The University of Amsterdam
Fair Distribution and Enhancing Reorganisation: Striking a Balance
Maria Louise Nitschke 11098333
Master’s Thesis LLM European Private Law
Insolvency Law Prof. Dr. Rolef J. de Weijs
Abstract
Reorganisation is micro- and macroeconomically beneficial if the struggling business has a sound business idea and is merely temporarily facing financial problems. From a microeconomic perspective, establishing a rescue culture is beneficial for the business, as the sound business idea can be further exploited and future cash flows will generate a surplus value. From a macroeconomic perspective, society as a whole will benefit as social costs inherent in business disappearance are minimalized.
Thus, insolvency laws need to enhance rescue attempts while at the same time ensuring fair distribution of the surplus value among stakeholders. Fair distribution requires deciding whether creditors and/or shareholders should be entitled to the surplus value. This means determining how pre-bankruptcy rights should influence the distribution and thus whether the APR should be embraced.
Creditors and shareholders both will try to grab as much of the surplus value as they can by threatening to withhold plan consent and thereby hamper reorganisation. In order to enhance reorganisation holdout positions must be weakened by renouncing unanimous consent. Voting in classes, adopting voting thresholds and cram down of dissenting classes mitigate holdout positions.
This thesis provides a normative analysis of the APR as main default distribution rule followed by the presentation of two sets of national distribution rulesand an evaluation of the APR.
The APR allows for a cram down of a dissenting class if no lower ranking class receives or retains any value. The APR thus emphasises on pre-bankruptcy rights and thereby upholds the difference between creditors and shareholders: they initially bargained for different legal positions. There are several benefits of the APR: (1) shareholders are prevented from excessive risk-taking as the APR puts them last in line; (2) over-all capital costs for the debtor decrease as the APR reduces the creditors’ risk and (3) the APR embodies the creditors’ bargain theory.
The evaluation embraces the APR in principle, pre-bankruptcy entitlements must be respected from a fairness viewpoint. The APR guarantees a fair distribution of surplus value, however strict adherence will hamper reorganisation, as essential shareholders are denied any incentives to participate in reorganisation. Thus fair distribution and enhancing reorganisation are partially conflicting goals.
An efficient insolvency law must find a balance. This thesis proposes to strike the balance through applying a mitigated APR. Two exceptions are deemed to be necessary in order to provide sufficient, but minimal incentives for essential shareholders. These derogations are (1) the new value exception and (2) an Equity-Retention-Plan for instrumental shareholders. Shareholders are not entitled to receive any of the surplus value from a fairness viewpoint, but only because without such an entitlement reorganisation would fail, essential shareholders would no longer participate in reorganisation. The shareholders’ part of the surplus has to be kept at a minimum level that nevertheless provides the latter with sufficient incentives to further reorganisation. An efficient insolvency law can ensure fair distribution only as long as this goal does not hamper reorganisation.
Table of Contents
Introduction ... 1!
Chapter 1: Notion of “fair” distribution ... 3!
I. Hold out problems ... 3!
II. Class composition ... 4!
1. Voting in groups and limits on class composition ... 4!
2. Thinkable manipulative class compositions ... 4!
3. Class composition requirements ... 5!
III. Cram down ... 5!
1. The APR and its advantages ... 6!
2. Critics of the APR: putting shareholders last in line may cripple reorganisation ... 7!
a) Putting instrumental shareholders last in line cripples reorganisation ... 7!
b) Putting shareholders last in line ignores their legal position ... 9!
3. Mitigating the APR: securing the contribution of essential shareholders ... 10!
Chapter 2: Distribution under the German Insolvenzordnung ... 11!
I. Right to file an insolvency plan, § 218 InsO ... 11!
II. Class composition, § 222 InsO ... 11!
1. § 222 I InsO: Class composition based on different rights ... 12!
a) § 222 I 2 Nr. 1 InsO: Creditors entitled to separate satisfaction ... 12!
b) § 222 I 2 Nr. 2 InsO: The senior creditors ... 13!
c) § 222 I 2 Nr. 3 InsO: The junior creditors ... 13!
d) § 222 I 2 Nr. 4 InsO: The shareholders ... 13!
2. 222 II InsO: Class composition based on different interests ... 14!
a) § 222 II 1 InsO: Equivalent economic interests ... 15!
b) § 222 II 2 InsO: Newly formed groups must adequately be separated from each other ... 15!
c) Necessity of a general abuse-control to prevent manipulative group composition? 16! III. § 244 InsO: Voting thresholds ... 16!
IV. § 245 InsO: Cram down ... 17!
2. § 245 I Nr. 2, II, III InsO: Members of the dissenting group adequately participate in the surplus value ... 18!
a) § 245 II InsO: Reasonable participation of creditors in the surplus value ... 18!
aa) § 245 II Nr. 1 InsO: No creditor receives economic value exceeding the full amount of its claim ... 18!
bb) § 245 II Nr. 2 InsO: Neither a lower-ranking creditor, nor the debtor, nor his shareholders receive an economic value ... 18!
cc) § 245 II Nr. 3 InsO: The insolvency plan must not put any equal ranking creditor class in a better position than the dissenting creditor class ... 19!
b) § 245 III InsO: Reasonable participation of shareholders in the surplus value ... 19!
3. § 245 I Nr. 3 InsO: The majority of classes accepted the plan ... 20!
V. The German balance between “fair” distribution and enhancing reorganisation ... 20!
Chapter 3: Distribution under the US Bankruptcy Code ... 23!
I. Right to file an insolvency plan, § 1121 BC ... 23!
II. § 1122 BC: Class composition ... 23!
1. Classification theories ... 24!
a) Class composition taking into account rights and interests ... 24!
b) Class composition solely taking into account rights ... 24!
2. § 1122(a) BC: Substantially similar claims and equity interests (prohibition of over
inclusion) ... 25!
3. Division of substantially similar claims/equity interests into more than one class: under inclusion ... 26!
a) Different interpretations concerning the permissibility of under inclusion ... 27!
b) Negative requirement of under inclusion ... 27!
c) Positive requirements of under inclusion ... 28!
aa) Legitimate business reason ... 28!
bb) Nature of claim approach ... 30!
cc) Plain meaning approach ... 31!
III. § 1126 BC: Voting thresholds ... 31!
IV. § 1129 (b) BC: cram down ... 31!
1. § 1129(b)(1) BC: no unfair discrimination ... 32!
2. § 1129(b)(1),(2) BC: Fair and equitable test ... 33!
a) § 1129(b)(2)(A) BC: Secured creditor cram down ... 33!
b) Unsecured creditor cram down, § 1129(b)(2)(B) BC ... 34!
c) § 1129(b)(2)(C) BC: Equity cram down ... 35!
d) Exceptions to the APR ... 35!
The American law allows for one exception to the APR, the new value exception. In addition, the ABI proposed a second exception to the APR, the SME Equity Retention Plan. ... 35!
aa) The new value exception ... 35!
bb) The SME Equity Retention Plan ... 37!
V. The US balance between “fair” distribution and enhancing reorganisation ... 39!
Chapter 4: Comparison of the two national systems ... 41!
