Over the years, the IMF has become increasingly involved in the promotion of orderly and effective insolvency systems among its members. Experience has demonstrated that reform in this area can play a major role in strengthening a country’s economic and financial system. For example, an effective insolvency system provides an important pillar of support for the domestic banking system by enabling banks to curtail the deterioration of the quality of their claims, including claims on the corporate sector, whether through a court-approved restructuring or, where necessary, through an efficient liquidation.
Insolvency reform can be particularly relevant for economies in transition, where it can play a critical role in addressing the problems of insolvent state-owned enterprises. In the context of financial crises, an orderly and effective insolvency system can provide an important means of ensuring an adequate private sector contribution to the resolution of such crises. Finally, although insolvency procedures are implemented through the courts, the very existence of an orderly and effective insolvency system establishes incentives for negotiations between debtors and their creditors, which may lead to out-of-court agreements being reached “in the shadow” of the law.
Drawing on its experience in providing technical assistance in this area, the IMF’s Legal Department has recently published a report entitled Orderly and Effective Insolvency Procedures: Key Issues. Although based on a comparative study of selected insolvency laws, the study is not intended to be a description of such laws. The approaches adopted by countries vary in a number of respects—these differences are attributable not only to divergent legal traditions but also to different policy choices. Because of these differences, international standards do not exist in this area, and the report does not attempt to propose such standards. However, in its discussion of the key issues in this area, the study weighs the advantages and disadvantages of possible solutions.
Overall objectives of an insolvency law
Although the insolvency laws of countries differ in important respects, most systems generally share two overall objectives.
Predictable, equitable, and transparent allocation of risk among participants in a market economy. Achievement of this objective plays a critical role in providing confidence in the credit system and fostering economic growth for the benefit of all participants. For example, the ability of a creditor to begin insolvency proceedings against a debtor as a means of enforcing its claim reduces the risk of lending, thereby increasing the availability of credit and, more generally, investment. An insolvency law also allocates risk among different creditors, which benefits borrowers as well. For example, if the insolvency law affords secured creditors special treatment vis-á-vis unsecured creditors, such treatment protects the value of security, which may be particularly important for those debtors that, because of their credit risk, cannot obtain (or afford) unsecured credit.
Predictability. Individual countries have made—and will continue to make—different policy choices about how their insolvency laws will allocate risk among participants. Regardless of these choices, however, it is generally recognized that the relevant risk allocation rules should be clearly specified in the law and that they should be consistently applied by the individuals and institutions charged with implementing them. As experience has demonstrated, no matter what policy choices countries make regarding the allocation of risks, participants will often be able to take measures (including through price adjustment) that will help them manage the risk in question when the application of these rules is relatively predictable. In contrast, when the rules or their application is uncertain, such uncertainty will erode the confidence of all participants and will undermine their willingness to make credit and other investment decisions.
Equitable treatment. A common feature of all insolvency proceedings is their collective nature. Unlike other laws (for example, foreclosure laws), an insolvency law is designed to address a situation in which a debtor is no longer able to pay its debts to its creditors generally (rather than individually) and, in that context, provides a mechanism that offers equitable treatment of all creditors. As the report notes, equitable treatment does not require equal treatment. On the contrary, to the extent that different creditors have struck fundamentally different commercial bargains with the debtor (for example, through the granting of security), differential treatment of creditors that are not similarly situated may be necessary as a matter of equity. For the benefit of all creditors, however, an insolvency law must address the problem of fraud and favoritism that often arises in the context of financial distress. Moreover, given the importance of international credit and investment, it is critical that the law ensure that there is no discrimination against foreign creditors. Finally, the collective nature of a proceeding can give reassurance to creditors that problems will be resolved in an orderly and equitable manner.
