The initial draft Directive from 2016 contained a rule providing the basic protection that shareholders of a financially distressed and reorganized company could not hold on to any value unless the creditors by majority vote consented thereto. Such a rule is in force in US and German law and is referred to as an Absolute Priority Rule (‘APR’). The US has been an important source of inspiration for implementing such a far-reaching reorganization procedure. The Absolute Priority Rule is generally considered to be one of the most important rules of US bankruptcy law, see recently the US Supreme Court in the famous Czyzewski v. Jevic Holding Corp case, calling the APR “quite appropriately, bankruptcy’s most important and famous rule” and “the cornerstone of reorganization practice and theory.”
Without much in-depth analyses or debate, the European Union is about to embark on a wild adventure. It seeks to implement the US reorganization culture, without however the most basic rule of protection. The new 2018 draft Directive suddenly provides that Member States can instead of APR also opt for Relative Priority (‘EU RPR’), which would mean that ‘dissenting voting classes of affected creditors are treated at least as favourably as any other class of the same rank and more favourably than any junior class’. It is no longer required that creditors are paid in full before shareholders are allowed to retain shares against the objections of creditors. This could possibly be interpreted to mean that if creditors get a payment of € 20 million on their total claim of € 300 million, they are treated more favourably than the shareholders that keep the full equity after reorganisation with a value of e.g. € 12 million. One should bear in mind that every reduction in debt accumulates one on one to the equity position.
We published an article on this remarkable shift in European Insolvency Law entitled ‘The Imminent Distortion of European Insolvency Law: How the European Union Erodes the Basic Fabric of Private Law by Allowing ‘Relative Priority’. Professor Madaus, as one of the most outspoken proponents of EU RPR already replied in his post ‘The new European Relative Priority from the Preventive Restructuring Directive – The end of European Insolvency Law?’ (original “Die neue European Relative Priority Rule der Restrukturierungsrichtlinie – Das Ende des europäischen Insolvenzrechts?”). We would like to use this forum of the Corporate Finance Lab to discuss this reply. By and large we conclude that we could not have voiced our concerns and objections to the inclusion of RPR in the Directive more clearly than professor Madaus did himself.
Madaus objects that in our analyses we lose sight of the very nature of the Preventive Restructuring Framework, namely that the Directive should not be considered normal insolvency law but seeks to prevent insolvency and is therefore pre-insolvency law. In German:
“Die Kritiker übersehen sodann, dass die Richtlinie gerade nicht den Fall von Plänen in der Insolvenz von Unternehmen regeln will, sondern vorinsolvenzlich wirken soll. Die Anwendung von zerschlagungsbasierten Bewertungen wie sie im Working Paper erfolgen, erkennen diesen entscheidenden Unterschied nicht. Auch wird übersehen, dass die meisten Mitgliedstaaten weit mehr Vorrechte für Gläubiger kennen als die im Working Paper angenommene Dualität von Secured und Unsecured Credit. Lieferanten würden als ungesicherte Gläubiger daher tatsächlich keine Werte erhalten, wenn man diese Rangklassen bei den Rechenbeispielen berücksichtigt.”
Apparently this Preventive Restructuring wants to be something different than insolvency law. The outcome in the words of Madaus could however very well be that the suppliers and other trade creditors would not get anything (“Lieferanten würden als ungesicherte Gläubiger daher tatsächlich keine Werte erhalten.”) Apparently under Relative Priority the suppliers and other trade creditors would be written down to a very large extent, but not necessarily completely. Whether it is a complete write down or a big hair-cut, here it becomes crystal clear that whatever the wordings and names used, the Preventive Framework is insolvency law since it forces upon creditors an involuntary curtailment of their rights and a reduction of their claims. Or in the words of Tollenaar: “On the other hand, in terms of its consequences, the procedure is nothing but an insolvency procedure (“if it’s not called a duck, but looks like a duck, swims like a duck and quacks like a duck, it probably is a duck”).” Also professor Eidenmüller was already critical as to the inherent ambiguities and concluded that the Directive is a twisted and truncated insolvency proceeding. And he is completely right. What is preventive or pre-insolvency about a forced write down of all or the larger part of creditors and how is it different from an ‘normal’ insolvency reorganisation procedure?
