Giving creditors a voice for a better insolvency process

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Community loan and repayment schedule. Mumbai, India
Photo: Simone D. McCourtie / World Bank

On October 15, 2018, Sears—once the biggest retailer in the world—filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. A reorganization plan allowing the company to reemerge from the $5.5 billion outstanding debt was finally approved by the U.S. Bankruptcy Court for the Southern District of New York. However, while aspirations of Sears as a debtor are widely discussed in public, interests of its creditors, including many small and medium enterprises, received little attention. Adequate protection of creditor’s rights is as important as those of the debtor, given that quick and efficient insolvency proceedings rest upon a balance of power between debtors and creditors. Below we provide a brief analysis of how stronger creditor’s rights are associated with a better insolvency process and access to finance. 

What is the evidence so far?

Research points to several reasons as to why strong creditor protection is essential for the efficiency of corporate insolvency and easier access to finance. Creditors are key participants in insolvency proceedings, as the maximized value of assets is closely tied to the recovery of creditors, whether financial lenders, employees or trade creditors. The higher the value of  debtor’s assets, the more money creditors should get back at the end of proceedings. Good practice suggests that legal frameworks establish express and direct provisions allowing very specific rights or safeguards for creditors as a group or to the individual creditor protecting a specific interest.

More active participation by creditors in the insolvency process allows them to be part of the decision-making process and balance the actions of debtor and/or insolvency administrator for a mutually beneficial outcome. As a corollary, the proceedings are used more effectively, contributing to the credibility of the overall resolving insolvency system. This is particularly important for developing economies with inefficient and biased administration of justice or with a new insolvency legal framework. In such economies, creditors’ active participation in the proceedings may help the courts to strike a fair balance between different stakeholders and thereby compensate for cases of insufficient institutional capacity.

Creditors’ participation matters because it brings their practical experience and expert knowledge about the debtor’s business to the fore. Depending on which option is likely to result in a more profitable return, creditors may either support liquidation of non-viable debtor or argue in favor of saving the company as a going concern. Their view thus may differ considerably from that of the debtor and/or insolvency administrator, prompting the judge to carefully weigh conflicting claims to make a fair and economically-justified decision.

For example, establishing the right of creditors to select the insolvency representative is  recommended good practice. Because the insolvency practitioner’s fees are deducted from creditors’ returns, they are highly motivated to seek out a professional who is familiar with the nature of the debtor’s business, activities or type of assets, or who has special knowledge to handle the particular circumstances of the case. The extra risk that an insolvency practitioner does not perform his/her duties properly can be further mitigated by provisions that allow creditors to move to replace him/her when required.  

Furthermore, when creditors are not protected or allowed to participate in insolvency proceedings, they will have less incentive to lend in the future, leading to less-developed credit markets.  In this regard, the research suggests that strong creditor rights ease access to finance for the private sector, lowering the cost of credit and eventually increasing the volume of private lending. In particular, it is shown that creditors are more willing to lend when they feel confident that their interests will be duly protected in case the debtor becomes bankrupt. As a result, in economies with solid creditor rights and safeguards, private firms enjoy easier access to credit.  

What does Doing Business data tell us?

Doing Business collects detailed data on both creditor’s rights and recovery rates. Creditor’s rights are measured through the availability of the following nine provisions in the legal framework of 190 economies included in the project: right to initiate liquidation and/or reorganization; right to vote on the reorganization plan; division of creditors into classes so that they can vote separately on the plan while treated equally; right to approve the selection of the insolvency representative; right to approve the sale of substantial assets; right to request information and right to object to decisions on creditors’ claims. The recovery rate is measured as cents on the dollar recovered by secured creditors through judicial reorganization, liquidation or debt enforcement (i.e. foreclosure or receivership).

We used the average of these nine indicators as a proxy to measure creditor’s rights. Analysis of these indicators provides support to the conventional wisdom that better creditor protection leads to a more favorable outcome for creditors in the event of a debtor’s default. In particular, we found that economies with more accessible insolvency proceedings for creditors, measured as the average of the nine indicators on creditor’s rights mentioned above, tend to have better recovery rates of creditors’ loans (figure 1). A 1 percentage point increase in the score of creditor’s rights is associated with a 1.9-point increase in the recovery rate at 1% significance level, after controlling for income per capita.

Figure 1. Creditor’s right is positively associated with recovery rate

As put forward both by existing research and Doing Business data, effective creditor’s rights are associated with higher recovery rates, suggesting that in the event of the debtor’s default, creditors with stronger protections are more likely to recoup their investments. Thus, private lending turns out to be less risky for creditors and, as a corollary, more affordable for borrowers, which can significantly facilitate the growth of entrepreneurial activity.

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