Anticipating financial distress: Could developing countries borrow from the French and the U.S. toolbox?

As the COVID-19 crisis continues to hurt economic activity, promoting and encouraging the rehabilitation of distressed but potentially viable businesses should be at the top of lawmakers’ priorities.  But many insolvency systems fall short in moving quickly to save viable businesses. This is in part because bankruptcy carries social stigma, which encourages debtors to delay recognition of financial challenges. In many countries, the absence of early warning systems, by which auditors or corporate bodies inform the directors of identified financial threats, further explains this tendency. As a result, insolvency proceedings often get started when there is nothing left to save. What could have been the reorganization of a distressed company—if tackled on time—ends up in a piecemeal liquidation, leaving both the debtor and its creditors dissatisfied. 

So how can we encourage a more proactive approach to dealing with financial distress? A look at the experience of France and the United States provides some lessons. Decades before the COVID-19 pandemic, the World Bank Principles for Effective Insolvency and Creditor and Debtor Regimes emphasized that debtors should have quick and early access to the insolvency system. The European Commission has also recently embarked on a process that led to the adoption of the 2019/1023 EU Restructuring Directive, which obliges EU member states to implement, among other mechanisms, “early warnings tools” and pre-insolvency proceedings, allowing for the timely initiation of a reorganization process. This increases the odds that viable businesses live on.  

France has been encouraging “early restructurings” and “early warning tools” for decades. Under French law, the prevention of insolvency takes the form of the “procedures d’alerte”, specific corporate mechanisms whereby auditors and other corporate bodies shall alert directors and, in certain cases, the commercial court, as soon as they detect any fact or symptom indicating a threat to the continuity of the business. The French system also contemplates financial incentives to support out-of-court restructuring negotiations. Among those, the “médiateur du crédit” (credit mediator) is a type of ombudsman assisting debtors in negotiating with private lenders. Broader financial support can be sought with ad hoc committees at the departmental or regional level. At the national level, the most strategic rehabilitation cases involving businesses with more than 400 employees are examined explicitly by the Inter-ministerial Committee for Industrial Restructuring, or CIRI. In 2020, CIRI supported around 60 strategic restructurings.  French practitioners observe this has been critical to mitigating the impact of the pandemic.  

To preserve the business as a going concern, the French system also provides for the “conciliation” (mediation) and the “mandat ad hoc” (ad hoc mandate). Both are informal, out-of-court procedures that are initiated by the commercial court before the debtor’s cessation of payments. They are based on confidential negotiations supported by insolvency practitioners appointed by the court. They often end with the signature of a restructuring agreement between the debtor and the main creditors. This agreement is sanctioned by the court in a “conciliation”, or purely contractual in the “mandat ad hoc”. Both procedures have no binding character for creditors who are not part of the restructuring agreement. 

Many other European countries, in their process of adopting the EU directive, are aligning their laws with the World Bank Principles by introducing flexible pre-insolvency mechanisms as well.  

Chapter 11 of the U.S. bankruptcy code pioneered a different approach allowing the debtor to file an in-court, voluntary petition to open a restructuring process without requiring the debtor’s insolvency or cessation of payments. A notable feature of Chapter 11 proceedings is significant judicial involvement. The opening of the procedure automatically triggers a universal stay of creditors’ individual pursuit and the approved rehabilitation plan is binding even for the minority of dissenting creditors. These facts, added to the high costs of Chapter 11 and its strict court supervision, give the process considerable predictability, and discourages unviable debtors from filing superfluously.  

Most advanced reorganization and insolvency systems have merits and challenges. Emerging markets and developing economies (EMDEs) can look at the different approaches described here and adopt what works best for them.  Some EMDEs may find the U.S. model challenging to implement because it requires very high capacity to supervise a debtor in possession and an adequate process for the selection, appointment, and training of ultra-specialized and well-resourced bankruptcy judges. The approach adopted in France (and in other EU countries) could be a source of ideas for EMDEs where consensus and more informal processes are a larger part of the business and social culture, and where the access to trained, experienced, and specialized judges remains an objective. Finally, jurisdictions don’t need to choose one system or the other. Rather, they can build the right combination of tools that works for them, considering their economic and financial resources, their institutional capacity, and their available expertise in the field of insolvency law.