European Bankruptcy Laws: Implications for Corporations Facing Financial Distress
Kaiser, Kevin M. J., Financial Management
Corporate bankruptcy laws have been an area of nearly constant change in many countries over the past century. Even with new Acts and Codes passed every several decades, however, there are still enormous differences between the bankruptcy laws of the industrialized nations. There are also still large differences in opinion, among legal academicians, practitioners, creditor organizations, and politicians, about what constitutes the "best" bankruptcy law. Indeed, even though formed after much debate and participation from many sectors of the economy and legal community, the US Bankruptcy Reform Act of 1978 has recently come under an intense wave of criticism and was substantially reformed itself in 1994.
Most generally, there are two alternative corporate bankruptcy structures: liquidation and reorganization. Bankruptcy laws in most countries have provisions, with varying accessibility, for both of these structures. For example, in the US, the Chapter 11 provisions of the US Bankruptcy Reform Act of 1978 are designed to encourage and facilitate reorganization. The provisions of Chapter 7, on the other hand, are intended to implement a quick and efficient liquidation. The characteristics of these two general structures vary dramatically from country to country, and the accessibility of the two structures, especially the reorganization provisions, also varies from country to country.
Each of the three European nations included in this paper has revised its bankruptcy code in the past decade. While each intended to improve the odds of rehabilitating a viable but distressed firm, none permit the debtor such power as that given to the debtor in Chapter 11. In the interests of space, this study focuses on the opportunities to reorganize a distressed debtor within the bankruptcy laws.
The Role of Bankruptcy Law. Bankruptcy law should provide a framework to permit viable but liquidity-constrained firms (those which can be reasonably expected to earn at least their cost of capital if continued but which are presently unable to meet their financial obligations) to reorganize and continue doing business and nonviable firms to be liquidated. The framework should be sufficiently clear and well structured that the process, be it reorganization or liquidation, and the identification of which process will be applied is as efficient as possible.
There are many factors which complicate the situation facing a distressed firm and its claimants, including; 1) information asymmetries, where different parties have access to different sets of information, 2) conflicts among claimants, and 3) the familiar holdout (or free-rider) problem. (For a recent synthesis of the theoretical literature on financial distress, see Chen, Weston, and Altman, 1995.)
The practical issues to be addressed by the bankruptcy code include determining whether reorganization should be attempted, assigning control and decision-making authority while the firm deals with its distress, and financing the viable, liquidity-constrained firm while it reorganizes. The success of the provisions which govern these decisions will depend upon how effectively they address the complicating factors mentioned above.
The efficiency of the code is determined by its ability to avoid costs. The costs of financial distress are both direct - those costs for which a check must be written, such as legal fees directly connected to the distress - and indirect - those costs which are less easily defined and measured, such as lost sales, use of management time, disruption of business, etc. As both of these are increasing as the time spent in distress increases (in addition to other factors), the efficiency of the code will hinge upon its ability to resolve the situation in a timely manner. These costs also depend upon the incentives of the controlling party in distress (to delay proceedings or resolve the distress quickly) and the incentives of the firm's management prior to insolvency (to seek the protection of the court or to engage in risk-taking in an attempt to avoid collapse). …