The severity of the financial crisis has made it necessary to adopt measures to facilitate the conversion of debt into equity

1. Proposal for a Directive on
Insolvency, Restructuring and Second Chance
Potential on NPLs and the « no creditor worst off » principle
Sophie VERMEILLE
Corporate & Restructuring Lawyer at DLA Piper LLP, Paris
Researcher in Law at the University of Paris (Panthéon - Assas)
Founder and President, Droit & Croissance / Rules for Growth
European Central Bank, 8 December 2016

2. Introduction
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PART I – The restructuring of corporate debt
from a Law and Economics Perspective
II PART II – Lessons from the French experience
III PART III – The proposal of the EU Commission
IV Part IV – The impact on the resolution of NPLs
References
Contact
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3. Introduction : New context, new challenges
 The severity of the financial crisis has made it necessary to adopt
measures to facilitate the conversion of debt into equity;
 Before the crisis, in most countries the alternative was limited to
rescheduling the debts or liquidating the debtor
 As competition intensified in a globalized world facing less inflation and
less growth companies have increasingly needed to restructure their
debt quickly and efficiently
 Financial innovations and products have made balance sheets much
more complex and the restructuring of their debts now involves new
market players with various bargaining powers
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4. Introduction : New challenges…. but lack of overarching vision
 Piecemeal reforms of Member States’ corporate insolvency laws in the
past few years have increased the byzantine complexity of
restructurings suffering from a lack of transparency
 The lack of reform of the Judiciary means that insolvency judges have
difficulties dealing with the new and complex capital structures
 The lack of data is an obstacle to measure the real efficiency of
insolvency procedures and advocate for reforms to improve it based on
facts rather than the assessments of players having a vested interest in
the existing legal framework
 The lack of Law & Economics approach to the analysis of the legal
framework governing insolvency
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PART I
Restructuring corporate debt
from a Law & Economics perspective

6. PART I – Restructuring corporate debt
from a Law and Economics perspective
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7. PART I – Restructuring corporate debt
from a Law and Economics perspective
 Pre-requisite N°1 : Protect property rights

 Respecting the priority of claims requires a predictable and established process
• There is an implicit «social contract» between creditors and shareholders
arising from the existence of the corporate structure,
• By contrast, there are multiple and explicit contracts governing the
relationship between various classes of creditors
• Secured vs. Unsecured creditors
• Senior vs. Junior creditors
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8. PART I – Restructuring corporate debt
from a Law and Economics perspective
 Protect property rights, i.e. protect the absolute priority rule and the “no worse
off” principle
 The absolute priority rule requires payment in full to a senior class of creditors
before any payments can be made to junior interests
 The no worse off principle means that each creditor can oppose the plan if he
can show that he would be better off in the event of liquidation
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9.  Pre-requisite N°2 : Reducing transaction costs

To achieve this goal, efficient bankruptcy proceedings should provide for :
• a transparent procedure including incentives to collect and dispensing
information
• an automatic stay with limitations
• a quick procedure to resolve conflicts over valuation
• a cram down mechanism to strip a minority of dissenting creditors from their
ability to create a hold out situation
PART I – Restructuring corporate debt
from a Law and Economics perspective
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PART I – Restructuring corporate debt
from a Law and Economics perspective
Law and Economics theory applied to restructurings teaches us three major
lessons :
First Lesson:
 Negotiations, whether out-of-court or during formal proceedings, always lead to
suboptimal agreements, if property rights are not respected,

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PART I – Restructuring corporate debt
from a Law and Economics perspective
Second Lesson:
 Respecting the absolute priority rule and the “no worse off” principle requires :
 a cram down process to organize the transfer of power away from the
shareholders and from the out-of-the-money creditors, because they still
have voting rights and can create a holdout situation : i.e. the control of
the company should be transferred to its so-called “residual” owners, that
is those creditors who can decide between taking their loss and sell the
assets of the company or take a chance on the company’s recovery by
converting their debt into equity, to the exclusion of any other class of
creditors whose interests are no longer aligned with the long term survival
of the company.
 a proper valuation methodology

