8. Business Rehabilitation
8.1 Issues Raised by the Law Commission
57. The Companies Act and the Insolvency Act in New Zealand provide procedures whereby companies and individuals may enter into binding compromises or arrangements with their creditors, but unlike many schemes in other jurisdictions these procedures do not:
- Impose an automatic moratorium on claims;
- Enable the company to continue to operate without interference while a plan is being formulated; and
- Provide for an independent administrator to be appointed.
The Law Commission was therefore asked to advise whether New Zealand should introduce a business rehabilitation regime (akin to voluntary administration and incorporating some of theses missing elements) into its insolvency laws.
58. Central to the approach adopted by the Law Commission is the view, expressed in paragraphs 218 - 220, that a key rationale for the introduction of a rehabilitation regime flows from the fact that, faced with insolvency, "... it would be unrealistic to expect debtors and creditors to act ... rationally in the absence of stern sanctions or incentives to bring about that result". Specifically:
- The stresses brought on by the prospect of business failure or the possibility that living standards may need to be reduced tend to make most people act irrationally at such times.
- Creditors may, in the absence of efficient and effective state enforcement of debtor conduct infringing acceptable bounds of commercial morality, be tempted to decline an economically reasonable offer to settle in order to exact some retribution against the debtor and demonstrate that other s dealing with the creditor should not regard it as a soft touch.
- Staff from the creditor organization may prefer a liquidation to a reorganization because they will not look forward to explaining their lending decision to their superior, while "a liquidator will rarely examine lending conduct of a creditor in the course of his or her duties.
59. The Law Commission notes that "At first sight there would appear little point in introducing different rehabilitation regimes to New Zealand given that none of the practitioners with whom we have consulted with (sic) consider that the lack of a stay against secured creditors is a problem" (para 233). In addition, the large number of small businesses (for which rehabilitation administration is not likely to be cost effective) and the small pool of insolvency practitioners reduce the apparent utility of such a regime. Nonetheless, the Law Commission considers that "... there are justifications for introducing a targeted rehabilitation regime in order to improve the law in this area". These justifications are:
- Voluntary administrations provide incentives for debtors with financial difficulties to face their creditors earlier;
- In good economic times laws should be developed that can cater for periods in which insolvencies may increase in number, especially in larger businesses controlling strategic local or national assets where a standstill period may be helpful in assessing whether there is a better outcome than liquidation;
- The desire to have a flexible range of remedies available to fit different circumstances; and
- A rehabilitation scheme which targets businesses run by honest and competent management may produce a reduction in the range of circumstances in which management of a debtor may wish to invoke statutory management (under the Investigation and Management Act 1989) for rescue purposes.
60. The Law Commission proposes that a new rehabilitation regime be developed, the target of which would be large businesses such as state-owned enterprises or utility companies which are run by "honest and competent management", but be applicable to smaller companies which can meet the following entry criteria:
- The company is insolvent;
- There is a real prospect that the creditors will agree to some proposal; and
- The proposal is "likely to achieve some purpose such as the rehabilitation of the company, or the realization of its assets at a higher price than in liquidation";
- Once the proposal is implemented, the firm would be solvent.
Entry to the regime would require that an appropriately qualified insolvency practitioner issue a certificate to this effect (para 276 - 279).
61. Upon receipt of the appropriate certificate, the Law Commission envisage that the court would grant a moratorium against secured and unsecured creditors for a period of 14 days, with an ability to extend the moratorium for a further period of 14 days if the insolvency practitioner certifies that there is a reasonable likelihood that the creditors will approve the proposed restructuring.
62. The Law Commission envisages the insolvency practitioner being given power of veto in respect of management decisions but the management of the business remaining, for the duration of the stay, under the control of the existing management. The stay, itself, would also prohibit management from using bank accounts so an injection of new capital would be required on any view if this regime was to be implemented" (para 284).
8.2 Issues Raised by the Proposed Rehabilitation Regime
63. The regime proposed by the Law Commission has the advantage that it would provide in New Zealand an option for rehabilitation that is more consistent with the insolvency regimes used by our major trading partners. By offering a formal mechanism for attempts at rehabilitation it may also encourage more voluntary agreements on rehabilitation. The question then is, how great are these advantages, who is most likely to use the regime, and what are the costs?
64. The personal profile of the business managers that the Law Commission is attempting to assist is not one commonly found in economic analysis. To be clear, we are asked to contemplate a regime for business people who may not act rationally in the period leading up to insolvency, but are otherwise "honest, competent but unlucky". We find in the report of the Law Commission no estimate of the actual number of business people fitting this description who populate our insolvency statistics, and we doubt that such statistics can be gathered given the difficulty of identifying these people. The difficulty of identification raises further concerns about how people who are neither honest, nor competent, or perhaps acted entirely rationally in choosing a path to insolvency, are to be screened from the pool of potential entrants to the regime. Finally we are unclear whether the Law Commission considers honesty to be a component of rationality: if it is, we are not clear why honest debtors and creditors would not reach an accommodation before the point of insolvency and /or without the need for the formal moratorium proposed by the Law Commission.
65. An alternative approach to the search for gaps in the insolvency regime is to consider whether there are some insolvencies where rehabilitation would be maximize the value of the firm but where secured creditors refuse to bear the costs of rehabilitating the firm and force liquidation instead. It is at least plausible that in the case of some small firms, such a scenario could have some relevance: Since secured creditors bear substantial costs associated with the monitoring of rehabilitations, the benefits from rehabilitation of small firms may be outweighed by the costs. In this case, any moratorium regime would simply be a means of imposing on creditors costs that they would not normally be willing to bear. Efficiency will only be improved by this action if the social benefits from rehabilitating the firm as a going concern outweigh the costs imposed on the secured creditors.
