Business and Commercial Law

DISTRESSED FIRMS

If a debtor becomes financially distressed, its assets are probably insufficient to pay all creditors and permit them a collective exit. Governance strategies are helpful; in bankruptcy, creditors may have appointment rights as respects crisis a manger and generally have decision rights s respects plans. These are complemented by other strategies, standards and trusteeship. Their application covers two phases; the period of transition into bankruptcy, strategies dela with shareholder -creditor agency problem and second the bankruptcy procedure, strategies deal with creditor-creditor agency problem.

The standard strategy

Widely used to protect corporation creditors. The implementing provisions have various labels, each imposes an ex-post liability according to an open-textured standard on persons associated with distressed companies. Ex-post liability means that is employed if something has gone wrong in lending relationship. Duties divide into three categories according to whom

they are target: directors, controlling shareholders, and favored creditors. Since they are not relevant unless the firm has failed, the application of standards is less sensitive to the coordination costs of creditors than rules strategy; instead, they are highly sensitive to the efficacy of judicial institutions called on to apply them. Directors In core jurisdictions, including de facto, or shadow directors, may be held personally liable for net increases in losses to creditors resulting from board's negligence or fraud when the company is, or is nearly insolvent. Duties can be framed and enforced with different levels of intensity. Intensity varies though substantive content: less onerous standard (fraud) or more intensive standard (negligence). The first is triggered only by actions so harmful to creditors as to call into question directors' subjective good faith, the second imposes liability for negligently worsening the financial position of the insolvent company. The intensity variesthough the duty's imposition trigger, the greater the degree of financial distress, the more targeted its effect on incentives. The intensity varies by enforcement, and is facilitated if duties are owed directly to individual creditors, reduced for duties owed only to company. Appropriate intensity of director liability depends on ownership structure or governance of debtor firm. Concentrated ownership, governance arrangements align managers-shareholder interest, dispersed ownership, no governance alignment managers-shareholders interest. Among our core jurisdiction, the lowest-intensity standard for directorial liability is employed in US and UK, while EU deploy more intensive standards. In US there is the technique of shift in the content of the duties of directors of insolvent firms (owed by corporation); if a transaction amounts to breach of residual distribution restrictions, it triggers negligence-based liability. In UK we apply the same technique; duty owed by company; imposes.negligence-based liability on directors for wrongful trading, if failed the duty to care. In EU directors face liability for negligence; in some jurisdictions they can be held liable for failing to take actions following loss of capital. Another difference in our jurisdiction lies in risk of public enforcement; most have directors' disqualification schemes that permit state to sanction failure by directors to meet standards of pro-creditor conduct by banning them from management. great role in UK, limited in others especially in US (only available for public traded companies). Criminal liability is also imposed on directors whose breaches of statutory duties worsen financial position of company. Shareholders All jurisdictions offer doctrinal tools for holding shareholders liable for debts of insolvent corporations, restricted usually to controlling or managing shareholders who abuse the corporate form. The three principal tools are the doctrine of de facto or shadow directors (extends

Liabilities of directors to person who acts as member of board, without formally having been appointed

Equitable subordination (subordination of debt claims brought by controlling shareholders against the estates of their bankrupt companies)

Piercing the corporate veil

The latter is used in extreme circumstances; that is, to hold controlling shareholders or controllers of corporation groups personally liable for company's debt. In no jurisdiction veil-piercing was directed against publicly traded companies and most successful cases involve fraud. US permits it when controlling shareholder disregard, the integrity of company by failing to observe formalities or to capitalize adequately or when there is an element of fraud or injustice; EU applies it similarly. By disregarding company's legal personality with regard to one party, the veil-piercing acts as a blunter instrument for controlling opportunism than, the other two doctrines. Occasionally used to protect creditors of

corporation groups.US: doctrine of subsequent consolidation (assets and liabilities of related companies in single pool); groups entered by control agreements is groups not entered by control agreement.

Creditors and third parties

Standard strategy employed in regards creditors and third parties; the focus is on recruiting third parties as gatekeepers or on preventing creditor from getting a better position. In the first we target third parties who enter into transactions with a debtor in vicinity of insolvency that are disadvantageous to the debtor; recruited as gatekeepers by making them wary of desperate transactions entered by distressed debtors; third party may find transactions set aside ex-post in bankruptcy and required to return benefits received (EU, action Paulina; US, fraudulent conveyance; UK, undervalue transactions). The second, targets insider creditors who influence distressed debtors in way harmful to other creditors; one version focuses on involvement of managers decisions.

