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CHAPTER 2 An introduction to the commencement standard
How did the invisible hand lose its grip?
The “invisible hand” is a term coined by Adam Smith (2016) during the 18th century in his book The Wealth of Nations, which invoked an enduring piece of imagery to describe the unintended social benefits of individual self-interested actions within the economy. As the invisible hand would have it, there is an incentive for third parties to seize control of a failing entity in order to salvage their claims. The notion of free market exchange automatically directing self-interest toward socially desirable ends is a core validation of the laissez-faire economic philosophy. However, as Baird (1991) explains, the collective interests of the group can be jeopardised when a single creditor exercises their rights over an insolvent estate. It is customary to expect the party that benefits from a particular legal rule to invoke it accordingly; however, insolvency is different. The beneficiaries of insolvency law are the creditors as a whole and not the individual creditors within the group. This is the so-called “common pool problem”, which arises where more than one person has rights over the same, finite fund of resources (Fletcher, 2005:9).
Insolvency law thus transforms what were initially multiple relationships between each creditor and the debtor into a unified whole, with the aim of administering and deriving maximum value from the debtor’s estate. To do so, insolvency laws place various protective and disciplinary mechanisms upon the ill debtor in reorganisation. The aim of these is to allow the debtor to overcome its financial difficulties and resume or continue normal commercial operations (United Nations Commission on International Trade Law, 2005:27). These mechanisms in effect introduce synthetic rules for the benefit of society in order to facilitate the rapid recovery of the firm in distress and ultimately maximise its return – violating the benign view of self-interest that the invisible hand embodies.
Insolvency serves the economic function of screening and eliminating only those firms that are economically inefficient and whose resources could be better used in some other activity (White, 1989:129). For reorganisation proceedings, this rule is fundamental, while it seeks to rehabilitate a distressed firm. Keep in mind that the same mechanisms that are intended to support a viable, financially distressed firm can also serve to give shelter to an injuriously uneconomical firm. Baird (1987) and Jackson (2001) have argued that market-based insolvency procedures are more efficient, and that financially distressed firms should be “auctioned” in the open market instead of attempting reorganisation. Rajan and Zingales (2003) suggest that market-based systems also seem to be more effective at forcing companies in declining industries to shrink and release capital. However, studies have shown there to be a net gain to creditors from reorganisation (Alderson & Betker, 1995; Eisenberg & Tagashira, 1994).
It is important therefore to distinguish between business failure and the economic function of insolvency. Insolvency is not intended to prevent the failure of inefficient firms. A firm can fail in the sense that its assets (resources) would be better used elsewhere, and this would be deemed acceptable (Boraine & Wyk, 2015:236). Business failure, however, does not necessarily mean that reorganisation has failed, but rather represents the desired outcome of an efficient process. Famous economist Joseph Alois Schumpeter reiterated this through the term “constructive destruction”, which sees the reallocation of investments as “constructively” destroying or replacing the old physical economy with the new (Omar, 2008:61). Pol and Carroll (2006), citing Schumpeter, state “[constructive destruction] could provide better results than the invisible hand and price competition”. One must keep in mind, though, that failure is itself constituted out of an assemblage of calculative technologies, expert claims and modes of judgement (Miller & Power, 2005). Professionals will undoubtedly perceive corporate events in distinctive ways.
This is where it gets interesting. It is an extension of finance theory that a firm’s financial health (its ability to pay its debts) is different from the firm’s economic health (its ability efficiently to provide goods or services) (Adler, 1997:334). This means that a firm riddled with debt can suffer financial distress while remaining economically viable. Conversely, a financially distressed firm could also be economically unviable, in which case there would be no benefit from its entering reorganisation proceedings, which would simply erode its value. This issue is easily concealed in the rather nebulous area where law and economics intersect. As King (1975:306) unravels it from an economic point of view, “failure” means nothing more than an excess of average costs (in the historical sense) over average earnings. That is, while the potential return on investment of a firm may have exceeded the potential return of the alternative investments available, the realised return of that firm in question may have fallen far short of expectations. Failure in this regard does not necessarily mean operations have ceased or the firm has failed to meet its financial obligations (Everett & Watson, 1998:373). On this premise, some firms are failures in this economic context and yet continue to operate. A reorganisation process unable to distinguish the viability of a firm will certainly go against the primary economic function on insolvency. Yet in most reorganisation laws, the commencement standard concerns itself simply with the financial health of a firm and is unable to assess its economic viability.
The introduction of reorganisation has introduced economic suppressants that operate deliberately and with sufficient control and intent to rehabilitate a distressed firm and enable it to re-emerge as a going concern. The invisible hand is not able to override these safeguards, though Smith argued:The removal of these controls therefore causes the “invisible hand to lose its grip” and leave economic forces vulnerable to abuse. Given reorganisation’s formidable power, the door to reorganisation remains a vital safeguard against such exploitation. Yet without a commencement standard able to recognise and deter uneconomical firms, reorganisation can potentially result in economic harm. It would be insufficient to rely on the “impartial spectator” for moral reasoning. For that reason, our research aims to explore the viability of a firm at the commencement of proceedings.
