Michael.1
Insolvency and related law and policy, and more

Michael Murray is an Australian author and commentator on corporate and personal insolvency law and related issues, in Australia and internationally. He has a strong law and policy background, is independent of any connections, and his views are his own. He gives no legal advice. 

Insolvency and debtor in possession – hospital or home care?

If Joe thought he might have a serious medical condition, but did not want to go to hospital for a period of some weeks to have it fixed, like many, Joe would hesitate to even seek advice.  It may be nothing and it will resolve itself.

If there were another option, that the condition could be resolved by some out-patient home-care process, Joe might be more inclined to have the condition looked at, earlier than later. 

The point of this is that human responses to illness are perhaps one way to more clearly see how those in business (directors) respond to the financial decline in health of their company.

 

The Australian hospital stay, or the US out-patient

Continuing with that comparison, there are broadly two options for directors:

  1. the Australian hospital stay for some weeks, at some expense, with the director incapacitated in a hospital bed, and with any decisions made for them by the doctor. This is the Australian voluntary administration process. Or,
  2. the US (and many other jurisdictions) out-patient model, with the director retaining control of their health, at home, under instructions and oversight by the doctor. This is the US debtor-in-possession (DIP) Chapter 11 process.

A comparison has been made that the ability of US directors to retain control, even under oversight, is an easier route to their seeking early advice and taking action. In contrast, the Australian directors face not only a loss of control of their business, but also an inquiry into and report on their conduct, often reinforcing their hesitation and delay.

And while there seems to be an almost xenophobic reactions against any US style law, DIP is common elsewhere and is currently a focus in SME insolvency law reform, by UNCITRAL, the World Bank and the European Commission, and the UK, among others.

While the Australian government endorses behavioural approaches to the design of law and its regulation, given that ‘small alterations to choice architecture can give effect to disproportionately large behavioural changes’, and particularly in tax law, there appears to be limited attention given to these approaches in insolvency law.  The circumstances of an insolvency and the balancing of the competing interests involved are replete with behavioural challenges.

Some behavioural approaches

All this may be arguable, not by me, but there are various behavioural theories that support the debtor in possession model.[1]  These include a tendency to give a higher and subjective value to an asset we own; which increases when we are in danger of losing it; coupled with an aversion to realising a loss on that asset. Such sentiments and behaviours can prevail when a director contemplates appointing a voluntary administrator (VA), to a business owned by the director that is in financial decline; and SMEs are likely fully owned by the directors.  Commitment to a particular endeavour can increase when it is failing, reinforced by a bias towards self-justification, an unwillingness to admit mistakes, and loss aversion, all of which might lead to a VA appointment only when the level of financial distress is dire.  There is also the bias, when faced with a hard decision, to stay with the status quo, heightened when the perceived loss is greater.

Then there are the legal ambiguities that support for example insolvent trading, reinforced in the current COVID-19 climate, whereby we construct our own self-serving interpretations of the legal requirements, supported by social norms based upon the behaviour of others. While continuing to trade during insolvency might be a breach a director’s duties, initiating a VA commonly results in a winding-up and job losses. Phoenixing can involve a new business and employee retention.  The company’s failure lay not with its director but with unfair COVID-19 border restrictions.  And any insolvency administration involves a ‘destruction of value’ and is costly and time consuming and is to be avoided.

Debtor in possession

On the other hand, a DIP model can ameliorate much of these adverse responses. It avoids the ‘loss’ of control of the business; directors can press on, albeit under oversight. Ownership of the business is a positive, prompting a commitment to its survival.  The stigma of failure, which might otherwise provoke commitment bias, is not as strong; it is more a hands-on managed revival, less publicly evident, and status quo bias is also softened.

All this falls within a legal and moral environment. Australia is seen to be severe on business failure – it was one of the last jurisdictions in the world to abolish debtors’ prisons. Consistent with that, a ‘debtor-friendly’ system would send ‘shockwaves’, leaving ‘some who ruined a business in charge’; instead, ‘directors … are meant to be sidelined’.[2] As for a one year, or less, period of bankruptcy ….

It is more acceptable – if not, it is said, a plus – to have failed in the US.  According to one of Australia’s ‘failed’ entrepreneurs, the view in the US is that

‘if you haven’t been in Chapter 11 you’ve never been in business’.[3]

And the UK has moved to more of a DIP style, and from a different starting point – would an Australian judge say that “ceasing to trade and liquidating too soon can be stigmatised as the cowards’ way out”?[4] – though, in reality, Australia’s safe harbour regime is itself DIP.

The trouble is …

The trouble with insolvency law reform in Australia is that it suffers from a lack of input from the behavioural and social sciences, and economics and more, and from too many accountants and lawyers, myself not excluded.

More than many other areas of law, insolvency deals with human behaviour in a range of contexts – involving loss of money, lifestyle, standing, with high stakes allowing compete absolution, but also scope for wrong dealing.  Law and less so accounting can devise the structures but to have those structures applied and be useful involves input from other disciplines; and other thinking, and internationally, referred to earlier.

So

So, passing over the usual knee-jerk lawyer/accountant hospital-stay responses to DIP style ideas, a home-care out-patient DIP system might be worth (at least) considering.

========================

 

[1] Usefully explained and argued in Restructuring companies in the twilight zone of insolvency: a model for Australia, PJ Westman, Honours Thesis, ANU, 3 November 2014.

[2] ARITA, various

[3] Poppy King, reported at [2001] 2(1) INSLB 20

[4] Re Continental Assurance Co of London plc [2007] 2 BCLC 287, Park J.

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