 Orderly & EffectiveInsolvency Procedures  Key Issues Legal Department International Monetary Fund 1999 Contents
Foreword Over the years, the IMF has become increasingly involved in the promotion of orderly and effective insolvency systems among its members. Experience has demonstrated that reform in this area can play a major role in strengthening a country's economic and financial system. For example, an effective insolvency system provides an important pillar of support for the domestic banking system by enabling banks to curtail the deterioration of the quality of their claims, including claims on the corporate sector, whether through a court-approved restructuring or, where necessary, through an efficient liquidation. Insolvency reform can be particularly relevant for economies in transition, where it can play a critical role in addressing the problems of insolvent state-owned enterprises. In the context of financial crises, an orderly and effective insolvency system can provide an important means of ensuring adequate private sector contribution to the resolution of such crises. Finally, although insolvency procedures are implemented through the courts, the very existence of an orderly and effective insolvency system establishes incentives for negotiations between debtors and their creditors, which may lead to out-of-court agreements being reached "in the shadow" of the law. Drawing on the lessons of experience, this report discusses the major policy choices to be addressed by countries when designing an insolvency system. The issues discussed are relevant to all countries, irrespective of the different stages of their development. As noted in the Introduction, while the report expresses certain preferences with respect to some of the more important of these choices, it does not attempt to establish standards in this complex area. Moreover, it may need to be updated in the future to take into account developments in this area. The report has benefited considerably from input from both the official and private sectors, and the IMF's Legal Department would like to express its thanks to those that have provided support during its preparation. With respect to input from the official sector: The report builds upon--and is consistent with--the Key Principles and Features of Effective Insolvency Regimes set forth in the report of the G-22 Working Group on International Financial Crises. Appended to the report is a contribution from the Secretariat of UNCITRAL (the UN Commission on International Trade Law) regarding cross-border insolvency problems and the model law prepared by UNCITRAL to address these problems. The report has benefited from comments by a number of international organizations, including the World Bank, the Organization for Economic Cooperation and Development, the European Bank for Reconstruction and Development, the Asian Development Bank, and the International Finance Corporation. Regarding assistance from the private sector: The Legal Department would like to thank INSOL International (the International Federation of Insolvency Practitioners), which provided useful comments and has expressed general support for the report. The Legal Department relied extensively upon the advice of a number of international insolvency experts, and would like to extend its particular thanks to the following experts, all of whom took considerable time in reviewing and providing guidance on earlier drafts of the report:
In addition, the Legal Department would like to express its special gratitude to Professor Christoph Paulus of the University of Humboldt (Germany), who participated in all stages in the preparation of the report and whose knowledge of comparative insolvency issues proved invaluable. Appreciation is also extended to Anthony Smits and Oscar Urizar, who provided valuable analytical and research assistance in the preparation of the report. Within the IMF's Legal Department, Sean Hagan drafted the report and coordinated the work of the research team, made up of Boyko Dimitrachkov, Seng Chee Ho, Nadim Kyriakos-Saad, and Rhoda Weeks. Sonia Piccinini devoted considerable time and effort in the preparation of this publication. The views expressed in the report are those of the IMF's Legal Department and should not be attributed to the Executive Directors or the Management of the IMF.
Recent experience has demonstrated the extent to which the absence of orderly and effective insolvency procedures can exacerbate economic and financial crises. Without effective procedures that are applied in a predictable manner, creditors may be unable to collect on their claims, which will adversely affect the future availability of credit. Without orderly procedures, the rights of debtors (and their employees) may not be adequately protected and different creditors may not be treated equitably. In contrast, the consistent application of orderly and effective insolvency procedures plays a critical role in fostering growth and competitiveness and may also assist in the prevention and resolution of financial crises: such procedures induce greater caution in the incurrence of liabilities by debtors and greater confidence in creditors when extending credit or rescheduling their claims. This report identifies and discusses the key issues that arise in the design and application of orderly and effective insolvency procedures. Although it is based on a comparative study of selected insolvency laws, it is not intended to be a description of those laws. As will be seen, the approaches adopted by countries vary in a number of respects, with these differences being attributable not only to divergent legal traditions but also to different policy choices. Because of these differences, international standards do not exist in this area, and this report does not attempt to propose such standards. However, in its discussion of the key issues in this area, the report weighs the advantages and disadvantages of possible solutions, and, in that context, sets forth conclusions in which preferences are expressed. Given the multiplicity of questions raised by insolvency proceedings and the diversity of responses in national laws, this report is necessarily selective. It focuses on the most important issues and the principal policy choices that need to be made when resolving these issues. An early caveat regarding labels is necessary: while these policy choices are often described as reflecting an underlying "pro-creditor" or "pro-debtor" attitude, these terms often have different meanings in different countries and, accordingly, they are not used extensively in this report. For instance, in some countries a pro-debtor insolvency law is understood as favoring the management of the debtor company, thereby allowing it to retain control of the company or to negotiate from a position of strength with its creditors. In other countries, insolvency law will be characterized as being pro-debtor primarily because it allows the enterprise to survive and the employees to keep their jobs, while the managers are replaced by an administrator and, eventually, a new owner of the enterprise. Similarly, pro-creditor laws may differ regarding the way they address the respective rights of secured and unsecured creditors. While secured creditors are often the main beneficiaries of outright liquidation proceedings in which the realization of their collateral will ensure the full and prompt payment of their claims, unsecured creditors may benefit from a rehabilitation procedure that will maximize the value of the debtor's assets and, therefore, the value of the unsecured creditors' claims. In any event, experience shows that the degree to which an insolvency law is perceived as pro-creditor or pro-debtor is, in the final analysis, less important than the extent to which these rules are effectively implemented by a strong institutional infrastructure. In particular, given the complex and urgent nature of insolvency proceedings, effective implementation requires judges and administrators that are efficient, ethical, and adequately trained in commercial and financial matters and the specific legal issues raised by insolvency proceedings. A pro-debtor law that is applied effectively and consistently will engender greater confidence in financial markets than an unpredictable pro-creditor law. The scope of this report is limited in a number of important respects.
This report consists of six chapters. Chapter 2 contains a discussion of the general objectives and features of insolvency procedures and, in that context, identifies the principal features of the two main types of procedures, namely, liquidation procedures and rehabilitation procedures. These features are described in greater detail in Chapter 3 (liquidation procedures) and Chapter 4 (rehabilitation procedures). Chapter 5 briefly discusses institutional aspects of insolvency procedures and, in particular, addresses the important role of the court and the administrator. Chapter 6 briefly reviews the major issues raised by cross-border insolvencies, and the Appendix contains a study prepared by the UNCITRAL Secretariat regarding the UNCITRAL model law that is designed to address these problems. 2 General Objectives and Features of Insolvency Procedures
Although the insolvency laws of countries differ in important respects, it is possible to identify two overall objectives that are generally shared by most systems. The first overall objective is the allocation of risk among participants in a market economy in a predictable, equitable, and transparent manner. The achievement of this objective plays a critical role in providing confidence in the credit system and fostering economic growth for the benefit of all participants. For example, in terms of the creditor-debtor relationship, the ability of a creditor to commence insolvency proceedings against a debtor as a means of enforcing its claim reduces the risk of lending and, thereby, increases the availability of credit and the making of investment more generally. An insolvency law also serves to allocate risk among different creditors, also for the benefit of borrowers. For example, if the insolvency law affords secured creditors special treatment vis-à-vis unsecured creditors, such treatment protects the value of security, which may be particularly important for those debtors that, because of their credit risk, cannot obtain (or cannot afford) unsecured credit.
Some of the key policy choices to be made when designing an insolvency law relate to how the above objectives are balanced against each other. In addition, choices need to be made on who will be the beneficiaries of the value that is maximized: while some countries view rehabilitation procedures as providing a way to enhance the value of creditors' claims through the going-concern value of the enterprise, other countries also view it as a means of providing a "second chance" to the shareholders and the management of the debtor. Still others view the continuation of the enterprise as primarily benefiting the employees. The protection of employees raises the larger issue of when reliance on the insolvency law should be avoided altogether so that certain public policy objectives can be achieved. For instance, to limit unemployment or rescue enterprises that are engaged in important national activities, the authorities may prefer to address the problems of a troubled company through various measures that will involve an extensive use of public funds and give the beneficiaries a substantial advantage over their less-favored competitors.1 When determining how to strike the balance between the various objectives described above, it is necessary to avoid easy stereotypes. Debtors are not always fraudulent or incompetent, and creditors are not always grasping and selfish. As borne out by recent experience, although companies may fail because of incompetence, they may also fail because of economic difficulties beyond their control. Viewed from the perspective of the economic policymaker, and in light of the above objectives, an effective insolvency law can clearly play a critical role in a number of areas. Generally, the discipline it imposes on a debtor increases the competitiveness of the enterprise sector and facilitates the provision of credit. More specifically, to the extent that the enterprise is owned by the state, subjecting the enterprise to the application of the general insolvency law sends a clear signal regarding the limitations of public financial support. In that context, the rehabilitation provisions of an insolvency law can effectively ensure that creditors contribute to the resolution of the financial problems of state-owned enterprises, thereby limiting the public cost of rehabilitation. With respect to the financial sector, an effective insolvency law enables financial institutions to curtail the deterioration of the value of their assets by providing them with a means of enforcing their claims. In that context, it can also facilitate the development of capital markets. For example, if an insolvency law is applied with sufficient predictability, a secondary market in debt instruments can develop that, among other things, will enable financial institutions to transfer their loans to other entities that specialize in the workout process. Finally, in the context of a financial crisis in which the entire enterprise sector is in distress, an effective insolvency law can provide a useful means of ensuring that private creditors contribute to the resolution of the crisis. For example, a rehabilitation procedure provides a way to impose a court-approved restructuring agreement over the objections of dissenting creditors. Not only does such a mechanism reduce the public cost of the crisis and relieve external financing needs, but it also strengthens the stability of the international financial system by forcing creditors to bear the costs of the risks they incur.
