21
Bankruptcy: Policy, Law, and Strategy
21A. Bankruptcy Policies, Restructuring, andEconomic Efficiency
IZAK ATIYAS
Introduction
The importance of bankruptcy laws for the development of debt instruments, as well as for financial markets in general, is well-known. Bankruptcy policies establish a formal procedure that may be initiated whenever a debtor is unable to meet contractual obligations to creditors. The procedure is designed to redistribute the rights to control the debtor firm and the rights to appropriate the income stream generated by it. When properly designed and implemented, bankruptcy mechanisms are believed to enhance economic efficiency by allowing the timely exit of unproductive economic units and regulating the transfer of the owner-ship of productive assets to more qualified entrepreneurs. Inadequate bankruptcy mechanisms, however, may cause excessive liquidation of assets or act as barriers to exit.
Bankruptcy procedures also make up an important component of countries' policies for industrial restructuring. In many countries, insuf-ficient capital mobility acts as a significant barrier that delays or hinders efficient restructuring. Many developed and developing countries have designed policies within given sets of rules to address the special problems of declining industries, and to remove barriers to capital
mobility and exit.1 Such policies attempt to facilitate restructuring,
including through capacity reduction, enterprise rehabilitation, or exit. Bankruptcy procedures can be seen as an important component of these policies.
Most bankruptcy laws prescribe variants of two distinct procedures. In the first procedure, bankruptcy liquidation, the debtors' assets are sold, and the proceeds are divided among creditors according to sharing rules that are determined by lawmakers. The second procedure, bankruptcy reorganization, is a process under the supervision of the court in which the claimholders of the debtor firm negotiate the res-tructuring of the debtor's liabilities and assets, possibly with the
tive of maintaining the company as a going concern. Negotiation is suc-cessful if an agreement is reached. The agreement may stipulate either the continuation of the firm as a going concern in restructured form or, in principle, its liquidation. If no agreement is reached, the reorganiza-tion process fails, and, most likely, bankruptcy liquidareorganiza-tion proceedings are initiated.
Bankruptcy reorganization procedures potentially play an important role in rehabilitating companies that are in financial distress and in default on debt payments. Rehabilitating such companies often entails turing the assets and claims on the enterprise. Firms in need of restruc-turing are often overindebted because of past macroeconomic policies that encouraged debt accumulation, earnings shocks that generated losses and reduced equity capital, or bad management. These firms often also need to reorganize their assets to increase productivity. Hence, a regu-lated process of debt renegotiation and asset reorganization may play an important role in industrial restructuring.
Depending on how they are designed, reorganization procedures may also act as barriers to exit, for example, by granting debtors too much protection. When debtors are granted excessive bargaining power during reorganization negotiations, they may abuse the process to delay exit or extract economically unjustified concessions from creditors. Therefore, the mechanisms designed in reorganization to resolve conflicts of interest between debtors and creditors, in particular the distribution of rights to control the enterprise's assets during reorganization negotiations, are essential determinants of not only the economic efficiency of the out-comes but also the extent to which bankruptcy laws can play a useful role in industrial restructuring.
Attempts to design or reform bankruptcy laws are often confronted with the following questions: Should bankruptcy policies allow for bankruptcy reorganization? If so, to what extent should bankruptcy poli-cies "protect" debtors; in other words, how should control rights be dis-tributed during reorganization? How should bankruptcy policies in developing countries take account of such structural characteristics as weak judicial systems and underdeveloped capital markets?
