Insolvency Law

“Critically discuss why the retention of commercial morality and public confidence is critical when constructing an insolvency law system. Identify and analyse measures that might be taken to ensure that a system ensures that commercial morality and public confidence is retained.”

Introduction:

In today’s rapidly changing global market, new concepts of commerce keeps reshaping the economy and a society that provides the use of credit by companies, there is always a certain degree of risks involved. If a number of creditors owed money and all had pursued the rights and remedies available, it would be a chaotic situation which would lead to unfairness as the creditors who enforce their claims with vigour would succeed in the long run. The main aim of insolvency law is to replace free for all legal regime with a proper process for orderly collection of the debtor’s assets and fair distribution thereof. Earlier insolvency law was concerned with individual insolvency, where there was no collective procedures leading to the creditor’s acting individually and the law had a punitive approach. Only later did the concept of rehabilitation developed. There was bifurcation of approaches towards the system which were all prone to manipulation and malpractices. Various committees were set up for credit, security and debt but none proved fruitful. The numerous loopholes led to the setting up of the Cork Committee to review and provide recommendations. It was then that the well-defined legislations on insolvency law developed whereby all abusive practices were taken into account, remedies were laid down and even the interests of secured and unsecured creditors were given life.

Insolvency law system has certain objectives that it tries to achieve, namely, to restore the debtor company to profitable trading, to maximize the return to the creditors as a whole, to establish a fair and equitable system for the ranking of claims and distribution of assets, identify the causes of company’s failure and imposing sanctions for culpable management by its directors and officers.

The challenge faced by most of the developing countries is to create effective enforcement and insolvency systems that foster strong credit cultures and enable economies to promptly respond to defaults in a way that promotes economic growth and competition and which aligns local commercial practices with the modern business tactics. An effective insolvency regime is the only possible way to foster public confidence which is required to fuel investment or commercial activity which will help respond to the financial risks and which is the purpose of this essay – to provide an overview of the insolvency system along with the measures necessary to make it functional and pro economic system. Therefore I shall discuss the ways of restoring public faith and series of different visions legitimating rationales for insolvency processes and ultimately the need for a sound legal system with criticisms.

Maintaining Commercial Morality And Public Confidence:

As I have discussed earlier the role that the Cork Committee had played to frame a sound system, it is significant to mention that the committee largely emphasized on maintaining commercial morality and confidence and also mentioned that the society needs to be satisfied in four matters, they are, whether or not fault attaches to the conduct of the insolvent , if it does the insolvent should be punished, that the insolvent’s conduct in future should be controlled while at the same time allowing re-establishment of trading and to what extent the responsibility of the insolvent is attributable to someone else. In addition to the above considerations, it also observed that the success of any insolvency law system is dependent on those who administer it. The report of the Insolvency Law Review Committee, Insolvency Law and Practice stated that English law always recognized community interest in insolvency law that is why insolvencies are resolved expeditiously restoring commercial morality and protecting from the adverse effects involved. There has been instances where the courts have refused arrangements between insolvents and creditors to foster morality. Public interest may be hard to define but is always taken into account in insolvency law as it has social outcomes for eg. losing jobs. Society therefore ensures public interest by investigating the affairs of the insolvent.

One most important requirement for public confidence in the system is the integrity and competence of those charged with implementation of the law and the system must be managed by experts rather than letting it go in the hands of unscrupulous creditors. There has always been a debate as to who should control the process of collection and distribution of assets to prevent abuse of powers as that itself hampers public confidence. There is no criminalization on insolvency but there is a state of affair which requires public explanation and inquiry. However, it is to be remembered that retaining and balancing commercial morality with insolvency is difficult as taking risks in an inevitable feature of growing company and failure too at times is attached to it.

