Doing Business 2015

Going Beyond Efficiency

Resolving insolvency
Measuring the strength of insolvency laws

ƒ Doing Business introduces a

T
he word bankruptcy often evokes participation in bankruptcy proceedings
new component of the resolving negative associations with fail- may lead to a lower cost of debt and a
insolvency indicator set this ure and shame. And fear of bank- higher aggregate level of credit; and that
year, the strength of insolvency ruptcy and its consequences can deter introducing reorganization proceedings
framework index. This indicator potential entrepreneurs from starting may reduce the rate of business failure.5
tests whether each economy has a new business venture. According to Moreover, efficient bankruptcy regimes
adopted internationally recognized a recent survey on entrepreneurship, with orderly procedures for the sale and
good practices in the area of people from a range of social and de- distribution of debtors’ assets can have
insolvency. mographic groups rank the possibility a positive effect on loan terms, leverage
ƒ The good practices underlying of going bankrupt as the greatest fear ratios and bank recovery rates.6
the new indicator are based on associated with starting a business,
2 sources—the World Bank’s above irregular income and lack of job Bankruptcy laws play such an im-
Principles for Effective Insolvency security.1 Yet evidence suggests that the portant role because they promote
and Creditor/Debtor Regimes and exit of firms from the market is a neces- predictability for both creditors and
the United Nations Commission on sary condition for economic growth, and entrepreneurs—by establishing the
International Trade Law’s Legislative efficient exit frameworks may in fact rules for the worst-case scenario. They
Guide on Insolvency Law. encourage greater entrepreneurial ac- allow entrepreneurs to determine the
ƒ OECD high-income economies have tivity and new firm creation.2 Moreover, maximum risk associated with a failed
the highest average score on the businesses started by previously failed venture.7 And they allow creditors to
strength of insolvency framework entrepreneurs can grow faster than calculate the maximum risk associated
index. South Asia is the region with those started by first-timers.3 with an unpaid loan. Collection of debt
the lowest average score on the through bankruptcy proceedings may
index. While reducing the stigma associ- be the least attractive option for any
ƒ Economies that have reformed ated with bankruptcy may be difficult, creditor, because these proceedings in-
their insolvency laws in the past policy makers can minimize the nega- volve several creditors trying to enforce
several years score substantially tive effects of business failures and take their claims against the same debtor.8
higher on the strength of insolvency advantage of their positive effects by So, having transparent, enforceable
framework index than economies adopting efficient and well-functioning rules on the types of decisions that
with outdated insolvency provisions. bankruptcy laws. Several studies show creditors can influence during bank-
ƒ Economies with better insolvency a strong link between bankruptcy laws ruptcy proceedings, on the priority of
laws as measured by Doing Business and credit market development, as creditors and on other important issues
tend to have more credit available to reflected by such aspects as collateral is critical for lenders—and becomes a
the private sector. eligibility requirements, access to loans key factor for them in fixing interest
to finance investments, access to long- rates and maturity terms for loans.9
term debt and the level of firms’ financ-
ing relative to their size.4 And studies on
the effects of bankruptcy reforms show
that speeding up the resolution of debt AN EXPANDED FOCUS FOR
disputes may increase the probability THE INDICATORS
of timely repayment; that increasing The Doing Business indicators on resolv-
the protection of creditors and their ing insolvency measure the efficiency
 RESOLVING INSOLVENCY 97

