Opening the Door for the Opportunistic Use of Interim Financing: A Critical Assessment of the EU Draft Directive on Preventive Restructuring Frameworks

The European Union Draft Directive on a Preventive Restructuring Framework and Second Chance (the ‘Draft Directive’) provides rules for adopting reorganisation plans in order to avoid insolvency. The Draft Directive also provides rules on the related problem of interim financing. According to the Draft Directive, interim financing should be encouraged and not be made subject to claw back unless parties have committed fraud or acted in bad faith. The Draft Directive thereby fails to recognise that finance transactions are too diverse in nature to provide the company and its financial creditors with a transaction avoidance free period. If the Draft Directive is adopted in its current form, it will open the door for opportunistic use of interim financing by both debtors and professional lenders. It will allow debtors to make final bets with other people's money and will also allow for conduit pipe financing reducing the exposure of existing shareholders. Lenders will also be able to make opportunistic use of the rules, most notably in the form of cross‐collateralisation and aggressive loan‐to‐own strategies under the guise of interim financing. There are several possible solutions to the potential for opportunistic use. The courts could be involved ex ante. This would, however, turn the Draft Directive into a fully fledged court supervised procedure instead of the currently intended preventive restructuring procedure which avoids such court procedures. An alternative would be to simply take out the provisions on interim financing. Another possibility would be to limit the protection offered in the Draft Directive to cases of new security against new money necessary and used for the continuation of the business. Copyright © 2018 The Authors International Insolvency Review published by INSOL International and John Wiley & Sons Ltd.     

Stiffing the creditor: Asset verifiability and bankruptcy

Evidence suggests that asset pledgeability, debt complexity, and control rights of dispersed debt influence financial distress resolution. We model how courts’ imperfect verifiability of assets and valuable control of misaligned creditors shape firms’ debt structure and create coordination problems that determine distress outcomes and financing. A key result is that an increase in verifiability allows financially constrained firms to fund projects by pledging more assets to misaligned creditors, making contract renegotiation in distress times more difficult and increasing the probability of bankruptcy. Since equity receives less in the event of distress, constrained firms choose riskier projects with higher returns. Consistent with our model, bankruptcy filings increase after the U.S. Supreme Court decision imposing a “market test” to assess the value of stockholders’ interest in debtor proposals. The effect is stronger for firms with low asset verifiability. These firms also experienced an increase in recovery rates, debt capacity, and risk-taking. Our findings suggest that reforms improving the verifiability of assets substantially impact credit access. However, our results also point out that improving asset verifiability may be insufficient for constrained firms with aligned creditors. Therefore, complementary reforms that facilitate firms’ access to creditors from different market segments may be necessary.     

Transposing the preventive restructuring directive 2019 into French insolvency law: Rethinking the role of the judge and rebalancing creditors' rights

In June 2019, the European Union adopted the Directive on Preventive Restructuring Frameworks. The objective of the Directive is to introduce a level‐playing field across all Member States in the area of pre‐insolvency restructuring. Member States have until 2021 to transpose the Directive into their domestic insolvency regimes. In April 2019, the French legislator adopted the “Pacte Law”, whose aim is, inter alia, the transposition of the European Directive on Preventive Restructuring. Although five preventive restructuring tools already exist in the French regime, the transposition of the Directive will have an impact on current restructuring practices as it will require: (i) rebalancing the involvement and role of judicial authorities in preventive restructuring proceedings; and (ii) rebalancing the involvement of, and protection granted to, creditors.     

A Primer on Distressed Investing: Buying Companies by Acquiring Their Debt

Distress or vulture investing requires a high level of business acumen combined with deep knowledge of accounting, finance, and corporate and restructuring law. In this paper, the authors provide a pedagogical discussion of an important—and socially beneficial—kind of vulture investing through which creditors often gain control of distressed companies. Such investing requires intensive information gathering and active participation by the investor, in contrast to most passive investing in publicly traded securities, as the investor seeks control over the distressed firm's equity. The process is made more risky and difficult by the many conflicting interests of creditors and equity holders who work throughout the process to protect their individual interests. The authors provide a detailed discussion of such conflicts and how restructuring practitioners seek to manage them.     

The Maturity Rat Race

Why do some firms, especially financial institutions, finance themselves so short‐term? We show that extreme reliance on short‐term financing may be the outcome of a maturity rat race: a borrower may have an incentive to shorten the maturity of an individual creditor's debt contract because this dilutes other creditors. In response, other creditors opt for shorter maturity contracts as well. This dynamic toward short maturities is present whenever interim information is mostly about the probability of default rather than the recovery in default. For borrowers that cannot commit to a maturity structure, equilibrium financing is inefficiently short‐term.     

