75240 JANUARY 2013 ABOUT THE AUTHORS VALENTINA SALTANE Measureable Results! A Topic Leader for the Doing Business project, Financial and Doing Business Project Encourages Economies Private Sector Development Vice Presidency, Valentina leads the research team for the Resolving to Reform Insolvency Frameworks Insolvency indicators and is a co-author of Doing Business 2012 Over the past 10 years, nearly 100 economies have reformed their insolvency and 2013. Before joining the World Bank Group in 2006, she regimes as a result of many factors, such as financial crises and to some extent the was a research analyst at the Law and Economic Consulting IFC/World Bank Doing Business project (Box 1). In the aftermath of the global Group and a program financial crisis, governments around the world implemented extensive insolvency coordinator for the World Resources Institute. reforms aimed at strengthening regulatory mechanisms for resolving insolvency cases—to stimulate entrepreneurship and generate a more efficient allocation of RONG CHEN market resources. This SmartLesson discusses two of the main best practices that joined the Doing Business team in February 2012 and currently stem from the key reform areas: determination of business viability, and introduction works on the Resolving Insolvency indicator. Prior to of reorganization proceedings. joining IFC, she worked for United Nations Population Fund and International Centre for Background Trade and Sustainable Development and was an investment consultant for a U.S. The IFC/World Bank data collection efforts series of insolvency reforms since 2008.2 The real estate investment trust. on the Resolving Insolvency indicator are number of insolvency reforms recorded by of paramount importance, because these Doing Business has almost tripled, increasing NURIA MOYA GUZM�N data help economies identify areas of much- from 10 reforms worldwide in Doing Business is a consultant for the Resolving Insolvency indicator at the Doing needed reforms. The 2008 financial crisis hit 2008 to 29 in Doing Business 2012. Business project, Financial and small and medium businesses worldwide, Private Sector Development Unit. Prior to joining IFC, Nuria worked pushing many to the edge of bankruptcy The Resolving Insolvency indicator examines as a production coordinator at with a series of aftershocks that contracted the time, cost, and outcome of insolvency Penguin Group and in credit financing, dampened market demand, proceedings involving domestic businesses development projects at the United Nations Development and tightened cash flows. For instance, from that operate in 185 economies. The data Fund for Women and the United 2008 to 2009, the number of businesses are derived from questionnaire responses Nations Educational, Scientific that filed for Chapter 11 in the United received from local insolvency practitioners and Cultural Organization. States soared from 6,971 to 11,785, and the and verified through the study of laws number of businesses that filed for Chapter and regulations in conjunction with public APPROVING MANAGER 7 increased from 560,015 to 819,362.1 information on bankruptcy systems. The Rita Ramalho, Program Manager, ranking on the ease of resolving insolvency Doing Business Unit, Financial and Private Sector Development Vice The upsurge of bankruptcy cases worldwide is based on the recovery rate, which is a Presidency. has challenged insolvency regimes in function of time, cost, and other factors unprecedented ways. The increase in such as lending rate and the likelihood that the number of firms in financial distress a company will continue to operate as a underscores the need for a transparent and going concern. The recovery rate is recorded predictable insolvency legal framework for as cents-on-the-dollar recouped by creditors reorganizing viable firms and liquidating through reorganization, liquidation, or debt unviable ones in a cost-effective and timely enforcement (foreclosure) proceedings. manner. It also calls for an efficient judicial system, equipped with specialized insolvency Lesson 1: Determine the viability of courts and administrators, to avoid case businesses facing insolvency backlogs and bottlenecks. In response to these urgent needs to strengthen insolvency A key characteristic of a good insolvency frameworks, 71 economies have initiated a regime is its ability to maximize an economy’s growth and employment 1 U.S. Courts on bankruptcy statistics http://www.uscourts. gov/Statistics/BankruptcyStatistics.aspx. Chapter 11 governs prospects by differentiating between viable the reorganization proceeding of businesses under the and unviable businesses. For a business that bankruptcy laws of the United States; Chapter 7 governs the 2 Major insolvency reforms counted according to the Doing liquidation proceeding. Business methodology. SMARTLESSONS — JANUARY 2013 1 (Figure 1). Analysis reveals a positive and statistically Box 1: IFC/World Bank Doing Business Project significant correlation between the use of insolvency administrators and the creditors’ recovery rates. The average recovery rate of economies where insolvency At the time of its launch in 2002, the Doing Business administrators determine the viability of firms is more project covered five indicator sets for 133 economies. than 10 percent higher than that of economies that use Currently, the project surveys 185 economies, ranking other mechanisms to distinguish viable from unviable them on 10 different indicator sets. The primary goal is businesses. Only about 4 percent of low-income to measure the business regulatory environment for economies grant an insolvency administrator the right to domestic small and medium enterprises. By collecting make a final decision about the future of businesses in comparable global data and ranking economies on the distress, whereas 20 percent of high-income economies ease of doing business, the project encourages do so. No economies in Europe and Central Asia or South governments to reform their business regulations to be Asia grant this power to insolvency administrators, while more conducive to doing business. 