Liquidation procedures are generally relied upon once there is no economically reasonable possibility of rehabilitation. Although such procedures can therefore be viewed as the second of the two components of the insolvency proceedings, they are dealt with first in this study because they are utilized most often, and are generally viewed as the “core” proceedings upon which rehabilitation procedures are constructed. While many companies successfully rehabilitate, they normally do so out of court and actually rely on the “shadow” of liquidation to facilitate rehabilitation.

Objectives of an Orderly and Effective Liquidation Procedure

Liquidation procedures are generally relied upon once there is no economically reasonable possibility of rehabilitation. Although such procedures can therefore be viewed as the second of the two components of the insolvency proceedings, they are dealt with first in this study because they are utilized most often, and are generally viewed as the “core” proceedings upon which rehabilitation procedures are constructed. While many companies successfully rehabilitate, they normally do so out of court and actually rely on the “shadow” of liquidation to facilitate rehabilitation.

Drawing on the overall objectives of an insolvency law described in the previous chapter, the most important objectives of an orderly and effective liquidation procedure may be described as follows.

(1) A primary objective is to maximize the value of the assets of the estate. Many of the features of the insolvency system are designed to achieve that objective. These features include the imposition of a stay on creditor enforcement of legal remedies that prevents a premature breakup; the appointment of an independent liquidator with broad powers; when the temporary continuation of the enterprise by the liquidator is considered necessary, the creation of incentives for creditors to provide financing through priority for post-petition financing; and the inclusion of “claw-back” provisions that recapture assets disposed of by the debtor to the detriment of the creditors.

(2) Another objective is to equitably treat similarly situated creditors. Insolvency creates a collective procedure that will only be effective if participants view it as equitable. This is achieved through the inclusion of a number of features, including claw-back provisions and the general stay on creditor enforcement of legal remedies.

(3) A final objective, albeit a much broader one, is to provide a mechanism that facilitates the making of investment decisions. If creditors can rely on a mechanism that enables them to enforce their rights against a debtor, this will assist them in making their investment decisions. The commencement criteria are critical for this reason. Moreover, if the distribution priorities following liquidation recognize the seniority established by contractual terms, creditors will feel confident that they are able to manage, at least to some degree, the risks that they incur when making investment decisions.

While the above objectives are normally mutually reinforcing, they can also, at times, be at odds with each other. Indeed, one of the challenges of designing an orderly and effective liquidation procedure is to strike an appropriate balance between competing objectives. For example, broad powers given to a liquidator to enable him to nullify transactions already entered into and to modify the terms of existing contracts may undermine the predictability in contractual relations that is critical to the making of investment.

Commencement Requirements

Qualification of the Debtor

The determination of which entities are eligible to be subjected as debtors to a country’s general insolvency law is an important threshold issue and has important implications for a country’s economy. For example, if the law excludes certain entities, these entities will be neither subject to the discipline imposed by an effective insolvency regime nor able to take advantage of the protection it affords. At the same time, important policy considerations may lead countries to establish special insolvency procedures for natural persons or for certain regulated entities. However, the exclusion of an enterprise from any form of insolvency regime should be avoided.

Natural/Legal Persons

An insolvency law should generally define which entities are subject to its provisions. It may decide to treat legal entities separately from natural persons, either through different statutes or through different chapters within the same statute. This separate treatment may arise for a number of reasons, including public policy concerns regarding consumer protection. Since this report is primarily concerned with the insolvency law’s treatment of those actors that have the greatest impact on the country’s economy, it does not express a preference as to whether natural persons should be subject to a special regime or the design of such a regime.

Government-Related Entities

It is universally recognized that sovereign nations are not subject to any insolvency law, international or national. Local government entities, such as municipalities, may be excluded from the scope of the insolvency law altogether or the law may establish a special regime for them.2 While the treatment of government-owned entities may also vary, there appears to be no reason why such an enterprise operating in the market place as a distinct entity should be excluded from the coverage of the general insolvency law unless the government has extended an explicit guarantee with respect to all its liabilities. As discussed in Chapter 2, the inclusion of a government-owned enterprise within the scope of the insolvency law has the advantage of both subjecting the enterprise to the discipline of the market place and sending a clear signal that government financial support will not be unlimited.

Financial Institutions and Other Regulated Entities

An insolvency law may exclude banks and insurance companies from the purview of general insolvency law on the grounds that the unique role played by these institutions in the economy and, in particular, the payments system merits a special regime. Whether financial institutions should be subject to a special insolvency regime and, if so, what the design of that regime should be is of critical importance to the IMF given its work in this area. For this reason, and as noted in Chapter 1, this issue will be the subject of a separate study. Countries may also wish to establish special regimes for other highly regulated entities, such as utility companies or, alternatively, may give the relevant regulatory agency a special role under the general insolvency law.

Foreign Debtors

Whether or not a debtor is owned by foreigners should not be a criterion for determining jurisdiction over insolvency proceedings. However, international insolvencies raise a number of complex jurisdictional issues, for the resolution of which international cooperation is necessary. On this cooperation, see the Appendix, which describes UNCITRAL’s model law on cross-border insolvency.

Principal Conclusions

While the exclusion of an enterprise from any form of insolvency regime should be avoided, countries may wish to establish special regimes outside the scope of the general insolvency law for individuals or highly regulated entities, such as financial institutions. However, government ownership of an enterprise should not, in and of itself, provide a basis for excluding an enterprise from the coverage of the general insolvency law.

Conditions for Commencement

Although insolvency laws generally provide for liquidation proceedings to be initiated by either a creditor or the debtor, they differ on the specific criteria that must be satisfied before the proceedings can commence. Moreover, a number of laws set forth alternative criteria. Nevertheless, a criterion that is relied upon extensively—and which is consistent with the overall objectives of insolvency—is one that allows for commencement when the debtor has ceased to meet its liabilities generally as they become due. The way in which this criterion is used by countries varies. In some countries, it provides the basis for the initiation of either a liquidation or a rehabilitation procedure and, where liquidation is chosen, the procedure can later be converted into a rehabilitation. In other countries, only a rehabilitation procedure may be initiated on the basis of this criterion and the procedure may only be converted into a liquidation once it has been determined that the enterprise cannot be rehabilitated. Under a third approach, this criterion is relied upon to commence a unitary procedure, and the choice between liquidation and rehabilitation is only made later.3

Given that the objectives of liquidation and rehabilitation proceedings are different, reliance on the same criterion for both proceedings by a number of countries requires some explanation. For example, while one could envisage such a criterion—which effectively provides evidence of illiquidity—as being appropriate for the commencement of rehabilitation proceedings, it may seem more logical to condition the opening of liquidation proceedings upon a demonstration of even greater financial distress, such as insolvency. If an insolvency test were relied upon exclusively and applied in the strict sense, liquidation proceedings would, at least in most cases, normally only be opened at a later stage, that is, when the balance sheet of the enterprise showed that the value of the company’s liabilities exceeded its assets.4

One of the principal reasons why countries often allow liquidation proceedings to be opened on the basis of a determination of a “general cessation of payments” can best be explained in terms of the objectives of these proceedings. To the extent that liquidation proceedings are designed to avoid a “grab race” by individual creditors that causes the dismemberment of the debtor to the detriment of the collective interests of creditors, waiting until the debtor is insolvent will often only interrupt the grab race that is well under way. Moreover, proving balance sheet insolvency is often difficult for creditors since they lack inside information.

