PSD Occasional Paper No. 14 February 1996 _ Bankruptcy Policy Izak Atiyas 5 The World Bank Private Sector Development Department PRIVATE SECTOR DEVELOPMENT DEPARTMENT OCCASIONAL PAPERS No. I Rhee, Katterbach, Belot, Bowring, Jun and Lee, Inducing Foreign Industrial Catalysts into Sub-Saharan Africa No. 2 Mody and Wang, Explaining Industrial Growth in Coastal China: Economic Reform...and What Else? No. 3 Biddle and Milor, Institutional Influences on Economic Policy in Turkey: A Three-Industry Comparison No. 4 Lanjouw and Mody, Stimulating Innovation and the International Diffusion of Environmentally Responsive Technology No. 5 Tan and Batra, Technology and Industry Wage Differentials: Evidence from Three Developing Countries No. 6 Navarro, Reversal of Fortune: The Ephemeral Success of Adjustment in Venezuela, 1989-93 No. 7 Morales, Bolivia and the Slowdown of the Reform Process No. 8 Ibrahim and Lofgren, Successful Adjustment and Declining Governance? The Case of Egypt No. 9 Tan and Batra, Enterprise Training in Developing Countries: Overview of Incidence, Determinants, and Productivity Outcomes No. 10 Sundaram, Teik and Tan, Vision, Policy and Governance in Malaysia No. 11 Tzannatos, Labor Policies and Regulatory Regimes No. 12 Kessides and Willig, Competition and Regulation in the Railroad Industry No. 13 Nagaoka, Antidumping Policy and Competition Private Sector Development Department Occasional Paper No. 14 Bankruptcy Policy Izak Atiyas February 1996 While this paper has been cleared for inclusion in the occasional paper series by the Competition & Strategy Group, Private Sector Development Department, the views expressed are those of the author(s) and should not be attributed to The World Bank or any of its affiliates. This paper forms a chapter in the book, titled Regulatory Policies and Reform: A Comparative Perspective, edited by Claudio Frischtak. The World Bank Private Sector Development Department 11 Contents 1. Introduction ................................................................................................................... 1 2. The Role of Bankruptcy Policy .................................................................................... 5 A Debt Collection Perspective.............................................................................................5 A Restructuring Perspective: Agency Problem s of D ebt.....................................................7 A dditional Stakeholders and Conflicts of Interest...............................................................9 The Tension Between the Creditors' Bargain and Restructuring.......................................10 3. Bankruptcy Policies in Industrial Countries.............................................................13 The U .S. Debtor-Oriented Approach.................................................................................13 Liquidation...................................................................................................................13 Reorganization.............................................................................................................14 Empirical Characteristics of Chapter 11 Procedures.................................................15 Chapter 11 Versus Inform al W orkouts........................................................................19 An Evaluation ..............................................................................................................21 The U .K . Creditor-Oriented Approach..............................................................................22 Liquidation...................................................................................................................23 Adm inistrative Receivership ........................................................................................23 Adm inistration .............................................................................................................24 Creditors'Bargain or Premature Liquidations........................................................... 25 The French Court-Controlled System ................................................................................26 In Search of a Better M odel.............................................................................................. 8 4. Bankruptcy Policies in Industrializing Countries.....................................................31 M ain Problem s...................................................................................................................31 Outdated Legislation...................................................................................................31 Lack of Differentiation Between Enterprises and Their Owners and Managers........32 Inadequate Judicial and Financial Infrastructure ......................................................32 Inadequate Supervision and Regulation of the Banking System..................................34 Regulatory Barriers to the M obility of Labor and Capitol .........................................35 Corporate Reorganizations in India...................................................................................35 Bankruptcy Reform in Colum bia.......................................................................................37 Bankruptcy Policy Reform in Industrializing Countries....................................................40 5. Topics for Future Researc ........................................................................................ 43 References .............................................................................................................................. 45 iv 1 Introduction 1.1 This paper examines the role of bankruptcy policies in market economies. Two somewhat different perspectives on the proper role of bankruptcy are presented. The first emphasizes the role of bankruptcy as a means to enforce debt contracts. Bankruptcy policy is primarily seen as a set of rules and institutions designed to address situations in which a debtor fails to meet its contractual obligations to creditors. Bankruptcy policy supplements other debt collection rules, addressing specific problems, or market failures, that nonbankruptcy debt collection rules fail to address. I call this the debt collection view of bankruptcy. 1.2 The second perspective focuses on bankruptcy's role as a mechanism of restructuring and exit. More generally, bankruptcy procedures can be construed as a component of policies for industrial restructuring. Many industrial and developing countries have specific policies designed to address the special problems of declining industries and to reduce barriers to factor mobility, capacity reduction, and exit.' These policies deal with firms in need of restructuring. Such firms often are overindebted, because of financial policies that encourage excessive debt accumulation, earnings shocks that generate losses and reduce equity capital, or simply bad financial management. A reorganization of firms' liabilities, or more generally, a change in their ownership structure, may improve their performance. Typically, such reorganization-entails the exchange of debt for equity, the extension of maturity, and reductions in principal and interest. Improving efficiency and profitability may also require asset restructuring: Companies may need to divest their unproductive units, eliminate unprofitable product lines, introduce new managerial practices, change their marketing orientations, and adopt more appropriate production technologies. Whenever a company is likely to regain viability through a restructuring of its assets and liabilities, the presence of a legal framework may facilitate renegotiations between the company's claimholders and increase the chances of an efficient restructuring. Bankruptcy laws may provide such a legal framework. 1.3 If a company cannot regain profitability even under the most efficient restructuring scheme, economic logic dictates that it should go out of business. Again, bankruptcy provides a mechanism through which such winding up can take place. Through liquidations, bankruptcy For a review of these policies in a sample of OECD countries, see Atiyas and others 1992. 2 Bankruptcy Policy law is believed to enhance economic efficiency by allowing the timely exit of unproductive economic units and by promoting the transfer of the ownership of productive assets to entrepreneurs or managers who can make better use of them. By facilitating the exit of inefficient firms, and thereby reducing excess capacity, bankruptcy policies also help eliminate an important potential barrier to entry. 1.4 In practice, most bankruptcy laws prescribe variants of two procedures. The first is bankruptcy liquidation, in which the debtor's assets are sold and the proceeds divided between creditors according to some priority rules determined by law. The legislation in some countries also allows for bankruptcy reorganization, a process under court supervision in which the claimholders of the debtor firm negotiate on whether and how to restructure the debtor's liabilities and assets, possibly with the objective of maintaining the company as a going concern. 1.5 The task of bankruptcy law is to formulate actual rules and procedures to be followed in practice. Bankruptcy legislation and policy both exhibit considerable variation across countries. To provide a common framework of analysis, the first chapter of this paper discusses why bankruptcy policy is necessary in the first place, from both a debt collection and a restructuring perspective, and derives the objectives of bankruptcy policy. It is argued that, in principle, these two perspectives are not necessarily in conflict with each other. Indeed, in a relatively flawless world, procedures that promote the most efficient restructuring of the debtor would also best serve the creditors' interests by maximizing repayments to the claims on the company-whether immediately (in the case of liquidation) or after the company, and claims attached to it, are reorganized. However, frictions do exist in the real world: Information is imperfect and often asymmetric, bargaining is often costly, and writing and enforcing detailed contracts are expensive if not impossible tasks. These imperfections, combined with conflicts of interest between the different types of claimholders, encourage uncooperative strategic behavior, with unintended and suboptimal outcomes. These problems create a tension between the debt collection and restructuring roles of bankruptcy policy. Unavoidably, actual bankruptcy policies try to strike a balance between these two roles. 1.6 The best way to illustrate these problems, and discuss possible solutions, is to examine the actual experience with bankruptcy laws and identify how different rules affect the strategic behavior of the different parties. The second chapter reviews the bankruptcy law and practice in a few industrial countries and presents the available empirical evidence on outcomes to which they lead. The chapter focuses on bankruptcy policy in the United States, the United Kingdom, and France, three fairly different approaches. This chapter also discusses the role of out-of-court workouts and their relation to formal bankruptcy. It argues that none of the three cases provides a model that satisfies the debt collection aspects of bankruptcy without sacrificing efficiency in restructuring. The chapter concludes with a discussion of the components of a possible improved model. 1.7 The third chapter concentrates on bankruptcy policy in developing countries. Shifting the analysis to developing countries requires an expansion of the paper's focus to include additional problems such as outdated legislation, inadequate skills, lack of processing capacity in Introduction 3 the court system, inadequate supervision and regulation of the banking system, and constraints that arise from the regulatory environment. It is argued that bankruptcy reform in most developing countries would be ineffective unless undertaken as part of comprehensive regulatory reform. 1.8 Before moving to the main discussion, it is useful to make a few points about the paper's limitations and focus. First, even though the economic literature on bankruptcy dates back to the late 1970s, a systematic theoretical and empirical analysis of bankruptcy models is quite recent compared to other areas of economic policy. Comparative, cross-country analysis is quite limited, and most efforts have concentrated on the problems of bankruptcy in the United 2 States. Information on bankruptcy in industrializing countries is even more scarce. The paper unavoidably reflects these limitations. 1.9 Second, the reader will notice that the bankruptcy procedures of industrial countries are discussed in greater detail than those of industrializing countries. The practical reason for this focus lies in the fact that both the analytical and empirical literature on bankruptcy in industrial countries is more advanced, allowing a more detailed analysis of the implications of different bankruptcy rules. Nevertheless, lessons drawn from the theory and practice of bankruptcy in industrial countries are relevant for industrializing countries that are ready to embark on reform, if only as a caution against making similar mistakes. This is especially so since industrial countries provide some of the basic models of bankruptcy, which industrializing countries often adopt in modified form. 1.10 Third, the paper does not address the problems of bankruptcy policy in formerly socialist economies. These countries face qualitatively different problems associated with bankruptcy and restructuring, including complications that arise because of ambiguities in and the transitional nature of ownership rights and the massive need for industrial restructuring (see Atiyas 1994; Mitchell 1990, 1993; and van Wijnbergen 1992). 1.11 Finally, bankruptcy itself is a topic with many elements. The paper focuses mainly on corporate, rather than personal, insolvencies. In addition, the coverage of the paper is also influenced by a presumption that a need for industrial restructuring represents an important policy agenda in most developing countries. A concern as to whether bankruptcy can play a positive role in restructuring without jeopardizing the interests of creditors (or the enforceability of debt contracts) is implicit throughout the paper. Because of this concern, a more detailed and comprehensive treatment of bankruptcy reorganizations relative to liquidations is provided. 2 The only exceptions are Franks and Torous 1992, Franks, Nyborg, and Torous forthcoming, Mitchell 1990, and White n.d. 4 Bankruptcy Policy 2 The Role of Bankruptcy Policy 2.1 This chapter summarizes two perspectives on the fundamental role of bankruptcy policy in market economies. The first emphasizes the role of bankruptcy in resolving collective action problems in debt collection. The second focuses on collective action problems in debt recontracting and restructuring. The implications of these two perspectives for the objective of bankruptcy policy are then discussed. A Debt Collection Perspective 2.2 Credit is one of the basic pillars of modem market economies. It is a mechanism through which surplus funds can be allocated to agents that need additional financial resources to realize their optimal consumption or investment plans. As with other types of contracts, the widespread use of credit contracts is predicated on their enforcement by the state. When a loan contract is breached, the creditor must be assured of recourse to legal remedies. 2.3 Outside bankruptcy, these remedies are enumerated in debt collection laws.3 These laws both prescribe a procedure whereby creditors can enforce their claims against a debtor and define the boundaries of creditors' rights. In terms of procedure, unless a creditor is secured by collateral that supports the loan, the rules of debt collection generally require the creditor to sue the debtor. If the creditor prevails in the lawsuit, the creditor may enforce the claim by foreclosing on real property or by physically seizing personal property. In some cases, the claim may also be satisfied by requiring a third party on which the debtor has a claim to make payments directly to the creditor; in the United States, for example, creditors may be able to seize part of a debtor's wages. In terms of creditors' rights, debt collection laws delineate which of a debtor's property or income can be acquired by creditors. For example, in the United States, the rules in most states limit the extent to which creditors can lay claims on a debtor's wages or the types of assets that creditors can seize. Laws often put "tools of trade" out of the reach of creditors as well. For a brief review of debt collection outside bankruptcy, see Baird and Jackson 1985. 