Corporate Insolvency Law - Theory and Application
University College London (UCL) - Faculty of Laws; South Square Chambers
This volume analyses corporate insolvency law as a coherent whole, stemming from common fundamental principles and amenable to being justified or criticised on that basis. The author explains why consistency of principle must be sought, and how it might be found in the relevant statutory and case law. He then constructs an egalitarian theory for the analysis of corporate insolvency law, based on the premise that all the parties affected by this law are to be treated as equals. He argues that this theory can reconcile the dictates of fairness with the demands of economic efficiency. The theory is employed to analyse some of the most important aspects of insolvency law. Why should the individualistic method of enforcing claims against solvent companies give way to a collective method during insolvency? Why are there different formal mechanisms for dealing with troubled companies? What role does the pari passu principle play in the distribution of an insolvent company's assets? The controversial issues of whether and when secured creditors should be accorded priority over others receives detailed consideration. The functional role of the floating charge and its relationship with receivership are also analysed in this context. The many questions relating to the operation of the new administration procedure introduced by the Enterprise Act 2002 are considered in the light of principle. The book also analyses the role of the wrongful trading provisions. It examines, finally, why insolvency law objects to certain transactions at an undervalue and those having a preferential effect.
The first chapter begins by sketching out the notion of equality employed here. In this book, equality is taken to be the central feature of a particular conception of the person. This conception is itself tied firmly to the notion of a society regarded as a fair system of co-operation amongst citizens who regard themselves and each other as free and reasonable, and therefore equal. The first task undertaken in the book is therefore to explain the role of insolvency law in such a society, and how that affects the ideal of equality crucial to the argument of the book. Two related objections are then considered, both of which deny that any consistency of principle can realistically be expected to be found in a diverse and long-evolving body of law such as that governing corporate insolvency. These objections are met by explaining how insolvency law is interpreted in this book. Since the book also concerns itself with the efficiency of the law, the relevant notion of efficiency is then described and defended. The chapter concludes with an overview of the remaining chapters.
Chapters 2 and 3 concern themselves with the principles that suspend (stay) unsecured claims in a company's insolvency. There are two broad themes underlying the arguments in these chapters. First, the analysis attempts to unearth and illuminate the principles underlying the stay on unsecured claims. But second, it trades on the longevity and uncontroversial character of this feature of insolvency law, setting it up as a paradigm or provisional fixed point that any theory of insolvency law must explain and defend. Since the stay on unsecured claims has been so widely accepted and for so long, very persuasive reasons indeed would have to be brought to show it should no longer be part of insolvency law. Till such reasons are adduced, a theory claiming to be that of our insolvency law, but which does not explain and justify the principles underlying the stay, must be considered a failure. Or at least that is what chapters 2 and 3 will claim.
Chapter 2 examines the Creditors' Bargain model of insolvency law. This well-known model asserts that the most prominent features of insolvency law are best seen as reflecting the notional agreement the creditors of a company themselves would strike if given the chance to bargain with each other before anyone lends anything. The perspective of the ex ante bargain is supposed to illuminate the deep structure of this law, and to confer justification on its rules by having reference to the virtue of autonomy. Chapter 2 asks if the model is consistent with its own premises, whether it can provide useful insight into insolvency law, and most importantly, whether it can generate normative appeal on egalitarian or indeed any other grounds. The principles underlying the stay on unsecured claims are used to demonstrate that the model has no explanatory or justificatory force. It seeks to rely on the self-interest of those subject to the stay to suggest they would consent to it. But it is based on nothing but creditors' hypothetical preferences, and provides no reason why these preferences should be considered binding. The model suggests no non-arbitrary time at which to make a determination of creditors' self-interest. Also, the point at which it asserts creditors would consent to the stay is such that creditors actually asked to bargain then would never come to any agreement. Or if they do, the agreement would be oppressive of weaker parties, would be strongly anti-egalitarian, and therefore would have no normative appeal. It follows that principles which can be argued for within the model have nothing to do with autonomy. Nor would they necessarily be efficient.
Chapter 3 develops an alternative model to analyse and justify insolvency law, referred to as the Authentic Consent Model (ACM). Consistent with the discussion above, its starting premise is that all (but only) those affected by insolvency law are to be given a choice in selecting the principles which would govern their rights, interests, and obligations. Once these parties have been identified, they are to be given equal weight in the selection process, since their legal status (whether they are employees, secured or unsecured creditors, etc.), wealth, cognitive abilities, and bargaining strength, all are morally irrelevant in framing rules of justice. The ACM operationalizes the constructive attributes described above by requiring all principles to be selected from its 'choice position'. Here, all the parties are deprived of any knowledge of personal attributes, and must reason rationally. It is shown that parties in the choice position would in fact choose the principles laying down the automatic stay on unsecured claims. The chapter argues that because of the construction of the choice position and the constructive attributes of the parties bargaining in it, the principles chosen are fair and just, and chosen in exercise of the parties' autonomy. As it happens, they are also efficient. The chapter concludes by highlighting how the egalitarian character of the ACM distinguishes it from the Creditors' Bargain.
Chapter 4 delves into the nature of the pari passu principle, which supposedly requires all unsecured claims of an insolvent company to be met proportionately from the insolvent's estate. The argument in that chapter suggests that there is widespread misunderstanding about the role of this principle. The principle is claimed by commentators to be responsible for the orderliness of corporate liquidation, to explain and justify the collectivity of the liquidation regime and the rules providing for the avoidance (or more accurately, adjustment) of certain types of transaction, and to ensure fairness to all of the insolvent's creditors. The central claim in the chapter, that none of these functions can properly be attributed to the principle, is illustrated by empirical evidence of how the estates of insolvent companies are in fact distributed, the statutory provisions which help put the principle in its proper place, and the case law said to support it. The ACM is deployed to demonstrate that the pari passu rule - often called the 'equality' principle - has little to do with 'real' equality. The chapter shows, finally, what it claims is the actual role of 'formal' equality of the sort enshrined in the 'equality' principle.
