Chapter 2. Bankruptcy and second chance for SMEs (Dimension 2) in the Western Balkans and Turkey

Mechanisms to help entrepreneurs overcome difficulties are underdeveloped

Business owners fearing failure or facing financial difficulties are not likely to ask for help, for three main reasons. First, they are afraid of losing control of their business. Second, they are concerned about the social stigma and the arduous process associated with bankruptcy. Finally, as entrepreneurs tend to be risk-prone individuals who are characterised by a high rate of optimism, they are often convinced that they will eventually be able to overcome the difficulties themselves (EC, 2011[13]). For this reason, information campaigns, training, call centres and anonymous self-assessment websites might be useful tools for entrepreneurs who fear failure and would like to have targeted information, learn or receive a discreet objective assessment of their situation.

These tools can also be helpful for potential entrepreneurs who would like to improve or assess their aptitude, skills and motivation to run their own business. As detailed in Annex 2.A, according to the Global Entrepreneurship Monitor, almost 30% of potential entrepreneurs fear failure across the WBT region (GEM, 2018[11]), hampering entrepreneurial activity.

Despite their potential positive impact, these tools remain undeveloped in the region, as was confirmed by interviews with SME representatives from the Western Balkans and Turkey. The only economy which currently has websites or call centres for entrepreneurs who fear failure is Turkey, where the SME Development and Support Organisation provides information on support programmes for SMEs.

North Macedonia has a project funded by the Instrument for Pre-Accession Assistance on strengthening the administrative capacities for implementing the legal framework for the bankruptcy and liquidation of companies (Ministry of Economy, 2017[14]). It proposes developing a self-test website, but this has not yet been established. The aim of the website would be to detect financially distressed companies early on, in order to help them in a timely manner. The project offers training for entrepreneurs who fear failure, organised in co-ordination with the Ministry of Economy, Economic Chambers, and the Chamber of Bankruptcy Administration. However, active entrepreneurs not in financial distress were reluctant to attend these courses, demonstrating that entrepreneurs do not seek help and advice before financial problems emerge.

Fully fledged early warning systems for distressed SMEs still do not exist

Company bankruptcy and liquidation can often be prevented if financially distressed companies are identified at an early stage. The earlier the problems are recognised, the better the chance the business will restructure successfully and continue to operate. Early warning systems identify enterprises that are financially distressed and in need of assistance. Among EU Member States, 14 countries have established early warning and help-desk mechanisms to prevent or coach entrepreneurs before going into bankruptcy (EC, 2017[15]); France has been one of the front runners in designing them (Box 2.1). Efficient early warning systems help regulate relations between companies and creditors, increasing SME owners’ awareness and helping them to identify and fix potential problems at the right time.

Such early warning infrastructure remains almost completely undeveloped in the WBT region. The current system adopted by the WBT economies only identifies distressed companies when they are already in the red zone, while ideally an early warning system should identify distressed companies in time to carry out a customised and solution-oriented reorganisation based on identified weaknesses. However, when firms are grappling with financial difficulties, it is sometimes central banks or tax administrations that take responsibility and react swiftly. In Albania, Kosovo, Montenegro, North Macedonia, Serbia and Turkey, these public institutions have established initiatives that act as early stage warning systems, detecting warning signs through financial tools such as tax declarations or bank loans.

In some cases, the tax administration, banks or private credit registries assign a risk classification. For instance, regulations oblige Montenegro’s Central Bank to collect data from different banks on entrepreneurs whose accounts are blocked, and to publish them on their website. While this system allows financially distressed companies to be identified before they file for bankruptcy, it does not provide enough time or a solution for reorganising the firm and the debt to prevent bankruptcy. The regulations also oblige the Central Bank to publish data on forced collection procedures, specifically by revealing the names of legal entities/entrepreneurs, their registration numbers, blocked accounts, as well as the number of uninterrupted days the account has been blocked.

In Kosovo, the detection of distressed companies relies on assessments conducted by the tax administration, which are based on companies’ tax declarations. The system identifies financially distressed companies by analysing all businesses’ corporate tax returns.

In Albania, the Central Bank publishes data on entrepreneurs’ blocked accounts from different banks on its website, allowing financially distressed companies to be identified before they file for bankruptcy. In addition, some banks and private credit registries have developed their own mechanisms to assess customers’ credit performance, by drawing on information from multiple sources such as tax declarations, social security declarations and balance sheets. These mechanisms have been designed with a view to reducing the number of non-performing loans.

While the mechanisms described above identify companies which are already in financial distress and are therefore not proper early warning systems, they could constitute a base on which governments could build more effective prevention policies.

The way forward for preventive measures

To enhance the insolvency regime and support enterprises in difficulties, policy makers should:

• Step up efforts to mitigate fear of failure. One of the ways entrepreneurs can overcome their fear of failure is by gaining more knowledge. Learning can strongly contribute to easing entrepreneurs’ fears, by diminishing their doubts about their own personal abilities. Therefore, creating new mechanisms or linking existing ones to disseminate information – such as web-based tools or call centres – would help entrepreneurs find sources where they can easily access information and improve their entrepreneurial skill sets. Canada’s Business Development Bank self-test is a good example of how potential entrepreneurs can be helped to identify their weaknesses and be linked to adequate support programmes (Box 2.2).

