1.2.1 Introduction

Once a situation of insolvency arises, an efficient corporate insolvency regime should perform two primary functions. First, it should provide a variety of tools to minimize the destruction of value associated with a situation of financial distress.Footnote ⁸ Second, it should facilitate the efficient allocation of the debtor’s assets.Footnote ⁹ The following sections will explain the strategies generally used by insolvency law to pursue these goals. If this ex post function of insolvency law is effectively achieved, insolvency law will be able to perform various socially desirable goals, including the maximization of the returns to creditors, the reorganization of viable but financially distressed companies, the reallocation of assets of nonviable firms towards more productive activities, and the promotion of financial stability. Moreover, from an ex ante perspective, it will be able to promote greater levels of entrepreneurship, innovation, access to finance, and economic growth.

1.2.2 Corporate Insolvency Law as a Mechanism to Minimize the Destruction of Value

When a company becomes financially distressed, value can be destroyed as a result of several factors. First, when debtors are unable to pay their debts, creditors become entitled to enforce their claims and ultimately seize the debtor’s assets. Therefore, the initiation of enforcement actions by creditors may end up destroying the going concern value of economically viable firms.Footnote ¹⁰ For that reason, insolvency law generally responds by imposing a moratorium (or “stay”) that stops creditors from initiating legal actions against the debtor.Footnote ¹¹ Moreover, by replacing all the creditors’ individual enforcement actions with a single procedure, insolvency law also has the ability to reduce collection costs.Footnote ¹²

Second, a situation of insolvency may incentivize key employees to abandon the firm. Similarly, suppliers may decide to terminate their business relations with the debtor, and lenders will unlikely be willing to keep extending credit to financially distressed firms – even if they are economically viable. As these circumstances can destroy value, insolvency law intervenes by adopting a variety of responses. For instance, when a company is subject to a formal insolvency or restructuring proceeding, many insolvency laws allow new suppliers, employees, and other contractual parties to obtain a priority – usually in the form of administrative expenses. In fact, in some jurisdictions such as the United States and Singapore, debtors can obtain new financing by providing lenders with various forms of priority that may range from an administrative expense priority to new liens, junior liens, and even senior liens.Footnote ¹³ These rules, generally known as debtor-in-possession (“DIP”) financing or rescue financing provisions,Footnote ¹⁴ provide viable but insolvent firms with the opportunity to keep financing their operations and pursue new investment projects with a positive net present value (“NPV”).Footnote ¹⁵ Thus, an insolvency proceeding can serve as a liquidity provider for viable but financially distressed firms.Footnote ¹⁶

Third, debtors facing financial trouble may have incentives to engage in various forms of opportunistic behavior that can destroy or divert value at the expense of the creditors. This opportunistic behavior may include the transfer of assets to related parties, borrowing money in an irresponsible manner, and investing in risky projects in a last-ditch attempt to rescue the insolvent firm.Footnote ¹⁷ It may also include actions seeking to keep nonviable firms alive by, for example, failing to take corrective actions in the event of financial distress or by postponing an inevitable liquidation once a company has initiated a restructuring or insolvency proceeding.Footnote ¹⁸ In order to address these problems, insolvency law responds through a variety of mechanisms. For instance, it often imposes special directors’ duties when a company becomes factually insolvent but it is not yet subject to a formal insolvency proceeding – that is, when the company is in the so-called “zone of insolvency.”Footnote ¹⁹ It also facilitates the avoidance of certain transactions that took place prior to the commencement of an insolvency proceeding.Footnote ²⁰ Additionally, once the debtor is subject to a formal insolvency proceeding, most jurisdictions around the world require the appointment of an insolvency practitioner (“IP”) to monitor or even replace the directors in the management of the debtor’s property and business affairs.Footnote ²¹ Moreover, creditors generally enjoy certain powers and decision rights during the procedure. By adopting these strategies, insolvency law seeks to minimize the value potentially destroyed by the opportunistic behavior of debtors.

