Shareholder liability Another frequently found policy is that of “big pocket liability”931. It contains doctrines like shareholder or lender liability. The underlying objective of those doctrines is to find in the case of insolvency another pocket to pay, preferably a deep one. Jurisdictions vary substantially in their position towards these issues. Generally, these liabilities are imposed among bystanders of the insolvent, who are not primarily responsible, but have substantial resources to pay and were to a varying degree involved in the decision making process of the debtor.932 Shareholders only incur liability under this head when they adopt the mantle of management by clothing themselves as managers. This tends to arise frequently within groups of companies, where a holding run the business and makes strategic decisions for several connected enterprises. Another practical example is the case of small or family businesses, where management and owners are almost identical. However, no case has been found where a public shareholder of a listed company has been held responsible for the liabilities of the company.933

929 See for example: Romanian Insolvency Code, Art.126, which grants the right to such an initiative to the syndic judge, to any of the creditors, to the local chamber of trade and industry or to the court ex officio 930 Romanian Insolvency Code, Art.124 931 Wood-Principles, 133 932 Wood-Principles, 133 933 Wood-Principles, 134


222

12. Involvement and protection of secured creditors

12.1. General One of the main obstacles for more traditional bankruptcy laws934 is that they commonly exclude secured creditors from the insolvency process, with the consequence that they are able to enforce their rights outside this process and thereby negatively affect the outcome of reorganisation and liquidation proceedings. However, modern insolvency codes usually include secured creditors in the process and make them thus subject to the general effects of insolvency.

12.2. Policy considerations There is again a natural tension between the objective of maximisation of asset value for the benefit of all creditors with along going enhancement of the chances of a successful reorganisation and the need to protect secured creditor and their interest in the collateral. Since any erosion of the value of security interests undermines the availability of affordable credit, balancing these two objectives requires careful consideration.935 The key question is how far should the insolvency law be able to interfere with contractual rights of the secured creditor by suspending their individual rights in exchange for a conversion into a collective right to claim and share in the estate of the debtor? Internationally, there exist two major approaches to deal with the problem.

12.3. Excluding secured creditors Firstly, there is the option to exempt secured creditors altogether from insolvency proceedings, with the effect that they are permitted to enforce their contractual rights and recover the collateral outside the ongoing insolvency proceedings. One argument in favour of this approach is that it creates strong incentives for a financially sound behaviour of the debtor. Furthermore, this policy reduces the price of credit since lenders are more convinced that their secured rights are protected and effectively enforceable. Additionally, the creditor who paid for the asset should have a right to the asset: the conditional security right is a fair exchange for the credit.936 934 Prior to recent changes, the Russian, the Polish Bankruptcy and the German Bankruptcy Code, § 157 did exclude secured creditors from bankruptcy proceedings. The Slovakian and the Indonesian Bankruptcy Code, for example, still exclude secured creditors from proceedings; See more generally: Balz, Schiffman, 68 935 See for a detailed discussion, B.I.3. 936 WB-Legal Framework, 6


223

On the other hand, there are arguments, especially in the context of a rescue or going-concern-sale, which are in disfavour of this option. The overwhelming objective of asset value maximisation requires preserving key assets of the enterprise. One might think on a situation, where for the debtor’s production necessary raw material, machines or other equipment is encumbered with security interests and the respective creditor would have a right to remove and sell those goods. The proceeds may or may not satisfy the creditors claim, but will most probably damage the remaining asset pool and as a result decreases the remaining asset value disproportionately. But even in liquidation, the liquidator may need some time to arrange for the asset sale with the highest return. The existing key assets are regularly encumbered by security interests and would fall outside the insolvency process. In particular, in modern commercial relations, where many debts are secured, such a policy would jeopardise the outcome of the whole insolvency process. Moreover, security violates the equitable treatment of creditors and thus infringes the pari-passu principle. Excluding collateral may even be against the interest of secured creditors as a class, if, for example, their claims are worth more when the debtors going concern value can be preserved and when assets are worth more than in a piecemeal liquidation. In short, extending the collectivisation of debt collection in insolvency to secured creditors is an absolute necessity in any modern economy.937 Only when secured creditors, having usually the largest claims and possess most business sense, are involved in the collective bargaining, the objective of asset value maximisation may be reached and a potential rescue gets a real chance.938

12.4. Including secured creditors Secondly, there is the possibility to generally include secured creditors in the process for a specified short period of time, during which the administrator seeks to sell the debtor enterprise as going concern, to negotiate a reorganisation plan or to sell assets piece-meal.939 During this period, the secured creditors` interest in the collateral should be protected940 against erosion, waste and improper conduct, supplemented with a right to accrued interest 937 Baird/Jackson-Corporate Reorganisations, 117; Balz-Sanierung, 26 938 Balz-Russia, 40 939 See for US-Bankruptcy Law: Baird-The Elements, §8(c) 940 E.g. US-Bankruptcy Code § 362(d)(1) gives the court the right to grant relief from the automatic stay, when the collateral is not adequately protected


224

on their claim.941 Thereby, the law should avoid any interference with actual value of the secured claims. Value of secured claims means in that way not only the amount of the underlying claims, but also the relative value which provides the concrete security interest.

12.4.1. Protecting the collateral

One way of protecting the value of the secured claim is to shield the value of the collateral itself, on the understanding that, upon liquidation, the proceeds of the sale of the collateral will be directly distributed to the secured creditor. Frequently found means to obtain such a protection is the granting of compensation for any depreciation occurred during stay942 and the payment of interest during the stay943, but only to the extent that the respective creditor is over secured and the protection and compensation for use and sale of collateral.944 When the administrator fails to sell the business or part of it, when the bid does not exceed the amount of the secured creditors claim upon the expiration of such a temporary stay and when the administrator or liquidator cannot guarantee the protection of the collateral, the secured creditor should have the right to immediately enforce his contractual rights and to recover its collateral. This is usually reached by a clause945, allowing the secured creditor to file for a lifting of a stay under such circumstances. 946 Modern Western laws947 protect the secured creditor’s interest in specific collateral through requirements of adequate protection, stay relief to enforce security interests on pledged assets, compensation for depreciation948, interest accrual for the over-secured creditors, and various other methods.949 Another technique of protecting the secured creditors claim is preserving the value of the asset used as security. The asset is valued upon the commencement of proceedings; the

941 Baird/Jackson-Corporate Reorganisations, 97 942 E.g. Croatian Bankruptcy Code, Art.80 943 E.g. Romanian Insolvency Code, Art.37; Bulgarian Commercial Code, Art.724 (1) 944 IMF-Report, 26 945 E.g. US-Bankruptcy Code § 362(d)(1) gives the court the right to grant relief from the automatic stay, when the collateral is not adequately protected 946 Averch-Lien Stripping, 82 947 E.g. US-Bankruptcy Code § 361; German Insolvency Code, § 169 948 German Insolvency Code, §172 grants the administer the right to use the encumbered asset but obliged him at the same time to compensate the secured creditor respectively 949 Averch-Lien Stripping, 82


225

amount based on this valuation remains fixed throughout the proceedings and is finally distributed as first priority claim to the secured creditor.950 This approach is to a certain degree pursued by several jurisdictions951 under examination but they do usually not grant a first priority to secured creditors.

12.4.2. Arguments for the inclusion and protection

The obvious advantage of this option is the maintenance of the pari-passu principle among all creditors in order to maximise the recovery for all of them. On the other hand, this approach renders the rights of secured creditors and their ability to recover debt less certain, what results economically in a higher pricing of credit.952 A more factual argument is that in modern credit systems the encumbered assets of participants reach often 75% of the available assets or even more. To exclude secured credit from insolvency proceedings would render the process unnecessary.953 Furthermore, a stay of secured creditor action is tolerable when the general law on secured credit allows creditors to “over secure” themselves, in other words, to take a substantial higher value of collateral than the amount of the underlying claim and thus being protected from delays and depreciations during the stay.954 Others955 suggest that secured creditors should be only affected from insolvency proceedings of its debtor when there is a prospect of rescue. Where it is clear that the corporate debtor will be liquidated piecemeal, the rationale of saving key assets is no longer relevant and thus proceedings should only affect unsecured creditors. Nevertheless, this approach requires under a unitary system, that until a decision is made whether to liquidate or reorganise the insolvent debtor, the general commencement effects should also be extended to secured creditors.956 Furthermore, a general inclusion of secured creditors in the insolvency process encourages the debtor to volunteer in a prospective rescue process. This in turn, is crucial to initiate the 950 IMF-Report, 27 951 E.g. Russia, Poland and Hungary; for a more detailed discussion on the priority ranking of secured credit for those countries see, D.VI.2.1. 952 WB-Towards Principles, 19 953 Balz, Schiffman, 69 954 Balz, Schiffman, 25; according to Lowitzsch/Pacherowa-Das novellierte polnische und slowakische Insolvenzrecht, 216 is this expected in Poland after the recent introduction of a stay under the Polish Bankruptcy Code 955 ADB-Report, 35 956 ADB-Report, 97


226

highly desirable rescue of enterprises since usually mainly the debtor initiate’s rescue-type proceedings. The inclusion and protection of secured creditors might be also justified from another point of view. Generally, secured creditors are interested in speedy proceedings to be satisfied from the proceeds of the collateral hold. They usually favour outright liquidation over any long-lasting rescue attempts. General creditors and shareholders, on the other hand, favour naturally rescue proceedings, since it may increase prospects of higher returns. Consequently, the inclusion of secured creditors in the process may be usually in the favour of general creditors, subordinated creditors and shareholders.957 Therefore, it is fair, to require a contribution from them in the form of additional compensation and interest payments to secured creditors as described above.958 With other words, market conformity requires that those interested in delay and inclusion pay those who are interested in avoiding it. That in turn reduces the incentive for junior classes to prolong proceeding.959 The underlying economic theory is that the outcome of insolvency proceedings should reflect the pre-insolvency entitlements among participants and thereby provide for market conformity.960 Rights, established outside insolvency, should be recognised and protected, in both their existence and value.961 A security interest provides its owner with the comfort to seize and sell the collateral and acquire the proceeds of the sale when the debtor fails with his repayment obligation. This right can be expressed in monetary terms and it is usually referred to as “time value” of the security interest.962 Any delay or other interference with the right of the secured creditor, to seize and sell the collateral, leads to value depreciations of that right and is thus not consistent with the principle of market conformity. In cases where the automatic stay is imposed on secured creditors the insolvency law interferes with the pre-insolvency rights of the secured creditor by deteriorating the time value of the pre-insolvency security interest. In order to rebalance the consequences on the time value of this right, the law should provide for compensation for the loss. Compensating the secured creditor thereby means to put him financially in a situation, where he would be without the interference by the insolvency law. This in turn suggests the payment of interests, the compensation for depreciation of value during the stay or the compensation for the use of collateral.963

957 Baird/Jackson-Corporate Reorganisations, 129 958 Balz-Logik und Grenzen, 1441; Baird/Jackson-Corporate Reorganisations, 129 959 Balz-Market Conformity, 175 960 See B.I.3.1. 961 Balz-Market Conformity, 174 962 For the valuation of the secured creditor’s right see: Baird/Jackson-Corporate Reorganisations, 114 963 Baird/Jackson-Corporate Reorganisations, 115


227

12.5. Examples The former Russian liquidation procedure (1992) excluded collateral from the insolvency estate and did consequently not impose any stay on secured creditor action.964 The only exception in insolvency proceedings was in a moratorium connected with external administration, but the stay was only temporarily for a maximum of 18 months.965 The new Bankruptcy Code (1998) does now include security in insolvency proceedings966 and imposes a stay on any creditor action967. However, once insolvency proceedings are commenced, secured creditors lose their pledge rights in rem against specific assets of the debtor.968 In return, secured creditors obtain a preferential right to recover ahead of general unsecured creditors but behind administrative costs969, personal injury and wage claimants.970 All secured creditors participate in the distribution of the proceeds on a pro rata basis, without regard as to whether they had held primary or subsequent security interests in the specific property of the debtor. A third priority is only granted in the amount of the value of the assets originally encumbered by the security interest. Any excess claim amount would be treated as a fifth priority general unsecured claim. The major obstacle for secured creditors is the provision that imposes a stay on any individual enforcement action and at the same time, stripping collateral under the distribution scheme, without providing for the lifting of the stay.971 However, the Russian Bankruptcy Code attempts to protect value of the secured claim through a provision, granting secured creditors priority over general unsecured creditors.972 Generally speaking, the statutory disregard for the property interest in the collateral itself may not necessarily mean that the Russian law is unfair to secured creditors and may result in the same or even greater recovery for a secured creditor than results from many Western systems.973 The loss of the interest in the specific collateral results only in a reduced recovery for the secured lender, when the payment of the claims with super, first or second priority diminish the amount distributable to secured creditors to less than the fair market value of the security interest. The separation of secured claims and respective property rights to the collateral in the case of insolvency may on the other hand support the rescue policy and hence, in doing so foster

964 Balz-Russia, 22 965 Balz-Russia, 39 966 Russian Bankruptcy Code, Art.103, 104 967 Russian Bankruptcy Code, Art.11 (4), each stage of the insolvency proceedings has similar stay provisions. See Russian Bankruptcy Code, Art. 57, 69, 98 968 Russian Bankruptcy Code, Art.109 (3) 969 Russian Bankruptcy Code, Art.106 (1) 970 Russian Bankruptcy Code, Art.106 (2) 971 EBRD-Summary of the Russian System, 6 972 Averch-Lien Stripping, 85 973 Averch provides an illustrative example: Averch-Lien Stripping, 85


228

reorganisation – a policy particularly crucial in transition economies.974 Under the Russian system, originally encumbered (key-) assets are in insolvency proceedings freely available for rescue or reorganisation attempts. The Polish Bankruptcy Law originally did not include secured creditors in insolvency proceedings, but granted the secured creditors a right to realise their security rights outside the insolvency process.975 However, the Polish legislator recently amended the law and now includes secured creditor in the proceedings.976 Similar to the Russian regulation, secured creditors loose their interest in the individual collateral at the opening of proceedings in the exchange for a third priority claim in the estate.977 Nevertheless, the Polish bankruptcy regime still excludes secured creditors from arrangements with the debtor and allows such proceedings only with non-preferential creditors.978 According to the Hungarian Bankruptcy Code979, security agreements are terminated with the opening decision, the respective collateral is returned to the administrator and secured creditors receive as compensation for the loss of their collateral a third priority in the distribution of the proceeds of the liquidation.980 The Romanian law generally includes secured credit in proceedings, but does not provide for an explicit provision, providing for the lifting of the stay in respective circumstances. Differently to the above mentioned insolvency laws, the Romanian Insolvency Code981 separates security generally from other unsecured assets of the debtor in the distribution process and assigns the proceeds from the liquidation of the collateral directly to the respective secured creditor, with the effect that the secured creditor will be satisfied prior to all other unsecured creditors. Furthermore, the Code982 allows for the accrual of post-petition interest on secured claims.

