UK Corporate Insolvency Laws: Following the Steps of Chapter 11
The Covid pandemic resulted in an unprecedented failure of millions of companies around the world. It is estimated that approximately 200,000 and 400,000 businesses failed during the pandemic in the U.S. and the UK respectively. Companies that face financial distress are subject to bankruptcy laws which differ depending on the jurisdiction they are subject to. In the US, Chapter 11 is considered a debtor-friendly federal law that aims to “reorganize” a failing entity. The UK’s insolvency laws were traditionally regarded as creditor-friendly before the Corporate Insolvency and Governance Act 2020 (CIGA 2020) was adopted. This article provides an overview of bankruptcy laws on both sides of the Atlantic. First, it briefly describes the mechanics of Chapter 11. Second, it discusses the extent to which legislative changes in UK corporate insolvency laws started to resemble the U.S. regime. The article concludes that the CIGA 2020 offers benefits, but also raises concerns because it wrongly assumes that management always possesses skills necessary to rehabilitate a failing company.
In the UK, “insolvency” is a broader term that can refer to not only corporations but also individuals, in which case it is referred to as “bankruptcy.” Under UK law, and contrary to the U.S. system, only individuals can apply for bankruptcy; corporations do not fall under this procedure. Thus, for the purposes of this article, the term insolvency in the context of UK laws should simply be regarded as bankruptcy applicable to U.S. corporations.
Chapter 11: A “Reorganization” Bankruptcy
In the American system, when a company is in the zone of insolvency or is insolvent under any one of the balance sheet, cash flow or adequate capital tests, management must choose the appropriate course of action. One of the ways to restructure the company’s operations and liabilities during times of distress is to utilize Chapter 11 by filing a bankruptcy petition – an in-court restructuring. This reorganization mechanism allows management to continue operating the business as a “debtor in possession” (DIP). An automatic stay is one of the debtor-friendly features of Chapter 11 which prohibits creditors from virtually all legal actions that might affect the company and its property. As a result, the company is provided with breathing space to propose a Plan of Reorganization (PoR) within 120 days of filing the petition.
Under Chapter 11, management controls the company unless a Trustee is appointed. Trustees are rarely appointed, and only when there are reasons to believe that fraudulent activities within the company might occur. Chapter 11 Trustees are not the same as U.S. Trustees: the latter bankruptcy actors are always appointed and are tasked with monitoring the filing of required financial schedules by the debtor and controlling the appointment of a committee of unsecured creditors. U.S. Trustees can also provide comments on the PoR.
The automatic stay feature, combined with the fact that Trustees rarely control the business in distress, means that U.S. corporations enjoy soft bankruptcy laws. Such laws put a lot of faith in the management’s ability to turn around a failing company with few external distractions such as the U.S. Trustees.
The CIGA 2020: One Step Closer to a US-Style Regime
The UK insolvency laws have undergone substantial changes over the past decades. Traditionally, administrative receiverships allowed a holder – usually a bank – of a qualifying holding charge secured over the whole, or substantially the whole, of the company’s assets to appoint a receiver. The receiver did not have an obligation to rescue the company but could strip down the company’s assets to satisfy the rights of secured creditors. Following the prohibition of administrative receiverships by Section 250 of the Enterprise Act 2002, the administration procedure gained popularity. Schedule B1 of the Insolvency Act 1986 requires an administrator to attempt to rescue the company first unless the administrator thinks that ‘it is not reasonably practicable to achieve that objective’. Companies in administration enjoy a moratorium – the equivalent of an automatic stay in Chapter 11. However, in contrast to Chapter 11, when a company enters administration, its directors hand over their powers to an insolvency practitioner (IP). The displacement means that it is the administrator that controls the company, which is characterized as the “practitioner-in-possession” (PIP) system.
The CIGA 2020 was introduced and rushed through the Parliament due to pressure caused by Covid-19 on UK businesses. The new law does not affect the administration procedure but introduces a standalone moratorium, moving the UK a step closer to becoming a DIP jurisdiction. The standalone moratorium provides directors with 20 days to generate a rescue plan for their company. The CIGA 2020 requires company management to be supervised by a ‘monitor’ – a person similar (but not identical) to a U.S. Trustee. The monitor must be an IP and is an officer of the court. She controls the company’s affairs to form a view as to whether the company can recover during the moratorium. Thus, the monitor does not acquire the powers of the board at the time of the moratorium but ensures that the directors act in accordance with relevant procedures. Nonetheless, the standalone moratorium is a DIP process and departs drastically from the PIP regime seen in the Schedule B1 administration.
Is the Introduction of CIGA 2020 the Right Step?
The administration procedure does not require administrators to rescue a company if creditors’ realizations would be higher without rescuing the company. Such strong creditor protection might result in liquidations of companies which would otherwise have chances of survival – in effect preventing job preservation and other economic benefits for the UK. Assuming an out-of-court restructuring is not a viable option, the management cannot obstruct the powers of an administrator controlling the company. The CIGA 2020 aims to modify this environment by allowing the management to “hold the keys” to an insolvent company through the standalone moratorium. However, evidence from the U.S. suggests the standalone moratorium might be too friendly for debtors.
Chapter 11 has been criticized for leaving too much power to company management because it “leaves an alcoholic in charge of a pub.” This argument might prove to be exaggerated if a company fails due to an external factor when management is not at fault (such as, for example, the pandemic) and where its skills and knowledge would help to make the company profitable again. On the other hand, external factors do not always justify why management should enjoy its powers during an insolvency. In the past, numerous companies disappeared due to external factors which merely accelerated their inevitable failure. For example, the U.S.-based photographic company Kodak filed for bankruptcy in 2012 because its management never attempted to innovate. A competitive market – the external factor – contributed to Kodak’s collapse not because of its rivals, but because of its management.
Kodak is a good indication of how unavailing the standalone moratorium introduced by CIGA 2020 might become in the UK. It might be inefficient because it could result in management gambling with creditors’ money if it turns out that it lacks the necessary skills to rescue a company ex post. However, given how young the CIGA 2020 is, the efficiency of the UK version of a DIP regime remains to be seen.
Jakub Kozlowski serves as a Graduate Editor of the NYU Journal of Law & Business. He is a Corporations LLM candidate at NYU where he focuses on M&A, private equity and securities law. He is also currently a Research Assistant at the Institute for Corporate Governance and Finance. Prior to attending NYU, Jakub completed the LLB and LPC in England and interned at several law firms in Poland and the U.S.