WORLD BANK GROUP INSOLVENCY AND CREDITOR/DEBTOR REGIMES TASK FORCE W O R K I N G G R O U P O N T H E T R E AT M E N T O F M S M E I N S O LV E N C Y Report on the Treatment of MSME Insolvency © 2017 International Bank for Reconstruction and Development / the World Bank 1818 H Street NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of the World Bank with external contributions. The findings, interpretations, and conclu- sions expressed in this work do not necessarily reflect the views of the World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Design & Layout: Aichin Lim Jones Photo Credits: World Bank Photo Library, Shutterstock Table of Content Foreword................................................................................................................................................................................III Executive Summary.............................................................................................................................................................V Acronyms and Abbreviations......................................................................................................................................... VII Chapter I: Overview............................................................................................................................................................. 1 Chapter II: Understanding MSMEs..................................................................................................................................3 Lack of a Consistent Definition....................................................................................................................................3 Economic Importance of MSMEs..................................................................................................................................3 MSMEs in Developed Economies.............................................................................................................................5 MSMEs in Developing Economies............................................................................................................................5 The Challenges Confronting MSMEs...........................................................................................................................5 Chapter III: MSMEs in Relation to Insolvency Law...................................................................................................... 7 Having an Efficient Insolvency System Is Critical – Especially for MSMEs........................................................ 7 Specific Challenges of MSMEs Entering Insolvency.................................................................................................9 Incentives to Access the Procedure......................................................................................................................10 Creditor Passivity.....................................................................................................................................................12 Limited Information during Insolvency................................................................................................................12 Accessing Financing during the Insolvency Proceeding...................................................................................14 Overlaps between Business Insolvency and Personal Insolvency gimes in the Case of MSMEs............14 Insufficient Assets to Fund the Insolvency Proceedings..................................................................................16 TABLE OF CONTENT i Chapter IV: Responses to MSME Insolvency Issues...................................................................................................19 Is It Necessary for the Insolvency System to Treat MSMEs Differently?...........................................................19 How Existing Standards Deal with MSME Insolvency............................................................................................19 Responses to MSME Insolvency Issues..................................................................................................................... 22 Insolvency Regimes that Eliminate Certain Elements of the Proceeding or Shorten Timelines.................. 23 Jurisdictions with Comprehensive MSME Legislation...........................................................................................30 Chapter V: Conclusions of the World Bank ICR Task Force Meeting, September 19, 2016 – Washington, DC....................................................................................................................... 33 Endnotes...............................................................................................................................................................................37 References....................................................................................................................................................................43 ii REPORT ON THE TREATMENT OF MSME INSOLVENCY Foreword The Report on the Treatment of MSME Insolvency The Modular Approach to MSME Insolvency: arises out of a panel presentation that took place Dr. Ronald Davis (University of British Columbia, during the 2015 meeting of the World Bank Group’s Canada), Dr. Stephan Madaus (Martin-Luther- Insolvency and Creditor/Debtor Regimes Task Force University Halle-Wittenberg, Germany), Dr. (the ICR Task Force) and subsequent discussion Alberto Mazzoni (President of Unidroit, Italy), Dr. among Task Force members in 2016. Following the Irit Mevorach (University of Nottingham, United discussion in 2015, the ICR Task Force resolved Kingdom), Dr. Riz Mokal (South Square Chambers; to prepare a report on the challenges, needs, and University College London; University of Florence), responses to MSME insolvency. As always, in light Justice Barbara Romaine (Alberta Court of Queen’s of the ICR Task Force mandate, the objective of Bench, Canada), Dr. Janis Sarra (University of this work is to inform the World Bank Group’s role British Columbia, Canada), and Dr. Ignacio Tirado as joint standard setter (together with the United (Universidad Autonoma De Madrid, Spain). The Nations Commission on International Trade Law) Modular Approach to MSME Insolvency influenced in the area of insolvency and creditor/debtor rights. the structure of this report and formed the foundation An earlier version of this report was distributed to of much of the material found in Chapters II and the 2016 ICR Task Force members, who positively III. Additionally, section B of Chapter IV was co- welcomed the discussion around this topic. During authored by Janis Sarra, Mahesh Uttamchandani, the 2016 meeting, the ICR Task Force was asked and Andres Federico Martinez. to consider the challenges faced by countries Finally, we are grateful to those who provided valuable attempting to reform their insolvency systems in input relating to their jurisdictions, including: Robert the context of MSME needs. The guidance from the Hertzberg (Partner, Pepper Hamilton LLP, and Past Task Force is included in Chapter V of this paper. President, INSOL International) – United States, This report is the result of the ICR Task Force’s Kazuhiro Yanagida (Partner, Yanagida & Partners) resolution. It has been developed under the – Japan, Justice June Young Chung (President leadership of Andres Federico Martinez, with Judge, Seoul High Court) – South Korea, and support from Nicholas Avis and Oleksandra Svyryba, Annerose Tashiro (Partner and Head of International and includes contributions from other World Bank Business Recovery / Cross-Border Restructuring and International Finance Corporation Staff and and Insolvencies, Schultze & Braun GmbH Consultants Farid Anvari, Yiannis Bazinas, Simon Rechtsanwaltsgesellschaft) – Germany. Bell, Fernando Dancausa, Matthew Gamser, Antonia Our appreciation is extended to Catherine Connor Menezes, Nina Mocheva, Will Paterson, and Ghada Lips for editing, and to Aichin Jones and Li Wen Teima. Comments were also provided by external Quach for design and production services. peer reviewer: Catherine Bridge Zoller (Principal Counsel, European Bank for Reconstruction and May 4, 2017 Development). Our appreciation is further extended to the team of seven leading academics, and a member of the Mahesh Uttamchandani Canadian judiciary, who co-authored the paper Chair, ICR Task Force FOREWORD iii Executive Summary Micro, small, and medium enterprises (MSMEs) process and those that are secured typically are among the largest commercial users of focus on enforcement of security at the first sign insolvency systems. MSMEs are a significant part of financial distress and thus efficiencies may be of the global economy – and just as there are large lost; numbers of MSMEs, there are large numbers of • Lack of information about MSME debtors – MSME insolvencies. However, there are very few MSME debtors may lack good records and specialized legal regimes for MSME insolvency; reliable financial information. This makes it most jurisdictions treat MSME insolvencies the harder to assess the viability of the MSME debtor same as for other corporate entities, or conversely, and erodes creditor trust in the MSME debtor natural persons, despite MSMEs’ unique attributes. and the effectiveness of insolvency processes; This Report: • Post-insolvency financing – many insolvency systems do not permit or incentivize • Considers the specific challenges of insolvent financing after formal insolvency proceedings MSMEs (including the difficulties of are filed even though such financing will be vital defining MSMEs and distinguishing them from to MSME survival. MSMEs are specifically large corporate entities); vulnerable to this risk; • Reviews and analyzes how legislation in • Insufficient assets to fund a formal insolvency different jurisdictions deals with the challenges procedure – MSMEs often lack the of MSME insolvency; and resources to cover the costs and fees for a formal • Considers if existing international standards are insolvency procedure; sufficient to address MSME insolvency. • Personal debts – MSMEs are often financed This Report establishes that some of the key with a mixture of corporate debt and personal challenges for MSME insolvency are: debt taken on by the entrepreneur (including potentially personal guarantees being granted); • Complex insolvency systems – these deter the failure of the MSME may thus have severe MSMEs from resorting to formal procedures consequences for the entrepreneur and their to tackle financial distress. Many countries family including social stigma; and use complex systems that unsophisticated MSMEs struggle to understand this complexity; • Natural persons – MSMEs might be informal thus discourages timely use of insolvency by entities that have not been incorporated, such MSMEs; as sole proprietorships. In many jurisdictions, they are therefore subject to the same insolvency • Creditor behavior – where creditors have few regime as natural persons, which might not have incentives to deal with MSME debtors through the necessary commercial controls in place to legal processes, those that are unsecured protect the financially distressed business of the generally have limited participation in the MSME. EXECUTIVE SUMMARY v This Report comes to the following main size), frameworks should not only focus on conclusions in relation to MSME insolvency: reorganization/restructuring, but also on ex- peditious liquidation mechanisms; • Any definition of MSME insolvency should not be overly prescriptive because of the varying • Due to the lack of sophistication on the part of definitions of “MSME” around the world; MSMEs, jurisdictions should consider providing out-of-court assistance to MSMEs such as • As a starting point, consideration should be given mediation, debt counselling, financial education, to addressing the particular issues that arise in or the appointment of a trustee (though it is the cases of MSME insolvency through specific noted that funding such assistance must be MSME provisions in the existing insolvency considered); frameworks; the ICR Task Force members did not endorse, at this stage, establishing separate • Further exploration is needed between the regimes for MSME insolvency, but they intersection of personal insolvency frameworks acknowledged that further investigation into this and MSME insolvency; and topic is needed; • Further exploration is needed to determine if it • Since the majority of MSMEs facing insolvency is advisable to revise some of the World Bank are more likely to liquidate and not go into ICR Principles to provide specific guidance for reorganization/restructuring (by virtue of their dealing with MSMEs. vi REPORT ON THE TREATMENT OF MSME INSOLVENCY Acronyms and Abbreviations CPA Certified Public Accountant ICR Insolvency and Creditor/Debtor Regimes IFC International Finance Corporation IMF International Monetary Fund MSME Micro-, Small-, and Medium-Sized Enterprises NPL Nonperforming Loan OECD Organisation for Economic Co-operation and Development OHADA Organization for the Harmonization of Business Law in Africa SBR Small Business Rehabilitation SME Small- and Medium-Sized Enterprises UNCITRAL United Nations Commission on International Trade Law WB-ICR Principles World Bank Principles for Effective Insolvency and Creditor/Debtor Regimes ACRONYMS AND ABBREVIATIONS vii CHAPTER 1 Overview Micro, small, and medium enterprises (MSMEs) of employees. This demonstrates that although form the foundation of the global economy. MSMEs are often categorized under one label, Although the diversity and sheer number of MSMEs there are vast differences among those companies make it difficult to properly quantify them and labeled as such. measure their impact, they represent the majority Studying MSMEs is difficult because there is no of businesses and are key drivers of employment, consistent or universally accepted definition of the economic growth, and entrepreneurship in virtually term. Countries and international organizations all economies. apply different measurements and tools when Just as MSMEs are present in large numbers, so too determining whether an enterprise should be do they fail in large numbers. In many economies, labeled as micro, small, medium, or large. Although they are among the largest commercial users of the this complicates the study of MSMEs, it has insolvency system. Yet many jurisdictions treat not hindered the development of a vast body of them the same, for insolvency purposes, as other scholarship. corporate entities, or consumers, without regard to Regardless of how different countries define their unique attributes. Given that many MSMEs, MSMEs, it is generally accepted that many of them particularly micro enterprises, are informally face common challenges. Informality is one. Many organized, commercial legal systems (including for entrepreneurs, for a variety of reasons, forgo formal insolvency) tailored to their needs play a critical registration of their enterprise and operate without role in encouraging such informal MSMEs to limited liability. This practice is seen around the formalize – a critical step in improving the economic world, but it is particularly common in developing and financial inclusion of the entrepreneurs and economies. However, for many entrepreneurs and employees of informal MSMEs. The report explores shareholders, the difference between an informal the specific challenges of insolvent MSMEs, looks and formal corporate structure is limited – in many at how legislation in different jurisdictions responds cases, MSME lenders require personal guarantees to these challenges, and begins the examination to secure loans, meaning the main advantage of a of whether current international standards are limited liability corporate structure is significantly sufficient to address the unique challenges, needs, reduced. and nature of MSMEs. Other challenges that commonly afflict MSMEs are MSMEs vary in size and nature, and the term their constrained access to credit and acute difficulty “MSME” encompasses a wide-ranging spectrum weathering macroeconomic and financial shocks. of businesses. Most MSMEs fall into the Furthermore, they may lack the sophistication or “micro” category, which usually includes sole knowledge to properly address complex processes proprietorships and single-employee businesses. with limited resources. Alternatively, firms at the other end – labeled as “medium” enterprises – may be starkly different The combination of challenges that MSMEs face from their micro counterparts and have hundreds makes it more difficult for MSMEs to manage the OVERVIEW 1 complexities normally required for insolvency Countries have adopted different approaches toward procedures. Perhaps unsurprisingly, MSMEs are the issue of MSME insolvency. Many countries treat one of the business structures that most often MSME insolvency with the same general procedures undergo insolvency proceedings. applicable to large corporations or conversely natural persons. Some other countries have tried Having an efficient, expeditious insolvency system to address the needs of MSME insolvency by in place that rescues MSMEs or swiftly reallocates tailoring their insolvency laws. They have done this their productive assets to more efficient activities is by shortening timelines for MSMEs, or eliminating paramount. Insolvency laws should be designed to certain formalities from the “standard” insolvency allow debtors and creditors to meet and interact to law. Other countries have implemented tailored resolve a situation of financial distress, as is deemed procedures that are specific to MSMEs, or provided most appropriate. There remains a question of some degree of procedural unification for personal whether broad parameters for corporate insolvency guarantors and companies undergoing connected systems, as reflected in the international standards, insolvencies. What these country experiences show can effectively respond to the needs of MSMEs. is that there are typically two ways in which MSME The insolvency process itself can be difficult for insolvency is being addressed – either first, by MSMEs. Of particular concern is the complexity and making slight modifications or allowing exemptions length of typical insolvency processes, especially in from certain requirements to the existing provisions developing economies where the institutional support in the insolvency legislation, or second, by drafting is lacking. When an MSME enters financial distress, entirely new provisions that target MSMEs, such as the solvency of the parties that are personally liable the cases of Japan and Korea. (by operation of personal guarantees or an unlimited The Report presents this material in detail with the liability business structure) for the debts needs to aim of triggering a discussion and providing inputs be addressed. Another issue is that many smaller to the next stage of the research, which is likely MSMEs may lack funds to cover the expenses of an to revolve around whether a specific legislative insolvency process or fail to generate an expectation treatment for MSME insolvency is appropriate for unsecured creditors to receive any returns. or not. The preliminary evidence collected so far Therefore, while insolvency laws require that suggests that changes to insolvency standards might creditors prove their claims, monitor the company be a possible remedy to adequately address the either individually or via a creditors’ committee, vote specific challenges of MSME insolvency. However, on restructuring proposals, etc., there are very limited the Report’s scope is limited to describing the incentives for creditors to actively participate in the present situation and does not address solutions to process. Finally, MSMEs usually have more acute the problems raised. issues in obtaining financing during restructuring, whenever the company is viable. 