Retention of public confidence can be critical while constructing a system as the implementation of the basic aims of insolvency law can be time consuming. Providing and equal, fair and orderly procedure with little delay and expense, to provide mechanisms which allow for the treatment of the affairs of insolvents before their position is hopeless, to provide relief and protection for individual insolvents from harassment, to provide procedures where the interests of both the creditor’s and debtor’s shall be looked into to prevent conflicts, to attempt to diminish the negative effects of insolvency on the public etc. has all been theoretically stated but the question is how far are they executed? There are various scholars elucidating variety of theories with regard to insolvency and all have tried to give an answer from their perspectives as to what is the main aim of insolvency law, but are they helping us balance the interest of the creditors and debtors or with the society at large? For example the creditor’s bargain theory which emphasizes on protection of the interests of the creditors but has been criticized on the ground that it lacks moral force. The approach that overcomes this former approach is the contractrian concept where Jackson seeks to justify insolvency law with reference to the rules that contract creditors would agree to from behind a veil and has been criticized as it fails to explain how agreements can be reached behind the veil. In contrast to the above approaches is the communitarian theory, but the demerit here is community interests cannot be identified. In stark opposition to the above approaches is the multiple values approach which takes into account various interests and includes the above approaches into its ambit. Practically, now the commercial world is characterized by competition and often conflict, so it is very essential to be to be clear about the insolvency law. All parties facing insolvency issues co-operate by being guided by public rules and procedures and co-operation can be achieved only when parties are given benefits. It works on the concept of reciprocity where everyone pursues their interests equally. Even then it has been criticized as those who are incapable of providing reciprocal interests are excluded from the concept of justice based on reciprocity. Moreover we will find that it has very little relevance in corporate insolvency because here even the weakest party can reciprocate by regulating their activities with fair insolvency policies. That again leaves us with the question as to what role does insolvency law play?

There are various alternatives to bankruptcy which a debtor can avail firstly the Debt Relief Order, secondly an informal arrangement with the creditors, thirdly administration order which is a court based process; fourthly individual voluntary arrangement.

Constructing An Insolvency Law System:

There are various factors that need to be analyzed before constituting an insolvency system. The basic principles itself suggests that insolvency law largely tries to balance the interests of the stakeholders, the creditors and the society at large. Therefore we need to strike a balance taking in account the fact that the interest of one stakeholder always conflicts with other and there has always been a debate as to what interests needs to be considered first, even though the priority claims are set out. Like Jackson coming from law and economics school of thought in U.S.A., takes the view that insolvency law is not concerned with the debtor or public interest but about the claims of the creditor’s but Miles, another scholar contests this view and has a more socialistic approach stating that the law is devoted for the debtor’s who are not able to pay their debts. Focusing on the balancing point, it can be quite a task to draw a balance between the creditors and debtors or even between the creditors themselves. One cannot look away from the fact that in insolvency situation creditors incur loss and it is justified for them to enforce their debts but at the same time mercy has to be shown to the debtor’s so that it can start anew which is an aim of the system. Coming to the conflicting interests between the secured and unsecured creditors, it is very unfortunate that the latter category usually are the one’s facing the harsh effect of insolvency albeit the Pari Passu principle. The principle maybe sound from the bankrupts viewpoint as it saves from being harassed and is a favourable way of resolution upholding public interests. Even then it is to be noted that this principle is restrictively applied as there are certain unsecured creditors given preferences, making them stand out in the priority list depriving the other unsecured creditors which again can be unjust. There is definitely a need for reform but the difficulty in laying down a concrete rule is that every case of bankruptcy is different which poses hardship in resolving matters. Nevertheless there is no dearth of suggestion like in “1994 JUSTICE, in its report, Insolvency law, an agenda for reform took up the idea of distinguishing between insolvents. It advocated that there should be two-tier bankruptcy system, a serious tier and a non-serious tier.” But the question is does drawing such line solve the issue? Does it have any balancing effect or does it complicate things? In my view it can make the matter worse as all debtors cannot be labelled as honest and unfortunate and this distinction can create opportunities for the greedy creditors. This can lead to more injustice. Therefore we need a system where all possibilities are covered, which is comprehensive yet self contained.

