SECTION 2 - THE BASIC ELEMENTS OF A FORMAL CORPORATE INSOLVENCY LAW REGIME

2.1 Introduction

One of the most important aspects of an insolvency process, whether a formal or informal process, is that it is a collective procedure. That alone distinguishes it from practically any other procedure known under any system of law or legal tradition (the procedure known as the "class action" might come closest to its collective nature). A collective process of this nature has to endeavour to accommodate all of those who are affected by or have an interest in the insolvent debtor. That, as will be seen, presents particular problems and issues. These are not easy problems to address in any environment.

Graphic 1 endeavours to present the range of interests which need to be accommodated for by an insolvency law. These include the insolvent debtor itself; its directors and shareholders; creditors who are secured to various degrees; employees; fiscal creditors; guarantors of the debtor; unsecured creditors. It also includes government, commercial and social institutions and practices of which some account must be taken in prescribing an insolvency law regime and in the practical operation of such a regime. No one person nor group of persons or institutions may assert a claim to be unaffected or uncontrolled by an insolvency law.

2.2 Corporate insolvency law regimes generally

A corporate insolvency law regime may be expected to provide for two types of process. One is liquidation (or "winding-up" or "bankruptcy", as it is sometimes called). The other is rescue, a generic term which embraces a number of processes variously titled as "composition", "arrangement", "reconstruction", "rehabilitation" and so forth. Other processes of various descriptions which provide for particular circumstances might also form part of the regime.

(a) Liquidation

The remedy of liquidation is a long historical and traditional method of dealing with the insolvency of a corporation. It is used, in effect, to terminate the commercial activities of an insolvent corporation. Liquidation tends to be close to "universal" in its concept, acceptance and application. It normally follows a pattern which includes:

• an application to a court or tribunal either by the corporation itself or by creditor(s);
• an order or judgment that the corporation be liquidated; ¡
• the appointment of an independent person to conduct and administer the liquidation;
• he immediate closure of the business activities of the corporation; ¡
• the termination of the powers of directors and employment of employees;
• the sale of the assets of the corporation;
• he adjudication of claims of creditors; ¡
• distribution of available funds to creditors (under some form of priority); and
• he ultimate dissolution of the corporation.

  The liquidation process is justified by the application of economic and legal theories. The economic theory maintains that in a competitive market economy an enterprise which is unable to compete has no place in and should be removed from the market place. A principal identifying mark of an uncompetitive enterprise is one which becomes insolvent. The legal theory supplements this by maintaining that such a process can only function effectively if it is regarded as a collective process, from the time of its inception. It follows that an ordered, civilized administration is necessary under which all creditors (of varying ranks and classes) should be bound and treated equally. The combination of these theories has cemented the liquidation process as the necessary basic component of an insolvency law regime.

(b) Rescue

An explanation of the term "rescue" is desirable. In the context of this report it means any form of process, by whatever name called, which provides for the continuation (and not the liquidation) of an insolvent corporate debtor.

This may take the form of a composition, by which the debtor and the creditors agree to a simple compounding of debts. For example, the creditors agree to receive a percentage of the debts they are owed in full, complete and final satisfaction of those debts. The debts of the corporation are thus reduced or satisfied, it becomes solvent and may continue on. A rescue might also take the form of a complex reorganisation under which, for example, the debts of the debtor are restructured (extended length of loan, extended period in which to make payment, deferral of payment of interest, possible change in the identity of lenders and so forth); the possible conversion of some debt to equity together with a reduction (or, even, extinguishment) of existing equity; the sale of some of its non-core assets; and the closure of non-profitable business activities.

However, rescue does not imply that the corporation, its creditors and its shareholders are or will be completely restored. Nor does rescue necessarily mean that ownership and management of an insolvent corporation will maintain and preserve their respective positions. In general, however, rescue does imply that under whatever form of plan, scheme or arrangement is agreed, the creditors will eventually receive more than if the corporation was immediately or soon liquidated.

Although something approaching a "rescue" process has been part of the insolvency law regimes of many countries for some time, they were generally very conservative in their nature and, as a result, little used. Most have recently been replaced or supplemented by more contemporary and efficient processes.

