The priorities dilemma in the EU preventive restructuring directive: Absolute or relative priority rule?

• Published date: 01 March 2021
• Author: Giulia Ballerini
• Date: 01 March 2021
• DOI: http://doi.org/10.1002/iir.1399

REVIEW ARTICLE

The priorities dilemma in the EU preventive

restructuring directive: Absolute or relative

priority rule?

Giulia Ballerini

Bocconi University, Milan, Italy

Correspondence

Giulia Ballerini, Bocconi University,

Milan, Italy.

Email: giulia.ballerini@phd.unibocconi.it

Abstract

The EU Directive on Preventive Restructuring Frame-

works gives the EU Member States (“MSs”) the choice

between implementing two fairness rules in cross-class

cram-down: the US-style absolute priority rule (“APR”)

or the newly conceived relative priority rule (“RPR”).

This article argues that there is no good reason for the

MSs to implement the RPR in domestic law. While the

APR effectively protects the rights of the dissenting

classes to get what they are entitled to, the RPR

increases moral hazard and opportunism. Also, it might

make debt investments in the EU unattractive. On top

of that, this article shows that the RPR lacks a clear the-

oretical justification. One of the main reasons why the

RPR was introduced in the Directive alongside the APR

is that the RPR was thought to provide a solution to

some of the APR's problems. This article considers

three of those problems (i.e., the “valuation problem”,

the “hold-out problem”and the “problem of the rele-

vant shareholders”) and explains the reasons why the

RPR is not an appropriate solution for these. Among

these three problems, the most troublesome one, from

the perspective of the EU, is that the APR makes it dif-

ficult to award value to the equity of SMEs (the “prob-

lem of the relevant shareholders”). This article argues

Received: 21 July 2020 Revised: 10 August 2020

DOI: 10.1002/iir.1399

© 2020 INSOL International and John Wiley & Sons Ltd

Int Insolv Rev. 2021;30:7–33. wileyonlinelibrary.com/journal/iir 7

that using the RPR to deal with this problem would

incentivize the shareholders to behave opportunistically

and to orchestrate the restructuring. Instead of the

RPR, this article suggests two alternative techniques

which MSs can enact to better address the issue: the

new value exception “in kind”and the disposable

income method.

1|INTRODUCTION

A key part of the EU framework to deal with firms in distress is the recent EU Directive on Pre-

ventive Restructuring Frameworks (“Directive”),

1

aiming at harmonizing the restructuring laws

of the various Member States (“MSs”).

2

Among other things, the Directive borrowed from

Chapter 11 of the US Bankruptcy Code

3

the cram-down mechanism,

4

which the Directive calls

the “cross-class cram-down”.

5

The cross-class cram-down allows the court

6

to confirm a restruc-

turing plan against the dissent of one or more classes of claimants. In order to overrule the dis-

senting class(es), the court must first verify that the plan affects the rights of the dissenting

class(es) in a way that is “fair”. The Directive indicates two alternative fairness standards

between which MSs can choose: the US-style absolute priority rule (“APR”) and the newly con-

ceived relative priority rule

7

(“RPR”).

8

Under the APR, the value created through the plan is distributed according to the hierarchy

of priorities defined outside of bankruptcy: senior classes first and then, once they are paid in full,

junior classes according to their rank. Shareholders, who are the residual claimants, can receive

some value only if the creditors are paid in full.

9

On the contrary, the RPR does not require that

senior classes are paid in full before junior classes: they just need to be treated “more

favourably”.

10

This means that the shareholders can retain part of their stake in the reorganized

firm against the dissent of a class of creditors as long as this class is treated“more favourably”.

In this Article, I argue that adopting the RPR would be a mistake. The APR is a rule of cred-

itor protection that ensures that the contractually-agreed payment priorities found outside of

bankruptcy are respected in restructuring. It stands on firm academic grounds and has been

used in the US for more than one hundred years.

11

On the contrary, the RPR is a new idea we

know very little about.

12

By only requiring that senior dissenting classes are treated “more

favourably”than junior classes, the RPR disregards the parties' legal entitlements and distorts

the incentives to negotiate around the restructuring plan. In addition, since it allows the share-

holders to deliberately save part of their stake in the firm at the cost of creditors, the RPR incen-

tivizes moral hazard and may make debt investments in the EU unattractive.

The RPR was introduced in the Directive alongside the APR (which was the only fairness

standard envisaged in the first draft of the Directive)

13

because the APR was considered problem-

atic “for a considerable number of Member States”.

14

More specifically, the requirement that

senior classes are paid in full before junior classes was criticized for being too strict and burden-

some.

15

The APR was also attacked for creating incentives to hold out and, more importantly, for

“[making] it very difficult to award value, under the plan, to equity”.

16

With respect to this last

criticism, the fear was that the APR would discourage early restructuring and the commitment of

shareholders who contribute to the restructuring with their debtor-specific knowledge, expertise,

8BALLERINI