Apart from the above discussion the reforms that are required are the need for a strong insolvency system as it is a vehicle for resolving disputes and if effective then it encourages prudent lending and a sound credit culture. Hence a well designed insolvency law provides valuable incentives for the maintenance of high standards of corporate governance. In this way public confidence in the integrity of credit system is advanced. An insolvency system must be compatible with the legal and commercial systems of the society. It must address all the interrelated issues and the process for resolution like emphasizing on collectivity regime rather than an individualized one. The law should also be integrated with the general law where it is to operate so that they can complement each other and there can be consistency in the legal framework. The rules must be such that the judiciary, regulators or the administrators are able to implement them effectively. The system should be properly monitored and most importantly the cross border issues must also be well-accommodated in the law. It should provide for rehabilitation where economically reasonable or liquidation where it is not. The debtor’s access to the system should be made friendlier and the creditors should be conditioned on showing proof of insolvency. The whole system of moratorium must be made all embracing and a creditors committee should be established to safeguard their interests. The law should provide for a commercially sound form of priority funding for the ongoing and urgent business needs of a debtor during the rescue process, subject to appropriate safeguards and for accountability and transparency.

In a speech in July 2008 to the Confederation of Business and Industry, several proposals to amend insolvency law was sought after. The first proposal is ‘super-priority’. In the US, there are a number of reputable lenders offering funds to distressed companies where the lender is protected by having priority over assets of the business but these proposals are still being scrutinized as there are questions which are left unanswered even now .Another proposal is to prevent unscrupulous creditors vetoing desirable restructurings . In addition measures should be taken to set up insolvency law courts with judges who are expertise in the field and in my view the alternative dispute resolution system should also be encouraged. Since insolvency is a global issue, the courts may be overburdened with litigations and the ADR like mediation or negotiation can be a good alternative for resolution of interests. It can also prove to be speedy and less expensive and more over the parties can understand each other’s interest and sign a fair deal.

The big question is how the Insolvency law in UK can be reformed? Lawyers aren’t sure whether UK insolvency and restructuring laws are effective or defective. As a poll for this month’s IFLR shows, the legal community is evenly split between those in favour of reform and those against it. One third of respondents (34%) wanted some reform of insolvency law but 33% think change is unnecessary. The credit crisis has introduced a period of turbulence in insolvency law and it is necessary that we are clear about the factors driving reforms. Three models of insolvency law reform can be distinguished: the ‘adaptive’, the ‘strategic’ and the ‘redirective’ approaches. An examination of four recently canvassed reforms of corporate rescue procedures raises questions about the ways in which insolvency processes are developed in this commercially important area. The reforms relate to new court-supervised restructuring procedures; super-priority funding; imports from Chapter 11. Seeing insolvency reforms in terms of the three proposed models offers the prospect of increased clarity on the case for legal change. Gilbey Strub, EHYA’s managing director explained, “Although the Enterprise Act 2002 was meant to increase the use of administration for company rescue, academic studies have widely concluded that it has failed to do so. Instead, nearly all large restructurings in the UK continue to be effected on an out-of-court, ad hoc, consensual basis, without a predictable legal framework or meaningful precedent to guide the process.” Even Rachel Evans in her article states that importing American Chapter 11 can give companies breathing space for rescue but however despite of all these enthusiasm lawyers cannot agree whether the reforms are appropriate or not.

Infact the UK insolvency law is actually attracting foreign companies in distress. Under the 2000 EC Insolvency Directive distressed companies have to be dealt with in the jurisdiction of their headquarters, unless they can show that their centre of main interest is elsewhere. German companies have taken advantage of the provisions, and restructured under UK law which has tripartite process. Therefore we see that the UK regime is more creditor friendly but the process has been criticized that it may have worked earlier but may not prove to be a success in the present scenario as from a legal dogmatic view the process is highly complicated for example in Spain, after reforming the insolvency law taking inspirations from U.S.Chapter 11, it has been stated that companies are reluctant to file under the new system as they are not sure how it will be interpreted. The only remedy is Europe wide harmonization as proposed by EHYA but its time taking as different places have different regimes and insolvency law in connected with various other laws, hence it is almost impossible but even then the EC can embrace Chapter 11 which is a court-supervised procedure that allows the management to remain in control of the company under so-called debtor-in-possession provisions, but there are lawyers who opposes this as they believe UK is not suited for Chapter 11.