(influential creditors may be held liable as de facto directors or, if ananimus society can be established, as partners of insolvent firms) other version on preferential transactions(creditor placed in better position than the others in bankruptcy).

Governance strategies

Appointment rights

Core jurisdiction give creditors power to initiate a change in control of assets of financially distresscompany by triggering bankruptcy proceedings. This can be done by a single creditor, US requires threecreditors, most jurisdiction permit managers to bring petition. The consequence of transition to bankruptcyis removal of the board from effective control of corporation assets, and its replacement with andadministrator or crisis manager; in general creditors have right to appoint this person but it is subject tooversight by the court, which plays a trusteeship role. An alternative to appointing a crisis manager is topermit the incumbent managers to remain “in situ”, economizing on costs,

and trusteeship strategy is related upon even more heavily to control shareholder-creditors agency costs.

Decision rights

In most jurisdictions, a proposal for exit from bankruptcy proceeding, by sale of closure of business or by restructuring of balance sheet, is initiated by crisis managers, subject to veto rights from creditors. Except for Italy and US where plan for restructuring is proposed first by debtor. Deciding upon a plan for exiting bankruptcy runs into creditor-creditor agency problems. Creditors in junior class (out of money) tend to prefer more risky outcomes, instead creditors in senior class (over secured) tend to prefer less risky plans. Jurisdiction that gives veto rights to creditors over the confirmation of restructuring plan try to reduce it by seeking to give only creditors who are residual claimants a say in the process. Most jurisdictions do not allow voting by either creditor who will recover in full or by junior creditors who are out of money under the plan.bankruptcy proceeding is pre-packaged any necessary agreements to secure approval are obtainedin advance.Incentive strategiesTrusteeship strategy arguably plays a more important role for creditor than shareholder protectionpurposes, whereas the converse is true for rewards strategy. The reasons are the incentive for agents to actin principals’ interest, and problems of creditor-creditor agency costs. Two principal types of trusteeship inrelation to bankruptcy firms: crisis manger who runs or oversees bankrupt firm and oversight role of courts.Courts are not primarily responsible for making decision how to exit, they just confirm significant decisionsand resolve questions and disputes. They also oversee decisions to sell assets.All our core jurisdictions, have adopted the same set of broad legal strategies: regulatory strategies forfirms not in default, coupled with governance strategies for firms in default. This similarity at frameworklevel masks variation at a micro level; oneway of characterizing these variations is to describe countries' legal regimes as being "debtor-friendly" or "creditor-friendly", according to the extent to which they facilitate or restrict creditor enforcement against a distressed debtor. In particular, the US is considered debtor-friendly, while the UK is considered creditor-friendly. However, the existence of different classes of creditors makes this binary division too simplistic. Countries with concentrated ownership, such as those in the EU, provide standard terms to facilitate contracting with creditors in the form of accounting principles and legal rules. On the other hand, countries with dispersed ownership, like the US and UK, have adopted market-oriented disclosure requirements and abstained from imposing capital constraints. Concentrated ownership means that the debt is concentrated, making creditor coordination easier. This facilitates both monitoring and renegotiation. On the other hand, dispersed ownership means that debt is more dispersed, increasing creditors' heterogeneity and coordination costs, thereby reducing

Advantages of Standard Terms

CHAPTER 6: RELATED-PARTY TRANSACTIONS

Related-party transactions fall under the broader category of “tunneling”, which covers all forms of misappropriation of value by corporate insiders. It is a technique for value diversion; transactions include both transactions in which related parties (directors or controlling shareholders) deal with the corporation, self-dealing and managerial compensation, and transactions in which related-party may appropriate value belonging to the corporation, taking corporate opportunities and trading in company’s shares.

Why are related party transactions permitted given their vulnerability to abuse by corporate insiders? No transitions costs; disclosure of trade secrets; confidential plans; better company’s knowledge. An ad hoc prohibition is not needed, they are unlikely to reduce the incentives to engage in one-shot appropriations of firms’ assets, these are in any event under general private or criminal law.

Further, unless legal system and enforcement agents can encompass every tunneling practice, ad hoc prohibition would just push insiders into using other tunneling techniques.

LEGAL STRATEGIES FOR