Several countries and regions around the world, including Singapore, the United Kingdom, and the European Union are amending their restructuring framework to implement a pre-insolvency mechanism that looks like a US Chapter 11 reorganization. However, unlike what happens in the United States, where unsuccessful reorganizations lead to Chapter 7 liquidations, companies using this ‘de facto Chapter 11’ (DFCH11) are still allowed to use the formal reorganization procedures existing in their insolvency jurisdictions if the DFCH11 fails.
In a recent paper, entitled ‘The Future of Reorganization Procedures in the Era of Pre-Insolvency Law’, I argue that, whereas the rise of the DFCH11 is not necessarily undesirable provided that some further protections are put in place, policy-makers do not seem to be adapting their formal reorganization procedures to this new era of ‘pre-insolvency law’, and some inefficiencies might be created from this lack of coordination between insolvency and pre-insolvency law.
Namely, I argue that debtors seeking to use formal reorganization procedures should be subject to stricter eligibility requirements in this new era of pre-insolvency law. After all, if companies do not use these pre-insolvency procedures that may facilitate, at a lower cost, a financial restructuring by providing some ‘insolvency tools’ such as a moratorium, cramdown and DIP financing provisions, or these pre-insolvency agreements fail, there will be reasons to believe that either the company is not viable or the creditors do not trust the managers. In either case, the company will not deserve to be reorganized. Therefore, unless some enhanced controls are put in place to prevent these companies from using formal reorganization procedures, there will be an increase in the number of debtors opportunistically filing for reorganization.
There are two general ways to prevent opportunistic filings in bankruptcy: (i) ex ante controls (eg, requiring debtors to prove certain financial and viability requirements) and (ii) ex post controls (eg, dismissing a bankruptcy case or imposing sanctions on the insolvent debtor or its directors). While I find more reasons to favour a system of ex post controls in countries without a DFCH11, the risk of using formal reorganization procedures opportunistically increases in jurisdictions with this pre-insolvency mechanism. Therefore, it makes more sense to apply a system of ex ante controls in these latter jurisdictions. Otherwise, the higher risk of opportunistic filings may lead to an increase in the cost of debt, harming firms’ access to finance in the country.
In my paper, I argue that debtors seeking to use formal reorganization procedures in countries with a DFCH11 should be subject to stricter eligibility requirements. First, debtors should show that the going concern value of the firm is higher than its liquidation value. By doing so, they will prove that the company is economically viable in the sense that the assets are best allocated in their current use. Second, the debtor should also prove that the company, with its current shareholders/managers, has the support of a minimum percentage of creditors as a means to demonstrate that a reorganization agreement will be feasible between the debtor and its creditors. Otherwise, a going concern sale will be more desirable if the problem is not the viability of the business but just the lack of trust in the current shareholders/managers. Finally, the debtor has to explain convincingly why it did not use the pre-insolvency framework or why the DFCH11 failed, since there might be some exceptional reasons justifying the commencement of a formal reorganization procedure (eg, lack of time to reorganize the company under the DFCH11 or inability to use avoiding powers to recover certain assets that can facilitate the reorganization of a viable business).
In my opinion, unless debtors filing for reorganization are subject to these higher eligibility requirements, several inefficiencies might be created. Ex ante, creditors might respond with an increase in the cost of debt as a result of the higher risk of opportunistic filings. Ex post, value can be destroyed if non-viable firms are allowed to use formal reorganization procedures, and jobs and wealth might be lost if economically viable businesses managed by the wrong people are not quickly sold as a going concern instead of being allowed to try (sometimes again) a reorganization agreement. Therefore, even though the ability to use reorganization procedures opportunistically will be more unlikely in jurisdictions where these procedures are managed by a third party (eg, administrator) rather than by the debtor itself (sometimes under the supervision of an insolvency practitioner), countries implementing a DFCH11 should make sure that their formal reorganization procedures have been adapted to this new era of pre-insolvency law.
Aurelio Gurrea-Martínez is an Assistant Professor of Law at Singapore Management University.