Forum Shopping and the Global Benefits of Soliciting Insolvency Keith Crawford University of Nottingham

Is Forum Shopping a Bad Thing? Resistance to forum shopping in insolvency is driven by a fear of a recovery in liquidation led “race to the bottom”. Empirical evidence of a tension between rescue recovery and recovery in liquidation suggests that the market structure is more likely to encourage a race to the top.

Insolvency Law as Commercial Constitution Commercial players act “in the shadow” of insolvency law, adapting their behaviour to expected outcomes. Impact of insolvency law goes beyond actual insolvency, including: – Defining conditions for investment – Removing poor players from the market – Limiting the public cost of financial crisis – Providing hard lines to social values towards issues like employment or the family home. The constitutional nature of insolvency law impacts on firm value, insolvent or otherwise.

Orderly and Effective Regimes An attractive regime is one that is “orderly” and “effective.” Regimes exist somewhere on a scale between creditor friendliness and debtor friendliness (creditor unfriendliness?) Effectiveness, creditor friendliness, and high returns to secured creditors in liquidation are often treated as being synonymous. This is an harmful over-simplification.

Creditor Friendly = Better Liquidation Returns?

The Grab Race Forum shopping is feared to be a race in which the winner is the “country that grabs first” (Lopucki) The IMF has expressed the concern that this creates a prisoners’ dilemma, where the players rational response is not in the collective (or indeed individual) self-interest. These concerns seem founded upon the belief that the most ruthless liquidator will attract the largest trade.

Insolvency Regimes are Non- Homogenous The successful regime is the one that most enhances the value of the firm. This is true for both liquidation and investment. Not all firms have the same needs. The inevitable consequence is specialisation. So even if the most ruthless liquidator was to win, there would still be a market for other types of insolvency regime.

Does First-Claim Enhance Firm Value?

First Claim Increases Risk Taking Increased creditor protection improves the marginal benefit of taking more risks. Financial institutions have been shown take more risks when they can get “better” secured credit. Increased risk taking results in increased failure in the long term. More failure means lower rescue returns over time. Enhanced risk taking also increases the risk of financial crisis, which significantly reduces firm value. Recall that the same players engaged in forum shopping are also typically engaged in investment in new business.

First Claim Reduces Rescue Recovery In regimes where recovery in liquidation is higher, acquisition is used less. Higher first claim recovery provides an incentive to dismember prematurely. This risks creating a non-cooperative equilibrium (more prisoners’ dilemma). Even in classically “creditor friendly” England, returns in rescue are 22% better than in liquidation. Effective rescue is better than liquidation.

Exploiting Comparative Advantage We can now produce a model which shows how this tension between increased recovery in liquidation and improved returns through rescue impacts upon forum shopping. This model is based on the following factors: – Increasing returns for secured creditors in liquidation reduces the probability of successful rescue, which reduces returns over time. – Structural reforms may improve (or weaken) both types of return, allowing for some regimes to establish an absolute advantage, but cannot remove this tension. – The trade off between rescue and liquidation is subject to diminishing returns.

What is Comparative Advantage? An absolute advantage means you are better at producing both types of goods than your competitor. A comparative advantage over your competitor means that it is relatively cheaper for you to produce one good than the other (the opportunity cost is lower). What this means is that even though the country with the absolute advantage is better at producing both goods, it is more profitable for it to trade with the nation with the comparative advantage.

Modelling Insolvency Competition Albion Developed Economy. Strong legal and commercial infrastructure. Experiencing political pressure to preserve internal production. Superior returns to Breton in both rescue and liquidation. Breton Transition Economy Developing legal and commercial infrastructure. Experiencing international pressure to encourage external investment. Comparative advantage in liquidation compared to Albion.

The Initial Impact of Forum Shopping Regimes where there is no forum shopping Regimes where forum shopping exists but does not influence policy:

How Forum Shopping Initially Influences Policy Breton competes by increasing liquidation returns at the cost of reducing rescue probability (and thus returns): This results in a redistribution of throughput:

The Race to the Bottom In Lopucki’s nightmare Albion responds by competing for liquidation: But the only response worse than this is to prevent forum shopping altogether:

Optimum Path: The Race to the Top Albion does better to respond by improving rescue: Giving Breton the space to improve rescue without losing comparative advantage:

Why Will the Market Choose the Optimum Path? Those financial institutions that exploit the comparative balance of trade to direct insolvent firms to the appropriate regime will make more money. The better financial institutions become at this, the more profitable they will be. Institutions who follow a liquidate or bust policy will quickly go bust themselves.

Re-Evaluating Competitive Qualities The London School approach has taught us that given the opportunity institutions will embrace appropriate rescue. Certain qualities will improve rescue without impairing liquidation returns: – Institutional Certainty – Speed of Resolution – Soft Regulatory Control – Information Sharing The only reason to compete for liquidation returns is when trying to break into the market.

Promoting the Race to the Top It is better to work smarter than to work harder: we don’t have to get all the business to make more money from it. Financial Institutions are repeat players in a strong position to effectively exploit the market. Exploiting comparative advantage allows us to specialise, benefiting both domestic and global markets. The positive qualities of specialisation ultimately result in more effective business rescue across the global economy.