Specific Issues for Consideration in Any New or Revised Procedure
Cost/Entry
In order to make the procedure accessible to directors of small and medium sized companies, it should not involve overly costly reporting requirements or court applications. The need for both a court order and a detailed independent report accompanying the application have proved fatal to its use in the United Kingdom.
If it is deemed necessary to have a professional report on the company's financial state and viability and genuineness of any proposal, it should not be so detailed as to be financially prohibitive for a company or a creditor (with appropriate assistance) to prepare. It is suggested that the Canadian approach under the BIA (see above) provides nearly the right balance between the need for a cheap process which directors will feel comfortable with and the need for a monitoring by a professional.
There are choices to be made as to the balance here. Canada is unique in having a non-court debtor initiated moratorium which is automatic (initially) without having to evidence a viable reorganisation proposal. This clearly solves the problem of making directors feel comfortable with the procedure, but as discussed above, the Canadian procedure may have gone too far, and some independent attestation of the prospect of a viable proposal might be needed at this initial stage, or at least within a very short timeframe of weeks.
Entry into the procedure should not be premised on proof of insolvency. In some jurisdictions an alternative is that the company is likely to be unable to pay its debts in future. Where there is a procedure with no court hearing, the matter is left to the veracity of directors and the professionalism of advisers or trustees appointed to supervise or monitor the debtor, as in Canada. However, the important point is that there is a need to encourage debtors to address financial difficulties as early as possible, and if an insolvency precondition is insisted upon, there is a danger that any new procedure becomes stigmatised as an insolvency procedure and thus avoided by directors. Therefore the choice for debtor initiation is between an open-ended entry, or a condition that the debtor believes it is insolvent or likely to become so in future.
In the case of creditor initiation, the same test should not be applied. Clearly it would be unfair (and impractical, given informational disadvantages for most creditors) if a company was involuntarily placed into any sort of formal procedure unless creditors could show that their rights were at risk due to insolvency or imminent insolvency. The same test should apply as on liquidation, if it is decided that creditors should be able to initiate a rescue procedure.
Who Can Initiate the Process?
Should creditors, as well as directors/the company, be able to apply/file? In some jurisdictions, creditors can only apply by court order. If court proceedings and independent reports are involved, some creditors may not have access to sufficient financial information for any application to be successful. If no court proceedings are involved, should only major secured creditors be able to apply, as in Australia? (It is not known at this stage if many do so there - it was intended to encourage them to embrace the concept of administration and feel in control of its initiation, but there are other incentives that could be given to secured creditors, such as superpriority for post -initiation lending, or a generous discretion in ensuring adequate protection of their interests.). In principle, subject to the point in the previous paragraph about the insolvency threshold, there is no reason why creditors should not be able to initiate a rescue procedure. Indeed, they should be encouraged to view such procedure as an opportunity to enhance their returns. In the UK, creditors can petition for administration orders, but there has been only one or two cases, usually secured creditors, where this has actually happened. Therefore, the problem may be more theoretical than real.
Court Involvement (Related to Cost)
Court control over initiation, as in the United Kingdom or Ireland, does provide a check against hopeless proposals, and enables creditors' views as to alternatives such as liquidation to be weighed at the initial stage. However, creditors can be placed in control of the proposal from an early stage after initiation so that check could be provided other than through routine court involvement.
Aside from the time of initiation of proceedings, court involvement during an administration can vary. Interested stakeholders should be able to come to court for rulings and to apply for leave to enforce their usual creditors' rights. However, in establishing such a system, experience in Australia and the United Kingdom, and especially in United States, has shown that insufficiently delineated powers and duties in legislation means that courts have more discretion, thus encouraging more applications to court during proceedings.
Who Is in Control?
The two traditional choices are the appointment of an outside professional "administrator" who replaces the management functions of directors (possibly leaving their residual duties) and replaces any receiver over any company assets, or leaving control in the hands of the directors, as in Chapter 11 in the United States. (A third possibility is a high degree of creditor control through a committee of creditors representing the majority of creditors' interests, or at least a committee which has an important role in directing the other controllers). This polarised debate is one of the most controversial in the field of corporate rescue. In caricature, the existing management are portrayed as responsible for the company's existing dire straits, so that they must be removed immediately from control and an objective third party professional installed. On the other hand, the view in the United States is that the existing directors may have invested skills, time and money in the enterprise over many years, and there should be no presumption that their removal is essential to any rescue- that decision can be left to the creditors when voting on reorganisation proposals. As pointed out above, this is a misconceived debate since it is the abstract concept of the "debtor in possession" which is created under US Chapter 11, and this means the corporate entity, not necessarily the management.
