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Barriers to Exit – MARTEL – December 2019 OECD discussion

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This presentation by Jocelyn Martel, Professor ESSEC, was made during the discussion “Barriers to exit” held at the 132nd meeting of the OECD Competition Committee on 4 December 2019. More papers and presentations on the topic can be found at oe.cd/bte.

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Barriers to Exit – MARTEL – December 2019 OECD discussion

  1. 1. BANKRUPTCY LAW AND BARRIERS TO EXIT OECD ROUNDTABLE Jocelyn MARTEL (ESSEC Business School) © MS Financial Accounting 2019-2020 December 4, 2019 1
  2. 2. 2  Role of bankruptcy law  Different types of bankruptcy laws  Bankruptcy laws and efficiency effects: A few examples  Evolution of bankruptcy laws and allocation of resources  Entry and Exit barriers  Bankruptcy Law and Exit Barriers  Bankruptcy Law and Antitrust Law: Conflicting Goals  Conclusions Presentation
  3. 3. 3 “The basic problem that bankruptcy law is designed to handle, both as a normative matter and as a positive matter, is that the system of individual creditor remedies may be bad for the creditors as a group when there are not enough assets to go around. Because creditors have conflicting rights, there is a tendency in their debt- collection efforts to make a bad situation worse. Bankruptcy law responds to this problem.” (Jackson, 1986)  Bankruptcy law should:  Offer a collective procedure in order to avoid a common property problem  Freeze the proceedings of all creditors  Allow for a valuation of the assets and the rights of all creditors involved  See to the distribution of the proceedings from the sale of the assets to creditors in the event of liquidation  Allow for a negotiation between the debtor and the creditors in the event of reorganization Role of a Bankruptcy Law (1)
  4. 4. 4  Desirable criteria for a bankruptcy law  Provide the right incentives before bankruptcy (ex ante efficiency)  Maximize the value of the firm in bankruptcy (ex post efficiency)  Save viable firms & eliminate non-viable firms (filtering failures)  Respect Absolute Priority Rule (APR)  Leave the firm’s future in the hands of affected creditors  Minimize bankruptcy costs  Possible conflicts between these objectives  Ex ante and ex post efficiency  APR application and ex ante / ex post efficiency (i.e. soft touch claims)  Filtering failures (Trade-off between Type I and II errors. Strong evidence from Canada) Role of a Bankruptcy Law (2)
  5. 5. 5 Different types of bankruptcy laws  A complete spectrum of bankruptcy regimes  Pro-debtor (i.e. France)  Pro-creditor (i.e. UK)  Hybrid (i.e. US, Canada)  Possible criteria  Automatic stay on creditors  Priority for new financing  Debtor’s in possession (DIP) financing  Creditors’ vote  Intervention of bankruptcy court & cramdown  Creditors’ committee  Job savings (???)  Fresh-start (entrepreneurs)  These criteria differ from one regime to another and have an impact on the outcome of the bankruptcy procedure
  6. 6. 6 Bankruptcy laws and efficiency effects: A few examples (1) Rules of law Ex ante effects Ex post effects Automatic stay ↑ Credit rationing (-) ↓ Excessive risk taking near bakruptcy) (+) ↑ Investment in human capital (+) ↑ Creditors’ monitoring (+) ↓ Common property (+) ↓ Race for the assets (+) ↑ Coordination of creditors and maximize firm’s value (+) ↓ Filtering failures (+) Enforcement of APR ↓ Monitoring costs (+) ↓ Management (equityholders) incentives for claims substitution (-) ↓ Excessive risk taking near bakruptcy) (+) ↑ Investment in human capital (+) ↓ Risk for individual creditors (+) ↓ Strategic behavior by creditors and debtor (+) ↓ Welfare (-) Creditors’ vote in reorganization (firm’s future in the hands of creditors) ↓ Monitoring costs (+) ↑ Incentives to max firm’s value Debtor in possession ↓ Management’s incentives (-) ↑ Incentives to reveal early financial distress (+) ↑ Entrenchment by managers ↑ Efficient use of resources for owner- manager firms
  7. 7. 7 Bankruptcy laws and efficiency effects: A few examples (2) Rules of law Countries Facts Automatic stay USA Canada France UK Germany Yes Yes Yes No (depending on the procedure) Yes Enforcement of APR (respect of seniority) USA Canada France UK Germany Yes (with deviations) Yes (with deviations) No (senior creditors not first) Yes Yes (with deviations) Creditors’ vote in reorganization USA Canada France UK Germany Yes Yes No (except for safeguard procedure) Yes Yes Debtor in possession USA Canada France UK Germany Yes Yes Yes (with administrator) No Yes (with court approval)