When designing an insolvency law, countries will need to address a common set of issues. Moreover, countries normally resolve these issues through the implementation of liquidation procedures and rehabilitation procedures. Common Issues Insolvency procedures generally require two elements. The first is a legal framework that sets forth the rights and obligations of participants, both substantively and procedurally. The second is an institutional framework that will implement these rights and obligations. A key question that arises in this context is the degree of discretion that the law gives to this infrastructure when it applies the law. Legal Framework An insolvency law must make policy choices with respect to a number of substantive issues, the most important of which include the following:
Notwithstanding the variety of substantive issues that must be resolved, insolvency laws are highly procedural in nature. The design of the procedural rules plays a critical role in determining how risk is to be allocated among the various participants in the proceedings. Perhaps the most critical procedural issue relates to the identification of the decision maker. For example, in the case of liquidation proceedings, in what circumstances can the creditors replace the liquidator? In the case of a rehabilitation procedure, should the determination of whether a successful rehabilitation is potentially feasible be made by the creditors, the administrator, the court, or a combination thereof? If a rehabilitation plan is approved by the creditors, can it subsequently be rejected by the court? Conversely, can the court impose a plan that has been rejected by a requisite majority of the creditors? As discussed below, to the extent that the law confers considerable responsibility upon the institutional infrastructure to make key decisions, it is critical that this infrastructure be sufficiently developed. Institutional Framework An insolvency law will need to provide for an institutional framework for its implementation. Since the adjudication of disputes is a judicial function, insolvency proceedings should be conducted under the authority of a court of law where judges will, at a minimum, be required to adjudicate disputes between the parties on factual issues and, on occasion, render interpretations of the law. The judiciary will only be able to fulfill this function if it is made up of independent judges with particularly high ethical and professional standards. Moreover, the court will also need to appoint qualified professionals (liquidators and administrators) who are designated to handle key administrative matters (recording, collection and evaluation of the assets and liabilities, management of the enterprise, etc.). The availability of an experienced cadre of such professionals with adequate commercial experience is essential to a successful implementation of the law. Among other things, safeguards will need to be in place to ensure that any conflict of interest is avoided between the designated professional and those parties that have an interest in the proceedings. To perform their tasks, the court and the designated officials will also have to rely on specialists (accountants, appraisers, and auctioneers). They will need to have access to the debtor's books and other relevant information. For a proper discharge of their functions, laws will have to require the keeping of books and the observance of accounting standards by debtors engaged in an independent business activity. Although it is not necessary for such provisions to be contained in the insolvency law itself, they are essential to its implementation. Exercise of Discretion How much discretion should the law give to judges and designated officials in the exercise of their duties? Mandatory rules, when precisely formulated, give legal certainty to the parties and avoid litigation; they facilitate the proceedings and reduce their cost. Moreover, specific rules and criteria provide for the predictability that is one of the overall objectives of an insolvency law. However, most laws give the court or the designated officials at least some degree of discretion when resolving disputes during the proceedings on the grounds that it is not feasible to foresee and regulate each and every possible situation. But to what extent should the court and the designated officials have the authority to make decisions on economic and business matters, in some cases over the objections of creditors? If a court is given such authority, it is no longer responsible solely for ensuring the legality of the proceedings; it becomes an active participant, with substantive decision-making powers on the appropriateness of certain outcomes, such as the continuation of the enterprise. The greater the discretion that the law confers upon the court and the designated officials, the greater need there is for an adequate institutional infrastructure. Countries that give their judges such a key role in the decision-making process often find it necessary to establish a specialized court system, such as a commercial court or a bankruptcy court. The members of the court may be professional judges, preferably with special training and experience, or may be elected by the business community. In cases where the judges do not have such experience, countries often prefer to rely on qualified liquidators or administrators--or the creditors themselves--to make these decisions. Liquidation and Rehabilitation When a debtor is unable to discharge its liabilities as they become due, there are usually a number of competing claims on its assets, whether they be unpaid loans, invoices, rents, taxes, or salaries. To satisfy those claims, a liquidation of all of the debtor's assets and a distribution of the proceeds may be necessary. In such cases, creditors may only receive a portion of the nominal value of their claims. Sometimes, however, a complete liquidation of the debtor's assets will not be the preferred course of action, either for the debtor or its creditors. Rather, a restructuring of the debtor's operations or balance sheet may allow the creditors to be fully repaid or, at least, to receive more than they would have received through liquidation. Although the insolvency laws of countries differ in a number of respects, almost all countries address the problems described above by including both liquidation procedures and rehabilitation procedures in their insolvency laws. Liquidation Procedures The need for liquidation procedures can be viewed from different perspectives. From one perspective, these procedures can be seen as addressing intercreditor problems. Specifically, when an insolvent debtor's assets are insufficient to meet its liabilities, an individual creditor's best strategy is to rush to take the necessary legal measures to attach and seize assets before other creditors have a chance to take similar action. Applying the prisoner's dilemma paradigm, while such behavior will appear rational from the perspective of individual creditors, such a "grab race" will not, in fact, be in the collective self-interest of creditors; not only are the legal actions taken by creditors costly, but such a disorderly piecemeal dismantling of the entity will lead to a loss in value for all creditors. An orderly and effective liquidation procedure addresses the inter-creditor problem by setting in motion a collective proceeding that seeks to achieve equitable treatment among creditors and to maximize the assets to be distributed to creditors. This is normally achieved by the imposition of a stay on the ability of creditors to enforce their rights against the debtor and the appointment of an independent liquidator whose primary duty is to maximize the value of the assets of the debtor prior to distribution to creditors. Viewed from a broader perspective, and as discussed earlier, such liquidation procedures constitute an important disciplinary force that is an essential element of a sustainable debtor-creditor relationship. For example, by providing an orderly and relatively predictable mechanism by which the rights of creditors can be enforced, these procedures provide creditors with an important source of comfort when they make their lending decisions. In this way, they can be seen as promoting the interests of all participants in the economy, since they facilitate the provision of credit and the development of financial markets. Rehabilitation Procedures In contrast to liquidation procedures, rehabilitation procedures are designed to give an enterprise some breathing space to recover from its temporary liquidity difficulties or more permanent overindebtedness and, where necessary, provide it with an opportunity to restructure its operations and its relations with creditors. As noted above, where rehabilitation is possible, such an approach will be preferred by creditors if the value derived from the continued operation of the enterprise will enhance the value of their claims. While the benefits of rehabilitation are widely accepted, the degree to which formal rehabilitation procedures are relied upon to achieve these objectives varies considerably among countries. It is generally recognized that, in many respects, the very existence of liquidation proceedings will facilitate the restructuring of an enterprise, since it creates the necessary incentives for an out-of-court restructuring. Indeed, even in economies with sophisticated rehabilitation procedures, most rehabilitations take place "in the shadow" of insolvency proceedings. Moreover, a liquidation procedure, once activated, can also provide a basis for restructuring if it allows the enterprise to be sold as a going concern. Notwithstanding the above considerations, there are a number of reasons why formal rehabilitation procedures can provide a mechanism for enterprise rehabilitation that serves the interests of all participants in the economy. First, out-of-court rehabilitation requires unanimity of creditors. With the growth of capital markets and the resulting increase in the number and diversity of creditors, both the debtor and those creditors that wish to restructure may need to rely on the formal rehabilitation provisions that exist in a number of countries, which enable the debtor and the majority of its creditors to impose a plan upon a dissenting minority of creditors. Indeed, this feature of rehabilitation proceedings further facilitates out-of-court restructuring insofar as it reduces the leverage of a "hold-out" creditor during such out-of-court negotiations. Second, in the modern economy, the degree to which an enterprise's value can be maximized through liquidation of its assets has been significantly reduced. In circumstances where the value of a company is increasingly based on technical know-how and goodwill rather than on its physical assets, preservation of the enterprise's human resources and business relations may be critical for creditors wishing to maximize the value of their claims. Third, rehabilitation procedures may be viewed as economically beneficial in the long run, since they encourage debtors to restructure before their financial difficulties become too severe. Moreover, some countries view such procedures as serving a broader societal interest, by giving debtors a second chance and, thereby, encouraging the growth of the private sector and an entrepreneurial class. Finally, and perhaps most important, as in the design of most other economic laws, economic efficiency is not the only consideration when designing insolvency laws. There are social and political factors that are