Economic Crisis and the Effectiveness of Insolvency Regulation

Author:Priit Manavald
Position:Magister iuris, Attorney-at-law, Law Firm Priit Manavald

1. Introduction - 2. The relationship between the number of insolvency proceedings and change in GDP - 3. Evaluation of the effectiveness of the legal regulation of insolvency - 4. Ways of overcoming insolvency in Estonia - 5. Conclusions

1. Introduction

In the circumstances of the economic recession, saving of money and the effective use of resources has become a highly popular subject. Also the effectiveness of legal regulation is without doubt an important part of this topic. The objective is not just the ensuring of legal regulation appropriate to the society's level of development but the ensuring of that with the least possible expense. Insolvency law and the regulation of economic relations arising from insolvency-one of the essential elements of legal order-is also of great importance and deserves at least as much attention as the rest of the elements of legal regulation. During an economic crisis, insolvency law obtains a much more prominent place in the social consciousness than usual. This is, above all, due to the rise in the number of insolvency cases (including bankruptcies). An increasing part of the society is beginning to sense insolvency-related issues as personal problems or at least as a source of personal problems.

The author of this article has set three objectives for himself: first, to examine the statistical relationship between the state's economic circumstances and the number of insolvency proceedings; second, to ascertain the principles according to which it is reasonable to evaluate the effectiveness of insolvency regulation, which, in turn, requires definition of the objectives of the legal regulation of insolvency; and, third, to compare different types of procedures and different regulations from the standpoint of expected effectiveness. However, the article also serves a purely practical purpose: to investigate whether the regulation in force in Estonia is sustainable in the circumstances of an economic crisis, and if not, what could be done to improve the regulation. The author has proceeded from the hypothesis that the regulation currently in force is not effective enough to handle the rising number of insolvency proceedings resulting from the economic crisis, and this is not a problem unique to Estonian regulation. Although the article mostly relies on Estonian data, most of the conclusions drawn are also applicable to other countries, with similar regulations. Because of the rising trend of insolvency proceedings, it is likely that finding ways for reducing procedure expenses-above all, for improving the effectiveness of the existing types of procedures and for using such types of procedures as involve the court and the state as little as possible-is unavoidable.

2. The relationship between the number of insolvency proceedings and change in GDP

Comparing the recent years' dynamic of bankruptcy matters filed in Estonian courts 1 , we will see that in 2007, there were 698 bankruptcy cases filed in courts; that is a 67.8% increase in comparison to the previous year, and the number of bankruptcy matters filed in courts in 2008 was 698, which is, in turn, 69.9% more than in the previous year. The data of 2009 are not directly comparable with those of previous years, because of a change in procedure rules 2 , but the total number of filings for action for proceedings concerning petition and other bankruptcy matters was 2,420, which means that the number has more than doubled3. Also, it cannot be claimed that the increase in bankruptcy matters has occurred proportionally to the decrease in other cases. In fact, both the total number of civil matters and the percentage of bankruptcy matters in relation to that number are on the rise. In 2007, 2008, and 2009, that percentage was 2.6%, 4.6%, and 8.2%, respectively4.

The facts presented speak for themselves; however, for planning of the measures necessary for updating the insolvency regulation, it is not enough to state the fact that the number of insolvency proceedings is likely to keep rising in the near future. It is important to know how much and when exactly it is going to increase. To get an overview of the situation, statistical parameters descriptive of essential relations must first be determined. Unfortunately, no statistical indicator provides a complete picture of the process. Each indicator only describes specific aspects of the reality, and making some kind of selection is unavoidable. In order to examine the statistical relations between the current economic situation and the number of bankruptcies, the author has chosen the following statistical indicators:

  1. Change in gross domestic product calculated via chain-weighting method in comparison with the same period of the previous year (real GDP growth) has been used as a characteristic of the dynamic of the state's economy. As shown by this indicator, Estonia's economic growth was relatively stable in the years 2001-2005, was exceptionally rapid in 2005 and 2006, began to decrease in 2007, and turned negative in 2008. In 2009, the downturn became very rapid. Such a development curve coincides very well with the common understanding of the development trends of the Estonian economy.

  2. The number of court-declared insolvency cases of companies-i.e., abated and declared bankruptcies-has been used as an indicator characteristic of the number of insolvency proceedings. The collected data indicated that the result does not change substantially with use of the ratio of the number of insolvency cases to 10,000 registered undertakings.

To get a good overview, it would be practical to use time-series that are as long as possible, but, unfortunately, the options are limited here. All elements of a time series must be determined on the same bases. In the years following the entry into enforcement of Estonia's first Bankruptcy Act (hereinafter 'BankrA') in 1992 5 , the number of bankruptcies was very small because the launch of the new system required some break-in time, while the number of registered companies was very large as a result of the low cost and ease of business registration proceedings. The number of companies registered in Estonia experienced a significant change in the years 1995-1997, when the principles for founding companies changed and companies were reregistered, moving from the register of enterprises, agencies, and organisations to the commercial register. Therefore, it would be misleading to compare the indicators of the years up to 1997 with those of recent years, which is why earlier years have been discarded in this study. The data, presented in table form, are the following:

Year Number of insolvency cases6 GDP7
1997 224 11.7
1998 275 6.7
1999 433 -0.3
2000 293 10.0
2001 257 7.5
2002 427 7.9
2003 459 7.6
2004 436 7.2
2005 419 9.4
2006 352 10.0
2007 202 7.2
2008 429 -3.6
2009 1055 -14.1

In order to show trends, the data have been presented in a line graph:


I will leave more precise correlation calculations to mathematicians, but it is easy to see the clear negative relation between GDP and the number of insolvency cases-the graph lines mirror each other. By examining the maximum and minimum points, one may notice that the relation occurs with a shift of about a year. This could also be formulated by saying that today's trends of GDP change are realised as a corresponding growth or decline in the number of bankruptcies one year later. Given the duration of bankruptcy proceedings 8 , the effect is likely to persist for many years. Decline in GDP therefore increases the work load of courts for more than a year.

It could be said that the author is 'breaking through an open door', and that such a result is entirely expected and this dependency has been noted in the professional literature before9. However, given the novelty of the situation for Estonia, pointing out this problem in such a way is probably necessary nevertheless. It is relevant to analyse whether and to what extent this (presumably well-known) trend has been taken into account in planning of the developments of the coming years. First and foremost, the question must be answered of whether the existing regulation is effective and inexpensive enough to be able to handle the sharp increase in the number of insolvency proceedings that is very likely to occur in the near future. Given that Estonia lacks experience with crises comparable to the current economic crisis, the study must rely mainly on the experience of other countries. As regards the economic effectiveness of the procedure, there are, however, several opportunities for drawing important conclusions from the statistics for insolvency proceedings in Estonia. Since reorganisation proceedings are still a very young type of procedure in Estonia, it is mostly the statistics pertaining to bankruptcy proceedings that can be used.

3. Evaluation of the effectiveness of the legal regulation of insolvency

The effectiveness of a system can be viewed as the ratio of the level of achievement of the system's objectives (the effect gained) to the resources employed or the expenses used to achieve this10. In order to evaluate a regulation's effectiveness, the objectives of the regulation must, therefore, be determined first. Without a clear idea of the objectives, the level of their achievement cannot be evaluated. Metaphorically speaking, a ship without a target port cannot have a stern wind. By formulating the objectives, one can evaluate to what extent and with what expenses the existing regulation aids in achieving these objectives or, to put it differently, how effective the regulation is. All of the above also applies to the legal regulation of insolvency. If one is to be able to choose between alternative regulations and the different possible procedures, evaluating their effectiveness is of central...

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