1.2.3 Corporate Insolvency Law as a Mechanism to Promote the Efficient Allocation of Resources

An efficient corporate insolvency framework should also facilitate the efficient allocation of resources in the economy. This function is achieved by making sure that the debtor’s assets are put to their best use.Footnote ²² If a company is not economically viable, this goal will be achieved by liquidating the company and reallocating the debtor’s assets towards more productive activities.Footnote ²³ If a company has a viable business but it is run by incompetent or unreliable managers, an efficient corporate insolvency framework should facilitate the sale of the business as a going concern. Finally, when a company’s assets are worth more if they are kept together under the current management team, an efficient corporate insolvency regime should provide the right tools to facilitate the survival and effective reorganization of the insolvent company.

Insolvency law uses a variety of mechanisms to facilitate the reorganization of viable but financially distressed firms. First of all, it provides an adequate forum for negotiations. On the one hand, an insolvency proceeding usually requires the involvement of independent and reliable third parties (e.g., insolvency courts and IPs) that can facilitate an environment of trust between debtors and creditors. On the other hand, debtors subject to an insolvency proceeding are generally required to provide information to the creditors.Footnote ²⁴ By doing so, the asymmetries of information between debtors and creditors can be reduced, increasing the likelihood of achieving a successful reorganization if the debtor is indeed an economically viable firm that, by being kept alive, can make the creditors as whole better off.

Second, insolvency law provides several tools to facilitate the approval of a reorganization plan. These tools generally include the possibility for a majority (or qualified majority) of creditors to impose a plan on dissenting creditors within a class, often known as intra-class cramdown or, simply, “majority rule.”Footnote ²⁵ In some jurisdictions such as the United States, Singapore, the United Kingdom, the Netherlands, Germany, Spain and China, debtors can also impose a plan on dissenting classes of creditors where certain requirements are met. This latter practice is generally known as cross-class cramdown or just “cramdown.” By providing these tools, insolvency law minimizes holdout problems, encourages ex ante bargaining, reduces negotiation costs, and facilitates the approval of value-enhancing reorganization plans that can save viable but financially distressed firms.Footnote ²⁶

An insolvency system that can effectively minimize the destruction of value while putting the debtor’s assets to their best use can generate various ex post benefits for the real economy. First, it will save viable businesses that would otherwise be shut down. Hence, insolvency law will be able to preserve jobs, business relationships, tax revenues, and other positive externalities created by keeping viable firms alive. Second, by liquidating nonviable businesses, insolvency law will serve as a valuable mechanism to reallocate resources towards more productive activities. Thus, it can contribute to the competitiveness of the economy. Third, minimizing the destruction of value and putting the debtor’s assets to their best use will help reduce the potential losses borne by creditors. In the context of financial creditors, this goal can reduce the level of non-performing loans in the banking sector and thereby promote financial stability.Footnote ²⁷ From the perspective of nonfinancial creditors, and particularly nondiversified creditors highly exposed to the debtor’s default, maximizing their recoveries in insolvency reduces the risk that the creditors themselves become insolvent. Therefore, it will also reduce the likelihood of observing an increase in the number of insolvency proceedings initiated by the creditors affected by a situation of insolvency of their debtors.Footnote ²⁸ Finally, if an insolvency system is efficient ex post and therefore manages to maximize the returns to creditors, it will incentivize lenders to extend credit at a lower cost. Thus, from an ex ante perspective, insolvency law can serve as a powerful mechanism to facilitate firms’ access to finance and the promotion of economic growth.

1.3.1 Introduction

While insolvency law seeks to solve similar economic problems across jurisdictions, the intensity of these problems and the desirability of a particular insolvency response depend on a variety of country-specific and firm-specific factors. These factors include divergences in corporate ownership structures, debt structures, levels of financial development, firm size, sophistication of the judiciary, credibility and expertise of insolvency practitioners, efficiency of insolvency proceedings, and the political economy of insolvency law.

1.3.2 Corporate Ownership Structures

In small companies and large firms with controlling shareholders (“controlled firms”), the shareholders are often involved in the management of the company. Even if they are not part of the board of directors, they have incentives to closely monitor the managers. This situation, along with the fact that the shareholders have the ability to appoint, remove, and remunerate the directors, will incentivize the directors to act in the interest of the shareholders. While this alignment of incentives between directors and shareholders can be desirable for solvent companies,Footnote ²⁹ it can entail certain risks when a firm becomes insolvent.