5 6 Bankruptcy Policy 2.4 At the same time, debt collection laws establish a priority ordering among different claims. In general, this priority ordering is formed on a first-come, first-served basis: A creditor that is first to acquire an interest in a particular asset generally has a right to be paid first out of that asset. For that reason, creditor remedies outside bankruptcy have been characterized as a kind of "grab law" (Jackson 1986). Of course, a creditor may also gain priority over an asset if the creditor and debtor agree in a debt contract that the creditor will acquire that asset in the event of a default. Securing a loan by a collateral, then, is tantamount to securing a higher place in the line of claimants to be paid by that collateral in the event of a default. 2.5 When a debtor has sufficient assets to pay all its creditors, debt collection laws provide an efficient mechanism to satisfy claims. They cease to be efficient, however, when the value of the debtor's assets is less than the face value of the creditors' claims. Given the first- come, first-served nature of debt collection, every creditor has an incentive to grab a piece of those assets before another creditor does so. In the absence of a mechanism whereby each creditor could be credibly committed to do otherwise, asset grabbing through individual remedies is the most likely outcome of a default. 2.6 There are several reasons why this "run to the courthouse" may yield inefficient outcomes, especially when the number of creditors is large. The most important problem has to do with the fact that asset grabbing by individual creditors results in the fragmentation of these assets or in their sale in a piecemeal fashion. If the assets are sold individually, their total value may be lower than if they had been valued collectively or in bundles. As a result, the total value 4 available to the creditors as a group may be reduced, a situation that has been called the common pool problem.5 The individual remedies prescribed in debt collection laws fail to resolve the common pool problem. 2.7 However, the existence of a common pool problem by itself does not obviate the necessity of a formal bankruptcy procedure established and implemented by the state. After all, the disposition of the assets of the debtor in the event of a default might have been specified ex ante in the debt contract. However, specifying all the division rules for all possible future contingencies would be extremely difficult and costly. It would require, for example, foresight regarding every possible combination of different types of liabilities that the debtor might contract in the future. The combination of common pool problems and costly (incomplete) 4 Note that the issue here is not only that the going-concern value of the firm may be higher than its liquidation value. Even in cases in which liquidation is the most efficient action, assets may still be worth more when sold in packages rather than individually. Jackson (1986) mentioned two additional problems associated with individual mechanisms of debt collection. Knowing that to be paid in full necessitates acting before other creditors, each creditor is likely to spend more resources monitoring the debtor and other creditors. Presumably, some of this expenditure is wasteful and could be avoided if debt collection were a collective process. The second problem has to do with attitudes toward risk. Suppose all creditors are unsecured. Then one can think of cases in which the expected value of what each creditor would receive under a first-come, first-served mechanism of debt collection would be equal to what each would receive under a collective mechanism that divided the assets available for distribution in proportion to each creditor's claims. If lenders are risk-averse, however, then the expected utility of (certain) payments under the collective mechanism would be higher than that of (uncertain) payments under the individual mechanism. The Role of Bankruptcy Policy 7 contracting therefore generates a useful economic role for bankruptcy. Bankruptcy resolves the common pool problem by preventing asset grabbing, binding the creditors to a collective mechanism of debt collection, and allowing for an orderly disposal of assets to repay creditors' claims. Some scholars, representing what may be called the "minimalist view" of bankruptcy, have argued that this should be the only principle guiding the design of bankruptcy law (see, for example, Jackson 1986). 2.8 An important implication of this view is that, in principle, bankruptcy law should respect prebankruptcy claims. This does not mean that bankruptcy should not impose any restrictions on these claims. Given that bankruptcy is a collective mechanism, and that it should prevent asset grabbing, some restrictions on individual claims are unavoidable. Rather, what is meant by "respect for prebankruptcy claims" is summarized in the concept of a "creditors' bargain": The bankruptcy system "should 'mirror' the agreement one would expect the creditors to form among themselves were they able to negotiate such an agreement from an ex-ante position" (Jackson 1982, p. 860; see also Baird 1986).6 That is, bankruptcy rules that do not violate the creditors' bargain should not create new claims or change the priority ordering of existing claims. 2.9 The logic behind the creditors' bargain is that not respecting prebankruptcy claims would allow stakeholders favored by the bankruptcy rules to transfer wealth from those that are disadvantaged, thereby distorting the original intent of bankruptcy (see Jackson 1986). However, the creditors' bargain can also be interpreted from the perspective of the development of the financial sector. Seen in this light, the bargain is a means to maintain creditors' confidence in debt instruments, and it therefore enhances intermediation. 2.10 The creditors' bargain would seem to provide a simple principle to guide the design of bankruptcy policy. For example, the company's assets can be sold and creditors repaid according to the original priority of claims. The issue starts getting more complicated, however, once one notes that under some circumstances it would be in the interest of the original claimants to restructure their claims rather than receive immediate payments. Should bankruptcy allow for such restructuring, and if so how? Before this question can be answered, an examination of why such restructuring may be desirable in the first place is necessary. The most relevant set of circumstances is associated with the adverse incentive effects of debt, discussed next. A Restructuring Perspective: Agency Problems of Debt 2.11 Whereas the preceding discussion of the common pool problem underscores the role of bankruptcy in resolving conflicts of interest among creditors, the agency problems of debt relate primarily to conflicts of interest between debtors and creditors. In environments in which default is an underlying concern, these conflicts of interest arise because debtors are typically interested in maximizing the equity value rather than the total value of the firm. Ex post, actions 6 Jackson (1986) described this as the requirement that bankruptcy should preserve the relative, as opposed to the absolute, values of claims. 1 8 Bankruptcy Policy that are conducive to that objective typically may reduce the value of debt. Ex ante, they generate welfare losses and increase the cost of debt financing. These welfare losses are called the agency costs of debt. 2.12 In principle, these agency problems could be resolved if it were possible to include in the debt contract covenants specifying all state contingent actions that borrowers could undertake. However, creditors often cannot perfectly monitor the actions of debtors after a debt contract is written, either because of imperfect information, costly contract enforcement, or both. It is often not even possible to envisage all the possible future contingencies. And even if it were possible, specifying actions for each contingency would be of no use unless those were costlessly verifiable by third parties, such as courts. 2.13 Agency problems associated with debt may cause inefficiencies by distorting the debtor firm's investment decisions. The literature has emphasized two main types of distortions. First, a debt overhang may cause insiders to forgo projects with positive net present values. A distortion arises because the firm undertakes the investment only if the expected returns are higher than the required debt repayment plus the cost of investment, whereas the efficiency rule is that expected returns should be higher than the opportunity cost of investment. Underinvestment is the result. Second, debt can encourage a firm to take excessive risk. To consider an extreme but illustrative case, suppose the value of equity is zero. The firm has the opportunity to invest in only one project, which has an uncertain return and a negative net present value. The firm would still invest in the project since, if it were successful, the return to equity would be positive. If the project was not successful, shareholders would get nothing, and the negative returns would be borne by creditors. While undertaking such investments jeopardizes the interests of debtholders, they may be unable to observe and prevent such investments.7 Whether a debt overhang results in under- or overinvestment depends on the specific circumstances. 2.14 The adverse incentive effects of debt and the associated agency costs are magnified during periods of financial distress and may make recontracting beneficial for both creditors and debtors. There may be circumstances in which a reduction in the face value of the claims on an overindebted firm would ameliorate the adverse incentive effects of debt to such an extent that the efficiency gains---or reduction in agency costs-would outweigh the reduction in the face value of the debt and benefit the creditors as a whole. Recontracting may also entail the conversion of debt into equity. If it also allows creditors to obtain some control rights, or creates mechanisms, even if temporarily, to better monitor the debtor, the adverse incentive effects of debt may be further reduced. As will be discussed below, such recontracting occurs quite frequently without any recourse to formal bankruptcy procedures, especially in industrial countries. 7 The classic expositions of the problems of under- and overinvestment are found in Myers 1977 and Jensen and Meckling 1976, respectively. The Role of Bankruptcy Policy 9 2.15 When the number of creditors is large, however, a collective action problem may prevent recontracting even when it is desirable for the creditors as a group. Take, for example, debt reduction, and consider the incentives of an individual creditor. If all other creditors were engaged in reducing the face value of their claims, the individual creditor would prefer to hold out and still reap the benefits of efficiency gains. Therefore, rehabilitation of the debtor through a renegotiation of debt reduction may require claimants to act collectively, in a coordinated fashion. A bankruptcy reorganization procedure may provide a forum for such collective action. 2.16 Note that the restructuring of the liabilities of a company through recontracting the original claims can be desirable in nonbankruptcy situations as well. However, in the context 6f defaults, rehabilitation of the debtor by means of restructuring may present a more efficient alternative to liquidation. This would be the case when, for example, the firm's current financial difficulties are due to a temporary liquidity crisis or when the value of the firm's intangible assets is high. Additional Stakeholders and Conflicts of Interest 2.17 The preceding discussion has implied that the only relevant parties to a bankruptcy are lenders and borrowers. It also identified two main types of conflicts of interest: those among lenders, arising due to collective action problems, and those between creditors and debtors. Clearly, this view is an oversimplification. . There are other stakeholders whose interests are affected by what happens in bankruptcy, for example, workers, suppliers, customers, and the state. 2.18 Some of the interests of these stakeholders are represented by specific financial claims against the debtor company. For example, the company may owe wages to its employees or may have purchased intermediate goods from its suppliers on credit. However, these explicit financial claims often do not capture all of the interests of these stakeholders. For example, employees may have wage agreements that represent claims on future earnings of the company. Consumers may hold warranties for products they have purchased. Finally, the interests of some parties are not represented by any type of explicit contracts, even though they are affected by what happens in bankruptcy. Examples are the disruption of implicit long-term contracts with employees and, in the event the firm liquidates, costs that would be borne by consumers in locating and purchasing from another company the spare parts for the products purchased from the bankrupt firm. Such interests are not represented in bankruptcy decisions even though they suffer real costs. 2.19 Often, the interests of these stakeholders are at variance with each other, not only because of collective action problems. The primary concern of lenders is repayment of loans. Workers, by contrast, may be interested not only in realizing their claims that arise due to unpaid wages, but also in maintaining employment. Hence, while creditors may wish to pursue liquidation, workers' interests may call for rehabilitation. And even lenders are not homogeneous in their interests. For example, whereas secured creditors are concerned mainly with taking 10 Bankruptcy Policy possession of the collateral, and therefore would not be worried if a viable firm were liquidated, unsecured creditors may be better served if the firm were maintained as a going concern. The Tension Between the Creditors' Bargain and Restructuring 2.20 The restructuring perspective discussed above suggests a straightforward objective: Bankruptcy laws should strive to maximize the value of assets under bankruptcy, net of various costs incurred as the procedure unfolds (discussed in some detail below). A corollary of this objective is that bankruptcy should promote the liquidation of companies whose (post- restructuring) going-concern value is less than their liquidation value. Conversely, whenever the going-concern value of the company is larger than the liquidation value, the company should be reorganized. Maximization of the value of assets would allow recontracting under bankruptcy, to reap any efficiency gains that may be available, and also would subsume efficiency of investment given agency problems of debt. 2.21 In principle, this objective-hereafter called the efficient restructuring rule of bankruptcy-need not contradict the creditors' bargain. After all, creditors as a class would benefit from the maximization of the value of the assets over which they have claims. For example, if it were possible to design a procedure that redistributed claims over the maximized value of assets without violating the pre-existing ranking of priority, such a mechanism would satisfy the creditors' bargain. However, given the various conflicts of interest afflicting bankruptcy, translating this objective into actual procedures, with their associated incentives and mechanisms of control, is a complicated task. 2.22 Given a set of rules, each stakeholder will act strategically, to maximize his or her own benefit. Strategic behavior, and imperfect and asymmetric information, often results in unintended outcomes. Bankruptcy rules designed to facilitate recontracting may allow for postbankruptcy bargaining, which may be costly. Or they may influence the bargaining power of the different parties. In particular, they may grant excessive bargaining power to the debtor and may eventually lead to outcomes that violate the creditors' bargain.9 Ultimately, such a procedure may act as a barrier to exit and may be used by debtors to defer liquidations. Similarly, bankruptcy rules that are designed primarily to repay creditors may end up liquidating viable firms or privileging some classes of creditors over others. These problems of institutional design create a tension between the objectives of respecting the creditors' bargain and promoting efficient restructuring. 