SECCIÓN CUARTA DEL REMATE

A firm that stays in a situation of financial tension or insolvency, defined according to Chapter 1, is facing a delicate situation from a legal point of view. This paragraph provides the legal definition of the state of insolvency, since this state opens the room for the application of legal rules about bankruptcy. According to Italian Bankruptcy Code (art. 5) “the state of insolvency appears through the default or other facts that show the debtor’s inability to regularly satisfy its obligations”. The default means the failure to perform contractual or legal obligations, typically the payment of a monetary amount within a certain expiry date, but also the delivery of a good, the performance of a service or the compliance with covenants, which are commitments towards lenders involving financial and cash flow management.

It follows that insolvency is the situation where the firm has already defaulted on a relevant obligation (under Italian law: valuable more than 30.000 Euro) or, at present, it is not able to pay the expiring debts on a regular basis, considering the anomalies in the means of payment or in obtaining the necessary amount of cash. Insolvency requires that the events of defaults must be proven and reasonably caused by the situation of distress, or that the firm stays in dangerous situations, classified by the law among “the other facts”, where the entrepreneur has abandoned the firm, the assets have been carried away or the business premises are suddenly closed. (Cian 2014)

The presence of default or its threat jeopardizes the survival of the business and it may cause a situation of trouble among creditors, since they may activate the instruments for the enforcement of their right provided by the Civil Law. It follows that creditors, under the supervision of the Court, have the power to expropriate the firm's assets (real estate, equipment, inventory), to sell them in a public auction and to retain the proceeds from disposal until its credit is fully satisfied. This system does not fit for the insolvency of a typical firm for two main reasons. First, the firm is a dynamic system, where, on a day by day basis, goods are bought from suppliers, then flow through a production process and finally they are delivered and disposed to clients. In this sense, the expropriation of a production facility, a piece of office equipment or a substantial portion of goods on inventory may block the entire corporate activity; in this way the proceeding creditor is satisfied while the other stakeholders that obtain benefit from their contributions to the conduct of business are damaged.

Secondly, if we consider that the insolvent firm owes a substantial monetary amount to a set of different creditors, the situation becomes dramatic since ordinary enforcement law is based on first come, first served principle: the creditors who start the enforcement procedure later bear

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the risk that the available assets have been exhausted by the claimholders who had taken the enforcement action on a timely basis. It must also be considered that the law fixes the par condicio creditorum (Absolute Priority Rule – APR) principle, which states that more creditors with the same grade of priority, when they enforce their claim, have the right to share the proceeds from execution proportionally to the amount of their claim.

To complete the general framework, an important issue must be specified. Exceptions of the principle of parity and equal treatment of creditors are granted by priority rights whose source is defined by the law. If the creditor owns a preference right over its claim, proceeds from the enforcement of the credit are first retained by the preferred creditor until the claim is fully satisfied. After the satisfaction of the preferred creditor, residual proceeds are devoted to non-preferred creditors. Typically, preference rights are negotiated between creditor and debtor according to the mandatory legal provisions and they are constituted by pledges on assets and mortgages on real estate, that give a preference right limited on proceeds from the encumbered asset.

It follows that, when a firm negotiates debt financings, the lender poses a special attention on obtaining a set of preference rights and guarantees that ensure the satisfaction of its claim in case of default. Moreover, preference rights negotiated between lenders and borrower shall be combined with preference rights directly originated by the law (for example about wages to employees, taxes, professional fees) thus establishing a hierarchy of preference rights on the firm’s real and financial assets.

About debt financing, the highest level of priority is given to senior secured debt (where secured means guaranteed by real guarantees such as special privileges, mortgages and pledges), then unsecured debt has a lower level of priority, while junior or subordinated debt has the right to be reimbursed after all the debt claims. At the lowest level we find equity claims, which are the residual claims, and in a situation of insolvency, they receive a payoff equal to zero, or even negative in the case the firm is not granted the legal benefit of limited liability.

Therefore, under ordinary legal system, the only threat of a business' insolvency, causes the run of debtholders and suppliers to ask for new guarantees and to consolidate their position as soon as possible: suppliers ask to be paid on cash and they may refuse the delivery of raw materials, short term loans are revoked, guarantees are activated, and enforcement actions are taken. All these initiatives erode the amount of assets available for the continuity of the ordinary business activity and for the satisfaction of claimholders who do not promptly take legal actions versus the distressed firm.

