The Relative Priority Rule (RPR) in the Preventive
Restructuring Directive: Turning a Creditor Protection Rule
into a Vehicle for Opportunistic Behaviour
LL.M. Thesis
Law and Finance
Student: Maryam Malakotipour Supervisor: dhr. prof. dr. Rolef J de Weijs
Table of Co ntents
ABSTRACT ... 3
1. Introduction: Priority Reorganisations ... 4
2. The Normative Framework of Reorganisation ... 7
2.1 Objectives of insolvency law ... 8
2.2 The Preventive Restructuring Framework is a subset of insolvency law: ... 10
3. Preventive Restructuring Procedure ... 13
3.1 The application of the principles in a hypothetical case ... 15
3.2 APR v. EU RPR in the Directive ... 16
4. The EU RPR v. US RPR ... 19
4.1 The EU RPR ... 19
4.1.a The EU RRP under the ELI Report ... 19
4.1.b Related governance issues ... 20
4.2 The US RPR ... 23
4.2.a History of priority rules in the US ... 23
4.2.b Diverse US RPR Proposals by US Scholars with some common features that are absent in the EU RPR ... 25
4.3 Other European scholars’ approach ... 27
5. Shortcomings of the EU RPR that Do Not Exist or Are Less Relevant to the APR ... 30
5.1 Uncertainty and unfairness ... 30
5.1.a Unfairness ... 31
5.1.b Uncertainty ... 32
5.2 The EU RPR doesn’t seem to have an issue with gifting: the consequence of RPR is just a bit less severe than class-skipping activities ... 35
5.3 Abusive Forum Shopping ... 38
6. The Way Forward: a Tailor-Made Approch to the APR ... 41
6.1 New Value Exception ... 41
6.2 Instrumental shareholders and essential suppliers ... 42
7. Conclusion ... 44
ABSTRACT
After almost three years of consultation and negotiations, the Directive on Preventive Restructuring Frameworks and Second Chance has now been adopted by the European Parliament and the Council. The Preventive Restructuring Framework holds the hands of likely insolvent enterprises or honest entrepreneurs to help them triumph over their financial difficulties and continue operating. One of the key elements of the Directive relates to the last-minute inclusion of a new priority rule, a so-called Relative Priority Rule (‘EU RPR’) which allows the value to flow from dissenting creditors to out of money shareholders as long as dissenting creditors are treated more favourably. The outcome of the newly introduced rule is distinct from the Absolute Priority Rule (‘APR’), which forbids distribution of any value to shareholders unless dissenting creditors are paid in full. Against this background, the present paper seeks to answer the following research question: which of the priority law regimes, the
APR or EU RPR, should be chosen in light of basic insolvency law goals? This paper argues
that the EU legislators seem to have overlooked the implications of the EU RPR: the EU RPR provides flexibility at the cost of certainty over the distributable amount of value to stakeholders. The resulting uncertainty would cause ex ante inefficient constraints on access to credit, entice ex post holdout behaviours and diminish bargaining powers of unsecured claimholders. In light of the addressed shortcomings, the present paper warns Member States not to be lured by apparent flexibility of the EU RPR and encourages national legislators to adopt a tailor-made version of the APR in line with the policy suggestions proposed in this paper.
Keywords: Preventive Restructuring Directive -- APR -- EU RPR -- Shortcomings of the EU
1. Introduction: Priority Reorganisations
On the 20th of June 2019, the European Parliament and the Council adopted the Directive on Preventive Restructuring and Second Chance with a view to protect viable enterprises or honest entrepreneurs, that are likely to become insolvent, from entering into a formal insolvency procedure.1 The starting point in any restructuring procedure is the existence of a restructuring plan which elaborates on, inter alia, debt restructuring and fund-raising strategies of the debtor to overcome financial distress. If the plan complies with the conditions specified in the Directive and attracts the requisite majority vote in each voting class of affected parties, it becomes enforceable against all the affected parties.2
A restructuring plan that is not accepted by the required majority vote in every voting class can become enforceable against the dissenting creditors through a so-called cross-class cram-down mechanism which facilitates entering into a preventive restructuring procedure and prevents possible hold-out behaviours. However, to ensure that the dissenting creditors are sufficiently protected, the Directive requires Member States to include several conditions for the judicial enforcement of a non-consensual plan.3 According to the proposal, one of the conditions is distribution of value to the dissenting classes of creditors in accordance to a priority rule, namely the Absolute Priority Rule (‘APR’) or the Relative Priority Rule (‘EU RPR’). In fact, Member States have a choice which priority rule to implement. Against this background, the core research question in this paper is as follows: which of the priority law regimes, the APR
or EU RPR, should be chosen in light of basic insolvency law goals?
Based on the APR, claims of creditors in a dissenting voting class has to be satisfied in full prior to distribution of any value to a more junior class. In October 2018, however, in a surprising last-minute change, the European Council introduced the EU RPR.4 While the earlier drafts had required the mandatory inclusion of the APR, the October 2018 version of
1 Directive of the European Parliament and of the Council of 20 June 2019 on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures and amending Directive 2017/1132/EU ((EU) 2019/1023, L 172/18) (‘Directive’). See also Proposal for a Directive 22 November 2016 of the European Commission on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures and amending Directive 2012/30/EU, COM (2016) 723 final, explanatory memorandum, 2. (‘2016 proposal’).
2 Article 9 Directive.
3 Article 11 Directive provides a list of requirements that a non-consensual restructuring plan has to fulfill in order to be enforceable against dissenting creditors.
4 Proposal for a Directive 16 October 2018 of the European Parliament and the Council of Europe on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures and amending Directive, 12536/18, 2016/0359 (COD), ‘General approach’, 5-6 (‘October 2018 Directive’).
the Directive included the EU RPR as a preferred alternative for the APR,5 and soon after the European Parliament voted in favour of the amended draft.6 The newly introduced priority rule provides that dissenting creditors only ‘need to be treated more favourably’ than junior classes. As far as the relationship between creditors and shareholders is concerned, this would mean that the old shareholders can retain value so long as dissenting classes of creditors are treated even slightly more favourably.
While the APR is considered a rule of creditor protection, 7 the EU RPR has been introduced with a view to avoid imposing the burdensome and costly requirements of compliance of the
inflexible priority rule, the APR.8 Leaving the choice between the APR and EU RPR to the
discretion of the Member States would require the national legislators to make compromises between flexibility and the degree of creditor protection.
In order to conclude which of the priority rules is in line with insolvency law objectives, the present paper is structured as follows: Section 1 sets a normative framework in order to discern the objectives of preventive restructuring procedures. As such, Section 2 of the present paper sheds light on the objective(s) of the Directive and it analyses whether a preventive restructuring procedure should seek a primary aim similar to a formal insolvency procedure, namely maximisation of value to creditors as a whole. Thereafter, Section 3 provides a brief overview of the steps that have to be taken in a preventive restructuring procedure. In addition, it relies on a hypothetical Preventive Restructuring Framework situation where the best-interest-of-creditors test and the priority rules are explained through a visualised balance sheet example.9 For the sake of simplicity, the arguments in the present paper are based on the assumption that the creditors are divided into two classes of secured and unsecured creditors. In addition, a discussion on Directive’s aim to provide a second chance for honest entrepreneurs, not being legal persons, is outside the scope of the present paper.
