The Pandemic as a Chance to Modernise Italian Insolvency and Restructuring Law

Abstract

The pandemic exerted a profound influence on Italian insolvency and restructuring law. In 2020, after several years of preparation, a wide-ranging reform, whose focus was to enhance the judicial management of distress, was about to enter into force in Italy. In that context, there were two events inducing a radical rethinking of that reform: the pandemic and the duty to transpose Directive (EU) 2019/1023 (which the Italian legislature had largely overlooked while devising the project for reform). The result of the rethinking has been a set of rules more restructuring-friendly, partly and initially conceived as a response to the Covid-19 emergency, but largely preserved also in the post-pandemic framework. Difficult challenges lie ahead, the main one being the heavy legacy of State-guaranteed corporate loans, for which an ad hoc scheme has been developed. A significant and lasting consequence of the legislation enacted during the pandemic is the suspension of the ‘recapitalise or liquidate’ rule, on which the Italian corporate law system has traditionally relied for crisis detection purposes. This paradigm shift comes at the same time as an increased emphasis on early detection of financial distress and an increase in directors’ responsibility in this regard.

1 The Applicable Insolvency Law in 2020 and the Duties of Directors of Distressed Companies

When the Covid-19 pandemic exploded in March 2020, Italian restructuring law was in transition. The work on a new insolvency law had been in the pipeline for years and had recently produced the Legislative Decree No. 14 of 12 January 2019, a large and complex piece of legislation, ambitiously labelled ‘Codice della crisi d’impresa e dell’insolvenza’ (hereinafter, ‘Insolvency Code’ or ‘IC’).¹ The new Insolvency Code was due to enter into force in August 2020. Judges and practitioners were busy studying it.

Drawing on the shared perception that access to the insolvency system occurs very late, thereby reducing the chances for the recovery of the business and aggravating the losses for creditors, the IC relied heavily on early warning, achieved through a combination of sticks and carrots.

The carrots were quite ordinary, and mainly took the form of leniency on criminal charges for pre-bankruptcy fraud.² The sticks, however, were significant: in case of an impending financial crisis, the debtor could be summoned before a panel of appointed experts (OCRI), following a notice by auditors or (for owed and unpaid tax or social security debts) by public creditors.³ A phase of negotiation would then follow.⁴ In case a solution was not found, and the debtor was insolvent, the panel would notify the public prosecutor, who could request the opening of insolvent liquidation.⁵

For reasons that are irrelevant here, the IC was not fully compliant with Directive (EU) 2019/1023 on preventive restructuring frameworks (hereinafter ‘PRD’).⁶ In particular, the scope of the judicial review of restructuring plans was much wider than permitted by the PRD, requiring the judge to evaluate the merit of the plan and allowing the plan to be confirmed only if its viability was ascertained as positive.⁷ Other parts of the IC were not in line with the PRD either, the most important being the rigidity of the rules on the distribution of the restructuring value, the lack of mechanisms to override shareholders’ veto power in restructuring processes involving debt-for-equity swaps, and the stringent prerequisites for going-concern restructurings.⁸

Until the planned entry into force of the IC in August 2020, the old bankruptcy law (Royal Decree No. 267 of 16 March 1942), updated by a series of extensive amendments adopted between 2005 and 2015, was still applied, with a complicated set of procedures and instruments that can be classified in three main categories:

• Straight insolvent liquidation (fallimento);

• Composition with creditors (concordato), governed by the majority principle and allowing both intra-class and cross-class cramdowns;

• Restructuring agreements (accordi di ristrutturazione), not binding on dissenting creditors and giving those involved in the restructuring, in the event of a subsequent insolvency of the debtor, an exemption from liability and avoidance actions.⁹

Insolvent liquidations were by far the prevalent procedure, ranging from approximately 7,000 in 2007–2009 to more than 12,000 in the years following the financial crisis (with a peak of almost 15,000 in 2014).¹⁰

Compositions with creditors and restructuring agreements amounted, together, to approximately 1/10 of the total number of cases. However, they usually involved larger firms, with a direct correlation between the complexity of the instrument and the size of the firm (compositions with creditors and restructuring agreements involving, on average, firms with an asset value, respectively, 6 and 24 times larger than of firms subjected to insolvent liquidation).¹¹

Italian insolvency law did not provide for an express duty to file for insolvency in case of financial or economic distress. Such duty, however, resulted indirectly from civil and criminal liability imposed on the debtor (and company directors) for deepening insolvency by not filing for bankruptcy when it was inevitable.¹² Moreover, since 2019, the Italian Civil Code states that directors of distressed companies must make timely use of the available instruments and procedures aimed at preserving the company as a going concern.¹³