974 Averch-Lien Stripping, 88; See also the previous discussion C.II.2. 975 Bickford-Law Reform, 948; Lowitzsch/Pacherowa-Das novellierte polnische und slowakische Insolvenzrecht, 216 976 Lowitzsch/Pacherowa-Das novellierte polnische und slowakische Insolvenzrecht, 216; Dziennik Ustaw 1998, No. 117, item 756; Polish Bankruptcy Code, Art.150 §2 977 Lowitzsch/Pacherowa-Das novellierte polnische und slowakische Insolvenzrecht, 216; Polish Bankruptcy Code, Art.204 (2b); See also the discussion on priorities D.VI. 978 Polish Bankruptcy Code Art.171 979 Hungarian Bankruptcy Code, Art.38(5) 980 Hungarian Bankruptcy Code, Art.57(1)(b) 981 Romanian Insolvency Code, Art.106 982 See: Romanian Insolvency Code, Art.37


229

The Bulgarian Commercial Code983, the Czech Bankruptcy and Composition Act984 and the Croatian Bankruptcy Code985 similarly include secured creditors in proceedings and preserve the interest of the secured creditors in the actual collateral during the insolvency process. The Slovakian Bankruptcy Code986, on the other hand, excludes collateral generally from proceedings and permits secured creditors to seize and sell their collateral outside the collective provisions of the insolvency process.987 The Indonesian Bankruptcy Law988 provides that secured creditors are generally entitled to enforce their rights regardless of the insolvency proceedings. However, for a limited period of up to ninety days from the court’s declaration of insolvency, secured creditors will generally not be entitled to enforce their security rights.989 This grace period may serve to maximise the asset value of a debtor enterprise or to improve the environment for rescue negotiations among the participants.990 The new German Insolvency Code991 now includes secured creditors generally in proceedings and provides the administrator with the corresponding right to remain encumbered assets in the estate.

983 Bulgarian Commercial Code, Art.722(1) 1 984 Czech Bankruptcy and Composition Act, Section 28 985 Croatian Bankruptcy Code, Art.81 986 Slovakian Bankruptcy Code, §14 (1)(c), 28 987 See also: Lowitzsch/Pacherowa-Das novellierte polnische und slowakische Insolvenzrecht, 216 988 Indonesian Bankruptcy Code (1998), Art.56; Kilgus-Das neue indonesische Insolvenzrecht, 49 989 Indonesian Bankruptcy Code (1998), Art.56 A (1) 990 Kilgus-Das neue indonesische Insolvenzrecht, 49 991 German Insolvency Code, §166; see also Gerhardt-Verfügungsbeschränkungen, 166; for the underlying reasons for the change of the German law see: Allgemeine Begründung des Regierungsentwurfes, BT-Drucksache 12/2443, 72f, 80f; Uhlenbruck-Neues Insolvenzrecht, 64; Gottwald/Adolphsen-gesicherte Gläubiger, 805


230


231

IV. Role of the Administrator

1. Rights to propose and recommend an administrator The insolvency administrator should be generally appointed by the court out of an available list of qualified professionals. However, in order to strengthen their influence over proceedings, creditors should have the right to propose an administrator of their own choice for the appointment or otherwise a right to recommend the replacement of an already appointed administrator with their own candidate.992

2. Rights to dismiss and replace an administrator Out of the same reasons, the law should generally provide creditors with the authority to dismiss and replace an existing administrator. Nevertheless, such provisions bear the risk that it may refer too much power to a majority class of creditors, since such provisions enable them to appoint their “own” administrator. In Germany, for example, the Insolvency Code993 provides for the right of the (main secured) creditors (Banks) to petition for the removal of the appointed administrator and to replace him with somebody of their own choice. Now, banks may propose their “own” administrators which could affect and possibly impair other creditors. However, the court has the right to refuse unsuitable or biased administrators. Similar concerns exist also in transition economies: the Slovenian legislator, for example, was reluctant to grant creditors wide powers in order to drive proceedings since they fear a dominance of major creditors (especially banks) which could lead to the distortion of the conduct of proceedings in their own favour. 994 Generally, as understandable as this argument is, it could be made in relation to any democratic institution.995 A solution is probably a provision, granting minority creditors a right to appeal against the appointment or performance of the newly appointed administrator and, simultaneously, grant them the right to propose their “counter-administrator” with the responding authority of the

992 E.g. Romanian Insolvency Code, Art.17 (1), (2); Russian Bankruptcy Code, Art.71; German Insolvency Code, §57; the Polish Code appears not to deal with this matter. 993 German Insolvency Code, §57 994 Deloitte-Restructuring, 17 995 Deloitte-Restructuring, 18


232

court to accept this proposal when its seems to be in the interest of the impaired creditor minority. Furthermore, provisions, which strengthen the civil and criminal liability of administrators, may reduce the risk of a biased conduct of the administrator towards certain creditors. 996 Examples The Russian Code (1998)997 provides the creditors` meeting with the power to remove the external administrator with the simultaneous approval of the candidacy of a new external administrator. The appointment is generally subject to appeal.998 According to the Romanian Insolvency Code999, the syndic judge may replace the administrator or liquidator after a respective application from creditors, or on its own discretion. Any creditor who is dissatisfied with the decision may contest against the appointment within 5 days.1000 The Polish Bankruptcy Code1001 grants the court the sole authority to replace the official receiver in the case he does not perform his duties properly. Under Polish law seems to exist no right for creditors to initiate the removal of the official receiver.

3. Interim administrator As mentioned before1002, the law may provide for interim protective measures to protect the assets of the debtor for the time until a regular administrator is appointed. The interim administrator will usually have similar powers as a regular administrator and is consequently charged with the task to take immediate measures to safeguard the future estate. Examples The Russian Code (1998)1003 for example, provides for an interim administrator taking over the execution powers of the debtor enterprise. However, the Russian concept of observation remains the existing management in place and restricts only certain activities without the

996 E.g. for Indonesia see Kilgus-Das neue indonesische Insolvenzrecht, 49 997 Russian Bankruptcy Code, Art.73 (1), 83 (4), with a similar situation for the bankruptcy liquidator, Art.116 998 Russian Bankruptcy Code, Art.73 (4) 999 Romanian Insolvency Code, Art.20, 22 1000 Romanian Insolvency Code, Art.17 (2) 1001 Polish Bankruptcy Code, Art.101 §1 1002 See D.II.7. 1003 Russian Bankruptcy Code, Article 59; see for criticism on the old Russian Code (1992) and the absence of special rules on provisional measures: Balz-Russia, 21


233

consent of the interim administrator.1004 The observation follows the concept of power sharing, while a following external administration removes the existing management completely.1005 The interim administrators main functions are to identify the creditors and notify them of the commencement of bankruptcy proceedings; quantify their claims; prepare an analysis on the financial condition of the debtor for submission to the court; approve or challenge certain types of transactions of the debtor and take measures to secure the debtor's property.1006 Furthermore, he has to initiate the first creditor meeting1007 and will be replaced by an elected external administrator or by a liquidator, when the court recognises the debtor as bankrupt without prospects of reorganisation.1008 Similar provisions contain the Romanian Insolvency Code1009, the Bulgarian Commercial Code1010 and the Slovakian Bankruptcy Code1011, providing the syndic judge or the court with the power to designate an interim administrator until the regular administrator is elected in the first creditor meeting.1012 The Polish Bankruptcy Code, on the other hand, provides generally for the possibility of an interim court order1013 before the opening decision, but does not provide explicitly for an interim administrator.

4. Rights, duties and liabilities of the administrator The administrator, as well as the liquidator in liquidation proceedings, plays a central role in insolvency proceedings. He is usually trusted with large estates and asset pools and is in the centre of a varying legal and economical decision-making process. Because of the key position of the administrator within the proceedings and in the field of conflict between debtor and the varying creditors, the law should clearly spell out the rights and duties1014 of the administrator.

1004 Russian Bankruptcy Code, Article 58; See: EBRD-Summary of the Russian System, 7: Management will have no power to decide on reorganization or liquidation, creation of subsidiaries or participation in other companies, establishment of branches and representative offices, payment of dividends, placement of bonds or other securities, withdrawal of a share of any shareholder or acquisition by the debtor of its shares owned by any shareholder. Various other transactions, e.g. transactions with immovable property or disposal of other property valued at more than 10 % of the aggregate book value of the companies assets, may require the consent of the interim administrator. 1005 See D.III.5. 1006 Russian Bankruptcy Code, Art.61, 62 1007 Russian Bankruptcy Code, Art.64 1008 Russian Bankruptcy Code, Art.67 (4) 1009 Romanian Insolvency Code, Art.31 (8) 1010 Bulgarian Commercial Code, Art.666 1011 Slovakian Bankruptcy Code, §9 (a) 1012 See: Romanian Insolvency Code, Art.17; Bulgarian Commercial Code, Art.667 1013 Polish Bankruptcy Code, Art.12 1014 Romanian Insolvency Code, Art.18; Russian Bankruptcy Code, Art.20, 74


234

Furthermore, the law should provide for rules of a possible liability of the administrator and in doing so, exactly define the incidents of such a liability. 1015

5. Standards and qualification requirements of the administrator The demands on the selection of those professionals are highly important for the success of proceedings. Countries1016 have developed varying means of selection, but usually require a professional, who is legally and economically trained and experienced and personal trustworthy.1017 However, since this important issue is not in the centre of this paper, it might be left apart for further research. Finally, the law should indicate whether only individuals1018 or also legal entities1019 are permitted to serve as administrator.

1015 Polish Bankruptcy Code, Art.102 provides for liability of the official receiver in the case of unconscientiously performance of his duties; Russian Bankruptcy Code, Art.21 - non-performance or improper performance of its duties are the criteria to make the administrator subject to liability; German Insolvency Code, §§60-62; for the German law: Smid-Haftung des Insolvenzverwalters, 337 1016 E.g. Romanian Bankruptcy Code, Art.17 (4); Bulgarian Commercial Code, Art.655; Russian Bankruptcy code, Art.19; Slovakian Bankruptcy Code, §8 1017 See: Smid-Das Insolvenzverfahren, 396 1018 E.g.: Russian Bankruptcy Code, Art.19 – as administrator may serve only individuals; Bulgarian Commercial Code, Art.655 (1) – only natural persons may become receivers; Slovakian Bankruptcy Code, §8 (1) – only individuals may be selected as trustee; German Insolvency Code, § 56, only natural persons may serve as administrator 1019 E.g.: Romanian Bankruptcy Code, Art.17 (4)


235

V. Reorganisation Plan

1. Provision of information It is ultimately for creditors to gather comprehensive information on the debtor and its business in order to be in the position to consider a proposed reorganisation plan. The law should therefore lay down the type of information to be provided by the debtor and the form and the time of the provision of this information.1020 Beside information about the current financial status, additionally, the law should require projections of profit/loss, cash flow and marketing but also an analysis of causes for the financial difficulty or insolvency and details for the re-examination of past transactions. Furthermore, the law should provide for the appointment of an independent person to review the information delivered by the debtor.1021

2. Who can propose a plan Management and the owners of the debtor should have an initial right to propose a reorganisation plan.1022 The debtor management has usually the most expertise and resources to design and propose a successful plan. Furthermore, giving the debtor an initial right to propose a plan increases the chances of reorganising a troubled enterprise successfully and is consistent with general objectives of insolvency.1023 But independent advisers or administrators and creditors should also be involved in devising and negotiating a plan.1024 Since a plan will only be successful when approved by a majority of creditors, any refusal of the proposed plan by creditors would turn proceedings into liquidation, when creditors would not have a right to propose their own (counter-) plan.1025

