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Insolvency law systems

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Critically analyse how insolvency law systems endeavour to balance, if at all, the interests of the various parties who are affected by insolvencies. Evaluate whether they are successful. To suggest that an insolvency law system endeavours to balance the interests of the various parties who are affected by insolvencies is to suggest that a jurisdiction, in constructing legislation regarding bankruptcy and insolvency procedure, has direct concern to ensure that all parties are treated fairly and equally in such proceedings. In this essay I shall argue that whilst, prima facie, it may well appear to be the case that modern insolvency law systems are attempting, with increasing ferocity, to balance the interests between creditors and debtors, the reason for attempting to balance these interests lies not with consideration of equity or fairness, but with economic considerations alone. In this way I will argue that an attempt to evaluate whether or not such a balance has been struck ‘successfully’ is a misplaced task; the successful balance is not one which results in the interests of the affected parties being balanced, this is merely an incidental phenomenon, rather one which results in the greatest resulting positive economy for any given jurisdiction. I shall therefore argue that insolvency law systems, rather than responding to the interests of the various parties to an insolvency, attempt to mould and shape the behaviour of these respective parties in a way which will prevent insolvencies from occurring in the first place. Therefore, in a very round-about way, insolvency law systems are endeavouring to truly balance the interests of the various parties who might be affected by potential insolvencies, albeit indirectly, for by preventing insolvencies from occurring, the full interests of all parties will be fully protected. Due to the complexity of my argument, and the limited scope available to me, I shall concentrate my discussion around an analysis of the UK’s insolvency law system. In the first part of this essay I shall discuss the economic implications of not affording the correct degree of focus to the varying potential parties of an insolvency proceeding. Whilst this discussion will be brief and general, the aim of this section is to justify my underlying-assumption that any consideration of how an insolvency law system should ‘protect’ the various stakeholders is, rather than an attempt to balance the interests [a concept which implies a degree of equity and fairness], based upon economic considerations alone [i.e. to prevent the far reaching economic consequences which would ensue were insufficient focus to be afforded to each of the parties involved]. I shall then embark on a critical analysis of the UK’s insolvency law system, and provide evidence which will support the conclusions as outlined in the introductory paragraph of this essay. Why is the distribution of assets at insolvency a matter of public concern? The answer to this question is relatively straightforward: In order for a modern capitalist economy to prosper and develop, new business ventures and entrepreneurialism must be encouraged. The government however has insufficient funds to be able to provide loans and grants for all such business, and as such, must rely on private credit providers, such as banks and building societies, to provide such funding. Such private creditors will however levy a charge for their loan services, the level of which is primarily determined through an assessment of the relative risk of providing such credit. The greater the level of risk, the greater the charge and the less affordable it will be for businessmen to engage such loans, resulting in less business ventures being pursued. The private creditors will assess the risk of the venture in question failing, and becoming insolvent, and will also assess how much of their credit could be recovered in such an eventuality. It is therefore necessary to have in place a public insolvency law system which will provide a procedure by which creditors can be assured they will have recourse to recover their monies in the eventuality of insolvency. Of course, in most cases of insolvency there are insufficient assets available to meet all the debts owed to the creditors, and as such, the creditors cannot be assured that they will retrieve all the monies owed; however, what can be assured is a certain procedure which will endeavour to maximise creditors’ ability to retrieve; such a procedure from which a reliable risk assessment can be made will not only encourage creditors to extend credit to prospective business ventures, but will ensure that the costs of such loans on these prospective businessmen are minimised. To reiterate, if an insolvency regime does not pay sufficient attention to the task of returning the debtor’s assets to the creditor, the availability of credit within that entire jurisdiction and the cost of such credit may be adversely affected; i.e. with the knowledge that upon insolvency, he would lose a greater proportion of his money, a creditor would naturally be less willing to extend credit to a debtor. An increase in the cost of the credit would be the natural response to such a creditor’s increased financial risk. This in turn would mean that fewer business ventures are able to secure their necessary finances, resulting in less jobs, and less entrepreneurialism, two factors whose promotion are deemed to be highly important to the success and prosperity of a capitalist jurisdiction. The same effect would result from an insolvency regime which was not clear in the way in which it prioritises creditor’s rights within insolvency proceedings, for if a creditor is unsure of what his position would be in the eventuality of his debtor becoming insolvent, then