...reorganisation creates highest economic value from the company's resources. Policymakers must understand this underlying policy and its trade-offs to prevent 'abuses' but permit 'strategic behaviour' consistent with desirable policy. Alternatives like the United States" 'Chapter 11 good faith test' and the little-known 'voluntary administration good faith test' are too uncertain. Instead, this article advocates for directors to value the business upfront before they conclude that reorganisation extracts the most value from the company's resources. This proposed additional 'value maximising test' would remedy the inadequacy of the current eligibility requirement.]



CONTENTS I Introduction II Strategic Behaviour or Abuse: A Theoretical Framework for the Debate A The Functions of Reorganisation B Strategic Behaviour C The Policies of Reorganisation 1 Value Maximising Policy 2 Distribution Policy D Abuse 1 Delay Creditors 2 Litigation Tactic 3 Directors' Escape Valve 4 Control of the Company 5 Employees 6 Future Claimants E Consolidating the Theoretical Framework III The Thresholds A The Intended Policies of Voluntary Administration B Insolvency Test 1 Insolvency 2 Directors' Opinion of Insolvency C Reforming the Insolvency Test D Good Faith Test 1 Chapter 11 Good Faith Test 2 Voluntary Administration Good Faith Test IV A Better Threshold A Assessing the Insolvency Test 1 Lack of Insolvency 2 Presence of Insolvency B Assessing the Good Faith Test 1 In Whose Interests? 2 Mixed Purposes C A New Value Maximising Test 1 The Elements V Conclusion

I INTRODUCTION

The debtor severs all its ties, including those with its creditors, shareholders, employees, suppliers, customers and the community. The participants of a reorganisation negotiate a new set of ties. The debtor emerges from reorganisation leaner and meaner. Those who have something to contribute can stay. Those who were a burden are cast off. Reorganisation reallocates resources of society. It assesses each participant's relationship and redefines it. Given reorganisation's formidable power, the door to reorganisation should only open for a debtor who satisfies certain criteria. The door should never open too widely. Nor should it close too sharply. It has to safeguard the reorganisation system against abuses and yet, at the same time, encourage at-risk debtors to enter.

Reorganisation is closely associated with a financially distressed corporate debtor's attempts to reorder its affairs and fight for survival. Reorganisations can involve a restructuring of the corporation's business operations, undertakings or investment activities, as well as its financial or capital structure.

Before a corporate debtor enters voluntary administration--the formal legal procedure for reorganisations set out in Part 5.3A of the Corporations Act 2001 (Cth) ('Corporations Act')--it must meet certain requirements. The current threshold criterion is that the company is, in the opinion of the directors, insolvent or is likely to become insolvent. (1)

In July 2004, the Joint Committee on Corporations and Financial Services recommended lowering this threshold 'insolvency test' to allow a debtor who merely 'may become insolvent' to enter voluntary administration. (2) Controversy ensued with some warning of potential abuse. (3)

The Corporations and Markets Advisory Committee ('CAMAC'), a governmental committee, considered a different threshold requirement along the lines of the 'good faith test' found in the reorganisation system in Chapter 11 of the United States Bankruptcy Code (4) ('Chapter 11'). (5) In addition to insolvency, this Chapter 11 good faith test examines various factors such as a debtor's subjective motives and ability to reorganise. (6) Yet the committee eventually abandoned the idea of adopting this test. (7)

Amidst this discussion, but unknown to many, the Australian courts have been more willing to experiment with an embedded good faith test to control access to the voluntary administration system. This 'voluntary administration good faith test' focuses more narrowly on the directors' purpose in reorganising. (8)

The policymakers are yet to resolve the dilemma.

This discussion about the threshold requirement to enter voluntary administration is part of a wider uncharted policy debate on permissible 'strategic behaviour' and impermissible 'abuse' of reorganisation. Policymakers are hesitant to characterise many corporate reorganisations as blatant abuses of voluntary administration despite the public outrage that the debtors may have caused. The reluctance in changing the threshold requirement of voluntary administration shows a fear of causing more undefined abuses. Contentious as this strategic behaviour versus abuse debate may be, it merely reflects the underlying tension among the competing policies of reorganisation. Policymakers cannot define abuse without first making some hard choices and resolving these competing policies.

This article seeks to make two contributions. First, it provides policymakers with a framework to differentiate an abuse of the reorganisation system from permissible strategic behaviour and singles out, as examples, certain uses of reorganisation as being the most undisputed abuses of the system.

As a starting position in the policy debate, the fundamental justification of reorganisation is an economic one. By keeping the company's assets and resources together in continued operation, reorganisation preserves and maximises the debtor's economic value as a going concern. Good policy demands that a debtor only reorganise if it is worth more as a result. This article identifies this rationale as the 'value maximisation' policy of reorganisation. It follows that a 'non-value maximising' use--reorganising the debtor without aiming for a more efficient or higher-valued use of scarce resources--is one of the most undisputed abuses of reorganisation.

