Contracting for a European Insolvency Regime

The European Commission has made a significant move to harmonise parts of Member States’ insolvency laws.  It has proposed a directive on pre-insolvency ‘preventive restructuring frameworks’ – the draft Restructuring Directive (RD).  If adopted, the RD would force the Member States to design restructuring proceedings that conform to the directive’s stipulations. The European Commission hopes that this would lower financing costs for European firms and give SMEs, in particular, access to local and efficient restructuring regimes.

In a recent paper, I argue that the Commission’s proposal of a ‘preventive restructuring framework’ is flawed because it creates a refuge for failing firms that should be liquidated. The overwhelming majority of firms in financial distress fall into this category. The Commission’s proposal is also flawed because it rules out going concern sales for viable firms. Such sales are usually a much more efficient process to restructure viable firms and keep them alive. Finally, the Commission’s proposal is flawed because it is, in essence, a twisted and truncated insolvency proceeding. It looks like a Chapter 11 proceeding but without strong court involvement from the beginning and without the tools needed for the court to guarantee a fair outcome of the process.

I also demonstrate that the Commission’s harmonisation plan is misguided. If implemented, financing costs for firms would rise because recovery rates for creditors would be lower compared to more efficient procedures (eg, liquidations, going concern sales, etc) and, more specifically, because secured creditors in particular have a weak position under the proposed ‘preventive restructuring framework’. The RD, if implemented by the Member States, would cast in stone an inefficient restructuring framework on a European-wide scale. It would prevent Member States from experimenting with more efficient procedures, and it would lead to more written-off loans instead of fewer non-performing loans. Hence, the European Commission should withdraw its proposal.

I suggest an alternative regulatory approach. European firms should have the option to choose a ‘European Insolvency Regime’ in their charter. This regime should be embodied in a ‘fully specified’ (complete) European Regulation, guaranteeing legal certainty to stakeholders. Firms need not opt into the European regime and could stick to their domestic insolvency regimes. Hence, horizontal regulatory competition between the Member States for the best ‘insolvency product’ would be preserved, and a new, vertical regulatory competition between the Member States and the EU would be introduced in the field of insolvency law.

Key design features of the proposed optional ‘European Insolvency Regime’ are the following: (i) it should be open for restructurings, going concern sales, and liquidations – firms should be channelled into the appropriate process based on the opinion of a court-appointed supervisor; (ii) it should be a fully specified (complete) and fully collective insolvency proceeding; and (iii) the proceeding should be conducted in DIP form with the mandatory appointment of a supervisor who performs important insolvency-related functions. 

If the European lawmaker were to change course and proceed as suggested in the paper, this would certainly mean more insolvency – and not just ‘pre-insolvency’ – regulation in a narrow sense than it had planned to do initially. At the same time, the draft RD is not a mere ‘preventive restructuring framework’. It is, in essence, a dysfunctional insolvency proceeding. Indeed, the European lawmaker does not inspire confidence, through its attempts ‘to sell’ Member States legal instruments under a misleading heading.

By contrast, the proposal developed in the paper claims to be a proposal for an insolvency proceeding, and that is precisely what it is. Nevertheless, given its optional character, it in no way infringes the regulatory traditions of the Member States or restricts their freedom to experiment with even more modern/creative proceedings. If the proposal developed in the paper is a failure, it simply will not be selected by firms, sending a signal to the European lawmaker to develop a better product. In this sense, the risk is low.

Finally, the analysis in the paper sheds a critical light on the European tendency to regulate out-of-court restructurings (workouts) by introducing sophisticated ‘pre-insolvency restructuring frameworks’. As the draft RD amply shows, once you start thinking about disciplining holdouts by sophisticated pre-insolvency restructuring proceedings, these proceedings quickly become complex and complicated. On the margin, they more-or-less resemble full-blown insolvency proceedings. But then the advantages of workouts, ie greater flexibility, lower costs, possibly even confidentiality, are lost.

It may be a preferable regulatory strategy to preserve the fully informal character of workouts and have full-blown insolvency proceedings as a backup – in the shadow of which the workout is negotiated.  This is, of course, how things are done on the other side of the Atlantic. To add some European ingredient to this, one could allow the courts to step in and discipline holdouts by imposing ‘cooperation duties’ on them in extreme cases. But that is another story.

Horst Eidenmüller is the Freshfields Professor of Commercial Law at the University of Oxford.