27 percent (the highest rate) of high-income OECD4 and Middle East and North Africa economies use insolvency IFC and the World Bank publish the country rankings in administrators to determine firm viability. annual Doing Business reports. This promotes competition among different states and inspires governments to expand their reform efforts even Lesson 2: Introduce a reorganization proceeding. further. Numerous economies have used the reports as a tool to inform their regulatory reform efforts. Many Doing Business data show that introducing an efficient governments, especially in low- and middle-income reorganization proceeding allows economies to advance economies, take Doing Business rankings seriously and in the ranking for ease of resolving insolvency. In the actively direct their reform efforts toward improving context of insolvency proceedings, the ultimate goal their rank. of reorganization is to allow the debtor to overcome its financial difficulties and resume or continue normal The Investment Climate Department at IFC provides commercial operations. In some cases, reduction of the local governments with technical assistance on the scope of the business or sale of the entire business as a Doing Business reform preparation and implementation. going concern would also be considered reorganization. The IFC/World Bank Doing Business subnational project also assists several countries with improving business regulations on a regional level. The IFC/World Bank Figure 1: Recovery Rates with/without Insolvency Doing Business project serves as a data platform for Administrators developing client engagement and generating reforms. is sustainable, this determination prevents premature liquidation, thus preserving the firm as an agent of future growth, protecting employees’ jobs, and safeguarding the network of suppliers and customers. For a business 4 OECD = Organisation for Economic Co-operation and Development. deemed unviable, a fast and low-cost liquidation proceeding permits an effective reallocation of resources to more productive and efficient sectors of the economy. Therefore, determining the viability of a business is the crucial first stage in resolving insolvency—keeping viable firms in existence and helping unviable firms make way for new firms, thereby promoting healthy competition in the economy. Note: The recovery rate and whether an insolvency In about half of the economies studied for Doing Business administrator makes the final decision on a 2013, insolvency laws establish objective criteria to company’s viability are positively correlated at a determine the type of proceeding to be initiated based statistically significant level of 5 percent, after on the viability of a business.3 The majority of economies controlling for income level. across all regions resort to the use of courts to decide Source: Doing Business 2013. whether a business should be liquidated. For example, in Hong Kong SAR, China, Section 178 of the Companies Though the Doing Business report does not pro- Ordinance (Chapter 32) specifies the standards to vide direct reform and policy recommendations to determine the viability of an insolvent firm, and the court governments (this is done by other IFC and World makes the final decision based on that regulation. Bank units), it does signal to policymakers what needs to be done to improve their debt enforce- ment mechanisms. (For an example of how the Recovery rates tend to be higher when specialized Doing Business data can be used as a tool to aid insolvency administrators make the final decision on the reform process, see Box 2.) firms’ financial conditions and their operational viability 3 The data sample contains 156 economies, excluding “no practice� economies and those with no data available on this issue. 2 SMARTLESSONS — JANUARY 2013 66 percent of high-income economies, and the average Figure 2: Most Common Insolvency Proceedings, by recovery rate is 61.8 cents on the dollar. Region Use of insolvency proceedings greatly varies across and within regions. For instance, 45 percent of OECD economies use reorganization as the most common insolvency proceeding to save viable firms and have an average recovery rate of 83 cents on the dollar, as opposed to 57 cents on the dollar with liquidation (Figure 2). In East Asia and the Pacific region, the average recovery rate for economies where viable businesses undergo reorganization is 82 cents on the dollar, more than twice that in economies that predominantly use liquidation or foreclosure to resolve similar insolvency cases. However, other regions, such as South Asia and Sub-Saharan Africa, lag behind, with less than 5 percent of their economies using reorganization proceedings to Note: The most common insolvency proceeding is save viable firms. This is, in part, because of the necessity coded as “foreclosure� for all economies in South to develop a strong institutional framework with active Asia. No economies in Sub-Saharan Africa are links between judicial courts and insolvency institutions. coded as “reorganization� for the most common Effective implementation of reorganization requires a insolvency proceeding. well-functioning insolvency regime to allow financial Source: Doing Business 2013. institutions to continue providing credit to the market and play an active role in the reorganization of firms. (See also Box 3.) Conclusion Incorporation of a reorganization proceeding in an insolvency framework helps add dynamism to the A sound insolvency regime can be an effective tool for economy and promote the development of an active fostering an efficient allocation of resources in an entrepreneurial culture. By preventing the unnecessary economy, thus increasing creditors’ recovery rates and liquidation of viable firms, reorganization offers a decreasing the cost and time needed to resolve insolvency turnaround opportunity for productive businesses facing cases. Evidence from the Doing Business data on the insolvency. Furthermore, reorganization encourages global practices for resolving insolvency reveals the an entrepreneurial culture of innovation through the importance of two prerequisites: 1) determining the introduction of a system that does not punish failure when viable firms can still