‘The Re Tea Corporation principle and junior creditors’ rights to participate in a scheme of arrangement – a view from Singapore'

This paper examines the application of the principle derived from Re Tea Corporation's case in recent schemes of arrangement to break negotiation deadlocks between senior and junior creditors of a financially distressed company. This paper argues against an overly technical application of the principle in Re Tea Corporation's case which might work injustice towards junior creditors by effectively shutting them out of a restructuring. This paper further explores how the holdout problem, which led to the formulation of the Re Tea Corporation principle in the first place, could be addressed while balancing the competing interests of junior claimants in a scheme of arrangement. Copyright © 2011 John Wiley & Sons, Ltd.     

Post‐IRCJ challenges: changing Japanese culture to enable early revitalization of troubled corporations

The Industrial Revitalization Corporation of Japan (IRCJ) was created in 2003 to restructure distressed debtor corporations with excessive debts before their bankruptcy with a view to deterring ever‐increasing non‐ and poor‐performing loans. The IRCJ successfully reorganized target debtor companies through the out‐of‐court workout with multiple financial institutions where unanimous consent of financial creditors is required. Since the lifetime of the IRCJ is limited, the IRCJ cannot rescue troubled corporations after the end of March 2005. From then onward, the out‐of‐court workout should be utilized more widely in Japan in order to revitalize distressed businesses at an early stage without impairing the rights of trade creditors and deteriorating the value of the businesses. To make the workout most effective, it is important to ensure that the statutory reorganization procedures, including the majority rule, are applied more flexibly and reliably. Copyright © 2005 John Wiley & Sons, Ltd.     

Question the Unquestionable Beauty of A Collective Proceeding for All Sovereign Debt Claims

The new challenges presented by the current Eurozone crisis and the NML Capital v. Argentina case are likely to shift the international community's attention from holdout behavior in foreign bonds restructuring to inter‐creditor issues. In the past years, many academics, and nongovernmental organizations concerned with debt relief, have put forward proposals to create a bankruptcy regime for states. But none of these proposals has seriously examined what rules should apply to treatment among creditors. Moreover, all insist that there must be a collective proceeding for all sovereign debt claims, without explaining why. This approach is simply taken for granted, as it is one of the fundamental principles of bankruptcy law. The article questions this orthodoxy through examining the nature of sovereign debt crisis, the feature of the limited pool of sovereign assets, and the nonliquidable fact of the sovereign debtor. It also argues that the common pool problem does not exist in the sovereign debt context.     

Rethinking priority: The dawn of the relative priority rule and the new “best interests of creditors” test in the European Union

This article identifies one aspect of the cross‐class cram‐down from the EU Directive on restructuring and insolvency that has not drawn wide attention to date. In addition to giving EU Member States the option of a “relative priority rule,” the European legislator has introduced a new “best interest of creditors” test, which does not—like in Chapter 11 of the US Bankruptcy Code—use the value that a party could expect in a hypothetical liquidation as a comparator but refers to the “next‐best‐alternative scenario.” First, this article addresses the concepts of the absolute and relative priority rule from the Directive and explores the motives for introducing the relative priority rule. In particular, a demand for more flexibility in restructuring negotiations, the call for an instrument to overcome structural hold‐out positions of preferential (priority) creditors in some Member States, as well as a trend in Europe to break with the “traditional laws of insolvency law” of law and economics seem to have inspired the legislator in drawing up the relative priority rule. This article then deals with the new “best interest” test and examines its interaction with the relative priority rule. It is shown that the concept of combining the new “best interest” test with the relative priority rule is coherent in theory. However, this article remains skeptical as to whether this interaction can succeed in practice, as the new “best interest” test is likely to add another stress point to the negotiations of restructuring plans.     

Hedge Funds and Chapter 11

This paper studies the presence of hedge funds in the Chapter 11 process and their effects on bankruptcy outcomes. Hedge funds strategically choose positions in the capital structure where their actions could have a bigger impact on value. Their presence, especially as unsecured creditors, helps balance power between the debtor and secured creditors. Their effect on the debtor manifests in higher probabilities of the latter's loss of exclusive rights to file reorganization plans, CEO turnover, and adoptions of key employee retention plan, while their effect on secured creditors manifests in higher probabilities of emergence and payoffs to junior claims.     

Strategic debt restructuring

We analyze a distressed firm indebted to many creditors. Thefirm's owners have the option of choosing the sequence of restructuringnegotiations with the creditors. We show that sequencing flexibilityis beneficial to firm owners, and that the optimal sequencingof restructuring negotiations involves exploiting the firm'sliabilities to some creditors so as to moderate the demandsof others. Moderately distressed firms will extract concessionsfrom all creditors. In this case, owners can gain if they cancredibly commit to conditional restructuring agreements thatlink the concessions of one creditor to concessions by others.     

