Dividing the insolvent’s pie - can the US show the Europeans the fairest way? : A comparative assessment of the need for an Absolute Priority Rule in European Insolvency Law

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Dividing the insolvent’s pie - can the US show the

Europeans the fairest way?

A comparative assessment of the need for an

Absolute Priority Rule in European Insolvency Law.

Supervisor: Rolef de Weijs Student: Mary Healy, 10846859 Date: 31/07/2015

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Chapter 1

1.1 Introduction

The business world requires risk, as without it the commercial world would cease to exist1.

Correspondingly, success and failure exist mutually in business. Ensuring that businesses, that engage in measured risk-taking, are not treated punitively when faced with failure is a necessity to safe-guard the entrepreneurial nature of the commercial landscape. In looking at these failures, it is evident that a business can have an unhealthy balance sheet all the while remaining a viable enterprise. The rehabilitation of such a business is good for society so that the accompanying benefits that it might generate are not lost.

This ideal is reflected in the reforms that many legal systems have undertaken in recent years to ensure a business seeks to reorganise before the possibility of liquidation. So too, the European Union (E.U.) has shifted its’ focus from liquidation to reorganisation within the E.U.’s legislative sphere. Previously in the E.U. Insolvency Regulation 2002 the emphasis was entirely on liquidation as illustrated by the secondary procedures contained in the Regulation, where the intended outcome of these procedures was the winding up of the business. However the recast introduced in December 2014, the secondary procedures no longer lead to liquidation. The E.U. Commission has published a Recommendation on a New Approach to Business Failure and Insolvency. However, in this Recommendation due consideration was not given to the protection of creditors’ entitlements and should be at the forefront of the E.U. legislators deliberations.

The central question that must be answered is “In the light of insolvency law theory and insolvency law’s goals, should an Absolute Priority Rule be part of future harmonised

1

Martin, The Role of History and Culture in Developing Bankruptcy and Insolvency Systems, B.C. Int'l & Comp. L. Rev. 2005/28, p. 3-13 [online]

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European Insolvency Law?” To make this determination the first step of this thesis demands thought be given to how such a rule would fit into insolvency law theory and goals. The creditors’ bargain theory provides a powerful justification for the existence of insolvency law. However, within the analysis undertaken it is demonstrated that this influential theory has limitations, in particular, its failure to explain anti-commons problems.

Anti-commons problems can arise where parties are bound to a collective procedure wherein all parties have a legal interest in a resource and one party can exercise a veto to obstruct use of said resource. Such holdout behaviour can be symptomatic of the negotiation process that takes place in reorganisation. To prevent holdout behaviour, this exploration and evaluation of the prevailing theories and legislations on insolvency, determines that cram down rules must be implemented to ensure that no creditor or group of creditors can block a viable restructuring plan. The research will illustrate that these rules can however be open to abuse from parties who wish to exert their will on dissenting parties. Thus, while is it is determined that the E.U. should implement a cram down rule, it must at the same time consider the Absolute Priority Rule. This rule is intended to protect creditors from misuse of cram downs and the overruling of dissenting creditors.

In addition to this theoretical analysis, a comparative view of the reorganisation procedures of the USA, Germany and England – considered amongst the most influential legal systems – will identify firstly; how the different legal systems respond to the complications of holdout behaviour and cram downs that can arise in reorganisation and secondly; whether creditors sufficiently protected.

This research determines that the concept of the Absolute Priority Rule should be considered by the E.U. but not its pure conceptual form rather a softer version should be implemented.

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Chapter 2

2.1 The of Insolvency Law and the Influential Creditors’ Bargain Theory

Insolvency law exists to solve the problems that are created when a company becomes insolvent and is unable to pay its outstanding debts. Creditors will each have different entitlements to a debtor’s estate and in these situations there are not enough assets to satisfy the different creditors’ claims. Insolvency law determines which creditors’ are entitled to which assets in the debtor’s estate and how the assets can be fairly distributed amongst the

creditors. Thus, creditors’ entitlements are central to insolvency law2. To ensure that these

entitlements are satisfied fairly3 amongst the creditors, insolvency law imposes a collective

debt collection system. Without this system, there could be a destructive grab for the debtors assets, as the creditors could individually pursue their own interests, in a selfish act to ensure that they receive satisfaction of their claim ahead of other creditors, with these actions harming the interests of the other parties involved.

The most influential insolvency law theory, the creditors bargain theory4, justifies the

imposing of such a collective system on creditors when insolvency occurs. The theory engages in a comparison of insolvency law to a common pool problem. To illustrate this theory consider a lake where a number of parties all have a right to fish in it, but there is no agreement as to how many fish a person can catch. As a result, the parties might act in a selfish manner catching as many fish as possible, exhausting the fish stock in the lake and thereby destroying the resources of the lake. The reason for such self-centred acts can be

explained by the concept of the “prisoners’ dilemma”5. In short, the dilemma occurs when

the parties are aware that if they decide to take collective action they may be better off collectively, but they cannot be certain that each party will agree to such action. This dilemma causes a lack of certainty between the parties and in their wish to preserve their own

interests they will act in manner that is at the expense of the other parties6. However if the

parties decide to act in a collective manner and limit the number of fish that could be caught, this would provide a steady stream of fish for each party and maintain fish levels in the lake,

which would be the optimal result.

This scenario showcases that even in the absence of insolvency law, creditors would agree upon a collective procedure due to their appreciation that being part of a collective would leave them in a better position than in a destructive individualistic grab for assets. Such a destructive grab would plunder the common pool of the debtor’s assets and destroy the going concern value of the business. This type of individualistic approach harms the creditors as a group by diminishing the value of the debtor’s estate. The collection of assets are more

2

Warren, Bankruptcy Policy, Uni. of Chicago L. Rev. 1987/54, p. 785. [online]

3

This system has existed for centuries. King Henry VIII’s reign (1507-1549), a debtor that was unable to pay his debts, both he and his assets were seized and the assets sold to pay his creditors “a portion, rate and rate alike, according to the quantity of their debts”3, and so came about the principle of pari passu distribution.

4

Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors Bargain, Yale Law Journal 1982/91 pp. 857-907 [online]. Jackson, The Logic and Limits of Bankruptcy Law, 1986. Thomas Jackson is one of the chief proponents of CBT and has written about it extensively.

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De Weijs, Too Big to Fail as a Game of Chicken with the State, Euro. Bus. Org. L. Rev., 2013/14 p. 257-258. Footnote 25 provides a detailed picture of the prisoners dilemma.