Whom is the Directive targeting?
One of the problems of the Relative Priority Rule is that it undercuts the already weak position of trade creditors. The Explanatory Memorandum to the Directive does seem to suggest that trade creditors will preferably be left out of the restructuring, where it provides:
“A successful restructuring plan will turn non-performing loans into loans a company can actually pay back. In liquidation, secured creditors have to consider the possibility of substantial reduction in the value of their claims. In restructuring, on the other hand, insolvency is avoided, contract debts are in general paid, and negotiations concern in most cases only the financial debt.”
We could not be more in agreement with the analysis of Madaus that there is indeed nothing in the Directive excluding these trade creditors from forced curtailment of their rights and forced reduction of their claims. Therefore, we should be concerned about their already weak position and stop pretending these trade creditors will be left untouched.
Whose interest does RPR protect at whose expense?
The Directive allows for replacement of APR by RPR and suggest that RPR would be beneficial for trade creditors. The EU Relative Priority Rule however allows shareholders to retain value whilst not paying creditors in full. We fail to see how allowing value to be allocated to shareholders protects (trade) creditors.
If the Directive and the advocates of RPR would indeed be sincere in the suggested ambition to protect trade creditors from losing out in Preventive Restructuring cases, the Directive should provide credence to its suggestions that RPR would actually protect creditors rather than allow for siphoning value away from creditors to shareholders. The Directive could e.g. limit RPR to divisions amongst creditors and still provide that no value can remain with the old shareholders unless the creditors as a group consent. This, however, never seems to have been the aim of Relative Priority as advocated in the Directive. It is clear that from the outset the goal was not to protect creditors, but rather the shareholders. This can be traced back to the notion defended by professor Madaus that the going concern surplus is not something for the creditors but necessarily remains with the shareholders also in case of insolvency. He argues that the “the legal ownership of the entity still rests with the shareholders”, hence, the extra value extracted in restructuring is considered as shareholders’ property no matter whether creditors are paid in full or not.
Criticism of APR in the US
Professor Madaus suggests that the APR is criticised in the US and should therefore not be adopted in the EU. He also point to the ABI report that suggests a tweak to APR. As Madaus also admits, the ABI however stays very close to the APR, whereas EU RPR does exactly the opposite of APR. This is exactly the point we made in our paper. The specific reference made by Madaus to the ABI proposal is another example of an inadequate reference to US law and US academic debate, similar to the inadequate and rather confusing references to the work of professor Baird on US Relative Priority in the European Law Institute Report. The ABI Report proposal for a Redemption Option Value should in no way be understood as a proposal in line with EU RPR which latter proposal allows for shareholders to remain in place. The ABI proposal for a Redemption Option Value seeks to protect a lower ranking class of creditors, commonly unsecured creditors, to get a small percentage out of encumbered assets. This option seeks to restore in part the balance between secured and unsecured creditors by giving ‘the immediate out of the money creditors’ a claim on encumbered assets equal to a redemption option. The redemption value option furthermore seeks to remedy the divergence of interests between creditors or at least appease the immediate out of the money group of creditors and thereby prevent lengthy and costly litigation.
The APR has recently been recognised by the US Supreme Court ‘bankruptcy’s most important and famous rule’ (see introduction above). Of course there is debate on such a crucial rule. Most suggestions for change in the US however stay close to the APR by respecting priorities whilst rounding the rough edges. That is indeed where the debate should be. EU RPR however disregards priorities to a large extent. The debate in the US does not offer general support for EU RPR but points in the opposite direction. APR is the central concept in US bankruptcy law and is widely recognized as such, even by the Supreme Court, though some have suggested small tweaks.
Flexibility of RPR
Madaus seems to suggest that the RPR gives the Member States flexibility: “Sie vermeidet im Gegensatz zur Absolute Priority Rule die insolvenzrechtlichen Vorrangregeln in den meisten Mitgliedstaaten”. Politically, this is probably a popular point to make, as Member States will generally like the ability to adopt the Directive as much as possible in line with their current national laws. Indeed, the explanatory memorandum to the introduction of the EU RPR mentions as exclusive reason for introducing this concept that Member States were not familiar with cross-class cram-down and APR. However, it would be a mistake to think that EU RPR indeed offers flexibility in this sense.
