EU’s great turnaround reform

Mihaela Carpus-Carcea, legislative officer in the Directorate-General for Justice and Consumers, presents the European Commission’s three-pronged proposal to boost the efficiency of insolvency procedures

On November 22 2016, the European Commission (EC) submitted to the Council of the EU and the European Parliament a proposal (COM(2016) 723 final) on harmonising key aspects relating to preventive restructuring procedures, second chance for entrepreneurs and measures to increase the efficiency of insolvency proceedings. The proposal is a follow-up to an EC recommendation of March 12 2014 for a new approach to business failure and insolvency, which has been implemented to some extent by several member states. The project of harmonising key insolvency aspects has received further impetus in the context of the EC's priority initiatives on a Capital Markets Union and the Single Market Strategy.

The 2015 Capital Markets Union Action Plan (COM (2015) 468 final) announced a legislative initiative on business insolvency, including early restructuring and second chance. This initiative was intended to address the main barriers to the free flow of capital and build on national regimes that work well. Aligning the procedures available to parties to restructure a debtor's business before it becomes insolvent will bring more legal certainty to cross-border investors. Making all insolvency procedures more efficient and therefore less lengthy will also lead to higher recovery rates for creditors. These measures are likely to make the EU a more attractive place for investors.

The Single Market Strategy (COM(2015) 550 final) also stated that the EC would support honest entrepreneurs and propose legislation to ensure that member states provide a regulatory environment that is able to accommodate failure without dissuading entrepreneurs. The European Single Market needs to encourage entrepreneurship and innovation and this cannot be done unless there is a change in attitude about failure.

The Economic and Financial Affairs Council (Ecofin)'s conclusions of July 2016 for a roadmap to complete the Banking Union underlined the importance of the work on minimum harmonisation in insolvency law to support efforts to reduce future levels of non-performing loans, improve the management of non-performing loans in member states and increase the resilience of member states' economies to economic shocks.

The proposal has three main parts: minimum standards on preventive restructuring procedures, minimum standards on second chance for entrepreneurs and certain measures to increase the efficiency of insolvency procedures in general. Mindful of the richness of the legal traditions in Europe, the proposal gives member states sufficient flexibility to implement the principles and rules laid down in the proposal. Member states may, among other things, choose to put in place a brand new pre-insolvency restructuring procedure or to improve existing procedures. Importantly, the proposal ensures that any national preventive procedure could be recognised in other member states of the EU.

Currently, every year in the EU, 200,000 firms go bankrupt. This means 600 companies every day. Half of all companies in Europe do not survive past their first five years of existence. About one in four insolvency cases are cross-border insolvencies. But the insolvency of one company, even when purely domestic, can have domino effects along the supply chain: one in six insolvencies is a knock-on effect of a previous insolvency.

In most member states, the most likely outcome for companies in financial difficulties is still a liquidation procedure rather than a restructuring. Small and medium-sized enterprises (SMEs) are particularly vulnerable due to high costs of restructuring, but these SMEs account for 99% of all EU companies. The prevalence of liquidation procedures has an impact on the average recovery rates for creditors: data shows that the highest recovery rates for creditors are in economies where restructuring is the most common insolvency proceeding: 83 cents on the dollar, versus 57 cents on the dollar in countries where liquidation is the prevalent outcome.

As a result of the failure of these companies, over 1.7 million people lose their jobs each year. These people have to look for new jobs and face uncertainty for their futures.

The proposal will increase the opportunities for viable businesses in financial difficulties to be saved rather than liquidated while at the same time ensuring a balance between the rights of debtors and creditors, with due regard to the interests of other stakeholders as well.

The proposal will give debtors access to early warning tools to detect a deteriorating development of their business

The proposal will give debtors access to early warning tools to detect a deteriorating development of their business. It will give companies in financial difficulty, wherever they are located in the EU, the chance to restructure at an early stage, and thus avoid insolvency when the company immediately loses value.

The debtor will remain in control of its assets and affairs to ensure a minimum disruption of the operation of the business. Appropriate supervision by an insolvency practitioner can be put in place in complex cases or where certain measures might affect the entire body of creditors (such as a general stay of enforcement).

The debtor can benefit from a court-ordered, temporary stay of enforcement actions (a breathing space) to facilitate negotiations with creditors and successful restructuring. The stay should not be in principle longer than four months, but member states could provide that it is extended if necessary to ensure the success of restructuring negotiations, in particular in more complex cases involving larger companies. Specific rules provide for the protection of employees' claims during the stay period.

To ensure that creditors' rights are properly reflected in the adoption of restructuring plans, for the purposes of voting on a restructuring plan they shall be treated in different classes reflecting their different interests. As a minimum, secured creditors should vote separately from unsecured creditors.

A court confirmation of the restructuring plan agreed by creditors will be necessary in certain well-defined circumstances, where there are dissenting creditors or where the plan provides for new financing.