Value maximisation, however, comes at a cost. In keeping the debtor's assets together, reorganisation necessarily affects individual claims against these assets in various ways. Trade-offs are inevitable. This impact on individual rights often provokes claims that a debtor or its directors are abusing the reorganisation system. (9) On the other hand, it may only be part of a debtor's legitimate strategic attempt to make the best economic use of its resources. To determine whether value maximising uses are permissible uses of voluntary administration, policymakers need to further balance the competing interests of individuals and value maximisation.

Second, this article seeks to give the policy debate a practical focus by critiquing the law surrounding the threshold requirements to enter voluntary administration. It asks whether the current voluntary administration threshold insolvency test or the alternative good faith test adequately differentiate permissible strategic behaviour from impermissible abuse of reorganisation. It concludes that the tests could be improved in order to ensure that debtors who enter administration are worth more after reorganisation than if liquidated immediately.

Rather, as a foremost measure to prevent the most undisputed abuse, a better voluntary administration threshold test would require an up-front valuation of how much a company would be worth if reorganised. A debtor may enter administration only if its business has greater value with reorganisation rather than without. This article advocates that the debtor's directors should assess the company's reorganisation value before they appoint an administrator and refers to this requirement as the 'value maximising test'.

This article has five parts. Part II constructs a theoretical framework that maps the policy tension between permissible strategic behaviour and impermissible abuse of reorganisation. It seeks to demonstrate that the most obvious abuses occur when reorganisation does not achieve the highest valuation for a debtor's resources. Determination of other impermissible abuses of reorganisation requires further balancing of conflicting interests. Part III lays out the law surrounding the operation of the threshold requirement to enter voluntary administration. The argument is advanced that Australia's voluntary administration has two contrasting threshold tests: the widely-recognised insolvency test and an embedded voluntary administration good faith test. This Part also comparatively scrutinises the Chapter 11 good faith test. Using the theoretical framework that Part II constructs, Part IV critiques the insolvency test and the voluntary administration good faith test, proposing that the threshold requirements include a new value maximising test. This new test is in addition to the principal insolvency test that requires the directors to find that the company is insolvent or likely to become insolvent. This test further requires the directors to value the company before they appoint an administrator and conclude that reorganisation will achieve the highest value for the company's resources. Part V concludes that a clear understanding of the value maximising policy enables differentiation between the most blatant abuses and permissible strategic behaviour. A more sophisticated understanding of the distributive effects of the value maximising policy brings the difficult trade-offs into sharp focus and highlights questions that policymakers cannot avoid.

II STRATEGIC BEHAVIOUR OR ABUSE: A THEORETICAL FRAMEWORK FOR THE DEBATE

A threshold requirement for a debtor to enter reorganisation protects the system against abuse. But what is an abuse of reorganisation? Existing Australian and American literature on corporate reorganisation leaves a noteworthy gap. (10) The following develops a framework that maps the unrecognised policy tension between simple strategic behaviour and blatant abuse of reorganisation. In doing so, this Part briefly explains the functions of reorganisation. It then dispels the belief that so-called strategic behaviour is incompatible with reorganisation policies. Lastly, it defines the underlying policies of reorganisation and the abuses that contravene them.

A The Functions of Reorganisation

So, what functions does reorganisation serve? (11)

The formal legal systems for corporate reorganisation evolved from bankruptcy and insolvency laws. The most uncontroversial justification of bankruptcy law is to solve the problems that arise when a debtor fails to pay its debts. Outside of bankruptcy, a creditor has a legal right to collect its debt against a debtor's assets when the debtor defaults. When a debtor defaults on multiple debts, creditors will scramble towards the debtor's assets. Creditors fear being the last in line and left with nothing if they let other creditors raid the debtor's coffers first. The unruly debt collections of creditors destroy the value of the debtor's business as a going concern. The debtor faces collapse. (12) This is known as the 'collective action' or 'common pool' problem. (13) Bankruptcy law presumes that diverse claimants who have claims against the debtor--both creditors and shareholders--are better off if they act as a group. (14) Bankruptcy forces the claimants to decide collectively what to do with the debtor by overriding the rights of individual claimants. (15)

Like traditional bankruptcy law, reorganisation has two functions: first, it gathers all the claimants in one forum to make a collective decision as to the future of a debtor and its resources; (16) and second, it overrides, alters and redistributes the rights of individual claimants. (17)

B Strategic Behaviour

The ability of reorganisations to change or redistribute the rights of claimants is unsettling. The critical question is: when should access to reorganisation and its redistributive power be allowed? Or conversely, when might access to reorganisation and its redistributive power be an abuse? The role of the threshold requirement for reorganisation is to make this rough distinction at the earliest possible stage.

Commentators have been uneasy about debtors reorganising and thereby redistributing individual claims and changing the rules of the game for the claimants and other participants. Labels to describe this behaviour vary and include: 'opportunism', (18) 'commercial [im]morality', (19) 'business strategy', (20) 'rent seeking behaviour', (21) 'strategic behaviour', (22) 'strategic manipulation', (23) 'strategic manoeuvring', (24) 'strategic insolvency', (25) 'strategic bankruptcy', (26) 'creative bankruptcy', (27) 'creative uses', (28) 'forum shopping', (29) 'conspiracy', (30) and 'abuses'. (31)

From the list, abuse is clearest in its normative disapproval. Abuse is defined as 'wrong or improper use, misuse'. (32) The other labels are vague, not just in semantics, but also in the behaviour described. In this article, 'non-abuses' come under the banner of strategic behaviour, referring to uses of reorganisation that affect individual rights and offend some moral norms, but which are nevertheless consistent with the policy of reorganisation. This is contrasted with abuse, which retains its 'improper use' definition in this article.