served by the existence of formal rehabilitation provisions and, in particular, the protection of employees of a troubled enterprise. These considerations explain why the design of rehabilitation provisions varies from country to country. When countries evaluate and reform their insolvency laws, the key question will often be how to find the appropriate balance between a variety of social, political, and economic interests that will induce all actors in the economy to participate in the system. While it is generally recognized that rehabilitation procedures are necessary, statistics show that, at least in a number of countries, up to 90 percent of insolvency proceedings end up in liquidation. Yet, statistics may be misleading. They often fail to capture the fact that larger companies (which have a greater impact on the economy) are more likely to be rehabilitated. Moreover, the failure of rehabilitation in these circumstances may often be due to the inadequate design or application of the rehabilitation procedure, and the conversion of rehabilitation into liquidation may reflect the fact that an enterprise with no chance of rehabilitation has used the rehabilitation procedure solely as a means of forestalling liquidation. Pre-Insolvency Procedures Some countries have adopted what can be described as "pre-insolvency" procedures that are, in effect, a hybrid of out-of-court rehabilitation and formal rehabilitation procedures. For example, in the United States, regulations have been issued that allow for the court to approve a reorganization plan under the rehabilitation chapter (Chapter 11) of the insolvency law even though the support required from creditors as a condition for court approval under this chapter was obtained through a vote that occurred before the actual commencement of the formal rehabilitation proceedings. Such "prepackaged bankruptcy" regulations are designed to minimize the cost and delay associated with formal rehabilitation procedures while providing a means by which a rehabilitation plan can be approved absent unanimous support of the creditors. Under French law, to facilitate the conclusion of an amicable settlement with its creditors, a debtor may ask the court to appoint a "conciliator." The conciliator has no particular powers but may request the court to impose a stay of execution against all creditors if, in his or her judgment, a stay would facilitate the conclusion of a settlement agreement. During the stay, the debtor may not make any payments to discharge prior claims (except salaries) or dispose of any assets other than in the regular course of business. The procedure ends when agreement is reached either with all creditors or (subject to court approval) with the main creditors; in the latter case, the court may continue the stay against nonparticipating creditors by providing a grace period of up to two years to the debtor. Still another method is the "London Approach." It is based on nonbinding guidelines issued by the Bank of England to commercial banks. Under this approach, banks are urged to take a supportive attitude toward their debtors that are in financial difficulties; decisions about the debtor's longer-term future should only be made on the basis of comprehensive information, which is shared among all the banks and other parties to a work-out. Interim financing is facilitated by a standstill and subordination agreement, and banks work together with other creditors to reach a collective view on whether and on what terms a company should be given a financial lifeline. Drawing on the success of the London Approach, a number of countries that have recently experienced international financial crises have put in place nonbinding principles or guidelines that are designed to promote out-of-court restructuring of enterprises through negotiations with their domestic and foreign creditors (e.g., the Jakarta Initiative). Such guidelines establish a collective framework for negotiations and provide for the availability of interim financing to enterprises by creditors and the provision of information by these enterprises so that their restructuring proposals can be effectively evaluated by creditors. The government generally plays the important but limited role of facilitating negotiations. Although this approach is designed to minimize recourse to the insolvency law, the effective application of the law is critical to the success of these informal procedures since it provides the necessary incentives for meaningful negotiations.
Relationship Between Liquidation Procedures and Although liquidation and rehabilitation procedures are often viewed as relatively distinct from each other, there are, in fact, considerable overlap and linkages between them, both as a matter of procedure and in terms of the substantive issues they address. Given the different objectives of these procedures, the determination of whether the enterprise is viable should, at least in theory, also determine which procedure should be used. As a matter of practice, however, when either of these procedures is initiated with respect to a debtor, it is often impossible to tell, at the time of commencement, whether the debtor should be liquidated or rehabilitated. In many countries, therefore, the party initiating the proceedings is given the choice between liquidation and rehabilitation procedures. However, when a creditor initiates a liquidation proceeding against a debtor, the law will often establish some mechanism that enables the proceedings to be converted into a rehabilitation proceeding. Conversely, in circumstances where a debtor seeks protection by commencing a rehabilitation proceeding, the law will often provide a means by which the proceedings can be converted into liquidation proceedings if it is determined that a successful rehabilitation is not likely (as discussed above, a key issue is the identity of the decision maker). As a general principle, therefore, although these are presented as "two-track" procedures, they are normally utilized sequentially; that is, a liquidation procedure will only run its course if rehabilitation efforts (whether formal or informal) have failed. With respect to the substantive issues that these procedures must address, there is also considerable overlap. This is due (at least in part) to the fact that the distinction between a "liquidation" and a "rehabilitation" is somewhat blurred. How does one classify the sale of an enterprise as a going concern? From one perspective, it can be viewed as a rehabilitation, because the enterprise continues its activities and employment is preserved. From another perspective, it can be viewed as a liquidation of the debtor's assets because the company that owns the enterprise is liquidated and the enterprise (as an economic unit) is now under new ownership. If, as in most cases, the sale of an enterprise as a going concern is considered a possible outcome of a liquidation proceeding, the continuation of the enterprise becomes just as critical as under a rehabilitation procedure, so similar safeguards regarding the stay on creditor actions and the treatment of contracts may be required. A number of countries reflect the above linkages in the design of their laws. For example, in some countries, liquidation procedures normally may be commenced only if all attempts to rehabilitate have failed. In effect, the law presumes that a company should be rehabilitated. The rehabilitation stage will only be skipped where there is clearly no hope for the enterprise (e.g., it is already out of business). Following a different approach, some countries that have recently revised their bankruptcy laws have introduced "unitary" proceedings as an alternative to separate, self-contained proceedings. For example, under the revised law of Germany, all insolvencies are conducted initially under the same rules and, for an initial period of up to three months, there is no presumption as to whether the enterprise will be rehabilitated or liquidated. The proceedings only separate into liquidation proceedings and rehabilitation proceedings once a determination has been made as to whether rehabilitation is, in fact, possible. The procedural simplicity of such an approach may have advantages, particularly where the capacity of the institutional infrastructure is limited. However, this trend toward "unitary" proceedings is a recent one and is still not reflected in the structure of the insolvency laws of many countries. For this reason, the structure of this report follows the twin procedure model that still prevails, identifying the linkages and differences between these proceedings as they arise. 3 Liquidation Procedures
Liquidation Procedure Liquidation procedures are generally relied upon once there is no economically reasonable possibility of rehabilitation. Although such procedures can therefore be viewed as the second of the two components of the insolvency proceedings, they are dealt with first in this study because they are utilized most often, and are generally viewed as the "core" proceedings upon which rehabilitation procedures are constructed. While many companies successfully rehabilitate, they normally do so out of court and actually rely on the "shadow" of liquidation to facilitate rehabilitation. Drawing on the overall objectives of an insolvency law described in the previous chapter, the most important objectives of an orderly and effective liquidation procedure may be described as follows. (1) A primary objective is to maximize the value of the assets of the estate. Many of the features of the insolvency system are designed to achieve that objective. These features include the imposition of a stay on creditor enforcement of legal remedies that prevents a premature breakup; the appointment of an independent liquidator with broad powers; when the temporary continuation of the enterprise by the liquidator is considered necessary, the creation of incentives for creditors to provide financing through priority for post-petition financing; and the inclusion of "claw-back" provisions that recapture assets disposed of by the debtor to the detriment of the creditors. (2) Another objective is to equitably treat similarly situated creditors. Insolvency creates a collective procedure that will only be effective if participants view it as equitable. This is achieved through the inclusion of a number of features, including claw-back provisions and the general stay on creditor enforcement of legal remedies. (3) A final objective, albeit a much broader one, is to provide a mechanism that facilitates the making of investment decisions. If creditors can rely on a mechanism that enables them to enforce their rights against a debtor, this will assist them in making their investment decisions. The commencement criteria are critical for this reason. Moreover, if the distribution priorities following liquidation recognize the seniority established by contractual terms, creditors will feel confident that they are able to manage, at least to some degree, the risks that they incur when making investment decisions. While the above objectives are normally mutually reinforcing, they can also, at times, be at odds with each other. Indeed, one of the challenges of designing an orderly and effective liquidation procedure is to strike an appropriate balance between competing objectives. For example, broad powers given to a liquidator to enable him to nullify transactions already entered into and to modify the terms of existing contracts may undermine the predictability in contractual relations that is critical to the making of investment.