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valuable collectively than the same assets scattered in the wind7. The creditors bargain

theory, therefore projects a justification for insolvency law, which seeks to protect the going concern value of the debtors estate by imposing a collective and compulsory proceeding on

creditors’8, in turn ensuring that the group rather than individuals, act as one in order to

maximise benefits for creditors as a whole9. The creditors’ bargain theory delivers a clear

understanding of what insolvency law seeks to achieve and why insolvency law exists when a debtor becomes insolvent and there is inadequate number of assets to divide between the creditors. However, the theory is limited in two aspects.

2.2 Limitations of Creditors’ Bargain Theory

The creditors’ bargain theory undoubtedly provides a strong rationale for the existence of insolvency law. However, it is limited in so far that insolvency law only exists to serve one group of interests – the creditors. The theory also fails to contemplate what happens when there is more than just a collective procedure to be considered.

Addressing the first of these points wherein the framework provides a solution for one group of interests, the creditors and ignores the other interests that are affected by a debtor’s insolvency. Jackson is steadfast in his opinion that this should be the case and that insolvency law should only be applicable to creditors due to their pre-insolvency rights. He maintains it should not extend to other parties who have no such rights, such as employees’ rights or

community interests, in the insolvency proceedings10.

That the theory limits insolvency law to serve only the interests of the creditors has resulted

in severe criticism11. While Professor Warren agrees with the theory that insolvency law

should protect the value of the debtors estate, this is the extent of her agreement with the theory. She argues that it is an over-simplification of the insolvency process to say it should only serve creditors as she sees no value dominating, but rather there should be a multi value

approach on how the losses can be distributed12. Roy Goode argues in a similar fashion, that

insolvency law already plays a redistributable role13, for instance, most jurisdictions grant

preferential status to certain parties: employees and tax authorities14, ahead of unsecured

creditors. Accordingly, insolvency law is a collective debt collection device, not just for creditors but also for the other parties involved in the insolvency proceedings.

7_{Jackson, The Logic and Limits of Bankruptcy Law, 1986, p. 14.} 8

Jackson, The Logic and Limits of Bankruptcy Law, 1986. Jackson also provides two additional reasons why creditors would favour a collective procedure. Firstly, if there is no collective procedure, an all-out battle might begin as each creditor tries to seize as many assets as possible, leading to significant legal costs for the creditors. Secondly, there would be less requirement for monitoring of debtors assets, as a creditor could be safe in the knowledge that no asset will be siphoned off in favour of another creditor.

9

Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors Bargain, Yale Law Journal, 1982/91, pp. 857-907 [online ]. Baird, Corporate Reorganisations and Treatment of Diverse Ownership Interests, Uni. of Chicago L. Rev., 1984/97, pp. 97-130 [online]. The authors espouse that insolvency law is only to serve the interests of creditors.

10

Jackson, The Logic and Limits of Bankruptcy Law, 1986, p. 26

11

See Warren, Bankruptcy Policy, Uni. of Chicago L. Rev. 1987/54, [online]. Goode, Principles of Corporate Insolvency

Law, 2011. Mokal, Corporate Insolvency Law: Theory and Application, 2005, Chapter 2. 12

Warren, Bankruptcy Policy, Uni. of Chicago L. Rev. 1987/54 [online] p. 777

13

Goode, Principles of Corporate Insolvency Law, 2011, p. 73.

14

In Ireland §285(7)(b) Company’s Act 1963 provides that the Revenue Commissioners shall have priority over the claims of holders of debentures under any floating charge created by the company.

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The second limitation is that the theory fails to acknowledge what can happen after the parties are in a collective procedure. The theory focuses on why the parties will come together in a collective manner, to overcome the common pool problem, but the theory does not deal with how the parties will negotiate in the collective proceedings. Creditors take part in the collective procedure to ensure that their interests are protected. However, they may try to further their own interests by demanding a bigger slice of the pie than is due to them by engaging in hold-out behaviour. This behaviour cannot be understood within the theoretical context of the common pool problems, but by applying the theory of anti-commons. Common pool problems are such that no parties can prevent another party or parties from using or

overusing a resource. The converse is true in an anti-commons situation15, where each party

can exercise a veto to block other parties in exercising their rights and this holdout behaviour

leads to underuse resulting in suboptimal outcomes16. This is an inefficient result and

something insolvency law does not or should not set out to achieve.

It should not be forgotten, however that despite its’ limitations the creditors’ bargain theory still espouses insolvency’s core goal; to preserve the value of the debtors estate through a collective procedure. The narrow conceptual scope of the creditors’ bargain theory should therefore be expanded to ensure a just and efficient allocation of resources amongst all parties.

2.3 Reorganisation and why it is desirable.

A debtor has two options available under insolvency law when they are unable to pay their debts as they fall due for payment, either liquidate or reorganise the company. Liquidation is the final act of the company as all of the assets are sold and the proceeds are distributed to the creditors according to priority. The company does not survive these final acts as it is dissolved leaving the creditors, hopefully, with some percentage of their total claim and with the shareholders’ equity completely wiped out. For centuries there was no other insolvency alternative for companies but to be liquated and terminated, a harsh fate for a possibly viable enterprise.

Reorganisation provides a different outcome, as the company survives. In recent decades

there has been a significant push by national legislatures17 to promote reorganisation on the

basis of protecting commerce, employment and local communities – the antithesis to

Jacksons’ theory18. The American Bankruptcy Commission (ABI) stated in a recent study

that “a robust, effective, and efficient bankruptcy system rebuilds companies, preserves jobs,

15

De Weijs, Harmonisation of European Insolvency Law and the Need to Tackle Two Common Problems, Int. Insol. Rev., 2011/21 pg. 72 . De Weijs provides an in depth analysis of the anti-commons problems in insolvency.

16

Ibid pg. 211

17

In England in 1982 the Report of the Insolvency Law Review Committee “the Cork Committee” stated that the

“fundamental purpose of reorganisation is to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources”, Goode, Principles of Corporate Insolvency Law, 2011, p. 75. In Ireland in Re

Atlantic Magnetics Limited (1993) McCarthy J stated that “Examinership (reorganisation) purpose is protection, protection

of the company and consequently of its shareholders, work force and creditors. It is clear that Parliament intended that the fate of the company and those who depend on it should not lie solely in the hands of one or more large creditors, who can by appointing a receiver effectively terminate its operation to the inevitable disadvantage of those less protected”.

18

Jackson, The Logic and Limits of Bankruptcy Law, 1986 p. 210. He argues there is a possibility that this policy could interfere with insolvency’s core role as a collective debt collection device, “thus reorganisation provisions should be tested …..as to whether they facilitate achieving the asset deployment of greatest benefit to the creditors as a group”.

