Debtor-friendly Insolvency Laws

When trying to encourage businesses, law-makers rarely focus their attention on bankruptcy laws, as can be seen from the low number of reforms recorded by Doing Business in this area.

However, during periods of crisis, countries are more likely to pay attention to them. And some countries–when going through hard times may enact temporary insolvency laws or amendments to the existing insolvency law to protect debtors that otherwise would become bankrupt. The main purpose of enacting these regulations is to prevent a “domino effect” where one bankruptcy would lead to another, and so on. This has been the case, for example, in some Latin American countries such as Colombia (1999) and Argentina (2002).

Which basic characteristics distinguish these laws from others? First, they are normally temporary. Second, they are remarkably “debtor friendly”. Scholars usually classify insolvency laws in two types, as far as the level of protection is concerned: debtor friendly laws vs. creditor friendly laws. The United States chapter 11 is perhaps the most known example of “debtor in possession” law, while some European laws that allow creditors to appoint a trustee and liquidate the debtor’s assets are considered creditor friendly. Of course, in the middle, there are many hybrids.

Expressly stated in the text of the law or not, at the moment where the Government in crisis passes the law, nobody seriously plans to keep it in the long term. But after the crisis, it might happen that to reform it again, some opposition arises, or Governments simply have other priorities. Reform of substantial laws can be procrastinated.

But there is a risk if these laws, originally aimed at being temporary, remain in place. Strong debtor protector laws, while maybe effective in the short term, arguably do not protect debtors –and the market in general - in the long term.

A recent study “Does Debtor Protection Really Protect Debtors?” (Berger, Cerqueiro and Penas, 2008) argues just that. After analyzing different levels of debtor protection across the US for personal bankruptcy, the authors conclude that in those states with strong debtor-friendly laws, small businesses are penalized by the credit market with more collateral requirements, shorter maturities, etc. Therefore, temporary insolvency laws enacted during crisis should be precisely that: temporary.