Chapter 5 addresses one of the most controversial issues in the literature of insolvency law, as to whether and how the priority accorded to claims secured by a fixed charge or mortgage against an insolvent company is justified. The arguments in the literature can broadly be construed in two ways. First and more obviously, they can be taken simply as contributing to the ongoing technical debate about the basis on which the priority of secured claims might be taken to be efficient. On this view, such arguments identify various such grounds (signalling, monitoring, control of creditor or debtor misbehaviour etc.), and suggest either that the priority of secured claims is efficient on some of these grounds, or that it has not been shown to be thus efficient. These arguments by themselves are of no direct interest to us here, since they seem to assume efficiency is a substantive goal of the law of secured transactions. To that extent, they are inconsistent with the view taken here, that efficiency could not be a substantive goal.
Second, however, some of this debate might be understood as being about, not whether the principles providing for the priority of secured claims serve the substantive goal of efficiency, but about whether they accomplish the objective of (say) controlling debtor misbehaviour (one variety of motivation costs) only in a wasteful way, or worse, whether they allow for the exploitation of some types of parties by others. On this view, these arguments obviously have a direct relevance to the project of this book. Exploited parties have not been treated as equals. And a rational scheme of fair co-operation would not tolerate waste. Such arguments also cohere with the rather simplistic pre-theoretical intuition that secured creditors are 'obviously' treated better than unsecured ones, which is unfair to the latter. So chapter 5 provides an analysis of the arguments construed in this second way. It uses economic theory and empirical data to find that these arguments are at best unproved, and more likely, false. It concludes by demonstrating that, taking into account the actual conditions under which security is demanded and offered, its priority over unsecured claims in the debtor's insolvency would in fact be part of a rational scheme of fair co-operation amongst equals.
Chapter 6 considers what it claims are the twin institutions of the floating charge and administrative receivership. It explains the distinctive role played by the floating charge by examining the empirical context in which it operates and by comparing the recoveries made by different classes of creditor in corporate liquidation. The analysis suggests that whereas the fixed charge in included in debentures so as to provide its holder with priority, the floating charge is a residual management displacement device. Its dominant role is to ensure the integrity of the debtor's estate when the latter becomes distressed and its management is displaced in favour of a specialist distress-oriented manager. This is where administrative receivership ('receivership') comes in. Traditionally, the replacement of the distressed company's management has been brought about by the appointment of a receiver (formerly, a receiver and manager). However, this chapter harnesses theory and evidence in favour of the argument that receivership is significantly destructive of social value, and that it is unfair and oppressive. Its virtual abolition by the Enterprise Act 2002 is therefore welcomed. However, the substitution of receivership with administration also, it is argued, signals the end of the usefulness of the floating charge. The chapter concludes by sketching out a case for the abolition of this type of charge.
Building on the understanding gained by the discussion in chapter 6 of the socially harmful features of administrative receivership, Chapter 7 discusses the administration procedure introduced by the Enterprise Act 2002. It explains how this procedure retains the only defensible feature of receivership, in that a selected creditor continues to be entrusted with the right unilaterally to displace the underperforming management of a distressed company. The chapter analyses the statutory hierarchy of objectives made available to the administrator and explains the standard to which he is expected to be held in choosing between them. Light is also thrown on the sort of factors that might justifiably be taken into account in making this choice. The relationship between the administrator's duties and the voting rights of creditors is examined, and the chapter concludes with a discussion of the sort of factors that might precipitate challenges by aggrieved creditors and members to the administrator's decisions and actions.
Chapter 8 considers the impact of insolvency on the obligations of the debtor's managers by examining the wrongful trading provisions in section 214 of the Insolvency Act 1986. It employs the tools of agency theory and the ACM to analyse the need for these provisions, their structure, role, and effect. It asks whether a scheme of fair co-operation about insolvency issues would include a section 214-type duty, and if so, why. The analysis reveals that the duty would not be equally relevant for all types of companies, and that the influence of the market for managerial labour ensures most section 214 actions are likely to be brought against directors of closely-held companies, and against shadow directors. The analysis utilises the insight that section 214 plays a role similar to that of security itself. An important aim of the chapter is to challenge the Law and Economics proposition that to re-distribute the rights of parties in a corporate liquidation creates socially wasteful incentives. After arguing that section 214 is redistributive in the relevant manner, the incentives created by those provisions for the managers of both healthy and distressed companies are examined. It is suggested that these incentives are generally socially efficient. In the result, the provisions would be acceptable to all those affected by them, regarded as equals.
Chapter 9, the concluding chapter of the book, analyses the rationale and structure of the provisions which reverse or adjust eve-of-insolvency transactions considered to have been tainted by the improper motives of either the directors or the creditors of a distressed company. The chapter identifies the three main norms underlying this part of the law, those of loss allocation, value maximisation and finality of transactions, and with reference to them, describes the general strategy that might be adopted in dealing with such tainted transactions. The law countering transactions at an undervalue is examined to determine whether some mutuality of intent is required in order to bring a transaction within the ambit of this law, the way in which a series of linked events might be treated as constituting a single transaction, and the extent to which events occurring after the conclusion of a transaction might be considered relevant in calculating the value received by the distressed company as a result of the transaction. The chapter also considers the notion of creditor equality underlying the law's objection to preferences, and concludes by sketching out the contours of a defensible preference law.
JEL Classification: D23, K19, K22, K39
Date posted: April 14, 2005