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and facilitates economic growth”19. Additionally the ABI states that the bankruptcy system

remains focused, more generally, on strengthening the economy and society thereby instilling confidence in businesses and markets. In order to achieve these objectives there has to be a “delicate balance that encourages appropriate growth and innovation in business, but provides

sufficient protection and certainty to creditors”20.

Similarly, the European Commission’s Recommendation on a New Approach to Business Failure and Insolvency is a far cry from the one-sided liquidation approach of E.U.

Insolvency Regulation 200021, where their perspective on insolvency has evolved to include

reorganisation. The objective of the Recommendation is “to ensure that viable enterprises in financial difficulties ……. have access to national insolvency frameworks that enable them to restructure at an early stage with a view to preventing their insolvency and therefore maximise the total value to creditors, employees, owners and the economy as a whole”22. Thus the focus of these legislators is on saving a viable business which will generate income for society as a whole rather than this income being lost when the company is liquidated. There is the acknowledgement that protection of creditors’ is essential as otherwise creditors may be reticent to engage in extending credit – a necessity for business to thrive. The advantage of reorganisation is that the creditors that remain involved with the newly restructured company may receive greater returns in the long term than they might receive in liquidation and other parties, such as employees and local community may also have an economic interest in the company. In an era where financing a business with debt has become the norm it is little wonder that legislators wish to promote reorganisation. This is particularly so for small to medium size businesses, which now provide two out of three private sector

jobs in the EU23. However, such promotion of these ideals must come with a system that is

just and equitable for creditors’ interests whose are impaired.

2.4 From Holdout Behaviour to Cram Downs

The aim of reorganisation is to alleviate the debtor of their financial encumbrance, so as to avoid liquidation, facilitating the rescue and return to health of an ailing but otherwise potentially viable company. This purpose is achieved by capturing the going concern value of the business.

A debtor can become insolvent because they are in financial distress24. This signifies that a

company is unable to service its debt but is otherwise able to cover its liabilities. If a company has enterprise value the proposed reorganisation plan will state whose rights will be impaired. As the debts of a company require restructuring it will be the creditors as part of the collective procedure, who will have to agree to the proposed plan as it will be all or part of their debt that is to be written down.

19

American Bankruptcy Commission, Commission to Study the Reform of Chapter 11, 2014 p. 2 [online]

20

Ibid p.8.

21

Council Regulation (EC) No. 1346/2000 on Insolvency Proceedings. The Regulation clear focus is on the liquidation of the company. This is illustrated when secondary proceedings Arts. 27-38 are opened they must be liquidation proceedings

22

European Commission, Commission Recommendation of 12.3.2014 on a New Approach to Business Failure and

Insolvency, para. 1 [ online via http://ec.europa.eu/justice/civil/files/c_2014_1500_en.pdf ]

23

See EU figures online via http://ec.europa.eu/growth/smes/index_en.htm

24

Schwartz, A Normative Theory of Business Bankruptcy, Yale Law Sch. Fac. Schol. Ser. 2005/303 p. 1200 [online]. The author distinguishes between financial and economic distress.

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For this reason, in order for such a plan to take effect, all creditors have to agree to the proposed plan. Obtaining total agreement to a plan is not easily done and because of this ‘all or nothing’ approach, holdout behaviour can occur. Such behaviour can manifest itself whereby one or more creditors may try to further their own interests by refusing to consent to the plan in order to negotiate an increase in the percentage paid to them. Or by holding out, creditors damage the going concern value so as to facilitate the capture the of business for themselves.

Creditors are aware that in a reorganisation they are guaranteed to receive at least the same value as they would in liquidation. This knowledge allows them to threaten a veto in order to demand an increase of this value which Warren describes as the price of their consent to the

proposed plan25. This behaviour has the effect of transferring value from the debtor’s estate

to a creditor, diminishing the going concern value of the business26. This situation is

indicative of the anti-commons problem. The suboptimal outcome of such obstructive behaviour is that it could lead to the abandonment of a sensible restructuring plan, aimed at the company returning to healthy financial position. Thus, a veto leaves all parties: debtor; employees; local community and other creditors in a worse position than they would have been under a restructured company.

The power that creditors can yield over a restructuring plan is considerable. To overcome such behaviour many legal systems have implemented a system, whereby the affected parties vote on the proposed plan. This fundamentally democratic process is fair and just. The consent of the majority is the most fitting way to overcome an anti-commons problem, where all parties have a vote and the will of majority controls which path will be taken. Dissenting

creditors will therefore have a plan that they object to, crammed down27 on them. Some legal

systems even provide the possibility to replace a dissenting creditor’s majority vote by a judicial decision if there is belief that the dissenting creditors are blatantly voting to obstruct

the reorganisation28. The cram down may be granted by judicial order on dissenting creditors

when it can be proven that the creditors will be no worse off under the proposed reorganisation plan as in liquidation.

A cram down provides leverage to the proposer of the plan to combat holdout behaviour. The justification for a cram down is that it prevents selfish or vindictive obstructive behaviour and by doing so preserves the value of the business. This allows for the distribution of that value

among the different participating parties in reorganisation29. But does a cram down allow for

equitable distribution? Consider, a plan that allows the shareholders to retain all or some equity in the company where dissenting creditor’s rights have been impaired. Is this a fair outcome for these creditors? Should shareholders be allowed to retain any equity in a company after reorganisation, considering that their equity disappears in liquidation? The Absolute Priority Rule may be the answer to these question.

2.5 The Protection Provided by the Absolute Priority Rule

25

Warren, Theory of Absolute Priority, Ann. Surv. Am. L. 1991/9 p. 31

26_{Ibid p.31} 27

A cram down occurs when a proposed plan which has been rejected by creditors, is to be “crammed down the throat” of the creditor to ensure the proposed plan is approved.

28

Germany provides for this under §245 Insolvenzordnung

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Holdout behaviour cannot be tolerated in reorganisation, but neither can the possibility of abuse of a cram down especially where opportunistic plans are proposed, which might see shareholders retain equity in a business when creditors’ claims have been impaired. The

proposer of a plan, who is generally the debtor30, will have greater information as to the state

of the financial distress of the business. The debtor having this insider information, can engage in conduct that is comparable to holdout behaviour and may decide to propose a plan that is in their own self-interest while the creditors bear the financial brunt of the restructuring plan.

To prevent such abuse the Absolute Priority Rule can intervene. The rule provides a form of protection to creditors by demanding that all higher ranking creditor claims cannot be impaired until all lower ranking claims have been written down. It enforces the fundamental priority ordering that exists in insolvency – preferential creditors, unsecured creditors, subordinated creditors and equity. Creditors’ whose claims have been impaired do not have to consent to a write down until shareholders’ equity is completely wiped out. The rule reflects basic corporate law philosophy. Shareholders’ as the residual claimants of a company are only entitled to the profits and net assets after all other contractual claimants – creditors,

employees etc. – have been paid in full31.

