UK insolvency reform: Mind over matter

Rachel Evans
Staff writer

"I can announce today that we will consult on taking the best aspects of the American Chapter 11 system and give good companies the breathing space to allow them to rescue or restructure the business in the face of the credit crunch." Stirring words from David Cameron, leader of the UK Conservative Party. His comments to the Confederation of British Industry in July prompted a rush of discussion in the mainstream press. What was this Chapter 11? And what was wrong with UK law as it was?

Meanwhile organisations such as the European High Yield Association felt their time in the spotlight had arrived. The EHYA has been campaigning for a more formal restructuring procedure since 2006. In an interview with IFLR in September, Gilbey Strub, managing director of the EHYA, described Cameron's proposals as "a positive development" that "mirrored" the EHYA's own intentions.

But despite enthusiasm for reform, opinion about change in the legal community is divided. The Big Question (p15) this month shows that lawyers cannot agree on what needs reform or on whether the EHYA's proposals – or Cameron's version – are appropriate. As Stephen Gale, a restructuring partner at Herbert Smith says: "The law has been changing in this area for 20 years. The framework is now working very well and we need a time of non-interference. Uncertainty is worse than a poor law."

Avoid the courts

In fact, UK insolvency law is actually attracting foreign companies in distress. Under the 2000 EC Insolvency Directive (effective 2002), distressed companies have to be dealt with in the jurisdiction of their headquarters, unless they can show that their centre of main interest, or Comi, is elsewhere. Although the numbers are small, several German companies have taken advantage of the Comi provisions, shown that their centre of main interest lies outside Germany, and restructured under UK law. Deutsche Nickel pioneered the process in 2004, Schefenacker followed in 2007 and other large companies have expressed interest. Restructuring and insolvency proceedings in the UK have three clear advantages over the German system: the company can be reorganised out of court, creditors remain active in the process and contractual certainty is maintained.

The UK has a tripartite insolvency process. Companies can enter liquidation, administration or consensually restructure out of court under a Company Voluntary Arrangement or scheme of arrangement. (Administration and liquidation replaced receivership in 2003, but companies formed before this date can still opt to enter receivership.)

Out of court restructurings are very difficult under the German system. Under the 1999 law, a company must file for insolvency within three weeks of discovering that it is over-indebted or facing a liquidity drought. These three weeks typically do not allow enough time for the company to come to terms with its creditors and restructure its commitments. "This is like a Damocles sword hanging over a company's head," says Annerose Tashiro, an insolvency specialist at Schultze & Braun. "The tight timeframe often means that companies run out of time to do a restructuring." As a result, a company that might easily be restructured consensually enters formal insolvency proceedings. (The German government however eased filing requirements for over-indebted companies in October. Over-indebted companies do not have to file for insolvency if in all likelihood they can continue to operate as a going concern rather than entering liquidation. This measure however is intended to address difficulties valuing assets in the present market and is due to end in 2010.)

The German court then appoints an administrator to oversee the insolvency. While in the UK an administrator is jointly chosen by the creditors, neither they nor the company has any say in the appointment in Germany. Local rather than national courts deal with proceedings, so the administrator is not necessarily best suited to manage the insolvency at hand.

The UK regime is also more creditor friendly. Unlike Germany, dissenting creditors cannot be crammed down. Cramdown refers to the process by which the approval of a class of creditors can be forgone if the group would not gain more from a standard liquidation. In Germany, creditor groups can be crammed down under an Insolvency Plan. This plan must be pre-agreed before the insolvency but usually guarantees a quicker solution and allows the company to remain in control and bypass administration. Cramdown allows a company to go ahead with the Insolvency Plan if a group of creditors disagrees with the majority, provided that group will not lose out from the company avoiding liquidation.

While this process has advantages, namely preventing out of the money creditors from stalling a restructuring, the UK regime achieves the same effect by less formal means. In the UK, a scheme of arrangement needs approval from 75% of creditors in each creditor class. A CVA, however, needs this approval from all creditors voting without class. If creditors would get nothing from a liquidation, they must be persuaded to accept the restructuring plan. The UK scheme therefore encourages more discussion and ensures that the rights of all creditors are taken into consideration.

The UK regime means that restructuring can take place outside the courtroom, and that when a company does enter formal proceedings the creditors and the company's management remain engaged in proceedings. As a result, companies are migrating to the UK from Germany, forcing the German government to consider reforming its law. Yet the EHYA is proposing a similarly rigid system for restructurings in the UK.

