Comparative Analysis of Bankruptcy Legal Provisions From Mexico and the United States: Which Legal System is More Attractive?

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1 Harvard University From the SelectedWorks of Jonatan Graham-Canedo May, 2007 Comparative Analysis of Bankruptcy Legal Provisions From Mexico and the United States: Which Legal System is More Attractive? Jonatan Graham-Canedo, Harvard Law School Available at:

2 Harvard Law School Comparative Analysis of Bankruptcy Legal Provisions From Mexico and the United States: Which Legal System is More Attractive? Jonatan Graham-Canedo May 2007

3 Comparative Analysis of Bankruptcy Legal Provisions From Mexico and the United States: Which Legal System is More Attractive? The objective of this article is to identify relevant procedural and substantive similarities and differences between Mexico s and the United States bankruptcy laws that can help to determine which of the two insolvency legal systems is more or less attractive or successful. The comparative analysis is pertinent because the U.S. and Mexico are commercial partners under the North America Free Trade Agreement ( NAFTA ) with a current overall economic exchange of over $300 billion dollars 1 per year. Because of this strong commercial relationship it is common for U.S. companies to conduct part of their business in Mexico and have assets, suppliers, and employees within its territory. A significant economic reality connects both countries; thus, when a transnational company of either nation becomes financially distressed it is convenient that the insolvency laws of both countries are mutually recognized and that they are procedurally and substantively harmonized. Harmonization maximizes the value of the estate for all creditors, and simplifies procedural and substantive law. With harmonization crossborder investments would be more secure in the event that a company becomes economically distressed and has assets located in Mexico and the U.S. In 2000 Mexican Federal Congress passed a new insolvency law (Ley de Concursos Mercantiles) ( Concurso Law ). Such law governs cross-border insolvency cases, and its provisions on said matter imports the United Nations Commission on 1 The number is the sum of importations and exportations between the U.S. and Mexico during National Institute of Statistics, Geography, and Information (Instituto Nacional de Estadística Geografía e Informática) at 2

4 International Trade Law ( UNCITRAL ) Model Law on Cross-Border Insolvency. 2 Actually, Mexico was one of the many Latin American countries that amended their bankruptcy laws during late 1990 s and the first years of this new millennium pursuant to the recommendations of UNCITRAL Model Law. This trend of amending or reviewing the regional insolvency laws was a reaction to the financial and economic condition of Latin America s economies, as well as an ever-increasing number of corporations under distress during the 1990 s decade. It was also a response to a global impetus of trying to save troubled companies rather than see them in liquidation. 3 Procedural Bankruptcy Law Comparison In Mexico there is a single insolvency process for merchants (both individuals and legal entities) in distress. Said process is governed by the Concurso Law and is known as Concurso Mercantil ( Concurso Process ). The Concurso Process consists of two consecutive stages: (i) the conciliation stage, which main purpose is to facilitate the reorganization of the debtors debt in order to preserve its business as a going concern; and (ii) the liquidation stage, which main purpose is to terminate the merchants businesses, sell its assets, and with the proceedings deriving from such sale pay as much as possible the debtor s debt and equity. In the U.S. the main types of formal procedures for companies in financial distress are Chapter 11 of the Bankruptcy Code, which principal objective is to regulate 2 Adopted by UNCITRAL on 30 May 1997, the Model Law is designed to assist States to equip their insolvency laws with a modern, harmonized and fair framework to address more effectively instances of cross-border insolvency. Those instances include cases where the insolvent debtor has assets in more than one State or where some of the creditors of the debtor are not from the State where the insolvency proceeding is taking place. The text of the Model Law is available at 3 Rodrigo Olivares-Caminal, Corporate Debt Restructuring in Latin America: New Developments-New Opportunities?, International Company and Commercial Law Review , (June 2005). 3