This is illustrated by Warren as she contrasts APR with the rules on dividend distribution to shareholders. These rules provide that shareholders’ have to be paid from earned surplus rather than from the general assets, otherwise there would be nothing left for creditors if the

company went bankrupt32. This restriction on payments to shareholders' is to protect the

legitimate interests of company creditors. A company operates at the shareholders’ risk, not creditors; shareholders’ profit from the company when times are good and bear the losses when times are bad. Shareholders’ have to accept the entrepreneurial risk that comes with running a business. This philosophy is upheld by the Absolute Priority Rule as the absolute priority order insisted upon by the rule ensures that equity is last in line to be paid.

A conceptual comparison can be drawn in a scenario where a shareholder of a ‘too big to fail’ financial institution seeks to retain equity even though the government will be forced to use public funds to save the institution from failure and the catastrophic effect it may have on the wider economy. Shareholders can partake in holdout behaviour as they know that the State must step in to save the institution, thereby by preserving their equity and the possibility that

their shares will recover in value33. Shareholders have nothing to lose by refusing to consent

to transfer their shares to a government run body or a rescue plan that may propose a debt for equity swap.

There can be a theoretical application of APR in a ‘too big to fail’ scenario which would see the higher ranking claims paid before the shareholders would be entitled to retain their equity. The majority of shareholders of financial institutions are dispersed, they add no value to the enterprise and under the principle of fairness shareholders should not be entitled to retain equity where other parties, such as creditors’ and public funds, provide the capital to prevent

30

US, England and Germany as will be seen in Chapter 3,4 & 5 in their reorganisation procedures it’s the debtor that generally proposes the plan.

31

Kraakman et al., Anatomy of Corporate Law, 2009 p. 28

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failure of such an institution. Otherwise the parties are in essence providing capital contribution to shareholders equity.

APR shields creditors from a comparable scenario where a shareholder acts in an opportunistic manner at the expense of creditors. A reorganisation plan may propose that shareholders’ retain equity while the creditors will in effect be funding a restructuring of a business by the writing down of their debt. APR therefore provides a degree of protection to creditors by regulating the conduct of the debtor who will most likely be proposing the plan. It ensures the long established tenet that creditors are to be paid ahead of equity. In the absence of APR, unscrupulous conduct on behalf of the debtor could go unchecked. In a legal system where a debtor is permitted to remain in control of a business during a reorganisation, they might act to depress the value of the business so as to ensure that no new buyer can be

found34. The debtor may seek to have their plan crammed down upon dissenting creditors’

who oppose the plan on the basis that they believe the debtor to be engaging in unsavoury conduct. A plan that provides for the debtor to retain equity while creditor’s interests are impaired does not follow the fundamental principle of insolvency. APR can curb this conduct.

APR can also restrain undesirable conduct by creditors’ who collude with the shareholders’ to capture a business. A powerful creditor such as the main supplier to a business is owed the majority of the outstanding unsecured debt. By virtue of this position they could exert a degree of control over reorganisation proceedings. They may wish to purchase the business for themselves, leveraging inside information from a debtor regarding the future financial potential of the company. With the other creditors’ debt removed from the company balance sheet after it is written down this powerful creditor would then be willing to accept a loss on their outstanding debt knowing that future earnings would exceed the original amount due. To secure the deal, this creditor might promise the shareholders’ some equity in the newly restructured business. This would be a win-win situation for a shareholder, who is guaranteed not to lose all of their original investment. This is unconscionable behaviour as it would lead to a reduction in the payment to the other unsecured creditors as the true value of a business may not be calculated correctly. These unsecured creditors may not have the financial resources to challenge the valuation of a business and as a result would receive a lesser amount that should have been achieved, if the process were adhered to correctly.

The Absolute Priority Rule is a simple rule intended to protect creditors in reorganisation. It has a significant impact on the bargaining power of the parties whose interests will be

affected by a reorganisation plan35. Reorganisation is a process of negotiation and

compromise for all parties. APR transfers some control to creditors’ in reorganisation negotiations as it counterbalances the leverage that a cram down can provide a debtor to force a plan upon a creditor against their will.

APR prevents misuse of the cram down rule as it should only be granted if APR has been complied with, whereby all higher claims must be satisfied before lower claims receive any satisfaction. Thus if APR is strictly enforced it will eliminate the shareholders’ equity in a business. This outcome is not optimal for a debtor if they have a desire to remain involved with a business. To do so, a debtor must secure the consent of creditors. This is a significant

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35

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bargaining chip for creditors as it forces a debtor to yield some concessions to the creditor.

Debtors will have to consider all creditors36 if they are proposing a plan and that each creditor

feels that they are treated fairly and equitably. If not a creditor may reject a plan and can claim violation of APR if the shareholder retains equity, a situation a shareholder will seek to avoid.

Balancing the leverage available to each party can lead to a straightforward negotiation of a

consensual agreement37. The Absolute Priority Rule ensures a pro rata equality of bargaining

power for parties whose entitlements will be impaired and leaves no creditor vulnerable to the imposition of a plan against their wishes.

2.6 The Problematic Nature of the Absolute Priority Rule

APR in theory can be perceived as a simple rule as it requires a straightforward application of the insolvency priority. But because the rule is absolute in preserving priority this rigidness can be problematic in the reorganisation of a company.

The basic tenet of insolvency law and the purpose of reorganisation is to preserve the going concern value of the enterprise. A value can be easily attached to assets that are contained on the business balance sheet, but what of an intangible asset such as the knowledge and expertise that shareholders may have? A rigid application of APR does not affect the restructuring of large corporations in same manner as an SME, as the shareholders are dispersed. There is no need to retain the old management in a large corporation as their skills and knowledge can be transferred to another person with similar qualifications in that

industry. These managers are, generally puppets for the puppeteers’ the senior creditors38.

Conversely in a small to medium size company, the going concern value is often connected to

the owner/manager39. Typically, the owner is also the manager and has intrinsic knowledge

and expertise of the business40. The value of such a shareholder is hard to quantify, as

without this knowledge it could well be very difficult to restructure the company. If the owner/manager was to depart the struggling company, this could affect the going concern value of the company and value preservation. The justification for such shareholders retaining equity under a reorganisation plan is that their value is an integral part of the going concern value of the company and is a necessity for a successful restructure. The rule of absolute priority when rigorously applied ensures that all higher ranking claims are paid, which would have the effect that the owners’ equity would be wiped out, thereby leaving the restructured company without the knowledge and skills that is required to get the company

36

In most legal systems creditors are most likely divided into classes where each creditor has a similar interest.

