90759 NOTE NUMBER 343 viewpoint PUBLIC POLICY FOR THE PRIVATE SECTOR juLY 2014 Debt Resolution and Business Exit This Viewpoint has been Insolvency Reform for Credit, Entrepreneurship, and Growth T r a d e a n d C o m p e t i t i v e n e s s G l o b a l P r a ct i c e prepared by the Debt Resolution & Business The willingness o f b a nk s a nd inv e s t o r s t o s up p o r t ne w b us in e s s e s Exit team of the World Bank Group Trade & d e p e nd s a great d e a l o n t he r ule s t ha t g o v e r n f a iling b us ines s e s . Competitiveness Global Ef f ective insolvenc y r e g im e s s a v e s t r ug g ling f ir m s whe n p o s si b l e , Practice. It is based upon or re allocate as s e t s o f f a iling f ir m s m o r e p r o d uc t iv e ly . T he s e research undertaken by Kristin van Zwieten, p roced ure s—f oc us e d o n t he e nd o f t he b us ine s s lif e c y c le — h a v e a Clifford Chance p rof ound imp act o n t he b e g inning . B a nk s a nd inv e s t o r s a r e m o r e Associate Professor of Law and Finance, University willing to le nd whe n t he y k no w t he y c a n r e c o v e r a t le a s t s o m e o f of Oxford, and T. Natalie the ir inve stme nt . Ent r e p r e ne ur s a r e m o r e willing t o e nt e r t h e m a r k e t Mrockova, doctorate candidate, University of whe n the y are n o t p ut t ing t he ir e nt ir e p e r s o na l f o r t une s a t r i s k . T h i s Oxford. The author is V iewp oint e xamine s lit e r a t ur e t ha t q ua nt if ie s t he im p a c t o f e f f e c t i v e Antonia Menezes, insolve ncy regim e s . Senior Private Sector Development Specialist. 1 Need for insolvency reform weak insolvency regimes, struggling companies The World Bank Group Enterprise Survey of and their assets often languish unproductively, businesses in 135 emerging markets shows limiting creditor recovery. In countries where that almost 60 percent of businesses require unincorporated businesses such as sole traders a loan at some point, while only just over one- are subject to personal bankruptcy regimes, third of businesses have a loan or line of credit. owners of struggling small businesses often face THE WORLD BANK GROUP Well-designed insolvency laws are one of the the threat of a lifetime of debt. Banks worried factors that can help businesses access these about their ability to recover loans may limit crucial loans. A number of published studies their lending to those borrowers that present the associate effective insolvency reform with a least risk, or they may impose extensive collateral lower cost of credit, increased access to credit, requirements that small entrepreneurs cannot improved creditor recovery, strengthened job meet. preservation, promotion of entrepreneurship, Given that market exit is an integral part of and other benefits for small businesses. Countries the business life cycle, particularly in times of that implement sound insolvency regimes crisis, even developed economies with more reduce the cost of credit and increase overall efficient insolvency regimes are faced with economic stability. In contrast, in countries with addressing business failure. More than five e b t R e s olution D ebt a n d B u s ine o l u t i o n and it Insolvency Reform for C i n e s s E x it Crredit, Entrepreneurship, and Growth years from the onset of the global financial crisis, ensures an orderly payment process, avoiding a many wealthier countries continue to flounder, chaotic race by creditors to collect. Unlike bilateral with weak financial markets and many indebted debt enforcement, all creditors participate in firms. The Credit Reform Economic Research insolvency proceedings, and effective insolvency Unit reported that between 2010 and 2011 regimes aim to provide a balance of both debtor corporate insolvencies increased by 6.4 percent protection5 and creditor recovery. Finding this in Belgium, 18.7 percent in Spain, and 7 percent balance is one of the main challenges that policy- in Ireland.2 Reorganizations of multinationals makers face when designing an insolvency law. such as U.S.-based General Motors,3 where at The best approaches will be tailored to meet the 2 least 1.2 million jobs in the automotive supply particular needs, characteristics, and economic chain were at stake, and Eurotunnel4 with 2,300 and social goals of a given country. The literature employees and 800,000 shareholders, emphasize shows that effective insolvency regimes preserve the far-reaching and cascading effects of business jobs by facilitating the survival of distressed but distress and subsequent business rescue on jobs, viable businesses, reduce credit risk, and attract business supply chains, and bank reserves. The venture capital and associated high-quality financial crisis has shown that even countries innovation, particularly vis-à-vis smaller firms.6 with more established and orderly insolvency procedures are looking at ways to make their I. Effective insolvency regimes are associated economies more resilient through improvements with a lower cost of credit in their debt resolution systems. Credit opens markets to entrepreneurs and promotes expansion of successful businesses. Benefits of effective insolvency frameworks Credit lines help to ease liquidity shortfalls The World Bank Development Report 2014 states inevitable to business. Constrained credit that “Bankruptcy