Qualification of the Debtor The determination of which entities are eligible to be subjected as debtors to a country's general insolvency law is an important threshold issue and has important implications for a country's economy. For example, if the law excludes certain entities, these entities will be neither subject to the discipline imposed by an effective insolvency regime nor able to take advantage of the protection it affords. At the same time, important policy considerations may lead countries to establish special insolvency procedures for natural persons or for certain regulated entities. However, the exclusion of an enterprise from any form of insolvency regime should be avoided. Natural/Legal Persons An insolvency law should generally define which entities are subject to its provisions. It may decide to treat legal entities separately from natural persons, either through different statutes or through different chapters within the same statute. This separate treatment may arise for a number of reasons, including public policy concerns regarding consumer protection. Since this report is primarily concerned with the insolvency law's treatment of those actors that have the greatest impact on the country's economy, it does not express a preference as to whether natural persons should be subject to a special regime or the design of such a regime. Government-Related Entities It is universally recognized that sovereign nations are not subject to any insolvency law, international or national. Local government entities, such as municipalities, may be excluded from the scope of the insolvency law altogether or the law may establish a special regime for them.2 While the treatment of government-owned entities may also vary, there appears to be no reason why such an enterprise operating in the market place as a distinct entity should be excluded from the coverage of the general insolvency law unless the government has extended an explicit guarantee with respect to all its liabilities. As discussed in Chapter 2, the inclusion of a government-owned enterprise within the scope of the insolvency law has the advantage of both subjecting the enterprise to the discipline of the market place and sending a clear signal that government financial support will not be unlimited. Financial Institutions and Other Regulated Entities An insolvency law may exclude banks and insurance companies from the purview of general insolvency law on the grounds that the unique role played by these institutions in the economy and, in particular, the payments system merits a special regime. Whether financial institutions should be subject to a special insolvency regime and, if so, what the design of that regime should be is of critical importance to the IMF given its work in this area. For this reason, and as noted in Chapter 1, this issue will be the subject of a separate study. Countries may also wish to establish special regimes for other highly regulated entities, such as utility companies or, alternatively, may give the relevant regulatory agency a special role under the general insolvency law. Foreign Debtors
Whether or not a debtor is owned by foreigners should not be a criterion for determining
jurisdiction over insolvency proceedings. However, international insolvencies raise a number of
complex jurisdictional issues, for the resolution of which international cooperation is necessary.
On this cooperation, see the Appendix, which describes UNCITRAL's model law on cross-border
insolvency.
Conditions for Commencement Although insolvency laws generally provide for liquidation proceedings to be initiated by either a creditor or the debtor, they differ on the specific criteria that must be satisfied before the proceedings can commence. Moreover, a number of laws set forth alternative criteria. Nevertheless, a criterion that is relied upon extensively--and which is consistent with the overall objectives of insolvency--is one that allows for commencement when the debtor has ceased to meet its liabilities generally as they become due. The way in which this criterion is used by countries varies. In some countries, it provides the basis for the initiation of either a liquidation or a rehabilitation procedure and, where liquidation is chosen, the procedure can later be converted into a rehabilitation. In other countries, only a rehabilitation procedure may be initiated on the basis of this criterion and the procedure may only be converted into a liquidation once it has been determined that the enterprise cannot be rehabilitated. Under a third approach, this criterion is relied upon to commence a unitary procedure, and the choice between liquidation and rehabilitation is only made later.3 Given that the objectives of liquidation and rehabilitation proceedings are different, reliance on the same criterion for both proceedings by a number of countries requires some explanation. For example, while one could envisage such a criterion--which effectively provides evidence of illiquidity--as being appropriate for the commencement of rehabilitation proceedings, it may seem more logical to condition the opening of liquidation proceedings upon a demonstration of even greater financial distress, such as insolvency. If an insolvency test were relied upon exclusively and applied in the strict sense, liquidation proceedings would, at least in most cases, normally only be opened at a later stage, that is, when the balance sheet of the enterprise showed that the value of the company's liabilities exceeded its assets.4 One of the principal reasons why countries often allow liquidation proceedings to be opened on the basis of a determination of a "general cessation of payments" can best be explained in terms of the objectives of these proceedings. To the extent that liquidation proceedings are designed to avoid a "grab race" by individual creditors that causes the dismemberment of the debtor to the detriment of the collective interests of creditors, waiting until the debtor is insolvent will often only interrupt the grab race that is well under way. Moreover, proving balance sheet insolvency is often difficult for creditors since they lack inside information. Reliance on a "general cessation of payments test," on the other hand, is designed to activate the proceedings sufficiently early in the debtor's financial distress that this race will be preempted. The obvious problem of this "preemptive" approach--the fact that liquidation proceedings will commence with respect to a financially troubled, but still viable, enterprise--may be resolved by providing the debtor the opportunity to transform the liquidation proceedings into a rehabilitation proceeding. As noted above, an alternative way to resolve this problem is to only allow the creditor to initiate a rehabilitation or "unitary" procedure on the basis of the general cessation of payments test, with the possibility of a subsequent conversion to liquidation. Although the "general cessation of payments" criterion is, in theory, often applied to both creditor- and debtor-initiated proceedings, the issues that arise in its application in these two different cases will vary. Each is discussed now in turn, as well as the initiation of liquidation proceedings by the government. Creditor Petitions When a creditor files a petition to commence a liquidation proceeding, how does it demonstrate that the debtor has generally ceased to make payments? As noted earlier, insolvency laws are designed to be utilized when a debtor is unable to make its payments generally. Recourse to other laws (e.g., the laws on foreclosure) is normally relied upon when only a small amount of the debtor's outstanding obligations are unpaid. However, while the creditor will be in a position to demonstrate the debtor's nonpayment on its own claim, it will generally not have evidence that the cessation of payments is, in fact, of a general nature. It is therefore important that the law avoid placing an unreasonably heavy evidentiary burden on the creditors. Laws differ in the way they address this problem. In some cases, they may require the petition to be filed by a number of creditors. In other cases, upon the filing of a petition by a single creditor, the debtor is required by the court to furnish information that will enable it to determine whether the nonpayment is the result of the dispute with the creditor or part of a more general pattern of nonpayment due to a lack of liquid assets. Whichever approach is followed, most countries presume that an enterprise is unable to pay its debts generally if it has, in fact, generally ceased making payments as they become due. The imposition of other hurdles upon creditors wishing to initiate liquidation proceedings should normally be discouraged. In particular, the law should not preclude or otherwise limit foreign creditors (i.e., nonresident creditors or nonresident-controlled creditors) from initiating liquidation proceedings. Given the important role that insolvency systems play in the development of commercial and financial relations, such a limitation would severely undermine a country's ability to attract foreign investment and access international capital markets. Debtor Petitions As a technical matter, the commencement criterion that is applied to creditor petitions will often be applicable to debtor petitions. In practice, however, since a debtor normally only initiates liquidation proceedings as a last resort, when it does so the insolvency law normally presumes that the debtor has reached a stage where it is unable to pay its debts. Thus, although the laws of most countries may, in theory, apply a similar criterion for both debtor- and creditor-initiated liquidation proceedings, in practice the application of the criterion will not be scrutinized in the case of debtor-initiated petitions. In some cases, the criterion is dispensed with altogether. The more difficult question that arises in the context of debtor-initiated petitions is whether the insolvency law should actually impose a duty upon a debtor to initiate proceedings at a certain stage of its financial difficulties. One approach to this problem is to include specific rules in the law that impose liability upon officers and directors for "trading while insolvent." The advantage of this approach is that it forces debtors to initiate either liquidation or rehabilitation proceedings at an early stage. Such early filings increase the chances for rehabilitation or, at a minimum, protect creditor interests by preventing the further dissipation of the enterprise's assets. However, the disadvantage of including such rules is that they may discourage management to attempt an out-of-court restructuring agreement, out of a fear that any delay in commencing formal proceedings may result in personal liability. If a country chooses not to rely on penalties as a means of forcing debtors to commence proceedings early, it may find it necessary to encourage debtors to do so through the creation of commencement incentives. As will be discussed in the next chapter, such incentives can be effectively incorporated into the rehabilitation procedure. Initiation by a Governmental Authority As noted in the previous section, regulated industries such as financial institutions may be subject to special insolvency regimes and, in these cases, the law may give the relevant regulatory agency of the government the exclusive authority to initiate insolvency proceedings against the debtor. In addition, the general insolvency law may give a governmental agency (normally the public prosecutor's office or the equivalent) the nonexclusive authority to initiate liquidation proceedings against any enterprise if it ceases its payments or, more broadly in other countries, if it is considered in "the public interest." In the latter cases, a demonstration of illiquidity may not be necessary, thus enabling the government to terminate the operations of otherwise healthy enterprises that have been engaged in activities--for example--of a fraudulent or criminal nature. While the exercise of such a police power may be appropriate in certain circumstances, efforts should normally be made to ensure that such powers are not abused and are exercised in accordance with clear guidelines. Court Decision
It is normally for the court of competent jurisdiction to determine if the relevant conditions for
commencement have been met. The decision should be published or made publicly available in
the court's registry. Because speed is critical in the context of insolvency proceedings,
consideration can be given to requiring that the court render a decision within a specified period
following the filing of a petition. Such a limit may be particularly important when the capacity of
the judiciary is limited.