2 REPORT ON THE TREATMENT OF MSME INSOLVENCY CHAPTER 2 Understanding MSMEs LACK OF A CONSISTENT DEFINITION To further complicate the matter, in some countries there are different official definitions of The term “micro, small, and medium enterprises” what constitutes a MSME based on the ministry, (MSME) has different definitions depending on the department, or context in which the term is used. context and location in which it is used. For example, a definition of MSME assigned by The number-of-employees criterion is the most corporate law or regulations may often be different common method of distinguishing MSMEs from from the definition assigned by other legislation – large enterprises. This criterion is often combined including the insolvency law or regulations – within with other criteria such as sales or loan size.1 A study the same country. by the World Bank found that the definition used by What all this demonstrates is that the definition the financial regulators in 50 of 68 countries used of MSME is not standardized. Depending on the number-of-employees criterion, and 29 of them the country, industry, and entity using the term, combined the number-of-employees criterion with MSME may take on a new meaning. This makes the other two criteria. The sales criterion was used comparisons between jurisdictions difficult. It also in a total of 41 of the 68 countries, and in 15 of the means that countries need to be careful in how they 68 countries loan size was used.2 define and regulate MSMEs in their legislation. As Within each criterion, the exact standard that is used this research highlights, merely because they are to define what constitutes a MSME varies greatly small does not mean that they are less complex. from country to country and region to region.3 There is no official definition of MSME adopted in Regarding the number-of-employees criterion, a this report, but rather we defer to each country’s study of 122 economies, as seen in Table 1, found definition – which, as stated, normally contemplates that the range of employees that represented the the number of employees alone or along with sales upper thresholds of a medium enterprise varied volume and/or loan size. Where necessary and between 19 employees in American Samoa to 3,000 appropriate, a definition may be provided, often in employees in China (though 249 is a more common the context of how the term was treated as part of a upper threshold). The lower threshold that dictates relevant study. Overall, the report is structured such the minimum criteria to count as a micro-enterprise that its content relies on the respective country’s also varies, but to a lesser extent: 83 of 110 definition, which typically is adapted to its specific jurisdictions set the threshold at one employee, and circumstances. 27 include companies with fewer than one employee (indicating that sole proprietors are included). Moreover, within some economies’ number-of- ECONOMIC IMPORTANCE OF MSMES employees criterion are sector-specific thresholds, Despite the absence of a uniform definition for as demonstrated by the aforementioned threshold MSMEs, there is no doubt that they play a crucial from China, which only applies to MSMEs in the role in the economies of both developed and transportation and construction sectors. developing countries. Measuring the impact of UNDERSTANDING MSMEs 3 Table 1: Select Sample of How MSMEs Are Measured (Based on Number of Employees) 4 Economy Micro Small Medium 37 Economies* 1-9 10-49 50-249 7 Economies** 1-9 10-49 50-99 American Samoa 1-4 5-9 10-19 Bahrain, Jordan, Uruguay 1-4 5-19 20-99 China <300 Industry <2,000 Industry <600 Construction <3,000 Construction <100 Wholesale <200 Wholesale <100 Retail <500 Retail <500 <3,000 Transportation Transportation <1,000 Post <400 Post <800 in Hotels & <400 in Hotels & Restaurants Restaurants United States 1-9 10-99 100-499 * Brazil, Bosnia and Herzegovina, Dominican Republic, European Union Member States, Iceland, Moldova, Macedonia FYR, Montenegro, Puerto Rico, Serbia, and Tunisia. ** Bangladesh, El Salvador, Islamic Rep. of Iran, Lebanon, Switzerland, Uganda, and the West Bank and Gaza. MSMEs, however, can be difficult because many Corporation (IFC) study of 132 countries found that MSMEs (particularly micro-enterprises) form part on average there were 31 MSMEs per 1,000 people, of the informal economy, meaning they are not and between 2000 and 2009 the number of MSMEs formally registered in their respective economies.5 per 1,000 people grew at 6 percent per annum.9 The Kushnir et al state that the difficulty in counting the growth rate for MSMEs was lower in high-income informal MSMEs is significant because MSMEs countries as compared to low-income countries.10 often outnumber formal MSMEs, particularly in One of the most notable benefits of MSMEs is their developing countries. In India, for example, there contribution to employment.11 An estimated 60 are roughly 17 informal MSMEs for every formal percent of private sector employment, or one-third MSME.6 High-income countries tend to have more of the world’s labor force, is attributable to MSMEs formal MSMEs, whereas informal MSMEs are (Box 2.1). The value generated by MSMEs is also more common in low-income countries.7 significant: they represent 52 percent of private Nevertheless, even when accounting for the sector value added (“value added” is the value of an difficulties in measuring MSMEs, it is clear that economy’s output less intermediate consumption, they play an outsize role in many economies. or GDP less taxes but including subsidies).12 In 2010, the total global number of formal and The importance of MSMEs was introduced as informal MSMEs was estimated to be 420 million to a key topic in the G20 agenda in 2010 and most 510 million, and in the developing world there were recently reaffirmed at the G20 Antalya Summit an estimated 365 million to 445 million formal and in 2015, where leaders placed a “special focus” informal MSMEs.8 A 2016 International Finance 4 REPORT ON THE TREATMENT OF MSME INSOLVENCY BOX 2.1: The Impact of MSMEs on Employment13 Formal MSMEs employ more than one-third of the world’s labour force.i In Canada, for example, small businesses employ 7.7 million employees, comprising 69.7 percent of the total private sector labour force and account for 78 percent of all private jobs created in Canada.ii In the European Union, 9.4 million jobs were created in the MSME sector in 27 European Union countries between 2002 and 2008.iii From a regional perspective, East Asia and the Pacific have the highest ratio of MSME employment to total employment, driven largely by China, where formal MSMEs account for 80 percent of total employment.iv The OECD countries report that MSMEs with fewer than 250 employees account for two- thirds of the formal work force.v on promoting programs that contribute to MSME of exports,” and in South Africa an “estimated 91 growth and employment.14 The importance of percent of the formal business entities […] that are them was again reinforced in the subsequent G20 [MSMEs] contribute 52-57 percent to GDP.”21 In meetings in 2016 and 2017. Ghana, MSMEs contribute about 70 percent to the country’s GDP.22 Overall, an estimated 33 percent MSMEs in Developed Economies of employment in developing countries comes from formal MSMEs.23 A 2014 report from the Bank for International Settlements found that “[i]n the non-government sectors of advanced economies, [MSMEs] account THE CHALLENGES CONFRONTING MSMES for over 95 percent of the total number of enterprises, MSMEs often face specific challenges that make 60 percent of total employment and over 50 percent them fundamentally different from large enterprises. of value added.”15 On average, 51 percent of the By definition, MSMEs are smaller, and they often GDP in high-income countries is produced by have less capital, a lower market share in their formal MSMEs.16 In the United States, 99 percent respective markets, a smaller workforce, and fewer of all enterprises are MSMEs, and they employ resources overall as compared to large enterprises. over 50 percent of private sector employees and These factors result in MSMEs operating differently generate 55 percent of net new private sector jobs.17 from larger businesses, and accordingly the Similarly, in the United Kingdom 99.9 percent of challenges and obstacles they face are unique. The enterprises are MSMEs, and they employ over 60 specific challenges confronting MSMEs also have percent of all private sector employees.18 consequences in the insolvency field, as highlighted more in depth in the next chapter. MSMEs in Developing Economies MSMEs fail in significant numbers. A 1999 study The influence of MSMEs remains significant in that analyzed bankruptcies in the United States low-income countries, although their impact is found that 80 percent of U.S. firms that filed for harder to measure because of higher levels of bankruptcy had assets under USD 1 million, informal MSMEs. An estimated 16 percent of and 88 percent had fewer than 20 employees.24 GDP in low-income countries is produced by Understandably, part of the explanation of why formal MSMEs19, and the informal MSME sector MSMEs fail in such large numbers is simply contributes about 40 percent of GPD.20 In specific because they constitute the largest proportion of countries, the impact of MSMEs on GDP is evident private sector businesses.25 However, their small – in Morocco, for example, “93 percent of industrial size and scope of operations contribute to their firms are [MSMEs], accounting for 38 percent of the high failure rates. As Davis et al suggest, MSMEs production, 33 percent of investment and 30 percent often have undiversified suppliers and customers, UNDERSTANDING MSMEs 5 making the loss of a significant counterparty or a members, the financial crisis continues to have a late payment more unsettling. In addition, MSMEs long-lasting impact on the provision of financing to frequently lack the resources to afford assistance MSMEs, making it difficult for MSMEs to secure from legal and financial experts. credit in some economies.31 Given that MSMEs are typically unable to access For many MSMEs, the cost of credit is prohibitive finance at levels similar to larger enterprises, because they are often subject to high collateral MSMEs often have difficulty weathering thresholds. For those that can secure debt, lenders macroeconomic and financial shocks, as observed frequently charge higher interest rates and fees as in Denmark, Italy, Spain, and Ireland when MSME compared to larger enterprises.32 Labor growth is also insolvencies exceeded 25 percent from 2007 to 2009 related to the ability to access finance. MSMEs that during the global financial crisis.26 Accessing credit have access to financing have employment growth 1 is necessary for many businesses to fund growth or to 3 percentage points higher than enterprises with to sustain operations during periods of cash flow no access to finance.33 Moreover, increased access to misalignment. Underserved or unserved financing finance has been correlated with higher numbers of needs may push an enterprise into insolvency. The MSMEs in an economy, thereby compounding the IFC estimates that half to two-thirds of formal benefits of increased access to finance.34 MSMEs lack proper access to finance.27 The total Furthermore, many entrepreneurs must take a high unmet credit need for formal and informal MSMEs level of personal financial risk to start a MSME, the around the world is estimated to be USD 3.1 trillion most common of which is personally guaranteeing to USD 3.8 trillion. In emerging markets, the total business loans. MSME owners are often required unmet need for credit is USD 2.1 trillion to USD to give personal guarantees to secure loans, and in 2.5 trillion.28 the event of bankruptcy, this means that individuals What is striking about the credit gap affecting may be liable regardless of whether the business was MSMEs is how it affects discrete groups within a corporate entity. This could result in a lifetime of the MSMEs category. When focusing on formal debt depending on the circumstances and governing enterprises (on which there are more data available legislation, thereby deterring entrepreneurs from than informal enterprises), the credit gap is most re-entering the market. acute in emerging economies. Fifty-two percent Entrepreneurs are further afflicted by the difficult to 64 percent of emerging market microenterprises task of securing start-up capital. As previously have unmet financing needs representing USD discussed, access to credit is already difficult 400 billion to USD 500 billion. Among SMEs, 55 for MSMEs with existing business operations – percent to 68 percent of have unmet financing needs, understandably, getting start-up loans is even more representing USD 900 billion to USD 1.1 trillion. In difficult. This is a greater constraint in emerging comparison, the credit gap in developed countries economies where angel finance, seed capital, is USD 100 billion to USD 200 billion, and USD and even venture capital tend to be considerably 600 billion to USD 700 billion for microenterprises underdeveloped. As the above suggests, MSMEs and SMEs, respectively.29 Among Organisation for face a number of challenges in their normal Economic Co-operation and Development countries operations that many larger enterprises do not. (OECD), the stock of outstanding loans to MSMEs When entering the zone of financial distress, new increased in 16 of 27 countries from 2013 to 2014, challenges appear, as described in the following but it remains below 2007 pre-crisis levels in seven chapter. countries (when adjusted for inflation, the number rises to 12).30 The OECD suggests that among its 6 REPORT ON THE TREATMENT OF MSME INSOLVENCY CHAPTER 3 MSMEs in Relation to Insolvency Law HAVING AN EFFICIENT INSOLVENCY report, if creditors have greater assurance of debt SYSTEM IS CRITICAL – ESPECIALLY FOR recovery through insolvency regimes, they will MSMES be more likely to provide financing through more innovative and better-suited financial products. It As mentioned in Chapter II, MSMEs play a large should be noted that for the purposes of this report, role in the global economy. They also fail in the focus is on how formal insolvency procedures large numbers. Since MSMEs are large users of can help address MSME financial distress. However, insolvency systems, it is necessary to ask whether informal procedures, such as workout frameworks existing insolvency frameworks address the needs that take place without any court involvement, or of MSMEs. hybrid procedures with limited court/institutional Effective insolvency regimes, if properly im- involvement, are also key in helping preserve viable plemented, may mitigate many of the challenges businesses and encouraging creditor-debtor dialogue facing MSMEs, as outlined in the previous chapter. and restructuring. Moreover, as workout regimes Consider access to credit – this is one of the greatest typically involve informal and private negotiations, challenges plaguing MSMEs, and it can be mitigated they provide greater flexibility, confidentiality, and by efficient insolvency systems. By replacing out- less onerous administrative requirements, which of-date insolvency legislation with a more effective is particularly useful when dealing with MSMEs. regime, lender confidence is increased because the Further information on informal workouts and the improved insolvency process provides lenders with different models they take can be found in other more certainty and predictability in regard to the World Bank Group publications.37 recovery of defaulted loans.35 This increases the As seen in Box 3.1, effective insolvency regimes amount of credit available in an economy and in turn form part of a well-functioning economy. The better reduces the credit gap. these insolvency regimes can address the challenges In addition, the issue of MSME insolvency is of and unique characteristics of their users, the better importance to the World Bank Group agenda of the outcome for the economy. In regard to MSMEs, financial inclusion, which is considered as a key an insolvency law is of particular importance enabler to reduce poverty and boost prosperity. to promote risk-taking and entrepreneurship, Financial inclusion focuses on providing individuals and reduce the stigma of bankruptcy, which can and businesses access to useful and affordable have widespread, and sometimes tragic, social financial products and services that meet their consequences.38 needs.36 Clearly, as described throughout this MSMEs IN RELATION TO INSOLVENCY LAW 7 BOX 3.1: “The Importance of Insolvency Law”39 Insolvency regimes that are responsive to the needs of MSMEs are particularly important. Insolvency law is broadly recognized as an essential tool in a well-functioning economic framework.i A balance of mechanisms that allow for timely and effective liquidation, but also for a “fresh start” for entrepreneurs and rehabilitation of viable businesses tends to enhance creditor recoveries and confidence. In turn, they can stimulate greater volumes of lending,ii at longer maturity periods,iii at lower costiv and lower levels of collateral.v Such mechanisms can also offer an effective framework for the creation of new business activity.vi Credible restructuring schemes can ensure that businesses with viable going-forward business plans can survive, in turn preserving jobs, supply contracts, customer goodwill, and economic stability more generally.vii From a macro financial perspective, effective insolvency laws enable financial institutions to resolve problem assets more efficaciously, thereby freeing up provisioning resources, strengthening investors’ perception of financial sector stability, pro tanto improving banks’ ability to lend, and thus particularly benefitting small and medium enterprises in many economies where such businesses are particularly dependent on bank funding.viii The World Bank has observed that effective insolvency systems enhance predictability and thus lender confidence in loan recovery on default, which encourages more lending and leads to financial inclusion for more businesses. Of significance for MSMEs globally are both the formal legal rules and informal societal rules and practice norms that affect entrepreneurs, including the design of