Needed Urgently: Good Bankruptcy

As the crisis unfolds, the need for a good bankruptcy regime is starting to dawn on policymakers. No matter how successful fiscal stimulus packages and other crisis response measures might be, there will soon be a flow of corporate bankruptcies. Previous crises show that such bankruptcies lag behind the start of a crisis by a year or two. As demand falls, businesses try to cut expenses, restructure payments, renegotiate with suppliers. Ultimately, many live on. But some fail.

For these, it is useful to have an efficient bankruptcy regime so creditors do not have to write off the whole value of the loan. But bankruptcy is never a popular reform, and governments typically get to it when the courts are already clogged with insolvency cases. By the time a reform is completed, more interventionist options (for example, the use of asset-management companies) are needed.

A recent survey of previous experience in bankruptcy reform suggests a menu of possible reform choices while in crisis. The analysis is to a large extent based on the data from the Doing Business project, and its section on Closing a Business.

Here we present the section on dealing with systemic distress:

"When distress is widespread, there is a danger that it may be self-reinforcing. Firms may have low incentives to restructure because other distressed firms and consumers have low demand for their products. Also, distressed firms are unable to repay debts, maintaining pressure on banks, which in turn restrict new lending. Banks may become insolvent, reducing the incentive of borrowers to repay loans. In past crises, several policies have been undertaken to avoid this situation. These are the super-priority of fresh capital, prepack bankruptcy, super bankruptcy, and debt-to-equity conversions for troubled banks.

1. Super-priority of fresh capital

Financing must be available during bankruptcy, otherwise businesses may not be able to emerge from the process. Without financing, bankruptcy could lead to liquidation—not a liquidation driven by market forces, but a fire sale due to the dislocation of the financial markets. In normal times, financial institutions would provide this financing. A solution is to reform the bankruptcy code and allow new capital to take priority over all old creditors, including secured ones. This gives an extra incentive to loan to distressed businesses.

In 2005, France adopted a new procedure that allows companies in financial difficulty to apply for bankruptcy protection before they are insolvent. The idea is to start reorganizing before it is too late. In addition, creditors that lend money to businesses that are in the pre-insolvency procedures will receive priority in the payment of claims, making it more likely that distressed businesses will get new loans.

2. Prepack bankruptcy

A prepackaged bankruptcy (a "prepack") calls for a firm to negotiate a reorganization plan with its creditors, and solicit acceptances of the plan, prior to filing for bankruptcy. The firm then files for bankruptcy and simultaneously files a plan of reorganization. Given the advance negotiation with creditors, a court hearing can be scheduled quickly, leading to a quick exit from bankruptcy. The recent bankruptcy of Chrysler in the United States is an example of a prepack.

Prepackaged bankruptcy is a hybrid of two methods of reorganizing distressed firms: workouts and bankruptcy. Prepacks combine the low costs of a workout with the benefits of formal reorganization. There are three reasons that firms might file a prepackaged bankruptcy instead of completing an out-of-court workout: binding holdout creditors, avoiding cancellation of indebtedness income, and preserving the firm’s net operating loss carry forwards.

First used in the Mexican crisis and expanded during the East Asian crisis, a variation of prepackaged bankruptcy are the so-called London rules. These apply during systemic distress and enable prepacks to work on a larger scale. Enhancements involve encouraging all (or most) financial institutions to sign on to these out-of-court accords under regular contract or commercial law. If so, agreements reached among the majority of creditors can be enforced on other creditors without going through formal judicial procedures.

3. Super Bankruptcy

Another approach, so far untested, is the adoption of “super bankruptcy,” a temporary tool to be used when a country faces systemic bankruptcy brought on by huge macro-economic disturbances. This approach was advocated by Joseph Stiglitz during the early stages of the East Asian crisis. The basic presumptions of the super bankruptcy are that management stays in place and that there is a forced debt-to-equity conversion. In a systemic crisis it can preserve the going-concern value of firms by preventing too many liquidations and keeping in place existing managers, who most often will know best how to run the firms.

An important design issue is when to call for super-bankruptcy, that is, when is the crisis of a systemic nature, and who has the authority to call for such a suspension of payments. The evidence from East Asia suggests that adopting a temporary super-bankruptcy is unnecessary. Corporations and banks moved slowly to restructure outstanding debt in the hope that economic recovery will obviate the need for write-offs (for banks) or surrendering of equity control (for large shareholders).

4. Debt-to-equity conversions for troubled banks

Banks who enter into this bankruptcy procedure would have their debt converted to equity. This scheme allows the banks to convert debt (commercial paper, bonds and interbank lending with a maturity longer than three days) into equity. This would make them solvent and ready again to lend to customers. Also, it recapitalizes the banking sector at no cost to taxpayers. Second, it keeps the government out of the difficult business of establishing the price of distressed assets. If all of an institution's debt is converted into equity, its total value—its assets plus its going-concern value—remains the same. The bankruptcy changes only the legal nature of the claims on this value.

A more interventionist version is the government taking equity in these distressed banks. An example is the U.S. Reconstruction Finance Corporation, the RFC. The RFC, which operated from 1932 to 1957, loaned or invested more than $40 billion to 5,685 banks, or 40 percent of all insured banks in the United States. The RFC’s discretion to support banks was limited and to be eligible for this program, banks had to agree to limit dividends and devote earnings to retiring the stock of the bank—essentially, buying out the government’s position. The RFC, whose stock was senior to all other types, could also only hold a maximum of 49 percent of the equity of a bank, which meant that there had to be some private funds."