66. A further possible rationale for a moratorium is that it would provide a mechanism for dealing with problems arising from actions of individual secured creditors that were detrimental to the interests of other secured creditors. An example might be that one secured creditor refuses to agree to a rehabilitation plan in the hope that this will force the other secured creditors to buy out its interest on favourable terms. A legal framework which gave the court the power to make a rehabilitation regime binding on all secured creditors might assist in overcoming this type of strategic behaviour.
67. Overall, it is our view that the lack of clarity about the precise nature of the problems that have motivated the suggestion for a rehabilitation regime mean that the Law Commission has not yet made the case that such a regime is needed. The proposed regime may be too costly for most small firms, while large firms (especially large infrastructure firms) should not need it. In large infrastructure firms such a high proportion of the value of the firm is made up by the cash flow that can be generated by tangible assets, it is relatively easy to achieve a "going concern" sale of such a business. If, during an insolvency proceeding, a decision was made to split up such a business, it is most likely to be because technological change has altered the optimal scope of firms in that industry. In this it would not be efficient to preserve the existing business under management that had failed to address the implications of technical change for the business.
8.3 Incentives Provided by the Proposed Rehabilitation Regime
68. The Law Commission argues that "Competent and honest management of a debtor should be given incentives to face up to creditors as early as possible so that the fear (whether justified or not) of precipitate action by a major creditor does not dissuade management from trying to salvage the business where appropriate" (para 287). Incentives are critical, as the Law Commission points out, but focusing only on incentives for managers of firms at the point of insolvency may result in a regime that provides much less efficient incentives overall.
69. Consideration of incentives should start with the incentives that exist for the managers of all firms to take actions that will minimize the probability that any exogenous change in economic conditions could bring them to the point of insolvency. Incentives need to be in place to provide for a business to be restructured or sold to superior management long before it reaches the point of insolvency, and a moratorium is not required for that. The more favourable to debtors is the insolvency and rehabilitation regime that we put in place, the weaker are the incentives to act before that point and the higher will be the cost of capital. For example, a soft landing in the insolvency and rehabilitation regimes may increase the incentives for management to gamble for resurrection rather than sell at a loss as the financial position of a business deteriorates.
8.4 Impact on the Cost of Credit
70. The Law Commission argues that its proposed rehabilitation regime will not increase the cost of credit because there are already provisions for a stay of action by creditors under the statutory management regime (para 281). In our view, the existence of the statutory management regime does not mitigate the potential impact on the costs of credit that results from the introduction of a new and more widely accessible regime providing for a stay of action by creditors. While the Law Commission proposal is to reduce the scope of the statutory management regime and increase the potential for rehabilitation, it is likely that the rehabilitation regime will become much more widely used than has been true for statutory management.
71. We have suggested that it is plausible that the true rationale for the introduction of a moratorium or rehabilitation regime is the imposition on secured creditors of costs that will impact on the terms on which they are prepared to make secured loans. This will certainly raise the cost of secured credit. This increase in the cost of secured credit across the whole market for business finance (ie across every secured credit transaction in the economy) must be assessed against the benefits derived from the relatively small number of rehabilitations facilitated by the moratorium.
72. The potential impact on the cost of credit is enhanced by particular features of the rehabilitation regime proposed by the Law Commission. During the moratorium the management would be prohibited from using the bank accounts, which means that new capital would need to be raised to finance operations during the moratorium. The injection of new capital will have an effect on the cost of credit, because that new capital will only be available if it is a priority claim on the assets of the firm.
73. The impact on the cost of credit will to some extent be determined by the liability of the insolvency practitioner. From time to time insolvency practitioners will inevitably sign the certificates to allow firms to enter the insolvency regime in error, imposing losses on creditors as a result. In these cases, creditors would naturally look to sue the practitioner for damages. Assumption of this liability by the state would reduce the care that insolvency practitioners took in signing certificates, increase the number of firms entering the regime and thus raise the cost of credit. Similarly, any move to use the statute to limit the liability of the insolvency practitioner will also increase the cost of credit.
8.5 Summary
74. We do not find convincing the rationale for a moratorium provided by the Law Commission, and we doubt that the target firms that they have identified actually require a moratorium to promote rehabilitation rather than liquidation when rehabilitation is efficient. Unless further work is undertaken to identify the precise market failure that any moratorium would be designed to address, there is a danger that the regime may not be appropriately designed to assist those segments of the market actually requiring it.
75. Whatever the rationale for the introduction of the moratorium regime, and despite the existence of a statutory management regime, we consider it highly likely that a moratorium will increase the cost (defined to include all terms of the contract) of secured credit.
8.6 Conclusion
76. In our view, the Law Commission has yet to make a convincing case for the licensing of insolvency practitioners, alternative arrangements for the enforcement of insolvency law (including the creation of the office of the Inspector General of Insolvency) and a moratorium regime. The case for the interventions and law changes recommended by the Law Commission cannot be made without further research that is designed to:
- More precisely identify the market failures justifying the intervention;
- Provide a basis upon which the magnitude and significance of the problems identified can be assessed; and
- Link more directly the recommendations made to the resolution of the market failures identified.
In each case, we suggest that this analysis should include a more detailed assessment of the potential costs associated with each of the changes recommended. The potential costs associated with licensing, the Office of the Inspector General and the moratorium regime require closer scrutiny since it is at least plausible that they will outweigh the benefits associated with the changes recommended by the Law Commission. An alternative, which may involve much less risk of inefficient outcomes, would be to provide the Insolvency and Trustee Service with more funding for enforcement, and to minimize other changes until the impact of this funding could be assessed.
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