Implementing an insolvency framework for micro and small enterprises

 

Micro, small and medium-sized enterprises (MSMEs) represent around 90% of businesses and more than 50% of worldwide employment. Despite their economic relevance, most insolvency jurisdictions fail to provide an adequate response for MSMEs in insolvency.

 

Professor Gurrea Martínez of Singapore Management University is an expert in insolvency and business restructuring and his recent work looks at international insolvency frameworks.

 

Read the original article: https://doi.org/10.1002/iir.1422

 

Image credit: Freedomz/ Shutterstock

 

 

Transcript:

 

Hello and welcome to Research Pod. Thank you for listening and joining us today. In this episode we look at the research of Aurelio Gurrea Martínez, assistant professor at the Yong Pung How School of Law at Singapore Management University.  Professor Gurrea Martínez is an expert in insolvency and business restructuring and his recent work looks at international insolvency frameworks for micro, small and medium-sized enterprises.

 

Micro, small and medium-sized enterprises (MSMEs) represent around 90% of businesses and more than 50% of worldwide employment. Despite their economic relevance, most insolvency jurisdictions fail to provide an adequate response for MSMEs in insolvency.

 

The World Bank and the United Nations Commission for International Trade Law have published principles and legislatives recommendations for the adoption of simplified insolvency frameworks for micro and small enterprises. Various countries around the world have also adopted special insolvency regimes for MSEs. Finally, COVID-19 and its severe impact on small businesses has encouraged many jurisdictions to include this reform in their political agenda.

 

So how are MSMEs special?

 

Unlike large enterprises, MSMEs typically have simple organisational structures. In fact, they are often single entrepreneurs with no employees. Also, their financial structures are usually very simple and only comprising a few creditors. In many countries, the majority of MSMEs are not incorporated – operating as sole proprietorships – or they might not even be part of the formal economy. Even if they are incorporated, the shareholders often act as guarantors of the MSME’s debts. Therefore, the individuals behind the MSME are exposed to unlimited liability for the firm’s debts. Any business in financial difficulty can face problems such as legal actions by the creditors that can destroy a business’s going concern value and lead to the termination of contracts that might otherwise help it trade out of difficulty. Also, debtors may engage in opportunistic behaviour at the expense of creditors.  And seeking professional advice comes at a price, whatever the size of the business.

 

Some of these problems can be exacerbated in the case of MSMEs. Most are managed by shareholder owners who may take more risks if they feel they have nothing left to lose. Also, emotional factors and lack of professional advice may encourage  owners to keep the business going even if it is no longer viable. In addition, financially distressed MSMEs may have few assets and find it difficult to access new finance.

 

Despite the particular features and problems of MSMEs, most countries subject MSMEs to the same insolvency framework as for larger companies. Insolvency proceedings are also a luxury that many MSMEs simply cannot afford. And even if they try to go down the insolvency route, the ordinary insolvency proceeding might not provide a suitable response to MSMEs, and the individuals behind the MSME might not even get a discharge of debts in many jurisdictions.

 

Failure to provide an adequate insolvency framework for MSMEs can generate several costs for society. For instance, it can hamper the reorganisation of viable businesses  and the rehabilitation of honest but unfortunate individual entrepreneurs. Therefore, it can  destroy wealth, jobs and growth. The lack of an attractive exit may also deter potential entrepreneurs from going into business. Finally, an unattractive insolvency system may also discourage firms from taking debt and risks, potentially harming innovation and firms’ access to finance.

 

These problems are beginning to catch the attention of regulators, academics and policymakers worldwide. Despite disagreements about the optimal design of an insolvency framework for MSMEs, most scholars and policymakers agree that the ordinary insolvency framework is too complex and too expensive for MSMEs. They also agree the individuals behind MSMEs should have access to an effective discharge of debts.

 

The author of the research we are talking about today, Professor Aurelio Gurrea Martínez, argues that an efficient insolvency regime for MSMEs should be based on four pillars: promotion of out-of-court restructuring for viable MSMEs; adoption of a simplified insolvency process based on a system of auctions; implementation of a discharge of debts for individual entrepreneurs; and adoption of active policies to reduce  the stigma associated with insolvency.

