Written by: Symi Dosanjh
The international legal response to the COVID-19 outbreak has involved the implementation of insolvency reforms. If a core business remains viable, insolvency law should act as a tool to protect companies experiencing an unexpected drop in revenue. The principal advantages of insolvency law firstly include providing systems to better facilitate the debt restructuring of economically viable firms. The Washington Post recently highlighted that Chapter 11 previously gave airline companies space to negotiate reduction of debt burdens: American Airlines, Delta, Frontier, Northwest, United and US Airways all filed for bankruptcy between 2002 and 2011 and emerged intact. Furthermore, insolvency eases the ability of creditors to enforce claims and seize assets: which can reduce the going concern value of businesses that would otherwise have been viable. According to the Review of Finance, insolvency liquidations in the UK have diminished 20% to 40% of company proceeds for medium sized companies.
What can we learn from the current application of Chapter 11 in the USA?
Harvey Miller’s legacy working with General Motors set the trend of Chapter 11 being used for ‘363 Sales’ of substantial assets rather than traditional reorganisations in the USA.
There are both benefits and disadvantages of carrying out 363 Sales in the COVID environment. For purchasers 363 Sales provide flexibility to negotiate terms similar to private sales: allowing the disposition of assets free of encumbrances including environmental liabilities and risk of fraudulent transferral. Furthermore, purchasers enjoy increased legal protection associated with purchasing assets through bankruptcy auctions. Similarly for the Debtor, Section 363 is more efficient as there is no process of approvals or voting, allowing for asset sale in return for quick cash through a competitive bidding process.
However, the biggest issue in relation to 363 Sales is the position of unsecured creditors, particularly in the light of COVID, unsecured creditors are already struggling to cover their own costs. Lenders were always eager to push through 363 Sales as they entail the credit sale of assets prior to restoring organisational value, without sharing restored value with creditors. Therefore, the quick sale prevents unsecured creditors benefiting from full recovery through true reorganisation. Finally, although the 2008 General Motors Sale was groundbreaking, it is still unclear when the courts will approve Section 363 Sales in the first place.
How is the UK system more closely emulating the US system?
There have been recent reforms to UK insolvency law in 2018 and furthermore in the light of COVID, moving the UK system nearer to the US. Traditionally the UK system of insolvency has aimed to be creditor friendly as typically external administrators gain control of the business throughout the process, whereas the US system has been borrower friendly. Traditionally, Chapter 11 Cases involve the debtor remaining in possession and continuing to operate the business rather than an external administrator being appointed.
Permanent measures recently introduced represent a shift in the UK toward a business rescue culture more in line with traditional U.S. insolvency. Firstly, there is a new moratorium during which no creditor action can be taken without court permission, and responsibility for the day-to-day running of the company remains with the directors. To qualify for the moratorium, it must be deemed that “rescue is more likely than not” and that a company is able to pay its on-going liabilities. Secondly courts are able to impose debt restructuring plan on dissenting creditors if it is “fair and equitable” to do so: known as a “cross-class cram down”.
Whilst the Absolute Priority Rule under Chapter 11 entails that any dissenting creditors must be paid in full before others, the UK system now goes even further by allowing the court to approve a debt restructuring plan even if dissenting creditors will not be paid in full. The criteria for which includes at least one class of impaired creditors who have not been paid in full voting in favour of the plan and furthermore the plan being necessary, just and equitable. Finally, The Corporate Insolvency and Governance Act (CIGA) also introduced temporary measures during COVID such as the suspension of directors’ personal liability for wrongful trading. Furthermore, restricting the use of debt recovery tools such as wind up orders and statutory demands from being made when unpaid debt is due to COVID-19.
Whilst the US bankruptcy law system has a great history of successfully facilitating the survival of viable firms. It would be an oversimplification to suggest that the US system consistently facilitates true reorganisation during bankruptcy due to the potential for misapplication of 363 Sales. The justification behind chapter 363 sales is in order to allow the effective and efficient separation of a business’ past problems and future prospects. The resultant vulnerability of unsecured creditors should only be justified if the business feature behind the asset sale is no longer of value.
In order to minimise the destruction of value in times of financial distress it is essential to ensure that insolvency law is capable of facilitating true reorganisation. Changes to the UK system which have involved more closely emulating the traditional application of Chapter 11 are advantageous as measures are now more likely to ensure that a firm will be able to survive during a black swan event if the core business model is still viable.
It is difficult to determine the effectiveness of these systems through analysing only the Insolvency Act(s) and Chapter 11 as there are additional mechanisms in both systems which facilitate firm rescue during a crisis. For example, Chapter 15 is a mechanism for cross border bankruptcies in the US which recently ensured that AllSaints would receive protection from US creditors as it had received a Company Voluntary Agreement in the UK. Furthermore, although insolvency law can provide directors with valuable breathing space and give the courts power to help facilitate reorganisation if the core business remains viable. We should judge the effectiveness of legal mechanisms in the light of the whole scope of financial, tax and economic responses in a particular jurisdiction.