Reliance on a “general cessation of payments test,” on the other hand, is designed to activate the proceedings sufficiently early in the debtor’s financial distress that this race will be preempted. The obvious problem of this “preemptive” approach—the fact that liquidation proceedings will commence with respect to a financially troubled, but still viable, enterprise—may be resolved by providing the debtor the opportunity to transform the liquidation proceedings into a rehabilitation proceeding. As noted above, an alternative way to resolve this problem is to only allow the creditor to initiate a rehabilitation or “unitary” procedure on the basis of the general cessation of payments test, with the possibility of a subsequent conversion to liquidation.

Although the “general cessation of payments” criterion is, in theory, often applied to both creditor- and debtor-initiated proceedings, the issues that arise in its application in these two different cases will vary. Each is discussed now in turn, as well as the initiation of liquidation proceedings by the government.

Creditor Petitions

When a creditor files a petition to commence a liquidation proceeding, how does it demonstrate that the debtor has generally ceased to make payments? As noted earlier, insolvency laws are designed to be utilized when a debtor is unable to make its payments generally. Recourse to other laws (e.g., the laws on foreclosure) is normally relied upon when only a small amount of the debtor’s outstanding obligations are unpaid. However, while the creditor will be in a position to demonstrate the debtor’s nonpayment on its own claim, it will generally not have evidence that the cessation of payments is, in fact, of a general nature. It is therefore important that the law avoid placing an unreasonably heavy evidentiary burden on the creditors. Laws differ in the way they address this problem. In some cases, they may require the petition to be filed by a number of creditors. In other cases, upon the filing of a petition by a single creditor, the debtor is required by the court to furnish information that will enable it to determine whether the nonpayment is the result of the dispute with the creditor or part of a more general pattern of nonpayment due to a lack of liquid assets. Whichever approach is followed, most countries presume that an enterprise is unable to pay its debts generally if it has, in fact, generally ceased making payments as they become due.

The imposition of other hurdles upon creditors wishing to initiate liquidation proceedings should normally be discouraged. In particular, the law should not preclude or otherwise limit foreign creditors (i.e., nonresident creditors or nonresident-controlled creditors) from initiating liquidation proceedings. Given the important role that insolvency systems play in the development of commercial and financial relations, such a limitation would severely undermine a country’s ability to attract foreign investment and access international capital markets.

Debtor Petitions

As a technical matter, the commencement criterion that is applied to creditor petitions will often be applicable to debtor petitions. In practice, however, since a debtor normally only initiates liquidation proceedings as a last resort, when it does so the insolvency law normally presumes that the debtor has reached a stage where it is unable to pay its debts. Thus, although the laws of most countries may, in theory, apply a similar criterion for both debtor- and creditor-initiated liquidation proceedings, in practice the application of the criterion will not be scrutinized in the case of debtor-initiated petitions. In some cases, the criterion is dispensed with altogether.

The more difficult question that arises in the context of debtor-initiated petitions is whether the insolvency law should actually impose a duty upon a debtor to initiate proceedings at a certain stage of its financial difficulties. One approach to this problem is to include specific rules in the law that impose liability upon officers and directors for “trading while insolvent.” The advantage of this approach is that it forces debtors to initiate either liquidation or rehabilitation proceedings at an early stage. Such early filings increase the chances for rehabilitation or, at a minimum, protect creditor interests by preventing the further dissipation of the enterprise’s assets. However, the disadvantage of including such rules is that they may discourage management to attempt an out-of-court restructuring agreement, out of a fear that any delay in commencing formal proceedings may result in personal liability. If a country chooses not to rely on penalties as a means of forcing debtors to commence proceedings early, it may find it necessary to encourage debtors to do so through the creation of commencement incentives. As will be discussed in the next chapter, such incentives can be effectively incorporated into the rehabilitation procedure.

Initiation by a Governmental Authority

As noted in the previous section, regulated industries such as financial institutions may be subject to special insolvency regimes and, in these cases, the law may give the relevant regulatory agency of the government the exclusive authority to initiate insolvency proceedings against the debtor. In addition, the general insolvency law may give a governmental agency (normally the public prosecutor’s office or the equivalent) the nonexclusive authority to initiate liquidation proceedings against any enterprise if it ceases its payments or, more broadly in other countries, if it is considered in “the public interest.” In the latter cases, a demonstration of illiquidity may not be necessary, thus enabling the government to terminate the operations of otherwise healthy enterprises that have been engaged in activities—for example—of a fraudulent or criminal nature. While the exercise of such a police power may be appropriate in certain circumstances, efforts should normally be made to ensure that such powers are not abused and are exercised in accordance with clear guidelines.

Court Decision

It is normally for the court of competent jurisdiction to determine if the relevant conditions for commencement have been met. The decision should be published or made publicly available in the court’s registry. Because speed is critical in the context of insolvency proceedings, consideration can be given to requiring that the court render a decision within a specified period following the filing of a petition. Such a limit may be particularly important when the capacity of the judiciary is limited.

Principal Conclusions

Where the law establishes separate liquidation and rehabilitation procedures, it should allow liquidation proceedings to be commenced on the basis of a petition filed by either a creditor or the debtor. When the petition is filed by a creditor, it is advisable that the principal commencement criterion be a demonstration that the debtor has ceased making payments generally. Various tests can be used to determine whether, in fact, a cessation of payments is general. With respect to petitions filed by debtors, an important policy choice needs to be made as to whether the law should impose specific penalties on management for failing to commence proceedings upon a general cessation of payments. If it is decided that such penalties should not be imposed, it is advisable that, as an alternative, the law provide adequate incentives in the rehabilitation procedure to encourage debtors to utilize those procedures at a sufficiently early stage. If the capacity of the judiciary is limited, it may be advisable to require that the court render a decision regarding the commencement of a proceeding within a specified period following the filing of a petition.

Consequences of Commencement: Establishing and Protecting the Estate

Once liquidation proceedings have commenced, an insolvency law will normally provide that control over the assets of the debtor is transferred to an independent official and the assets are protected from the actions of both the debtor and its creditors. Although this section will describe those assets that are subject to this protection as the “estate,” differences in legal traditions of countries require an important, albeit technical, qualification regarding the use of this term. Specifically, the concept of an “estate” is only familiar in those countries that recognize divided ownership and trusts. In such countries, legal title over the assets is transferred to the designated official (“trustee”), and beneficial ownership in the “estate” vests with those that are eligible to receive the proceeds of the assets of the estate following liquidation, namely, the creditors. However, in those countries that do not recognize divided ownership, legal title continues to be retained by the debtor. Irrespective of the legal tradition of the country, the insolvency law of any country will normally need to address two issues. First, what property of the debtor will become subject to the control of the liquidator and be available for liquidation, that is, what are the assets of the “estate” (as a functional rather than legal concept)? Second, what measures will be taken to protect these assets from actions taken by the debtor and its creditors?

Assets of the Estate

As a general rule, the assets of the estate should include the property of the debtor as of the date the insolvency proceedings begin plus the assets acquired by the liquidator after that date. The liquidator should normally have the authority to abandon property of the debtor that it views as burdensome (e.g., useless equipment).

Property of the Debtor

The property of the debtor should normally include all assets in which the debtor has an ownership interest, whether or not these assets are in the debtor’s possession at the time of the commencement of the proceedings. This would include all tangible assets that would be readily found on the debtor’s balance sheet (e.g., cash, equipment, inventory, and real estate). It would also include intangible assets, which, depending on the stage of development in the country’s property law, will differ. Although it may be necessary to exempt some assets in the case of individuals, such an exemption is less justified—and not common—in the case of enterprises.