It is to be noted, moreover, that, at the time, Italian company law provided for the so-called ‘recapitalise or liquidate’ rule (hereinafter, ‘ROL’).¹⁴ In its basic terms, ROL states that if, as a consequence of accrued losses, the net assets, at book value, fall below the minimum capital required to establish a company (in Italy, EUR 50,000 for stock companies and only EUR 1.0 for limited liability companies), the company will be dissolved and liquidated (in a solvent liquidation, i.e., with appointment of liquidators by the shareholders, or through an insolvency procedure if the company is balance-sheet insolvent), unless such losses are covered (through subsequent income or shareholder contribution) within a certain period. To retain their shares, therefore, shareholders must exercise their call option to pay off at least some debt (or, in any case, to restore positive net assets), otherwise the company must stop operating as a going concern, entering into solvent liquidation. The impossibility to continue normal operations, in turn, often causes losses in the value of the assets, triggering insolvency and pushing the company into insolvent liquidation.¹⁵

2 Reaction to the Pandemic

2.1 April 2020: A System-wide Standstill

When Covid-19 hit Italy, in February 2020, a number of emergency decree-laws were enacted, which in the following weeks, in striking progression, involved ever larger areas of social and economic life.¹⁶

The bulk of the measures concerning business support took the form of financial aid (initially in the form of postponement of payments and later as direct aid).¹⁷ Several aspects of business law, however, were touched upon, notably the fact that online shareholder and board meetings were allowed notwithstanding any different (or lacking) indication in the company by-laws.¹⁸

Insolvency law was also an obvious target. Most of the measures concerning insolvency and restructuring law were included in Decree-law No. 23 of 8 April 2020. These measures can be divided into six categories:

• (1) The entry into force of the new IC was postponed to September 2021, as the Italian government considered it unwise to modify the rules on business insolvency during the pandemic;¹⁹

• (2) Procedural deadlines for debtors that had filed for restructuring were extended by six months;²⁰

• (3) Filing for insolvent liquidations was not allowed until 30 June 2020, not only by creditors and the public prosecutor, but (at least initially) also by the debtor itself;²¹

• (4) The operation of ROL was suspended, with the effect that, in case of an asset deficiency as defined above, directors were no longer bound to liquidate the company failing its recapitalisation;²²

• (5) The subordination of shareholders’ and intra-group loans in favour of the company, provided for by Articles 2467 and 2497-quinquies of the Civil Code, was also suspended for loans made until 31 December 2020;²³

• (6) Notwithstanding the pandemic and the associated uncertainties about the survival of the company, financial statements could be prepared under the legal assumption of the company’s ability to continue as a going concern, provided that such ability had been present before the pandemic.²⁴

No specific exemption from directors’ liability for wrongful trading was provided for, even though it can be argued that precluding the debtor from filing for insolvency is indirectly achieving the same result.

2.2 May 2020: Performing First Aid

The flurry of measures to help firms cope with the pandemic only intensified in May 2020. Apart from allowing more flexibility in restructuring procedures, in the form of an easier exit from judicial composition in case of an agreement with creditors, existing laws were extensively amended to support the capitalisation of firms, via tax incentives for equity injections by shareholders in the form of capital increases. With the same goal an exceptional possibility was granted to capitalise costs (instead of recording them in the profit and loss account) and to record intangible assets on the balance sheet even beyond the cases in which this is routinely permitted by accounting standards.²⁵

Most of the support measures, however, came about through a multi-faceted programme of State aid,²⁶ allowed under EU law by the Temporary Framework of the European Commission,²⁷ whose main pillars were:

• (1) Compensation for direct damages suffered by businesses as a consequence of the pandemic (loss of turnover, mainly), which was automatically permitted under Article 107(2)(b) of the Treaty on the Functioning of the European Union (TFEU);

• (2) Financial support to businesses under Article 107(3)(b) TFEU, which allows the European Commission to declare an aid compatible with the internal market when it is granted ‘to remedy a serious disturbance in the economy of a Member State’.

