Promoting Orderly and Effective Insolvency Procedures

• Author: Sean Hagan
• Position: Assistant General Counsel in the IMF's Legal Department

Insolvency laws are still viewed by many merely as mechanisms for cleaning up economic trash. However, they play a far more important role. If effectively designed and implemented, they can boost confidence in an economy, thereby fostering growth and helping to prevent or resolve financial and economic crises.

Effective insolvency systems facilitate the rehabilitation of enterprises and also provide an efficient mechanism for the liquidation of those enterprises that cannot be rehabilitated. The reform of the insolvency system has become an important component of IMF-supported economic programs in many countries because of the impact such reform can have on a country's economic and financial system.

In economies in transition, for example, making state-owned enterprises subject to insolvency laws sends a clear signal that there is a limit to the amount of public financial support these companies can count on. Moreover, under the rehabilitation procedures included in most insolvency laws, creditors can be required to participate in the resolution of state enterprises' financial problems, lowering the cost to the public budget.

An effective insolvency system can also enable financial institutions in a country whose financial sector is in distress to curtail the deterioration of their assets by providing them with a means of enforcing their claims. It can also bring about the deepening and broadening of capital markets-for example, by stimulating the development of a secondary market in debt instruments that allows financial institutions to transfer their loans to entities specialized in the workout process.

Finally, in circumstances where the corporate sector is in distress because of an international financial crisis-as was the case in the recent Asian crisis-an effective insolvency law can ensure that private creditors contribute to the resolution of the crisis. For example, rehabilitation procedures may allow the courts to impose restructuring agreements over the objections of creditors, not only reducing the public cost of the crisis and relieving external financing needs but also buttressing the stability of the international financial system by forcing creditors to bear the costs of the risks they have incurred.

Aims of an insolvency system

Although the insolvency laws of countries differ in important respects, most systems share two objectives. The first is to allocate risk in a predictable, equitable, and transparent way, thereby bolstering confidence in the credit system; the second is to maximize the value of the insolvent entity.

The first objective needs to be seen from a number of different perspectives. In terms of the creditor-debtor relationship, a creditor's right to initiate insolvency proceedings against a debtor as a means of enforcing its claims reduces lending risks and therefore results in an increase in available credit. The allocation of risk among creditors is also important-for example, by affording secured creditors special treatment vis-à-vis unsecured creditors, the law can protect...