I. Class composition ... 41!
1. Over inclusion ... 41!
2. Under inclusion ... 41!
3. Conclusion ... 43!
II. Voting thresholds ... 43!
III. Cram down ... 44!
1. Majority consent on a class level ... 44!
2. Fair and equitable treatment and the APR ... 45!
3. No unfair discrimination ... 45!
Chapter 5: Critical assessment of default distribution rules ... 47!
I. Criteria to evaluate default distribution systems ... 47!
1. The macroeconomic perspective: Optimal use of assets ... 47!
2. The microeconomic perspective: Fair distribution ... 47!
3. Legal certainty: Feasibility ... 47!
II. Critical review of Madaus’ default distribution system ... 48!
III. Critical review of Jackson and Baird’s default distribution system ... 49!
IV. Embracement of the APR ... 49!
1. Critical review of the German and US distribution system ... 50!
2. Critical review of the Equity Retention Plan ... 51!
Chapter 6 - Conclusion: Embracement of the APR and its two mitigations ... 54!
I. The APR as a default rule for dissenting classes or as individual minimal guarantee? .... 54! II. The two exceptions to the APR: New value exception and SME Equity Retention Plan55!
Introduction
In times of financial difficulties, business assets shall be put to their best use. Optimal use of assets is beneficial for all involved stakeholders and society as a whole. Micro- and macroeconomic perspectives are aligned.
How assets are put to their optimal use, depends on the circumstances. In the long run, stakeholders and society are better off if businesses lacking a sound business idea are shut down. In case of a good business idea, the latter can generate future cash-streams, the generated surplus can be distributed to the old stakeholders. Reorganisation is thus beneficial from a microeconomic perspective. From a macroeconomic perspective exploiting the sound business idea entails survival of the company and thereby limits social costs1.Survival of the debtor can either be accomplished by a going-concern liquidation (third party acquirer) or by means of reorganisation (virtual sale to stakeholders).
Reorganisation can have several benefits over going-concern liquidation, e.g. non-transferable assets are maintained. In addition, a third party acquirer will most likely pay less for the business than an informed stakeholder due to information asymmetries. Reorganisation is thus beneficial on the macro- and on the microeconomic perspective, as stakeholders get a higher pay-out rate. Thus, legislators strive to establish a rescue culture and enhance reorganisation. In case of reorganisation old stakeholders become the new owners. To simplify the complex question which stakeholders become the new owners, creditors will be seen as one homogenous group. The question is whether creditors or shareholders should be the new owners.
From a microeconomic fairness viewpoint, creditors should become the new owners. Their pre-bankruptcy rights entitle them to the surplus value: reorganisation is done for their benefit. In addition, reorganisation requires creditors to consent to a partial debt-write down or a deferral. Creditors are always essential for reorganisation and must be compensated. However, this distribution excludes old shareholders and can stifle reorganisation if shareholders are essential for successful reorganisation. Shareholders are essential if they are the only ones willing to contribute new funds or if they have special skills (instrumental shareholders). Reorganisation requires creditors and essential shareholders to co-act. The surplus value then probably should be shared between creditors and essential shareholders. The two goals of fair distribution and enhancing reorganisation are conflicting: Giving the whole business to creditors would be fair but can stifle reorganisation in case of essential
1 Baird, Bankruptcy’s Uncontested Axioms, Yale L.J. 1998, p. 577 (online)
shareholders.
In my thesis I will therefore examine how insolvency law can ensure a fair distribution of surplus value among stakeholders in a reorganisation without stifling rescue attempts.
Distribution of the surplus value among stakeholders can be seen as a two-step procedure. First, the shareholders’ part of the surplus has to be determined, second the creditors’ part of the surplus has to be further subdivided among different creditor classes. I will emphasise on the first step only.
As method I use a normative analysis of the legal problem followed by a description of two national sets of distribution rules.
In a first chapter Iwill examine solutions proposed in literature concerning fair distribution of surplus value in reorganisation. In particular I will discuss advantages and drawbacks of the APR.
In a second and third chapter, I will present two sets of national distribution rules, the German and the American distribution rules. In particular, I will analyse the national provisions concerning class composition, voting thresholds and cram down. As unanimous stakeholder consent to reorganisation is unlikely, the legislator must provide safeguards to overcome unjustified dissent and thereby give reorganisation a viable chance. Cram down is by far the most controversial criterion out of the three. However, class composition, voting thresholds and cram down are intertwined, as they all influence the distribution of the surplus value. Analysing class composition and voting thresholds is a prerequisite for a cram down analysis. The German law constitutes an important European legal system and will therefore be included in my research. So far, Germany is not considered to have any substantial rescue culture, however it strives to establish one. A first step towards a rescue culture was the introduction of the ESUG (Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen) in 2012. The second national legal system that will be studied is the US restructuring tool as established under Chapter 11 of the Bankruptcy Code (BC). The German system has drawn largely from the latter, it will be interesting to analyse the differences. In a fourth chapter, I will compare the distribution rules in both legal systems following a functional approach.
In a fifth chapter, I evaluate the presented cram down rules and in a last chapter I provide a short conclusion including a cram down rule I deem to be fair.
Chapter 1: Notion of “fair” distribution
Restructuring means that an insolvent business survives by means of a (partial) debt write-down and business continuation by the old debtor/old creditors. If there is a sound business idea, restructuring can be economically beneficial. The business is merely temporarily facing economic and not structural problems.
Different stakeholder groups have to contribute to reorganisation and thus make the creation of surplus value possible. Distribution questions are at the heart of reorganisation. Stakeholders are free to distribute the surplus as they see fit as long as they reach an agreement.
Obviously, every single stakeholder -acting as a homo oeconomicus- will try to “grab” as much of the surplus value as possible. Stakeholders might threaten to withhold plan approval, which would endanger reorganisation. To weaken individual holdout positions, voting occurs on a class level. However, this is not sufficient as a whole class can hold out for strategic reasons, additional cram down rules are necessary.
I. Hold out problems
The distribution of surplus value creates hold out issues2. Hold out positions in reorganisation can be seen as a specification of anticommons situations: Several parties are entitled to the common use of a good, but each party can prevent the others from benefitting from the good3. In reorganisation, each stakeholder can block the other stakeholders from seizing the surplus value by denying plan approval and thus prevent the most efficient economic outcome. Holdout positions entail underuse4, only joint action of all stakeholders prevents inefficiency. In reorganisation anticommons problems are aggravated as reorganisation follows an all-or nothing approach. Without limitation, stakeholders can demand a high price for their approval, as the latter is indispensable to create the surplus. Disapproval of the insolvency plan should be caused by stakeholders believing they would be better off in liquidation as compared to reorganisation. Instead, withhold is merely caused by strategic behaviour. Stakeholders as a whole think they are better off with reorganisation, but by holding out individual stakeholders hope to be even better off5. Hold out for the wrong motives must be
2 More generally: Heller, The Tragedy of the Anticommons: Property in the Transition from Marx to Markets, Harv. L. Rev. 1997-98, p. 677 (online)
3 Ibid, p. 668
4 De Weijs, Harmonisation of European Insolvency Law and the Need to Tackle Two Common Problems: Common Pool and Anticommons, INSOL 2012, p. 72 (online)
5 Fennell, Commons, anticommons, semicommons, 2010, p. 42 (online via http://ssrn.com/abstract=1348267)
restricted, reorganisation must be protected against transgression of individual stakeholders or stakeholder groups6.