2.23 Potentially strategic or disruptive behavior can be checked and kept under control by the court. The motive and behavior of the court is determined partly by the law itself, or by its current interpretation. For example, in cases in which a company wants to use bankruptcy procedures not to resolve financial distress but primarily to transfer wealth from other ' This is the criterion most widely used to assess the efficiency of bankruptcy rules. See, for example, White 1989. 9 Note that in the context of recontracting, the creditors' bargain would require that the rules governing renegotiations not grant any bargaining power to any of the claim holders that was not envisaged in the original distribution of claims. The Role of Bankruptcy Policy II stakeholders to holders of equity, the law may instruct the judge to reject the petition. The law may prescribe the appointment of a trustee and endow that trustee with substantial decisionmaking authority, which would also limit strategic behavior by stakeholders. 2.24 In practice bankruptcy laws try to strike a balance between debt collection and restructuring. They differ in the way they distribute decisionmaking authority among the different stakeholders of the company and the court. As will be discussed below, none of the existing models of bankruptcy provides a perfect solution, and each has its own shortcomings. It is useful to examine actual bankruptcy rules and to identify the types of incentives they provide, the outcomes they produce, and problems they pose. More specifically, it would be useful to answer the following questions: How are control rights and decisionmaking authority distributed among the debtor, the creditors, and the court? How are secured creditors treated? How long do firms remain under bankruptcy? What is the likely efficiency of the bankruptcy outcomes associated with different designs? To what degree are creditors' original bargains protected? What are the roles of the court and the court-appointed trustees? These questions are addressed in the next two chapters. 12 Bankruptcy Policy 3 Bankruptcy Policies in Industrial Countries 3.1 This chapter reviews and evaluates the bankruptcy codes of the United States, the United Kingdom, and France. These three codes differ substantially in the way they distribute decisionmaking authority among the debtor, the creditors, and the court. While the U.S. policy grants substantial bargaining power to debtors, the U.K. law is more creditor-oriented. The French legislation, like U.S. law, is debtor-oriented; although it is designed to preserve going- concern value, it grants more power to judges than to the debtor firm. These differences notwithstanding, discussions of bankruptcy law reform in the three countries reveal a tendency toward convergence: The U.S. system is criticized for being too lenient toward debtors; the U.K. system is seen as encouraging liquidations too rapidly; and a recent reform of the French code represents an attempt both to further protect creditors' rights and to increase the power of the court. It is possible to detect a tendency in bankruptcy reform efforts across countries to enhance the possibility of maintaining going-concern values without granting bargaining power to the owners and managers of debtor firms. The U.S. Debtor-Oriented Approach 3.2 The legislation covering liquidations and reorganizations is described first. This discussion is followed by an overview and an evaluation of empirical work on bankruptcy reorganizations and informal workouts. Liquidation 3.3 Liquidation procedures spelled out in Chapter 7 of the U.S. Bankruptcy Code provide the basic framework for bankruptcy, for both firms that enter reorganization and those that file for liquidation. When a firm files for liquidation, the bankruptcy court appoints a trustee to close down the debtor firm, sell its assets, and deliver the revenues to the court. The court then uses the revenues to pay creditors. 3.4 The order in which creditors are paid is determined by the absolute priority rule, which specifies the following order of payment: first, the administrative costs of bankruptcy, including the fees for the trustee, and debts incurred after the filing of bankruptcy; second, claims 13 14 Bankruptcy Policy that receive priority by statute, such as taxes, rents, and unpaid wages; third, unsecured creditor claims including trade credits, utilities, damage claims, and claims of long-term bondholders; and last, equity. Higher-priority claims must be paid in full before any payments are made to lower- priority claims. Hence, shareholders receive no payments unless all other creditors have been paid in full. 3.5 The absolute priority rule places secured creditors outside the priority ordering. These creditors have priority over funds received by the liquidation of the assets pledged as collateral. To the extent that these funds are insufficient to cover the entire claim, the balance is owed by the debtor and is considered part of the remaining unsecured claims. In principle, secured creditors may receive a payment even if all other creditors receive nothing. Reorganization 3.6 The 1978 Bankruptcy Code, which replaced the Chandler Law of 1938, introduced significant changes to reorganization procedures in the United States.10 The main purpose of these changes was to increase the likelihood tfat the firm would emerge from bankruptcy as a going concern. Essentially, Chapter 11 of the code allows for the renegotiation of the claims on the debtor firm. It also prescribes a set of rules, including procedural rules, that govern negotiations. 3.7 A Chapter 11 case can be initiated voluntarily by a debtor or involuntarily by three or more creditors. The debtor need not be insolvent. Asset grabbing is prevented by an automatic stay invoked as soon as the bankruptcy petition is filed. The stay bars any judicial or administrative actions against the debtor and suspends all principal and interest payments. In particular, secured creditors lose their rights to seize or foreclose on the debtor's property. A key characteristic of Chapter 11 is that the current management of the company remains in control (as debtor-in-possession) until a reorganization plan is approved by the court (after it is negotiated with creditors)." The firm's management conducts the business of the firm but is monitored by the court. The debtor-in-possession also takes on fiduciary responsibilities; it has obligations to both shareholders and creditors. A creditors' committee representing the interests of unsecured creditors is formed to oversee the procedure. Although interest accruals on unsecured debt cease, secured debt continues to accumulate interest. 3.8 During the first 120 days of the filing, the debtor has the exclusive right to propose a reorganization plan. This exclusive period can be, and often is, extended by the court. The plan may envisage the continuation or the liquidation of the debtor firm. It separates creditors into classes and specifies how the claims will be repaid or reorganized. An accompanying disclosure 'nFor a brief history, see International Financial Law Review 1990. White 1984 presents a detailed comparison of the two laws. If the incumbent management engages in fraud or is deemed incompetent, the court may appoint a trustee to assume management. Such appointments are rare, however, and not easily granted by courts (International Financial Law Review 1990, p. 54). Bankruptcy Policies in Industrial Countries 15 statement provides information that creditors need to make an informed judgment on the plan. Secured creditors are treated individually. 3.9 The code specifies two procedures for the adoption of the plan. The unanimous consent procedure requires the approval of each class of creditors, by two-thirds of the face value of the claims of that class and one-half of the number of creditors. Under the unanimous consent procedure, the plan may reduce the claims of secured creditors, but in that case secured creditors have a right to vote on the plan. Under the cramdown procedure, the court may approve a plan even if some classes of creditors object. In that case, the dissenting class must be treated "fairly and equitably." For secured creditors, this means that they retain their liens and receive periodic cash payments equal to the depreciation of the value of the collateral. For unsecured creditors, fair and equitable treatment requires that they be paid an amount equivalent to what they would have received under liquidation according to the absolute priority rule. Since this payment requires a valuation of the assets, cramdowns are more costly than unanimous consent procedures. Under both procedures, the plan is binding for all creditors once it is approved. 3.10 The code also has provisions to assist the firm in obtaining financial resources to maintain operations. Under the terms of debtor-in-possession financing, the debtor can raise unsecured loans as an administrative expense of bankruptcy, which has a high priority. If the debtor cannot obtain a loan at the administrative expense priority, the court may allow the firm to obtain a loan that ranks higher than all other administrative expenses or allow the debtor to raise secured loans. 3.11 The code grants the debtor-in-possession significant powers to recover certain prepetition transfers of the debtor's property, called avoidance powers. Their purpose is to prevent or reverse transfers that would enable some creditors to obtain more than their fair share of the debtor's assets-thereby violating the collective nature of bankruptcy-simply because these creditors either were able to move with greater speed or had more leverage to exact concessions from the debtor.'2 Empirical Characteristics of Chapter 11 Procedures 3.12 What types of outcomes do these rules generate in practice? A few indicators were compiled in several recent empirical studies on bankruptcy reorganization in the United States: 3.13 Costs of bankruptcy. The costs associated with bankruptcy are often classified as either direct costs or indirect costs. Studies have shown that direct costs, such as fees for lawyers, the trustee, and investment banking services, range between 2.8 and 7.5 percent of the book value of the assets of the debtor company. Indirect costs arise from suboptimal actions associated with financial distress and bankruptcy. Some of these costs to the firm result from the 12 The transfers that can be voided include those made in preference to some creditors within 60 days prior to the filing of the bankruptcy petition (that is, if the transfer enables the creditor to receive more than it would have if the debtors' estate were being liquidated) and fraudulent transfers occurring within one year prior to the petition in which the debtor receives less than equivalent value in exchange for such transfer and was either insolvent or rendered insolvent by that transaction. 16 Bankruptcy Policy higher transactions costs associated with bankruptcy status.13 Others result from the strategic behavior of the firm while under bankruptcy and include agency costs and the cost of suboptimal investment decisions. The time spent in dealing with creditors and the bankruptcy court is another indirect cost to the firm. If Chapter 11 proceedings involve asset sales, and if assets are specific, the firm's going-concern value will decrease. The indirect costs of bankruptcy are believed to be larger than the direct costs. 3.14 Violations of the absolute priority rule and the bargaining power of the debtor. Widespread violations of the absolute priority rule have been presented as evidence of the inability of the Chapter 11 system to safeguard the creditors' bargain. In many Chapter 11 cases, the absolute priority rule is violated because shareholders retain some claims in the reorganized enterprise even though more senior claim holders are not paid in full. In Franks and Torous's (1989) sample of 30 firms, the absolute priority rule was violated in 21 cases; in 18 cases, the agreements awarded some payments to stockholder. Eberhart, Moore, and Roenfelt (1990) found that the mean percentage deviation from the absolute priority rule in terms of excess payments received by shareholders amounted to 7.6 percent of the total value paid to all claimants, ranging between 0 and 35 percent. In a sample of 30 cases, they found that 23 violated the absolute priority rule. In his study of 37 firms that had filed for bankruptcy, Weiss (1990) found that the absolute priority rule was violated in 29 cases. Priority was rarely violated for secured creditors. Shareholders retained some ownership or received cash payments in 30 cases, 28 of which were in violation of the absolute priority rule. As for unsecured creditors, priority was violated among different classes; for example, general creditors received some payments before senior bondholders had been paid in full. 3.15 There are several possible explanations for deviations from the absolute priority rule, not all of which reflect violations of the creditors' bargain (see Baird and Jackson 1988). If the firm is worth less than the amount owed the senior creditor, the senior creditor may wish to retain or recombine with the current owners of the firm because they have specialized skills that increase the value of the assets. As a result, while intermediate creditors are paid little or nothing, the current owners retain some stake in the reorganized firm. In this case, deviations from the absolute priority rule do not violate the creditors' bargain. The second explanation for a deviation from the absolute priority rule is that increasing the owners' stake in the financially distressed firm reduces their incentives to invest in excessively risky projects (Eberhart and Senbet 1993; White 1989). In this situation a violation of the absolute priority rule is seen as a measure that ameliorates overinvestment problems and one that need not violate the creditors' bargain. If, however, a violation of the absolute priority rule reflects bargaining power that the debtor gained from the renegotiation rules, it is likely that the creditors' bargain will be violated. 3.16 Several aspects of Chapter 11 grant the debtor substantial bargaining power. First, the debtor retains control over the firm. Second, the exclusive period gives the debtor a first-mover 13 For example, if entering bankruptcy damages the firm's reputation, the firm will have to spend more resources to convince trading partners to continue their business, and trading partners will require more advantageous terms. Similarly, the loss of consumer confidence may require management to sell products and services at a lower price. Bankruptcy Policies in Industrial Countries 17 advantage in making proposals for an agreement. Third, automatic stay and the consequent cessation of interest accrual on the claims of unsecured creditors make this group of creditors more willing to accept plans that dictate only partial and low repayment rates on their claims. Fourth, even though costly cramdown procedures are rarely used in Chapter 11 proceedings and cramdowns do not always favor debtors, the threat of their use may be an effective instrument to convince creditors to accept a particular reorganization plan. Finally, the debtor has substantial ability to delay the bankruptcy proceedings. If delays hurt creditors but not the debtor, the debtor gains added leverage over creditors. 3.17 Delays in Chapter 11 proceedings. Chapter 11 cases last a long time. In the sample of 30 firms that Franks and Torous (1989) examined, the period varied from 37 days to 13.3 years and averaged 4 years. In the study by Eberhart, Moore, and Roenfelt (1990) the time between the filing of a bankruptcy petition and plan confirmation varied from 10 months to more than 6 years, with an average of 2.1 years. In White's (1989) sample of 26 firms, the average case took 17 months. Weiss (1990) calculated an average of 2.5 years, with the range from 8 months to more than 8 years. 