Bankruptcy reform : breaking the court logjam in Colombia

Privatesector P U B L I C P O L I C Y F O R T H E The World Bank September 1995 Note No. 51 Bankruptcy Reform—Breaking the Court Logjam in Colombia Izak Atiyas Ideally, bankruptcy policy should encourage the solution to these problems: it shifted the bank- reorganization of companies whose liquidation ruptcy procedures from the traditional judicial value is smaller than their value as a going con- system to a credible administrative agency with cern, and the liquidation of companies for which more expertise in handling workouts.2 The re- the opposite is true. In addition, it should en- sult was a process with more authority, more courage a speedy resolution of financial distress. flexibility, and more speed. Colombia’s reform The longer a company stays in bankruptcy, the provides a workable model for other countries greater the loss of value and the more difficult it suffering from congested courts. becomes to rehabilitate the company and to pay off its creditors. The crucial issue in bankruptcy Prereform: Two judicial forums, is designing a process that will distribute confusion, and high cost decisionmaking authority among the debtor, the creditors, and the oversight agency in a way that In common with other countries, Colombia had achieves these objectives. When that process two insolvency procedures. The first, the con- gives the debtors too much power, they can sim- cordato, was basically a financial reorganization ply delay in order to force concessions from procedure, designed to reach a conciliatory creditors, with the result that firms that should agreement between a company experiencing fi- be liquidated may end up being reorganized. nancial difficulties and its creditors, with the pur- And when it gives creditors too much power, pose of rehabilitating the debtor’s business. The too many liquidations may occur, leading to the second, the quiebra, was a liquidation proce- loss of going concern values. dure. Once a company entered quiebra, its as- sets were sold and the proceeds distributed to Recently, Ramachandran (1995) has suggested creditors. However, and in contrast to most other that the allocation of decisionmaking power in countries, Colombia had two institutions deal- bankruptcy law affects only the tactics of the ing with bankruptcy—the court system and the parties involved and not the eventual outcomes.1 Superintendency of Companies. The Superin- The view taken here is that if changes in the tendency was mainly a watchdog agency that bankruptcy law, procedures, and institutional monitored companies’ compliance with com- structure can help speed the pace at which com- pany law. It had oversight of firms with more panies move out of bankruptcy, outcomes are than 100 workers, firms with foreign liabilities likely to improve. As Colombia’s experience exceeding a third of their assets, and firms that shows, that pace can be determined by the rules were more than 50 percent government owned. governing the process. Before undertaking re- form in 1989, Colombia provided a good ex- Reorganization procedures were of two types. ample of the kinds of problems and inefficiencies The first was optional. It was used mainly by that arise when debtors are granted excessive small and medium-size companies, and the power, there are multiple forums for dealing with competent authority was the district judge. By bankruptcy, and the judicial system suffers from contrast, the larger firms under the supervision a lack of skills and limited processing capacity. of the Superintendency of Companies had to The reform introduced an innovative institutional go through a mandatory concordato if they Private Sector Development Department ▪ Vice Presidency for Finance and Private Sector Development Bankruptcy Reform—Breaking the Court Logjam in Colombia were unable to repay their debts. These firms There were other ways to delay bankruptcy could not be liquidated until after a reorgani- procedures. To cause a hearing to be post- zation had been attempted, overseen by the poned, debtors could simply fail to show up, Superintendency. behavior against which the creditors had no remedies. The parties could appeal almost ev- Delays easy and disruptive ery decision of the judge or the superinten- dent. Objections could also be raised by In mandatory concordatos, the debtor retained creditors who were free-riding, that is, black- the management of the company unless fraud mailing other creditors to gain favorable treat- was established. Following admission to the ment in the negotiations. The limited processing process, the first step was to validate the list of capacity of the court system contributed to the claims. Any objections raised by the parties in- delays. It could take judges a long time to con- volved had to be resolved at this time. Once firm a plan already agreed to by the creditors disagreements were resolved, the parties were and the debtor. In May 1989, of the sixteen convened in a hearing in which they voted on cases in which an agreement had been reached a proposal to reorganize the liabilities (and, in and needed only to be confirmed by the judge, principle, the assets) of the company. If an nine had been awaiting confirmation for more