One solution for hold out problems would be to insist on the application of pari passu. Every stakeholder having the same rank would receive the same pro rata share. Hold out would no longer pay off. However, reorganisation heavily relies on putting to use the different willingness of stakeholders to contribute to reorganisation. Some stakeholders might be willing to cede some of their entitlements. Consequently, the creation of surplus value and its amount relies on the deviation of pari passu7. Holdout should be restricted in order to make reorganisation possible. However, insisting on pari passu decreases the plan proponent’s flexibility and thus hinders reorganisation; strict application of pari passu would be self-defeating.
II. Class composition
Class composition has a twofold aim, on the one hand it uses the different willingness of stakeholders to contribute to reorganisation, pari passu only applies within a class. On the other hand voting on a class level weakens individual hold out positions.
1. Voting in groups and limits on class composition
Instead of voting in a plenary assembly, each class must accept the plan by a majoritarian vote within the class8.
Abusive class composition must be forbidden. Firstly, the insolvency plan foresees different curtailment of different groups, it is important for each stakeholder to which group she belongs. The law must provide for rules limiting the plan proponent’s ability to place stakeholders in random groups. Group composition rules must ensure that no stakeholder is treated unfairly due to belonging to a certain group. Secondly, class composition solely aiming at reaching the required majorities must be forbidden.
2. Thinkable manipulative class compositions
The plan proponent might artificially put a dissenting stakeholder in a class together with approving stakeholders, who then outvote the dissenting stakeholder. Namely, the plan
6 De Weijs, Harmonisation of European Insolvency Law and the Need to Tackle Two Common Problems: Common Pool and Anticommons, INSOL 2012, p. 67 (online)
7 For a concrete example: Ibid, p. 75
8 Madaus, Rescuing companies involved in insolvency proceedings with rescue plans, Report NVRII – NACIIL Conference on „Corporate Rescue“ 2012, p. 25
proponent could put a senior creditor in a class of junior creditors willing to accept the plan. The class-majority votes in favour of the plan, the negative vote of the dissenting stakeholder will not reflect on the result.
Alternatively, the plan proponent could form a class of dissenting stakeholders. This alternative requires a cram down. However, the plan proponent prevents the accepting stakeholders being outvoted by dissenters and thereby secures the consent of another class. This might be important, as cram down rules often require at least one class to accept the plan.
Furthermore, the plan proponent might split up a class of consenting stakeholders in order to artificially increase the number of consenting classes. This is important if the law requires a certain threshold of groups to accept the plan in order to cram down dissenting groups.
3. Class composition requirements
Each stakeholder must be guaranteed to receive at least the liquidation value. All stakeholders within a class are treated equally; a majoritarian vote within a class can only bind the dissenting minority if the proposed curtailment affects all group members equally. This requires stakeholders within a class to have the same legal priority. This requirement prevents over inclusion and thus artificial placement as described in the first possibility of manipulative class composition.
Furthermore, in order to enhance reorganisation, the plan proponent must be allowed to make use of the different willingness to contribute to reorganisation. The proponent can sub-divide classes according to the stakeholders’ different willingness to contribute due to different indirect interests.
This under inclusion must be limited in order to prevent the second and third abusive class composition possibilities. Under inclusion requires a valid reason, a solely strategic motive is insufficient.
III. Cram down
Majoritarian voting within a group is the first safeguard against individual hold out positions. But this is not deemed to be sufficient; a whole group can hold out for strategic reasons. Cram down means overruling a dissenting class by the court. Therefore cram down is not linked to individual holdout, but to the holdout of a whole class.However, as not every group dissent is obstructive, it is necessary to separate obstructive/strategic hold outs from
“justified” opposition. Since reorganisation is about distributing the surplus, a denial of approval is justified if the dissenting class does not get a “fair” share of the surplus value. In practice, shareholder hold outs are commonplace since plans often foresee that they cannot retain any of their shares. The shareholders try to hold on to their shares by opposing the plan. Therefore, it is important to sort out whether old shareholders should be allowed to retain (some of their) shares.
1. The APR and its advantages
As will be explained later, US and German law allow a cram down of a dissenting class if the Absolute Priority Rule (APR) is respected. Absolute priority means that a dissenting class can only be crammed down if no lower ranking class receives/retains any value. The APR relies on the order of priority as established under non-bankruptcy law and transfers this order of priority to reorganisation. The surplus value is distributed accordingly if the stakeholders do not agree on an alternative distribution.
There are several arguments in favour of a default distribution respecting the pre-bankruptcy order of priority.
First, the APR has a disciplinary effect on shareholders, as it prevents a “soft landing”9 of shareholders in case of insolvency. Unlike creditors’ return on investment, shareholders’ return on equity depends on the firm’s success. Naturally, higher risks entail the possibility of a higher return. Shareholders profit from these higher returns, while creditors do not due to their fixed rate of interest. If shareholders were not last in line, they would take excessive risk: They then benefit if things go well and do not bear the full downside, as they share the remaining assets with creditors in case of insolvency. The APR provides the right incentives and thus reduces the risk of business failure10, which is desirable from a macroeconomic perspective.
Second, the APR maintains the different legal positions of senior and junior lenders’ claims in reorganization. Without such distinction it would be easier for the debtor to find new junior investors for risky investments. The latter would get at least a share in insolvency, as senior lenders would not be granted priority11.
9 Adler & Ayres, A Dilution Mechanism for Valuing Corporations in Bankruptcy, Yale L.J. 2001-2002, p. 88 (online)
10 Ibid, p. 88 11 Ibid, p. 88-89
Third, secured claims lower the debtor’s overall financing costs, as the priority inherently entails a lower interest rate. Naturally, secured creditors will only accept a lower interest rate if their priority is also respected in insolvency12.
Fourth, reorganisation means that creditors cannot directly access the proceeds of the going-concern value as they would in liquidation. In exchange for this deferral, their position shall be strengthened13.
Last and most important, the APR is the rule creditors would have agreed upon in a hypothetical bargain. Liquidation and reorganisation both can be seen as a procedure consisting of two independent steps. First, the assets are sold, in liquidation to a third party acquirer, in reorganisation to the old creditors. Second, the proceeds are distributed to the stakeholders. Liquidation and reorganisation differ in the first step. However, there is no reason why the second distribution-step should differ14, distribution in reorganisation should follow the same rules as distribution in liquidation. Therefore, distribution in liquidation must be examined. In liquidation, distribution should be done according to the order of priority. A collective procedure reduces monitoring costs and increases the value of the pool of assets. Unsecured creditors will willingly participate in this collective procedure, whereas secured creditors will only participate if their secured rights are protected in bankruptcy. The APR guarantees their pre-bankruptcy priority15 and thereby justifies a collective procedure.