5 It seems that the preferred rule is the RPR since article 11 (1) (c) of the Directive allows for implementation of the APR by ‘way of derogation from the RPR’.
6 The European Parliament voted in favour of the October 2018 proposed text on 28 March 2019. See European Parliament legislative resolution of 28 of March 2019 on the proposal for a directive of the European Parliament and the Council on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures and amending Directive 2012/30/EU (Com (2016) 0723- C8-0475/2016-2016/0359 (COD)) 7 In Czyzewski v. Jevic Holding Corp, US Supreme Court (137 S. Ct. 973) 22 March 2017 (‘Czyzewski v. Jevic’) the US Supreme court considered the APR “as the cornerstone of reorganization practice and theory”. See also Jonathan C Lipson, ‘The Secret Life of Priority: Corporate Reorganization After Jevic’ (2018) 93 Washington Law Review 631.
8 October 2018 Directive 5-6.
9 It is worth mentioning that the arguments in this paper should be read with large companies and professional shareholders in mind. As it becomes more clear in Section 6, the dynamics of preventive restructuring for Small and Medium-sized Enterprises (SME’s) can be different.
The remainder of the present paper is devoted to the discussion on the choice between the two priority rules. Although the debate between the APR and RPR is not new, at least among American scholars, this paper concentrates on the comparison between the APR and EU RPR and provides a fresh perspective on the issue of relative priority rule. The comparison in Section 4 between the underlying rationales for proposing the US RPR, and arguments of some European scholars, whose notions seem to have been influential on the introduction of the EU RPR, illustrates that the latter does by no means share any characteristics or objectives with the US RPR. Subsequent to highlighting the differences, Section 5 addresses the shortcomings of the EU RPR arguing that the EU RPR has the potential to turn against creditors. Considering that the strict application of the APR is also not without issues, as Section 6 elucidates, the recognition of certain grounds for the derogation from the APR is able to lessen the inflexibility of the APR and most importantly, protect dissenting creditors from the potential unfair and uncertain outcomes that are attached to the application of the EU RPR.
2. The Normative Framework of Reorganisation
Prior to delving into the discussion on the priority rules, it is crucial to identify the objectives of the Directive and interests that should be afforded special consideration in preventive restructuring procedures. The aim of the Directive is to rescue viable enterprises, maximise the total value to creditors, owners and the economy as a whole and prevent unnecessary job losses.10
The communitarian vision of the Directive, however, does not appear to sit well with the dominant normative theory of insolvency law, which views insolvency law as a collective debt collection law that targets maximisation of the total value that can be distributed to creditors as the primary goal.11 The dominant normative theory of insolvency law is built upon the notion
that the pursuit of individual interests (creditor remedies outside bankruptcy) result in a value destructive race among creditors to be placed in front of the line for particular assets. For this reason, the collective nature of insolvency law makes creditors as a group better off since it preserves the going concern value of assets, prevents costly all-against-all litigation and removes individual monitoring costs.12 Jackson’s Creditors’ Bargain Theory, goes a step further and argues that even in the absence of insolvency laws, creditors would ex ante agree amongst themselves upon rules of collective debt collection to reap benefits from the addressed advantages.13
10 Recitals 3 and 35 Directive. Proposal for a Directive of the European Parliament and the Council on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures and amending Directive 2012/30/EU, recital 2 (‘Commission proposal’). See also Nicolaes W A Tollenaar, ‘The European Commission’s Proposal for a Directive on Preventive Restructuring Proceedings’ (2017) 30 (5) Insolvency Intelligence 65, 65. 11 Rolef J de Weijs, Aart Jonkers and Maryam Malakotipour, ‘The Imminent Distortion of European Insolvency Law: How the European Union Erodes the Basic Fabric of Private Law by Allowing ‘Relative Priority’ (RPR)’ (2019) Amsterdam Law School Research Paper 2019-10, 4 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3350375> accessed 08 June 2019. Kristen Van Zwieten, Goode on Principles of Corporate Insolvency Law (4th ed., 2017) 74 notes as follows: (“Corporate
insolvency law has three overriding objectives: to maximize the return to creditors; to establish a fair and equitable system for the ranking of claims and the distribution of assets among creditors, involving a limited distribution of rights; and to provide a mechanism by which the causes of failure can be identified and those guilty of mismanagement brought to book and, where appropriate deprived of the right to be involved in the management of other companies.”). See also, Ian F Fletcher
and Bob Wessels, ‘Harmonisation of Insolvency Law in Europe’ (Report for Netherland Association of Civil Law 2012, Ch 7, pp.107-135) para 148. The authors consider the “the maximisation of the assets of the estate of the debtor for the benefit of
the body of creditors, in a transparent, predictable and efficient way” as the goal of insolvency law.
12 Thomas H Jackson, The Logic and Limits of Bankruptcy Law, (Beard Books 2001) 122; Rolef J de Weijs, ‘Harmonisation of European Insolvency Law and the Need to Tackle Two Common Problems: Common Pool and Anticommons’ (2012) 21 International Insolvency Review 67, 69-70.
13 Thomas H Jackson, ‘Bankruptcy, Non-bankruptcy Entitlements and the Creditors’ Bargain, (1982) 91 (5) Yale Law Journal 857, 860 argues that a “more profitable line of pursuit might be to view bankruptcy as a system designed to 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.' It is this approach that I characterize as the "creditors' bargain." The Creditor’s Bargain Theory is,
however, criticised for its shortcoming to address anticommons problems, which occur when there is a common good and each party has the power to block the use of others. Section 5.1.b discusses about the anticommons issue and tools to prevent hold-out behaviours that may arise in the context of reorganisation.
However, the notion of recognising maximisation of the total value to creditors as the primary objective of insolvency law is not passed unchallenged. Prominent scholars such as Prof. Warren and Prof. Westbrook perceive reorganisation as a tool to prevent a debtor from going into liquidation and serve other interests in addition to those of creditors14 such as continuation of business to prevent loss of jobs and foster the economic life of the country.15 Similarly, the
EU legislators perceive the Preventive Restructuring Framework as an instrument to serve a wide range of interests, such as preserving jobs, maximising total value to creditors as well as to owners and the economy as a whole.16
The invocation of an insolvency law tool (restructuring)17 to serve all the addressed individual
interests is unrealistic and raises issues;18 most importantly, it causes repercussions on
allocating values among stakeholders. This Section explains why the Directive should not allocate a similar weight to serving the interests of non-investors and shareholders on the one hand, and the interests of creditors on the other.