agreement was reached, it went to the district than a year. judge for confirmation. If there was no agree- ment, the procedure was declared failed and a High cost quiebra was initiated. As a result of these delays, bankruptcy proce- The concordatos were typically plagued by de- dures often failed to yield efficient outcomes. lays. From a sample of 190 firms that had en- Firms that needed to be liquidated often ended tered bankruptcy between 1982 and 1989, there up being reorganized. And firms that were liq- were 82 cases in which no agreement had been uidated often ended up with all their assets reached by May 1989. Of these, 54 had been stripped, so that there was nothing left to re- going on for more than two years, 36 for more pay creditors. than three years, and 16 for more than five years.3 Most delays occurred during the vali- After a financial crisis in the early 1980s, man- dation of claims, a part of the process vulner- datory reorganizations reached an economically able to opportunistic behavior. Although the significant scale in Colombia. In 1986 and 1987, validation of claims was overseen by the Su- for example, about 60 of the 1,000 or so manu- perintendency, objections had to be resolved facturing companies supervised by the Super- by the district court. As a result, the resolution intendency were under reorganization. These of bankruptcy procedures often depended on companies held assets valued at about 12 per- the lengthy resolution of several additional, par- cent of the country’s total manufacturing as- allel cases in different courts. Debtors wanting sets, and as much as 20 percent of the assets in to delay procedures, in order to extract con- some sectors, such as textiles. Thus, the per- cessions from creditors or to strip the assets of formance of the companies in bankruptcy the firm, could easily find excuses for filing weighed heavily in the performance of their objections. For example, the law required from industries. the creditors “at least summary proof” of their loans; the fact that many loan documents, es- Reform of the concordato: pecially for smaller creditors, were inadequately One forum and no delay tactics prepared helped the debtors in that respect. There were no measures in the law to penal- In the 1989 reform of the mandatory reorgani- ize debtors or creditors for filing objections sim- zation procedures, the most significant change ply to gain time or to disrupt the process. was the designation of the Superintendency as the sole competent authority. The Superinten- dency was thus endowed with the authority to TABLE 1 DURATION OF REORGANIZATION PROCEDURES decide on matters that had previously gone to the district judge. Most important, it was given Duration Procedures initiated Procedures initiated the authority to resolve disputes arising from objections raised during the validation of (months) before the reform after the reform claims. It was also authorized to confirm any 12 or less 28 (18) 8 (32) agreements reached between the parties. Grant- ing these judicial powers to an administrative 13 to 24 51 (34) 7 (28) authority created a constitutional controversy, 25 to 48 44 (29) 2 (8) resolved only when a new constitution was in- 49 or more 17 (11) — troduced that permitted an administrative au- Unfinished 12 (8) 8 (32) thority to assume the functions of a judge. Total 152 (100) 25 (100) The reform also introduced time limits for the different stages of reorganization. For example, Note: Figures in parentheses are percentage shares of the total. Prereform figures cover the decade prior to reform. To make the results more comparable, the second as soon as the Superintendency approves an column concentrates on those cases initiated between May 1989 and the end of 1991. application for a concordato, all evidence of Without the cutoff more recent cases would not have had enough time to come to closure and so the ratio of unfinished cases under the new code would have been claims on the firm must be provided within biased upwards. twenty days. The parties then have five days Source: Colombia Superintendency of Companies. to object to the claims and must attend a pre- liminary hearing within the next fifteen days. The rules governing the final hearing are also quite strict. If the debtor does not show up Impact and lessons and cannot justify his absence within three days, a new hearing is convened during which an With the reform still relatively new, it is hard agreement may be approved by vote of only to evaluate its overall impact. But it seems that the creditors. If the creditors do not show up bankruptcy cases are being resolved more or an agreement is not reached, the hearing quickly. The proportion of cases in which an can be convened only once or twice more, af- agreement is reached within a year has in- ter which the concordato is declared failed. creased from 18 percent to 32 percent (table 1). Before the reform, only 52 percent of cases In another move to expedite the process, the resulted in an agreement within two years; this reform ruled out appeals for many decisions ratio has now increased to 60 percent. These of the competent authority. Where appeals are percentages probably underestimate the real possible, they do not suspend the process. The benefits