However there are scholars who support the Pre-packs strategy whereby an agreement for the sale of the business and assets of an insolvent company is negotiated prior to the instigation of formal insolvency proceedings and the supporters view this as the best option to sell a going concern as it gives a certain outcome but it has been criticized for it may not adequately expose the business to the market and so may fail to maximise value, that they are insufficiently transparent, and are biased towards secured creditors .

The EBRD regularly carries out surveys to see how effective are the insolvency law in the country of operation. These laws are measured against the international standards and this has led the EBRD to frame core principles for a modern insolvency law regime like the ILR should perform bankruptcy and restructuring, should provide for immediate interim measures, should provide a clear test for initiating proceedings, should facilitate cross border insolvencies.

V. Finch draws our attention to the fact that there is a recasting of insolvency law taking place in philosophies and actors; that a fundamental philosophical change is now occurring so that the law, in combination with corporate and creditor practice, is moving from a focus on ex post responses to one that involves influencing the ways that corporate actors manage the risks of insolvency ex ante. The Enterprise Act for instance did more than just rescue encouraging those with troubled companies to think of insolvency risks in advance. It provided that administrators should act in the interests of the company’s creditors as a whole and, second, it set down inclusive procedures and enforcement provisions that ensured that the interests of creditors would be taken into account and protected when the administrator took decisions about the company’s prospects. This way the whole focus of insolvency law shifted from collecting debts to managing risks. Nonetheless it has been argued that this may lead to the banks adopting other policies resulting in diminution in incentives to monitor the activities of the debtor company but keeping in mind the market situation it will still help underpin the risks involved. As mentioned earlier there is recasting of actors too like the banks now shall be more careful on lending making them more active than before. They will no longer be passive and distant from the troubled company but use its skills and professionals to help prevent troubles. This again can be argued to a point that being excessively monitored by the banks may make the company’s officers resort to self defence mechanisms diverting their mind from managing business to managing clear records. This Act has also highlighted a positive aspect in relation to the unsecured creditors, whose interests are also to be considered before formulating strategies. The new changes in the Enterprise Act are based on the principle of equity and efficiency. These are the collective insolvency proceedings in which all creditors take part and not just fixed and floating charge holders have say in it. Under these collective proceedings a duty is owed to all classes of creditors and an office holder has to account for his dealings with a company’s assets to all creditors.

Sensing the need for an effective insolvency law during this economic downturn the government has said that evolving a bankruptcy law is the prime priority. Sumant Batra, president of UK-based International Association of Restructuring and Insolvency Professionals discussed insolvency provisions in the Companies Bill 2009 with ET said the proposed insolvency law seeks to achieve a fair balance between restructuring and liquidation. It will allow distressed enterprises to explore possibilities of an easy and efficient revival. If revival is not the solution, it will allow easy liquidation to maximize returns for stakeholders. It seeks to salvage viable businesses and preserve jobs, while enabling financial institutions to prevent deterioration of assets by giving them a means to enforce claims. The IMF too has been active in this regard and has emphasised on the need to have a regulatory framework that will be effective for those for whom the insolvency law exists.