1020 See for example: Slovakian Bankruptcy Code, §4b (1)(b); Russian Bankruptcy Code, Art.34; Polish Bankruptcy Code, Art.9 §2; Romanian Insolvency Code, Art.26; German Insolvency Code, §§20, 97 1021 WB-Towards Principles, 70; see for example the possibility to use the assistance of other professionals under the Polish Bankruptcy Code, Art.97 §2 1022 See for example Chapter 11 US-Bankruptcy Code, section 1121 provides the debtor for 120 days with the exclusive right to file a plan. After expiration of that period any party in interest may file a plan, which could be the trustee, a creditor, the creditor’s committee or a shareholder 1023 See B.I.3. 1024 WB-Towards Principles, 71 1025 The Romanian law provides in the case that several plans receive the necessary majority the debtor plan shall be confirmed by the syndic judge, Romanian Insolvency Code, Art.68 (2); a similar provision contains the Bulgarian Commercial Code, Art.704 (2)


236

As a matter of practice, the mere possibility of a creditor plan will serve to encourage the debtor to propose a plan which has a reasonable chance of receiving the necessary creditor support.1026 The Bulgarian Commercial Code1027, for example, grants additionally twenty percent of the total amount of employees the right to propose a reorganisation plan. The draft proposal to the German Insolvency Code considered a proposal right of creditor groups as well as shareholders, but was finally reduced to the debtor and the administrator.1028 Generally, the law should be not restrictive in this respect and grant all interested parties a right to propose a plan and thus encourage the creativity and resources of all parties involved. However, the law should be more restrictive in setting time limits and frames for the presentation of a plan1029, since this places desirable pressure on both the debtor and the creditors to endeavour a satisfactory arrangement. Combined with the provision that will lead to a conversion to liquidation unless a plan is agreed within a limited period of time1030, a commercial environment is created which causes both sides to work towards a beneficial result.1031 Examples Under the Russian Bankruptcy Code (1998)1032 only the administrator has the obligation and the right to develop an external administration plan. However, after the end of the observation phase the creditor meeting decides to enter in external administration proceedings and is thus decisive for the initiation of reorganisation proceedings.1033 The Romanian Insolvency Code1034 grants the debtor, creditors holding at least one third of the outstanding secured debt or unsecured debt and shareholders with at least one third of the share capital, the right to propose a plan of reorganisation. The Polish law1035 gives only the debtor a right to propose an arrangement with its creditors.

1026 IMF-Report, 51 1027 Bulgarian Commercial Code, Art.697 (7) 1028 German Insolvency Code, §218, see Allgemeine Begründung zur Insolvenzordung, BR-Drucksache 1/92, 196, Heidelberger-Kommentar, §218, 9 1029 See for example: Romanian Insolvency Code, Art.66, 67 1030 See for example: Romanian Insolvency Code, Art.69 (2) 1031 ADB-Report, 45 1032 Russian Bankruptcy Code (1998), Art.82 (1) 1033 Russian Bankruptcy Code, Art.68 (1) 1034 Romanian Insolvency Code, Art.59 (1) 1035 Polish Bankruptcy Code, Art.175 §1


237

3. Content of the plan

3.1. General In order to reorganise the insolvent or financially troubled debtor successfully, the general law has to provide for a modern legal framework, allowing and ruling different financing techniques and other measures.1036 Furthermore, the law should facilitate the quick and easy approval from certain regulatory bodies as competition control, fiscal regulation or foreign exchange control.1037

3.2. Content of a plan Western insolvency laws generally leave the contents of a reorganisation plan mainly to the market place and do not interfere with decisions made by the relevant creditor body. The underlying theory is that a reorganisation might be only successful when creditors are able to use any, under the general law, available financing and restructuring technique. However, a pre-condition therefore is that the participants are experienced with reorganisations and the respective jurisdiction has developed well-accepted rules and traditions in conduct rescues. In transition economies, a rescue culture is frequently non-existing and reorganisation proceedings may be somehow unknown to local participants. Therefore, it seems to be suitable for reorganisation provisions in transition economies to list and specify alternative means to restructure the finances and operations of a debtor enterprise.1038 Such measures could include the modification of rights of holders of claims, both secured and unsecured; the sale of substantial parts of the debtor’s assets or the debtor enterprise as a whole; the merger or consolidation of the debtor with another enterprise; the issuance of securities of the debtor for cash, for existing securities, or in exchange for other claims; and the amendment to the debtor’s charter to provide for new classes of voting securities with preferences with respect to ordinary dividends and liquidation distribution.1039 The reformed German insolvency law1040, for example, now provides even for an insolvency plan which may provide not only for reorganisation of the debtor, but also for the sale as going concern or the liquidation, depending what measure promises the highest return for

1036 Lowitzsch/Pacherova-Das novellierte polnische und slowakische Insolvenzrecht, 217 1037 WB-Rehabilitation, 25 1038 See for example: Russian Bankruptcy Code, Art.85; Bulgarian Commercial Code, Art.700; Croatian Bankruptcy Code, Art.213 1039 Bickford-Bankruptcy Law Reform, 945 1040 German Insolvency Code, Part VI, §§ 217-269


238

creditors.1041 The underlying theory suggests that market-forces are more appropriate to determine the future of the debtor enterprise than judicial or administrative decisions. The main advantage of such a comprehensive plan is its quality as private agreement. All creditors have the chance to participate in the plan negotiations and are thus able to input their interests respectively. Furthermore, its character as a private agreement may increase the overall acceptance among participants. However, German practitioners assume that only in 5-8% of all insolvency cases a plan will be drawn and the remaining cases will be dealt with in ordinary liquidation proceedings.1042 Moreover, the plan should be able to foster and stimulate competition among different methods available to deal with the insolvent debtor. On one hand, the plan should be open for all available techniques and measures which may serve objectives of insolvency. As mentioned before, on the other hand, the law should allow the proposal of competing plans in order to make use of different resources and creativity of the participants.1043

3.3. Debt to equity conversion In order to serve the objectives of insolvency and strengthen the position of creditors in the process, the insolvency regime should provide for a debt to equity conversion. The merit of this procedure is that it replaces the bargaining among creditors, who have naturally different objectives with a vote by a homogenous group of shareholders.1044 In a debt-equity swap, the debts of an insolvent enterprise are cancelled and the former creditors become shareholders of the debtor corporation. A decision about the debtor’s future, whether it should survive as going concern or being closed down or restructured, is made by the new shareholders. Such a provision is consequential since decision-making powers have already moved from the debtor (management and shareholders) to the creditors.1045 Such a conversion might be straightforward where only one class of creditors (e.g. unsecured creditors) exist. Their portion on the issued shares is measured according to their share in the debt. More problematic is the situation where different classes of creditors (e.g. secured, unsecured or priority creditors) are involved, since it might be unclear to what fraction of the debt each group is entitled to.1046

1041 A similar system provides the Romanian Insolvency Code, Art.59 (2) 1042 Eidenmüller-Unternehmenssanierung, 51 1043 Eidenmüller-Unternehmenssanierung, 62; see the examples at D.V.2. 1044 See as proposal for a general alternative procedure (Aghion-Moore-Hart procedure) to the usual reorganisation procedure: Aghion-Improving Bankruptcy, 861 1045 Balz, Schiffman, 69: one of the features of insolvency is that corporate governance shifts from the debtor to its creditors. 1046 WB-Economic Dimensions, 5


239

Some commentators1047 even suggest replacing the whole conventional insolvency process by a procedure where all existing debt is exchanged into equity; the former creditors become shareholders and then putting the company’s future to a simple vote. This procedure is expected to overcome some deficiencies of the usual insolvency process.1048 As a correlative, former creditors shall have options to repurchase their equity for a pro-rata value of the debts for the case that the equity is worth more then the debt on a pro-rata basis.1049 In a transition economy, a debt to equity conversion may be contrary to the governmental policy not to privatise certain enterprises and more importantly, not to loose control over key industries to foreign investors. Many foreign investment legislations in those countries provide for barriers on foreign investment. The legislator should balance both policies and bring existing investment laws in line with the rescue regime. Another obstacle with existing reorganisation laws is that they often exclude debt write-offs or they impose limitations and restrictions on it. A debt write-off might be only possible when the debtor pays preferential creditors in full1050 or a certain percentage of the non-preferential debts upfront or within a specified period.1051 Furthermore, secured and priority creditors are often exempted from provisions allowing debt write-offs.1052

3.4. Examples Under the Russian Bankruptcy Code, a plan may encompass a change in the type of activity of the debtor, closure of unprofitable production, liquidation of receivable accounts or the transfer of debtor's claims, sales of portions of the debtor's property or even the sale of all of the debtor's business.1053 In case of such a block sale, the purchaser must assume all agreements, rights and liabilities concerning the debtors' employees.

1047 Aghion-Improving Bankruptcy, 861 1048 Aghion-Improving Bankruptcy, 861 1049 Bebchuk-A New Approach, 799 1050 Polish Bankruptcy Code, Art.174: an arrangement is only admissible where a guarantee for preferential debtors exists 1051 Vitrjaanskij-Länderbericht, 248: Under the old Russian Bankruptcy Code (1992) a composition agreement was only valid when the debtor pays a minimum of 35% of the debt within two weeks from the settlement to creditors; under Czech law, the creditors have to pay within one year at least one third of the outstanding non-priority debt in involuntary composition proceedings (Czech Bankruptcy and Composition Act, Art.40 (1)(e)), or at least 45 percent within 2 years in voluntary composition proceedings (Czech Bankruptcy and Composition Act, Art.50 (1)(d)) 1052 Deloitte-Restructuring, 7; see for example: Czech Bankruptcy and Composition Act, Art.38 (2)(a) exempts secured creditors since they are not affected from the composition 1053 Russian Bankruptcy Code, Art.85


240

The availability of debt to equity swaps to restore the debtor from indebtedness under Russian law remains uncertain. A conversion of the debt into equity only seems accomplishable through a two-step procedure as (1) acquisition of convertible bonds in exchange for a cancellation of the outstanding loan indebtedness and (2) acquisition of shares through exercise of the call option, provided for in the convertible bonds. This is because a shareholder cannot be released from his obligation to pay for shares being issued by the company, including the way of set off of an obligation owed by the company to him.1054 Nevertheless, the management of the debtor are not allowed to decide on the required issuance of such bonds after the implementation of observation proceedings.1055 It is further unclear whether an external manager or bankruptcy liquidator upon institution of external administration or bankruptcy liquidation himself has a right (with the approval of the creditors’ committee or creditors’ meeting) to adopt a corresponding decision.1056 As becomes apparent, it would be much easier and more predictable to deal with debt to equity swaps explicitly in the Russian Bankruptcy Code. The Romanian Insolvency Code1057 and the Bulgarian Commercial Code1058, on the other hand, provide explicitly for the conversion of creditor claims into shares or similar equity. Similar to the German Insolvency Code provides the Romanian Code also for liquidation and reorganisation measures under a plan.1059 The other laws1060 examined do not provide for modern reorganisation proceedings, but rather for a composition or arrangement. They do not mention the possibility of a debt to equity swap.

1054 See: Russian Civil Code, Art. 99 (2), Federal law on Joint-Stock Companies, No. 208-FZ of December 26, 1995, Art.34 (2), EBRD-Summary of the Russian System, 12 1055 Russian Bankruptcy Code, Art.58 (3) 1056 EBRD-Summary of the Russian System, 12 1057 Romanian Insolvency Code, Art.65 (a); EBRD-Summary of the Romanian System, 2 1058 Bulgarian Commercial Code, Art.700 (2) 1059 Romanian Insolvency Code, Art.59 (2), 60, 65 1060 Polish, Czech, Slovakian and Hungarian bankruptcy laws


241

4. Considering diverse interests in the voting system

4.1. General As mentioned earlier1061, major advantage of a plan is that a certain quorum of creditors can through their respective voting also legally bind dissenting creditors.1062 In that way, the plan is the instrument to balance the different interests existing among different creditors.

4.2. Voting system Generally, every creditor should have the right to participate in the voting process and should therefore obtain respective voting rights.