The next section of this paper discusses some market imperfections that provide the economic rationale for bankruptcy (especially reorganization) policies. The following sections present an international comparison of bankruptcy laws and some thoughts on bankruptcy policies for develop-ing countries.2
The Economics of Bankruptcy Policies:
Common Pool and Agency Problems
An important economic function of the state in capitalist economies is to enforce contracts or impose damages or penalties on the party that breaches a contract. In the case of debt contracts, a breach occurs when the borrower does not repay the debtor. When a debtor defaults on a loan, the creditor has generally two options outside bankruptcy. If the loan is secured, the creditor can have resort to the security by seizing the assets that serve as collateral. If the loan is not secured, the creditor can pursue other legal action permissible under debt-collection laws. For example, in the United States, the creditor can sue the debtor; if success-ful, the creditor may foreclose on real property or seize personal property.3
However, these methods of enforcing loan contracts become inade-quate when the number of creditors is large, and especially when the value of the debtor's assets is inadequate to pay all claims. Typically, debt-collection laws function on a first-come, first-served basis. Under these conditions, a coordination problem arises, as each creditor rushes to seize assets before the others, resulting in a fragmentation of the debtor's assets, which is costly if the firm is worth more as a whole than as the sum of its individual assets. It has been argued, therefore, that a coordinated settlement of claims through a bankruptcy procedure may be in the inter-est of the creditors as a whole. Hence, the main purpose of the bank-ruptcy policy can be seen as solving the "common pool" problem.4 Bankruptcy typically resolves common pool problems by triggering an "automatic stay," that is, by forbidding creditors from grabbing assets through individual debt-collection action.
The common pool problem has an important variant in the case of firms that suffer from debt overhang. When creditors cannot perfectly monitor the actions of a borrower, it may be in their interest as a whole to reduce the face value of the claims on an overindebted firm; by pro-viding better incentives to the firm and, therefore, enhancing efficiency, debt reduction may increase the value of the remaining stock of debt claims. However, the common pool problem may prevent such a debt reduction, even when it is an efficient outcome. No single creditor may have an incentive to reduce the face value of his or her claim; each indi-vidual creditor bears the cost, while other creditors are seen to benefit from the efficiency gain. Rehabilitation of the debtor through debt reduction may require a collective action that may not be possible to implement through the market mechanism. A bankruptcy reorganization
procedure may provide a forum in which such collective action can take place.
While the common pool problem is seen as an important economic jus-tification for bankruptcy policies, conflicts of interest between creditors and debtors pose another major problem that bankruptcy policies must address. In environments where bankruptcy is an underlying concern, these conflicts of interest, or "agency problems," arise because debtors are typically interested in maximizing the equity value rather than the total value of the firm, even though actions that are conducive to that objective typically may reduce the value of debt.5 Several examples of such activities have been given in the literature.6 In principle, such agency problems could be resolved if covenants could be included in the debt contract that would state contingent actions that the borrowers would undertake ex post. However, creditors often cannot perfectly monitor the actions of debtors after a debt contract is written because of such prob-lems as imperfect information and the costliness of contract enforcement. These conflicts are magnified during periods of financial distress, when the value of the owners' stake in the debtor company is diminished. This situation reinforces equity holders' incentives to transfer wealth from creditors by, for example, taking on excessive risk, assuming new (espe-cially secured) debt, stripping assets, or even conveying them to third par-ties for personal gain. These incentives make the renegotiation of claims on the enterprise more difficult.
In principle, bankruptcy policies should address agency problems by generating incentives to maximize the net value of the assets involved. In particular, the rules should ensure that debtor companies liquidate, con-tinue operation, or reorganize whenever it is socially optimal to do so.7 The rules should also encourage the maximization of the value of the assets under bankruptcy without jeopardizing the terms of the original debt contracts. Striking a balance between promoting the restructuring of viable firms and protecting creditors' rights is one of the most difficult issues in bankruptcy law design.
Bankruptcy policies set the rules to be followed under liquidation and reorganization, and establish the options available to the parties. These policies determine who has the right to initiate bankruptcy proceedings; they also set priorities among different types of creditors upon liquidation of the debtor's assets, lay down procedures to be followed during liqui-dation, establish the degree to which contracts established prior to bankruptcy can be voided, and determine the extent of the protection granted to the debtor's assets from legal actions undertaken by the cred-itors. Furthermore, bankruptcy policies determine the manner in which debtor and creditors can jointly exercise control over the firms' assets
under a reorganization process, choose the parties that are authorized to prepare a reorganization plan, establish the voting rules whereby the dif-ferent classes of creditors can approve an agreement for reorganization, and set the degree to which secured creditors' claims can be reduced. In addition, bankruptcy policies define the role of the government and the role of courts in the process.