law and the depth of resale supplies, on the other hand, limit growth as markets are particularly important to liberate liquidity concerns reduce lenders’ willingness productive resources from an unproductive to take risk. A 2007 study in China showed that enterprise and to ensure that creditors and after the enactment of credit and property rights potential investors in other enterprises are reforms, firms could more readily invest in growth protected if a business fails.” Insolvency law opportunities, with less sensitivity to cash flow.7 provides an orderly process for the reorganization The World Bank Group World Development or liquidation of insolvent entities in a collective Indicators have shown that access to credit is a manner. It serves as an important safety net for constraint in many parts of the world. Table 1 business activity, ensuring that when businesses shows that in many countries, domestic credit face financial difficulties, mechanisms are provided by banks as a percentage of GDP is available to either rescue them or maximize the below 50 percent. value realized from their assets through their Indeed, the World Bank Group Enterprise deployment to more productive firms. It also Surveys8 of more than 130,000 firms in 135 Table Domestic credit provided by banking sector (% of GDP) 1 Region Domestic credit as a percentage of GDP for 2012 Least developed countries: UN classification 29.9% Middle East & North Africa 37.4% Europe & Central Asia 62.6% South Asia 71.1% Latin America & Caribbean 73.6% East Asia & Pacific 141.5% European Union 156.0% OECD members 205.8% Source: World Bank Development Indicators (Financial Indicators) countries documents that access to a bank loan or credit to SMEs of reorganization and liquidation line of credit is restricted in developing regions— reforms. Supplementing their analysis of loan- particularly Africa—in relation to the number of level data with firm-level data on borrowers, firms requiring such financing. Table 2 shows that the authors found that the liquidation reform more than half of firms in developing regions led to a decrease in interest rates, although the need a loan, but in none of these regions are reorganization reform had the opposite effect.9 more than half the firms able to access credit, In particular, firms with higher numbers of bank with access acutely tight in the Middle East. creditors saw the most pronounced reduction in Insolvency laws directly affect the willingness of interest rates due to the enhanced coordination 3 lenders to extend credit, and the terms on which provided by the bankruptcy law. they are prepared to lend. A study across France, Germany, and the United Kingdom showed that II. Effective insolvency regimes are associated banks price loans based on their rights in case with increased availability of credit of default, and price them higher to mitigate Effective insolvency systems enhance creditor-unfriendly aspects of the bankruptcy law. predictability and thus lender confidence in The study sampled similar small and medium loan recovery upon default, which encourages enterprises (SMEs) that had defaulted on bank more lending and leads to financial inclusion loans. The authors examined whether differences for more businesses. in the level of creditor rights in bankruptcy in A 2012 study of Brazil’s 2005 bankruptcy the different jurisdictions had an impact on law reform compared accounting data pre- and lending terms. After adjusting for other factors, post-reform from 698 publicly traded firms10 in they found that French banks required more Brazil, Mexico, Argentina, and Chile to evaluate collateral, and specific forms of collateral, than the impact of the reform on loan terms and levels in the other two countries because of provisions of debt. The authors put their firm-level data in in the French bankruptcy code, which were context by considering aggregate data on credit unfavorable to creditors. The study also found market development in Brazil as compared with that France, the least ‘creditor friendly’ country the other countries. The authors reported a among the three, had a significantly lower rate of statistically significant increase in the Brazilian business recovery than in Germany or the United private credit market after the 2005 reform, an Kingdom. Limiting the availability of credit increase not replicated in the other jurisdictions enabled French banks to mitigate, but not fully that had not implemented insolvency reform. avoid, the costs of “unfriendly” bankruptcy laws. At the firm level, the authors reported a 10- to Reforming an insolvency regime can help 17-percent increase in total debt and a 23- to lower interest rates, making credit more 74-percent increase in long-term debt, although affordable. A 2012 study examined Italy’s 2005 with no evidence of change in short-term debt. reform of its reorganization and liquidation The authors attributed a significant fall in trade procedures under the bankruptcy law. The study credit to the increased availability of other separately analyzed the impacts on the cost of forms of debt financing. They also reported a Table Enterprise Survey data reporting firms’ access to credit 2 Economy Percentage of firms with a bank loan/line of credit Percentage of firms not needing a loan East Asia and Pacific 37.7 44.9 Eastern Europe and