The support in the form of compensation played a very important role. At the peak of the pandemic, the State paid significant contributions to firms for lost turnover and to employees for lost wages, increasing the already high public debt.²⁸

The second (and more substantial) form of State aid was mainly channelled through bank loans, awarded with a guarantee from a State-controlled entity for 80 percent of the amount.²⁹ Although the support programme allowed a contribution also in the form of equity or quasi-equity (subordinated financial instruments), the applicable prerequisites and the required procedures made this kind of support very hard to obtain. The vast majority of the Covid-related State aid therefore took the form of liquidity support, with EUR 128 billion lent by banks with State guarantees in 2020 alone.³⁰

The State guarantee, however, came at the price of making restructuring more difficult for borrowers, in case of later financial distress. If the bank calls in the guarantee of the State following the borrower’s default, the claim of the State for the amount paid will enjoy priority over all unsecured creditors.³¹ This, in turn, will raise the State’s expected recovery in case of a debtor’s liquidation and therefore make the State less likely to agree to a debtor’s restructuring proposals implying a reduction in creditors’ claims. We will return to this point later.

2.3 Effect of the Measures

While the temporary measures concerning bankruptcy and restructuring procedures came to an end in the first half of 2020, other measures had a measurable and lasting impact.

Both bankruptcy and restructuring procedures declined considerably (by about 30 percent) compared to historical levels.³² Tens of thousands of companies availed themselves of the possibility to continue operating notwithstanding an asset deficit following the suspension of ROL,³³ and, arguably, many more took the opportunity to prepare the financial statements for the year 2019 (which were due to be approved in spring 2020, just when the pandemic broke out)³⁴ under the legal assumption of the company’s ability to continue as a going concern.

3 Towards a New Framework

In 2021, the Italian economy showed a higher-than-expected performance. A generally favourable climate, together with the approval of the National Recovery and Resilience Plan (financed by the EU under the Next Generation Europe programme),³⁵ helped fuel recovery. After the 2020 standstill, the number of restructuring and bankruptcy procedures slowly picked up, but without returning to pre-pandemic levels.³⁶

As we have seen, however, the volume of debt linked to Covid, and thus its overhang, was considerable (and, at least in the first half of 2021, continued to grow following the extension of the possibility to obtain State-guaranteed loans). The time appeared right, therefore, to adjust the Italian legal framework to the European Preventive Restructuring Directive, while at the same time making it more suitable for less favourable times, should these come.

In April 2021, the Ministry of Justice appointed an ad hoc commission, with the multiple but related tasks of proposing appropriate emergency provisions in insolvency law, identifying possible amendments to the Insolvency Code (which was scheduled to enter into force in September 2021) to make it more suitable for the new post-pandemic environment, and formulating proposals for adapting the IC to the provisions of the PRD, which was due to be transposed by July 2022.³⁷

In August 2021, upon the recommendation of the ad hoc commission, the Italian Government enacted Decree-law No. 118 of 24 August 2021, with the explicit goal of facilitating non-destructive solutions for firms in financial distress because of Covid-19.³⁸

This decree:

• (1) further postponed, until May (eventually to 15 July) 2022, the entry into force of the Insolvency Code;

• (2) introduced a brand-new instrument, called ‘negotiated composition’ (composizione negoziata);

• (3) introduced another new proceeding, which allows a debtor-in-possession liquidation (concordato semplificato per la liquidazione del patrimonio), in case the negotiated composition did not lead to a solution agreed with creditors.

Negotiated composition is effectively a space where the debtor can negotiate with some, or all, of its creditors, with the help and under the supervision of an independent expert. The debtor continues to manage the business with a view to preserving the continuity of the business, informing the expert in advance of any act outside the ordinary course of business. Such acts cannot be challenged in case of a later insolvency of the debtor, unless the expert has expressly opposed them.³⁹ Creditors are required to cooperate in good faith in the restructuring attempt by participating in the negotiations. Financial creditors, moreover, are under a specific duty to give prompt and reasoned feedbacks to the debtor’s requests.⁴⁰

A petition to a judge will be required only if the debtor requests measures which affect third parties:⁴¹ a stay on all creditors or some of them, sale of the business disencumbered by the successor liability ordinarily provided for by Article 2560 of the Civil Code,⁴² or new financing that enjoys priority in a subsequent liquidation of the debtor.⁴³

If debtor and creditors do not reach an agreement with the assistance of the expert, the debtor can resort to ordinary instruments and procedures,⁴⁴ but also to the new debtor-in-possession liquidation mentioned above. This procedure does not require a vote by creditors, and merely requires that creditors are no worse off than in an insolvent liquidation and the value is distributed according to the absolute priority rule (APR).⁴⁵ Its features, which include a relatively quick going-concern sale, seem particularly suitable for the quick exit of small enterprises from the market, in line with international policy recommendations and with the proposal for a new Directive on insolvency law by the European Commission.⁴⁶