3.18 Delays can be caused by the existence of a large number of creditors or inadequate financial records, both of which can generate time-consuming disputes. Delays can also be caused by the strategic actions of debtors. Often, debtors bring lawsuits against creditors, question the validity of claims, or even defy court orders. If the value of the assets under bankruptcy decreases over time, even if due only to mounting indirect costs, and if the value of shareholders' claims is close to zero, the debtor may reduce the value of creditors' claims by delaying the proceedings. This provides the shareholders with a credible threat: By delaying the process, the shareholders lose nothing, but they can generate substantial losses on creditors. This threat increases shareholders' bargaining power and allows shareholders to dictate plans that violate the absolute priority rule.14 Eberhart, Moore, and Roenfelt (1990) found a positive correlation between delays in proceedings and violations of the absolute priority rule, suggesting that such delays indeed reflect the debtor's bargaining power. 3.19 Change in ownership and control. Evidence on management turnover and changes in ownership under bankruptcy reorganization is important for several reasons. First, in cases in which the firm's poor performance is caused by inept management, a change in management may be an important component of restructuring. Second, if creditors can increase their ability to control and monitor the actions of the debtor, agency costs may be reduced. Third, low managerial turnover itself may reflect the debtor's bargaining power. 3.20 The general presumption is that Chapter 11 grants substantial control to the incumbent owners and managers of the debtor enterprise because management retains control unless a trustee is appointed by the judge (LoPucki 1983a, 1983b). Even though the legislation 14 In a slightly different interpretation, Franks and Torous (1989) suggested that violations of the absolute priority rule may reflect the creditors' purchase of the shareholders' option to delay the proceedings. 18 Bankruptcy Policy allows for the appointment of a creditors' committee, LoPucki reported that committees were appointed in only 40 percent of the 57 cases she studied and that most were ineffective. 3.21 In a more recent study, Gilson (1990) examined 111 publicly traded companies that had experienced severe financial distress. Sixty-one had filed for bankruptcy under Chapter 11, and 50 had restructured their debt privately. He concluded that financial distress generates significant changes in management and ownership. In 75 percent of the cases, banks and other creditors received significant blocs of voting power in the restructured firms. For those firms that restructured their debts, banks received stock in the restructured company in 47 percent of the cases. Their share in ownership averaged 37 percent. Creditors acquired ownership in 75 percent of the Chapter 11 cases and collectively retained about 79 percent of the bankrupt firms' equity.15 In the 12 cases in which creditors controlled seats on the board of directors, they averaged 38 percent of the seats. Gilson also found evidence of a significant shift of control from the incumbent management and board of directors to nonmanagement bondholders and creditors. On average, only 46 percent of incumbent directors and 43 percent of the chief executive officers were still with their firms when the bankruptcies or debt restructurings concluded. About 16 percent of chief executives leave each year. These results are consistent with those of an earlier study by Gilson (1989) in which he documented an annual turnover in top management of 52 percent following financial distress compared with an annual turnover of 12 percent for a random sample of firms. 3.22 These findings underscore substantial changes in the management of bankrupt firms, certainly more than one would expect from the LoPucki study. They may also reflect means to reduce the agency problems of debt. But a question still remains: Do these remedies transfer sufficient power to creditors to enable them to influence decisions, particularly about issues where the interests of owners and creditors differ. According to Gilson (1989, 1990) some 50 to 60 percent of managers still remain in control at the end of one year of renegotiations, and stockholders continue to control a nontrivial number of seats on the board. 3.23 Success of Chapter 11 filings. Most firms involved in Chapter 11 procedures end up in liquidation. According to a study by the Administrative Office of the Courts (cited in Westbrook 1993), a confirmed agreement is reached in about 25 to 30 percent of Chapter 11 cases. Even then, one-fourth of these plans envisage the liquidation of*the companies. The ratio of successful cases has been increasing from a low of 13 percent in 1982, perhaps suggesting the presence of a learning process, that is, an increased capability in the industry to structure successful agreements. Data also show that larger firms are more likely than smaller firms to conclude a plan to reorganize. 3.24 Postbankruptcy performance. Hotchkiss (1992) studied the postbankruptcy performance of firms that had successfully completed a Chapter 11 procedure, with a confirmed reorganization plan. In her sample of 197 companies, more than 40 percent continued to experience operating losses in the three years following bankruptcy, and 32 percent filed for 1 In the rest of the cases, the firms either were liquidated or merged into other firms. Bankruptcy Policies in Industrial Countries 19 Chapter 11 or went through an informal workout for a second time. Hotchkiss found a close association between the continued involvement of incumbent management and poor postbankruptcy performance. She also discovered that the postbankruptcy performance of firms was worse than the earnings forecasts that management had presented to the court and creditors as part of the reorganization plan. Overall, the evidence suggests that Chapter II is biased toward the continuation of firms that should be liquidated. Chapter 11 Versus Informal Workouts 3.25 Informal, out-of-court workouts, an alternative to formal Chapter 11 proceedings for the renegotiation of the claims on a debtor company, offer several advantages. First, it has been argued that the transactions costs associated with informal workouts are lower than those incurred in bankruptcy. Gilson, John, and Lang (1990) found that the average time spent under Chapter 11 is 20 months, versus 15 months under an informal workout. In Franks and Torous's (1993) study, the differential is even greater: 27 months versus 17 months. These findings suggest that indirect costs may be lower in informal workouts. Gilson, John, and Lang estimated the direct costs of informal workouts to be less than 1 percent of the book value of assets, whereas estimates of the direct costs of Chapter 11 proceedings range from 2.8 to 7.5 percent. 3.26 Another advantage of informal workouts is that in principle only claims that are experiencing repayment difficulties need be restructured. If renegotiation is costly, then this also leads to cost savings over Chapter 11. For example, Gilson, John, and Lang found that only 70 percent of firms that undertook informal workouts and that had publicly traded debt outstanding actually restructured such debt.'6 3.27 If it is true that informal workouts are less costly, and hence provide a larger value of assets to be renegotiated, then one would expect that most recontracting of claims would take place out of court. In fact, as Gilson, John, and Lang argue, the larger the difference in the costs associated with each of the systems, the more likely it is that firms will prefer informal to formal restructurings. 3.28 However, informal workouts are vulnerable to the hold-out problem mentioned in the earlier discussion of the agency problems of debt. Their success often requires the unanimous agreement of creditors whose claims are in default. Such unanimity may be impossible if individual creditors hold out in order to free-ride on the benefits of debt restructuring or to obtain more favorable treatment.17 A dissenting creditor excluded from the restructuring plan can resort to individual remedies or force the debtor into an involuntary bankruptcy. The voting rules of Chapter 11 alleviate the hold-out problem. When a reorganization plan has the required 6 Two features of Chapter 11 may partly compensate for its cost disadvantages. The first is the automatic stay, which prevents costly fragmentation of the firm's assets. The second is availability of-debtor-in-possession financing, which may help preserve the firm's value during negotiations. However, the net effect of these provisions depends on the nature of agency problems, as discussed below. 17 See Gertner and Scharfstein 1991 for a theoretical treatment of this problem in informal workouts. 20 Bankruptcy Policy minimum number of votes in each class of creditors, it is confirmed and becomes binding on all the creditors. Moreover, dissenting classes can be forced to comply with the plan through a cramdown procedure.18 3.29 The hold-out problem in informal workouts is likely to be less severe when the claims on the firm are privately held, and among a few creditors, as in the case of bank loans. The problem is typically more severe when creditors are unsophisticated or diffuse, as in the case of trade creditors or publicly traded bonds. The situation is even more complicated because the Trust Indenture Act of 1939 requires the consent of every bondholder in order to change the principal amount, the interest rate, or the maturity of a bond, all of which would be essential in a restructuring.19 3.30 Empirical evidence generally confirms the importance of hold-out problems and indirect costs. Gilson, John, and Lang (1990) examined 189 financially distressed firms, of which 80 had successfully restructured their debts and 89 had failed and filed for bankruptcy reorganization. Firms that had successfully concluded their debt restructurings had relatively more bank debt. Bank debt is hypothesized to be easier to negotiate because banks are more sophisticated and less numerous than other kinds of creditors, resulting in fewer hold-outs. Similarly, successful informal workouts are also characterized by a lower number of debt contracts per unit value of book liabilities, a variable that again captures creditors' incentives to hold out. These firms also have higher market value-replacement cost ratios. This ratio is an indicator of the going-concern value that might be lost in a formal reorganization, if reorganization resulted in higher sale of assets.20 3.31 Additional evidence on indirect costs is provided by Franks and. Torous (1993), who compared 37 firms that had filed for Chapter 11 with 45 firms that had successfully completed an informal workout. (About half of the firms that petitioned for Chapter II had done so after attempting and failing in an informal workout.) Their study revealed that recovery rates for creditors' claims are higher in informal workouts (80 percent) than in Chapter 11 reorganizations (51 percent). Regression analysis revealed that although the recovery rates were not related to the firms' performance, they were significantly negatively related to higher asset sales. Following 18 Gilson, John, and Lang (1990) mention asymmetric information as a second problem that may cause the failure of informal workouts. Insiders normally have better information about the true value of the firm than creditors. Shareholders or management have an incentive to use this advantage to misrepresent the value of the firm and thus gain more favorable terms in the restructuring. Since rational creditors are aware of insiders' incentives, the asymmetry in information may cause renegotiations to fail. Gilson. John, and Lang argue that the insiders' information advantage in Chapter II is much smaller due to the disclosure requirement. 1 As a result, restructurings of publicly held bonds are often done through exchange offers, in which the firm offers cash and a package of debt and equity securities in exchange for the existing bonds. To avoid a hold-out problem and encourage bondholders to participate in the exchange, the firm often includes more senior bonds in the package. Moreover, bondholders are asked to eliminate the protective covenants of the old bond; hence, the offer is often contingent on acceptance by a specified majority of bondholders. 20 This going-concern value is probably due to intangible assets. The presence of intangibles, which may be lost in a Chapter 11 proceeding, may also discourage junior creditors from holding out. Bankruptcy Policies in Industrial Countries 21 a suggestion from Shleifer and Vishny (1993), Franks and Torous interpret asset sales as an indicator of the indirect costs of financial distress arising from distressed or "fire" sales. Distressed sales of assets generate revenues that are lower than their long-run equilibrium values, which, all else constant, decreases the financial resources available to repay creditors. Interestingly, asset sales have a larger negative effect on recovery rates for firms under Chapter 11, providing additional evidence that Chapter 11 suffers from higher indirect costs. 3.32 Finally, Franks and Torous (1993) found that deviations from the absolute priority rule for equity are higher in informal workouts (9.5 percent) than in Chapter 11 reorganizations (2.5 percent). Equity deviations are correlated with two characteristics. The first is the insiders' option to delay the renegotiation process. In informal workouts this takes the form of a threat to file for Chapter 11; in Chapter 11 it reflects the threat to delay the firm's emergence from reorganization. Note that the value of this option is highest when the value of equity is close to zero or when the value of the firm is close to the face value of debt. Deviations from the absolute priority rule for equity are positively correlated with the value of the option. 3.33 The second characteristic that is correlated with equity deviations is the complexity of the firm's capital structure, which is captured by size. It is hypothesized that the larger the firm, the more difficult it would be for creditors to act cooperatively, and thus the easier for equity holders to gain concessions. Indeed, Franks and Torous found the deviations to be positively correlated with size. Interestingly, the impact of size is smaller for firms under Chapter 11, suggesting that relative to informal workouts, those aspects of equity bargaining power related to complex capital structures may be' diminished under Chapter 11. This result is probably associated with creditors' greater ability to act cooperatively. In general, only equity holders gain in informal workouts, whereas junior debt holders also gain under bankruptcy. An Evaluation 3.34 Empirical evidence seems to suggest that renegotiations through informal workouts entail smaller transactions costs than Chapter 11 proceedings. However, informal workouts are more vulnerable to hold-out problems.21 Firms with simpler capital structures or fewer creditors are more likely to be successful in informal workouts. 3.35 The evidence also reveals the interdependency between informal workouts and Chapter 11 reorganizations,22 and is consistent with the hypothesis that formal reorganizations are subject to higher transactions costs. In cases where most of these costs are likely to be borne by creditors (that is, when the value of equity is close to zero), the procedural rules of Chapter 11 grant significant bargaining power to debtors by providing them with an option to delay the procedures. (This is partly compensated by increasing the ability of creditors to act in a more 21 The informal workout of Donald Trump provides a recent example. According to news articles, the creditors were convinced by their counsel that a Chapter 11 case would be a drawn out, conflictual, costly process. Under the threat of that prospect, Trump was able to get an extremely favorable agreement in the informal workout (Washington Post, November 29, 1992). 22 See Gertner and Scharfstein 1991 for a formalization of this linkage between informal workouts and formal organizations. 