of insolvency (bankruptcy) frameworks index widens the reach of the resolving and what protections are available
around the world. Until this year the insolvency indicator set to debtors and to dissenting creditors.
focus was on capturing the time, cost unsecured creditors. ƒ The creditor participation index
and outcome of the most likely in- measures whether creditors partici-
court proceeding involving a domestic Both the World Bank principles and the pate in important decisions during
debtor in each economy. These 3 UNCITRAL guide avoid using the term insolvency proceedings, such as ap-
measures were then used to calculate bankruptcy and instead use the broader pointment of the insolvency repre-
the recovery rate—how much of its term insolvency. The 2 guidebooks sentative and sale of assets during
loan a secured creditor would be able to generally agree on the objectives of an the proceedings; whether creditors
recover at the end of the proceedings. effective and efficient insolvency re- have access to information about
gime, and both provide specific recom- the debtor and the proceedings;
This year Doing Business has introduced mendations on each of these objectives and whether creditors can object to
an important change in methodology (the UNCITRAL guide, a multivolume decisions affecting their rights, such
for the resolving insolvency indicators. publication, covers a multiplicity of op- as approval of claims submitted by
Besides measuring the recovery rate, it tions). The good practices tested under other creditors.
now also tests whether each economy the new indicator are closely linked
has adopted internationally recognized with the objectives identified in both The information used to compile the
good practices in the area of insol- guidebooks and follow the provisions strength of insolvency framework in-
vency. A new indicator, the strength of elaborated in them (table 12.1). dex was provided by private and public
insolvency framework index, measures sector insolvency practitioners in each
good practices in accordance with The strength of insolvency frame- economy with reference to the appli-
principles developed by the World Bank work index measures whether each cable laws and regulations. The Doing
and the United Nations Commission on economy has adopted internationally Business team analyzed both primary
International Trade Law (UNCITRAL)— recognized good practices in 4 areas: and secondary sources in evaluating
the World Bank’s Principles for Effective commencement of insolvency pro- to what extent insolvency laws in each
Insolvency and Creditor/Debtor Regimes ceedings, management of the debtor’s economy accord with internationally
(referred to here as the “World Bank assets, reorganization proceedings and accepted good practices. Based on this
principles”) and UNCITRAL’s Legislative creditor participation in insolvency analysis, the team assigned a score for
Guide on Insolvency Law (“UNCITRAL proceedings. Each of these topics is each of the 4 component indices. The
guide”).10 addressed by a separate component sum of these 4 scores is the score on
index through several questions. the strength of insolvency framework
The purpose behind expanding the ƒ The commencement of proceedings index. (For a more detailed description
scope of the methodology is to capture index measures what type of pro- of the scoring methodology, see the
multiple aspects of the insolvency ceedings (liquidation, reorganization data notes.)
framework in each economy. The new or both) debtors and creditors can
strength of insolvency framework in- initiate and what standard is used
dex measures the quality of insolvency to declare a debtor insolvent.
laws, while the previous methodology ƒ The management of debtor’s assets WHERE ARE GOOD
(recovery rate) captures the insolvency index measures whether, during PRACTICES MOST
practice. Thus the expanded meth- insolvency proceedings, a debtor can COMMON?
odology will provide a more complete continue transactions essential to the OECD high-income economies have
and balanced view of the insolvency survival of the business and terminate the highest scores on average on the
framework in each economy by ad- contracts that are overly burdensome; strength of insolvency framework
dressing both the quality of the law whether preferential and undervalued index and on each of the 4 component
and the efficiency of its implementa- transactions made by the debtor prior indices (figure 12.1). Among the econo-
tion. One of the findings this year is to the commencement of insolvency mies in this region, Germany and the
that economies with a higher quality can be avoided; and whether the debt- United States have the highest scores.
of insolvency laws as measured by the or can obtain new financing during Europe and Central Asia has the second
strength of insolvency framework insolvency proceedings to support its highest average score on the strength
index experience on average higher continuous operation. of insolvency framework index, though
recovery rates.11 Additionally, while ƒ The reorganization proceedings index there is a substantial difference be-
the previous methodology focused measures whether and how credi- tween the average score of Eastern and
mainly on secured creditors, the new tors vote on a reorganization plan Central European economies and that
98 DOING BUSINESS 2015

implemented many of the good prac-

TABLE 12.1 Objectives of an effective insolvency regime as identified by the World
tices measured by the index as part of
Bank principles and the UNCITRAL guide and measured by the resolving insolvency
indicators their reform efforts.