and Protecting the Estate Once liquidation proceedings have commenced, an insolvency law will normally provide that control over the assets of the debtor is transferred to an independent official and the assets are protected from the actions of both the debtor and its creditors. Although this section will describe those assets that are subject to this protection as the "estate," differences in legal traditions of countries require an important, albeit technical, qualification regarding the use of this term. Specifically, the concept of an "estate" is only familiar in those countries that recognize divided ownership and trusts. In such countries, legal title over the assets is transferred to the designated official ("trustee"), and beneficial ownership in the "estate" vests with those that are eligible to receive the proceeds of the assets of the estate following liquidation, namely, the creditors. However, in those countries that do not recognize divided ownership, legal title continues to be retained by the debtor. Irrespective of the legal tradition of the country, the insolvency law of any country will normally need to address two issues. First, what property of the debtor will become subject to the control of the liquidator and be available for liquidation, that is, what are the assets of the "estate" (as a functional rather than legal concept)? Second, what measures will be taken to protect these assets from actions taken by the debtor and its creditors? Assets of the Estate As a general rule, the assets of the estate should include the property of the debtor as of the date the insolvency proceedings begin plus the assets acquired by the liquidator after that date. The liquidator should normally have the authority to abandon property of the debtor that it views as burdensome (e.g., useless equipment). Property of the Debtor The property of the debtor should normally include all assets in which the debtor has an ownership interest, whether or not these assets are in the debtor's possession at the time of the commencement of the proceedings. This would include all tangible assets that would be readily found on the debtor's balance sheet (e.g., cash, equipment, inventory, and real estate). It would also include intangible assets, which, depending on the stage of development in the country's property law, will differ. Although it may be necessary to exempt some assets in the case of individuals, such an exemption is less justified--and not common--in the case of enterprises. Assets excluded from the estate will normally include assets of a third party that are in the possession of the debtor when the proceedings commence, for example, trust assets and bailments. The treatment of assets being used by the debtor pursuant to a lease agreement where the lessor retains legal title (title retention agreements) merits special attention. In countries where the provision of such title financing is of considerable importance, it may be appropriate to respect the creditor's legal title in the asset and allow it to be separated from the estate. Other countries may choose to scrutinize such financing arrangements to determine whether such leases are, in fact, disguised secured lending arrangements, in which case the lessor would be subject to the same restrictions as the secured lender. Whether the debtor's property located outside of the country where the proceedings are taking place will become part of the estate raises important cross-border issues and is addressed in the contribution of the UNCITRAL Secretariat, set forth in the Appendix. Post-Commencement Assets The estate should normally include all assets acquired by the liquidator after the commencement of the liquidation proceedings. Perhaps the most important among these assets are those acquired by the liquidator by exercising avoidance powers, which are discussed in a subsequent section. Moreover, to the extent that the liquidator continues to operate the debtor's business prior to liquidation, assets acquired during this period would normally be included in the estate. Protecting the Estate An essential objective of an effective insolvency system is the establishment of a protective mechanism to ensure that the value of the estate's assets is not diminished by the actions of various parties in interest. The parties from whom the estate needs the greatest protection are the debtor and its creditors. In the former case, the debtor must be displaced from any position of influence or control over the operation of the business since, upon the opening of the liquidation proceedings, beneficial ownership in the assets of the estate effectively shifts from the debtor to its creditors. Protective measures are therefore also needed to ensure that the debtor does not remove assets from the estate immediately before or after the liquidation proceedings commence. While creditors are the future beneficiaries of the estate, one of the fundamental principles of insolvency law is that measures are also needed to protect the creditors' collective and common interest from individual actions of one of them. The "stay" on creditor actions against the estate that is normally established once the liquidation proceedings commence enhances the collective interests of creditors by imposing limitations on the exercise of individual creditor interests. However, as will be discussed in subsequent sections, the nature and scope of this stay varies considerably among countries, this variation reflecting differing legal traditions and policy choices. Interim Protective Measures Between the time when the debtor or creditor petitions the court to open liquidation proceedings and the time this petition is granted, the debtor's assets are in danger of being dissipated even before the estate has been created. Upon the filing of the petition, the debtor may be tempted to transfer assets out of the business. Moreover, upon learning that a petition has been filed, other creditors may take remedial legal actions against the debtor to preempt the effect of any stay that will be imposed when the court makes a positive determination. An insolvency law should therefore consider providing for the imposition of interim protective measures to preserve the estate before the opening of an insolvency proceeding. Generally, the court will impose such measures at its discretion or upon a creditor's request. Interim protective measures may include appointing a preliminary liquidator, prohibiting the debtor from disposing of assets, sequestering some or all of the debtor's assets, and suspending enforcement of security interests against the debtor (the treatment of secured creditors is discussed extensively below). In some countries, if the debtor enters into transactions during this period, those transactions are void. Since these are provisional protective measures that are provided before a judicial determination is made that the commencement criteria have been met, the court may request a petitioning creditor to provide evidence that the measure is necessary and, in some cases, may require a bond from the petitioning creditor. Protection Against the Debtor Once the liquidation proceedings are opened, the conservation of the estate requires the imposition of comprehensive measures to protect the estate from the debtor. For this reason, the debtor is normally divested of all rights to manage and operate the business and a liquidator is appointed to assume all responsibilities divested by the debtor, including the right to initiate and defend legal actions on behalf of the estate and the right to receive all payments directed to the debtor. Initially, the liquidator inventories the estate's assets and may freeze (or "seal") them. Upon the commencement of the proceedings, any actions that are taken by the debtor that are detrimental to the estate are normally void. Upon the commencement of the proceedings, the debtor should be required to disclose all of its assets and liabilities and any questionable transactions. Violations of this rule should give rise to penalties. There may be circumstances in which a liquidator or the court determines that the most effective means of liquidating the estate is to sell it as a going concern. In such situations, even though the law may give him complete control over the estate, the liquidator may decide to permit the debtor to retain some control over the operation of the business until it is sold. In these cases, the liquidator would be liable for the wrongful acts of the debtor during this period and would normally only take such a step after consultation with the creditors. Protection Against Creditors One of the principal purposes of an insolvency law is to provide for the imposition of a "stay" on the ability of creditors to enforce their rights through legal remedies during the period of the liquidation proceedings. Such a stay is necessary not only to provide the liquidator with adequate time to avoid making a forced "fire sale" that fails to maximize the value of the assets being liquidated, but also to provide the liquidator with an opportunity to sell the enterprise as a going concern. Notwithstanding the above, the scope of the rights that are affected varies considerably among countries. There is little debate regarding the need to impose a stay on the ability of unsecured creditors to attach assets as a means of enforcing their contractual claims and precluding all creditors from initiating legal proceedings to recover debts that accrued before the proceedings were initiated. Although the stay may need to apply to secured creditors for a limited period, the coverage of secured creditors raises a number of difficult issues, which are discussed in the next section. Regarding the ability of creditors to exercise other contractual rights, countries vary as to whether they give the liquidator the power to interfere with set-off rights and contractual provisions that provide for termination upon bankruptcy or those that preclude assignment. These subjects are also discussed later. One of the key issues in the design of an effective insolvency law is how to balance the immediate benefits that accrue to the estate by having a broad stay with comprehensive powers given to the liquidator, on the one hand, and the longer-term benefits that are derived from limiting the degree to which this stay interferes with contractual relations with creditors, on the other hand. Protection Against the Liquidator
Given the broad powers that are conferred upon the liquidator, the estate must be protected
against abuse or incompetence by the liquidator. As will be discussed later, such measures should
normally include court supervision, creditor or court approval, and personal liability.
During the proceedings, all assets over which the liquidator exercises control should be protected
by a "stay" on the ability of unsecured creditors to enforce legal remedies against the assets of the
estate. Although the scope of the stay may vary among countries, it should, at a minimum,
preclude unsecured creditors from (i) attaching, selling, or taking possession of assets as a means
of enforcing their claims, or (ii) initiating legal proceedings to recover debts incurred before the
liquidation proceedings were commenced. While the stay should apply to secured creditors for a
limited period, important limitations need to be imposed with respect to the coverage of these
creditors (see next section).
Once a petition for commencement has been filed, it is advisable to give the court the authority to
impose interim measures to protect the debtor's assets pending a determination of
commencement by the court. The range of measures should normally include full or partial
divestiture of the debtor's control over the assets, the appointment of an interim administrator,
and the imposition of a stay on the ability of creditors to attach
assets.
