A long-form opinion piece by Special Counsel Jeffery Black on how a US Chapter 11 review could impact Australian insolvency law.
This article was originally published in the Australian Insolvency Journal and is reproduced with permission.
Framing our domestic insolvency law reform agenda through cross-border comparison
Some recommendations from a major review of US Chapter 11 are relevant to Australian insolvency law reform.
Chapter 11 of the US Bankruptcy Code (Code) has interested domestic financial services participants for many years. That is to say, the current discussion around the merits or otherwise of adopting Chapter 11, either in whole or in part, in our restructuring and insolvency regime is not a fad.
In addition, in the aftermath of the global financial crisis, a number of countries have undertaken substantive reviews of their insolvency laws (and in some cases, rolled out reform legislation). A formal 'root and branch' review of our own insolvency laws should be undertaken in the near term for a number of reasons.
Firstly, the final report of the Financial System Inquiry delivered on 7 December 2014 (FSI Report) incorporated a narrow overview of corporate insolvency and its regulation. Secondly, to a limited extent, the process is already underway: on 7 November 2014, the Federal Government released the Insolvency Law Reform Bill 2014 (2014 Bill).
While significant, the 2014 Bill deals principally with regulatory and process issues as opposed to substantive insolvency law. The Government's stated purpose of the reforms is to 'strengthen and streamline Australia's personal bankruptcy and corporate insolvency regimes [by empowering] creditors to better protect their own interests by enhancing communication and transparency between insolvency practitioners and creditors'.
This stated aim would tend to support Australia's creditor-focused culture. Of particular interest is the fact that the Government has stated its 'second wave of reform to strengthen our insolvency laws' will be announced after it has considered the findings and recommendations in the FSI Report; it is hoped that this second phase will include a substantial review of our insolvency laws.
Thirdly, the relevant data suggests that our voluntary administration system averages returns to creditors of less than 10 cents in the dollar, with problematic evidence of businesses being restored; and further, since 2006, the proportion of all companies under external control that have used voluntary administration has halved (to just 14 percent of all corporate insolvency appointments).
Fourthly, industry groups and leading practitioners – both prior to, and since, the FSI Report – have argued persuasively in favour of reform in order for our restructuring and insolvency regime to improve its social and economic outcomes. Finally, it is time: Part 5.3A of the Corporations Act 2001 (Act) is over 22 years old, and the Harmer Report is over 27 years old.
Evolution of financial markets, products, and participants
Of course, the overarching justification for change and reform in the near term is the fact that financial markets, capital structures and participants have evolved significantly over the past 25 years or so, and in some respects these changes have outgrown our current legislative framework. Corporate balance sheets, in particular, have changed dramatically over the past few decades, with enormous growth in amount and variation of corporate indebtedness and the amount and types of debt secured by all or substantially all of a debtor's assets.
Other shifts in the commercial landscape have included the increased complexity and globalisation of corporate groups, the birth and explosive growth of distressed debt trading, the evolution away from traditional buy-and-hold lenders to more sophisticated and nimble investors, the introduction and development of derivatives and other new complex credit products, and the increased prevalence of disputes and litigation in insolvency cases. Finally, we have a new security regime in the Personal Property Securities Act 2009.
Of course, we have also had a global financial crisis and in its aftermath the current regime has been tested and found wanting in a variety of respects.
Background to current discussion
The FSI Report recommended that there should be consultation 'on possible amendments to the external administration regime to provide additional flexibility for businesses in financial difficulty'.8 The FSI Report found that submissions 'indicate that Australia's external administration provisions are generally working well and do not require wholesale revision,' but also noted that submissions highlighted 'a few elements of [Chapter 11] merit consideration'.
The FSI Report proposed that more work needs to be done to determine the value of two proposals, namely: (i) protecting directors through 'safe harbour' provisions that permit restructuring efforts for distressed companies without invoking external administration; and (ii) suspending the enforcement of 'ipso facto' clauses during restructuring efforts. Despite the fact that successive Australian governments have rejected any change in corporate insolvency law, it seems readily accepted amongst some industry participants that these two proposals should be implemented.
In contrast to the position in Australia, the developments in the financial services sector described above (together with other factors) prompted the American Bankruptcy Institute, in 2011, to organise a Commission to Study the Reform of Chapter 11 (Commission). Since that time, the 23-member Commission, together with approximately 140 practitioners, academics and judges appointed to topic-related advisory committees, studied and held hearings regarding a plethora of Chapter 11 issues, large and small.