 

Promoting out-of-court restructuring for viable but financially distressed MSMEs would have several benefits. It would reduce the economic and reputational costs associated with the initiation of a formal insolvency proceeding.  Therefore, saving those costs would maximise the value of the MSME for the benefit of debtors and creditors. It would also reduce the number of insolvency proceedings of small businesses managed by the judiciary. Thus, it can improve the efficiency of judicial systems. Finally, it should be kept in mind that reaching an out-of-court agreement is more feasible with a debtor that only has a few creditors, as it generally happens in the context of MSMEs. Additionally, trying to reach an out-of-court agreement can serve as a mechanism to test the viability of the business and whether the creditors trust the individuals behind the MSME.

 

To promote out-of-court restructuring, regulators and private actors should start by enacting some good practices for workouts. These practices generally require good faith negotiations between debtors and creditors, as well as standstill agreements to prevent creditors from engaging in opportunistic behaviour. They typically include also disclosure of obligations for debtors and, if it is affordable, the involvement of reliable third parties acting as mediators, conciliators or restructuring advisors.

 

If out-of-court restructuring fails, there are many chances that the MSME is not viable or the creditors do not trust the individuals behind the MSMEs. Also, it should be kept in mind that most MSMEs do not have a significant going concern value. Therefore, regulators should adopt different policies to prevent the use of reorganisation procedures for non-viable MSMEs. To address this problem while providing viable MSMEs the opportunity to survive, Professor Gurrea Martínez’s proposes a simplified insolvency process based on a system of auctions.

 

According to this proposal, any interested party, including the individuals behind the MSME, would be allowed to bid for a firm’s assets. Bids could include cash offers for the entire business or individual assets, as well as non-cash offers such as reorganisation plans. All offers would then be subject to a creditor vote. If creditors support a reorganisation plan, the auction process would end with an actual reorganisation, which is often described as a hypothetical sale of the firm’s assets. If creditors opt for selling the assets, the process would end with an actual sale. This sale of the firm’s assets could still save a business if the bidder acquires the assets as a going concern.

 

While the procedure takes places, someone needs to lead the insolvency process. Ideally, Professor Gurrea Martínez suggests the adoption of a debtor-in-possession model supervised by an insolvency practitioner. One benefit of this is that business owners might be tempted to seek help earlier if they know they can keep their business going while attempts are being made to save it. If business decisions have to be taken, owners are usually also in the best position to make them. The role of the insolvency practitioner would be to supervise the process.

 

Unfortunately, many MSMEs might not be able to afford the fees of an insolvency practitioner. If so, it has been suggested that countries can recognise this problem as a “market failure” and intervene by appointing a public trustee. Alternatively, they can adopt a “private solution” that would allow the individuals behind the MSME to keep managing the firm. If this model is adopted, however, various safeguards should be adopted to protect the interest of the creditors.

 

The simplified insolvency process should include various measures to reduce the costs of the procedure. For example, the procedures should be initiated automatically upon the petition of the debtor, ideally with the use of standardised forms. Allowance and verification of claims should take place within a shortened time frame, and the whole process would take place virtually. To help finance the procedure, Professor Gurrea Martínez argues that debts and expenses needed to preserve value should be treated as administrative expenses. Also, a system of litigation funding should  be permitted.

 

Professor Gurrea Martínez’s third pillar for an efficient insolvency regime for MSMEs consists of adopting an effective discharge of debt for the honest but unfortunate individual entrepreneurs behind the MSME. Ideally, this discharge of debts should take place during the same simplified insolvency process.

 

Last but not least, he argues that regulators, policymakers and market actors should adopt more active policies to reduce the stigma associated with insolvency. One way to do so is by separating insolvency law from criminal law, making sure that only criminal business behaviour is punished.  In addition, stigma could be reduced by changing the language and referring to “debtors” rather than “bankrupts” and “restructuring” rather than “insolvency”. Also, the way insolvency law has been traditionally taught and understood should change: insolvency law not only deals with insolvent firms. Since the treatment of debtors and creditors in insolvency will affect how market actors make decisions, insolvency law affects the whole business community, including solvent companies and lending practices.

 

Professor Gurrea Martínez argues that the traditional insolvency framework existing in most jurisdictions around the world fails to provide an effective response to MSMEs. Therefore, his research can help jurisdictions adopt more attractive insolvency frameworks for the majority of the businesses existing in their economies: micro, small and medium-sized enterprises.

 

That’s all for this episode – thanks for listening, and stay subscribed to Research Pod for more of the latest science. See you again soon.

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