Assets excluded from the estate will normally include assets of a third party that are in the possession of the debtor when the proceedings commence, for example, trust assets and bailments. The treatment of assets being used by the debtor pursuant to a lease agreement where the lessor retains legal title (title retention agreements) merits special attention. In countries where the provision of such title financing is of considerable importance, it may be appropriate to respect the creditor’s legal title in the asset and allow it to be separated from the estate. Other countries may choose to scrutinize such financing arrangements to determine whether such leases are, in fact, disguised secured lending arrangements, in which case the lessor would be subject to the same restrictions as the secured lender.

Whether the debtor’s property located outside of the country where the proceedings are taking place will become part of the estate raises important cross-border issues and is addressed in the contribution of the UNCITRAL Secretariat, set forth in the Appendix.

Post-Commencement Assets

The estate should normally include all assets acquired by the liquidator after the commencement of the liquidation proceedings. Perhaps the most important among these assets are those acquired by the liquidator by exercising avoidance powers, which are discussed in a subsequent section. Moreover, to the extent that the liquidator continues to operate the debtor’s business prior to liquidation, assets acquired during this period would normally be included in the estate.

Protecting the Estate

An essential objective of an effective insolvency system is the establishment of a protective mechanism to ensure that the value of the estate’s assets is not diminished by the actions of various parties in interest. The parties from whom the estate needs the greatest protection are the debtor and its creditors. In the former case, the debtor must be displaced from any position of influence or control over the operation of the business since, upon the opening of the liquidation proceedings, beneficial ownership in the assets of the estate effectively shifts from the debtor to its creditors. Protective measures are therefore also needed to ensure that the debtor does not remove assets from the estate immediately before or after the liquidation proceedings commence.

While creditors are the future beneficiaries of the estate, one of the fundamental principles of insolvency law is that measures are also needed to protect the creditors’ collective and common interest from individual actions of one of them. The “stay” on creditor actions against the estate that is normally established once the liquidation proceedings commence enhances the collective interests of creditors by imposing limitations on the exercise of individual creditor interests. However, as will be discussed in subsequent sections, the nature and scope of this stay varies considerably among countries, this variation reflecting differing legal traditions and policy choices.

Interim Protective Measures

Between the time when the debtor or creditor petitions the court to open liquidation proceedings and the time this petition is granted, the debtor’s assets are in danger of being dissipated even before the estate has been created. Upon the filing of the petition, the debtor may be tempted to transfer assets out of the business. Moreover, upon learning that a petition has been filed, other creditors may take remedial legal actions against the debtor to preempt the effect of any stay that will be imposed when the court makes a positive determination. An insolvency law should therefore consider providing for the imposition of interim protective measures to preserve the estate before the opening of an insolvency proceeding. Generally, the court will impose such measures at its discretion or upon a creditor’s request. Interim protective measures may include appointing a preliminary liquidator, prohibiting the debtor from disposing of assets, sequestering some or all of the debtor’s assets, and suspending enforcement of security interests against the debtor (the treatment of secured creditors is discussed extensively below). In some countries, if the debtor enters into transactions during this period, those transactions are void. Since these are provisional protective measures that are provided before a judicial determination is made that the commencement criteria have been met, the court may request a petitioning creditor to provide evidence that the measure is necessary and, in some cases, may require a bond from the petitioning creditor.

Protection Against the Debtor

Once the liquidation proceedings are opened, the conservation of the estate requires the imposition of comprehensive measures to protect the estate from the debtor. For this reason, the debtor is normally divested of all rights to manage and operate the business and a liquidator is appointed to assume all responsibilities divested by the debtor, including the right to initiate and defend legal actions on behalf of the estate and the right to receive all payments directed to the debtor. Initially, the liquidator inventories the estate’s assets and may freeze (or “seal”) them. Upon the commencement of the proceedings, any actions that are taken by the debtor that are detrimental to the estate are normally void.

Upon the commencement of the proceedings, the debtor should be required to disclose all of its assets and liabilities and any questionable transactions. Violations of this rule should give rise to penalties.

There may be circumstances in which a liquidator or the court determines that the most effective means of liquidating the estate is to sell it as a going concern. In such situations, even though the law may give him complete control over the estate, the liquidator may decide to permit the debtor to retain some control over the operation of the business until it is sold. In these cases, the liquidator would be liable for the wrongful acts of the debtor during this period and would normally only take such a step after consultation with the creditors.

Protection Against Creditors

One of the principal purposes of an insolvency law is to provide for the imposition of a “stay” on the ability of creditors to enforce their rights through legal remedies during the period of the liquidation proceedings. Such a stay is necessary not only to provide the liquidator with adequate time to avoid making a forced “fire sale” that fails to maximize the value of the assets being liquidated, but also to provide the liquidator with an opportunity to sell the enterprise as a going concern.

Notwithstanding the above, the scope of the rights that are affected varies considerably among countries. There is little debate regarding the need to impose a stay on the ability of unsecured creditors to attach assets as a means of enforcing their contractual claims and precluding all creditors from initiating legal proceedings to recover debts that accrued before the proceedings were initiated. Although the stay may need to apply to secured creditors for a limited period, the coverage of secured creditors raises a number of difficult issues, which are discussed in the next section. Regarding the ability of creditors to exercise other contractual rights, countries vary as to whether they give the liquidator the power to interfere with set-off rights and contractual provisions that provide for termination upon bankruptcy or those that preclude assignment. These subjects are also discussed later. One of the key issues in the design of an effective insolvency law is how to balance the immediate benefits that accrue to the estate by having a broad stay with comprehensive powers given to the liquidator, on the one hand, and the longer-term benefits that are derived from limiting the degree to which this stay interferes with contractual relations with creditors, on the other hand.

Protection Against the Liquidator

Given the broad powers that are conferred upon the liquidator, the estate must be protected against abuse or incompetence by the liquidator. As will be discussed later, such measures should normally include court supervision, creditor or court approval, and personal liability.

Principal Conclusions

Upon commencement of the liquidation proceedings, all assets in which the debtor has an ownership interest as of that date should be transferred to an independent, court-appointed liquidator. The debtor should be required to disclose all assets and questionable transactions.

During the proceedings, all assets over which the liquidator exercises control should be protected by a “stay” on the ability of unsecured creditors to enforce legal remedies against the assets of the estate. Although the scope of the stay may vary among countries, it should, at a minimum, preclude unsecured creditors from (i) attaching, selling, or taking possession of assets as a means of enforcing their claims, or (ii) initiating legal proceedings to recover debts incurred before the liquidation proceedings were commenced. While the stay should apply to secured creditors for a limited period, important limitations need to be imposed with respect to the coverage of these creditors (see next section).

Once a petition for commencement has been filed, it is advisable to give the court the authority to impose interim measures to protect the debtor’s assets pending a determination of commencement by the court. The range of measures should normally include full or partial divestiture of the debtor’s control over the assets, the appointment of an interim administrator, and the imposition of a stay on the ability of creditors to attach assets.

Proceedings: Specific Issues

Treatment of Encumbered Assets and Secured Creditors

Creditors generally seek security for the purpose of protecting their interests if the debtor fails to repay. If security is to achieve this objective, it can be argued that, upon the commencement of insolvency proceedings, the secured creditor should not in any way be delayed or prevented from immediately foreclosing upon its collateral. Whether or not this argument is accepted, the introduction of any measures that erode the value of security interests requires careful consideration. Such an erosion will ultimately undermine the availability of affordable credit: as the protection provided by security interests declines, the price of credit will invariably need to increase to offset the greater risk. Indeed, under certain market conditions, creditors may be unwilling to provide even secured credit at any price.