As mentioned in Section 1.2, the shareholders of financially distressed firms may have incentives to engage in various forms of behavior that can destroy or divert value at the expense of the creditors. Hence, as the directors are still appointed and removed by the shareholders (when they are not the shareholders themselves), a situation of insolvency in small companies and large controlled firms will increase the risk of opportunism of shareholders vis-à-vis creditors. As a result, insolvency responses empowering directors by providing them with broad discretion in the zone of insolvency or adopting a DIP model for the governance of insolvency proceedings can be riskier for creditors. Therefore, all else being equal, more interventionist responses restricting the power of corporate directors, such as the imposition of a duty to initiate insolvency proceedings once a company becomes insolvent or the mandatory appointment of an IP during a formal insolvency proceeding, may be more justified in small companies and large firms with controlling shareholders.Footnote ³⁰ In the absence of these responses, even if the directors do not ultimately seek to favor the shareholders at the expense of the creditors, the higher risk of shareholder opportunism may make lenders more reluctant to extend credit, harming firms’ access to finance and the promotion of economic growth.Footnote ³¹

In contrast, in large companies with dispersed ownership structures, generally found in the United Kingdom and the United States,Footnote ³² the management is typically separated from the shareholders. Therefore, as the shareholders may not have a significant influence on the management, the directors will not have the same incentives to act in the best interests of the shareholders. In that context, it could be argued that, since the remuneration of managers often includes stock options and other forms of equity-based compensation,Footnote ³³ the interests of managers and shareholders are aligned. Nonetheless, while the shareholders only have their investments at risk, the managers may also jeopardize their jobs if the company ends up in an insolvency proceeding and is ultimately shut down. Therefore, managers should have incentives to avoid excessive risk-taking in the zone of insolvency.Footnote ³⁴ Additionally, the fact that managers may need to seek employment elsewhere if the company is liquidated should discourage them from engaging in any opportunistic behavior. Thus, the risk of opportunism of shareholders vis-à-vis creditors will be lower. As a result, all else being equal, insolvency responses providing greater powers and discretion to managers, such as the adoption of a DIP model or more flexible duties in the zone of insolvency, may be more justified in companies with dispersed ownership structures.

1.3.3 Debt Structures

When a company has a dispersed debt structure, as typically observed in the context of large companies in the United States,Footnote ³⁵ creditors face greater coordination problems.Footnote ³⁶ Likewise, the existence of multiple creditors increases the risk of experiencing the type of holdout problems that insolvency law seeks to solve.Footnote ³⁷ Therefore, in companies with those features, the imposition of a moratorium stopping creditors from enforcing their claims or the adoption of cramdown provisions will be especially needed to protect viable but financially distressed firms. Similarly, other rules often provided by insolvency law, such as the possibility of creating a committee of creditors or appointing an insolvency practitioner, will also be more justified when companies have dispersed debt structures.

In contrast, when a company has a concentrated debt structure with a few creditors, as generally occurs in small and medium-sized enterprises as well as in large firms mainly relying on bank finance, creditors will be in a better position to coordinate their actions.Footnote ³⁸ Moreover, debtors will be able to interact more easily with their creditors. Hence, negotiating and reaching an out-of-court agreement will be more feasible.Footnote ³⁹ As a result, a duty to initiate insolvency proceedings, or the existence of insolvency provisions requiring the creation of a committee of creditors or the appointment of an insolvency practitioner, will generally be less desirable in companies with concentrated debt structures.

1.3.4 Level of Financial Development

In countries with developed financial systems, such as the United States, the United Kingdom, Hong Kong and Singapore, viable but financially distressed debtors usually have more financing options. Therefore, the type of underinvestment problem that insolvency law seeks to minimize can often be less significant.Footnote ⁴⁰ However, in countries without developed financial systems, companies generally face greater financing needs. Therefore, the underinvestment problems usually existing in a situation of insolvency will be exacerbated. As a result, the implementation of various strategies to incentivize lenders to extend new credit, for example by providing them with a priority for the new financing, will be even more justified.

