The Role of Corporate Insolvency Law in the Promotion of Economic Growth
By Aurelio Gurrea-Martínez (Singapore Management University)
Despite the bad connotations traditionally associated with insolvency proceedings, corporate insolvency law plays an essential role in the economy. Namely, a well-functioning insolvency regime can be a powerful tool to promote entrepreneurship, access to finance, innovation, and economic growth. In order to achieve these goals, however, a corporate insolvency regime should perform two primary functions: (i) minimising the destruction of value generated in a situation of insolvency; and (ii) putting the debtor's assets to their best use.
How corporate insolvency law can minimise the destruction of value
A situation of insolvency usually leads to a destruction of value at the expense of debtors, creditors, employees and society as a whole. First, when debtors are unable to pay their debts, creditors become entitled to enforce their claims and ultimately seize the debtor’s assets. Therefore, their individual enforcement actions may end up destroying the going concern value of economically viable companies just facing financial difficulties. As a response to this problem, corporate insolvency laws generally provide viable debtors with a moratorium (or automatic stay) that will stop creditors from enforcing their claims while facilitating a more coordinated action among them. Thus, the use of a moratorium not only preserves value for the debtor and society as a whole but it can also promote a more efficient action by the company's creditors (Jackson, 1986).
Second, the existence of a situation of insolvency may incentivise key employees to abandon the firm. Similarly, suppliers and lenders may decide to terminate their business relations with the debtor if they know that their claims might go unpaid. Therefore, as these circumstances can also destroy value for a viable company facing financial difficulties, insolvency law helps minimise these costs by providing various regulatory responses. On one hand, insolvency laws may prohibit the termination of ipso facto clauses, that is, contractual terms allowing parties to terminate a contract if their debtor initiate an insolvency proceeding. On the other, corporate insolvency law generally allows post-petition claimants to obtain a priority for their new claims, usually in the form of administrative expenses. Moreover, in some countries, such as Singapore and the United States, the existence of rescue (or DIP) financing provisions allow debtors to borrow money providing lenders with a super priority. Therefore, corporate insolvency law can serve as a 'liquidity provider' for companies facing a problem of financial distress (Ayotte & Skeel, 2013).
Third, debtors facing financial trouble may have incentives to engage in a series of opportunistic behaviours that can destroy or divert value at the expense of creditors. These opportunistic behaviours may include the transfer of assets to related parties, borrowing money in an irresponsible manner, or investing in risky projects as a last attempt to rescue the firm (Armour et al, 2017). In order to solve these problems, insolvency law provides several mechanisms, including avoidance actions and, in some jurisdictions, special duties and liability in a situation of insolvency (Gurrea-Martinez, 2020a). Likewise, once the debtor is subject to an insolvency proceeding, most jurisdictions around the world require the appointment of an insolvency practitioner to manage or supervise the debtor. By doing so, the risk of engaging in opportunistic behaviour will be notably reduced.
As a result of the aforementioned legal strategies seeking to address some of the economic problems generally existing in a situation of financial distress, corporate insolvency law can serve as a valuable tool to preserve value for the benefit of debtors, creditors and society as a whole.
How corporate insolvency law can put the debtor's assets to their best use
The second function performed by an efficient corporate insolvency regime is making sure that the debtor's assets are put to their best use (White, 1989). If a business is not competitive enough in the marketplace, this outcome will be achieved by reallocating the assets of these businesses towards more productive activities. If a company has a viable business but the creditors do not trust the shareholders/managers, an efficient corporate insolvency framework should promote the preservation of these businesses through going concern sales. Finally, if a company is economically viable, and therefore it is worth more if the assets are kept together under the management of the existing shareholders/directors, corporate insolvency law should provide the right tools to facilitate the reorganisation of these companies by letting them emerge from bankruptcy with a new financial structure more suitable to the company's generation of cash-flows. This reorganization is achieved through a variety of mechanisms. First, insolvency law provides an adequate forum for negotiations. On one hand, an insolvency proceeding usually requires the involvement of independent and reliable third parties (e.g., bankruptcy court) that can create trust. On the other hand, debtors subject to an insolvency proceeding are generally required to provide information to the creditors. Therefore, the combination of trust and lower asymmetries of information between debtors and creditors is expected to favour negotiations. Second, insolvency law provides several tools that can help facilitate a financial restructuring. These tools include the possibility for a majority (or qualified majority) of creditors to impose a decision on dissenting minority creditors and, in some jurisdictions such as Singapore and the United States, even the possibility that a reorganization plan can be imposed on dissenting classes of creditors. By providing these tools, insolvency law avoids holdout problems, encourages ex ante bargaining, reduces negotiation costs, and facilitates the reorganisation of viable but financially distressed businesses.
