Pre-pack in Dutch Insolvency Law: Costs & Benefits for Share- and Debtholders, Employees and Society
A new tool has been added to Dutch Insolvency Law: the pre-pack. This modernisation of insolvency law has been criticised and disputed. Is the pre-pack a step forwards or backwards?
Recently the Dutch House of Representatives (“Tweede Kamer”) adopted a bill that introduced the pre-pack in the Netherlands (Wetsvoorstel “Continuïteit Ondernemingen I”, or “WCO I”) – with an important amendment to the original proposal: employee representatives can influence the procedure. Some view this as a modernisation of the old insolvency law that dates from 1893. But in fact the old insolvency law could also be labelled as very modern. Especially in this age of digitalisation and acceleration it is a wonderful method for selecting value-destroying firms. It is not abnormal that firms fail, it is the essence of a restless and relentless capitalism. Rather than giving insolvent firms the benefit of the doubt, I have strong doubts about the (nett) benefits of this new arrangement.
This assessment is based on the essence of capitalism, what are its main forces? And what is the function of a firm? Capitalism is (and was) about experimenting and finding new ways of combining and splitting knowledge (the mother resource that can be referred to with a more general concept: Dawkins’ meme). An economy is a coordinated system of distributed knowledge. Capitalism is about using and creating knowledge. A successful company bundles and unbundles different resources, but other firms also pull these resources. Even when it is successful and solvent, a firm is continuously exposed to ‘pulling’ activities on its knowledge by other firms that are trying to substitute, bypass, copy, imitate, extract, steal, buy, use, transmit or transform it. Reallocation of resources when solvent is not a strange thing, for an insolvent/bankrupt firm it is not strange either. To realise the ‘meme potential’ these resources should move freely to the best (attractive) use and cluster, awaiting to be appropriated (e.g. copied) by other combinations, or “die”. These resources should be (re)allocated freely in markets. Memes self-organise in value chains with many links – it is a kind of a complex adaptive system - called the business ecology. The firm is therefore only a temporary shell/vehicle around clustered resources - a tiny fraction within the value chain. Firm value and viability are the outcome of an uncertain and complex process; they cannot be known in advance. The firm – as a shell of the resources - is not always a source of success, it can also be the source of failure. Bankruptcies are a sign of the strength of the economy because resources are freed from their (value destroying) yoke. The pre-pack procedure interferes with this picture in assuming that Insolvency Practitioners (IPs) can estimate the value and viability of a company, it is subjective and arbitrary, it distorts competition and interferes in markets, creates the wrong incentives, prohibits the free allocation of resources to alternative applications because they stick to their present employment, and probably keeps alive businesses that should have been dissolved. These are all disadvantages. What are the benefits of the pre-pack? Keeping (parts of) the insolvent firm intact as a going concern. I think the benefits are rather limited – because insolvent firms in general have low value-creating potential. Besides, these benefits are reaped by the wrong stakeholders. Shareholders/connected parties – who usually receive nothing when a company is bankrupt in the old procedure – can buy the assets at a bargain price. Shareholders can misuse the pre-pack and play with other people’s money. This can be detrimental to debtholders, employees, competitors and even societies.
The pre-pack is an ‘efficient selling mechanism’ that keeps (part of ) the insolvent firm intact. Firms in financial distress can, prior to a possible bankruptcy, negotiate behind the scenes – not in public, but under hand – with potential takeover candidates. This process is guided by the intended IP. Once agreement has been reached the firm is declared bankrupt and the assets sold immediately to this bidder. The company restarts with a clean slate, having been stripped of its debts and employees. This looks like creating a situation of insider trading (pre-knowledge) on the stock market, the very thing that governments try to fight and conquer. The end justifies the means: “downsizing” the number of potential bidders. But what about the end or the puropose of the secret negotiations?
The underlying idea of the pre-pack is that keeping the firm intact – as a going concern – reduces the chance of value losses. The going concern value is assumed to be higher than the liquidation value. If bankruptcy is (publicly) announced stakeholders withdraw their cooperation and leave the company. When the company disintegrates, its value (and level of employment) will decline like a melting ice cube. The Dutch debt recovery rate figure (the percentage of debt that is paid out of the proceedings of the assets of a bankrupt firm) are very low. Also the number of bankrupt companies that make a restart is very low. The often-drawn conclusion is that bankruptcies cause a loss of value. But I think it is the other way around. Why do companies become bankrupt? Because they do not create value. Why do they not restart? Because they are not viable. Value and viability are the key words in the European Insolvency Recommendation (2014), however they remain undefined. That is the essence of capitalism. Bankruptcy is a method that selects poorly performing firms. Viability and value assessment is best done by markets, not by secret negotiations. The valuable resources probably already left the company; the value has already declined. The old insolvency law is a rather objective procedure: not paying your debt means you are out of business. This creates an equal, level playing field. The pre-pack method introduces subjectivity and is arbitrary. It is a myth that insolvent companies are in principle viable and value creating. It possible that IP’s give these firms the benefit of the doubt. With a little creativity and fantasy there are always arguments to keep a firm alive. Restarted firms have a high chance of (insolvency) recidivism. Restarts stimulate old ways of production because resources stick to their business. The procedure interferes with the free allocation of resources.
The Dutch Council of State (2015) expressed serious objections to this insolvency modification. It concluded that viability and value are unknown. The Graham Review (2010) concluded that “it is common, where there is a connected sale, for the purchase price to match the valuation figure”. Companies that have performed well and have adapted to their circumstances can sometimes be surprised by restarted (formerly insolvent) competitors with a clean slate. This distorts competition because shareholders/connected parties can continue their business with a new downsized business facilitated by the pre-pack.
The amendment of introducing labour representatives will slow down the negotiations and enhance both the group of insiders and the probability of leakage of information. The labour representatives will be focussed on employment rather than creating a viable business model.
The pre-pack method fails to recognise the role of markets and firms in our capitalist system. Value and viability are the outcome of a complex and uncertain process. Only markets can solve this problem, not an omniscient IP. Because of the doubts about the benefits and costs involved, I have strong doubts myself about the (nett) benefit of the pre-pack.