In a letter to HM Treasury in February this year, the industry body argued for a court-driven restructuring procedure: "Out-of-court restructurings may have worked, albeit imperfectly, in the past, but are not adequate to address the challenges of the present," said the EHYA. The association wants a court-granted three-month stay of enforcement against creditors of distressed companies, and a court-appointed monitor to evaluate the company while the stay is in effect. Under the plans, this monitor would be required to report back to the court after 14 days of the stay on the likelihood of the company reaching agreement with its creditors and successfully restructuring under a CVA or scheme of arrangement. The court could again get involved to solve issues of valuation.

But as Uwe Goetker of McDermott Will & Emery points out, "the UK's CVA and the fact that you can do an informal restructuring is its biggest advantage as Germany doesn't provide for out of court proceedings which can force creditors by majority vote into a compromise." Tashiro agrees: "In the UK it's possible to have a CVA out of administration. It works because it's a strong tool but isn't a formal procedure. From a legal dogmatic standpoint, it is highly complex but it grants flexibility. And creditors have more control of the process which encourages earlier talk of insolvency and therefore faster workouts."

Uncertain contracts, uncertain laws

The EHYA's stay of enforcement could not only damage UK law by pushing restructurings into court, it could also undermine contractual certainty. The EHYA wants the stay of enforcement to "render unenforceable any contractual clause that gives a party the right to terminate or modify the terms of the contract solely on the grounds of the filing for the automatic stay", and allows companies "to request the court to disapply any contractual negative pledge which prevented the company from borrowing funds".

This challenges UK contract law. As Georgia Quenby, of McDermott Will & Emery says: "In terms of contract, I lean towards the English law principle of freedom of contract. A company ought to be able to say that it only wants to contract with another party while that party is solvent." The EHYA does not propose a stay on suppliers or customers terminating contracts for non-payment or non-performance, but disregarding clauses that do refer to the stay as a just cause to terminate a contract undermines the principles of contract law. And this at a time when lenders are already unwilling to lend.

Instead of giving companies the "breathing space" to restructure, the EHYA's proposals to vary termination clauses could discourage lenders from contracting with riskier companies and might encourage these lenders to pull out as soon as companies get into trouble. As Goetker at McDermott says: "If there's a block against terminating a contract, companies might decide to terminate sooner rather than later. And if somebody is forced into maintaining a contract, that contract should be fully fulfilled." In Germany, this latter point is particularly pertinent. By law, an administrator can terminate or maintain a distressed company's contracts. But if the administrator decides to maintain the contract, that contract must be honoured in full or the administrator could be personally liable.

However, the uncertainty that the EHYA's proposals would cause run deeper than individual contracts and insolvencies. Company liquidations in the UK rose by 15% in the second quarter of 2008, compared to the same period in 2007, and by a further 10.5% in the third quarter, according to figures from The Insolvency Service. With so many companies going bust – and more expected in the wake of Lehman's high-profile collapse in September – now is not the time for significant reform of the UK's tested insolvency regime. "Our law is not perfect but right now it should be left alone, there has been enough meddling," says Stephen Gale of Herbert Smith. "You need certainty in a downturn and a procedure that everyone understands."

Spain is a good example of the dangers of reform. Its insolvency law was streamlined in July 2003 (effective September 2004) to create one regime for all companies and individuals. Taking inspiration from both German law and America's Chapter 11, the process is court based. Three administrators are appointed and a majority must agree on all actions taken by the company. Restructurings can happen outside court, but they are not protected by a framework so any party can walk away from the discussions. While Spanish lawyers broadly agree that the new law has improved Spain's previous system, doubts remain about its efficacy. The new law has not been tested by a major insolvency case, and lawyers report that its novelty is discouraging companies from filing.

"People are reluctant to file under the new insolvency law because they don't know how it will be interpreted," says Rafael Sebastian of Uría Menéndez. "But an increasing number of companies are having to file for insolvency even though it's unchartered water." In July, Martinsa Fadesa became the first listed institution in Spain to file for insolvency as a result of the credit crunch. The real estate company, with assets worth an estimated €10.8 billion, commenced insolvency proceedings when it failed to secure a €150 million loan as part of a restructuring plan. The case is only four months old, but already problems with the new system are clear. The case was filed at a local court in La Coruña where the judge ruled that law firms bidding to advise on the case would have to wait until he, and the administrators, returned from holiday a month later for confirmation of the mandates.