1.3.5 Firm Size

The costs of insolvency proceedings for micro- and small enterprises (“MSEs”) are generally prohibitive.Footnote ⁴¹ Additionally, MSEs have certain features that may undermine the desirability of insolvency proceedings. For example, MSEs usually have simple financial structures comprising a few creditors.Footnote ⁴² Therefore, it will be easier for MSEs to negotiate and reach an informal agreement with their creditors.Footnote ⁴³ As a result, a formal insolvency proceeding might not be needed. Even if an insolvency proceeding is needed, either for the liquidation of nonviable MSEs or the reorganization of viable MSEs unable to reach an out-of-court agreement, the procedure needs to be significantly simplified.Footnote ⁴⁴ Thus, the size of a firm may affect the optimal design of insolvency proceedings.

1.3.6 Sophistication of the Judiciary

In countries with a sophisticated judicial system comprising efficient, reliable, independent, competent, predictable, and well-equipped courts, the involvement of judges in insolvency proceedings can be value-enhancing.Footnote ⁴⁵ Indeed, judges can act as reliable intermediaries that, apart from facilitating negotiations and a fair process, may have the knowledge, credibility, and experience to make certain decisions that can add value for the benefit of debtors, creditors and society at large. Therefore, in jurisdictions with sophisticated judicial systems, such as the United States, the United Kingdom, and Singapore, the involvement of courts in insolvency proceedings can be justified. Unfortunately, many jurisdictions around the world – and certainly most emerging economies – do not have a judicial system that meets all the conditions that this book will identify as a “sophisticated judiciary,” that is, a judiciary that is efficient, reliable, predictable, independent, competent, and well-equipped. In some jurisdictions, the weaknesses of the judicial system derive from the lack of an independent, predictable, and reliable judiciary. In other countries, judges may be independent, but they may not have the competence or experience needed to handle insolvency disputes. Finally, there are jurisdictions with independent, reliable, and competent courts, but the judicial system is not very efficient or the judges do not have the resources to effectively handle insolvency proceedings. Regardless of the weakness, in the absence of some of these features making a judiciary “sophisticated,” the involvement of courts in insolvency proceedings should be reduced.

1.3.7 Credibility and Expertise of Insolvency Practitioners

In countries with an independent and highly qualified body of insolvency practitioners, the mandatory appointment of an IP can often be justified on the basis that these professionals can create value by adding credibility and expertise to the insolvency proceeding. However, many jurisdictions do not have a large body of independent and highly qualified IPs. Therefore, due to the fees charged by IPs, the mandatory appointment of these professionals can often end up doing more harm than good for the creditors. As a result, countries should carefully assess whether the appointment of an IP is justified in every insolvency proceeding. Additionally, even if an IP is appointed, the role and powers of these actors should be reduced if they do not meet certain requirements in terms of competence, credibility and experience. This goal can be achieved through a variety of strategies, including the empowerment of creditors at the expense of IPs and the adoption of a governance model of insolvency proceedings that allows the managers of the insolvent firm to keep running the company even if an examiner is potentially appointed to monitor the debtor. Additionally, in the absence of a significant pool of highly qualified insolvency practitioners, the appointment of an IP should be exclusively decided by debtors and creditors, especially in countries with weak institutional environments.

1.3.8 Efficiency of Insolvency Proceedings

The efficiency of insolvency proceedings, at least in terms of speed of the procedure and recovery rates obtained by creditors, significantly differs across jurisdictions. For example, while countries like the United States and Germany have relatively efficient insolvency proceedings, many jurisdictions have lengthy insolvency proceedings that generally provide creditors with very low recovery rates.Footnote ⁴⁶ As a result, the initiation of insolvency proceedings may end up being detrimental for both debtors and creditors. For this reason, the use of such inefficient proceedings should be minimized. This can be achieved through a variety of strategies, including not imposing a duty to initiate insolvency proceedings,Footnote ⁴⁷ favoring out-of-court restructurings and hybrid procedures,Footnote ⁴⁸ and relying more on contractual and market-based mechanisms.Footnote ⁴⁹