2.1 Objectives of insolvency law
Proponents of modern interpretation of insolvency law such as Kristen Van Zwieten argue that exclusive focus on maximising returns to creditors ignores the fact that there might be other ways to protect creditors that serve other interests, such as those of employees, shareholders and the local community.19 However, this broad perception of the objectives of insolvency law can be repudiated on two grounds. Firstly, regarding the interests of non-investors, the major
14 Elizabeth Warren, ‘Bankruptcy Policymaking in an Imperfect World’ (1993) 92 Michigan Law Review 336, 355 notes as follows: “Business closings affect employees who will lose jobs, taxing authorities that will lose rateable property, suppliers
that will lose customers, nearby property owners who will lose beneficial neighbours, and current customers who must go elsewhere.” See also Vanessa Finch and David Milman, Corporate Insolvency Law: Prospective and Principles (3rd edn, 2017), Ch.2.
15 Donald R Korobkin, ‘Contractarianism and the Normative Foundations of Bankruptcy Law’ (1993) 71 Texas Law Review 541 notes that the proper aim of insolvency law is to address the interests of all affected interested parties, including non-investors: employees, rehabilitation and community. For a discussion on communitarian approach see also, Karen Gross, ‘Taking Community Interests into Account in Bankruptcy’ (1994) 72 Wash University Law Review 1031; Karen Gross, ‘Failure and Forgiveness: Rebalancing the Bankruptcy System’ (1999) 33 Journal of Consumers Affairs 212. An intermediary approach, which is inclined towards Jackson’s theory is the ‘procure theory’, which is proposed by Charles W Mooney, ‘Normative Theory of Bankruptcy Law: Bankruptcy As (Is) Civil Procedure’ (2004) 61 Washington and Lee Law Review 931. The author notes that “the core of procedure theory is that bankruptcy law exists in order to maximise the recoveries for holders of legal
entitlements ("rightsholders'') in respect of a financially distressed debtor.” However, the theory does not follow Jackson’s
creditor bargain or the common pool issue. 16 Recital 2 of the Directive.
17 Section 2.2 of the present paper explains why the Preventive Restructuring Framework should be considered as a subset of insolvency law.
18 Van Zwieten, (n 11) ftn. 110 criticises communitarian approach “for its indeterminacy and the wide range of interests that
would have to be considered." See also Ren Yongqing, ‘A comparative study of the corporate bankruptcy reorganization law of the U.S. and China’ (PhD Thesis, University of Groningen 2011) 40.
19 Van Zwieten (n 11) 93 states as follows: “to focus so exclusively on maximizing returns to creditors is to ignore the fact
that there may be different ways of protecting creditors, some of which will also benefit other interests, such as those of employees, shareholders and the local community, and in so doing may even advance creditors’ interest.”
difficulty is defining the values held by them. For instance, with respect to the concerns on
future employment,20 there does not seem to be a strong connection between rescuing an enterprise and preserving jobs. In the presence of market competition, the death of a corporation is followed by the birth of new corporations and the benefit of competing enterprises.21 Thus, it is ambiguous to what extent rescuing a business can prevent job losses.
In addition, as Prof. Baird noted, the protection of some values such as employment opportunities requires consistent protection within the context of the whole legal system; otherwise, the lack of coherency between bankruptcy law and non-bankruptcy law results in forum shopping.22 In fact, rescuing enterprises for the purpose of promoting wide range of
interests turns to be counterproductive rather than efficient. Therefore, the primary target of insolvency law has to be narrowed down, at least, to serving the interests of investors rather than the community as a whole.
Secondly, as mentioned above, attaching similar weights to diverse interests embraces repercussions on allocating values among stakeholders. Even if a debtor introduces a restructuring plan which is capable of serving interests of both stakeholders and a community as a whole, in the absence of a clear priority rule, the abstract and heterogeneous objectives of the Directive do not appear to be of help since they do not shed light on how to distribute value
among stakeholders.23 The introduction of the EU RPR, which emanates from the abstract
goals of the Directive, will even exacerbate the distributional issues. Based on the EU RPR,24 distribution of any value to junior stakeholders- such as shareholders- is allowed as long as the dissenting senior classes are treated more favourably. It seems that the legislators have contradicted themselves. If one follows the EU RPR, the realisation of both objectives -maximisation of value to creditors as a whole as well as to owners- would not be possible since the new priority rule permits transferring value to shareholders before dissenting creditors are
20 Mooney (n 15) 957 rightly noted, to the extent that an employee has an employment contract with the debtor, the employee is considered as a creditor; “of interest here are employees who care about future employment, to which the
employees presumably hold no legal entitlement.”
21 Christopher W Frost, ‘Bankruptcy Redistributive Policies and the Limits of the Judicial Process’ (1995) 74 North Carolina Law Review 75, 130 noted that “[w]hile liquidation may harm the community served by the closed enterprise, it may benefit
a distant community served by a competing enterprise.” See also Thomas Jackson and David Skeel, ‘Bankruptcy and Economic
Recovery’ in Martin Neil Baily, Richard J Herring and Yuta Seking (eds) Financial Restructuring to Sustain Recovery (Brookings Institution Press, 2013); Gerard McCormack, ‘Business Restructuring Law in Europe: Making a Fresh Start’, (2017) 17 (1) Journal of Corporate Law Studies 167, 177-178.
22 Douglas G Baird, ‘Loss Distribution, Forum Shopping, and Bankruptcy: A Reply to Warren’ (1987) 54 University of Chicago Law Review 815, 828-31; Mooney (n 15) 931 also argues that “it is incoherent to provide different substantive rules in
bankruptcy when those substantive rules are equally applicable outside bankruptcy.”
23 Jackson and Skeel (n 21) 24 note, “when reorganisation “works” because it keeps assets from being ripped apart, there is
likely to be a large congruence between the decision about what to do with assets and the spillover effects on workers and others.”
paid in full.25 In light of the foregoing arguments, it is appropriate and practical to follow the commonly accepted overriding objective of insolvency law, which is the maximisation of the total value to creditors as a whole and establishing a fair and equitable system of distribution of assets among creditors. However, an equally relevant question to this paper that may arise is as follows: should a preventive restructuring procedure, which is applicable to likely insolvent debtors, be governed by insolvency law? Based on the discussions provided below, the answer is in the affirmative.
2.2 The Preventive Restructuring Framework is a subset of insolvency law:
A tactic to evade from realising the objective of maximisation of the total value to creditors is to exclude the Directive from the scope of insolvency law. Prof. Madaus has taken a contractual approach to restructuring proceedings and describes them as procedures in which a restructuring plan becomes enforceable against all affected parties through judicial assistance.26 In his view, the core distinction between insolvency and restructuring is as follows: on the one hand, insolvency proceedings are only invoked in insolvency and the collective debt enforcement mechanism aims to prevent value-destroying asset grabbing efforts of parties. Restructurings procedures, on the other hand, can be used anytime, either during formal insolvency proceedings or where the insolvency of the debtor is only a distant threat. Unlike insolvency law, the purpose of restructuring law is to prevent the underuse of common goods that results from hold-out behaviours of voters.27 He further notes that a contractual approach to restructuring is able to safeguard distribution of value according to the rights and expectations of all stakeholders outside of insolvency proceedings, based on which it is possible to prioritise interests of shareholders over creditors.28 However, the discussed argument can be repudiated on following grounds.