bankruptcy laws, the structure of capital markets, and the perception of stigma related to personal responsibility.ix Cost-effective insolvency proceedings can encourage inefficient firms to exit, encourage greater entrepreneurial activity and new firm creation, and can result in greater returns to creditors.x Timely resolution of financial distress can reduce uncertainty for entrepreneurs, creditors and management, and improve asset value and transparency.xi A well-functioning MSME insolvency regime can heighten the salience of the downside risk of a venture, in turn increasing the number and variety of people pursuing entrepreneurial activities.xii It can benefit lenders because of the certainty in recovery rules, in turn increasing confidence in lending. The efforts of organizations such as UNCITRAL and the World Bank have contributed significantly to creating model insolvency legislation, best practice guidance, and to helping governments implement reforms.xiii The effectiveness of insolvency laws nevertheless varies among countries around the world. xiv According to a survey on debt enforcement in 88 countries, referenced by a World Bank Research Paper, bankruptcy procedures are time-consuming, costly and inefficient in being able to preserve the business as a going concern; in only 36 percent of countries is the business preserved as a going concern; and an average of 48 percent of the business’s value is lost in debt enforcement.xv The World Bank Group Doing Business report for 2014 found that among 38 selected indicators/measures of the regulatory and institutional environment, the secured creditor recovery rate in distress scenarios was the single most valuable measure.xvi The World Bank also examined MSMEs that had defaulted on bank loans and found that differences in the level of creditor rights in bankruptcy in the different jurisdictions had an impact on lending terms, particularly those used by bank creditors; and that legislative reform regarding liquidation led to a decrease in interest rates, although reorganization reform had the opposite effect.xvii Moreover, a research study for the International Monetary Fund reports that six years since the global financial crisis, the problems of high levels of corporate debt and nonperforming loans (“NPLs”) persist in several European countries.xviii It found that SMEs in general are more leveraged and reliant on bank financing than large firms and have significantly higher non-performing loan (“NPL”) ratios. It also found that given the large number of SMEs, their small size and heavy reliance on collateral, SME loan restructuring is more costly and riskier for large firms than for banks, and current frameworks are ill-suited for SMEs, both in the ways they limit restructuring options and how they prevent speedy liquidation and exit.xi 8 REPORT ON THE TREATMENT OF MSME INSOLVENCY Better legislation can reduce the cost of credit. Finally, as referenced in Box 3.1 above, an insolvency This is important for MSMEs because a lower regime for MSMEs might be needed on a temporary cost of credit makes financing more accessible basis, to specifically and urgently address MSME and affordable. In Brazil, reforms to its insolvency financial distress arising in a crisis, similar to what legislation caused an average reduction in the cost several European countries experienced in the wake of credit ranging from 7.8 percent to 16.8 percent of the global financial crisis.43 In such situations, from the level prior to the reforms being enacted. MSME weaknesses can further erode banks’ asset A study involving SMEs in France, Germany, and quality and profitability, with increasing levels of the United Kingdom found that banks priced their NPLs economy-wide. The faster the banks’ balance loans based on their expected rights in the event sheets can be strengthened, the easier it will be to of a default. Conversely, “creditor unfriendly” free up credit for new loans.44 Although the analysis insolvency regimes resulted in higher costs.40 of MSME financial distress in a crisis context is not within the scope of this report, it should be noted When companies undergo reorganization and that the International Monetary Fund (IMF) has business rescue, job preservation is promoted with examined different tools that European countries efficient insolvency laws. In the United Kingdom, implemented to quickly and effectively deal with revised reorganization laws resulted in new debt recovery following a crisis.45 For instance, the owners retaining all of an enterprise’s employees analysis mentions Latvia, Moldova, Portugal, and in 65 percent of receivership and administration Ukraine as introducing fast-track court approval cases where the business was sold as a going procedures to support the rescue of viable businesses concern.41 Job preservation for MSME employees at an early stage, and other countries implementing is particularly important because MSMEs are the out-of-court restructuring frameworks, such as largest source of employment in many economies. Portugal, which adopted guidelines to facilitate Effective insolvency regimes can also be used to debt recovery through mediation, with a specific spur entrepreneurship and reduce the personal risk focus on MSMEs.46 that individuals who create enterprises are forced to shoulder. If a business defaults on a loan that SPECIFIC CHALLENGES OF MSMES the entrepreneur personally guaranteed, then that ENTERING INSOLVENCY guarantor is liable to repay the business’s debts. Apart from the challenges outlined in the previous This may result in the guarantor being held liable chapter regarding MSME operations in normal for the business’s debts long after bankruptcy. circumstances, there are several challenges Debtor-friendly personal bankruptcy laws provide that arise specifically when MSMEs face acute a safety net for entrepreneurs. By granting debtors financial distress. These challenges include a lack some concessions, individuals are less likely to be of incentives to access the insolvency procedure, deterred from pursuing entrepreneurial ventures creditor passivity, limited information, overlaps because of the risk of guaranteed loans, and with the personal insolvency regime, and difficulty experienced entrepreneurs who undergo bankruptcy accessing new finance. Another challenge, more can quickly recover from their mistakes and re- closely related to the end of a MSME’s existence, enter the marketplace. Although entrepreneurship is how to deal with insolvency cases where the is hard to measure, economies with effective MSME’s assets are insufficient to cover the insolvency laws are known to have higher levels cost of the proceedings (the so-called “no-asset of venture capital funding (venture capital is often cases” or “insolvent insolvencies”). It is also used to fund entrepreneurship, so higher levels of worth mentioning that the absence of reporting venture capital funding suggest higher levels of requirements and frequent informality of MSMEs entrepreneurship).42 MSMEs IN RELATION TO INSOLVENCY LAW 9 may exacerbate the difficulties of identifying sophistication to identify and react to financial financial distress at an early stage. These challenges distress.47 This may result in MSMEs waiting too are not exhaustive and they are not always present, long before initiating the insolvency process. This but they are the most common and often the most problem is particularly acute for MSMEs given the concerning. limited incentives they have for starting a complex and burdensome proceeding, often without an The challenges discussed below may afflict large effective business rescue framework, as is the case enterprises as well as MSMEs. However, they arise in many of the insolvency processes around the more frequently in MSME insolvency proceedings world. Also, the social barriers48 and reputational than in large enterprise insolvency proceedings. stigma associated with the insolvency system may discourage MSME representatives from resorting Incentives to Access the Procedure to formal insolvency proceedings. Davis et al have Prior to entering an insolvency proceeding, many summarized this challenge as follows: MSMEs are disadvantaged because they lack the BOX 3.2: “The Debtor’s Position, Role and Obligations in MSME Insolvencies”49 In many countries, the insolvency system is infrequently used, and in the cases where it is used, cases are often limited to value-destructive piecemeal liquidation or even to no-asset cases. This tendency generates a negative reputation for the insolvency system, which is perceived by the market as an inefficient tool, to be avoided at all costs. A country with a non-functional market exit system sees its credit affected and its economy grows—if at all—at a rate under its potential. The legislator needs to break the vicious circle by active measures that modernize the system and by creating incentives for market stakeholders to start using insolvency as a tool to heal sick but viable businesses, not as an ineffective way to bury dead ones. In the field of MSMEs, where often individuals—and families— are involved, the legislator must often consider social problems, such as reputational damage or the involvement of the entire household in the entrepreneurial project. These circumstances act as an additional barrier to the use of the system. The absence of a rescue culture and the aforementioned social constraints requires a double system of sanctions and incentives to ensure the use of the system at adequate levels, as illustrated by the incentives discussed above. Yet, experience shows that incentives are often not enough. More drastic measures have to be implemented in the form of sanctions and compensation for damages when certain circumstances accrue. In this section, these sanctions are analyzed in some detail, with particular regard to wrongful trading/duty to file rules, which serve the double purpose of ensuring an early filing of insolvency and protecting creditors from a management of the business that undermines their legitimate expectations to the benefit of shareholders. The problems, however, do not only lie with the lack of use of the insolvency system. If and when the lack of rescue culture, the social stigma, and poor market perception are overcome, problems may nonetheless arise concerning the manner in which debtors utilize the MSME insolvency regime. 10 REPORT ON THE TREATMENT OF MSME INSOLVENCY In many countries, insolvency laws are designed access the insolvency procedures in a timely way – with the complexity and sophistication of large when entering the so-called “twilight zone” period companies in mind. For a MSME, the complexity – that often include a duty to file for insolvency of insolvency proceedings often is a disincentive or a regime based on wrongful trading. The World to seek timely remedies to financial distress. Some Bank Principles addressed this issue in their latest features in insolvency systems that may play a revision (2015) in Principle B2: disincentive role are: (1) the automatic separation “Laws governing directors’ obligations in the of management from the ordinary administration of period approaching insolvency should promote the business upon filing for insolvency (including responsible corporate behavior while fostering rehabilitation); (2) the copious documentation reasonable risk taking and encouraging business required to start the process that often includes a reorganization. The law should provide appropriate legal requirement to file audited balance sheets for remedies for breach of directors’ obligations, which several periods; and (3) the uncertainty in the costs may be enforced after insolvency proceedings have generated by the many participants involved in the commenced50.”51 process. As described by David et al in Box 3.3 below, a Regardless of whether a MSME is a corporate pre-insolvency regime that focuses on facilitating or not, directors tend to delay filing for a formal the rescue of viable businesses is particularly insolvency process. Several corporate insolvency critical for MSMEs, and can help address debtor systems contemplate “sticks” when directors fail to moral hazard. BOX 3.3: “MSME Obligations at Times Approaching Insolvency”52 When insolvency is imminent, debtors should have greater regard to the interests of creditors and should attempt to address the distress situation. Yet, at that time, small entity debtors may be very reluctant to access the insolvency system, concerned about stigma, about losing their business, which is likely their only source of income, and being overly optimistic about the business’ prospects. Debtors may also be prone to adopt more high-risk strategies, attempting to avoid at all costs losing their business or the business’ assets. They may be inclined to collaborate with related persons or powerful creditors, hide or dispose of assets. The problem is particularly acute where debtors use the corporate form for their MSMEs. Incorporated MSME managers, who are likely to also be the business owners, may consider that they are safe from the outcomes of insolvency as they are protected by limited liability. Small debtors are also likely to be less concerned about returning to the managerial labour market and thus more prone to act self-servingly. Unincorporated MSMEs may take excessive risks if they consider that they will be released from liabilities through an insolvency discharge. A regime that focuses on the period of imminent insolvency is particularly important for encouraging action at an early stage and for facilitating rescues of viable businesses, aspects that are critical to the procedural framework contemplated for MSME insolvencies. Therefore, a regime for pre-insolvency obligations can complement the procedural framework and enhance it. It can provide an educational tool for MSMEs with regard to the proper means for addressing the situation of financial distress and the proper use of the module options. A regime that addresses the obligations of debtors at times approaching insolvency can respond to such concerns as debtor moral hazard. It can deter irresponsible behaviour at times of financial distress and provide guidance to debtors with regard to the appropriate actions they should take. MSMEs IN RELATION TO INSOLVENCY LAW 11 Incentivizing MSMEs to file for insolvency Creditor passivity often arises when creditors procedures is challenging – and incentivizing them weigh the amount they estimate they will receive to do so in a timely fashion is even more challenging. from participating in the insolvency process against This is especially the case when MSMEs operate as the amount of time and money this effort requires. unincorporated entities and when they are family If the costs outweigh the return, then creditors make businesses. It is legitimate to pose the question of the rational decision to not get involved. whether a tailored MSME insolvency regime could In many large enterprise insolvency cases, the generate more incentives – and how to achieve the value of the debt to which creditors have a claim objective of MSMEs tackling distress in a timely way. is high. The potential for recovering this claim is increased because large enterprises often tend to Creditor Passivity have large estates with many assets. In these cases, MSME insolvency systems require that debtors the expected return for participating creditors and creditors put an early effort into resolving outweighs the costs of participating, so creditors the business’s issues in a timely manner, and pre- are more active in the insolvency process. In the insolvency regimes (that are used to pre-emptively case of many MSME insolvencies – particularly dealing with financial distress before businesses are those where the debtor is toward the “micro” end insolvent) are becoming increasingly important. of the spectrum and has few assets – the return that Regarding financial creditors and MSMEs, this is creditors can expect to receive is simply not high most likely to involve only one or two institutions. enough to justify the costs of participating. In these However, creditor passivity can hamper this cases, creditors choose to remain passive. process, as early and proactive actions result in the best outcomes. BOX 3.4: “Creditor Passivity and Reckless Behaviour”53 Limited resources in MSME insolvencies lead to very limited expectations for unsecured creditors regarding any substantial distribution in respect of their claims. Thus, unsecured creditors often have little incentive to incur further costs (e.g., travel costs, communication costs, investment of time) with regard to the insolvent debtor by participating actively in negotiations or proceedings. Overall, it is rational for a creditor not to participate unless it has a special interest in the result of the proceedings – most notably because it is personally connected to the debtor (by family ties, or as an employee), or where it appears that some value may be recoverable. Secured creditors, on the other hand, are interested in the enforcement of their security, which usually occurs through sale of the debtor’s assets. This interest may result in the liquidation and winding up of the debtor’s business. This type of enforcement often does not require any court proceedings or supervision; it could as well be done using out of court auctions or transactions. Aiming at saving the cost and delay of court hearings, it is rational for secured creditors to argue in favour of quick out–of- court auctions. In the context where the approval of restructuring Limited Information during Insolvency plans requires the majority of stakeholders to vote positively, creditor passivity makes it more Ineffective gathering and dissemination of information complicated to save the business, even when the to relevant parties can strain the insolvency system. business is viable. As seen in Box 3.5, the insolvency system works best 12 REPORT ON THE TREATMENT OF MSME INSOLVENCY BOX 3.5: “Addressing Information Gaps”54 One of the main obstacles to the proper implementation of a MSME system, and a major contributing cause of debtor misbehaviour is the absence of adequate information in the MSME insolvency process. An effective MSME insolvency system would work substantially better if the debtor provides the necessary information and is willing and available to collaborate throughout the entire procedure. In some cases, and in some jurisdictions, however, particularly in the less developed economies, the very existence of the information cannot be taken for granted. when debtors provide creditors and other relevant those applied to formal enterprises (particularly parties with the information they require. Many debtor large and publicly traded ones). Large corporations MSMEs, however, may have difficulty collecting often maintain sophisticated records that are and disseminating the required information because available to shareholders, creditors, and the public. of inefficient or non-existent recordkeeping systems, MSMEs – even those that are formally registered whether caused by a lack of resources or simply not but not publicly traded – have fewer