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Legal and institutional frameworks for managing bankruptcy are an effective way to ease pressure on households and businesses overburdened by unsustainable debt from the pandemic.¹ However, a sudden rise in nonperforming loans (NPLs) and bankruptcies stemming from the inability of firms to meet their repayment obligations (figure 3.1) poses a significant challenge to the capacity of insolvency systems to resolve bankruptcies in a timely manner, even in advanced economies with strong legal frameworks and effective institutions. This is, in part, a function of the complexity of court-led insolvency processes. According to World Bank data, in the average country resolution of a corporate bankruptcy case can drag on for more than two years. Complex liquidations can take even longer, even in well-functioning judicial systems.

Figure 3.1 Share of enterprises in arrears or expecting to be in arrears within six months, selected countries, May¨CSeptember 2020

If overindebtedness rises rapidly, the absence of effective legal mechanisms to declare bankruptcy or resolve creditor-debtor disputes invites political interference in the credit market in the form of debt relief mandated by the government. Such action often becomes the only alternative for resolving unsustainable debt. Indeed, emerging economies have made extensive use of politicized debt forgiveness programs, which frequently compromise credit discipline and the ability of creditworthy borrowers to obtain loans in the longer term.²

Improving institutional capacity to manage insolvency is therefore critical to economic recovery for several reasons. Insolvency reforms are associated with wider access to credit,³ improved creditor recovery, stronger job preservation,⁴ higher productivity,⁵ and lower failure rates among small businesses. ⁶ Cost-reducing reforms can also create the right conditions for nonviable firms to file for liquidation,⁷ which will facilitate the flow of credit to more productive parts of the economy. In short, reforms to strengthen insolvency frameworks in the COVID-19 era help with both crisis management and recovery.

The following reforms are recommended to ease COVID-19 debt distress and facilitate an equitable economic recovery. The chosen reforms can be taken up by economies at varying stages of development, varying degrees of sophistication in their existing insolvency laws, and varying levels of institutional capacity. They are demonstrably effective and grounded in empirical research and lessons from experience.

Strengthening formal insolvency mechanisms

A strong formal insolvency law regime defines the rights and behaviors needed to make in-court and out-of-court workouts orderly. ⁸ A well-designed system offers incentives to motivate creditors and debtors to cooperate in the resolution process. Other tenets of a strong system include predictable creditor seniority rules that define the order in which debts are repaid; ⁹ timely resolution, which creates a positive feedback loop motivating all actors to engage in out-of-court workouts; ¹⁰ and adequate expertise in the complexities of bankruptcy law. Finally, early warning tools for the detection of business distress as soon as possible hold great promise for assisting in the identification of debtors in financial difficulty before their difficulty escalates to the point of insolvency.¹¹

Facilitating alternative dispute resolution systems

Alternative dispute resolution (ADR) frameworks can provide more rapid and less expensive resolution of disputes relative to the formal court system, while retaining some of the rigor that courts provide. In an ADR process, the debtor and creditor engage directly with one another, facilitated by a third party such as a mediator or arbitrator. Resolutions are contractually binding, and participants can maintain confidentiality. ADR processes vary by the degree to which they involve court supervision. Mediation is entirely out of court (though courts can refer parties to mediation), whereas hybrid arrangements are subject to either some degree of court supervision or judicial confirmation of an agreement reached outside court. Significant creditor buy-in and cohesion are needed within the ADR process because holdout creditors unwilling to make concessions can grind the process to a halt. Active communication and consensus-building by regulators with the private sector through instruments such as framework agreements or rules that permit restructuring agreements that bind dissenting minority creditors can help address the challenges associated with creditor cohesion.

The United Kingdom is often cited as an example of a jurisdiction with an effective ADR framework. The London approach, a nonlegislative set of cultural norms and principles fostered by the Reserve Bank, ¹² the manner in which creditors voluntarily and collectively approach debtor distress. Its key tenets are that reliable financial information about the debtor exists and is shared among creditors, who work collectively to resolve the issue and share the burden of concessions equally.¹³ The London approach requires significant creditor cooperation, which may be lacking in some jurisdictions. An effective way to facilitate restructuring in a context in which there might be less creditor cohesion is to have the courts approve and bind creditors to out-of-court agreements (for example, this approach is used in France). Another approach is the use of a contract among creditors that sets the rules for the restructuring process. A recent example of this approach is Turkey¡¯s updated Framework Agreements on Financial Restructuring, which is a coregulatory model subject to the oversight of the regulator, with a more limited role for the courts (and perhaps therefore attractive to countries with weak or low-capacity judiciary systems).

Establishing accessible in-court and out-of-court procedures for small businesses

The COVID-19¨Cdriven economic crisis has had an outsized impact on micro-, small, and medium enterprises (MSMEs) because of the lower levels of available capital and greater exposure to vulnerable sectors typical of these enterprises. Small and medium businesses frequently lack the resources and expertise to understand and use complex and costly insolvency systems effectively. Exacerbating these structural problems, the pandemic has hit small businesses harder than large businesses. According to the World Bank¡¯s Business Pulse Survey, from June to September 2020, 48 percent of MSMEs overall (including 53 percent of microenterprises within that group) reported they were in arrears or expected to be in arrears within six months, compared with 36 percent of large enterprises (figure 3.2). Furthermore, 83 percent of MSMEs overall (including 84 percent of microenterprises within that group) reported lower monthly sales than in the previous year, compared with 73 percent of large enterprises (figure 3.3).

These factors underscore the need for dedicated reforms in insolvency systems that cater to small and medium businesses. Such reforms include supporting efficient debt restructuring among viable firms, such as simplifying legal processes, keeping debtors in control of their businesses if possible, making fresh financing available, and using out-of-court proceedings to keep costs down. With these reforms, policy makers can help facilitate the survival of viable but illiquid firms and the swift exit of nonviable firms.

The historical benefits of implementing specialized procedures for MSMEs in response to high NPL levels can be seen in Southeast Asia, which experienced widespread debt distress in the 1980s and 1990s. NPL rates exceeded 40 percent in some jurisdictions, and MSMEs were unable to obtain credit or were subjected to high interest rates. In response, the Republic of Korea, Malaysia, and Thailand, for example, implemented reforms that defined separate procedures for large complex cases and for small firms. In Korea, restructuring agreements were reached by mid-2003 for about 80 percent of registered cases, representing about 95 percent of total (corporate) debt.

Promoting debt forgiveness and long-term reputational protection for former debtors

A significant proportion of emerging economies do not have personal bankruptcy frameworks. Thus in those countries, many overindebted households and small business entrepreneurs have few options. It can be particularly devastating for small business owners, who often finance their businesses, at least in part with debt that has been personally guaranteed. In the context of COVID-19, many borrowers are facing these challenges through no fault of their own. Courts should aim to resolve no-income, no-asset cases quickly, and the law should provide mechanism for a discharge and fresh start for all natural person entrepreneurs. Cost (such as court filing fees) and practical inaccessibility (such as that stemming from overly burdensome or confusing procedures) should be reduced and (where possible) eliminated for personal bankruptcy, especially for no-income, no asset cases.

Conclusion

Debt is critical to prosperity and progress. If debtors cannot meet their obligations, they require sophisticated legal and institutional frameworks. Inaction or mismanagement in such circumstances can lead to substantial economic harm. These reforms are aimed at avoiding such harm and laying a foundation for an equitable recovery in this unprecedented context of COVID-19.