Treatment of Encumbered Assets and Secured Creditors Creditors generally seek security for the purpose of protecting their interests if the debtor fails to repay. If security is to achieve this objective, it can be argued that, upon the commencement of insolvency proceedings, the secured creditor should not in any way be delayed or prevented from immediately foreclosing upon its collateral. Whether or not this argument is accepted, the introduction of any measures that erode the value of security interests requires careful consideration. Such an erosion will ultimately undermine the availability of affordable credit: as the protection provided by security interests declines, the price of credit will invariably need to increase to offset the greater risk. Indeed, under certain market conditions, creditors may be unwilling to provide even secured credit at any price. Notwithstanding this imperative, it is increasingly recognized that permitting secured creditors to freely separate their collateral from the other assets in the estate can frustrate the basic objectives of insolvency proceedings. As will be discussed in Chapter 4, this is particularly obvious in the case of rehabilitation. Where estate assets essential to the operation of the debtor's business are encumbered by the security interests, the fact that secured creditors can immediately enforce their claims at the commencement of the rehabilitation proceedings may make it impossible for the debtor to keep its business in operation while it formulates a rehabilitation plan. However, this is also true--but to a lesser extent--under liquidation proceedings: the exclusion of secured creditors from the general stay on creditor actions may frustrate the liquidator's ability to maximize the value of the estate prior to distribution. In particular, if important assets serve as collateral, the liquidator will be unable to sell the debtor's business--or any business division--as a going concern. Moreover, even if the debtor's assets cannot be sold as a going concern, a temporary stay will give the liquidator time to arrange a sale that will give the highest return for the benefit of all unsecured creditors. To balance the above considerations, any stay on secured creditors must be accompanied by measures that protect the interests of secured creditors during the liquidation proceedings. Two measures are of particular importance. First, the stay should be in place only when it protects the value of the estate. Thus, upon commencement of a liquidation proceeding, it is reasonable that the stay automatically apply to secured creditors for a brief period (e.g., 30 or 60 days), to give the liquidator the opportunity to assume its duties and take stock of the assets and liabilities of the estate. While the court would have the authority to extend such a "cool down" period, it should normally only be granted upon a demonstration by the liquidator that such an extension provides a necessary means of maximizing the value of the estate because, for example, there is a reasonable possibility that the enterprise, or units of the enterprise, can be sold as a going concern. To provide additional protection, the law should impose a limit on how long the stay can be extended. Such a limit may be particularly important in cases where the capacity of the institutional infrastructure is limited. The second set of measures that are necessary to protect the interests of secured creditors are those that maintain the economic value of the secured claims during the period of the stay. Various approaches can be taken to achieve this protection. Protecting Collateral One means of protecting the value of the secured claim is to protect the value of the collateral itself, on the understanding that, upon liquidation, the proceeds of the sale of the collateral will be distributed directly to the creditor to the extent of the value of the secured portion of its claim. If this approach is followed, the following steps need to be taken to protect the collateral. Compensation for Depreciation. During the period of the stay, it is possible that the value of the creditor's collateral will depreciate. Since, at the time of the eventual distribution, the extent to which the secured creditor will receive priority will be limited by the value of the collateral, such a depreciation will prejudice the secured creditor's interests. Accordingly, as is specifically provided by a number of laws, the liquidator should be required to compensate the secured creditor for the amount of this depreciation, either by providing substitute collateral or by making periodic cash payments that correspond to the amount of depreciation. Payment of Interest. Some countries that protect the interests of the secured creditor by preserving the value of the collateral also allow for payments of interest during the period of the stay, but only to the extent that the creditor is oversecured, that is, to the extent that the value of the collateral exceeds the value of the secured claim. By permitting the payment of interest only in these circumstances, the law provides a strong incentive for a creditor to seek collateral that exceeds the value of its claim. Protection and Compensation for Use. In some cases, the liquidator may find it necessary to use or sell encumbered assets prior to liquidation. For example, to the extent that the liquidator is of the view that the value of the estate can best be maximized if the business continues to operate for a temporary period, the liquidator may wish to sell inventory that is partially encumbered. Thus, in cases where secured creditors are protected by preserving the value of the collateral, it would seem appropriate for the law to give the liquidator the choice of providing the creditor with substitute equivalent collateral or paying the full amount of the secured claim. Lifting the Stay. In cases where the insolvency laws require that the value of the collateral be protected during the period of the stay, a mechanism needs to be in place to ensure that the stay will be lifted when necessary to protect the secured creditor's interests. At least two circumstances can be envisaged. Under the first, the secured creditor requests the lifting of the stay on the grounds that it is not receiving adequate protection. Alternatively, the liquidator, on its own initiative, may release the collateral on the grounds that the provision of adequate protection may not be feasible or would be overly burdensome to the estate. In addition, the law may create exceptions to the stay to exclude assets that are generally not needed to sell the business as a going concern, such as cash collateral. Protecting the Value of the Secured Claim
As an alternative to a system that preserves the value of the asset used as security, some countries
protect the interests of secured creditors by protecting the value of the secured portion of the
claim. Specifically, immediately upon the commencement of the proceedings, the encumbered
asset is valued and, based on that valuation, the value of the secured portion of the creditor's
claim is determined. This value remains fixed throughout the proceedings and, upon distribution
following liquidation, the secured creditor receives a first-priority claim to the extent of that
value. Moreover, during the proceedings, the secured creditor receives the contractual rate of
interest on the secured portion of the claim to compensate him for the delay that is imposed by
the proceedings.
(1) For a brief--and specified--period following the commencement of the liquidation
proceedings (e.g., 30 or 60 days), the general stay on creditor enforcement should also apply to
secured creditors, thereby precluding them from enforcing their contractual rights upon the
collateral during the proceedings, subject to the qualifications described below. The stay should
normally be extended beyond this period by the court only upon a demonstration by the
liquidator that such an extension provides a necessary means of maximizing the value of the
assets of the estate for the benefit of creditors generally (e.g., because of the possibility of selling
the enterprise or units of the enterprise as a going concern). It may be advisable for the law to
impose a limit on the period of extension.
(2) Exceptions to this stay may be appropriate with respect to those assets that are generally not
necessary for a sale of the business as a going concern (e.g., cash collateral).
(3) During the period of the stay, a mechanism should exist that ensures that the interests of the
secured creditor are adequately protected. Where this protection is provided by preserving the
value of the creditor's collateral, these measures should include, for example, compensation for
the depreciation of the collateral and, if the collateral is to be used or sold by the liquidator, the
provision of replacement collateral. Countries may, as an alternative, protect the interests of the
secured creditor by fixing the value of the collateral at the commencement of the proceedings and
giving the secured creditor a first-priority claim based on that value, plus a priority claim for
regular payments of contractual default interest.
