Lecture 2: The objectives of insolvency policy

Question 1

Describe the historical development of insolvency law.

Answer 1

• The first official procedure for bankruptcy may be traced back to 1542 (remember no companies at this point)
• Penal aims rather than rehabilitative
• Seizure of assets or ‘body’ (i.e. imprisoned)
• Distinction was made between traders and non traders (until 1861) - traders might become bankrupt of no fault of their own.
• Corporate insolvency laws began in 1844
  
  • Joint Stock Companies Act 1844 - a company a separate legal entity.
  • Companies Act 1862 (liquidation procedures included, winding up decisions)
  • Companies Act 1985
• Creditors would work together and seize assets for the benefit of all creditors.
• Penal aims - debtor thought of as a criminal - punished for debts.
• Balance between rehabilitation of bankrupt person and maximising returns to creditors.

Question 2

What was the aim and implications of the Cork Report?

Answer 2

• An advisory committee was established in 1973
  
  • Aim was to undertake a comprehensive review of UK insolvency law
  • Report published in 1982
  • Finally incorporated into law in 1986 (the Insolvency Act 1986)
  • Formed the basis of modern insolvency law
  • Cork recognised the plight of unsecured creditors and the economic significance of secured creditors
  • Also aware of abusive practices of directors - suitable legislation for delinquent or rogue directors.
  • Sought to introduce a workable body of rules
• Kenneth Cork - prominent insolvency professional as the time. Tasked with review.

Question 3

What were the aims and principles of the Cork Committee? (10)

Answer 3

• To support the credit system
• To identify and manage an insolvency earlier rather than later
• To prevent conflicts between creditors
• To realise the assets
• To distribute the proceeds from assets fairly and equitably
• To ensure the processes of realisation and distribution are administered honestly and competently
• To determine the causes of failure and punish appropriately
• To recognise and protect the interests of other groups in society beyond the creditors, shareholders, directors and employees
• To preserve viable commercial enterprises
• To ensure due recognition of UK procedures abroad

Question 4

What were the two significant changes to UK law as a result of the Cork Report?

Answer 4

• Legal procedures for dealing with abusive practices.

- Introducing a “rescue procedure” inso legislation (administration) - idea of rehabilitation.

Question 5

What are the limitation of the Cork principles?

Answer 5

Arguably too many principles - how do you rank them?

Some are conflicting - how do you support the credit system and protect other groups/society’s interests.

Question 6

What is the creditors’ bargain?

Answer 6

(insolvency theory) An economic perspective.
• The objective of insolvency law is to maximise returns to creditors
Focus is upon ‘property rights’ and efficient use of assets.
• The company represents a common pool of assets
• Upon insolvency, individual creditors may seek to pursue a course of action which favours their position, but not the collective interests of the creditors as a whole
• Creditors want to maximise the value of the firm.

Protection of non-creditor interests is not the primary purpose of insolvency law.

Shouldn’t be a variation in pre-bankruptcy rights unless it would result in higher aggregate returns.

Creditors would form an agreement ex-ante (the bargain)

Requires negotiation but the more creditors there are, the harder it is to negotiate.

• Conclusion is that bankruptcy should enforce a collective system
  
  • A unique, but limited function
  • Force those with interests in the company’s assets to put those assets to the use the group as a whole would favour

Question 7

What are property rights in relation to insolvency?

Answer 7

those that have a legitimate interest in the company’s assets are the ones we should be dealing with. Contractual entitlements.

Question 8

What do Baird and Jackson (1984) argue in terms of pre-bankruptcy rights?

Answer 8

That they should not be changed.

Only time that they would be changed is if the result would be higher aggregate returns.

Question 9

Describe the asset deployment and asset distribution question put forward by Baird and Jackson (1984).

Answer 9

The difference between the size of the pie and the size of the slice.

Asset deployment - what should we do with the company’s assets (size of the pie).

Asset distribution - the size of the slice (how do we carve up the pie).

Distribution concerns are a non-bankruptcy question - should be decided ex-ante by policy makers.

Rights of secured creditors should only be change ex-post if it increases the size of the pie (absolute priority right).

Question 10

What is an absolute priority right?

Answer 10

the idea that senior claimants should be paid before junior claimants.

Question 11

According to Baird and Jackson (1984) what are the implications of varying right ex-post?

Answer 11

• If you vary rights ex-post, it creates uncertainty for lenders - can affect the cost of finance (raised interest rates)

Question 12

Why is the timing of enforcement important for secured creditors? Baird and Jackson (1984)

Answer 12

Timing of enforcement is important for protection of secured creditors because:
- Secured creditors want their money back as soon as possible (due to depreciation, time value of money, uncertainty of reorganisation).
-Unsecured creditors want to push for prolonged proceedings.
• Baird and Jackson argue for the full compensation of secured creditors so that junior claimants bear the risks and rewards of a prolonged reorganisation.

Question 13

What are the criticisms of the creditors bargain?

Answer 13

• Problems with the existence of a ‘common pool of assets’ - might only be perceived as a pool of assets from the point of view of secured creditors.
• Differences in the ability of creditors to bargain - not necessarily fair.
• Why shouldn’t insolvency policy bring in value judgements on relative priorities?
• Ignores non contract creditors

Question 14

Describe the broad based contractarian approach of insolvency.