Asset Sales and Secured Creditor Control in Restructuring: A Comparison of the UK,US and Canadian Models

The primary insolvency restructuring mechanism in the UK is administration under the Insolvency Act 1986, as amended by the Enterprise Act 2002. In an administration, an insolvency professional known as an administrator, who is accountable to the insolvent company's creditors as a whole, is appointed to oversee the restructuring. The administration process was designed to rehabilitate distressed but viable companies and businesses and to maximize creditors' recoveries. Increasingly, however, insolvent companies are using this process to sell substantially all of their assets through pre‐packaged administrations or ‘pre‐packs’. In a pre‐pack, the insolvent company and its senior creditors negotiate the terms of the sale prior to initiating administration proceedings and appointing an administrator. The administrator then implements the deal, often with little or no input from junior creditors or other stakeholders. Both the US Bankruptcy Code and the Companies' Creditors Arrangement Act in Canada permit insolvent companies to sell substantially all of their assets under the auspices of the restructuring legislation. This article compares pre‐packs with these US and Canadian processes, arguing that they are all functionally equivalent in that they facilitate quick realizations for secured creditors by bypassing traditional restructuring processes. This analysis suggests that pre‐packs may give too much control over the restructuring process to secured creditors, encouraging rent‐seeking and other value‐destructive behaviours that undermine the fundamental goals of insolvency law. Copyright © 2017 INSOL International and John Wiley & Sons, Ltd.     

CEO inside debt and internal capital market efficiency

Agency theory argues that managerial equity-based incentives are more effective when firm solvency is likely while debt-based incentives are more effective when firms face a greater likelihood of bankruptcy. We examine the relation between chief executive officers' (CEOs') inside debt holdings and the internal capital market allocation of multi-segment firms. We find that CEO inside debt holdings are associated with conservative capital allocation to firm segments, with the result driven by financially distressed firms. Further analysis indicates that although CEO inside debt, on average, is negatively related to firm value, the relation is positive for financially distressed firms. Our evidence indicates that inside debt holdings align the interests of managers and external creditors, inducing managers to pursue conservative capital allocation strategies that appear to be optimal for firms facing insolvency.     

How does credit risk affect cost management strategies? Evidence on the initiation of credit default swap and sticky cost behavior

In this paper, we examine the effect of credit defaults swaps (CDS) initiation on reference firms' cost management strategies. CDS contracts provide insurance protection for creditors, inducing a shift in bargaining power from borrowers to creditors and an excessive incidence of bankruptcy. Anticipating more intransigent creditors in debt renegotiations and higher bankruptcy risk, CDS firms are incentivized to mitigate risk through decreasing cost stickiness after CDS initiation, as cost stickiness lowers liquidity and triggers early covenant violations. We find that, on average, CDS initiation is associated with a decline in reference firms' cost stickiness. This association is more pronounced for less liquid, financially distressed, and lower credit quality firms. We also find that CDS firms with a reduction in cost stickiness will exhibit lower future bankruptcy risk than CDS firms without such as reduction in stickiness. Collectively, our findings suggest that the CDS-induced “empty creditor problem” causes reference firms to undertake more conservative cost management practices to alleviate downside risk.     

How do banks resolve firms’ financial distress? Evidence from Japan

The main purpose of this paper is to investigate how banks resolve firms?? financial distress in Japan. Our results show that distressed firms that have more unsecured bank debt are more likely to restructure debt successfully out of court. Second, private debt restructuring is conducted during the year in which a financially distressed firm would be compelled to report negative net worth because of substantial accounting losses if no debt restructuring plans were implemented. Third, firms that are already in a negative net worth situation are more likely to receive debt forgiveness and/or debt-for-equity swaps. Finally, both the 1-year-lagged total liabilities-to-assets ratio and accounting losses are positively related to the private workout level. These results suggest that banks resolve firms?? financial distress in shareholders?? and creditors?? interests. We argue that, along with bankruptcy laws, the stock exchange rules and the fact that banks are allowed to hold shares in these firms affect the resolution of firms?? financial distress.     

Corporate assets as a trust: for whom are corporate officers trustees in insolvency? the role of incentives in maintaining the trust

Uncertainty is a constant theme when corporations are in financial distress. Yet any successful restructuring of an insolvent corporation requires numerous stakeholders, including creditors, employees and suppliers, repose some degree of trust in those corporate officers who are trying to continue to operate the firm while restructuring it into a viable entity. This article looks at the issue of the positive and negative incentives that can be generated for corporate officers and directors from both their continuing control of corporate assets and their potential personal liability arising from corporate activity both before and after the corporation became insolvent. The potential role these incentives can play in providing a basis for the trust needed to meet the other governance challenges that arise in a restructuring is reviewed in the context of recent developments in Canada concerning the duties of corporate directors to creditors during insolvency. Also reviewed is the role of directors' insurance and indemnification in altering the incentives' effects on directors' behavior. Finally a critical appraisal is given of the present legal regime's provision for compromise of claims against corporate officers during restructuring, as well as the proposal to amend the law to allow complete exoneration of corporate directors from certain liabilities on insolvency. The article urges caution in altering the effects of incentives that may create the necessary basis for trust in the distressed corporation's officers amongst those stakeholders whose co‐operation is crucial to restructuring. Copyright © 2003 John Wiley & Sons, Ltd.     

