Volume 42 | Number 3 Summer 2007
V. Creditor Rights and Insolvency
At the formative stage of economic development, the risk and incidence of defaults by debtors often prevent the efficient deployment of funds for investment. A proper framework of law that provides both for company incorporation and the orderly resolution of proceedings for recovery and insolvency is therefore a crucial foundation of development.
A. Insolvency
A functioning legal framework for insolvency management is essential in the operation of any modern market-based economy. No commercial sector can function effectively without mechanisms to recognize and govern the exit of insolvent participants. Furthermore, the financial sector will limit credit creation for many companies and individuals if lenders are uncertain that their status as secured creditors will prevail upon the liquidation of their debtors, or that a reliable means will be available for the enforcement of properly-constituted security. The general objectives of a system of corporate insolvency have been described as the reduction of uncertainty, promotion of efficiency, and fair and equitable treatment for all participants.81 A functioning insolvency regime can thus help reduce and simplify the risks associated with lending and the potential cost of debt service; if this is the case, long-run credit availability and capital investment will increase.82
Functioning insolvency procedures are thus central to the legal and institutional environment for sound finance in any market-based economy, regardless of whether public policy requires the law to favor debtors or creditors. A well-administered insolvency system may be valuable in promoting market discipline. Effective insolvency laws provide the means for the identification of non-competitive participants and, in some cases, for their controlled exit. It thus provides an effective penalty for the least competitive as well as a potential solution to the ensuing reallocation of resources. While this view stresses the retroactive character of insolvency law, it also has a considerable preventive element by creating incentives for the uncompetitive to improve performance and to avoid the sanction of administration by a third party on its creditor’s behalf.
A number of international organizations and associations have assisted the development of standards for modern insolvency law and related systems. Many of these activities have focused in particular on norms and standards for cross-border insolvency cases, such as the UNCITRAL Model Law on Cross-Border Insolvency and the EU Insolvency Regulation of 2000.83 A working group chaired by the legal department of the IMF presented a document containing detailed principles for the development of workable, modern insolvency legislation.84 While there is no internationally agreed key standard in the area of insolvency, the World Bank is coordinating efforts to develop such a benchmark and is working with UNCITRAL to develop a suitable framework for its implementation.
The World Bank first issued its Principles and Guidelines for Effective Insolvency and Creditor Rights Systems in April 200185 and a revised version under development will take into account feedback from insolvency assessments conducted under the IMF-World Bank Reports on Observance of Standards and Codes (ROSC) initiative.86 The Bank is also preparing a technical report containing detailed implementation guidelines to support the principles. UNCITRAL released a Legislative Guide on Insolvency Law in 2005, a combination of model provisions, recommendations, and explanatory notes that builds upon the work of other international organizations, including the World Bank, IMF, and ADB.87
The World Bank identifies nine objectives for effective corporate insolvency:88
1) Integrate with broader national legal and commercial systems.
2) Maximize the value of a firm’s assets by providing an option to reorganize.
3) Strike a careful balance between liquidation and reorganization.
4) Provide for equitable treatment of similarly situated creditors, including foreign and domestic creditors.
5) Provide for timely, efficient, and impartial resolution of insolvencies.
6) Prevent the premature dismemberment of a debtor’s assets by individual creditors seeking quick judgments.
7) Provide a transparent procedure that contains incentives for gathering and dispensing information.
8) Recognize existing creditor rights and respect the priority of claims with a predictable and established process.
9) Establish a framework for cross-border insolvencies, with recognition of foreign proceedings.
In supporting these objectives, the thirty-five World Bank insolvency principles cover five main areas: first, a legal framework for creditor rights (principles 1-5);89 second, a legal framework for corporate insolvency (principles 6-16); third, corporate rehabilitation (principles 17-24); four, informal workouts and restructuring (principles 25-26); and five, institutional and regulatory frameworks for implementation of the insolvency system (principles 27-35).
The most recent version of the UNCITRAL Guide has two parts.90 The first deals with the design of the key objectives and structure of an insolvency law, while Part II includes core insolvency law provisions. Regretfully, until the revised World Bank principles and final UNCITRAL Guide are integrated, approved, and released, it is impossible to identify an international consensus in this area.
