May, 2009, Leora Klapper, DECRG-FP
As the global economic downturn continues to worsen, prospects of illiquidity and potential insolvency are becoming more likely around the world. Many countries and firms are already affected through declining demand, inability to raise financing due to the credit crunch, drops in foreign investment, and reductions in remittances. One of the important concerns for policymakers is the effectiveness of existing bankruptcy regimes. Financial crises during the past decade (Russia, East Asia, Argentina) drew attention to the importance of effective mechanisms to resolve corporate financial distress, which facilitates the efficient reallocation of assets.1 The market for corporate control and the formal bankruptcy/liquidation processes of a country are two key mechanisms through which corporate assets are reallocated. Ideally, an economy would only allow the best users of economic resources to retain the right to use those assets and any sub-optimal use would result in either a take-over by a more proficient owner or an asset sale.
Yet the use of formal legal bankruptcy procedures to resolve financial distress varies around the world, for example, from 0.04% in India to 4.0% in the United States over the 1990’s (Claessens and Klapper, 2005). These differences can be explained by variations in legal systems, accounting standards, and regulatory frameworks, as well as differences in the development of financial and capital markets, and macroeconomic factors. These findings suggest that country and institutional characteristics affect the way that financial institutions and commercial creditors confront financial distress. Furthermore, bankruptcies are less common in countries with concentrated banking relationships, consistent with other evidence that bankruptcies are more common in firms with more complex capital structures (Babchuck, 1998).
In practice, bankruptcy is a complicated and difficult process, and research suggests that in most countries existing bankruptcy regimes do not perform very well even in normal times (Djankov et al., 2008). A survey of insolvency practitioners from 88 countries on debt enforcement indicates that bankruptcy procedures are time-consuming, costly and inefficient (i.e., unable to preserve the business as going concern). In only 36% of countries, the business is preserved as a going concern, and an average of 48% of the business’ value is lost in debt enforcement. In developing countries simpler procedures such as quick foreclosure and transfer of control of the firm to secured creditors work best, whereas more elaborate procedures including reorganization (which is most likely to preserve the business as a going concern), are likely to be more successful in richer countries with greater capacity for enforcement. Furthermore, there is evidence that weaker bankruptcy regimes have a real effect on the number of firms using the formal bankruptcy system (Claessens and Klapper, 2005). A study of 37 industrial and developing countries finds that during the 1990s, bankruptcies are higher in countries with Anglo-Saxon legal systems, greater judicial efficiency, market-oriented financial systems (characterized by multiple banking relationships), and overall greater economic development (Table 1).
Firm-level characteristics – including performance, leverage, and ownership – also affect the resolution of financial distress. For instance, following the East Asian financial crisis, an analysis of publicly listed firms that entered formal legal bankruptcy protection – using new bankruptcy laws introduced during the crisis – finds that bankruptcy is used more when there is both stronger creditor rights and judicial efficiency (Classens, Djankov, and Klapper, 2003).
For example, possible outcomes for firms in distress may include out-of-court renegotiations, acquisitions by healthy firms, or in-court reorganizations or liquidations (Dahiya and Klapper, 2007). Data on stock market delistings of firms in 40 countries around the world is used to study the use of liquidation versus mergers as a mechanism to resolve financial distress. This paper finds that equity market delistings occur more frequently in countries with strong shareholder rights. Furthermore, both strong creditor and shareholder rights increase the use of bankruptcy, relative to acquisitions, as a mechanism to resolve financial distress.
Importantly, systemic crisis periods are also periods of great opportunity for meaningful reform that would otherwise be stymied by powerful political interests. Claessens et al. (2002) provide examples of such reforms from East Asian financial crisis, which include the passage of improved bankruptcy laws in South Korea, Thailand and Malaysia, and the formation of specialized bankruptcy courts in Indonesia and Thailand. Another example of a successful reform comes from Colombian bankruptcy reform introduced in the midst of a major financial crisis in late 1999. Gine and Love (2008) show that the reform significantly improved the efficiency of the bankruptcy process by streamlining reorganization proceedings.
In recent years, private equity investors, hedge funds, and other institutional investors have played an active role in providing capital to distressed firms. For example, "PIPES" – private equity in publicly listed companies – is commonly used by US companies when the general market and the firm's stock are performing poorly (Na, 2009). A current project studies the unique use of PIPES in 19 Asian markets during the current financial crisis. (Dahiya, et al, 2009).
Bebchuk, Lucian. 1988. “A New Approach to Corporate Reorganizations.” HarvardLaw Rev. 101 (January): 775–804.
Claessens, Stijn and Leora Klapper, 2005, “Bankruptcy around the World: Explanations of its Relative Use,” American Law and Economic Review, 7 (Spring): 253-83.
Claessens, Stijn, Simeon Djankov, and Leora Klapper, 2003, "Resolution of Corporate Distress in East Asia", Journal of Empirical Finance 10:1, 199-216.
Claessens, Stijn, Simeon Djankov, and Ashoka Mody, 2002, "Resolution of Financial Distress: An International Perspective on the Design of Bankruptcy Laws", The World Bank, Washington DC.
Dai, Na, 2009. “The Rise of the PIPE Market”, Companion to Private Equity, Douglas J. Cumming, ed., Wiley.
Dahiya, Sandeep and Leora Klapper, 2007. “Who Survives? A Cross-Country Comparison”, Journal of Financial Stability 3:3, 45-76.
Dahiya, Sandeep, Leora Klapper, and Harini Parthasarathy, 2009. “PIPEs and Financial Crises”, Ongoing Project.
Demirguc-Kunt, Asli, and Luis Serven. 2009. "Are All the Sacred Cows Dead? Implications of the Financial Crisis for Macro and Financial Policies.” Policy Research Working Paper 4807. World Bank, Washington, D.C.
Djankov, Simeon, Oliver Hart, Caralee McLiesh, and Andrei Shleifer, 2008, “Debt Enforcement around the World,” Journal of Political Economy, 116 (6): 1105-49.
Gine, Xavier and Inessa Love, 2008, “Do Reorganization Costs Matter for Efficiency? Evidence from a Bankruptcy Reform in Colombia,” Policy Research Working Paper 3970. World Bank, Washington, D.C.
The resolution of distressed banks and other financial institutions is beyond the scope of this paper. For a current discussion see Demirguc-Kunt and Serven (2009).