he must perceive a higher risk, and respond by increasing the price of his credit. On the other hand, an insolvency regime must not impose too harsh a burden upon the debtors, as it is important that a bankrupt debtor is able to retain certain assets such as the tools of his trade, so that he/she may continue to earn a sufficient income, not only to live, but also to be in a position to pay back some of his outstanding debts. A system which allows for such latitude will reassure creditors that their debts, whilst not immediately recoverable, are at least recoverable over a prolonged period of time. A system which allows such latitude also gives failing businesses a chance to get back on their feet and perhaps eventually emerge from the dark depths of debt, and actually flourish. The degrees of focus afforded to the creditors and debtors of a potential insolvency must therefore be set through these considerations of policy rather than common law considerations of fairness and equity. As such it is necessary for a jurisdiction to have an insolvency law system which is designed by the legislature rather than the judiciary [who have no remit in such political considerations], and as such is fully codified. Case Study: The UK’s insolvency law system. The Insolvency Act 1883 formed the basis of the bankruptcy system in the UK for over 100 hundred years, “and was designed to ensure that an independent and impartial examination took place into the causes of each bankruptcy, as well as into the conduct of each bankrupt.” [Johnson, 2002]. There was a clear policy message engrained within this legislation; bankruptcy is matter of public concern, affecting the whole community, and a debtor who has become insolvent/bankrupt is not someone who can be trusted by society or given a second chance to succeed in business. In 1977, the Government instructed Sir Kenneth Cork to chair a Committee to review this Act. Their findings suggested that reform was needed to move the UK’s insolvency law system away from the harsh treatment of debtors towards what they saw as a more practical ‘rescue’ approach, where debtors would be encouraged to continue business wherever possible in order to earn extra income to pay off their existing debts and pull themselves out of their dire financial straits. [Cork Committee, 1982] Not all of the reforms suggested by the Cork Committee were adopted by the Insolvency Act 1986, but evident within this act was recognition that time had come to shift the balance away slightly from a creditor’s-only protection towards a protection of the debtor’s interest, and an attempt to rescue wherever possible the companies in question. The reason for this shift of balance has nothing to do with the interest of the individual debtor, and fairness thereto, but rather towards the wider implications of not affording such protection, as discussed earlier in this essay, that it is better for the economy to allow a debtor to continue to trade so that he may not only pay off his creditors in full over time, but so that the business may be saved. The introduction of general automatic discharge for bankrupts after three years, as contained within the 1986 Act, showed that the UK’s Insolvency law regime would no longer exude such distrust in insolvent debtors, and would be prepared to allow such unfortunates another chance to contribute to the UK’s thriving economy. Also, the introduction of Administration procedures suggested a move away from the receivership processes of old towards a process by which a company who is unable to pay its debts might be saved, either in whole or in part, through a voluntary arrangement or scheme of arrangement through which a more beneficial realisation of assets might be achieved than would be the case through the process of liquidation [D. Webb, 1991]. I argue that this demonstrates the UK’s commitment to the goal of preserving businesses from fatality at all costs. Research conducted by Bulow and Shoven (1978), Jackson (1982, 1986) and Webb (1991) suggests that the receivership process actually created incentives for certain creditors to prematurely and inefficiently liquidate companies; this would be fatal to the UK’s objective, as it would encourage creditors in certain situations to fight for immediate recovery. Likewise, the introduction of voluntary arrangements reflected a move away from the ‘debt collection’ agenda towards the rescue approach; a process by which a company could be saved through arrangement reached by the company with its shareholders and creditors, supervised by an insolvency practitioner and approved by meetings convened under the authority of the court. Whilst a noteworthy attempt to rescue business, there was no procedure in place to provide a stay on creditors actions, and as such, before any arrangement could be reached, individual creditors could launch recovery actions which could, especially for smaller businesses, prevent the company from continuing to trade, thus preventing the success of any voluntary arrangement to rescue the company in the future. The recession of the 1990’s demonstrated this weakness of the voluntary arrangement scheme in the 1986 Act. A solution to this problem was offered by the Insolvency Act 2000; the Act provides the management of a small company a moratorium; 28 days in which creditors will be prevented from instigating enforcement action so that they can make their voluntary arrangement proposal to the creditors. Of less practical significance, but a good demonstration of the UK’s commitment towards a rescue approach was the notion of ‘intensive care’, under which a company is nursed back to health with a minimum of publicity. Of course this would only be possible with companies who have a small number of creditors who are all willing to co-operate. The Enterprise Act, which received Royal Assent on the 7th November 2002, replaced administrative receivership