B. Interaction between Creditor Rights and Insolvency
Debtor-creditor laws include systems for collecting debts and insolvency systems for terminating the collection of unpaid debts. Collection systems include: secured transactions, using movable property as collateral; mortgages, using fixed property as collateral; and unsecured lending, a system that employs no property or other rights as collateral.91 One view of the interaction between secured lending and insolvency law sees each as addressing distinct problems, with separate solutions. A secured lending system determines how lenders are repaid, whereas an insolvency system establishes the appropriate treatment for defaulting borrowers.
At the same time, there are important points of intersection between secured transactions and insolvency, and the two systems must be integrated. Neither system can substitute for the other. Thus, reforms of debtor-creditor laws must embrace both secured lending and insolvency law, as well as other closely related areas of law. The need for such drafting integration may be more widely realized in East Asia now, as governments contemplate reform, than would have been the case prior to the 1997-98 financial crisis.
Secured transactions have often been seen as important in improving general welfare by helping create and encourage certain benefits for society as a whole. Regardless of the nature of preferred insolvency laws, East Asian national economies are likely to advance by improving their respective laws on secured lending. This relies on the premise that general access to credit, and the specific terms on which it becomes available, will improve in the borrower’s favor as the quality of collateral-taking improves.92 Effective secured transactions systems that allow for movable property to be used as collateral may allow distressed firms to gain access to credit and so avoid the final resort of insolvency. In such conditions, creditors may anticipate repayment without necessarily initiating the insolvency process.
All security interests must be properly publicized. An effective method of publication puts both existing and potential creditors on notice that a debtor company has fewer unencumbered assets available in which potential lenders might obtain meaningful interests. It also provides notice as to the order of priority for the distribution of assets if a company becomes insolvent. Filing or registration systems are comparatively more effective than inefficient systems that rely on possession as a form of security. The efficient enforcement of security interests is central to an effective secured transactions system. It also promotes both informal and judicially supervised workouts. An efficient system will minimize the need for judicial assistance wherever possible and expedite the enforcement process.
In the interaction between secured transactions and insolvency, the essential need is for insolvency law to respect the pre-existing priority rights of secured creditors. If the law poses unreasonable threats to secured lending, banks might increase transaction charges or restrict access to credit. In addition, when a company contemplating insolvency charges or mortgages assets to a creditor in exchange for identifiable value to the company, then as a general rule such charges or mortgages should not be voided by subsequent insolvency proceedings. Secured creditors should also be permitted to convert unsecured debts into secured debts, providing such transactions are completed substantially before the commencement of any insolvency proceedings. The law should provide that fraudulent or commercially unfair transactions that have a security component may be avoided. As a general rule, pre-petition interests should continue in post-petition proceeds, while post-petition grants of security should be permitted. Last, as a general rule, priorities in insolvency should be abolished.
Overall, East Asian economies would benefit from enacting insolvency laws that respect the pre-existing rights of secured creditors. However, in deciding to what extent exceptions may be permitted and how best to balance the needs of secured transactions and insolvency, law-makers in East Asia must first determine which approach they believe most appropriate.
C. Creditor Rights and Insolvency in East Asia
The appraisals given in Table 7 acknowledge extra-legal regulatory guidance for collaborative multi-creditor practice, for example in Hong Kong, Indonesia, Malaysia and Thailand. Regulators in these jurisdictions have attempted to instill informal out-of-court corporate workout practices similar to the well-established “London Rules,” or “London Approach,” promoted in the 1970s by the Bank of England as an alternative to formal court-based corporate insolvency proceedings involving multiple financial creditors.93 After the onset of the Asian financial crisis, such out-of-court workout procedures were applied more frequently than court-based formal reorganizations, although the results were not consistent in all jurisdictions.94 Most jurisdictions also set up public administrative agencies to assist with the restructuring of domestic financial intermediaries and the disposal of non-performing loans (NPLs).
