Creative Destruction in Small Business Bankruptcy

Two distantly related items caught my eye this morning, as both reinforce the need for "creative destruction" as a response to all-too-common small business failure.

The first was a NYT piece on the travails of a female entrepreneur in China. It tells a heart-wrenching story of a system in which the state brutally represses honest but unfortunate debtors, including via the infamous blacklist that prevents defaulters from using air and train travel (effectively curtailing re-entry into business, even if financial and economic factors might otherwise allow this). This is a story about what it looks like when there is no bankruptcy backstop, no reset button to start fresh and undertake a new venture with the hard lessons of failure firmly in mind.

The other item explores the transition from such an unforgiving system--in Spain--after the introduction of a discharge for (most) small business debt. The linked Bank of Spain working paper offers further evidence of the salutary effects of small business bankruptcy that discharges individual entrepreneurs and encourages them to restart. The reform fostered the "creative destruction" of these entrepreneurs' ventures, with the failed firms exiting the market (rather than lingering as productivity-depressing zombies), which "leads to technological change and higher productivity growth" as "the introduction of the fresh start policy promoted firm creation among Spanish micro-firms, especially in companies with a high share of intangible assets, which are likely to be involved in innovation activities, and in sectors with high productivity." Nicely linking the two contrasting accounts from China and Spain, the Bank of Spain paper concludes, "This finding also suggests that a starkly pro-creditor personal bankruptcy law with no real fresh start, like the Spanish one before 2015, may be an important barrier to entry for small businesses." Indeed.

It still surprises me that lawmakers around the world continue to resist this long-established truth for small business, powerfully undermining the most important driver of economic development worldwide. Worse yet, the mere introduction of a personal bankruptcy law with a debt discharge is not enough--the system actors have to actually support a fresh-start policy rather than actively undermining it, which turns out to have been the disappointing result of the first two years of such a system in Shenzhen, China. One hopes that national legislatures, like small entrepreneurs, can learn from failure and move forward with proper personal bankruptcy laws when given a fresh opportunity to do so.

Third-Party Releases Clearly Endorsed in the 2nd Circuit, At Long Last

Yesterday's 2nd Circuit opinion reconfirming Purdue Pharma's settlement/restructuring plan is an enlightening read for those interested in third-party releases. In what seems to me (and the concurrence) a bit of a reach, the 2nd Circuit conceded that statutory authority more specific than section 105 was needed to support third-party releases, but the Court found such support in section 1123(b)(6): “a plan may . . . include any other appropriate provision not inconsistent with the applicable provisions of this title.” Hmmm. That's quite a slender reed on which to balance such a powerful action. More interesting, the Court set forth a series of seven tests to gauge whether any given third-party release is appropriate. One key test is rather vague (whether the plan provides for the fair payment of enjoined claims), but at least we now have a roadmap for getting to an effective third-party release. Or do we? The Court in a crucial passage emphasizes "to the extent that there is a fear that this opinion could be read as a blueprint for how individuals can obtain third-party releases in the face of a tsunami of litigation, we caution that the key fact regarding the indemnity agreements at issue is that they were entered into by the end of 2004—well before the contemplation of bankruptcy." So the type of pre-bankruptcy planning we've seen in other cases may be a bridge too far, at least in the 2nd Circuit. This latest opinion seems to add weight to recent arguments that bankruptcy court is, indeed, an appropriate and effective venue for resolving sticky mass-tort issues, though the policy debate will doubtless continue.

New Year, New Personal Bankruptcy Law--in Kazakhstan

The list of countries with new personal insolvency laws continues to grow. Bloomberg noted today that the President of Kazakhstan had signed a new law setting out several procedures for relieving the debts of non-entrepreneur individuals (sole proprietors remain relegated to the existing law on rehabilitation and bankruptcy). The text of this 30 December 2022 law is here (in Russian only), and most of its provisions will become effective in 60 days, around March 1, 2023. 

The structure of this law and its four pathways to relief are clearly inspired by the 2015 law of Kazakhstan's northern neighbor. This indicates a continuing trend, as new personal insolvency laws are generally based on a model from the law of a country the adopting country respects, and the model in this case is a fairly good one (the parent law is described here and here). The Kazakh law differs in some respects from this predecessor model, but the basic system is the same: (1) a no-asset procedure ("out-of-court bankruptcy") providing a simple discharge to debtors with debt below about $11,000 (i.e., 1600 "monthly calculation units," which for 2022 was KZ₸3063, just over US$7, so 1600 x $7 = $11,200), (2) a 5-year payment-plan procedure ("restoration of solvency") for debtors with regular income who choose to propose a 5-year plan for court (not creditor) approval, (3) a traditional liquidation-and-discharge procedure ("judicial bankruptcy") unfolding over six months and leaving the debtor with exempt property, including a sole residence, and (4) a settlement option ("amicable agreement") for debtors who manage to convince their creditors to agree to a private compromise (read: never!).

While the requirements for accessing the no-asset out-of-court bankruptcy procedure seem wildly unrealistic and uniquely austere (no property of any kind!?), the new Kazakh system is fairly well structured. Judging by the northern neighbor's recent experience with its very similar set of procedures, it seems most likely the payment-plan procedure will be selected by very few debtors, and the courts will reject the unviable plans of the few debtors who try to pursue this route. Judicial bankruptcy will become the main pathway to relief, which seems to be within reach for ordinary Kazakh citizens. Eventually, the extremely restrictive access requirements for out-of-court no-asset bankruptcy seem likely to be relaxed--either in practice or in a first round of law reform--and that procedure will become the workhorse for the personal bankruptcy system.

Yet another laboratory to observe the effects of the messy compromises that create personal insolvency procedures--and thank goodness, yet another large population of debtors who finally have access to legal relief from debts that would otherwise hound them and their families forever, with no hope of recovery. The new year brings new hope for such families in Kazakhstan!