The hearings included testimony from more than 90 witnesses. On 8 December 2014, the Commission released a nearly 400-page report, setting forth its recommendations for reform of Chapter 11 (ABI Report).
Where the Commission's recommendations go from here is not yet clear. Implementation of the recommendations is probably not imminent. The controversial nature of some of the recommendations, together with the present political dynamic between the branches of federal government in the US, is unlikely to produce legislation containing any of the recommendations in the near term.
The ABI Report is significant for prospective Australian insolvency law reform for two reasons. Firstly, any prior views on the merits of Chapter 11 must now be re-evaluated by reference to this comprehensive report. Secondly, its recommendations can guide our own reform considerations. This article provides an overview of five broad categories of Commission recommendations that are of significance to our reform agenda.
Debtor in possession and the 'estate neutral'
The ABI Report confirms that the 'debtor in possession' concept – whereby the incumbent directors and management (who are most familiar with the underlying business) remain in control of the debtor during the pendency of the bankruptcy case – is a central feature of the Code, and should remain as the default rule under Chapter 11. The principal justification is that this model permits the debtor to continue its operations with minimal disruptions while still serving the interests of the debtor's creditors (and, often, its equity holders).
The key arguments against this concept are well known: allowing the incumbent management team to remain in control rewards subpar performance and undermines confidence in the reorganisation process; and the management team may be motivated by factors not necessarily aligned with the best interests of the bankruptcy estate.
However, the Commission noted that a Chapter 11 filing is frequently triggered by an economic downturn, a fluctuation in markets particular to the debtor's industry, or a failed (but not negligent) business strategy. In addition – and perhaps to dispel a few myths around the debtor in possession concept – the debtor often replaces some or all of its directors or officers, prior to the Chapter 11 filing, and often appoints a chief restructuring officer.
The Code also places certain checks on the debtor's power and decision-making authority:
- the debtor in possession may be replaced by a trustee
- an unsecured creditors' committee is usually appointed to oversee the debtor in possession's conduct and to represent the interests of unsecured creditors
- major decisions and transactions require notice and a hearing, and court approval, and
- the US Trustee and parties in interest have standing to be heard on matters in the case.
In addition, the directors and officers are bound by their state law fiduciary duties (which the Commission determined were sufficient, thereby not requiring equivalent duties to be introduced into the Code).
The Commission recommended the introduction of a more flexible 'estate neutral' in place of an examiner in certain circumstances. Although not a mandatory appointment, the estate neutral would be a 'disinterested person' and could operate in cases where an independent assessment was necessary because it was difficult for a debtor to investigate itself, or the debtor or other stakeholders were otherwise too vested in their respective positions to identify areas of potential compromise (this role may include facilitation of dispute resolution, or the function of mediator).
The appointment standard would also be flexible and tailored by the Court to the particular case, on a 'best interests of the estate' basis. This role resembles that of a 'Monitor' under the Canadian Companies' Creditors Arrangement Act, and should be viewed as a favourable development by the Australian market.
SME scheme, and concerns around costs
The Commission recommended the creation and implementation of specialist procedures for Chapter 11 with respect to small-to-medium enterprises (SMEs). The SME procedures would focus on speed, efficiency, and cost effectiveness (relative to the size of the debtor). The SME debtor would otherwise have the benefit of all other aspects of the Chapter 11 regime.
The following aspects unique to the SME case are worth noting:
- The criteria for qualification are (a) no publicly traded securities in the debtor's capital structure, or that of an affiliated debtor, and (b) less than US$10 million in assets or liabilities on a consolidated basis.
- Within 60 days of commencement of the case, the SME debtor should develop and file a timeline for giving effect to a plan of reorganisation (the usual exclusivity periods for proposing a plan otherwise apply).
- The SME plan of reorganisation should include an equity retention structure in order to protect the interest of unsecured creditors 14 (notwithstanding the fact such a structure does not comply with the 'absolute priority' rule 15).
