The Imminent Distortion of European Private, Company and Insolvency Law by the Introduction of Relative Priority European Style

By Rolef de Weijs, Aart Jonkers  and Maryam Malakotipour

One stone can change the current of a river. Likewise, one small seemingly technical rule can alter the entire legal system and with it the basic fabric of society.

The European Parliament is about to enact a Directive on Preventive Restructuring Frameworks. Last minute a completely new and never tested nor explained legal concept referred to as Relative Priority was inserted, probably without realizing its ramifications. This new rule is likely to distort basic private law, basic company law and basic insolvency law. Most likely, the European Parliament thinks it is saving businesses and thereby jobs and while at it, also strengthening the position of Small and Medium Enterprise (‘SME’) Businesses in Europe. It will not do that. Much more likely is that Relative Priority will turn against the interests of SME’s.

Regardless of whether one has the interest of large banks and the stability of the financial system in mind or the interest of SME’s, the Relative Priority Rule (RPR) is an untested underexplored rule that will upend general commercial law.

1. Why does Priority matter? General protection against abuse and opportunistic use of insolvency law

It all comes down to the question who is allowed to get something out of a failing or financially distressed company. There is one basic rule underlying insolvency law which also protects society and the integrity of the insolvency system itself. That rule is that if creditors are not being paid, shareholders cannot hold on to any value unless the creditors explicitly consent thereto. Take a big retail chain selling toys, for example. Suppliers, banks and tax authorities know that they will not be left empty-handed while the shareholders remain in control of the company and its assets, unless they as a group of creditors explicitly consent thereto.

This outcome of shareholders bearing first losses is the most basic starting point for all insolvency procedures resulting in a dismantling of the company and the sale of the assets or business, also referred to as liquidation procedures. Insolvency or financial distress in itself should, however, not necessarily lead to the liquidation of the business and the company. Instead the law could offer a framework for reorganization, the outcome of which is ideally that the company as a legal entity survives the insolvency procedure and is made viable again. The main justification of such a procedure is that an operating company will be worth more than a liquidated company and therefore also creditors will benefit if the company is reorganized.

The EU is now betting on this strategy by trying to be more creative in dealing with insolvent and financially distressed companies. The EU aims to implement far-reaching reorganization procedures by means of the so called Directive on Preventive Restructuring Frameworks. [1] This should allow companies to reorganize at an early stage to prevent liquidation. This in itself is worth pursuing. One should, however, not be lured into thinking that such Preventive Restructuring Frameworks are not insolvency procedures. There is no magic here and for the non-initiated, the term might be confusing or even misleading. Although there will be no liquidation of the company and not even a formal court supervised insolvency procedure, there will be parties, most frequently creditors, whose legal rights will be curtailed against their wishes and without their consent. This is mainly achieved by so called cram-down and cross-class cram-down procedures, in which majorities can bind minorities and hold out creditors can be overruled by courts. Or, in the words of Tollenaar: “On the other hand, in terms of its consequences, the procedure is nothing but an insolvency procedure (“if it’s not called a duck, but looks like a duck, swims like a duck and quacks like a duck, it probably is a duck”).“[2]

Because these preventive reorganization procedures will lead to a reduction in debt for the company, the initial question as to whether parties can abuse or opportunistically use insolvency laws resurfaces. The initial draft from 2016 for the Preventive Restructuring Framework contained a rule providing the basic protection that shareholders could not hold on to any value unless the creditors by majority vote consented thereto. Such a rule is in force in US and German law as part of reorganization procedures and is referred to as an Absolute Priority Rule (APR). Since not all Member States yet have a fully functioning reorganization procedure, not all Member States have had to provide for such basic protection. The US has been an important inspiration for implementing a far-reaching reorganization procedure. The Absolute Priority Rule is generally considered to be one of the most important rules of US bankruptcy law, see recently the US Supreme Court in Jevic, calling the APR “quite appropriately, bankruptcy’s most important and famous rule” and “the cornerstone of reorganization practice and theory.”[3]

2. Relative priority as advocated in the Directive

For two years, from 2016 until the end of 2018, the draft of the Preventive Restructuring Framework was circulated and discussed. Although there was and still is unease as to whether the Directive is actually needed and for which kind of problems it would provide a solution,[4] there was always the basic underlying protection that shareholders could not retain value if the company did not pay its creditors in full, unless the creditors would agree thereto.

