United Kingdom Insolvency Law - Theory

Theory

In order to find a coherent rationale for insolvency law, to develop a set of principles to understand it, and to guide thinking on what insolvency law should be, a large variety of different theories have been developed. Since the 1970s, particularly from the time of the Bankruptcy Reform Act of 1978 in the United States, and since the Insolvency Act 1986 in the UK, two broad strands of thought emerged. The first and very prominent view, stemming primarily from work by Thomas H. Jackson and Douglas Baird is known as the "creditors' bargain model". The authors posited (adapting visibly a methodology from A Theory of Justice (1971) by John Rawls) that if one wished to determine what the best bankruptcy rules were, it could be discovered by imagining that hypothetically all creditors, secured and unsecured, could set down and reach an agreement about how assets would be distributed. Jackson, Baird and other co-authors argued that the primary (and almost exclusively) good thing that modern insolvency law achieves is to create a collective debt collection mechanism among creditors. Imagining what would happen if the law did not have collective insolvency rules, it was argued there would be significant increase in costs as individual creditors attempted to ensure repayment, namely (1) the costs of uncertainty in racing to court to claim one's entitlement, and so higher, duplicated monitoring costs by each creditor before a company goes insolvency (2) the risk that a company would be dismantled bit by bit, when acting together creditors would agree that a company could be kept or sold as a going concern, and (3) higher administrative costs of collecting debts individually, when a collective procedure would save time and money. Such individual action exemplifies both the economic model of the prisoners' dilemma (because without knowing or trusting what another individual does, everyone can reach worse outcomes for the group) and the tragedy of the commons (because individual action leads to quicker depletion and exhaustion of a common pool of resources, as opposed to collective planning to preserve assets for future use). Hypothetically, all creditors would agree by consent for their mutual benefit to set up a collective procedure. In reality, transaction costs and hold-up problems prevent mutual agreements being made. But then the law should mimic what would have been agreed in absence of such real world costs. Jackson and Baird further argue that hypothetical creditors would also choose pari passu distribution, but also it is "a key assumption that consensually negotiated security interests have aggregate efficiencies". The law protecting security interests should be inviolable, because it increases the amount of credit available to a company, which through the continuation of business indirectly benefits all creditors. Any other groups of creditor, if they lose out from this insolvency model, ought to be protected by labour, tort or social insurance laws outside the scope of insolvency law. Deviating from Jackson and Baird's simplified law of debt collection mechanisms and priority rules would bring undue costs, because it is not what would have been agreed. This would mean that insolvency law should have no requirement that a company should be rescued (unless creditors agree to it) and should have no classes of preferential creditor (except for unlimited security interests).

A comprehensive challenge to Jackson and Baird's theory, which more closely resembles actual legal policy, came initially from Elizabeth Warren. Warren argued that Jackson and Baird's model is dangerously oversimplified, and based on untested hypothetical assertions about behaviour. First, every system of insolvency law must necessarily make choices about how losses are distributed among creditors with multiple interest. Among these diverse interests include weaker creditors, particularly employees, who are less capable than others at diversifying the risks of insolvency. There is a distinct community interest in companies that survive, and no good reason why only creditors with provable proprietary interests in a company's winding up should be taken into account. This means it is reasonable to give preference to more vulnerable creditors, and to expect secured creditors take on some additional risk to ensure businesses survive for the greater good. The Baird and Jackson view essentially amounts to "single-value economic rationality, an excuse to impose a distributional scheme without justifying it, and, incidentally, a way to work in a damn good deal for secured creditors." Additionally, Lucian Bebchuk has argued that the institution of security interests operates as a partially unjustified negative externality against unsecured creditors. It is not clear, argues Bebchuk, that security interests are in fact efficient, and they are capable of subsidising their activities by diverting wealth from unsecured creditors to themselves without any agreement. In the UK, Roy Goode argues that banks usually take security interests, not because they would otherwise charge a higher interest rate (and so increasing credit to businesses for the benefit of all creditors) but because they calculate the market will bear it. The taking of security depends, not on efficiency, but on bargaining power. Riz Mokal, also deeply critical of the creditors' bargain model, suggests that if one were to follow Baird and Jackson's methodology but in a truly value neutral way, one would ask what creditors would hypothetically agree to if they did not know who they were at all (i.e. whether they were voluntary or involuntary creditors, secured or unsecured). This would likely lead to a result where secured credit was not inviolable, and insolvency law could take account of diverse interests, including corporate rescue.

In the UK, the theories underpinning actual insolvency law policy generally stem from the Report of the Review Committee on Insolvency Law and Practice produced by committee chaired by Kenneth Cork in 1982. The central argument of the report was that too many companies were simply left to fail when they could be revived, saved or brought to a close in a more orderly way. Cork advocated that the law should encourage a "rescue culture", to restore companies back to profitability, which would be in the longer term interests of creditors. Moreover, the Report suggested that insolvency law should "recognise that the effects of insolvency are not limited to the private interests of the insolvent and his creditors, but that other interests of society or other groups in society are vitally affected by the insolvency and its outcome." This largely reflected the previous common law position, which rejected debt collection as being the sole aim, and viewed insolvency to be a matter of public interest. The Cork Report was followed by a White Paper in 1984, A Revised Framework for Insolvency Law which led to the Insolvency Act 1986.