22 Bankruptcy Policy coordinated manner.) Ex ante, shareholders' ability to threaten creditors to effectively decrease the value of the firm, and consequently the value of the creditors' claims, grants the shareholders bargaining power in informal workouts as well. 3.36 What are the implications for the creditors' bargain and restructuring? Since the bargaining power of the debtor derives primarily from the rules that govern the reorganization process, rather than the original contracts, granting such power violates the creditors' bargain. Considering investment efficiency, the important provisions of Chapter I1-such as automatic stay, equity violations of the absolute priority rule, and debtor-in-possession financing- generally increase incentives to invest. Hence, the net effect on efficiency depends on the nature of the agency problem. If the firm suffers from underinvestment, then reorganization under Chapter 11 may improve efficiency. However, in the case of overinvestment, these provisions of Chapter 11 exacerbate the problem (Gertner and Scharfstein 1991). The empirical evidence summarized above suggests that the latter is most frequently the case. Overall, Chapter 11 does not seem to promote the maximization of the value of assets under bankruptcy. Rather, it seems to encourage the rehabilitation of firms whose liquidation value is larger than their going-concern value. 3.37 Another problem with granting excessive bargaining power to debtors, as emphasized by the debt collection view of bankruptcy, is that the procedure becomes quite vulnerable to abuse by firms that utilize it for purposes other than managing insolvency. Chapter 11 is especially susceptible to that problem because eligibility does not depend on the firm's being in a state of insolvency or even illiquidity. An example is the 1983 bankruptcy filing of Continental Airlines, which was motivated not by a concern about illiquidity or insolvency, but by the desire of the airline's management to renegotiate with labor.23 The U.K. Creditor-Oriented Approach 3.38 Whereas the main purpose of Chapter 11 of the U.S. Bankruptcy Code is to maintain the debtor firm as a going concern, the primary objective of the United Kingdom's 1986 Insolvency Act is to encourage the repayment of creditors' claims.24 Before enactment of the 1986 law,25 the predominant insolvency procedure was receivership. However, receivership was believed to lead to the liquidation of companies that could be reorganized. To counter this weakness, the 1986 law introduced an alternative called administration. Although the administration procedure has been labeled by some as the U.K. equivalent of Chapter 11, it prescribes a fundamentally different set of rules and procedures for the treatment of insolvent 2 See Graham 1992 and Kallen 1991 for more examples. 24 This section relies on Clarke 1993, Franks and Torous 1992. Rajak 1988, Webb 1991. and the International Financial Law Review 1990. 2s The U.K act was based on the recommendations of the Report of the Review Committee on Insolvency Law and Practice (1982). Bankruptcy Policies in Industrial Countries 23 debtors. Most important, all procedures envisaged in the act have a common feature: On their initiation, managers and owners lose their control over the debtor company. 3.39 An interesting provision of the U.K. law requires managers to declare insolvency as soon as a reasonable prospect for avoiding a default ceases to exist. Managers who fail to do so can be disqualified from holding a position on the board of any company for as long as 15 years.26 The intention of the provision is to encourage an earlier declaration of insolvency to avoid value losses. 3.40 The three options under the U.K. system-liquidation, administrative receivership, and administration-are discussed below. Liquidation 3.41 A creditor or the company itself can request the appointment of a liquidator. The role of the liquidator is similar to that in the United States: to sell enough assets to satisfy all creditors' claims in accordance with their respective legal rights. Administrative Receivership 3.42 A receiver is an individual appointed by a secured creditor (the appointor) to enforce its security. Whereas a receiver is appointed over a particular asset, an administrative receiver is appointed over the entire company's assets by the holder of a "floating charge," which in most cases is a bank.27 The receiver decides whether the company should be maintained as a going concern. If the receiver decides not to do so, he sells the assets to pay the claims of the appointor. The balance is then passed to a liquidator. If the company has positive cash flow, it is often possible to sell the business; if cash flow is negative, additional financing is required. Such financing is often secured from the appointor. Going-concern sales are often made to incumbent management, possibly due to management's superior knowledge about the true state of the business (Franks and Torous 1992). 3.43 The receiver is mainly responsible to the appointor. By contrast, the administrative receiver is responsible to the preferential creditors, to the appointor, and, to a lesser degree, to junior creditors. To protect the interests of other creditors, the law imposes restrictions on the behavior of the receiver; for example, he is required to sell the assets for a full price. Franks and Torous (1992) reported a case in which a receiver was successfully sued for failing to advertise properly the sale of an asset. 3.44 Nevertheless, the incentive of the administrative receiver to realize the going-concern value of a debtor firm is relatively small. When a conflict of interest is likely to arise between a 26 Franks and Torous (1992) reported that as of September 1991 more than 1,000 directors had been disqualified. 27 A fixed charge is a security over a particular asset, whereas a floating charge gives security over a pool of assets or over the whole company. Under a floating charge, assets of the company may be used freely by the managers unless and until the charge "crystallizes" due to, for example, a default. On crystallization, it becomes a fixed charge over the relevant assets. 24 Bankruptcy Policy secured creditor and junior creditors, the administrative receiver is likely to decide in favor of the secured creditor who appointed him. The absence of an automatic stay also limits the behavior of the administrative receiver. The appointment of a liquidator usually prevents the administrative receiver from managing the firm as a going concern. It is also unlikely that an administrative receiver would decide to rehabilitate a company if faced with opposition from the appointor. According to Clarke (1993), the main factor that discourages administrative receivers from rehabilitating a company in such circumstances is that they are professionally dependent on a small group of financial institutions that makes most appointments. She also indicates, however, that once an administrative receiver decides to rehabilitate a company, with the consent of the appointor, administrative receivership is probably the procedure most likely to succeed. Administration 3.45 Either the debtor company or a creditor can request the appointment of an administrator to represent all creditors' claims. The court will appoint an administrator only if at least one of the specified purposes can be achieved, namely, to maintain the company as a going concern, to secure a more advantageous realization of the company's assets, or to come to an arrangement with creditors. Once an administrator has been appointed, an automatic stay is in force over all proceedings and actions against the company, and a liquidator cannot be appointed. 3.46 The administrator takes over the management and control of the company and has extensive powers, including the power to remove the company's management. He is required to produce formal proposals for an arrangement within three months of his appointment. The proposal is submitted to a creditors' meeting, where it is voted on. Confirmation requires an affirmative vote by creditors representing at least 50 percent of the outstanding claims. 3.47 The administration procedure, which is much more conducive to maintaining the company as a going concern than is administrative receivership, is nonetheless rarely used. Creditors secured by a floating charge may prevent the granting of an administration order by appointing a receiver before the court rules on the request for administration. Furthermore, an administrator can be appointed only if the receiver resigns his office. This provision limits the use of administration. Generally, secured creditors rarely have incentives to relinquish control to an administrator, since a receiver better serves their interests.28 The administration procedure is most often used in cases where no creditor is secured by a floating charge. 3.48 As noted by Franks and Torous (1992), the administration procedure seems to suffer from a fundamental inconsistency. The appointment of an administrator is likely to be most warranted when the conflict of interest between secured and unsecured creditors is acute. This would happen, for example, when the liquidation value of a company is less than its (uncertain) value as a going concern yet covers the face value of the secured creditor's claim. In such cases the secured creditor is likely to prefer liquidation, whereas the interests of unsecured creditors, as 28 The benefit derived from the automatic stay provision of administration is one incentive for a creditor to opt for this alternative rather than receivership. Bankruptcy Policies in Industrial Countries 25 well as the restructuring criterion, favor continuation. Although an administrator could in principle prevent a premature liquidation and maintain the going-concern value, it is under these exact circumstances that the secured creditor is likely to preempt an administration order. Creditors' Bargain or Premature Liquidations 3.49 The shareholders or incumbent management of the debtor are afforded smaller, if any, bargaining power by the U.K. insolvency procedures than they would be by the U.S. bankruptcy reorganization procedure. Control in the U.K. system is exercised by the receiver, administrator, or liquidator, all of whom are certified insolvency practitioners (and often accountants). The ability of secured creditors to block an administration procedure has been interpreted as a guarantee that the Insolvency Act obeys the creditors' bargain (Webb 1991). Indeed, although detailed statistical evidence is not available, there exists a general presumption that in most cases absolute priority among different classes of creditors is honored. Nonetheless, by favoring secured creditors, the U.K. system may jeopardize the interest of junior creditors. The U.K. code thus can be said to respect the bargain of the secured creditors rather than that of all creditors. 3.50 The U.K. procedures are also believed to entail lower transactions costs. Shareholders have no power to delay the process, receivership results in a speedy settlement of claims, and the receiver can act without having to report back to the creditors or the court on a day-to-day basis. Perhaps most important, none of the procedures involves costly and convoluted bargaining. 3.51 However, whereas the U.S. system creates strong incentives to maintain a company as a going concern even when it is worth more in liquidation, the U.K. system may do just the opposite. By emphasizing the rights of creditors, and in many cases giving priority to secured creditors, the system may result in premature liquidations. Although it may be too early to judge the impact of the administration procedure, the small number of administration cases-perhaps a few hundred compared with thousands of receiverships-suggests that administration has not produced a radical change in the U.K. insolvency system. 3.52 As for investment efficiency, the U.K. code is more likely than its U.S. counterpart to exacerbate problems of underinvestment. If maintaining the debtor firm as a going concern requires new financing, it is more difficult to raise such financing in the U.K. system because no automatic priority is granted to such financing as it is in the U.S. system. Acquiring such priority for new financing would require the consent of existing creditors. 3.53 To summarize, the U.K. system avoids some of the main problems of the U.S. reorganization procedures and more closely respects the creditors' bargain. However, these advantages are achieved possibly at the cost of premature liquidations and underinvestment. The introduction of the administration procedure does not seem to have compensated for these shortcomings. The main problem seems to be that the creditors' bargain is interpreted too narrowly, in a way that favors one group of creditors at the expense of others. One may hypothesize that a system that represents all creditors, and that attempts to resolve conflicts of interest between different classes by promoting a course of action that maximizes repayment to 26 Bankruptcy Policy all creditors, may help prevent premature liquidations. To achieve such a system may require weakening the ability of secured creditors to veto the appointment of the administrator. The French Court-Controlled System 3.54 The French Insolvency Act, enacted in 1985 and reformed in 1994, has three stated objectives: maintain the firm in operation, preserve employment, and enforce credit contracts. The law prescribes a single process for all cases of insolvency covering both reorganization and liquidation. There are two procedures, one ("simplified procedure") for small firms (those with less than 50 employees or sales less than 20 million francs) and another ("general procedure") for large firms. 3.55 An interesting aspect of the French legal framework regulating situations of financial distress is that it is directed partially at preventing bankruptcies.29 The Bankruptcy Prevention Act of 1984 prescribes several preventive measures aimed at assisting the debtor in reestablishing its financial health before defaulting or becoming obligated to file for bankruptcy. The purpose of the act is to provide a framework for negotiations between a company and its principal creditors and the expert assistance to help the company resolve its financial difficulties, thereby promoting informal workouts. 3.56 A company seeking relief under the 1984 act petitions a commercial court. If the court is convinced that bankruptcy is inevitable, it appoints a conciliator under whose supervision the company and its creditors negotiate an agreement, which they file with the relevant agencies. The agreement is treated as confidential. Failure of the debtor to comply with the terms of the agreement is deemed an act of bankruptcy. 3.57 Under the general procedure, the court appoints an administrator and a representative of the creditors. The commencement of bankruptcy also initiates a six-month observation period (which may be extended for an additional six months), during which payments to creditors are halted.30 Any financing secured during the observation period is treated as a priority claim. Control of the debtor may remain with the current management, under the supervis'ion of the administrator, or the court may order the administrator to assume effective control. The observation period ends with a judge's decision on whether the company will continue in the same legal form, be sold to third parties, or be liquidated. 3.58 The administrator, having decided that the company has a chance of survival, prepares a plan of reorganization. The plan may include debt write-offs, sale or shutdown, or even the addition of certain lines of business. It may envisage continuation or the partial or total sale of the company. Under a continuation plan, the owners of the company remain the same, although equity may be restructured. The court also may impose the replacement of the managers. Once 29 This section draws primarily on Biais 1994, International Financial Law Review 1990, Malecot 1992, Mitchell 1990, and Simeon and others 1990. 3 Under the simplified procedure, the observation period is shorter and the appointment of an administrator is not mandatory. Bankruptcy Policies in Industrial Countries 27 it receives the plan, the court schedules a hearing at which all relevant parties, including workers' representatives, can voice their views. But they can neither vote on the plan or veto it. The decision on whether to adopt the plan rests with the court. 3.59 A reorganization plan also may envisage the sale of the company. The Insolvency Act emphasizes and facilitates the sale of the business, in part or as a whole, as a solution to the company's problems. Potential purchasers may bid for its sale as soon as bankruptcy starts. Purchase offers must provide details on how future activities will be financed and on future levels of employment. The law instructs the judge to choose the sale that ensures the highest level of employment and of payment to creditors. 