Variations in Bankruptcy Policies Across Countries
Different countries have taken different approaches to resolving the common pool and agency problems. They have also struck different bal-ances between protecting creditors' rights and encouraging restructuring.
United States
In the U.S. reorganization procedure, which is governed by Chapter 11 of the Bankruptcy Code,8 debtors retain significant control rights and substantial bargaining power during negotiations. The debtor remains in possession of the assets and continues managing them unless the court finds it necessary to appoint a trustee. The debtor also has the authority to design and propose a reorganization plan. Recent empirical studies, as well as evidence of a more anecdotal nature, suggest that these features of the legal framework allow debtors to extract significant concessions from creditors.9 In particular, shareholders and management can threaten creditors by delaying the bankruptcy process. If the net value of the assets has fallen and the value of equity is close to zero, delays impose losses on creditors but not on the shareholders, who basically have nothing to lose.
United Kingdom
Whereas the bankruptcy legislation in the United Kingdom prior to 1986 emphasized winding-up over reorganizations, the Insolvency Act, 1986, provides two mechanisms for debtors' rehabilitation: administra-tion and administrative receivership.10 The basic duty of an administrator, who is appointed by the court, is to take over the management of the company, prepare proposals for its rehabilitation, and carry out these pro-posals.11 The administrator has wide administrative and management powers.
An administrative receiver has functions similar to those of an adminis-trator, except that it is appointed by holders of debentures secured by a floating charge, rather than by the court.12 The authorities of the admin-istrative receiver include those granted to the administrator, as well as any additional authority envisaged in the debenture. Under the U.K.
legisla-tion, therefore, in contrast to the U.S. legislalegisla-tion, the incumbent man-agement loses control over the assets of the company.13 More important, holders of debentures secured by floating charges may pre-empt the appointment of an administrator by appointing an administrative receiv-er. By exercising that prerogative, secured creditors dominate the process.
France
The French legislation14 is explicitly designed to save the debtor's enterprise and labor force, as well as to discharge all liabilities. It is dif-ferent from the bankruptcy laws in the United States and the United Kingdom in that it prescribes a single bankruptcy procedure involving several stages. First, except when the enterprise has ceased all activities or when its rehabilitation is obviously not possible, all bankruptcy proceed-ings begin with a period of observation, during which an economic and financial account is drawn up and a rehabilitation plan—setting forth pro-posals either to continue or to transfer the enterprise's activities—is pre-pared. Then, before the period of observation expires, the court either adopts the proposed plan or, if no continuation or transfer is possible, declares a judicial liquidation of the debtor enterprise.
The court initiates a bankruptcy proceeding by appointing an adminis-trator, whose functions include the preparation of the economic and financial account, as well as the plan of rehabilitation. The legislation assigns substantial decision-making power to the court. For example, it is up to the court to decide whether the administrator will merely oversee management operations, assist the debtor in current management activi-ties, or take full control of the enterprise. It is possible for the court to decide that the debtor is totally divested of all rights pertaining to man-agement of the enterprise and disposition of assets. Furthermore, the leg-islation allows the court to adopt the proposed rehabilitation plan even if the debtor, the creditors, or the workers' representatives object. In a reform in 1994, the protection of secured creditors was strengthened somewhat, but the dominant position of the court was left fundamentally intact.
Comparison of Bankruptcy Laws in the United States, the United Kingdom, and France
There is general agreement that bankruptcy codes should include reor-ganization as an option. The question then is, To what extent should the bankruptcy process protect debtors? For example, should the debtor retain the right to control the firm's assets under bankruptcy? How
permitted under U.S. or applicable copyright law.
should bankruptcy reorganization be designed so that it encourages the restructuring of viable firms without jeopardizing the creditors' rights?
The U.S. Bankruptcy Code appears to have incentives to delay and defer liquidation, especially by granting the debtor the ability to impose costs on creditors by delaying the process; the U.K. Insolvency Act, by contrast, may prompt premature liquidations by emphasizing only the rights of creditors—and, in most cases, the rights of only secured credi-tors. Also, the U.S. Bankruptcy Code frequently tends neither to help uphold the original debt contracts nor to protect creditors' contractual rights by allowing outcomes that transfer wealth from creditors to debtors; by contrast, the receivership in the U.K. Insolvency Act results in a speedy settlement of claims. Also, by giving priority to new financ-ing, the U.S. Bankruptcy Code perhaps facilitates access to new financing at the expense of a higher ex ante cost of capital. In summary, both laws are imperfect in terms of economic incentives.