Notwithstanding this imperative, it is increasingly recognized that permitting secured creditors to freely separate their collateral from the other assets in the estate can frustrate the basic objectives of insolvency proceedings. As will be discussed in Chapter 4, this is particularly obvious in the case of rehabilitation. Where estate assets essential to the operation of the debtor’s business are encumbered by the security interests, the fact that secured creditors can immediately enforce their claims at the commencement of the rehabilitation proceedings may make it impossible for the debtor to keep its business in operation while it formulates a rehabilitation plan. However, this is also true—but to a lesser extent—under liquidation proceedings: the exclusion of secured creditors from the general stay on creditor actions may frustrate the liquidator’s ability to maximize the value of the estate prior to distribution. In particular, if important assets serve as collateral, the liquidator will be unable to sell the debtor’s business—or any business division—as a going concern. Moreover, even if the debtor’s assets cannot be sold as a going concern, a temporary stay will give the liquidator time to arrange a sale that will give the highest return for the benefit of all unsecured creditors.

To balance the above considerations, any stay on secured creditors must be accompanied by measures that protect the interests of secured creditors during the liquidation proceedings. Two measures are of particular importance. First, the stay should be in place only when it protects the value of the estate. Thus, upon commencement of a liquidation proceeding, it is reasonable that the stay automatically apply to secured creditors for a brief period (e.g., 30 or 60 days), to give the liquidator the opportunity to assume its duties and take stock of the assets and liabilities of the estate. While the court would have the authority to extend such a “cool down” period, it should normally only be granted upon a demonstration by the liquidator that such an extension provides a necessary means of maximizing the value of the estate because, for example, there is a reasonable possibility that the enterprise, or units of the enterprise, can be sold as a going concern. To provide additional protection, the law should impose a limit on how long the stay can be extended. Such a limit may be particularly important in cases where the capacity of the institutional infrastructure is limited.

The second set of measures that are necessary to protect the interests of secured creditors are those that maintain the economic value of the secured claims during the period of the stay. Various approaches can be taken to achieve this protection.

Protecting Collateral

One means of protecting the value of the secured claim is to protect the value of the collateral itself, on the understanding that, upon liquidation, the proceeds of the sale of the collateral will be distributed directly to the creditor to the extent of the value of the secured portion of its claim. If this approach is followed, the following steps need to be taken to protect the collateral.

Compensation for Depreciation. During the period of the stay, it is possible that the value of the creditor’s collateral will depreciate. Since, at the time of the eventual distribution, the extent to which the secured creditor will receive priority will be limited by the value of the collateral, such a depreciation will prejudice the secured creditor’s interests. Accordingly, as is specifically provided by a number of laws, the liquidator should be required to compensate the secured creditor for the amount of this depreciation, either by providing substitute collateral or by making periodic cash payments that correspond to the amount of depreciation.

Payment of Interest. Some countries that protect the interests of the secured creditor by preserving the value of the collateral also allow for payments of interest during the period of the stay, but only to the extent that the creditor is oversecured, that is, to the extent that the value of the collateral exceeds the value of the secured claim. By permitting the payment of interest only in these circumstances, the law provides a strong incentive for a creditor to seek collateral that exceeds the value of its claim.

Protection and Compensation for Use. In some cases, the liquidator may find it necessary to use or sell encumbered assets prior to liquidation. For example, to the extent that the liquidator is of the view that the value of the estate can best be maximized if the business continues to operate for a temporary period, the liquidator may wish to sell inventory that is partially encumbered. Thus, in cases where secured creditors are protected by preserving the value of the collateral, it would seem appropriate for the law to give the liquidator the choice of providing the creditor with substitute equivalent collateral or paying the full amount of the secured claim.

Lifting the Stay. In cases where the insolvency laws require that the value of the collateral be protected during the period of the stay, a mechanism needs to be in place to ensure that the stay will be lifted when necessary to protect the secured creditor’s interests. At least two circumstances can be envisaged. Under the first, the secured creditor requests the lifting of the stay on the grounds that it is not receiving adequate protection. Alternatively, the liquidator, on its own initiative, may release the collateral on the grounds that the provision of adequate protection may not be feasible or would be overly burdensome to the estate. In addition, the law may create exceptions to the stay to exclude assets that are generally not needed to sell the business as a going concern, such as cash collateral.

Protecting the Value of the Secured Claim

As an alternative to a system that preserves the value of the asset used as security, some countries protect the interests of secured creditors by protecting the value of the secured portion of the claim. Specifically, immediately upon the commencement of the proceedings, the encumbered asset is valued and, based on that valuation, the value of the secured portion of the creditor’s claim is determined. This value remains fixed throughout the proceedings and, upon distribution following liquidation, the secured creditor receives a first-priority claim to the extent of that value. Moreover, during the proceedings, the secured creditor receives the contractual rate of interest on the secured portion of the claim to compensate him for the delay that is imposed by the proceedings.

Principal Conclusions

As a general principle, an insolvency law should strike a balance between, on the one hand, preventing secured creditors from undermining the objective of maximizing the value of the assets of the estate and, on the other hand, protecting the interests of such creditors so that the value of their security—and, as a consequence, the availability of credit—is not eroded. To implement this principle, the liquidation procedure should normally provide for the following.

(1) For a brief—and specified—period following the commencement of the liquidation proceedings (e.g., 30 or 60 days), the general stay on creditor enforcement should also apply to secured creditors, thereby precluding them from enforcing their contractual rights upon the collateral during the proceedings, subject to the qualifications described below. The stay should normally be extended beyond this period by the court only upon a demonstration by the liquidator that such an extension provides a necessary means of maximizing the value of the assets of the estate for the benefit of creditors generally (e.g., because of the possibility of selling the enterprise or units of the enterprise as a going concern). It may be advisable for the law to impose a limit on the period of extension.

(2) Exceptions to this stay may be appropriate with respect to those assets that are generally not necessary for a sale of the business as a going concern (e.g., cash collateral).

(3) During the period of the stay, a mechanism should exist that ensures that the interests of the secured creditor are adequately protected. Where this protection is provided by preserving the value of the creditor’s collateral, these measures should include, for example, compensation for the depreciation of the collateral and, if the collateral is to be used or sold by the liquidator, the provision of replacement collateral. Countries may, as an alternative, protect the interests of the secured creditor by fixing the value of the collateral at the commencement of the proceedings and giving the secured creditor a first-priority claim based on that value, plus a priority claim for regular payments of contractual default interest.

(4) Where the liquidator is unable to provide a secured creditor with the type of protection described above, the stay against the secured creditor should be lifted.

Avoidance of Pre-Commencement Transactions and Transfers

A debtor may enter or be placed into insolvency proceedings days, weeks, months, or sometimes years after recognizing that this outcome is inevitable. In anticipation of the formal commencement of insolvency proceedings, therefore, debtors may deviate from their ordinary business practices by attempting to hide assets from their creditors, incurring artificial liabilities, favoring certain creditors over others, or making donations to relatives or friends. Even though some of these activities might be perfectly permissible outside an insolvency context, the detrimental effects of such actions for the general unsecured creditors—that is, those who were not parties to the said actions and who are not fully secured—become unacceptable once a procedure has been opened, since this undermines the objective of equitable treatment among creditors.