The case is due to close in mid-2009 and will set a needed precedent for subsequent distressed companies and their creditors. But it could be years before creditors and companies have confidence in Spain's insolvency law. For example, in 2000 the European Commission directed that multinationals must be restructured in the jurisdiction of their headquarters, or their centre of main interest (as discussed above). As a result, the EC called for greater collaboration between countries on the insolvencies of multinational companies. But this is still not the norm. As one cross-border insolvency lawyer reports: "Banks in Italy don't recognise your signature so there's first the practical issue of getting control of a company. And then when you're identifying creditors, you can only speak to the tax office – a company creditor – via certain forms. The administrator knows that there's a claim by the tax office, but they can't get proof of that claim."

Harmonising solutions

One alternative to country-specific reforms – such as the EHYA proposes for the UK – is Europe-wide harmonisation. But as the problems some lawyers have encountered in implementing EC directives suggest, a harmonised approach to insolvency in Europe will not be easy. The EHYA's desire for its UK reforms to "ostensibly serve as a template for pan-European harmonisation" is rather optimistic.

"My kids will probably be retired before that happens," says Ansgar Zwick, a managing director at Houlihan Lokey, Germany. His French colleague François Faure explains: "These things take an extremely long time. There are EU directives in place but countries have very different regimes. You'd have to harmonise everything or nothing because there are so many links between insolvency law, corporate law and civil law." Property law also varies from country to country, as do fiduciary duties, liability law and employment law.

For example, the French approach to employees differs greatly from that in the UK. In France, employees' jobs and wages are given more consideration than in the UK, where the emphasis is on the creditors' rights. This is not just due to France's active unions; pensions are distributed to workers through their salaries. In the UK, pensions are managed by funds that are often creditors in the distressed company. As a result, UK law protects pensions by upholding the rights of the pension-fund creditors, while French law protects pensions by upholding the rights of the employees. These different approaches to one issue would have to be reconciled for a European insolvency law to be feasible.

The likelihood of a Europe-wide insolvency law is therefore slim, with lawyers rating its probability as low as 5% in the next 30 years. Non-binding principles would be a welcome first step but as the EU gets ever bigger, harmonisation of its disparate insolvency laws, even to provide an informal tick-list for proceedings, gets harder.

Choose: harmonisation or Chapter 11

But if the EC fails to push for harmonisation, no matter how difficult, EC countries could find themselves compelled to embrace American practices, such as Chapter 11.

Chapter 11 is one of two insolvency options open to distressed companies in America. While Chapter 7 is used to liquidate companies and sell off their assets, Chapter 11 allows a company to operate as a going concern as it tries to restructure its obligations. Chapter 11 is a court-supervised procedure that allows the management to remain in control of the company under so-called debtor-in-possession provisions.

The law also includes an automatic stay on enforcement of debts by creditors, the ability to vary contracts if doing so would be beneficial to the company, and allows the company to seek additional funds from super-priority lenders after filing for insolvency. Companies can also cram down, and thereby ignore, dissenting creditor classes that vote against a rescue plan when that class will get more under the restructuring than in liquidation, or when more junior creditors are entitled to nothing.

Chapter 11 has proved relatively successful in the US, leading several European countries to adopt Chapter 11-type measures. As Zwick at Houlihan Lokey comments: "With Chapter 11, people know without fail how the process will work. All the stakeholders not just the creditors are taken into account." Germany revised its insolvency law in 1999 and incorporated some of Chapter 11 into its Insolvency Plan procedure. These plans, although rare due to the time constraints of filing for insolvency in Germany, allow cramdowns, as mentioned above. Groups of creditors can be crammed down if they would gain more from the Plan than a liquidation. This makes it more likely that an Insolvency Plan will be successful.

German insolvency law also allows the company's management to avoid a potentially inexperienced administrator by applying to become the debtor in possession (though these petitions only affect about 5% of insolvencies) and allows any administrator to terminate or maintain contracts.

Similarly, the French sauveguarde has been billed as Chapter 11 "à la française" in the sense that it protects a company from the demands of its creditors. The management remains in control of the company, as under Chapter 11, and a court-appointed administrator monitors the process. Two creditors' committees have the power to approve the sauveguarde plan: the credit institutions' committee and the main suppliers' committee. Unlike the US, creditors are not divided into committee by class and whether they are secured, unsecured or subordinated creditors.

Chapter 11 seems to be gaining credence as a means to rescue insolvent companies. The Czech Republic and Romania have used Germany's reforms as a blueprint for their own, pushing Chapter 11 into Eastern Europe. Now the EHYA and the UK Conservative Party want to incorporate features of Chapter 11 into UK law, notably the automatic stay, the availability of additional funding and cramdown.

