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Centre for Commercial Law in Asia

Implementing an Efficient Insolvency Framework for Micro and Small Enterprises

Implementing an Efficient Insolvency Framework for Micro and Small Enterprises

By Aurelio Gurrea-Martinez (Singapore Management University)

I. Introduction

Micro, small and medium-sized enterprises (MSMEs) represent about 90% of businesses and more than 50% of employment worldwide. Therefore, they play a major role in any economy, and even more in emerging markets. While the definition of 'small business' and 'MSME' differs across jurisdictions, these firms are usually defined based on several variables (eg, number of employees, revenues, assets) and they share some common features. First, they have very simple organizational structures. In fact, many of them do not even have employees. Second, most MSMEs have simple asset and financial structures, and they mainly rely on bank finance as their primary source of finance. Third, many small businesses are not incorporated. Hence, entrepreneurs do not enjoy the benefits associated with the corporate form, including the existence of limited liability. Even if incorporated, the shareholder/manager usually running a small corporation often acts as a guarantor for the company's debts. As a result of these factors, the life and welfare of the individuals behind MSMEs are inevitably tied to the business' fate.

II. The weaknesses of the traditional insolvency system for MSMEs

Unfortunately, most countries around the world have failed to respond to the particular features and problems of MSMEs in insolvency. With a few exceptions, most insolvency jurisdictions subject MSMEs to the same framework and insolvency proceedings existing for large companies.

These one-size-fits-all insolvency proceedings can be very costly for MSMEs, especially taking into account that many of these firms might not even have assets to fund the costs of the procedure. Therefore, initiating an insolvency proceeding is a luxury that many MSMEs cannot afford. Even if they can, they face a second problem: the insolvency procedure may not be suitable for their particular features. Even if it is, there is a third problem: many insolvency jurisdictions around the world do not provide an effective discharge of debts for individuals. Therefore, since sole traders and shareholders/managers often act as guarantors for the company's debts, there should be more coordination between the systems of corporate and personal insolvency (Sarra, 2016). Otherwise, honest but unfortunate sole traders and shareholders/managers of small companies will not find the insolvency system appealing even if, despite the potential attractiveness of the corporate insolvency framework, they do not enjoy an effective discharge of debts under the personal insolvency system.

III. The costs of having an inefficient insolvency framework for MSMEs

The unattractiveness of the insolvency framework for MSMEs can generate various costs for the economy. Ex post, it can hamper the reorganization of many viable MSMEs, the efficient reallocation of assets of non-competitive businesses, and the rehabilitation of honest and unfortunate entrepreneurs. Therefore, an unattractive insolvency framework can destroy wealth, jobs and growth. Ex ante, since many entrepreneurs would be discouraged from starting a business or, if they so, they may have incentives to take suboptimal levels of debt and risk as a means to minimize the risk of insolvency, an unattractive insolvency framework for MSMEs can ultimately harm entrepreneurship, innovation and access to finance in a country.

IV. Legislative and academic proposals to enhance the insolvency framework for MSMEs

The World Bank has published various reports suggesting policy recommendations to deal with MSMEs in insolvency. UNCITRAL is currently working on a simplified insolvency regime for small firms. Various authors have suggested a variety of policy recommendations to enhance the insolvency framework for MSMEs. More recently, many countries around the world have implemented  (eg, United States, Myanmar, Colombia) or are planning to implement (eg, Australia, Singapore) special insolvency rules for MSMEs. Therefore, the treatment of MSMEs in insolvency has become one of the most relevant topics in the international insolvency debate, especially as a result of the COVID-19 pandemic.
 
V. How to build an efficient insolvency framework for MSMEs
 
In the absence of empirical evidence showing the effects of the insolvency reforms implemented by some countries adopting special rules for MSMEs, it is difficult to suggest an 'optimal' insolvency framework for small businesses. Still, here are some tentative ideas that can hopefully help regulators and policymakers build an attractive insolvency framework for MSMEs.
 
1. Favoring out of court restructuring for economically viable firms
 
Regulators, practitioners and policymakers should promote the use of out of court restructuring (including mediation to facilitate workouts) in the context of viable MSMEs facing financial trouble. On the one hand, these mechanisms can save the significant costs associated with the commencement of an insolvency proceeding. Therefore, this solution should be beneficial for debtors, creditors and society as a whole. On the other hand, MSMEs often have very simple financial structures with a few creditors. Therefore, reaching an out of court agreement is more feasible for these firms. In order to facilitate this strategy, regulators or private actors should enact some good practices for out of court restructuring. Then, they should make sure that the insolvency and business community are aware of them. Examples of these good practices have been published by various organizations, including INSOL, the World Bank and the Association of Banks of Singapore. They can all serve as a valuable guidance for countries without these types of practices.
 