Answer 14

Principle of inclusion - could place behind a veil of ignorance anyone that can be affected by the insolvency not just creditors.

On an ex-ante basis, all of these groups has to come up with some form of plan of action. Prioritise aims.

Principle of rational planning (the maximisation of aims)

• But greatest protection for those most badly affected - most vulnerable should be protected.
• But potential trade-offs between principles of justice and wealth maximisation
• Problem of indeterminacy - if you don’t specify clearly in advance who stakeholders are it creates problems on an ex-post basis. Too many interests and haven’t defined who these interests are - hard to implement in the real world.

Question 15

Describe the Communitarian Approach to insolvency

Answer 15

Prioritises the interests of the ‘community’ - mainly employees, supply chain, neighbouring property owners, public generally and investors. Anyone with legitimate interest in the company.

More subjective

Acknowledges that continuation of the company may be more desirable than liquidation even if this does not maximise returns to creditors.

• Again, problem of indeterminacy
  
  • what do we mean by ‘community interests’?
  • How do we judge different community interests? (Employment vs environmental concerns, consumer interests) Up to a judge – who makes the best case.

Question 16

What are the opinions of Warren (1987) on bankruptcy law? (Communitarian)

Answer 16

• Bankruptcy law should be concerned with distributing the losses amongst a number of different actors
  
  • How should the losses be distributed?

• Idea of ‘escape valves’ from contracts
And contract enforcement should not “offend deeply held social norms”

• Centrality given to distributional concerns.
• You can break a contract, there are ways out of them. Contract enforcement should not conflict with society.

• Delays are a good thing - buying time for vulnerable people (employees find new work, customers finding somewhere else to buy product).

Question 17

What are Warren (1987)’s redistributive principles? (5)

Answer 17

• Relative ability to bear the costs of default
• Incentive effects on pre-bankruptcy entitlements
Period leading up to insolvency, you might be forced to give money taken from company back in the process of insolvency.
• Similarities among creditors
• Owners bear the loss of business failure
• Benefit to the bankruptcy estate

Question 18

What is Baird and Jackson’s (1984) view on communitarianism?

Answer 18

• Argue that it is too difficult to assess the wider effects of business failure
• A focus upon ideas of what is ‘good’ and ‘just’ is simply not practical
• Idea of a ‘market’ economy - a basic feature that some businesses will fail, bankruptcy law should provide an efficient way for failed businesses to exit the market.
• Risk of preserving ‘zombie entities’ - company continuing when there is no hope for it. No buyers.

Question 19

Describe the forum vision philosophy.

Answer 19

• The objective of insolvency law is to establish a forum for discussing all interests affected by corporate failure
• Ultimately, participants would seek to define corporate goals (ongoing debate)
  
  • With the help of professional advisors

Similar to contractarian

• Law should provide a breathing space, puts a break on creditor action.
• Allows interested parties to try and work out what’s best for the company.
Being considered more for informal reorganisations.

Question 20

What is the problem with the forum vision?

Answer 20

• Problem with this philosophy is that not enough guidance will be offered on important issues, e.g. how much representation should each stakeholder group have? How should you balance representation against efficiency concerns?

Question 21

Describe the ethical vision philosophy

Answer 21

Promoted by Schuman 1973
• The ethical vision, as promoted by Shuchman, 74 brings in a new dimension by introducing moral concerns. The theory champions the idea that the philosophical foundation of formal insolvency rules should not disregard the moral issues. As such, the situation of the debtor, the moral worthiness of the debt and the size, the situation and intent of the creditors ought to be considered in laying the foundations for insolvency law. To achieve this, however, reliance on the Judiciary to evaluate the moral needs and desserts of creditors, and the moral worthiness of the debtor is necessary; which in essence results in placing a large degree of faith on the individual’s (judge’s) moral judgment.

• Based on the concept of ‘marginal utility’

• Seek to construct a matrix based on utilitarian morality
• Trying to maximize total utility.

Question 22

Describe the multiple value philosophy

Answer 22

• Insolvency law should encompass a range of values
• Both economic and non economic
• Based on principles of fairness, moral and social values
But how you do decide which values to give greatest weight to?

Question 23

What are the problems of control of managerial power?

Answer 23

Linked to contractual models of the firm.
Managerial expertise is linked to natural entity views of the firm.

Control mechanisms have failed - may be better to rethink models of the firm rather than develop new internal controls and laws.

Question 24

How is managerial power legitimated?

Answer 24

• Managerial power is legitimated through the common purposes of shareholders, creditors, employees and the community.

Question 25

How is there a separation of ownership and control?

Answer 25

• Separation of ownership and control
• Managers have power given by shareholders (owners).
• Internal controls, corporate governance and legislation - control managers.
• Maybe methods of controlling manager power through internal control systems is not effective.

Question 26

What are Finch’s explicit values of insolvency?

Answer 26

Open acknowledgement of values that a democratic society would agree upon:
• Efficiency - the creditor’s bargain (is the process economically efficient)
• Expertise - who is dealing with the process (managers, externally appointed insolvency practitioners.
• Accountability - accountability of practitioners (how are they remunerated, who decides if they’ve done a good job).
• Fairness - how do we ensure relevant people are involved in decision making.

• Identification of values leads to transparency
  
  • So greater awareness of what trade-offs are being made