Viewpoint lr;sf, No. 187 June Reforming Insolvency Systems 2 1 32 in Latin America MWalcolm Rowat Argentina, Colombia, Costa Rica, and Peru have recently revised their insolvency laws. The Argentine reforms are of special note because they have been complemented by labor law reforms. But reforms are still on the drawing board in many other countries in Latin America-including the big economies of Brazil and Mexico-where the laws tend to be very old, formalistic, not enforced, out of touch with today's business practices, and heavily skewed to favor preserving the enterprise to protect employment at the expense of creditor protection. Moreover, judicial decisionmaking is unpredictable, and corruption is rampant. In some countries anticreditor political pressures appear to have stalled the reform process. This Note assesses the weaknesses of insolvency law in Latin America and proposes some common solutions. Conflicting interests operation and preserving employment. To mini- mize the risk of being trapped in bankruptcy cases, iMost insolvency systems share two prime objec- French banks provide mostly short-term credit, tives: allocating risk among participants in the renewing the loans only if the risk of bankruptcy economy in a way that is predictable, equitable, over the next period is low. Yet this short-term and transparent, and maximizing the value of the financing increases the risk of bankruptcies caused insolvent firm for the benefit of all interested par- by transitory decreases in firms' cash flows. ties and the broader economy. Disputes usually center on how to maximize value-whether In the absence of an effective avenue for collec- through liquidation or reorganization, whether tion and a viable insolvency system, creditor with the existing management or under new banks have turned to the state for bailouts- management. and at whose expense. Once this sometimes billions of dollars worth. After the is settled, the dispute then becomes a matter of 1994 financial crisis in Mexico, for example, the hierarchy-who gets paid. howA much, and when. state responded to banks' request for a bailout by creating special vehicles to purchase troubled Where to strike the balance between the rights of loans. Mexican bankers resorted to the govern- debtors and creditors is a political decision. In ment in part out of a feeling that the insolvency Latin America the balance has historically favored system is ineffective in controlling credit losses. preserving the enterprise to protect employment. While the consequences of a policy favoring Weak creditor protection may also deter banks preservation of the enterprise have not been stud- from lending. One legal practitioner observes ied closely in Latin America, one possible effect is that Brazilian concordata (reorganization) and a tendency to provide overly short-term credit. bankruptcy laws enable solvent debtors, without This is shown by an analysis of the French insol- showing compelling need, to obtain a morato- vency system. which emphasizes keeping firms in rium on their debt, allowing them to repay it in The World Bank Group - Finance, Private Sector, and Infrastructure Network Reforming Insolvency Systems in Latin America depreciated currency, or to have part of their in their jurisdiction is less virulent than it once debt extinguished. In both cases unsecured cred- was. itors run the risk of substantial losses, and even secured creditors can suffer losses. WVith sophis- Fourth, a 'rescue culture"-where credlitors' inter- ticated lenders clearly understanding these risks, ests are protected-is unlikely to thrive in the conventional, unsecured lending may not take region without better enforcement. Skepticism-if place. not cynicism-about the functioning of the current systems is pervasive. Regardless of the text of the Current problems law, faith in the svstem is unlikely where creditors find, for example, as they have in Mexico, that the There are five main categories of problems. First, executive branch at the state level has refused to many of the current insolvency laws are rigicl, for- give the police the power to execute judgments malistic, and old. In Mexico few suspenisfon de out of political concerns over the public's reaction pagos proceedings (suspension of payments pro- to enforcement. Such skepticism is widespread ceedings, the closest thing in M9exico to a reor- among general counsels of Mexican banks, which ganization) succeed. And in Brazil as well as face a large backup of collection cases. Their view Mexico many of the insolvency provisions are is that creditors have little chance of collecting on simply theoretical or are not followed in practice. their debt in the current political environment and Both countries have insolvency schemes that date that judges do whatever they can to prevent col- from the 1940s, with provisions still on the hooks lection. One bank alone is reputed to have 35,000 that were designed to accommodate the difficulty collection cases pending. This situation has led of communicating before telecommunications. some to observe that in Mexico the issue is less the While age alone is no reason to reform a law, lack of a rescue culture than the existence of a Cul- most of the region's economies have changed ture of nonpayment. radically in recent years, while the laws have not. That the ahsence of