3.60 If the court deems that the company cannot be rehabilitated or sold, it can order the company's liquidation. In that case, a liquidator is appointed, and the assets of the company are sold to satisfy creditors' claims. 3.61 According to a recent study, about 94 percent of all bankruptcy cases end in liquidation (Biais 1994). For cases involving large companies, this rate drops to 40 percent. According to evidence from the Toulouse region, 80 percent of reorganizations end with continuations when the firms are owned by managers (private proprietorships), whereas 80 percent of larger, publicly held companies end up in sales. The observation period is about one month in cases that end in liquidations and seven months in those that end in reorganizations. 3.62 Based on a sample of 1,000 firms (and 1,200 loans), Malecot (1992) reported that the average recovery rate for bank loans is 69 percent under plans that envisage continuation and 55 percent under liquidations. Biais (1994) cited evidence that repayment rates for creditors are below 35 percent in sale reorganizations in the Toulouse region. Also, in 99 percent of cases that end in continuation, incumbent managers remain in charge. 3.63 The main distinguishing feature of the French system is the exclusive power of the court to determine the course and outcome of the bankruptcy process. Because the three objectives identified in the law-maintaining the firm as a going concern, preserving employment, and satisfying creditors' claims-are potentially contradictory, the court often must strike a balance between them. Most judges who administer bankruptcy proceedings are businessmen, which possibly encourages economic reasoning in the resolution of bankruptcy. A study reported by Biais (1994) found that when the court was faced with a variety of offers, it acted to preserve employment in 33 percent of the cases, to maintain economically viable firms in 26 percent of the cases, and to pay back creditors in 24 percent of the cases. In addition, the work force and management agreed with the decision of the court in 80 percent of the cases, whereas the creditors agreed in only 23 percent of the cases. 3.64 Despite the limited empirical evidence, it is safe to conclude that the French bankruptcy system was not designed to satisfy the creditors' bargain. Regarding investment efficiency, given the law's concern with employment and maintaining the debtor as an operating 31 Under the previous law, a certain percentage of creditors had to approve a rehabilitation plan. Under the current law, a court may adopt a plan even if all the parties object to it. 28 Bankruptcy Policy unit, underinvestment or premature liquidations are not likely to pose a significant problem. In fact, if anything, the law may result in overinvestment and deferred liquidations. Even though there may be a bias toward maintaining as going-concerns even firms that are worth more under liquidation, debtors are not likely to benefit from excessive bargaining power either, for two reasons. The first reason is that the law limits the duration of the observation period. French debtor firms typically spend less time under bankruptcy reorganization than their U.S. counterparts. Second, debtors have little control over the company during the observation period, and they have no right to propose a plan (although they can influence its design). 3.65 Amendments to the French Insolvency Act-a new law adopted in 1994-introduced some significant changes. First, bankruptcy prevention mechanisms were strengthened by requiring the social security agency to warn the court when a company fails to pay its contributions. Second, the court can grant an automatic stay or even impose a reorganization plan on dissenting minority creditors in the prebankruptcy stage. Both these changes increase the role of the court in resolving financial distress. As for the formal bankruptcy procedure, the changes introduce more protection for creditors' rights. Most important, the new law requires the purchaser to repay secured creditors in full. In Search of a Better Model 3.66 Bankruptcy law in industrial countries has so far been unable to satisfy the debt- collection aspect of bankruptcy without sacrificing efficiency in restructuring. The problem can be stated as follows: How can control rights and decisionmaking authority be distributed in bankruptcy reorganization so that the emerging institutional structure encourages outcomes that maximize the total value of the firm, rather than specific claims on it, without violating the creditors' bargain? 3.67 The U.S. code-if not directly, through granting bargaining power-grants the debtor-in-possession substantial control rights and decisionmaking authority, which results in delayed liquidations. Although the U.K. code gives a leading role to secured creditors, premature liquidations become the main problem. The French system grants the judge power to impose solutions on all parties. But without a personal stake in the whole process, this third party is not compelled to work to maximize the value of the company subject to the creditors' bargain. 3.68 The review in the preceding chapters helps in identifying some elements of an improved reorganization procedure. The U.S. model suggests that an improved model would reduce the bargaining power of the debtor. Two modifications are suggested. The first is to introduce tighter limits on the reorganization process, which judges are obligated to enforce. Doing so would decrease debtors' ability to threaten creditors by delaying the procedure and would curtail debtors' bargaining power in informal workouts. The second, more important change would be to curtail the control rights of the debtor once a firm is in bankruptcy. This can Bankruptcy Policies in Industrial Countries 29 be achieved by having the judge automatically appoint and grant substantial managerial authority to a trustee, who might be monitored by the court and the creditors.32 3.69 The discussion on the U.K. system suggests that to prevent premature liquidations, the power of secured creditors to veto the appointment of an administrator should be reduced. Unsecured creditors thus would not be marginalized in the decisionmaking process. The administrator would still have as a mandate the maximization of the value of the firm. 3.70 With these changes, the U.S. and U.K. systems would be much more similar to each other than they are now. In both systems, substantial responsibility and decisionmaking authority would be given to third parties, such as trustees and administrators. To preserve the creditors' bargain, any reorganization plan prepared by the administrator would be subject to the creditors' approval. With the threat of delay removed, the outcome of the voting system would more closely reflect the creditors' preferences, rather than the bargaining power of the debtor. 3.71 The main difference between the modified U.S. and U.K. systems proposed here and the French system is that the creditors would retain voting power. Whether the administrator would be appointed by the court or by the creditors, the boundaries of his authority would have to be worked out. In addition, the law would have to give the administrator and the court an economically meaningful mandate. Commercialization of administrators' services, and perhaps linking their rewards to the bankruptcy outcome, may increase market discipline on the whole process.33 3.72 A very different solution, one that simulates the market mechanism more closely, was proposed by Aghion, Hart, and Moore (1993). Once a firm files for bankruptcy, all debts would be canceled, and ownership rights would be allocated according to absolute priority. Senior creditors would receive actual shares; junior creditors would receive options to buy shares at a price equal to the claims of the senior creditors. Shareholders would have an option to buy shares at a price equal to the face value of the claims of all creditors. This mechanism aligns incentives among creditors, and between creditors and shareholders (and hence encourages the realization of maximum value for the firm), and preserves the absolute priority rule at' the same time. Nevertheless, it also requires a well-functioning financial market so the parties can raise 32 More specific measures of a similar spirit have been proposed by LoPucki (1993). He proposes that (a) the judge eliminate the interests of insolvent shareholders, and (b) the judges' discretion to extend the exclusive period be curtailed. 3 The Economist ("When firms go bust," August 1, 1992, p. 63-65) calls this approach to reform "beefing up the bureaucracy." 30 Bankruptcy Policy the cash necessary to exercise their options. If such financing is not available, ownership of the firm is effectively transferred to senior creditors (or, more correctly, to the particular class of creditors ranking above the class that cannot raise financing). Efficient,34 but nevertheless unfair,35 outcomes are likely to be the result. 3 For example, transfer of ownership to secured creditors with floating charges would presumably make them interested not in realizing their security, but in maximizing the value of the firm. In this way, asset fragmentation would be avoided and going- concern value would be preserved. 3 Aghion, Hart, and Moore (1993) note that this transfer of wealth from junior to senior debt would be compensated ex ante by more favorable pricing of junior debt. 4 Bankruptcy Policies in Industrializing Countries 4.1 As noted in the introduction, bankruptcy policy in industrializing countries suffers from a set of fundamental shortcomings not (or no longer) encountered in the industrial world. Some of these pertain to bankruptcy laws, but more concern the general institutional and regulatory environment. 4.2 An overview of these shortcomings is provided here, followed by a discussion of corporate reorganization procedures in India to illustrate some of these problems in some detail. Bankruptcy reform in Colombia is then reviewed, along with some of the factors that explain its relative success. Finally, implications for bankruptcy policy are suggested. Main Problems 4.3 The main problems of bankruptcy policy in industrializing countries include outdated legislation, lack of differentiation between enterprises and their owners and managers, an inadequate institutional structure, poor supervision and regulation of the banking system, and regulatory barriers to the mobility of labor and capital. These are discussed below. Outdated Legislation 4.4 Bankruptcy laws in many industrializing countries are outdated. In Venezuela, for example, rules governing bankruptcy procedures were established in the commercial code. The rules were inspired by the French and Italian legislation in the late nineteenth century. The Venezuelan code took its current form in a reform undertaken in 1919. 4.5 The Turkish code was inspired by Swiss legislation dating to the late nineteenth century. Although several amendments to the code were enacted throughout the 1980s, the core of the code was not substantially changed. 4.6 The age of a piece of legislation, of course, is not in itself evidence of inadequacy. The problem is that the framework of bankruptcy law in industrializing countries in general is ill suited to address the insolvency problems of modern corporations. For the most part, the law has not been informed by the substantial learning in this area over the past two decades, especially in industrial economies. 31 32 Bankruptcy Policy Lack of Differentiation Between Enterprises and Their Owners and Managers 4.7 Bankruptcy laws often fail to make a clear distinction between a company as a productive unit and its owners and managers.36 A direct consequence is that the rehabilitation of a debtor company means that its owners must be "saved" as well. Reorganization procedures are typically perceived as a mechanism for providing the owner a "breathing space," rather than one that aims at preserving or enhancing the going-concern value of the enterprise. 4.8 This view has several implications. First, in cases in which failure of the enterprise is primarily due to mismanagement by owners and managers, the probability of inefficient outcomes is increased: Firms that might be viable under more able management may be liquidated or, conversely, firms may be rehabilitated without fixing the root causes of their failure. Second, striking a balance between adhering to the creditors' bargain and restructuring is more difficult. A legal framework that emphasizes rehabilitation ends up providing excessive bargaining power to the owners and managers of the debtor enterprise and grossly violates the creditors' bargain. A legal framework that aims at protecting creditors' rights, by contrast, is likely to encourage substantial losses in going-concern values. 4.9 An important version of this problem occurs when the code associates default (and bankruptcy) with fraudulent behavior. The reorganization procedure in the Turkish code restricts eligibility to "honest" debtors. In Venezuela the establishment of bad faith on the part of the debtor results in the termination of the reorganization procedures and initiates a liquidation procedure. Fraudulent behavior by management may therefore result in liquidation of a firm that has higher value under continuation. In Colombia the initiation of a liquidation procedure triggers a criminal investigation of the debtor. The emotional aggravation as well as the possible loss in reputation associated with such an investigation might well deter the debtor from making a bankruptcy filing. In addition, prebankruptcy agency problems that encourage excessive risk taking might also be exacerbated. Inadequate Judicial and Financial Infrastructure 4.10 In many countries the processing capacity of the court system is severely limited. Courts are underfinanced and underendowed with staff and equipment, and record keeping is poor. As a result of these deficiencies, bankruptcy procedures are extremely lengthy, even absent delays due to strategic behavior of interested parties. The situation in Colombia prior to a reform that revamped the bankruptcy system is a case in point. The Colombian reorganization procedure required court approval of the agreement reached by a debtor and its creditors. Of a sample of 19 cases awaiting such approval in 1989, nine had been waiting for more than a year. 3 In many countries, the distinction between owners and managers is not pronounced. Most companies are family-owned and managed. Diffuse ownership is rare. Even large companies, which may employ professional staff in higher-level management positions, are tightly controlled by owners. Bankruptcy Policies in Industrializing Countries 33 When limited processing capacity combines with strategic behavior, delays of course increase further. 4.11 The skills needed to ensure successful reorganizations are also relatively scarce. Because judges typically are poorly informed about corporate finance, the proceedings seldom benefit from economic reasoning. One of the major deficiencies of reorganization procedures in India is inadequate project appraisal skills (discussed below). The extent to which judges can make a valuable contribution to the recontracting process thus is severely limited. By contrast, one of the major reasons for the apparent success of bankruptcy reform in Colombia is that the competent authority is well endowed with the necessary technical and financial skills (see below). 4.12 Trustees appointed by the court typically are not capable of handling the complicated financial transactions that may be required for successful reorganizations, nor do they have the skills to run a company on even a temporary basis. The Venezuelan law, for example, only requires a trustee to be 21 years old, to be a businessman or a lawyer, and not to have declared bankruptcy. Most trustees are lawyers, yet a common concern among professionals who take part in bankruptcy procedures in Venezuela is that trustees lack the necessary skills to handle bankruptcy cases. 4.13 Another problem common to industrializing countries is deficient legal documentation. Before reforms in Colombia, inadequately prepared loan documents made validation of debt claims one of the major causes of delays in reorganization procedures. Debtors that wanted to prolong the proceedings could contest the validity of debt claims; their objections had to be resolved in ancillary lawsuits, which dragged on because of the limited capacity of the court system. 