Global Insolvency and Bankruptcy Practice for Sustainable Economic Development

General Principles and Approaches in the UAE

Dubai Economic Council, Adrian Cohen, Tarek Hajjiri, Kenneth A. Loparo, Mockler, Tarek Hajjiri

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137515759
• Topic: Business
• Subtopic: Contabilità finanziaria
• Index: Business

How an economy handles financial and business distress has a major impact on confidence in business, the availability of investment, the cost of credit, and economic growth. The financial crisis of 2007-2008 and its aftermath was a catalyst to legal reform in the field of bankruptcy and restructuring law and brought an added focus to the systemic threat of bank failure to the financial system. This book explores the general principles and practice of legal reform within bankruptcy. From a variety of specialists including practitioners, lawyers, bankers, accountants and judges from the United Arab Emirates, the UK and Singapore, it provides a variety of perspectives on the topic. Chapters include topics such as the 'Four Pillars of Regulatory Framework', the history and application of the UNCITRAL Model Law on Cross-Border Insolvency, the challenges for financial institutions and the treatment of the insolvency of natural persons. The book also offers a comparative study of Islamic Shari'ah principles with modern bankruptcy regimes, an analysis of bankruptcy in the UAE and an evaluation of the legal infrastructure of the DIFC Courts. The authors explore core questions surrounding bankruptcy law, including its ability to facilitate the turnaround of business, to enable efficient reallocation of capital, to provide coherent rules for entrepreneurs, investors, employees, and creditors, and to provide for both appropriate sanctions and for rehabilitation.?

1

Regulatory Framework Priorities – The Four Pillars

Gordon Stewart

If one looks back at the history of relations between debtors and creditors in mature financial markets, one can detect a general trend. In Victorian times in England, those who did not pay their debts was liable to end up in debtor’s prison. An example of such a prison was Marshalsea, where Charles Dickens’ father was incarcerated. By all accounts, nineteenth-century prisons in the United Kingdom were grim places. Failing to pay debts was regarded as immoral and, besides legal sanctions, a defaulting debtor was liable to be socially ostracised and, sometimes literally, pilloried. I have a print on the wall of my office entitled Examination of a Bankrupt before his Creditors. Suffice to say, it does not look like a pleasant experience.

Debt and credit are closely bound up with concepts of business and trade. Taking a step back, there is a widely held academic view that mankind’s development took off when we moved from the hunter-gatherer stage and became farmers.¹ This gave more time for specialisation and encouraged trade, initially by barter. Leaping forward in evolutionary time, improved means of transport enabled goods traded to be moved over greater distances. When ships became bigger, so international trade developed – helped, of course, by Captain Cook and other sailors who had the courage to test and disprove the theory that the earth was flat (and that if you sailed for long enough you would eventually topple off the edge of the world ... ). A powerful merchant class emerged. But sailing long distances – from Europe to, say, the East Indies (and back) – was still a hazardous endeavour. Not every ship made it there and back. If a ship did manage the return journey, however, the rewards for the merchant could be spectacular. And a merchant would want to maximise his profit from such a successful voyage. That would be best achieved by having his ship full to capacity. But even wealthy merchants would often not be able to fund a ship full to the gunnels with oriental spices and textiles. Unless ... he borrowed money to finance the purchases, to be repaid when his ship came in. So merchants would often take out a loan to finance a voyage – they would leverage their position. Trading involved taking risks.

Trade mushroomed in the nineteenth century, and it came to be seen that risk-taking, within reason, was a good thing, something an enlightened state might encourage. The innovation of the limited liability company was a step in that direction. At the same time, personal bankruptcy laws started to be less penal in effect and began progress towards the current modern regime, which is aimed more at giving the bankrupt a fresh start than at in punishing him.

All this represented a cultural shift whereby the entrepreneur was to be protected from personal liability by being allowed to incorporate and the individual who went bust was to be given a means – through the bankruptcy laws – of discharging his debts and returning to society. And this trend has continued up to the present day. Although sometimes criticised, the UK has led the way in reducing the amount of time a bankrupt needs to spend before receiving a discharge from his debts: it is now down to one year in a straightforward case. The European Union-wide applicability of the European Insolvency Regulation (and the general freedom of movement within the European Union) has led to financially troubled individuals moving their residence to England to take advantage of English bankruptcy laws. While some have criticised the availability of such a manoeuvre – calling it ‘bankruptcy tourism’ – the result has been that other European countries have started to examine their own bankruptcy laws to see if some modernisation would not be appropriate, rather than see their citizens having to emigrate. The Republic of Ireland, which historically had a ten-year period before discharge, has dramatically reduced that to three years in recent legislation.

There may be sceptics who wonder whether this early exoneration of defaulting debtors will encourage bad practices or habits. Has there been an epidemic of serial bankrupts? The statistics suggests not. Despite the prospect of a swift discharge, people still do not want to become bankrupt – understandably. There are still inhibitions resulting from being (or having been) bankrupt and there is still stigma. The evidence suggests that what causes people to go bankrupt – including those who may go bankrupt more than once – are what might be termed “life events”. These would be loss of job, personal injury, death of a breadwinner or marital breakdown.

