The corporate insolvency process is essential within the context of general commerce and financial transactions. During this process, commercial law is usually ruthless, because at this point, the existing assets are insufficient to pay all the creditors. As a result, the principal goal of the Insolvency process is to gather in and distribute the limited assets to business creditors in an orderly manner. Other objectives include rescuing the business, restructuring the business or rebuilding the business’ capital structure.
Cash is king for any business venture. Business operations and growth usually consume a substantial amount of the business capital. Consequently, when a business runs out of cash, it tends to be the end of the road for that business. That is, unless the founders, managers or investors are willing to take some drastic action to refinance the business. This situation can happen fast (such as when the business gets hit by a disaster) or the business may slowly bleed cash over a period.
Furthermore, the proceedings occur in an emotionally charged environment because lenders and creditors feel betrayed. The company may also need to fire some staff. Thus, unless the law chooses which creditors should be paid, a free-for-all ensues, as creditors fight for a piece of the small pie.
Creditors: Who are they?
- Banks
- Bond Holders
- Investment Companies (these include Venture capital companies, Hedge funds, and other non-bank lenders).
- Employees
- Suppliers
- Landlords
- Tax authorities
- Judgment creditors
Precursors to the Corporate Insolvency process
Insolvencies may be caused by misfortune or mismanagement, or both. Mismanagement revolves around poor financial and cost controls. These include creating a poor product, borrowing too much, hiring too many employees and imprudent business ventures. Some insolvencies occur due to internal or external fraud and embezzlement. Misfortunes occur where the business takes a reasonable risk, but the investment loses value to natural, political, economic, operational or social disasters. This includes fires, natural disasters, and the insolvencies of major debtors.
In order to trigger insolvency proceedings, some events usually occur:
- There must have been a prior commercial relationship between the debtor and the creditors. This transaction must have given rise to certain obligations between the parties. These include payment and performance obligations.
- An event of default (EoD) must have occurred or the debtor must have been unable to meet an agreed obligation(s).
- The offended party usually gives the other party some time to repair the default (Cure Period). This could vary, but it usually ranges from 1 week to 3 months. If the Cure Period lapses or there isn’t one to begin with, the creditor has a right to pursue legal action against the company for the immediate payment of all outstanding obligations (Acceleration).
Features of the Insolvency Process
Insolvency has a profound effect on normal legal relationships. The directors are disqualified from working, assets are seized without compensation, and contracts are voided. Employees sometimes lose their jobs and pensions, and secured interests are debased. The market loses another potentially profitable business.
The insolvency process is a collective process and it has the following features:
- Actions against the business by individual creditors are frozen. As a result, disappointed creditors will be legally prevented from seizing the assets of the business. The right of execution are stayed and replaced by a right to claim a dividend payment from the pool of assets.
- All assets of the company are gathered into a pool, which will be used to pay creditor claims. However, due to the substantial amount of exceptions to this rule, the applicability of this feature is doubtful in reality. In many situations, creditors are paid according to a hierarchy of payment.
- Creditors are paid pari passu. This means they are supposed to be paid pro-rata out of the assets of the company, according to their claims. In reality, this may be wishful thinking, as various creditors are paid according to their negotiating positions.
Policies of Corporate Insolvency Law
Insolvency law is pre-occupied with the following interests:
- Protection of Creditors equality by preventing disorderly and discriminatory actions by individual creditors.
- Maximisation of creditor returns
- Protection of the debtors interests and company (where possible). This is done by levelling down security interests, termination of onerous contracts, and refusal of insolvency set offs.
These interests are shaped by ancient attitudes to commerce and finance such as financial discipline and prudence. Formerly, the insolvency regimes favoured by many jurisdictions expressed moral disapproval of defaulting debtors. However, attitudes are rapidly changing towards a desire to save and rescue businesses that have potential.
Governments now aim to help deserving businesses survive a temporary cash-flow challenge. Corporate law generally recognizes insolvency risks, and many corporate governance and accounting rules have evolved to anticipate and prevent insolvencies. In addition, most commercial agreements contain protections against insolvency.
