What Can Restructuring Laws Do?
Corporate bankruptcy law is a tool to resolve the financial distress of corporations. Unviable corporations are liquidated and the proceeds distributed to the creditors. Viable corporations are restructured and put on a new financial footing. Following the model of Chapter 11 of the US Bankruptcy Code, many jurisdictions worldwide have strengthened or introduced such restructuring options in their bankruptcy laws. In the European Union (EU), for example, a ‘Restructuring Directive’ was adopted in 2019 which seeks to harmonise Member States’ pre-insolvency restructuring regimes. Germany, for example, implemented this Restructuring Directive with a new restructuring law, the Unternehmensstabilisierungs- und -restrukturierungsgesetz (StaRUG), which entered into force on 1 January 2021.
Bankruptcy laws, including restructuring laws, are usually not designed to process the financial failure of masses of similarly situated firms. The typical scenario is the financial distress of an individual firm which may or may not have a viable business model. Of course, bankruptcy laws are also capable of managing the simultaneous influx of a greater number of distressed firms if, for example, a certain business sector is disrupted by innovation or particularly affected by an economic downswing. But geopolitical and macroeconomic shocks and the associated economic fallout in the sense of millions of struggling firms are a different matter. The run to the bankruptcy court might bring the machinery of bankruptcy justice to a standstill.
Since the beginning of 2020, the world has seen two such shocks. The first came with the Covid-19 pandemic. Governments worldwide imposed lockdowns. Firms could not trade and lost revenues on an unprecedented scale. Governments extended massive packages of relief to businesses, often in the form of loans. Keeping businesses out of bankruptcy appeared to be the overriding goal—at enormous costs to the taxpayer. The second shock came with the war in Ukraine. Energy costs soared and supply chains were disrupted. Once more, governments have stepped in with energy cost subsidies and other forms of financial assistance for businesses, seeking to prevent mass bankruptcy filings.
In a recent article (forthcoming in the European Business Organization Law Review, EBOR), I investigate the merits of these anti-bankruptcy policies. I make two claims, one narrow and focused on German bankruptcy law, and the other broad with a cross-jurisdictional reach. My narrow claim relates to the new German restructuring law mentioned above, the StaRUG. I argue that this law is a superfluous and flawed instrument. It should be repealed. The case against the StaRUG does not rest on arguments about shock events. Rather, the StaRUG is just a particularly un-useful restructuring tool.
My second claim is much broader. I argue that bankruptcy laws, including restructuring laws, are generally ill-suited to deal with the economic consequences of geopolitical or macroeconomic shocks. Bankruptcy laws are not designed to provide the structural assistance at the scale that businesses affected by these events need. Hence, the post-Covid anti-bankruptcy policies of many states are justified in principle. At the same time, massive state aid for distressed businesses in times of crisis and, in particular, ad hoc bailouts of large firms are also problematic. I propose that firms’ resilience against geopolitical or macroeconomic shocks should be strengthened, and that best practices for bailouts should be developed. I’ll elaborate in the following.
Structural limits of restructuring laws
Millions of firms have faced or are facing severe financial distress after the onset of the pandemic or during the current energy crisis. Both types of events severely affect the cash flow of businesses, but they do so differently. The pandemic led to lockdowns, and lockdowns caused businesses to experience a severe and abrupt loss of revenue. Businesses were (temporarily) prevented from trading. They could not make any (or only very little) money.
The current energy crisis has created a different problem for businesses. The war in Ukraine has led to severe disruptions in supply chains and to rising energy prices for electricity and fossil fuels, in particular for gas. As a consequence, businesses face severe cost increases. Supplies have become (much) more costly, as has production, especially in energy-intensive industries. As demand for most goods and services is not completely inelastic, firms cannot recoup these cost increases in full by raising prices. A severe cash flow problem looms.
What can a bankruptcy restructuring do to solve these problems? Restructuring laws seek to modify the financial structure of a distressed business. Creditors’ claims are cut or exchanged for new (debt or equity) claims. The main goal usually is to reduce the debt of the company to a sustainable level. At the same time, in the context of a financial restructuring, often the business itself is restructured, ie an economic restructuring is undertaken. However, it is important to note that the legal technology which is central to a restructuring proceeding seeks to modify the financial claims against a business. It cannot change its economic structure.