4.2.1. Necessary majorities

Voting rights should be generally according to the amount of debt owned; and a simple majority vote should bind all creditors. The quorum and the necessary majority should be determined with respect to claims represented – not claims existing.1063 Likewise, the effect of a majority vote not to approve a plan should result in the immediate liquidation of the creditor.1064 The prospect that a debtor will be liquidated unless an agreement can be reached produces a powerful incentive for the efficient operation of the reorganisation process. The law should avoid requiring qualified majorities1065 or unanimity where it seems to be not necessary. The negative consequences of provisions, where creditor unanimity is required to agree debt write-offs, were seen in Hungary after the 1992 insolvency reform. Filings increased considerably after changes in the law but only few reorganisation plans have been agreed,

1061 See C.III.4.5. 1062 E.g. Polish Bankruptcy Code, Art.194; Romanian Insolvency Code, Art.69 (1) 1063 Balz, Schiffman, 70; E.g. Romanian Insolvency Code, Art.67 (6) requires a simple majority in value of represented claims in each class; Russian Bankruptcy Code, Art.83 (3) provides that the plan be considered as approved if supported by more than half the represented creditor votes; similar Bulgarian Commercial Code, Art.703 (4) 1064 E.g. Russian Bankruptcy Code, Art.83 (4) 1065 Polish Bankruptcy Code, Art.186, for example, requires a vote of the majority of creditors representing two third of the general value of debts to adopt an arrangement; Czech Bankruptcy and Composition Act, Section 38 (1) requires a vote of more than three quarters of all filed claims; Hungarian Bankruptcy Code, Section 19 (4), 9 (4) requires a two third majority of the outstanding debts and additionally half of the creditors to agree to a composition proposal


242

since economically necessary debt write-offs could not be negotiated with 100% creditor consent.1066 However, a qualified majority (e.g. two-third) might be justified when proposing certain substantial measures. Romania, for example, did require a 100% creditor approval in their old law, but abolished the provision in its 1995 new insolvency law and required a two-third-creditor majority for plan confirmation instead.1067 The Romanian Law enumerates thereby only three classes of claims.1068 The law now mandates that a plan shall be confirmed by the syndic judge if at least two of the specified three categories accept the plan with a simple majority in value in each category.1069

4.2.2. Definition of value

The principle of market conformity suggests to measure influence and voting rights according to the real insolvency value of claims and not to the nominal amount. Such a system would strengthen the position of secured creditors since a high percentage of credit is encumbered and unsecured creditors get regularly only a low dividend on their claims. Consequently, the fair market value of secured claims is much higher than the respective value of unsecured credit. However, the German insolvency reform1070 did address the issue, but retained the old system of nominal values where secured and unsecured creditors have voting rights according to the nominal amounts of their claims due to expected difficulties in the implementation process.1071

4.2.3. Finality of the voting result

The final decision of the creditors, either to reorganise or liquidate the debtor, should not be subject to further court approval, nor should the court or the relevant agency have the right to disregard any creditor decision, but the court should have the right to scrutinise that the participants have complied with the prescribed formalities and procedural rules. 1066 Deloitte-Restructuring, 27; see for more details on the Hungarian experience at D.II.5.3 1067 Romanian Insolvency Code, Art.68, 67; Ramasastry, Central and Eastern Europe, 197 1068 Romanian Insolvency Code, Art.67 (4): secured creditors, creditors mentioned in Art.108 (3)(6) (certain labour contracts and sustenance obligations) and unsecured creditors 1069 Romanian Insolvency Code, Art.67 (6), 68 (1) 1070 Balz-Russia, 42; Maus-Insolvenzplan, 707 1071 Balz-Market Conformity, 175


243

However, in the Philippines, the Securities and Exchange Commission (SEC), acting in an extra-judicial capacity, has a unique extraordinary power to set aside the decision of the creditors not to approve the proposed rescue plan. In this way, the SEC can, in effect, impose a plan upon creditors if it is of the opinion, that the “non-approval-decision” of the majority of creditors is “manifestly unreasonable”.1072 That runs quite contrary to the general standards which grant creditors wide reaching powers to determine the future of the debtor. However, under the unique situation of a transition economy, such a provision may provide a means to implement other pressing government policies.1073 The SEC could use the provision, for example, in the restructuring process of financially struggling SOE’s and other important industries and thereby shifting the burden of the reorganisation process further to their creditors. Nevertheless, one should be aware of the possible negative consequences of similar provisions, since they tremendously affect the predictability and risk assessment of investments. The Polish reorganisation law refers to the court and the judge-commissioner wide discretions in order to approve arrangements between the debtor and creditors.1074 Both the court1075 and the judge-commissioner1076 have the right to reject an approval on several grounds. The court, for example, may refuse to approve the arrangement where it conflicts with decency or public order.1077 In addition, the court may reject the approval of the arrangement on the grounds that the conditions of the arrangement are too disadvantageous to the creditors who have voted against the arrangement.1078 Furthermore, the Polish law excludes secured and preferential creditors from arrangement proceedings and allows arrangements only between the debtor and non-preferential creditor.1079

4.2.4. Secured creditors in the voting process

Secured creditors should participate in the proceedings and should vote on the plan when the rescue proposal affects their rights.1080 Considering the situation of secured creditors in the process, there would normally not be a need to grant them voting rights, since their interests 1072 ADB-Report, 47 1073 See B.I.3.11/12. 1074 A similar provision contains the Czech Bankruptcy and Composition Act, Section 40 1075 Polish Bankruptcy Code, Art.191-192 1076 Polish Bankruptcy Code, Art.177-178 1077 Polish Bankruptcy Code, Art.191 (3) 1078 Polish Bankruptcy Code, Art.192 1079 Polish Bankruptcy Law, Art.171 1080 See for example: Croatian Bankruptcy Code, Art.219, 234 secured creditors shall generally not been affected by a plan, but only if they are affected shall they participate in the voting process


244

will not be impaired by the plan. Traditional composition plans1081 did usually not include participation of secured creditors and entitled them to receive full payment on their claims upon the plans approval. Taking into account that such a solution may reduce the chances of a successful reorganisation, a participation of secured creditors is necessary. By way of example, it may improve chances for a successful rescue to keep key assets, which are encumbered with security interests within the business, rather than returning them or the resulting value to the respective secured creditor. The question of whether a plan should be imposed against the consensus of a secured creditor, is somewhat difficult to answer and is dealt with a great variety among jurisdictions. Some favour automatic imposition of a plan on all secured creditors, if a certain majority of a secured creditor class has voted affirmatively for a plan. Others favour no imposition other than by consensual arrangement. A middle course approach is one which only imposes a plan upon a dissenting secured creditor if a court makes an order to that effect. In such a case, the proponent has generally to prove that the security interest will be deteriorated or the value of the collateral affected. Generally, one has to consider that the position is far different from the decision whether to impose on secured creditors some form of temporary stay.1082

4.2.5. Voting in classes

The varying interests of different types of creditors should be reflected in the voting system by introducing different classes or categories of creditors. To address this problem, many jurisdictions have introduced a voting system divided into several classes.1083 This concept is based on the fact that different types of creditors have different rights and interests. Secured creditors, for example, may have only an interest in a short-term recovery of their exposure1084, while unsecured creditor may have a long-term interest to reorganise the debtor enterprise in order to receive a higher payment as in liquidation.1085 Other creditors (e.g. suppliers, ongoing trade creditors) may have an interest in keeping the debtor enterprise in the market, since they expect further economical

1081 Secured creditors are for example excluded from voting on a plan under: Czech Bankruptcy and Composition Code, Section 38 (2)(a); Slovakian Bankruptcy Code, Section 38 (2)(a) 1082 ADB-Report, 98 1083 See for example: Bulgarian Commercial Code, Art.703 (2), which provides for 5 separate voting classes; the Romanian Insolvency Code, Art.67 (4), provides for 3 classes; Croatian Bankruptcy Code, Art.218 (1) provides for 3 classes with the option that employees may form a separate class if their claims are substantial 1084 Baird/Jackson-Corporate Reorganisations, 106 1085 Baird/Jackson-Corporate Reorganisations, 107


245

advantages from an ongoing business relationship.1086 However, a majority of secured creditors may be willing to accept “haircuts” when they can improve the viability of the debtor in the long-term. But also priority creditors, like employees, may have a strong interest in the survival of the debtor, rather than insisting on immediately full payment of outstanding salaries. The collective nature of the proceedings has the consequence that individual interests of the claimants are diverse and frequently contrary to each other and, therefore, the best interest of all claimants as a group may be not conform with the individual interests of the different claimants. To the extent that majority support is obtained from each of these classes, all secured creditors and priority creditors would be bound by the terms of the plan. In these circumstances, the law should require that any dissenting creditor is entitled to receive at least as much as he would have received under liquidation (best interest test).1087 Some jurisdictions1088 have additionally introduced “cram-down” provisions, to further enhance the chances of a reorganisation. These provisions provide that even the majority vote of one class can bind other dissenting creditor classes. To protect mainly secured and priority creditor and to remain priority rules established in liquidation procedures, they apply the “absolute priority rule”.1089 According to this rule, a dissenting class of creditors may not involuntarily receive less than the full value of their claim if creditors of a junior class receive any value.1090 Beside the many advantages of this system, the introduction of voting in classes complicates the process and makes it less predictable. Especially, where jurisdictions provide for several classes of unsecured creditors (trade creditors, unsecured finance creditors etc.), authorities need wide discretion to establish classes and to assign creditors to a certain class. That requires frequently economical expertise and the understanding of interests from creditors involved. Since especially in transition economies these resources within the judiciary and other related professions are limited, those countries should carefully consider the introduction of a high number of different voting classes.1091

1086 IMF-Report, 55 1087 EBRD-Summary of the Romanian System, 7: However, a similar pre-existing provision in the Romanian Code has been eliminated under the 1999 amendments. 1088 E.g. US Bankruptcy Code, § 1129; German InsO, § 245 1089 For the absolute priority rule see already B.I.3.2.2. 1090 E.g. US Bankruptcy Code, § 1229(a)(9); German Insolvency Code, § 245 (1) 2, (2) 2 1091 IMF-Report, 56; the Romanian legislator, for example, reduced the available creditor classes to three: (a) secured creditor, (b) certain privileged creditor and (c) unsecured creditor, Romanian Insolvency Code, Art.67 (4)


246

Shareholder consent may be required by constitutive instruments or the company law when an alteration of the equity structure is proposed. However, some laws modify such rules of the company law and accept a plan even against objections of shareholders.

5. Protection of impaired creditors As mentioned before, the voting process includes basically two methods protecting dissenting creditors. Firstly, as a general rule, the best interest test provides for the protection of dissenting creditors in the way that a plan is only confirmed and thus binding on all participants, if all creditors will receive at least as much under a plan as under an outright liquidation.1092 Secondly, the absolute priority rule provides that creditor classes, which are overruled by a voting of other creditor classes, shall not be forced to receive less than the full value of its claims if according to the plan creditors of a junior class receive any value. For this purpose, seniority is based on the ranking applicable in liquidation.1093

6. Participation of foreign investors Particularly in times of financial distress and crisis, transition economies might experience a lack of financial and operational domestic resources to facilitate the restructuring of domestic enterprises. Only the participation of foreign investors may provide the necessary funds or other investments. However, transition economies are traditionally resistant to foreign investment, out of the fear, that foreigners may control substantial parts of the domestic economy. A successful reorganisation process may therefore require the removal of limits and restrictions on foreign investments, while the latter policy requires remaining such rules. Furthermore, the law should generally be accessible to national and foreign debtors and creditors alike. The law should therefore not separate between nationals and foreigners. In transition economies, however, it may be even necessary or at least advantageous to explicitly grant foreign creditors the right to formally participate in the insolvency proceedings on an equal basis with domestic creditors.1094

1092 E.g. Croatian Bankruptcy Code, Art.247 1093 IMF-Report, 53 1094 See for example: Russian Bankruptcy Code, Art.11 (1), 1 (6), which explicitly grants foreigners (legal entities and individuals) a right to participate as creditor in bankruptcy proceedings; the Polish Bankruptcy Code, Art.152 §2 states that foreign creditors shall set a residence address for service in Poland and thereby indirectly permit participation of foreign creditors; the Bulgarian Commercial Code, Art.616 (3) provides explicitly for the equal treatment of foreign creditors with domestic creditors in bankruptcy proceedings


247

VI. Priorities and the Treatment of Secured Creditors

1. General remarks All insolvency laws should incorporate provisions providing for a ranking between different categories of creditors. That seems not to be straightforward, since one of the main objectives of insolvency law is the equal treatment of creditors.1095 However, the equal treatment shall only apply to similar situated creditors and the ranking shall reflect the different positions or the different bargaining power1096 of creditors. A main policy choice, when designing or redesigning any insolvency regime, is the priority given to diverse creditors in regard to the distribution process of debtor assets. A different treatment of diverse creditors for distribution purposes does not necessarily violate the pari-passu clause since creditors have different bargaining power deriving from their different positions obtained prior to insolvency proceedings of the debtor. As a general rule, the hierarchy of claims established outside insolvency, or the rule of absolute priority, should be possibly maintained in insolvency. Where an insolvency regime disregards the terms of pre-existing contracts, perverse incentives for the abuse of the process may be created. Generally, senior claims should therefore be paid in full before more junior claims (including equity). Clear rules for ranking the priority of both existing and post-petition creditor claims are important in order to provide clarity to lenders, who may be deterred if there is uncertainty as to where they stand in the event of insolvency proceedings.1097 However, as will be discussed in more detail in due course, the traditional privileges and priorities for certain pre-insolvency creditors may revalue or re-inflate claims by the very fact of insolvency and thereby, redistribute wealth under a presumed standard of equity.1098 Furthermore, priority rules are an important tool to control creditor behaviour and to achieve desirable macroeconomic, social and political goals. By the way of example, granting secured creditors a high priority means encouraging secured credit.1099 Some jurisdictions do not only grant a variety of priorities, they also include them in different legislation. Poland, for example, in addition to the priorities listed in the Bankruptcy Act, grants priorities to creditors in the Civil Procedure Act. The law should be clear in this point 1095 See B.I.3.3. 1096 See Jackson-Bankruptcy, 858; Baird-The Uneasy Case, 128 1097 G22-Report, 46 1098Balz-Market Conformity, 171


248

and list priorities exclusively in the insolvency law or refer in it to priorities contained in other laws.1100 Another negative example in this concern appeared from the Romanian insolvency regime.1101 Romania granted taxes and governmental charges high priority outside the Romanian Insolvency Code, which did possibly exceed the priority granted to secured credit. Since tax and other administrative liabilities were substantial, the Romanian legislator had to clearly point out how the actual priority ranking among competing creditors is. This obstacle was partly removed with the 1999 amendment of the Law. For claims of the state, emerging from taxes, fines, and other sums that represent public income, Romania introduced a fourth priority in the priority ladder of the Code.1102 However, another provision1103 returns to the state the previous rights in the case, the assets available do not satisfy the budgetary claims considering the mentioned fourth priority of them.