How corporate insolvency law contributes to the real economy
If the aforementioned functions are properly performed, corporate insolvency law can play a major role in the promotion of economic growth. Ex post, it can contribute to the real economy in several ways. First, corporate insolvency law can save viable but financially distressed companies. Therefore, it can preserve jobs, business relationships with third parties (e.g., suppliers), and the generation of wealth for society. Second, by liquidating non-competitive firms, insolvency law will serve as a valuable mechanism to reallocate resources towards more productive activities. Third, due to the ability of insolvency law to preserve value, creditors can maximise their recoveries. And if so, their financial position will not be significantly undermined by the situation of insolvency of their debtors. Therefore, the maximisation of the returns to creditors will reduce the risk of having a 'domino effect' in corporate insolvencies (especially among small and non-diversified creditors more exposed to the debtor's default) while preserving the stability of the financial system if these creditors are financial institutions.
Ex ante, however, the role of corporate insolvency law can be even more important for society. Namely, the ability of an insolvency regime to promote economic growth will largely depend on how debtors and creditors are treated in insolvency proceedings. From the perspective of debtors, if companies (or their shareholders/managers) know that, in the event of insolvency, a variety of tools will help them preserve value and fix their financial problems, they will have incentives to pursue more investment projects, hire people, borrow money and take risks. Therefore, corporate insolvency law can be a powerful tool to promote entrepreneurship, innovation, job creation, access to finance and economic growth. However, in order to achieve these goals, corporate insolvency law should not punish honest and diligent directors just because their companies became insolvent. Otherwise, these people might be discouraged from taking risks or serving on corporate boards. Besides, in a system with a very harsh liability regime for corporate directors, the initiation of the insolvency proceeding might take place at a later stage (Baird, 1991; Adler et al, 2006). Therefore, an unattractive insolvency regime for debtors or corporate directors can be harmful for the promotion of entrepreneurship, innovation, and access to finance, as well as for the successful rehabilitation of economically viable companies, the quick liquidation of non-competitive businesses, and the maximisation of returns to creditors.
From the perspective of creditors, corporate insolvency law can even become a more powerful mechanism to foster growth. Indeed, since insolvency law helps preserve value, creditors will be able to maximise their returns. As a result, from an ex ante perspective, they will have more incentives to lend money at a lower cost. Hence, an efficient insolvency system capable of preserving value and allocating resources efficiently will facilitate firms’ access to debt finance (Armour et al, 2015). Thus, companies will be in a better position to obtain the financial resources needed to pursue investment projects that can ultimately generate jobs, wealth and social welfare.
Due to the complexity, interdisciplinary and increasingly global nature of corporate insolvency law, the only way to keep improving our insolvency laws and practices is by working together and learning from each other. After all, despite the divergences existing on insolvency laws around the world, generally justified on the basis of several country-specific factors, including the sophistication of the judiciary, divergences in corporate and debt ownership structures, and different political economies, a financially distressed firm faces similar economic problems regardless of the jurisdiction, and insolvency legislators employ similar strategies to address those problems (Gurrea-Martinez, 2020b). Besides, the preservation of value and the generation of growth can reasonably be seen as universal goals pursued by any corporate insolvency regime. For this reason, I would like to encourage every member of the international insolvency community to be part of the Singapore Global Restructuring Initiative by contributing to our blog, engaging in our discussions, and joining us for our academic activities and events. Thus, we will all be able to build better insolvency systems that can help us create jobs and improve people's welfare by promoting entrepreneurship, innovation, access to finance and economic growth.