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FEATURE STORY June 28, 2017

Helping Small Businesses Handle Insolvency: World Bank Group Report Insolvency Treatment

Micro, small, and medium enterprises (MSMEs) drive employment, economic growth, and entrepreneurship across the globe.

They form a large part of the global economy: In emerging markets, there are between 365-445 million MSMEs, which contribute over 50% of total employment and up to 40% of national income.

Since not all small businesses are bound to succeed, it’s important to have a fair and effective insolvency system in place to ensure that business failure can be resolved either by rehabilitating the viable ones or liquidating the non-viable ones, and timely reallocating capital and labor.

In cases, when small businesses fail and there is no effective insolvency system to ensure that capital is reallocated and that entrepreneurs can re-enter the economy, billions of dollars in business value, jobs, and capital can be lost or sidelined.

In many countries, however, bankruptcy laws are designed with the complexity and sophistication of large companies in mind, not to address issues relevant to micro and small businesses. The complexity of insolvency proceedings often becomes a disincentive for small business owners facing financial distress to seek timely access to the insolvency system.

Yet, MSMEs are often the largest users of insolvency systems, because they often don’t have sufficient access to credit and can have difficulties weathering financial shocks. When approaching financial distress, small business owners face challenges such as limited information, few financing options, and overlaps between business and personal debt.

The new World Bank Group’s report on the Treatment of MSME Insolvency looks at challenges of insolvent MSMEs, how legislation in different jurisdictions responds to them, and whether current international standards adequately address the needs of small businesses restructuring and exit.

An insolvency system specifically designed for MSMEs may better serve their needs, the report finds. However, international policymakers and practitioners are some way off being to develop such systems and so further consideration of this issue is needed.

Since many small businesses - particularly micro enterprises - are informal, commercial legal systems tailored to their needs could also encourage them to formalize. This would be a critical step in improving the economics and financial inclusion of small entrepreneurs and their employees.

 Efficient insolvency regimes also allow for a “fresh start” for entrepreneurs and rehabilitation of viable businesses tends to enhance creditor recoveries and confidence. In turn, they can stimulate greater volumes of lending, at longer maturity periods, at lower cost and lower levels of collateral. Such mechanisms can also offer an effective framework for the creation of new business activity.

Since the majority of MSMEs facing acute financial distress are more likely to liquidate, legal frameworks should focus on fast liquidation mechanisms that permit a rapid reallocation of assets to productive activities.

Countries should also consider providing out-of-court assistance to small business owners such as mediation, debt counselling and financial education.

The report also studies country experiences in dealing with MSME insolvency. Some countries, such as Germany or Argentina, have made slight modifications or allow exemptions from certain requirements to the existing provisions in the insolvency legislation based on distinguishing “small cases” from others, while others, such as Japan and Korea, have drafted new provisions that target small businesses.

The next stage of the research will examine whether specific legislation for MSME insolvency is appropriate or not and its impact on financial systems and the real sector. However, evidence so far suggests that changes to the global insolvency standard might be a possible solution to adequately address the specific challenges of small businesses facing insolvency. 

The World Bank produced this report as part of its mandate as a global standard-setter for Insolvency and Creditor Rights (ICR) systems, together with the United Nations Commission on International Trade Law (UNCITRAL), as designated by the Financial Stability Board.