Make or Break Time for Insolvency Law? Towards a Business Restructuring Law 

by Antonio Fernández Rodriguez

Published: July, 2010

Insolvency Law can hardly reconcile business preservation and creditors satisfaction, so it usually sacrifices one or the other principle being therefore qualified as more or less debtor friendly. The question is whether preservation of business should take place in a prior stage, that of the pre- insolvency, leaving liquidation for the terminal insolvency situations. That would require broadening the scope of the Law, in order to include pre- insolvency solutions, the failing of which would lead to liquidation; we would be talking about a Restructuring Law instead of an Insolvency Law.



The traditional function of Spanish insolvency legislation has been linked to the orderly satisfaction of the creditors of an insolvent common debtor. It was thought that execution levied individually by creditors against the debtor’s assets could lead to inefficiencies and unfairness, with a fire sale of assets to the most diligent or best informed creditors, or simply to those who were lucky enough to have their applications for execution heard quicker at courts with a smaller backlog of cases. For this reason, individual executions were replaced by compulsory universal execution against the debtor’s assets in order to use the proceeds to satisfy creditors.



However, it soon became apparent that compulsory universal execution, despite being more orderly than individual execution, was largely prey to the same inefficiencies, since on entering liquidation, the assets, and particularly the business assets, suffered a spectacular loss in value leading to a diminished ability to satisfy creditors. Thus creditors were given the authority to decide whether to replace compulsory universal execution against the debtor’s assets with an arrangement with the debtor that would enable the business to continue and its future profits to be used to achieve a better level of debt satisfaction.



This being the case, more recently new ideas regarding the purposes that Insolvency Laws should serve star ted to emerge as a result of the ever- increasing complexity of commercial and economic dealings in the 20th century and the highly sophisticated nature of economics as a discipline for the study of systems and structures of economies, in general, and businesses, in particular.



First of all, formal insolvency proceedings have begun to find their place within market economies, as opposed to planned economies, as an essential means of ridding the market of operations for which there is no demand, poorly organized under takings or operations which, in short, have lost out to business competition, thus reassigning the means of production used by them to other operations.



In this purgative function, insolvency proceedings play a secondary role, since the preferred remedy is for the trader to acknowledge its failure in time and to voluntarily realign its business approach before the trader’s ability to satisfy its creditors in full is jeopardized. However, when the trader does not do so, formal insolvency proceedings are a coercive means to this end and are accompanied by scrutiny of the debtor’s conduct in order to hold it to account for any liabilities it may have incurred by letting things come to a head.



Secondly, the idea that there may be aspects of general interest to the wider community in preserving the business infrastructure is beginning to take hold. The pains taken by modern States to preserve companies manifest themselves in many ways depending on the various reasons why it may be advisable or indeed necessary to preserve certain operations and on the intensity of the public interest perceived in them.



At the one extreme are those operations that are structurally loss making/inefficient but necessary for an acceptable coexistence, and which, not being viable according to free market rules, must be taken on by the State within the so-called public sector of the economy, normally as a monopoly. The preservation of these operations means that they fall outside the scope of formal insolvency proceedings, just as they elude free market rules.



Next along the scale, but by now subject to free market rules, are a series of operations which require a high degree of concentration in order to be efficient, thereby gaining a size and a systemic significance which requires, on the one hand, a certain degree of regulation by the public authorities and, on the other, a special regime to monitor their solvency, accompanied by “quasi-insolvency” proceedings (procedimientos “paraconcursales”) with preservation being their aim and with a high degree of intervention by the authorities. These activities include regulated sectors, such as the banking and insurance industries, and there is debate as to whether large concerns should also be “above” business risk, avoiding conventional formal insolvency proceedings and falling within the scope of these preservation-oriented administrative processes (this avoidance of formal insolvency proceedings has caused many in recent times to again heed the axiom “too big to fail”).



Lastly, as regards all other economic activities, it is understood that there is a general interest in preserving business which may be viable and which, circumstantially, find themselves in distress. Specifically, this general interest takes the form of maintaining employment and productivity and trying to avoid the inherent destruction of value inevitably entailed by almost all reassignments of means of production.



In line with this approach, the idea of preserving companies becomes one of the guiding principles of Insolvency Laws, with the huge difficulty involved in trying to reconcile this aim with the traditional objective of such Laws, which was primarily to satisfy creditors by levying collective and orderly execution against the debtor’s assets.



Bearing in mind that the liquidation of assets in order to satisfy creditors’ claims and the preservation of the company may be incompatible, the Spanish Insolvency Law has had to signpost which of the two aims or principles are to take precedence; accordingly, the Preamble to the Law clearly states that the satisfaction of creditors is the “essential aim of insolvency proceedings”: in other words, where there is a conflict, the liquidation of the company takes priority over its preservation.



The priority chosen by our Law is not without its practical consequences. As statistics show, more than 95% of companies that go into formal insolvency are ultimately liquidated. Faced with this reality, the Spanish Insolvency Law is often accused of not being fit for purpose, namely, the company’s preservation.