The formative decade of Israel's reorganization law: 1995–2004

The article analyses closely the major developments that took place between 1995 and 2002, both as a result of legislation and judicial law making. In 1995, the Knesset, the Israeli legislature, enacted a moratorium statute. This statute stays all pending proceedings against a financially distressed corporation which has applied to the court requesting its reorganization through a compromise or arrangement scheme. The moratorium statute influenced significantly this scheme and effectively reshaped it in a reorganization‐friendly manner. The article submits that the moratorium statute has effectively transformed the nature of secured creditors' rights from rights‐in‐kind to rights‐in‐value. In addition, the article will demonstrate the relative contribution of both the Supreme Court and the district courts to reorganization law's development. The Supreme Court established the grand premises for judicial law making in corporate reorganization by holding that the statutory substantive norms which apply in corporate liquidation apply in reorganization as well mutatis mutandis. For their part, the district courts contributed to the law making in two primary aspects of corporate reorganizations: First, by requiring that in reorganization cases a court‐appointed trustee shall manage the corporation and negotiate on its behalf with the creditors. Secondly, the courts developed the practice of auctioning the firms undergoing reorganizations as a means for maximizing the return to the creditors. Copyright © 2005 John Wiley & Sons, Ltd.     

A theory of relativity in restructuring developed with the Coase Theorem

This article addresses a key topic in restructuring law, namely the alternative legislative rules for setting priorities for payments and rights among stakeholders in a statutory restructuring programme. The EU Member States have now implemented the Restructuring Directive (2019/1023), which gives two options for the priority rules and the outcomes of the new laws seem to vary significantly. As this legislation is important also for the efficiency of the capital markets, it is good to investigate the potential impacts the new legislative structures may bring for the process. In the article the author argues, by using the Coase Theorem, a leading theory in law and economics, that wider powers for a court to consider the interests of all parties in restructuring could be a preferable legislative solution to restructuring law. It would protect generally the creation of a restructuring surplus, as an individual class would be unable to use its rights as a tool for gaining further benefits. Relativity would stimulate the bargaining of property rights in the process and would follow the Coase Theorem, according to which bargaining between individuals or groups related to property rights will lead to an optimal and efficient outcome.     

Recognition of Debt Restructuring and Resolution Measures under the European Union Regulatory Framework

Under the proposed Bank Recovery and Resolution Directive (BRRD), member states will be required to provide for bail‐in powers to restructure failing financial institutions. At this moment, the Dutch, French, UK and German legislator already provide public authorities with resolution powers. In order to be effective in debt restructuring of failing (non‐)financial institutions, the measures taken by the resolution authorities need to be enforceable (before all courts) and effective in the entire European Union. Given the fact that not all the firm's debt is issued in the home jurisdiction, the question of recognition is critically important. In regard of non‐financial firms, the Dutch, UK, French and German jurisdictions provide for court proceedings to impose a collective settlement reached by the debtor and the majority of its creditors binding on the opposing minority. Out‐of‐insolvency plans approved by the court are recognised under the Brussels I Regulation. If the EU Insolvency Regulation reform proposal is adopted, these court‐approved debt restructuring plans in insolvency situations will be subject to the recognition regime of this regulation. Credit institutions, insurance undertakings, investment undertakings holding funds or securities for third parties and collective investment undertakings are excluded from the scope of the Insolvency Regulation whereas the scope of application of the Reorganisation and Winding Up Directive is limited to credit institutions. The regime under the future BRRD and the Single Resolution Mechanism is limited to credit institutions. National (private international) law determines the recognition of resolution measures taken by the authorities of another member state. Copyright © 2014 INSOL International and John Wiley & Sons, Ltd     

Debtor-in-possession financing and the resolution of uncertainty in Chapter 11 reorganizations

This paper investigates the use of debtor-in-possession (DIP) financing by firms reorganizing under Chapter 11. A model is developed in which there is asymmetric information between the creditors of a distressed firm and its management. In this context, it is demonstrated that reliance on DIP financing resolves informational asymmetries regarding the true economic value of distressed firms. The model's conclusions are empirically supported in the paper and by results of extant research. The signaling role of DIP financing is evidenced both by the positive stock price reaction to DIP announcements and the fact that firms employing DIP financing have more successful reorganizations.