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PART I – Restructuring corporate debt
from a Law and Economics perspective
Third lesson:
Two options, the plan can be “fair and equitable” if:
 the rights of unsecured and junior creditors are preserved by
reference to the liquidation value only
 The rights of unsecured and junior creditors are preserved by
reference to the going-concern value which is greater than the
liquidation

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 The question of valuation in Europe is resolved according to two different
approaches : the English vs. the US/German approach:
 The English approach is based on the liquidation value; while
 The German/US model is based on the going-concern value.
 In Continental Europe, most countries consider that valuation is not a
matter for the Court and have chosen not to address this question. This is why
they offer no guarantee that the absolute priority rule and the no worse off
principle properly respected.
PART I – Restructuring corporate debt
from a Law and Economics perspective

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PART II
Lessons from the French experience

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2.1 – The nature of the problem
 Creditors are divided into three classes of creditor only:
 trade creditors;
 banks; and
 bondholders.
 This division is made regardless of the creditors’ seniority.
In each class of creditor, each member holds one vote and the majority
threshold is two thirds;
 For example, secured and unsecured creditors or junior and senior
creditors find themselves in the same class and have equally-
weighted voting rights amounting to the sum of their claim.
 This mechanism is referred to as a single-limb aggregated voting
procedure, and it applies to each of the three separate classes of
creditor.
 This is a clear violation of the rights of the senior and secured creditors.
PART II. Lessons from the French experience

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2.2 - The narrow procedural impact of this problem on out-of-court negotiations:
 Companies cannot properly deleverage their balance sheet due to the common
disregard for the rights of creditors and the “absolute priority rule” agreed by contract;
 Therefore, a large amount of companies (especially LBO companies) abuse the pre-
insolvency proceedings by filing for it a number of times;
 Meanwhile, the management is focused on other issues than the business;
 Lengthy and costly negotiations are an expensive option for debtors;
 Debtors are unable to solve their operational difficulties quickly and decisively;
 In practice, fresh money investors demand double digit interest rates, in spite of
their super-senior priority privilege, and expect the same return as a shareholder would
under “normal” (non-distressed) circumstances, proving that the company has not been
properly deleveraged and that substantial risks remain.
PART II. Lessons from the French experience

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2.3 - The broader economic impact of this problem on the French economy
 85% of French companies successfully emerging from formal insolvency proceedings
(redressement judiciaire) on a standalone basis, end up in liquidation again within
five years, showing that these formal proceedings are highly ineffective;
 This figure falls to 50% for companies emerging from another type of formal
proceedings (procédure de sauvegarde), which demonstrates that these are ineffective
as well;
 There is no market for DIP financing available to French debtors who have filed for
formal insolvency proceedings;
 Banks and other lenders often demand significantly greater collateral and personal
guarantees than in other jurisdictions such as Germany or the UK;
 Businesses are forced to rely excessively and dangerously on obtaining trade credit
in order to finance their working capital needs.
PART II. Lessons from the French experience

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PART III
The proposal of the EU Commission

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3.1 Focus on preventive restructuring tools
• The debtor should be able to
• restructure at an early stage, as soon as it is apparent that there is a
likelihood of insolvency;
• keep control over the day-to-day operation of its business;
• request a temporary stay of individual enforcement actions;
• A restructuring plan adopted by the majority of creditors (as prescribed by
local law) should be binding on all creditors provided that the plan is confirmed
by a Court;
• New financing necessary for the implementation of a restructuring plan
should not be declared void, voidable or unenforceable for being detrimental to
the general body of creditors
 This provides for flexibility but not at any cost for creditors
PART III – The proposal of the EU Commission