1.3.9 Political Economy of Insolvency Law

The design of an insolvency regime often reflects different goals and political economies. For instance, in various countries around the world, such as Mexico, France and Ecuador, the insolvency legislation clearly favors employees over other creditors.Footnote ⁵⁰ In India, the creditor-oriented insolvency reform adopted in 2016 was justified, at least in part, by the need to create an efficient insolvency proceeding that, by promoting a quick reorganization of viable companies and the swift exit of nonviable businesses, could facilitate access to credit and the competitiveness of the economy while reducing the levels of NPLs in the banking sector and promoting investor confidence.Footnote ⁵¹ In many countries in the Middle East and Asia, individuals do not have access to an effective discharge of debts as a result of a variety of factors including culture and religion.Footnote ⁵² Other jurisdictions, such as Singapore, have embarked on insolvency reforms with the purpose of strengthening their position as an international hub for debt restructuring.Footnote ⁵³ Meanwhile, many insolvency reforms around the world have taken place because countries sought to improve their positions in international rankings such as the World Bank’s Doing Business Index,Footnote ⁵⁴ or because an insolvency reform was a condition to obtain financing from international organizations.Footnote ⁵⁵ Finally, many insolvency reforms are often implemented as a response to a specific crisis, as it was observed in the 1990s and early 2000s in Asia, in various European countries after the 2008 financial crisis, or more recently in many jurisdictions around the world during or in the aftermath of the coronavirus (“COVID-19”) pandemic.Footnote ⁵⁶

1.4.1 Introduction

Insolvency law seeks to solve similar economic problems across jurisdictions. As has been mentioned, however, the intensity of these problems and the desirability of a particular insolvency response depend on a variety of country-specific and firm-specific factors. As will be shown in Chapter 2, there are many similarities among emerging economies. Some of these similarities, such as the prevalence of MSEs and large controlled firms, can also be found in most advanced economies.Footnote ⁵⁷ Yet, there are other features that are more prevalent in emerging economies. For the purpose of this book, one of the most important features is the existence of a weak market and institutional environment.

When it comes to the design of insolvency law, Chapter 3 will show that there are also many similarities across jurisdictions, even between advanced economies and emerging markets. This is often the result of a variety of factors, including legal origins, geographical location, undesirable legal transplants and the adoption of “international best practices” that do not take into account a country’s market and institutional environment. It will be argued that the lack of an insolvency framework tailored to the specific features of emerging economies has contributed to the failure of insolvency law in these countries, as evidenced by the low usage of insolvency proceedings in most emerging economies, and more generally by the inability of the insolvency system to deliver the expected outcomes in terms of creditor recoveries, reorganization of viable companies and quick liquidation of nonviable firms.Footnote ⁵⁸ As a result, insolvency law fails to serve as a catalyst for growth in countries where promoting this goal is more urgently needed.

1.4.2 Building Blocks for the Design of Insolvency Law in Emerging Economies

A well-functioning insolvency system generally requires an attractive insolvency law for debtors and creditors, a strong institutional environment, and a developed restructuring ecosystem comprising a qualified body of lawyers, insolvency practitioners, bankers, investors, and other relevant actors.Footnote ⁵⁹ Unfortunately, as will be shown in Chapters 2 and 3, these elements – or some of them – are not generally found in emerging economies. Moreover, while amending an insolvency legislation can be relatively feasible, building a strong institutional environment and a developed restructuring ecosystem is certainly complex. It generally requires time, resources and political will to embark on legal, educational, and institutional reforms whose benefits will only be shown in the long run. For that reason, while these reforms are implemented, this book suggests an insolvency framework for emerging economies taking into account the current market and institutional environment existing in these countries. The proposed approach for the design of insolvency law in emerging economies is based on three premises that are derived from the reality existing in these countries, as will be shown in Chapters 2 and 3.