2. Priority ladder In the attempt to reflect the different positions of creditors, insolvency systems have developed a ranking system of claims (priority ladder), which may provide for the level of claims of secured creditors, administrative creditors, post-petition creditors, budgetary creditors, tort creditors, employees, general unsecured creditors or subordinated creditors. This list is not concluding and intends to repeat only the most common categories. However, systems balance priorities of those categories differently and following varying policy goals. The subsequent discussion may reveal some of those policies and further intends to analyse the suitability of the priority system to reach these objectives, especially in the context of the transition process.

2.1. Secured creditors

2.1.1. First priority rule

Generally, the insolvency law must provide secured creditors with a high priority over other claims. Depending on how protection of secured claims is achieved in the proceedings1104, creditors should have a first priority claim according the claim value preserved or the value fixed. For the amount that the claim exceeds the value of the collateral, the creditor shall only have an

1099 IMF-Report, 39 1100 Deloitte-Restructuring, 10 1101 Bufford-Romanian Bankruptcy Law, 260; Romanian Ordinance No.11 of 1996; Capatina-Länderbericht Rumänien, 355 1102 Romanian Insolvency Code, Art.108 (4) 1103 Romanian Insolvency Code, Art.109 1104 Either through preserving value or through fixing value, See for a respective discussion D.III.12.


249

unsecured claim against the estate. Exceptions to this general rule should be very limited, but might be tolerable for administrative costs and post-petition credit.1105 However, others argue that the first-priority-rule of collateral shall be applicable without exceptions and that in the case administrative claims and some privileged unsecured creditors supersede secured credit, secured creditor cannot calculate in advance what their claims will be worth in insolvency. The advantage of secured credit – namely, security – would be lost.1106

2.1.2. Limitations on the first-priority-rule

Some jurisdictions1107 have considered a system, whereby secured creditors would have to give up a certain percentage of the value of their collateral for the benefit of administrative and other unsecured creditors. Critics fear, that such a system would weaken the credit system, since secured credit would become more expensive and more difficult to attain.1108 Systematically, two ways would be possible: the general limitation of secured credit1109 (fixed-fraction priority or partial priority rule) or the retention of a proportion of the collateral for unsecured creditors.1110

a. Rationale for restrictions

However, justification for such a regulation of the market might be not easy to find.1111 Generally, secured credit reduces the costs of credit, since the repayment risk of creditors decreases. A secured creditor can rely on a valuable security interest and is not only referred to the general ability of the debtor to repay (its solvency). Such a risk reduction affects the price for credit – interests rates of secured credit are generally below the rates of unsecured credit. On the other hand, however, the granting of security increases the repayment risk for the remaining unsecured creditors since secured creditors “absorb” valuable assets of the estate, originally additionally available for the satisfaction of unsecured creditors. Secured

1105 IMF-Report, 39 1106 See Smid-Das Insolvenzverfahren, 396, for the case that employee claims receive a higher priority than secured creditors. 1107 See for example Czech Bankruptcy and Composition Act, Section 28 (4) 1108 Balz, Schiffman, 69; Schwarcz-The Easy Case, 23 1109 Bebchuk-The Uneasy Case, 857 1110 Balz, Schiffman, 69: “The authorities of an Eastern European country recently considered a system whereby secured creditors would have to give up a certain percentage of the value of their collateral for the benefit of administrative or unsecured creditors.” 1111 Balz, Schiffman, 69


250

credit therefore negatively affects the remaining unsecured creditor and impairs their repayment chances in the case of the debtors’ insolvency. Secured credit can be distinguished as the granting of security for existing debt and the granting of security for new money. The first situation may impair the position of unsecured creditors, since previously available assets are “removed” from a future estate of the debtor without any comparable advantage for the remaining creditors. The latter situation is different: unsecured creditors are given a valuable asset as well – they receive the equivalent benefit in form of the proceeds of the loan or other credit. There is even a possible further gain for unsecured creditors – the new money may improve liquidity and financial stability of the debtor enterprise and thereby reduce the repayment risk for all creditors in general.1112

b. Four different scenarios

Going more into detail, one may be able to shape four different situations which may require different treatment in relation to the initial question. Collateral may be granted for new money (or credit in general) at a time when the debtor is already insolvent or at the “vicinity of insolvency” (1), or at a time where the debtor is fully solvent (2), or for pre-existing debt when the debtor is solvent (3) and finally, for pre-existing debt in an situation, where the debtor is already insolvent or at the “vicinity of insolvency” (4). The last case is frequently dealt with by preference law of the respective insolvency regimes and discussed at an earlier point.1113 In such a case, unsecured creditors are obviously prejudiced, since they loose an asset originally available for their satisfaction in the case of the insolvency of the debtor and they do not get any equivalent for the loss, since the debtor grants the security for an already existing credit. Case number three describes the situation where a solvent debtor grants a security interest for a pre-existing debt. The situation is similar to the foregoing, with the only difference that the debtor is still solvent and hence possibly able to repay creditors from the remaining pool of assets even without the collateral granted for the pre-existing debt. Nevertheless, it does affect the value of the remaining pool of assets without compensating the unsecured creditors with the inflow of a new credit. Also this situation may be more vulnerable for legislative interference.

1112 Schwarcz-The Easy Case, 3 1113 E.g. US Bankruptcy Code, § 547: trustee may avoid transfer of collateral, made within 90 days prior to the insolvency of the debtor; see for preference rules generally, D.III.10.


251

The second case, on the other hand, is different to number 3 and 4 in so far as it covers the situation where the solvent debtor grants a security interest in exchange for a new credit. One could argue that the debtor receives an equivalent for the given security interest in the form of the credit. If this would be true, unsecured creditors would be not negatively affected by the transfer of collateral, since the net value of the assets available for unsecured creditors would be the same, prior to and after the transaction.1114 However, this might be only a pure economical and theoretical explanation without taking the reality into account. The security granted has usually a predictable long-term value (mortgages), while the credit is usually money. Money is easier than most other forms of assets to hide or misuse. To prevent such misuse, most of the commentators assume, that some form of general monitoring of the debtor is desirable.1115 Some1116 of them suggest that secured creditors should be exposed to increased risk in order to encourage them to efficiently monitor their borrowers. Thereby, the risk increase could be achieved through the reduction of security by granting only a partial priority for the security interest.1117 On the other hand, one may assume that new money or other credit, which is extended in exchange for the transfer of the collateral, may decrease the default risk of the debtor.1118 Notwithstanding, whether the debtor uses the money for the extension of its operation or the mere reduction of its external indebtedness, the risk of illiquidity1119 and the following insolvency will be considerably reduced. The consequences for unsecured creditor are significant: by avoiding insolvency, unsecured creditors are paid in full, while this outcome is highly unusual in insolvency1120, even in cases with a limited impact of secured credit. Some scholars1121 assume and try to prove that the gain unsecured creditors have from the insolvency risk reduction of the debtor through the inflow of new money, may considerably exceed the disadvantage, they face by the partial loss of assets to secured creditors. This would favour a full priority rule over a partial priority rule. Another argument against a partial priority rule might be the fact that such a rule may restrict the availability of credit.1122 A partial priority rule would consequently render 25% of the

1114 Schwarcz-The Easy Case, 5 1115 Schwarcz-The Easy Case, 6 1116 Bebchuk-The Uneasy Case, 909 1117 Bebchuk-The Uneasy Case, 909: Under this partial priority rule a fixed fraction of a secured creditor’s claim would be treated as a secured claim, and the remainder would be treated as an unsecured claim. Thus, under a 75% fixed-fraction rule, 75% of a secured claim would be given full priority over unsecured claims, and the remaining 25% would become an unsecured claim. 1118 Schwarcz-The Easy Case, 8 1119 Schwarcz-The Easy Case, 8: Illiquidity is perhaps the leading cause of business bankruptcies. 1120 Schwarcz-The Easy Case, 12: In the US historical data show that a typical unsecured creditor recovers usually only a very small portion of its claim, perhaps 5 to 20 cents on the dollar. 1121 Schwarcz-The Easy Case, 24 1122 Balz, Schiffman, 69; Schwarcz-The Easy Case, 20:”I will assume that a 75% partial priority rule would cause between 10 and 25% of debtors that need liquidity to be unable to find willing lenders”


252

secured claims unsecured and thereby impose the general default risk in that proportion among secured lenders. As a result, creditors may be less willing to extend secured credit. On the other hand, one should consider that such a rule would commonly apply to all creditors in the market. Market conditions would probably adjust to the new circumstances, with a possible increase of interest rates but creditors would still need to do business – and this business is extending credit to market conditions. The increase of respective interest rates would shift the burden from other unsecured creditors to the debtor – a justifiable result, in line with the advantages gained from the new money.

c. Impact on transition economies

The above mentioned reflects briefly the ongoing discussion in the US and one may wonder, if similar arguments would be valid in the transition economies situation. Especially transition economies are known for abrupt currency depreciations, asset devaluations and other negative effects on economical bases. Corruption, mismanagement and cronyism are features, not solely, but more frequently prevalent in transition economies. Any corrective measures, as the suggested monitoring enforced through a partial priority rule on secured creditors, may have positive effects on macro economical stability as a whole. For the argument against a partial priority rule for secured credit exist no empirical evidence – but it sounds convincing, that the extension of new money will considerably reduce the insolvency risk of the debtor. But this conclusion implies the assumption that under a partial priority rule no or less secured credit would be extended. Such a conclusion cannot be followed. Furthermore is to recall that we are currently talking about situation number two - where the solvent debtor grants a security interest in exchange for new credit. We are not dealing with an insolvent or financially troubled debtor. But when the debtor is financially solvent, the argument that a full priority rule may have a positive effect on the debtors’ solvency and liquidity and therefore providing a comparative advantage to unsecured creditors, may be somehow misleading. As mentioned somewhere else1123, particularly in the context of transition economies may exist further arguments supporting a temporary disorder of the priority ladder as known from Western jurisdictions. Coming back to our four scenarios, the first case deals with the situation, where collateral is granted for new money (or credit in general) at a time, when the debtor is already insolvent


253

or at the “vicinity of insolvency”. This situation is so different to the previously examined in that here actual insolvency or financial difficulties have already occurred. Under such circumstances, secured credit may be the only means for the debtor to return to viability since other options like unsecured credit, equity sale or the sale of assets are not available or feasible. Therefore, it may be in the obvious interest of all participants (unsecured creditors, other secured creditors, the debtor and the current secured lender) to honour the security interest and to support the full priority rule for secured credit. However, the treatment in jurisdictions may be differently where they provide for a floating or fixed charge. Creditors with a security interest over all the property of a debtor enterprise may be required to satisfy preferential or priority creditors from the proceeds of the secured property. Nevertheless, this is just a logical consequence since otherwise policies of the jurisdiction to grant priority for certain claims would be undermined and rendered unnecessary.1124 Additionally, many jurisdictions do still not recognise some common and necessary forms of security interests (non-possessory).1125 Consequently, such security will be not identified as providing for priority treatment in insolvency of the debtor and the creditor is treated as general unsecured creditor.1126

d. Interim result

In concluding this discussion, one may justify the interference of the insolvency regime with secured credit particularly in transition economies in the situation where collateral is given from a solvent debtor in exchange for a loan or other credit. An interesting approach therefore might be the, here examined in more detail, partial priority rule. However, transition economies subordinate secured credit frequently to tax, administration and/or employee claims, which are usually sufficiently large to seriously devalue the security interest. This might be the wrong approach to rebalance the impact of secured credit on unsecured creditors and undermines the flow of credit mainly from the banking sector, since repayment risks increase accordingly. Banks may either refuse to extend credit at all or add risk premiums, which will considerably increase the cost of credit.1127

1123 See B.I.3.11/12. 1124 ADB-Report, 98 1125 This is a common problem in many transition economies, See Breidenbach-Thesen, in Drobnig (Hrsg.) Systemtransformation, 357 1126 Romania, David-Praktische Probleme, 374 1127 Deloitte-Restructuring, 16


254

A possible solution would be a gradual approach, allocating the risks involved among unsecured, secured creditors and debtors alike rather than an all-or-nothing approach, which would shift the whole risk to one group of the participants. In a later discussion1128 we will review more comprehensively other means and instruments, which may be suitable to rebalance the impacts of a first priority, granted to secured creditors.

e. Examples

Under the Russian Bankruptcy Code (1998)1129 administrative costs1130, tort creditor1131 and employee claims1132 rank ahead claims of secured creditors1133. But even in liquidation secured creditors have no right to the collateral or the respective liquidation proceeds from the individual security interest, but only to a monetary claim according to the proportion of their claim in relation to the claims of other secured creditor.1134 Once a debtor is declared bankrupt, secured creditors lose pledge rights in rem against specific assets of the debtor.1135 In return, secured creditors receive a preferential right to recover ahead of general unsecured creditors, but behind personal injury tort claims and wage claims.1136 In fact, the law attempts to preserve the value of the asset used as security1137 and not the security itself. All secured creditors participate in the distribution of bankruptcy proceeds on a pro rata basis, without regard as to whether the secured creditor had held primary or subsequent security interests in a specific property of the debtor.1138 One might wonder, why the Russian legislator did not consider frequent criticism and advise1139 when deciding to take over the existing priority ladder insofar unchanged from the