For this reason, insolvency laws should set forth a mechanism that recaptures assets whose transfer prior to the commencement of the proceedings has such a detrimental effect. The design of the avoidance provision requires the resolution of a number of technical issues that will, in turn, reflect important policy choices. On the one hand, the stronger such avoidance rules, the greater the increase in the value of the estate for the advantage of the common creditors. In addition, strong avoidance rules may, in some cases, assist the debtor in its out-of-court negotiations since it creates a disincentive for a single creditor to take legal action to obtain an advantage, thereby facilitating collective creditor action. On the other hand, it should be borne in mind that very broad avoidance powers may undermine the predictability of contractual relations. This is particularly the case where the transactions and transfers are perfectly normal, but are voidable simply because they occurred in the proximity of the commencement of the proceedings.

Designing the Mechanism

In many respects, designing an avoidance provision involves making choices regarding evidentiary rules. One approach emphasizes the reliance on generalized, objective criteria for determining whether transactions or transfers are avoidable. Did the transaction or transfer take place within the period prior to commencement that is specified in the law? Does the transaction or transfer contain any of the general characteristics specified in the law (e.g., inadequate consideration)? Another approach emphasizes case-specific, subjective criteria. Is there evidence of an intent to hide assets from creditors? Was the debtor insolvent when the transaction or transfer was made and did the counterparty know of this insolvency? As is always the case in insolvency, there are advantages and disadvantages to both approaches. Generalized, objective criteria provide for simplicity in application. However, if relied upon exclusively, they can also result in arbitrariness. For example, while perfectly legitimate and useful transactions that fall within the specified period may be voided, fraudulent or preferential transactions and transfers that happen to fall outside the period may be protected. To prevent such arbitrariness, consideration should be given to designing an avoidance provision that attempts to reach an appropriate balance between both approaches. Whatever approach is adopted, it is generally accepted that stricter rules should be applied to transactions and transfers made to insiders (i.e., persons who have a close corporate or family relation to the debtor or its creditors). A stricter regime for such transactions is generally justified on the grounds that insiders are more likely to be favored and tend to have the earliest knowledge of when the debtor is, in fact, insolvent.

Set forth below are the categories of transactions and transfers that are most commonly covered under avoidance provisions.

(1) Transactions and transfers made where there is evidence of the debtor’s actual intent to defraud creditors by placing assets beyond their reach and where the counterparty knew of such an intent. Such transactions and transfers constitute actual fraud in that there is evidence that both the debtor and the counterparty had the subjective intent to defraud creditors. Many insolvency laws do not limit the period during which such transactions and transfers can be avoided.

(2) Transactions and transfers with a third party for inadequate consideration. This category is often described as giving rise to constructive fraud: an intent to defraud is presumed whenever the transaction is unbalanced and does not appear to be made at “arm’s length.” Gifts (which can include, for example, debt forgiveness) are also included in this category. While most laws specify a maximum retroactive period (calculated from the date of commencement) during which such transactions and transfers can be voided, some laws also require a finding that the debtor was insolvent or was about to become insolvent when the transaction or transfer took place.

(3) Transactions and transfers to creditors that are “voluntary.” Unlike (1) and (2) above, these transactions and transfers are limited to those with creditors and address the problem of preferential treatment of certain creditors over others. Many laws provide that, where the debtor gives a benefit to an individual creditor who is not legally entitled to that benefit, such a transaction or transfer is evidence of a preference and is avoidable. Such transactions and transfers include, for example, early payments on a debt or the provision of a security interest on an existing debt. As in the case with (2) above, a maximum retrospective period is normally established in the law, with many countries also requiring evidence of insolvency (or near insolvency) when the transaction took place.

(4) Ordinary transactions and transfers with creditors. A number of countries allow for the nullification of transactions with and transfers to creditors, even when they do not include any “voluntary” features; for example, payments made to a creditor on or after the due date. The rationale for including such transactions and transfers is that, in cases where such transactions and transfers occur very close to the commencement of insolvency, there should be a presumption that insolvency actually existed when the payment was made and that, therefore, the creditor in question received preferential treatment. Since these transactions and transfers are normal in every other sense, the retroactive period is very brief (30–90 days). Moreover, some countries will only allow for nullification if the creditor knew (or should have known) that the debtor was insolvent. Other countries make exceptions for transactions and transfers made in the ordinary course of business. Thus, for example, while payment made upon the receipt of goods that are regularly delivered (and paid for) could not be nullified, payment on a long overdue debt could be.


If a transaction or transfer falls into the above categories, the law will either render it automatically void or make it voidable. If the latter approach is followed, the exercise of discretion will be required, which is normally left to the liquidator, as to whether the avoidance of the transaction or transfer will be beneficial to the estate, taking into account the delays involved in recovering the transfer (which may be of relevance when liquidation is imminent) or the possible costs of litigation. The scope of the liquidator’s discretion is, of course, limited by its own obligation to maximize the value of the estate, and it may be responsible for its failure to do so, depending on the scope of its liability (which is discussed in a subsequent section). In that context, the law may permit a creditor or the creditors’ committee to act on behalf of the estate and to void these transactions and transfers. A creditor could be allowed by the law to obtain a court injunction requiring the liquidator to initiate an avoidance action that appears to be beneficial to the estate.

Principal Conclusions

The liquidation procedure should set forth a mechanism that enables the liquidator to recapture assets that the debtor transferred prior to commencement, where such transfers prejudice creditors generally. The avoidance provision should specify the type of transactions and transfers that should be covered and the maximum “suspect period” prior to commencement during which these transactions and transfers will be subject to avoidance. Stricter rules should normally apply to transactions and transfers with insiders. At a minimum, it is advisable for the following types of transactions and transfers to be included.

(1) Transactions and transfers made where there is evidence of the debtor’s actual intent to defraud creditors by placing assets beyond their reach and where the counterparty knew of such an intent. No maximum period need be specified in the insolvency law.

(2) Transactions and transfers for inadequate consideration, including gifts, that took place when the debtor was insolvent or about to become insolvent, with a maximum period specified.

(3) “Voluntary” transactions and transfers to creditors, where, for example, the debtor makes early payments on a debt or provides a security interest on an existing debt. A demonstration of actual or imminent insolvency may be necessary, with a maximum period specified.

In addition, it may be desirable—but is not necessary—to provide the liquidator with the authority to nullify transactions and transfers to creditors that are not in any way irregular but that occur during a very brief period (no longer than 90 days unless the creditor is an insider) and where there is evidence that the creditor knew or should have known of the insolvency. However, there may need to be exceptions for transactions and transfers made in the ordinary course of business.

Treatment of Contracts

It is inevitable that, at the commencement of a liquidation proceeding, the debtor will be party to a contract that has not yet been fully performed. Insolvency laws will, to varying degrees, give the liquidator the authority to interfere with the terms of contracts that, ordinarily, have not been fully performed by both the debtor and the counterparty. While this interference serves to further one of the broad objectives of liquidation proceedings, that of value maximization, it often needs to be weighed against competing social and political interests, particularly with respect to labor and lease contracts. Moreover, as in the case of avoidance provisions, the right of liquidators to interfere with the terms of unperformed contracts will undermine the predictability of commercial and financial relations. As will be seen, defining the scope of a liquidator’s powers in this area requires a balancing of these considerations.


As a general matter, it is important that a liquidator or the court be given the authority to terminate a contract in which both parties have not yet fully performed their obligations. For example, before commencement of the proceedings, the debtor may have reached an agreement with a supplier to deliver goods for a specified price. When the liquidation proceedings commence, only some of the goods may have been delivered and payment may still be due. In these circumstances, the liquidator should normally be given the right to terminate the contract, in which case the counterparty would be excused from performing the rest of the contract and would become an unsecured creditor with a claim equal to the amount of damages caused by the termination.