The new 2018 draft suddenly and surprisingly provides that Member States can also opt for Relative Priority instead of Absolute Priority. Although Absolute Priority would still be allowed, it seems that the preferred rule is now Relative Priority. The new art. 11 Directive stipulates that:

1 (c ) [] dissenting voting classes of affected creditors are treated at least as favourably as any other class of the same rank and more favourably than any junior class [EU RPR]; (…)

2 (a) By derogation of point (c) of the first paragraph, Member States may provide that a dissenting voting class of affected creditors is satisfied in full by the same or equivalent means if a more junior class is to receive any payment or keep any interest under the restructuring plan [APR].[5]

This is the stone that alters the course of the river entirely. Relative Priority as understood in the draft EU Directive provides that creditors should ‘be treated more favourably’ than shareholders. It is no longer required that creditors are paid in full before shareholders are allowed to retain shares. This could possibly be interpreted to mean that if creditors get a payment of € 20 million on their total claim of € 300 million, they are treated better than the shareholders that keep the full equity after reorganisation with a value of € 12 million.

Rather confusingly, Relative Priority in this Draft Directive is something completely different from what US scholars before have also coined Relative Priority (‘US RPR’). Unfortunately, in underlying Reports it is not made clear that where EU RPR and US RPR use the same names, they are entirely different concepts. Since the Reports do refer to the US Relative Priority, there is also the risk of confusion. The Report of the European Law Institute for example refers explicitly to the work of US professor Baird in arguing in favor of EU RPR:

“A more flexible (relative) priority rule would better reflect pre-insolvency entitlements as it allows to create a new capital structure that also keeps everyone in the picture. As Douglas G Baird puts it: “Such a new capital structure can be consistent with the firm’s current financial condition (doing away with such things as the obligation to pay dividends and interest as well as stripping junior investors of voting or other control rights), yet still recognize the junior investors’ right to any excess that remains when, at some time in the future, all the accounts are ultimately squared. This is the essence of relative priority.“[6]

Although the names are the same, the outcome of EU RPR and US RPR will be exactly the opposite. US professor Baird explains the working of the RPR he has in mind as follows:

“Implementing relative priority is simple. The senior investor is given all the equity in the reorganized firm, and the junior investor is given a call option on this equity with a strike price equal to the amount owed the senior investor.”^[7]

Where the outcome of Relative Priority under the European Preventive Restructuring Directive in most cases will be that the shareholders remains fully or partly in place, the Relative Priority Rule professor Baird has in mind, removes the old equity all together and leaves them with an option to regain the shares in exchange for full payment of the creditors at a later date.

 

3. Why Relative Priority European Style should not be implemented

There are several reasons why Relative Priority European Style should not be adopted.

First of all, it is unclear what it would mean or how it should be implemented. It has not been tested in practice anywhere nor is it anywhere elaborated how it is supposed to function. To take a completely new idea which would revolutionize European Insolvency Law into European legislation without academic and societal debate is surprising, to say the least, especially as this new concept radically alters what is seen as bankruptcy law’s most important and famous rule in the US. This is all the more surprising given the fact that the proposed Directive is strongly inspired by US law on reorganization.

More important is that introducing Relative Priority would remove the basic protection against abuse and opportunistic use of insolvency procedures. Although it is unclear how Relative Priority should operate in practice, it is clear that shareholders can retain most or possibly even all of the equity. Shareholders will be able to opportunistically orchestrate the need for reorganization and retain value at the cost of creditors. An equally disturbing outcome will be that shareholders will no longer be dissuaded from taking excessive risks since they will no longer risk to be wiped out first. In his book, Saving Capitalism, Reich presents insolvency law as one of five basic building blocks of capitalism.[8] If insolvency law is allowed to develop in such a way that it is no longer working for but rather against creditors and for shareholders, the basic fabric of our private law, our market economy and our society changes and it will not be for the better.

On a more practical level, the problem with the Relative Priority Rule is that it will work as a wrecking ball for all other fields of law as well. Basic private law provides that debtors have to pay their debts. Basic company law provides that debtors can incorporate into a limited liability company as to which the shareholders are entitled to the upside (profits and/or increase in value) of the business but at the same time will lose their investment first if it goes wrong. Basic insolvency law provides that in case of insolvency of a company, equity is wiped out first and the procedure is there to maximize value for all creditors. All these rules are degraded to mere suggestions for multiparty negotiations. Although we are sympathetic to the overall attempt of the Directive to reorganize viable businesses, the case in favour of reorganization and preventive restructuring procedures is not so clear and evident that all other legal rules should give way.

