Problems with the Consolidated Bankruptcy Bill

- Ministry of Justice Notice No. 2004-38 -

1. Background and Focus of the Amendment Bill

The Ministry of Justice has submitted to the National Assembly a bill titled the “Debtor Rehabilitation and Bankruptcy Act” (hereinafter, the “Integrated Insolvency Act”), the main contents of which include introducing a personal rehabilitation system that would allow debt adjustment for debtors with regular income, such as wage earners, without resorting to bankruptcy proceedings.

At first, this bill was pursued with the aim of enabling the government to take the lead in efficiently restructuring insolvent companies that had proliferated after the IMF economic crisis. More recently, however, with the sharp increase in individual credit defaulters, the Ministry of Justice submitted the bill in September of this year based on the recognition that, for the national economy, it is necessary to open a path for economic activity not only for corporations but also for individual debtors.

Of course, in order to efficiently support the rehabilitation of insolvent companies, the government has already amended the relevant laws—the Corporate Reorganization Procedure Act, Composition Act, and Bankruptcy Act—three times, in 1998, 1999, and 2001. In addition, to help individual credit defaulters resume economic activity, there have been systems such as individual financial institution credit recovery support, bad banks, and personal workouts, under which defaulters and financial institutions privately agree to extend debt repayment periods or reduce overdue interest. Where such private resolution is not possible, the courts have operated personal rehabilitation and personal bankruptcy systems.

However, these debtor rehabilitation and bankruptcy systems have been criticized on grounds of fairness and efficiency because the applicable subjects differ among the relevant laws and the rehabilitation procedures are bifurcated into corporate reorganization and composition. Accordingly, the government is seeking to enact the so-called Integrated Insolvency Act, which would consolidate these laws into a single statute and provide measures such as strengthened supervision over companies undergoing rehabilitation proceedings.

With respect to individual credit defaulters, the bill seeks to introduce a personal rehabilitation system for debtors with regular income, such as wage earners, allowing debt adjustment without bankruptcy proceedings so that they do not suffer the social and economic disadvantages resulting from a bankruptcy declaration. It also seeks to add provisions on international insolvency in line with the age of globalization and to remedy other operational problems in the current insolvency law system.

A controversial issue in this regard is that reducing a debtor’s debt ultimately means that the creditor must give up property rights. In other words, to the extent that the debtor’s debt is discharged, either the creditor must suffer a property loss or the state must support that loss. Ultimately, the validity of the bill depends on the extent to which it can prevent moral hazard among debtors.

II. Main Contents of the Bill and Review

1. Issues

The main features of this Integrated Insolvency Act bill are, first, to abolish the composition system for corporations and instead bifurcate procedures into corporate rehabilitation and bankruptcy; and second, to introduce a personal debtor rehabilitation system to prevent the bankruptcy of debtors with continuous and recurring income, such as salaried workers and the self-employed, and to promote their economic recovery.

In this regard, the Ministry of Justice has stated that the bill is desirable from the standpoint of international consistency because it is modeled on UN conventions and the like. However, because debtor rehabilitation and bankruptcy ultimately involve the debtor’s rehabilitation through the creditor’s relinquishment of property rights, the matter must be handled with balanced consideration of both the national economy and the creditor’s property rights. If too much emphasis is placed on the national economy, there may be an infringement of the people’s fundamental right to property, and moral hazard among debtors may also arise. On the other hand, if debtor rehabilitation and bankruptcy are not permitted, economically active individuals and companies with a high possibility of rehabilitation may be lost, which in the long run is likely to have a negative effect on our economy. Therefore, this Integrated Insolvency Act bill should be enacted with full consideration of both interests.

2. Petition for Commencement of Rehabilitation Proceedings

First, with respect to petitions for commencement of rehabilitation proceedings, the bill allows not only individuals but also corporations to file when there is a likelihood that facts constituting insolvency or grounds for bankruptcy may arise. It also allows filing, where such likelihood exists, by creditors holding claims equivalent to at least 10% of capital, or by shareholders or equity holders owning at least 10% of the equity interest. In the case of debtors other than stock companies or limited liability companies, creditors with claims of at least 30 million won may also petition for rehabilitation proceedings (Draft Article 35).

A question raised in this regard is that, while the bill substantially narrows the scope of judgment concerning commencement of a debtor’s rehabilitation proceedings—by deleting from the acts formerly constituting quasi-fraudulent bankruptcy offenses such acts as “waste” and “incurring obligations on manifestly disadvantageous terms” on the grounds that these concepts are vague and leave room for arbitrary judgment, thus violating the principle of clarity—it at the same time allows creditors or shareholders owning at least 10% of capital, and creditors with claims of at least 30 million won against individual debtors, to apply for commencement of rehabilitation proceedings, making it highly likely that debtors will obtain rehabilitation opportunities (Draft Article 661).

In addition, where a debtor seeks discharge, the prior system required a separate petition for discharge after a bankruptcy declaration, whereas under the bill a petition for discharge may be filed from the time of the bankruptcy petition itself, enabling the bankrupt to obtain a discharge decision more quickly (Draft Article 556).

