1 Introduction

Although the insolvency laws of countries differ in important respects, most effective insolvency regimes share two overall objectives, from a macroeconomic point of view. The first overall objective is the allocation of risk among participants in a market economy in a predictable, equitable and transparent manner. The achievement of this objective plays a critical role in providing confidence in the credit system and fostering economic growth for the benefit of all participants. Further, an insolvency law also serves to allocate risk among different creditors, as well as between creditors and equity holders, also for the benefit of borrowers.

­­ a. Predictability

Individual countries make different policy choices as to how their insolvency laws will allocate risk among participants. Irrespective of these different choices, however, it is generally recognized that the relevant risk allocation rules should be clearly specified in the law and that they should be consistently applied by the individuals and institutions that are charged with implementing them. Experience has demonstrated that no matter what risk allocation choices countries make, participants are often able to take measures (including through price adjustment) to help manage the risk in question if the application of these rules is relatively predictable. In contrast, when the rules or their application are uncertain, such uncertainty erodes the confidence of all participants and undermines their willingness to make credit and other investment decisions. To the maximum extent possible, pre-insolvency entitlements and contractual rights should be preserved and enforced.

b. Equitable Treatment

A common feature of all insolvency proceedings is their collective nature. Unlike other laws (e.g., foreclosure laws), an insolvency law is designed to address a situation in which a debtor is no longer able to pay its debts to its creditors generally (rather than individually) and, in that context, provides a mechanism that will provide for the equitable treatment of all creditors. For the benefit of all creditors, however, an insolvency law must address the problem of fraud and favoritism that often arises in the context of financial distress. Moreover, given the importance of international credit and investment, the law must ensure that there is no discrimination against foreign creditors. Finally, the collective nature of a proceeding can give reassurance to creditors that problems will be resolved in an orderly and equitable manner. An insolvency administrator can, for example, issue statements that can calm markets effectively.

c. Transparency

Closely related to the objectives of predictability and equity is that of transparency. During insolvency proceedings, interested participants must be given sufficient information for them to exercise their rights under the law. When the institutions charged with implementing the law (the court and the court-appointed administrator) make decisions, it is also important that the law provide adequate guidance as to the exercise of their discretion and, in the case of the court, require that judicial proceedings be open and that the rationale underlying the court’s decision be made publicly available.

Second Objective: Protect and maximize value for the benefit of all interested parties

The second objective of an insolvency law is to protect and maximize value for the benefit of all interested parties and the economy in general. Indeed, this objective is frequently the factor that would decide whether to pursue a rehabilitation of the debtor enterprise, or to proceed to liquidate it. In the context of rehabilitation, the objective is most obviously pursued during rehabilitation, where value is maximized by continuing a viable debtor enterprise. But it is also a primary objective of procedures that serve to liquidate enterprises that cannot be rehabilitated. The achievement of the value maximization objective is often furthered by the fulfillment of the objective of equitable risk allocation.
Some of the key policy choices to be made when designing an insolvency law relate to how the above objectives are balanced against each other. In addition, choices need to be made on who will be the beneficiaries of the value that is maximized: while some countries view rehabilitation procedures as providing a way to enhance the value of creditors’ claims through the going-concern value of the enterprise, other countries also view it as a means of providing a “second chance” to the shareholders and the management of the debtor.

Viewed from the perspective of the economic policy-maker, and in light of the above objectives, an effective insolvency law can clearly play a critical role in a number of areas. Generally, the discipline it imposes on a debtor increases the competitiveness of the enterprise sector and facilitates the provision of credit. More specifically, to the extent that the enterprise is owned by the state, subjecting the enterprise to the application of the general insolvency law sends a clear signal regarding the limitations of public financial support.

2 Two Main Components of Insolvency Laws –
Liquidation and Rehabilitation

In essence, an insolvency law serves to address the rights and obligations of different parties with respect to a debtor which cannot pay its debts. When a debtor is unable to discharge its liabilities as they become due (i.e., is “insolvent”), there are usually a number of competing claims on its assets, whether they be unpaid loans, invoices, rents, taxes or salaries. To satisfy those claims, a liquidation of all of the debtor’s assets and a distribution of the proceeds may be necessary. In such cases, creditors may only receive a portion of the nominal value of their claims.

Sometimes, however, a complete liquidation of the debtor’s assets may not always be the preferred course of action, either for the debtor or its creditors. Rather, a restructuring of the debtor’s operations or balance sheet may allow the creditors to be fully repaid or, at least, to receive more than they would have received through liquidation. Consequently, the majority of modern insolvency regimes will also contain mechanisms through which an insolvent debtor can be “rehabilitated” through a rearrangement of the debtor’s business affairs.

a. Liquidation Procedures

The need for liquidation procedures can be viewed from different perspectives. From one perspective, these procedures can be seen as addressing inter-creditor problems. Specifically, when an insolvent debtor’s assets are insufficient to meet its liabilities, an individual creditor’s best strategy is to rush to take the necessary legal measures to attach and seize assets before other creditors have a chance to take similar action. While such behavior will appear rational from the perspective of individual creditors, such a “grab race” will not, in fact, be in the collective self-interest of creditors; not only are the legal actions taken by creditors costly, but such a disorderly piecemeal dismantling of the debtor entity will lead to a loss in value for all creditors.
An orderly and effective liquidation procedure addresses the inter-creditor problem by setting in motion a collective proceeding that seeks to achieve equitable treatment among creditors and to maximize the assets to be distributed to creditors. This is normally achieved by the imposition of a stay on the ability of creditors to enforce their rights against the debtor and the appointment of an independent liquidator whose primary duty is to maximize the value of the assets of the debtor prior to distribution to creditors.

Viewed from a broader perspective, and as discussed earlier, such liquidation procedures constitute an important disciplinary force that is an essential element of a sustainable debtor-creditor relationship. In this way, they can be seen as promoting the interests of all participants in the economy, since they facilitate the provision of credit and the development of financial markets.

b. Rehabilitation Procedures

In contrast to liquidation procedures, rehabilitation procedures are designed to give a debtor enterprise some opportunity in appropriate cases to recover from its temporary financial difficulties or more permanent over-indebtedness and, where necessary, provide it with an opportunity to restructure its operations and its relations with creditors. As noted above, where rehabilitation is possible, such an approach will be preferred by creditors if the value derived from the continued operation of the enterprise will enhance the value of their claims.

c. Relationship between Liquidation and Rehabilitation

Although liquidation and rehabilitation procedures are often viewed as relatively distinct from each other, there are, in fact, considerable overlap and linkages between them, both as a matter of procedure and in terms of the substantive issues they address.