1128 See D.VI.3. 1129 Russian Bankruptcy Code, Art.106 1130 Russian Bankruptcy Code, Art.54 1131 Russian Bankruptcy Code, Art.107 1132 Russian Bankruptcy Code, Art.108 1133 Russian Bankruptcy Code, Art.109 1134 Russian Bankruptcy Code, Art.114 (3) 1135 Russian Bankruptcy Code, Art.109 (3) 1136 Russian Bankruptcy Code, Art.106 1137 See the respective discussion, D.III.12. 1138 EBRD-Summary of the Russian System, 6 1139 See Balz-Russia


255

1992 law. How have the experiences been with a system which is usually not in the favour of international lenders, western policy makers and financial organisations? Has the lower priority granted to secured creditors really distracted lenders and other creditors, which usually extend credit only for security? As mentioned before, insolvency laws are frequently viewed from either a creditor’s perspective or a debtor’s perspective. From a pure secured creditor’s perspective, the higher distribution priority for administrative, tort and wage claims may provide the secured creditor with some unpredictability by complicating the risk assessment at the time of the investment decision. Particularly, the amount of tort claims may be somewhat unforeseeable – one just imagines a mining accident, explosion or other disaster. But also administrative costs may become substantive and might be able to significantly devalue the collateral. As established elsewhere in this paper, according to a more economical analysis1140, the insolvency law should avoid any unnecessary interference with pre-insolvency entitlements or other entitlements created outside insolvency. A consequent effect of any disregard of pre-insolvency entitlements is that it provides a perverse incentive to general creditors to file for insolvency. The law should provide for market conformity: the creditor’s bargain, in sum, and ask what the creditors would agree to in advance to maximise returns from a limited pool of assets, if they knew that individual creditors` rights could not be enforced and that they would be forced into a collective proceeding like insolvency.1141 On one hand, one could argue, that the Russian Code does not comply with these theories, since it revalues the position of tort and wage claimants against secured creditors compare to their respective pre-insolvency situation. On the other hand, it could be argued, that the Russian insolvency system adequately addresses the creditors` bargain and common pool issues. Specifically, the stripping of security interests permits the efficient liquidation of assets and may thereby maximise the common pool for all creditors. Moreover, the security interest stripping may enhance the prospect of a successful reorganisation of the debtor. Replacing the secured creditors` security interest with a priority over general unsecured claims represents the type of bargain, which creditors would have reached in advance of insolvency.1142

1140 See Baird-Corporate Reorganisations, 103 1141 Averch-Lien Stripping, 90 1142 Averch-Lien Stripping, 90


256

However, as mentioned above1143, insolvency deals not only with wealth and other related monetary matters of creditors, but is also considering and balancing other community and social interests. Granting administrative costs a super priority is commonly accepted as a pre-condition for any successful liquidation or rescue. The higher priority for tort claimants may be justifiable by the fact that those creditors did not extent credit voluntarily, but were forced into their creditor position. A comparison with a contractual creditor may fail, since the tort creditor did not have the chance to negotiate security interests or other preferential treatment. A reasonable justification for the priority of wage claimants may be more difficult to find. They are contractual creditors with a general possibility to negotiate security interests or other preferential treatment in advance. However, usually employees do not have the bargaining power to negotiate any preferential treatment with its employers. Generally, one may consider employees as employees rather than as contractual creditors of the debtor.1144 Furthermore, the social security system in the Russian Federation does in its current stage not provide the necessary financial protection for employees of insolvent companies. Wages are frequently not paid for several months until a company goes into insolvency proceedings. Nevertheless, a limitation of this preferential treatment and the immediate development of a sufficient social safety net should be considered.1145 The Russian Code provides another instrument, which may lessen the negative effect of the existing priority rules on secured creditors. Generally, outside insolvency secured creditors may simply ask to have the collateral returned, in the case that the debtor has not paid the secured claim. This option is restricted as soon as insolvency proceedings are commenced. The Code provides tort claimants and employees certainly with a higher priority than secured creditors, but does not grant them the right to file a petition and thus initiate proceedings.1146 This restriction increases indirectly the chances of secured creditors to enforce their security rights individually outside insolvency. As mentioned earlier1147, policy choices in insolvency should always comply with the underlying cultural attitude in a society. The Russian Law limits freedom of contract by preferring the interests of certain classes of creditors – tort and wage claimants – regardless 1143 See B.I.3.11. 1144 Gross-Failure and Forgiveness, 152 1145 See D.VI.3. 1146 Gutbrod-Das neue russische Insolvenzrecht, 41 1147 See B.II.2.2.


257

of what a security agreement may have established. This policy has deep roots in both Russian and Soviet civil law and Russian society, based on paternalistic policies, established by the tsars and followed by the protective communistic state. The fact that it does not accord with Western notions of security or the nature of insolvency does not necessarily mean that it is “wrong”, “unfair” or even inappropriate in a market economy.1148 Another related obstacle is the fact that secured creditors will be granted a third priority for their whole claim irrespectively of the value of the underlying collateral. Originally, unsecured creditors may tend to upgrade their fifth priority claims to third priority claims by acquiring worthless collateral. As mentioned earlier, secured claims are satisfied by a simple quotation of the remaining values (after first and second priority claims are paid in full1149), regardless of the actual value of a single security interest. However, the Russian law may provide for a protection against such dilution of the respective creditors rights by stipulating that claims may only have a third priority as far as they are secured by a respective security interest.1150 As mentioned before1151, the Polish Bankruptcy Code now includes secured creditors in insolvency proceedings. The Polish law grants to general secured creditors a third priority1152 after administrative costs1153 and secured tax and social security creditors.1154 Thereby, it is an interesting development to grant tax and social security creditors the right to acquire collateral in the debtor enterprise and grant to them explicitly a higher priority as to general secured creditors. The Romanian Insolvency Code1155 separates security generally from other unsecured assets of the debtor in the distribution process and assigns the proceeds from liquidation of the collateral directly to the respective secured creditor, with the effect that the secured creditor will be satisfied prior to all other unsecured creditors. The Romanian Code follows in that way a system, which protects the value of the secured claim by preserving the value of the security interest itself.1156 Nevertheless, the Code allocates the costs and expenses of the sale of the encumbered asset to the respective secured creditor1157 and thereby reduces the impact of the administration of

1148 Averch-Lien Stripping, 92 1149 Russian Bankruptcy Law, Article 114 (2) incorporates the idea of the absolute priority rule 1150 Gutbrod-Das neue russische Insolvenzrecht, 40 1151 See D.III.12. 1152 Polish Bankruptcy Code, Art.204 (2b) 1153 Polish Bankruptcy Code, Art.204 (1) 1154 Polish Bankruptcy Code, Art.204 (2a) 1155 Romanian Insolvency Code, Art.106 1156 See D.III.12.4.1. 1157 Romanian Insolvency Code, Art.106 (1) 1.; for a similar provision provides the German Insolvency Code, § 170


258

the security on unsecured creditors. Such a treatment seems fair, since those costs are caused by secured creditors and should therefore been not born by the estate. The Romanian legislator newly introduced a provision dealing explicitly with under-secured or partially secured claims.1158 According to this provision, the amount of the underlying debt not covered from the proceeds received through the sale of the collateral are solely unsecured claims without priority treatment. Furthermore, the Code1159 allows for the accrual of post-petition interest on secured claims in order to protect the interests of secured creditors in the time value of the affected collateral. An interesting example for the application of the partial priority rule applies the Czech Bankruptcy and Composition Act.1160 The law grants secured creditors generally the right to receive full satisfaction directly from the sales proceeds of the respective collateral, but limits this to 70 percent of the value of it in the case that the remaining assets would not be sufficient to pay the trustee’s expenses and the costs for the administration of the estate.

2.2. Costs of administration Administrative expenses are generally court costs and the fees of the liquidator and other professionals, payments relating to contracts, which were entered into or continued by the administrator after commencement and all other costs, relating to collection, management and distribution of the assets of the estate.1161 However, since it might be desirable to treat administrative costs in a closer sense (fees of the administrator and related professionals and court costs) differently to administrative costs in a wider sense (costs, which are born by ongoing business activities of the administrator – post-petition credit) the law should clearly define what it considers as administrative costs.1162 Administrative claims may receive preferential treatment1163 and even priority over secured credit.1164

1158 Romanian Insolvency Code, Art.106 (2); See for the situation before the changes: EBRD-Summary of the Romanian System, 3; Bufford-Romanian Bankruptcy Law, 262 1159 See: Romanian Insolvency Code, Art.37 1160 Czech Bankruptcy and Composition Act, Section 28 (4) 1161 The Hungarian Bankruptcy Code, sec.57 (2) provides for an unusual extensive definition of “costs of liquidation”, which is granted a first priority. It covers beside more common debts also pre-insolvency wages and other personnel costs including social security contribution. (Sec.57 (2)(a)) 1162 See for example: Croatian Bankruptcy Code, Art.205 (2) 1163 Bulgarian Commercial Code, Art.722 (1) 3., grants bankruptcy costs a third priority after secured credit and claims for which the right to foreclose is exercised; Czech Bankruptcy and Composition Act, Section 31 (2) with a comprehensive list on preferential claims which arose after the opening of proceedings, expenses of the trustee and costs for the administration of proceedings have thereby the highest priority; Croatian Bankruptcy Code, Art.205 (1) 1., provides costs of the bankruptcy proceedings a first priority and in Art.205 (1) 2., obligations that have arisen after the opening a second priority 1164 Hungarian Bankruptcy Code, Section 57 (1)


259

The justification for this privileged treatment is the fact that only such a treatment may attract the necessary financial and human resources, since nobody wants to extend voluntarily credit as unsecured or respectively as a non-priority creditor to an insolvent party.1165 Experienced and well-trained professionals as administrator, counsel, accountant or investment banker, are more and more essential for a successful insolvency administration. Similarly, post-petition credit is indispensable for the reorganisation, the going-concern sale or the ordered liquidation of the debtor, but may rank behind real administrative costs.1166 In the case that the available assets do not satisfy all administrative claims, the law should provide for a ranking of different classes of administrative costs with a priority for the fees and expenses of the administrator.1167 The law should not generally give priority to administrative costs over secured debt. However, as mentioned before, it might grant priority over secured claims for the preservation, insurance and the sale of the collateral.1168 Nevertheless, experiences in Western jurisdictions reveal that especially costs for several professionals may extremely inflate administrative cost and thus impair dramatically the chances for repayment of unsecured non-priority creditors. Therefore, the law should provide for an upper ceiling, limiting the ability for professional fees to be considered as priority administrative claims. One possibility to do this might be to link the amount of professional fees available as priority claims to the total amount of outstanding debt or the respective size of the debtor. Examples The Russian law1169 treats all administrative costs (fees of the administrator, court costs and claims arising from the continued business of the debtor) on equal footing and gives a super priority to such claims over other claimants. The Polish Bankruptcy Code grants cost of bankruptcy or arrangement proceedings a first1170 and dues generated from the acts of the official receiver and administrator during the proceedings a second1171 priority.

1165 IMF-Report, 40 1166 See therefore the subsequent discussion 1167 German InsO, §§ 209, 54; a good example provides also the Czech Bankruptcy and Composition Act, Section 31 (2); Croatian Bankruptcy Code, Art.205 (1) 1168 Balz, Schiffman, 69; e.g.: Romanian Insolvency Code, Art.106 (1) 1. 1169 Russian Bankruptcy Code, Art.106 (1) 1170 Polish Bankruptcy Code, Art.204 §1 (1) 1171 Polish Bankruptcy Code, Art.204 §1 (2)


260

The Romanian Code1172 gives taxes, stamps and any other expenses, related to the procedure, a first priority among unsecured creditors.

2.3. Post-petition credit

2.3.1. General

One of the major problems in rescue situations, in liquidation situations where it is necessary to continue with the business for a period or where a sale of the debtor as going concern is attempted, is that the debtor enterprise is frequently in urgent need of ongoing funding in order to pay for necessary supplies of goods and services to maintain its business activities. In the state of insolvency, creditors are normally not willing to extend further credit because of the threatening repayment risk. In order to promote rescue efforts of the debtor where feasible, the law should provide some kind of assurance for the eventual repayment or recovery of this funding.

