SECTION 3 - THE BASIC ELEMENTS OF INFORMAL CORPORATE INSOLVENCY PRACTICES

3.1 Informal work-out

The concept of the informal work-out emerged some ten years ago in some countries, notably the USA and England, as a serious alternative to the application of formal insolvency law processes. Some commendable pioneering work to encourage the development of this approach was done, in a non official capacity, by the Bank of England. It has since been further developed by some of the leading English commercial banks. This development has become known as "the London approach", a description which may or may not be unfortunate depending on one's view.

In America, the concept of the informal work-out has become possibly more developed. It is now sometimes used as the preliminary to that which has become known as a "pre-packaged" chapter 11.

3.2 Reasons for development

The reasons for its development are important because they suggest that even the more developed and "modern" formal rescue regimes are not entirely suitable to the task of rescue. It is claimed that, first, there is a need for something more flexible and less rigid than the process which is available under formal insolvency rescue regimes and that, secondly, many cases of corporate financial difficulty require greater early pro-active response from creditors which is not normally possible under the formal rescue regimes.

3.3 Necessary conditions

The informal work-out depends, for its effectiveness, on a number of well defined initial premises. These may be summarised as follows:

• ¤ the fact that there is a significant size of debt owed to a number of different creditors (mostly these would be bank or other financial institution creditors) and the present inability of the corporate debtor to service that debt;
• the attitude that it may be preferable to negotiate an arrangement for the financial difficulties of the corporate debtor, as between the corporate debtor and the financiers and also between the financiers themselves;
• the availability of relatively sophisticated refinancing, security and other commercial techniques that might be employed to alter, rearrange or restructure the debts of the corporate debtor or the corporate debtor itself;
• the sanction that if the negotiation process cannot be started or breaks down there can be relatively swift and effective resort to the application of an insolvency law; and
• the prospect that there may be a greater benefit for all through the negotiation process than by direct and immediate confrontational resort to the insolvency law.

To be effective it requires the employment of a number of skills and processes. Graphic 3 presents a diagram of a typical informal process.

3.4 Main processes

(a)The creation of a "forum" in which both debtor and creditors can initially come together for the purpose of exploring and negotiating an arrangement to deal with the financial difficulty or insolvency of the debtor. This "forum" is not only for the benefit of the two sides (debtor and creditors), but also for the creditors, between themselves.

(b) The appointment of a "lead" bank creditor to provide leadership, organisation, management and administration.

(c) The selection of a committee which is representative of creditors (commonly called a "steering" committee) to assist the lead creditor and to act as a provisional sounding board toward proposals for the corporate debtor.

(d) A "standstill" (an agreement to suspend adverse actions by both creditors and the debtor) during a defined, preferably short, time period. The standstill may be compared to the "moratorium" or stay of actions and proceedings which has become an important feature of formal rescue insolvency law regimes.

(e) The gathering and provision of complete and accurate information regarding the corporate debtor, including its business activities, current trading position, general financial position and assets and liabilities. This may be compared to the statutory requirement for the provision of similar material which is found in most of the formal rescue regimes.

3.5 Practical processes and problems

(a) Commencing the process

A work-out essentially involves bringing debtor and creditors (at least, the main creditors) together. Someone has to initiate the prospect of intercourse. This is really up to the debtor and/or one or more of the main bank creditors. None of the overseas examples of the work-out process rely upon a facilitator to impose, initiate or help the process along.

Sometimes this presents a difficulty. A corporate debtor may, for example, be willing to have dialogue with its main bank creditor (who might be expected to be in a position of considerable control) but may be unwilling or not appreciate the desirability of discussions with a number of creditors.

As between the creditors themselves, some of them will be concerned for their own position and may not wish to participate in nor contemplate a "collective" approach.

These types of problems can sometimes be overcome. An approach in the main jurisdictions has been to use the sanction of quick and convenient access to formal insolvency law procedures as a "bargaining" factor in the commencement and progression of an informal work-out. The availability of this type of sanction can influence both a corporate debtor and its creditors. If a corporate debtor refuses to participate in an informal process which has been initiated by some of its creditors, it will almost certainly lead either to individual creditor enforcement action or the application of the formal insolvency procedures which the debtor will not be able to delay nor defeat. Unwilling creditors face much the same sanction and may find that they are subject to a formal collective process which effectively prevents them from enforcing their individual rights.