The existing literature leaves a gap: an uncharted tension between strategic behaviour and abuse of reorganisation. Many do not realise that this so-called strategic behaviour may be consistent with desirable reorganisation policy. Hence, strategic behaviour could remain an allowed incidence of reorganisation and is distinct from the undesirable abuse.

Take for example 'forum shopping'. Douglas G Baird and Thomas H Jackson contend that bankruptcy should not change pre-bankruptcy rights because this change causes 'forum shopping' or the choosing between bankruptcy and non-bankruptcy forums for different sets of rights. (33) To them, forum shopping is undesirable. (34) Baird and Jackson's criticism, however, prompted Lynn M LoPucki and William C Whitford to state that:

we are unconvinced that forum shopping, as Baird and Jackson define the term, is a bad thing. If chapter 11 can resolve the financial difficulties of a reorganizing company in a way that yields more societal wealth than resolutions that would be reached outside bankruptcy, then the choice to file bankruptcy seems to us a good thing, and encouragement of it is no vice. (35)

Criticisms of the purported costs of strategic behaviour are also unconvincing. For example, Jackson and Robert E Scott are critical of the costs of enforcing the rules regulating access to the system, the screening costs to differentiate desirable and undesirable uses, and the uncertainty costs of 'wasteful or excessive precautionary behaviour.' (36) Barry E Adler also disapproves of strategic behaviour because of the allegedly protracted negotiation and litigation, delay and inherent uncertainty associated with it. (37) However, the uncertainty surrounding strategic behaviour arguably arises because the rules of reorganisation are unclear. Jackson and Scott recognise that ad hoc rules cause uncertainty. (38) As they concede, a fixed, across-the-board rule would lessen the uncertainty. (39) According to this view, strategic behaviour need not be uncertain.

Previous literature often describes strategic behaviour as involving deliberate, active and voluntary decision-making by the debtor or its directors. (40) However, decision-making has many shades and, by itself, does not make strategic behaviour undesirable. The debtor or its directors may make a conscious decision to reorganise and the decision may still be consistent with desirable reorganisation policy. As Donald R Korobkin puts it:

'Strategic bankruptcy' criticism of Chapter 11 ... often blurs a critical distinction. That managers use Chapter 11 as a 'financial tool' in their corporate planning--as they would any other important law--is not by itself grounds for complaint. Presumably, Chapter 11 exists to be used, and one would want corporate managers to be rational planners, using all available opportunities to benefit their various constituencies. Nonetheless, what is troubling about strategic bankruptcies is the possibility that managers may use Chapter 11 in ways that are fundamentally unfair, or otherwise unwarranted. We thus need to distinguish between 'desirable' and 'undesirable' strategic bankruptcies. (41)

This begs the question: what are the undesirable or impermissible abuses of reorganisation?

C The Policies of Reorganisation

Identifying an abuse of reorganisation involves highly normative judgement of whether an action contradicts desirable policies. There needs to be 'some normative standard that determines what constitutes a proper and an improper use of bankruptcy law.' (42) A threshold requirement for reorganisation could keep behaviour inconsistent with desirable policies out of the system.

1 Value Maximising Policy

The underlying so-called value maximisation policy provides the primary justification of reorganisation--reorganisation produces a more efficient and hence higher-valued use of resources. (43) Creating a collective decision, reorganisation would preserve and maximise the going concern value of the debtor or its business. Reorganisation is justified if the debtor or its assets are worth more economically if reorganised than if not. The assumption is that a higher-valued use of the debtor's resources indirectly benefits the participants of reorganisation as a whole, be it the shareholders, creditors, employees, suppliers or the community. This value maximisation policy draws from both a narrow 'asset maximising' approach and a wide 'rehabilitation' approach.

The narrow asset maximising approach aims to create the largest pool of money to pay the creditors and shareholders. (44) The two most notable law and economics theorists of bankruptcy law, Baird and Jackson, are the leading proponents of this approach. (45) The most economically efficient use, or the highest realisable value of a debtor's assets, would presumably maximise this pool of money. (46) Hence, a debtor should only continue in business if its intrinsic economic value is greater than the value realisable by immediately selling its business and assets. (47) Otherwise, selling or liquidating its assets is preferable, so as to allow these assets to flow to other higher-valued uses in society. (48)

Economic efficiency is a justifiable aim. However, better return for claimants, as Baird and Jackson see it, is not always an accurate measure of economic efficiency. Business failures produce external costs such as the loss of jobs, and have adverse effects on suppliers and the welfare of the wider community. (49) The highest return for claimants may not be the best outcome for the society's overall economic wealth, (50) For example, the claimants may want to liquidate the debtor immediately...

NOTE: All illustrations and photos have been removed from this article.



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