Although a rule titled ‘Absolute Priority’ sounds like a harsh, inflexible concept, this intuition disregards the context. The Directive forces all Member States to introduce new and far-reaching reorganization procedures in which reorganization plans can even be accepted against the majority vote of creditors in one or more classes, by way of a cross-class cram-down. The APR simply protects against unfair cross-class cram-downs that would not be in line with bargained for priorities. The national law of a Member State dictates what those priorities are. The APR thus protects the integrity of the national private law system of a Member State against the intrusive reorganization procedure that the EU now forces upon Member States.
The EU RPR is on the other hand not a flexible rule. Member States have to choose for either APR or RPR. RPR provides that a higher class should be treated more favorably than a lower class. Apart from the fact that no one has ever explained what that means in practice (we argued you cannot compare treatment of shareholders to treatment of creditors, at least not in percentages), this in no way allows Member States to somehow cater for the national law priorities. Rather, it would force Member States to disregard their own priorities. EU RPR does provide flexibility in another way: cross-class cram-down by the courts will get much easier because many more reorganization plans would fit this vague test. The EU RPR will most likely lead to much more cram down litigation and while at it a subsidy for shareholders at the cost of especially trade creditors.
End of European Insolvency Law?
There is one element we do not seem to agree upon. Madaus believes that we foresee as a doom scenario the end of European Insolvency Law. That is not the case. We expect a strong increase in insolvency reorganization cases and foresee that the rules of insolvency will trump all other legal rules, even the rule of law itself by not awarding parties their bargained for rights. We therefor by no means foresee the end of European Insolvency Law, but rather a takeover of all other fields by European (Pre-) Insolvency Law.
We would like to leave it to the interested readers themselves whether they are of the opinion that the two underlying reports of hundreds of pages and the 8 pages devoted to Relative Priority devoted therein that are being referred to by Madaus, provide sufficient ground for the drastic move to jettison the most fundamental rule of reorganization from the future EU framework of reorganization. We therefore conclude with copying the relevant passages with insertion of the links.
”Schließlich und vor allem verkennen die Autoren die tatsächliche Wirkungsweise der nun in Art. 11 normierten Prüfung. Die European Relative Priority Rule unterscheidet sich grundlegend von der US Version, da sie zwar deren Kritik an der Absolute Priority Rule aufnimmt (so insbesondere der zitierte Bericht, den ich mit Bob Wessels für das European Law Institute erstellt hatte), nicht aber deren Lösungsvorschlag. Stattdessen wurde ein eigenständiger Ansatz gewählt, der von einer Forschergruppe aus Italien, Spanien, Deutschland und England erarbeitet und im finalen Art. 11 verankert wurde. Erläuterungen finden sich im Abschlussbericht auf S. 45-47 sowie in einer ausführlichen Diskussion der Regel in Brüssel im Juli 2018.“
We invite all to join the debate, which we believe has not even started.
 580 U.S. -_, 137 S. Ct. 973, 979 (2017), Czyzewski v. Jevic Holding Corp
 N.W.A. Tollenaar, The European Commission’s Proposal for a Directive on Preventive Restructuring Proceedings, Insolvency Intelligence, 2017, p. 5.
 See H. Eidenmüller. Contracting for a European Insolvency Regime. European Business Organisation Law Review: DOI 10.1007/s40804-017-0067-1, p. 288.
 Directive on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures and amending Directive 2012/30/EU, COM (2016) 723 final, Explanatory Memorandum, p. 13.
 Madaus in B. Wessels and S. Madaus, Instrument of the European Law Institute, Rescue of Business in Insolvency Law, 2017, available on ssrn. (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3032309&download=yes). See also S. Madaus, ‘Rescuing companies involved in insolvency proceedings with rescue plans’, NACIIL Annual Report 2012, available on: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2271979&download=yes