The SME case structure should be of particular interest in Australia, as we assess similar concerns in connection with the treatment of SMEs under our voluntary administration regime. It has been argued that the one size-fits-all model of our regime is not appropriate for SMEs, given the regime imposes 'an uncommercially high cost structure for the vast majority of [SMEs] in financial distress and that this structural cost factor makes voluntary administration less attractive than a voluntary liquidation'.
Prohibition against enforcement of 'ipso facto' clauses
The ABI Report recommends modifications to the assumption of executory contracts pursuant to s 365 of the Code. Under the proposal, a debtor would remain free from performance obligations under an executory contract from the commencement of its case until the assumption of that contract, provided that the debtor in possession pays on a timely basis for any goods or services provided post-petition under the contract.
However, the rate for such post-petition payments would remain fixed at the pre-petition level, and not be subject to adjustments or modifications based on the debtor's bankruptcy filing, insolvency or pre-petition default. Further, debtors would not be required to cure historical non monetary defaults prior to the assumption of an executory contract or unexpired lease if those defaults are impossible to cure at the time of the proposed assumption.
In this way, the debtor's ability to insist on continued performance by contract counterparties is further strengthened. The prohibition on enforcement of 'ipso facto' clauses by counterparties of a Chapter 11 debtor will remain a mainstay in the US system, in contrast to the present Australian regime.
The Commission recommended a number of changes to s 363 of the Code, which governs a debtor's ability to use, sell or lease property outside the ordinary course of business. The proposals cover standard of review, sale of assets free and clear of interests, credit bidding, and finality of sale orders. In terms of the initial proposal, bankruptcy courts must approve non-ordinary course transactions proposed to be entered into by debtors.
Courts use a business judgment standard that focuses primarily on the decision-making process of the debtor's board. The Commission recommended a slightly higher standard, known as the enhanced or intermediate business judgment standard, in which courts review not only the process implemented by the debtor but also the reasonableness of the board's business judgment under the circumstances. The recommendation, if adopted, would give the court a much more active role in determining the appropriateness of the decision to sell. It could add challenges, costs and time to the bankruptcy process.
In addition, the Commission proposed an entirely new section to govern the sale of all or substantially all of a debtor's assets (the so-called '363x sale') – a practice that has increasingly been used in recent years as an alternative exit strategy to a plan of reorganisation. However, the Commission noted that 363x sales can be conducted extremely quickly, more quickly than is necessary in many cases.
This may lead to less robust auctions, lower recoveries, and a lack of sufficient disclosure (relative to the plan process). Accordingly, the Commission recommended adding protections to the sale process, similar to those afforded to creditors in the Chapter 11 plan process; and the Commission recommended that 363x sales should not generally be permitted in the first 60 days following the commencement of a Chapter 11 case.
The term 'claims trading' generally refers to the buying and selling of claims against a bankrupt company. Although such trading is not new, it has grown exponentially in recent years. Some argue that it destabilises reorganisation efforts, removes 'interested' creditors from the process, and provides arbitrage and takeover opportunities that may depress value and harm returns to other creditors.
Arguments in favour of claims trading include the fact that it provides liquidity and an efficient exit strategy for creditors who do not wish to be involved in the case, it may consolidate claims against the debtor and minimise the number of stakeholders in reorganisation negotiations, and it may permit the entry of longer term, well-capitalised investors into a restructuring process.
The Commission agreed that a robust secondary market exists for claims trading and that this market enhances liquidity opportunities for both debtors and creditors. Notwithstanding the fact that transparency and disclosure are key aspects in this process, the Commission perceived little benefit to increased regulation of claims trading activities, and recommended no change to the current law governing the trading of claims in a Chapter 11 case or the disclosure of creditor interests already required under the Code.
This recommendation should find general support amongst participants in the developing secondary debt market in Australia.
The goal of reform
Just as 'debt' means different things to different financial stakeholders, the method for resolving the uncertainty that confronts debtors and creditors when indebtedness approaches, or becomes, 'insolvency' differs between jurisdictions. This obvious reality is even more challenging in a world of global financial markets and transactions, cross-border judicial cooperation, and the instantaneous connectivity brought about by the digital age.
Accordingly, it is incumbent upon industry participants to consider equivalent laws, and where applicable, reform agendas, of foreign jurisdictions when assessing their own and the need for reform. The mission statement for any reform agenda should be to significantly improve our insolvency regime by making it a more viable and effective restructuring option for distressed companies of all sizes, including SMEs.