37

Warren, Theory of Absolute Priority, Ann. Surv. Am. L. 1991/9 p. 10 [online]

38

Baird & Rasmussen, Reply: Chapter 11 at Twilight, Stan. L. Rev 2003/673, [online]

The authors provide numerous examples of senior creditors taking control of the business. For example, on page 684 “Kmart left Chapter 11 with its CEO of its principal creditor as chairman of the board” and on page 682 ICG Communications senior creditors were in control of the process and a the new CEO was recommended by one of the principal creditors.

39

Baird, & Rasmussen, Control Rights, Priority Rights and the Conceptual Foundations of Corporate Reorganisations, Virginia Law Review 2001/921 p. 924 [online]

40

Baird & Rasmussen, Reply: Chapter 11 at Twilight, Stan. L. Rev 2003/673, p. 686 – 688. The authors provide an interesting example in 26 Trumbull Street regarding the going concern value of a small company. This location had a number of restaurant closures, so the furniture and fittings no longer had value in that building. The location finally became successful when an experienced restaurateur opened Vito’s and its value as a going concern was dependant on the owner remaining in place.

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back on its feet. The possibility of the original owner remaining part of the company is unlikely if all their equity is wiped out. The rule, therefore, sometimes has the effect of wiping out the substantial part of going concern value of small to medium size companies. Furthermore, the possibility of an owner’s equity being wiped out has led some owners to

delay the possibility of reorganisation41. In other words, debtors postpone the inevitable

irrespective of entering either reorganisation or liquidation, as either way they will be left without their equity. Some owners will try to trade themselves out of the trouble they find themselves in, rather than giving up ownership of the company they founded or inherited. APR does not encourage the preservation of jobs and protection of the local community if an owner takes this stance which are within the objectives of the legislators.

Another problematic aspect of the Absolute Priority Rule, is the issue of valuation of the business. Valuation is required when APR is to be applied as it is necessary to determine how

all the interests involved will be satisfied42. When valuation of the business is made in the

present, future potential is reduced to values in the present. There are various methods of determining the value of a business but in practice the valuation is based on subjective

predications, estimates of the present value of the business’s future earning capacity43. The

valuations requirement in APR can affect the going concern value of the company as the prolonged negotiations over the valuing of a company in the present and future diminishes the going concern value as a struggling business value diminishes daily.

Undoubtedly the concept of APR has its virtues, but the rule can hinder a successful reorganisation, in particular for SME’s. Creditors’ entitlements and how they behave to protect these entitlements is a necessary consideration in insolvency law. How countries approach these issues must be examined by the E.U. before harmonisation of insolvency law. These following Chapters focus on three of the most influential legal systems, USA, German and English. A comparison of each system will demonstrate, firstly how and by whom the process is controlled, secondly how reorganisation plans are accepted and ultimately approved, and lastly how each system protects creditors who are not in agreement with the proposed plan.

41

Madaus, Rescuing Companies Involved in Insolvency Proceedings with Rescue Plans, NACIL Reports 2012, p. 89 [online]

42

Baird & Bernstein, Absolute Priority, Valuation Uncertainty, and Reorganisation Bargain, Yale Law Journal, 2006/115 p. 1937 [online]

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Chapter 3

3.1 Brief Overview of the US Chapter 11 Procedure

The US has a long history with business reorganisation going back to the Bankruptcy Acts of 1867 and 1898 where it was policy to rescue and rehabilitate a business debtor providing them a fresh start and enable them to contribute to society once again. The theory that a business generally is more valuable to creditors and society as a whole if it reorganises rather

than liquidates also emerged during this period44. This approach contrasted with the

Europeans throughout last century, where liquidation was the only option for businesses, exerted as a punishment for their failure. Thus, with its progressive attitude and long history of reorganisation, the US Chapter 11 reorganisation procedure is both in theory and practice the most influential insolvency procedure in the world as a number of countries have derived inspiration from it45.

3.1.1 Presentation of a Plan

Chapter 11 focuses on protecting the going concern value of the business over liquidation value. The US legislator decided that when a company files for Chapter 11 procedure the

running of a company, generally46, remains in the hands of the debtor in possession (‘DIP’).

These are usually the same person that managed/owned the company before the filing a Chapter 11 petition. The DIP maintains control over the company’s assets, under the duties

and restrictions set down in 11 U.S.C.A § 1107(a)47. They have a broad discretion in the day

to day operations of the company and conducts daily operations without court review. Thus the DIP retains control of the business even though it is their management that has possibly placed the company in such peril. Consequently it has been said that the Chapter 11

procedure is very ‘pro-debtor’48.

In Chapter 11 there is no requirement for insolvency as a company may for a number of reasons decide to restructure. They could for example be facing massive tort liabilities. It will, usually, be the debtor that proposes the plan as they have the exclusive right to file a plan over a period of 120 days. This period also provides the debtor with a moratorium which prevents enforcement of securities or judgments. The debtor will try to stabilise finances within this timeframe and formulate a restructuring plan. Thus before the presentation of a plan the debtor will be required to negotiate with creditors’ to restructure the business as it is the creditors’ who take a ‘haircut’ on their entitlements. This is an obvious necessity for restructuring as almost by definition their claims will be in excess of the debtors’ available

44

American Bankruptcy Commission, Commission to Study the Reform of Chapter 11, 2014 p. 9 [online]

45

Wessels, B & de Weijs, R., Proposed Recommendations for the Reform of Chapter 11 U.S. Bankruptcy Code,

Ondernemingsrecht, 2015/37, para. 1. The countries mentioned who have taken inspiration from the Chapter 11 are Spain, Germany and Italy.

46

Unless a trustee is appointed due to fraud, mismanagement or incompetence and the evidence is overwhelming 11 U.S.C.A § 1104(a)(1). Or an examiner is appointed to investigate the affairs of the company in the interest of creditors and equity holders §1104(b)

47

11 U.S.C.A § 1107(a)

48

Morrison & Ayotte, Creditor Control and Conflict in Chapter 11 Bankruptcy, Journal of Legal Analysis 2009/1 pp. 511-551. The authors disagree with this view and provide empirical data to confirm that creditors are mainly in control of the Chapter 11 process.

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assets. A company proposing a plan must do so in good faith and issue a disclosure statement containing adequate information for a creditor to appropriately deliberate on the proposed

plan49. The creditors then can make an informed decision on whether to accept or reject a

plan.