The commencement standard
The standard held for the commencement of insolvency proceedings is a fundamental component of an insolvency law’s architecture. As the foundation upon which insolvency proceedings can be commenced, this standard identifies the debtors who may enter the protection and disciplinary mechanisms of the insolvency law. The most desirable features of the commencement standard would balance transparency and certainty to afford convenient, cost-effective and swift access to proceedings (United Nations Commission on International Trade Law, 2005). Should the standard be too rigid, it might deter both debtors and creditors from commencing with proceedings and in turn incur damaging costs caused by the delay. On the other hand, a standard too lenient would permit abuse by debtors not in financial distress, frustrate creditors or simply facilitate the avoidance of onerous obligations. Unfortunately, this balance is not easily achieved, and criteria are often too ambiguous or cumbersome, leading to litigation at the outset of proceedings that makes for an inefficient system (White, 1989).
The commencement standard will typically take a different form in the case of either liquidation or reorganisation proceedings, the latter being the focus of this study. The standard applied to reorganisation proceedings remains a highly complex instrument that is forced to continuously adapt to modern economic life. It must, in addition, consider social and political factors in its design (Blazy, Chopard, Fimayer & Guigou, 2011:136; International Monetary Fund, 1999). As a result, reorganisation has become a dynamic and creative field playing an increasingly important role in business (Girod & Karim, 2017:132). Almost ninety countries across the world have reformed their insolvency laws since World War II, and more than half of them have done so during the last decade (Gine & Love, 2010:1). Reorganisation is now more accessible than ever before. The door to reorganisation is, therefore, a critical component of reorganisation success and should only open for a debtor who satisfies a criterion that is intricately woven into the objective for which proceedings have been instituted. The commencement standard for liquidation (winding-up) proceedings may share some commonality with reorganisation as both are in pursuit of a collective response to a debtor’s general default, however, there are some distinct differences that should be noted. Liquidation as commonly defined by statute as a process in which the debtor’s assets are realised and the creditors’ claims are met as far as possible concluding with the extinguishment of the firm’s personality (Westbrook, 2010:126). The definition, therefore, does not preclude the preservation of the business, as the sale of the debtor’s business as a going concern is certainly possible under liquidation (barring some jurisdictions). However, the disposition of liquidation does require that the assets be disposed of as quickly as possible only entertaining the survival of the business insofar as this is necessary for the liquidation process. The commencement standard, therefore, applied to liquidation is not concerned with the viability of the firm. The focus therefore of liquidation remains the realisation of assets and foreclosure of the legal entity as opposed to reorganisation which aims to preserve the business. The rigidity of the liquidation process may hinder its ability to preserve the firm as a going concern as effectively as reorganisation laws permit. Judicial approval is often needed to commence with liquidation proceedings, thereby hampering the speed and ease of access that is required by a firm typically seeking to preserve its operations. Liquidation will furthermore utilise more stringent insolvency tests in contrast to reorganisation procedures (United Nations Commission on International Trade Law, 2005, p. 53). There are certainly a number of differences to take note of between the commencement criteria applied to liquidation in contrast to reorganisation however our focus will now return to reorganisation. To best understand the optimal timing of commencement of reorganisation, one can view it in relation to the “zone of insolvency”, a period of financial distress1 sandwiched between solvency and complete insolvency (Mattocks, 2008:1).
Declaration Regarding Plagiarism
Table of Contents
List of tables
List of figures
List of abbreviations
Glossary
Preface
CHAPTER 1
Introduction
Business rescue summarised
Importance of the study
Problem definition
Research ethics
Referencing technique
Research methodology
Arrangement of chapters
CHAPTER 2
How did the invisible hand lose its grip?
The commencement standard
Reorganisation triggers
Commencement gateway
Gap period for commencement decision
Good faith test
The commencement standard for business rescue
Commencement standards in major jurisdictions
CHAPTER 3
Introduction
Key Concepts
Value maximisation principle
Stakeholder theory perspective
Legal analysis
Discussion and conclusion
References
CHAPTER 4
Introduction
Defining reasonable prospect
Value maximisation
Likelihood of Liquidation (LOL)
Research methodology
Proposed framework
Limitations and future research
References
CHAPTER 5
Introduction
The Likelihood of Liquidation Framework
Methodology
The Delphi Method
SMART
Findings
AHP
Findings
Proposed framework
Assigning values to the LOL indicators
LOL Score
Conclusion
Limitations and Future research
References
CHAPTER 6
Introduction
Summary of main findings
Conclusion
Implications for further research (limitations)
Implications for practitioners
Implications for policy-makers
List of references
APPENDICES