However, there is a spectrum of possibility. For example, while under Chapter 11 the "debtor in possession" is the company during the procedure, so that directors may retain control, two further possibilities are that the court could appoint an Examiner to oversee the debtor in possession, with such functions as the court orders; secondly, more frequently the management that was responsible for the company's parlous state is quickly superseded as part of reorganisation proposals or creditor pressure, so that it would be rare for Chapter 11 to actually result in old management retaining control.
At the other end of the spectrum, though an administrator in Australia or the United Kingdom may replace management, it is not envisaged in either procedure that the administrator would be in that position for long, and the administrator can employ existing management to assist if necessary. The United Kingdom Insolvency Bill provides for a procedure whereby management does stay in control for a short stay during which a proposal can be put to creditors.
One approach to this issue is to recognise that unless there is any suggestion of malpractice, incompetence or other default, it is more efficient and cost-effective for existing management to continue in control of a company, with or without outside assistance or monitoring. Clearly the professional costs of a team of qualified managers and the cost of their time on the learning curve should only be incurred if necessary to protect further loss to creditors. It should not be assumed that there will be widespread abuse simply because no outside professional takes control. While that may be one outcome, the other checks and balances within a system would have to be taken into account, such as the role played by creditors (and the court) in the particular process.
Powers and Duties of Administrator
Where any independent administrator is given powers of management (rather than an independent professional with powers of monitoring and reporting but with the debtor remaining in control) those powers should be at least as wide as a combination of a receiver and liquidators' current contractual and statutory powers. This would enable the administrator or practitioner to maximise objectives of survival or sale as a going concern, compromise or at least a better result than on a liquidation. (It is recognised that corporate rescue procedures should not, where possible, be protracted, and are designed to be short-term procedures. However, whether or not some of these "liquidation" powers would be frequently used, their inclusion would be prudent). In order to counter any possible self-interested choices by directors, administrators should be given the same investigative and reporting powers as liquidators, and equal ability to challenge voidable transactions or directors' reckless or wrongful trading conduct. While it may be possible to give directors incentives, through statutory defences and possibly costs priority mentioned below, to seek help at an appropriate early stage, the ability of an administrator to report, investigate and challenge unlawful conduct or suspect transactions would act as a deterrent to directors and their associates against viewing administration as a "soft option". This suggestion is an improvement upon the current Australian and Canadian systems, though it is understood that there have been calls to tighten up reporting of directors' default in both Canada and the UK.
The powers of an administrator should be at least as wide, but also wider, given that they should have the benefit of a moratorium as well as powers in some circumstances to dispose of secured property without consent. Under such a scheme, directors will still need incentives to prefer administration rather than liquidation, and these will be a combination of defences to wrongful trading and other liability, as well as the prospect of survival of their business.
Duration of Moratorium
There is little point in having an initial moratorium from creditor action for so short a period that it does not enable genuine negotiations to take place with a view to a viable reorganisation proposal. The minimum automatic period, on notice of intention to file as in Canada, should be around 21 days, 28 days being more usual.
It is then necessary to have ability to extend this, usually on application to court. The onus of proof should then be on the debtor, with independent corroboration through a professional report on viability, to convince the court that a viable proposal is likely within any extended moratorium period.
The remaining question would be whether there should be a maximum period of six months or a year after which no further extension should be granted.
A related question would then be what would happen at the end of that period. Would it be possible, as in the United States, to file for further protection and submit a new plan, and if so, how many times? Or should liquidation automatically ensue as in Canada? In the UK it has been proposed that no filing will be allowed if there has been a previous one by that debtor within 12 months.
Width of Moratorium and Court Power to Modify
Section 42 Companies (Investigation and Management) Act 1989 contains a good example of a relatively wide moratorium. The narrowest form would prohibit winding up resolutions and all other proceedings against a company. A wider form would include other forms of legal process, execution and attachment, forfeiture and distress. Wider still would include contractual termination notices, and all forms of set-off. Lastly, of course, it is necessary to have a moratorium which prevents secured creditors from enforcing security (and the definition of secured creditors is important here- recent problems have been caused in the UK when forfeiture by peaceable re-entry was held to be outside of the moratorium, and this is now being altered by Parliament).
It should be a fundamental principle with all such moratoria (including Part XIV Companies Act 1993 and statutory management) that they do not remove rights and remedies, but merely prohibit them for the duration of the moratorium (though in practice, depreciation of value of enforcement rights is inevitable in some cases.
