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World Bank Principles for Effective Insolvency & Creditor Rights Systems

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The brief summary of the key elements of the World Bank Principles for effective insolvency & creditors rights systems is given below:

Credit Environment:

  • Compatible credit & enforcement Systems-

The regularized system of credit shall be supported by the mechanisms that provide the effective, transparent along with the reliable methods for recovering a debt, comprising seizure & sale of immovable plus movable assets & sale or collection of intangible assets, for instance, debt owed to the debtor by third parties. An efficient system for imposing debt claims is crucial to the functioning credit system, particularly for unsecured credit. A creditor’s ability to take possession of the debtor’s property & to sell it to satisfy the debt is the simplest, most effective means of making a sure quick payment. It is far more effective than a threat of an insolvency proceeding, which often requires the level of proof & the prospect of procedural delay that in all but in extreme cases makes it not credible to the debtors as leverage for payment.

  • Collateral Systems-

One of the pillars of the modern credit economy is an ability to own & freely transfer ownership interests in property, & to grant the security interest to the credit providers with respect to such interests & rights as the means of gaining access to credit at more reasonable prices. Secured transactions play an enormously important role in a well-functioning market economy. The Laws on the secured credit mitigate lenders’ risks of the default & thereby increase the flow of capital & facilitate low-cost financing. Discrepancies & uncertainties in a legal framework governing security interests are the main reasons for high costs and unavailability of credit, especially in developing countries.

The legal framework for the secured lending addresses a fundamental features & elements for a creation, recognition & enforcement of security interests in all the types of assets, movable & immovable, tangible and intangible, including inventories, receivables, proceeds and future property, & on the global basis, including both possessory & non-possessory interests. The law should include any or all of the debtor’s obligations to the creditor, present or future & between all the types of persons. In addition, it should provide for effective notice & registration rules to be adapted to all types of property, & clear rules of priority on competing for the claims or the interests in the same assets.

For security rights & notice to third parties to be effective, they must be capable of being publicized at reasonable costs & easily accessible to the stakeholders. The reliable, affordable, public registry system is therefore important to promote the optimal conditions for asset-based lending. Where several registries exist, a registration system should be integrated to the maximum extent possible so that all the notices recorded under secured transaction legislation can be easily retrieved.

  • Enforcement Systems-

A modern, credit-based economy requires predictable, transparent and affordable enforcement of both unsecured and secured credit claims by efficient mechanisms outside of insolvency, as well as a sound insolvency system. These systems must be designed to work in harmony. Commerce is a system of commercial relationships predicated on express or implied contractual agreements between an enterprise and a wide range of creditors and constituencies[1]. Although commercial transactions have become increasingly multifaceted as more & more sophisticated techniques are developed for pricing & managing risks, basic rights governing these relationships & the procedures for enforcing such rights have not changed much. These rights allow the parties to rely on the contractual agreements, fostering confidence that fuels investment, lending & commerce. Conversely, uncertainty about the enforceability of contractual rights increases the cost of credit to compensate for the increased risk of non-performance or, in severe cases, leads to credit tightening.

  • Credit Information Systems-

The modern credit-based economy requires access to complete, accurate & reliable information concerning borrowers’ payment histories. This process should take place in the legal environment that provides a framework for the creation & operation of effective credit information systems. Permissible uses of the information from credit information systems should be clearly circumscribed, especially with regards to the information about the individuals.

Legal controls on the type of information collected & distributed by the credit information systems that may often be used to advance public policies, comprising anti-discrimination laws. Privacy concerns should be addressed through a notice of the existence of such a system, notice of when any information from such a system is used to make adverse decisions, & access by data subjects to stored credit information with an ability to dispute & have corrected inaccurate or incomplete info. An effective enforcement & supervision mechanism should be in place which provides efficient, inexpensive, transparent and predictable methods for resolving disputes concerning the operation of credit information systems along with the proportionate sanctions which inspire compliance but that are not stringent as to discourage the operations of such systems.

  • Informal corporate workouts-

Corporate workouts should be supported by the environment that inspires the participants to restore the enterprise to the financial viability. Informal workouts are negotiated in a “shadow of the law.” Accordingly, the enabling environment must include clear laws & procedures that require disclosure of or access to timely & the accurate financial information on a distressed enterprise; encourage lending to, investment in or the recapitalization of viable distressed enterprises; support the broad range of the restructuring activities, such as debt write-offs, rescheduling’s, restructurings & debt-equity conversions; & provide favorable or neutral tax treatment for such restructurings. A country’s financial sector should promote an informal out-of-court process for dealing with the cases of corporate financial difficulty in which banks & other financial institutions have a significant exposure— especially in the markets where the enterprise insolvency is the systemic one.