Considering also that the activation of multiple enforcement procedures leads to the multiplication of legal and procedural costs, while increasing the uncertainty on the outcome,

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this messy situation opens the room for the need of an exceptional legal system regulating bankruptcies and corporate reorganizations, to sort out the overall problems of a distressed firm in an efficient, timely and equal way.

According to Buttignon (2008), corporate reorganization legal frameworks shall be declined into dimension of efficiency, timeliness and equality of the resolution of the situation of corporate crisis. Efficiency dimension refers to the principle that potential contribution to value creation of a resource is maximum weather the resource is devoted to its optimal use and it stays in combination with other valuable assets. So, an efficient reorganization framework should direct the decisions about the future utilization of corporate resources and assets (restructuring, transfer or liquidation) at the only aim to maximize the value created for all the stakeholders.

Timeliness assumes a key importance in the field of corporate restructuring, since a long situation of uncertainty deteriorates more and more deeply the image and reputation of the firm toward all internal and external stakeholders, reducing over time the value of intangible assets and resource, and therefore the Enterprise Value. In this sense “the principle of timeliness represents a declination of the efficiency dimension in a dynamic sense” (Buttignon 2008, page 246).

Then, the equality principle is related to the fair distribution of the restructuring costs and the sacrifices requested to stakeholders of the distressed firm. Given the fact that total value of assets is lower than the value of outstanding claims, the loss should be split among shareholder according to an equality principle.

Practically, principle of par condicio creditorum and strict priority rules, while they ensure fair distribution of losses, they do not guarantee full efficiency and timeliness, since they pose the incentive for opportunistic behaviour and further disruption of value. As it will be seen in Chapter 3, controlling shareholders, through directors appointed by them, own an informational advantage about the situation of distress and they also have a specific know-how for the diagnosis and resolution of the crisis: in this sense they are the best candidates to ensure best utilization of assets and the maximization of value. Unfortunately, according to the status of residual owners, they cannot enjoy the value created by their effort on restructuring until all debtholders have been completely satisfied, so they have the incentive to abandon the control of the firm. It follows that it exists a trade-off between efficiency and equality: whether the crisis is at early stage, it is reasonable to give incentives to the directors and shareholders in charge to quickly implement the restructuring. In this way the equality is violated, since shareholders receive some benefits, but maximization of overall Enterprise Value is ensured.

As counterbalance, all the valuations about the equality and the reasonableness of a certain

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restructuring plan with respect to the creditors’ interest should be reserved to creditors themselves, who have the right to receive transparent information on a timely basis.

Bankruptcy and corporate restructuring law, trying to reconcile the needs of efficiency, timeliness and equality, creates an exceptional regime, where the principle of first come, first served on the enforcement of claims leaves its space to collective and negotiated procedures.

The system is usually completed by provisions that limit the power and the freedom of directors and top managers in a troubled firm, by including obligation of information and external supervision by the public authority. The limitation of power, enforced through criminal consequences in case of breach, is aimed at avoiding opportunistic behaviour that damages the corporate creditors.

Insolvency law is an institutional variable that is strictly related to various elements such as juridical tradition, attitude toward entrepreneurship, relationships among firms and capital markets, political considerations; the interaction of these forces creates characteristic practices for each country. For example, in the United States, the Bankruptcy Reform Act, in force since 1978, is based on two pillars: Chapter 7 and Chapter 11. While Chapter 7 refers to the compulsory cessation of the going concern of the business and the following liquidation of the corporate assets, Chapter 11 is the framework for the restructuring in continuity of the insolvent firm. These two pillars are related, since under a restructuring procedure, whether the agreement among parties is impossible to be reached, the restructuring plan is not feasible, or a situation of irreversible crisis is ascertained, the Chapter 11 is converted into a Chapter 7 procedure. The main features of the latter procedure are that the collection of outstanding claims toward the insolvent firm is stopped, the control of the overall firm is taken by a receivership whose activity is to sell out in a competitive auction all the assets of a firm, on aggregated or individual base, while resolving all the pending disputes. At the end of the liquidation, legal and administrative costs of receivership are paid, then net proceeds are distributed to claimholders according to a strict priority rule: a creditor belonging to a lower preference level cannot be paid unless the creditors of all the upper preference levels are fully paid; according to par condicio creditorum, the claimholders with the same preference right must be paid with same percentage on the nominal amount of credit. (Berk & DeMarzo 2011, page 545)