Why it Matters
Why does a good insolvency regime matter?
Keeping viable businesses operating is among the most important goals of bankruptcy systems. A good insolvency regime should inhibit premature liquidation of sustainable businesses. It should also discourage lenders from issuing high-risk loans—and managers and shareholders from taking imprudent loans and making other reckless financial decisions (2). A firm suffering from bad management choices or a temporary economic downturn may still be turned around. When it is, all stakeholders benefit. Creditors can recover a larger part of their investment, more employees keep their jobs, and the network of suppliers and customers is preserved.
Studies show that effective reforms of creditor rights are associated with lower costs of credit, increased access to credit, improved creditor recovery and strengthened job preservation (3). If at the end of bankruptcy proceedings creditors can recover most of their investments, they can keep reinvesting in viable firms and improving companies’ access to credit. Similarly, if a bankruptcy regime respects the absolute priority of claims, this allows secured creditors to continue lending and maintains confidence in the bankruptcy system (4).
Economy-specific research has shown that insolvency reforms that encourage debt restructuring and reorganization reduce both failure rates among small and medium-size enterprises and the liquidation of profitable businesses. After Belgium introduced a new bankruptcy law in 1997 that encouraged corporate rehabilitation rather than liquidation, bankruptcies among small and medium-size enterprises fell by 8.4%. (5) Similar results have been observed in Thailand and Colombia. In Thailand evidence suggests that reform of the bankruptcy laws reduced the expected costs of financial distress. (6) In Colombia bankruptcy reform made reorganization an attractive option for distressed but viable firms by reducing its costs, although this mainly benefited larger firms. About 40% of firms filing for reorganization under the old bankruptcy law underwent liquidation, while only about 26% did so under the new law. (7) Research has also shown that bankruptcy reform can aid in the quick recovery of an economy during a recession, as in Chile during the early 1980s and in Colombia in 1999. (8)
Even when bankruptcy laws are similar across economies, the use of bankruptcy procedures can differ because of differences in the efficiency of debt enforcement. If courts cannot be used effectively in a case of default, creditors and debtors are likely to engage in informal negotiations outside of court. And in economies with weak judiciary systems borrowers are more likely to exhibit risky financial behavior, which could lead to more defaults and higher levels of financial distress. Conversely, if a legal system is strong and debt enforcement procedures are well observed, debtors and borrowers are more likely to avoid taking unnecessary risks and to make prudent financial decisions. (9)
1. Djankov, Simeon, Oliver Hart, Caralee McLiesh and Andrei Shleifer. 2008. "Debt Enforcement around the World." Journal of Political Economy 116 (6):1105–49.
2. Claessens, Stijn, and Leora Klapper. 2003. "Bankruptcy around the World: Explanations of Its Relative Use." Policy Research Working Paper 2865, World Bank, Washington, DC.
3. Armour, John; Menezes, Antonia; Uttamchandani, Mahesh; and Van Zweiten, Kristen. “How Creditor Rights Affect Debt Finance” in Research Handbook on Secured Financing in Commercial Transactions (Dahan, F., ed.), 2015, Elgar Publishing.4. Simeon Djankov, "Bankruptcy Regimes during Financial Distress," World Bank, Washington, DC, 2009.
5. Dewaelheyns, Nico, and Cynthia Van Hulle. 2006. "Legal Reform and Aggregate Small and Micro Business Bankruptcy Rates: Evidence from the 1997 Belgian Bankruptcy Code." Small Business Economics 31 (4): 409–24.
6. Foley, C. Fritz. 1999. "Going Bust in Bangkok: Lessons from Bankruptcy Law Reform in Thailand." Giné, Xavier, and Inessa Love. 2006. "Do Reorganization Costs Matter for Efficiency? Evidence from a Bankruptcy Reform in Colombia." Policy Research Working Paper 3970, World Bank, Washington, DC.
7. Bergoeing, Raphael, Patrick J. Kehoe, Timothy J. Kehoe and Raimundo Soto. "A Decade Lost and Found: Mexico, and Chile in the 1980s." In Timothy J. Kehoe and Edward C. Prescott, editors, Great Depressions of the Twentieth Century, 217–56: Giné and Love (2006).
8. Claessens and Klapper (2003).
9. Claessens and Klapper (2003).