Some scholars have mentioned about the concept of Rescue Culture as an effective measure for retention of commercial morality. Rescue Culture as defined by Kharbanda and Stallworthy, as the process of ‘strategies for rescuing companies in distress’. As Finch proclaims, “the route to a clear design of (an) insolvency/rescue regime is to decide on an appropriate balance of interests and to set up a procedure that pursues those interests consistently with that balancing”. But there are authors like Baird that see rescue culture as being tipped in the balance towards the enforcement of the creditors rights above all, perhaps fuelled by problems encountered in such cases as the “Midatlantic National Bank case”and is termed as the ‘credit wealth maximisation theory.’ In essence, here insolvency law is seen as a ‘collectivised debt collection device’. Nonetheless we should bear in mind the rationale of rescue culture and for this a balance has to be maintained which is not draconian in nature but protective of all interests .In the writings of Rasmussen and Donald Korobkin jobs can be saved, and hopefully the company, or a substantial part of it can go on to flourish and provide a realisation of much of its debt and a stimulus to the economy as it begins to trade as a more profitable concern.

Criticisms And Problems Faced By Insolvency Law System:

In spite of having legislations on insolvency law, it faces problems when coming to execution level. The most common obstructions as laid down by the World Bank are political constraints- conflicting interests of the state can complicate decision-making on commercially reasonable terms. For example, in systems with weak regulatory frameworks, the state’s role in addressing the problems of insolvency may be more proactive but it can in extreme cases lead to potential conflicts of interest. Other problems include weak financial systems mostly prevalent in many developing countries having ineffective banking supervisory practices and regulations which is often combined with lax credit practices, risk management techniques, and ineffective regimes for taking and enforcing security, weak and underdeveloped capital markets due to the reduced number of players on domestic exchanges, poor regulation, lack of transparency and a lower level of market confidence, ineffective corporate governance and lastly ineffective legal framework – the strongest external factor in inducing financial discipline and in the developing countries it tends to be more fragmented and less reliable where rights are poorly defined and with weaker rights, lenders and creditors are often relegated to a passive role in the bankruptcy process. In short insolvency laws must balance creditors, debtors and the society and severe penalties should be avoided as this can slow economic growth which depends on the willingness of people to invest in corporations and giving less powers to creditors will restrict their lending’s, thereby calling for a balanced law which again is seldom seen.

In addition to the above problems, even the Cork Committee Report which had played an influential role initially has been criticised that the philosophy relies to a higher degree than is acceptable on bias instead of analysis. The outcome is that some of the recommendations are inconsistent with the aims set out for reform. It emphasizes on maintaining commercial morality as a basic object of the legislation but this expresses the hard line philosophy in common law countries, where, the core idea is that tough law is required to deter defaulting debtors. It is erroneous because deterrents are unnecessary in encouraging potential insolvents to respect moral standards.

Being insolvent is not a crime and hence depicting harsh punishments won’t resolve the issue. We have to look at punishments from retributive or utilitarian angle. A debtor defaulting is not a moral wrong and this is the reason why constructing a system is critical in this field and even if we do have a system how farfetched is it is another thought that would naturally cross our minds. Analysing various texts and articles we still do not have a system which focuses on debtors and creditors alike and at the same time provides well founded relief to the unsecured creditors who are always facing the uncertainties of insolvency. If not dealt at the right time insolvency law will not only be a device for debt collection but shall raise social, political and moral issues.

Conclusion:

In a market economy firms fail which is not a bad thing and even if we contemplate a world without insolvency the dynamics of private bargaining would still exist making things worse. The banks, creditors and the owners wouldn’t bother about their employees losing jobs or of the firm failing. No doubt a sound insolvency proceeding is best to avoid conflict of interests and a collective insolvency proceeding is well suited or else the creditors would rush towards the debtors assets, without giving it an opportunity to recover and start anew. Hence we may not desire a world without bankruptcy because the self interest of the creditors leads to collective action problems and a legal mechanism is needed to ensure that the self interest of the individuals do not run counter to the interests of groups.

But the whole concept of reorganization is different as it focuses not on creditor’s interest but on the interest of the society which again is difficult to implement as one cannot precisely analyse what is best for society. Even embracing the “rehabilitation” goal does little to reduce insolvency disputes and the most common dispute is on priorities. Therefore insolvency law cannot put an end to these issues regardless of what goals it sets. Hypothetically we can imagine a society from which the phenomenon of insolvency is totally absent, where all transactions in the community take place strictly on cash basis, then no individual would ever arrive at a position where one’s liabilities exceed his assets. In such a society there would be no debtor and creditor relationship, but even in such a credit free society economic ruin would occur.