4.14 Inadequate documentation also facilitates asset stripping. Even when assets are pledged as collateral, owners and managers can remove them from the enterprise or transfer them preferentially to friends or family members. In the latter case, insufficient documentation makes it more difficult for judges or trustees to exercise avoidance powers and recover the-transferred assets. 4.15 Problems with legal registries are also common. In Jamaica a mortgage can be registered either under the Companies Act with the registrar of the companies or under the Registration of Titles Act. In the event of liquidation, which is governed by the Companies Act, mortgages not registered under the Companies Act can be treated as invalid. The flow of information between legal registries is very poor in many countries, allowing fraudulent transfers and registration of more than one claim against a single collateral. The main effects of these shortcomings is to reduce financial intermediation. To the extent that lending does take place, however, these problems make it more difficult to resolve conflicts in situations of insolvency. 4.16 Finally, inadequate accounting and disclosure rules increase information costs associated with financial distress and bankruptcy. Absence of these rules makes it more difficult for stakeholders to assess the value of the various options available to them. In particular, it complicates a correct appraisal of the going-concern value of the firm and its liquidation value. 34 Bankruptcy Policy The degree of asymmetry of information between owners and other stakeholders also may increase. When accounting rules are lax or not standardized, and a company's books do not convey credible information about the company's true financial situation, insiders typically possess more information than outsiders. This situation aggravates agency problems associated with debt financing, expands the scope for disruptive behavior, and increases the cost to reach an agreement under bankruptcy reorganization. Inadequate Supervision and Regulation of the Banking System 4.17 Bankruptcy law attempts to resolve collective action problems in debt collection and therefore presumes that creditors will actively seek repayment. Its effectiveness in inducing efficient restructuring and exit is similarly predicated on such behavior. In industrializing countries, where capital markets are typically underdeveloped, the banking system is the major creditor of the corporate sector, especially for large firms. Absence of adequate supervision or prudential regulation may under certain circumstances diminish banks' incentives to behave as aggressive creditors. 4.18 Banking systems typically suffer from a variety of market failures and policy-induced imperfections. One widespread example is explicit or implicit deposit insurance.37 Another is imperfect or asymmetric information about the quality of the assets of the bank. These imperfections may create incentives for banks to take on excessive risks at the expense of depositors and the state, .especially when financial distress among borrowers creates distress in the bank as well. This may in turn discourage active debt collection, or recourse to bankruptcy, and may even induce banks to refinance bad loans. 4.19 In industrial countries, supervision and regulation of the banking system curtails such behavior by forcing banks to maintain and disclose accurate assessments of the riskiness of their assets, discouraging excessive risk taking (by requiring banks to maintain a minimum level of equity capital), and in extreme cases penalizing poor performance or excessive risk taking. These in turn increase incentives for debt collection and recourse to bankruptcy. In many industrializing countries, however, especially those that have not embarked on financial sector reform, banking regulation and supervision are weak or ineffective. As a result, main creditors in the financial system have no incentives to behave as bankruptcy law typically presumes they will.", 4.20 Perhaps a more fundamental problem exists when the creditor banks are owned by the state. In such cases, the problem is not inadequate supervision or regulation but the fact that their behavior is influenced by political considerations, or that their economic mandate requires them to deviate from sound commercial practices. Under political influence, banks may make loans 3 Deposit insurance is implicit whenever depositors expect to be bailed out by the state in the event of bank failure, even if no explicit legal scheme protects depositors' claims on the bank. 38 Mitchell 1993 provides a comprehensive discussion of various factors that may induce "creditor passivity" in the context of the formerly socialist economies of Europe. Bankruptcy Policies in Industrializing Countries 35 without regard to some firms' creditworthiness. If such loans are not repaid, pressure can be put on banks to delay or even forgo attempts at debt collection. In many cases, the economic mandate of such banks has been to allocate loans on the basis of industrial or social policy criteria, rather than economic viability. Or banks have been asked to act as the disbursement agency of the government's economic ministries or the central bank. In these cases as well, banks have no incentive either to collect debts or to initiate bankruptcy.39 Regulatory Barriers to the Mobility of Labor and Capital 4.21 The degree to which bankruptcy can successfully carry out its debt-collection and restructuring roles critically depends on the absence of regulatory barriers to the mobility of labor and capital. While the mobility of these two factors can be taken for granted in most industrial countries, there are significant restrictions in many industrializing ones. 4.22 Constraints on labor redeployment or retrenchment eliminate one of the most crucial potential sources of productivity increases and reduce the attractiveness of restructuring. Even though the main objective of these restrictions in many countries is stated as the protection of labor, labor ultimately carries the main cost of immobility. Inability to undertake corrective measures often encourages managers and owners to salvage whatever they can from the firm through asset stripping. Company revenues dry up, production stops, and wage claims are rarely repaid. 4.23 Restrictions on capital can also hamper restructuring. Restrictions on sales of assets or land eliminate one of the most valuable sources of finance for corporate reorganizations. Corporate Reorganizations in India 4.24 Reorganization procedures in India are illustrative of many of the problems just discussed. The barriers to industrial and corporate restructuring in India involve the legal framework for corporate reorganization and liquidation as well as regulations that constrain the mobility of labor and capital.40 4.25 The legal framework for formal corporate reorganizations in India is laid out in the Sick Industrial Companies (Special Provisions) Act of 1985, designed to expedite the rehabilitation of faltering industrial firms. One of the main shortcomings of the act is the criteria it establishes for eligibility: To benefit from the act, a company's cumulative losses must be larger than its net worth. Designing a viable rehabilitation plan for a company with such a poor financial structure would be quite difficult. Nonetheless, qualifying companies are referred to the Board for Industrial and Financial Reconstruction (BIFR). If the company chooses to propose a rehabilitation scheme, it must be accepted by all involved parties (creditors, labor, state and 3 Goswami and others 1993 and Anant and others 1994 offer vivid descriptions of the implications of these problems for reorganizations in India. 4" This discussion draws principally on Goswami and others 1993. 36 Bankruptcy Policy central governments) to receive the board's approval. If the company offers no proposal, and the board decides that it is in the public interest to rehabilitate the company (which it always does), it appoints an operating agency (usually a financial institution) to examine the company's potential for rehabilitation. The agency's report to the board may include a proposal for rehabilitation or a recommendation for liquidation. If the agency proposes that the company be liquidated and one or more parties disagree, the board can either refer the case to the high court for liquidation or sell the assets. The board remits the sale proceeds to the high court for distribution to claim holders. 4.26 The board's procedures are lengthy. The mean duration of the cases handled between 1987 and 1992 was slightly more than one year. Over 19 percent of the cases were resolved after three years. Procedural rules are a principal cause of delays. The procedures require unanimous consent of all parties at almost all stages, which is to say that all parties have veto powers and can delay the proceedings as a matter of bargaining strategy. Goswami and others (1993) noted that: 4.27 Promoters veto original OA [operating agency] reports on the ground that they have better schemes; three months later they present something that is unviable and unacceptable to the BIFR. Consultants prepare estimates of productivity and profitability that often exceed those of the best firms in the industry (p. 20). 4.28 Procedures can also be stopped by appeals. Although there are cutoff dates for claim holders to take action in appeal cases, there are no limits on the time taken by the board or the appellate authority. 4.29 A second cause of delay is the board's preference for exhausting all possibilities of rehabilitation, even though, by the very nature of the eligibility criteria, most cases involve firms that are not viable. This preference precludes the board's using the threat of winding up (liquidation) to encourage consensus. Even when the company fails to carry out a sanctioned scheme, the case is referred back to the board rather than sent directly to be wound up. 4.30 Insufficient staff also contributes to delay. In 1993 the board consisted of a chairman and six members, to whom 1,010 cases were referred between 1987 and 1992. This staff shortage also caused cases to be determined without sufficient analysis. 4.31 Another deficiency of the Indian system is that the criteria used to determine the feasibility of rehabilitation schemes are flawed. Goswami and others (1993) found that very few of the board-sanctioned rehabilitation schemes satisfied the minimal viability criteria: The return on new loans and the return on equity, properly discounted, should be positive. As a result, firms that should have been liquidated were maintained as going concerns, often with vast injections of new, subsidized financial resources. Not only were the criteria established to assess the viability of rehabilitation schemes based on undiscounted financial flows; in addition, as is banking practice in the public sector, banks' success was judged by the volume of deposits and loans rather than portfolio quality or loan recovery. Banks thus had incentives to treat bad accounts as operationally sound, since recognizing a bad loan as such would have ultimately reduced the size of the bank's loan portfolio (Anant and others 1994). Bankruptcy Policies in Industrializing Countries 37 4.32 According to Goswami and others (1993), a large percentage of the companies that were put under a rehabilitation plan failed to improve their performance. In 1991, 39 of the 164 schemes sanctioned that year had failed, and 64 of the companies continued to incur losses. Most rehabilitation plans actually made recovery in performance difficult by further increasing the debt burden of the company through injection of new subsidized loans. The conversion of debt to equity was disallowed by the Reserve Bank of India until 1992. Even after conversions were allowed, however, they were used only infrequently because of the tax disadvantages. 4.33 Finally, as in the United States, the incumbent management retains control under Indian bankruptcy law. The Companies Bill allows creditors to request a change in management if they can prove improper behavior or if management has suspended payments to creditors. But improper behavior is hard to prove. And as for defaults, Indian courts have taken the view that defaults of limited liability companies are not covered by the Companies Bill. 4.34 Cases referred to the high court for liquidation take at least 10 years to conclude, and creditors rarely recover any of their claims. Although the time to conclude a case could be significantly shortened if the board sold the company's assets, the board has rarely chosen this option. 4.35 In most cases both the creditors' bargain and the restructuring criterion of bankruptcy are grossly violated. However, even if the provisions of the bankruptcy law were vastly improved, new and more efficient principles were identified to guide the behavior of the Board, and its technical and processing capacity was increased, several aspects of India's economic and regulatory environment would still limit efficient corporate reorganization. First, the sale of surplus land is tightly restricted by both the Urban Land (Ceiling and Regulation) Act and local governments. Second, the Industrial Disputes Act stipulates that state governments must approve labor cutbacks; state governments have consistently refused to grant such permission. These regulations severely constrain the flexibility of enterprises in responding to financial distress and prevent them from raising finance. Bankruptcy Reform in Colombia 4.36 The rules governing insolvency procedures in Colombia underwent significant reform in 1989. The experience in Colombia is interesting for two reasons: the prereform bankruptcy system provides a vivid example of the problems associated with an extremely debtor-oriented code, and the reform introduced innovative institutional solutions to these problems. 4.37 Before 1989 there were two insolvency procedures in Colombia. The first was basically a reorganization procedure, designed to conclude a conciliatory agreement between a company experiencing financial difficulties and its creditors with the purpose of rehabilitating the debtor's business. The second was a liquidation procedure. Reorganization procedures were of two types: The first procedure was optional and used mainly by small and medium-size companies. The competent authority was the district judge. Firms under the supervision of the Superintendency of Companies that experienced insolvency problems, by contrast, had to go 38 Bankruptcy Policy through a mandatory reorganization procedure.4' These firms could not petition for liquidation before reorganization was attempted. 4.38 Mandatory reorganizations, which were overseen by the superintendency, were widespread in Colombia. In 1986 and 1987, for example, 60 of some 1,000 manufacturing companies supervised by the superintendency were under reorganization. According to data from the superintendency, the value of their assets was about 12 percent of total assets, reaching 20 percent in some sectors such as textiles. 4.39 Under the mandatory procedure, the debtor retained management of the company unless fraud was established. The superintendency validated the list of claims, and any objections raised by the involved parties were resolved. The parties were then convened in a hearing, where they voted on a proposal for agreement. If an agreement was reached, it was sent to the district judge for confirmation. If no agreement was concluded, a liquidation procedure was initiated. 4.40 The procedures were typically lengthy. As of May 1989, of 82 cases in which an agreement had not been reached, 54 had been ongoing for more than two years and 36 for more than three years. The stage that caused most of the delays was the validation of claims. Debtors used their option to delay by raising objections, which had to be resolved by the district judge. The fact that many loan documents, especially those involving small creditors, had been inadequately prepared helped the debtors in that respect. The debtors had other means to delay the process as well. For example, by not attending the hearing, they could ensure postponement. The creditors had no remedies against such behavior. In addition, the parties could appeal almost every decision of the judge or the superintendent. Objections or delays sometimes were filed by creditors "friendly" to the debtor. Finally, the limited processing capacity of the court system also contributed to the delays. In May 1989 there were 16 cases in which an agreement had been reached and awaited confirmation by the judge; of these, nine had been languishing for more than a year. 4.41 Decree 350, enacted in 1989, reformed the mandatory reorganization procedures. The most significant change was designation of the superintendency as the sole competent authority for mandatory cases. The superintendency was thus endowed with authority to decide on matters that had previously required the intervention of the district judge. Most important, the superintendency was granted the authority to resolve disputes arising from objections raised during the validation of credits. The superintendency was also authorized to confirm agreements 42 reached between parties. 