3. Economic Analysis of Insolvency Regimes
3. Investment in the creation and expansion of business enterprises constitutes the driving force of economic growth in market economies, but since not all of those investments will prove to be commercially viable, some businesses will fail. Insolvency regimes regulate the terms on which businesses that are unable to pay their debts as they fall due are liquidated or reorganized. Insolvency regimes:
Facilitate the orderly reallocation of economic resources from business investments that are not viable to more efficient and profitable activities;
Provide incentives that will influence the willingness of entrepreneurs to undertake risky investments in business enterprises;
Provides incentives that will have a material impact on the actions of the owners of declining businesses in the period leading up to the declaration of insolvency; and
May, through these incentives as well as through its impact on the probability of repayment and the transactions costs faced by creditors of insolvent business, affect the cost of credit for business.
4. An efficient insolvency regime should:
Encourage the dissolution of non-viable and inefficient businesses and the survival of efficient ones. "Filtering failure" occurs in systems which prolong survival of inherently inefficient businesses or premature dissolution of efficient ones (Fisher and Martel 1996:15).
Maximise the value of liquidated assets. Independent administrators who take control of the business at the point of insolvency are responsible for winding it up and selling the assets for maximum value if it cannot be returned to viability. The imposition of stays on creditors allows a liquidator time to arrange a sale to yield the highest maximise return for the benefit of all unsecured creditors.
Provide for an equitable distribution of liquidated assets amongst creditors (e.g. employees, sub-contractors, suppliers, financial creditors) based on the requirement to honour the contracts associated with each one. For example, any insolvency regime that did not honour the priority rights of secured creditors would increase the cost of secured credit for business as a whole.
Minimise the incentives and the opportunity for debtors to run down unsecured assets as the point of insolvency approaches. Owners who declare insolvency do not expect to receive any return on their equity, so at the point of insolvency high-risk investments with a small probability of returning the business to solvency but a high probability of reducing funds available to creditors will look extremely attractive. The economics literature refers to this strategy as "gambling for resurrection". The economics literature also uses the term "looting" to refer to the purposeful and self-interested actions of entrepreneurs who respond to the incentives providing by impending insolvency by diverting funds from the payment of creditors to providing higher salaries or benefits for themselves.
Provide effective mechanisms for identifying and prosecuting any managers or directors whose illegal actions contributed to the insolvency of the firm or the extent of the losses suffered by creditors.
Reduce transactions costs and disputes associated with the insolvency procedures by establishing clear and predictable processes and by providing all stakeholders with information about how the insolvency regime will operate.
5. Internationally, insolvency systems are often referred to as favouring debtors or creditors. In the US, the system is "debtor-oriented". This system provides opportunities for business to restructure operations and recover from debt. However, reorganisation often fails and is prolonged, costly and does not honour credit contracts. In other countries (e.g. Australia, U.K., Canada), creditors exercise more control over the reorganisation of the business, and have greater rights to require liquidation. Systems placing an emphasis on creditor rights appear to generate better outcomes (Bickerdyke et al 2000).
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