Against this background, it becomes clear why a bankruptcy restructuring is not the right tool to help the millions of firms which are financially distressed because of geopolitical and/or macroeconomic shocks such as the Covid-19 pandemic or the current energy crisis. A bankruptcy restructuring cannot produce the missing revenues which firms have lost because of the lockdowns. Similarly, a bankruptcy restructuring cannot force suppliers of goods and services to charge lower prices for their supplies. It cannot reduce energy costs either.
Hence, structurally, a bankruptcy restructuring is not the right tool to address the problems caused for businesses by the Covid-19 pandemic and/or the ongoing energy crisis. Other tools are needed, such as cash subsidies, loans or regulatory interventions in (energy) markets to limit price increases—and thus help the distressed businesses.
This is not to say that bankruptcy proceedings are unnecessary or should be avoided at all costs. Shock events such as the pandemic or the energy crisis have different effects on different firms. Businesses hit the hardest are generally those that have the most vulnerable capital structure, ie the highest debt levels. Specifically with respect to the energy crisis, energy-intensive firms which massively use fossil fuels are at high risk. Some firms will not be able to avoid (imminent) insolvency despite the general financial assistance offered by the state, and these firms should enter a formal liquidation or restructuring proceeding. This implies that measures such as suspending filing duties or similar provisions, such as wrongful trading rules, are highly problematic. Distressed businesses should initiate formal bankruptcy proceedings if their continued trading poses a risk to existing and future creditors. So, in essence, bankruptcy is and should be the second but not the first line of defence against shock events such as the pandemic or the energy crisis.
Note that this argument is not an argument based primarily on the scale of the regulatory problem caused by these events. It is an argument based on the structural possibilities and limitations of bankruptcy (restructuring) laws. The influx of millions of distressed businesses into bankruptcy (restructuring) proceedings creates a different set of problems. First, even in restructurings, asset sales are usually part of the mix of adopted measures, and the simultaneous bankruptcy of millions of businesses would severely depress asset prices, leading to suboptimal results. Second, bankruptcy courts would be overwhelmed. In theory, this problem could be solved by providing much more resources to the bankruptcy system. In practice, this is not possible, at least not on short notice. And it would not be the best solution either. Bankruptcy (restructuring) proceedings involve significant curtailments of creditors’ claims. Procedures must contain due process safeguards, such as judicial oversight. If a restructuring is done on the basis of a structured bargaining procedure, the process takes some time and is usually procedurally intricate. Hence, bankruptcy (restructuring) proceedings come with certain fixed costs.
If one wanted to design a restructuring proceeding that is calibrated to manage the simultaneous influx of thousands or millions of similarly situated firms, it probably would be much simpler and less complex than the restructuring proceedings as we know them. Structured bargaining and class-wise voting as, for example, in Chapter 11 are too complex and costly. A simple majority rule based on debt value and a rule of equal treatment of all creditors—secured and unsecured—could be key features. Even such a procedure could not solve the fire-sale problem mentioned above, however.
The second manifestation of the anti-bankruptcy policy of many states in the face of geopolitical shock events are ad hoc bailouts of ‘critical firms’ such as the German flagship airline Lufthansa or gas importer Uniper. These bailouts are not mass events. To the contrary, these are single large firms which experience severe financial distress and are rescued by the government. In principle, these cases appear to be perfect examples for the proper use of complex restructuring proceedings such as Chapter 11 or StaRUG. The size of the firms and their economic relevance certainly justify the costs of initiating and running a complex structured bargaining procedure. Nevertheless, they are bailed out frequently—for good reason?
The problems with using a bankruptcy (restructuring) procedure to manage the financial distress of these firms are again structural. Lufthansa was brought down by a severe case of revenue loss in 2020 as air travel came to an abrupt standstill during the first wave of the pandemic. Uniper suffered from exploding costs when the spot price for gas skyrocketed in the spring/summer of 2022. So, all the arguments discussed above to justify cash assistance by the government apply. But why were these firms deemed worthy of extraordinary help, going much beyond the assistance available to all firms?