Usually a strictly implemented APR does not distribute any value to shareholders, as they are last in line. Shareholders can easily be crammed down if the APR is strictly implemented.
2. Critics of the APR: putting shareholders last in line may cripple reorganisation
a) Putting instrumental shareholders last in line cripples reorganisation
If shareholders are essential, a strict application of the APR can cripple reorganisation.
Baird and Jackson question the necessity of the APR. The latter prohibits the senior owner to directly negotiate with a junior class (shareholders), while at the same time ignoring an intermediate class. If the intermediate class dissents and is not satisfied in full, the APR
12 Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors’ Bargain, Yale L.J 1981-1982, p. 871 (online)
13 Rusch, The new value exception to the Absolute Priority Rule in Chapter 11 Reorganizations, Pepp. L. Rev 1991-92, p. 1322-23 (online)
14 Jackson, Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors’ Bargain, Yale L.J 1981-1982, p. 894-895 (online)
forbids a cram down of the dissenting class, the negotiation between senior owner and junior owner fails. The APR in its pure form gives the intermediate class the power to participate in negotiations. Their bargaining leverage solely stems from the APR, not from being essential to restructuring16. The APR entitles many stakeholders to take part in the distribution negotiations (e.g. intermediate classes via prohibiting freeze out and junior classes via the possibility to insist on valuation hearings), it thereby cripples negotiations and prevents an optimal use of the assets.
In cases where the junior class is essential to restructuring and the intermediate class is not, this leads to an inefficient use of the firm’s assets. This undermines the goal of insolvency law, which aims at optimizing the value of assets17.
Another major drawback is that the APR prevents freeze out even if the residual owner’s claim is seriously curtailed. This is to say that the residual owner can be clearly identified. In this case, even if the business flourishes, the residual owner’s claim can still not be satisfied in full, the intermediate class will under no circumstances get anything. Nevertheless, the APR gives the intermediate class bargaining leverage. Without her consent, no stakeholder can benefit from reorganisation: The residual owner and the junior owner cannot reorganise without the intermediate class’s consent. Even if the claim of the intermediate class is worthless and if she is not instrumental to reorganisation, she still gets a share of the surplus value because her consent has to be bought by the other stakeholders in order to comply with the APR18.
Baird and Jackson question the APR’s suitability by referring to its major exceptions made by courts. Courts mitigate the APR in cases where junior classes are essential; otherwise intermediate classes could prevent the creation of surplus value. Courts allow a deviation from the APR in case of instrumental junior classes, such as instrumental workers, suppliers or managers19. The authors conclude that the many substantial deviations demonstrate the rule’s unsuitability.
Instead, a better set of rules should pacify distribution battles and thereby enhance reorganisation. The authors argue that a single party should be allowed to negotiate with whomever she sees fit, this party should be the residual owner20. The latter has the strongest incentive to negotiate in the interest of asset maximising because she directly profits from the
16 Baird & Jackson, Bargaining After the Fall and the Contours of the APR, U. Chi. L. Rev. 1988, p. 788 (online)
17 Ibid, p. 787 18 Ibid, p. 776-77 19 Ibid, p. 788 20 Ibid, p. 761-62
upside and bears the downside21. The authors recognize that it might be difficult to identify the residual owner due to valuation uncertainties. They concede that freeze out of an intermediate class may constitute a valid problem if the residual owner is wrongly identified due to undervaluation of the firm. The APR prevents this freeze out problem, however its drawbacks are disproportional22.
b) Putting shareholders last in line ignores their legal position
The APR looks at the shareholders’ position in liquidation and transfers it to reorganisation. As shareholders are last in line in liquidation, they cannot retain their shares in reorganisation. Madaus stresses that this economic viewpoint disregards the shareholders’ legal position. Equity interests do not only incorporate an economic value but also entitle shareholders to participation rights, the latter remain unaltered by insolvency23.
Madaus favours sharing the surplus between creditors and shareholders. Reorganisation requires the creditors to (partially) discharge their debts and the decision to continue the business. Shareholders’ legal rights are untouched by insolvency; they do not transfer to creditors. Therefore, reorganisation requires the coaction of creditors and shareholders, consequently, each party is entitled to participate in the surplus value24. Figuratively, in insolvency, the business belongs to the creditors. In reorganisation, the creditors sell the business to the old shareholders, thus creditors become sellers and shareholders are buyers, reorganisation is a virtual sale25. As both parties are crucial to this virtual sale, they should both share the surplus value. Creditors and shareholders are free to distribute the surplus value as they see fit26. However, if they cannot reach an agreement due to strategic hold out positions, a cram down is required. Cram down rules cannot depend on the APR, as both creditors and shareholders are entitled to a part of the surplus value.
Madaus proposes that the cram down rules for equity holders rely on two basic tests: (1) the shareholders’ best interest test and (2) non-curtailment of membership rights. Namely, the second test would be fulfilled by a debt-for-equity swap leaving creditors with preferred stock (entitling them to dividend payments, but excluding them from voting decisions) and
21 Ibid, p. 787-88 22 Ibid, p. 762
23 Madaus, Reconsidering the Shareholder’s Role in Corporate Reorganisations under Insolvency Law, INSOL 2013, p. 111 (online)
24 Ibid, p. 112 25 Ibid, p. 112
26 Madaus, Rescuing companies involved in insolvency proceedings with rescue plans, Report NVRII – NACIIL Conference on „Corporate Rescue“ 2012, p. 6
shareholders with ordinary stock (entitling them to voting decisions, but excluding them from dividend payments before creditors’ reduced claims have been paid in full). Madaus considers this default rule as fair as it divides the surplus value between creditors and shareholders: creditors’ reduced claims will be paid out of the company’s future revenues and the shareholders will get the company’s upside once these reduced claims have been fulfilled27.
3. Mitigating the APR: securing the contribution of essential shareholders
Another possibility is to embrace the APR in principle because distribution according to the priority under non-bankruptcy law is deemed to be advantageous at the bottom line. Nevertheless one major exception mitigates the APR. If shareholders are essential for reorganisation, strict application of the APR will hinder reorganisation, as shareholders cannot retain any value. This implies that shareholders will walk away and not contribute to reorganisation. But reorganisation sometimes depends on their contribution; they must be given some incentives.
Madaus derives the shareholders’ participation from general considerations of their legal position, independent of their essentiality for reorganisation. Consequently, Madaus always wants shareholders to participate in the surplus value.
In contrast, this solution wants shareholders to participate only if they are essential. The old shareholders have bargaining power if they can provide new tangible or intangible contributions (capital or special skills) worth more than a third party’s contribution28. Due to information asymmetries, outside-investors are likely to provide capital on less favourable terms. Inside knowledge attributes bargaining leverage to old shareholders.