Although the Preventive Restructuring Framework is outside formal insolvency and merely applicable to likely insolvent enterprises, in terms of consequences, the procedure is de facto an insolvency procedure: most notably, the Directive utilises insolvency principles such as the availability of a stay, APR and cross-class cram-down mechanism that seek to enhance the total distributable value to creditors.29 In the words of Tollenaar: "On the other hand, in terms
25 The subsequent Sections of this paper substantially discuss the implications of the new rule.
26 Stephan Madaus, ‘Leaving the Shadows of US Bankruptcy Law: A Proposal to Divide the Realms of Insolvency and Restructuring Law’ (2018) 19 European Business Organisation Law Review 615.
27 Ibid., 625, 632-633. A comprehensive explanation and distinction between the common pool problem and tragedy of anticommons is provided in Section 5.1.b.
28 Ibid., 640.
29 Anne Mannens, ‘Puzzling Priorities: Harmonisation of European Preventive Restructuring Frameworks’ (Oxford Law
of its consequences, the procedure is nothing but an insolvency procedure (“if it’s not called a duck, but looks like a duck, swims like a duck and quacks like a duck, it probably is a duck”)."30
In fact, from a procedural perspective, it is best to view the Preventive Restructuring Framework “as an alternative approach to an otherwise soon bankrupt corporation.”31
Nevertheless, it is worth noting a distinction between the formal insolvency and a preventive restructuring: unlike a liquidation procedure that can be viewed as rule-based, reorganisation procedures are more principle-based because the outcome of the latter is more open-ended and usually depends on the negotiations between the parties. 32 This distinction, however, does not
exclude preventive restructuring from the scope of insolvency law; it even signals the need for an additional layer of protection to safeguard creditors’ interests since the preventive restructuring procedure requires a lesser degree of judicial involvement.33 The foregoing argument is in line with the World Bank’s 2012 report, which notes that formal and informal restructuring “procedures are not separate from each other but, rather, they exist in a
continuum of different degrees of formality and court intervention.”34
Furthermore, similar to the uncertainties attached to the valuation of an enterprise, determining the viability of a business is a delicate matter since it is based on judicial speculations on the future performance of the business. Excluding the Preventive Restructuring Framework from the scope of insolvency law makes the judicial decision on the viability of an enterprise even more sensible. Rescuing a mistakenly presumed viable enterprise (an inefficient preventive restructuring framework) can potentially lower the net assets available for distribution in case of potential subsequent insolvency of the debtor and entrance into formal insolvency proceedings.35 While the shareholders are not thoroughly worse off as a result of the inefficient
2015 on Insolvency Proceedings (recast) OJ L141/19. Under article 1(1) of the Regulation, the new definition of insolvency proceedings under the European insolvency Regulation (recast) expands the scope of insolvency law to circumstances where there is a likelihood of insolvency.
30 Tollenaar (n 10). The author has also addressed the "schizophrenic character" of the Directive: on the one hand, the debtor has the exclusive right of initiating the procedure to prevent collective debt enforcement of creditors. On the other hand, the Directive recognises preventive solutions as ‘growing trends in insolvency law’ and utilises the insolvency principles such as the APR to protect dissenting creditors from cross-class cram-down.
31 De Weijs, Jonkers and Malakotipour (n 11) 25.
32 Rolef J de Weijs and Meren Baltjes, ‘Opening the Door for the Opportunistic Use of Interim Financing: A Critical Assessment of the EU Draft Directive on Preventive Restructuring Frameworks’ (2018) 27 International Insolvency Review 223, 236. 33 Recital 29 of the Directive states, “except in the event of mandatory involvement of judicial or administrative authorities
as provided for under this Directive, Member States should be able to limit the involvement of such authorities to situations in which it is necessary and proportionate, while taking into consideration, among other things, the aim of safeguarding the rights and interests of debtors and of affected parties as well as the aim of reducing delays and the cost of the procedures Less judicial involvement is one of the aims in the directive.”
34 Jose M Garido, ‘Out-of-Court Debt Restructuring’ (World Bank Study 2012) para. 103 (‘World Bank Report’). See also para. 6 of the report where the author notes that “in this continuum, purely contractual, out-of-court restructuring would be at
one end, whereas formal, fully-fledged insolvency proceedings, traditionally aimed at the liquidation of the debtor’s business, would be at the other.”
35 Ibid., para.6. Garido states as follows: “A completely informal workout may be the first step towards a fully formal
Preventive Restructuring Framework since they were only one or few steps away from being entirely wiped out, it generates additional losses to the detriment of creditors. It is worth noting that generally, non-adjusting creditors suffer the most from an inefficient preventive restructuring procedure. If the inefficiency of the procedure is not substantial, and the available assets for distribution can still fulfill secured creditors’ claims, the unsecured creditors will be the group that is going to suffer the most.36
In conclusion, the Preventive Restructuring Framework, as a tool of insolvency law, has to be
primarily concerned with serving the interests of creditors as a group, which can indirectly
result in the realisation of other interests that the Directive is seeking to serve, namely rescuing businesses and saving jobs. The remainder of this paper assesses which of the priority rules (APR or EU RPR) should be chosen to maximise creditors’ value while establishing a procedure that ensures all classes of creditors are entitled to fair and equitable distribution from the estate.
process. Of course, a reorganization procedure may also result in liquidation. Therefore, the possible relations and connections of the different procedures are manifold, with multiple overlapping and possible combinations.”
36 Horst Eidenmüller, ‘Contracting for a European Insolvency Regime’ (2017) European Corporate Governance Institute (ECGI) Working paper 341/2017, 24.
3. Preventive Restructuring Procedure
This Section provides an overview of the basic requirements and procedure of the Preventive Restructuring Framework.
Based on the Directive, when a viable enterprise is likely to be insolvent, debtors should have access to a Preventive Restructuring Framework that enables them to prevent insolvency.37
The Directive has set the basic framework and left the crucial elements of the procedure to the discretion of the Member States. For instance, national legislators have to define “insolvency”, “likelihood of insolvency”, and “SMEs”38 and introduce a viability test as a condition for
access to a preventive restructuring procedure.39 Once the enterprise fulfills the requirements
of the likelihood of insolvency and a viability test, the debtor has the right to decide on entering the Preventive Restructuring Framework and submit a restructuring plan.40 Article 8 of the Directive requires a non-exhaustive list of elements to be addressed in the plan;41 the content of the plan may include a wide range of measures such as extension or reduction of debt, a debt for equity swap, a sale of assets or business units.42
The proposed plan has to be then voted by the affected parties.43 According to the Directive, the affected parties should be grouped into separate classes in order to reflect sufficient commonality of interest.44 The criteria for forming the classes are to be decided according to the national law of the Member States however as a minimum requirement, creditors of secured and unsecured claims shall be treated in separate classes.45 When the required majority vote of
37 Recital 1 and article 1(1) Directive. 38 Article 2 (2) Directive.
39 Recital 26 Directive. Based on article 4 (3), “[m]ember States may maintain or introduce a viability test under national law,
provided that such a test has the purpose of excluding debtors that do not have a prospect of viability, and that it can be carried out without detriment to the debtors' assets.