World Bank principles UNCITRAL guide Resolving insolvency indicators

East Asia and the Pacific and Sub-
Integrate with a country’s Provision of certainty in Saharan Africa are tied with the
broader legal and commercial the market to promote
systems economic stability and third highest score. Economies
growth with some of the highest scores in
Maximize the value of a firm’s Maximization of value New indicator tests whether the value of the Sub-Saharan Africa are those that
assets and recoveries by of assets debtor’s assets can be preserved by continuing
creditors contracts of the debtor essential to survival of adopted the OHADA (Organization
its business, by rejecting overly burdensome for the Harmonization of Business
contracts, by invalidating preferential and
undervalued transactions and by obtaining Law in Africa) Uniform Act Organizing
post-commencement financing. Collective Proceedings for Wiping Off
Provide for the efficient Existing indicators test whether viable Debts. In East Asia and the Pacific
liquidation of both nonviable businesses can be reorganized and whether there is great variation in the strength
businesses and businesses businesses in liquidation can be sold as a going
whose liquidation is likely to concern. of insolvency frameworks. Economies
produce a greater return to that have recently amended their
creditors and reorganization
of viable businesses insolvency laws, such as China,
Strike a careful balance Striking a balance New indicator tests whether creditors and Cambodia and the Philippines, receive
between liquidation and between liquidation and debtors have access to both liquidation and high scores, while other economies
reorganization, allowing reorganization reorganization proceedings and what the basis
for easy conversion of is for declaring a debtor insolvent. have no formal insolvency framework,
proceedings from one such as Palau and the Marshall Islands.
proceeding to another
Provide for equitable Ensuring equitable New indicator tests how similarly situated
treatment of similarly treatment of similarly creditors vote on a reorganization plan and
The region with the lowest average
situated creditors, including situated creditors what treatment they receive under the plan. score on the strength of insolvency
similarly situated foreign
and domestic creditors
framework index is South Asia. Very
few economies in the region have
Provide for timely, efficient, Provision for timely, Existing indicators test how long the
and impartial resolution of efficient and impartial proceedings take and how much the insolvency laws that facilitate the
insolvencies resolution of insolvency proceedings cost for the creditors. continuation of the debtor’s busi-
Prevent the improper use of New indicator tests the basis for commencing ness during insolvency proceedings.
the insolvency system insolvency proceedings.
Economies in the Middle East and
Prevent the premature Preservation of the This principle is tested by the strength of legal North Africa score only slightly better.
dismemberment of a debtor’s insolvency estate rights index.a
assets by individual creditors to allow equitable Only 2 economies in this region have a
seeking quick judgments distribution to creditors reorganization framework, and many
Provide a transparent Ensuring a transparent New indicator tests the level of creditor lack a designated insolvency law; in-
procedure that contains, and and predictable participation during insolvency proceedings,
consistently applies, clear insolvency law that including their ability to request information stead, provisions related to insolvency
risk allocation rules and contains incentives for and to challenge decisions directly affecting are found in company laws and com-
incentives for gathering and gathering and dispensing their rights.
dispensing information information mercial codes.
Recognize existing creditor Recognition of existing New indicator tests whether post-
rights and respect the creditor rights and commencement creditors receive priority over In Latin America and the Caribbean
priority of claims with a establishment of clear existing creditors. This principle is also tested some economies have well-developed
predictable and established rules for ranking of by the strength of legal rights index.b
process priority claims insolvency laws, such as Brazil, Mexico
Establish a framework for Establishment of a Because Doing Business focuses on domestic and Colombia, for example, all of which
cross-border insolvencies, framework for cross- entities and transactions, the indicators do not score relatively high on the strength of
with recognition of foreign border insolvency test this principle.
proceedings insolvency framework index. But most
of the smaller economies in the region,
a. The strength of legal rights index (part of the getting credit indicator set) tests whether the insolvency framework
includes automatic stay (moratorium) provisions, which suspend all individual creditor actions during insolvency. particularly island economies, still use
b. The strength of legal rights index tests the level of priority of secured creditors’ claims as compared with other winding-up provisions in companies
claims—tax claims, employee claims, judgments.
Source: Analysis based on World Bank (2011b) and UNCITRAL (2004). acts that have not been amended for
several decades.
of Central Asian economies. Economies Romania, the former Yugoslav Republic
that have recently reformed their of Macedonia and Montenegro—have This analysis shows that economies
insolvency laws—such as Bulgaria, the region’s highest scores, having that have reformed their insolvency
 RESOLVING INSOLVENCY 99

of an insolvency representative, who

FIGURE 12.1 OECD high-income economies have well-developed insolvency
often has the authority to act on behalf
frameworks and the highest recovery rates
of the debtor and make key decisions
Average strength of Average recovery rate
about the management of its assets.
insolvency framework index (0–16) (cents on the dollar) Almost 60% of economies exclude
16 100
creditors from the process of choosing
the insolvency representative. Lack of
12 75 meaningful participation can affect
creditors’ confidence in the system,
making them less cooperative and
8 50 more litigious and thus prolonging the
proceedings.