(4) Where the liquidator is unable to provide a secured creditor with the type of protection
described above, the stay against the secured creditor should be
lifted. Avoidance of Pre-Commencement Transactions and Transfers A debtor may enter or be placed into insolvency proceedings days, weeks, months, or sometimes years after recognizing that this outcome is inevitable. In anticipation of the formal commencement of insolvency proceedings, therefore, debtors may deviate from their ordinary business practices by attempting to hide assets from their creditors, incurring artificial liabilities, favoring certain creditors over others, or making donations to relatives or friends. Even though some of these activities might be perfectly permissible outside an insolvency context, the detrimental effects of such actions for the general unsecured creditors--that is, those who were not parties to the said actions and who are not fully secured--become unacceptable once a procedure has been opened, since this undermines the objective of equitable treatment among creditors. For this reason, insolvency laws should set forth a mechanism that recaptures assets whose transfer prior to the commencement of the proceedings has such a detrimental effect. The design of the avoidance provision requires the resolution of a number of technical issues that will, in turn, reflect important policy choices. On the one hand, the stronger such avoidance rules, the greater the increase in the value of the estate for the advantage of the common creditors. In addition, strong avoidance rules may, in some cases, assist the debtor in its out-of-court negotiations since it creates a disincentive for a single creditor to take legal action to obtain an advantage, thereby facilitating collective creditor action. On the other hand, it should be borne in mind that very broad avoidance powers may undermine the predictability of contractual relations. This is particularly the case where the transactions and transfers are perfectly normal, but are voidable simply because they occurred in the proximity of the commencement of the proceedings. Designing the Mechanism In many respects, designing an avoidance provision involves making choices regarding evidentiary rules. One approach emphasizes the reliance on generalized, objective criteria for determining whether transactions or transfers are avoidable. Did the transaction or transfer take place within the period prior to commencement that is specified in the law? Does the transaction or transfer contain any of the general characteristics specified in the law (e.g., inadequate consideration)? Another approach emphasizes case-specific, subjective criteria. Is there evidence of an intent to hide assets from creditors? Was the debtor insolvent when the transaction or transfer was made and did the counterparty know of this insolvency? As is always the case in insolvency, there are advantages and disadvantages to both approaches. Generalized, objective criteria provide for simplicity in application. However, if relied upon exclusively, they can also result in arbitrariness. For example, while perfectly legitimate and useful transactions that fall within the specified period may be voided, fraudulent or preferential transactions and transfers that happen to fall outside the period may be protected. To prevent such arbitrariness, consideration should be given to designing an avoidance provision that attempts to reach an appropriate balance between both approaches. Whatever approach is adopted, it is generally accepted that stricter rules should be applied to transactions and transfers made to insiders (i.e., persons who have a close corporate or family relation to the debtor or its creditors). A stricter regime for such transactions is generally justified on the grounds that insiders are more likely to be favored and tend to have the earliest knowledge of when the debtor is, in fact, insolvent. Set forth below are the categories of transactions and transfers that are most commonly covered under avoidance provisions. (1) Transactions and transfers made where there is evidence of the debtor's actual intent to defraud creditors by placing assets beyond their reach and where the counterparty knew of such an intent. Such transactions and transfers constitute actual fraud in that there is evidence that both the debtor and the counterparty had the subjective intent to defraud creditors. Many insolvency laws do not limit the period during which such transactions and transfers can be avoided. (2) Transactions and transfers with a third party for inadequate consideration. This category is often described as giving rise to constructive fraud: an intent to defraud is presumed whenever the transaction is unbalanced and does not appear to be made at "arm's length." Gifts (which can include, for example, debt forgiveness) are also included in this category. While most laws specify a maximum retroactive period (calculated from the date of commencement) during which such transactions and transfers can be voided, some laws also require a finding that the debtor was insolvent or was about to become insolvent when the transaction or transfer took place. (3) Transactions and transfers to creditors that are "voluntary." Unlike (1) and (2) above, these transactions and transfers are limited to those with creditors and address the problem of preferential treatment of certain creditors over others. Many laws provide that, where the debtor gives a benefit to an individual creditor who is not legally entitled to that benefit, such a transaction or transfer is evidence of a preference and is avoidable. Such transactions and transfers include, for example, early payments on a debt or the provision of a security interest on an existing debt. As in the case with (2) above, a maximum retrospective period is normally established in the law, with many countries also requiring evidence of insolvency (or near insolvency) when the transaction took place. (4) Ordinary transactions and transfers with creditors. A number of countries allow for the nullification of transactions with and transfers to creditors, even when they do not include any "voluntary" features; for example, payments made to a creditor on or after the due date. The rationale for including such transactions and transfers is that, in cases where such transactions and transfers occur very close to the commencement of insolvency, there should be a presumption that insolvency actually existed when the payment was made and that, therefore, the creditor in question received preferential treatment. Since these transactions and transfers are normal in every other sense, the retroactive period is very brief (3090 days). Moreover, some countries will only allow for nullification if the creditor knew (or should have known) that the debtor was insolvent. Other countries make exceptions for transactions and transfers made in the ordinary course of business. Thus, for example, while payment made upon the receipt of goods that are regularly delivered (and paid for) could not be nullified, payment on a long overdue debt could be. Implementation
If a transaction or transfer falls into the above categories, the law will either render it
automatically void or make it voidable. If the latter approach is followed, the exercise of
discretion will be required, which is normally left to the liquidator, as to whether the avoidance
of the transaction or transfer will be beneficial to the estate, taking into account the delays
involved in recovering the transfer (which may be of relevance when liquidation is imminent) or
the possible costs of litigation. The scope of the liquidator's discretion is, of course, limited by its
own obligation to maximize the value of the estate, and it may be responsible for its failure to do
so, depending on the scope of its liability (which is discussed in a subsequent section). In that
context, the law may permit a creditor or the creditors' committee to act on behalf of the estate
and to void these transactions and transfers. A creditor could be allowed by the law to obtain a
court injunction requiring the liquidator to initiate an avoidance action that appears to be
beneficial to the estate.
(1) Transactions and transfers made where there is evidence of the debtor's actual intent to
defraud creditors by placing assets beyond their reach and where the counterparty knew of such
an intent. No maximum period need be specified in the insolvency law.
(2) Transactions and transfers for inadequate consideration, including gifts, that took place when
the debtor was insolvent or about to become insolvent, with a maximum period specified.
(3) "Voluntary" transactions and transfers to creditors, where, for example, the debtor makes
early payments on a debt or provides a security interest on an existing debt. A demonstration of
actual or imminent insolvency may be necessary, with a maximum period specified.
In addition, it may be desirable--but is not necessary--to provide the liquidator with the authority
to nullify transactions and transfers to creditors that are not in any way irregular but that occur
during a very brief period (no longer than 90 days unless the creditor is an insider) and where
there is evidence that the creditor knew or should have known of the insolvency. However, there
may need to be exceptions for transactions and transfers made in the ordinary course of business.
It is inevitable that, at the commencement of a liquidation proceeding, the debtor will be party to a contract that has not yet been fully performed. Insolvency laws will, to varying degrees, give the liquidator the authority to interfere with the terms of contracts that, ordinarily, have not been fully performed by both the debtor and the counterparty. While this interference serves to further one of the broad objectives of liquidation proceedings, that of value maximization, it often needs to be weighed against competing social and political interests, particularly with respect to labor and lease contracts. Moreover, as in the case of avoidance provisions, the right of liquidators to interfere with the terms of unperformed contracts will undermine the predictability of commercial and financial relations. As will be seen, defining the scope of a liquidator's powers in this area requires a balancing of these considerations. Termination
As a general matter, it is important that a liquidator or the court Continuation In some cases, continuation of a contract will be more valuable to the estate than its termination. For example, the debtor may be the lessee under a lease agreement where the rental is below market value, and a substantial term still remains under the lease. In these cases, the liquidator may wish to continue the lease in order to sell the debtor's business as a going concern with the lease intact. To give some assurance to the counterparty, it is generally recognized that the liquidator should indicate whether it will continue or terminate the contract within a specified period following the initiation of liquidation proceedings. Moreover, in the event of continuation, the law should protect the counterparty by ensuring that the cost of performance and any damages arising from a breach by the liquidator be an administrative (i.e., priority) expense. Since the granting of such a priority will constitute a risk for other creditors (who will be paid after the priority creditor), a liquidator will normally seek to continue only those contracts that it expects to be profitable. As long as the terms of the contract in question do not preclude the liquidator from continuing the contract, the liquidator's assumption is unobjectionable. Indeed, subject to the principle of "quid pro quo," it is appropriate that the liquidator have this option. However, one of the key issues raised under an insolvency law is whether a liquidator may elect to continue a contract even if such continuation is inconsistent with the terms of the contract. Many commercial and financial contracts provide that initiation of an insolvency proceeding will automatically constitute an event of default under the agreement by the debtor, giving the counterparty the unconditional right to terminate the contract (sometimes referred to as "ipso facto" clauses). Under one approach, such termination clauses will be honored, in which case the liquidator will be able to continue the contract only if the counterparty elects not to terminate the contract. In such cases, the counterparty may be induced to consent to continuation because it is usually afforded priority of payment for services rendered after the commencement of bankruptcy proceedings. In contrast to this "consensual" continuation approach, another approach actually allows the liquidator to continue the contract over the objection of the counterparty; that is, any termination clause will be nullified by operation of the bankruptcy law. Assignment The ability of a liquidator or administrator to continue the contract over the objection of the counterparty provides the debtor with a particularly important tool to effect a rehabilitation (as is discussed later). In the context of liquidation, this ability will also be of considerable benefit when, following a decision to continue the contract, the liquidator can assign the agreement to a willing third party for value. Applying the example, described above, of the lease agreement that provides for rental payments that are below market value, the liquidator may wish to enhance the value of the lessee's estate by assigning the lease to a third party for a price. However, many agreements preclude a party from assigning the lease without the consent of the counterparty and, in many countries (particularly of the civil law tradition), assignment will not be permitted--even in insolvency--without the consent of all parties, unless it is part of the sale of a business as a going concern. Nevertheless, consistent with the broad assumption powers provided to a liquidator discussed above, some countries provide in the insolvency law that the effectiveness of these nonassignment clauses are null and void, thus enabling the liquidator to effect the assignment for the benefit of the estate. While this option is considered of critical importance in the liquidation proceedings of some countries, it is entirely foreign to many others and is precluded. The ability of the liquidator to elect to continue and assign contracts in violation of the terms of the contract can have significant benefits to the estate and, therefore, the beneficiaries of the proceeds of distribution following liquidation. However, this ability clearly undermines the contractual rights of the counterparty to the contract. Moreover, assignment raises issues of prejudice to the nondebtor party to the agreement, especially where it has little or nothing to say in the selection of the substitute to the debtor. Therefore, in circumstances where such continuation and assignment are allowed, it would be appropriate to require the liquidator to demonstrate to the counterparty that the assignee can adequately perform under the contract. Moreover, as noted above, any claims arising from the performance of the contract after the commencement of insolvency proceedings should be treated as an administrative expense and, therefore, be given priority in distribution. Special Contracts Irrespective of the breadth of the termination or continuation powers given to a liquidator, exceptions may need to be made for certain contracts. Perhaps the most notable example of a liquidator's rejection powers being limited is in the administration of labor contracts. Although the protection of labor contracts will be particularly relevant in rehabilitation proceedings, it may also be relevant in liquidation proceedings. Specifically, in circumstances where the liquidator is attempting to sell the enterprise as a going concern, a higher price may be obtained if the liquidator is able to terminate onerous employment contracts. Countries may specifically limit this capability out of concern that this type of liquidation may be used expressly to eliminate the protection afforded to employees by such contracts. An additional issue relates to lease agreements: if the debtor is a lessor, limitations may be imposed on the ability of the liquidator to terminate lease agreements.