40 Article 4 (7) Directive. Based on the subsequent subparagraph, the restructuring frameworks are also available upon the request of creditors and employees, however, it is subject to the agreement of the debtor. The Directive seems to be flexible in relation to which party has the right to submit the plan. According to the second limb of Article 9 (1), “[m]ember States may also provide that creditors and practitioners in the field of restructuring have the right to submit restructuring plans and provide for conditions under which they may do so.”
41 Article 8 (1) (h) Directive. See also recital 42 (“Member States should be able to require additional explanations in the
restructuring plan, concerning for example the criteria according to which creditors have been grouped, which may be relevant in cases where a debt is only partially secured. Member States should not be obliged to require an expert opinion regarding the value of assets which need to be indicated in the plan.”).
42 Tollenaar (n 10) 67.
43 Based on article 2 (2) Directive, 'affected parties' means creditors, including, where applicable under national law, workers, or classes of creditors and, where applicable, under national law, equity holders, whose claims or interests, respectively, are
directly affected by a restructuring plan. 44 Article 9 (3) Directive.
affected parties is obtained in each class,46 the consensual plan47 becomes binding on all the affected parties, including the dissenting voters in those classes, provided that the plan complies with a number of other conditions listed in article 10 (2).48 One of the requirements that has to be examined, upon the request of the affected parties, by a judicial authority is compliance with the ‘best-interest-of-creditors test’. Based on the test, unless the creditors agree otherwise, no dissenting creditor may receive a value under the plan that is less than the value that such creditor could receive in the event of liquidation whether piecemeal or by sale as going concern or in the event of the next best alternative restructuring plan scenario.49 In
addition, in order to minimise holdout behaviours of affected parties, the Directive has stepped further and, similar to the US Chapter 11, introduced the cross-class cram-down mechanism.50
According to the rule, a plan that is not accepted by the required majority of votes within one or more classes (a non-consensual plan) can become binding provided that it complies with the following additional requirements: i) the plan has to be accepted by at least one affected class that is in the money51 and ii) it complies with either the EU RPR or APR.52 The subsequent Subsection refers to a hypothetical Preventive Restructuring Framework situation where the best-interest-of-creditors test and the priority rules are explained through a visualised balance sheet example.
46 For a restructuring plan to be accepted under German law requires approval of at least half the number of creditors in each class. In addition, the creditors voting in favour have to represent at least half of the total amount held by all voting creditors (article 244 InsO). English Scheme of Arrangement requires approval of a majority in excess of 75% in value of the creditors and a simple majority in number (Section 899 English Companies Act 2006). US law requires a majority of two-third in amount and a majority in number of creditors (1126 (c) US Bankruptcy code). See also, Reinhard Bork, Rescuing Companies
in England and Germany’ (OUP 2012) 251; Rolef J de Weijs, ‘Harmonization of European Insolvency Law: Preventing
Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide’ (2018) 15 European Company and Financial Law Review 403, 433. See also recital 47 Directive.
47 This term is borrowed from the US Chapter 11. See Tollenaar (n 10) 68.
48 Article 10 (2) Directive is read as follows: “Member States shall ensure that the conditions under which a restructuring plan
can be confirmed by a judicial or administrative authority are clearly specified and include at least the following: (a) the restructuring plan has been adopted in accordance with Article 9; (b) creditors with sufficient commonality of interest in the same class are treated equally, and in a manner proportionate to their claim; (c) notification of the restructuring plan has been given in accordance with national law to all affected parties; (d) where there are dissenting creditors, the restructuring plan satisfies the best-interest-of-creditors test; (e) where applicable, any new financing is necessary to implement the restructuring plan and does not unfairly prejudice the interests of creditors. Compliance with point (d) of the first subparagraph shall be examined by a judicial or administrative authority only if the restructuring plan is challenged on that ground.”
49 For the definition of the ‘best-interest-of-creditors test’ see Article 2 (6) Directive. See also recitals 49 and 50.
50 The cross-class cram-down mechanism is implemented in jurisdictions such as the US, Netherlands and Germany. See article 245 InsO, article 1129 US Bankruptcy Act and article 146 Fw, respectively. The UK, however, has not yet included the possibility of a cross-class cram-down by a court. See Jennifer Payne, ‘Debt Restructuring in English Law: Lessons from the US and the Need for Reform’ University of Oxford Research Paper 89/2013, 12.
51 According to article 11 (1) (b) (ii) Directive the determination of whether a class is in the money or not is based on a going concern value of the enterprise is considered.
3.1 The application of the principles in a hypothetical case
As discussed above, a restructuring plan has to satisfy the best-interest-of-creditors test and in case of the application of the cross-class cram-down mechanism, compliance with either the RPR or APR is required. This part illustrates how the mentioned conditions affect the interests of creditors and shareholders.53
Imagine a moderately leveraged Pizzeria with a €1000 worth in assets and €350 in secured bank loan and €540 in unsecured creditors, with an equity value of €110, suddenly faces a liquidity default: due to short term factors such as difficulty in generating revenue its cash flow is not high enough to cover the current coupon payments or debt repayments. If this situation lasts for a longer period, the aggrieved creditors are likely to file for bankruptcy in order to revive their claims through a formal insolvency procedure. However, entrance into a formal insolvency procedure is unfortunate for the shareholders since they will be last in the line and lose the right to the relevant licenses. The controlling shareholders would try to overcome the financial distress by invoking the Preventive Restructuring Framework, which requires compliance with the conditions mentioned above, inter alia the ‘viability test’ and ‘best-interest-of-creditors test’.54
Assume the judge, upon the request of affected parties, conducts the best-interest-of-creditors test based on a hypothetical piecemeal liquidation and concludes the estimated enterprise value to be €450 (Figure 1). In this hypothetical liquidation scenario, the secured creditors would be able to fully revive their €350 claim, while the remaining €100 has to be shared among the suppliers that have an aggregate claim of €540, resulting in an 18.5% payout.55
[Figure 1]
53 The balance sheet illustration is inspired by de Weijs, ‘Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide’ (n 46). In his paper, Prof. de Weijs has applied the Financial Mind Map, developed by the JBR Institute method of using balance sheets.
54 Based on the second limb of article 10 (2) of the Directive the compliance with the best-interest-of-creditors test’ has to be examined if the restructuring plan is challenged on that ground.
If the plan provides suppliers with a payout of more than 18.5%, it would be in compliance with the best-interest-of-creditors test. How would then the balance sheet of the restructured Pizzeria look like? Since the Pizzeria is worth more going concern, the estimated value of the enterprise is expected to be higher than the liquidated value, for example, €850. The restructured balance sheet with the estimated going concern value of €850 and debt write down to 20% (reducing the total supplier claim to €108) results in positive equity (Figure 2).
[Figure 2]
The question that arises is who is entitled to the surplus reorganisation value, shareholders or creditors? if the required majority is reached in each class, the proposed plan becomes immediately binding. Hence, the distribution of the surplus value would be based on the plan’s stipulation. If, however, one of the classes does not reach the requisite majority, the court can apply a cross-class cram-down mechanism. It then has to examine compliance with a priority rule, which would be either the EU RPR or APR. As it is illustrated in the subsequent Subsection, the application of the mentioned priority rules may lead to different outcomes.