(b) Engaging advisors

Few, if any, attempts are made at a work-out without the involvement of independent experts and advisors from various disciplines (legal, accounting, business reorganisation, marketing and so forth). It is often the corporate debtor, sometimes creditors, who will refuse this because of cost, intrusion, surrendering control and so forth. But it is normally a necessity. Information, independently verified, is the prime pursuit of the creditors.

The argument of the creditors, which would seem somewhat indefensible, is that this would happen under a formal insolvency rescue regime so why should it not happen in the informal situation.

(c) Classes of creditors

Creditors will rarely be in the same position as one another. For example, some will have security, others will not. Of those who have security, some will have better security than others. There may be issues between creditors of competing priority rights (or rights generally) in respect of the same security property. Unsecured creditors may also have different rights. Some may have guarantees from third parties. Lease finance creditors may seek to recover their equipment. Some creditors may be subrogated to others.

This complexity often presents critical problems, particularly if the aim of the process is to maintain the assets and business undertakings of the corporate debtor together. If some creditors have commenced recovery or enforcement action it may be difficult to dissuade them from continuing with that enforcement. The prospect of a work-out breaking down because of the differences between creditors can only be dealt with by a combination of pursuasion that there is a prospect of a better result through the work-out process and the threat of the sanction of imposing a formal insolvency process which has the effect of restraining all creditors from pursuing their individual rights.

(d) Dissenting creditors

Unanimity amongst creditors cannot be anticipated nor expected. In part, the problem of dissenting creditors can only be dealt with as mentioned above or by the application of some "peer" group pressure on the dissenting creditor (with the reminder that there may be "other occasions"). Because it is an informal process there are no rules of enforcement by which a dissenting creditor may be compelled or bound to the view of the majority. This sometimes results in the trading of "distressed" debt. A bank creditor may not, for example, be willing to participate in the work out process or may not be prepared to wait or renegotiate the eventual repayment of the debt. There are traders who might be prepared to acquire the debt. If this occurs the debt trader becomes the creditor and engages in the work-out.

(e) Outside creditors

In most cases of informal work-outs it is impossible to involve every creditor in the work-out process. One problem is often the sheer number of creditors. Another is the inefficiency of involving creditors who are owed small amounts. Yet another problem is that many creditors do not have the commercial expertise and knowledge to participate in the process. But, left out from the "forum" though they may be, they cannot be forgotten nor ignored. Some of them may be important. They might be suppliers of essential goods or services or they may participate in essential parts of the production process of the debtor corporation.

It is often the case in an informal work-out that these smaller creditors are paid in full and encouraged to continue their supplies of goods or services. From the perspective of the major creditors, this type of "favouritism" does not normally cause much harm.

(f) Cash flow/liquidity problem

If a corporation becomes a candidate for a possible work-out it will normally require continued access to established lines of credit or the provision of fresh credit. There can be a problem with both. The normal reaction of a lender will be to terminate or close off any further credit. This problem can only be dealt with by evaluation and negotiation. If the lender is already secured there may not be a problem in permitting further credit. But the real problem arises when all lines of credit have been exhausted (or terminated) and there is a pressing need for cash flow and liquidity. This can only be provided by what is often referred to as "new money". The problem is whether the creditor or creditors who might be willing to supply this new money can be reasonably guaranteed that, if the worst happens, they will be repaid in full.

As between the creditors who are participating in the attempted work-out, they may agree amongst themselves that if one or more of their number provide "new money" the rest of those creditors will subrogate their claims to enable the "new money" to be repaid ahead of those claims. Thus, as between that group of creditors, there is a contractual agreement for the eventual repayment of the new money to the creditor who provides it.

However, if the attempt at the work-out does not succeed and the debtor corporation is liquidated, there is a further issue of how a claim for the repayment of that new money will be treated in a liquidation. Unless there is a security for the new money it will be an unsecured claim. And because the liquidation law will normally apply the principle that treatment of creditors in the same class must be equal, the claim for payment of the new money will be the same as any other claim of a non secured creditor.

In some countries there are legislative provisions which provide for some type of "super priority" to accommodate this type of problem. It is also desirable that the formal insolvency law requires that a contract of subrogation between creditors may be recognised, applied and enforced in a liquidation or rescue process.

Later in this report the development of the informal work-out process in some of the RETA economies is examined.