Navigating the labyrinth
The European Commission has identified the labyrinth of European insolvency laws as one of the key barriers to cross-border investment, and it intends to address this issue as part of its Capital Markets Union (CMU) package of reforms. The Commission seeks to address the following areas where national insolvency regimes differ significantly:
- Standards applied by national courts when reviewing applications for a stay of individual enforcement actions (i.e. moratoria)
- Criteria for opening insolvency proceedings
- Levels of discretion held by courts to allow the adoption of and/or change to restructuring plans
- Availability of discharges for bankrupt individuals, businesses, or owner/managers (i.e. a second chance)
- Priority of claims on insolvency
- Rules surrounding the avoidance of detrimental contracts
- Qualifications and eligibility of insolvency practitioners themselves.
On November 22, 2016, the Commission published a draft directive designed to harmonise restructuring frameworks of each Member State. Its aim is to develop and recommend a principles-based early restructuring and second chance legislative initiative by building on national regimes that work well. This follows the conclusion of a consultation in June 2016, where the Commission canvassed stakeholders’ views on common principles and standards for national insolvency frameworks.
Our starting point
The recast EC Insolvency Regulation 2015 (EIR) determines the proper jurisdiction for a debtor's insolvency proceedings and the applicable law to be used in those proceedings. It also provides for mandatory recognition of those proceedings in other Member States.
Where a debtor’s centre of main interests is within a Member State, the EIR recognises that Member State as the appropriate forum for main insolvency proceedings concerning the debtor, and provides for automatic recognition of those proceedings by the courts of other Member States. Any further proceedings in other Member States where the debtor has an “establishment” are secondary to those main insolvency proceedings and relate only to assets in that secondary Member State.
The EIR – which, in its original form, came into force in 2002 – has proved to be a useful tool in European cross-border restructurings and insolvencies. The amendments made when the EIR was recast with effect from June 2017, implemented changes which, amongst other things, introduced a mechanism for co-ordinating insolvencies within cross-border corporate groups, which is a welcome development.
The path to harmonisation
The draft directive is designed to harmonise restructuring frameworks in each Member State, introduce a four-month period of protection from enforcement action to facilitate a restructuring plan, prevent dissenting minority creditors and shareholders blocking restructuring plans and protect new financing for restructured companies.
Harmonisation of insolvency laws has been on the EU agenda for some time. The Commission’s recommendations of March 2014 on a new European approach to business failure and insolvency invited Member States to put in place effective pre-insolvency procedures to help viable debtors to restructure, and reduce the period of bankruptcy for honest entrepreneurs to no more than three years. In its CMU Action Plan, the Commission noted that the recommendations had only been implemented partially across Member States and noted that differences in national insolvency and restructuring regimes constituted a barrier to the free flow of capital.
The draft directive does not, however, seek to harmonise core aspects of insolvency law, such as rules on conditions for opening insolvency proceedings, a common definition of insolvency, ranking of claims and avoidance actions – the commentary to the draft directive notes that such matters are intrinsically connected with other areas of national law such as tax, employment and social security law, and harmonisation would be too far-reaching. Instead, the proposals focus on adapting national insolvency procedures to enable debtors in financial difficulties to restructure their debt before insolvency.
How to get there
The draft directive makes the following key proposals to encourage cross-border investment and the harmonisation of the restructuring process in the internal market:
- Member States should have preventive restructuring frameworks consisting of one or more procedures or measures whereby a debtor can effectively negotiate and adopt a restructuring plan.
- The debtor should be left in possession of its assets and affairs when negotiating and implementing a restructuring plan. Mediators or supervisors (practitioners in the field of restructuring) may have a role, but such practitioners should not be appointed by a judicial or administrative authority in every case.
- The debtor should have access to a stay of individual enforcement actions to allow negotiations to take place and to fend off hold-out creditors, without the threat of insolvency proceedings and with continued performance of essential contracts.
- This will be granted by a judicial or administrative authority for a maximum of four months, extendable a total maximum of 12 months.
- Restructuring plans should contain minimum mandatory information.
- Restructuring plans to be adopted by affected creditors or classes of creditors. Where creditors with different interests are involved, they should also be treated in separate classes. As a minimum, secured creditors should always be treated separately from unsecured creditors. Member States may also provide that workers are treated in a class separate from other creditors.
- Shareholders and other equity-holders should not be allowed to obstruct the adoption of restructuring plans of a viable business, provided that their legitimate interests are protected.
- Rules should be provided, setting out when and how to determine value in order to ensure fair protection for dissenting parties.