a rescue culture creates Second. the high degree of judicial discretion needless losses is borne out by current practice. increases uncertainty and financial risks and en- tn Mexico securedl creditors regularly accept set- courages corruption (though in Argentina recent tlements worth far less than the value of their col- reforms have diminished this discretion). Judges lateral, recognizing that a court process is likely have the power to make such critical decisions as to brinig only delay and even loweie value. Across selecting the trustee and deciding contested issues Latin America creditors tend to lose all expecta- of fact and law. In some cases they can decide tion of a meaningful recovery once a debtor what is in the best interests of all concerned. Some enters the insolvency process, deterring them observers have accused the courts of having a from getting involved with the system. Instead, paternalistic and interventionist perspective that creclitors rend to write off a debt once a borrower values the general interest over the collective is in bankuLiptcy. In Brazil a "white concordata" judgment and interest of the stakeholders. process has developed in which creditors agree to accept payouts below the statutory minimums Third, corruption is rampant. References to the once a debtor threatens to file for falenyia 'mafia" that works the bankruptcy field are com- (liquidation). mon. The sense is not that organized crime is somehow endemic in the svstem, but that a core Fifth, as noted, there is a powerful, explicit bias group of players control the field and exact kick- in favor of labor. In Brazil. Mexico, and backs and bribes in exchange for favorable treat- Venezuela labor claimants receive a high degree ment. While opinions about the severity of the of preference and protection. For example, labor problem vary, they vary wvithiin a narr-ow range, claimants in Mexico are not affected by insol- with some observers believing that the problem vency moratoriums, are free to pursue their claims outside the bankruptcy court. and effec- past dealings, particularly wxith regard to trans- tively have priority over secured creditors. fers. collateral arrangements, and the like. * Trustees should also be given greater power to New priorities recover assets wrongfully transferred, particu larly overseas, through better procedural pro- A common set of essential reforms can be pre- visions, both domestic and international. scribed for all countries in Latin America, although the priority and sequencing of reforms Help preserve going-concern value before and in a country will depend on its circumstances. during insolvency. To aid the preservation of going-concern value, insolvency laws in most Crack down on corruption. The widespread cor- Latin American countries need to be revised to ruption in the insolvency system-not only provide for more timely and predictable relief, by: among some judges but also among the core Defining more precisely the standard to be met players (trustees, debtors, creditors)-calls for a before insolvency relief can he granted (such multipronged strategy: as failure to pay a fixed number of creditors * Requiring disclosure of behind-the-scene deal- within a certain period). ings (such as collusive bidding or wrongful Permitting and encouraging insolvency relief transfers of value from debtors to creditors). so that it is more broadly available (as in the * Creating incentives for ferreting out corruption. Costa Rican reform), not just for extreme finan- * Setting rules of conduct-emphasizing trans- cial disaster. parency, accountability, and conflict of Fixing a definite period, prior to a bankruptcy interest-for trustees in insolvency cases. filing, within which a judge or trustee can void * Fostering associations of insolvency profes- transactions that may be fraudulent or harmful sionals to help improve knowledge, standards, to other creditors (probably 3 to 12 months). and practice through education, peer pressure. Revising avoidance statutes to encourage res- and political influence (as in Canada). olutions before petitions are filed. (Under the new Argentine law a mortgage or lien is not Delink criminal and bankruptcy issues. Many avoidable if the unsecured debt had matured, Latin American countries have laws that classify encouraging commercial banks to grant con- bankruptcies by different degrees of fault (with cessions during a workout.) no differentiation between the business and the u Providing protection for postpetition creditors businessman), some of which can result in crim- to encourage the granting of credit during inal sanctions and bar insolvency relief (as in insolvency proceedings. Mexico). By mixing the business and criminal Eliminating provisions that needlessly drive aspects of insolvency, these laws deter owners toward liquidation (such as those prohibiting and managers of failing businesses from seeking the sale of assets before they are appraised, or outside help early. Criminal conduct should not making creditors that, as a group, have voted preclude insolvency relief to a business in crisis. for a debtor to stay in business liable to third parties if the debtor cannot perform). Foster transparency. To ensure that all partici- u Providing for exits other than liquidation if a pants in the insolvency process have accurate debtor fails