12.2 Chapter 2: The justification for and purpose of bankruptcy law

A new procedure can only be designed if it is clear what its intended purpose should be. To be able to determine the purpose of pre-insolvency proceedings, I first revisited the purpose of insolvency law in general. The influential creditors’ bargain theory that Jackson and Baird developed in the 1980s serves as a starting point.

In their enquiry into the normative foundation of insolvency law, Jackson and Baird propose viewing collective insolvency proceedings as the result of what one could expect the creditors to have agreed with each other in terms of coordinating their individual enforcement efforts in the possible future event of insolvency of their debtor, if they were able to reach such agreement in an ex ante position at a time when insolvency is not to be foreseen. Jackson and Baird propose that in this ex ante position the creditors would agree to exchange their individual enforcement rights for a collective enforcement process in the event of insolvency of their debtor. They suggest that the creditors would have agreed to such exchange if coordinated enforcement through a collective enforcement system leads to higher recoveries for the creditors as a whole than an uncoordinated cascade of individual enforcement actions. The normative foundation of insolvency law is thus essentially the deemed ex ante consent of the creditors, a hypothetical social contract between them. Jackson and Baird call it the “creditors’ bargain”.

According to the creditors’ bargain theory, a normative foundation for insolvency law can thus be considered to be present where the collective system has the primary aim and effect of maximising returns to the creditors as a whole, rather than pursuing rescue of the business as an independent policy objective. Pursuing the latter objective can operate to the detriment of the creditors. This is not what the creditors would have bargained for in exchange for handing in their individual enforcement rights.

In its core, the creditors’ bargain theory thus implies that a normative foundation for insolvency law exists if the creditors as a whole are better off with the proposed collective system than they would have been if they had kept their individual enforcement rights.

The creditors’ bargain theory is based on liquidation (selling to a third party in exchange for cash). Jackson and Baird compare collective to individual liquidation. If one compares collective to individual liquidation, it is safe to assume that, assessed from an ex ante position, the creditors as a whole will be better off under the collective enforcement system. A coordinated sale in a collective liquidation procedure will generally generate higher returns than a multitude of uncoordinated individual enforcement sales.

The situation becomes more opaque, however, if one compares a restructuring to collective liquidation. By “liquidation” I do not mean a piecemeal sale of the business, but the conversion of its value into liquid assets through a sale (generally as a going concern) to a third party for cash. By “restructuring” I mean the implementation of a transaction whereby the value of the company is distributed to the creditors “in kind”, i.e. in the form of various financial (debt and equity) instruments, without the value of the business being made liquid. There is no principle difference between a liquidation and a restructuring. In a liquidation the business is sold to a third party for cash. In a restructuring the business is conceptually sold to the creditors themselves. The main differences between a liquidation and a restructuring are the form of the distribution and the valuation. In a liquidation the creditors are paid in cash (liquid assets). In a restructuring the creditors are paid in non-cash (financial instruments). In a liquidation, valuation is determined by the market. In a restructuring, no transaction on the open market takes place. Instead, valuation takes place on the basis of a “paper” valuation exercise and, if disputed, has to be determined judicially.

One cannot be certain in advance that the creditors as a whole will be better off in a restructuring than they would be in a collective liquidation. A restructuring may benefit one subgroup but prejudice another. More specifically, the group of creditors who may be worse off in a restructuring, are the creditors who prefer to receive cash and would receive cash in a liquidation, but who are required to accept a distribution in non-cash under the terms of the restructuring. I expand on the difference between cash and non-cash and explain why having to accept non-cash can constitute a hardship, even though the expected cash distribution and the proposed non-cash distribution might be considered to have the same value.

If a restructuring can indeed benefit one subgroup but prejudice another, how then can one determine whether, on balance, the creditors as a whole will be better off under the terms of the restructuring than in a collective liquidation? Even if one were able to establish a net benefit for the creditors as a whole, one can question whether it is fair to sacrifice the interests of the group that is worse-off for the benefit of the group as a whole. I suggest that it is not.

To establish a normative foundation for a restructuring procedure, I propose a refinement of the creditors’ bargain theory. This refinement is, in essence, that a sufficient justification for a restructuring system can be found if and to the extent that all constituencies benefit from the system, or at least that no subgroup can be identified that is worse-off under the restructuring than without. In these circumstances it is safe to assume that the proposed restructuring system will lead, on balance, to a net benefit for the creditors as a whole, without sacrificing the interests of a specific subgroup. This test – that no subgroup may be worse-off with a proposed measure than it would be without the proposed measure – is in essence the so-called Pareto-efficiency standard.