reporting seeing a need for them. requirements, thus lowering the obligation to engage in comprehensive recordkeeping. The informal nature of many MSMEs, particularly in developing countries, further complicates The issues arising when records are not kept up recordkeeping. The legal obligations imposed on or kept at all are most problematic in relation to informal enterprises are often less stringent than financial information, as discussed in Box 3.6. BOX 3.6: “Financial Information in MSME Insolvency”55 Financial information is a key element in the mechanics of a market economy. Without proper, reliable, comparable financial statements, stakeholders cannot make investment decisions and the ex post control of the behaviour of market agents is not possible. This risk exists for all market participants, including –and in no less degree—MSMEs. Experience shows that information problems are more important the smaller the business is. Especially in developing economies, the level of informality is high: sometimes entrepreneurs and small entities do not have a legal duty to file proper accounts, or the duty is only rarely enforced; owners and managers have little or no knowledge of account drafting; and public training courses and awareness campaigns are very scarce. MSMEs conduct their activity “the way it’s always been”, with, at best, home-based accounting practices. This situation is incompatible with the proper development of the MSME sector, and, hence, of the economy of a given jurisdiction. An adequate level of formality and, more precisely, sufficient financial information, are key to a workable system to tackle MSME insolvency. Without it, access to finance is limited, risk seems higher, and therefore the price of financing is also more expensive. In case of financial difficulties, out of court agreements are hindered, many insolvency tools are useless (liability of directors, avoidance actions, etc.), and there are perverse incentives to destroy value by owners of distressed MSMEs. The entire system to tackle business distress might be thwarted. Even in those countries where there is a proper system of debt discharge, the fresh start of the debtor is hampered by the impossibility of making a proper assessment of the discharge test, given the lack of information, at least in those systems where the discharge is based on an ad hoc analysis of the debtor’s behaviour. MSMEs IN RELATION TO INSOLVENCY LAW 13 Out-of-date or non-existent record books make Accessing Financing during the Insolvency it hard to judge whether a MSME is approaching Proceeding insolvency, essentially preventing the MSME from Accessing finance is vital for MSMEs, even more so proactively addressing the impending situation. when they face financial distress. Many insolvency Insolvency laws are usually very detailed about the systems do not make it easy for MSMEs to access documents required from debtors, which enable post-filing or post-commencement financing, even them to file for a voluntary insolvency process. though survival of the enterprise may depend on it Balance sheet information is needed, for example, to with the alternative being liquidation. For example, prepare the list of creditors and calculate assets and out-of-date legislation does not allow a super- liabilities, which are required by most insolvency priority to be granted to those creditors that provide regimes. Many MSMEs, especially those on the a MSME with additional finance. The importance “micro” end of the spectrum, struggle to provide and challenges of accessing financing for distressed such basic information because of inadequate MSMEs has been described in Davis et al (Box 3.7). recordkeeping. BOX 3.7: “Financing MSME Proceedings”56 In many jurisdictions, MSMEs have difficulties accessing sufficient levels of financing. This situation particularly arises at the inception of the business life and, even more intensely, when the business suffers liquidity tensions and financial distress. The rescue of viable MSMEs may only happen if the business receives financing. Otherwise, the activity comes to a stop and piece-meal liquidation is the only real alternative. In most jurisdictions, but particularly where the market still needs development, the absence of a rescue culture and the stigma associated with it, the lack of an enabling legal framework, the lack of real possibilities to lower the risk of lending for small debtors (e.g., no assets free for collateral, limited ability to offer personal guarantees), and the passivity of creditors, thwart the continuation of the business activity, frustrating chances of business recovery and value preservation. In this light, the legal and institutional frameworks of a country need to provide the mechanisms to ensure that troubled but viable businesses are able to access financing with a view to trading out of their difficulties. Possible mechanisms to enhance access to finance at times of distress, with reference to relevant key stages of MSME insolvency and with particular consideration of the specific problems encountered in the MSME context, are discussed below. The position of the debtor that went through the insolvency process and how the financing framework can enhance the concept of “fresh start” and encouragement of new businesses is also discussed. It should be stressed, however, that there does not appear to be a single effective strategy for financing of MSMEs in distress, given the size and range of such businesses. The universal features to consider when designing the framework must be efficiency and affordability. Implementation should be left to national variations, based on different socio-economic contexts and variety of legal traditions. Most traditional insolvency systems do not consider Overlaps between Business Insolvency and the possibility of super-priority for fresh funds, or Personal Insolvency Regimes in the Case of provisions that encourage access to finance for MSMEs companies undergoing rehabilitation. A particular issue that arises for MSME insolvency Consideration should be given as to whether, in the is the overlap and conflicts between regimes for specific case of MSMEs, provisions of this nature insolvency of businesses and regimes for insolvency could be introduced and how. of natural persons. 14 REPORT ON THE TREATMENT OF MSME INSOLVENCY Whereas one of the main purposes of a business their contracts of employment. The application insolvency regime is to ensure the orderly resolution of the insolvency regimes to such large corporate of debt and distribution of value to creditors entities will usually not impact the personal assets whenever the business is unviable (frequently or status of the directors or employees of the involving the dissolution of the debtor company), entity (except to the extent they hold equity, which the purpose of a personal insolvency regime is to is lost because equity holders are typically the couple, and also balance the distribution of value to lowest ranking creditors of the entity). Creditors creditors with a basis for the debtor to continue their are looking to the assets of the company only so economic life (since, once the insolvency process that the corporate veil is fully maintained in legal for a natural person is concluded, the debtor will proceedings (except where there has been fraud or usually still be in existence). The nature of many other breach of duty by employees of the entity). MSMEs, particularly microbusinesses, is such A MSME, however, will, even if it is a company, that a clear distinction between the business and frequently feature the directors of the entity providing the persons operating it does not always exist and not just equity but also debt funding to the company. it is not clear which insolvency regime (business There will often be poor or non-existent records of or personal) is better suited to apply to MSMEs. transactions and relationships between entrepreneurs A MSME may be incorporated as a corporate and the company. There may be no clearly established entity or unincorporated; from a legal standpoint, ownership of key commercial assets (such as tools this has several consequences for the limitation of or other essential equipment) between the controllers liability and applicability of a personal or corporate and the company (since the controllers may, as insolvency law regime to the business, depending founders of the business, have simply purchased on each country’s legislation. commercial assets themselves with their own money) and the entrepreneur and their family may Overview of issue engage in work and activity for the MSME that is In contrast to the insolvency of large corporate not documented or remunerated following typical entities, where the owners, directors, employees, commercial practices. The entrepreneur may use and debt providers are largely separate and distinct personal monies to fund or support the business classes with distinct interests, in the case of MSMEs, without necessarily documenting such expenditures these roles may significantly overlap. As discussed as a loan to the business or in any other way. The in Chapter I, MSME entrepreneurs may not comply money that an entrepreneur invests in a MSME may with corporate registration requirements or even itself be borrowed from a creditor who expects to establish companies and (as discussed in more look to the natural person as the relevant debtor, not length below) may provide personal guarantees to the MSME. The personal assets of the entrepreneur creditors of the MSME. may also be of equal or greater value than that of the MSME; this would encourage lenders to seek In the case of a large corporate entity: (1) the entity recourse personally to the entrepreneur, not the will frequently receive debt funding from external MSME. This is especially true in economies where lenders (many of whom will not have any equity the commercial practices still have a strong personal interest in the entity); (2) there will be at least some component (e.g., where credit information systems equity providers who have no other interest in the are underdeveloped). company; (3) the company will be controlled by directors who are supported by equity holders (but In such circumstances, even where there is, as a will themselves be employees with usually low matter of law, a corporate veil in place because levels of equity themselves); and (4) the entity will the MSME business was established as a separate employ other employees who have no relationship legal entity, as a matter of fact there will be little (such as debt or equity) with the entity other than distinction between the affairs of the MSME and MSMEs IN RELATION TO INSOLVENCY LAW 15 the personal affairs of the entrepreneur. These a new approach to business failure and insolvency. issues are most prevalent in the case of micro and The European Commission also proposed a new small businesses in developing economies. Directive on preventive restructuring frameworks, second chance and measures to increase the It can, therefore, be argued that at least some efficiency of restructuring, insolvency, and discharge MSMEs operate, and are lent to by creditors, procedures.58 in such a way that the assets and/or legal status of the entrepreneur can hardly be meaningfully The creditor solution of seeking personal guarantees distinguished from the MSME. and/or security over personal assets effectively amounts to extending the reach of business insolvency Practical effects of the issue regimes to personal assets. This may raise a series Where relevant legal regimes permit, creditors of policy questions that relate to the intersection have developed a particular commercial and risk- with personal insolvency regimes. A particular management solution to deal with the nature of many concern is that personal insolvency regimes typically MSMEs when there is a high degree of involvement carve-out certain assets from the reach of creditors, with an entrepreneur’s personal affairs and/or the considering those assets practically inappropriate for personal assets are of greater value than the business the discharge of debts. Another issue that may require assets. In such circumstances, creditors seek to further analysis is the applicability of a personal bring the personal assets of the entrepreneur within insolvency regime (or not) to an unincorporated the scope of MSME insolvency through personal MSME and the process to separate business assets guarantees and security over personal assets. A from personal assets to respond to commercial personal guarantee typically extends liability for the debts. For all intents and purposes, lenders’ use debts of the MSME to the entrepreneur; the effect of personal guarantees and taking of security over of this is that personal effects as well as business personal assets result in there being no corporate assets owned personally by the entrepreneur may veil for affected entrepreneurs; this has significant be affected by the insolvency of the MSME (so that implications in the many jurisdictions that have no even if the MSME is a legal entity, the corporate personal insolvency regime and thus subject debtors veil is effectively pierced). Also, where a personal to lifelong debt repayments. The absence of any insolvency regime exists, it may be triggered in personal insolvency laws coupled with creditor parallel to the business insolvency regime applying policies may run contrary to longstanding policy to the MSME. When an entrepreneur owns a home, aims of enabling business failure and debt write-off lenders typically take security over it, since an to encourage entrepreneurship. entrepreneur’s residential property may often be of Considering the significant proportion of businesses greater value than the business assets of the MSME that are MSMEs in developing economies, it is or other personal assets. Arguably, from a creditor clear that practical consequences of the overlaps perspective, the problem can be solved where there between business and personal insolvency issues is are personal assets to lend against so that creditors significant and consideration may be given to treat do not need to consider the relationship between the these issues specifically in the World Bank ICR entrepreneur and their MSME nor the potential impact Principles. of personal insolvency law. An added complexity is that many countries do not have a personal insolvency Insufficient Assets to Fund the Insolvency system in place, which jeopardizes the chances of the Proceedings personal debtor to obtain a “discharge.” Providing the entrepreneur with the opportunity for a fresh start is Related to the challenges above, many MSMEs that essential, as recognized by the World Bank in earlier meet the criteria for commencement of insolvency publications57 and more recently recognized by the proceedings are never formally declared bankrupt European Commission in its recommendation on and liquidated. Often, this is because MSMEs 16 REPORT ON THE TREATMENT OF MSME INSOLVENCY tend to wait too long to file an insolvency petition, of their business. The absence of assets may also to the point that when the petition is filed, the be the result of fraud, with debtors taking money remaining funds are insufficient to cover even the out of a business for personal use, concealing or administrative costs and fees, let alone provide any transferring assets to related parties, and engaging meaningful recovery to creditors. While this may in similar practices that might contribute directly not be a MSME-specific issue, in reality, MSMEs to the failure of the business. Thus, no-asset cases are more likely to face such a scenario. As explained not only present issues relating to the preservation above, the reasons for that are multiple: (1) lack of of economic value and creditor recovery, but also sophistication to navigate the complex insolvency relate to the integrity of the insolvency system and system if the country does not have a simplified its role in setting the right incentives for debtors by MSME regime (Box 3.2); (2) greater perception promoting responsible risk taking and encouraging of stigma related to personal responsibility in the fair commercial conduct.61 case of failure59; and (3) lack of sufficient internal There are currently at least two approaches to control mechanisms, as prescribed by general dealing with no-asset insolvency cases: corporate law for large corporations. • Some insolvency laws provide that when, at As a result of lateness, many MSME insolvency the time of filing, it appears prima facie that the filings are classified as no-asset cases and insolvency debtor’s assets are not sufficient to cover the laws differ in their approach to their administration. costs, the court should deny the petition, or order Despite the prevalence of no-asset cases in judicial termination of the proceedings, if the absence of practice across a number of jurisdictions, especially sufficient assets is determined post opening62; in developing countries, few insolvency laws and provide a mechanism for their administration.60 While creditors (especially unsecured) would prefer • Some insolvency systems not only provide for to open proceedings and pursue the recovery of opening the proceedings in such circumstances, hidden or transferred assets in order to maximize but also provide a specific mechanism to cover the their chances of meaningful recovery, this can entail necessary funds either by requiring the petitioning significant costs (e.g., the remuneration of insolvency creditor(s) to provide them individually or by practitioners and experts, court fees, etc.) that exceed creating a specially designated fund, financed by the potential benefits. In many instances, only a close individual creditor contributions and/or the public examination of these cases can uncover the debtor’s budget. full financial situation, possibly enable the avoidance Greece and Poland are among the countries that of transactions or allow creditors to hold the debtor have opted for not opening insolvency proceedings liable for malfeasance, and request compensation. if the debtor’s assets are not sufficient to cover the costs.63 Thus, debtors are not declared bankrupt, The approach of an insolvency regime to no-asset and remain in the Business Registry (sometimes insolvencies may have a considerable effect on called “zombie companies”). debtor and creditor incentives and influence the conduct of the debtor on the verge of insolvency. Bulgaria, Serbia, and Romania, where no-asset cases While a MSME might be in a no-asset situation present a significant percentage of all insolvency because of normal business practice, or lack filings, have chosen other approaches. The Bulgarian of sophistication and perception of stigma, as Code of Commerce (Art. 629b) provides that, when explained above, it could also result from improper the debtor’s assets do not cover the expenses of business conduct. For instance, debtors may take proceedings, the court may determine the amount unreasonable risk as they approach insolvency, required to cover the administrative expenses, set a gambling for their recovery in an attempt to avoid time limit for creditors to advance this amount, and an insolvency filing and continue the operation open insolvency proceedings. When the amount is MSMEs IN RELATION TO INSOLVENCY LAW 17 not advanced within the specified time limit, the and court fees and remuneration of the insolvency debtor is declared insolvent and proceedings are administrator are covered by the country’s public immediately terminated.64 budget. In Serbia (Art. 13, Serbian Bankruptcy Law), The way an insolvency system deals with no-asset bankruptcy proceedings are terminated immediately cases is an important policy decision that is usually when it is established that the value of the affected by many factors such as the country’s debtor’s assets is lower than the expenses of the legal tradition, the public perception toward debt bankruptcy proceeding or that the debtor’s assets and fraudulent debtors, and so on. The prima are of negligible value. However, any petitioner, the facie rejection of such cases may result in reduced debtor or a creditor, may request the continuation creditor recovery and “zombie companies” that are of proceedings if it deposits the necessary assets to not properly liquidated. Additionally, the rejection cover the expenses of proceedings, as prescribed by of no asset cases creates the potential for owners/ the bankruptcy court. directors to avoid liability for malfeasance, since their business is never subject to court bankruptcy The establishment of a fund to cover expenses proceedings. in no asset insolvencies can be found in several jurisdictions. For example, in Armenia, under the Considering MSMEs are most likely to face a no- Law on Bankruptcy (enacted in 2006, as amended asset insolvency situation, it may be worthwhile in 2016), the absence of sufficient assets to cover exploring whether the insolvency system could the costs of proceedings is not grounds for rejection envisage a mechanism for opening and administering of the insolvency petition or the termination of such proceedings, specifically in the context of insolvency proceedings. Proceedings are opened, MSME insolvency. 