It is necessary to give discretion to an administrator and the court, preferably with some statutory guidelines (these have been lacking in Australia) to allow the moratorium to be lifted in favour of some creditors, particular secured creditors. This involves balancing the interests of all creditors that the rescue attempt or compromise proposal continue, for which purpose it may be necessary to prevent a creditor exercising rights or remedies in relation to a particular asset or bundle of assets, against the individual creditor's pre-insolvency contractual rights, particularly secured creditors where the argument is that they have bargained on the strength of security rights and remedies.
It is axiomatic that any moratorium in a rescue procedure extends to secured creditors. To leave secured creditors outside of the procedure and able to continue to exercise contractual remedies is to fail to recognise that the collective insolvency procedure is wealth-maximising for all creditors including secured creditors. It is equally important that secured creditors receive "adequate protection" for their security during an administration or reorganisation proposal process.
Where property owned or hired out by a creditor is vital to the continuation of the rescue attempt, principles can be developed to ensure that the value to the owner /lessor is preserved, for example by agreeing that rental payments during the insolvency will be a priority expense.
In cases not involving owners or secured creditors, a more finer balancing exercise has to take place, for example whether a personal grievance litigation can be continued during the administration. This is more likely to turn on the inconvenience and cost to the administrator and company in having to deal with the claim, balanced against the individual's loss and hardship if the claim cannot be continued (for example, if a limitation period may expire if the claim cannot be continued).
Rights of Secured Creditors (and Meaning of Secured Creditor)
Should certain secured creditors (those who could normally appoint a receiver to control the business on debtor default) be able to "veto" the insolvency rescue from continuation? It has been seen that in some jurisdictions chargeholders are given a period during which to decide whether or not to appoint a receiver, after which in theory they are bound by the moratorium, (though they may or may not be able to vote at creditors' meetings). In other jurisdictions such as Canada (and proposed in the UK) the opposite is true, the chargeholders must give notice to the company, during which time the company can file for protection. This latter is far more controversial and is seen as a dilution of secured creditor's bargained-for pre-insolvency rights.
In those jurisdictions where certain secured creditors can "veto" the continuation of a rescue attempt, only those creditors who can control all or substantially all of the business and undertaking of the company can "veto" the procedure, since the argument is that (a) rescue procedures are sometimes used because no receiver is in control (or none can be appointed and (b) secured creditors' contractual rights should be treated as paramount.
The first of these is arguable and subject to statistical verification; the second is cultural and political, and finds favour in systems where secured creditors' rights have always been given precedence (as they have in New Zealand to date). In New Zealand the terminology would have to be considered in the light of the Personal Property Securities legislation. The Law Commission in its recent advisory report to you on Priority Debts has recommended that there be harmonisation of the definition of "secured creditor", especially in the light of the Personal Property Securities Act definition.
Those that support the view that secured creditors should be able to continue to enforce their security and have a veto on the successful continuation of any rescue procedure, would argue that the idea has emerged from the function of receivers appointed under all-embracing fixed and floating charges. It is fundamentally an issue of control. From a "rights" point of view, the secured creditor might argue that the right to take control of the business through a receiver is a bargained-for part of its security. From an outcomes point of view, they might argue that administrators or other rescue procedures are not necessary where there is such a chargeholder, since the receiver can effectively rescue any business worth rescuing. The answer in both these cases is to refer back to the section on Receivership in this paper, where it is pointed out that receivers do not owe real duties to anyone except their appointor, and do not concern themselves with the maximisation of returns to other creditors; secondly, the view that receivers will rescue all businesses which are worth rescuing is challenged on the empirical evidence available. In any event, the evidence in countries such as the UK and Australia shows that secured creditors are often quite content to allow a trusted professional to act as administrator, even if not appointed by them.
Secondly, what rights should secured creditors have during the moratorium, particularly with regard to exercising their remedies with leave of court or consent of debtor or administrator, and how should "secured creditors" be defined for this purpose and for voting purposes. For example, should it include lessors forfeiting a lease? Personal Property Securities legislation will avoid many of the definitional problems that have arisen elsewhere (such as having to extend the definition to cover retention of title claims or finance leases). Which type of secured creditors should have the value of their security safeguarded if the debtor/administrator is given power to dispose of property as if it was not subject to the security (this is a usual and valuable power enabling extraction of optimum going concern or break-up value from a business or bundle of assets).
