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Business & Law Research Network

Distress and insolvency

Creation of a good business environment, promotion of trade and investment are among the top priorities for many governments. Due to risks intrinsically connected to entrepreneurial activities, companies may experience financial difficulties and become insolvent. When it happens, the question of whom to blame frequently arises. The answer which often comes to mind is – debtor’s management.

The need to develop rules for effective restructurings, and value-saving insolvency proceedings may require adopting separate rules for situations of financial distress, as opposed to ‘business-as-usual’ course of affairs. An important part of such rules should be the rules on director’s duties and liabilities in insolvent or near-insolvent companies.

Research projects

Private enforcement of directors' duties and fraud by the insolvent practitioner'

Directors are the driving force behind a successful company. In the vicinity of insolvency, directors are seen to be the key actors in pursuing and promoting early restructuring by taking the necessary steps to avoid insolvency. In order to achieve the European goal of incentivising directors to timely restructure, it is crucial to have a coherent system of rules that encourage directors to take the necessary steps to avoid insolvency. In order to scrutinize the normative value of existing directors’ duties in the vicinity of insolvency, not only the rules but also the enforcement of these rules – e.g. by directors’ liability proceedings - in practice should be taken into consideration. More specifically, the doctrine of directors’ liability emerges eminently in bankruptcies, when the company offers no or insufficient recourse to settle his debts. In addition, recent amendments of the Dutch Bankruptcy Code have placed great emphasis on the enforcement of directors’ duties by the insolvency practitioner. The insolvency practitioner is instructed to investigate the causes of the insolvency and, in that context, is obliged to investigate possible irregularities. Insolvency practitioners are the first to assess directors’ behaviour and have, to some extent, exclusive enforcement powers.

This research provides insight into the way insolvency practitioners investigate and redress irregularities. The goal of this research is to more thoroughly understand the process of insolvency investigations and contribute to the existing knowledge by empirically analysing such investigations. This research directly contributes to insolvency practice, in particular by facilitating insolvency practitioners to gain insight in their assessment of directors’ behaviour and possibly to develop professional standards for conducting insolvency investigations with regard to directors’ duties. In addition, this research is conducted against the background of recent European and international developments and therefore it is envisaged that expanding this study to other jurisdictions by using the same research design will increase its relevance for both the academic as the practical debate.

Contact: Jessie Pool


Employment Retention Post-Bankruptcy: Does Strategic Bankruptcy Create Value?

Although an extensive body exists of research on strategic bankruptcy, the definition and evidence about whether such filings really preserve and/or create value – even as a paradoxical survival mechanism – remain ambiguous. The aim of the study is to investigate whether strategic bankruptcy and financial distress affect employment retention – through the lenses of real options and debt overhang theory. Using a sample of bankruptcies in the period 2012 until 2015, employment retention post-bankruptcy was evaluated as a consequence of the bankruptcy mechanism and the severity of financial distress pre-bankruptcy. The results indicate that the type of bankruptcy (either strategic or non-strategic filing) plays an important role in determining the employment retention rate after bankruptcy. Moreover, robust covariance matrix estimation analysis shows that the severity of financial distress pre-bankruptcy plays a marginal role in the employment retention rate post-bankruptcy. Therefore, strategic bankruptcy in its current form may be the best – and only – real option against uncooperative and opportunistic stakeholders in the absence of statutory composition legislation. As to the timing of bankruptcy filing, the results indicate that accelerated filing is the preferred option when bankruptcy becomes unavoidable. The capital advice to managers in practice, however, remains to restructure and recover before attempting bankruptcy restructuring as the severity of both direct and indirect bankruptcy costs should not be underestimated.

If a debtor with a business is declared bankrupt and an ‘insolvency office holder’ (IOH, such as an administrator, bankruptcy trustee, receiver etc.) is appointed, one of his tasks/duties is to investigate the causes of the bankruptcy: why did the business fail? One of the reasons for such investigation is the quest for possible irregularities that might have caused the bankruptcy and could lead to liability of related third parties, such as (de facto) directors, shareholders, financers or others. Although the outcome of such investigation could have serious implications and consequences for those third parties, the way and manner it need to be conducted is hardly regulated and in practice often on a case-by-case basis. The aim of this project is to review the existing regulatory framework (‘law in the books’) in a number of jurisdictions and to check how practice works (‘law in action’).