4 25
The data for the component indices
also point to economies with particular
0 0
strengths in the areas measured. For
OECD Europe & East Asia Sub-Saharan Latin America Middle East & South example, Germany is one of 51 econo-
high income Central Asia & Pacific Africa & Caribbean North Africa Asia
mies that receive full points on the
Average strength of Average recovery rate commencement of proceedings index.
insolvency framework index The country has unified insolvency
proceedings, which means that when
Source: Doing Business database. a debtor or creditor files for insolvency,
there is no requirement to specify
laws in the past several years score that preservation of insolvent busi- whether liquidation or reorganization
substantially higher on the strength nesses in these economies is virtually is requested. But a debtor may submit
of insolvency framework index than impossible, so that the only option for a reorganization plan together with
economies that rely on old insolvency an insolvent debtor is to sell its assets. its insolvency petition or at a later
provisions in companies acts and stage, and creditors may request the
commercial codes. More than 40% of economies lack spe- insolvency administrator to prepare
cific provisions in their insolvency laws a reorganization plan based on the
that would allow debtors to maintain financial evaluation of the company.
contracts supplying essential goods and The standard for initiating insolvency
WHAT ARE RELATIVE services during insolvency proceedings. proceedings is flexible and includes
STRENGTHS AND While some of these economies require both illiquidity (inability to pay debts
WEAKNESSES? utilities to continue providing services to as they mature) and overindebtedness
The strength of insolvency framework insolvent customers, for many debtors (the debtor’s assets no longer cover
index can be a meaningful instrument this is not enough to ensure continuous existing liabilities). The German insol-
for governments to use in reforming operation. For example, a manufactur- vency framework also allows the com-
their insolvency system, because it ing company must have raw materials mencement of insolvency proceedings
enhances the ability to identify areas to continue operating. And a retail when illiquidity is imminent, which may
where each economy can improve. The business cannot operate without mer- encourage debtors to file for insolvency
data for the component indices point chandise. If suppliers can cancel their before their financial circumstances
to 2 areas where many economies can contracts as soon as a debtor becomes become too dire.
improve: reorganization proceedings insolvent, the debtor’s business op-
and creditor participation (figure 12.2). erations must stop, greatly reducing the Japan is one of 26 economies that re-
There is also room for improvement in value of its assets. ceive full points on the management of
the management of the debtor’s as- debtor’s assets index. Reorganization
sets, to facilitate continuous operation Many economies do not allow creditors and liquidation proceedings in Japan
during insolvency. to participate in important decisions are covered by 2 separate laws. Both
throughout insolvency proceedings. laws include provisions that facilitate
A third of the economies covered by Among the first and most important the continuation of the debtor’s busi-
Doing Business have no formal judicial decisions made after insolvency ness during insolvency. For example,
reorganization framework. This means proceedings begin is the appointment both prohibit the termination of
100 DOING BUSINESS 2015

the plan. To ensure equitable treatment

FIGURE 12.2 Two areas where many economies can improve are reorganization
of dissenting creditors, the Cambodian
proceedings and creditor participation
law requires that they receive at least
Average index score as much under the reorganization plan
as % of best score as they would receive in liquidation.
100

Despite Cambodia’s adoption of a

80 modern and comprehensive insolvency
law, however, recovery rates remain
60 very low. As this example illustrates,
a modern law is not enough to achieve
40 an efficient insolvency practice; effec-
tive implementation and a developed
20 judiciary framework are also essential.

