The case for unifying the EU's insolvency laws

Author: | Published: 1 Jul 2005
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Over the last five years, there have been a number of big insolvencies and debt restructurings across Europe. It must be obvious to all objective commentators that Europe simply does not have an effective, or indeed any, legal regime to support court-supervised restructuring, as opposed to bankruptcies or liquidations. It is astonishing that there is simply no legal middle ground between out-of-court restructurings, with all of their vagaries, uncertainties and differences of approach, and liquidations. Why does Europe not have an equivalent to the US practice of court supervised debt restructuring?

The principle that it is preferable for insolvent companies (as well as their creditors and other stakeholders) to be reorganized rather than liquidated has long been recognized in the US and is now accepted in most European jurisdictions. However, while the US Bankruptcy Code's Chapter 11 provides a clear framework for such reorganizations, the equivalent statutory regimes in Europe do not.

Chapter 11 provisions significantly improve companies' prospects of restructuring their balance sheets and avoiding insolvency. These provisions are not perfect, but after more than 20 years of application in the US, most commentators would probably agree that Chapter 11 provides a comprehensive and workable mechanism for delivering a restructuring.

The key provisions operating to minimize destruction of value in liquidation are:

  • early protection - a company is able to file for Chapter 11 protection voluntarily and, importantly, can do so regardless of whether it can show that it is, or is likely to be, insolvent;
  • the automatic stay, which prevents both secured and unsecured creditors from taking proceedings against the company, (also leading to a sensible and practical approach to handling secured claims);
  • so-called debtor-in-possession powers, which permit existing management to continue running the company;
  • priority for debtor-in-possession (DIP) financing - this super-priority status has resulted in the evolution of a specialized market place where the DIP can borrow fresh funds to continue its business during the restructuring; and
  • limitations on contractual termination provisions.

In addition, two sets of provisions that particularly help insolvent companies to restructure allow the US Bankruptcy Court to reorganize the equity of an insolvent company without a vote of the shareholders and provide for the Court to enforce a reorganization plan despite objections from some creditors (known as cramdown provisions).

The absence of provisions equivalent to some or all of the above in Europe both affects the economics of restructurings in Europe and adds an onerous layer of complexity and transaction risk.

Debt-for-equity swaps

If approached from a balance-sheet perspective, shareholders of an insolvent company no longer have any economic interest in the company; put another way, shareholders will not be entitled to any recovery in the liquidation of an insolvent company that will inevitably follow if the company cannot be restructured. Debt-for-equity swaps reflect the fact that this economic interest has passed from shareholders to creditors and represent an efficient means both of preserving the value of the company's assets, by allowing it to continue in business, and applying those assets in satisfaction of the claims of creditors.

The US Bankruptcy Code gives the Bankruptcy Court wide powers to reorganize the equity of an insolvent company without the consent of existing shareholders; although shareholders will be deemed to vote against any plan under which their interests are impaired or extinguished, they will not be able to block its implementation.

It seems no European country gives its courts similar powers. As a consequence, a debt-for-equity swap in Europe will usually depend on existing shareholders of companies voting to create new equity that will then be distributed to creditors in satisfaction of their claims, diluting the holdings of those existing shareholders. However, the need for a vote of existing shareholders gives them a veto over any restructuring plan. Even though they have no economic interest, those shareholders will often retain an equity stake in the company as the price for approving the issue of new equity.

Insolvent companies and their creditors are understandably reluctant to condition restructurings on a vote of parties with no economic interest in the company, particularly shareholders. On the other hand, the directors will usually wish to give shareholders an opportunity to vote through a restructuring. Practices will differ from case to case and country to country, but the creditor outcome will broadly depend on two factors. First, the approach of the directors; for example in the Marconi restructuring there was no shareholder vote required after the appropriate waiver was sought and obtained from the UK Listing Authority, while in the MyTravel case shareholder approval was a condition of the deal. Second, the outcome will depend on what the alternatives are if the shareholders are asked to vote and vote against the restructuring. If the answer is liquidation, then shareholders are effectively given the opportunity to blackmail creditors with the threat of liquidation; if there is an alternative, this threat does not exist. For example, with British Energy, once the company was able to delist there was an alternative method of carrying out the restructuring. However, given the proposed changes to the UK's listing rules, which would require shareholder approval for delisting alone, the creation out of court of alternative structures to liquidation remains uncertain.

It is striking, that even after the UK's Enterprise Act 2002, administration has not generally been used to restructure large or complex corporates.

Binding dissenting creditors

Most European regimes now provide for majorities of creditors to bind minorities to a restructuring proposal. One notable exception is the current French regime, which requires unanimous consent for restructurings involving impairment of the rights of creditors (except in the case of a plan de continuation, extending maturities for up to 10 years, which requires no consent from creditors at all). New (though delayed) legislation is expected to provide for majorities of creditors to have the power to bind minorities, but it seems highly probable that financial institutions that are not licensed as such in France or the EU will not be subject to these provisions and that the unanimous consent of such institutions will still be required.