5 reorganization; Chapter 7, which provides for liquidation; and Chapter 15, which regulates cross-border insolvency cases in which U.S. courts will be involved 4. Mexico and the U.S. follow a universal approach to international bankruptcy 5 cases. The Concurso Law recognizes foreign insolvency proceedings; as a result, a foreign court may exercise jurisdiction over the property and the business of a foreign merchant located within the Mexican territory. The Concurso Law also recognizes foreign representatives and foreign creditors who shall have the same rights and access as Mexican creditors do in bankruptcy proceedings. Chapter 15 of the U.S. Bankruptcy Code recognizes foreign insolvency procedures and balances the right of U.S. courts to administer assets of a debtor with ties to the United States with the rights of foreign courts with respect to assets of the same debtor. 6 The regulation described above allows judicial cooperation in insolvency matters involving both countries; it permits domestic courts to initiate bankruptcy procedures concurrent to foreign proceedings. Hence, U.S. and Mexican courts have legal capacity to cooperate in joint bankruptcy proceedings. In fact said cooperation capability has already been proven. An example is Satelites Mexicanos (Satemex) restructure proceeding which was managed by a Mexican Federal Court and a United States Bankruptcy Court in New York. The Conciliator (Concliliador) appointed in the Mexican process, Mr. Thomas 4 Chapter 15 brings in the UNCITRAL Model Law on Cross-Boarder Insolvency. 5 Under [pure] universalism, the bankruptcy regime of the debtor firm s home country would govern, and that regime would have extraterritorial reach to treat all of the debtor s assets and claimants worldwide. Frederick Tung, Is International Bankruptcy Possible?, 23 Mich. J. Int'l L. 31(2001). 6 Karen E. Wagner, A Practical Insight to Cross-Border Corporate Recovery & Insolvency, The International Comparative Legal Guide to: Corporate Recovery and Insolvency 228, 231 (2007). 4

6 Heather 7, declared that the case was notable for the cross-border cooperation, stating that the two judges worked together, informally, but remarkably well. 8 Substantive Bankruptcy Law Comparison As described before, procedural harmonization of insolvency laws in the U.S. and Mexico has been achieved satisfactorily because both countries have adopted the UNCITRAL Model Law. There are however, important differences in substantive matters of their respective bankruptcy laws. 9 I will analyze three bankruptcy substantive subjects that are regulated in a more or less different way by the insolvency laws of Mexico and the U.S. and that can serve as a basis to determine which legal system is more efficient and/or more attractive. 1. Creditors Priority. Mexico and the U.S. have different priority rankings for the payment to the impaired creditors in the event of the debtor s liquidation. This difference is very relevant to establish which bankruptcy legal system is more attractive. Both countries diverge substantially in their treatment of labor and, to a lesser extent, tax claims within bankruptcy estate. 10 In Mexico wages for the last two working years, prior to the date of the declaration of insolvency, and employees claims for labor indemnifications, have priority over any other category of creditors claims. 11 This rule places labor credits in a dominant position. Beside this rule, the Concurso Law follows a traditional ranking of 7 Partner of White & Case. 8 Satmex Reaches Milestone, Latinlawyer, v. 5, issue 10, at 9 (2006). 9 Emilie Beavers, Bankruptcy Law Harmonization in the NAFTA Countries: The Case of the United Status and Mexico, Columbia Business Law Review, issue 3, 965, 968 (2003). 10 Id. at Alejandro Sainz & Manuel Ruiz-de-Chavez, A Practical Insight to Cross-Border Corporate Recovery & Insolvency, The International Comparative Legal Guide to: Corporate Recovery and Insolvency 155, 158 (2007). See also Article 123, XXIII, of the Mexican Constitution and Article 224, I, of the Concurso Law. 5

7 credits: Expenses incurred in the administration of secured assets should be paid first. Then, secured creditors must be paid with the proceeds from the sale of mortgaged or pledged assets. If the value of said assets is not sufficient to cover the debt, then the secured creditors will be considered as unsecured for the balance due. Common unsecured creditors of commercial transactions collect pro-rata from the outstanding balance. Finally, non-commercial creditors have the right to collect form any remaining amount. The U.S. Bankruptcy Code also follows a traditional ranking of claims, where secured creditors have first priority with respect to their security interests. The Code establishes an administrative priority in which claims such as fees of professionals involved in the bankruptcy, post-petition financings, and others, should be paid before other unsecured claims. Unsecured creditors come at last and among them there is a priority ranking. For example, pursuant to section 507 of Chapter 11, wages claims earned within 180 days prior to filing have priority over other general unsecured creditors, but such claims are capped at certain amount. In the U.S. labor claims never get priority over secured creditors. Tax credits also receive a different priority ranking in the U.S. and Mexico. In Mexico the government s tax claims have priority over unsecured claims, but they shall be collected after payment to the secured creditors. 12 However, such claims are not managed before the same courts that carry on the bankruptcy procedures; instead they should be determined and collected by administrative courts. The rationale for separating tax claims is that taxes are considered legally essential for the operation of a company. Article 69 of the Concurso Law provides, however, that any proceeding initiated against 12 Id. at

