The COVID-19 pandemic is causing financial distress to economically viable firms on an unprecedented scale. In this post, we introduce the novel idea of creditor cooperation duties to stabilize corporate workouts.
The prospect of widespread defaults by viable firms triggered by the COVID-19 pandemic has prompted emergency legislation around the globe. To a significant degree, these measures aim to keep distressed firms out of formal bankruptcy proceedings. For example, duties to initiate such proceedings have been suspended in Germany, Italy and Spain; rules that govern the liability of directors of near-insolvent or insolvent companies have been relaxed in Australia, Singapore, Germany and the UK. The policy rationale of these measures is to minimize the economic loss inflicted on firms by formal bankruptcy proceedings. For viable firms in particular, indirect bankruptcy costs can be huge, eliminating up to 20% of firm value.
Lawmakers so far have been less concerned with what happens to financially distressed firms outside of the bankruptcy process. Even with massive public or private sector liquidity assistance, most of these firms will eventually be forced to restructure their debt. The assumption seems to be that creditors and corporate debtors should be able to agree to a debt-rescheduling plan in a workout, ie in an out of court restructuring. After all, saved bankruptcy costs translate into significant efficiency gains of a workout.
In a workout, creditors must solve a loss/gain-sharing problem, and because they find themselves in a multi-party prisoners’ dilemma, there are, inevitably, holdouts (free riders). Strategic actions of creditors destabilize workouts. But creditors can, to a certain extent, contract out of this dilemma. For example, most countries other than the U.S. afford parties flexibility in choosing a qualifying majority that may amend the core payment terms of a bond issue (Sec. 316(b) of the Trust Indenture Act prohibits such collective action clauses). Further, for a long time, coordination between different types or groups of creditors was supported by informal rules and business practices such as the London Approach to corporate workouts or the INSOL Principles for a global approach to multi-creditor workouts. Consequently, it is not surprising that creditor autonomy and contractual freedom are central to the workout regimes in many jurisdictions. Neither in the U.S. nor in the UK, for example, have the courts imposed ‘cooperation duties’ on holdout creditors and forced them to participate in a workout.
The COVID-19 pandemic should give lawmakers pause to reassess the current legal position. First, ex ante contractual arrangements between creditors to facilitate restructurings are feasible only within a specific debt instrument such as a bond or syndicated loan. They do not address the coordination problem between different groups of creditors. For this, more general rules or principles are needed. However, already prior to the pandemic informal rule systems and business practices for workouts had essentially lost their function. Such rules and practices are sensible tools to the extent that the debt structure of a corporate is concentrated, homogenous and stable—such as when a firm’s key financing is provided by a handful of commercial banks in a syndicated loan. Dispersed debt-holders with heterogeneous interests and an unstable composition of the creditor body is a ground on which neither the London Approach nor the INSOL Principles can flourish. Second, the scale of COVID-19 induced insolvencies is unprecedented. Millions of economically viable firms worldwide might be affected and in urgent need of a debt restructuring. It would neither be prudent nor just to rely on private action and contracting alone to stabilize workouts on such a scale. Providing a generally applicable legal framework that maximizes the rescue chances for as many of these firms as possible should be a first-order public concern. Third, we cannot rely on the threat to force a formal bankruptcy process—such as Chapter 11—to discipline holdouts, because this threat is not credible in every jurisdiction. Bankruptcy courts are or will be overwhelmed by failing firms. Even more importantly, the bankruptcy costs for firms sunk by the pandemic are very high (the overwhelming majority of these firms ‘just’ have a cash flow problem).
Hence, courts or legislatures should consider developing ‘creditor cooperation duties’ to stabilize corporate workouts. Such duties would replicate the contours of a hypothetical inter-creditor agreement amongst all creditors, which the creditors do not conclude ad hoc—because of the strategic incentives and transaction costs they face—but which they would have concluded had agreeing to one been feasible. Creditors would no longer be free to ‘do what they want’ in a workout setting. As a minimum, they would be obliged to negotiate a restructuring plan in good faith. Such negotiation duties can be effective to achieve coordination. Experience tells that merely being forced to engage with other stakeholders and provide reasons for one’s bargaining position has a cooperation-enhancing effect. Under certain conditions, cooperation duties might also force creditors to agree to a proposed workout arrangement. If the plan foresees a Pareto-efficient outcome compared to a (hypothetical) bankruptcy process and respects the ranking of claims under such a process, non-participation of a creditor should not be tolerated. A creditor who torpedos an efficient workout plan for maximum (unreasonable) gain would run a liability risk if the debt-rescheduling effort collapses and the firm is forced to file for bankruptcy.
Cooperation duties would only kick in to the extent that they are necessary to stabilize a workout. Hence, if creditors are able to achieve coordination ad hoc though private bargains, there usually is no good reason to impose cooperation duties by the law. However, such duties could play a useful role to prevent ransom demands by certain (groups of) creditors. Further, cooperation duties would not block all individual enforcement efforts. Such efforts create positive ‘information externalities’ by putting other creditors on alert that the debtor’s finances might be in dire straits. Cooperation duties would arise only after a workout process has been initiated by the debtor or a creditor (group).
Finding a doctrinal basis for creditor cooperation duties is no small task. An indirect basis for creditor cooperation duties could be a duty to perform in good faith in the form of an implied term in contracts between the debtor and its creditors. More direct (and controversial) strategies might be found in an extension of rules in negligence or in the law of partnership. For sure, doctrines would need to be stretched. But we are living in extraordinary times, which arguably demand extraordinarily creative legal thinking. The task is to prevent debt gamblers from turning a global human tragedy into an economic nightmare. Creditor cooperation duties in a corporate workout could achieve just that, and if the courts do not feel able to make a first move in this direction, emergency legislation could provide the necessary framework.
This post comes to us from Horst Eidenmüller, Statutory Professor of Commercial Law at the University of Oxford; and Kristin van Zwieten, Clifford Chance Associate Professor of Law and Finance at the University of Oxford.