In some cases, continuation of a contract will be more valuable to the estate than its termination. For example, the debtor may be the lessee under a lease agreement where the rental is below market value, and a substantial term still remains under the lease. In these cases, the liquidator may wish to continue the lease in order to sell the debtor’s business as a going concern with the lease intact. To give some assurance to the counterparty, it is generally recognized that the liquidator should indicate whether it will continue or terminate the contract within a specified period following the initiation of liquidation proceedings. Moreover, in the event of continuation, the law should protect the counterparty by ensuring that the cost of performance and any damages arising from a breach by the liquidator be an administrative (i.e., priority) expense. Since the granting of such a priority will constitute a risk for other creditors (who will be paid after the priority creditor), a liquidator will normally seek to continue only those contracts that it expects to be profitable.

As long as the terms of the contract in question do not preclude the liquidator from continuing the contract, the liquidator’s assumption is unobjectionable. Indeed, subject to the principle of “quid pro quo,” it is appropriate that the liquidator have this option. However, one of the key issues raised under an insolvency law is whether a liquidator may elect to continue a contract even if such continuation is inconsistent with the terms of the contract. Many commercial and financial contracts provide that initiation of an insolvency proceeding will automatically constitute an event of default under the agreement by the debtor, giving the counterparty the unconditional right to terminate the contract (sometimes referred to as “ipso facto” clauses). Under one approach, such termination clauses will be honored, in which case the liquidator will be able to continue the contract only if the counterparty elects not to terminate the contract. In such cases, the counterparty may be induced to consent to continuation because it is usually afforded priority of payment for services rendered after the commencement of bankruptcy proceedings. In contrast to this “consensual” continuation approach, another approach actually allows the liquidator to continue the contract over the objection of the counterparty; that is, any termination clause will be nullified by operation of the bankruptcy law.


The ability of a liquidator or administrator to continue the contract over the objection of the counterparty provides the debtor with a particularly important tool to effect a rehabilitation (as is discussed later). In the context of liquidation, this ability will also be of considerable benefit when, following a decision to continue the contract, the liquidator can assign the agreement to a willing third party for value. Applying the example, described above, of the lease agreement that provides for rental payments that are below market value, the liquidator may wish to enhance the value of the lessee’s estate by assigning the lease to a third party for a price. However, many agreements preclude a party from assigning the lease without the consent of the counterparty and, in many countries (particularly of the civil law tradition), assignment will not be permitted—even in insolvency—without the consent of all parties, unless it is part of the sale of a business as a going concern. Nevertheless, consistent with the broad assumption powers provided to a liquidator discussed above, some countries provide in the insolvency law that the effectiveness of these nonassignment clauses are null and void, thus enabling the liquidator to effect the assignment for the benefit of the estate. While this option is considered of critical importance in the liquidation proceedings of some countries, it is entirely foreign to many others and is precluded.

The ability of the liquidator to elect to continue and assign contracts in violation of the terms of the contract can have significant benefits to the estate and, therefore, the beneficiaries of the proceeds of distribution following liquidation. However, this ability clearly undermines the contractual rights of the counterparty to the contract. Moreover, assignment raises issues of prejudice to the nondebtor party to the agreement, especially where it has little or nothing to say in the selection of the substitute to the debtor. Therefore, in circumstances where such continuation and assignment are allowed, it would be appropriate to require the liquidator to demonstrate to the counter-party that the assignee can adequately perform under the contract. Moreover, as noted above, any claims arising from the performance of the contract after the commencement of insolvency proceedings should be treated as an administrative expense and, therefore, be given priority in distribution.

Special Contracts

Irrespective of the breadth of the termination or continuation powers given to a liquidator, exceptions may need to be made for certain contracts. Perhaps the most notable example of a liquidator’s rejection powers being limited is in the administration of labor contracts. Although the protection of labor contracts will be particularly relevant in rehabilitation proceedings, it may also be relevant in liquidation proceedings. Specifically, in circumstances where the liquidator is attempting to sell the enterprise as a going concern, a higher price may be obtained if the liquidator is able to terminate onerous employment contracts. Countries may specifically limit this capability out of concern that this type of liquidation may be used expressly to eliminate the protection afforded to employees by such contracts. An additional issue relates to lease agreements: if the debtor is a lessor, limitations may be imposed on the ability of the liquidator to terminate lease agreements.

Exceptions to the power of the liquidator to continue contracts can generally be placed in two categories. First, if the liquidator is given the power to nullify termination provisions, specific exceptions may be made to this power for specific types of contracts. Perhaps the most important exceptions in this category are short-term financial contracts, such as swap and futures agreements, which are discussed later. The second category relates to those contracts where, irrespective of whether the law provides for the nullification of a termination provision, the contract cannot be continued because it provides for performance by the debtor of personal services.

Principal Conclusions

Liquidation procedures should give the liquidator the authority to terminate or continue contracts that have not been fully performed by both parties. Designing the scope of this power requires making important policy choices: while broader termination or continuation powers maximize the value of the assets of the estate, they also cause greater interference with contractual relations. Moreover, these powers may need to be limited with respect to certain types of contracts.

(1) Termination. The liquidator should have the authority to terminate unperformed contracts. Upon termination, the counterparty will become an unsecured creditor with a claim equal to the amount of damages caused by the termination. Countries may choose to limit this power with respect to special contracts, such as labor contracts or lease agreements (where the debtor is the lessor)—a limitation that will be relevant in liquidation proceedings where there is an intent to sell the enterprise (or a business unit of the enterprise) as a going concern.

(2) Continuation and assignment. The liquidator should normally have the power to choose to continue performance of the contract (including assignment of performance) if such continuation is not precluded by the contract’s terms. If such a decision is made, the counterparty should be afforded priority of payment (as an administrative expense) for any performance rendered after the commencement of the liquidation proceedings. If a country chooses to allow the liquidator to continue or assign a contract in contravention of its terms, it should require the liquidator to demonstrate that the contract can be adequately performed by the liquidator or the assignee. Exceptions to continuation powers will normally need to be made with respect to special contracts, such as financial and personal services contracts.


An important issue that arises in the design of an insolvency law is the treatment of a creditor who, at the time of the initiation of the liquidation proceedings, also happens to be a debtor to the estate. If the fundamental principle of equality of treatment of similarly situated creditors were applied, the outcome would be relatively straightforward: the liquidator should be able to receive the full amount owed by the creditor and the creditor’s claim would be satisfied to the extent to which all other unsecured creditors get satisfied upon the liquidation of the estate. However, an alternative approach permits the creditor, in these circumstances, to exercise set-off rights against the estate after liquidation is initiated, with the effect that, depending on the size of the estate’s claim on the creditor, the creditor’s claim may be satisfied in full.

There are several reasons why it may be appropriate to include the right of set-off in an insolvency law. The first is that of fairness: notwithstanding the importance of equality of treatment among creditors, it is considered unfair for a debtor to refuse to make payment to a creditor but, at the same time, to insist upon payment from that creditor. In addition, since many counterparties are banks, the right of set-off is particularly beneficial to the banking system and, because of the important credit creation role of banks, is therefore considered to be of general benefit to the economy. By virtue of their core functions (lending and deposit taking), banks that have lent to an entity that has gone bankrupt will often find that they have financial obligations to the debtor in the form of deposits. A post-commencement right of set-off would allow the banks to offset their unpaid claims with the debtor’s deposits even though these reciprocal claims are not yet due and payable.