Under Chapter 11 a proposed plan must be in the ‘best interests’ of the creditors, meaning that each creditor must receive payment equal at least in value to the amount that creditor

would receive in liquidation in Chapter 750. To satisfy this test, debtors when proposing a

plan will offer creditors more than they would receive in liquidation. This may be a nominal figure, as in the normal course of insolvency unsecured creditors in liquidation receive next to nothing on the claim that is owed to them. This test can lead to disputes over the valuation of the business as a debtor can apply a low valuation to the business which may be contrary to what creditors believe the business is worth. Should creditors wish to oppose confirmation of the plan, they can do so if they can prove the business should be valued higher thereby

ensuring a higher return on their claim under Chapter 751. Valuation of a business is highly

subjective and costly to determine, therefore for unsecured creditors who oppose a composition plan this is not an option pursued lightly.

3.1.2 Acceptance and Approval of a Reorganisation Plan

Confirmation of a reorganisation plan requires approval from creditors whose claims and interests have been impaired. These creditors are divided into classes according to their similar rights and interests, for example unsecured creditors will be classed together. Each impaired member of a class receives a vote, but there is nothing contained in the Chapter 11 procedure that all creditors must vote on the plan. The voting thresholds for approval of a plan by classes of creditors whose rights are impaired, is that each class must hold a majority

of more than one-half in number, and at least two-thirds in amount52 of those that voted, to

accept the plan. A plan will be deemed to be accepted if all the impaired classes of creditors agree to the proposed plan. However if all impaired class are not in agreement, then one class

of creditors can accept the plan provided its fair and equitable53.

Therefore, the thresholds for approval of the plan are low as a reorganisation plan could be approved by less than fifty percent of the creditors. This leaves the dissenting creditors in a vulnerable position as one class of creditors, such as senior creditors, could bind all the other creditors to the plan when a cram down is ordered by a court. This creates an inequality of bargaining power as the debtor only requires one class to approve of their plan and the debtor understandably would seek the approval of the financial institutions as they are necessary for the future of the business. Such an imbalance of power damages the interests of the weaker parties, such as unsecured creditors, as the law tips the balance of power to larger parties who have the wealth and strength to enforce their will on all parties in the reorganisation procedure. As previously discussed, voting thresholds are a necessary part of the

49 11 U.S.C.A § 1125(a)(1) 50 11 U.S.C.A § 1129(a)(7)(ii) 51

Epstein, Nickles & White, Bankruptcy, 1993, p. 762

52

11 U.S.C.A § 1126 (C)

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reorganisation procedure, but they do have the effect that dissenting creditors can losing their rights when can other parties vote with no regard for the dissenting creditors’ claims.

3.1.3 Protection of the Creditors under the Absolute Priority Rule

When one or more class of creditors have rejected a proposed reorganisation plan, the debtor can request a cram down from the court to overrule their decision. This court would grant such an order “if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the

plan”54. This ‘fair and equitable’ treatment of dissenting classes has been long recognised in

US Bankruptcy law. It was established in the seminal case of Northern Pacific Railway Co. v Boyd where the US Supreme Court held that "[I]f purposely or unintentionally a single creditor was not paid, or provided for in the reorganization, he could assert his superior rights against the subordinate interests of the old stockholders in the property transferred to the new

company."55A line can be drawn from this statement to the fundamental ordering in

insolvency, creditors are to be paid in full before equity receives any distribution.

The absolute priority rule stems from this broad principle whereby reorganisation plans have to be fair and equitable. The rule is codified under § 1129(b) (2) (B) (ii). The section provides for unsecured creditors that “the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest

any property”56. The rule will only be enforced if the proposed plan violates APR. Thus the

court will grant a cram down provided the rule of absolute priority has been adhered to – lower ranking creditors and shareholders may not receive anything until all higher ranking creditors have been paid in full.

This provision tips the balance of power back in the dissenting creditors favour as it encourages debtors to negotiate. The rule provides that a debtor, whether a small or large company, cannot keep any equity unless all creditors are paid in full or they obtain agreement from each class. The leverage the debtor had in seeking a cram down is mitigated by the absolute priority rule as it transfers some leverage to the unsecured creditors. The creditors who engage in the reorganisation procedure also share some of the power. Under the voting thresholds the majority can exert their will, but the dissenting minority have protection against a cram down by invoking the absolute priority rule. Therefore, the classes of creditors have to compromise and negotiate before the plan is proposed to ensure that all impaired classes reach a settlement that is agreeable to all thereby avoiding the ‘absoluteness’ of APR.

3.1.4 Tempering the ‘Absoluteness’ of the Absolute Priority Rule

The US courts recognised that the absolute nature of the rule can be problematic. Its ‘absoluteness’ can hinder a successful reorganisation of a healthy company. The US courts in order to solve the problems that the rule can generate have introduced the ‘new value’ exception to APR (§3.1.4.1). Furthermore in recognition of the obstacles that APR can create

54

11 U.S.C.A §1129 (b)

55

Northern Pacific Railway and Northern Pacific Railroad Company, Appts v. Joseph Boyd, 228 U.S. 482 (33 S. Ct. 554, 57 L. Ed. 931) 1913

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to a successful reorganisation for SME’s, the American Bankruptcy Institute has issued a recommendation for shareholders’ of SME’s to retain equity (§3.1.4.2).

3.1.4.1 ‘New Value Exception’

The courts have introduced the ‘new value exception’ which allows original owners to retain

the equity they had in the company. The Supreme Court in Case v Los Angeles Lumber57

decided and concluded that shareholders who retained equity had to contribute more than simply participating in the new restructured company. To retain such interests they must contribute ‘new value’ to the rescued company, provided that the ‘new value’ fulfil certain requirements: (1) the contribution is new and substantial; (2) must be contributed in money or money’s worth; (3) the contribution is ‘necessary’; (4) reasonably equivalent of retained stake. This exception requires a shareholder to take an entrepreneurial risk in the company as the ‘new value’ is a contribution to the balance sheet similar to the creditors ‘hair cuts’ are a contribution to the shareholders equity.

There has been much debate in the US among scholars’ and courts as to whether the ‘new value exception’ is contained within the Bankruptcy code. The debate surrounds two differing opinions. The first theory is that the ‘new value exception’ can be inferred from the language contained in the code, in particular, the phrase ‘on account of such junior claim or interest’ which thereby permits shareholders to commit new value to the business because of

this status58. Whereas the second opinion implies, in simple terms, that as the legislators did

not include the exact phrase in the Code then there is no exception to be applied59. The

controversial debate still continues, even after the ruling in the 203 North LaSalle60 case,

where it was hoped some clarity would be brought to the issue. The US Supreme Court confirmed the existence of the ‘exception’ in certain circumstances but the application of the

exception varies in the lower courts61 as the Court did not confirm the conditions for its

application.

