Introduction to Insolvency Law PDF

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Introduction to Insolvency LawInsolvency: Basic Definition Insolvency is the inability to pay debts when they are due. Questions What counts as the inability to pay debts? Can we carry out a corporate reduce and avoid liquidation?Insolvencies are Messy There are many creditors  Mostly these are...

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LW225- Company Law

Introduction to Insolvency Law Insolvency: Basic Definition  Insolvency is the inability to pay debts when they are due.

 Questions What counts as the inability to pay debts?

 Can we carry out a corporate reduce and avoid liquidation?

Insolvencies are Messy  There are many creditors  Mostly these are small businesses  The costs of running an insolvency are high (legal costs)

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 Most creditors receive only a small percentage of what they are owed- and this may force them into insolvency in their turn

Statutory Definition  Insolvency Act 1986, s.123 (1) A company is deemed unable to pay its debts: (a) if a creditor (by assignment or otherwise) to whom the company is indebted in a sum exceeding £750 then due has served on the company, by leaving it at the company's registered office, a written demand (in the prescribed form) requiring the company to pay the sum so due and the company has for 3 weeks thereafter neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor, or (b) if, in England and Wales, execution or other process issued on a judgment, decree or order of any court in favour of a creditor of the company is returned unsatisfied in whole or in part, or ....

LW225- Company Law

(e) if it is proved to the satisfaction of the court that the company is unable to pay its debts as they fall due [cash-flow insolvency]. (2) A company is also deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities [balance-sheet insolvency].

Two Types of Insolvency  CASH-FLOW INSOLVENCY  When an insolvent debtor cannot pay a debt or debts because they do not have the money.  BALANCE-SHEET INSOLVENCY  When liabilities exceed assets.

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Cash-Flow Insolvency What does ‘Unable to Pay Debts’ Mean?  Re European Life Assurance Society (1869) (Sir William James V-C):  “the inability to pay debts must refer to debts absolutely due” (p. 127).  Present debt  S.28 Companies Act 1907:  “if it is proved to the satisfaction of the court that the company is unable to pay its debts, and, in determining whether a company is unable to pay its debts, the court shall take into account the contingent and prospective liabilities of the company”.  Debt + liabilities  Cork Report (1982)  “the sole ground upon which the court may make an insolvency order in respect of a debtor, whether individual or corporate, will be that the debtor is unable to pay his or its debts» (para.535.)  Debt  27(1)(a) IA 1985:  A company can be admitted to administration “if the court is satisfied that a company is or is likely to become unable to pay its debts.”  Debt (present + future)

LW225- Company Law

Cash-Flow Insolvency, Current Position  Nevertheless:  Re Cheyne Finance Plc (in receivership) [2007] EWHC 2402 (Ch)  [C]ash flow or commercial insolvency is not to be ascertained by a slavish focus only on debts due at the relevant date. Such a blinkered review will, in some cases, fail to see that a momentary inability to pay is only the result of a temporary lack of liquidity soon to be remedied, and in other cases fail to see that due to an endemic shortage of working capital a company is on any commercial view insolvent [...] [at 51].

Balance-Sheet or Absolute Insolvency Issues  REMINDER - Balance-Sheet Insolvency:  The situation in which the company’s liabilities (including contingent and prospective ones) exceed its assets (s.123(2) IA 1986).  ISSUES  How do we calculate this?  What is the appropriate legal test?  Should contingent assets be included?

Debt-to-Equity Ratio

LW225- Company Law  Debt-to-equity ratio calculated by dividing a company’s total liabilities by its shareholder equity.  Measure of the degree to which a company is financing its operations through debt versus wholly owned funds

Test for Balance Sheet Insolvency Under S.123(2) IA 1986

LW225- Company Law  Originally thought to be ‘point of no return’ test.  See CA in BNY Corporate Trustee Services Ltd v Eurosail-UK (2011)  Now: ‘balance of probabilities test’  Supreme Court in BNY Corporate Trustee Services Ltd v Eurosail-UK (2013)

Balance of Probabilities Test  ‘the need to satisfy the court, on the “balance of probabilities”, that a company had insufficient assets to be able to meet all its liabilities, including prospective and contingent liabilities.’  Supreme Court in BNY Corporate Trustee Services Ltd v Eurosail-UK (2013) at [48].

