European bankruptcy laws - out of pocket

Dec 30th 2008 PARIS From The Economist print edition Europe’s flawed insolvency regimes will face a severe test in 2009 THE word “bankrupt” originally came from Italy, deriving from banca rotta, or broken bench. When a medieval moneylender could not pay his debts, his bench was broken in two, sometimes over his head. Things are not quite so brutal these days, but European countries still deal with insolvent firms far more harshly than America does, and most such firms end up in liquidation. They often treat creditors badly too, meaning that neither side ends up satisfied. Observers worry that Europe will cope with the coming flood of defaults far less effectively than America, meaning a slower recovery. Standard & Poor’s (S&P), a rating agency, reckons that 60-75 European companies from its speculative-grade category could default on a total of €20 billion-25 billion ($28 billion-35 billion) of debt in each of 2009 and 2010, taking the overall default rate up as high as 11.1%, compared with 3.2% for the past 15 years. In more normal times, most distressed companies would work things out with their creditors in private restructuring processes. But a combination of high leverage and so-called “covenant-lite” loans, which mean that a firm can get into serious trouble before breaching loan conditions, is likely to mean that many more companies will end up in a formal, legal process. In addition, out-of-court restructurings usually involve lenders making new money available, which is less likely in today’s market conditions. In recent years several European countries have tried to change their systems so that companies have a better chance of survival. Britain, France, Germany, Italy and Spain have all introduced insolvency reforms designed to “rehabilitate” companies. But these are mostly untested and, in some cases, controversial. In France, for instance, where according to S&P 90% of insolvency proceedings result in liquidation, new pre-insolvency proceedings came into effect three years ago. The most important of these is the procédure de sauvegarde, inspired by Chapter 11 of America’s bankruptcy code. It prevents the seizure of assets, allows managers to stay on and sets up creditors’ committees for the first time. But unlike Chapter 11 sauvegarde is still a process in which a court makes the key decisions, which creditors dislike. Some firms have been accused of using it to deny creditors their rights. In July 2008 Belvédère, a French drinks company, put itself into sauvegarde after breaking a loan covenant, a move that infuriated bondholders. They have gone to court to try to force Belvédère out of the procedure. In 2007 Eugene Perma, a hair-care group, filed for sauvegarde and thus avoided a demand for repayment from Bear Stearns, an American bank. “Sauvegarde has given rise to pernicious effects where debtors have filed safeguard actions in order to freeze their payments to creditors and to try to jeopardise their negotiating position,” says Sandra Esquiva-Hesse, a restructuring expert at Paul Hastings, a law firm in Paris. France’s insolvency process was designed to protect companies and jobs, and gives creditors little influence. As a result recovery rates are low (see table). That can be a big problem, especially for smaller firms. A customer of Frantz Electrolyse, a car-parts firm in Paris, went into insolvency in October, owing €80,000, and Jêrome Frantz, the firm’s director-general, says he expects to get only about €20,000 back in two to three years’ time. France’s low recovery rates could put companies like his at risk in the difficult times to come, he says. Cultural differences America’s Chapter 11 has been criticised for being too lenient on companies, but it is well tested, predictable and accepted by debtors and creditors alike. In Britain the European High Yield Association (EHYA), a lobby group for participants in the leveraged-finance market, has called for a Chapter 11-style insolvency process. About a fifth of Britain’s private-sector employees work for heavily indebted companies owned by private-equity firms, notes Christopher Hall, a lawyer who sits on the EHYA’s insolvency-reform committee. The social and economic consequences if they end up in liquidation would be grave, he says. As in France, British insolvency usually results in liquidation—although in contrast to France and some other continental European countries, at least one side ends up happy: creditors can expect to get most of their money back. That said, one big difference between the British system and Chapter 11 is that in Britain suppliers have the right to terminate contracts in the event of bankruptcy, quickly disrupting a firm’s activities, whereas in America counterparties have to stay as long as they receive reasonable reassurance that they will be paid. Britain’s insolvency process has other flaws, too: the collapse of Lehman Brothers in 2008 revealed big shortcomings in the way it handles investment banks. Lehman’s customers found that their assets were trapped while administrators went through the bank’s books. In December officials from Britain’s financial-services regulator went to New York to study America’s bankruptcy code, which has special provisions for investment banks. Spain is already in the grip of a wave of defaults by property companies: Martinsa-Fadesa and Promociones Habitat, two huge developers, filed for bankruptcy in July and November respectively last year. The cases will test a new insolvency regime which took effect in September 2004. So far, says Ignacio Pallarés, a lawyer with Latham & Watkins in Madrid, there is no sign that the new rules have had much effect on the country’s 90% liquidation rate. Creditors still have little say in the process. In Italy a new regime has helped to empower creditors, says Agnès de Petigny, an insolvency specialist at S&P in Paris, but it is untested and it is unclear exactly who wields influence in the process. Because of the stark differences in treatment of creditors in Europe—Britain, Ireland, the Netherlands and Scandinavian countries are the friendliest, with Belgium, Germany, Portugal and Switzerland in the middle and France, Italy and Spain the worst, according to S&P—the next few years are likely to see jurisdictional battles. According to European Union law, a company can request to file for bankruptcy in the country where it has its “centre of main interest”, and creditors will fight to avoid the worst regimes. In countries where creditors cannot avoid a raw deal, companies’ cost of capital could rise sharply. But at least one good thing may come out of the wave of defaults about to hit Europe. It is not only legal systems that are to blame for the high level of liquidations. The stigma of insolvency is so strong, especially among family-owned firms, that owners may admit they are in trouble only when it is too late. “The more companies go into insolvency for an in-court restructuring, the more it will become normal,” says Frank Grell, an insolvency partner at Latham & Watkins in Hamburg, “and the stigma will go away.”