18 REPORT ON THE TREATMENT OF MSME INSOLVENCY CHAPTER 4 Responses to MSME Insolvency Issues IS IT NECESSARY FOR THE INSOLVENCY They form the basis for the analysis conducted by SYSTEM TO TREAT MSMES DIFFERENTLY? the World Bank Group in the ICR Report on the Observance of Standards and Codes (ROSC). In this If an insolvency regime is compliant with section, we consider the application of principles for international standards and effectively addresses in-court processes to MSME insolvency. Under the many of the challenges facing large corporations, ICR Initiative, the World Bank Group carries out its the issue then becomes whether such an existing mandate as a global standard setter for ICR systems, insolvency regime can also provide MSMEs together with the UNCITRAL, as designated by the with these benefits. As Davis et al write in Box Financial Stability Board. 4.1, the common practice of using the same or similar insolvency procedure for MSMEs and One of the main questions that persists in the large enterprises may produce suboptimal results. treatment of MSMEs in insolvency is whether there Instead, they suggest that MSMEs may be better are sufficient tools in the international domain to served by a separate insolvency system that is help guide countries in their domestic law reform specifically designed for MSMEs. processes. As noted above, the two primary international instruments – jointly designated as As stated in the overview, the purpose of the the international standard by the Financial Stability paper is simply to trigger a discussion on these Board – are the World Bank Principles and the matters. Although Davis et al present a compelling UNCITRAL Legislative Guide on Insolvency Law. argument for creating a new insolvency regime UNCITRAL does mention small businesses in the specific to MSMEs, further investigation is needed. Legislative Guide. The Legislative Guide aims The following section examines how existing to provide a comprehensive statement of the key standards treat MSMEs, and whether changes to objectives and principles that should be reflected in a these principles can better address the challenges State’s insolvency laws. While it provides a valuable MSMEs face. The chapter concludes with case reference tool for national legislative authorities studies on how countries approach MSMEs in their by reviewing the adequacy of their laws and existing legislation. regulations or enacting new ones, and discusses the obstacles facing small creditors in terms of barriers HOW EXISTING STANDARDS DEAL WITH to participation, there are few policy suggestions MSME INSOLVENCY specifically for MSMEs. Part one of the four-part The World Bank Principles for Effective Insolvency Legislative Guide discusses the key objectives and Creditor/Debtor Regimes, together with the of an insolvency law, the types of mechanisms United Nations Commission on International Trade available and the institutional framework required Law (UNCITRAL) Legislative Guide on Insolvency, to support an effective insolvency regime. It does are the internationally recognized benchmarks for not specifically address the particular challenges Insolvency and Creditor/Debtor Regimes (ICR), facing MSMEs that have been highlighted in this both in respect to in-court and out-of-court processes. Task Force paper, aside from briefly noting that the RESPONSES TO MSME INSOLVENCY ISSUES 19 BOX 4.1: “One Size or Strategy for MSME Insolvency Will Not Fit All”65 The public policy in many jurisdictions is to encourage the formation and growth of MSMEs, yet that policy does not necessarily align with treatment during financial distress. Insolvency processes in many countries are too expensive and unwieldy for MSMEs. As noted previously, the broad range of definitions for MSMEs in various jurisdictions is highly problematic for the types of issues facing MSMEs. One size does not fit all. Often, on MSME insolvency, there are few or no assets to realize. Liquidation is the most prevalent outcome, which can result in loss of value to creditors and debtors. Insolvency regimes not designed to address MSME failure can fail to distinguish viable businesses from non-viable ones. As noted [in the previous chapter], the owners of small businesses usually need to secure business loans with their personal assets or personal guarantees, creating a convergence and blurring of distinctions between personal and business liability in practice, a factor not accounted for in most insolvency law regimes globally. Researchers have observed that while the personal guarantee of a firm’s owner might encourage a level of financial discipline, in countries without a personal bankruptcy framework, a single business failure can doom an owner to a lifetime of outstanding debt;i effectively preventing such individuals from re-entering the market as experienced.ii Evidence suggests that exactly the opposite approach better serves standard public policy objectives. One study that compared self-employment in 15 countries in Europe and North America from 1990-2005 found that the more forgiving the personal bankruptcy laws, measured particularly in reference to the time a bankrupt individual has to wait to be discharged from pre-bankruptcy debts, combined with ready access to limited liability protections, the more entrepreneurial activity was enhanced.iii The failure to recognize this convergence of personal and business debt means that debtors may have access to effective liquidation or rehabilitation schemes only if they fit within very specific criteria. For example, in Canada, there is a highly streamlined mechanism for MSME businesses under Division II consumer proposal provisions of the BIA, which are accessible to self-employed individuals and sole proprietors whose debts are less than 250,000 CAD (USD 185,435), excluding a mortgage or hypothec on the individual’s principal residence, if 50 percent or more of their debts are business-related.iv But these mechanisms are not available where the individual has incorporated the business. Nor are insolvency regimes only relevant to one end of the MSME lifecycle. Access to credit is particularly important for MSMEs. The global MSME lending volume is estimated to be 10 trillion USD, of which 70 percent is in high-income OECD countries.v On average, small and medium enterprise loans constitute 13 percent of gross domestic product (“GDP”) in developed countries and 3 percent in developing countries.vi In a survey of 130,000 firms in 135 countries, the World Bank Group found that there is unmet demand for bank loans and lines of credit in developing regions, particularly Africa.vii The survey found that while almost 60 percent of businesses require a loan at some point, just over a third of businesses have a loan or line of credit. The survey results revealed that well-designed insolvency laws are a factor in accessing credit, directly related to creditor confidence in the ability to recover.viii In turn, access to credit can assist with fostering entrepreneurship and the creation of new business activity. 20 REPORT ON THE TREATMENT OF MSME INSOLVENCY costs and fees associated with accessing insolvency Part three of the Legislative Guide addresses proceedings may be of particular importance to the treatment of enterprise groups in insolvency, small- and medium-size businesses. both nationally and internationally; it is not directly applicable to the overwhelming majority Part two of the Legislative Guide deals with core of MSMEs and there is no specific reference to features of an effective insolvency law, including smaller debtor companies in this section. Part four standardized commencement criteria, stays, post- of the Legislative Guide focuses on the obligations commencement finance, participation of creditors, that might be imposed on the directors and officers expedited reorganization proceedings, simplified responsible for making decisions when an enterprise claims procedures, conversion of reorganization faces insolvency or becomes insolvent. This section to liquidation, and clear rules for discharge of the refers to family members and senior employees of debtor and closure of insolvency proceedings. small family-owned companies being considered While these elements are directly relevant to de facto directors, some criteria for that assessment, MSMEs, they assume that debtor companies have and potential resultant liability. The UNCITRAL the financial and human resources to undertake the Model Law on Cross-Border Insolvency (1997) and processes envisioned, which is not the reality for the its Guide to Enactment make no specific reference vast majority of insolvent MSMEs. The Legislative to MSMEs. Guide does make reference to cost burdens that deter creditors and discourage commencement of Part I C of the World Bank Principles contains the proceedings, “of particular importance in the case of legal framework for insolvency and deals with insolvency of small and medium-size businesses.” different stages of the process, including the due It also notes the issue of overlap of consumer and process, commencement criteria, governance of small business debt as follows: insolvency processes, administration, claims and claims resolution procedures, and reorganization One issue that may need to be taken into account in proceedings. While some of the Principles are more considering discharge of natural persons engaged relevant to MSMEs than others, there is little or no in a business undertaking is the intersection of specific reference to MSMEs. business indebtedness with consumer indebtedness. Recognizing that different approaches are taken to Both documents reflect how insolvency systems the insolvency of natural persons (in some States a have been designed in many States. Such systems natural person cannot be declared bankrupt at all, have been designed with larger enterprises in while in others there is a requirement for the person mind, assuming “an extensive insolvency estate of to have acted in the capacity of a “merchant”) and significant worth, and the presence of creditors and that many States do not have a developed consumer other stakeholders with sufficient value at stake that insolvency system, a number of States have they participate in and oversee the process.”66 insolvency laws that seek to distinguish between In April 2014, after an extensive and thorough those who are simply consumer debtors and those preliminary analysis, UNCITRAL’s Insolvency whose liabilities arise from small businesses. Since Working Group V declared that “the mechanisms consumer credit is often used to finance small provided by the Legislative Guide were not business either as start-up capital or for operating sufficient to address all of the needs of MSMEs; funds, it may not always be possible to separate the thorough treatment of the issues would require debts into clear categories. For that reason, where both a consideration of matters not yet addressed a legal system recognizes both consumer and in the Legislative Guide as well as the tailoring business debt, it may not be feasible to have rules of solutions already in the Legislative Guide on the business debts of natural persons that differ to specifically address MSMEs.”67 The Group from the rules applicable to consumer debts. RESPONSES TO MSME INSOLVENCY ISSUES 21 observed, for example, that “the application of countries that are part of the Organization for the elements of the insolvency law, such as creditor Harmonization of Business Laws in Africa (OHADA) committees, the central role of the courts and eliminate certain requirements when dealing with extensive involvement of insolvency professionals, MSMEs as compared to larger enterprises or might not be appropriate for MSME regimes.”68 focus on making insolvency proceedings faster for MSMEs, such as India and the United States. These The World Bank, while it has dedicated considerable latter models of insolvency frameworks generally resources to the financing and education of represent tweaking, and not significant changing, MSMEs, also does not have a specific approach of the “general” framework. The countries included to MSME insolvency that addresses the problems in this report were selected as a sample only. There identified above. Its extensive studies acknowledge are several other regimes (including, but not limited that MSMEs are collectively the largest employers to Iceland, Portugal, etc.) whose MSME-specific in many low-income countries, facing barriers to provisions deserve to be studied more in depth as access to capital and financial services. The World well. Bank has developed a wide range of available instruments to help meet the challenge of MSME An important distinction must be drawn between finance, including data analysis, financing, risk- “small cases” and “MSME-specific” procedures. sharing, technical assistance, a financial inclusion Many jurisdictions adopt legislation that applies to support framework, and working globally with “small cases,” and the eligibility criteria for these standard-setting bodies to develop guidelines, proceedings often coincide with the requirements standards, and good practices. However, to date, to be considered a MSME. The general idea that there has not been the development of similar if an enterprise meets a certain threshold – such as instruments and policies expressly aimed at MSME the number-of-employees or revenue criterion – it insolvency. The World Bank Insolvency and is assumed to be a MSME and therefore subject to Creditor/Debtor Regimes Task Force, Report of the a special proceeding that may reduce formalities, Working Group on the Treatment of the Insolvency shorten deadlines, reduce certain fees, etc. However, of Natural Persons very briefly mentions small a criterion based on the number of creditors is also business in the context of overlap of consumer frequently used to separate small and standard and business credit in small businesses. Hence, cases. In such examples, enterprises that may not the current Task Force offers the potential to make commonly be seen as MSMEs may fall under a significant contribution to the development of the “small case” criteria. If considered by itself, instruments and approaches to MSME insolvency this number-of-creditors criterion means that a that address the core problems with the current company – no matter its size by other measurements framework. – is subject to a “small case proceeding” simply because it has a number of creditors below a certain RESPONSES TO MSME INSOLVENCY threshold. As seen in the country examples below, ISSUES some countries have adopted this path – in those cases, we conclude that although MSMEs might Jurisdictions around the world have taken steps to not be the exclusive beneficiaries of “small case” accommodate MSMEs through what they perceive proceedings, such proceedings are the one generally to be more appropriate insolvency legislation. A few applicable to MSMEs. jurisdictions, such as Japan and Korea, have enacted new legislations that create tailor-made MSME The following case studies show how select countries insolvency procedures. In these jurisdictions, the structure their MSME insolvency procedures. The insolvency framework that applies to MSMEs is insolvency frameworks are organized based on different from the “general” insolvency framework. one of two categories: frameworks that eliminate Other jurisdictions, such as Argentina and the 17 elements of a “general” insolvency procedure, and 22 REPORT ON THE TREATMENT OF MSME INSOLVENCY frameworks that are tailored to MSMEs. Although (2) there are no more than 20 unsecured creditors; the case studies are divided into categories, they or (3) there are no more than 20 employees. If one are not mutually exclusive, so the category each of the requirements is met, then the legislation jurisdiction is assigned is based on its dominant contemplates a series of consequences. The “small traits. Given the recent nature of several of the case” procedure is triggered ex-officio, regardless country examples included below, consideration of whether the debtor or the creditor files. should be given to further explore the success stories What are the main differences between the process and impacts of each regime, in future publications. for “small cases” and the general insolvency process? Insolvency Regimes that Eliminate Certain Elements of the Proceeding or Shorten The law contemplates four differences for “small Timelines cases,” in contrast to large cases: Some jurisdictions opt to modify certain parts of • The formalities for the debtor to open the process the “general” insolvency proceeding for MSMEs. are lighter. One of the main simplifications refers For example, in Argentina, there are no longer to the filing requirements. While the general creditor committees and some fees have been insolvency procedure requires the debtor filing either eliminated or reduced. Similarly, in OHADA for reorganization to attach a certified opinion of countries, certain document filings are not required, a certified public