4.42 Decree 350 also introduced other significant changes. For example, tight time limits were assigned to the various stages of reorganization, and many decisions of the competent 4 These were firms that employed more than 100 permanent workers, firms whose foreign liabilities exceeded one-third of the value of assets, or those in which the government had a majority interest. 4 Granting judicial powers to an administrative authority created a controversy that was resolved with the adoption of a new constitution enabling an administrative authority to assume the functions of a judge. Bankruptcy Policies in Industrializing Countries 39 authority were rendered nonappealable. The decree also allows creditors to establish various mechanisms of control and monitoring during the procedure and requires the formation of a committee of creditors consisting of representatives of all classes of creditors (including public agencies, workers, and financial and nonfinancial creditors). The appointment of an examiner of the property, credits, and affairs of the debtor is also mandated. Both the committee and the examiner are given the right to request that the competent authority remove the firm's owner from the management team. 4.43 A comprehensive evaluation of the impact of the reform is premature. However, evidence to date on mandatory procedures suggests that these reforms have led to substantial improvement (Table 4.1). As can be seen, the percentage of cases in which an agreement was reached within a year increased from 18 percent to 32 percent after enactment of Decree 350. Similarly, whereas prior to reform only 52 percent of the cases resulted in an agreement within two years, this ratio increased to 60 percent under the new law. Table 4.1: Time to Conclude a Mandatory Reorganization Procedure under Colombia's Old and New Bankruptcy Laws Cases Initiated under the Commercial Code" Cases Initiated under Decree 3506 Duration (Percentage of Total) (Percentage of Total) 12 months or less 18 32 13-24 months 34 28 25-48 months 29 8 49 months or more 11 0 Not concluded 8 32 Total 100 100 A: Cases initiated before May 1989. b: Cases initiated between May 1989 and December 1991. Source: Superintendency of Companies, Bogotd. 4.44 Although no comparable data exist for the optional cases that still take place in the court system, there is consensus among professionals, lawyers, and the business community that, even though the two procedures are governed by very similar legislation, it takes much longer to reach an agreement in the optional system under the court system than in the mandatory system under the superintendency. The reasons are the following. First, relative to judges, the superintendency has more flexibility to resolve disputes. Second, the staff of the superintendency is likely to focus more on economic solutions to the problems posed by cases rather than on strict procedural problems. Third, and perhaps most important, the superintendency is being increasingly equipped with the commercial, financial, economic, and technical know-how, both to handle the various restructuring issues raised during reorganizations, and to mediate between conflicting parties to forge mutually beneficial and acceptable solutions. 40 Bankruptcy Policy Bankruptcy Policy Reform in Industrializing Countries 4.45 The tension between satisfying the creditors' bargain and preserving going-concern value gains added significance in the context of bankruptcy reform in industrializing countries. Inadequate enforcement of credit contracts, and the consequent insufficient protection of creditors' rights, is one of the important causes of the underdevelopment of financial markets. Lenders try to compensate for these deficiencies by imposing high collateral requirements or by rationing credit away from large portions of potential borrowers. Hence, reforming bankruptcy laws so as to uphold the creditors' bargain would have the beneficial effects of increasing financial intermediation and encouraging the development of financial instruments. In an environment where weaknesses in contract enforcement mechanisms already hinder the development of the financial sector, a bankruptcy system that gave excessive bargaining power to debtors would seriously jeopardize willingness to lend and exacerbate credit rationing. 4.46 However, an approach to bankruptcy that emphasizes debt collection may also lead to substantial losses in the going-concern value of debtor firms. Such losses may be especially high in countries going through significant changes in policy regimes, and where the business sector requires substantial restructuring to regain competitiveness, as in the aftermath of a trade reform. Under these circumstances bankruptcy policy should encourage reorganizations. Either way, the opportunity cost of establishing an inefficient bankruptcy system is probably higher in industrializing countries, as they face sharper trade-offs between debt collection and restructuring. The situation is further aggravated by insufficient capacity in the court system and the relative lack of workout skills, since these make it more difficult to monitor and control strategic behavior under bankruptcy. 4.47 Given these constraints, how should industrializing countries approach bankruptcy reform? First of all, bankruptcy reform should be carried out in parallel with reform of other types of regulatory policy that have an impact on bankruptcy outcomes. As suggested by the previous discussion, the supervision and regulation of the financial system, accounting and disclosure rules, and regulations that restrict the mobility of labor and capital should 6ccupy top positions on the reform agenda. A general improvement in loan documentation and legal registries is also key. Without an improvement in the relevant regulatory environment, bankruptcy reform is bound to have only a limited effect. 4.48 Second, correcting some of the fundamental shortcomings of bankruptcy legislation is likely to improve outcomes significantly. Bankruptcy laws should distinguish clearly between the productive enterprise and its owners and managers, and decouple the fate of the first from that of the second. This step would introduce significant flexibility and increase the number of options available to interested parties. In addition, default should be divorced from any association with fraudulent behavior. Decisions about whether to liquidate a firm or maintain it as a going concern could then be made based on economic criteria rather than on the ethical standards of its owner or manager. 4.49 As for a bankruptcy model, the question is, how can bankruptcy policy encourage reorganizations without jeopardizing debt collection? The starting point could be that, whereas Bankruptcy Policies in Industrializing Countries 41 the law should explicitly provide for reorganization, it should not grant the debtor excessive bargaining power. This objective would require that owners and managers relinquish control rights over the firm once it is in bankruptcy reorganization or, in a less extreme option, that creditors be allowed to request the removal of management on the basis of protecting their economic interest. 4.50 Where should decisionmaking authority be placed?43 The low level of processing capacity and skills in the court system warns against a model that requires the active participation and decisionmaking power of judges. A quasi-judicial body that focused exclusively on bankruptcy reorganizations might help to expedite these procedures. As discussed above, this option was tried in Colombia and India. While reorganization procedures in India still present serious problems, Colombia seems to have benefited significantly from reform. 4.51 In addition to the fact that the regulatory environment in Colombia is much less restrictive, the essential differences between the two countries' systems-which can account for the difference in success-are the following. First, India's Board for Industrial and Financial Reconstruction makes every effort to save a company from failure. Rather than a mandate of law, this seems to be a political mandate. By contrast, the Superintendency of Companies in Colombia takes a more business-like perspective. Second, the superintendency is increasingly staffed with accountants and financial analysts, as well as lawyers. Moreover, being the supervisor of the companies, it already has detailed accounting and financial information on their performance. In India most members of the reconstruction board are career bureaucrats who have no expertise in financial matters. Third, interested parties have less veto or other power to delay the procedures in Colombia; the superintendency is quite powerful. In India, by contrast, unanimous consent is almost always required. Another important attribute of the superintendency in Colombia is that it is widely recognized, by both the banking system and industry, as an impartial and competent institution. 4.52 Similar arrangements can be made in countries in which these conditions are likely to hold and the independence of the quasi-judicial agency from political influence can be guaranteed. Representation of the private sector in the agency may help to preserve independence. 4.53 Another possibility is to establish specialized commercial or even bankruptcy courts. But this may be a luxury for many countries, especially those whose judicial systems are already strained and underfinanced. Overall judicial reform is likely to be necessary in such countries, and bankruptcy may have a low priority. 4.54 In cases in which administrative or quasi-judicial solutions are not feasible, it would be preferable to grant greater control powers to banks, or creditors in general, rather than to debtors for two main reasons. First, if judicial capacity is low, it would be difficult for judges to 4 The term "decisionmaking authority" refers to the authority to decide whether the company can be rehabilitated, to prepare a reorganization plan, and to impose a plan despite dissenters. A judge can exercise this authority directly, or indirectly by appointing and monitoring an administrator or a trustee. 42 Bankruptcy Policy control the strategic behavior of debtors with substantial bargaining power. As a result, procedures might be delayed for a long time, as the prereform experience in Colombia shows. As discussed earlier, such delay is likely to lead to substantial losses in the value of assets under bankruptcy and to result in outcomes that are inefficient from both debt collection and restructuring points of view. Second, however underdeveloped, banks are likely to possess the strongest appraisal and workout skills in the economy. 4.55 Finally, private banks in many industrializing countries are owned by financial- industrial business groups. This raises the possibility that in addition to debt collection, banks might also be motivated to use bankruptcy for anticompetitive purposes-for example, to drive from the market competitors of industrial members of their business group. Prevention of such predatory behavior would require an increase in competition in the banking system as well as effective application of competition policies. 5 Topics for Future Research 5.1 Research on the efficiency properties of different bankruptcy models is still in its infancy, and more analytical and empirical work is required to better inform policymaking in this area. Research on the bankruptcy laws of industrializing countries that have not yet undertaken reforms would provide further insights on the main problems of the legislation, in particular how private agents have responded to the shortcomings of the legislation. Are informal workouts widespread? How common is private arbitration? Or is the main consequence of the inadequacies of the legislation a low level of financial intermediation? 5.2 Analyses of bankruptcies in industrializing countries that have undertaken reforms are needed in order to understand which models work better under developing-country conditions. In addition to analyses of the legislation, detailed studies of individual cases, as well as statistical analyses of the characteristics of firms that enter bankruptcy, would be useful. In this regard, the pattern of recovery rates across various stakeholders, time spent under bankruptcy, and firm performance following reorganization are empirical areas that deserve special attention. 5.3 Regarding industrial countries, empirical work-which to date has concentrated mainly on the United States-should be expanded to cover other bankruptcy models, especially those in Europe. For the United Kingdom, it would be interesting to examine companies under administrative receiverships and compare cases where the company is preserved as a going concern or sold with little fragmentation of its assets with those where the company is sold piecemeal. Is it the conflict of interest between secured creditors and other stakeholders (especially unsecured creditors) that accounts for the differences? Further work on administrations would also be helpful. Are most administrations preempted by the actions of secured creditors? Finally, in-depth studies of large cases may reveal whether liquidations do indeed result in a loss of going-concern value. More information on the extent of informal workouts in countries other than the United States would be valuable. 5.4 For all industrial countries, more information on the postbankruptcy performance of companies under different bankruptcy models is needed. Assuming that a higher rate of failure after bankruptcy reorganization reflects deferred liquidations, a comparison of postbankruptcy survival and failure rates would provide an important indicator of the relative efficiency of different bankruptcy laws. 43 44 Bankruptcy Policy 5.5 Little attention has been devoted to whether early detection of financial distress can help prevent further financial deterioration and thus avoid costly bankruptcy. More detailed examination of the French and U.K. laws, and their early-warning mechanisms, would be very informative in that respect. If early, detection is desirable, what type of rules would best encourage voluntary cooperative behavior to resolve financial distress before bankruptcy becomes inevitable? Does public policy have a useful role in early detection? 5.6 Recourse to bankruptcy is much less frequent in Japan and Germany than in the United Kingdom and the United States, especially for large firms. It is generally believed that in these countries, the banking system takes a much more active role in recontracting firms out of financial distress and acquires significant control rights over firms' operations during the process. Moreover, banks also provide considerable expertise to help a turnaround. It would be interesting to know, first of all, how these workouts compare to those in the United States. Do the debtors have more or less bargaining power (for example, are violations of the absolute priority rule more or less widespread)? How do the incumbent management and nonbank creditors of the companies fare in these workouts? 5.7 In general, the role and fate of incumbent management in bankruptcies and workouts is another area that deserves investigation. There seems to be a consensus, at least in the popular press, that the removal of incumbent management at the time of a bankruptcy filing should be facilitated in the United States. The argument is that if incumbent management had something valuable to contribute to the firm, it would be hired by the creditors. There is some evidence on management turnover during periods of financial distress and under bankruptcy in the United States. 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