Insolvency Law as a Catalyst for Growth

The role of insolvency law in the real economy

Insolvency law plays an essential role in the real economy. From an ex ante perspective, that is, before a situation of insolvency arises, the design of insolvency law affects how debtors and creditors make decisions. For instance, if creditors believe that an insolvency system does not protect their rights or it does not help them maximize their recoveries if their debtors become insolvent, they will rationally become reluctant to extend credit. Therefore, an unattractive insolvency regime for creditors will harm firms’ access to finance and the promotion of economic growth. Similarly, an insolvency system that severely punishes honest but unfortunate debtors may discourage individuals from starting a business or taking risks. As a result, it will reduce the levels of entrepreneurship and innovation in a country.  Likewise, if an insolvency regime imposes a tough liability regime on the directors of insolvent firms even when it is shown that they acted in good faith, highly qualified managers may be discouraged from serving on corporate boards or they will be incentivized to take suboptimal levels of debt or risk. Alternatively, they will require higher salaries or more protective insurance policies whose costs will be borne by the shareholders and ultimately consumers. Hence, insolvency law has a direct impact on a country’s real economy even if borrowers do not eventually become insolvent and the insolvency system is not finally used. As a result, insolvency law can paradoxically be more relevant for solvent than for insolvent firms. 

Yet, the raison d’être of insolvency law is to deal with a situation of insolvency. Therefore, insolvency law is expected to play an essential role ex post, that is, once a situation of insolvency occurs. On the one hand, an efficient insolvency framework should maximize the returns to creditors. By doing so, it will be able to reduce the losses eventually borne by the creditors of an insolvent firm and it will indirectly perform other valuable functions for the real economy such as preventing other situations of insolvency and reducing the levels of non-performing loans (“NPLs”) in the banking sector.  On the other hand, an efficient insolvency regime should facilitate the reorganization of viable but financially distressed companies as well as the quick liquidation of nonviable firms. Thus, insolvency law will contribute to the efficient reallocation of resources in the economy. Moreover, if a viable firm is saved, insolvency law will also have the ability to benefit employees, suppliers, tax authorities, and other stakeholders.

Additionally, adopting an attractive insolvency framework for debtors and creditors can bring other benefits to a local economy. For instance, a jurisdiction with an efficient insolvency framework for creditors will become a more attractive forum for lenders and financial services.  Similarly, an efficient insolvency framework for debtors may increase the number of companies potentially interested in operating or conducting a debt restructuring in a particular jurisdiction. As a result, countries can benefit from the job opportunities created in the legal and financial industries, as well as other sources of income generated by increased levels of trade, foreign investments, consumption, and tax revenues. 

              Therefore, insolvency law can serve as a catalyst for growth. Thus, even though an efficient insolvency system is essential for any country, it becomes even more relevant for emerging economies due to their potential for growth and their greater financial needs. Unfortunately, many emerging economies do not have efficient insolvency frameworks. Sometimes, the existence of inefficient insolvency frameworks is due to the lack of political will to embark on insolvency reforms. In other countries, however, the insolvency legislation has been modernized in the past decades. Yet, the insolvency system does not seem to work effectively. In fact, it might not even be used – or at least not very often.

The need to reinvent insolvency law in emerging economies and beyond

              In my recent book, entitled 'Reinventing Insolvency Law in Emerging Economies', I argue that insolvency law in many emerging economies fails to serve as a catalyst for growth. This failure is mainly due to the design of an insolvency legislation that is not tailored to the market and institutional environments generally existing in emerging economies. Therefore, insolvency law in emerging economies needs to be reinvented. The book also provides a critical analysis of the design of insolvency law in many advanced economies where the insolvency system has proven to be unattractive for debtors, creditors or both. Therefore, it is argued that insolvency law needs to be revisited beyond emerging economies.  

