A comparison of US, UK, and German insolvency codes - Special Issue: European Corporate Finance

Financial Management (Financial Management Association), Autumn, 1996 by Julian R. Franks, Kjell G. Nyborg, Walter N. Torous

This paper describes three insolvency codes, those of the United Kingdom (UK), Germany, and the United States (US), and appraises their efficiency against a number of benchmarks.(1) These codes have been chosen because they cover a broad spectrum of debtor- and creditor-oriented insolvency procedures.

An important difference between the three codes is the allocation of control rights. For example, Chapter 11 in the US allows the debtor to retain control of the firm and provides it with the exclusive right, at least for a limited period, to propose a plan of reorganization. In contrast, in the UK, receivership gives control rights to a particular secured creditor, who has no duty to take account of the interests of other more junior creditors. Under the current German code, strong control rights are given to secured creditors and this has the effect of favoring the liquidation of the enterprise rather than its maintenance as a going concern.

All three codes have been subject to serious criticisms which have given rise to new or impending legislation. The concern expressed of the UK code has been that it encourages creditors to prematurely liquidate the firm when it is worth more as a going concern. (See Kaiser, 1996.) The 1986 Insolvency Act was designed to rectify the more obvious shortcomings. However, the new procedures have been invoked in a relatively small number of cases, and in 1994, the UK government issued a Consultation Document inviting evidence from interested parties with a view to further legislation.

In Germany, criticism of the existing code centered on premature liquidations arising from the ability of secured creditors to repossess their assets and so precipitate the closure of the firm. (See Kaiser, 1996.) New legislation was passed in 1994, to come into force in 1999, which will limit the powers of the secured creditors to repossess their assets. It will also allow other creditors more control over the proceedings so as to reduce the discretion of the administrator to delay sale and liquidate.

In the US, new legislation was passed in 1994 which increases protection for some creditors as well as expedites the bankruptcy process. In addition, there has been an increasing use of reorganizations outside the formal bankruptcy process, what Jensen (1989) has described as the "privatization of the bankruptcy process."

International comparisons should be of interest on a number of accounts. First, the high level of insolvencies due to the recession in Western Europe in the early 1990s has led to a further review of insolvency procedures by regulators to determine if particular provisions provide the correct incentives to liquidate or maintain an insolvent company as a going concern.

Second, the newly emerging nations of Eastern Europe must establish their own codes, and this paper provides information on the strengths and weaknesses of competing creditor- and debtor-oriented codes. Also, when the EU harmonizes the insolvency codes of the Union, an appropriate model must be chosen as the basis for harmonization.

Third, companies with international operations should take account of the fact that the design of a code and the costs of insolvency, both direct and indirect, will vary across jurisdictions, and thereby alter the location of borrowing and lending decisions.

Section I of the paper examines criteria for judging the efficiency of an insolvency code. Section II describes the three insolvency codes in some detail, Section III compares the three codes, and Section IV discusses the implications for their efficiency in the light of the benchmarks discussed earlier. Section V examines some of the implications for the design of bankruptcy procedures. Section VI provides conclusions.

I. Criteria for Judging the Efficiency of a Bankruptcy Code

Efficiency can be evaluated at three stages in the bankruptcy process - ex ante, interim, and ex post - depending upon the information available at the time. As defined by Holmstrom and Myerson (1983), the ex ante stage is the time before individuals are in receipt of any private information; the interim stage is when private information is received, but not shared; and, finally, the expost stage is when all private information has become common knowledge.

In the context of bankruptcy, the ex ante stage is prior to the onset of financial distress, for example, when the debt contract is signed. The interim stage is when the firm's distress becomes common knowledge, precipitating restructuring, and if this fails, formal bankruptcy. At this interim stage, creditors, managers, and owners have different information regarding the firm's liquidation and going-concern values. For example, a creditor whose claim is secured by a particular asset may have monitored its value throughout the life of the loan and have better information about its value than other creditors, or indeed the firm itself. Moreover, insiders are likely to have different information than outsiders about the going-concern value of individual divisions or the firm as a whole.