The French system has chosen another approach by granting substan-tial decision-making authority to the court and judges, rather than to the creditor or the debtor. The problem with this approach is that the court may not have any incentive to act in a way that would maximize the value of the firm. Because the decisions of the court, which has no stake in the process, dominate those of other parties who do have a stake in the pro-cess, bankruptcy outcomes may be inefficient and fail to protect creditors' rights.
A better balance may be reached by, on the one hand, requiring that the debtor lose control rights once the company is under bankruptcy and, on the other, not granting control rights or decision-making authority to one set of creditors at the expense of others. This approach would require granting a substantial role to a trustee or an administrator, as in the U.K. system, while curtailing the veto power of secured creditors.
Problems of Bankruptcy Policy in Developing Countries Bankruptcy policy in developing countries faces additional problems.15 First, in many cases, the law itself is outdated. It does not sufficiently dif-ferentiate between the enterprise and its owners and managers, so that rehabilitation of the enterprise as a going concern almost always implies that the owners must be bailed out as well. This lack of differentiation limits the flexibility of the process and restricts the number of options. Moreover, in many countries, bankruptcy has criminal implications, a problem that unnecessarily increases the stigma attached to going bankrupt. Second, there are problems of institutional and financial infra-structure. The processing capacity of the court system, as well as the
number of expert bankruptcy practitioners, is limited. Judges are often inexperienced in dealing with conflicts that arise from financial and com-mercial transactions. In addition, information dissemination and legal documentation in the financial system may be imperfect if accounting and disclosure rules are inadequate.
These features might suggest that bankruptcy procedures in develop-ing countries should not require extensive judgments and evaluations from the court system, and that reorganization procedures are more likely to produce efficient outcomes if, during negotiations, creditors or their representatives are able to control the activities of the debtor firm, including by taking over its management. However, the latter conclusion needs to be qualified. First, in many developing countries, banking sys-tems are oligopolistic; collusive behavior among banks is widespread. Granting banks a dominant role under bankruptcy would not lead to competitive solutions and might possibly encourage abusive behavior on their part. Second, banks are often owned by conglomerates that hold industrial interests as well. In these circumstances, the bankruptcy process may be used to increase the dominant market positions of conglomerates at the expense of firms that are not members of conglomerates. The pol-icy implication would seem to be that, in order to produce efficient results, a reform that would introduce a creditor-oriented bankruptcy law should be preceded by the establishment and effective implementation of competition policies.
In a recent reform of bankruptcy procedures in Colombia, a different approach was taken: the Superintendency of Companies, an administra-tive body, was granted judicial powers and made the sole competent body overseeing the bankruptcy and reorganization of large companies. The bargaining power of debtors was curtailed by imposing tight time limits on the different stages of the bankruptcy process. In addition, the technical and financial expertise of the Superintendency was enhanced through the hiring of additional financial experts. The Superintendency of Companies now analyzes bankruptcy reorganization primarily as an economic and business problem, rather than as a purely legal problem. Preliminary empirical evidence suggests that these changes have actually improved the procedures, which take less time than before.
Conclusion
The bankruptcy process is a mechanism that is used as a last resort in corporate restructuring. It should be seen as one of a multitude of avail-able mechanisms promoting restructuring in the industrial sector. Informal reorganizations, undertaken out of court with the participation
of agents that specialize in corporate workouts, is an important comple-ment to formal bankruptcy procedures. Informal workouts are less costly than formal bankruptcy reorganizations. They work best when the num-ber of creditors with claims to be reorganized is relatively small. The dis-advantage is that informal workouts require the consent of all creditors in that particular class, whereas formal bankruptcy often requires the con-sent of some fraction of the creditors. Hence, when the number of cred-itors is large, it is more difficult to resolve the common pool problem in informal workouts, and formal bankruptcy may be necessary.
