20201027 generated funds
That funds generated by the stricken business will not immediately be diverted to banks and other creditors will go some way towards any revival. Image Credit: Ador T. Bustamante/Gulf News

There is a common flaw when it comes to conceiving a bankruptcy law as merely a type of debt collection device. Or as an alternative loss spreading mechanism superimposed on existing companies.

Rather, bankruptcy law is best conceptualized as creating and supporting a distinct bankruptcy market in its own right. This implies that it is corrective in nature, as its purpose is to remediate the problems of insolvency so that insolvent debtors and their property may again participate fully in ordinary non-bankruptcy markets unburdened by the waste and distorted decision-making insolvency generates.

Operationally, the new bankruptcy amendments further allows the market to perform the corrective function through its features of debt collection, debt forgiveness and debt adjustment. Among other things, these signature features of the law aim to promote improved decision-making regarding the disposition of the debtor and its assets. And enforce as a secondary matter, the payment of claims to reduce costs and prioritize debtor liabilities.

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A fair chance

These are beneficial, whether evaluated in terms of equity (fairness), efficiency (wealth maximization) or the preservation of entitlements (protected interests). Given this desirability, the corrective market approach is superior to the debt collection approach as it allows for alternative proposals to be evaluated with a more rigorous framework to maximize value.

A standalone problem

This approach more appropriately accounts for - and accommodates - what the bankruptcy law should be doing. The creation of its own distinctive market in response to the problem of insolvency is desirable because these problems are complex, and by their very nature require a curated market regime to resolve these matters adequately.

Of course, these mechanisms are required (as envisaged by Keynes in 1944), because when sentiments turns sour, globetrotting bankers suddenly turn into jelly as credit evaporates. Lax lending turns into no lending at all, and as asset prices collapse, and as buildings turn into “ghost towers”, banks are left holding significant non-performing loans with very little hope of recovery. (Which explains their counter-intuitive response to current market conditions by tightening credit).

Panic buttons

Panic reaches its deafening crescendo and Keynes’ inimitable words resonate once more: “As soon as a storm rises, bankers behave like a fair weathered sailor who abandons the boats which might carry him to safety by his haste to push his neighbor off and himself in”.

The current law strengthens the mechanism of bankruptcy protection by coordinating the mechanism of debt collection, debt adjustment and debt forgiveness by granting the “stay” that is much needed, and which banks were reluctant to provide. Specifically, the debt collection features are subordinated to debt forgiveness on the principle that the proper allocation of assets is more important than the payment of claims.

Diverts the cost of bankruptcy

Secondly, it takes into cognizance the pandemic conditions that has caused such disruption and pain, and allows for obligations processed through the court to be modified under the debt adjustment mechanisms. Losses are thus channelled away from those who can cause contagion to spread and towards those who are the cheapest avoiders of the costs of insolvency.

The key takeaway is the streamlining done to reduce the cost of enforcement. The relegation to secondary significance is vital for this acknowledges that the efficient deployment of assets is more important than vindicating the pre-bankruptcy collection rights of the creditors.

Banks will have to step up

This will be welcome relief to the SMEs and individuals who have suffered egregiously as a result of the pandemic, and will finally force banks to come to the party, while protecting the rights of investors. And avoid further disruption in the asset markets.

After all, the aim of bankruptcy law is to be ameliorative in that it avoids the costly and damaging process of non-bankruptcy debt enforcement. And allows for a mechanism whereby banks cannot just be the “fair weathered sailor”.

In the coming weeks, as the law is tested, there will undoubtedly be more amendments as individuals and SMEs rush for protection. But the spirit of the law in its pursuit of cost reduction and efforts to address the more comprehensive issue of remedy to the problem of insolvency shine brightly.

This will allow for a more transparent allocation of assets and business revival during these troubled times. It is precisely to avoid the destiny of fair weather surplus recycling and leading to a crash that an efficient bankruptcy law is vital.

- Sameer Lakhani is Managing Director of Global Capital Partners.