Central Asia 41.2 46.4 Latin America and Caribbean 47.6 42.1 Middle East and North Africa 6.0 38.1 South Asia 34.8 40.3 Sub-Saharan Africa 23.8 34.1 D ebt R e s olution and B u s ine s s E x it I n s o l v e n c y R e f o r m f o r C r e d i t , E n t r e p r e n e u r s h i p , a n d G r o w t h 7.8- to 16.8-percent reduction in the cost of debt the percentage of domestic credit by the banking financing for the Brazilian firms.11 In short, the sector is 0.70. The correlation is significant even study found that the reform helped make credit at the 1 percent level. More developed insolvency more available, and on better terms.12 systems that have a variety of tools to address Just as an effective insolvency system promotes financial distress are positively associated with access to credit, a weak system inhibits it. A 2008 higher levels of credit and, conversely, less study comparing 88 countries found that failure developed systems with lower aggregate credit to enforce debt contracts, including inefficient levels have lower recovery rates. bankruptcy proceedings, reduced the amount It is interesting to note that a 2014 study tested 4 and quality of available credit at the macro level.13 the effect of 38 selected indicators on seven The World Bank Group Doing Business report measures of the regulatory and institutional for 2014 uses a resolving insolvency indicator to environment. Among the 38 indicators, the measure the time, cost, and outcome of insolvency study identifies the recovery rate of the resolving proceedings involving a financially distressed insolvency indicator of the Doing Business report small domestic company.14 The methodology as the single most valuable measure.15 for measuring the recovery rate for creditors— the percentage of their original investment III. Effective insolvency reforms are they recover in a liquidation or reorganization associated with increased returns to proceeding—depends on these three variables. creditors If a distressed company emerges from the Studies have shown that insolvency reforms proceedings as a going concern, the recovery rate improve creditor returns in cases of loan tends to be higher than when a failed company’s default. A 2007 study in Mexico showed that the assets are sold piecemeal. Figure 1 shows a strong enactment of a new corporate insolvency law, correlation between the indicator’s recovery which was designed to reduce delay and ensure rate and the availability of domestic credit better filtering of non-viable from viable debtors, from a country’s banking sector (measured as a increased the average recovery rate for secured percentage of GDP). The correlation coefficient creditors from 19 cents on the dollar to 32 cents between the Doing Business 2014 recovery rate and on the dollar, and shortened the duration of proceedings from an average of 7.8 years to 2.3 Figure Credit, debt recovery correlation years.16 1 120 A 2012 study of 348 formal insolvencies in the United Kingdom showed that giving unsecured creditors more control in insolvency through 100 the new administration procedure increased gross levels of returns. The study examined the Japan effects of abolishing the use of receivership, 80 whereby, a creditor with security over the whole Mexico of a company’s assets could appoint a receiver to assume control over the debtor and conduct a 60 ”private liquidation.” Administration, introduced greater accountability to unsecured creditors through a combination of improved voting rights 40 and fiduciary duties. In addition to increasing South Africa the gross level of returns, administration also reduced the duration of cases from a median of 20 Vietnam 602 days17 under the receivership procedure to 358 days18 for the administration procedure. The São Tomé and Principe study showed that the financial gains in returns 0 Ϫ50 0 50 100 150 200 250 300 350 400 from using the administration procedure were partially offset by an increase in the costs, because of more court appearances and procedural R eorganization proceedings present the best outcomes Figure  2 requirements.19 The Doing Business report’s resolving insolvency DB 14 recovery rate 100 indicator for 2014 illustrates that economies that combine developed insolvency systems with 90 effective reorganization frameworks produce 80 79.2 Receivership higher recovery rates for creditors compared to 70 Reorganization countries that have not updated their insolvency 60 Liquidation procedures (see Figure 2). 50 52.7 Foreclosure 40 IV. Effective insolvency reforms are 33.1 30 29.8 associated with job preservation through 20 reorganization and business rescue 10 Businesses in severe financial distress, such as a cash-flow crisis, sometimes have no option 0 0 50 100 150 200 but to liquidate and close. If well managed, Domestic credit provided by banking sector (% of GDP) this can result in the redeployment of assets to more productive firms and improved economic Note: Size of the bubble shows the number of economies. Number inside the bubble shows average recovery rate. efficiency. However, it can also lead to significant job losses and diminished value for owners and proceedings, 65 percent concluded with the new creditors. A business that can overcome financial owner preserving the entire work force. For pre- difficulties will be able to preserve jobs, keep packaged sales, full