Bankruptcy restructuring proceedings are structurally limited in what they can do. As discussed, these proceedings aim to rearrange the financial claims against the distressed entity. As a consequence, the key stakeholders in a corporate restructuring are the company’s creditors and the debtor corporation and its shareholders. The decision to continue running the firm as a going concern (in a restructured form) or to close it down is typically made based on the effects of the decision on these financial stakeholders. The whole bankruptcy machinery of a ranking of claims, of voting, and of plan confirmation is calibrated such that the interests of those with a financial claim against the business are satisfied to the extent possible under the circumstances and according to the ordering of claims prescribed by the law.
What is typically not relevant is whether and to what extent the interests of those external to the bankruptcy process are affected. Bankruptcy is concerned with what can be described as ‘microeconomic efficiency,’ ie firm-level efficiency, compared to a wider notion of efficiency which encompasses costs and benefits accruing to those who do not participate in the bankruptcy process and have no voice in it (‘macroeconomic efficiency’).
Shutting down Lufthansa or Uniper, for example, may create significant negative effects on the wider economy and society which go much beyond the consequences for those who hold financial claims against these firms: business partners might be pulled into insolvency, regional or even national unemployment levels could rise, and the living conditions of many individuals be severely worsened. Conversely, maintaining these firms as going concerns could avoid or at least contain these negative externalities. With respect to certain firms which perform important critical functions in and for a national economy, these effects can be of significantly greater magnitude than the effects of the firm’s distress on the firm level alone. But the bankruptcy process does not account for such positive or negative externalities. This is the structural reason the German government was justified in bailing out critical firms such as Lufthansa or Uniper. Bankruptcy is the wrong tool to restructure such firms. Their continued operation typically has significant positive, and their liquidation significant negative effects on the wider economy and society. Hence, ad hoc bailouts are a necessary crisis management tool.
Lufthansa and Uniper are non-financial firms. Many will recall that a similar policy discussion took place during and after the great financial and economic crisis regarding banks and other financial institutions. The key argument against using traditional bankruptcy procedures to deal with the financial failure of ‘systemically relevant’ financial firms was also based on externalities. It was feared that their collapse could bring the whole financial system down and cause havoc to the world economy. The emerging regulatory consensus at the time was that some kind of special restructuring regime for financial institutions was needed which would allow for a rapid recapitalisation. In Europe, this was achieved through the ‘Bank Recovery and Resolution Directive.’
This points to the direction the discussion on bailouts of non-financial firms should take: we need to think about the legal framework which governs such bailouts. The United Nations Commission on International Trade Law (UNCITRAL) could start work on ‘Principles on Ad Hoc Bailouts of Critical Firms.’ The idea would be to draw on existing legislative sources—such as rules on state aid, restrictions on foreign direct investment or on the Golden Shares’ jurisprudence of the Court of Justice of the EU (CJEU)—to distil underlying principles that might determine which firms should be candidates for such bailouts, and on what conditions.
Another avenue for reform could be the establishment of a bailout fund which would be financed by regular contributions from businesses. The key idea behind this proposal is twofold. The first is to increase the involvement of the private sector in the financing of bailouts, partially correcting the current situation which, arguably, is characterised by a privatisation of gains and a socialisation of losses. A second benefit of such a fund could be to delay or even make superfluous (in some instances) state intervention and help, if and to the extent the fund is able to reduce or even eliminate the financial distress of affected businesses. In essence, the fund would provide a form of insurance against financial distress for its contributing members.
Similar schemes exist in many jurisdictions already, albeit with a relatively small scope. In Germany, for example, the Pensions-Sicherungs-Verein has existed since 1975. It receives contributions from member firms (currently more than 100,000). Its goal is to make sure that pension schemes operating at the level of an individual business are not affected by an insolvency of that business. This idea could be expanded to cover the financial consequences of distress situations caused by macroeconomic or geopolitical shock events more broadly, at least partially.
Horst Eidenmüller is a Statutory Professor for Commercial Law at the University of Oxford, a Professorial Fellow of St. Hugh’s College, Oxford, and a Research Associate of the European Corporate Governance Institute (ECGI) in Brussels.
This post is published as part of the 'Corporate Restructuring Laws under Stress' OBLB series (see our series here).
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