Finally, it should be noted that restructuring is in many countries impeded by important shortcomings of the general regulatory environ-ment, such as restrictions on the mobility of capital and labor and inade-quacies of the social safety net. Unless undertaken as part of a general overhaul of the regulatory environment aimed at eliminating these short-comings, a reform of the bankruptcy system alone is bound to be ineffective.
of the U.S. Bankruptcy Code
ROGER M. WHELAN
Introduction
An important aspect of the U.S. bankruptcy system is the emphasis and importance placed on financial rehabilitation—both for individuals and businesses. Chapter 11 of the Bankruptcy Code,1 which generally pertains to business reorganization, is a special relief chapter of the Bankruptcy Code; only persons (individuals, partnerships, or corpora-tions) who are otherwise eligible for relief under Chapter 7 of the code (the special relief liquidation chapter of the code) may seek relief under this chapter. There is, however, no requirement that the person seeking relief under Chapter 11 be insolvent.2
Because of the cyclical nature of the business economy and the diverse types of business problems that have arisen in the past few decades, numerous businesses, ranging from small, single-asset real estate cases3 to multinational corporations, have successfully sought relief under the wide-ranging provisions of Chapter 11. Essentially, the goals of Chapter 11 are (i) to provide a statutory framework within which a debtor may formulate a plan of reorganization resulting in a broad discharge of indebtedness and other protective devices that will enable the business to continue its operations or, alternatively, (ii) to provide an organized plan of liquidation in order to maximize the going-concern value of the failed business for its creditor constituency.
In the first instance, the filing of a Chapter 11 case (primarily consist-ing of a petition seekconsist-ing relief under Chapter 11, detailed schedules set-ting forth a complete and comprehensive description of assets and claims, an exhibit setting forth a summary of the financial structure of the debtor, and detailed answers dealing with various aspects of the debtor's financial transactions) triggers the imposition of an "automatic stay," which, subject to certain defined exceptions, creates a court-imposed moratorium on adverse actions pending or threatened against the debtor or the debtor's property.4
An important development in many Chapter 11 cases is the appoint-ment and role of the unsecured creditors' committee. In addition, for partnerships or corporations, an equity security holders' committee may also be appointed. The Office of the U.S. Trustee, acting independently
of the court, will appoint a representative creditor committee, usually drawn from the 20 largest unsecured creditors and consisting of 3-5 members. This committee may retain counsel, and the expenses of the committee members incurred in connection with the performance of their duties are subject to reimbursement from the debtor's estate. The committee possesses broad powers of inquiry and provides input during the ongoing phases of the debtor's business operations. The committee also has legal authority to assert and pursue individual causes of action to enhance the estate if the debtor fails or refuses to pursue such actions. If the debtor's management has engaged in fraud, gross mismanagement, or essentially any conduct constituting "cause," the bankruptcy court may oust the "debtor in possession" (the new legal entity created by the filing of the Chapter 11 petition) and order the appointment of an inde-pendent trustee to render and investigate the debtor's conduct. The appointment of an independent trustee will also result in recommenda-tions concerning the debtor's future business operarecommenda-tions in the Chapter
11 case.5
Rights and Powers of Debtors in Possession
During every Chapter 11 case, the debtor in possession has all the rights and powers of a trustee. These rights and powers are set forth as follows:
Right to Reject or Assume Executory Contracts6 or
Unexpired Leases
The right to reject or assume executory contracts or unexpired leases is an important aspect of all bankruptcy law. On the one hand, it enables the debtor in possession to rid itself of burdensome contracts or leases, subject only to the right of the nondebtor party to file a claim for dam-ages sustained as a result of this breach; on the other hand, the debtor, in those cases in which a decision was made to derive the benefits of an advantageous executory contract, has the right to assume such a contract, even where there was an existing default, subject only to the debtor's obligation to cure existing defaults, compensate the nondebtor party for actual damages sustained as a result of the prepetition breach, and pro-vide assurance of future performance.
Right to Avoid or Annul Certain Prepetition Transactions
The right to avoid or annul prepetition transactions most frequently asserted pertains to certain transfers of the debtor's property that were
