Neta Nadiv, Lecturer and Academic Director of Legal Clinics at Harry Radzyner Law School, Inter Disciplinary Center, Herzlia
Introduction
Despite its importance and deep repercussions for society, Personal Insolvency rules (PI) receive little attention compared to corporate bankruptcy. Consequently, many fundamental questions regarding the purpose and likely impact of PI rules remain largely unaddressed.
In the following lines, I will discuss the little known – yet practically very important – recent shift of approach in the application of PI rules towards “corporate” responsibility, under which Courts tend to recognize special obligations binding corporate actors in PI proceedings.
To this aim, I will review some recent Israeli courts’ rulings – particularly the District Court’s case in Shams.[1] This case is of defining importance in understanding the repercussions of the “corporate responsibility approach” in that the court adopts a broad outcome-based understanding of insolvency and rethinks the idea of equality of creditors.
Towards “Corporate” Responsibility.
PI law is undergoing a shift of approach towards a “corporate responsibility” model. Under this model, Courts around the World increasingly tend to attribute special responsibilities to big corporate actors in Public Insolvency proceedings vis-à-vis non-professional and individual actors.
The idea is that corporate actors possess vast economic and organizational resources, which allow them to better manage transactions and anticipate risks. In response to the additional means of big corporations, Courts assign duties of enhanced caution and obligations of transparency and good faith when said big corporations are dealing with smaller and less economically powerful actors. The “corporate responsibility” model thus recognizes that the different nature and means of the actors involved in PI cases must translate in a different distribution of liabilities among them.
The approach of the Israeli Courts
A number of recent cases in the field of PI shows that Israeli Courts are also inclined to adopt a corporate responsibility approach to insolvency proceedings.
In International Bank[2], courts focused on the question of whether, in a PI case, one of the creditors (a bank) could obtain an extension of the date for filing a debt claim. On appeal against the District Court’s decision denying such extension, the bank observed that its request was justified on the ground of the “astronomical” amount claimed. According to the bank, the District Court’s ruling would indeed lead to the absurd result of not allowing it to claim the debtor’s huge debts, violating its right to property as a creditor, even if the delay to file the claim did not cause any damages to the debtor. The bank further observed that the District Court erred in favouring formal procedural requirements (deadline to file the claim) over broader considerations of justice and the principle of equality between creditors.
The honourable Judge Danziger of the Israeli Supreme Court rejected the Appeal by reason of the bank being “a large, strong and organized body“, as opposed to other non-professional creditors. Being in the position of a “strong creditor” the bank was thus expected to conduct itself according to the rules of procedure. Judge Danziger held that the bank “[…] has the necessary legal and logistical tools. This is not contrary to the principle of equality, since this observance is not only attributed to banks but also to other large and organized bodies and is justified both for reasons of efficiency and for considerations of distributive justice.” [originally in Hebrew].
Biton[3] was regarding the case of a small business owner who found himself insolvent after a large client went bankrupt. One of his creditors, a bank, had granted him a conspicuous loan without investigating his financial conditions and previous financial obligations to ascertain whether he would be able to meet the additional financial obligation.
In attributing the liabilities of the case, District Court Judge Maor observed that the bank’s behaviour equated to a lack of good faith of professional creditors, and this had to be taken into account in the division of the assets among the creditors during the liquidation procedure. He thus penalised the bank accordingly.
The Justice established a distinction between two categories of creditors: professional creditors and ordinary creditors. He specifically observed that the bank – a professional, powerful creditor – turning a blind eye to financial risks it could have foreseen could not be treated as any other creditor. Contrarily, failure to exercise due diligence in the financial operation that led to PI of the debtor could be seen as having contributed de facto to such situation of insolvency.
The Case in Shams
The recent Israeli District Court decision in Shams further expands the PI “corporate liability” doctrine to creditors’ liability in bankruptcy cases. The case concerns 17 debt claims filed against a 24-year-old debtor. The debtor declared that he had become financially ill when – in an attempt to start an independent business – he took out various loans which were granted to him by one professional (a bank) and other non-professional creditors without the appropriate checks on his financial situation and ability to repay them.
Judge Maor found that the professional creditor applying to have its credit repaid – the bank – was fully responsible for the debtor’s position, having granted loans to the debtor without the appropriate due diligence and even after it became clear that he would not be able to repay them. As the bank had acted “unfairly” towards the debtor, it was responsible for his economic loss and the other (non-professional) creditors were thus entitled to receive priority in the repayment of their credit from the debtor. To that aim, Justice Maor made use of the legal doctrine of “Equitable Subordination” of corporate law as an exception to the principle of equality between creditors in PI proceedings. “Equitable subordination” is a doctrine typical of corporate cases and refers to the legal action by which a court postpones payment to one specific creditor until other creditors are paid.[4]
Shams is based on – and expressly recalls – the UK Financial Conduct Authority’s (FCA) decision in Wonga,[5] regarding an arrangement between the UK and Wonga, a non-bank loans company for households, which afforded loans (although of modest sums) to about 45,000 customers without carrying out checks on their overall financial situation and ability to repay the debt. The investigation begun by the Office of Fair Trading (OFT) and taken forward by the FCA found Wonga liable of using unfair and misleading debt collection practices. Wonga thus had to write off many of the customer’s loans and significantly reduce the interest rates for the rest of them.