0
Switzerland is one of only 3 econo-
OECD Europe & East Asia Sub-Saharan Latin America Middle East South Asia mies that receive full points on the
high income Central Asia & Pacific Africa & Caribbean & North Africa
creditor participation index. The Swiss
Commencement of Management of Reorganization Creditor insolvency law allows creditors to
proceedings index debtor’s assets index proceedings index participation index participate in many important deci-
sions during insolvency. For example,
Source: Doing Business database. creditors can reject the administrator
appointed by the court and must
contracts on the sole ground that to continue operating while they also approve the handling of the debtor’s
the debtor has become insolvent and recognize and preserve the priority assets during insolvency proceedings.
allow the debtor (or an administrator of existing creditors with preferential They can obtain copies of records re-
or trustee in bankruptcy) to decide claims. lated to the insolvency proceedings so
which contracts should be continued as to stay informed about every stage
during insolvency and which should be Cambodia is one of 17 economies that of the process. And they have the right
terminated. This allows the business receive full points on the reorganization to object to decisions directly affecting
to receive essential goods and services proceedings index. In 2007 Cambodia their rights—for example, they can
that will enable it to survive while elimi- adopted a new insolvency law that, dispute decisions accepting the claims
nating overly burdensome obligations among other features, introduced a of other creditors.
that may threaten its operation. Both reorganization procedure. Under the
laws also allow the avoidance of pref- new law, when a reorganization plan
erential and undervalued transactions is proposed, all creditors whose rights
concluded before the commencement are impaired or modified by the plan WHAT ARE THE LINKS
of proceedings. vote on whether to approve or reject it. WITH CREDIT MARKET
This includes secured and preferential DEVELOPMENT?
In addition, in both liquidation and creditors, because they may represent Analysis of the data collected for the
reorganization proceedings the debtor a substantial share of the value of the strength of insolvency framework
(or an administrator or trustee in bank- debt and their participation may be index confirms the connection many
ruptcy) is allowed to take new loans necessary to achieve successful reor- researchers have made between
if necessary for continuation of the ganization. But creditors whose rights insolvency laws and credit market
business, though approval of the court are not affected do not have the right development. Economies that score
may be required. New loans are treated to vote, as this would grant them un- well on the index have higher levels
as common benefit claims and receive necessary influence. For the purposes of credit provided to the private sec-
preference over the claims of general of voting on the plan, creditors are tor by domestic financial institutions
unsecured creditors but not over those classified into different classes based (figure 12.3).
of secured creditors, whose preference on their interests (secured claims, tax
remains unchanged. Such provisions claims, unsecured claims). All creditors These results suggest that the quality
on post-commencement financing within a class must be treated equally, of bankruptcy laws is important not
permit a debtor in financial difficulties and at least one class must approve for its own sake but as an indication of
 RESOLVING INSOLVENCY 101

FIGURE 12.3 Economies with strong insolvency frameworks have higher levels of NOTES
domestic credit provided to the private sector
This case study was written by Klaus Koch
Saldarriaga, Olena Koltko and María Antonia
Strength of insolvency
framework index (0–16), 2014 Quesada Gámez.
16
1. European Commission 2012.
2. Cirmizi, Klapper and Uttamchandani 2010.
3. Stam, Audretsch and Meijaard 2006.
12 4. See Araujo, Ferreira and Funchal (2012)
for a summary of different studies on the
relationship between creditors’ rights and
economic development.
8
5. Klapper 2011.
6. Cirmizi, Klapper and Uttamchandani 2010.
7. Lee, Peng and Barney 2007.
4 8. Haselmann, Pistor and Vig 2010.
9. Qian and Strahan 2007.
10. World Bank 2011b; UNCITRAL 2004.
0 11. For more on the relationship between the
0 100 200 300 strength of insolvency framework index
Domestic credit to private sector (% of GDP), 2013 and the recovery rate, see figure 1.7 and
the related discussion in the overview.

Note: Domestic credit to private sector refers to financial resources provided to the private sector by financial
corporations, such as through loans, purchases of nonequity securities, and trade credits and other accounts
receivable, that establish a claim for repayment. The correlation between the strength of insolvency framework index
and domestic credit to private sector as a percentage of GDP is 0.40. The relationship is significant at the 1% level
after controlling for income per capita.
Source: Doing Business database; World Bank, World Development Indicators database.

and perhaps a step toward a better- economies, such as Latin America and
developed financial system. Where the Caribbean and East Asia and the
credit institutions and entrepreneurs Pacific.
can anticipate the outcome of the
worst-case scenario—when a busi- The strength of insolvency frame-
ness fails to pay its loans and several work index can be a useful tool for
creditors must compete for the best governments seeking to reform their
return—more banks will be willing insolvency laws because it helps in
to lend and more entrepreneurs will identifying specific areas where in-
be willing to take on the challenge of solvency regulations are lacking. The
starting a business. results suggest that there is oppor-
tunity in many economies to improve
reorganization proceedings, facilitate
the continuation of businesses during
CONCLUSION insolvency and allow greater par-
Analysis of the data collected for the ticipation by creditors in insolvency
strength of insolvency framework proceedings.
index shows that economies with
recent changes to their insolvency
frameworks have better-quality laws.
Among other economies, several still
have no formal insolvency framework
and many more rely on outdated
companies acts and commercial
codes for insolvency rules. Differences
in regulatory quality are especially
apparent in regions with emerging