Research: Jan Adriaanse & Reinout Vriesendorp

Business failure is usually considered to be the abnormal outcome of businesses. However failure is not uncommon. Failure (or more general disappearance) is one of the great unmentionables in the world of business. However, the process of business turnover is the essence of capitalism, the formula of success (and failure) is unknown. Failure at the individual (business) level is the key to success of the system as a whole; entrepreneurial delusion is profitable at the society level. In the end markets win because evolution is “cleverer” than firms. Business life is just too complex. There are no simple rules – no holy grail - for these decisions. In spite of this, most micro economics and management textbooks give the impression that running a business is easy and that maximizing and success are simple. Business failure textbooks contain simple “frameworks” for classifying failure and curing firms in decline. There is a difference however; micro-economic textbooks contain one universal rule: equate price with marginal costs. Curing and classifying business failure textbooks contain (too) many rather simple different frameworks and step-by-step procedures. However these causes are very trivial, state the obvious, overlap, contradict, are influenced by the Halo effect, assume that failures must have causes and thus that somebody is too blame.

What are the reasons that failure is so endemic, why is it not noticed in thoughts, theories and policies that reflect optimism and survival bias, and is it a positive or negative phenomenon? This study combines empirical, normative, theoretical, methodological and philosophical views. Additionally it considers biological (extinctions) and scientific (falsification) analogies. Approaches from micro economics, meso economics, management strategy, theory of the firm, finance, turnaround management, corporate and insolvency law are taken into account.

Contact: Tim Verdoes

Legal professionals are trained to consider the facts to incorporate only relevant factors in their judgments and decision. Advances in psychological research, however, have pointed out that judgment and decision-making processes can be subject to cognitive errors and mental shortcuts, so-called ‘heuristics and biases’. These heuristics often evolved to facilitate and speed-up cognitive processes, but they can also lead people’s judgments to go astray under conditions of uncertainty or time-constraints. In such cases, seemingly irrelevant factors can significantly influence people’s judgments, causing people to deviate from the rational norm.

This research investigates to what extent cognitive biases influence legal professionals’ judgments in the context of business failure and director liability. The difficulty in such cases is that judgments need to be made in hindsight. That is, while the outcome of a certain course of events is known. When evaluations of ex-ante decisions are influenced by ex-post information, this is called ‘outcome bias’. Special attention is given to how judgments, concerning for example foreseeability, proximate cause, and ultimately liability, are influenced by ex-post information. In addition, the research investigates whether individual factors, such as personality and beliefs influence the impact of outcome information on judgments and which mechanisms can be deployed to protect oneself from biases.

Contact: Niek Strohmaier

Related to the previous project, studies reveal that the IOH and judges dealing with insolvency investigations and subsequent litigation based thereon, f.i. director’s/shareholder’s liability, are likely to be subject to and influenced by the risks of cognitive biases such as outcome bias and hindsight bias (see other CBL project ‘Cognitive biases in legal decision making’ by Niek Strohmaier). The goal of this project is to find or (further) develop (existing) methods and skills for the actors in such processes to (i) become aware of such biases and their consequences for their judgment and (ii) minimize the impact thereof.

The Story Behind Bankruptcy: when business gets personal

The number of bankruptcies in a specific period, and levels of debt, are well documented but little is known about the consequences of bankruptcies beyond the numbers. In this study, Dutch entrepreneurs who went through debt rescheduling after personal bankruptcy, were interviewed in order to gain an understanding of the private, personal and social implications of bankruptcy. Recently, systematic investigations of the implications of bankruptcy have been published. However, research has not yet taken the phenomenological experience of the bankrupt entrepreneur into account. Insights into these experiences are of critical importance for obtaining a comprehensive understanding of the impact of the bankruptcy process, and for engaging in a meaningful reform of bankruptcy law. During the interviews in this study, the entrepreneurs reflected on the early days of their business venture, the moment of first detecting the prospect of business failure, their personal experiences during business failure, and the aftermath of bankruptcy and debt rescheduling. The findings indicate that a bankruptcy experience can be compared to losing a loved one: a psychological process similar to mourning. The findings show that a lack of empathy, respect and transparency by formal institutional representatives such as judges, trustees and administrators is seen by the entrepreneurs as ‘emotional punishment’, and can be considered as a major source of their grief. Because of this grief, the bankruptcy and debt rescheduling experience can be extremely stressful causing severe psychological and physical distress. Implications for theory and practice are discussed.

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