The Avoidance of Pre-Bankruptcy Transactions: An Economic and Comparative Approach

Abstract

Most insolvency jurisdictions provide several mechanisms to reverse transactions entered into by a debtor prior to the commencement of the bankruptcy procedure. These mechanisms, generally known as claw-back actions or avoidance provisions, may fulfill several economic goals. First, they act as an ex post alignment of incentives between factually insolvent debtors and their creditors, since the latter become the residual claimants of an insolvent firm but they do not have any control over the debtor´s assets while the company is not yet subject to a bankruptcy procedure. Second, these devices may prevent the race to the debtor’s assets when the insolvency threatens. Therefore, the existence of avoidance actions may reduce, at an early stage, the ‘common pool’ problem that bankruptcy law seeks to solve. Third, avoiding powers can be helpful to prevent the problem of overinvestment faced by a debtor willing to gamble the firm´s assets when it is in financial trouble. Fourth, the existence of avoidance actions may also protect the interests of both the debtor and its creditors as a whole when the former is facing financial trouble and some market participants want to take advantages of this situation. Fifth, the avoidance of transaction prevents opportunistic behaviors by a debtor in financial trouble, since it may have incentives to siphon or dilute assets in several ways. Finally, the avoidance of pre-bankruptcy transactions can also be helpful for the early detection of financially distressed debtors, and therefore it may encourage managers to take corrective actions in a timely manner. As a result of these goals, the existence of avoidance powers seems to be socially desirable, since it helps maximize the value of the firm. However, the use – and even existence – of avoidance actions is not costless. On the one hand, it implies litigation costs. On the other hand, it can also harm legal certainty, since the use of avoiding powers implies to reverse perfectly valid transaction entered into by two parties even in the absence of bad faith. Therefore, insolvency legislators should carefully deal with these costs and benefits generally associated with avoidance provisions in order to assure the economic desirability of avoidance powers. On the basis of this exercise, this paper analyze, from a comparative and functional approach, the optimal way to design claw-back actions across jurisdictions.