Law Notes Debt Restructuring Notes
Debt Restructuring Law notes recently updated for exams at top-tier British Universities. These notes, written at King's College London, cover all the LLB banking law cases and so are perfect for anyone doing an LLB in the UK or a great supplement for those doing LLBs abroad, whether that be in Ireland, Hong Kong or Malaysia (University of London). These were the best Debt Restructuring Law notes the director of Oxbridge Notes (an Oxford law graduate) could find after combing through over a hundr...
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Theoretical Framework
Corporate insolvency as a “tragedy of the commons”:
Debtor company has multiple creditors
Race to first enforce = Each creditor exercising its individual enforcement right = Forcing the debtor into insolvency = Destroying the going concern surplus in the debtor company
The “going concern surplus” = The difference in value between the business being kept together as a single functioning unit, and the business being taken apart and sold of piecemeal basis
E.g. A functioning restaurant with a good chef and a good setup can be sold for greater value than taking it apart and selling its assets (such as kitchen equipment, furniture, etc.) separately
Differentiating cash-flow distress from economic distress:
Financial distress may be temporary, such restructuring + keeping the debtor in business may actually preserve the value in its business
Economic distress = Fundamentally poor business setup, such that liquidation might be the better option
The trend of collective enforcement stems from the “prisoners’ dilemma”:
Creditor 2 | |||
Creditor 1 | Break-up value = 8 Going concern value = 12 Nominal claim = 7 | Enforcement and no corporation | Corporation and no enforcement |
Enforcement and no corporation | 4;4 | 7;1 | |
Corporation and no enforcement | 1;7 | 6;6 |
Socially optimal outcome = Both cooperate; preserve the going concern surplus of 12; each get 6
But each creditor is incentivised to enforce (because he cannot be assured that, if the cooperates, the other creditor will do the same)
Result = The nash equilibrium outcome of the 4;4 split
“Tragedy of the commons” because of individual enforcement rights + absence of any mechanism to facilitate communication and collaboration
Corporate insolvency law addressed this “tragedy of the commons”
Reducing the degree of mismatch between individual enforcement rights and the common pool
Privatisation (e.g. administrative receivership, where the rights of the creditors are bundled up and entrusted to a lead creditor, and the lead creditor takes over the insolvency process procedurally). This used to be the main procedure in English insolvency law until 2002.
Collectivisation (e.g. administration, where all the creditors forced into collective decision-making, and their individual enforcement rights are transformed into participation and voting rights). A comprehensive moratorium stops each creditor from enforcing individually and thus preserves the going concern surplus.
And a “tragedy of the anti-commons”:
But collectivisation might also result in a “tragedy of the anti-commons”
Veto rights = Incentivising holdout behaviour, because a creditor may attempt to extract more value than he would otherwise get by threatening to thwart any attempt to take action
Solution = Majority voting, cramdowns (i.e. overcoming a holdout by any particular class of creditors), and information rights
The “tragedy of the anti-commons” stems from the “game of chicken”:
Creditor 2 | |||
Creditor 1 | Break-up value = 8 Going concern value = 12 Nominal claim = 7 | No cooperation | Cooperation |
No cooperation | 4;4 | 7;5 | |
Cooperation | 5;7 | 6;6 |
Creditor 2 | |||
Creditor 1 | Break-up value = 8 Going concern value = 10 Nominal claim = 7 | No cooperation | Cooperation |
No cooperation | 4;4 | 7;3 | |
Cooperation | 3;7 | 5;5 |
What is the difference between the two?
The problem becomes more pronounced as the going concern value decreases
C1 might push for too much because it thinks that the going concern value it greater than it actually is; C2 is incentivised to not cooperate at all; they thus arrive at the most socially inefficient outcome
Fragmentation of debt + Increasing complexity of property rights = Worsening the “tragedy of the anti-commons”
Equity and debt derivatives
How do credit default swaps (“CDSs”) make cooperation even more difficult?
CDS = The creditor is hedged and protected against any losses
He does not care about preserving the going concern value of the debtor, because he will be compensated by his swap counterparty for his loss anyway
He may actually be better off by pushing as hard as he can during negotiations
Distortion of interests:
T hedged creditor no longer has any economic interest in the debtor
Collateralised debt obligations
Distressed debt trading
Distressed debt traders buy up distressed debt at a massive discount
They are interested in quick and easy profits
This leads them to favour a piecemeal sale for quicker (albeit lesser) profits
They can profit either way because they purchased the distressed debt at such a steep discount
Distorted incentives
Opaque players
Repeat players — such as banks — might have a quid-pro-quo understanding with the other creditors
Hedge funds, private equity funds, and sovereign wealth funds, on the other hands, might not be repeat players and might therefore be unconcerned about their reputation altogether
Holdouts more likely
Possible contractual solutions:
The “Menu Approach”: ex ante and ex post re-pricing of property rights
The “Bankruptcy Contract Approach”: switch from “collectivisation” to “privatisation” (and vice versa)
The “Bankruptcy Waiver Approach”: limited cooperation and insulation of cooperators from non-cooperators
Rasmussen’s “Menu Approach”
Assumptions:
Bankruptcy law as an implicit term in the lending agreement
It determines the lender’s pay-out
It is factored into the lending decisions and risk assessment
The interest rate charged on the loan thus depends on the applicable bankruptcy law
No common pool problem, because the borrower would anticipate the common pool problem, and would therefore offer contractual terms that mimic the most efficient bankruptcy regime
N.b. “Bankruptcy” applies to both natural persons and corporations in US law, whereas, in UK law, the latter is known as corporate insolvency
Equity would bear the cost of an inefficient race
Equity would therefore draft the most beneficial bankruptcy regime
...
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Debt Restructuring Law notes recently updated for exams at top-tier British Universities. These notes, written at King's College London, cover all the LLB banking law cases and so are perfect for anyone doing an LLB in the UK or a great supplement for those doing LLBs abroad, whether that be in Ireland, Hong Kong or Malaysia (University of London). These were the best Debt Restructuring Law notes the director of Oxbridge Notes (an Oxford law graduate) could find after combing through over a hundr...
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