be saved. For example, creditors receive higher recovery rates from businesses that keep Box 2: Streamlining the Process in Chile operating as going concerns than from firms that are sold piecemeal. Continued operation also results in the Chile provides a good example of recent reforms preservation of more jobs, supply chains, and customer designed to streamline the process of determining networks. the viability of businesses facing financial difficulties. In February 2010, the government of Chile enacted Law 40.416, introducing economic insolvency Globally, the average recovery rate of economies that advisors endorsed by the Superintendence of widely use a reorganization proceeding to preserve viable Bankruptcies to determine the viability of firms firms is more than two times higher than the recovery rate in financial distress. Upon the request of a small of economies where liquidation or foreclosure is the most or medium firm, the economic insolvency advisor commonly used proceeding. In most cases, reorganization conducts a study of the firm’s financial situation and allows companies to continue operating as going recommends reorganization if the firm is found to concerns. This significantly improves insolvent businesses’ be viable, or liquidation if it is deemed unviable. asset value compared to piecemeal sale of assets, which is usually conducted in a liquidation proceeding.5 According If the business complies with a set of requirements, to the Doing Business data, only 6 percent of low-income the advisor can issue an insolvency certificate economies tend to use reorganization proceedings to save validated by the Superintendence of Bankruptcies viable businesses in distress, and they have an average allowing the firm to defer trials for a period of recovery rate of 15.6 cents on the dollar. Conversely, up to 90 consecutive days. This comprehensive assessment of an insolvent firm’s financial situation viable insolvent businesses undergo reorganization in (to determine its viability) is expected to provide 5 According to the Legislative Guide on Insolvency Law (United Nations Commis- sufficient evidence for appropriate insolvency sion on International Trade Law, 2005), liquidation usually results in the dissolu- proceedings to commence and lay a foundation for tion or disappearance of a debtor that is a commercial legal entity and discharge the smooth processing of insolvency proceedings. of a natural person debtor. Although generally requiring the sale or realization Active reforms for resolving insolvency allowed of assets to occur in a piecemeal manner as quickly as possible, some insolvency Chile to improve the recovery rate from 19 cents on laws permit liquidation to involve the sale of the business in productive units or the dollar in 2004 to 30 cents in 2013. as a going concern; under other laws that is permissible only in reorganization. SMARTLESSONS — JANUARY 2013 3 Box 3: Dramatic Improvement in Latvia Latvia has been closely monitoring its progress on the Resolving Insolvency indicator, and its bankruptcy specialists have been working over the years to advance Latvia’s ranking. The country’s recent insolvency reforms exemplify an introduction of the reorganization proceeding into the insolvency legal framework. Since 2007, Latvia has introduced successive reforms to streamline insolvency proceedings and strengthen its regulatory framework. On November 1, 2010, Latvia passed its new Insolvency Law introducing reorganization to complement the existing liquidation proceeding. To do so, Latvia extended the responsibilities of insolvency administrators, making them liable for damages caused to the state, debtors, or creditors and putting them in charge of communicating with creditors. The law restored the debtor’s ability to settle its obligations and introduced a wide range of methods to keep a viable company operating as a going concern by, for example, increasing the debtor’s capital share. As a result of these successive reforms, Latvia experienced the biggest improvement worldwide on the ease of resolving insolvency. From 2009/10 to 2010/11, creditors’ recovery rate increased from 32 cents on the dollar to 56 cents. One of the important goals of a fully developed insolvency framework is to maximize the value of an insolvent estate and optimize the results for the parties involved in insolvency proceedings. It is desirable to have different insolvency proceedings available under legal frameworks to support flexible and practical arrangements that recoup more investments for creditors. viability of businesses in order to establish an shortening time limits of insolvency appropriate insolvency proceeding, and 2) procedures, and strengthening the rights of introducing reorganization proceedings, as a secured creditors. Economies vary complement to liquidation ones, to prevent significantly in their social and economic premature termination of viable firms. needs, so there is no “one-fits-all� insolvency reform. IFC/World Bank reform units need In addition to these prerequisites, many to work closely with client economies to economies have implemented other diagnose their inefficiencies in resolving important reforms to improve insolvency insolvency and help them develop resolution mechanisms, such as specifying appropriate reform strategies to make the professional or academic qualifications resolving insolvency faster, cheaper, and of insolvency administrators, introducing or more efficient. DISCLAIMER SmartLessons is an awards program to share lessons learned in development-oriented advisory services and investment operations. The findings, interpretations, and conclusions expressed in this paper are those of the author(s) and do not necessarily reflect the views of IFC or its partner organizations, the Executive Directors of The World Bank or the governments they represent. IFC does not assume any responsibility for the completeness or accuracy of the information contained in this The Doing Business team thanks contributors for providing survey data. document. Please see the terms and conditions at www.ifc.org/ smartlessons or contact the program at smartlessons@ifc.org. 4 SMARTLESSONS — JANUARY 2013