Creditors Rights and Insolvency Systems
Effective creditor rights and insolvency systems play a vital role in helping to sustain financial soundness, and they promote commercial confidence by enabling market participants and stakeholders to more accurately price, manage, and resolve the risks of default and nonperformance. The extension of credit is predicated on repayment, and its costs are influenced by the risks and potential for default, as well as the associated costs and delays of recovery. Insolvency systems also promote a number of salutary goals: to promote market discipline, as well as good corporate and financial governance; to support optimal resolutions of financial distress for businesses; and to mitigate asset deterioration through swift and reliable enforcement channels. Experience with financial crises has shown that effective creditor rights and insolvency systems also facilitate prompt resolutions and recovery.
Attracting loans and investment requires that repayment risks be reasonable and manageable. Systems of credit protection, resolution, and enforcement will underpin and uphold those expectations in the commercial relationship. Collateral is increasingly significant and quite varied in today’s markets. With competitive pressures on domestic and international businesses, those businesses must tap latent asset values to secure financing and capital so they can grow their business. Modern security laws take advantage of current developments in access to security in all of its various forms and shapes. Collateral without reliable enforcement, however, affords little genuine protection. Consequently, the full dimension of broad security must be complemented by effective and efficient enforcement processes.
A modern, credit-based economy requires (a) predictable, transparent, and affordable enforcement of both unsecured and secured credit claims by efficient mechanisms outside of insolvency and (b) a sound insolvency system. The systems must be designed to work in harmony. Commerce is a system of commercial relationships predicated on express or implied contractual agreements between an enterprise and a wide range of creditors and constituencies. Although commercial transactions have become increasingly complex as more sophisticated techniques are developed for pricing and managing risks, the basic rights governing those relationships and the procedures for enforcing the rights have not
changed much. Those rights enable parties to rely on contractual agreements, thus fostering confidence that fuels investment, lending, and commerce. Conversely, uncertainty about the enforceability of contractual rights increases the cost of credit to compensate for the increased risk of nonperformance, and in severe cases, uncertainty leads to credit tightening.
The legal framework for creditor rights includes mechanisms that provide efficient, transparent, and reliable methods for recovering debt, including seizure and sale of immovable and movable assets, as well as sale or collection of intangible assets such as debt owed to the debtor by third parties. An efficient system for enforcing debt claims is crucial to a functioning credit system, especially for unsecured credit. A creditor’s ability to take possession of a debtor’s property and to sell it to satisfy the debt is the simplest, most-effective means of ensuring prompt payment. It is far more effective than the threat of an insolvency proceeding, which often requires a level of proof and a prospect of procedural delay that in all but extreme cases make it not credible to debtors as leverage for payment.
Although much credit is unsecured and requires an effective enforcement system, having an effective system for secured rights is especially important in developing countries. Secured credit plays an important role in industrial countries, notwithstanding the range of sources and types of financing available through both debt and equity markets. In some cases, equity markets can provide cheaper and more attractive financing. But developing countries offer fewer options, and equity markets are typically less mature than debt markets. As a result, most financing is in the form of debt. In markets with fewer options and higher risks, lenders routinely require security to reduce the risk of nonperformance and insolvency.
The legal framework for secured lending should provide for the creation, recognition, and enforcement of security interests in all types of assets—movable and immovable; tangible and intangible, including inventories, receivables, proceeds, and future property and, on a global basis, including both possessory and nonpossessory interests. The law should encompass any or all of a debtor’s obligations to a creditor—present or future and between all types of persons. In addition, it should provide for effective notice and registration rules to be adapted to all types of property, and it should set clear rules of priority on competing claims or interests in the same assets.
The legal framework for corporate insolvency should establish a collective process for resolving or adjusting the rights and interests of a variety of stakeholders in a failed business. Each country’s system balances a number of policies and objectives as determined by the policy makers within that country. Invariably, a system includes a number of potentially diverging policies and interests that must be balanced and harmonized to make it functional and meaningful within the context of the needs of a particular country. The policies and interests that must be balanced include governmental and political objectives, cultural and social concerns, and economic and commercial interests. A country’s system is also defined by three main pillars—the legal, institutional, and regulatory frame – works—each of which is equally important to creating an effective and efficient system for users. The absence or inefficiency of any one of those pillars compromises the entire system.
Though approaches vary, a number of common objectives and goals apply to commercial insolvency systems. They should attempt to
• Provide for timely, efficient, and impartial resolution of insolvencies.
• Integrate with a country’s broader legal and commercial systems.
• Maximize the value of a firm’s assets and recoveries by creditors.
• Provide for (a) efficient liquidation of nonviable businesses and those where liquidation is likely to produce a greater return to creditors and (b) rehabilitation of viable businesses.