But although cramdown provisions of this type do exist under many European regimes, they are generally only available in the context of an insolvency proceeding, which usually results in far greater destruction of value than is the case in restructurings under the US Bankruptcy Code. In principle, out-of-court implementation structures - essentially exchange offers - could be used to overcome this difficulty, but in many European jurisdictions the directors face criminal sanctions if they do not put the company into an insolvency proceeding within a very short period of becoming aware that it is insolvent.

The UK is one jurisdiction where both of these problems can be avoided. Schemes of arrangement can be used to bind minorities to a restructuring proposal outside an insolvency proceeding. Also, there is no absolute mandatory obligation on directors to file insolvent companies and directors will, in appropriate circumstances, avoid doing so while attempts are made to achieve a restructuring. With the Telewest restructuring, for instance, the directors were prepared to wait almost two years for an out-of-court restructuring to be implemented. However, the fact that the company is not in an insolvency proceeding creates problems of its own. Schemes of arrangement for insolvent companies usually (in theory) calculate creditor entitlements by reference to rights in an insolvency, but this is not always a straightforward analysis where different types of alternative proceeding would produce different results. With MyTravel, some of the debt instruments contained provisions subordinating claims in liquidation. Such claims would not have been subordinated by an administration; on the other hand, liquidation would almost certainly have destroyed value for all creditors, value that the restructuring on the table was clearly intending to preserve for stakeholders. One question that therefore arose was whether it was fair for the scheme to analyze economic entitlements by reference to a liquidation, rather than an administration, thus giving effect to the subordination provisions. Creditors challenged the court's initial liquidation-based approach and although the matter came before the Court of Appeal, its decision has done little to clarify the position. There is a school of thought that if creditors are offered what they would have received in a theoretical liquidation then they have no other rights. This cannot be right as a matter of commercial sense, but given that the law does not seem to have recognized this yet, there is still considerable scope for uncertainty.

Where they do exist, European cramdown provisions are very different in substance from those to be found in the US Bankruptcy Code. In some cases, this is a straightforward difference of approach. For instance, under the US Bankruptcy Code, the majorities required to approve a plan are calculated by reference to those voting, an approach widely followed in Europe (for instance in the UK and Germany). In Italy, however, abstentions count as votes in favour of the plan, making it considerably more difficult in practical terms for dissenting creditors to block.

Other differences may appear to be points of detail, but can be crucial in practice. The position on voting claims under US Trust Indenture Act-governed bonds in Chapter 11 is well established (ultimate beneficial holders vote directly). In the UK, where this problem has been addressed most frequently in Europe, companies have generally concluded that the prudent course is to definitize, so that ultimate beneficial holders become legal owners of the bonds, before voting.

Under the US Bankruptcy Code, subordination provisions are recognized and any plan must provide for the claims of dissenting creditors in any class to be satisfied ahead of any claims of creditors junior to them. Few European regimes provide for creditors to vote in different classes at all. In the UK, where schemes of arrangement do call for creditors to be separated into classes, the scheme must be approved by all of the classes and there are no statutory provisions permitting the scheme to be implemented without the approval of a so-called out-of-the money, subordinated class of creditors. The asset transfer route can provide a way around this - often referred to as a Tea Corporation scheme. This involves the transfer of assets and in-the-money liabilities to a new parent, leaving out-of-the-money liabilities behind in the old parent. This is workable, but (given that the asset transfer cannot be effected by operation of the statute) requires the directors to take the risk of allegations by the out-of-the-money creditors that the transaction has defrauded them or has been made at an unfairly low price and should be set aside. This was another issue that was raised, but not resolved, in MyTravel.

Learning from Chapter 11?

The introduction of the Enterprise Act 2002 and the new administration regime was thought by many to push UK insolvency law closer to Chapter 11 style proceedings. The UK has historically been a creditor-friendly jurisdiction and the general abolition of administrative receivership was supposed to temper this approach. But the Act produced a number of safe harbour exemptions from the abolition of administrative receivership, many of which are aimed at bigger value transactions, which, in turn, made it likely large-scale restructurings will continue to follow the creditor-friendly route. Just as inclusions in the Act strayed from Chapter 11 ideals, certain omissions proved that the Act was no Chapter 11 imitator, including failure to include provisions enabling non-consenting creditors to be crammed down and provisions enabling the DIP to assume or reject executory contracts. This, despite the government's declared desire to mirror the entrepreneurial freedom of the US and introduce legislation that removed the stigma associated with business failure.

Insolvent European companies are now restructured much more frequently than they are liquidated, but such restructurings are rarely implemented entirely within the established framework of a statutory regime. If a formal regime is involved at all, it will almost always be supplemented by an out-of-court process or be dependent on the consent of one or more stakeholders. This adds a considerable layer of uncertainty and transaction risk and, as observed above, can alter the economics of a deal. There is no tried and tested, coherent set of provisions that practitioners can rely on. Practitioners are obliged to find solutions that work around cumbersome regimes and to fashion ad hoc restructuring frameworks. In addition, although basic provisions of corporate law and typical financing structures are broadly similar in most European jurisdictions, the problems that have to be addressed in putting together restructurings vary considerably from country to country.