accountant (CPA) on both the and documents that are difficult to produce or to list of creditors and the list of assets, the opinion fully complete do not need to be filed provided the from the certified public accountant is merely debtor files an acceptable explanation. optional for “small cases,” according to Art. 289 Some insolvency systems make few exceptions for LCQ. “small cases” except for changes in the length of • The establishment of a creditors’ committee the insolvency proceedings. In India, the insolvency is not mandatory, in contrast to the general regime that was approved in 2016 provides for a insolvency process. “fast-track” for MSMEs – that is, enterprises that • The special proceedings specified in Art. 48 do meet certain criteria may have shorter deadlines not apply. Art. 48 opens up the opportunity for and reduced timeframes in which to conduct an creditors to compete with the debtor in offering insolvency proceeding. In the United States, some alternative restructuring proposals. In other deadlines are reduced while other deadlines, such as words, according to Art. 48, when creditors do the length of a reorganization plan, are eliminated. not ratify a reorganization plan proposed by the The framework adopted by OHADA would also fit debtor, instead of leading to bankruptcy directly, into this category as it imposes shorter timeframes it opens a process during which any creditor or than do regular proceedings. interested party may file an offer to purchase the equity capital of the company. ARGENTINA • Finally, the insolvency practitioner’s functions Eligibility to be considered “small case”: Under do not end with the ratification of the agreement, the Ley de Concursos 24522 (Bankruptcy and unless creditors determine so. The rationale is Liquidation Law) are Arts. 288 – 89 that address that typically a creditors’ committee controls small reorganizations and liquidations. To qualify the reorganization agreement; this is optional in for special treatment under the above Articles, the “small cases.” debtor must have one of the following characteristics: (1) liabilities do not exceed a sum that is equivalent The application of the “small procedure” does to 300 minimum wage payment (approximately not have any consequences in terms of shortening USD 154,652 at the August 2016 exchange rate); deadlines, unlike some other jurisdictions below. RESPONSES TO MSME INSOLVENCY ISSUES 23 GERMANY agencies are, for example, the debtor advisory agencies of the welfare organizations. Suitable Eligibility to be considered “small case”: The persons are typically the lawyers. German Insolvency Code (Insolvenzordnung) submits “small insolvencies” to the same process as • Step 2. The judicial settlement plan- envisaged for consumer insolvencies. Specifically, proceedings: If the extra-judicial attempt to Part Nine of the Code applies to consumers reach a settlement with the creditors fails, the (consumer is defined as a natural person who debtor can file a request to open insolvency pursues or has pursued no self-employed business proceedings. Besides the certificate of the activity) and also to other debtors who have pursued suitable agency or person, the debtor must self-employed activity provided that their assets are submit a settlement plan and records of its assets comprehensible and no claims exist against them and its income, its creditors and its debts. Since from employment contracts (Art. 304). The assets the law envisages a pre-packaged procedure, of a debtor are considered comprehensible if the the debtor must submit (upon petition) this plan debtor has 20 or fewer creditors at the time the for the settlement of its debts (Art. 305[4]). The request is made to open insolvency proceedings. settlement plan has to contain all provisions that are suitable for an appropriate settlement of the The number of employees and revenues from the debts. It can be identical to the plan on which company do not determine its eligibility as a “small the debtor´s extra-judicial settlement attempts case.” were based. The courts accept even a so- What are the main differences between the process called “zero-plan.” These are settlement plans for “small cases” and the general insolvency of debtors with no income and no assets and process? that provide no payments to the creditors. The effect of the acceptance of the “zero-plans” by In general, the Insolvency Code envisages a the court is that debtors either in the settlement simplified, pre-packaged restructuring procedure plan-proceedings or at the latest after the six for the reorganization of the debtor’s business in years of the discharge proceedings can be freed the cases described above. Art. 304 includes three of their debts even if they cannot pay anything steps: to their creditors. Upon submission of the petition, the court will suspend proceedings for a • Step 1. Attempt of extra-judicial settlement: maximum period of three months (Art. 306) and Consumers and small debtors (as defined communicate the plan (along with the inventory) above) are required to attempt an out-of-court to the creditors designated by the debtor, in settlement before filing for the commencement addition to a request to submit their objections of formal proceedings. One of the reasons or comments within a month (Art. 307[1]). If for this obligation is that the courts cannot be no objections have been voiced against the plan, burdened with too many insolvency proceedings. then it shall be deemed approved and binding Therefore, the debtor must submit, together with upon the parties in the same manner as a civil the filing request, a certificate issued by a suitable settlement under the civil code (Art. 308). As person or authority (or “agency”) that, within the a result, the approval process for the plan is last six months before the filing, an unsuccessful expedited. If, on the other hand, objections attempt has been made to settle out of court with have been voiced by creditors, the court may the creditors on the basis of an enclosed plan. nevertheless set them aside if the plan has Art. 305 specifies that the primary reasons for been approved by more than half of the total the plans failure must be explained. The federal creditors holding more than half of total claims states can determine which preconditions an (Art. 309[1]). If, however, a dissenting creditor: agency or person has to meet to be regarded (1) does not participate in the plan on equal as “suitable” according to the law. Suitable 24 REPORT ON THE TREATMENT OF MSME INSOLVENCY terms; (2) is likely to be placed at an economic The benefits of the simplified insolvency procedure disadvantage in comparison to the outcome of are that it provides for an expedited process for the opening formal insolvency proceedings; or (3) verification of creditors’ claims and for resolving manages to cast serious doubts on the existence contested claims. In particular, if a creditor presents or the exact amount of a claim in a manner that any challenges to the procedure for the verification affects whether the participation of a creditor in of claims or objects to the final list of creditors, the plan should continue, then the court will not the supervising judge and not the court as a whole confirm the plan and ordinary reorganization (as is the case in general proceedings) makes proceedings will be reopened ex-officio (Art. the decision by summary motion. The creditor 311). Where the majority of the creditors object can then object to the court, which issues a final to the plan, the settlement plan-proceedings end decision provided that the claim does not exceed and insolvency proceedings are opened. EUR 80,000 (approximately USD 85,000) (Art. • Step 3. Insolvency and discharge proceedings: 163). The simplified procedure therefore has only a After the failure of judicial settlement plan- limited scope and does not extend to any aspects of proceedings and if the bankruptcy estate covers the procedure other than the verification of claims. the costs of the proceedings, the insolvency In light of the rising number of nonperforming proceedings are opened. The court appoints loans (NPLs) affecting SMEs in Greece, the a trustee who liquidates the estate of the simplified procedure was deemed inadequate. Law debtor and distributes the proceeds among the 4307/14 introduced a new, voluntary, out-of-court creditors. After that, over the next five to six restructuring framework for SMEs as described years, the debtor has to transfer all his attachable below. wage claims to a trustee to be appointed by the court. The trustee distributes the collected Eligibility to use the restructuring framework of money among the creditors once a year. Wage the law: The law aims to facilitate an adjustment of assignments or wage pledges of the debtor remain debts for small enterprises and professionals. Small valid for a period of two years after the opening enterprises are identified as businesses that, for the of the insolvency proceedings. Only after this year ending on December 31, 2013, had a turnover period can the trustee seize the attachable part of of less than EUR 2.5 million (approximately USD the wages. After six years, the court decides on 2.7 million), whereas professionals are defined as the discharge of debts. The discharge shall be for legal or natural persons who are registered on a the benefit of honest debtors only.69 special registry in order to conduct their businesses and for the year ending on December 31, 2013, GREECE and had a turnover of less than EUR 2.5 million (approximately USD 2.7 million). As a result, the Eligibility to be considered “small case”: The law covers not only commercial enterprises but Greek Insolvency Code makes provisions for “small also persons pursuing non-commercial business insolvencies.” Under Art. 162 of the Code, debtors activities such as mechanics, doctors, pharmacists, whose inventory (estate) is less than EUR 100,000 etc. Furthermore, the persons described above need (approximately USD 107,255) can undergo the to fulfill the following requirements in order to simplified insolvency procedure. be able to utilize the framework provided by the Number of employees and number of creditors do law: (1) they must not be subject to any procedure not determine eligibility as a “small case.” under law 3869/2010 on the restructuring of debts of natural persons; (2) they must be active in What are the main differences between the process for business and not subject to any formal insolvency “small cases” and the general insolvency process? procedure under the Greek Insolvency Code; and (3) the persons in charge of the business or the RESPONSES TO MSME INSOLVENCY ISSUES 25 professionals themselves must not have been open-ended process. However, the insolvency convicted of tax evasion, trafficking, racketeering, professional petitions the court to extend the 90- or any form of fraud against the State. day deadline by an additional 45 days if instructed to do so by a decision of the creditors’ committee What are the main differences between the approved by a 75 percent majority. An extension framework envisaged by the law and the general may be requested only once and may only be granted insolvency process? by the Adjudicating Authority if it determines that Under Art. 61, debtors may request a write-down the complexity of the case warrants it (Art. 56). of their financial obligations from their lenders Regarding the rest of the process, the general (defined as banks and other credit institutions) provisions of the Insolvency Resolution Procedure according to the framework. A debtor’s write- apply “as the context may require” (Art. 58). down can amount to no more than EUR 500,000 (approximately USD 536,225) per debtor but (1) at OHADA the same time must include at least 50 percent of the credit institutions’ total claims; or (2) following the The Organization for the Harmonization of Business write-down, the outstanding debts do not constitute Laws in Africa, which comprises 17 mostly more than 75 percent of the debtor’s net financial West African states, recently adopted a uniform position. The credit institutions are free to accept or insolvency law that is directly applicable in all its reject such a proposed write-down or offer it under member state jurisdictions. Among other reforms, different terms. the law provides for new simplified regulation of MSMEs, developed in recognition of the fact that INDIA most businesses in the OHADA region are small scale and that the longer it takes to address their Eligibility to be considered “small case”: The financial distress, the less likely the possibility of Indian Insolvency and Bankruptcy Code of 2016 recovering any assets. The focus of the reforms is (IBC) contains a “fast track corporate insolvency to simplify and reduce the cost of procedures, with resolution process” (Arts. 55 – 58), which applies an understanding that while it is more difficult to to: (1) debtors with assets and income below a reorganize smaller businesses in the same way as level prescribed by the Central Government; (2) larger ones, there still needs to be an attempt to debtors with a certain number of creditors and a rescue them. certain amount of debt prescribed by the Central Government; and (3) any other type of debtors Eligibility to be considered “small case”: The prescribed by the Central Government (Art. 55). OHADA states ultimately agreed that in the context The procedure may be initiated either by the debtor of their member state economies, a “small business” or its creditors upon submission of proof of the would constitute a proprietorship, partnership, debtor’s insolvency and its eligibility to undergo a or other legal entity having less than or equal to fast-track resolution process (to be determined by 20 employees and a turnover not exceeding CFA the implementing regulations). franc 50 million (approximately USD 80,000) in the 12 months prior to proceedings.70 Moreover, a Number of employees does not determine eligibility small business MSME has the option to select the as a “small case.” simplified proceedings, but is not obliged to do so.71 What are the main differences between the process The simplified proceedings apply to three of the for “small cases” and the general insolvency four procedures set out in the law, namely règlement process? préventif (preventive settlement); redressement The fast-track procedure envisages completion judiciaire (reorganization), and liquidation des within 90 days as opposed to the ordinary biens (liquidation). They are simplified insofar as 26 REPORT ON THE TREATMENT OF MSME INSOLVENCY many of the formalities related to the filings or Redressement judiciaire (reorganization) hearings are no longer necessary, which facilitates As with preventive settlement, the form of faster processes. simplified reorganization proceedings is derogation What are the main differences between the process from the general reorganization process.73 As with for “small cases” and the general insolvency the general proceeding, the filing must be made by process? a debtor within 30 days of insolvency (using the cash-flow test), but with fewer documents required, Règlement préventif (preventive settlement) and must be accompanied by a sworn statement The provisions for règlement préventif, or preventive attesting that the case meets the conditions of a settlement, are simplified by derogations from the simplified reorganization. The reorganization plan “main” or overall règlement préventif proceeding. must be filed within 45 days of the declaration They provide that any small business as defined of insolvency.74 Unlike the more detailed above may open proceedings before it is insolvent. reorganization plan in the general reorganization The filing requirements are also simplified. For process, in the simplified proceeding the plan may instance, the procedure can be opened even when no be limited to payment terms, debt relief, and the plan or arrangement has been provided, and although possible guarantees that the entrepreneur must make documents demonstrating the financial situation of to ensure its execution. The financial statements the small business need to be filed, they do not need and economic records do not have to be submitted to be audited or include comprehensive financial with the simplified reorganization plan.75 The court statements or cash-flow statements as required can decide to convert a general reorganization to a for the regular proceeding.72 In the event that any simplified reorganization within 30 days of opening other documents required cannot be provided or are the proceedings following representations from incomplete, the request must indicate the reason for the administrator.76 At the request of the debtor or their absence or incompleteness. As stated above, administrator, the court can decide not to follow the the debtor may request regular proceedings instead simplified reorganization process. of the simplified procedure. The decision of the Liquidation des biens (liquidation) competent court to apply the simplified procedure is not subject to appeal. The simplified procedure The conditions for opening the simplified not only imposes shorter timeframes compared liquidation are the same as for reorganization. to the general procedure, it also stipulates that However, in addition to meeting the definition of the administrator must file the debtor-creditor small business, there is an additional condition that agreement within two months after the opening the debtor does not own any immovable property. A of proceedings instead of the regular three (with sworn statement that the debtor meets the relevant a possible extension of 15 days instead of one conditions for a simplified liquidation proceeding month). The restructuring plan must be prepared by must also be submitted. After the opening of a the debtor with the assistance of the administrator liquidation proceeding, the liquidator may prepare and can have simpler content than the plan under and file a report with the competent court within the general proceeding. This may include the 30 days of appointment. On the basis of the report, settlement of liabilities, particularly the terms and the court may apply a simplified liquidation conditions for the discharge of liabilities, write-offs, procedure after having heard or summoned the time extensions, the persons required to perform debtor. The court has the right to refuse to apply the arrangement, and, if applicable, the guarantees the simplified liquidation proceedings, even if the provided to ensure the plan’s implementation. The relevant conditions are met. Unlike with the general court may order that the administrator remains in liquidation proceeding, the court may determine place to monitor the implementation of the plan. that the sale of the debtor’s property should be a RESPONSES TO MSME INSOLVENCY ISSUES 27 private sale agreement.77 The trustee must take most recent balance sheet, statement of operations, action on the agreement within 90 days. Any cash-flow statement, and federal tax return to the remaining property is sold at public auction.78 bankruptcy petition when it files for