8 the debtor to collect taxes will be suspended while the Concurso Process is pending. Tax claims in the U.S. do not receive priority over secured claims. They are unsecured credits and are even ranked lower than labor credits. There are various consequences deriving from the dissimilar approaches the two countries take with respect to the priority of creditors. An important one is that funds deriving from the liquidation of the debtor s estate will be distributed differently, depending on where the main proceeding is conducted. It is clear that creditors, particularly secured creditors, will be better off if the main proceeding is managed by a U.S. Bankruptcy, while employees will prefer that the same takes place in Mexico. Therefore, when possible, creditors will seek to file a bankruptcy petition with a U.S. court and will argue that such proceeding should be the main one. UNCITRAL Legislative Guide on Insolvency Law drafted with the objective of proposing harmonization of substantive bankruptcy law establishes nine key objectives of insolvency regimes. 13 Key Objective number 9 Reorganization of existing creditor rights and establishment of clear rules for ranking priority claims, expresses that free market conditions should govern and be the ones that determine the rank of credits. It literally states: To the greatest extent possible, those priorities should be based upon commercial bargains and not reflect social and political concerns that have the potential to distort the outcome of insolvency. 13 1) Provision of certainty in the market to promote economic stability and growth; 2) Maximization of value of assets; 3) Striking a balance between maximization and reorganization; 4) Ensuring equitable treatment of similarly situated creditors; 5) Provision for timely, efficient and impartial resolution of insolvency; 6) Preservation of the insolvency estate to allow equitable distributions to creditors; 7)Ensuring a transparent and predictable insolvency law that contains incentives for gathering and dispensing information; 8) Reorganization of existing creditor rights and establishment of clear rules for ranking priority claims; and 9) Establishment of a framework for cross-border insolvency. Legislative Guide on Insolvency Law, U.N. Comm n on International Trade Law (2005) available at 7

9 However, UNCITRAL also recognizes that insolvency laws must balance the interests of the debtors stakeholders and the relevant social, political and other policy considerations that have an impact on the economic and legal goals of insolvency proceedings 14. Thus, UNCITRAL acknowledges the importance of making insolvency laws compatible with the legal and social values of the society of the country in which they are based. In the case of Mexico, labor rights are deemed as a major victory of the working social class and of the Mexican State as a whole. Moreover, such rights have been incorporated in Article 123 of the Mexican Constitution which makes them fundamental rights of the labor class. Said article represents one of the bastions of the Constitution. UNCITRAL suggests that the way to avoid forum shopping is by harmonizing insolvency laws and specifically recommends that labor claims should be treated as common unsecured credits. While from a pragmatic perspective this is true, the U.S. should also recognize and respect Mexico s legitimate commitment before its working social class. Both countries need to work together and find solutions to prevent forum shopping by creditors. Perhaps a way would to establish a differential treatment of Mexican labor credits; for example, a first payment subject to today s priority, but capped in its amount; and the outstanding balance, if any, could be considered as a common unsecured credit. Finally, with respect to the creditors priority, another impact of giving a first priority to labor claims that I should note here is that it deters potential lenders to finance the debtor under reorganization. The U.S. strongly foments the access of credit by debtors subject to a bankruptcy process. The Bankruptcy Code is designed to encourage post- 14 Id. at 9. 8

10 petition lending by giving these lenders special protection 15. Debtors can, for instance, offer to post-petition lenders security interests over the property they acquire after the bankruptcy is filed. On the other hand, Mexico s priority of credits acts as a disincentive to give credits to debtors under financial distress. 2. The Option for a Cramdown. The U.S. and Mexico bankruptcy proceedings provide different mechanisms to confirm reorganization plans ( Plan ). Mexico does not have an option for a cramdown. The Concurso Law does not grant an option to confirm a Plan once all classes of creditors have rejected the one proposed. In the U.S., on the other hand, if the Plan satisfies the requirements of section 1129(b) of the Bankruptcy Code it may be confirmed even if the same was previously rejected by the impaired creditors classes participating in the bankruptcy proceeding. The capacity of confirming the plan under these adverse circumstances is known as cramdown. A debtor who whishes to cramdown a plan must count with at least the consent of one class of the impaired creditors and fulfilled the requisites of section 1129(b). Generally, these requirements are that: Debtors must receive as much as they would in liquidation (the best interest of creditors test); No junior creditor shall receive any distribution before a senior class is paid in full (the absolute priority rule ); and The plan must be fair and equitable Elizabeth Warren & Jay Lawrence Westbrook, The Law of Debtors and Creditors 459 (Erwin Chemetrinsky et al. eds., Aspen Publishers 2006). 16 Section 1129(b)(2) sets forth minimum requirements for a plan to be found fair and equitable, leaving to courts the imposition of any additional requirements in particular cases. Wagner, supra note 6, at 231; also Warren & Lawrence, supra note 15 at