The "rescue" process is not so universal as that of liquidation and thus does not follow such a common pattern or process. However, to the extent that similarities may be detected among the widely differing processes that might be termed "rescue", it may be said that the key or essential elements include:

• the voluntary submission by a corporation to the process (which may or may not involve judicial proceedings and thereafter judicial control or supervision);
• an automatic and mandatory stay or suspension of actions and proceedings against the property of the corporation affecting all creditors for a limited period of time;
• the continuation of the business of the corporation either by the existing management, an independent manager or a combination of both;
• the formulation of a plan which proposes the manner in which creditors, equity holders and the corporation itself (including its business and assets) will be treated;
• the consideration of and voting on acceptance of the plan by creditors;
• possibly, the judicial sanction of an accepted plan; and
• the implementation of the plan.

However, within that similarity of framework there are many variations and divergences.

The rescue concept, like winding up, also rests upon a fusion of economic and legal theories for its justification. The economic theory (which is a more contemporary theory than the one which is used to justify the liquidation process) maintains that not all enterprises which fail in a competitive market place should necessarily be liquidated. A corporation with a reasonable prospect of survival (for example, one which has a profitable or potentially profitable business) should be given that opportunity. It can be demonstrated that there is greater value (and, by deduction, greater benefit for creditors in the long term) in keeping the essential business and other component parts of such a corporation together.

The legal theory maintains that rescue requires a law which:

• permits quick and easy access to the process; ¡
• provides sufficient protection for all of those involved in the process (which primarily includes the corporation and its property and the various ranks and classes of creditors);
• provides a structure which permits the negotiation of a commercial plan;
• enables a majority of creditors in favour of a plan or other course of action to bind all other creditors by the democratic exercise of voting rights; and
• provides for judicial or other supervision to ensure that the process is not subject to unfair manipulation or abuse.

This legal theory also places considerable emphasis on the concept of the collective nature of the procedure.

It is of critical importance to this modern process that the opportunity, whether prompted by possible sanction or encouraged by possible benefit, should be available to a corporation in financial difficulty to commence the process before it is too late. It is also critical to the modern rescue process that attempts by creditors, whether secured or otherwise, to intervene upon the process and pursue their independent individual rights should be restrained, by automatic operation of the legislation, as far as possible.

Another essential requirement is that the process must be transparent and be capable of relatively quick resolution. It is not appropriate, in the modern context, for the rescue process to be subject to delay or extensive time periods for the performance of various parts of the process. The creditors of the corporate debtor must be fully informed and involved in the decision process.

(c) Special insolvency laws

In a market economy the liquidation and the rescue process should not be the subject of political or government influence or intervention. However, the presence of some exceptional economic, social or other such circumstance might sometimes justify a special process and the involvement or intervention of government. Typical of such a process is one that might sometimes be applied when the banking sector of a country is itself in financial difficulty.

2.3 Important features and standards of an insolvency law regime

This section presents some basic standards regarding the liquidation and rescue processes. The discussion is confined to the following main important features and elements:

• application of the law
• separate/joint process ¡
• access
• immediate/interim effects
• administration
• important liquidation features
• important rescue features
• role of creditors
• priorities between creditors
• avoidance of transactions
• sanctions
• cross border considerations.

Graphic 2 presents a diagram of process for both liquidation and rescue modes.

2.4 Application of the law

Principle suggests that the liquidation and rescue processes of an insolvency law regime should apply to all forms of corporation, both private corporations and state-owned. It may be necessary or desirable to separate out corporations which are engaged in some particular enterprises. For example, the insolvency of banking and insurance corporations should normally be governed by special insolvency legislation or be subject to special rules of the insolvency law. Very few, if any, jurisdictions would permit a banking corporation (whether private or state owned) to be subject to a basic corporate insolvency law without some involvement of regulatory bodies.

Principle also dictates that state owned corporations (other than banks) which compete in a market economy should be subject to the same commercial and economic processes as privately owned corporations, including the basic insolvency law. While it can be argued that state owned corporations in a transitional economy might be best dealt with by special insolvency processes, under normal market economy conditions they should not be afforded different treatment than that which applies to private corporations.