The implications of Shams
Shams seems to be a case of defining importance in PI, both in terms of the legal principles it affirms and its repercussions on subsequent case-law of Israeli Courts.
Although Judge Maor did not erase or change the amount of the debtors’ debt by lowering the interest rate, he adopted an interventionist approach that – by means of the corporate policy rule of equitable subordination – absolves responsibility on the individual creditor and tackles the fundamental principle in PI proceedings of equality of the creditors in view of the substantively dominant position of corporate actors.
Indeed, the Justice in the matter of Shams observed: “In these circumstances, there is no alternative but to correct the distributive distortion caused by the Bank’s behavior towards the other creditors, and the collection of the Bank’s debt will be postponed until after repayment of the debt to the other creditors” (originally in Hebrew).
Subsequent decisions of Israeli Courts also took a similar instance to Shams. In the matter of Finger,[6] where the debtor was declared insolvent on the basis of various loans granted to a debtor over a relatively short period of time from professional creditors (banks and companies providing non-bank credit), the District Court found that the irresponsible behavior of the professional creditors contributed to the debtor’s situation of insolvency. The Court recalled that “in the matter of Shams, it is determined that the professional creditor has the duty to examine and manage the risk of non-repayment of the credit and its suitability to the customer’s measurements, ie. the professional creditor must conduct a process of clarification with the debtor about the borrower’s ability to repay the new loan or credit… non-fulfillment of the obligation of examination by the professional creditor harms the creditor before him (who may have performed the appropriate tests) and an ordinary creditor (who does not have the ability to conduct the appropriate tests, but is in a position of oblivion equal to that of the professional creditor)“. (originally in Hebrew).
The case in Dror[7] concerned a credit from 7 different “professional creditors” held by the debtor over a period of two years during which the debtor was unable to work. The Special Administrator in the bankruptcy proceeding argued that the debtor should be discharged from his debts, thus imposing on the creditors responsibility for the risk they took upon granting credit when the debtor was already in debt to other creditors. The District Court agreed with the Special Administrator, observing that: “The Western world is moving towards accepting responsibility and placing it on the professional credit. In the Finger case I was cited an example from the UK in which a large non-bank loan company named Wonga was placed after it granted loans without checking the repayment ability of the debtor“. (originally in Hebrew).
Conclusions
A well-functioning insolvency framework is an essential part of a healthy socio-economic environment. A properly designed and operating bankruptcy model can help promote a stable market for consumer credit, and make creditors more willing to lend and individuals more willing to borrow.
Generally speaking, PI and bankruptcy laws tend to balance two basic policy goals: providing creditors with a mechanism for facilitating their individual or collective recovery from defaulting debtors, and providing debtors with tools of relief from their indebtedness and related burdens. From this second viewpoint, insolvency or bankruptcy regimes should also reduce the incidence of household over-indebtedness ex ante and reduce the private and social costs of over-indebtedness.
To this aim, some corrections may be necessary. A recent (and welcome) trend of regulators and courts in PI rethinks the concept of equality of actors in bankruptcy and insolvency procedures and takes into account the reality of the vast tools and expertise that strong corporate actors possess.
This approach recognizes a “special responsibility” on professional actors in managing insolvency and bankruptcy situations due to their enhanced power and means, which will hopefully lead to increased caution on their part, with an overall benefit for society as a whole.
[1] Dist.C 34802-03-16 Shames v. Official Receiver Tel Aviv, IsrSC, February 25 [2018]
[2] HCJ 9181/08 The First International Bank of Israel Ltd. v. Nesher Naftali, IsrSC, May 21 [2013]
[3] Dist.C 2216/04 Biton v. Official Receiver Tel Aviv, IsrSC, August 8 [2017]
[4] Paul Wallace, Simplifying the Muddled Doctrine of Debt Recharacterization, 86 Miss. L.J. 183 (2017)
[5] Financial Conduct Authority (FCA), “Voluntary Application for Imposition of Requirement: Wonga Group Limited” (25.06.2014) and “OFT Requirement Notice: Wonga.com Ltd” (21.05.2012) Available at: https://www.fca.org.uk/search-results?search_term=wonga
[6] Dist.C. 18314-07-14 Finger v. Official Receiver, IsrSC, May 5 [2018]
[7] Dist.C. 9556-10-16 Dror v. Official Receiver, IsrSC, July 1 [2018]