The Road Towards Good Bankruptcy Governance: A Comparative Law and Economics Perspective

In my paper ‘The Road Towards Good Bankruptcy Governance: A Comparative Law and Economics Perspective’ (published in the conference proceedings booklet ‘Party-Autonomy and Third Party Protection in Insolvency Law’ (J.L.L Gant ed., INSOL Europe)), I seek to ignite discussion on the topic of good bankruptcy (or insolvency) governance and to inspire idealistic researchers to become involved in this discussion. Three key aspects of good bankruptcy governance are addressed in this paper.

First, an attempt is made to define the concept of ‘good bankruptcy governance’, which I narrow down to the following question: ‘In whose interest should the management of a corporation or insolvency estate act?’. A short comparative analysis of the US, the UK, Belgium and the Netherlands does not provide a clear answer.

However, some room for common ground can be found by turning to an economic analysis of law. I defend the view that the internal function of a legal system implementing good bankruptcy governance is to ensure that the management of a financially distressed company, such as a liquidator of an insolvency estate, acts in the best interest of the present and future creditors, including the interest of the structural subordinated shareholders, as the (new) residual owners of that firm/insolvency estate. To put it bluntly: corporate law should protect shareholders; insolvency law, creditors; employment law and social security law, employees; consumer law, consumers; etc.

Although we are not living in the era of Milton Friedman anymore (eg the Accountable Capitalism Act and the new Statement on the Purpose of a Corporation), I would still dare to say that this view also applies to reorganization proceedings. After all, I am not saying that stakeholders other than shareholders and creditors should not be protected in insolvency proceedings – they should, but not by the notion of the corporate/insolvency estate interest, as other branches of law are better equipped for that. I present anecdotal evidence that can be found in recent European legislative developments to support this view. An extended version of this argument (in Dutch) can also be found in my earlier publication in the Tijdschrift voor Privaatrecht (TPR).

Secondly, a theoretical model to identify shortcomings in the current bankruptcy governance system is built on the basis of Goshen and Squire’s agency-principal costs theory. The main takeaway of this theory (at least for this paper) is that a shift in control rights from the agent to the principal is (Kaldor-Hicks) efficient if the agent costs decrease more than the principal costs increase; or a decrease in principal control is efficient if the principal costs decrease more than the agent costs increase.

In contrast to Goshen and Squire (whose research primarily focused on corporate law), I argue that rules implementing a system of good bankruptcy governance should sometimes be mandatory, because of the possibility of severe contracting failures on the part of the (non-adjusting) creditors. Promoting mandatory rules implies accepting inefficiencies: some creditors would be better off if it were possible to deviate from certain existing/proposed bankruptcy governance rules (for instance, due to the presence of an extremely loyal and competent management in high-tech startups). This, however, is not an insurmountable problem as long as the goal of this paper is clearly stated, that is, to achieve a Kaldor-Hicks efficient bankruptcy governance model. This means that a model that tries to minimize the total control costs in the majority of insolvency proceedings is being built. Furthermore, the argument is presented that both agent-constraining and principal-empowering control rights are needed to achieve a Kaldor-Hicks efficient bankruptcy governance system.

Thirdly, the model is applied to the current bankruptcy governance system, in particular to personal civil liability and remuneration of the liquidator.

I find that the Belgian rules concerning liquidators’ personal civil liability are inefficient. Currently, only (the representative of) the insolvency estate has standing to sue the liquidator in his personal capacity for his (dis)honest mistakes, and to claim damages for the losses the insolvency estate suffered. This means that the liquidator is expected to monitor himself and to sue himself for his own improper conduct (so-called ‘inherent conflicts’ or extremely high agent conflict costs). A transfer of the control right to bring liquidator liability lawsuits from the agent to the principal (ie creditors) is required. In this respect, the United States (eg DiStefano v Stern (In re JFD Enters.)) and the United Kingdom (Insolvency Act 1986, s 212) can serve as examples.

The cost-benefit analysis of the rules concerning the remuneration of the liquidator is less clear. I identify two different approaches to principal control (trusteeship  and principal-empowering strategy) in four legal systems (Belgium, the Netherlands, the  United States and the United Kingdom), but suggest more comprehensive research into the various interconnected bankruptcy governance mechanisms is necessary in order to be able to call one approach superior to the other.