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5.2 Mandatory stay
 A temporary stay of individual enforcement actions filed by creditors
 The stay will be mandatory as soon as
 a group of creditors representing a significant amount of the claims and likely
to be affected by the restructuring plan support the negotiations on the
adoption of a restructuring plan; and
 a restructuring plan has a reasonable prospect of being implemented and
of preventing the insolvency of the debtor.
 The duration of the stay should not exceed four months. Member States
may provide that the period can be renewed upon evidence of progress in the
negotiations on a restructuring plan. The total duration of the stay should not
exceed 12 months.
When the stay is no longer necessary to facilitate the adoption of a
restructuring plan, the stay should be lifted.
PART III – The proposal of the EU Commission

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5.3 Adoption of the plan
• Any affected creditor should have a right to vote on the adoption of a restructuring
plan, including affected equity holders.
• Affected parties should be treated in separate classes according to the class formation
criteria. As a minimum, secured and unsecured claims shall be treated in separate
classes for the purposes of adopting a restructuring plan. Member States may also
provide that workers are treated in a separate class of their own.
• Class formation shall be examined by the judicial or administrative authority when a
request is filed for confirmation of the restructuring plan.
• The plan must be adopted by affected parties, provided that a majority in the amount
of their claims or interests is obtained in each and every class.
• Where the necessary majority is not reached in one or more dissenting voting classes,
the plan may still be confirmed if it complies with the cross-class cram-down
requirements.
PART III – The proposal of the EU Commission

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5.4 Safeguard measures
•The restructuring plan must comply with the best interest of the creditors test (i.e. no
worse off principle)
• Any new financing is necessary to implement the restructuring plan and does not
unfairly prejudice the interests of creditors.
• If a restructuring plan is not approved by each and every class of affected parties, it
should be confirmed by a Court and will become binding upon one or more dissenting
classes if
• (a) the restructuring plan has been approved by at least one class of affected
creditors, other than an equity-holder class and any other class which, upon a
valuation of the enterprise value, would not receive any payment or other
consideration if the normal ranking of liquidation priorities were applied, and
• (b) complies with the absolute priority rule.
• The treatment of shareholders should not be different than that of junior creditors,
which is an issue for most lawyers in Europe
PART III – The proposal of the EU Commission

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5.5 Valuation
• A liquidation value should be determined by the Court where a restructuring plan is
challenged on the grounds of an alleged breach of the best interest of the creditors
test.
• An enterprise value shall be determined by the Court on the basis of the value of the
enterprise as a going concern in the following cases:
▫ (a) where a cross-class cram-down application is necessary for the adoption of
the restructuring plan;
▫ (b) where a restructuring plan is challenged on the grounds of an alleged breach
of the absolute priority rule
• Experts should assist the Court
 Issues to consider
 Difference with Chapter 11
PART III – The proposal of the EU Commission

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5.6 Judiciary
• The Court should receive initial and further training to a level appropriate to their
responsibilities
• The matters should be dealt with in an efficient manner which ensures expeditious
treatment of the procedures and that the members of the judiciary in charge have the
necessary expertise and specialization.
PART III – The proposal of the EU Commission

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PART IV
The impact on the management of NPLs

26.  Why improving the efficiency of corporate insolvency law should be a
priority for the resolution of NPLs?
An efficient legal framework is necessary to improve both
 the transparency of bank balance sheets by helping to identify
NPLs (First objective)
 the resolution of NPLs (Second objective)
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Part IV – The impact on the management of NPLs