4 The New Restructuring Law and the Legacy of the Pandemic

The Covid-19 emergency led to postponing the entry into force (scheduled for 2020) of the rigid 2019 version of the Insolvency Code. The IC was extensively amended in June 2022, also with the goal of aligning it with the PRD.⁴⁷ The IC now contains a set of sufficiently flexible instruments and procedures aimed at facilitating the restructuring of the business, i.e.:

• Instruments based on creditor consent only: accordo di ristrutturazione dei debiti (debt restructuring agreement), and piano di risanamento attestato (certified restructuring plan);

• An instrument and a procedure able to bind creditors within a class: accordo di ristrutturazione a efficacia estesa (restructuring agreement with extended effects) and piano di ristrutturazione soggetto ad omologazione (restructuring plan subject to judicial confirmation); the difference between the two lies mainly in the ways creditors express their consent or dissent to the plan (contract v. vote);

• A procedure able to also bind creditors of non-consenting classes, provided that the value is distributed according to a fairly complex set of rules: concordato preventive (judicial composition with creditors).⁴⁸

The rules on the management of the business during the restructuring process differ significantly between the various instruments and procedures. In all cases, however, the court’s authorisation is required for the plan, or for any act or business decision, to directly or indirectly affect non-consenting creditors or third parties.

The goal of favouring early countermeasures to distress is mainly achieved through incentives, among which the negotiated composition stands out, allowing the possibility of opening negotiations in a protected environment without the risk of sliding into insolvency proceedings, which is a significant shift from the original design of the IC (see Sect. 1).

The new law allows for corporate restructuring, empowering directors with the exclusive authority (and responsibility) to start the restructuring process and propose the plan.⁴⁹ Once the restructuring has been initiated, shareholders may no longer remove directors from office unless for cause.⁵⁰ The plan can modify the corporate structure and shareholders’ rights without requiring their approval, which can be substituted by a mechanism of class formation and confirmation of the plan.⁵¹

If attempts to restructure the business fail, or are not initiated, the procedure for insolvent liquidation can be opened, at the request of the debtor, of creditors or of the public prosecutor. The old name ‘fallimento’ (failure) has been changed into ‘liquidazione giudiziale’ (judicial liquidation), to reduce the stigma associated with the term ‘failure’.

On 15 July 2022, the modified IC finally entered into force.

A complete assessment of the functioning of the IC exceeds the scope of this article, and would in any case be impossible given that the new rules have not been sufficiently tested. However, it appears that the influence of the pandemic on Italian restructuring law has been positive.

In this respect, the following innovations can be attributed to the Covid legislation, which are to be welcomed:

• The negotiated composition;

• The focus on renegotiation of debts, contracts⁵² and creditor duties during the negotiation;

• The debtor-in-possession (piecemeal or going-concern) liquidation;

• The focus on early warning as a product of a friendlier restructuring environment rather than on constraints.

This more balanced approach has been stimulated also by the need to adapt Italian restructuring law to the PRD, which for the judge envisages a role more akin to that of a referee, intervening only in case of obvious violations of the law or when a proposed plan is clearly doomed to fail. This is in stark contrast to the trend which slowly became dominant after 2013, whereby judges often stepped in to prevent perceived ‘abuses’ of the restructuring system and to evaluate the merit of the plan.⁵³ This trend led to the provision, included in the original 2019 version of the IC (Article 48) and mentioned above, that allowed confirmation of restructuring plans only if their feasibility was positively proven, a proof that is almost impossible to achieve for going concern plans even in a non-post-Covid environment. This provision has been repealed from the final version of the IC, which now stipulates that the judge must confirm the plan unless it has no reasonable prospect of preventing the insolvency of the debtor (a sort of ‘negative viability test’).⁵⁴ Whether the judiciary, which successfully lobbied for the 2019 version, will accept this reduced/diminished role is an open question.

Finally, a clear legacy of the pandemic is the continuing suspension of ROL. This rule, until 2020 an integral part of the early warning system in Italian company and insolvency law, was initially suspended as a reasonable response to the pandemic. This suspension has been extended three times since,⁵⁵ so that it is now uncertain if ROL will ever become effective again. Although its suspension is, at least for now, limited to accounting losses accrued until 31 December 2022, the deadline to bring the net assets back to the applicable minimum (EUR 50,000 for stock companies and EUR 1.0 for limited liability companies) is in the very distant future.⁵⁶

In case of an asset deficit, company directors face no rule explicitly barring them from running the business as usual, as long as the company is able to pay its debts as they fall due. A cultural shift from a rule (positive net assets) to a standard (solvency) may soon take place,⁵⁷ and the provisions of the IC that require directors to structure the internal organisation of the company such as to be able to foresee the risk of financial distress at least 12 months in advance⁵⁸ (which is far from obvious in MSMEs) may help this transition.