The UK is not suited to Chapter 11

But some lawyers do not believe that Chapter 11 is suited to the UK. They argue that campaigns by the EHYA, for example, are prompted by American lobbyists. "A lot of capital structures around European companies involve American debt," says Herbert Smith's Gale. "And the US likes the world to follow its structure and system. Behind the arguments of the EHYA is a desire to have the world play on the US field, as it would prefer to use procedures from over there." This is something that the organisation strenuously denies, but there are other arguments against taking aspects of Chapter 11 into UK law.

Cramdown is a controversial aspect of the US system because it disregards the opinions of creditors and relies on an accurate evaluation of what a class could expect under a liquidation compared to a restructuring. While out of the money stakeholders should not be able to hold a company to ransom, some argue that a formal cramdown procedure is unnecessary.

A UK scheme of arrangement needs to be approved by shareholders after gaining 75% approval from all creditor classes. But if equity has been completely eroded, shareholders do not have this power. Such a minor change could easily be made to CVAs to prevent creditors from blocking a restructuring if they have no real economic interest remaining without introducing cramdown, and its committees, wholesale.

Chapter 11 proceedings can also be very expensive. The company has responsibility for drawing up a rescue plan while management runs the day-to-day business and creditors debate with the company through committees. All this has to be paid for out of the company's funds, quite a big ask from a financially distressed institution. The process is also not well set up to deal with companies suffering as a result of the liquidity crisis. Companies can seek extra cash from super-priority lenders – meaning that these lenders will be paid back before all others – but many institutions don't have the cash to lend and are risk adverse.

And the prevalence of cov-lite loans in the boom years preceding the credit crunch means that companies are only triggering their covenants when they are in serious distress. This diminishes the likelihood of a successful restructuring or creditors getting their money back. As Georgia Quenby says: "One of the interesting things to happen in the US this year is that Chapter 11s have been hard to do. By the time a company triggers its covenants, there's nothing but fumes left and nothing to put through a Chapter 11."

While Chapter 11 has clearly introduced some useful reforms into Europe, the credit crunch has neutered its effectiveness. Now is not the time to introduce aspects of it to the UK.

All in the mind

The UK's insolvency and restructuring system is fit for purpose. The fact that companies can restructure outside of court, under CVAs or schemes of arrangement, is popular with distressed companies and a major reason why companies from other EC jurisdictions have migrated to the UK. Equally, the UK's formal insolvency proceedings work. Liquidation does what it says, and administration provides a means by which insolvent companies can be rescued.

Or at least it would, if people believed it could.

The problem with administration is not legal but psychological. In theory, administrators can not only save a business (as receivers could under the old regime) but the company shell in which the business operates. But there have been few if any cases where a company has been rescued by administrators; in virtually all rescues, the business, not the company, has been saved. This has made administration a last resort for companies that have tried and failed to restructure, rather than a white knight regime. As Gale says: "You would not use an administration if you could rescue the company, you'd only use it if there's no hope."

This was not the intent. When the government established the administration regime in 2002 as part of the Enterprise Act, it wanted to save distressed companies rather than just their businesses. But this hasn't happened and administration has become shorthand for a moribund company. "This is one of the most convincing arguments for reform to the UK's insolvency laws," says Richard Tett of Freshfields Bruckhaus Deringer. "There remains a perception that any company in insolvency is a failure and that administration spells the end of the company. Administration can quickly deliver a pre-agreed solution and rescue the business. However, it is almost unheard of for a company to enter administration, trade on and then exit after reaching an agreement with its creditors."

However, while Chapter 11 in the US does allow companies to do this, its problems – high cost, court intensive – are not necessarily compatible with the UK's less formal restructuring culture. They also seem to be at odds with the prevailing financial climate. The courts are already overrun with administrations; a new process that requires a monitor would only create extra work. And insolvent companies may not be in a position to obtain the extra funding that a Chapter 11-style process would require because banks don't want to lend, even on a super-priority basis.

But the main argument against reforming the UK's laws is the uncertainty that this would create at a time when companies and lenders are already skittish. "If you're trying to restart the economy, lenders will only lend where the regime is robust and they know that they can get their money back," says Quenby. "So, at a time when the economy is struggling, reform would make it harder for lenders to commit to businesses if they can't see how they get their money out."

Instead, campaigners such as the EHYA need to focus on changing attitudes to the UK's existing regime. Administration, with a few tweaks, could become the in-court rescuing regime it was intended to be, making a Chapter 11-style process unnecessary. It's just unfortunate these changes couldn't be made before the recent turmoil. As Gilbey Strub said of the EHYA's proposals in September: "We voiced our proposals at the peak of the bubble in the hope that reforms could be put in place by the next downturn. We're now in that downturn and it's a little bit disappointing that it's taken a credit crisis to get the government's attention."