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Simeon Djankov

November 2nd, 2020

Reform bankruptcy laws to save businesses from going under

0 comments | 3 shares

Estimated reading time: 10 minutes

Simeon Djankov

November 2nd, 2020

Reform bankruptcy laws to save businesses from going under

0 comments | 3 shares

Estimated reading time: 10 minutes

Faced with the prospect of hundreds of thousands of businesses going under, the UK changed its bankruptcy laws in June. Other G7 countries that put temporary changes in place should follow suit, says Simeon Djankov (LSE).

Given the pressure businesses are under, it might seem puzzling that the number of corporate bankruptcy filings in the United States in the first half of 2020 fell by 10 percent relative to last year. The same pattern of decline in filings is seen across other G7 economies. In Germany, the fall is by 12%; in Japan and the UK, by a third; in Canada by two-fifths; in France by half. Italy has not reported official figures for 2020.

But the reason for this decline is simple: the pandemic has induced temporary amendments to bankruptcy procedures in all G7 countries. These changes typically include two provisions:

1) a suspension of the obligation to file for bankruptcy during the pandemic, which France, Germany and Italy have extended into 2021;

2) a preferred status for newly-granted loans, in order to motivate creditors to provide additional liquidity to businesses in distress.

The UK made permanent changes to bankruptcy law, and the insolvency regime became more similar to a US bankruptcy, with more power in the hands of the debtor company. US bankruptcy provisions are considered the gold standard among advanced economies. Evidence from the US shows that nearly 70 percent of insolvency cases that pass the initial screening result in the successful survival of the business. In contrast, under the old UK insolvency law only 14% of companies succeeded in keeping their business operating.

UK adds three features to its bankruptcy law

The amendments to the UK law, adopted in June 2020, share three features with US Chapter 11 provisions. First, they introduce a moratorium, during which the company benefits from a payment holiday from the majority of its debts. Second, the amendments allow the debtor to propose a rescue plan that can be forced onto every creditor if the majority of creditors agree. Thirdly, suppliers are prevented from terminating their deliveries once they find out that the debtor has trouble paying all of her creditors. These amendments increase the chance that the business will emerge from insolvency as a going concern.

theatre michigan
The Broadway Theatre, Mt Pleasant, Michigan in April 2020. Photo: Dan Gaken via a CC BY 2.0 licence

Moratorium

The moratorium gives companies breathing space to construct a rescue plan. During this two-months period, no action can be taken against the company without a judge’s order. Decisions are left in the hands of the company’s management, which provides a new balance between protecting the interests of creditors and giving the company the best chance of survival.

Rescue plan

This feature allows insolvent companies to propose a plan to creditors. Dissenting creditors are bound by the plan, if the majority of creditors support it. Companies will only benefit from this feature if sanctioned by the court and if the court is satisfied that those creditors would be no worse off than if the company entered an alternative insolvency procedure.

Termination clauses

Suppliers often stop supplying a company that has entered an insolvency process, as they risk not getting paid. However, failure to protect the continuation of trade endangers the survival of potentially viable businesses. In cases where a company has obtained a moratorium, the company’s suppliers are prevented from stopping supplies or altering the contractual terms, as long as they continue to be paid.

Why the change?

The coronavirus survey by the UK Office for National Statistics shows that 64% of businesses across all industries were at risk of insolvency in September 2020, with 43% of businesses running on less than half year’s cash reserves. A deluge of bankruptcies may ensue once temporary COVID provisions are lifted in November. The permanent amendments to the UK bankruptcy regime ensure that insolvent firms have a higher chance of survival.

Will other G7 economies follow?

In times of crisis, improving businesses’ chances of survival becomes even more pressing. Our research on bankruptcy procedures around the world shows that the type of changes the UK has enacted increase the probability a firm will survive, as they continue operating during their restructuring. New research by Olivier Blanchard, Thomas Philippon and Jean Pisani-Ferry suggests that the number of firms needing debt restructuring is likely to be large and the courts are going to be overwhelmed, so standard insolvency procedures will not work.

The German government has announced its intention to follow the UK’s lead in revising bankruptcy rules. Canada and Italy are looking for ways to simplify the insolvency process for small companies. Some economists are concerned that keeping insolvent firms alive will drain resources from the healthy parts of the economy. Research by Joseph Gagnon shows these fears are fundamentally misguided. Policies that force businesses to shut down permanently risk slowing down the post-COVID recovery.

This post represents the views of the author and not those of the COVID-19 blog, nor LSE.

About the author

Simeon Djankov

Simeon Djankov is policy director of the Financial Markets Group at LSE and a senior fellow at the Peterson Institute for International Economics (PIIE). He was deputy prime minister and minister of finance of Bulgaria from 2009 to 2013. Prior to his cabinet appointment, Djankov was chief economist of the finance and private sector vice presidency of the World Bank. He is the founder of the World Bank’s Doing Business project. He is author of Inside the Euro Crisis: An Eyewitness Account (2014) and principal author of the World Development Report 2002. He is also co-editor of The Great Rebirth: Lessons from the Victory of Capitalism over Communism (2014).

Posted In: #LSEThinks | Economics and finance | Restructuring business, trade and the future of work

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