  8. 8. 8 Evolution of bankruptcy laws and allocation of resources (1)  Bankruptcy laws evolve over time and this impacts on the allocation of resources  International trend to converge towards US Chapter 11  [Misleading?] perception that debtor-friendly systems (i.e. US) may dominate creditor- friendly system.  Example: Canada  Before 1993: Canadian Bankruptcy Act (BA) (enacted in 1949)  Derived form UK insolvency law: strongly creditor oriented  After 1993: Canadian Bankruptcy & Insolvency Act (BIA)  Objectives: To align with Chapter 11 (more debtor friendly) • To encourage financial reorganization in order to save jobs that would be lost in the event of liquidation • Increase workers protection for the unpaid wages
  9. 9. 9 Evolution of bankruptcy laws and allocation of resources (2) Law section Bankruptcy Act (BA) Bankruptcy & Insolvency Act (BIA) Stay of proceedings Upon filing a proposal --unsecured claims only for up to 30 days (extendable with court approval) Upon filing a NOI -- all claims for up to 30 days (extendable with creditor and court approval). Upon filing a proposal --unsecured claims only for up to 21 days (extendable with court approval) Proposal vote 50% number / 75% in value 50% number / 66,7% in value Secured creditors Unconstrained Claims stayed during NOI period; option to participate in proposal Government claims Preferred claims and paid in full upon plan approval Super-priority status for DAS; ordinary status for all other claims Employee claims Preferred claims and paid (up to a certain amount) upon plan approval Limit for preferred wage claims increased
  10. 10. 10 Evolution of bankruptcy laws and allocation of resources (3)  Outcome for Canada (Fisher & Martel)  Proportion of firms opting for reorganization over liquidation: multiplied by 10  Mainly due to the introduction of the NOI  Compared with the BA firms, BIA firms are  Smaller in size  Poorer financial health  Higher proportion of government claims (soft touch claims)  Offer lower return to unsecured creditors and spread over a longer period  Higher direct bankruptcy costs and time in reorganization  No significant change in the proportion of firms completing the reorganization process  Strong presumption that the new system increased Type I errors and bankruptcy costs and delayed the efficient reallocation of resources  Based on calculations, the BIA has preserved very few jobs  Could be a popular tool for governments but not an effective tool for preserving employment
  11. 11. 11  Citation: “When considering entry in a new market, ask: What are the barriers to exit”  Entry and exit barriers are key factors for an efficient allocation of resources to higher value uses  Entry and exit rates are correlated and thus reducing exit barriers makes it easier for firms to enter an industry  Empirically shown that a reduction in exit barriers contributes to productive growth (See McGowan & Andrews, OECD) Entry and Exit Barriers
  12. 12. 12 Bankruptcy Law and Exit Barriers (1)  Bankruptcy law is a mean to deal with the exit of financially distressed firms and the reallocation on resources  Bankruptcy law also impacts on a firm’s ex ante decision to enter in an industry  Individual components of bankruptcy laws may represent barriers to exit (…and to entry)  Extensive literature on the impact of the bankruptcy regime on the ease of exit for financially distressed firms and productivity growth  ↓ bankruptcy costs and time in bankruptcy ⇒ ↑ ease to exit and to enter  ↓ filtering failures ⇒ ↑ efficient separation of viable and non-viable firms and ease to exit  ↓ bankruptcy court & external interventions ⇒ ↓ incentives to introduce extra-financial elements which may result in an inefficient allocation of resources  Stay of proceedings on creditors ⇒ ↓ common property problem and race for the assets
  13. 13. 13 Bankruptcy Law and Exit Barriers (2)  Strong focus on the Fresh Start policy  Allowing for a second chance increases innovation, risk-taking and incentives to enter in an industry  Only valid for entrepreneurs  Fresh start makes no sense for corporations. The capital (financial, physical and human) of failed firm is simply redeployed to more productive uses  Trade-off between systems  Soft landing system (lower penalties following failure) may  Reduce ex ante incentives for managers  Encourage excessive risk taking  Increase financing cost  Decrease incentives for claims substitution