Moreover, it is not even clear the European version of Relative Priority will aid reorganization. The Absolute Priority Rule incentivizes the shareholder to negotiate and come up with a good plan that is acceptable to all, because the shareholder knows cram-down is only possible after full payment of higher classes,[9] whereas the EU RPR incentivizes shareholders to aim for cram-down and engage in costly valuation and fairness discussions. The EU RPR is therefor likely to lead to more costly litigation and less cooperation. The US version of Relative Priority in turn seeks to facilitate negotiations further, by awarding all value to the higher class and leaving the lower class with an option.[10] Relative Priority European Style opens up the multiparty negotiations to an infinite number of possible outcomes. Baird therefore describes the European style Relative Priority as playing tennis without a net.

The RPR European style also works counterproductively in relation to other recently adopted measures. The RPR will in essence amount to a subsidy to shareholders at the cost of creditors. This subsidizes overleveraging of companies, whereas the EU has recently been trying to reduce such subsidies that stimulate too much debt in the economy, for example with the Anti-Tax Avoidance Directive and the Directive on Combating Late Payment in Commercial Transactions. The EU has recently also been very active in the field of addressing problems connected to Non-Performing Loans (NPL’s) on the balance sheets of banks. Allowing shareholders to siphon value away from creditors increases the problems with NPL’s.

Especially problematic is that some advocates of Relative Priority frame the rule as improving the position of SME companies.[11] We expect exactly the opposite will happen. Although the suggestion is made in the Directive that trade creditors should be paid in full, there is not a single provision actually protecting their interests. They would have been protected by the Absolute Priority Rule, which can now be replaced by a Relative Priority Rule European Style. Since it is a standard Private Equity strategy to finance a business with as much debt as possible, preferably trade creditors, this becomes all the more problematic. SME trade creditors are often forced into the position of provider of cheap and non-interest-bearing credit as part of an overleveraged structure. Under Relative Priority EU style, insolvency would actually turn against such creditors and add insult to injury by not protecting against shareholders retaining part or all equity in the company against the consent of creditors.

If the real goal of Relative Priority would be to provide an exception to Absolute Priority for the case of small family owned businesses such as a violin manufacturer as opposed to a large retail chain, one should not upend all of the basic principles underlying private law by abolishing Absolute Priority all together. Rather, one should consider introducing a tailor-made exception to Absolute Priority only for SME’s where the shareholder also is instrumental to the longevity of the company. In the US such a narrow exception has been proposed under the name of an SME Equity Retention Plan, which somewhat resembles the technique of the US Relative Priority Rule advocated by Baird. Where it is difficult to imagine how such an SME Equity retention could ever turn against SME’s, it is impossible to guarantee that the RPR will not turn against SME’s in their already precarious position of trade creditor.

See for a longer and more academic version of this article SSRN.

[1] Proposal for a Directive on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures and amending Directive, 15556/18, 2016/0359 (COD), ‘Confirmation of the final compromise text with a view to agreement’, article 11.

[2] N.W.A. Tollenaar, The European Commission’s Proposal for a Directive on Preventive Restructuring Proceedings, Insolvency Intelligence, 2017, p.5.

[3] See US Supreme Court, Czyzewski v. Jevic Holding Corp (580 U.S. , 137 S. Ct. 973, 979 (2017); See also J.C. Lipson, The Secret Life of Priority: Corporate Reorganization after JEVIC, Washington Law Review 2018, Vol. 93, p. 645-646

[4] The assumptions on which this far-reaching shift are based have been questioned, but that is not the focus of this article. See on that point: T. Verdoes & A. Verweij, The (Implicit) Dogmas of Business Rescue Culture, International Insolvency Review, winter 2018, p. 398-421

[5] Acronyms APR and EU RPR were added by the authors.

[6] Madaus in B. Wessels and S. Madaus, Instrument of the European Law Institute, Rescue of Business in Insolvency Law, 2017, available on ssrn. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3032309&download=yes), p. 334.

[7] D.G. Baird, Priority Matters: Absolute Priority, Relative Priority and the Cost of Bankruptcy, University of Pennsylvania Law Review, March 2017.

[8] R. Reich, Saving Capitalism. For the Many, Not the Few, London: Icon Books 2016.

[9] J.C. Lipson, The Secret Life of Priority: Corporate Reorganization after JEVIC, Washington Law Review 2018, Vol. 93, p. 672-674.

[10]  D.G. Baird, Priority Matters: Absolute Priority, Relative Priority and the Cost of Bankruptcy, University of Pennsylvania Law Review, March 2017.

[11] R. Mokal and I. Tirado, ‘Has Newton has his day? Relativity and realism in European Restructuring’ Eurofenix 2018/19, p. 22.