12.4 Chapter 4: Governance: a hybrid democratic/judicial model

In Chapter 4 I discuss the mixed democratic and judicial nature of the governance in a plan procedure that is intended to serve as an insolvency instrument. Such a procedure cannot be purely democratic.

In the context of insolvency it is, in particular, necessary to be able to bind dissenting out-of-the money classes. A dissenting class cannot be bound by democratic decision. A majority decision of any one class can bind dissenting members only within that same class. It cannot be imposed across classes. A majority of classes who vote in favour cannot bind a minority of other classes who vote against. Nor can a large class voting in favour bind a smaller class that votes against.

Dissenting classes can be bound only by virtue of a court decision. A court decision is needed particularly to determine who still has an economic interest and who does not, and to impose a plan on dissenting out-of-the-money classes.

The necessity to be able to disenfranchise dissenting out-of-the money classes of their rights by virtue of a court decision is an inherent consequence of the deficit that is particular to insolvency. Without this judicial power, a plan procedure cannot effectively serve as an insolvency instrument. In particular, the procedure then cannot ensure that the available value is distributed in accordance with the applicable order of priority. Value can then dissipate to those who are not entitled to value at the expense of those who are.

Democratic decision-making plays a role where creditors who still have an economic interest are concerned. They determine democratically how they wish to deploy the available value: convert it into cash (liquidate) or receive it in some other form (restructure). The creditors who no longer have an economic interest have, in principle, no say, or at least no veto.

The main advantage of a democratic system is that it allows for a distribution of the available value in a different form than cash (i.e. a restructuring). A distribution in a form other than in cash should not be possible without at least majority consent of the relevant in-the-money creditors. In the context of a restructuring these creditors must, in effect, decide whether they wish to reinvest in the business the cash that they would otherwise receive upon liquidation. This is a decision that expressly rests with the creditors themselves, and not with a judge or an administrator, and therefore requires consultation of the creditors.