Personal bankruptcy laws are part of the jigsaw of insolvency law. Is insolvency law important? If so, why? The answer is that it is important. To quote that highly respected commentator, Philip Wood Q.C.,

Insolvency law is the root of commercial and financial law because it obliges the law to choose. There is not enough money to go round and so the law must choose who to pay. The choice cannot be avoided, compromised or fudged. On insolvency, commercial law is at its most ruthless: it must decide who is to bear the risk so that there is always a winner and a loser, a victor and a victim. On bankruptcy it is difficult to split the difference. That is why bankruptcy is the most crucial indicator of the attitudes of a legal system in its commercial aspects and arguably the most important of all commercial legal disciplines.²

An interesting sign of the importance of insolvency laws can be observed if one stands back and look at the bigger picture. Businesses make up the industrial capital of a state. If a business is in the wrong hands it may go bankrupt – go into liquidation – and those assets and that industrial capital are not being used to best effect. Similarly, the claims of creditors to monies in the hands of liquidators represent money which those creditors do not have and cannot spend or invest. One role of insolvency laws is to take assets from the incompetent or fraudulent and put them in new hands: in the hands of those who, hopefully, will make better use of them. Or it may be that the managers of the business were unlucky: in which case an enlightened law may give them a second chance. And even when the outcome is liquidation and mere payment of dividends on claims, the more efficiently creditors receive money that is due to them to do with as they think fit, the better.

So much for the history. What of the present day? What is best in class in terms of states’ insolvency laws currently?

The four pillars of the restructuring world

One of the primary activities of INSOL International is to show to emerging jurisdictions that are keen to improve their restructuring and insolvency regimes the way that other jurisdictions have developed, and hence to present what might be termed “best in class”. This is not to suggest that there is only one right set of laws or to suggest that one size fits all. Jurisdictions may look to their legal and cultural traditions in deciding what suits and works best for them. INSOL has been instrumental in organising an annual African Round Table (ART), and representatives regularly attend from countries in the OHADA group of French-speaking nations in sub-Saharan Africa. It is not surprising to find that these countries look to Paris and French law for their inspiration.

What are the fundamental elements of the better restructuring and insolvency regimes? What supports the superior systems? I believe there are four pillars: the law, the culture, the practitioners and the courts.

The law

You may ask: do good laws really matter? Well, take the crisis in the US car industry in 2009. Both GM and Chrysler entered Chapter 11³ and emerged with their businesses rescued. In the case of Chrysler, the turnaround was achieved within 41 days, and with GM, it was a mere 39 days. And by 2011, GM had retaken the number 1 spot in the world rankings for car sales (replacing Toyota), selling 7.5 million vehicles in 120 countries. They generated record annual profits.

When GM sought bankruptcy protection under Chapter 11, it was the largest industrial bankruptcy ever and the third largest overall. Normally, a Chapter 11 involves the promulgation of a plan of reorganisation on which the various creditor classes vote. The plan can itself involve a sale of the company’s business. But there is also section 363 of the Bankruptcy Code which enables a sale of the business not through a plan. The section was used in both GM and Chrysler. Such rapid section 363 sales caused some controversy. In the GM case, there were allegations that the sale was effectively a “sub rosa plan” – that is a plan by another name but with less disclosure to the creditors than would be the case in a plan.⁴ However, such rapid sales are possible where there is a commercial necessity. The role of the federal Government was material, however. The purchasing entity of GM received certain support, which meant that the employees and their pensions were protected. But the crucial aspects for the court, when it came to the hearing to sanction the sale, were the commercial necessity for a quick sale and the fact that it was demonstrably the case that the offer made for the GM business was the best obtainable in the circumstances. In his judgment, Judge Gonzales, of the Southern District of the New York Bankruptcy Court, gave a thorough and convincing explanation for the court’s sanction of the sale.

In the case of Chrysler, the company had in fact stopped production, which was a strong indication that there was considerable urgency. The metaphor used in court was that this was a case of “melting ice cubes” where, absent a sale, there might be no business left to sell or save. Now, not long before Chrysler’s filing for Chapter 11, the US Government had introduced TARP, the Troubled Asset Relief Program, which enabled the Government to buy, or lend on the security of, difficult-to-value or illiquid assets of qualifying financial institutions. Chrysler’s finance arm was a qualifying institution and received a TARP loan. Liquidity was also provided to “New Chrysler”, the bidder for the Chrysler operations.⁵ Dissentient creditors complained about the liquidity being given to New Chrysler and hence objected to the section 363 sale, but the Court was satisfied that the best bid possible had been elicited – comprising a price of $2 billion plus the assumption of liabilities.

So, a good law can facilitate business rescue. But what are the key elements of a good restructuring and insolvency legal structure?

