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Corporate Bankruptcy Costs and Recoveries in the UK

posted by John Armour

I'm thrilled to have been invited to be guest blogger on Credit Slips for this week. I'm hoping to cover a number of issues; starting with some recent empirical work I've been doing on business and consumer bankruptcy, then some comments on recent issues in European bankruptcies that may be of interest to readers.

I'm going to start today by discussing the impact of the UK's most recent reform of corporate bankruptcy law. Details below the fold.

Until 2003, the UK had a strikingly creditor-oriented corporate bankruptcy regime. A creditor with a floating lien (known as a 'floating charge' in the UK) covering all, or substantially all, of a corporate debtor's assets was able, if the debtor defaulted, to take control of the business by appointing a 'receiver'. The receiver essentially took over the powers of the debtor's board, but owed fiduciary duties only to the appointing creditor. Thus a senior creditor called the shots over what should happen to the debtor's business-- closure or going concern auction. The widely-held perception was that, where the senior creditor was overscured, insufficient effort might be exerted in the realisation of the assets, perhaps leading to "type II" error-- that is, good firms being closed by trigger-happy receivers. Moreover, the direct costs of receivership were very high: a leading empirical study by Franks and Sussman found them to be in the region of 25% of the net market value realised from selling the firm's assets. This was interpreted by some as further evidence of the lack of incentives for oversecured senior creditors to monitor proceedings.

The UK government's response to these concerns was to legislate for the abolition of receivership, through the corporate bankruptcy provisions of the Enterprise Act 2002. This legislation provides that floating charge holders must now appoint an 'administrator', rather than a receiver. The administrator has similar powers-- also taking over from the debtor firm's board-- but, unlike a receiver, owes fiduciary duties to all the debtor firm's creditors. Moreover, an administrator's proposals to realise the debtor's assets, or to restructure its debts, must be approved by a majority of its creditors. In short, the administrator running the new-style insolvency proceedings is now accountable to the unsecureds as well as the senior creditor.

In a recent research project, my co-authors Audrey Hsu, Adrian Walters, and I investigated the impact that this reform had on UK insolvencies. We gathered data on 102 receiverships commencing before the Enterprise Act 2002 came into force on 15 September 2003, and 182 administrations after the change. Directors of bankrupt UK companies are required to prepare a "statement of affairs" detailing their estimates of the value of corporate assets immediately on entry to proceedings. These, and the details of the ultimate realisations achieved by receivers or administrators, are publicly-available via the UK's Register of Companies. From these data, we were able to compare costs and realisations before and after the change in the law.

The results? We found that, consistent with predictions, the gross realisations from bankruptcy sales increased under the new law, controlling for a number of other factors such as size, duration, industry, and sale type. The intuition here is that accountability to junior creditors gives administators better incentives to maximise realisation values than receivers have, accountable only to senior creditors. This was borne out by a further test that showed that all the difference between the old and new law was occurring in cases where the senior creditor was oversecured.

So far, so good: the law reform looks like a textbook exercise in the amelioration of perverse incentives. Except when we looked at the results from our analysis of direct costs: with similar controls, the proportion of the debtor firm's estate being spent on costs had actually increased under the new law. In interviews with practitioners, we came across an explanation. Senior creditors, typically banks, had formerly negotiated with a panel of insolvency practitioners who would act as receivers: the prospect of future business kept rates in check. The same firms of practitioners, when negotiating over fees in new-style administrations, were facing numerous and widely-dispersed unsecured creditors, many of whom would not expect to be involved in another bankruptcy. As a result, a 'retail' rather than a 'wholesale' rate for fees could be charged.

The net result for creditors seems to be that the increased realisations are eaten up by higher fees under the new law. Insofar as a general implication can be taken from this, we think it says that not only does the configuration of legal accountability in bankruptcy matter, but also the degree of dispersion of the class(es) of claims to whom accountability is owed by the persons(s) conducting the case.  If you are interested, you can read the full paper on SSRN here. Apologies for the long post, and thanks for sticking with it!

Comments

Discover also has a clause in their contracts that allows them to use the NAF (national arbitration forum) in which is paid by discover and discover is paid for using them, therefore siding with Discover in 99.999 of the cases. Now the catch is the arbitration process is a violation of your constitutional rights to due process ( trial by jury ). The arbitration can not be allowed if you do not agree to the suit. Both parties must have an EQUAL amount to lose, where they start with a winning hand.

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