24th February 2014
Businesses and investors involved in cross-border trade and transactions will require sound knowledge of different insolvency regimes, according ratings agency Fitch. In particular the changing aspect of European systems, which are increasingly mirroring US-style chapter 11 rescues, need to be understood.
The advice came as the firm reports that losses from the next leveraged finance default cycle could be far in excess of previous cycles. According to the agency, this is down to “weakening new-issue rating mix in bond and loan markets as leverage levels rise and covenants become increasingly lax in both the US and European markets”.
Sharon Bonelli, managing director in US corporates, says: "Knowledge of insolvency regimes will be critical to cross-border investors when determining recovery and pricing in relative creditor rights.”
Fitch carried out a comparative study of insolvency regimes in the US, the UK, Germany, France and Luxembourg, explaining that these represent a broad mix of different legal systems that are attempting to adapt to the complexities of global business operations and capital flows. As the report notes, the different systems in place produce a “profound” effect on the structural developments of capital markets.
For example, the report highlights that while European systems must deal with creditor-in-possession framework legacy, the US system places more emphasis on a debtor in-possession framework that seeks to rescue the distressed company.
European regimes have traditionally assumed that debtors and creditors had explored and exhausted all possible channels, with liquidation via sale of the company or its assets the main way for resolving creditor claims. However, the Fitch report suggests things are changing.
"In recent years, as European corporate finance has emphasised more diffused US-style capital market products and practices, insolvency laws have been amended to include mechanisms that aim to replicate the spirit of the US Chapter 11 framework, while the specifics continue to differ substantially," says Karsten Frankfurth, senior director in the EMEAleveraged finance group.
Indeed, the Europe Union is currently pressing ahead with reforms to cross-border insolvency rules that aim to offer viable businesses a ‘second chance’ by creating a "rescue and recovery" culture in the 27-nation bloc. Approximately 200,000 firms go bankrupt in the EU each year, with a quarter of these insolvencies possessing some kind of cross-border element.
The proposals, which have so far met with strong support, aim to shift from liquidation towards a new approach of helping businesses to overcome financial difficulties. “The first option for viable businesses should be to stay afloat rather than liquidating,” said vice-president Viviane Reding, the EU's justice commissioner.
However, despite convergence between US and European approaches, significant differences remain, particularly with regard to concepts like priority and proportionality, according to the report. Fitch says: “Consequently, forum shopping, with the UK Scheme of Arrangement process the established pre-insolvency forum of choice, and ad hoc judicial activism highlight greater uncertainty in comparison with established US tenets.”
And whilst moves towards a more “rehabilitative” framework develops in Europe, there is underway right now a major review of US bankruptcy practices. Businesses and investors will have to work hard to keep pace with the changes taking place.