• Strike a careful balance between liquidation and reorganization, allowing for easy conversion of proceedings from one procedure to another.
• Provide for equitable treatment of similarly situated creditors, including similarly situated foreign and domestic creditors.
• Prevent the improper use of the insolvency system.
• Prevent the premature dismemberment of a debtor’s assets by individual creditors who are seeking quick judgments.
• Provide a transparent procedure that contains—and consistently applies—clear risk allocation rules and incentives for gathering and dispensing information.
• Recognize existing creditor rights, and respect the priority of claims with a predictable and established process.
• Establish a framework for cross-border insolvencies, with recognition of foreign proceedings.
Where an enterprise is not viable, the main thrust of the law should be swift and efficient liquidation to maximize recoveries for the benefit of creditors. One the one hand, liquidations can include the preservation and sale of the business, as distinct from the legal entity. On the other hand, where an enterprise is viable—meaning it can be rehabil – itated—its assets are often more valuable if retained in a rehabilitated business than if sold in a liquidation. The rescue of a business preserves jobs, provides creditors with a greater return on the basis of higher going-concern values of the enterprise, potentially produces a return for owners, and obtains for the country the fruits of the rehabilitated enterprise. The rescue of a business should be promoted through formal and informal procedures.
Rehabilitation should (a) permit quick and easy access to the process, (b) protect all interested parties having a financial stake in the outcome of the process, (c) permit the negotiation of a commercial plan, (d) enable a majority of creditors in favor of a plan or other course of action to bind all other creditors (subject to appropriate protections), and (e) provide for supervision to ensure that the process is not subject to abuse. Modern rescue procedures typically address a wide range of commercial expectations in dynamic markets. Though those types of laws may not be susceptible to precise formulas, modern systems generally rely on design features to achieve the objectives outlined earlier.
Corporate workouts should be supported by an environment that encourages participants to restore an enterprise to financial viability through informal workouts that are negotiated in the “shadow of the law.” Accordingly, the enabling environment must (a) include clear laws and procedures that require disclosure of or access to timely and accurate financial information on the distressed enterprise; (b) encourage lending to, investment in, or recapitalization of viable distressed enterprises; (c) support a broad range of
restructuring activities such as debt write-offs, reschedulings, restructurings, and debt – equity conversions; and (d) provide favorable or neutral tax treatment for restructurings.
A country’s financial sector should promote (possibly with help from the central bank or finance ministry) an informal out-of-court process for dealing with cases of corporate financial difficulty in which banks and other financial institutions have a significant exposure—especially in markets where enterprise insolvency is systemic. An informal process is far more likely to be sustained where there are adequate creditor remedies and insolvency laws.
Strong institutions and regulations are crucial to an effective system for commercial enforcement and insolvency proceedings. The institutional framework has three main elements: the institutions responsible for the proceedings, the operational system through which cases and decisions are processed, and the requirements needed to preserve the integrity of those institutions—recognizing that the integrity of the system is the linchpin for its success.
A sound regulatory framework requires insolvency administrators who are competent to exercise the powers given to them and who act with integrity, impartiality, and independence. Finally, the bodies responsible for regulating or supervising insolvency administrators should be independent of individual administrators and should set standards that reflect the requirements of the legislation and public expectations of fairness, impartiality, transparency, and accountability.
In 2001, the World Bank endorsed the “Principles and Guidelines for Effective Insolvency and Creditor Rights (ICR) Systems”3 (principles) for use in connection with assessments of creditor rights, commercial enforcement, and insolvency systems under the program to develop reports on the observance of standards and codes ( ROSC).4 The principles provide a framework for comprehensively assessing the effectiveness of insolvency and creditor rights systems against international best practices. The principles contain a set of core principles elaborated under 35 topics in four primary areas: (a) creditor rights and enforcement systems (for secured and unsecured credit); (b) corporate insolvency systems (liquidation and rescue legislative procedures); (c) credit risk management, debt recovery, and informal enterprise workout practices; and (d) effective implementation of legal mechanisms (institutional and regulatory frameworks).
The insolvency and creditor rights assessments have a number of applications for international financial institutions, policy makers, and the private sector. The assessments support diagnostic and strategic work, underpin policy dialogue and lending operations, and provide input to technical assistance and capacity building efforts. Assessments can be seen as building blocks for diagnostic work such as investment climate assessments in which creditor rights and enforcement systems are viewed as pivotal to assessing nonperformance and regulatory risks for lending and investment. They also provide useful inputs into key policy documents, such as sectoral strategies for the private and financial sectors or countrywide development strategies. As in the case of other Bank-led ROSC assessments, their strengths lie both in the systematic standardized coverage and in their ability to benchmark against an internationally recognized standard, and they provide an easy guide to policy dialogue and reform.