2. Fast-track insolvency process based on a system of auctions
 
If the out of court agreement fails, there will be reasons to believe that the company is not economically viable or the creditors do not trust the shareholders/managers. In those cases, the company should not be reorganized. Therefore, even though it is possible that the workout failed due to various factors other than the viability of the business (e.g., holdout problems, bad negotiations/advisors, etc), the insolvency system should prevent the use of reorganization procedures by non-viable businesses. In my view, the best way to deal with this problem while still providing viable businesses unable to reach a workout the opportunity to survive is by implementing a fast-track, single-entry insolvency procedure for MSMEs based on a system of auctions. Under this system, any interested party (including the existing shareholders/managers) would be allowed to bid for the company's assets. Thus, the insolvency proceeding would become an auction process for the sale of assets, as -with some variations- has been suggested by the academic literature and supported by empirical studies. After selling the assets separately (if nobody is interested in acquiring the assets as a going concern, probably because the business is not viable) or as a going concern (if the shareholders/managers or any external bidders believe in the viability of the business and they want to keep it alive), the company should be quickly dissolved. Thus, the process would conclude with a business rescue (through a going concern sale) or a piecemeal liquidation. The entire procedure should be managed within weeks. Therefore, reducing the length of the procedure is essential. It is also important to make sure that the sale of assets is conducted through a public, transparent and competitive auction. To facilitate this goal, regulators should promote the use of technology and internet-enabled platforms. Any possible investigation of the debtor's or director's behavior should not stop the process. Hence, these investigations should be conducted, if so, separately.
 
3. Governance of the fast-track insolvency proceeding 
 
While the auction takes place, the procedure needs to be managed. Unfortunately, many insolvent MSMEs cannot afford the appointment of an insolvency practitioner. In these situations, countries could adopt two possible strategies. On the one hand, they can recognize this situation as a 'market failure' and respond with a governmental intervention consisting on the appointment of a public trustee (Harris and Murray, 2020). This person would manage the procedure and would conduct any investigation potentially needed. Alternatively, a country can adopt a 'private solution' based on a debtor in possession model. Therefore, the procedure would be managed by the company's directors, as it happens in the US Chapter 11 (although in a US Chapter 11 reorganization procedure the debtor in possession is subject to the supervision of the court, and a trustee or an examiner can be exceptionally appointed in cases of fraud and mismanagement) and in most countries around the world for solvent liquidations. In cases of adopting a 'private solution', however, various safeguards should be implemented to protect the interest of the creditors. Among others, the directors should be liable for damages, and the creditors should keep the power to appoint an insolvency practitioner even if, due to the lack of assets, creditors may find it hard to get an insolvency practitioner interested in managing the case. If a private solution is adopted, the insolvency legislation should facilitate a system of litigation funding. Thus, any investigations and actions potentially brought against the debtor (eg. liability of directors, avoidance actions) can be funded by third parties. Thus, neither taxpayers nor insolvency practitioners will have to bear the costs of these actions and investigations. Favoring a system of litigation funding can create several benefits, including the disqualification/liability of wrongfully behaved debtors/directors, the maximization of the returns to creditors, and the financing of the insolvency practitioner potentially appointed to manage the case. Moreover, as a result of the credible threat of being subject to investigations and, if so, liability and avoidance actions, the existence of litigation funding can lead to a better behavior from directors and other market participants from an ex ante perspective.
 
The desirability of each solution - private or public- will depend, among other factors, on the institutional framework existing in a country. In countries with reliable institutions and efficient public administrations, as it happens in many advanced economies, the appointment of a public trustee may work. However, in countries with more problems of corruption and inefficiencies in the public sector, as it generally occurs in emerging economies, the private solution will probably be more desirable.
 
4. Personal insolvency regime
 
Since many MSMEs are not incorporated or, even if they are, the shareholders/managers usually act as guarantors for the company’s debts, any effort to enhance the attractiveness of the corporate insolvency regime should be accompanied by a simultaneous reform of the regime of personal insolvency in order to allow an effective discharge of debts for honest and unfortunate debtors. Otherwise, in addition to other harmful effects potentially generated by the lack of a discharge of debts for individuals, the corporate insolvency regime will still be unattractive for the sole traders and shareholder/managers running MSMEs.
 
VI. Conclusion
 
Many countries around the world are currently implementing, or are planning to implement, special insolvency rules for MSMEs. While the adoption of simplified insolvency frameworks for MSMEs has been studied in the past decades, and even more in the past years, it has become more relevant in times of COVID-19. This post has sought to suggest some tentative ideas to implement an efficient insolvency framework for MSMEs. I hope it can be useful, even if it is just for the academic and policy debate very much needed in these challenging times.