The American Bankruptcy Institute (ABI) Commission, on the reform of Chapter 11, recommends that the conditions laid down in Case should be codified. However, the question remains that a ‘new value exception’ may only apply to large corporations with a stronger possibility of finding an investor. An SME in financial distress may struggle to obtain new finance and the ABI have recommended a reform to the absolute priority rule for SME’s.

3.1.4.2 Absolute Priority Rule and SME Equity Retention Plan

As discussed, the absolute nature of APR can hamper the confirmation of a rescue plan that would help a financially distressed but potential viable business return to health. Rather APR can be the nail in the coffin of a business, in particular, an SME and this is an issue that the ABI considers in their report on Chapter 11.

57

Case v. Los Angeles Lumber Products, 308 U.S. 106 ( 1939). For summary of the case and its impact see Bob Rasmussen,

The Story of Case v. Los Angeles Lumber Products: Old Equity Holders and the Reorganised Company, Vanderbilt Law and

Economics Research Paper 2007/08

58

Epstein, Nickles & White, Bankruptcy, West Publishing Co, p. 845

59

Warren, Theory of Absolute Priority, Ann. Surv. Am. L. 1991/9 p.31

60

Bank of America National Trust and Savings Assn. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 1999

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Among the recommendations to reform certain areas of the Chapter 11 procedure. One of the recommendations concerns APR and the impact it has on the reorganisation of SME’s in particular, these are businesses that would most likely have an owner-manager. There may be value attached to these shareholders’ and in reorganisation they may wish to retain equity in the company, even though the creditors have not been paid in full. This would be a violation of the absolute priority rule if the court must impose a cram down on the dissenting creditors. The rule in its present condition may stop some owners entering Chapter 11 if their equity is to be wiped out. This is an inefficient outcome for insolvency law in the US as SME’s

account for an equivalent of roughly 40 percent of the US GDP62. Thus SME’s are hugely

important to the economic growth of the US economy, yet the current rules are an obstacle to a successful reorganisation.

The proposal defines an SME as having no publicly traded securities in its capital structure

and less than $10 million in assets or liabilities on a consolidated basis63. The SME Equity

Retention Plan is only applicable when it is not accepted by any class of unsecured claims

and is crammed down on these dissenters.64 The main requirements of the plan are twofold: i)

the pre-petition equity holders remain involved to support the debtors’ emergence from Chapter 11 and ii) the reorganised debtor must pay the unsecured creditors annually its excess

cash flow65. Before the fourth anniversary of the effective date, the prepetition equity will

retain 100 percent of the common stock and will be entitled to 15 percent of the dividends, whereas the unsecured creditors receive 100 percent of preferred stock and are entitled to 85

percent of the dividends.66 After the date of the fourth anniversary if the unsecured creditors

full face amount of debt has not been repaid or if it has been reduced, the preferred stock is converted into 85 percent of common stock or the equivalent remaining amount. Thereby the unsecured creditors could become the majority shareholder holding 85 percent of the

company with old equity just retaining 15 percent67.

Thus, under these proposals, the only way to prevent a class of unsecured claims becoming a shareholder is to repay their debt within the four years. This is an incentive to the old equity holder to work hard during these years if they wish to retain ownership of their business. Is this too much of a burden for the old owners and is it realistic to think that all debt will be paid off in four years? Consideration should be given as to whether it is a little improbable that a company could really turn its business around in such a short time period. Furthermore, would an owner be inclined to work hard in order for their business to be viable again, only to be left with minimal ownership. The proposal is possibly a little unrealistic in regards to the percentages, but the sentiment is just and equitable. Old equity has to contribute to reorganisation either by providing value in monetary terms or by providing the value that is attached to the shareholders themselves.

62

American Bankruptcy Institute, Commission To Study The Reform of Chapter 11, 2014, p. 276

63

Ibid pg 279. The ABI undertook extensive research to make this determination. On page 286 there is an insightful pie chart on the revenue of debtors who filed for bankruptcy in 2014 with 62% with revenues under $500,000.

64 Ibid pg 297 65 Ibid pg 297 66 Ibid pg 297 67_{Ibid pg 297 & 298}

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Chapter 4

4.1 Brief Overview of Restructuring Procedure in Germany

When one thinks of Germany, efficiency and proficiency spring to mind. Therefore it is surprising that Germany insolvency law has been criticised as being inadequate to support successful company restructuring preferring to punish the debtor by liquidating the business. These criticisms led to the introduction of a new Insolvency Statute, Insolvenzordnung (InsO)

in 1999. However, even with the introduction of the new statute, the inadequacies remained68

and a number of significant amendments have been made. The last major reform was the Act

for the Further Simplification of Company Restructuring (ESUG)69 March 2012 with further

amendments in a second reform in July 2014.

This major reform package of the ESUG has brought about a simplification in the way companies are restructured in Germany, so that companies struggling financially will file for

insolvency before the financial situation becomes irreversible70. The most important new

provisions in the ESUG allow for an increase in creditor participation in reorganisation through the Preliminary creditors’ committee, strengthening the creditors position by permitting the impairment of shareholders’ interests and adopting a similar approach to Chapter 11’s ‘debtor in possession’ proceedings, permitting self-management in insolvency

“Eigenverwaltung”. There has been an increase in the number of insolvency applications71

that have been made since these reforms were introduced in Germany in contrast to the little

used former insolvency plan procedure72.

4.1.1 Presentation of a Plan - Insolvenzplan

The purpose of the Insolvenzplan is to preserve the company’s going concern value and to evaluate whether there is a possibility to restructure the company so that might be viable in the future. The plan can be submitted only by the debtor and the insolvency practitioner to the court73.

68

Ringe, Forum Shopping under the EU Insolvency Regulation, Euro. Bus. Org. L. Rev. 2008/9, p. 585. Schefenacker this infamous case saw a Germany company convert itself into a English company and move its centre of main interests to England in order avail of the English restructuring procedure. The reason for the conversion was that German restructuring law was perceived to be too rigid and did not facilitate successful restructuring. The criticisms levelled at the German restructuring law were parties lack of influence over the appointment of insolvency practitioner, mandatory insolvency application, conflicts between company and insolvency law and lack of possibility for a debt equity swap. This case along with Deutsche Nickel are said to have influenced the German legislature to look at reform.