2.5 Separate/Dual process

There is some debate whether the processes of liquidation and rescue should be separate processes or whether they should be both available under a single process. This is sometimes more a matter of form and perception rather than substance. Thus, for example, when a corporation is reported as having "filed for bankruptcy" (as, for example, in USA) one might fear that it is to be liquidated whereas, in fact, this is simply the legal, common or popular name given to the formal route toward either liquidation or the possibility of a rescue.

There are cost and efficiency advantages if both processes can be accessed under the one procedure. For example, if a corporation seeks a formal reorganisation, but fails, the result should be automatic liquidation without the necessity of having to commence a new procedure for liquidation. Graphic 2 shows two points in the process at which there should be provision for transmission from rescue to liquidation mode. These are when a rescue proposal is rejected by creditors or if the rescue plan cannot be effected.

Another aspect of this area should also be considered. There is a need to safeguard against the rescue process being used as some type of shelter, safe haven or as a delaying tactic on the part of a corporation which has no real potential to be the subject of a rescue. This can be best achieved by either providing for an early assessment of whether there is any real prospect of rescue (for example, by some initial proof of that prospect before the rescue process commences) or permitting the process to commence but ensuring that a definitive and transparent proposal is made without extensive delay.

2.6 Access to the process

Policy considerations suggest that access to the process should be convenient, inexpensive and quick. If access is too restrictive it can deter both debtors and creditors. Delay can result in insolvent corporations, which should be liquidated, being left uncontrolled with the likely dissipation of assets. Restricted access can be particularly harmful to the possibility of rescue. However, if it is too unrestricted there is a possibility of the process being abused, particularly by creditors.

The preferred policy is to make access easy for a debtor corporation by requiring simple threshold proof of the basic criteria (insolvency or financial difficulty). This can be easily provided by reference to balance sheet or cash flow. For a creditor, although there should be a requirement of threshold proof (insolvency), there is also a practical need for a creditor to be able to present proof, in relatively simple form, which establishes a presumption of insolvency on the part of the corporate debtor. It is suggested that clear evidence of a failure of the corporate debtor to pay a matured debt is all that should be required.

2.7 Immediate/interim effects of commencement of the process

There are three important matters to consider under this heading. One is management of the affairs of the debtor corporation. The second is the stay or suspension of actions or proceedings against or affecting the property of the debtor corporation. The third concerns the ongoing funding of the business operations of the debtor corporation.

(a) The continued management of the debtor corporation

If a debtor corporation is to be liquidated, the total powers of management should pass to an independent administrator as soon as possible.

In the case of a rescue, the options are:

• retain power in the existing management;
• remove power from the existing management of the debtor corporation and give total power to an independent administrator; or
• provide for a type of fusion by appointing an independent person to exercise supervisory and, if necessary, ultimate power of management but, at the same time, retaining existing management.

  The removal of all power from existing management, except in particular circumstances, can cause damage and can result in repercussions. For example, if a debtor corporation is seeking a genuine rescue, the removal of or an extreme reduction in the powers of management might sometimes remove the incentive. If, on the other hand, the creditors have little or no confidence in existing management, to maintain existing management with no check on powers can antagonise creditors.

  Sometimes the solution will depend on whether the process is voluntary (where the debtor corporation has applied) or if it is involuntary (where a creditor or creditors have applied and the debtor corporation is hostile). There will also be cases in which it will be necessary to appoint a provisional or interim independent administrator.

(b) Stay or suspension of actions

The policy issue is whether there should be an immediate stay or suspension of actions and proceedings against property of the debtor corporation and, if so, the terms and conditions of such a stay or suspension. This raises the problem of the extent to which an insolvency law should intrude into and interfere with accepted commercial practices and processes. For example, should an insolvency law restrain the rights of secured creditors?

For policy and pragmatic reasons there must be some restraint on some creditors if a fair and ordered administration is to result. For this reason, it is highly desirable that some form of stay or suspension comes into immediate effect once an application has been made, particularly by a debtor corporation, for relief under the insolvency law. This so-called "automatic" stay or suspension is a feature of many modern insolvency regimes. If a creditor or creditors have applied, there should not be an immediate stay or suspension until the application has been heard and determined, but a stay should be capable of being applied, on an interim basis, if circumstances can be shown to warrant it.