The proposal also facilitates new financing and interim financing, in that it guarantees a minimum protection from avoidance actions in subsequent insolvency procedures. Member states may go further should they wish to further compensate the risk undertaken by such creditors and give new financing super-priority status.

Shareholders will not be allowed to obstruct unreasonably the adoption of restructuring plans that are able to restore the viability of the business.

Several of the provisions have been designed with a focus on reducing cost and complexity and providing incentives to address financial difficulties early for SMEs as debtors, while others aim at improving the protection of SMEs as creditors in the supply chain.

Once an entrepreneur goes bankrupt and irrespective of whether he/she has been acting in good faith, the possibilities to discharge debt and have a fresh start are still limited, despite reforms in this area undertaken by several member states in the past few years. The lack of a strong second chance culture for entrepreneurs has an impact on entrepreneurship and innovation: almost half of all potential European entrepreneurs say they are held back by the fear of going bankrupt and its consequences.

In May 2011, member states committed to reduce discharge periods for entrepreneurs to a maximum of three years by 2013. Yet today it is still very hard or impossible for entrepreneurs to have an early restart after a first failure. In some member states discharge periods are much longer, while in others the conditions for obtaining it are prohibitive.

The proposal will put in place a limitation of the discharge period for honest, over-indebted entrepreneurs to a maximum of three years. Many honest entrepreneurs caught in debt traps could thus return to the productive economy. Member states are free to maintain or introduce stricter conditions to discourage bad faith, fraud and abusive applications. This measure is expected to lead to up to three million new jobs.

Member states may also decide to extend the second chance provisions to consumers, depending on their national circumstances.

Having efficient insolvency procedures is key to ensuring a swifter handling of such cases and increasing the overall recovery rates and the residual value of potential non-performing loans.

The low recovery rates are, in no small part, due to the length and inefficiency of procedures especially in some member states: in 10 member states it takes creditors more than two years (and up to four) to recover a claim in insolvency. Lengthy, inefficient and costly insolvency proceedings in some member states were found to be a contributing factor to insufficient post-crisis debt deleveraging in the private sector and to exacerbate debt overhang. But procedures could be shortened and made more efficient, and thus limit the loss of value for all stakeholders involved. The proposal contains several measures to that effect.

In 10 member states it takes creditors more than two years (and up to four) to recover a claim in insolvency

First, it is proposed to improve the training and specialisation of the judiciary and administrative authorities, to ensure that they are able to make complex decisions with potentially significant economic and social repercussions in the shortest period possible.

Second, improvements are proposed as regards the transparency of the rules on appointment, supervision and remuneration of insolvency practitioners, and thus contributing to mutual trust between courts and insolvency practitioners in different member states.

Finally, the introduction of distance means of communication in court procedures will help shorten the length of procedures, but will also further involve smaller and cross-border creditors for whom the disproportionate costs of pursuing their claims means that often they abandon such claims.

It is also important to collect reliable and comparable data on multiple procedures, their outcome, length and costs to assess how member states are implementing the directive and how well their systems are performing. The proposal puts in place data collection obligations for the member states.

Changing the EU insolvency landscape started with the revision of the Insolvency Regulation (Regulation (EU) 848/2015) establishing rules on jurisdiction, applicable law and recognition of cross-border insolvency procedures. The Regulation will enable the recognition of preventive restructuring procedures, however it makes no provision for harmonising the substantive requirements under such procedures. The Regulation will also enlarge the coverage of personal insolvency procedures leading to a discharge of debt, but does not establish any benchmarks in terms of length of the discharge period. Finally, the Regulation will provide for cooperation and communication in cross-border cases and will interconnect national insolvency registers, thus making a first step towards the digitalisation of insolvency procedures.

The Regulation will enter into force on June 26 2017.

The Commission's proposal on preventive restructuring and second chance is likely to bring more coherence among member states' insolvency frameworks, thus improving legal certainty for investors and facilitating the cross-border flow of capital. Businesses will have better tools to address their financial difficulties in times of crisis early on and as a result, the ratio of restructurings to liquidations will increase and more jobs will be saved. At the same time, the rules will help prevent the accumulation of non-performing loans and make the overall insolvency procedures more efficient, thus cutting costs and time spent in proceedings and increasing the recovery rate for creditors.

The European Parliament and the Council are now examining the Commission's proposal, which is likely to enter into force two years from the moment an agreement is reached and the Directive is adopted by the co-legislators.

About the author
		Mihaela Carpus-Carcea Legislative officer, European Commission Brussels, Belgium T: +32 229 91111 W: www.ec.europa.eu Mihaela Carpus-Carcea joined the European Commission in 2009 and has worked in the Directorate-General for Justice and Consumers as a legislative officer since 2010. Among the legislative projects in her responsibility were the 2014 Commission recommendation on a new approach to business failure and insolvency and the 2016 Commission proposal for a directive on preventive restructuring procedures and second chance. Before joining the Commission, Carpus-Carcea worked in private practice and in academia. She has a PhD in European Union law from the University of Birmingham.