In both Hong Kong and Singapore, systems and practice are well-established and generally sophisticated, but legislative reform has tended to lag both market practice and the willingness of the courts to intervene creatively in cases of corporate distress.
Table 7: Development of Effective Insolvency Systems
| Legal framework for corporate insolvency | Corporate insolvency implementation | Judicial decisionmaking and enforcement | Effective insolvency practitioners | |
|---|---|---|---|---|
| Cambodia | NA | NA | 1 | 1 |
| China95 | 2/3 | 1 | 1 | 1/2 |
| Indonesia | 2/3 | 1 | 1 | 1/2 |
| Malaysia | 4 | 4 | 4 | 4 |
| Philippines | 2/3 | 2/3 | 2 | 2/3 |
| South Korea | 4 | 3/4 | 3 | 3/4 |
| Taiwan | 3 | 3 | 3 | 3 |
| Thailand | 3 | 2/3 | 2/3 | 2/3 |
| Vietnam | 1/2 | 1/2 | 1 | 1 |
| Hong Kong | 4 | 5 | 5 | 5 |
| Singapore | 4/5 | 5 | 5 | 5 |
1. Insolvency: Pre-1997 Overview
Among the jurisdictions in this study, only Singapore had an insolvency regime adequate to deal with a high number of corporate failures at the opening of the Asian financial crisis. All other jurisdictions were hampered by antiquated or inadequate laws and procedures, many of which dated from colonial times. None maintained an effective formal corporate rescue procedure. Hong Kong and Malaysian corporate insolvency procedures were modeled on mid-20th century English law. Thai law dating from 1940 was influenced by English personal bankruptcy laws, while Indonesian law was mainly Dutch in origin and dated from the late 19th century. South Korea’s insolvency regime drew on Japanese law, which derived from German, Austrian, and U.S. principles and statutes. Taiwan’s laws were also derived from Japan’s laws and later, to a lesser extent from U.S. law, with the last pre-1997 amendments dating from the early 1980s. China’s insolvency laws were written more recently, with bankruptcy provisions for state-owned enterprises (SOEs) enacted in 1986, and provisions for non-SOE enterprises with legal person status, in 1991. Vietnam’s laws dated from 1994. These regimes used liquidation-based procedures, with the exception of Singapore. Cambodia still lacks an insolvency framework. For the most part, these insolvency laws were under-utilized.
Insolvency law in Hong Kong, Malaysia, and Singapore share the same basic structure of detailed liquidation or winding-up procedures and an abbreviated scheme of arrangement procedure for use in corporate rescue. The liquidation procedures in these jurisdictions are still the region’s most efficient, although in need of modernization, but the scheme of arrangement procedure is cumbersome and expensive. Hong Kong and Malaysian procedures do not provide for an automatic stay on creditor claims in the absence of a winding-up order; Singapore operates a stay only on unsecured creditors. In none of these three jurisdictions are there mechanisms to force uncooperative secured creditors to the bargaining table. The result is that prior the Asian financial crisis, the procedure was rarely employed, although it saw more use in Singapore than in Hong Kong and Malaysia. Singapore also introduced judicial management procedures in 1987. These procedures may be initiated either by a debtor company or its creditors, and the procedure provides for an automatic stay while a judicial manager assumes the responsibility for running the company and proposing a plan of reorganization for creditor approval.96
The evolution of South Korea’s insolvency regime has been more complicated. Until recently, the law had three parts, all dating from 1962, which concerned bankruptcy, composition, and reorganization. Rather than develop an insolvency solution, South Korea translated and enacted Japanese laws, so that the Bankruptcy Act was based on the Japanese Bankruptcy Act 1922, itself derived from German law. The Composition Act was based on a Japanese composition law taken from Austrian law; the Reorganization Act copied the Japanese Reorganization Act 1952, derived in turn from the U.S. Bankruptcy Act 1898. The composition law was triggered by a debtor’s filing and only provided for temporary relief until creditors voted on a composition plan. The more complicated reorganization process was better suited for larger, public companies.