In the environment of the "rescue" culture, the dictates of policy suggest that where there is a genuine aim of effecting a rescue, the extent of automatic stay or suspension should be very wide and all embracing. The rationale for this is that attempts at rescue will fail unless the essential assets and component parts of the debtor corporation and its businesses are maintained.

However, where it is clear that the corporate debtor will be liquidated that rationale is no longer relevant and the stay or suspension should only affect unsecured creditors.

(c) On-going funding

The third aspect concerns the continued funding of the business activities of the debtor. If the debtor is suited only to liquidation, the problem of on-going funding will not, except in rare cases, be a problem. Usually the business of the debtor will have been closed down or will be in the stages of closing down. However, where a genuine prospect of rescue exists, on going funding may be of critical importance. If a debtor has no available funds to meet its immediate cash flow needs (for example, to pay for supplies, to pay wages to employees) a rescue will fail unless those funds can be provided.

An insolvency law can help this situation by providing power to obtain funding and by providing assurances and protection for the eventual repayment of the funding. Most insolvency regimes do this by, firstly, recognising the need for and sanctioning such funding and, secondly, by creating a "super priority" for its repayment. That is normally effective, however, only from the point in time that a debtor corporation is under the legal control or ambit of the rescue process. There is a problem if there is some gap in time between the initiation of the process and that point. As may be seen later, this is a problem that sometimes confronts the formal rescue process and invariably confronts an informal rescue or "work-out" process.

Tentative proposal Under the liquidation process If the debtor corporation has applied for liquidation or if it is determined that the debtor corporation is only suited to liquidation, the powers of the existing management should be removed and an independent administrator should be appointed to assume those powers and the conduct of the liquidation. Secondly, the stay or suspension of actions and proceedings against the property of the debtor corporation should be confined to unsecured creditors only. Thirdly, since there would be little or no requirement for on-going funding for such a debtor corporation, no particular provision need be made for it. Under the rescue process In the case of a genuine rescue attempt, the position should be quite different. In that case it is suggested that the existing management might continue but with overall supervisory and ultimate power in an independent administrator. Secondly, the stay or suspension of actions and proceedings against the property of the debtor corporation should apply to all creditors (secured or otherwise) for a reasonable length of time, but subject to applications by affected creditors for relief from the stay. Thirdly, the legislation should both sanction and provide a "super priority" (ahead of all creditors) for funding of necessary on-going and urgent business needs of the debtor corporation.

2.8 Administration of the process

An insolvency law will break down and become ineffectual without adequate administration and supervision of the processes provided for in the law. Two areas require particular attention.

(a) Initial process

First, for the initial process, swift and largely rigid time limits are necessary. It is a judicial function or the function of a regulatory authority to ensure that the process is implemented without delay. The experience in most jurisdictions is that a specialist court or other tribunal (or, certainly, experienced judges or officials) is often required to deal with the initial processing of insolvency cases and then be available to exercise a general supervisory capacity to ensure that the administration takes its course and that the system is not abused.

(b) Subsequent progression

A second requirement is that once the process has been commenced, there must be a steady, certain and ordered progression of each case. For cases of liquidation, the experience in many jurisdictions is that they are usually best administered through a special government agency. Sometimes, if the liquidation is complex, the administration is transferred out to specialist private administrators with suitable qualifications and experience.

Cases of rescue are normally not suited to administration by a government agency. It is preferable for such cases to be administered (or supervised) by an independent private administrator. It is that person who has the task of bringing the various interest groups together and proposing and/or assessing a rescue plan.

Tentative proposal The insolvency legislation should provide for swift and strict time limits for the initial processing of an insolvent corporation. The court or other tribunal system must be properly resourced to enable the process to be implemented. The longer term administration of an insolvent corporation which is being liquidated may be conducted through a special government agency but with provision to enable more difficult and complex cases of liquidation to be administered by an outside independent specialist insolvency administrator. The government agency must be properly resourced to enable it to perform its functions efficiently. Cases of rescue should be administered by an independent specialist administrator. All cases of liquidation or rescue should be subject to supervision by the appropriate court or tribunal.