First, there need to be laws governing the conduct of directors. What are their duties and responsibilities when the corporation is in the “twilight zone” – when it has financial difficulties and it is unclear whether it will survive or fail? At one extreme, one does not want to have directors filing for insolvency – with all the dislocation and stigma that this may cause – before it is really necessary. On the other hand, if a business is making unsustainable losses and damaging the interests and likely return to creditors day after day, then reckless continuation or even negligent continuation of trading by directors needs to be checked. In some jurisdictions, if the directors surround themselves with proper advice, the law may be unwilling to attack something that is seen as simply a matter of business judgement. In other countries, it may be an offence – sometimes a criminal offence – not to file in the face of illiquidity or, even, a deficit on the balance sheet. As we shall see, one of the key roles of insolvency laws is that they constitute the backdrop against which the players act out their parts – that is, the stakeholders seek to negotiate a consensual solution to the company’s difficulties. Laws fail to strike the right balance if directors are forced to file for insolvency too early in the play. A strict requirement to file in the face of balance sheet insolvenc’ is particularly unhelpful.⁶

Even if a business cannot be saved, it is still important that a legal system has an efficient liquidation procedure to get money back to the creditors for them to spend or invest. Again, does that really matter? Well, take two examples: Lehman Brothers and Enron. The liabilities of Enron were some $67 billion and those of Lehman Brothers a mind-boggling $613 billion. Yet the US Chapter 11, and the English administration systems, stood up well to the challenges posed by these cases and, notwithstanding the vast complexities involved, within the space of a few years, large amounts of money – colossal sums of money in the case of Lehman – were returned to creditors.

Since Roman times, the law has been suspicious of activity and transactions completed just before the commencement of formal insolvency. The law views the insolvent estate as extending not just to the assets at the date of insolvency but to assets which have wrongfully moved out of the insolvent company in a period before the formal insolvency (the so-called look-back or vulnerability period). So good modern systems need to have appropriate clawback laws. They often have names like preference, fraudulent preference, transaction at undervalue and transaction in fraud of creditors.⁷ Again, there is need for balance. Not every transaction with a company in financial difficulty should be open to attack, or companies in that position would be frozen and doomed because counterparties would not deal with them for fear of clawback. An example is when a company needs to borrow more to meet a liquidity spike. That type of creditor support is often helpful and, indeed, crucial. On the other hand, the law should stop management or controllers feathering their nests just before a collapse.

The system will want to have a good rescue or restructuring law. This may be designed to do two things. First, to give a corporation some breathing space – say, from hostile creditor action resulting from its illiquidity – so that the corporation itself may be saved together with its business. Or, if that is not possible, the law should enable the business or the best parts of the business to be maintained and sold to a purchaser for the best price obtainable at the time. An aspect of such a law will be a moratorium shelter: that is, a law which prevents creditors taking action against the company. If there is a need to compromise debts or convert some creditor claims into equity in the company, then a mechanism for implementing a scheme or a plan supported by an appropriate majority of the creditors should be available. A typical safeguard against abuse of power by the majority will be that there should be a fairness hearing before the court, prior to the scheme or plan being sanctioned.

One policy decision for legislators is whether, on the commencement of a rescue procedure, to leave management in control – a so-called debtor-in-possession system – or to replace or supplement management with an administrator (or some such: an insolvency practitioner). Again, a jurisdiction will decide what best suits its culture. Those who favour debtor-in-possession feel that it strikes a better balance between the interests and powers of debtor/management and creditor. Those who favour the passing of control to insolvency practitioners feel that debtor-in-possession is too close to “leaving the fox in charge of the chicken coop” for comfort. If the route of having insolvency practitioners is followed, it will be likely that the jurisdiction will want to licence and regulate such practitioners in order that there is both integrity and sufficient competence in the system.

Besides GM and Chrysler, discussed above, are there other high profile success stories which demonstrate the benefits of effective laws? A good example of a major restructuring in the UK market, and one which focused attention on the uses and advantages of UK law’s schemes of arrangement, was that of Marconi Corporation. Marconi – a legendary name of great historical resonance – was in the telecoms sector, which, at the time, was overpopulated with players. Marconi found it could not meet its debt covenants. Some of its creditors felt that in an overcrowded sector, one or more companies should simply go to the wall. A more enlightened creditor gro...

Table of contents

• Cover
• Title
• 1  Regulatory Framework Principles The Four Pillars
• 2  Regional and Global Initiatives and Lessons: UNCITRAL Global Insolvency Standards
• 3  The Changing Landscape and Challenges for Financial Institutions
• 4  Law and Development in the Treatment of the Insolvency of Natural Persons: The World Bank Report on the Treatment of the Insolvency of Natural Persons
• 5  Insolvency in Shariah and Law: A Comparative Study
• 6  Bankruptcy and Bankruptcy Procedure in the United Arab Emirates
• 7  Legal Infrastructure of the DIFC Courts
• 8  Legal Infrastructure in the UAE Initiatives and Development, Banking and Financial Environment
• Index