Difference Between Cash-Flow and Balance Sheet Insolvency Cash-Flow VS Balance Sheet  BNY Corporate Trustee Services Ltd v Eurosail-UK 2007-3BL plc (2013) – Lord Walker  ‘the ‘cash-flow’ test is concerned, not simply with the petitioner’s own presently-due debt, nor only with other presently-due debt owed by the company, but also with debts falling due from time to time in the reasonably near future. What is the reasonably near future, for this purpose, will depend on all the circumstances, but especially on the nature of the company’s business.’

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Insolvency Theories

 John Rawls (1921-2002), a theory of justice  Veil of ignorance

Creditors’ Wealth Maximisation Theory  Thomas Jackson  Robert Scott  Douglas Baird

LW225- Company Law  Key attributes of insolvency law:  System of rules and principles designed to maximise the return to creditors.  ‘collectivised debt collection device’;  Response to the “common pool” problem created when diverse co-owners assert rights against a common pool of assets.  Pre-insolvency entitlement should in general be unaffected by the debtor’s insolvency.

 Can pre-insolvency entitlements be impaired?  Only when necessary to maximize net asset distributions to the creditors as a group; and  Never to accomplish purely distributional goals.  Why should insolvency law follow these precepts?  To avoid incentives to file (Eisenberg, 1981; Shanker, 1975)); and  Because this would be the agreement reached by the contractual creditors behind a “transparent” ‘veil of ignorance’.

Creditors’ Wealth Maximisation Theory: A Critical Analysis  What are the benefits of this theory?

 Attractive to creditors because it reduces strategic costs;

 Administratively efficient; and

 Increases the aggregate pool of assets.

LW225- Company Law  What are the drawbacks?

 No distributional goals

 Rescue is not an autonomous goal of insolvency law.

 Failure to consider the interests of those who are not contractual creditors, such as community at large and certain tort claimants (Gross, 1994).

 Failure to recognise the existence of non- efficiency objectives (Korobkin, 1991 and 1997).

 Inapplicable to modern corporations, that have no pool of assets.

 The ‘veil of ignorance’ approach is deceptive because in real life, creditors differ in their knowledge, skill, leverage and cost of litigating (Carlson, 1987).

 Failure to consider distributional and equality questions.

 Based on unsound economic analysis (Warren, 1987).

 Response: Expanded Framework

 A creditors’ wealth maximisation conceptualisation that incorporates a “common disaster” component to explain and justify the existence of some distributional goals in insolvency law - Jackson and Scott (1989).

Broad Contractarian Theory

LW225- Company Law  Key attributes of insolvency law: 1. Not a maximiser of economic outcomes, but a system for rendering richer, more informed decisions in response to financial distress. 2. Governing principles: inclusivity and rational planning.

Broad Contractarian Theory: A Critical Analysis  What are the benefits of this theory?  Protection of a wider range of parties (not simply contractual creditors);  Protection of a wider range of interests (not simply proprietary rights);  Promotion of rescue and restructuring goals. ▪ What are the drawbacks?  Protection of so many interests may result in legal uncertainty;  Legal uncertainty means higher litigation costs and higher costs of financing.

Broad Contractarian Theory: Criticisms

LW225- Company Law  Focus on maximisation of aims is unwarranted (Bradley, 1992).  Uncertainty would lead to catastrophic effect on the cost of credit.  Rational planning does not justify distributional goals (Finch and Milman, 2017).  Practical implementation (Moss, 2015; Bork, 2017).

Communitarian and Multiple Values Theories  Insolvency Law is “an attempt to reckon with a debtor’s multiple defaults and to distribute the consequences among a number of different actors” (Warren, 1987).  Key attributes of insolvency law:  No focus on private rights (CWM) but on weighting the interests of a broad range of parties.  No one value dominates.  Distributive goals are a key characteristic of insolvency law (risk-adjustment).  Why should insolvency law follow these precepts?  Because individuals are not selfish, rational calculators; and  Because they bring to the implementation of rules that address the issues usually raised in insolvency procedures (law-in-action as opposed to law-in-books).  What are the consequences?  Liquidation should give way to rescue.  No neat priority of values: communitarian views are «dirty, complex, elastic, interconnected» views of insolvency from which it is neither possible nor necessary to fully articulate all the factors relevant to a policy decision (Warren, 1987).

Communitarian and Multiple Values Theories: A Critical Analysis  What are the benefits of this theories?  From economic to non-economic dimension.