of the reform. Since parties dissatis- reform also allows the creditors to establish fied with the way the Superintendency handles mechanisms for control and monitoring dur- the procedures have some room to appeal, 4 in ing the procedure. It requires the formation of principle, the gains described above should be a creditors committee of representatives of dif- contrasted with any additional delays caused ferent classes of creditors (including workers, by appeals. But data on appeals are not avail- public agencies, and financial and nonfinancial able. However, the business community, includ- creditors). It also requires the appointment of ing both creditor banks and debtors, have an examiner of the property, credits, and af- generally welcomed the reform, suggesting that fairs of the debtor. Both the committee and the improvements are real and substantial.5 examiner have extensive functions. In particu- lar, both can request that the competent au- No comparable data exist for the optional cases thority remove the debtor from the management that still take place in the traditional court sys- of the firm. tem. But there is a general consensus among  Bankruptcy Reform—Breaking the Court Logjam in Colombia professionals, lawyers, and the business com- ing the traditional courts into any step of the munity that, even though these cases are gov- process would slow the entire process. Not erned by similar legislation, it takes much every country has an entity like the Superin- longer to reach agreements in the optional con- tendency ready to step into the breach. An cordatos under the court system than in the important—and sometimes rare—attribute of mandatory concordatos under the Superinten- the Superintendency is its reputation in both dency. There are several reasons for this dif- the banking system and the business commu- nity as an impartial and competent institution free from politics. When there are entities that, with a bit of nurturing, could assume a role Giving the Superintendency the sole like that of the Superintendency, deciding whether to improve the traditional court sys- legal authority to handle the entire tem or to switch to the alternatives by giving them the necessary legal powers is a matter of bankruptcy process effectively prevents judgment. The greatest danger lies in creating parallel courts with overlapping jurisdictions. delays due to frivolous but time- consuming appeals. Illustration by Ruth Sofair Ketler. 1 Ramachandran (1995) concentrated mainly on the transition econo- mies of Eastern Europe and the former Soviet Union. 2 This approach is an example of the out-of-court institutional solu- tions mentioned by Fleisig (1995). ference. First, giving the Superintendency the 3 In the United States, where bankruptcy reorganizations are also sole legal authority to handle the entire bank- considered lengthy, the process is estimated to take an average of one and a half to two years between filing and resolution. In France ruptcy process effectively prevents delays due and the United Kingdom, the period is shorter. to frivolous but time-consuming appeals. Sec- 4 Ramachandran (1995) points out that one result of moving proce- This series is published ond, the Superintendency staff are competent 5 dures out of the court system may be an increase in appeals. to share ideas and invite Since in the new system most appeals cannot delay negotiations, in analyzing the financial situation of compa- objections cannot be used as a tactic. Thus, under the new system, discussion. It covers financial and private nies, they are more likely than the courts to frivolous objections intended to delay the process are less likely. sector development as rule on the merits of the claims, and they are well as industry and better mediators. Third, setting time limits for References energy. The views expressed are those of each step in the process, together with the Fleisig, H. 1995. “The Power of Collateral.” FPD Note 43. the authors and are not elimination of several judicial forums, has Ramachandran, S. 1995. “Bankruptcy’s Role in Enterprise Restructur- intended to represent speeded the entire bankruptcy process. ing: A Hammer to Turn a Screw?” FPD Note 38. an official statement of Bank policy or strategy. Colombia’s experience could teach other coun- Izak Atiyas, Private Sector Development Comments are welcome. tries some useful lessons. First, setting time lim- Please call the FPD Department Note line to leave a its for the steps in the bankruptcy process has message (202-458-1111) advantages—although, of course, unrealistic or contact Suzanne deadlines should be avoided. They are likely Smith, editor, Room G8105, The World Bank, to be violated often, allowing appeals on pro- 1818 H Street, NW, cedural grounds. Second, when traditional court Washington, D.C. 20433, procedures for bankruptcy are difficult to or Internet address ssmith7@worldbank.org. change, an attractive alternative is to legally empower another entity to handle the entire 9 Printed on recycled process. In doing so, governments should guard paper. against implicitly allowing multiple legal forums by permitting interim steps to be appealed in the traditional courts. The strength of a chain is determined by its weakest link, and allow-