with administration as the government’s favoured way of dealing with ailing companies [Fletcher, 2004]. This relatively recent development can be seen as a further consolidation of the UK’s commitment to preventing the fatality of business through insolvency. This Act introduced a number of reforms to further help ‘rescue’ ailing companies. The timescales provided for by the Act are themselves important: After being appointed, an administrator has exactly 8 weeks in which to make his proposals to the debtor’s company creditors. Application to the courts for the commencement of the administration process must be accompanied by a letter from the administrator stating that he consents to being appointed and that he believes that the purpose of administration in the particular case at hand is reasonably likely to be achieved through this process [para18]. An administrator is unlikely to consent to his appointment, or agree that the process is likely to succeed, without first being provided with and then considering all the relevant information relating to the ailing company in question. In practical terms, this means that bank creditors must try to always have such information on hand, so when trouble hits, they will be ready to approach an administrator. These timescales provided for by the Act can only be interpreted as a way of compelling banks to instigate more stringent monitoring procedures with regards to their investments. Whilst it is true that banks have always monitored their debtors closely, [J. Armour and S. Frisby, 2001], the particular timescales provided by the Enterprise Act 2002 give these monitoring procedures an official urgency. In contrast with the old process of receivership, the Enterprise Act stipulates that administrators should act in a way which promotes the interests of all a company’s creditors as a whole. The Act sets out provisions of enforcement and procedures to ensure that the interests of all the creditors are considered [para 49-58, 74 and 75]. This further increases the urgency of the bank’s monitoring procedures, for the banks are afraid that administrators will be too bogged down in these procedures to be able to protect their interests, and as such work harder to maximise their potential control of the new administrative process by collecting more, better and earlier information. This is categorical evidence that the insolvency process has shifted away from its 1883 role as ‘debt collector’ towards its 21st Century role as ‘insolvency risk manager’. Other changes in corporate procedure stand to reinforce these concerns to monitor companies ahead of trouble, and of particular note are the reporting requirements contained in the Operating and Financial Review (OFR). The OFR regulations 2005 stipulate that the OFR [which are a mandatory annual requirement for the 1290 quoted British companies] must contain analysis of the development and performance of the business of the company throughout the financial year, including an evaluation of the position of the company at the end of the year. It must also contain a report of the main trends and factors underlying the development, performance and position of the business of the company during the financial year, and the main trends and factors which are likely to affect the company’s future development, performance and position. This focus on looking forward towards possible future risks and uncertainties is of particular relevance here, and whilst, through choice, many companies may not expend huge energies into ensuring that these mandatory reports are completed with the greatest level of accuracy and consideration, it may well become the case that banks will use their lending powers to insist that companies who borrow from them complete their OFRs in ways which not merely identify key business risks, but that will isolate risks which potentially may threaten the viability of the business. In this way the banks will both gain new stocks of information which would aid their application for administration, should a situation arise which would warrant such action, and will also be able to learn more about insolvency risk management in general. This may prove to be a significant step towards a preventative philosophy of insolvency law. Also reinforcing this pre-insolvency scrutiny of corporate management is the Companies (Audit, Investigations and Community Enterprise) Act 2004, s9 of which demands that company directors state in their annual director’s report that ‘there is no relevant audit information that they know of and know that the auditors do not know of’, and actually holds the directors criminally liable if they make such a false statement, wither knowingly or recklessly. This further shifts the focus towards pre-insolvency assessment, and may potentially help to avoid reaching the point where the risks become reality. Also of note are the recent changes which can be observed in the ways in which banks have altered their approaches in dealing with loans made to companies which are potentially high-risk. In the past, negative and positive covenants would have been employed to ensure that the borrower provides the banks with a variety of information throughout the year relating to the status and future status of the companies in question, but now increasingly banks are becoming involved themselves with the processes, and one they perceive that a company to whom they have lent money is in a high risk position, the bank will instigate ‘intensive care’ strategy, putting the company in touch with their ‘Business Support Teams’. All this attention to risk strategy management has spurned a noticeable increase in the number of trained professionals in this field, which in turn helps banks and companies to avoid risks which might previously, under the lower levels of scrutiny, have lead to un-rescue able insolvency. One of the legal issues involved here is