The economic functions of corporate insolvency law

         The book starts by analyzing the role of insolvency law in the real economy, emphasizing the two primary functions that, from an ex post perspective, an efficient insolvency system should perform. The first function consists of minimizing the loss of value experienced by financially distressed firms. This can be done through a variety of tools used by insolvency law that may range from a moratorium or a majority rule to provisions such as restrictions of ipso facto clauses, a cross-class cramdown, or the existence of debtor-in-possession ('DIP') financing. The second function consists of promoting the efficient allocation of the debtor’s assets, that is, making sure that the assets are put to their best use regardless of the outcome of the insolvency process (e.g., reorganization, piecemeal liquidation or going concern sale). By achieving these functions, it is argued that insolvency law will be able to perform various socially desirable goals, including: (i) the maximization of the returns to creditors; (ii) the reorganization of viable but financially distressed companies; (iii) the preservation of the jobs created by viable but insolvent firms; (iv) the reallocation of assets and employees of nonviable firms towards more productive activities; and (v) the promotion of financial stability. Moreover, from an ex ante perspective, an insolvency system will be able to foster entrepreneurship, innovation, access to finance, job creation and economic growth.

Factors affecting the optimal design of insolvency law

The book argues that, while insolvency law seeks to solve similar economic problems across jurisdictions, the intensity of these problems and the desirability of a particular insolvency response depend on a variety of country-specific and firm-specific factors that should be considered in the design of insolvency law. These factors include divergences in corporate ownership structures, debt structures, levels of financial development, firm size, sophistication of the judiciary, credibility and expertise of insolvency practitioners, efficiency of insolvency proceedings, and the political economy of insolvency law.

After examining the market and institutional environment existing in emerging economies (Chapter 2), and the similarities and divergences observed in the design of insolvency law around the world (Chapter 3), the book suggests different pillars for the design of insolvency law in emerging economies (Chapter 4-8) and beyond (Chapter 9).

Building blocks for the design of insolvency law in emerging economies

The proposed approach for the design of insolvency law in emerging economies is based on three premises that are derived from the analysis conducted in Chapters 2 and 3. The first premise is that emerging economies generally have a weak market and institutional environment. As a response to this reality, it is argued that the involvement of courts, insolvency practitioners, and public authorities should be minimized in insolvency proceedings in emerging economies. As discussed in Chapters 4 to 8, this goal can be achieved by adopting several strategies such as reducing the power and discretion of courts and insolvency practitioners, promoting market and contractual solutions led by debtors and creditors, and empowering creditors in insolvency proceedings.

The second premise is that most emerging economies have inefficient insolvency proceedings as a result of an unattractive insolvency law, an unattractive market and institutional environment, or both. Therefore, the initiation of insolvency proceedings usually ends up being value-destroying. As a response to this reality, it is argued that the usage of formal insolvency proceedings should be minimized in emerging economies. As mentioned in Chapters 4 to 8, this goal can be achieved by adopting various strategies such as the promotion of workouts and hybrid procedures, not requiring corporate directors to immediately initiate insolvency proceedings once a company becomes insolvent, and allowing companies to choose their insolvency forum.

The third premise is that most firms in emerging economies are micro and small enterprises ('MSEs') and medium and large companies with controlling shareholders. As a response to this reality, the insolvency framework suggested in the book includes various aspects that seek to address the particular problems and needs of those firms. Moreover, while MSEs and controlled firms prevail in most countries around the world, emerging economies present some unique features that require different solutions, as discussed in Chapters 6 and 7. For example, some of the challenges faced by MSEs in insolvency can be addressed by promoting workouts and implementing a simplified insolvency framework for MSEs that significantly reduces the involvement of courts and public authorities. For controlled firms, it is argued that the higher risk of opportunism of shareholders vis-à-vis creditors can be partially addressed by empowering creditors in insolvency proceedings and requiring the appointment of an insolvency practitioner that, as a general rule, should serve as a monitor instead of an administrator replacing the debtor’s management team.

Conclusion

Insolvency law can serve as a catalyst for growth. Unfortunately, many countries often adopt insolvency laws that usually replicate practices and procedures existing in countries with totally different market and institutional environments. My book argues that these undesirable legal transplants have led to the failure of insolvency law in emerging economies, undermining the ability of insolvency law to reduce poverty and promote growth in countries where achieving these goals is more urgently needed. As a result, insolvency law in emerging economies needs to be reinvented. The book also provides a critical analysis of the design of insolvency law in many advanced economies where the insolvency system has proven to be unattractive for debtors, creditors or both. Therefore, it is argued that insolvency law may also need to be revisited beyond emerging economies.  

Aurelio Gurrea-Martínez is an Associate Professor of Law and Head of the Singapore Global Restructuring Initiative at Singapore Management University. 

This article is a summary of the first chapter of the book. It can be found here and the entire book here.