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Chile's recent reforms used Colombia, Mexico and Brazil among others as models. Here Chilean capital Santiago. (Photo: Bug Planet)
Monday, February 2, 2015

Latin America: Failed Bankruptcy Laws

Are the region's bankruptcy laws stifling entrepreneurship?


Inter-American Dialogue


In some countries considered leaders in innovation, such as the United States, Japan and South Korea, resolving bankruptcy-related issues takes an average of six months to 1.5 years, while in the majority of Latin American countries, the process takes between three and five years, according to a recent study by the World Bank and International Finance Corporation. Some countries in the region, such as Chile last year, have moved to reform insolvency laws in an effort to spur entrepreneurship. How big of an impediment to entrepreneurship and innovation are the region's bankruptcy laws? Should governments make reforming such laws a priority? Which countries could provide models?

Alberto Pfeifer, visiting professor of international negotiation at the Institute of International Relations at the University of São Paulo in Brazil: 
Innovation is about taking risks. The risk of failure is part of the process; the risk of bearing the cost of failure should not be. The best incentive to foster innovation is to support entrepreneurial experimentalism. That means alleviating the cost of bankruptcy to innovators; otherwise the very possibility of having to face the burdensome cost of a foreclosure will prevent entrepreneurs from even thinking about opening a small start-up company. Alas, this is basically the tale of Latin America's innovation paradox: so much entrepreneurial drive, so many people employed by microbusinesses--more than half of the population owe their paychecks to firms with less than five workers--and yet the curse of starting small, and forever being small, because it's too risky to try new things and eventually go big. For sure, never-ending poor physical infrastructure, mediocre educational levels and even a failure-averse attitude take their toll in terms of lousy productivity and in impeding more innovation from spreading around. But better regulation could provide a short-term, low-cost boost to productivity and innovation around Latin America. Remedies zeroing in on insolvency and bankruptcy legal frameworks are readily available and might well increase the amount of domestic credit to SMEs. There is plenty of sound regulation related to insolvency procedures worldwide, from national law to regional procedures to principles developed by intergovernmental organizations such as UNCITRAL, OECD and the World Bank. It should be the task of any hemispheric intergovernmental organization to take the lead in terms of collecting best practices on insolvency regulation, developing a framework adapted to the general Latin American judicial and bureaucratic environment and fighting for its adoption by all the countries that still lack sound legislation.

Joy K. Gallup, partner in the Latin America and Corporate practices of Paul Hastings, LLP:
 Bankruptcy laws that hasten insolvent companies into liquidation are a significant disincentive to entrepreneurship and innovation, and Latin America's bankruptcy laws have been moving away from that for a number of years. Economists have concluded that entrepreneurs are more likely to start businesses in jurisdictions with bankruptcy laws that are friendlier to debtors and have also done studies that indicate a positive correlation between countries with debtor-friendly bankruptcy codes and the level of technological innovation in those countries. While the overall length and uncertainty of the bankruptcy process is one of the factors that can negatively affect both debtors and creditors, the ultimate outcome appears to impact innovation and entrepreneurship most directly. In countries where the rules are clear (for instance, having an automatic stay to prevent the disorganized seizure of assets) and allow the debtor to have a greater chance of reorganizing its business and avoiding liquidation, the level of innovation is greater. So should Latin American governments focus on bankruptcy code reform? Absolutely, if their bankruptcy codes do not allow for meaningful reorganizations. Chile's recent reforms were meant to do just that, and used Colombia, Mexico and Brazil among others as models. Mexico's recent 'creditor-friendly' reforms may have gone a little too far: by imposing a one-year time limit for reorganizations before forcing the debtor into liquidation, these reforms may have the effect of encouraging third-party debt investment initially, but ultimately these time limits may be too restrictive for debtors to reorganize--thus discouraging entrepreneurship and innovation.

Boris Kozolchyk, president and executive director of the National Law Center for Inter-American Free Trade (NLCIFT) and Evo de Concini Professor of Law at the University of Arizona: The problem that good-faith creditors, secured and unsecured, face in most Latin American countries is twofold: As stated by the IFC, it takes an average of three to five years to resolve bankruptcy issues, and as unmentioned by the IFC, prior to judicial bankruptcy proceedings, many debtors do business in a continuous state of de facto bankruptcy in which they dare their creditors to seek an involuntary bankruptcy. This enables these bad-faith debtors to take advantage of their unpaid creditors by continuing to extract unfavorable terms from them. In my experience, this is a widespread state of affairs throughout Latin America, with the exception of Chile and Colombia. On the other hand, if the insolvent debtor is acting in good faith, wishes and seriously tries to pay but cannot pay all his obligations, in most Latin American nations (with the exception of Chile and hopefully Colombia in the near future) his business career will be over, with no second, let alone third or fourth chances at commercial success. In most Latin American countries, such a debtor can only be discharged upon full payment, and if he cannot pay when told to do so by a court, he is very unlikely to get credit at market rates ever. Thus, in answer to your questions: Yes, the insolvency and bankruptcy laws of Latin America are a major impediment to entrepreneurship and innovation, and yes, governments would be well-advised to reform their secured transactions and bankruptcy laws as a priority. Chile could provide such a model, as does the United States, whose bankruptcy laws including debtor rehabilitation were very influential in drafting Chile's.

José Ernesto Amorós, professor and executive director of the Entrepreneurship Institute in the School of Business and Economics at the Universidad del Desarrollo in Chile: It could be a psychological issue, but the change from a formal 'Bankruptcy Law' to a novel 'Re-entrepreneurship Act' transformed the mindset of many new and small-business owners in Chile. The new 'Law on Reorganization and Liquidation of Assets of Persons and Companies,' the real name of Law 20,720, which was enacted on Oct. 10, 2014, significantly modernized all the processes related to bankruptcy, and allows a less cumbersome, less expensive and more concentrated process. For the entrepreneurs, this is big step in order to facilitate re-entrance. The law allows debtors and creditors to negotiate on equal footing and solves one of the most dramatic issues for many entrepreneurs in the country: not being stigmatized or carrying a backpack for life, as it was before. Thanks to this law, a formal bankruptcy very clearly separates the person from the firm and rescues one of the most important values of entrepreneurship dynamics (very well accepted in the Anglo-Saxon culture): if the firm fails, that doesn't necessary involve a personal failure. According to the National Association of Entrepreneurs, ASECH, about 25 percent of entrepreneurs consolidate a business only in the second attempt, while 14 percent had four failures before consolidating their business. So failure is part of the normal process. In practical terms, the new law gives the opportunity for a fast and cheap dissolution process. Under the old system, the bankruptcy process could take 4.5 years on average, while Law 20,720 establishes that individuals ought to have their resolution in four months, and in the case of legal persons, companies' situations, it ought to be one year. Debtors can pay also with common assets and not with familiar patrimony. And also a very important issue is that the records go to the firm not to the person; this opens new opportunities for new firm creation after the restructuring process.

Republished with permission from the Inter-American Dialogue's daily Latin America Advisor