69

Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen

70

Eurojuris International, Major Changes in German Insolvency Law, 08-03-2012 [online] ‘One of the most criticised weakness of German insolvency proceedings was the relatively high percentage of companies that were irrevocably destroyed during insolvency proceedings’

71

Tschentscher, The Modern German Insolvency Regim e, Inter. Corp. Res. 2013/3. In the short period between 1 March 2012 and 8 October 2012, some 1502 insolvency applications were presented that made use of the new tools available under the reformed law, the vast majority being applications for (variations of) debtor in- possession style

'self-administration' proceedings.

72

Mayer Brown, German Insolvency Law An Overview, 30-10-2014 p. 1 [online]

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The ESUG reform introduced a new debtor self-administration (Eigenverwaltung)

procedure74, which is comparable to the Chapter 11 procedure of allowing the debtor to

remain in possession of the company and manage its affairs throughout the insolvency proceedings. This reform is an exception to the insolvency practitioner taking control of the

company and is being increasingly enacted in restructuring cases75. The debtor is supervised

and advised by a Court appointed insolvency monitor76 and the monitors’ consent may be

required for any major business decisions77. Thus, the insolvency monitor provides protection

for creditors if the debtors management of restructuring in any way detrimental to the creditors.

The most significant rule is possibly that the Court must accept a petition for self-administration if it has been unanimously agreed upon by the preliminary creditors

meetings78. Thus, a debtor, in preparing a petition to remain in control of the company, must

negotiate and gain the support of the creditors. The creditors then have the power to ensure that the restructuring plan is agreeable to them. Unanimous agreement may be difficult to obtain but to assuage the creditors, companies will often appoint an insolvency practitioner as

general manager or Chief Restructuring Officer before filing for insolvency79. Therefore

while the debtor may have control over the restructuring proceedings they are undoubtedly directed by the creditors, who hold the power to have the self-administration order revoked if certain requirements are not met. The conclusion must be that the creditors feel that self-administration will give them the best chance of recovering part of their claim and they still have the power to influence restructuring proceedings.

The German Insolvency Statue also provides for the opening of preliminary insolvency proceedings (vorläufiges Insolvenzverfahren). This is where one of the most important

reforms of the ESUG, where in the court appoints a preliminary creditors committee80. The

creditors committee appoints the preliminary insolvency practitioner. The insolvency practitioner must be qualified and once the committee has given their unanimous support to them, the Court, in principle must recognise the appointment or provide justification for the

refusal81. The impact this reform is significant as it enables the creditors to exert their

influence on the insolvency proceedings by choosing an insolvency practitioner that will have the creditor’s business strategy in mind to restructure the failing, but possibly healthy company. Previously the position of creditors was such that they could not influence the choice of insolvency practitioner who was chosen exclusively by the court. This led to the destruction of the going concern value of the company’s assets as the insolvency

practitioners’ task was solely to realise the sale of the assets as quickly as possible82 in order

to satisfy the creditors’ claims. When the insolvency proceedings are opened that the

74_{§270 InsO} 75

Wessels & de Weijs (Ed), ABI Advisory Committee on Comparative Law, Question 4, Role of Administrators and

Monitors: Germany p. 15 76 §270 (C) InsO 77 §275 InsO 78 §270 (3) InsO 79

Wessels & de Weijs. (Ed), ABI Advisory Committee on Comparative Law, Question 4, Role of Administrators and

Monitors. Germany p. 15 80 § 21(2)(1)(a) InsO. 81 §27(2)(5) InsO 82

Plank, Meyer-Löwry & Pickerill, New Germany Insolvency Code, ABI Journal, March 2012/31 pg 3 [online] The authors provide reasons as why insolvency practitioners liquidated quickly, partially to limit his or hers liability due to deterioration of assets post filing. Also to avail the full benefit of salary payments guaranteed for three months by the German Federal Employment Service.

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preliminary insolvency practitioner is appointed as the insolvency practitioner83 who has

already been hand-picked by creditors.

Thus two competing plans may be presented to the court, by the debtor or insolvency practitioner, after the opening of insolvency proceedings. The insolvency plan will contain provisions with regards to how the debtors assets will be affected pertaining to creditors’

claims and if for example a debt for equity swap is to take place84. In order for the plan to

take effect it has to be approved by the debtor, creditors and the shareholders who vote on the plan85.

4.1.2 Acceptance and Approval of a Reorganisation Plan

The rules for acceptance and confirmation of the reorganisation plan under German insolvency law are heavily influenced by Chapter 11. The creditors may be placed into

different classes in accordance with their similar rights and interests86 providing for equal

treatment of the creditors whose claims have been impaired within a class. A class of creditors can accept a plan where they are more than half in number, and also represent one

half of the total amount of claims are necessary in each class87. Furthermore, not all creditors

who are entitled to vote may have their vote counted as under §242 InsO voting in writing shall not be counted unless received by court one day in advance of voting meeting.

For a reorganisation plan to be confirmed a majority of more than 50 percent of all voting

classes must accept the plan88. §243 and §248 InsO provides that each group with voting

rights shall vote separately. In principle, this pertains to the debtor, all classes of creditors and the shareholders. When the plan is rejected by a majority vote within a class, there is a

possibility of a cram-down89, if the ‘best interest test’ has been satisfied. Under the test, a

plan may be confirmed if the Court is of the opinion the members of the voting groups “are

likely not to be placed at a disadvantage by the insolvency plan”90. Accordingly, it is highly

unlikely that that a court would think of the shareholders as disadvantaged, as in liquidation their equity is wiped out.

The thresholds are low as the requirement for acceptance of the plan is just over fifty percent majority of creditors in a class. But a majority of classes must accept the plan. This is not a significant protection for creditors who disagree with the plan. If there are five classes only three need to agree. This could lead to under handed negotiation tactics from parties who pursue their own interests. In addition to the protection that the creditors committee now provides for all creditors the German legislature has also taken inspiration from the US and APR is codified under §245(1)(2) of the German Insolvency Act.

83

§27(1) InsO

84

A debt for equity swap is now permissible after the ESUG reforms under §225(a) InsO and is seen as strengthening the creditors position. It was not available to creditors previously due to impairing shareholder interests. It is restructuring instrument used regularly in the UK and US and provides effective means of restructuring a company. Under German law it is now achieved either by an increase of capital through in kind contributions (Sackapitalerhöhung) or a share deal. Creditors have to agree to become shareholders in the new company.

85 §243, §248 InsO 86 §222 InsO 87 §244 InsO 88 §245(3) InsO 89 §245 InsO 90_{§245 (1) InsO}

Dividing the insolvent’s pie - can the US show the Europeans the fairest way? : A comparative assessment of the need for an Absolute Priority Rule in European Insolvency Law