2.3.2. Protection of post-petition creditors

A recommendable and frequently found method to do this is by granting a super or high priority for post-petition credit.1173 Generally, the law should not grant to post-petition credit a higher priority than to secured credit, since it might run the risk of undermining the value of security.1174 Another way, followed by certain jurisdictions, is an option allowing the administrator to give a security interest on unencumbered assets to the post-petition creditor. Frequently, there will be no unencumbered assets available for security purposes since the level of secured financing and trading is generally high and remaining assets might be not suitable or sufficient as collateral. One could consider the possibility of imposing additional or further security on existing secured property interests for the purpose of protecting a creditor of post-petition credit. That would consequently mean that the post-petition creditor acquires a “secured priority” on an asset which already serves as collateral for a secured

1172 Romanian Insolvency Code, Art.108 (1) 1173 WB-Towards Principles, 68; See for example: Croatian Bankruptcy Code, Art.205 (1) 2., grants post petition credit a second priority after costs of the administration; Hungarian Bankruptcy Code, Section 57 (1)(2) grants costs of liquidation a first priority, which seem to include cost for the temporary continuation of activities as well, secured creditors have only a second priority; Slovakian Bankruptcy Code, § 32 (1)(a) grants post-petition credit a second priority after the fees of the trustee; Romanian Bankruptcy Law, Art.108 (1)(2) grants post-petition financing a second priority after administrative costs; US-Bankruptcy Code, §364 (d)(1) grants post-petition financing only a super-priority if financing is not available on any other basis; German Insolvency Code, §55 (2) grants post-petition credit a super-priority 1174 IMF-Report, 60


261

creditor. Undoubtedly, such a provision may undermine certainty, predictability and significance of secured credit and thus damage the credit system as a whole.1175 However, one may consider applying the principles of the partial priority rule1176 with the consequence that ordinary secured creditors would have to give up a portion of their collateral, in order to protect post-petition creditors in the case they would not be satisfied in full under a respective distribution according to the priority ladder and other unencumbered assets are not available. The provision on post-petition credit is a main obstacle of many insolvency laws of transition economies with severe consequences for the prospect of rescues and even the sale of a debtor as a going concern. Many jurisdictions do not mention the possibility of “new money” at all1177 and others do not provide for a sufficient protection of post-petition creditors.1178

2.3.3. Examples

The new Russian law (1998)1179 mentioned the issue in the case of an External Administration but does not grant those post-petition claims automatically and explicitly a high administrative priority without consent of the creditors.1180 On the other hand, the law grants administrative priority to obligations of the debtor which arose in the course of observation, external administration, or bankruptcy liquidation.1181 The Romanian Insolvency Code1182 grants claims representing credits, granted by banks during the period of reorganization, as well as claims resulting from the continuation of the debtor’s activity, a second priority after administrative costs. The Polish Code1183 does not mention the problem of post-petition explicitly, but grants obligations entered into by the administrator during the insolvency proceedings a second priority.

1175 ADB-Report, 99 1176 See the discussion above D.VI.2.1.2. 1177 ADB-Report, 37: E.g. Indonesia, Malaysia, Philippines 1178 ADB-Report, 37: E.g. Korea, Thailand; Bulgarian Commercial Code, Art.722 (1) 7., provides only a seventh priority for receivables which have emerged after the opening of proceedings; Czech Bankruptcy and Composition Act, Section 31 (2)(e) provides for claims arising from contracts concluded by the trustee or which were not cancelled at the opening of proceedings only a fifth priority after taxes and social security contributions 1179 Russian Bankruptcy Code, Art.79 1180 EBRD-Summary of the Russian System, 6 1181 Russian Bankruptcy Code, Art.106 (1) 1182 Romanian Insolvency Code, Art.108 (2) 1183 Polish Bankruptcy Code, Art.204 §1 (2)


262

2.4. Wages, taxes and personal injury claims

2.4.1. General

Comparing several jurisdictions, there are certain categories of creditors, who will receive payment before others. The underlying ranking reflects frequently political or economical policies prevailing in the respective country. As commendable those policies might be, the introduction of additional priorities undermines the efficiency and overall effectiveness of the proceedings for a number of reasons. Firstly, they may distract other unsecured creditors to participate in the insolvency process since they revaluate the claims of a privileged class of unsecured creditors. Furthermore, they may complicate negotiations of a reorganisation plan to the extent that they require the creation of separate creditor classes to reflect the priority in question.1184 The types of privileged unsecured creditors vary from country to country.

2.4.2. Employee salaries and benefits

Some jurisdictions1185 grant a priority for employee salaries and benefits. Those countries attempt to afford employees special protection by giving them priority over other unsecured creditors. Such privileges are generally consistent with the special protection, which is afforded to employees in other areas of insolvency law.1186 On the other hand, one might argue that such privileges do discourage the promotion of efficient social safety net systems – a probably more systematic tool to protect redundant employees.1187 Modern economies usually provide redundant employees affected by the insolvency of its employer with a safety net commonly funded by contributions of solvent enterprises and their employees. However, similar instruments are frequently not available in transition economies or at least not stuffed with the necessary funds to support victims of potential mass insolvencies. But apart from these social considerations exist several other reasons to grant employees priority over other unsecured creditors. 1184 IMF-Report, 40 1185 Russian Bankruptcy Code, Art.106 (2) grants employees a second priority after administrative costs (super priority) and tort claims (first priority); Romanian Insolvency Code, Art.108 (3) grants employees a third priority after administrative costs (first priority) and post-petition credit (second priority); Croatian Bankruptcy Code, Art.71 2., grants employee claims a second priority after tax and state budget claims (first priority); Bulgarian Commercial Code, Art.722 (1) 4., grants employees for wages emerged one year prior to the opening a fourth priority after security, claims for which the right to foreclose is exercised and bankruptcy costs 1186 IMF-Report, 40


263

Firstly, they may not be capable to cover the losses effected by the loss of their jobs and consequently unable to pay their own creditors. That may lead to knock-on insolvencies and social hardship and might thereby affect other communities. Secondly, employees do usually not voluntarily extend credit to their employers since they do not enter willingly in a debtor-creditor relationship, but in an employer-employee relationship. Employees are regularly not able to make an ex-ante assessment of the insolvency risk of its employer nor do they have the bargaining power to negotiate a contractual security interest for their salaries. Furthermore, if employees are not paid in the insolvency of their employer, they may be not willing to work and participate in the reorganisation phase. Because, when a work force is critical to a reorganisation effort, it makes sense to pay these workers, as their labours will inure to the benefit of other creditors.1188 The priority for employee salaries may also include social security charges (health insurance, pension contributions) not paid by the debtor prior to the commencement of proceedings.

2.4.3. Tax and state budget claims

Other jurisdictions1189 grant priority to tax claims with the justification, that it may be beneficial in a reorganisation procedure, since tax authorities can delay the collection of taxes in order to support rescue efforts of the troubled company.1190 However, such incentives can be counterproductive since it constitutes state subsidies and undermines the disciplinary function of market forces.1191 Furthermore, such rights may encourage inefficient government tax collection systems, a main obstacle especially in transition economies.1192 Other policies justify tax priorities by the government’s necessity of tax revenues. Furthermore, one may suspect, in the case where a company would be able to discharge their tax liabilities under the insolvency law, many companies may only initiate insolvency proceedings to reduce the annoying tax burden. 1187 ADB-Report, 98 1188 Gross-Failure and Forgiveness, 152 1189 ADB-Report, 49: e.g. Indonesia gives tax claims priority over all other claims; Russian Law (1998) grants mandatory payments to the budget a fourth priority, Art.106 (2); Romanian Insolvency Law, Art.108 (4), grants taxes, fines and other public income also a fourth priority; Polish Bankruptcy Code, Art.204 §1 (3), taxes and other public tributes as well as social insurance premiums due for one year preceding the opening of proceedings have a fourth priority; Croatian Bankruptcy Code, Art.71 1., grants taxes and other revenues of the state budget or budget of local governments a first priority; Czech Bankruptcy and Composition Act, Section 31 (2)(d) grants taxes and social security contribution a fourth priority ranking ahead claims for post-petition credit 1190 E.g. Garrity-Korean Bankruptcy Law, 276: The Korean Corporate Reorganisation Act (Art. 122) provides the possibility to postpone, reduce or exempt tax payments through the reorganisation plan. 1191 IMF-Report, 40 1192 ADB-Report, 98


264

On the other hand, the state budget may, in contrast to the employee, sustain losses from an insolvent taxpayer. Granting tax a priority may furthermore affect other taxpayers with a negative end result for the fisc. Imagine the priority granted to the fisc deprived several other creditors of their claims and affects their solvency as well. The fisc may gain its revenue with the first debtor, but may loose with the other failing creditors. Furthermore, other creditors may claim deductions on income tax returns for bad debts by creditors who will receive little or nothing as a result of the fisc’s privilege.1193 Examples As mentioned before1194, granting priorities to the public fisc may discourage creditors to externalise costs of the default. Thereby, priorities may be granted in liquidation as well as in reorganisation. Under Chapter 11 of the US-Bankruptcy Code for example, a reorganisation plan may be not confirmed, unless the tax debts are scheduled for repayment in full.1195 Nevertheless, the US-Bankruptcy Code does allow debtors to stretch out tax obligations for a period up to six years with or without the consent of the taxing authority.1196 However, tax remains the biggest revenue source of the government and will therefore continue to receive preferential treatment in insolvency. The legislator should carefully consider how to design priorities and preferential treatment in order to avoid excessive interference with other participants. The Polish Code1197 provides an interesting limitation on the priority for tax and other state claims. It limits the period, in which such claims would receive a priority, up to one year prior to the filing of insolvency. Consequently, the fisc has an incentive to collect outstanding taxes on a timely basis and subordinated creditors are protected from extensive tax and social insurance claims. As mentioned elsewhere, another interesting provision of the Polish Bankruptcy Code1198 provides that tax or social security creditors, secured with a pledge or mortgage, rank ahead “general” secured creditors.

1193 Balz, Schiffman, 68 1194 See General Objectives: internalise costs 1195 US-Bankruptcy Code, § 1129(a)(9)(C) 1196 Bufford-What is Right, 841; US-Bankruptcy Code, § 1129(a)(9)(C) 1197 Polish Bankruptcy Code, Art.204 §1 (3) 1198 Polish Bankruptcy Code, Art.204 §1 (2a)


265

2.4.4. Claims for personal injury Russia1199 provides a further, quite uniquely first priority for claims for personal injury, which it did not change in their 1998 law, although it was frequently criticised in the 1992 law.1200 The situation of tort claimants is quite different from other claimants who have extended credit on a voluntary basis. One may therefore broadly distinguish between voluntary and involuntary creditors. Voluntary creditors are usually contractual creditors, which had the chance and ability to assess ex-ante the solvency and the default risk of the debtor and to price the risk respectively in their credit terms or, alternatively, bargain and negotiate a security interest. However, as we have already seen1201, that may be only theoretically the case since some voluntary creditors may have no sources to assess the credit risk of its debtor sufficiently, nor enough bargaining power to negotiate a valid and sufficient security interest. Nonetheless, on the other hand, we have involuntary creditors, which did extend their credit not on a voluntary basis and did consequently not have the chance to prior risk assessment or security negotiation. Typical examples are tort creditors and other statutory creditors (fisc, administration).1202 A frequently chosen way to rebalance their actual disadvantage against voluntary creditors is to grant them priority over other unsecured creditors in the insolvency process. Some jurisdictions rebalance that distortion by granting particular involuntary creditors statutory liens to protect their respective interest. However, even among involuntary creditors may be some (e.g. the fisc), which are better able to withstand the loss. We remember the goal of creditor equality1203 – the important result should be the outcome for every creditor in its individual position. Tort creditors are usually more affected by the insolvency of its injurer and therefore may need protection through statutory priority in insolvency. But even among tort creditors may exist different situations and needs. Some observers1204 suggest introducing a judicial control of the need and the specific situation of the individual tort claimant in order to get priority or preferential treatment. Thereafter, only claimants, who can prove the existential necessity of preferential treatment in insolvency, may obtain a priority status over other unsecured creditors. That might be justifiable and practical in a jurisdiction with a well-working judiciary, but may be very difficult to implement in

1199 Russian Bankruptcy Code, Art.106 (2) 1200 Balz-Russia, 32 1201 See D.VI.2.4.2. 1202 Bufford-What is Right, 840 refers to it as non-contractual debt 1203 See B.I.3.3. 1204 Gross-Failure and Forgiveness, 173


266

transition economies, where shortcomings of the judiciaries are a common and well-known obstacle. According to this, the granting of security to all tort claimants1205 under the Russian Code may be justified in the context of the special transition problems. Another feature, which was quite unique in the 1992 Russian law, was a priority for employee shareholders deriving probably from general privatisation philosophy. Such a privilege for shareholders may negatively affect capital markets, is not conducive to efficient corporate governance and is contrary to the objective of creating an efficient labour market. Furthermore, it does not enforce the risk capital function of equity and reduces possibilities for sophisticated corporate debt financing. The provision was therefore extinguished in the new Bankruptcy Code (1998).1206

3. Priority rules and possible substitutions or limitations

3.1. General As mentioned before, privileges are frequently justified by the following reasons: existing social needs to protect less powerful market participants; certain creditors have not voluntarily extended credit (tort creditors) and had therefore not the chance to risk assessment and negotiation of contractual security interests; contractual security is not available to certain groups of creditors; there are strong social and economical incentives for certain creditors to not enforce their claims individually before insolvency; and finally, general fiscal implications. But even when those reasons are recognised as urgent policy issues in the respective jurisdictions, it might be debatable whether there is a justification for a general application of some priority rules in transition economies. Mainly to criticise is the effect of privileges in the context of the absolute priority rule, where a senior class of creditors has to be paid in full, before any junior class can receive anything.1207 This treatment is neither able to satisfy main objectives of insolvency nor to balance diverse interests and rights of participants. Furthermore, privileges are jointly accountable for the frequently found disinterest of general unsecured creditors to participate in proceedings. Under many insolvency laws of transition economies, which are still having a separate composition law, priority creditors have to

1205 Adler-World Without Debt, 826 is even of the opinion that should be also the case under the US bankruptcy system 1206 Balz-Russia, 37 1207 Balz-Russia, 33


267

receive payment in full before a rescue would be available – this reduces the chances of a successful reorganisation significantly. Finally, privileges violate one of the basic tenets of the economic analysis of insolvency law; they distort the value of pre-insolvency entitlements.

