The COVID-19 pandemic is causing financial distress to economically viable firms on an unprecedented scale. In this post, we introduce the novel idea of creditor cooperation duties to stabilize corporate workouts.
The prospect of widespread defaults by viable firms triggered by the COVID-19 pandemic has prompted emergency legislation around the globe. To a significant degree, these measures aim to keep distressed firms out of formal bankruptcy proceedings. For example, duties to initiate such proceedings have been suspended in Germany, Italy, and Spain; rules that govern the liability of directors of near-insolvent or insolvent companies have been relaxed in Australia, Singapore, Germany, and the UK. The policy rationale of these measures is to minimize the economic loss inflicted on firms by formal bankruptcy proceedings. For viable firms in particular, indirect bankruptcy costs can be huge, eliminating up to 20 percent of firm value.
Lawmakers so far have been less concerned with what happens to financially distressed firms outside of the bankruptcy process. Even with massive public or private sector liquidity assistance, most of these firms will eventually be forced to restructure their debt. The assumption seems to be that creditors and corporate debtors should be able to agree to a debt-rescheduling plan in a workout, i.e. in an out of court restructuring. After all, saved bankruptcy costs translate into significant efficiency gains of a workout.
In a workout, creditors must solve a loss/gain-sharing problem, and because each creditor’s dominant strategy is to free ride on the restructuring contributions of others, solving this problem is anything but certain. The presence of holdouts destabilizes workouts. But creditors can, to a certain extent, contract out of this dilemma. For example, most countries afford parties flexibility in choosing a qualifying majority that may amend the core payment terms of a bond issue (The U.S. is an exception; Sec. 316(b) of the Trust Indenture Act prohibits such collective action clauses). Further, for a long time, coordination between different types or groups of creditors was supported by informal rules and business practices such as the London Approach to corporate workouts or the INSOL Principles for a global approach to multi-creditor workouts. Consequently, it is not surprising that creditor autonomy and contractual freedom are central to the workout regimes in many jurisdictions. Neither in the U.S. nor in the UK, for example, have the courts imposed “cooperation duties” on holdout creditors and forced them to participate in a workout.
The COVID-19 pandemic should give lawmakers pause to reassess the current legal position. First, ex ante contractual arrangements between creditors to facilitate restructurings are feasible only within a specific debt instrument such as a bond or syndicated loan. They do not address the coordination problem between different groups of creditors. For this, more general rules or principles are needed. However, informal rules and business practices for workouts had essentially lost their function even prior to the pandemic. Such rules and practices are sensible tools to the extent that the debt structure of a company is concentrated, homogeneous, and stable – such as when a firm’s key financing is provided by a handful of commercial banks in a syndicated loan. Dispersed debt-holders with heterogeneous interests and an unstable composition of the creditor body is a situation in which neither the London Approach nor the INSOL Principles can flourish. Second, the scale of insolvencies prompted by COVID-19 will probably be enormous. Millions of economically viable firms worldwide might be affected and in urgent need of a debt restructuring. Providing a generally applicable legal framework that maximizes the rescue chances for as many of these firms as possible should be a first-order public concern. Third, we cannot rely on the threat to force a formal bankruptcy process such as Chapter 11 to discipline holdouts, because this threat is not credible in every jurisdiction. Bankruptcy courts are or will be overwhelmed by failing firms. Even more important, the bankruptcy costs for firms that may fail because of the pandemic are very high (the overwhelming majority of these firms will just have a cash flow problem).
Hence, legislatures should consider developing “creditor cooperation duties” to stabilize corporate workouts. Such duties would replicate the contours of a hypothetical inter-creditor agreement among all creditors and, at a minimum, would require them to negotiate a restructuring plan in good faith. Experience shows that merely being forced to engage with other stakeholders and provide reasons for one’s bargaining position has a cooperation-enhancing effect. Under certain conditions, cooperation duties might also force creditors to agree to a proposed workout arrangement. Assuming the plan would have a Pareto-efficient outcome comparable to a (hypothetical) bankruptcy process and would respect the ranking of claims under such a process, non-participation of a creditor should not be allowed. A creditor who torpedoed an efficient workout plan for unreasonable gain would risk liability if the debt-rescheduling effort collapsed and the firm was forced to file for bankruptcy.
Cooperation duties would only kick in to the extent that they were necessary to stabilize a workout. Hence, if creditors are able to achieve coordination ad hoc though private bargains, there usually is no good reason to impose cooperation duties by the law. However, such duties could play a useful role to prevent unreasonable demands by certain creditors. Further, cooperation duties would not block all individual enforcement efforts. Such efforts can create positive “information externalities” by putting other creditors on alert that the debtor’s finances might be in bad condition. Cooperation duties would arise only after a workout process had been initiated by the debtor or a creditor group.
Finding a doctrinal basis for creditor cooperation duties is admittedly a challenge. An indirect basis could be a duty to perform in good faith as an implied term of contracts between the debtor and its creditors. A more direct (and controversial) approach might be based on an extension of negligence principles or the law of partnership. In any event, these are extraordinary times, which arguably demand extraordinarily creative legal thinking. The task is to prevent debt gamblers from turning a global human tragedy into more of an economic nightmare. Creditor cooperation duties in a corporate workout could be a way to do that.
This post comes to us from Horst Eidenmüller, Statutory Professor of Commercial Law at the University of Oxford, and Kristin van Zwieten, Clifford Chance Associate Professor of Law and Finance at the University of Oxford.