5 The Lesson Learnt and the Foreseeable Trend

While recovering from Covid-19, the Italian economy has been hit, as others, by inflation and the consequences of the war in Ukraine, with resulting increases in energy prices. Some typical Italian energy-intensive industries (e.g., tiles), once very profitable, face an uncertain future.

Many Italian firms seem to have seized the opportunities and incentives following Covid-19 to cut costs, streamline production and rebuild (or strengthen) their equity base, but the corporate debt overhang is significant, and State-guaranteed loans amount to 30% of total corporate debt.⁵⁹ Although the numbers of restructurings and insolvencies are still surprisingly low, they are slowly increasing.⁶⁰ For sure, the new restructuring framework will be intensely tested in the coming years.

While the reformed restructuring framework appears to be adequate to the challenge, allowing both restructurings and quick going-concern business sales, significant challenges lie ahead, the most significant of which are listed below:

• (1) For sound prudential reasons, during the last decade Italian banks were urged by the competent authorities (ECB and Banca d’Italia) to identify debtors’ difficulties at an early stage and they were pressed to divest themselves of most of their non-performing exposures,⁶¹ which were then massively sold to credit servicers.⁶² The sale initially concerned loans to insolvent debtors, and then (increasingly) those to debtors still active and in need of banking services, often in the process of restructuring. Although there have been improvements over time,⁶³ the management of the latter is still far from efficient: on the one hand, for banks, prudential regulation makes the holding of restructured debt very costly (in terms of capital requirements) and new loans to distressed debtors virtually impossible even in the context of a court-supervised restructuring;⁶⁴ on the other hand, credit servicers, being focused on a quick return on assets purchased at a steep discount, are not necessarily well positioned (or incentivised) to make new loans or provide banking services to debtors. Therefore, there is a real risk that early identification of distress by banks and/or debtors themselves (a reasonable objective, at least in theory), if followed by a sale of the loans to credit servicers, will actually worsen the situation of debtors worthy of restructuring.

• (2) The Italian judiciary is not particularly business-friendly,⁶⁵ and Italian restructuring law, resulting from the multiple layers of reforms described above, is very complicated. This may lower the predictability of outcomes, potentially discouraging debtors from accessing the system, thus undermining one of the main goals of the reform, which is to induce firms to tackle distress at an early stage. The stigma associated with failure and liquidation has been reduced, also by renaming insolvent liquidation and suppressing the term ‘fallimento’ from all legislative texts, but it is still present, being deeply entrenched in the Italian tradition.

• (3) The most visible legacy of the pandemic, though, is the staggering amount of corporate debt guaranteed by the State. The relatively low level of risk of loss for banks (due to the State guarantee) may pose an incentive for them to adopt an overly aggressive approach towards the debtor, also due to the fact that, under the applicable rules, the State only pays out the guarantee after the bank has exhausted all avenues of loan recovery. The magnitude of the problem is increased by the fact that the State’s recourse, as we have seen, enjoys preferential status over unsecured debt, thus making restructuring more difficult for the debtor. For that very reason, in order to prevent the potential (and not necessarily justified by the conditions of the debtors) default of a large amount of State-guaranteed loans, in September 2022, the Italian government set up a scheme based on a State-owned asset management company, AMCO, which can purchase the entire debt pool of the distressed debtor, managing it with a ‘patient’ and value-maximising approach.⁶⁶

  The fact that AMCO is a company that has already been competing in the market for many years with a satisfactory track record, and that it finances the purchase of the debt through bonds bought by private investors, reduces (although it cannot entirely eliminate) the risk that the scheme will end up isolating from market forces the companies whose debt has been purchased, and that the scheme will end up being a de facto nationalisation of large parts of the Italian industrial/business sector, which would be an unfortunate and very worrying outcome.

  The European Commission has approved the scheme, on the grounds that, through this, the State is not granting any further aid to distressed firms, but rather is trying to efficiently manage the cost of the aid it already provided to them during the pandemic. Whether this ‘systemic’ remedy will avoid the risk of banks activating the State guarantee at the first sign of debtors’ difficulties, thus accelerating and aggravating their distress, remains to be seen.

Systemic crises are often opportunities to rethink the applicable insolvency and restructuring frameworks. This seems to have happened in Italy: even though the human and economic cost of the pandemic has been immense, its legacy on the insolvency and restructuring frameworks appears, overall, positive.