When Insolvency Law Meets Systemic Risk: Director Duties and Congestion Costs

Insolvency duties are generally understood as mechanisms for preventing insolvent or nearly insolvent debtors from taking excessive risks at creditors’ expense. To that end, such duties may place restrictions on a debtor’s ability to take on additional debt, broaden fiduciary obligations toward creditors in the zone of insolvency, or ultimately require that a firm file for bankruptcy. Such duties typically impose personal liability on directors and managers of distressed firms. Their logic draws on moral hazard theory: as a firm’s value deteriorates, its shareholders have less to lose and are therefore more willing to engage in risky behavior. This firm-level thinking about insolvency duties has shaped decades of debate, particularly in the United States, where scholars continue to argue over the effects of this moral hazard and whether creditors need additional protection in the form of insolvency duties.

The focus on these firm-level incentives, however, ignores the systemic costs of such duties. In my article, ‘Insolvency and Systemic Risks: The Macroeconomic Costs of Director Duties in Crisis’, I argue that a legal regime intended for idiosyncratic failures can magnify the impact of systemic shocks. When distress is widespread and liquidity scarce, the threat of civil or even criminal liability may push directors to initiate insolvency proceedings prematurely, which can produce high macroeconomic costs in times of crisis via several mechanisms.

During such shocks, a rush to the courthouse may result in a phenomenon which I have termed ‘bankruptcy congestion’, a surge in filings that overwhelms courts and floods markets with distressed assets at fire-sale prices. This congestion can, in turn, increase adjudicatory expenses, further depress sale prices, and lead to inefficient liquidations. These costs are non-linear and escalate sharply once filings surpass a certain threshold.

Imposing insolvency duties during systemic shocks also reveals a deeper weakness in many legal regimes: the difficulty of distinguishing temporary illiquidity from true insolvency. During crises, firms facing short-term liquidity shortages may still be viable, yet insolvency duties in some jurisdictions, especially those that rely on cash-flow tests, can compel them to file. Without access to debtor-in-possession financing or timely government support, the slide from illiquidity to unnecessary liquidation can be swift. A rigid legal duty, rather than the feared moral hazard, becomes the proximate cause of value destruction.

To address these problems, my article explores reactions to the COVID-19 financial shock in three jurisdictions. In the first two—Germany and Australia—regulators moved quickly to suspend or relax their strict insolvency duties, recognizing that rigid duties risked overwhelming their courts and forcing otherwise viable firms into premature bankruptcy. In the United States, however, because directors face no liability for delaying a filing, no regulatory intervention was required. Instead, market actors negotiated standstills and adopted other contractual amendments to avoid defaults. Ultimately, all three countries avoided a surge in bankruptcy filings during the pandemic. 

The approaches taken by these jurisdictions underscore the need for crisis-responsive tools within the insolvency framework. For that reason, I propose a Material Adverse Systemic Event (MASE) carve-out: a targeted exemption that suspends insolvency duties during periods of severe macroeconomic disruption. Under this approach, directors could defer insolvency filings during systemic shocks, ensuring that legal obligations do not trigger premature bankruptcies in volatile conditions. I suggest that such a mechanism would help avoid congestion costs and distribute the burden of macroeconomic risks more fairly and efficiently. Rigid insolvency duties, by contrast, impose undue hardship on debtors during downturns and fail to account for the unpredictable, unavoidable, and uninsurable nature of systemic shocks.

Alternatively, where legal change is infeasible, contractual solutions provide an additional path. The article therefore recommends incorporating automatic debt-deferral clauses and liquidity-support provisions into debt contracts, enabling firms to pause repayment obligations and avoid defaults during crises without the need for statutory intervention. Mechanisms of this kind, such as ‘Climate-Resilient Debt Clauses’ in sovereign debt, already exist and could be adapted to private-sector lending, although designing appropriate triggers remains a central challenge.

My article contributes to the growing literature on the role of insolvency law during macroeconomic crises. Much of the existing debate adopts a microeconomic perspective, focusing on whether insolvency procedures should bar or complement government support at the firm level. By contrast, my analysis focuses on the congestion effects of insolvency duties that emerge when distress is widespread. In doing so, it reframes insolvency duties as rules with macroeconomic consequences rather than merely firm-level governance tools. This perspective extends scholarship on creditor rights and bankruptcy initiation by highlighting an overlooked point: insolvency law can, under certain conditions, amplify systemic risks.

Viewing insolvency law through a macroeconomic lens is crucial in an era of increasingly frequent shocks from climate-related disasters, geopolitical instability, and global supply disruptions. As these events impose sudden and severe liquidity pressures on debtors, the risks associated with rigid insolvency duties become more acute. Insolvency law must therefore adopt countercyclical tools to promote macroeconomic stabilization.

The full paper is available here.

Adi Marcovich Gross is an incoming Professor of Law at the Reichman University School of Law (beginning in Spring 2026) and a Visiting Scholar at the Wharton School.