However, given that the essence of rehabilitation proceedings is fundamentally debt relief, this legal system in effect restricts creditors’ property rights. Of course, property rights may be restricted where necessary to preserve the economic order. But this bill, which abolishes devices that could prevent moral hazard by debtors and instead seeks to provide more opportunities for rehabilitation proceedings, may raise problems from the standpoint of fairness. Ultimately, the commencement of rehabilitation proceedings depends on the court’s decision, which must be made rationally in light of all relevant circumstances. Thus, until now the courts may be said to have been the final bulwark against moral hazard by debtors.

However, since this judicial role appears likely to be constrained by Draft Article 661, there is concern as to who will be able to prevent moral hazard among debtors. Indeed, the result may instead be that financial institutions become reluctant to lend, greatly diminishing the function of banks—as channels for supplying industrial capital—which has been a driving force of industrial development.

3. Recognition of Management Rights of Owners of Insolvent Firms under Court Receivership

Under current law, in the case of companies placed under court receivership, the court appoints an administrator, and the representative of the insolvent company is not allowed to participate in management. Under the bill, however, the debtor or the corporation’s representative is, in principle, to be appointed as administrator; exceptionally, a third party is to be appointed as administrator where (1) the rehabilitation debtor itself, or the representative of a rehabilitation debtor that is not an individual, has reached financial collapse through embezzlement, concealment of property, or grossly irresponsible management for which he bears substantial responsibility; (2) the creditors’ council requests such appointment and there is good cause; or (3) the rehabilitation debtor’s liabilities significantly exceed its assets (Draft Article 75).

This proposal may help rehabilitate small and medium-sized enterprises that have become insolvent due to temporary financial pressure and the like. However, the exception clauses mentioned above are framed in very abstract terms, and thus their effectiveness is uncertain.

In other words, because an owner of an insolvent company bears very little personal risk when proceeding through court receivership, the possibility of moral hazard is very high, and this is likely to disrupt the market order formed in the market for corporate control.

To solve this problem, it would be desirable to impose strict duty and liability provisions where the owner of an insolvent company retains management control.

4. Personal Rehabilitation System

The personal rehabilitation system applies to salaried workers or self-employed persons whose total personal debt does not exceed 1.5 billion won (1 billion won in secured debt + 500 million won in unsecured debt) and who earn a certain monthly income above the minimum cost of living (Draft Article 579). The debt repayment period is up to eight years, during which the debtor must pay each month the amount remaining after deducting the minimum cost of living and taxes from income. After the repayment period ends, the court grants debt relief through a discharge decision (Draft Articles 634 and 635). In addition, because it is desirable, for the prompt rehabilitation of individual debtors, to simplify the claim confirmation procedure, the bill does not establish a separate claim filing and investigation procedure; instead, it provides a period for objections to claims, and claims to which objections are raised are to be confirmed by the court’s claim confirmation decision (Draft Articles 614 through 616).

This personal rehabilitation system is one handled by the courts when private resolutions such as personal workouts or bad banks between financial institutions and individual debtors are not possible. Compared with the current personal bankruptcy system, both systems share the common feature that the court prohibits compulsory execution against the debtor’s property. However, in personal bankruptcy all assets are disposed of and the debtor even loses eligibility to run for public office and to sit for examinations, whereas under the personal rehabilitation system the debtor can receive debt relief while keeping his job. In that respect, it is a highly favorable system for individual debtors.

However, this system raises concerns about abuse by unscrupulous debtors, in that debts as large as 1.5 billion won can be discharged so long as the debtor is merely diligent for eight years. The fundamental purpose of the system is to draw into the economically active population those who are hardworking but have unavoidably fallen into bankruptcy due to temporary economic hardship, not simply to exempt debtors from responsibility.

In light of this, the total debt ceiling of 1.5 billion won may be said to lack reasonableness. Also, considering fairness vis-à-vis debtors whose debts exceed 1.5 billion won, it is difficult to see this amount as consistent with the fundamental purpose of the system. Moreover, not establishing a separate claim filing and investigation procedure for the sake of simplifying the claim confirmation procedure may be understood as omitting a procedure necessary to adequately examine whether debtors are abusing the system.

To prevent debtors from abusing this system, it is necessary above all to lower the ceiling of 1.5 billion won. In addition, requiring procedures through which it can be investigated whether the debtor is seeking to abuse the system would be a legislative approach more consistent with the system’s fundamental purpose.

III. Conclusion

The bill on the Debtor Rehabilitation and Bankruptcy Act announced in September of this year is understandable in its fundamental purpose of rescuing those who diligently and faithfully managed businesses or lived ordinary personal lives but became victims of the economic crisis and are unable to fully perform their roles as economic actors, so that they may contribute to the national economy.

However, given that claims and debts are legal effects arising from private economic activity, this Integrated Insolvency Act bill would appear to bring changes to the basic framework of the law of obligations.

Therefore, it is important that this Integrated Insolvency Act bill be reviewed more fully within the framework of the current private law system and undergo in-depth discussion.

In particular, it should be reexamined whether this Integrated Insolvency Act bill may encourage moral hazard among debtors. If it is enacted as currently drafted without such reconsideration, the foundations of capitalism—which presuppose private autonomy and the protection of property rights—could be endangered.

Samhyun Jeon (Professor, Department of Law, Soongsil University; Chairman, Corporate Litigation Research Association)

Wiki:

https://www.cfe.org/w/bbsDetail.php?idx=77

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Original title: 통합도산법안의 문제점

Author: Sam-hyun Jeon

Date: 2004-10-05

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=bill&pn=3&idx=25834