The Philippines civil law system has long-standing common law aspects, found also in some contemporary European jurisdictions, in that its supreme court decisions are binding as precedents. The pre-1997 Philippines insolvency law dated from 1909 and included a rarely used liquidation procedure and a corporate rescue suspension of payments process taken from Spanish law that was available only to solvent companies experiencing temporary cash flow problems. Any proposal for debt rearrangement required the full payment of debts, and so was rarely used. A rehabilitation procedure was introduced as an alternative to the inflexible suspension of payment process under a 1976 presidential decree, later amended in 1981. Rather than giving jurisdiction for rehabilitation and suspension of payments to the judiciary, however, the amendment granted jurisdiction to the Securities and Exchange Commission (SEC). The rehabilitation procedure provided few rules and contained curiosities, such as providing that creditors were not obliged to approve a rehabilitation plan, and at times treating secured and unsecured creditors alike.
Indonesian and Thai insolvency law also provided for liquidation and suspension of payments procedures, which were also rarely used. Indonesian debtors are able to present a plan of composition even within the liquidation process. The suspension of payments process provides the debtor with additional time to finalize a repayment plan. Under Thai bankruptcy law, composition is possible either pre-petition or post-petition. An unusual aspect of the Thai Bankruptcy Act 1940 is that its presumption of insolvency appears to have been influenced by the acts of bankruptcy in 19th century English law.
Taiwanese bankruptcy law dates from 1935 and provides for both liquidation and composition. The reorganization law under the Company Law, applicable to public companies, was similar to that in Korea. The reorganization law had not been amended in many years and was over-reliant on the court. The effectiveness of the old law has been criticized for its inconsistency “due in part to a lack of commercial viability on the part of the companies undergoing reorganization.”97 The lengthy reorganization process also enabled some companies to avoid bankruptcy by abusing the reorganization procedures.98
China was spared the most severe economic problems of the Asian financial crisis, and as of 1997 was the only jurisdiction in the study group whose bankruptcy laws had recently been promulgated. Nevertheless, at the time of the financial crisis, China was affected by domestic concerns resulting from the poor financial condition of its SOEs and state-owned banks. The insolvency framework in China at that time was an overlapping patchwork that included: a forty-three provision 1986 Bankruptcy Law for SOEs; eight provisions in Chapter XIX of the 1991 PRC Civil Procedure Law applicable to non-SOE enterprises with legal person status; judicial interpretations of these short laws, notably the 2002 interpretation by the Supreme People’s Court; and most importantly, several policy decrees issued by the central government which are crucial in understanding the government’s approach to insolvency issues. Although the number of insolvencies in China has been increasing, it is generally considered to be far lower than the number of insolvencies that would correspond to the true condition of most SOEs and banks, gauged by generally accepted accounting standards. A new bankruptcy law, under discussion for more than a decade, was finally enacted in August 2006 and is discussed below.
Vietnam enacted a bankruptcy law in 1993 that came into operation in the following year. Unlike China’s bifurcated approach—with separate laws for SOEs and non-SOE legal person enterprises—Vietnam had a unified law. The Vietnamese law was also more expansive than the former Chinese act in that it also applied to enterprises lacking legal personality (e.g., partnerships and sole proprietorships). In practice, however,, the law was cumbersome in application and rarely used. Its requirement that a debtor exhaust “all financial measures” before being eligible for bankruptcy effectively led to a two-year delay before a bankruptcy could be commenced. A new Vietnamese bankruptcy law came into operation in 2004.99 Cambodia is currently considering enactment of its first insolvency law.
The profound impact of the 1997 crisis led to an immediate call to reform or replace archaic liquidation regimes and supplement them with modern corporate rescue procedures, including both formal court-based regimes and out-of-court and administrative procedures. Since the crisis, two waves of reform have crossed the region. The first included insolvency reforms in Indonesia, Malaysia, the Philippines, South Korea, Taiwan and Thailand. The second includes the new bankruptcy laws enacted in Vietnam in 2004 and China in 2006 and ongoing law reform efforts in Cambodia, Hong Kong, and Singapore, although th
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Footnotes
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