3.2 APR v. EU RPR in the Directive
Enforcing a restructuring plan against the dissenting vote of the majority in a class is an unpracticed concept in some jurisdictions.56 The Directive, inspired by the US Chapter 11 and German InsO, obliges the Member States to introduce a cross-class cram-down mechanism. In addition, similar to the US and Germany’s rules, the 2016 proposal of the Directive required the fulfillment of ‘the-best-interest-of creditors test’ and the ‘APR’ as preconditions for
56 English and Australian Schemes of Arrangements are examples of jurisdictions without the cross-class cram-down mechanism. It is however noteworthy to mention that the inclusion of the mechanism to the English Scheme of Arrangement has been proposed; see Jason Harris, ‘Class Warfare in Debt Restructuring: Does Australia Need Cross-Class Cram Down for Creditors’ Schemes of Arrangement?’ (2017) 36 (1) University of Queensland Law Journal 73. Singapore’s Scheme of Arrangement included the mechanism in 2017. See Wai Yee Wan and Gerald McCormack, ‘Transplanting chapter 11 of the US bankruptcy code into Singapore's restructuring and insolvency laws: Opportunities and challenges’ (2018) Journal of Corporate Law Studies
cramming down a dissenting class of voters.57 Based on the APR, the dissenting class of creditors has to be paid in full before distributing any value to a lower ranking class. The inclusion of the APR as a mandatory requirement when dissenting class of creditors are clammed down reflects a balanced solution. While a cross-class cram-down mechanism prevents possible holdout behaviours and facilitates the implementation of the restructuring plan, the APR protects the dissenting class of creditors by ensuring that they are paid in full before junior classes obtain any value. In the hypothetical Pizzeria example, compliance with the APR would result in the distribution of the entire surplus value (€392) to the trade creditors. Therefore, the suppliers would be able to revive €500 (€108 + €392) out of their total claim of €540 (payout percentage of 93%).
However, the introduction of the RPR, as a preferred rule over the APR revealed a surprising move by the EU legislators. The EU RPR, under Article 11(1) (c) of the Directive, stipulates that:
“[ ] dissenting voting class of affected creditors are treated at least as
favourably as any other class of the same rank and more favourably than any junior class.”58
Given that there is no further explanation in the Directive, this general and ambiguous definition of the European RPR means that a restructuring plan can be enforceable against dissenting creditors who are not paid in full but treated only a little better than old equity. From the wording of the EU RPR it can be inferred that the rule requires to compare the absolute amount shareholders receive to the amount that the junior creditors as a group receive.59 This approach however disregards the decrease in payout percentage to the creditors compared to a scenario where the APR is applied.
In our example, the application of the EU RPR can potentially lead to a range of possible outcomes, based on which the shareholders would be also able to retain value while the higher-ranking class is not fully paid. For instance, if the suppliers receive €192 of the expected surplus value, resulting in a 56% payout,60 and the shareholders obtain the remaining amount (€200),
57 Article 11 (1) (c) 2016 Proposal. 58 Article 11 (1) (c) Directive.
59 De Weijs, Jonkers and Malakotipour (n 11) 18.
60 The suppliers with the combined claim of € 540 would be able to obtain €300 (€108+€192) which results in a 56% payout as to the original claim of €540.
the plan would be in compliance with the RPR simply because the suppliers are treated more favourably than the old shareholders (Figure 3).
[Figure 3]
The €200 that the suppliers could have obtained through the APR, is now transferred to the old shareholders.
This outcome is even more surprising when one compares the old shareholders’ value with their initial capital contribution (€110). While the soon bankrupt shareholders were close to being wiped out, the EU RPR made them better off by diverging large part of surplus value from the suppliers whose claims are not fully realised.61 The following Section makes a comparison between the relative priority rules proposed by US scholars and the one introduced in the Directive.
61 Section 5.1.b steps further and adds a new class of creditors to further illustrate the unfair and unpredictable distributive outcomes that may result from the application of the EU RPR.
4. The EU RPR v. US RPR
4.1 The EU RPR
The EU RPR appears to emanate from a Commission-funded project on restructuring best practices (‘CODIRE project’),62 which makes references to the European Law Institute Report (‘ELI Report’).63 As the references in the ELI Report suggest, the idea for EU RPR seemingly
has its roots in the proposals of US bankruptcy scholars, in particular, Prof. Baird, criticising the APR. However, based on the present paper’s comparative analyses, there is a considerable difference between the objectives of the EU RPR and US RPR, and the application of each of the priority rules would even lead to exactly opposite results. In addition, as the following study suggests, the rationale for supporting the EU RPR is different and contradictory among its proponents.
4.1.a The EU RRP under the ELI Report
The most drastic opposition against the APR and support for the EU RPR can be found in the ELI Report. The Report’s core argument for supporting the RPR has its roots in Prof. Madaus’ proposal to govern restructuring proceedings by a law distinct from the realm of insolvency law, the so-called restructuring law.64 Having this belief, Madaus argues that the legal ownership of the entity still rests with the shareholders,65 hence, the extra value extracted in restructuring is considered as shareholders’ property no matter creditors are paid in full or not.
Madaus considers the APR as a one-sided law, which only concerns about the interests of creditors and asserts the priority that the APR is referring to reflects the priority order in a formal insolvency procedure. He argues that “legal rights are independent of their economic
value",66 and shareholders should not be treated based on their entitlements in an insolvency scenario. The author further notes that the fact that equity is wiped out in liquidation is merely
62 Lorenzo Stanghellini, Riz Mokal, Christoph G Paulus, Ignacio Tirado, Best practices in European Restructuring:
Contractualised Distress Resolution in the Shadow of the Law (Wolters Kluwer 2018).
63 Bob Wessels and Stephan Madaus, Instrument of the European Law Institute, Rescue of Business in Insolvency Law (ELI Report) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3032309&download=yes>.
64 Madaus, ‘Leaving the Shadows of US Bankruptcy Law: A Proposal to Divide the Realms of Insolvency and Restructuring Law’ (n 26).
65 Madaus in ELI Report (n 63). See also Sthephan Madaus, ‘Rescuing Companies Involved in Insolvency Proceedings with
Rescue Plans’ (NACIIL Annual Report 2012) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2271979&download=yes> 9-10 the author states as follows: "It is
quite obvious that creditors are not entitled to a reorganisation surplus value by the legal position based on their claim against , a debtor as equity interest is not part of the debtor’s estate and thus not part of a creditor’s entitlement under the law of execution or insolvency law."The author further states that "[a]dditional protection by an APR against a distribution of wealth
under insolvency law to the benefit of other parties than creditors does not seem necessary as creditors cannot claim additional value under non-bankruptcy law."
66 Stephan Madaus, ‘Reconsidering the Shareholder’s Role in Corporate Reorganisations under Insolvency Law’ (2013) 22 International Insolvency Review 106, 11.
due to the dissolution of the company;67 considering that in a restructuring procedure the enterprise is rescued, equity holders are still the owners of the enterprise and should be able to retain some value before senior creditors are fully paid.