retention of the work force supply chains intact, and retain asset value. was achieved in 92 percent of the cases.22 Even Formal insolvency tools have been shown to be where some job loss occurred, job retention was effective in encouraging the healthy recovery still significant. In 73 percent of the cases where and rehabilitation of financially distressed firms. business sales resulted in some job loss, the new A corporate reorganization code in Colombia owner was able to retain at least three-quarters of enacted in 1999 dramatically improved the the work force. For prepackaged sales involving efficiency of reorganization proceedings. some job loss, 95 percent concluded with at least The duration of the proceedings fell from an three-quarters of the work force still on the job.23 average of 34 months to 12 months. The authors These numbers demonstrate the ability of a well- of a study of the code found that, post-reform, functioning insolvency regime to preserve jobs liquidating firms were unhealthier than before on a meaningful scale. and reorganizing firms were healthier. They concluded that the reform allowed for self- V. Effective personal insolvency reforms selection of healthy firms to opt for reorganization support entrepreneurship rather than liquidation, and to do so sooner. After Entrepreneurship creates jobs, increases controlling for macroeconomic conditions, the productivity, and promotes innovation.24 Recent authors found that reorganized firms were able studies show that start-ups and newly established to recover faster under the new law, and achieved firms produce multiplier effects that can increase greater equity value.20 long-term employment growth rates at companies Effective reorganization in countries such as throughout an entire region.25 Colombia and Belgium can allow a company’s Venture capital funding provides valuable workforce to remain employed and productive. support to entrepreneurship and innovation. A This outcome can also be achieved through 2004 study of the United States and 10 European formal procedures that facilitate the sale of countries found a correlation between debtor- the company’s business on a going concern friendly personal bankruptcy regimes and basis. Recent studies in the United Kingdom21 levels of venture capital funding. The authors showed that of all the sales of businesses as going speculated that greater protections for personal concerns during receivership or administration assets, with more “forgiving” bankruptcy regimes, D ebt R e s olution and B u s ine s s E x it I n s o l v e n c y R e f o r m f o r C r e d i t , E n t r e p r e n e u r s h i p , a n d G r o w t h made entrepreneurs more willing to commit micro businesses. The reform involved three their own resources and better able to attract major changes: other venture capital.26 n Introduction of a new court-supervised At the level of bank lending to businesses, reorganization procedure. effective insolvency laws strengthen creditor n Implementation of an early warning system rights and promote access to credit and growth. for financial distress by the establishment of At the level of the individual entrepreneur or special units in charge of monitoring firms’ consumers, laws that are more debtor-friendly financial health. can also encourage growth. Entrepreneurs n Amendments to the liquidation procedure to 6 often have to commit personal assets to start ensure the recognition of retention of title a business, and personally guarantee loans to interests, thereby strengthening property the new venture. A safety net provides a certain rights. level of protection through personal insolvency The authors reported a lower failure laws, and appears to encourage the risk-taking rate in the post-reform period than in the necessary for entrepreneurship and innovation.27 period immediately preceding reform. After Several studies have shown a connection controlling for various factors, they found that between a country’s personal insolvency law and the reduced failure rates occurred in small and entrepreneurship. A 2003 survey compared asset micro businesses in two sectors in particular— exemptions during insolvency proceedings (for manufacturing and trade.31 They attributed the the residential home, personal effects, retirement improvement to the strengthened the recognition accounts, and other personal assets) among U.S. of proprietary interests in liquidation. states. The survey of 20,000 families found that Small and medium enterprises were most there are more entrepreneurs in those states affected by Italy’s 2006 insolvency reforms. In with higher asset exemptions.28 A 2008 study a study comparing interest rates pre- and post- that compared self-employment in 15 countries reform, “riskier” SMEs, those more likely to in Europe and North America between 1990 default, were shown to have lower interest rates and 2005 found that more forgiving personal after the liquidation reform. The authors of bankruptcy laws, measured particularly in the study used loan-level data on 202,964 SMEs reference to the time a bankrupt individual has and 1,097 banks to prove their assumption that to wait to be discharged from pre-bankruptcy improved creditor control during liquidation debts, combined with ready access to limited raised the liquidation value of firms, which led liability