Even among countries that do not provide for a general right of set-off in the context of insolvency, set-off will still normally be permitted in two circumstances: if both claims are mature at the time insolvency takes place, or if the mutual claims arise from the same transactions.

The right of set-off interacts with other provisions of insolvency in a number of important respects. For example, the right of a creditor to set-off following the initiation of insolvency proceedings will be subject to the avoidance provisions if the claim held by the debtor was received by the creditor during the suspect period. In addition, to the extent that an insolvency law generally nullifies termination (“ipso facto”) clauses and, thereby, allows the liquidator to assume unperformed contracts, a creditor will only be able to exercise set-off rights regarding mutual monetary claims if the right of the liquidator to nullify such clauses is expressly limited to allow for a creditor to terminate the contract and set off these claims. This is particularly applicable in the context of short-term financial transactions, which is discussed in detail in the next section.

Principal Conclusions

A pre-commencement right of set-off existing under general law should be protected during liquidation proceedings and generally should be exercisable by both the creditors and the estate. Moreover, the law should also permit post-commencement set-off if the mutual claims arise under the same transaction. In addition, countries may also wish to consider allowing for post-commencement set-off in other circumstances, particularly with respect to mutual financial obligations.

Financial Contracts and Netting

Depending on how an insolvency law addresses issues relating to the treatment of contracts and set-off rights, it may or may not need to include specific provisions regarding certain types of short-term financial contracts, including derivative agreements (e.g., currency or interest rate swaps). The terms of the master agreements governing these individual transactions, which have become increasingly standardized, normally contain provisions that enable one party, upon the commencement of the insolvency of the other party, to net the total of all its gains and losses and all unpaid amounts on separate transactions. Such “close-out netting” provisions, which aggregate all independent payment obligations, are normally effective only upon the insolvency of one of the parties if the insolvency law contains two features. First, it must allow for the termination (or “close-out”) of all outstanding transactions under the agreement upon the insolvency of a party, and second, it must allow for the noninsolvent party to set off its claims against its obligations to the insolvent party.

As was discussed earlier, a number of countries have insolvency laws that do not contain both these features. With respect to termination, some countries allow a liquidator to elect to continue the contract in contravention of the termination provisions of the contract. With respect to set-off, a number of countries do not allow for the set-off of independent financial claims that are not mature at the time of commencement.

Many countries that do not possess general rules that provide for both termination and set-off have carved out exceptions to these general rules for the specific purpose of allowing “close-out netting” for financial contracts. They have done so because such transactions have become an increasingly important component of the global financial market and, in the absence of certainty regarding netting upon the insolvency of one party, access to such transactions would be severely restricted. Notwithstanding these important advantages, it is recognized, however, that such a “carve-out” will complicate the law and will result in preferential treatment for certain types of creditors.

Principal Conclusions

In countries where post-commencement set-off is not permitted for mutual financial obligations or where the liquidator is able to interfere with contract termination provisions, it may be necessary to make an exception to these rules so that “close-out netting” provisions contained in financial contracts between the debtor and another party can be applied with certainty.

Liquidation and Distribution

Liquidation Procedure

An effective insolvency system must also provide for procedures that ensure the assets of the estate are sold and distributed in a timely, predictable, and equitable manner. Moreover, the liquidator should try to ensure that the sales price is maximized but that the cost of the sale and the distribution is limited. This subsection deals with procedural aspects of the liquidation process, while the next subsection provides a comparative analysis of the substantive priority rules for distribution.

In many respects, the first step in the liquidation procedure is the identification and collection of the estate’s assets. Once the assets have been identified, the liquidator must identify and verify the liabilities of the estate. It then must sell the assets in accordance with a transparent procedure that will maximize the value of the assets being sold. Finally, it must distribute the proceeds in accordance with the priority rules set forth in the law. The verification of claims procedure, the treatment of claims of foreign creditors, and the procedure applicable to the sale of the assets are all important related issues.

Verification of Claims

Most laws provide for the liquidator to verify the claims of the creditors of the debtor. This involves not only an assessment of the underlying legitimacy and amount of the claim, but also a determination of the category within which this claim fits for distribution purposes (e.g., secured versus unsecured, pre-petition versus post-petition). Most laws place the burden upon the creditors to produce evidence of their claims to the liquidator for its review. If the liquidator challenges any aspect of a creditor’s claim, this dispute will need to be adjudicated by the relevant court. Some countries also permit other interested parties, including creditors, to challenge a claim. In that context, review of a final list of creditors’ claims might be advisable, at one or more creditor assemblies following preparation of such a list by either the court or the liquidator. As a means of ensuring transparency, it is critical that adequate and timely notice be provided. If it is, liquidation can be expedited by establishing deadlines by when creditors must file their proof of claims. As a sanction for delay, it may be provided that late-comer creditors will either be excluded from distributions altogether or participate ratably only in the distribution of any assets remaining after the verification of claims.

Foreign Creditor Claims

As noted elsewhere, foreign creditors should normally be afforded nondiscriminatory treatment during the insolvency proceedings.5 The valuation of foreign exchange claims is of particular relevance to foreign creditors. For verification and distribution purposes, such claims are normally converted into the domestic currency at the exchange rate prevailing on the day when the proceedings are opened. Accordingly, to the extent the domestic currency depreciates or appreciates during the period prior to distribution, the amount of foreign exchange actually received by the creditor will be affected. To address this problem, consideration could be given to revising this approach so that the exchange rate prevailing at the time of distribution is utilized, at least in circumstances where the depreciation or appreciation exceeds a specified percentage.6

Methods for Disposition of Assets

The sale of assets as part of a going concern or as part of business units often produces greater value for creditors at distribution than does a sale of individual assets. Although an insolvency law may reflect this preference in the law itself, this may not be necessary since it is assumed that the liquidator will follow whichever course will maximize the proceeds for distribution.

One area, however, where the law will normally need to provide some guidance is the sales procedure that may be utilized by the liquidator. To ensure that the liquidator sells the assets in question in a manner that will maximize the sales price, some limits may need to be imposed on the discretion of the liquidator’s ability to choose the method of sale. In cases where the liquidator chooses to conduct the sale privately rather than through a public auction, the law may need to ensure that the sale is adequately supervised by the court or that it is approved by the creditors. To avoid collusion, the law may need to specifically preclude the sale from being made to insiders, that is, to the debtor, the creditors, or related parties. As long as the sale is adequately supervised, however, an absolute prohibition on sales to insiders may not be necessary. Whichever method is utilized, it is critical that creditors receive adequate notice of the sale.

Principal Conclusions

The procedure for liquidating assets should be timely and efficient and should provide for a sale that maximizes the value of the assets being liquidated. To that end, the law should normally allow for both public auctions and private sales, with the requirement that, in the latter case, the sale is either supervised by the court or approved by the creditors, or both. Adequate notice of any sale should be given to creditors.

Priority of Distribution

All insolvency laws need to incorporate the principle that, for purposes of determining the priority of distribution of the proceeds of the estate, creditors should be ranked by categories. Such a ranking is not, in and of itself, inconsistent with the principle of equitable treatment. On the contrary, to the extent that different creditors have struck fundamentally different commercial bargains with the debtor, the ranking of creditors may actually be required as a matter of equity. Indeed, the priority system can provide an important instrument for facilitating the provision of credit. Most important, if a secured creditor is given the equivalent of a first priority at the time of distribution (or receives directly the proceeds of the sale of collateral), it facilitates the provision of secured credit.

