The design of bankruptcy law may have a significant impact on people´s access to finance, the asset and capital structure of firms, and the level of innovation and entrepreneurship in a country. For this reason, it seems relevant to analyze the operation of bankruptcy law in a particular jurisdiction, as a way to determine its potential impact on the real economy. A higher or lower rate of bankruptcy procedures is not necessarily good or bad for society. It depends on the underlying reasons for the higher or lower usage of bankruptcy procedures.
In my recent paper, entitled “The Low Use of Bankruptcy Procedures in Spain: Reasons and Implications for the Spanish Economy”, I explore the underlying reason for the low rate of business bankruptcies in Spain, and the implications that the low usage of bankruptcy procedures may have for the Spanish economy.
There are two main hypotheses that may explain the low level of business bankruptcies in Spain: (i) Spanish firms minimize ex ante the risk of bankruptcy; or (ii) Spanish firms resolve their financial trouble without using formal bankruptcy procedures. This paper proposes an intermediate hypothesis. On the one hand, it argues that Spanish firms choose asset and capital structures that minimize ex ante the risk of bankruptcy as a consequence of Spain’s unattractive bankruptcy law, a creditor-friendly corporate law, and a poor law of secured transactions. On the other hand, when insolvency threatens, firms avoid the use of bankruptcy procedures due to the unattractiveness of the Spanish bankruptcy system for both debtors and creditors. Therefore, the use of bankruptcy procedures is not only minimized ex ante, but also avoided ex post.
From the debtor’s perspective, corporate directors are exposed to a very harsh liability regime under Spanish bankruptcy law. Likewise, individual debtors do not enjoy an effective discharge of debts. Moreover, the Spanish Bankruptcy Act 2003 establishes an old-fashioned section, inexistent in most insolvency jurisdictions, in which the court may ‘label’ the debtor (or, if a corporation, the directors) as 'guilty', even when it is shown that the debtor´s insolvency was generated or exacerbated by reasons totally unrelated to the debtor´s (or directors’) actions. From the creditors’ perspective, the lack of adequate protection for secured creditors, the poor protection of unsecured creditors, the incentives created by the legislator to promote reorganization over liquidation regardless of the debtor´s viability, the absence of credible mechanisms to quickly distinguish between viable and non-viable firms, and the inexistence of an effective absolute priority rule, make Spanish bankruptcy procedures very unattractive to lenders. Moreover, since the mortgage system is very efficient in Spain, banks have incentives to lend on a secured (or even over-secured) basis, so they can avoid the harmful effects of the bankruptcy system. Hence, as pointed out by previous studies (Celentani et al, 2010; García-Posada and Mora-Sanguinetti, 2012), Spanish firms have incentives to invest (or over-invest) in non-specific assets such as equipment and real estate. Thus, not only they able to reduce the risk of bankruptcy by investing in less risky assets, but they can also have better access to finance, since these assets can be easily given as debt collateral.
Nevertheless, the ex ante prevention of the risk of bankruptcy through these asset and capital structures is not costless for the Spanish economy. On the one hand, it leads Spanish firms to reduce their investments in research, innovation, and other valuable (but risky) assets. On the other hand, the greater use of the mortgage system may destroy the going concern value of economically viable firms just facing financial trouble. Therefore, it will reduce the pie available for distribution and, if so, it may generate an ex ante increase in the cost of debt, making people´s access to finance more difficult. Likewise, several costs can be created when a firm avoids ex post the use of the bankruptcy system. First, an improper delay of the bankruptcy petition may hamper both the debtor´s assets and the likelihood to turn around an economically viable business. Second, the reluctance of the debtor to file for bankruptcy may exacerbate several problems potentially arising in the vicinity of insolvency such as asset dilution (eg, deviation of assets to related parties) or asset substitution (eg, investing in risky projects with negative net present value).
Unlike previous studies, this paper argues that the low usage of bankruptcy procedures in Spain is also due to other variables such as the design of a creditor-friendly corporate law, a poor law of secured transactions, the use of workouts, and some economic and sociological factors generally generated or at least exacerbated by the legislator. These latter factors, empirically tested through several interviews, include: (i) the stigma associated with Spanish bankruptcy procedures; (ii) the high level of risk aversion faced by Spanish entrepreneurs (especially small and medium size entrepreneurs); (iii) the bad perception of the Spanish bankruptcy system; and (iv) the low recognition of business success linked to the bad connotations of business failure in Spain. Likewise, it is shown that the high dependence of Spanish firms to bank finance and the poor culture of bank lending in Spain also contributes to the inefficient design of the asset and capital structure of Spanish firms. On the one hand, Spanish banks have traditionally lent money on a secured (or even over-secured) basis instead of basing their financial decisions on the debtor´s ability to generate cash-flows. Therefore, this culture of bank lending exacerbates the problem associated with the inefficient design of the asset structure of Spanish firms. Likewise, it also encourages (or, at least, allows) firms to invest in negative net present value projects. Hence, since Spanish banks do not invest in gathering information about the viability of the debtor´s business, and they do not monitor the debtor´s activities, they are not fulfilling with one of the economic functions that justifies their existence and, in part, their fees.
On the basis of this exercise, this paper contributes to the literature by introducing new variables that help explain the relative use of bankruptcy law. Likewise, it proposes a structural reform of the Spanish Bankruptcy Act 2003 to make bankruptcy procedures more attractive to both debtors and creditors. Finally, it suggests the reform of several non-bankruptcy laws to promote the optimal design of the asset and capital structure of Spanish firms. Thus, by allowing firms to choose those asset and capital structures that maximize their value, it will be possible to improve the competitiveness and growth of the Spanish economy.
Aurelio Gurrea Martínez is a SPILS Fellow at Stanford Law School and Executive Director of the Ibero-American Institute for Law and Finance.