Where does the problem lie? The problem is twofold and stems, first, from the fact that an attempt is made to reconcile these two aims in the context of formal insolvency proceedings through an arrangement between the debtor and its creditors; this is recognised in the Preamble to the Law, which states that “even though the purpose of the insolvency proceeding is not to turn around enterprises, an arrangement for continuity may be the instrument for saving those considered fully or partially viable, to the benefit not only of the creditors but also of the insolvent enterprise itself, its employees and other interests.” In doing so, the principle of preservation of companies is linked to the authority already held by creditors to decide whether to replace collective execution against the debtor’s assets with an arrangement with the debtor that enables the business to continue and its future profits to be used to achieve a better level of debt satisfaction. Other aspects are added to reinforce this principle, including allowing the debtor to remain at the helm of its business until a vote is taken on the arrangement, keeping its contracts in force and unaffected by the formal insolvency proceeding and, as a last resort, where liquidation is unavoidable, encouraging the disposal of the business units as a whole concern, that is, attempting to avoid, as far as possible, the piecemeal break-up or isolated sell-off of its constituent parts.



Nevertheless, procedurally speaking, the arrangement with creditors is the last stage of the formal insolvency proceeding, usually reached by a company reeling already after a protracted court proceeding and with extremely scant possibility of salvation. Preserving a company should not be left to the last minute, by which point the impairment of the debtor’s assets is so severe that the available solutions are all but non-existent, but rather insolvency should be tackled early on so as to resolve situations of distress in the initial stages, where the range of solutions available is infinitely greater.



In this respect, Spain’s Insolvency Law hits the nail squarely on the head: by introducing into Spanish law the concept of “imminent technical insolvency,” which is an unprecedented development in this country’s legal tradition, and borrowed from German law. Imminent technical insolvency allows traders to tackle insolvency early on the basis of foresight, as stipulated in Article 2.3 of the Insolvency Law: “A debtor is deemed to be in a state of imminent technical insolvency where it foresees that it will be unable to meet its obligations in a regular and timely manner.” Pursuant to this provision, foresight of technical insolvency may be linked to the earliest stages of financial distress, that is, the structural and non- circumstantial loss of profitability or the break-even point, since from that moment on it is foreseeable that losses (sooner or later, depending on the company’s equity) will become pathological. Indeed, the reference to “timeliness” means that foresight may be linked to mere liquidity gaps.



However, while Spain’s Insolvency Law successfully deals with what we could call the diagnosis, it fails miserably when it comes to the cure, by signaling formal insolvency proceedings at court as the sole means for resolving these preliminary stages of technical insolvency. A formal insolvency proceeding, given its origin and purpose, is a mechanism essentially geared towards satisfying creditors rather than preserving the company, and to do so it must be surrounded by disclosure, safeguards for creditors – in short, a judicialised approach – making it of little use for rescuing companies.



The preservation of companies is not easily reconcilable with the lengthy and costly court proceedings entailed by formal insolvency proceedings and perhaps we would be better served by leaving such proceedings to do what they were really designed to: liquidate the common debtor’s assets in an orderly and collective manner in order to satisfy creditors’ claims where the business is no longer viable.



That said, new concepts need to be introduced to facilitate the aim of turning around and saving companies from the earliest stages of technical insolvency. In short, it is a question of providing traders with a range of restructuring tools to help them tackle situations of financial distress in the pre-insolvency phase, when creditors’ rights are not so seriously threatened and the principle of preserving the company can take precedence over the satisfaction of creditors’ claims.



In Spain, there have been insistent calls for early solutions of this type since the onset of the current serious financial crisis, although it was only in late March 2009 that the Spanish lawmakers finally heeded such calls and began to timidly incorporate these solutions into the Insolvency Law. Refinancing as a pre- insolvency solution has gained widespread acceptance and has been shielded from the possibility of subsequent asset claw backs in formal proceedings where businesses are no longer viable, provided that certain causal and formal requirements are met.



Yet this timid reform remains far removed from an orderly and systematic body of law in step with other Spanish legislation in order to meet the needs of businesses in the 21st century in terms of insolvency prevention. A qualitative conceptual leap is required in order to realise that what companies need today and are demanding is, so to speak, a Business Restructuring Law: (i) guided by the principle of preserving companies, which can now be given precedence, since only pre-insolvency situations are involved in which there is not yet a threat of such proportions to creditors that it obliges the law to treat the satisfaction of their claims as a priority; (ii) which envisages an earlier event triggering the application of the law, such as the non-circumstantial loss of profitability or a gap in financing, placing effective restructuring tools at the disposal of traders, both on an operating and financial level, thereby allowing businesses to return to the parameters required to operate in the free market; and (iii) integrating, in short, court-driven insolvency proceedings as a residual, fall-back solution for companies whose viability cannot be salvaged through such business restructuring tools, thereby regaining its traditional and distinctive purpose of liquidation.



Authors:
Antonio Fernández, Head
Borja García-Alamán, Partner
Adrian Thery, Partner
Juan Verdugo, Senior Associate



Restructuring and Insolvency Department
Garrigues
Hermosilla 3
28001 Madrid
Spain
Tel: +34 91 514 52 00
Fax: +34 91 399 24 08
Email: [email protected]
Website: www.garrigues.com


 

MEMBER COMMENTS

WSG Member: Please login to add your comment.

dots