Just as it is crucial that secured creditors be included within the scope of a moratorium against creditor action, it is equally important that secured creditors rights are not diluted, but merely postponed. While this can be achieved by provisions that enable secured creditors to come to court at any stage when they feel their interests are being prejudiced, it can also be built into reorganisation plan rules, so that secured creditors will receive "adequate protection" in the form of e valuation of their collateral so that its priority (for capital and interest) is preserved in any plan, or for example, that they will be compensated for any depreciation in the cash value of their collateral during the reorganisation. The courts in the UK and Australia have managed to devise discretionary guidelines along these lines, in the absence of compliance with which the stay will be lifted against secured creditors, whereas the US has strict rules built into the Code. It should be stressed that the postponement of secured creditors rights through a moratorium needs to be balanced by this protection, the ability to apply to court for relief from the moratorium, and preferably by strict time limits for the continuation of the moratorium. With these safeguards in place, it should counter any suggestion that a reorganisation is being continued "at the expense" of secured creditors or that their security is slipping away in the meantime.
Voting Procedures
A variety of combinations of voting procedures exist, for example whether proposals should pass by a clear majority in number, a three-quarters or two-thirds majority in value, or combinations of value and number voting. An important factor is how far votes of connected persons should be discounted, if at all. In addition, consideration should be given to whether secured creditors should be able to vote, or whether they should only be able to vote to the extent of any unsecured portion of their claim. If secured creditors (and priority creditors) are able to enforce their claims or are given priority notwithstanding the compromise of unsecured claims, then there is no need for them to vote. On the other hand, in jurisdictions such as the UK where this is the case, debate has revolved around whether in fact it is better to allow secured and priority creditors to vote and thereby be bound by a proposal, either because it is necessary to use secured property or because some compromise of their absolute claims is desirable.
Adequate precedents already exist in Part XIV and the Seventh Schedule to the Companies Act 1993, though it should be pointed out that one of the major impediments to the use of compromise schemes is the need for separate class voting, which is often seen as unnecessarily complex. It may be that this is one reason for the lack of use of Part XIV (if indeed it is been infrequently used, as one suspects).
Unnecessarily complex class voting procedures may be counterproductive in terms of attracting debtors to use the procedure. It is suggested that for most small to medium sized companies, class-voting procedures (especially for unsecured creditors) are unnecessary, potentially litigious, and may be detrimental to the success of some rescues.
Procedure on Failure and Relationship to Other Procedures
As stated above, the question may need to be addressed what should happen if a rescue procedure fails. Should automatic liquidation ensue, and should future rescue attempts in relation to that company (perhaps if by directors only) be banned for a certain time; if so, how long?
Secondly, the relationship between current procedures such as liquidation, Part XIV and/or any new procedure which may be recommended, must be addressed. At present the relationship between liquidation and Parts XIV and XV are unclear, and leave something to court discretion.
Thirdly, if a relatively accessible procedure is recommended without undue court involvement, as in Australia, should it be equally without court involvement at the termination point. It does not necessarily follow that it should. In Australia, creditors determine the outcome of an administration and any deed of company arrangement within it. In the UK, no administration order can terminate without a court order discharging or varying the original court order. Some thought will need to be given to whether ease of termination as well as ease of initiation might encourage bad faith filings. In the United States it is certainly arguable that there are insufficient checks on access and continuation of Chapter 11 filings, and no penalties for repeat filings. However, there is no independent administrator in that jurisdiction. Where there is an independent administrator, particularly with a licensed insolvency profession, as in the UK, much emphasis can be placed on the view of that professional as to the stage that the company has reached. In Canada, the strict statutory timetable under the BIA Division 1 procedure seems to mitigate against abuse of reorganisation procedure, since there will be an automatic conversion to liquidation if no proposal has been filed within a certain timescale, or if creditors reject it. Presumably it would be necessary to allow for modifications of the original proposal, within a strict timescale. This could be combined with a rule prohibiting new reorganisation filings within, say, 12 months. Any longer may inhibit genuine repeat filings.
It is important to have a flexible "menu" of procedures available, with relatively quick and easy conversion from administration to liquidation, but also the reverse. While in some jurisdictions there has been discussion of one "gateway" procedure, so that it is left to a court to decide whether liquidation or rescue should be attempted, in most jurisdictions where there is the more attractive twin track or multi track approach, it should be possible for stakeholders to apply to terminate the existing direction of the procedure and substitute another. If, for example, a liquidator formed the view that the company could be rescued or was susceptible to a compromise scheme if there was an adequate moratorium protecting it, she should be able to apply to convert the proceeding into a rescue procedure.