These essential shareholders must be given some of the surplus value because they are necessary for reorganisation. Even though shareholders initially bargained for a position that according to the APR is wiped out in insolvency, they have new bargaining leverage resulting from their essential position. Therefore, sufficient incentives are necessary, as successful reorganisation depends on essential shareholders’ participation, exceptions to the APR are required. Propositions for these exceptions will be presented in the descriptive part in chapter 3 (Chapter 3 III.2.d) and evaluated in chapter 5 (Chapter 5 IV.1,2) and chapter 6.
27 Madaus, Reconsidering the Shareholder’s Role in Corporate Reorganisations under Insolvency Law, INSOL 2013, p. 116 (online)
28 Baird & Jackson, Bargaining After the Fall and the Contours of the APR, U. Chi. L. Rev. (1988), p. 740.
Chapter 2: Distribution under the German Insolvenzordnung
In Germany, reorganisation rules are contained in the Insolvenzordnung, which came into force in 1999. §§ 217 et seqq. contain legal rules concerning the Insolvenzplanverfahren (insolvency plan procedure), the German restructuring tool. In 2012, the ESUG (Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen) amended the Insolvenzplanverfahren in order to make restructuring more attractive. In the following, I will describe the German distribution rules, namely rules concerning the right to propose an insolvency plan, class composition, voting thresholds and cram down.
I. Right to file an insolvency plan, § 218 InsO29
§ 218 stipulates, that the debtor and the insolvency administrator can submit a reorganisation plan. Individual creditors cannot propose an insolvency plan30. However, the creditors’ assembly can advise the insolvency administrator on the plan proposal and instruct the insolvency administrator to submit an insolvency plan, § 218 II and § 218 III.
II. Class composition, § 222 InsO
The plan initiator aims to compose the groups in order to maximise the plan’s chances of approval31. However, he is not free in composing the groups, § 222 introduces boundaries to ensure a distribution deemed to be fair.
According to § 243 the voting takes place within the groups as opposed to the plenary assembly of all stakeholders.
§ 222 regulates group composition. § 222 I 1 separates stakeholders according to their different rights. § 222 I 2 enumerates the different rights: creditors entitled to separate satisfaction (secured creditors), non-lower-ranking creditors (senior creditors), lower-ranking insolvency creditors (junior creditors) and persons with a participating interest in the debtor (shareholders).
A group composition only based on different rights leads to heterogeneous groups; even though having the same priority in insolvency stakeholders may have different intentions32. This is problematic as § 226 mandates that every member within a group shall be treated equally. Members of the same group with different intentions are unlikely to approve the
29 All § without nomination of the Code refer to the InsO
30 Geiwitz & Dankelmann, commentary, in: Beck OK InsO, § 218 Rn. 7 31 Andres, commentary, in: InsO Andres/Leithaus, 2014, § 222 Rn. 1 32 Ibid, § 222 Rn. 2
same set of arrangements in the plan. An insolvency plan is more likely to succeed if the group-members are not only aligned in their rights but additionally have similar intentions. Therefore, § 222 II facultatively permits to additionally take into account different interests when forming classes.
1. § 222 I InsO: Class composition based on different rights
§ 222 I bases class composition on legal rights and enumerates four different legal positions according to the priority in liquidation.
The formal act of class composition is a crucial prerequisite for the distribution of the surplus value as stakeholders within a group must be treated equally, § 226. In theory, the plan proponent is free to choose how to curtail the stakeholders’ rights. However, in the absence of a choice, §§ 223-225 provide default plan provisions. They represent the legislator’s understanding of fair distribution.
a) § 222 I 2 Nr. 1 InsO: Creditors entitled to separate satisfaction
The German law distinguishes between creditors entitled to separate the collateral and creditors entitled to separate satisfaction. § 222 I 2 Nr. 1 merely concerns the latter, creditors entitled to separate the collateral do not participate in reorganisation.
§ 222 I 2 Nr. 1 stipulates that creditors entitled to separate satisfaction form a group of their own. §§ 49-51 define which creditors are entitled to separate satisfaction.
The principle default rule is set out in § 223 and states that the rights of creditors entitled to separate satisfaction shall not be encroached upon. Any curtailment of their security rights – provided that the collateral is valuable- would put them in a worse position as compared to liquidation. The secured creditors could invoke § 251 I Nr. 2, which would lead to the court’s denial of sanctioning. The default rule in § 223 I ensures that a valuable security interest will not be encroached upon by the plan due to its intrinsic value in liquidation. It thereby increases the plan’s chances of success.
A curtailment of a valuable security interest and thus a deviation from § 223 I is possible only on a voluntary basis33. Deviation from the default rule in the insolvency plan is possible as set out in § 223 II.
33 Ibid, § 223 Rn. 1
b) § 222 I 2 Nr. 2 InsO: The senior creditors
§ 38 defines the notion of senior creditors as personal creditors holding a senior claim against the debtor.
The legislator does not provide a default rule for senior creditors, because they occupy a medium position in the hierarchy of creditors. Secured creditors are in the top position and hence basically placed outside of insolvency proceedings. Junior creditors occupy the lowest creditor position. For these two legal groups the legislator provides default rules, as their economic position is relatively easy to determine.
c) § 222 I 2 Nr. 3 InsO: The junior creditors
Junior creditors are defined in § 39, notably shareholder loans will be subordinated, § 39 I Nr. 5.
The default rule in § 225 I provides that subordinated claims will be released, as always the plan can deviate from this rule, § 225 II.
This default rule again concerns the fair distribution of the surplus value. If the junior creditors participated in the surplus value, the higher-ranking creditors would probably be put in a worse position as compared to liquidation. Hence, the court would have to deny the plan’s sanction, § 251 I Nr. 234.
d) § 222 I 2 Nr. 4 InsO: The shareholders
Since the introduction of the ESUG shareholders also form a group if their rights are impaired by the plan, § 222 I 2 Nr. 4. The ESUG dissolves the separation of insolvency and company law35. Before the ESUG came into force, impairment was only possible if the shareholders consented.
In a normal liquidation procedure shareholders are last in line. Without § 222 I 2 Nr. 4 the order of priority would be impaired in case of successful reorganisation as the debtor survives and shares may increase in value. Shareholders would profit from creditors contributing to the reorganisation. § 222 I 2 Nr. 4 thus reinforces the order of priority. § 222 I 2 Nr. 4 is therefore in line with the default rules in §§ 223-225, 251 I Nr. 2 that distribute the surplus value in accordance with the order of priority.
The introduction of § 222 I 2 Nr. 4 might be seen as an important step towards creditor protection and thereby towards introducing a rescue culture. Dissenting shareholders can be
34 Ibid, § 225 Rn. 1
35 Simon & Merkelbach, Gesellschaftsrechtliche Strukturmaßnahmen im Insolvenzplanverfahren, NZG 2012, p. 122 (online)
crammed down, § 245. Creditors might not be willing to reorganise when shareholders’ entitlements remain untouched. However, weakening the shareholders’ position is not necessarily enhancing reorganisation, as they might deny further support if the plan provides too weak incentives for shareholders to reorganise. In this particular provision, the German legislator favours creditor protection over enhancing reorganisation. In order to redress the balance between the two opposing goals and hence to establish a rescue culture, the German legislator has to provide for other rules that will make reorganisation attractive for shareholders, too.