27. Part IV – The impact on the management of NPLs
First objective : an efficient legal framework to improve the transparency
of bank balance sheets
 The valuation of bank assets is more of an art than a science
 The benchmarking of bank balance sheets in an international context is of
limited relevance considering the difference in regulatory obligations and
accounting practices
 Several corrective measures have been taken, notably regarding the
accounting for provisions and losses
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 Counterparty risk is primarily affected by:
 the order of payment of creditors and shareholders, that is to say, the priority
contractually agreed by them (for example, by signing subordination agreements);
and
 the effectiveness of the collateral granted, that is to say, the ability of the bank
to enforce the security granted to it by the debtor; or,
 failing that, when the law prevents the bank from realising its security upon the
bringing of insolvency proceedings against the debtor, the respect for the
priority ranking of the secured creditors in the order of payment of creditors.
 This will depend on both:
 the substantive law applicable to insolvency proceedings, and
 the procedural law determining, for example, the time needed for the adoption of
the restructuring plan that will protect the rights of the secured creditors vis-à-vis
other creditors.
 It is unreasonable to expect the staff of the ECB to
 have a clear understanding of the consequences of the various laws governing
insolvency and security pledges in each Member State.
 tailor questionnaires for the purpose of assessing the quality of the banks’
assets in each Member State.
Part IV – The impact on the management of NPLs

29.  Change in the accounting for losses:
 Until recently, the use of backward looking recognition for losses could
lead to their under estimation
 The adoption of forward looking recognition of losses has forced banks
to better anticipate their loss in the event of a default
 Anticipating their exposure to loss will be facilitated by a more efficient legal
framework where the counterparty risk will depend only on 1) the debtor’s
own financial difficulties and 2) the seniority of the creditor’s claim.
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Part IV – The impact on the management of NPLs
First objective : an efficient legal framework to improve the transparency
of bank balance sheets

30. Part IV – The impact on the management of NPLs
Second objective : Improve the resolution of NPLs
1. A more efficient corporate insolvency law would improve the resolution of
NPLs
 The quality of the judiciary is of paramount importance for the resolution
of NPLs. Courts have a decisive impact not only on formal insolvency
proceedings but on out of court, informal proceedings as well, because
parties must negotiate in the “shadow” of the presumed outcome of
formal proceedings.
 The more existing seniority rights are enforced before Courts, the
more incentive for the parties to reach a consensual out-of-court
agreement to quickly restructure the debt.
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31. Part IV – The impact on the management of NPLs
Second objective : Improve the resolution of NPLs
2. A more efficient corporate insolvency law would improve the disposition of
NPLs
 Where secondary markets for NPLs are liquid, both the bank and the
debtor have an interest in disposing of the loan.
 The efficiency of corporate insolvency law lowers the discount applied to
the market price of NPLs and facilitates their disposal.
 In addition, the more efficient the corporate insolvency law, the easier it is
for so-called “distressed“ or “special situations” funds to enter the market
for NPLs. Because such funds are looking to take over the control of the
debtor, they can offer a premium over what other investors in distressed
debt can offer.
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32. Available on ssrn.com
A Critical Appraisal of French insolvency law Through the Lens of the Law and Economics Movement:
A Solution for the Future ?” by S. Vermeille, A. Pietrancosta, 2010
“Risk Sharing and Value Sharing: A Study of the Effects of French insolvency law on Out-of-Court Debt
Renegotiations” by S. Vermeille, B. Chopart, S. Portsmouth, L. Grégoire Sainte-Marie, 2011
“How Law & Economics Analysis Can Solve the Problem of Over-Indebtedness in LBO Target Companies --
Promoting Changes in French insolvency law” by S. Vermeille, S. Bardasi, 2014
“A European Credit Law of Non-Financial Institutions for the Benefit of the Banking Union” by S. Bardasi,
A. Bézert, A. Salord, S. Vermeille, 2014
“Potential economic gains from reforming insolvency law in Europe” by Association for Financial Markets
in Europe, Weil Gotshal & Manges, Frontier Economics, 2016
“Crossroads in EU harmonization on restructuring and insolvency: Towards a market-based model or one
where the “senior takes all”?” by Adrian Thery, 2016
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References

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Contact
Sophie VERMEILLE
Droit & Croissance
Rules for Growth Institute
+ 33 (0) 6 73 04 89 90
svermeille@droitetcroissance.fr
www.droitetcroissance.fr
http://fr.linkedin.com/in/sophievermeille