Exceptions to the power of the liquidator to continue contracts can generally be placed in two
categories. First, if the liquidator is given the power to nullify termination provisions, specific
exceptions may be made to this power for specific types of contracts. Perhaps the most important
exceptions in this category are short-term financial contracts, such as swap and futures
agreements, which are discussed later. The second category relates to those contracts where,
irrespective of whether the law provides for the nullification of a termination provision, the
contract cannot be continued because it provides for performance by the debtor of personal
services.
(1) Termination. The liquidator should have the authority to terminate unperformed
contracts. Upon termination, the counterparty will become an unsecured creditor with a claim
equal to the amount of damages caused by the termination. Countries may choose to limit this
power with respect to special contracts, such as labor contracts or lease agreements (where the
debtor is the lessor)--a limitation that will be relevant in liquidation proceedings where there is
an intent to sell the enterprise (or a business unit of the enterprise) as a going concern.
(2) Continuation and assignment. The liquidator should normally have the power to
choose to continue performance of the contract (including assignment of performance) if such
continuation is not precluded by the contract's terms. If such a decision is made, the counterparty
should be afforded priority of payment (as an administrative expense) for any performance
rendered after the commencement of the liquidation proceedings. If a country chooses to allow
the liquidator to continue or assign a contract in contravention of its terms, it should require the
liquidator to demonstrate that the contract can be adequately performed by the liquidator or the
assignee. Exceptions to continuation powers will normally need to be made with respect to
special contracts, such as financial and personal services
contracts. Set-Off An important issue that arises in the design of an insolvency law is the treatment of a creditor who, at the time of the initiation of the liquidation proceedings, also happens to be a debtor to the estate. If the fundamental principle of equality of treatment of similarly situated creditors were applied, the outcome would be relatively straightforward: the liquidator should be able to receive the full amount owed by the creditor and the creditor's claim would be satisfied to the extent to which all other unsecured creditors get satisfied upon the liquidation of the estate. However, an alternative approach permits the creditor, in these circumstances, to exercise set-off rights against the estate after liquidation is initiated, with the effect that, depending on the size of the estate's claim on the creditor, the creditor's claim may be satisfied in full. There are several reasons why it may be appropriate to include the right of set-off in an insolvency law. The first is that of fairness: notwithstanding the importance of equality of treatment among creditors, it is considered unfair for a debtor to refuse to make payment to a creditor but, at the same time, to insist upon payment from that creditor. In addition, since many counterparties are banks, the right of set-off is particularly beneficial to the banking system and, because of the important credit creation role of banks, is therefore considered to be of general benefit to the economy. By virtue of their core functions (lending and deposit taking), banks that have lent to an entity that has gone bankrupt will often find that they have financial obligations to the debtor in the form of deposits. A post-commencement right of set-off would allow the banks to offset their unpaid claims with the debtor's deposits even though these reciprocal claims are not yet due and payable. Even among countries that do not provide for a general right of set-off in the context of insolvency, set-off will still normally be permitted in two circumstances: if both claims are mature at the time insolvency takes place, or if the mutual claims arise from the same transactions.
The right of set-off interacts with other provisions of insolvency in a number of important
respects. For example, the right of a creditor to set-off following the initiation of insolvency
proceedings will be subject to the avoidance provisions if the claim held by the debtor was
received by the creditor during the suspect period. In addition, to the extent that an insolvency
law generally nullifies termination ("ipso facto") clauses and, thereby, allows the liquidator to
assume unperformed contracts, a creditor will only be able to exercise set-off rights regarding
mutual monetary claims if the right of the liquidator to nullify such clauses is expressly limited to
allow for a creditor to terminate the contract and set off these claims. This is particularly
applicable in the context of short-term financial transactions, which is discussed in detail in the
next section.
Financial Contracts and Netting Depending on how an insolvency law addresses issues relating to the treatment of contracts and set-off rights, it may or may not need to include specific provisions regarding certain types of short-term financial contracts, including derivative agreements (e.g., currency or interest rate swaps). The terms of the master agreements governing these individual transactions, which have become increasingly standardized, normally contain provisions that enable one party, upon the commencement of the insolvency of the other party, to net the total of all its gains and losses and all unpaid amounts on separate transactions. Such "close-out netting" provisions, which aggregate all independent payment obligations, are normally effective only upon the insolvency of one of the parties if the insolvency law contains two features. First, it must allow for the termination (or "close-out") of all outstanding transactions under the agreement upon the insolvency of a party, and second, it must allow for the noninsolvent party to set off its claims against its obligations to the insolvent party. As was discussed earlier, a number of countries have insolvency laws that do not contain both these features. With respect to termination, some countries allow a liquidator to elect to continue the contract in contravention of the termination provisions of the contract. With respect to set-off, a number of countries do not allow for the set-off of independent financial claims that are not mature at the time of commencement.
Many countries that do not possess general rules that provide for both termination and set-off
have carved out exceptions to these general rules for the specific purpose of allowing "close-out
netting" for financial contracts. They have done so because such transactions have become an
increasingly important component of the global financial market and, in the absence of certainty
regarding netting upon the insolvency of one party, access to such transactions would be severely
restricted. Notwithstanding these important advantages, it is recognized, however, that such a
"carve-out" will complicate the law and will result in preferential treatment for certain types of
creditors.
Liquidation Procedure An effective insolvency system must also provide for procedures that ensure the assets of the estate are sold and distributed in a timely, predictable, and equitable manner. Moreover, the liquidator should try to ensure that the sales price is maximized but that the cost of the sale and the distribution is limited. This subsection deals with procedural aspects of the liquidation process, while the next subsection provides a comparative analysis of the substantive priority rules for distribution. In many respects, the first step in the liquidation procedure is the identification and collection of the estate's assets. Once the assets have been identified, the liquidator must identify and verify the liabilities of the estate. It then must sell the assets in accordance with a transparent procedure that will maximize the value of the assets being sold. Finally, it must distribute the proceeds in accordance with the priority rules set forth in the law. The verification of claims procedure, the treatment of claims of foreign creditors, and the procedure applicable to the sale of the assets are all important related issues. Verification of Claims Most laws provide for the liquidator to verify the claims of the creditors of the debtor. This involves not only an assessment of the underlying legitimacy and amount of the claim, but also a determination of the category within which this claim fits for distribution purposes (e.g., secured versus unsecured, pre-petition versus post-petition). Most laws place the burden upon the creditors to produce evidence of their claims to the liquidator for its review. If the liquidator challenges any aspect of a creditor's claim, this dispute will need to be adjudicated by the relevant court. Some countries also permit other interested parties, including creditors, to challenge a claim. In that context, review of a final list of creditors' claims might be advisable, at one or more creditor assemblies following preparation of such a list by either the court or the liquidator. As a means of ensuring transparency, it is critical that adequate and timely notice be provided. If it is, liquidation can be expedited by establishing deadlines by when creditors must file their proof of claims. As a sanction for delay, it may be provided that latecomer creditors will either be excluded from distributions altogether or participate ratably only in the distribution of any assets remaining after the verification of claims. Foreign Creditor Claims As noted elsewhere, foreign creditors should normally be afforded nondiscriminatory treatment during the insolvency proceedings.5 The valuation of foreign exchange claims is of particular relevance to foreign creditors. For verification and distribution purposes, such claims are normally converted into the domestic currency at the exchange rate prevailing on the day when the proceedings are opened. Accordingly, to the extent the domestic currency depreciates or appreciates during the period prior to distribution, the amount of foreign exchange actually received by the creditor will be affected. To address this problem, consideration could be given to revising this approach so that the exchange rate prevailing at the time of distribution is utilized, at least in circumstances where the depreciation or appreciation exceeds a specified percentage.6 Methods for Disposition of Assets The sale of assets as part of a going concern or as part of business units often produces greater value for creditors at distribution than does a sale of individual assets. Although an insolvency law may reflect this preference in the law itself, this may not be necessary since it is assumed that the liquidator will follow whichever course will maximize the proceeds for distribution. One area, however, where the law will normally need to provide some guidance is the sales procedure that may be utilized by the liquidator. To ensure that the liquidator sells the assets in |