2. 222 II InsO: Class composition based on different interests
§ 222 II allows to further differentiate stakeholders by taking into account their interests. The newly formed groups assemble stakeholders with the same legal position and similar economic interests.
This addition of economic criteria weakens the general insolvency principle of pari passu36. Stakeholders with equal rights can be put into different groups and thus be treated differently, § 226 only mandates equal treatment within a group. However, the loosening of pari passu only concerns the surplus value as § 251 I Nr. 2 secures the liquidation value for every stakeholder.
The further facultative differentiation leads to more homogenous groups. This homogeneity of groups has two advantages.
On the one hand the homogeneity increases the legitimate power of a majority decision within the group. The majority decision is deemed not only to represent the interests of the majority, but also those of the minority because their crucial interests are aligned37. The higher the degree of homogeneity of interests within a group, the more probable the majority vote is also in the interest of the dissenting minority38.
On the other hand more homogenous groups allow the plan to generate a higher surplus value by varying from the one-size-fits-all approach39. More homogenous groups allow for more specific regulations for each group adapted to their interest, §§ 222 II, 226. Some groups have a crucial interest in the survival of the debtor and might thus be willing to contribute more than other stakeholders.
36 Smid, Kontrolle der sachgerechten Abgrenzung von Gläubigergruppen im Insolvenzplanverfahren, InVO 1997, p. 174
37 BT, Entwurf einer InsO, BT-Drucks. 12/2443, 1992, p. 92 38 Eidenmüller, commentary, in: MüKo InsO, 2014, § 222 Rn. 4
§ 222 II requires two cumulative conditions40: stakeholders must have equivalent economic interests and the newly formed groups must be adequately separated from each other.
a) § 222 II 1 InsO: Equivalent economic interests
§ 222 II intentionally does not enumerate criteria to define equivalent economic interests. The broad flexibility in creating the groups41 enhances the creation of surplus value42.
These economic interests must be insolvency related and directly or indirectly directed towards monetary payment. Conformity of all economic interests is rarely given; conformity of the most important economic interests suffices43.
Equivalent economic interests are deemed to exist if the vote is representative for the whole group44. Whether an equivalent economic interest exists cannot be determined in abstract but only with a specific case at hand. Equivalent economic interests can result from the amount and the importance of the claim for the creditor, its legal cause, the period of the claim or the creditor’s interest to continue business relations with the debtor45.
An equivalent economic interest therefore means that members of this group have an equivalent willingness to contribute to reorganisation46, which can be used to enhance reorganisation and increase the surplus value.
b) § 222 II 2 InsO: Newly formed groups must adequately be separated from each other Stakeholders, whose most important economic interests are identical, have to be put into the same group47, § 222 II 2.
§ 222 II 2 hinders the artificial creation of groups in order to comply with the cram down requirement in § 245 I Nr. 348. The latter only allows a cram down if the majority of groups voted in favour of the plan. Without the requirement of adequate separation, the plan proponent could artificially enlarge the number of groups voting in favour of the plan49.
40 Gottwald, Insolvenzrechts-Handbuch, 2015, § 67 Rn. 47 (online)
41 BT, Entwurf eines Gesetzes zur weiteren Erleichterung der Sanierung von Unternehmen, BT-Drucks. 17/5712, 2011, p. 54.
42 Lüer & Streit, commentary, in: Uhlenbruck InsO, 2015, § 222 Rn. 28 43 Eidenmüller, commentary, in: MüKo InsO, 2014, § 222 Rn. 89 44 Ibid, § 222 Rn. 88
45 Lüer & Streit, commentary, in: Uhlenbruck InsO, 2015, § 222 Rn. 29
46 Ibid, § 222 Rn. 29; Kaltmeyer, Der Insolvenzplan als Sanierungsmittel des Schuldners, ZInsO 1999, p. 259
47 Eidenmüller, commentary, in: MüKo InsO, 2014, § 222 Rn. 101 48 BT, Entwurf einer InsO, BT-Drucks. 12/2443, 1992, p. 199 49Eidenmüller, commentary, in: MüKo InsO, 2014, § 222 Rn. 101
c) Necessity of a general abuse-control to prevent manipulative group composition?
Due to the voting in groups and not in the plenary assembly, it is possible that a minority in heads and/or value outvotes the majority50. Class composition is crucial for the voting result. A general abuse-control to prevent manipulative class composition might be necessary. The German legislator does not provide for a general abuse-control nor have the courts introduced one51. It is presumed that a general abuse-control is not necessary as the requirements concerning class composition are strict and prevent manipulative group composition. Furthermore, § 245 I Nr. 2 only allows a cram down if all groups adequately participate in the generated surplus value. Adequate participation is presumed if no stakeholder having the same or a lower order of priority gets a better treatment, § 245 II. The risk that the surplus value will be distributed unfairly due to the manipulation of group composition is consequently limited. The risk consists only in not getting more than the “fair share” as interpreted by the legislator52.
Fair distribution of value is guaranteed by cumulating the requirements concerning class composition, required majority and cram down, which must be seen in concert.
III. § 244 InsO: Voting thresholds
All classes have to approve the plan. § 244 provides the required majorities. § 244 I sets the majorities for creditor classes, § 244 III determines the majorities for shareholder classes.
§ 244 I requires for creditor classes the cumulative approval of 50% both in value (§ 244 I Nr. 2) and in a headcount test (§ 244 I Nr. 1). A simple majority is sufficient. Until 1999, the law required a majority in value of 75%. However, the legislator wants to facilitate restructuring and not overly burden the plan’s approval by setting a high threshold53. Furthermore, it is presumed that the homogeneity of the classes resulting from § 222 leads to homogenous interests within the classes. Thus, the majority vote has a high legitimate power, as it can be presumed that the decision is also in the interest of the dissenting minority54.
50 Hingerl, Gruppenbildung im Insolvenzplanverfahren, ZInsO 2007, p. 1337
51 Kaltmeyer, Der Insolvenzplan als Sanierungsmittel des Schuldners, ZInsO 1999, p. 263 52 Eidenmüller, commentary, in: MüKo InsO, 2014, § 222 Rn. 111
53 BT, Entwurf einer InsO, BT-Drucks. 12/2443, 1992, p. 208 54 Hintzen, commentary, in: MüKo InsO, 2014, § 244 Rn. 3
§ 244 III applies to shareholder classes and only requires a majority in value test (50%). This waiver of the headcount test is in line with company law, where voting thresholds only take into account the majority in value55.
Non-attending and non-voting stakeholders are not taken into account; passive behaviour shall not hinder the plan56. This is especially important in cases of one-person classes.
IV. § 245 InsO: Cram down
Cram down rules come into plan when a whole class -as opposed to individual members within a class- denied plan consent.
§ 245 introduces the cram down rule, the vote of the dissenting class shall be deemed to be consenting. § 245 I enumerates three cumulative requirements:
Firstly, the members of the dissenting class are likely not to be placed at a disadvantage by the plan compared with their situation in liquidation.
Secondly, the members of the dissenting class participate to a reasonable extent in the surplus value.