“After a year of delays Geithner and Bernanke have come to agree about the need for a new insolvency regime for systemically important financial institutions. This new insolvency regime will allow to take over in orderly way rather than a disorderly bankruptcy like in the case of Lehman. Thus it is about time to pass legislation allowing an orderly nationalization of large insolvent banks minimising fiscal costs and systemic risk”. It is brilliant that the government is getting aware and also spreading the awareness which has helped in critical analysis of the legal system, thereby effectuating into a new, well designed system. There is a need to formulate a theoretical basis encompassing all interests, maybe distant from the actual market scenario but that shall be the basis for progress in the law as case laws or rules cannot stand without a strong pillar and will help in creating a piece of legislation that is comprehensive, lucid and enforceable. An insolvency law cannot meet its ends if a base is muddled and since we cannot imagine a world without insolvency, we might as well go in the system and bring about remedies.

Bibliography

Textbooks

• • V.Finch, “Corporate Insolvency Law: Principles and perspectives”, published by University of Cambridge, 2002.

• • R.M.Goode, Principles of Corporate Insolvency,” second edition, ( Sweet and Maxwell limited ) 2005.

• • Fiona Tolmie, “Corporate and personal insolvency ,” second edition, Cavendish publishing ltd.

• • Jukka kilpi; “The ethics of Bankruptcy”, 1998, Rutledge ltd.

• • Rizwaan Jameel Mokal, “ Corporate Insolvency Law- Theory and Application, Oxford University Press, 2005.

• • Ian Fletcher ; “ The Law of Insolvency”; Fourth edition, Sweet and Maxwell ltd. 2009.

Articles

• • R.Mokal, ‘An Authentic Consent Model: Contractarianism, Creditor’s Bargain and Corporate Liquidation’, Legal studies,(2001), Vol. 21 No.3 Pp.400-443.

• • V.Finch, ‘The Measures of Insolvency Law’, Oxford journal of legal Studies, (1997), Vol. 17(2):227, retrieved on 13/11/2009, www.oxfordjournals.org.

• • The Insolvency Service, ‘Alternatives to Bankruptcy’, retrieved on 15/11/2009, http://www.insolvency.gov.uk/bankruptcy/alternativestobankruptcy.htm.

• • Noriel Roubini, ‘Its time for a special insolvency regime for systematically important financial institutions’, March 25th 2009, www.rgemonitor.com/roubinimonitor/256158/it_is_time_for_a_special_insolvency_regime_for_systemically_important_financial_institutions_nonbank_financial_firms_and_bank_holding_companies.

• • Claire Sharp, ‘English Insolvency Law-Does it require American amendments’, (2008) 6CRI 174, www.lexisnexis.com.

• • V.Finch, ‘The Dynamics of Insolvency Law-Three Models of Reforms’, Law and Financial Markets Review (2009) 3(5) Pp. 438-448, retrieved on 15/11/2009, www.lse.ac.uk/collections/law/staff/vanessa-finch.htm.

• • A.Keay, ‘Balancing Interests In Bankruptcy law’,(2001) CLWR 206, retrieved on 14/11/2009, http://www.lexisnexis.com/uk/legal/search/journalssubmitForm.do.

• • The World Bank, ‘Principles and Guidelines for Effective Insolvency and

Creditor Rights System’, April 2001,retrieved on 22/11/2009,

www.worldbank.org/ifa/rosc_icr.html.

• • Core Principles for an Insolvency Law Regime, retrieved on 15/11/2009,

http://www.ebrd.com/country/sector/law/insolve/core/index.htm.

• • World Bank Consultation Draft, ‘Effective Insolvency System-Principles and Guideline’, October 2000, retrieved on 22/11/2009, www.worldbank.org/finance/assets/images/DL_2_2_consultation.pdf.