that with these new levels of pre-insolvency scrutiny, and also with these banking initiative designed to help companies avoid insolvencies or recover therefrom, might the banks be seen to be ‘shadow directors’ under s 215 of the Insolvency Act 1986 and fall within the scope of liability under s214 of that Act? For example, where a bank runs an ‘intensive care’ program over an ailing company, the bank may give ‘directions or instructions’ to the client company, and as such, prima facie, might appear to satisfy the criteria set out is s215 of the Act. In the case of Re PFTZM Ltd Jourdain v Paul Judge Baker QC stated that in light of the banks good intentions it was unlikely that it would be treated as a shadow director, even where it exercised a considerable degree of control over the management of the company. Milman (1987) comments that this is a questionable proposition as it confuses objective conduct with subjective motivation. The case of Re Tasbian Ltd (No 3) held that a company doctor or management consultant may in certain circumstances be deemed as a shadow director, and it is not necessarily straightforward to see why the bank in their role as management consultant might not also be held to be liable in the same way. No case has yet come to court in which a bank was held so liable, and it seems that it is unlikely that such a case will succeed, unless the bank are deemed to have made directions or instructions which the directors ‘follow in a consistent pattern’ [as held in the Becker case would need to be the case], as distinct from giving professional advise or merely imposing conditions for making or continuing a loan [Re A Company, [1988]] An important point here is that even if the bank is held to act as shadow director, it will only be liable for wrongful trading under the Insolvency Act s214(2)(b) if it continues to act as a shadow director after it knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation [Re Continental Assurance, [2001] ]. What bank would continue an intensive care program after it believed the liquidation of the company was inevitable? And so we see that rather than attempting to balance the interests of the parties affected by insolvency, the roles of these parties has changed. In light to the move towards a risk assessment and preventative insolvency law system, the directors of companies will be subjected to a greater degree of scrutiny at an earlier stage in the demise of the company. Secured creditors, i.e. the banks, will have an increased role and vested interest in ensuring that the companies to whom they have lent money stay afloat. The role of unsecured creditors [a group which I have not discussed in any great detail within the scope of this essay] has not changed very much, although it must be noted that para 3(2) 49, 51-57 of the Enterprise Act 2002 stipulates that the Insolvency Practitioner must heed their interests when deciding strategy, and their enthusiasm to use their voice and speak up might by encouraged by the ring fencing provisions of the Enterprise Act 2002, which may yield improvements in their potential returns (V. Finch, 2005). In conclusion, I would argue that insolvency law systems are not concerned with balancing the rights of the individual parties affected by insolvencies, but are rather concerned with protecting economic ideals of increased entrepreneurialism and employment. The example of the UK Insolvency law system demonstrates that rather than an attempt to balance the interests of the parties involved, attempts have been made to ensure that fatal insolvencies are reduced to a minimum. This has been brought about through a careful and deliberate remoulding of the roles of the various parties, and through a recasting of the underlying philosophies of insolvency law from a system designed to organise and distribute debt, to a system designed to promote pre-insolvency risk assessment and management. As a result, less fatal insolvencies will occur, and therefore one could argue that in this way, the rights of all the parties to insolvencies have been successfully balanced, for if a company is rescued from bankruptcy rather than simply realised in order to pay off its creditors, then all parties are effectively achieving what they desire; the debtor is allowed to continue his business, and the creditors will as a result be able to reclaim their loan repayments. References: Armour J. and S. Frisby, 2001. ‘Rethinking Receivership’, 20 OJLS 23 Bulow, J and Shoven J (1978). ‘The Bankruptcy Decision’, Bell Journal of Economics, 9, 437-56 Finch, V. 2005. ‘The Recasting of Insolvency Law’. The Modern Law Review, 68, 5, pp 730 Fletcher (2004) ‘UK Corporate Rescue: Recent Developments- Changes to Administrative Receivership, Administration and Company Voluntary Arrangements- The Insolvency Act 200, The White Paper 2001 and The Enterprise Act 2002’ 5 EBOR 119 Jackson, T. H. (1982) ‘Bankruptcy, Non-bankruptcy Entitlements, and the Creditor’s Bargain’. Yale Law Journal, 91, 857-907 Johnson, 2002 http://www.dti.gov.uk/ministers/speeches/MJohnson131102.html [accessed 2nd January 2006, 3:15pm] Milman, D. and Rushworth J. (1987) Receivers and Receiverships. Bristol: Jordans Webb, D. (1991) ‘An Economic Evaluation of Insolvency Procedures in the UK. Does the 1986 Insolvency Act Satisfy the Creditor’s Bargain?’ Oxford Economic Papers 43, 139-157 Cases Cited: Re A Company No 005009 of 1987, ex p Copp [1988] 4 BCC 424 Secretary of State for Trade and Industry v Becker (2003) 1 BCLC 555 Re Continental Assurance plc. [2001] All ER 229 Re PFTZM Ltd Jourdain v Paul [1995] BCC 280 Tasbian Ltd (No 3) [1991] BCC 435 Statutes Cited: The Insolvency Act 1883 The Insolvency Act 1986 The Insolvency Act 2000 The Enterprise Act 2002 Companies (Audit, Investigations and Community Enterprise) Act 2004 Operating and Financial Review Regulations 2005
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