Chapter 11. The exclusivity period for the debtor is longer UNITED STATES (180 days in comparison to 120 days for a regular debtor); however, the debtor is under a rather strict Eligibility to be considered “small case”: In 2005, 300-day deadline to propose a plan, which has to the United States introduced a simplified, expedited be approved within 45 days of filing. Nevertheless, reorganization process for “small business debtors” the debtor may file a reorganization plan without in Chapter 11 of the U.S. Bankruptcy Code. Small filing a separate disclosure statement if the court business debtors are classified as such based on determines that adequate information is contained a two-part test: (1) the debtor is engaged in non– in the plan. An additional advantage is that the law real estate activity with total fixed debts of USD sets no limit on the duration of the reorganization 2,566,050 or less; and (2) the U.S. Trustee has not plan, which is favorable for small businesses appointed a committee of unsecured creditors, or that need additional time to restructure their the court has determined that the committee of mortgage or equipment loans. During the course of unsecured creditors is not sufficiently active and proceedings, a small business debtor is also under representative to provide effective oversight of the stricter monitoring by the U.S. Trustee, who must debtor. investigate the debtor’s viability, inquire about its What are the main differences between the process business plan, review and monitor the debtor’s for “small cases” and the general insolvency activities, and, as appropriate, seek dismissal of the process? case for cause, including a belief that the debtor is not viable or is otherwise unable to confirm a plan. The main aspects of this process are simplified Finally, during the case, the small business debtor voting requirements, shorter deadlines, and more must also file with the court periodic financial and stringent oversight and reporting obligations. More other reports on its cash flow and profitability. specifically, a small business debtor must attach its 28 REPORT ON THE TREATMENT OF MSME INSOLVENCY Insolvency Regimes that Eliminate Certain Elements of the Proceeding or Shorten Timelines Argentina Germany Greece India OHADA United States To qualify The assets of Under Art. 162 Under Art. 55 A “small A “small busi- for special a debtor are of the Code, - 58 of the new business” ness” debtor is Eligibility to be considered “small case” treatment, the considered debtors whose Indian Insolven- constitutes a classified as such debtor must comprehensible inventory (es- cy and Bank- proprietorship, based on a two- have one of if the debtor tate) is less than ruptcy Code partnership, part test: (1) the EUR 100,000 of 2016 (IBC): or other legal debtor is engaged the following has 20 or fewer (approx. USD (1) a debtor entity having in non–real characteristics: creditors at the 107,255 at with assets and 20 or fewer estate activity (1) liabilities time the request April 21, 2017, income below a employees and with total fixed do not exceed is made to open exchange rate) level prescribed a turnover not debts of USD 300 minimum insolvency can undergo by the Central exceeding CFA 2,566,050 or wages proceedings. the simplified Government; (2) francs 50 mil- less; and (2) the (approx. USD insolvency a debtor with a lion (approx. U.S. Trustee has Number of 154,652 at procedure. certain number USD 80,000) not appointed employees and of creditors and in the 12 a committee of August 2016 revenues from Number of exchange a certain amount months prior unsecured credi- the company do employees rate); (2) no of debt as pre- to proceedings. tors or the court not determine and number of more than 20 scribed by the has determined creditors do not its eligibility as Central Govern- that the commit- unsecured determine its a “small case.” ment; and (3) tee of unsecured creditors; eligibility as a any other type creditors is not or (3) no “small case.” of debtors as sufficiently ac- more than 20 prescribed by the tive and rep- employees. Central Govern- resentative to ment. provide effective oversight of the Number of debtor. employees does not determine eligibility as a “small case.” RESPONSES TO MSME INSOLVENCY ISSUES 29 Jurisdictions with Comprehensive MSME permitted in a small case. Third, under the general Legislation rehabilitation process, though the content of any modification of rights based on a rehabilitation Some countries, like Japan and Korea, adopt plan shall apply equally to rehabilitation creditors, comprehensive laws that are specifically designed it would be possible to make certain differences to apply to MSMEs. The legislation in the following among creditors if the legal requirement were countries is considered comprehensive because satisfied. On the other hand, under a small case, such it is specifically designed to apply to MSME discrimination among creditors in the rehabilitation insolvency. It does not merely eliminate an element plan is not allowed. of a “general” insolvency framework or reduce a timeline, but rather creates a framework for MSME Unlike in general civil rehabilitation proceedings, insolvency that is significantly different from the where the court appoints a supervisor to oversee framework applied to larger enterprises in the same the debtor’s conduct of business, in small cases jurisdiction. the court is allowed to appoint an “individual rehabilitation commissioner,” who may be JAPAN assigned with one or more of the following tasks: (1) investigating the status of the rehabilitation Eligibility to be considered “small case”: Even debtor’s property and income; (2) assisting the though the general civil rehabilitation procedure court in the valuation of rehabilitation claim; and/ is primarily, albeit not exclusively, aimed at the or (3) making recommendations necessary for the restructuring of MSMEs, the Civil Rehabilitation rehabilitation debtor to prepare a proper proposed Act of Japan (Act No. 225 of December 22, rehabilitation plan (Art. 223). As a result, the 1999) also contains special provisions on the individual rehabilitation commissioner does not rehabilitation of individuals with small-scale debts. interfere significantly with the debtor and also does These provisions apply to an individual debtor, who not impose such high costs on proceedings. is likely to earn income continuously or regularly in the future and whose total claims amount to less Another benefit of this special process relates to than JPY 50 million (USD 455,000).79 As a result, less stringent procedural requirements for proof and these provisions only apply to consumers and small objection of claims (Art. 226) as well as a general individual proprietors. exemption of the debtor from the duty to prepare balance sheets (Art. 228). In particular, when a Number of employees and number of creditors do debtor or creditor(s) file an objection to a claim, not determine eligibility as a “small case.” the court reviews the legitimacy or amount of the What are the main differences between the process claim in summary, rather than plenary, proceedings. for “small cases” and the general insolvency The court makes a binding decision only on the process? creditors’ voting rights in the creditors’ meeting, and there are no provisions for appeal. Some of the main differences can be summarized as follows: First, in small cases, creditors are not In addition, the law specifies that a rehabilitation generally required to file their claims with the court, plan may only provide for an extension of the term because the claims are regarded as filed when the of the debt if it meets the following requirements: schedule of the creditors is prepared by the debtor (1) the payment plan specifies that the creditor and submitted to the court. The debtor is required receives a payment more than once in three months; to prepare the schedule of the creditors and submit and (2) the extension may not exceed three years it to the court so that the case is regarded as a small from the date of the confirmation of the plan, and in case. Second, any avoidance claim would not be special circumstances five years (Art. 229). The law also adopts a “negative approval standard” for the 30 REPORT ON THE TREATMENT OF MSME INSOLVENCY approval of the rehabilitation plan by the creditors. What are the main differences between the process More specifically, a plan is accepted if the creditors for “small cases” and the general insolvency that reject the plan in writing are owed half or less process? of the total allowed claims and number less than Upon the opening of the court proceedings, a half of all the creditors (Art. 230). Following the trustee is not appointed and the debtor (or in the creditors’ approval, the court will confirm the plan case of a legal entity, the debtor’s managers) retains if: (1) creditors receive at least as much as they the management of the business. Furthermore, as would in liquidation; and (2) the minimum payment with general proceedings, an examiner is appointed thresholds prescribed by the law are met. These to assess the debtor’s financial condition. In the minimum payment thresholds are (1) 20 percent of SBR procedure, however, the examiner is usually the face value of total claims if the total amount of an experienced deputy court clerk (in the case such claims are JPY 30 million (USD 273,000) or of an individual debtor) or an accounting firm less; and (2) 10 percent of the face value of total (in the case of a legal entity debtor) and uses a claims if the total amount of such claims is over simplified accounting method compared to general JPY 30 million (USD 273,000) and JPY 50 million proceedings. In addition, there is no fee for a (USD 455,000) or less (Art. 231). court clerk. The small business procedure also simplifies the requirements for the approval of a KOREA plan. Under ordinary business rehabilitation, a plan Eligibility to be considered “small case”: Korea needs to be approved by at least three quarters of recently introduced a specialized procedure for the amount of secured claims allowed and of the small businesses (Small Business Rehabilitation amount of unsecured claims. Under the SBR, the [SBR] Procedure). In order to request the opening requirement of secured creditors is the same, but, of this specialized procedure, the debtor: (1) has to as for unsecured creditors, approval is required be a business income earner (not a wage income by either two thirds of the amount of total claims earner); (2) may be an individual or a legal entity; or one half of the amount of total claims and one and (3) must have less than KRW 3 billion (USD half of the number of total creditors. This way it is 2.57 million) in total secured and unsecured debts. harder for one major creditor to block the approval Only debtors may commence this simplified of the reorganization plan. procedure. RESPONSES TO MSME INSOLVENCY ISSUES 31 CHAPTER 5 Conclusions of the World Bank ICR Task Force Meeting September 19, 2016 – Washington, DC MSMES FACE SPECIFIC CHALLENGES IN recoup their costs for recovery. Participating INSOLVENCY FRAMEWORKS actively in a complex restructuring process is often an expensive task, even for sophisticated Task Force Members agreed with the challenges creditors. Therefore, efficiencies may be lost if confronting MSMEs listed in the Report. Members viable small businesses’ assets are enforced by noted that even if these challenges are also ones that secured creditors at the first sign of financial larger enterprises face, they are often exacerbated distress and unsecured creditors remain passive. and more acutely felt by MSMEs. The challenges discussed earlier in the report were: • Limited information. Information transparency to creditors and other relevant parties aids the • Complex insolvency systems. Many country insolvency process to run smoothly. Information insolvency frameworks are too complex for disclosure builds trust between parties and leads unsophisticated MSMEs to use and understand. to a better understanding of the debtors’ financial The complexity and stigma of the procedure position, enabling creditors and insolvency can act as a disincentive to access the system administrators, as well as other relevant parties, in a timely way. Further, these frameworks are to make an objective assessment of the viability likely to be costly and time intensive. At a period of a debtor’s business. However, many debtor when the enterprise is facing financial difficulty, MSMEs often lack good recordkeeping systems. entrepreneurs may not have the funding or time They also frequently have little incentives to required to complete an insolvency process seek the help of financial professionals or do not designed with large corporations in mind. see a need to keep records in the first place. Also, MSMEs often have little liquidity at their disposal and are less sophisticated than larger • Accessing financing during the proceeding. corporations. A temporary and minor lack of Many insolvency systems do not incentivize liquidity could rapidly spiral into liquidation provision for MSME access to financing post in a way it may not for a larger business and filing in an insolvency procedure. However, thus MSMEs are more affected by insolvency financing, particularly fresh funds, are vital procedures that prevent re-entry into economic to MSME survival, especially when they face life. Insolvency procedures for MSMEs, which financial distress. are rapid, simple to follow (e.g., with easy-to-use • Insufficient assets to fund the insolvency forms), and have minimal court involvement, proceeding. MSMEs may not commence an may improve participation, increase debt insolvency procedure because they wait too recovery, and enable entrepreneurs to get back long to file a petition and the remaining funds to their activities faster. are insufficient to cover even administrative • Creditor passivity. Large creditors often do costs and fees. Two approaches are common in not have the financial incentive to spend time cases where no assets remain: not opening the and resources dealing with MSMEs’ relatively case or establishing a common fund to pay for smaller debt cases considering they may not even the insolvency process. A deeper analysis of the CONCLUSIONS OF THE WORLD BANK ICR TASK FORCE MEETING 33 impact of each in practice may be beneficial to owed. For example, some tax authorities cannot better understand which works best in practice. provide debt forgiveness, which may stifle attempts to resolve insolvency and rehabilitate In addition to the above, the Task Force suggested a viable enterprise. Certain countries also do two challenges that were not included in the draft not provide tax incentives for tax write-offs for Report circulated to the Task Force prior to the bad or renegotiated debts, leaving less incentive September 2016 meeting. for creditors to agree to restructurings. This is • First, micro and small entrepreneurs face particularly important for MSMEs, because the particular difficulties with a mix of personal amount of assets is often small compared to the and corporate debt when under financial restructuring costs; any additional incentive for stress. In an insolvency situation, the failure of creditors to restructure could have a positive the enterprise could lead to severe consequences impact. for the entrepreneur and their family associated Task Force Recommendations: The Definition of with many personal insolvency regimes. For MSME and Existing Insolvency Framework example, if a business defaults on a loan that the entrepreneur personally guaranteed, the • The Task Force recommended that the guarantor is personally liable to repay the definition of MSME should not be overly business debt. If that debt cannot be paid back prescriptive. Members observed that the or renegotiated, the entrepreneur may have to definition of MSME varies around the world. As resort to personal bankruptcy. However, some noted in the Report, such a definition may include countries do not have personal insolvency laws, features such as the number of employees, and others with personal insolvency laws may sales, or loan size. Each jurisdiction may have no discharge or a long waiting period have legitimate local reasons for its particular before discharge, as well as heavy penalties definition of MSME, so the Task Force did not for personal bankruptcy. This could result in recommend making any one definition definitive the entrepreneur being unable or unwilling to in order to allow for flexibility. re-enter the market productively and therefore • The Task Force also suggested modification of lower growth overall. Adding to this problem, the existing insolvency framework rather than insolvency frameworks often lack the ability a separate regime for MSMEs, as a preliminary to register one-person business units. Such position. However, further investigation is business units may be easier for entrepreneurs to needed to come to a final conclusion on this point. formally register, enabling more entrepreneurs At the meeting, a number of MSME insolvency to have recourse to corporate insolvency law framework country examples were discussed. The instead of relying on personal insolvency law, Task Force noted that, for many countries, simple if such a framework exists in the country. The modifications to existing insolvency frameworks discussion during the 2016 Task Force led to the could be the most practical and efficient method inclusion of Chapter III.B.v. of this report. of taking into account the distinctiveness of • Second, the Task Force raised the issue MSMEs at this stage. This contrasts with other of involving taxation authorities in the approaches, which create an entirely separate insolvency framework. Members noted that regime for MSME insolvency. Such approaches in many countries taxation authorities did not may be appropriate for developed countries with actively contribute to the objectives of the more resources and a robust legal environment. insolvency framework of maximizing value However, they would not likely be effectively and saving viable enterprises. Instead, many tax implemented in many developing countries, as authorities participated purely to recover debts they may lack the resources and infrastructure 34 REPORT ON THE TREATMENT OF MSME INSOLVENCY necessary for implementation. It was agreed that procedures frequently require production further discussion on the impact that both types of financial and legal documents as well as of approaches have had in practice is needed to navigation through complex legal processes, the come to a definitive conclusion in this regard. Task Force suggested that jurisdictions might want to consider furnishing the MSME debtor with Other Considerations – Liquidation and non-judicial assistance. Such assistance could Assistance to the Debtor take the form of mediation, debt counselling, The Task Force discussed a number of other financial education, or the appointment of a considerations for policymakers in designing an trustee. However, members noted that there was insolvency framework that specifically considers an outstanding question of who would fund such MSMEs. assistance. • The Task Force noted that the majority of Further Exploration Warranted MSMEs facing insolvency are more likely to liquidate. Only a small fraction is likely to be Given the Task Force’s discussion on these able to take advantage of a restructuring regime. challenges, Members agreed that further exploration Therefore, it was recommended that frameworks into whether the World Bank ICR Principles should should not only focus on restructuring, but be amended to treat MSMEs was warranted. should also take into account that the majority of Therefore, the Members recommended that the cases will end in liquidation. Bank, along with its partners, should further study whether the Principles should provide specific • The Task Force noted the importance of non- guidance for dealing with MSMEs. judicial assistance. Since MSMEs often lack financial and legal sophistication and insolvency CONCLUSIONS OF THE WORLD BANK ICR TASK FORCE MEETING 35 Endnotes 1. Oya Pinar Ardic, Nataliya Mylenko, and Valentina 11. Edinburgh Group. “Growing the Global Saltane. 