Vol 7 (2010) - Issue 4

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The Freedom to Fail: Why Small Business Insolvency Regimes are Critical for Emerging Markets

In India, the father of 16-year-old Dharmendra committed suicide by swallowing pesticide. A small-scale farmer from the Punjab region, he was steeped in debt, and even by selling his land, he was unable to clear or waive these owed sums. Faced with the burden of bearing these obligations for a lifetime, he chose suicide, passing on his debts to his son to try to repay. This story is not uncommon in India nor in other parts of the globe, and crosses various sectors from agriculture to retail. Such problems partly arise because insolvency frameworks do not adequately regulate sole-proprietor debt and the rights of creditors who lend to them. Without an easy method of exiting the market and the possibility of debt resolution with creditors, small business entrepreneurs face potentially lifelong battles stemming from a single business failure.

Improving the regulation of small business insolvency, specifically sole-proprietorship insolvency, can assist the functioning of a country’s financial markets and contribute to overall economic growth. Despite its importance, relatively little has been written on why efficient exits for entrepreneurs matter, how productive assets (and individuals) can be recycled more efficiently back into the economy and the restructuring options available to these enterprises. This article examines why emerging countries should regulate the insolvency of small and medium enterprises, and how most emerging market insolvency frameworks tend to ignore the needs of these businesses. Finally, it suggests a route for better regulating small business debt, with a primary focus on the country’s legislative framework and institutional fabric. Underpinning these issues is the overarching argument that an effective insolvency regime is one that is balanced and recognises that debtors need protection, as well as creditors. Tilting a regime only towards creditor protection could have a negative impact on entrepreneurship, as businesses become reluctant to bear too much risk.

Conversely, a regime that only protects debtors could make access to finance even more difficult and expensive, as the risk is shifted to financial institutions. Policymakers should therefore be sensitive to this balance, and understand why all enterprises, even micro and small businesses, require good regulation if entrepreneurship and economic growth is to thrive.

I. What are small and medium enterprises?
Small and medium enterprises (SMEs) are businesses that are typically defined by the number of employees or their turnover and/or assets. For instance, the World Bank defines a microenterprise as one with less than 10 employees, less than USD 10,000 in assets and less than USD 100,000 in annual sales. Ultimately, the characteristics of an SME reflect not only a country’s economy, but its social and political dimensions, and accordingly, definitions of SMEs vary across countries and regions.

From a legal form standpoint, SMEs can be divided into two broad categories: corporate and non-corporate entities. Corporate entities under most legal systems, enjoy the protection of limited liability for shareholders, such as limited liability companies or partnerships.