Read our article:Cross Border Insolvency and Bankruptcy

Insolvency Law Systems Commercial insolvency-

Though approaches differ, effective insolvency systems have a number of aims & objectives. The Systems should aspire to:

  • Integrate with the country’s broader legal as well as the commercial systems;
  • Maximize the value of the firm’s assets & recoveries by the creditors;
  • Provide for both the efficient liquidation of nonviable businesses & those where liquidation is likely to produce the greater return to the creditors[2] & reorganization of feasible businesses;
  • Strikecareful balance between liquidation & reorganization, allowing for easy conversion of the proceedings from one proceeding to another one;
  • Provide for the reasonable treatment of similarly situated creditors, together with similarly situated foreign & domestic creditors;
  • Provide for timely, efficient & impartial resolution of insolvencies;
  • Prevent the improper use of an insolvency system;
  • Prevent premature dismemberment of the debtor’s assets by an individual creditor seeking the quick judgments;
  • Provide the transparent procedure which contains, & consistently applies, clear risk allocation rules & incentives for gathering & dispensing information;
  • Recognize the existing creditor rights & respect the priority of the claims with the predictable & established process; &
  • Establish the framework for cross-border insolvencies, with the recognition of the foreign proceedings.

Where an enterprise is not feasible, the main thrust of law should be swift & efficient liquidation to maximize the recoveries for the benefit of the creditors. Liquidations can comprise the protection& sale of a business, as distinct from the legal entity. Alternatively, where the enterprise is feasible, i.e it can be rehabilitated, its assets are often more valuable if they are retained in a rehabilitated business than if sold in the liquidation.

The rescue of the business preserves jobs, provides creditors with the greater return based on the higher going concern values of an enterprise, potentially produces the return for the owners & obtains for a country the fruits of the rehabilitated enterprise. The rescue of the business should be promoted through formal & informal procedures. Rehabilitation should permit quick & easy access to the process, protect all those involved, permit a negotiation of the commercial plan, enable the majority of creditors in favor of the plan or other course of action to bind all other creditors (subject to the appropriate protections) & provide for the supervision to ensure that a process is not subject to abuse.

Implementation:

  • Institutional and Regulatory Frameworks

Strong institutions and regulations are crucial to an effective insolvency system. The institutional framework has 3 main elements: the institutions responsible for the insolvency proceedings, the operating system through which cases & decisions are processed & the requirements needed to preserve the integrity of those institutions— recognizing that the integrity of the insolvency system is the linchpin for its success.

  • Overarching considerations of sound investment climates

Transparency, accountability & corporate governance. Minimum standards of transparency & corporate governance should be established to foster communication & cooperation. Disclosure of the basic information—as well as the financial statements, operating statistics & detailed cash flows—is recommended for the sound risk assessment. Accounting & auditing standards should be compatible with the international best practices so that the creditors can assess credit risk & monitor the debtor’s financial viability. The predictable, reliable legal framework & judicial process are needed to implement reforms, ensure fair treatment of all the parties & deter unacceptable practices.

Corporate law & regulation should guide the conduct of the borrower’s shareholders. The corporation’s board of directors should be responsible, accountable & independent of management, subject to the best of the practices on corporate governance. The law should be imposed impartially & consistently. Creditor rights & insolvency systems interact with & are affected by these additional systems, & are most effective when good practices are adopted in other relevant parts of a legal system, especially the commercial law.

  • Transparency and Corporate Governance

Transparency & good corporate governance are the cornerstones of the strong lending system & corporate sector. Transparency exists when information is assembled & made readily available to other parties & when combined with a good behavior of “corporate citizens,” creates an informed and communicative environment conducive to greater cooperation among all parties.

Transparency & corporate governance are especially important in emerging markets, which are more sensitive to the volatility of external factors. Without transparency, there is a greater likelihood that the loan pricing will not reflect the underlying risks, leading to higher interest rates & other charges. Transparency & strong corporate governance are needed in both domestic & cross-border transactions & at all phases of investment—at inception when making a loan, when managing exposure while the loan is outstanding, & especially once the borrower’s financial difficulties become apparent & the lender is seeking to exit the loan.

Transparency increases confidence in decision making & so encourages the use of out off-court restructuring options. Such options are preferable because they often provide the higher returns to the lenders than straight liquidation through a legal process—& because they avoid the costs, the complexities & the uncertainties of the legal process.

  • Predictability

Investment in emerging markets is discouraged by a lack of well-defined & predictable risk allocation rules & by the inconsistent application of the written laws. Moreover, during the systemic crises, investors often demand uncertainty risk premiums too onerous to permit markets to clear. Some investors might avoid emerging markets entirely despite the expected returns that far outweigh known risks. The Rational lenders will demand risk premiums to compensate for the systemic uncertainty in making, managing & collecting investments in emerging markets.

The likelihood that creditors will have to rely on risk allocation rules increases as the fundamental factors supporting investment deteriorate. That is because the risk allocation rules set minimum standards that have considerable application in limiting downside uncertainty, but that usually don’t enhance returns in non-distressed markets. During actual or the perceived systemic crises, lenders tend to concentrate on reducing risk, & risk premiums soar. At these times the inability to predict downside risk can cripple the markets. The effect can impinge on other risks in a country, causing lender reluctance even towards the untroubled borrowers.

Read our article:Insolvency and Bankruptcy Board of India

Narendra Kumar

Experienced Finance and Legal Professional with 12+ Years of Experience in Legal, Finance, Fintech, Blockchain, and Revenue Management.

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