2011. “Small and Medium Enterprises: Economy Through SMEs.” Accessed A Cross-Country Analysis with a New Data Set.” August 5, 2016, 7. http://www.edinburgh-group. Policy Research Working Paper 5538, World org/media/2776/edinburgh_group_research_-_ Bank Financial and Private Sector Development growing_the_global_economy_through_smes.pdf. Consultative Group to Assist the Poor, Washington, 12. Ibid. DC. Accessed August 3, 2016. http://elibrary. worldbank.org/doi/pdf/10.1596/1813-9450-5538. 14. G20, “G20 Leaders’ communiqué Antalya summit, 15-16 November 2015.” Accessed August 2. Ibid. 5, 2016. http://www.consilium.europa.eu/en/press/ 3. See, for instance, the European Commission press-releases/2015/11/16-g20-summit-antalya- recommendation regarding the definition of communique/ at 2. MSMEs in the European Union: http://eur-lex. 15. Ryan Banerjee. 2014. “SMEs, Financial europa.eu/legal-content/EN/TXT/PDF/?uri=CELE Constraints and Growth.” BIS Working Papers No. X:32003H0361&from=EN. 475, Bank for International Settlements. Accessed 5. Khrystyna Kushnir, Melina Laura Mirmulstein, August 5, 2016. and Rita Ramalho. 2010. Micro, Small, and Medium 16. European Investment Bank / Dalberg. 2011. Enterprises Around the World: How Many Are Report on Support to SMEs in Developing Countries There, and What Affects the Count? Washington, Through Financial Intermediaries. Accessed August DC: World Bank. Accessed July 27, 2016. 5, 2016. 8. www.eib.org/attachments/dalberg_sme- 6. Ibid. briefing-paper.pdf. 7. Ibid, 4. 17. MSME in this study is defined as an enterprise with fewer than 500 employees. Shahin Firoozmand, 8. Peer Stein, Tony Goland, and Robert Schiff. 2010. Philip Haxel, Euijin Jung, and Kati Suominen. Two Trillion and Counting: Assessing the Credit 2015. “State of SME Finance in the United States Gap for Micro, Small, and Medium-size Enterprises in 2015.” Tradeup and Nextrade Group, as cited in in the Developing World. Washington, DC: World Davis et al, supra, note 12 at 16. Bank. Accessed July 25, 2016, at 1. http://www.ifc. org/wps/wcm/connect/3d5d09804a2d54f08c1a8f 18. UK Department for Business, Innovation, and 8969adcc27/Two+trillion+and+counting.pdf?MO Skills, Statistical Release: Business Population D=AJPERES. “MSME” in this context is defined Estimates for the UK and Regions 2015 (14 October as an enterprise with fewer than 250 employees. 2015), as cited in Davis et al, supra, note 12 at 16. 9. Kushnir et al, supra, note 4 at 3-4. 19. European Investment Bank / Dalberg, supra, note 15 at 8. 10. Ibid, 4. 20. Edinburgh Group, supra, note 10 at 8. ENDNOTES 37 21. Ibid. Washington, DC: World Bank. Accessed July 27, 2016, 4. http://documents.worldbank.org/curated/ 22. Ibid. en/804781467990954208/pdf/WPS7604.pdf. 23. Kushnir et al, supra, note 4 at 4. 34. Kushnir et al, supra, note 4 at 1. 24. E. Warren, J. L. Westbrook. 1999. “Financial 35. World Bank. 2014. Debt Resolution and Characteristics of Business in Bankruptcy.” Business Exit. Viewpoint 343, 5. https://www. American Bankruptcy Law Journal 73: 499-589, as wbginvestmentclimate.org/advisory-services/ cited in Davis et al, supra, note 12 at 19. regulatory-simplification/debt-resolution-and- 25. Davis et al, ibid, 19. business-exit/upload/VIEWPOINT_343_Debt_ Resolution.pdf. 26. Organisation for Economic Co-operation and Development (OECD). 2009. “The Impact of 36. World Bank. April 2017. Financial Inclusion the Global Crisis on SME and Entrepreneurship Overview. http://www.worldbank.org/en/topic/ Financing and Policy Responses,” as cited in Davis financialinclusion/overview. et al, ibid, 20-21. 37. World Bank. 2016. A Toolkit for Out-Of-Court 27. Peer Stein, Oya P. Pinar Ardic, and Martin Workouts. Washington, DC: World Bank; and Hommes. 2013. Closing the Credit Gap for Formal World Bank Group. 2012. Out-Of-Court Debt and Informal Micro, Small, and Medium Enterprises. Restructuring. Washington, DC: World Bank. Washington, DC: World Bank. Accessed July 27, 38. Mahesh Uttamchandani and Antonia Menezes. 2016. 11. http://www-wds.worldbank.org/external/ 2010. “The Freedom to Fail: Why Small Business default/WDSContentServer/WDSP/IB/2015/03/17 Insolvency Regimes Are Critical for Emerging /000477144_20150317085503/Rendered/PDF/949 Markets.” International Corporate Rescue 7 (4): 110WP0Box380p0Report0FinalLatest.pdf. 262–68. 28. Stein et al (2010), supra, note 7 at 1. “MSME” 40. Ibid, 5. in this context is defined as an enterprise with fewer than 250 employees. 41. Ibid. 29. International Finance Corporation. 2013. 42. Ibid. “Access To Credit Among Micro, Small, And 43. Wolfgang Bergthaler, Kenneth Kang, Yan Liu, Medium Enterprises.” Accessed July 27, 2016, 1. and Dermot Monaghan. 2015. Tackling Small and http://www.ifc.org/wps/wcm/connect/1f2c968041 Medium Sized Enterprise Problem Loans in Europe, 689903950bb79e78015671/AccessCreditMSME- European Department. International Monetary Brochure-Final.pdf?MOD=AJPERES. Fund, Legal Department, and Monetary and Capital 30. OECD. 2016. “Financing SMEs and Markets Department, 6. Entrepreneurs 2016: An OECD Scoreboard.” Paris: 44. Ibid. OECD Publishing, 36. 45. Yan Liu and Christoph B. Rosenberg. 2013. 31. Ibid. “Dealing with Private Debt Distress in the Wake 32. Stein et al, 2013, supra, note 25 at 11. of the European Financial Crisis: A Review of the Economics and Legal Toolbox.” Working Paper. 33. Meghana Ayyagari, Pedro Juarros, Maria Washington, DC: International Monetary Fund. Soledad Martinez Peria, and Sandeep Singh. 2016. Access to Finance and Job Growth: Firm- 46. Ibid, 11. Level Evidence across Developing Countries. 38 REPORT ON THE TREATMENT OF MSME INSOLVENCY 47. OECD. 2009. “The Impact of the Global Crisis 2012. “Efficiency and Effectiveness of Insolvency on SME and Entrepreneurship Financing and Proceedings in Poland.” Report available only in Policy Responses,” as cited in Davis et al, supra, Polish). See UNCITRAL Legislative Guide on note 12 at 20–21. Insolvency Law, paras 72-73. 48. Mahesh Uttamchandani and Antonia Menezes, 61. See UNCITRAL Legislative Guide on 2010. Insolvency Law, para. 73 50. “This principle addresses only accountabilities 62. In these situations, the creditor can pursue of directors in the period when they know or ought individual enforcement actions and may resort reasonably to have known that the enterprise to non- insolvency remedies to challenge certain imminently or unavoidably faces insolvency. debtor transactions. General principles for corporate governance and officer and director liability to their shareholders 63. Per Art. 6 of the Greek Insolvency Code, the are dealt with under the OECD Principles for court must dismiss an application for insolvency if it is proven that, although the general requirements Corporate Governance.” of the law have been met, the debtor’s estate is 51. World Bank Principles, B2. insufficient to cover the expenses of proceedings. Thus, no-asset cases are prima facie assessed and 57. World Bank. 2013. Report on the Treatment rejected as such by the court. The 2010 Polish of the Insolvency of Natural Persons. Bankruptcy and Recovery Law specifies, in Art. http://siteresources.worldbank.org/INTGILD/ 13, that the court must dismiss a petition when the Resources/WBInsolvencyOfNaturalPersons assets of the insolvent debtor do not cover the costs Report_01_11_13.pdf. of the proceedings. Furthermore, the court must also 58. “European Commission Recommendation of dismiss a petition if the insolvency estate possesses 12.3.2014 on a new approach to business failure and sufficient assets, but they are encumbered to such insolvency” available at http://ec.europa.eu/justice/ an extent that the residual assets cannot cover the civil/files/c_2014_1500_en.pdf and Proposal for a costs of proceedings. The 2015 amendments to the Directive Of The European Parliament And Of The law also required the court to reject the petition if Council on preventive restructuring frameworks, the assets could cover the administrative expenses second chance and measures to increase the but were not sufficient to “cover any of the debts efficiency of restructuring, insolvency and discharge owed to its creditors.” procedures and amending Directive 2012/30/ 64. Nevertheless, creditors are able to resume EU” available at http://ec.europa.eu/information_ proceedings within a year if they prove that the society/newsroom/image/document/2016-48/ estate has sufficient assets or they deposit the proposal_40046.pdf. amount specified by the court. Thus, even though 59. Davis et al, supra, note 12 at 20–23. the termination of proceedings is the norm, the law allows interested parties to open proceedings in 60. For instance, in Germany, in 2014, around 10,000 case they agree to cover the costs. petitions (representing 8 percent of total petitions) were dismissed for lack of assets. (Statis.de). In 66. Davis et al. Poland, in 2009, almost 20 percent of the filings (51 67. United Nations Commission on International out of 246 cases) in the District Court for Wrocław Trade Law. 2014. Report of the Working Group Fabryczna were “motion rejected” cases for lack of V (Insolvency Law) on the Work of Its Forty- sufficient assets to cover the proceedings. In 2010, Fifth Session. New York: United Nations. https:// they were about 35 percent of the cases filed (76 out documents-dds-ny.un.org/doc/UNDOC/GEN/ of 216). Sylwia Morawska. The Morawska Report. V14/028/64/PDF/V1402864.pdf?OpenElement. ENDNOTES 39 68. Ibid. would likely earn income at least once every three months in approximately three to five years. 69. According to Art. 290, therefore - on the request of a creditor - the discharge will be refused if the debtor: Box Citations These citations apply to the quoted text in the - has been convicted of a bankruptcy crime, Report’s boxes. All citations come from the Davis - within the last three years before the opening of et al paper. the proceedings made false statements to obtain a loan or grants from public funds or to avoid Box 2.1 making payments to public funds, i. Shahin Firoozmand, Philip Haxel, Euijin Jung, - obtained discharge of debts within the last 10 and Kati Suominen. 2015. “State of SME Finance years, or in the United States in 2015.” Tradeup and Nextrade - neglected his information and cooperation Group. duties during the proceedings. The discharge has the effect that the debtor is freed from all debts ii. Industry Canada. Key Small Business Statistics except: August 2013, at 8, figures are for 2012, and job creation figures represent the period from 2002- - from claims to maintenance that arose during 2012. https://www.ic.gc.ca/eic/site/061.nsf/vwapj/ the insolvency proceedings (see Art. 40), KSBS-PSRPE_August-Aout2013_eng.pdf/$FILE/ - from obligations of the debtor incumbent on KSBS-PSRPE_August-Aout2013_eng.pdf. him under a tort by wanton act, insofar as the iii. Oya Pinar Ardic, Nataliya Mylenko, Valentina creditor has stated this legal reason when filing Saltane. 2011. “Small and Medium Enterprises: the corresponding claim with the administrator, A Cross-Country Analysis with a New Data Set.” and Policy Research Working Paper 5538, World - from fines and from interest-free loans granted Bank Financial and Private Sector Development to the debtor to pay the costs of the insolvency Consultative Group to Assist the Poor, Washington, proceedings (see Art. 302). DC, 6-8. 70. Article 1–3. iv. Khrystyna Kushnir, Melina Laura Mirmulstein, 71. Article 1–2. and Rita Ramalho. 2007. Counting MSMEs Across the World. Washington, DC: World Bank, 72. Article 6–1. 7. http://www.ifc.org/msmecountryindicators. This 73. Article 145–1. database is current as of August 2010 and updates and expands on the January 2007 Micro, Small, 74. Article 145–3. and Medium Enterprises: A Collection of Published 75. Article 145–4. Data, 2. http://www.ifc.org/msmecountryindicators. 76. Article 145–5. v. Ardic et al, supra note iii. 77. Article 179–6. Box 3.1 78. Article 179–6. i. The Financial Stability Board, which monitors the global financial system, recognizes “Insolvency 79. The expression “earn income continuously or and Creditor Rights” as one of 14 policy domains regularly in the future” is generally interpreted “designated as key for sound financial systems,” in practice as meaning that the individual debtor in which internationally recognized “best practice 40 REPORT ON THE TREATMENT OF MSME INSOLVENCY standards” are considered as “deserving of 272 (Lee et al); M.W. Peng. 2003. “Institutional priority implementation depending on country Transitions and Strategic Choices.” Academy of circumstances.” Financial Stability Board. Key Management Review 28 (2): 275-296. Standards for Sound Financial System.s (http:// x. Elena Cirmizi, Leora Klapper, and Mahesh www.fsb.org/what-we-do/about-the-compendium- Uttamchandani. 2010. “The Challenges of of-standards/key_standards/. Accessed March 7, Bankruptcy Reform.” Policy Research Working 2016). Paper 5448, World Bank, Development Research ii. J.P. Fan, S. Titman, and G. Twite. 2012. “An Group Finance and Private Sector Development International Comparison of Capital Structure and Team, Washington, DC, 4. Debt Maturity Choices.” Journal of Financial and xi. Ibid, 5. Quantitative Analysis 47 (1): 23-56. xii. Lee et al, supra note ix. iii. Ibid. xiii. United Nations Commission on International iv. See J. Qian and P.E. Strahan. 2007. “How Laws Trade Law (UNCITRAL). Legislative Guide and Institutions Shape Financial Contracts: The on Insolvency Law. New York: United Nations Case of Bank Loans.” Journal of Finance 62 (6): Publication. No.E.05.V.10; World Bank. 2015. 2803-34. Principles on Effective Insolvency and Creditor/ v. S.A. Davydenko and J.R. Franks. 2008. “Do Debtor Regimes (revised May 2015). Bankruptcy Codes Matter? A Study of Defaults in xiv. See O. Couwenberg. 2001. “Survival Rates in France, Germany, and the UK.” Journal of Finance Bankruptcy Systems: Overlooking the Evidence.” 63 (2): 565-608. European Journal of Law and Economics 12 vi. See J. Armour and D. Cumming. 2008. (3):253-73; S. Claessens and L.F. Klapper. 2005. “Bankruptcy Law and Entrepreneurship.” “Bankruptcy Around the World: Explanations of American Law and Economics Review 10 (2): Its Relative Use.” American Law and Economics 303-50; S.H. Lee, Y. Yamakawa, M.W. Peng, and Review 7 (1):253-83. J.B. Barney. 2011. “How do Bankruptcy Laws xv. Cirmizi et al, supra note x at 6. Affect Entrepreneurship Development Around the World?” Journal of Business Venturing 25 (5): 505- xvi. Ibid, 4. 20. xvii. Ibid, 3. vii. See E.S. Hotchkiss, K. John, R.M. Mooradian and K. Thorburn. 2011. “Bankruptcy and the xviii. Wolfgang Bergthaler, Kenneth Kang, Yan Resolution of Financial Distress.” Handbook Liu, and Dermot Monaghan. 2015. Tacking Small of Empirical Corporate Finance: Empirical and Medium Sized Enterprise Problem Loans in Corporate Finance 2: 235. Europe. Washington, DC: International Monetary Fund, European Department, Legal Department, viii. S. Aiyar, W. Bergthaler, J.M. Garrido, A. and Monetary and Capital Markets Department, 6. Ilyina, A.A. Jobst, K. Kang, D. Kovtun, Y Liu, D. Monaghan, and M. Moretti. 2015. “A Strategy for xix. Ibid. Resolving Europe’s Problem Loans.” IMF Staff Discussion Note, SDN/15/19. Box 3.3 ix. S. Lee, M.W. Peng, and J.B. Barney. 2007. i. Unlike medium-size businesses, some of which “Bankruptcy Law and Entrepreneurship may feel attracted by the prospect of seeking Development: A Real Options Perspective.” competing forms of financing from a plurality of Academy of Management Review 32 (1): 257– banks, virtually all micro and small businesses ENDNOTES 41 work with one bank only. Furthermore, even in iii. Ibid. those rare cases where a business belonging to the iv. Janis Sarra. 2015. “Micro, Small and Medium MSME field is a non-sporadic customer of several Insolvent Enterprises: Do We Need Statutory banks, there is still a privileged relationship with Reform in Canada? First the Data… then the one of them, called to play a leading role vis-à-vis Reform.” Annual Review of Insolvency Law 2015, the others. Thus it may be safely stated that most J. Sarra and B.E. Romaine, eds. Toronto: Carswell. MSMEs fall either within the scope of the one- 2016. bank relationship model or within the scope of the leading-bank relationship model. Hence, the sole v. Oya Pinar Ardic, Nataliya Mylenko, Valentina bank or the leading bank, together with the debtor, Saltane. 2011. “Small and Medium Enterprises: are, in the field of MSMEs, optimal addressees of A Cross-Country Analysis with a New Data Set.” the law reform suggestions that are considered by Policy Research Working Paper 5538. World this paper to have, if implemented, the best chances Bank, Financial and Private Sector Development to minimize the negative social impact of MSME Consultative Group to Assist the Poor, Washington, insolvencies. DC, 6-8. Box 4.1 vi. Ibid. i. M. Uttamchandani and A. Menezes. 2010. vii. Ronald Davis, Stephan Madaus, Alberto “Freedom to Fail: Why Small Business Insolvency Mazzoni, Irit Mevorach, Riz Mokal, Barbara Regimes Are Critical for Emerging Markets.” Romaine, Janis Sarra, and Ignacio Tirado. 2016. International Corporate Rescue 7 (4): 262-68. “The Modular Approach to MSME Insolvency.” Draft Working Paper. File on record with World ii. J. Armour and D. Cumming. 2008. “Bankruptcy Bank Group and authors. Law and Entrepreneurship.” American Law and Economics Review 10 (2): 303-50. viii. Ibid. 42 REPORT ON THE TREATMENT OF MSME INSOLVENCY References Aiyar, S., W. Bergthaler, J.M. Garrido, A. Ilyina, Cirmizi, Elena, Leora Klapper, and Mahesh A.A. Jobst, K. Kang, D. Kovtun, Y. Liu, D. Uttamchandani. 2010. “The Challenges of Monaghan, and M. Moretti. 2015. “A Strategy for Bankruptcy Reform.” Policy Research Working Resolving Europe’s Problem Loans.” IMF Staff Paper 5448, World Bank, Development Research Discussion Note, SDN/15/19. Group Finance and Private Sector Development Team, Washington, DC. Ardic, Oya Pinar, Nataliya Mylenko, and Valentina Saltane. 2011. “Small and Medium Enterprises: Claessens, S., and L.F. 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