- Rules in respect of new and interim financing necessary to implement a restructuring should provide protection from anti-avoidance laws and give priority to the relevant financing over unsecured creditors.
- Member States should be obliged to impose specific duties on directors in near-insolvency situations to incentivise them to pursue early restructuring when a business is viable.
The draft directive continues slowly through the legislative process. The response to the draft directive from Member States has been muted. Commentators and professional bodies across Europe have highlighted a number of potential difficulties with the implementation of the draft directive in its current form. Amendments were put forward by European Parliamentary Committees towards the end of 2017. It remains to be seen what form the draft directive will take in its next iteration. It is expected that, once it has been finalised, Member States will be required to implement its provisions within two years. However, it is likely that it will take a considerable period before the draft directive is in a form which attracts a consensus of support among Member States.
Although “Brexit” seems likely to mean that the UK will not be bound to implement the draft directive, the UK restructuring regime already includes many of the elements found in the draft directive. In addition the UK insolvency regime has been the subject of a wide-ranging review which appears likely to result in further reforms which will be broadly consistent with the draft directive.
In a consultation paper published in May 2016, the UK Insolvency Service sought views on whether the UK’s regime required updating in light of international principles developed by the World Bank and the United Nations Commission on International Trade Law (UNCITRAL), recent large corporate failures and an increasing European focus on providing businesses with the tools to facilitate company rescue. In March 2018, BEIS consulted on proposals for extending the powers to review sales of businesses in distress and related value extraction schemes and strengthening the corporate governance regime pre-insolvency. A Government response following those consultations was published on August 26, 2018 makes proposals for:
- A moratorium against creditor action for companies facing prospective insolvency where on the balance of probabilities, a rescue is more likely than not, with a view to existing management seeking resolution through an informal restructuring with creditors, or a formal insolvency procedure. The moratorium would be supervised by an insolvency practitioner monitor. The proposed term of the moratorium is 28 days subject to extension for a further 28 days, and beyond with creditor agreement.
A new restructuring procedure binding all creditors, through a cross-class cram down allowing the management of the company to seek the approval of restructuring proposals by 75 per cent of a class of creditors by value, and more than 50 per cent by number, binding on the minority. As with schemes of arrangement under the Companies Act 2006, the courts will oversee the process of setting classes and approving proposals.
- Restricting suppliers from exercising termination clauses in contracts for the supply of goods and services on the grounds of counterparties entering formal insolvency procedures or being the subject of a moratorium or restructuring plan.
Strengthening corporate governance in pre-insolvency situations.
- Greater accountability of directors in group companies when selling subsidiaries in distress.
- Extending the current investigation regime under the Company Directors Disqualification Act 1986 to include former directors of dissolved companies.
- Enhancing existing recovery powers of insolvency practitioners in relation to value extraction schemes which have been designed to remove value from a firm at the expense of its creditors when a firm is in financial distress.
Meanwhile, the Commission is working towards establishing a decentralised system to interconnect insolvency registers and to support cross-country access to information about whether directors have been disqualified. The former has been legislated for in the (recast) EIR, and the requirement to establish national insolvency registers came into force on June 26, 2018, with the EU interconnected register coming into force in June 2019.
The Commission also aims to increase legal certainty on the effects of assignment of claims on third parties (where the original creditor transfers the claim to someone else) in jurisdictions where this is not already clear. In March 2018, the Commission published a proposal for a regulation on the law applicable to the third-party effects of assignments of claims.
As part of its package of proposals on non-performing loans, the Commission has included (in its proposal for a directive on credit servicers, credit purchasers and the recovery of collateral) that Member States implement a form of accelerated extrajudicial collateral enforcement.
It looks as though the Commission’s efforts to date amount to tinkering around the edges rather than a fundamental recasting of existing national rules. The draft directive does not harmonise core aspects of insolvency such as rules on conditions for opening insolvency proceedings, a common definition of insolvency, ranking of claims and avoidance actions.
It is commendable that the Commission is looking to identify ways to address conflict of law issues, encourage cooperation between national authorities and enhance the efficiency of fragmented national insolvency regimes. However, advocating for changes in national laws in this area will be a longer term challenge, since insolvency regimes vary greatly across the EU and are deeply entrenched in national law, given the numerous links between insolvency law and connected areas of national law, such as tax, employment and social security law.
In the long-term, harmonising these aspects would be useful for achieving full cross-border legal certainty. However, prescriptive harmonisation could require significant Member State resources and far-reaching changes to commercial law, civil law and company law, whereas flexible provisions risk failing to bring about desired changes.