The first premise is that emerging economies have a weak market and institutional environment. As a response to this reality, this book argues that the involvement of courts, insolvency practitioners, and public authorities should be minimized in insolvency proceedings in emerging economies. As discussed in Chapters 4 to 8, this goal can be achieved by adopting several strategies such as reducing the power and discretion of courts and insolvency practitioners, promoting market and contractual solutions led by debtors and creditors, and empowering creditors in insolvency proceedings.

The second premise is that most emerging economies have inefficient insolvency proceedings as a result of an unattractive insolvency law, an unattractive market and institutional environment, or both. Therefore, the initiation of insolvency proceedings usually ends up being value-destroying. As a response to this reality, this book argues that the usage of formal insolvency proceedings should be minimized in emerging economies. As mentioned in Chapters 4 to 8, this goal can be achieved by adopting various strategies such as the promotion of workouts and hybrid procedures, not requiring corporate directors to immediately initiate insolvency proceedings once a company becomes insolvent, and allowing companies to choose their insolvency forum.

The third premise is that most firms in emerging economies are MSEs and medium and large companies with controlling shareholders. As a response to this reality, the insolvency framework suggested in this book proposes various recommendations to address the particular problems and needs of those firms. Moreover, while MSEs and controlled firms prevail in most countries around the world, emerging economies present some unique features that require different solutions, as discussed in Chapters 6 and 7. For example, it will be argued that some of the challenges faced by MSEs in insolvency can be addressed by promoting workouts and implementing a simplified insolvency framework for MSEs that significantly reduces the involvement of courts and public authorities. For controlled firms, it will be pointed out that the higher risk of opportunism of shareholders vis-à-vis creditors can be partially addressed by requiring the appointment of an IP generally acting as a monitor. Moreover, it will be argued that courts should not be involved in the appointment and removal of IPs. Instead, the power to appoint an IP should be given to debtors or creditors, and creditors should always have the ability to remove insolvency practitioners.

1.5.1 The Need to Reinvent Insolvency Law in Many Advanced Economies

This book concludes by pointing out that insolvency law also needs to be reinvented in many advanced economies.Footnote ⁶⁰ Namely, Chapter 9 will argue that insolvency law in many advanced economies has also failed to effectively minimize the destruction of value generally experienced in a situation of insolvency while simultaneously promoting the efficient allocation of the debtor’s assets. As a result, many viable firms often end up in a piecemeal liquidation, the assets of nonviable companies are not quickly reallocated towards more productive activities, and creditors cannot maximize their recoveries in insolvency proceedings. These aspects help explain, among other aspects, why insolvency law is not very popular in many jurisdictions, including advanced economies. Even though it will be pointed out that the stigma and bad reputation of insolvency proceedings have some historical and cultural elements, this book argues that the negative connotations of insolvency proceedings have been exacerbated by a legal and institutional reality: the fact that insolvency proceedings in many jurisdictions have proved to be unattractive for debtors, creditors, or both. Therefore, the failure of insolvency law in many advanced economies will also justify the need to rethink insolvency law in these jurisdictions.

Many legal, economic and institutional features generally existing in emerging economies can also be found in some advanced economies. As has been mentioned, one of them is the prevalence of MSEs and large controlled firms.Footnote ⁶¹Likewise, many advanced economies have inefficient insolvency proceedings,Footnote ⁶² or they do not have competent and efficient courts to handle insolvency proceedings.Footnote ⁶³ For that reason, it will be argued that many advanced economies can improve the attractiveness of their insolvency system by adopting some of the policy recommendations suggested for emerging economies.

1.5.2 Adjusting the Proposed Insolvency Framework for Emerging Economies

Some emerging economies may not have the weaknesses identified in Chapters 2 and 3, or they may decide to embark on significant reforms seeking to improve their market and institutional environment. If so, the policy recommendations suggested in this book would need to be adjusted accordingly. For instance, if an emerging economy significantly improves the sophistication of its judiciary, the role and powers of judges in insolvency proceedings can be expanded. Similarly, IPs may play a greater role in jurisdictions that manage to develop a sophisticated body of insolvency practitioners. Therefore, the insolvency framework suggested in this book has been designed taking into account the current market and institutional environment existing in most emerging economies. However, it needs to be adjusted to the particular features of a country and how those features evolve over time.