2.9 Particular liquidation features

The main aspects of the liquidation of an insolvent corporation concern the following:

• termination of the business activities; securing the assets, books and records; dealing with outstanding contracts and so forth;
• convening a meeting of creditors with representatives of management (directors) to explain the causes of the insolvency and provide a forum for questions and examination;
• the realisation of assets;
• assessing and adjudicating the claims of creditors;
• investigating the conduct of the corporation and reporting on that investigation; ¡
• taking action to recover assets of the corporation; setting aside unlawful asset dealings;
• distribution of proceeds of sale of assets to creditors according to the legislative priorities and reporting to creditors;
• dissolution of the corporation.

  Tentative proposal The administration of a corporation in liquidation is a public responsibility and should be viewed as part of the overall regulation of corporations. It is possibly best handled by a specialist government agency which must be adequately resourced and financed.

2.10 Particular rescue features

The two most important things about the rescue process are:

• the conduct of a thorough independent assessment of the business activities, assets and liabilities and general affairs of the corporation;
• the preparation and objective assessment of a proposal or plan of rescue.

  Transparency of the process is important. Creditors must be given full information about the corporation and a full assessment of any proposal. A proper assessment of a proposal normally requires that a comparison is made between the result that might be obtained if the corporation was liquidated and the result that is likely to be obtained if the proposal is accepted.

  In some jurisdictions, the plan for the rescue of the corporation is often proposed by existing management. In other jurisdictions the proposal is prepared by an independent administrator, usually in conjunction with existing management or ownership. Either way, there is a need for independent assessment of the proposal.

  Tentative proposal An insolvency law regime should provide, as part of the rescue process, for an independent investigation and report of the affairs and the financial position of the corporation. It should also provide for an independent assessment of any rescue proposal in respect of the corporation.

  2.11 The position and role of creditors

  Unless creditors are involved in the insolvency process the law will seem irrelevant. Although, in the case of liquidation, the creditors may not have much need for intervention or decision, it is nonetheless important that they be involved and receive reports on the conduct of the liquidation. In the case of a rescue, the creditors are vitally important. In all jurisdictions it is the decision of the creditors which will determine whether a proposal of rescue is accepted or not (and, under some regimes, if it is not accepted, that the company be liquidated).

  This raises the issue of the voting rights of creditors and the involvement of other interests.

  For reasons of principle, policy and pragmatism, an insolvency law, despite that it is a collective legal process, cannot:

• accord equality to different, competing interests; nor
• depend upon the need for unanimity within different interest groups for its application.

  Yet it is most necessary that the process has binding effect.

  The interests of which account should be taken are owners (shareholders), secured creditors, preferred (or priority) creditors, ordinary unsecured creditors and persons who own property which is used, leased or occupied by the corporation. Sometimes, depending upon policy dictates, account is also taken of employees as a further separate interest group.

  When it comes to decision making as part of the rescue process the interests of creditors should prevail. That is dictated by the fact that, because the corporation is insolvent or in extreme financial difficulty, the capital or equity of owners will have been severely depleted, if not completely lost and, although they have been affected, it is the creditors whose interests should become paramount.

  As between creditors themselves, a system of voting rights and their exercise is used to:

• distinguish between creditor interest groups; and
• bind creditors to decisions reached in accordance with the exercise of voting rights.

  In many jurisdictions the voting rights of creditors are measured by reference to their number and the value of the debts owed to them. Thus, for example, the approval of a proposal of rescue might require a majority in number and a majority in value of creditors to vote in favour. This can sometimes produce the problem of a deadlock. There may be a majority in number but not a majority in value or vice versa. In other jurisdictions the voting is determined by simple majority in number only.

  Under any system of voting it is important to ensure that voting powers are not manipulated and that the interests of genuine creditors are not interfered with nor prejudiced by the voting powers of persons who are connected to the corporation (insiders).

  Another difficulty is sometimes experienced in dealing with the voting powers of secured creditors. If the rescue proposal is such that it might affect secured creditors (in the sense of reducing the value of their security or seriously impairing their rights to enforce the security), they should normally be afforded voting rights as a separate class.

