The crucial role of insolvency law in job creation and preservation

When companies face financial trouble, potential job losses can be a major risk for people and—depending on the size of the company or industry in trouble—a risk to local or national economies. An efficient insolvency system can mitigate this risk while contributing to the creation of more and better jobs. As jobs are the most critical tool in fighting poverty, a better understanding of the effects of insolvency law on employment is vital for development work.

Preserving Jobs by Helping Distressed Firms Get Back on Track

A key function of insolvency law is facilitating the reorganization of viable but financially distressed companies. By allowing such firms to restructure their debts and operations, insolvency law helps preserve jobs that would otherwise be lost in liquidation. For instance, in Portugal, it was shown that the layoff rate in reorganization cases is 56%, compared to 93% in liquidations. The evidence suggests that practices and insolvency reforms that reduce the time and costs of insolvency proceedings—such as pre-packs and simplified reorganization procedures—increase the likelihood of preserving viable but financially distressed firms and the jobs they create. Moreover, these positive effects on job preservation are enhanced by the presence of efficient bankruptcy courts. This underscores the importance of accompanying insolvency reforms with an improvement of a country’s institutional environment, as highlighted in the World Bank Principles for Effective Insolvency and Creditor/Debtor Regimes.

Creating Jobs by Fostering Access to Finance and Stimulating Entrepreneurship

An efficient insolvency system can increase the availability of credit and reduce borrowing costs for firms. For example, in Brazil, a reform that increased creditor protection while improving the efficiency of the insolvency system led to a 17.8% increase in total debt and a 16.78% drop in the cost of credit. In Italy, a reform that empowered debtors at the expense of creditors in reorganization raised financing costs by 11.6% while subsequent reforms strengthening creditors rights in liquidation reduced the total cost of bank financing by 7%. Therefore, insolvency reforms that strengthen creditors’ rights and reduce the time and costs of insolvency proceedings may have a positive impact on lending markets. In turn, they can stimulate entrepreneurial activity and job creation. For example, some studies have shown that having access to a loan increases a firm’s number of permanent employees by 3.1%, and other  studies have found that firms with access to a loan have an annual employment growth that is 3.29% larger than for firms with no access. Additionally, it has been shown that reforms in personal insolvency laws that promote discharge of debts and a fresh start for individual entrepreneurs increased the average rate of self-employment around 3.8%.

Creating Better Jobs by Facilitating Firm Exit and the Efficient Reallocation of Capital

Another essential pillar of a well-functioning insolvency system is to facilitate the speedy liquidation of non-viable firms. By providing a swift exit to unviable businesses, the insolvency system can reduce the number of zombie firms while facilitating the reallocation of resources towards more productive activities. Evidence from Japan and OECD countries shows that reducing zombie firms encourages investment and job creation in healthier businesses. Moreover, as evidenced in South Korea, an insolvency reform that facilitates the exit of inefficient firms can also lead to productivity growth and, in turn, the creation of more and better jobs.

The Need for Insolvency Reforms Balancing Debtor and Creditor Rights

Insolvency reforms need to be done right. An effective insolvency regime should ensure that a debtor's assets are put to their best use, keeping economically viable businesses alive through effective reorganization procedures. Efficient liquidation procedures and safeguards are necessary to prevent non-viable firms from exploiting reorganization processes, thus maintaining a balanced system. By adopting such reforms, insolvency systems can help preserve jobs in viable businesses and foster job creation by facilitating access to finance and the exit of non-viable firms.

Policy Recommendations

To maximize the potential of insolvency law to create and preserve jobs and ultimately foster prosperity and growth, policymakers should focus on several key areas, including:

1. Maximizing Returns to Creditors: Reducing the length and costs of insolvency proceedings and promoting the efficient allocation of the debtor’s assets
2. Strengthening Reorganization Procedures: Adopting tools to support viable businesses without opportunistically favoring debtors at the expense of creditors
3. Promoting Pre-Packs: Facilitate the use of pre-packaged sales of assets, pre-arranged restructurings and other forms of accelerated reorganizations
4. Discharge of Debts for Individual Entrepreneurs: Facilitate a discharge of debts for honest but unfortunate individual entrepreneurs
5. Adopting Simplified Procedures for Small Businesses: Implement fast, low-cost insolvency processes for small businesses, in line with the World Bank Principles For Effective Insolvency and Creditor/Debtor Regimes and Part V of the UNCITRAL Legislative Guide on Insolvency Law
6. Improving Institutional Environments: Strengthening judicial systems and investing in capacity building

Conclusion

A well-functioning insolvency system can contribute to the preservation of jobs if viable firms are kept alive. Yet, the impact of insolvency law on employment goes beyond the preservation of jobs. By fostering access to finance and facilitating the exit of non-viable firms, insolvency law has the potential to contribute to the creation of more and better jobs. To achieve that goal, an insolvency system needs to balance debtor and creditor rights and be supported by a strong institutional environment.