The Modular Approach to Micro, Small, and Medium Enterprise Insolvency

Historically, insolvency systems have been designed with larger enterprises in mind. They assume an extensive insolvency estate of significant worth, and the presence of creditors and other stakeholders with sufficient value at stake that they participate in and oversee the process. These assumptions undergird mechanisms by which creditors and other stakeholders may ensure that the insolvency process faithfully serves their interests, for an independent professional to run the business undergoing an insolvency process, and for extensive judicial oversight.

These assumptions and features are incongruent with the reality of micro, small, and medium enterprises ('MSMEs'). Mirroring the general population of businesses and reflecting the particular fragility associated with smaller asset bases and relative absence of risk diversification, the vast majority of businesses entering insolvency proceedings are MSMEs. On MSME insolvency, little or no value is available for distribution to anyone other than secured creditors in a significant proportion of insolvency estates, and secured creditors tend to have effective collection methods under non-insolvency law. Correspondingly, most secured and unsecured creditors, as well as other stakeholders, are rationally disinterested in the insolvency process. In many cases, it is not worthwhile for either the estate or most stakeholders to engage lawyers to represent them in court. Estates may possess inadequate value even to pay an independent insolvency professional.

Such incongruence between the design of insolvency regimes and the nature of most of the businesses to which they apply leaves the insolvency process unbalanced, inadequately supervised, non-efficacious, and sometimes, simply unfeasible. Policy-makers and legislators have often responded through ad hoc changes to the ‘standard’ regime, such as by shearing some elements of the insolvency process when applied to smaller businesses, by shortening statutory timelines, and by dispensing with the necessary participation of certain stakeholders. The resulting processes have been marked by arbitrary boundaries, rigid preconditions for availability, and limited effectiveness.

This paper systematically rethinks the treatment of distressed MSMEs. At its core is a new ‘Modular Approach’ to MSME insolvency. This approach is modular in two ways: (i) it allows national policy makers to choose from a range of available options including in terms of the involvement of appropriate institutions; (ii) subject to national authorities’ design decisions, the Modular Approach provides an essential ‘core’ process in each case, and allows relevant stakeholders to invoke additional tools (‘modules’) if and when the benefits of wielding those tools in the particular case outweigh the costs.

The Modular Approach shares with ‘standard’ insolvency regimes the core objectives of preserving and maximizing the value in the insolvency estate, ensuring distribution over an appropriate period of time of the highest feasible proportion of that value to those entitled to it, providing due accountability for any wrongdoing connected with the insolvency, and enabling discharge of over-indebted natural persons. The Modular Approach differs in the way it pursues these objectives. Its basic assumption is that the parties to a particular insolvency case are best placed to select the tools appropriate to that case. The role of the legal regime should be to provide these tools in a maximally flexible way, while creating the correct incentives for their deployment.

Traditionally, legal systems provide particular ‘packages’ or combinations of these tools and label them ‘workout’, ‘liquidation’ and ‘restructuring’. The Modular Approach unpacks those combinations. It assumes a core process, geared towards enabling the entrepreneur to propose a restructuring of the business’ liabilities and to obtain discharge of any unrepayable obligations. The entrepreneur, who may operate through a legal entity or as a sole trader, may access any of the full range of insolvency law mechanisms to enable attainment of these objectives. At the same time, creditors and other stakeholders have the right to adequate notification of each step in the process, coupled with the power to override the entrepreneur’s choices where a sufficient proportion of them consider it appropriate to do so. Judicial involvement is not required as a matter of course, though, again, it may be requested by the stipulated proportion of creditors. The process may obtain and retain momentum by virtue of the presumptions that stakeholders who have not positively objected to a step in the process have consented to that step, and that the non-exercise of procedural rights within the process precludes the relevant stakeholders from objecting to the part of the process to which the unexercised rights relate. Stakeholders are divided into appropriate classes; they must act by stipulated majority by value; and stipulated majorities by value of a class may bind dissenting minorities.

The Modular Approach is designed to provide appropriate incentives for the entrepreneur and other stakeholders alike. Entrepreneurs have positive incentives to commence the insolvency process in a timely manner: they do not have to declare the business insolvent; they may, in principle, retain its management; and they have the right to propose how the insolvency should proceed. Entrepreneurs also face negative incentives that discourage non-timely commencement of insolvency proceedings, in that the Modular Approach imposes personal liability for any additional loss suffered by the business’ creditors because of blameworthy delay in commencement. The Modular Approach acknowledges that in many MSME insolvencies, unsecured creditors are rationally disinterested, given their limited economic stake and the very limited likelihood of any recovery in the process. They need not actively participate in the process if, upon due notification, they do not consider it worth the time and expense of participating. As noted, their abstention is deemed approval, and the insolvency process may continue apace. Negative incentives for creditors arise because the non-exercise of procedural rights amounts to a waiver of such rights. Positive incentives arise in creditors’ ability, acting with others who together hold a sufficiently large proportion of the claims against the enterprise, to override the entrepreneur’s choice of tools and to select a destiny for the business different to the one favoured by the entrepreneur.

The Modular Approach also responds to differences in the economic, social and legal circumstances of different countries. It does so by guiding national policymakers with respect to the factors relevant to determining the proper boundaries between ‘standard’ and MSME insolvency regimes, and by identifying three functions: management, administrative and judicial. The Approach explains the costs and benefits of assigning those functions to different entities.