protections, enhance entrepreneurial to lower interest rates for the SMEs in the riskier activity.29 A 2009 study, again comparing U.S. group.32 In China, a 2013 study of reforms that states and their bankruptcy exemptions for made it easier for secured creditors to foreclose personal property, found that the probability of on collateral and restricted expropriation of starting a business is 25 percent higher in states private property held by local government found with higher exemptions.30 that the changes enabled firms to respond to growth opportunities due to greater access to VI. Effective insolvency reforms are credit with less sensitivity to cash flow.33 associated with benefits for small firms Small and micro firms may be the primary Conclusion beneficiaries from certain insolvency reforms. Effective insolvency regimes have a dual aim: to When increased availability of debt financing save viable businesses and to ensure that non-viable leads to businesses being able to pay suppliers businesses can quickly exit the market, allowing on time, or allows a company to finance cash the deployment of assets to more productive firms. shortfalls through credit lines, small businesses In achieving these dual goals, strong insolvency are less susceptible to failure due to liquidity regimes aim to balance creditor and debtor rights, issues. A 2008 study examined the impact of a maximizing recovery, providing a safety net for reform by Belgium in 1997 affecting small and financially distressed debtors and impacting numerous economic indicators including credit, 6. E. Cirmizi, L. Klapper and M. Uttamchandani, job preservation, and entrepreneurship. Moreover, “The Challenges of Bankruptcy Reform,” The World the quality of an insolvency regime affects the Bank Research Observer Advance Access willingness of investors, banks, companies, and (July 2011). entrepreneurs to take risks and invest in growth. 7. D. Berkowitz, C Lin & Yin Ma 2013 As the studies described here demonstrate, an 8. http://www.enterprisesurveys.org/data/explore effective insolvency system can enhance all of topics/finance these measures and promote economic growth. 9. Rodano, Serrano-Velarde, Tarantino (2012) Empirical evidence points to the importance 10. 338 (around half) Brazilian firms, 108 Mexican, 82 7 of developing effective and efficient insolvency Argentine and 170 Chilean. systems through thoughtful, targeted reform, and 11. Depending on which model was used: Araujo, the results can be felt economy-wide, in improved Ferreira and Funchal 2012 investment climate, economic growth, and job 12. Funchal 2009 creation. 13. Djankov, Hart, McLiesh and Shleifer 2008 14. Doing Business 2014 15. Kray and Tawara (2014) – upcoming. 16. M. Gamboa-Cavazos and F Schneider, 2007) Notes 17. Mean was 627 days 1. This Viewpoint was prepared under the World 18. Mean was 357 days Bank Group Debt Resolution & Business Exit 19. Armour, Hsu and Walters 2012 (DRBE) program, under the leadership of Mahesh 20. Gine and Love 2010 Uttamchandani. The DRBE program is part of 21. Frisby 2007, Polo 2011 the World Bank Group’s Trade & Competitiveness 22. i.e. sales negotiated in anticipation of the Global Practice Business Regulation work, led by commencement of the formal proceedings, and Najy Benhassine. The author wishes to gratefully executed on entry into those proceedings. acknowledge the contributions to this viewpoint 23. Ibid. by Angana Shah, Andres Martinez and Fernando 24. Mirjam Van Praag, Peter H. Versloot, Dancausa. (University of Amsterdam), “The Economic 2. Creditreform Economic Research Unit Benefits and Costs of Entrepreneurship: A Review 3. Sean P. McAlinden, Debra Maranger Menk, of the Research”, Foundations and Trends in “The Effect on the U.S. Economy of the Successful Entrepreneurship, Vol. 4, No. 2, pp. 65-154, 2008. Restructuring of General Motors”, CAR Research Available at SSRN: http:/ssrn.com/abstract= Memorandum, Center for Automotive Research, 1625828. December 5, 2013, describing the effects of a scenario 25. Mirjam Van Praag, Peter H. Versloot, (University where General Motors was not rescued, and suppliers of Amsterdam), “The Economic Benefits and Costs were bankrupted in a cascading effect, with estimated of Entrepreneurship: A Review of the Research”, job losses of 1.2 million. Foundations and Trends in Entrepreneurship, Vol. 4, 4. New York Times, January 15, 2007, “French court No. 2, pp. 65-154, 2008. Available at SSRN: http:/ssrn approves Eurotunnel restructuring – Business- .com/abstract=1625828. International Herald Tribune” and “Insolvency warning 26. Armour, J., “Personal Insolvency and the Demand at Eurotunnel”, BBC News, July 13, 2006, news.bbc. for Venture Capital”, European Business Organization co.uk/2/hi/business/5175188.stm describing the Law Review (2004) at 87. 2,300 employees and 800,000 shareholders who would 27. Uttamchandani and Menezes 2010 be affected in addition to Eurotunnel riders if a 28. Fan and White 2003 reorganization deal could not be reached. 29. Armour 2009 5. The nature of the ‘protection’ required will of course 30. Mathur 2009 vary depending on whether the debtor is an individual 31. N Dewaelheyns and C van Hulle 2008 person or a legal entity such as a limited liability 32. Rodano, Serrano-Velarde, Tarantino (2012) corporation. 33. 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