Rethinking Priority: The Dawn of the Relative Priority Rule and the New ‘Best Interest of Creditors’ Test in the European Union
By Axel Krohn (Martin-Luther-University Halle-Wittenberg)
The European Directive on restructuring and insolvency (“Directive”), which came into force in July 2019, has triggered a series of interesting debates. The possibility for EU Member States to subject the cram-down from Article 11 to a “relative priority rule” (“EU RPR”) when implementing the Directive into national law has proven to be particularly controversial.
Despite a confusing conceptual overlap with approaches presented in the US, the European interpretation of “relative priority” breaks new ground. The rule stipulates that, under a restructuring plan, dissenting voting classes have to be treated merely more favorably than any junior class. Although the Directive allows national lawmakers to refrain from the EU RPR and introduce a familiar “absolute priority rule” (“APR”) — that is, that a dissenting class of creditors must be paid in full before junior parties may receive any distributions — the EU RPR has already found supporters in various jurisdictions and therefore deserves a thorough examination.
In a recent article, I identify one aspect of the cram-down that has received little attention to date. In addition to the EU RPR, the European legislature has introduced a new “best interest of creditors” test (“EU BIT”), which does not — as known from US bankruptcy law — use the value that a party could expect in a hypothetical liquidation as a comparator but refers to the “next-best-alternative scenario.” Although the concept of combining the EU RPR and the EU BIT is coherent in theory and may even eliminate some misconceptions about the EU RPR, the interaction of the two cram-down elements is likely to raise problems in practice.
First, my article discusses the concepts of the two priority rules and traces the motives of the European legislature for introducing the EU RPR. Three aspects in particular appear to have been at the forefront during the drafting of the rule. For one, the European legislature wished to create more flexibility in plan negotiations and thus respond in particular to special needs in the restructuring of smaller businesses. The rule may bring advantages, especially when it is reasonable to enable existing shareholders to participate in the continued business by means of an equity interest. Second, with regard to some Member States, the desire has arisen to create an instrument to overcome structural blocking positions of certain preferential (priority) creditors, in particular tax authorities. Finally, there is a trend in Europe that conceives of preventive restructuring frameworks as rehabilitation procedures that enable a structured contractual renegotiation of debts (rather than debt-collection) and should therefore not be subject to the “traditional laws of insolvency law,” including the common-pool notion and the APR.
Then, I deal with the new EU BIT and examine its interaction with the EU RPR. It is worth noting that the EU BIT plays a much more important role in an EU RPR cram-down than under an APR. By moving away from the traditional liquidation benchmark and instead linking to the “next-best-alternative scenario,” the test protects precisely the value that can be achieved from the perspective of a creditor outside insolvency without cooperating with other parties. The then remaining reorganization surplus, which is subject to the EU RPR, is that fraction of the going concern surplus which can only be achieved through the combined efforts of all parties involved, but which creditors cannot claim in an individual case of enforcement.
Despite this harmonious interaction in theory, doubts may be expressed as to whether the combination of the EU RPR and the EU BIT would work in practice. The new focus on the hypothetical next-best-alternative scenario value will likely lead to an additional stress point in plan negotiations. The EU RPR, which does not itself contain a clear guideline for the distribution of the remaining surplus, is then to be applied between two unclear values, namely the hypothetical next-best-alternative scenario value and the presumed reorganization value. It is reasonable to assume that the resulting distributional uncertainty will cause new hold-up potential and render it difficult to realize consensual plans, especially in larger restructuring cases. Also, it seems likely that unsophisticated junior creditors will face difficulties in defending their rights adequately in view of the potentially unclear next-best-alternative scenario value, and that others will try to use this to their advantage in complex negotiations.
(*) A modified version of this post was published on the Harvard Law School Bankruptcy Roundtable blog.