3.2. Devices However, there might be several instruments and devices available which may render privileges unnecessary or at least limit their impact on the outcome for proceedings but, at the same time, attempt to support valid goals, commonly prevalent in transition economies.

3.2.1. Social security system

In order to foster social security in relation to insolvencies and its impact on redundant employees, a country should introduce a social safety net for employees in insolvency. Germany, for example, has a system based on insurance, where the unpaid employees get paid up to 3 months of outstanding salary1208 and the insurer is then subrogated to employee claims as a general creditor in insolvency proceedings. This system is financed by the non-insolvent enterprises.1209 (Insolvenzausfallgeld) A similar system exists under Polish law. Every solvent employer pays 0,5 % of the salary of his employees into a “Fund for guaranteed employee contribution”. In the case of the insolvency of the employer and its inability to pay outstanding pre-insolvency wages, the Fund will pay up to three months of the outstanding wages.1210 Exceeding wage claims get a first priority together with administrative cost and post-insolvency claims are treated as post-petition credit with super-priority.1211

1208 German Social Code, §§183 1209 German Social Code, §§358 1210 Brol-Das polnische Konkursrecht, 313 1211 Polish Bankruptcy Code, Art.204 §1


268

3.2.2. Partial priority A means to limit the impact of privileges on non-priority claimants is the reservation of a maximum percentage of assets for privileged classes: privileged classes of creditors may be satisfied only from a percentage of available assets.1212 The German law1213, for example, provides under certain circumstances for a Social Plan, according to which redundant worker may receive up to two and a half month of salary as super priority claim ranking ahead other privileged and non-privileged creditors. However, the therefore available assets are limited to one-third of the total assets and payments to the respective redundant workers are reduced pro rata when the total payment would exceed one third of the available assets.

3.2.3. Weighting of different types of privileges

To circumvent the impact of a strict lexical ordering of privileges, a legislator may grant different multipliers to various groups of claims. Thereby, for example, a tort claimant may get a multiplier of 2,0 for its claim, an employee 1,5 and other general unsecured creditor 1,0. These weightings would be recognised in the distribution but possibly also in the voting process, with the consequence, that none of the unsecured creditors would be completely locked out from the outcome of proceedings. Furthermore, such a treatment of different claims would allow allocating respective rights more flexible and equitable among varying creditors.1214 However, this approach proposed from Balz has so far not been yet tested in actual legislation.

3.2.4. Limitations on privileged claims

A more frequently used approach to the problem is the introduction of monetary and time limitations on certain privileged claims. Generally, respective creditors may only receive a privilege up to a certain amount of the claim and/ or within a certain time period before the opening of proceedings. Such limitations may serve several purposes: they may reduce moral hazard among management and foster managerial discipline, promote an efficient tax collection process and protect other subordinated creditors. These limitations are from several jurisdictions primarily applied for general wages1215, managerial wages1216 and taxes revenues.1217

1212 See also the discussion on the Partial Priority Rule for secured credit; D.VI.2.1.2. 1213 German Insolvency Code, §123, see also Schwerdtner-Sozialplan, 1137 1214 Balz, Schiffman, 67; Balz-Russia, 34 1215 US Bankruptcy Code: 90 days prior to insolvency, $4.000 per employee; Romanian Bankruptcy Code, Art.108 (3) wages for a period up to six month prior filing; Slovakian Bankruptcy Code, § 33 (3) wages


269

4. Preferential treatment of small and medium size creditors1218 Nevertheless, there may be also situations which call for the consideration of a preferential treatment of other creditors.

4.1. Priority for creditors irreparable injured by pro-rata treatment1219 As mentioned before1220, one goal of the insolvency process is to achieve creditor equality – commonly attempted to achieve through a pro-rata distribution among unsecured creditors. But pro-rata treatment among very different situated unsecured creditors may not provide for equality in terms of the respective outcome as proposed in this paper.1221 For one creditor, immediate cash payment may be of vital importance while a wealthier creditor may not be depending on the outstanding money at all. On the other hand, economical theories suggest avoiding any redistributive effect of the insolvency law.1222 However, one may be able to identify situations where it might be justifiable to deviate from pro-rata sharing among unsecured creditors and to rebut the presumption of equality of treatment among unsecured creditors.1223 Such a situation would be conceivable if a general unsecured creditor, by receiving its quote of the remaining asset value after secured and priority creditor are paid, would come under existential pressure by suffering irreparable injury.

generally only for up to three month prior to the opening and Bulgarian Commercial Code, Art.722 (1) 4., wages only for one year prior to the opening decision 1216 Slovakian Bankruptcy Code, §66 h, wages of management only up to the amount of 10,000 Sk monthly 1217 Polish Bankruptcy Code, Art.204 (3) grants priority for taxes only for up to a year prior insolvency 1218 See for example: Garrity-Korean Bankruptcy Law, 276: Under the Korean Corporate Reorganisation Act (Art. 112-2 (1) may such creditors receive direct payment outside the reorganisation plan; according to the Polish Bankruptcy Code, Art.175 §3, the debtor may grant in its arrangement proposal special benefits to creditors with small active debts 1219 Gross-Failure and Forgiveness, 165 1220 See B.I.3.3. 1221 See B.I.3.3. 1222 See B.I.11.4. 1223 Gross-Failure and Forgiveness, 165


270

4.2. Implementation This approach could be implemented by creating an accelerated priority for those creditors and deleting one of the other less justifiable priorities.1224 Thereby, one of the above discussed instruments or devices might be used to limit the impact of privileges on the other participants. Particularly the weighting system, as suggested above, might be suitable to have a limiting effect on such a privilege. Creditors, claiming such a priority, would bear the burden of proof at a hearing before the responsible court. They would need to establish that the failure to receive different treatment would cause a hardship and irreparable injury. Defining this term may provide some difficulties, but the reason for such a treatment may bring some clearance. This approach reflects a social dimension of insolvency which is to prevent social hardship. Accordingly, a creditor should be eligible to this priority when pro-rata treatment would negatively affect its viability. This approach applies to both natural person creditors and creditors with legal personality. However, potential candidates of this exception to the general pro-rata rule may be individual creditors (e.g. free contractor) or small creditors (small trade creditors). But beside the social goal, the approach may satisfy some other objectives of insolvency as well. By preventing the eligible creditors to fail on their obligations it may prevent a chain of knock-on insolvency. Furthermore, this technique may protect entrepreneurial resources by protecting those creditors. The method is supposed to be particularly valuable for transition economies, since there small businesses do regularly not have the financial cushion to outlive the insolvency of a major business partners or customers. Furthermore, individual entrepreneurs and small businesses are as correlative to SOE’s an important force in the transition process and essential for the development of an efficient and well-functioning market economy. The protection of them may be justifiable against the interference with general pro-rata treatment among unsecured creditors. On the other hand, requirements on the standard of proof and substantial demands for eligibility should be high and allow the remedy only for a specific, narrow set of circumstances. Otherwise, the approach would negatively affect mainly large businesses, what might result in a reduced willingness of those creditors to lend and thereby affect debtors which are depending on the credit of large creditors. Viewing the technique from a creditor perspective, one might argue that creditors as a whole would dislike the suggested approach because it provides for a further deterioration of the pro-rata sharing rule and one or more creditor could obtain a greater and earlier distribution than others. But, on the other hand, creditors may be convinced from the merits of the system

1224 Such a method may be combined with the weighting system as suggested under D.VI.3.2.3.


271

and may appreciate the system since it would be available to them if they need it prospectively. Additionally, if creditors were aware of the possibility that a limited pool of creditors may receive such treatment, they could assess and respectively price this risk in advance.

5. Protection of foreign currency creditors As mentioned earlier1225, foreign creditors should receive equitable treatment to national creditors since foreign investment or credit may be particularly important for transition economies. An important feature in the distribution process is the treatment of foreign currency claims. Generally, foreign currency claims are converted into domestic currency upon the commencement of formal proceedings1226 or the request of the creditor to register its claim in the table of claims1227 at an exchange rate prevailing at this time. Accordingly, the foreign currency creditor carries the risk of currency depreciations for the time between commencement of proceedings and the final distribution of the liquidation proceeds. Since particularly in transition economies such proceedings are frequently longer lasting, there may be, especially in less stable currency markets, a considerable risk for those creditors to suffer heavy losses. The law should therefore provide for a conversion of foreign currency claims into domestic currency at the time of the final distribution of proceeds.1228 However, voting rights should continue to be determined according to the amount of the claims at the time of commencement.1229

1225 See V.6. 1226 Polish Bankruptcy Code, Art.160 1227 Romanian Insolvency Code, Art.93, see also: Capatina-Länderbericht Rumänien, 354 1228 See Török-Länderbericht Ungarn: The Hungarian insolvency law seems to provide for the conversion at the time when the court decides about the final distribution of the available assets among creditors. 1229 IMF-Report, 38


272


273

E. Concluding Remarks and Outlook In summing up this paper, the author does not intend to repeat the great variety of topic-relevant issues discussed. Nonetheless, it might be appropriate to refer to some points, which may also correspond with the expectations outlined at the outset of the thesis. Firstly, the discussion has shown that the unique situation in transition economies influences the needs and demands of the prevailing insolvency regime and may require unique solutions. The determining circumstances in transition economies may differ considerably from those of highly developed market economies. Transition economies have frequently developed their own means and techniques to deal with these circumstances. That, on the other hand, has affected the comparative approach to many problems identified in this paper. A comparative analysis of laws does regularly require a common ground for such an undertaking. Since the current situation in transition economies differs significantly from the respective situation in Western economies, a comparative approach to those issues was not always easy to find. Secondly, these differing circumstances in transition economies form additional goals of the insolvency regime or, at least, do limit some and extend others. The objectives of communities, for example, affected by the insolvency of a market participant, are from great importance particularly in transition economies. Frequently, other means to protect those interests are not available in these countries and legislators referring to the insolvency law to buffer the impact of insolvency on those communities. However, the paper has also shown that the unique characteristics of transition economies are limited to the transition process. In other words, the insolvency law should only respond to unique transition problems for a limited period in which the economy adjust to respective market-based principles. Additionally, the thesis has revealed some other, more practical interrelations. Throughout the paper, the importance of the leverage function of the underlying legal system was highlighted. Thereby, leverage functions exist for the general legal system to foster insolvency proceedings in general, for liquidation proceedings to foster formal reorganisation and for formal rescue laws to foster and support informal workouts. Only the threat of the efficient and easy accessible underlying law may persuade participants to initiate respective proceedings. Furthermore, the study has exposed that under Western thinking, liquidation and reorganisation should be treated equally. The law should avoid extensive interference with


274

the asset maximisation theory, according to which the procedure should be applied, promising the highest return for creditors. But it was also established that this may not be fully applicable to transition economies. There frequently exist circumstances which require a procedural or substantial bias of the law for reorganisation proceedings. Moreover, results throughout the paper have suggested that informal workouts are of enormous importance, particularly for transition economies. Those techniques enable a successful restructuring process without essential participation of the judiciary on a day-to-day basis. There are several attempts in transition economies to promote out-of-court restructurings. A remarkable development, analysed in more detail, is the appearance of structured workout initiatives in several Asian economies, set up as response to the Asian financial crisis. Some approaches applied in those programs may be also from advantage for other transition economies. The facilitation of ex-ante workout agreements, for example, may be a useful tool to compensate shortcomings in the formal insolvency regime of transition economies. A closely related problem deals with the implementation of workout agreements through the formal insolvency regime. As we have seen, the workout approach has a main obstacle in comparison to formal proceedings – it is legally not binding among dissenting creditors. To rebalance this shortcoming, the formal insolvency regime should recognise and implement pre-packed reorganisation plans. Another central issue is concerned with the absolute priority rule and its unlimited application to secured and other privileged creditors. The absolute priority rule articulates that no junior class of creditors may receive anything if more senior classes are not paid in full. That leads consequently to results which are not in line with several objectives of the process. The paper proposes a limitation of the absolute priority rule through several means, which will cause a more gradual approach to the issue. At this point it might be only referred to the partial priority rule for secured credit and the introduction of a weighting system for all types of claims. In this context, the paper proposes that an extensive priority system may serve prevailing objectives in transition economies, but is not always the best means to do so. Varying tools may be necessary to limit the negative impact of extensive priorities. However, the thesis also implies that under certain circumstances a preferred treatment of small and medium-sized creditors might be essential. Especially in the transition process


275

fulfil those participants an essential function and are frequently existentially threaten by insolvencies of their debtors. Throughout the work, it became apparent that the insolvency regimes of transition economies have unique elements, but also many elements in common with their Western counterparts. Furthermore, it was shown that many transition economies are constantly reviewing and amending their insolvency laws to keep path with the ongoing transition process. Nevertheless, many insolvency laws of transition economies are characterised by loopholes and shortcomings. The dissertation has also revealed elements of the insolvency law of transition economies which are unique to the transition process. Most importantly, transition economies have frequently redefined their insolvency objectives and consequently address and emphasis other issues than many Western laws. The development of insolvency laws in transition economies will continue to be a central factor determining the speed of those countries turning towards more market-based economies and will therefore remain a key issue of the legal, economical and political transition process.

INSOLVENCY LAW REFORM - World Banksiteresources.worldbank.org/GILD/Resources/InsolvencyLaw...Mike...

Documents

Transcript of INSOLVENCY LAW REFORM - World Banksiteresources.worldbank.org/GILD/Resources/InsolvencyLaw...Mike...