4. A Framework for Considering Insolvency Law
In this section of the paper, the focus moves from the liquidation/bankruptcy legal framework to a business/consumer insolvency public policy taxonomy. The reasons for this are that:
- Business insolvency, whether corporate or individual (as partnerships or sole traders) occur for similar underlying reasons; and
- The reasons for personal insolvency arising out of business failure and consumer-related indebtedness differ significantly.
Insolvency law is considered from three perspectives in the paragraphs below: the objectives of insolvency from a debtor and creditor perspective, the causes of insolvency, and the impacts that insolvency has. Each of these is considered in terms of business failure and consumer-related indebtedness.
4.1 Business Insolvency
4.1.1 Debtor Objectives in Business Insolvency
The individual debtor in financial difficulty will be seeking relief from outstanding debt and legal action by creditors, and a simple, quick procedure for administering the insolvency. Rehabilitation, in the sense of discharge from debt and in the sense of encouragement of sensible risk-taking, is an important aim for a debtor. Debtors will also want certainty concerning their legal position and information on the steps that must be taken to use the bankruptcy procedure.
Companies, partnerships and sole traders will want an insolvency procedure to achieve similar objectives. The directors and people involved in business insolvency will be focusing on rescue for the business initially and failing that, a simple and quick liquidation procedure. Other important factors will be avoiding stigma and the ability to return to normal business activity.
The debtors, whether businesses or individuals, will be interested in suspending creditors' rights and remedies in favour of one procedure. This is because the collective procedure prevents creditors pursuing individual remedies that are detrimental to any rescue of the company and will not maximise the pool of assets available for distribution to all creditors.
4.1.2 Creditor Objectives in Business Insolvency
Creditors will focus on maximising returns to themselves. However, the individual and collective interests of creditors differ. If a debtor is or may be insolvent, each individual creditor has an incentive to look after their own interest at the expense of other creditors and the total pool of assets.
To avoid destructive fights between creditors and races among creditors to the courts, insolvency law provides all creditors with some measure of equality. In the case of corporate liquidation, a trustee acts on behalf of unsecured creditors to realise and distribute the company's net assets and distribute them in accordance with clearly defined rules. This pari passu principle is critical to the effective and efficient operation of insolvency law.
4.1.3 Societal Objectives in Business Insolvency
Business failure, whether corporate or individual, can arise for four reasons. Before describing those reasons, it is important to point out that these categories are simply a framework for analysis. In a real sense, the categories are on a continuum with some blurring of distinctions between neighbouring categories. In stark terms, the reasons for business failure are set out in 4.1.3.1 - 4.1.3.4 below.
4.1.3.1 The Unavoidable Cost of Rational Risk-Taking
This category recognises that all business decisions are made without full information, markets are unpredictable, and unforeseeable externally caused change occurs (e.g. new government regulation). Any of these characteristics can mean business decisions that were rational at the time they were made could subsequently lead to insolvency.
Rational risk-taking is at the heart of entrepreneurial activity. It is something that society wishes to promote and encourage. For this category of business failure, there are strong arguments for promoting societal attitudes and insolvency laws that avoid stigma and provide the opportunity for rehabilitation or corporate rescue with a view to resuming full business activity as quickly and efficiently as possible. At the same time, it is important to promote creditors' rights to recover debts.
4.1.3.2 Managerial Mistakes
Managers and owners can have good business skills but may nevertheless make mistakes that lead to insolvency. These can be judged to have been mistakes at the time, not just with the benefit of hindsight. A general expectation is that such persons can be expected to learn from their mistakes and, given further opportunity, have good prospects of becoming successful entrepreneurs. The societal objectives are largely the same as for the previous category: avoidance of stigma, opportunities for rehabilitation and corporate rescue and creditors' rights to recover debts.
4.1.3.3 Lack of Business Skills
Some managers and owners may not have good business skills. Furthermore, they may not have the potential to ever learn the art of being successful entrepreneurs. In such cases, the aim is not to rehabilitate them back into business activity. However, there is still a rehabilitation aim in the sense that these individuals should be given opportunities to contribute to society in other ways. Insolvency law may have a role to play in encouraging people to move to areas where they are competent.
4.1.3.4 Dishonesty
Societal objectives are somewhat different in relation to this category of business failure. Some persons who commit insolvency-related crimes may be open to rehabilitation. However, there are some who appear before the courts time after time with no real intention of ever making a positive contribution to society. The objective is to make it as difficult as possible for such individuals to continue to exploit corporate governance and insolvency laws to make personal gains at the expense of society as a whole and the individuals that suffer financial hardship and personal anguish as a result of the offender's conduct.
To promote these objectives it is necessary to:
- Clearly define offences of dishonesty;
- Have a well resourced agency that actively enforces the law; and
- Provide for maximum penalties that give the courts ample scope to punish the offender with sufficient severity to deter further transgressions by the same person or by others.
4.2 Consumer-Related Insolvency
Personal insolvency arises when a person cannot pay their debts as they fall due. Consumer insolvency is a subset of personal insolvency. The purpose of it is to provide financial relief for honest individuals who find themselves in financial difficulty. This provides the opportunity for:
- the debtor to make a fresh start more easily; and
- creditors to obtain a quick distribution of assets in accordance with the pari passu principle.
Also, the law aims to protect society from dishonest and reckless conduct by debtors.
Since the last review of personal insolvency legislation in the 1960s, the number of consumer bankrupts has increased and now surpasses the number of business-related bankrupts. This appears to be linked to the increasing availability of credit.2 However, credit availability is not the underlying cause of consumer-related insolvency. Rather, consumer over-indebtedness is caused by:
- Inability to meet repayments because of changing circumstances: e.g. job loss, separation or illness.
- Lack of awareness of the consequences of taking out consumer credit. Consumers may agree to act as a guarantor without understanding the full nature of the obligations incurred.
- Recklessness. Consumers can knowingly obtain credit when they know it is or may be beyond their means to meet all repayments as they fall due. In these circumstances, the debtor may risk serious asset loss.
- Dishonesty. The most common forms of criminal conduct by debtors include concealing or removing property, destroying or falsifying documents relating to their affairs, failure to keep proper records, absconding, and obtaining credit contrary to a court order. Although dishonest behaviour may not be the sole cause of an insolvency, it will almost certainly lead to bankruptcy, as creditors will be reluctant to participate in informal or formal arrangements with the debtor.
4.3 Uncertainty and Compliance Cost Issues
Evaluating policy alternatives requires considering not only the merits of each alternative but also its implementation costs. These costs can fall on businesses, enforcers and regulators in the form of excessive uncertainty, enforcement costs and litigation costs.
Compliance costs can vary significantly depending on the insolvency law model adopted. Simple rules and efficient, predictable and quick processes can generally be expected to reduce compliance costs and should be used where they will lead to accurate outcomes (in terms of deterring undesirable conduct and promoting desirable conduct) nearly all of the time.
However, simple rules may lead to a significant number of arbitrary and indiscriminate outcomes. In this case it may be desirable to make the rules more complex in order to promote a greater level of desirable outcomes.
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