Encouragement of Informal Workouts
Informal workouts will always happen. Given that they promote the objective of early "treatment" of financial problems, the issue is whether steps should be taken to investigate whether New Zealand could benefit from following the route taken in other jurisdictions, usually through their central bank, to promote and encourage informal workouts by issuing guidelines on protocol covering such matters as an informal moratorium, appointment of a lead bank and provision of ongoing finance. Clearly these informal rules are playing an important role in Asia, largely due to cultural factors. However, the UK has successfully developed the London Rules and INSOL, the international insolvency body, is investigating a more global accord. Clearly such protocols are more suitable to large or significant restructuring attempts and may not necessarily be adopted for all jurisdictions. There is some evidence that the London Rules are founded on traditional London clearing bank practice and will be less adaptable to a changing lending culture, or other jurisdictions (Other than through existing legislation, I am not aware of what informal procedures exist for identifying or limiting New Zealand financial sector's exposure to corporate financial failure in this and other ways).
However, it should be stressed that informal arrangements are not inconsistent with formal rescue procedures. Indeed, it is well recognised that informal workouts take place "in the shadow of the law", and therefore the parties' minds will be focused by the alternative formal structures that await them if the informal rescue fails. Providing for a formal rescue procedure will not necessarily lead to a large fall in informal workouts, since whatever the rules for formal rescue procedures, there will always be cost and secrecy attractions of the informal route. To the extent that there is a fall in informal rescues, this might not necessarily be detrimental, given that some of these workouts will not necessarily be maximising the returns to all creditors (in addition, they may have the effect of concealing director delinquency).
Funding for Reorganisations
As with informal workouts or statutory compromises, funding for ongoing trading, either in the immediate moratorium period or the medium term, can be left to consensual arrangements. Usually, it is provided by existing lenders to the company. Alternatively, provision can be made for a market, as exists in some jurisdictions, for insolvent debt, and secondly a market for special provision of finance to distressed companies. 32If there is not such a market it may evolve naturally, but it could also be created by intervention in the market, as an objective of insolvency and finance law. Thus, in Thailand and Malaysia, State organisations have been created to deal in non-performing loans and return proceeds to creditors, reportedly with limited success.
However, the more usual method of legislative encouragement is (a) to ensure that funding arrangements are part of any proposal and attested by a professional or the court to be viable (as in Canada or the US) and (b) to give superpriority to "post-petition lending", i.e. to give secured or other creditors priority over existing preferential creditors, and even over pre-insolvency secured creditors. (I note that the Law Commission did not raise this issue in its paper on preferential debts, since there is no such superpriority at present and it only arises in relation to a rescue procedure). In the United States Chapter 11 procedure there is also provision for compulsion in use of book debts and other collateral by the debtor without the permission of the secured creditor, with appropriate safeguards. The UK DTI report on Business Rescue also raises this issue of ability to use book debts while trading.
Lastly, tax incentives could be provided to financiers of companies trading during rescue.
Could Part XIV be Modified Sufficiently?
Without pre-empting any final report on whether a new or revised procedure should be adopted, and if so with what features, the issue of whether Part XIV Companies Act could be modified sufficiently to achieve the objectives of a simple, cheap and accessible rescue procedure which would obviate the need for a major procedure such as voluntary administration is one that has been canvassed amongst commentators.
In order to modify Part XIV , an automatic wide moratorium against creditor action would be needed. Arguably, the need for separate classes of creditors to be identified should also be removed.
This would be an improvement on the current situation, but even with a wide judicial interpretation of "compromise", it would not provide a mechanism such as exists in Australia or the United Kingdom whereby an independent person can replace management and can continue trading the company as a going concern for a period of time. Of course, it might be possible for the company to continue trading within the terms of the Part XIV arrangement, but the company directors would not be protected from potential liability for insolvent trading. Although the United Kingdom government is reforming the law because of the lack of a moratorium of a relatively short time while the existing or new management is in control, they are not proposing to abolish administration orders, so it is acknowledged that at least for larger companies, the advantages of an independent professional representing all creditors, with full management powers and the protection of a moratorium, is valuable.
Two aspects of modification of Part XIV which were addressed by the Joint Insolvency Committee in 1994 and which are still relevant are:
- the need for an independent report; and
- the need for an independent supervisor or monitor of the arrangement.
In the United Kingdom the government has recommended the second of these in order to counter allegations that it is proposing a Chapter 11 style charter for bad management to stay in control. Only in the United States can a Chapter 11 procedure be commenced without any professional report testifying as to its viability (there are other checks in that system, but most involve court applications). Two points should be made at this stage. The higher the level of professional reporting and monitoring, the higher the cost, thus making it proportionately less attractive to companies. Secondly, there is at present no regulated insolvency profession in New Zealand, whereas that is not the case in Australia, Canada and the United Kingdom. Higher levels of professional endorsement or certification of the viability and genuineness of rescue proposals puts higher emphasis on integrity, judgment and qualifications of those professionals.
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