Thirdly, the majority of the voting classes approved the plan.
The ulterior motive is to prohibit obstructive voting behaviour57. Holdouts due to disruptive behaviour and inequitable egoistic motives shall be disregarded58 in order to guarantee an optimal outcome for stakeholders59. § 245 is vital in order to enhance reorganisation60.
1. § 245 I Nr. 1 InsO: Members of the dissenting group shall not be put in a worse position by the plan as compared to liquidation
§ 245 I Nr. 1 secures each stakeholder’s minimal compensation. Without an insolvency plan, the stakeholders get the liquidation value (going-concern value or piecemeal liquidation-value). The minimum position in § 245 I Nr. 1 is determined by the highest feasible value without reorganisation61.
55 BT, Entwurf eines Gesetzes zur weiteren Erleichterung der Sanierung von Unternehmen, BT-Drucks. 17/5712, 2011, p. 34
56 BT, Entwurf einer InsO, BT-Drucks. 12/2443, 1992, p. 208
57 Wegener, Sanierungshindernisse durch mangelnde Gläubigerbeteiligung im Planverfahren, ZInsO 2002, p. 1158
58 BT, Entwurf einer InsO, BT-Drucks. 12/2443, 1992, p. 208 59 Drukarczyk, commentary, in: MüKo InsO, 2014, § 245 Rn. 1
60 Braun, commentary, in: Nerlich & Römermann InsO, 2016, § 245 Rn. 1 61 Andres, commentary, in: InsO Andres/Leithaus, 2014, § 245 Rn. 3
In practice this requirement heavily relies on estimation62. Furthermore, the surplus value is unsecure as it depends on the future profitability of the debtor. Its amount is estimated and has to be discounted, the discount rate is disputable63.
2. § 245 I Nr. 2, II, III InsO: Members of the dissenting group adequately participate in the surplus value
Adequate participation does not mean that the surplus value will be divided equally among all stakeholders64. The German legislator merely provides a negative interpretation of the term “adequate participation” in § 245 II, which narrows the plan proponent’s freedom to distribute the surplus value in case of missing unanimity of all classes.
The negative requirements defining the term “reasonable participation” distinguish between creditors and shareholders.
a) § 245 II InsO: Reasonable participation of creditors in the surplus value
§ 245 II introduces three requirements that must be met in order to determine whether a dissenting class reasonably participates in the generated surplus value.
aa) § 245 II Nr. 1 InsO: No creditor receives economic value exceeding the full amount of its claim
The first requirement to cram down a dissenting class is that no creditor receives economic value exceeding the full amount of its claim. This requirement ensures that no creditor will be put in a better position in reorganisation, as she would have been in without insolvency. In practice, this requirement poses estimation problems. Especially, debt-for-equity-swaps require a company evaluation entailing additional legal uncertainty65.
bb) § 245 II Nr. 2 InsO: Neither a lower-ranking creditor, nor the debtor, nor his shareholders receive an economic value
§ 245 II Nr. 2 introduces an absolute priority rule (APR): the legal priority in a liquidation procedure determines the distribution of the surplus value for a dissenting class66. No lower
62 Drukarczyk, commentary, in: MüKo InsO, 2014, § 245 Rn. 43 63 Ibid, § 245 Rn. 50-52
64 Ibid, § 245 Rn. 20
65 Braun, commentary, in: Nerlich & Römermann InsO, 2016, § 245 Rn. 3 66 Wittig, Obstruktionsverbot und cram down, ZInsO 1999, p. 376
ranking class can receive any value before higher-ranking dissenting classes are satisfied in full.
The APR is especially unfavourable for shareholders. A strict application of the APR would mean that the old shareholders couldn’t retain any shares in the debtor. The German cram down rules are inspired by US law. However, § 1129 (b) (2) (B) (ii) BC is less strict as it only prohibits a cram down if shareholders receive an economic value on account of their interest. US law allows a cram down even if shareholders receive an economic value if this value is due to newly added value. This exception to the APR is called “new value exception”.
The wording of § 245 II Nr. 2 does not explicitly outline any exception to the APR, one could thus interfere that the German legislator introduced a strict APR67. In this case reorganisation would always entail a change of ownership. However, this was not the legislator’s intention as shown in the explanatory statement to § 24568. The latter underlines that the continuation of the business by the debtor or its shareholders does not necessarily entail the attribution of an economic value to the debtor/shareholders. The German law, although merely implicitly, provides for a new value exception. The crucial point is not the existence of the exception, but its requirements. The debtor/shareholders are deemed not to receive an economic value if their contributions as stipulated by the insolvency plan (e.g. providing new capital, know-how or the accomplishment of labour) offset the remaining value of their shares69. In this case, they create new value, a cram down of a higher ranking class is possible. However, the application of this requirement poses considerable difficulties in practice as it heavily relies on evaluation: the debtor’s/shareholders’ contribution and the remaining value of the shares have to be evaluated.
cc) § 245 II Nr. 3 InsO: The insolvency plan must not put any equal ranking creditor class in a better position than the dissenting creditor class
A creditor class cannot be put in a worse position than an equal ranking creditor class against its will. § 245 II Nr. 3 is a complement to the APR, not only lower ranking stakeholders but also equal ranking creditors cannot be put in a better position than the dissenting class.
b) § 245 III InsO: Reasonable participation of shareholders in the surplus value
A shareholder class reasonably participates in the surplus value if no creditor receives economic benefits exceeding the full amount of its claim (§ 245 III Nr. 1) and no equal
67 Ibid, p. 376
68 BT, Entwurf einer InsO, BT-Drucks. 12/2443, 1992, p. 209 69 Wittig, Obstruktionsverbot und cram down, ZInsO 1999, p. 377
ranking shareholder is put in a better position than the dissenting shareholder class (§ 245 III Nr. 2).
3. § 245 I Nr. 3 InsO: The majority of classes accepted the plan
§ 245 I Nr. 3 states that a cram down is only possible if the majority of classes accepted the plan.
By requiring the majority of classes to accept the plan, the German legislator endangers his ulterior motive to prohibit obstructive voting behaviour. § 245 I Nr. 3 facilitates holdouts that menace economically promising insolvency plans. Unlike § 245 I Nr. 1 and § 245 I Nr. 2, the third requirement does not seek to prevent inequitable and egoistic voting decisions.
Instead, the legislator presumes that the plan’s legitimate power is sufficient only if the majority of groups accepted the plan70. § 245 I Nr. 3 makes sense if a majority decision could be presumed to guarantee an economically optimal insolvency plan71. However, this presumption is wrong due to egoistic holdout positions. It must therefore be stated that § 245 I Nr. 3 is self-defeating. The cram down provision only partially fulfils its purpose to prevent unjustified disapproval. A class’s disapproval is already unjustified if the plan fulfils the requirements as set out in § 245 I Nr. 1, 2. § 245 I Nr. 3 is counter-productive. Neither of the two conflicting goals (creditor protection and enhancing reorganisation) is furthered, § 245 I Nr. 3 cripples reorganisation without any valid justification.