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 Principles of fairness and justice  Wider considerations of interests.  Assist decision-makers in identifying controversial issues.  What are the drawbacks?  Directors and IPs accountable to stakeholders?  IL takes on issues that should be dealt outside insolvency.  Indeterminacy.  Problem of weighting principles.  Litigation. Communitarian and Multiple Values Theories: Criticisms  Contractarians and Communitarians ignore each other (LoPucki, 2004).  Should judges decide on values? (Schermer, 1994). Reforming the UK Corporate Governance  Crisis- Late 1980s/ early 1990s  The credit crunch and the walker report  The UK corporate governance code

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Insolvency Theories

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Contractualist Approaches

 Contractualists’ view: businesses could select ex ante, when they are still trading profitably in the market, the system of rules that would apply to them should they file for insolvency.  How to deal with corporate distress?  Adler (1993) – chameleon equity corporation;  Bebchuk (1988) – debt-for-equity swap.

Contractualist Approaches: A Critical Analysis  What are the benefits of this theory?  Facilitates life to investors;  Efficient and high-value;

LW225- Company Law  Valuation is carried out by the market;  Simplicity and de-regulation;  Maximisation of creditors’ returns.  What are the drawbacks?  No or limited protection to non-contractual claimants;  Naïve approach (financial investors);  Underestimates the windfalls that may result from fluctuations in the market value of the debtor;  Unbalance of powers in the claimants;  Litigation and valuation issues if non-cash bid are permitted.

Contractualist Approaches: Criticisms  Some of the concerns raised for creditors’ wealth maximisation theories.  Ignores anti-common situations (de Weijs, 2012).

Team Production Theory of Corporate Law 1. “Team members” delegate to the corporation’s board of directors ultimate authority over:  The direction of the enterprise; and  The distribution among the team members of production rents and surpluses. 2. Team members do not entirely rely on the board for their compensation. 3. The board is independent, not subject to the supervision of any team member. 4. The board ensures that each team member receives what is due according to their respective contribution to the company’s rents and surpluses (i.e. profits).

Team Production Theory of Insolvency Law  Key attributes

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 Preserve and continue the corporation by reorganising it; or  Serve all corporate constituencies fairly in a liquidation procedure.  Why should insolvency law follow these precepts?  Shareholders and creditors are members of a production team.  Directors run corporations to protect the firm-specific investments of all team members; and  TPTs support communitarian approaches while adopting a contractarian perspective.

Team Production Theory: A Critical Analysis  What are the benefits of this theory?  Attempts to identify economically efficient outcomes.  Focus on actual, not ideal contracts signed by the team members (positive and normative).  Explains features that made no sense in CWM approaches (e.g. distributive goals and debtor-in-possession).  What are the drawbacks?  Case-by-case approach.  Limited relevance.  Wholesale grant of unfettered powers to directors.

Team Production Theory: Criticisms  More faithful account of reality, but  Underestimates the complexities of real practice (e.g. conflicts between different creditors).

Corporate Rescue Administration and its Purposes

LW225- Company Law  Administration procedure - Insolvency Act 1986 (as amended), Sch. B1.  It provides a company with a breathing space to allow a rescue package or more advantageous realisation of assets to be put in place.  The aim of administration proceedings is to rescue and rehabilitate insolvent but potentially viable companies.

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The Moratorium  IA 1986, Sch B1, para 42-44: a legally binding halt to any legal proceedings against the debtor.  Phase I – From the initiation of the process.

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 Phase II – From the admission of the company in administration.  Effects  No enforcement of securities.  No right of forfeiture by peaceable re-entry.  No repossession of goods (some exceptions).  No legal process may be commenced or continued.  NO “serial filings”: no out-of-court appointment by the company or its directors if the company benefited from a moratorium in the last 12 months (IA 1986, sch B1, paras 23-24).

Notification of the Administrators Appointment  As soon as reasonably practicable after becoming the administrator of a company, the administrator shall: (IA 1986, sch B1, para 46:  Send a notice of his appointment to the company (rule 3.27 IR 2016).  Publish a notice of his appointment in the prescribed manner (Gazette).  Send a notice to the Registrar of Companies (7 days from appointment).  Send a notice to the creditors.

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Creditors’ Meeting  The administrator’s proposals are presented for consideration.  Creditors wishing to attend have to send the details of their claims.  Majority: 50%+ in value of those creditors present and voting.  Only impaired creditors can vote....