Transparency. During the course of insolvency proceedings, it is important that interested participants be given sufficient information to enable them to exercise their rights under the law. It is critical, for example, that creditors receive adequate notice of meetings when creditor decisions are to be taken and that they receive sufficient information from the debtor to ensure that their decisions are informed. In circumstances where decisions are made by the institutions charged with implementing the law (the court and the court-appointed liquidator or administrator), it is also important that the law provide adequate guidance about the exercise of their discretion and, in the case of the court, require that judicial proceedings be open and that the rationale underlying the court’s decision be made publicly available.
Protecting and maximizing value for the benefit of all interested parties and the economy in general. This objective is most obviously pursued in the context of rehabilitation, where value is maximized through the continuation of a viable enterprise. But it is also a primary objective of procedures that liquidate enterprises that cannot be rehabilitated. Achievement of value maximization is, in many cases, furthered by the fulfillment of the objective of equitable risk allocation. For example, nullification of fraudulent transactions that occurred before the commencement of an insolvency proceeding ensures that creditors are treated equitably and also enhances the value of the debtor’s assets. However, the nullification of prior transactions also extends to nonfraudulent transactions, which can undermine predictability. Similarly, during the insolvency proceedings, many countries give the liquidator or the administrator (depending on the nature of the proceedings) the authority to interfere with the terms of a contract previously entered into between the debtor and a counterparty. While the exercise of this authority provides an important means of maximizing the value of the assets of the debtor, it also undermines the predictability of contractual relations, which is critical to the making of investment decisions.
Some of the key policy choices in the design of an insolvency law relate to the way the above objectives are balanced against each other. In addition, choices need to be made regarding who will be the beneficiaries of the value that is maximized. Some countries view rehabilitation procedures as a means for enhancing the value of creditors’ claims through the going-concern value of the enterprise. Other countries view these procedures as a way to provide a “second chance” to the shareholders and the management of the debtor. Still others view the continuation of the enterprise as being primarily for the benefit of the employees.
The protection of employees raises the larger issue of when reliance on the insolvency law should be avoided altogether, so that certain public policy objectives can be achieved. For instance, as a means of limiting unemployment or rescuing enterprises engaged in important national activities, the authorities may prefer to address the problems of a troubled company through measures that will involve an extensive use of public funds and give the beneficiaries a substantial advantage over their less-favored competitors.
When determining how to strike a balance between the various objectives, policymakers must take care to avoid easy stereotypes. Debtors are not always fraudulent or incompetent, and creditors are not always grasping and selfish. As borne out by recent experience, although companies may fail because of incompetence, they may also fail because of economic difficulties beyond their control.
An effective insolvency law can ensure that private creditors contribute to the resolution of financial crises.
Role for insolvency law
Viewed from the perspective of the economic policymaker, it is evident that an effective insolvency law can play a critical role in several areas. The discipline it imposes on a debtor increases the competitiveness of the enterprise sector and facilitates the provision of credit. More specifically, to the extent that the enterprise is owned by the state, subjecting it to the application of the general insolvency law sends a clear signal about the limitations of public financial support. In that context, the rehabilitation provisions of an insolvency law can provide an effective way of ensuring that creditors contribute to the resolution of the financial problems of state-owned enterprises, thereby limiting the public cost of rehabilitation.
With respect to the financial sector, an effective insolvency law enables financial institutions to curtail the deterioration of the value of their assets by providing them with a way of enforcing their claims. It can also facilitate the development of capital markets. For example, if an insolvency law is applied with sufficient predictability, a secondary market in debt instruments can develop, which, among other things, will enable financial institutions to transfer their loans to other entities that specialize in the workout process.
Finally, in the context of a financial crisis where the entire enterprise sector is in distress, an effective insolvency law can ensure that private creditors contribute to the resolution of the crisis. For example, a rehabilitation procedure provides a means for imposing a court-approved restructuring agreement over the objections of dissenting creditors. Not only does such a mechanism reduce the public cost of the crisis and relieve external financing needs, but it also strengthens the stability of the international financial system by forcing creditors to bear the costs of the risks they incur.
Copies of Orderly and Effective Insolvency Procedures: Key Issues, prepared by the IMF’s Legal Department, are available from IMF Publication Services for $22.00 each. See page 397 for ordering information.