V. The German balance between “fair” distribution and enhancing reorganisation The legislator does not expressly indicate how it wants to balance the two partially conflicting goals of enhancing reorganisations and “fair” distribution. § 1 expresses that insolvency proceedings, including reorganisation, aim at creditor satisfaction as opposed to shareholder contentment. Thereby the German legislator interprets fair distribution to mean creditor satisfaction. However, § 1 InsO should not be construed as favouring creditor satisfaction over reorganisation. Without reorganisation no surplus value arises, a non-existing surplus cannot be used for creditor satisfaction. Consequently there must be a balance between creditor satisfaction and enhancing reorganisation, which partially comes at the creditors’ cost. Inter alia, incentives for instrumental shareholders must be provided.
70 Braun, commentary, in: Nerlich & Römermann InsO, 2016, § 245 Rn. 2
Group composition and required majorities predetermine class consent, hence whether a cram down is required. Class composition, required majorities and cram down provisions are closely intertwined.
Enhancement of reorganisation can be seen in § 222, which allows for flexible group composition. If the groups were only composed according to stakeholders’ rights, § 222 I, reorganisation would often fail. A more flexible group composition approach according to § 222 II allows the plan proponent to partially circumvent the requirement of pari passu by creating more and more homogenous groups. The proponent will take into account the diverging willingness of stakeholders to contribute to reorganisation, which depends on their different interests. A plan that takes into account different interests by treating stakeholders differently is more likely to be accepted. Such a plan providing different provisions aligned to different interests will in general create more surplus value. A surplus that would not have been created in the first place cannot be distributed72.
§ 244 provides further enhancement. The low required majorities within a group facilitate plan acceptance.
Until 2012, company law and insolvency law were strictly separated. Shareholders were not part of the insolvency plan, their rights could only be curtailed with the shareholders’ consent. This approach honoured that equity interests are not part of the debtor’s estate, equity cannot be distributed to creditors. However, shareholder holdouts could cripple reorganisation, as shareholder rights could not be curtailed against their will. Neither was fair distribution guaranteed, nor was reorganisation enhanced.
In 2012, the ESUG introduced § 222 I 2 Nr. 4 and § 225a III. § 225a III allows the insolvency plan to provide for any rule permissible under company law. Shareholders now constitute a class, § 222 I 2 Nr. 4. § 245 provides the cram down provision based on the APR, which puts shareholders last in line. The ESUG transfers the insolvency principle that equity is wiped out first to reorganisation.
But strict application of the APR discourages shareholders from participation. Reorganisation requires instrumental shareholders to participate, rigid application of the APR cripples reorganisation. Sufficient incentives for instrumental shareholders must be provided. The InsO provides an incentive by allowing for the new value exception.
The APR and its exception thus balance the tension between the creation of surplus and creditor satisfaction.
72 Ibid, p. 262
In conclusion, the InsO enhances the creditors’ position by transferring the APR from liquidation to reorganisation in case of lacking unanimous consent. In case of unanimous group consent, the surplus value can be distributed freely.
Reorganisation is favoured inter alia in order to enhance creditors’ payout rate. The only shareholder incentive is the new value exception. As the InsO aims at creditor satisfaction, shareholder incentives are kept at a minimum. This minimum is deemed to constitute a sufficient incentive for instrumental shareholders to reorganise.
Chapter 3: Distribution under the US Bankruptcy Code
The Bankruptcy Code came into force already in 1979. Chapter 11 of the Bankruptcy Code deals with reorganisation.
Within the last 37 years, the economic framework has changed and a call for reform has been put on the agenda. The ABI set up a commission that works on propositions amending Chapter 1173. One major drawback of the current Bankruptcy code concerns SMEs: Chapter 11 does not work efficiently for SMEs, this is especially unfortunate as the majority of business insolvencies concern SMEs74. The commission inter alia proposes the institution of an exception to the APR for SMEs, the so called Equity-Retention-Plan. The latter aims at striking a balance between fair distribution and providing shareholder incentives.
In the following, I will examine the US distribution rules, namely who can present an insolvency plan, class composition, voting thresholds and cram down rules.
I. Right to file an insolvency plan, § 1121 BC75
All stakeholders have the right to file an insolvency plan under chapter 11. The debtor has an exclusive right during the first 120 days after the order for relief, § 1121(a) read in conjunction with § 1121 (c)(2). If the debtor does not file a plan within 120 days, every interested party can file an insolvency plan.
If the debtor has filed a plan within 120 days, she will be granted 180 days starting with the date of the order for relief during which all classes need to accept the plan, § 1121(c)(3). After expiration of 180 days, every stakeholder has the right to file a competing insolvency plan if the debtor’s plan has not been accepted.
II. § 1122 BC: Class composition
Class composition is important in several ways: First, § 1123(a)(4) BC stipulates that stakeholders within a class must be treated equally, unless the concerned stakeholder consents to a less favourable treatment. Second, class composition directly influences plan approval: voting majorities within the separate groups depend on their composition. Disregarding the possibility of a cram down, the court can only confirm a reorganisation plan if all groups consent, § 1129(a)(8). Thus, class composition is crucial not only for the allocation of the surplus value but also for reaching the required majorities.
73 ABI, Commission to study the reform of Chapter 11, 2014, p. 2 74 Ibid, p. 2
§ 1122 regulates the composition of classes. § 1122(a) postulates that only substantially similar claims or interests can be put in one class. § 1122(b) contains an exception stating that small-unsecured claims can be separated from the other unsecured claims and form a distinct group if this is reasonable and necessary for administrative convenience. § 1122(b) thus contains a de-minimis exception to the general rule as stated in § 1122(a).
1. Classification theories
The written law does not specify further rules concerning class composition; the law does not determine the exact amount of the plan proponent’s discretion in setting up classes76. There are two different classification theories interpreting the legislator’s silence.
a) Class composition taking into account rights and interests
This theory states that stakeholders with similar rights and “interests” should be put into one class. The resulting homogeneity ensures that a dissenting minority is nevertheless fairly represented by the majority vote77.
b) Class composition solely taking into account rights
The second theory requires that classes should be formed in accordance with the priority in liquidation. In principle a class comprises all stakeholders with the same right even if they all have different indirect interests. The thus formed classes are often large and might be inhomogeneous. In practice, courts do not apply this theory in its pure form, but mitigate it as will be further developed in I.3.
c) Notion of fairness according to these theories
The second theory regards distribution of surplus value on a class-level, not on an individual class-member-level. The majority of a class can outvote the dissenting minority; by accepting the plan it can cede some of its surplus value to a junior class. This vote is binding for the dissenting minority within the group. According to this approach, distribution must be fair to a class as a whole and not to each and every member of this class. The classes are very large and often comprise stakeholders with different indirect interests, hence the majority does not necessarily represent the “interests” of the dissenting minority.
76 Baird, Elements of Bankruptcy, 2010, p. 237
77 Norberg, The National Bankruptcy Review Commission’s Recommendation on Classification of Claims in Chapter 11, Miss. C. L. Rev. 1997-1998, p. 413 (online)