11 In the case of Mexico, the Concurso Law permits to reach a plan of reorganization without unanimous vote of all creditors; yet certain mandatory percentages of votes and other legal requirements must be met. However, what is important to underline is that in Mexico creditors with secured interests can never be crammed down. Article 160 of the Concurso Law provides that all secured creditors that do not approve the Plan may foreclose their guaranties, unless the Plan establishes they will be paid in full (including principal and accessories due), in terms of the contract they entered to with the debtor. The nonexistences of a cramdown recourse means, of course, that the debtor is left with one legal option less. However, cramming down a Plan is a last shot for the debtor, and it usually turns negotiations between the debtor and the creditors into adversarial confrontations. Furthermore, the process is time consuming and expensive 17. Perhaps and this is just a personal assumption when the debtor knows that his best alternative to a negotiated agreement is liquidation, he will make his best effort in reaching a Plan that satisfies the necessary majorities in each class of impaired creditors. Thus, in my opinion, the fact that there is no cramdown option in Mexico does not necessarily mean that the Mexican insolvency proceeding is less attractive to management of companies in distress. 3. Control of the Debtor Throughout the Insolvency Process The Mexican Concurso Law and Chapter 11 of the U.S. Bankruptcy Law authorize the debtor to remain in control of the business after the bankruptcy has been filed. In the U.S., the debtor s management will continue in control of the administration as a debtor in possession, absent a legitimate and valid request by creditors that a trustee 17 Wagner, supra note 6, at

12 should be appointed to manage the estate. 18 If a trustee is appointed, it will replace the board of directors whose members will need to resign. Once liquidation is initiated under Chapter 7, a trustee shall be appointed to liquidate the company s assets and make distributions to creditors 19. Under the Concurso Law debtors may continue in possession of the estate; however a Conciliator (Conciliador) will always be appointed and he will have the responsibility of reviewing the debtor s management and accounting. The appointed Conciliator may, at any time, request the court the removal of the debtor from the administration of the business in order to protect the estate 20. In the event that the liquidation (quiebra) stage initiates, the Debtor (and thus, if applicable, the Board of Directors) will be removed from the administration and a Receiver (Síndico) will be designated by the bankruptcy court. The Receiver will have the broadest legal authority to carry on the liquidation of the debtor. Thus, in both countries the general rule is that debtors shall be maintained in possession of the estate during the reorganization proceeding. In the U.S. the impaired creditors may request the removal of the debtor from the administration, whereas in Mexico only the Conciliator has that prerogative. This means that while in the U.S. the impaired creditors are who directly monitor the debtor s administration; in Mexico it is the Conciliator who directly performs that function. Also, in both countries the debtor will be removed from the administration once the liquidation proceeding begins. Finally, 18 Disputes among creditors are common in chases where some of them believe that the debtor in possession operations will only favor one particular creditor (normally the largest and most powerful), not all creditors collectively. See Warren & Lawrence, supra note 14 at 437. An example of these disputes can be found at In Re Marvel Entertainment Group, Inc. C.A.3. (Del.), I such case a trustee was appointed after a creditor obtained control of the debtor s board of directors. The appointment was upheld. 19 Wagner, supra note 6, at Sainz & Ruiz-de-Chavez, supra note 11, at

13 the two countries give broad discretionary faculty to judges to decide if the debtor should be removed from the administration of the estate. Conclusions Mexico and the U.S. have modern bankruptcy laws that have incorporated most recommendations contained in the UNCITRAL Model Law on Cross-Board Insolvency. Procedurally their laws have already been harmonized and there are no substantial differences that would make one jurisdiction more efficient or attractive to either debtors or creditors. Both countries follow a universal approach and, therefore, promote judicial cooperation in insolvency proceedings. The U.S. and Mexican substantive bankruptcy laws differences deter creditors from filing bankruptcy petitions in Mexico and are an incentive for them to push courts to declare that the main proceeding should be managed by U.S. courts. On the other hand, employees of debtors in distress will find more attractive that insolvency main processes take place in Mexico. The most significant difference of the two countries substantive bankruptcy laws is the different ranking they give to creditors. The fact that labor and tax claims have a dominant priority in Mexico has adverse consequences to both the U.S. and Mexico. It foments forum shopping and it also discourages pos-petition financing to debtors subject to an insolvency proceeding in Mexico. For this reason the two countries need to work together and harmonize their laws, but such harmonization must acknowledge their different economic and political ideologies. 12

14 Finally, debtors subject to reorganization proceedings in Mexico, do not have the option to cramdown impaired creditors to accept a Plan. However, I suggest here that the absence of a cramdown alternative might actually promote amicable negotiations between debtors and creditors. 13