Some European jurisdictions do have the benefit of one or more of the key provisions of Chapter 11, particularly those designed to stabilize a company while it attempts to identify a solution to its difficulties, but without the benefit of the whole package, big problems remain. For example, in January 1999, Germany implemented a new approach to insolvency in the form of the Insolvenzordnung code (insolvency code). Certain features of the insolvency Code do echo Chapter 11 principles - for example, it is intended to promote a rescue-led culture and among other things allows the business to elect to become a DIP instead of automatically appointing an administrator. On the other hand, some omissions from the code leave it a long way short of matching Chapter 11, not least regarding an inability to restructure the equity without shareholder consent.

Italy's creditor-hostile insolvency laws came under the microscope after the collapse of Parmalat. The outdated insolvency regime was specifically criticized for being insufficiently responsive and for permitting judicial administrators too great a power to dispose of assets with little or no input from creditors. The initial legislative response to Parmalat came in December 2003 when the Italian government approved an emergency law to speed up the insolvency procedure for companies with more than 1,000 employees and a minimum of €1 billion in liabilities. Under the new process the administrator enjoys broader powers including the power to void transactions even where the company is being restructured or after a restructuring plan has been approved.

Why is there not a greater call for Chapter 11 style provisions to be imported wholesale into European jurisdictions?

One answer is that restructuring and insolvency are profoundly political, culturally sensitive areas of practice. Most of the restructurings referred to in this article involved debt-for-equity swaps. Such restructurings are designed to allow the business to continue; they provide considerable protection to employees and suppliers; but they do so at a cost to shareholders. A number of recent European restructurings demonstrate a different approach, which depends on the state or national financial institutions to help protect the status quo for the equity, typically through rights issues or new money, or even financial assistance directly from the state. The strict Anglo-Saxon approach involved in debt-for-equity swaps may conflict with the expectations of shareholders that other means of supporting the company, and protecting their position, will be found, even when the company is insolvent.

Individual European countries are showing a willingness to introduce reforms, but consistency across Europe could in practice only be achieved through the EU. The Virgos-Schmidt report on the Convention of Insolvency Proceedings refers to the difficulty of imposing a unified procedure given the need to take into account "safeguards and privileges existing only in one or other member state" and perceived "over-rigid centralization which hitherto appeared to be unacceptable to some member states". The Convention merely sought to regulate cross-border issues and avoid competing insolvencies. Whether the project has achieved even these limited goals is open to debate. As the Eurofoods case arising out of the Parmalat collapse demonstrates, by conferring primary proceeding status on the first filing and requiring jurisdiction issues to be argued first in the jurisdiction where that primary proceeding is filed, the EU Regulation actually encourages a race to the courthouse. Furthermore, well over a year after the opening of proceedings for Eurofoods in Ireland was first challenged, the European Court of Justice has still not ruled on that challenge. Overall, the EU Regulation is an extremely timid measure that has had a limited effect on big out-of- court restructurings. There must be real doubt whether the creation of a substantive pan-European insolvency regime is a realistically achievable goal for the EU.

The Anglo-Saxon model

One alternative would be for European states to look to the Uncitral Model Law on cross-border insolvency. This initiative of the United Nations Commission on International Trade Law is a harmonization measure, its primary driver being to introduce communication between different national courts and provide a set of rules governing the initial coordination process governing a cross-border insolvency. In brief, the rules place a broad freeze on any prejudicial creditor or debtor activity while permitting the debtor business to continue operating until the courts decide how best to proceed. Although it does not go far in terms of substance, it would go significantly beyond the limited effects of the EU Regulation, reducing the amount of forum shopping presently taking place. Ironically, the only major western economy to adopt the Model Law is the US.

It is high time that Europe had a proper legal framework for court-supervised restructuring as an alternative to liquidation. Despite the lack of sufficiently substantive supranational initiatives in Europe, the UK is well placed to take the lead in driving European insolvency reform in this direction. Restructuring practitioners in London are familiar with the Chapter 11 regime and lead the way in creating similar solutions for European restructurings, reflecting a common, Anglo-Saxon commercial approach. A willingness to make changes would have a considerable impact on the rest of Europe, particularly given the prevalence of English law and jurisdiction clauses in European financing documents. Moreover, the depth of Chapter 11 jurisprudence produced by the US courts would be a rich guide to drafting a domestic version.

The current EU Trade commissioner is often portrayed as a supporter of the US approach to insolvency. Whether this view attracts further political capital in Europe remains to be seen, but reforms implemented to date have not begun to tackle the problem. A real opportunity exists to reinforce the UK's position as the pre-eminent financial jurisdiction in Europe - an opportunity that it would be foolish to waste.

Andrew Wilkinson heads Cadwalader, Wickersham & Taft LLP's European financial restructuring practice. Tony Horspool is a special counsel and Ian McKim an associate in the firm's London office