  Tentative proposal An insolvency law should make proper provision for the involvement of creditors as part of the liquidation or rescue process. In particular: the insolvency law should clearly define the voting rights of creditors and should prescribe minimum requirements for the approval of a plan of rescue; provision should be made for voting by classes of creditors, particularly secured creditors, if the rescue proposal is required to bind such classes; the law should also provide protection against manipulation of the voting system and, in particular, should ensure that a court or other tribunal is empowered to set aside the results of voting which are obtained by the exercise of votes of insiders or persons who are related to the corporation, its shareholders or directors; and the effect of a vote of the requisite majority of a class should be made binding on all creditors of that class.

  2.12 Priorities between creditors

  A major difference in the insolvency law regimes of different countries is in the ranking of preferred or priority creditors. Many insolvency law regimes, for example, provide that debts such as tax debts and debts due to employees are to be paid in full, ahead of all other creditors. To give greater effect to one of the underlying principles of an insolvency law - equal treatment for creditors - the modern approach is to endeavour to limit priority claims as much as possible. Clearly, secured creditors are entitled to be paid their claims from the proceeds of secured property. It must also be the case that the costs of the insolvency administration (whether under a liquidation or rescue process) should be paid in priority to any other claim. However, with those exceptions, it should be the aim of a modern insolvency law regime to limit the number of priority claims to as few as possible.

2.13 Avoidance of transactions

One of the more extraordinary policies of established insolvency law regimes is to include provisions which have retrospective effect. These are designed to upset past transactions to which an insolvent corporation is a party which have had the effect of either reducing the net worth of a corporation (for example, by gifting its property or transferring or selling property for less than its fair commercial value) or of upsetting the principle of equal sharing between creditors of the same class (for example, by payment of a debt to an unsecured creditor or granting a security to a creditor who is otherwise unsecured when other unsecured creditors remain unpaid).

This aspect of an insolvency law regime is much debated. The debate centers not so much on the policy behind such provisions but on how effective in practice such provisions are and the somewhat arbitrary rules that are necessary to define, for example, time periods and the nature of the transactions themselves. There is some validity in the criticism that the actual operation and enforcement of such provisions is not, in many cases, effective.

Nonetheless, it may be submitted that avoidance provisions are important because, first, they are sound in policy; secondly, they may result in recovery for the benefit of creditors; and thirdly, provisions of this nature help to create a code of fair commercial conduct and are part of appropriate standards for corporate governance.

Tentative proposal An insolvency law regime should contain adequate provisions relating to avoidance of transactions which result in damage to creditors or conflict with the principle of equal treatment of creditors of the same class.

2.14 Civil sanctions against management and others

The conduct and behaviour of owners and directors of a corporation is primarily a matter of corporate law policy and regulation. It should not, for example, fall to an insolvency law to remedy defects in that area of legal regulation nor to police corporate governance policies. However, if the consequence of the past conduct and behaviour of persons connected with an insolvent corporation is that damage and loss is caused to the creditors of the corporation (for example, by fraud or irresponsible behaviour), it is the appropriate province of an insolvency law to provide for the possible recovery of the damage or loss. This should extend to powers of inquiry and examination.

Tentative proposal An insolvency law regime should contain provisions for the civil sanction of fraudulent and other conduct which causes damage or loss to creditors of an insolvent corporation.

2.15 Cross-border considerations

The growth of both regional and international trade and commerce has focused attention on the many problems associated with cross-border insolvency. The trading and business activities of a corporation may result in the corporation having businesses, assets and trading activities in more than one country. If that corporation becomes insolvent and is subject to an insolvency administration in one jurisdiction it has become increasingly important that the other jurisdictions in which its business activities are situated can respond to and, hopefully, cooperate in the overall administration of the corporation. This is a particularly important factor in relation to a corporation which is proposing a rescue.

Uniform cross-border insolvency legislation which would equip every country with similar legislative provisions regarding recognition, relief and cooperation between and with the courts, regulators and administrators of other countries is a possibility. In this respect the model cross-border insolvency law proposed by the United Nations Commission for International Trade Law (UNCITRAL) of May 1997 is relevant.

Tentative proposal An insolvency law regime should include the provisions of UNCITRAL cross-border model law.