However, the author’s justification for treating preventive restructuring procedure outside the scope of insolvency law is unfounded. The mere fact that the corporation is not dissolved but rescued should not be a reason for excluding the Preventive Restructuring Framework from the realm of insolvency law. The crucial factor that is not considered is the detrimental effect of such exclusion on the effectiveness of insolvency law (see Section 2). There is no clear demarcation between pre-insolvency and insolvency. A pre-insolvent corporation with liquidity issues may soon become incapable of paying its debts and become insolvent. The governance of the Preventive Restructuring Framework, based on objectives different from those of insolvency law, neglects the protections that creditors in a formal insolvency procedure are entitled to enjoy. In addition, due to the application of the cross-class cram-down mechanism, there will be dissenting parties whose legal rights will be curtailed against their consent.68 Given that the Preventive Restructuring Framework is outside formal insolvency, cramming down creditors’ rights without applying the APR is even more problematic than in formal insolvency because the procedure is less transparent and involves a lower degree of judicial supervision. In other words, keeping out the procedure from the scope of insolvency law creates an unleveled playing field to the detriment of dissenting creditors, possibly trade creditors who have been “forced into the position of credit provider by payment terms and
denying interest.”69
4.1.b Related governance issues
The subsequent subsection takes a closer look into another aspect of creditors' rights under the Directive, which together with the EU RPR has the potential to exacerbate the unequal powers of shareholders and creditors.
According to the Directive, debtors have the right to initiate a preventive restructuring procedure.70 In addition, article 4 (8) of the Directive leaves the extension of the right to
67 Ibid.
68 De Weijs, Jonkers and Malakotipour (n 11) 15.
69 De Weijs, ‘Harmonization of European Insolvency Law: Preventing Insolvency Law from Turning against Creditors by Upholding the Debt–Equity Divide’ (n 46) 443. De Weijs notes that financial leverage is considered as an attractive strategy for shareholders: by financing a large part of their capital with debt, instead of equity, the Return on Equity (ROE) increases substantially. Considering that raising fund through debt may also entail interest payment, a more naïve and attractive strategy is to extend payment terms to trade creditors and not pay any interest on their claims. The decrease in equity investment and lower aggregate interest payment would both have a substantial positive effect on the ROE.
creditors and employees’ representatives to the discretion of Member States. However, it is crucial to note if a Member State decides to extend the right, creditors and employees’ representatives would be only able to initiate the process subject to the agreement of the debtor. Notably, the Directive instructs Member States that they may limit the requirement to obtain debtor’s agreement to cases where debtors are SMEs.71 While the restriction to the right of
creditors seems to be protective of debtors that are SMEs, it does not offer an effective protection to creditors, who themselves may be considered as SMEs.
The grant of the conditional right to creditors means that in fact only the debtor can initiate a restructuring procedure. In a system where creditors’ commencement right is subject to the approval of the debtor, the procedure would be vulnerable to potential governance issues: if debtors realise that a Preventive Restructuring Framework affords special consideration to the interests of creditors- for instance, due to the application of the APR for enforcing a non-consensual plan- they may be enticed to avoid entering into the restructuring framework and stick to their optimistic hopes on potential future growth of the enterprise. This outcome is in contradiction with the very purpose of the Directive that aims to rescue distressed enterprises in the early stages of their financial distress.
The other crucial factor that may also create an unleveled playing field among creditors and shareholders relates to the right to propose a restructuring plan. Based on article 9 (1) of the Directive, next to the right of debtors to submit restructuring plans, Member States may decide whether they want to extend the right to creditors and practitioners and provide for conditions under which they may do so.72 As it can be inferred from the Directive, national legislators have ample room in implementing this provision.
The first possibility is to provide the exclusive right to propose a plan to debtors.73 However, similar to the addressed issue of granting conditional right to file for preventive restructuring procedure, it leads to governance issues:74 this right together with the EU RPR, provide
controlling shareholders with an opportunity to expropriate creditors by enacting plans that only comply with the minimum requirements of the protection of creditors. Although the best-interest-of-creditors test aims to protect dissenting creditors by ensuring that they are not worse off under a restructuring plan than in liquidation, a hypothetical piecemeal liquidation or going
71 Article 4 (8) Directive.
72 Article 9 (1) Directive.
73 ELI Report (n 63) 313 notes that with respect to European Union Member States, “only the new French law allows for a
competing plan of a member of the creditors’ committee in a Procédure de Sauvegarde and empowers the court to decide which plan to confirm.”
concern sale scenario is unable to present a coherent and accurate picture of the creditors’ position in case of formal insolvency.75 In addition, the holdout position that debtors enjoy may cause an undue delay, lead to the transfer of wealth and harm the business.76 In anticipation of this unfavourable outcome, article 12 (2) of the Directive requires Member States to ensure that “equity holders are not allowed to unreasonably prevent or create obstacles to the
implementation of a restructuring plan.” However, the subjective nature of this provision
deems to be ineffective to prevent opportunistic use by shareholders of preventive restructuring.
An alternative possibility is to allow classes of creditors to put their plans, directly, for a vote of the stakeholders. The plan that proves to be more attractive to the voters, would then be enforceable provided that it complies with other requirements of the Directive. 77 This approach is familiar to US practice. Based on Chapter 11 of the US Bankruptcy Act, there is a four-month period, starting from the date that the request for initiating a restructuring procedure is filed, where debtors have an exclusive right to propose their reorganisation plan.78 After the exclusivity period ends, creditors’ committees or other stakeholders would be entitled to propose competing resorganisation plans. A significant advantage of this option is that through the effective involvement of creditors it would be more likely to obtain the requisite vote in each class of voters and avoid enforcement of the plan through a cross-class cram-down mechanism.
As the foregoing suggests, there is a close interaction between the priority rules and the right of parties to initiate a preventive-restructuring procedure and propose restructuring plans. Extending the rights to creditors and imposing the APR as a mandatory priority rule for enforcing a non-consensual plan decrease the disparity between creditors and shareholders’ powers and facilitate restructuring. Due to the active role of creditors in drafting competing restructuring plans and the increase in their bargaining power as a result of the application of
75 Jennifer Payne, Schemes of Arrangement: Theory, Structure and Operation (OUP 2014) 249. 76 Tollenaar (n 10) 73. See also, Harris (n 56).
77 Stanghellini et al (n 62) 38-39. The authors discuss an additional possibility which all creditors to make restructuring plans and provide the debtor with the right to decide on presenting the plan for a vote of the stakeholders. However, considering that the plan provided by creditors may never be put to a vote it would be unlikely for them to exercise such an information-incentive option.
78 Article 1121 (b) US Bankruptcy. Based on article 1121(d) US Bankruptcy, the time period to file can be extended up to 18 months after the petition date. The court does also have the authority to lessen the exclusivity period.
the APR (see Section 5.1.b), there would a higher chance of reaching a consensual plan that is enforceable against all affected parties.
The subsequent Subsection explores the history of priority rules in the US and relative priority proposals by US scholars. It concludes that the US version of the relative priority rule has exactly opposite effects from the EU RPR.