to obtain the required consents from and timely information, priority should be given creditors to a proposal. (In Argentina share- to maximizing transparency. holders' interests can be sold to third parties.) * Current statutes slhould be revised to require meaningful disclosure of information. particu- Protect collateral. To give workouts a real chance larlv financial information. of success, secured creditors could be barred * Trustees and other stakeholders should be from pursuing mortgage claims for a reasonable given greater power to investigate debtors' period during a nonliquidation proceeding. But Reforming Insolvency Systems in Latin America the debtor should compensate the creditors participation, predictability, enforcement, and appropriately for the value of the collateral that it fair and transparent distribution of assets. consumes. Conventions ensuring cross-border cooperation Reduce delay in bankruptcy proceedings. While have been difficult to achieve. But recent initia- promptness is a v irtue in nearly all judicial pro- tives on several fronts may be promising. In the ceedings (as long as quality is maintained), bank- private sector Committeej of the International Bar ruptcy proceedings in particular demand rapid Association has prepared a concordat providing resolution because of the costs of delay to a firm's procedures and administrative arrangements for going-concern value and its underlying assets. cross-border court cooperation, which has been Judges should be educated about these costs, and successfully implemented in a case involving U.S. needless legal impediments that slow insolvency and Canadian courts. Probably more important for proceedings should be eliminated. These include Latin American countries is the model law on the procedures for proof of claims, the ability to cross border insolvencies dcvelopcd in 1997 by routinely appeal decisions, and the need for per- the United Nations Commission on International sonal validation of claims in court hearings. Trade Law (UNCITRAL) to foster procedural and administrative coordination among courts. This Enhance flexibility in reorganization. Current insol- law should be adopted by Latin American coLun- vencv stanutes have excessively formalistic and tries as a useful starting point for effective collab- Viewpoint is an open rigid requirements for reorganizations. Flexibility oration across borders. forum intended to should be built into the relevant laws to: encourage * Allow for more than just a predetermined pav- Provide specialized courts and training. The coln- debste on ideas, out schedule (as in Brazil and Mexico). lexities of insolvencv exacerbate the problems innovations, and best * Allow for capital restructuring, including debt- of inadequate judicial training in Latin America. practices for expanding to-equity conversions. Special training on bankruptcy and insolvencv the private sector. The views published are * Make adequate provisions for executory con- law is essential for judges, along with training on those of the authors and tracts (for example, contracts that are only par- business concepts such as accounting, deriva- should not be attributed tially completed). tives, netting, and interest and exchange rates. to the World Bank or any of its affiliated organiza- - Address the setoff of debts in financial contracts. tions. Nor do any of the * Provide for insolvencies of groups of affiliates The specialized nature of bankruLptcy law also conclesions represent (not permitted in Brazil and Mexico). requires specialized bankrtuptcy courts. Such oflcialnpolcy of the * Provide for the special needs of small and couIts have been successfully piloted in sevxeral Executive Directors or medium-size businesses, for example. by sim- countries in the region. Where specialized courts the countries they plifying insolvency procedures for them (as is are not feasible in the near term because of a lack now done in Argentina). of resources or qualified judges, insolvency cases To order additional could he routed to designated commercial law copies please call Promote cooperation in cross-border insolven- judges. Another possibility is to use nonjudicial 202 458 tilt1 or csntact Suzanne Smith, editor, cies. Latin America has long adhered to the "ter- mechanisms to resolve cases, as in Colombia, or Room FltK 208, ritorialitv" principle in cross-border insolvency formal alternative dispute resolution programs, The World Bank, cases. with each state asserting sovereignty. With xv-hich could be annexed to courts or free- 1818 H Street NW, Washington, D.C. 2433, the globalization of investment bringing about standing. or Internet address more joint ventures and other transactions that ssmith7@worldbank.org. cross national boundaries, there is a growing This Note is basea on Malcolm Rowat and Jose Asaigacraga. Latin available on line need to harmonize bankruptcy and reorganiza- A7nmzeoarcrtrIsolIr'etic-Srstcnms. A ConrpcratireAswsrernenzt(r'irld lank (www.worldbark.org/ tion proceedings across borders. Those involved Technical Papei 433, WXashin9gtorn D0 C 1999), htmlifpd/notes/). in cross-border bankruptcy proceedings want P Printed on recycled the same results that they would seek in a Mtalcoln Rouwat, Private Sector Development paper. domestic case: reasonable notice, access and Department (mrowat@uworldbank.org)