Bankruptcy codes vary from country to country in terms of the magnitude of the costs imposed on financially distressed firms, the transparency of the restructuring procedure, and the interest groups that receive primary protection. These factors significantly affect the prospects for achieving the two major goals of any bankruptcy system: minimizing costs and ensuring the survival of firms that are economically viable.
Most bankruptcy systems fall into two categories: those in which the market determines the distressed firm's value, often through an auction-type procedure; and those premised on court-mediated reorganization, in which debt restructuring enables the firm to continue operating, often under the same management. Creditors' rights also vary from code to code, typically being scaled back in reorganization plans while receiving greater protection in market-based schemes.
Sweden's bankruptcy system is a pure embodiment of the auction form. There the auction of bankrupt firms is mandatory, and the highest bidder decides whether to keep the firm intact or use its assets piecemeal. The procedure is swift—the average sale takes place within two months of filing—low cost, and highly transparent. Creditors are paid according to absolute priority, and payment must be in the form of cash generated by the auction.
Bankruptcy procedures in the U.K. are also market-based, with a focus on protection for secured creditors. Unlike other systems studied, the U.K. system does not impose an automatic stay of debt during the proceedings, and administrative receivers have broad discretion to take whatever actions they determine will best protect the favored interest group.
By contrast, the French bankruptcy code favors reorganization, for the express purpose of preserving employment opportunities. Creditors cannot participate in the reorganization planning, and both the government and employees have priority claims on proceeds from the sale of collateral. German bankruptcy law also favors reorganization but allows just three months for a plan to be submitted and requires creditor approval by majority vote before the plan can be implemented.
The relative efficiency of these varied systems in holding down costs and ensuring the survival of viable firms is still at issue. Critics of the auction system claim that illiquid markets could prompt fire sales at depressed prices; critics of reorganization, however, argue that this approach—though favored by regulators, employees, and management—engenders lengthy negotiations, thereby increasing costs and enabling powerful, and management-friendly, special interests to dominate the proceedings. And there are concerns that both systems may unintentionally provide incentives for delayed filing and anticipatory risk-shifting behavior by management.
Though no one best system has yet emerged, empirical evidence reveals certain relevant, and in some instances unanticipated, trends. Studies to date do not support concerns about delayed filings and illiquid markets. They do, however, indicate a positive relationship between the duration of bankruptcy proceedings (typically longer in reorganization) and their direct costs (administrative and legal).
High costs in turn affect creditor recovery. A 2000 study shows a 69 percent recovery rate for secured creditors in the low-cost and relatively swift Swedish system. Two subsequent studies find similar recovery rates (69 percent and 75 percent) for banks in the market-based U.K. system, compared with 59 percent for banks in Germany, where time limits are placed on reorganization, and only 47 percent for banks in the lengthier and more costly French system. It is also possible that market systems may be more transparent, reducing the uncertainty associated with filing and thus increasing the availability of new capital.
Given the French system's explicit bias toward continuation, one might anticipate a high rate of viable survival to result, but this does not appear to be the case. One study indicates that only 15 percent of French firms filing for bankruptcy survive as going concerns, compared with 60 percent in the U.K. Another study finds higher piecemeal liquidation rates in France (62 percent) than in Germany (57 percent) or the U.K. (43 percent).
The picture is complicated by the fact that the European Union favors reorganization along the lines of the U.S. model, causing countries with market-based systems, such as Sweden and the U.K., to begin introducing reorganization elements into their codes, and countries that already favor reorganization, such as Germany and France, to reinforce this design.
This development is ironic because the U.S. system, which favors reorganization under Chapter 11 of the U.S. Bankruptcy Code, has become so burdened with costs and delays and so dominated by a corporate roundtable of special-interest groups (attorneys, investment banks, consultants) favoring the status quo that many participants take steps to circumvent the proceedings. A study indicates that as many as 75 percent of filing firms avoid court-imposed solutions, either by selling assets in bankruptcy (50 percent) or by negotiating out-of-court settlements subject to subsequent court approval (25 percent)—strategies that introduce de facto market elements into the reorganization scheme.
It also appears that the U.S. system does not foster efficient continuity. Studies show that firms emerging intact from Chapter 11 proceedings underperform the competition—in contrast to surviving firms in Sweden, which perform on a par with industry competitors for several years—and that one-third of all U.S. firms filing for bankruptcy require restructuring again within five years, with firms that retained the same management refiling at the highest rate.
These findings indicate that the U.S. reorganization model may not be the best—even for the U.S. Our knowledge of comparative systems is still limited, and there is a need for further study of bankruptcy in many different countries before definitive conclusions can be drawn. In the meantime, regulators should take a closer look at the evidence before initiating further pro-reorganization changes.