Another acceptable basis for providing priority relates to the conduct of the insolvency proceedings themselves. Specifically, to create incentives for professionals, particularly the liquidator, to perform the necessary services to ensure the insolvency proceedings are orderly and effective, the insolvency law must normally provide that these professionals receive compensation from the proceeds of liquidation on a priority basis. Applying the same principle, to attract financing once the insolvency proceedings have commenced, priority will also need to be given to “post-petition” creditors. While the provision of this assurance is generally viewed as essential in the context of rehabilitation proceedings, it can also be important in the context of liquidation proceedings, particularly where the liquidator considers that the value of the estate can be maximized by the temporary continued operation of the estate (which may occur, for example, if it is attempting to sell the enterprise as a going concern).

While a ranking based on either contractual terms or the provision of services or financing during the insolvency proceedings, as described above, may provide an important means of meeting the objectives of liquidation proceedings, the relevance of “privileges” based on social and political consideration may be less obvious, but these are still very prevalent.

Secured Claims

The method of distribution to secured creditors depends on the method used to protect the secured creditor during the proceedings. If these interests were protected by preserving the value of the collateral, the secured creditor has a first-priority claim on the proceeds of its collateral to the extent of the value of the secured claim. Alternatively, if the interests of the secured creditor were protected by fixing the value of the secured portion of the claim at the time of the commencement of the proceedings, the creditor has a first-priority claim to the general proceeds with respect to that value. Of course, if the secured creditor’s claim is in excess of the value of the collateral or (if the alternative approach is followed) the value of the secured claim as determined at commencement, the unsecured portion of its claim will be treated as an unsecured claim for distribution purposes.

Exceptions to this first-priority rule should be limited. One such exception relates to administrative expenses associated with the maintenance of the collateral. Specifically, if the liquidator has expended resources in maintaining the value of the collateral, it may be reasonable for these expenses to be deducted as administrative expenses.

Administrative Expenses

Subject to the above exceptions, the first priority for distribution among unsecured claims will normally be payment of administrative expenses. Administrative claims usually include court costs and fees of the liquidator, payments relating to contracts that were entered into—or continued—by the liquidator after the commencement of the proceedings, and all other expenses relating to the collection, management, appraisal, and distribution of the assets of the estate. As noted above, priority for such expenses is justified by the fact that, absent such preferential treatment, the liquidation process would not be able to attract the resources, both human and financial, necessary to make it succeed. Some countries give the same rank as administrative claims to claims for employee compensation that have accrued prior to the commencement of the proceedings. As with other privileges described below, this ranking reflects a policy choice to ensure that the rights of employees are safeguarded in the context of insolvency proceedings.

Privileged Creditors

Once secured claims and administrative expenses have been satisfied, the means by which the remaining resources are distributed vary considerably among countries. Insolvency laws often identify a number of different types of privileged prebankruptcy creditors that will receive distribution before the unsecured creditors. In those countries that have eliminated most of these statutory privileges, any balance after distribution will flow directly to unsecured creditors. Although political pressure may require granting such privileges, they undermine the efficiency and overall effectiveness of the proceedings for a number of reasons. From the perspective of the general unsecured creditors, such privileges are inequitable since they effectively revalue the claims of a privileged class of unsecured creditors. As a result, unsecured trade creditors and banks may become disinterested in the proceedings, which will adversely affect the conduct of these proceedings. Moreover, they may complicate the negotiations of a rehabilitation plan to the extent that they require the creation of separate creditor classes to reflect the priority in question.

The types of privileges provided by countries vary and, in some cases, seem to reflect the leverage of particular interest groups in the political process of the country in question. Two categories of privileges, however, are particularly prevalent. The first provides priority for employee salaries and benefits (social security claims and pension claims). Such privileges are generally consistent with the special protection that is afforded to employees in other areas of insolvency law. The second category relates to tax claims of the government. This latter privilege has been justified on the grounds that giving the government priority with respect to tax claims can be beneficial to the rehabilitation process in that it gives the tax authorities an incentive to delay the collection of taxes from a troubled company. However, the creation of such incentives can in fact be counterproductive. Not only does failure to collect taxes compromise the uniform enforcement of the tax laws, but it also constitutes a form of state subsidy and, thereby, undermines the disciplinary forces that an effective insolvency law is designed to support.

Unsecured Creditors

Once all privileged creditors have had their claims satisfied, the balance, if any, of the proceeds will be distributed on a pro rata basis to unsecured creditors. There may be subdivisions within the class. For example, if a creditor has agreed to subordinate its claims, this should be respected. Certain claims, such as gratuities, fines and penalties, shareholder loans, and post-petition interest on general unsecured claims are treated as subordinate claims by some countries while they are treated as nonallowable (excluded) claims by others.


In the unlikely event that there is any balance to distribute to shareholders, it will be distributed in accordance with the ranking of shares specified in the company law and corporate charter.

Principal Conclusions

The rules establishing the priority to be given to classes of creditors when distributing the proceeds of the sale of the estate’s assets should pay due regard to contractual terms that provide for security or subordination. Thus, as a general rule, if the assets of the estate are encumbered, the proceeds of their sale should first be distributed to secured creditors to the extent of the value of their secured claim, plus any compensation arising from the stay that has not already been paid during the proceedings. Priority rules should also be designed to facilitate the effective functioning of the insolvency procedure. Accordingly, administrative expenses (encompassing payment for the services of professionals, including the liquidator, and claims of post-petition creditors) should be given priority over unsecured claims. The inclusion of other statutory privileges, while they may be considered necessary for social or political reasons, should be limited to the extent possible since they generally undermine the effectiveness and efficiency of insolvency proceedings. As with all other aspects of insolvency proceedings, the priority rules should not discriminate against foreign creditors.


Following distribution, it is likely that a number of creditors will not have been paid in full. This raises the question of whether such creditors will still have an outstanding claim against the debtor or, alternatively, the debtor will be released or “discharged” from these residual claims.

When the enterprise is a limited liability company, the question of discharge following liquidation does not arise: either the law provides for the disappearance of the juridical entity or, alternatively, the entity merely continues to exist as a shell with no assets. In any event, the shareholders are not liable for the residual claims and the issue of their discharge does not arise. However, if the enterprise is an individual (sole proprietorship), a group of individuals (partnership), or an entity whose owners have unlimited liability, the question arises whether these individuals will still be personally liable for the unsatisfied claims following liquidation.

Insolvency laws vary significantly with respect to the question of discharge. In some, the debtor is still liable for unsatisfied claims, subject to the statute of limitations. Such a rule emphasizes the value of a debtor-creditor relationship: the continued responsibility of the debtor following liquidation serves to both moderate a debtor’s financial behavior and encourage the creditor to provide financing. On the other hand, some countries provide for a complete discharge of an honest, nonfraudulent debtor immediately following liquidation. This approach emphasizes the benefit of the “fresh start” that discharge brings and is often designed to encourage the development of an entrepreneurial class. Other laws attempt to strike a compromise: discharge is granted after a period following distribution, during which time the debtor is expected to make a good faith effort to satisfy its obligations.

On the question of discharge, it is not feasible to have rules on the business debts of individuals differ from the rules that apply to the consumer debts of that individual. As discussed earlier, the treatment of consumers is generally outside the scope of this report.

Principal Conclusions

The discharge of individual debtors following the liquidation of their enterprise may provide an appropriate means of giving them a fresh start. However, this option should not be made available to those who have engaged in fraudulent behavior or who have failed to disclose material information during the proceedings.