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Michael Murray’s on-going commentary on issues in corporate and personal insolvency law and related policy and law reform, in Australia and internationally. Given the scope of insolvency, this extends to business, consumer and professional conduct, and ethics, governance and regulation, criminal, tax, environmental and administrative law, and the courts and government.

 

OECD report – “low personal costs to entrepreneurial failure with high barriers to restructuring”

Economic analyses of insolvency in Australia are strangely limited, given that a major purpose of an insolvency regime is its support of economic efficiency.  Particular economic purposes of any insolvency regime include the disposal of non or poorly functioning businesses and the re-allocation of their resources to others for better economic use. An OECD paper offers thoughts on the features of insolvency regimes that should be developed, or minimised, in order to support these economic purposes.  Australia’s regimes is referred to as having minimal personal costs to entrepreneurial failure but with high barriers to restructuring.  

A poorly run business is either prompted to initiate the appointment of a liquidator because of the risk of the director’s personal liability, or is forced to accept the appointment on the initiative of a creditor and a decision of a court. Competition also acts to support this process.

It does always work that way, in particular where economic conditions are good, competition is limited and interest rates are low. Many businesses are able to get by in a ‘zombie’ state neither losing or making money, but not investing, developing or expanding

Insolvency regimes, zombie companies and capital re-allocation[1]

This OECD paper explores the cross-country differences in the design of insolvency regimes and their potential links with two inter-related sources of labour productivity weakness:

  1. the survival of zombie firms, that is, firms that would typically exit in a competitive market; and
  2. capital misallocation.

The paper constructs new cross-country policy indicators of insolvency regimes based on countries’ responses to a recent OECD questionnaire,[2] which aimed to better capture the key design features of insolvency which impact the timely initiation and resolution of insolvency proceedings.

According to these metrics, cross-country differences in the design of insolvency regimes are significant. Firm level analysis shows that reforms to insolvency regimes which reduce barriers to corporate restructuring and the personal cost associated with entrepreneurial failure may reduce the share of capital sitting in zombie firms.

These gains are partly realised via the restructuring of weak firms, which in turn spurs the reallocation of capital to more productive firms.

These findings carry strong policy implications, in light of the fact that there is much scope to reform insolvency regimes in many OECD countries and given evidence that rising capital misallocation and the increasing survival of low productivity firms have contributed to what is acknowledged as the productivity slowdown over the past decade.

As the paper says, zombie firms that would typically exit or be forced to restructure in a competitive market “are increasingly lingering in a precarious state, which may weigh on average productivity and crowd-out growth opportunities for more productive firms”.

In some countries, these problems are likely to be symptomatic of the inability of their insolvency regimes to facilitate the exit or downsizing of non-viable firms and the restructuring of viable firms that encounter temporary financial distress.

The paper says that the available cross-country indicators of insolvency regimes, for example the World Bank ‘Doing Business’ Reports, have drawbacks, making it difficult to identify the contribution of insolvency regimes to productivity performance and generate country-specific proposals for reform.

Thirteen key design features of insolvency regimes that are relevant to productivity outcomes

The OECD questionnaire aimed to capture the key design features of insolvency regimes that are relevant to productivity outcomes. Thirteen key features are identified, which may have adverse consequences for productivity growth by delaying the initiation of and increasing the length of insolvency proceedings.

Two features that raise the personal costs to failed entrepreneurs

  • time to discharge and
  • fewer exemptions.

Three absent mechanisms that would aid prevention and streamlining

  • early warning mechanisms,
  • pre-insolvency regimes and
  • special insolvency procedures for small and medium-sized enterprises (SMEs).

Five features that may potentially impose barriers to restructuring

  • creditors’ inability to initiate restructuring,
  • an indefinite stay on assets,
  • lack of priority given to new financing,
  • no cram-down of restructuring plans on dissenting creditors and
  • the dismissal of incumbent management during restructuring.

Three other factors

  • a high degree of court involvement,
  • a lack of a distinction between honest and fraudulent bankruptcy and
  • restrictions on individual and collective dismissals during proceedings.

Australia?

Those skilled in the disciplines applied in the OECD paper might assist in determining Australia’s impediments, or prompts, in serving the purposes of insolvency. As mentioned, the paper’s passing reference to Australia is that in common with some other countries, we combine “low personal costs to entrepreneurial failure with high barriers to restructuring”.

Our privatized regime

One comment on our system is the complete privatisation of the corporate insolvency regime, with fees recoverable only from the company’s remaining assets, with no government liquidator to attend to what might be termed the assetless exit of a business with corporate misconduct potentially involved. A ‘phoenixed’ company with no assets would not be sought out by a private liquidator, whose income depends on assets remaining or likely to be recovered in order to pay their fees. This is an impediment for a director seeking to have their company wound up voluntarily, and an impediment to a creditor who may have to offer money to secure the appointment of a liquidator.

Phoenixed zombies

This issue has received limited government focus in Australia but has had significant attention in the well known ‘phoenix company’ work of Professor Helen Anderson and others. Their last report of February 2017 recommended that

“if liquidators are to be charged with the primary responsibility for investigating wrongdoing – in addition to their important enforcement role in bringing asset recovery actions – these investigatory responsibilities should be expressly stated in the Corporations Act and adequate funding should be provided”.

Otherwise, one consequence can be that zombie firms, if they do exit, do so with no or limited regulatory oversight and their capital is invariably misallocated unlawfully.

[1] OECD Economics Department Working Paper No 1399, McGowan, Andrews and Millot

[2] To which Australia apparently responded.

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