  14. 14. 14 Bankruptcy Law and Antitrust Law: Conflicting Goals (1)  Bankruptcy law is one among a large set of corporate law that impact on the life and death of corporations  Some of the laws may have conflicting goals  Particularly true of bankruptcy law and antitrust law  Bankruptcy law:  Offer a collective proceedings for financially distressed firms  Objective is to maximize the value of the firm (straight reorganization or asset sales (M&A)) and creditors’ recovery  Antitrust law:  Prohibits transactions (M&A) that may substantially reduce competition or lead to cartels or monopolies  Allows business transactions for which efficiency gains (synergies) may outweigh losses due to higher market concentration
  15. 15. 15 Bankruptcy Law and Antitrust Law: Conflicts Goals (2) Banruptcy Law  Backward-looking  Deals with downstream investors (debtor and creditors) affected by bankruptcy  Promotes rapid solution including asset sales to minimize uncertainty, costs and maximize value. Focus on highest bidder rather than antitrust issues Short calendar Bankruptcy courts may be constrained to interpret antitrust laws before approving a plan Antitrust Law  Forward-looking  Deals with upstream consumers who may not be present when a firm goes bankrupt  The analysis of the impact of the transaction on competition is typically long (avoid unscrambling the eggs) and costly  Long calendar  Does not promote asset sales (M&A) unless justified by notable efficiency gains  Antitrust authorities may challenge confirmed bankruptcy decisions  Concern about anti-competitive behavior of creditors and bankruptcy participants from setting an agreement in order to restrain trade (i.e. price fixing, market shares or customer allocations)
  16. 16. 16 Bankruptcy Law and Antitrust Law: Conflicts Goals (3)  These conflicting goals may lead to: inefficient resolution of financial distress sub-optimal enforcement of antitrust law  There are conditions under which both laws may be compatible  In the U.S. there exist the Failing-Firm Defense or Imminent Failure  Antitrust mechanism for asset sales in corporate reorganization  Allows a M&A to proceed in bankruptcy to avoid the loss of productive asset value  Conditions for the failing firm:  Unable to meet its financial obligations in the near future  Unable to reorganize successfully under Chapter 11  Has made unsuccessful good-faith efforts to elicit reasonable alternative offers that would keep its assets in the relevant market and pose a less severe danger to competition than does the proposed M&A  Struggling firms trying to merge or sell assets but that do not satisfy the failing firm test may meet government opposition to the transactions
  17. 17. 17 Conclusions (1)  The efficient allocation of resources are affected by a number of market failures  The life and death of corporations are governed by a full set of regulations which may impact on their ability to enter or exit an industry  A large number of bankruptcy proceedings involve the sales of part or all the assets of the failing firm. This may raise antitrust issues especially when the buyer is from the same industry  Yet, bankruptcy and antitrust laws may have conflicting objectives: Creditors vs. consumer interest
  18. 18. 18 Conclusions (2)  A too strict enforcement of antitrust laws may lead to the inefficient dismantlement or allocation of otherwise productive assets and a reduction in the recovery rate for creditors  A too light enforcement of antitrust laws may lead to reduced competition and consumer losses in the future  Optimal enforcement of antitrust law?  In the case of a financially distressed firm, antitrust issues often (but not always) come after bankruptcy issues.  Very difficult for a bankruptcy judge to get a complete picture of the antitrust impact of a sales of assets in Chapter 11  Antitrust authorities bears the responsibility of setting up a quick and complete process for evaluating these transactions and ensures a rapid and value maximizing bankruptcy process  Likely outcome: under enforcement of antitrust regulations

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