4.2 The US RPR
4.2.a History of priority rules in the US
The US legal history is not unfamiliar with the concept of relative priority. In the late 19th and
early 20th centuries, most of the US fast growth railroads could not meet their fixed obligations
and over half of those companies reorganised through the equity receivership procedure. In the proceeding, a court-appointed receiver had to be in charge of administrating and selling the assets over which there is dispute; in fact, the receivership provided an umbrella under which committees that represent claimants with similar interests could form a single reorganisation Committee. The participants in the Committee, who were normally old shareholders and sophisticated creditors, would receive in accordance to the plan, and the remaining claimants that did not participate would be entitled to nothing or only a fraction of their claim. The role of the reorganisation Committee would be deciding on the amount of distributable assets to each claimant and attending the sale of the railroad. Due to the market illiquidity, the reorganisation Committee could commonly make a winning bid and acquire the company for less than the going-concern value. The active participation of old shareholders was helpful since they were the ones who were familiar the most with the railroad system. Furthermore, they were often required to pay an assessment (inject new funds) in exchange for stocks in the reorganised railroad and subordinated notes or preferred stocks. As a consequence, the old shareholders were able to maintain their position in the reorganised entity while not all creditors were paid in full. It is worth noting that unlike unsecured creditors, general creditors were in a less vulnerable situation due to their active participation in making reorganisation plans and the doctrine of necessity.79
79 The necessity of payment rule was first established in a US Supreme Court case, Miltenberger v. Logansport Railway Co., US Supreme Court (106 U.S. 286) 20 November 1982. In National Railroad Passenger Corporation v. Boston and Maine
Corp., US Supreme Court (450 U.S. 982) 25 March 1992, 138 the court defined the necessity of payment rule as "the existence of a judicial power to authorize trustees in reorganization to pay claims where such payment is exacted as the price of
A chain of Supreme Court judgments altered the conventional practice, which eventually resulted in the emergence of the APR in the US Bankruptcy Code. The origin of the APR in the US can be traced back to the Supreme Court's judgment in Northern Pacific Railway Co.
v. Boyd.80 In 1913, the US Supreme Court prohibited a complete freeze-out of intervening creditors and held that shareholders could be included in a reorganisation plan only if creditors were given a ‘fair offer’,81 but the recognition of whether a plan is fair was left for the lower courts to decide. The judgment resulted in the appearance of two schools of thought advocating different rules, namely the relative and absolute priority rules.
Robert Swaine came up with the so-called idea of relative priority and suggested not to collapse all future assets and values to their present value so that equity holders would be able to possess the option value of their old share in the new firm. Furthermore, he believed that "the test of
fairness is whether each class of security holders which retains any interest in the property retains approximately its relative position with respect to the other security holders.”82 His ideas, however, were subjected to criticism by few lawyers including Jerome Frank who viewed the relative priority as a tool for old shareholders and professionals to expropriate value from unsophisticated creditors. Frank supported the APR and argued that reorganisation of a firm should be a day of reckoning on which we sort out claims according to their priority. While the underlying rationale in the RPR was providing motivation to old shareholders to cooperate and preserve going concern value, the advocates of the APR were aiming to preserve the legal entitlements of investors.83
The enactment of the ‘fair and equitable’ requirement in the 1934 reorganisation Statute was not comprehensive enough to solve the uncertainties that arose after Boyd. The two Supreme Court cases, Church Street Building and Los Angeles Lumber Products, decided in 1936 and 1939,84 respectively shed light on the interpretation of the term ‘fair and equitable’. Based on the former, shareholders cannot rely on relative priority to claim a right and according to
Lumber, the terms ‘fair and equitable’ require compliance with the APR. Nowadays, there is
providing goods or services indispensably necessary to continuing the rail service … .” See also Russell A Eisenberg and Frances
F Gecker, ‘The Doctrine of Necessity and its Parameters’ (1989) 73 Marquette Law Review 1, 3.
80 Northern Pacific Railway Co. v. Boyd, US Supreme Court (228 U.S. 482) 28 April 1913; Michelle Harner, ‘Final Report of the ABI Commission to Study the Reform of Chapter 11’ (2014) Book Gallery <http://digitalcommons.law.umaryland.edu/books/97> 213 (‘ABI Report’).
81 Douglas G Baird and Robert Rasmussen, ‘Boyd’s Legacy and Blackstone’s Ghost’ (1999) University of Chicago Working paper series 94, 13.
82 Robert T Swaine, ‘Reorganization of Corporations: Certain Developments of the Last Decade’ (1927) 27 (8) Columbia Law Review 901, 912.
83 Baird and Rasmussen (n 81) 31.
84 Church Street Building, US Supreme Court (299 U.S. 24) 9 November 1936; Los Angeles Lumber Products Co, US Supreme Court (308 U.S. 106) 6 November 1939.
no doubt that the requirement of fair and equitable in Section 1129 (b) (2) of the US Bankruptcy Code is read as adherence to the APR. Nevertheless, there are still ongoing discussions around opting an alternative priority rule. The American Bankruptcy Institute (‘ABI’), Prof. Casey and Prof. Baird have been skeptical about the APR; the following Subsection provides a brief overview of their proposals.
4.2.b Diverse US RPR Proposals by US Scholars with some common features that are absent in the EU RPR
The ABI considers the APR as an inflexible and unfair rule which collapses all future possibilities.85 The members of ABI are against strict application of the APR and argue value
allocation is highly dependent on the relevant business cycle at the time of the value realisation event, for instance, plan confirmations.86 Accordingly, the ABI proposes a mechanism that enables to adjust distributions to stakeholders that may occur due to material changes to the value of the firm. The so-called ‘Redemption of Option Value’ mechanism that ABI advocates provides immediately junior creditors with the possibility to redeem in full the allowed claim of the impaired senior creditors receiving the restructuring value. The Commission further notes that the redemption option value attributable to immediately junior class has to be the value of a hypothetical option to purchase the firm which has an exercise price equal to the redemption price and a duration equal to the redemption period.87 It is worth noting that the Commission’s proposal is flexible with respect to the form of distribution of value: the value distributed to the immediately junior class does not necessarily have to be in the form of an actual option.88
Casey, on the other hand, proposes a mechanism that ensures an optimal answer to the choice between sale or reorganisation in order to maximise the expected value for the senior and junior
creditors while respecting non-bankruptcy rights. The ‘Option-Preservation Priority'89
mechanism proposed by Casey respects non-bankruptcy entitlements and creates the following priorities at the time of a sale: "(1) the senior creditor's non-bankruptcy liquidation value of
the collateral; (2) the junior creditor's option value; and (3) the senior creditor's right to the residual value-after the junior option has been paid out-up to the face value of the senior
85 ABI Report (n 80) 218-224.
86 Ibid. 87 Ibid., 219. 88 Ibid.
89 Anthony Casey, ‘The Creditors’ Bargain and Option-Preservation Priority in Chapter 11’ (2011) 78 University of Chicago Law Review 759, 763-766 does not make an explicit reference to the term ‘relative priority’.