• Develop a fully fledged early warning system in order to effectively protect companies from bankruptcy. SME owners have a tendency to underestimate their financial difficulties and resist taking action to alleviate them. Therefore, governments should consider introducing a system which would convince entrepreneurs to initiate recovery measures without delay. This system might take different forms, but should include certain essential features. First, it should include special detection procedures to screen and monitor early signs of SMEs in financial difficulties. Second, these identified SMEs need to be approached and provided with advice on objectively assessing their financial situation, as well as on the different options available to them to recover. Once they are better informed, SMEs would be able to take the required steps at an earlier stage, increasing their chances of survival. To that end, Early Warning Europe (Box 2.3) offers a blueprint of how economies can build a customised early warning system, advise entrepreneurs in financial distress and reintegrate them into the economy.

Out-of-court settlements are available, but not automatically linked to formal bankruptcy proceedings

Out-of-court settlements can resolve disputes between debtors and creditors, or avoid company insolvency, reducing the burden on economies’ judicial systems. This offers a speedy, less expensive and less formal solution than court proceedings and avoids damaging the failed entrepreneur’s reputation. Economy-specific research has shown that insolvency reforms that encourage debt restructuring and reorganisation reduce both failure rates among SMEs and the liquidation of potentially profitable businesses (Hart, 2000[21]). According to the Balkan Barometer, in 2017 nearly one-seventh of entrepreneurs in the WBT region launched a court action to resolve an overdue payment issue (RCC, 2017[10]). One can imagine the burden on the judiciary systems of processing this number of cases.

Most WBT economies have introduced appropriate measures to provide honest entrepreneurs with alternative settlement procedures that allow them more time to restructure their businesses. However, none of them have a clear link which allows formal bankruptcy proceedings to be triggered automatically if the debtor and creditors cannot reach a full agreement.

In some of the assessed economies, out-of-court settlements are loosely regulated, as they are not prohibited. This is the case in Bosnia and Herzegovina, where the Law on Bankruptcy Proceedings in the entity of the Republika Srpska does not prohibit out-of-court procedures.7 However, the law specifies that out-of-court settlements can take place if one of the creditors is a bank, and that they must be mediated by the chamber of commerce.

Montenegro has a similar approach to regulating out-of-court settlements. The legislation states that having accepted a petition to initiate bankruptcy procedures, the court might refer the petitioner to a mediation procedure. This approach can involve debtors, creditors, banks and the mediation centre in the whole process. This legislation seeks a compromise between the survival of financially distressed companies and macroeconomic stability.

The Serbian legal framework allows entrepreneurs to go into mediation as a pre-bankruptcy alternative to settle debts. However, bankruptcy proceedings need to be initiated first. Then, the creditors or the bankruptcy administration, with the consent of the creditors’ committee, may propose resolving a dispute through mediation, which cannot take more than 30 days.

Some of the economies opt for having a more strictly regulated approach to the out-of-court settlement alternatives. North Macedonia offers two schemes that provide protection from creditors. First, the distressed business is protected by the Law on Out-of-Court Settlement, which grants a preventive concordat period of 120 days, during which the debtor has the time to draft and negotiate a restructuring plan with creditors. This pre-bankruptcy measure can have one of three outcomes:

1. 1. If all the creditors approve the debtor’s plan, it leads to an effective new debt settlement.

2. 2. If creditors holding more than 51% of the total debt approve the debtor’s plan, it will allow for a fast-track in-court bankruptcy reorganisation.

3. 3. If only those creditors holding less than 51% of the total debt approve the debtor’s plan, it leads straight to simple in-court bankruptcy liquidation.

Second, SMEs encountering financial difficulties in North Macedonia are also protected by the Law on Bankruptcy, which provides them with three more options for reorganisation: 1) debtor-initiated bankruptcy reorganisation via a short-track procedure of 60 days; 2) regular creditor-initiated in-court bankruptcy reorganisation; and 3) the bankruptcy administrator’s proposal for a reorganisation plan, with the consent of the creditors.

Albania’s regulations offer SMEs the option of a reorganisation plan which needs to be reviewed and voted on by the creditors’ board. Out-of-court procedures can start when this plan is approved by a court judgment. Importantly, SMEs are liquidated if their reorganisation proposals are rejected. Turkey has recently introduced the concordat regime, which gives the debtor a maximum of two years’ protection following the acceptance of the reorganisation plan by the creditors’ board and a final validation from the insolvency officer.

In Kosovo, the law states that the reorganisation process may take different forms, such as debt forgiveness, debt rescheduling, debt-equity conversions or the sale of the business or parts of it.

Insolvency regimes have been strengthened in most of the economies

Insolvency laws lay out the necessary legislative framework to give certainty over how insolvency proceedings are to be dealt with. They ensure that the liquidation of assets and distribution of the proceeds are done in a fair and orderly way among creditors. By doing so, they allow for better financial inclusion, and reduce the cost of obtaining credit (World Bank, 2018[22]). Moreover, insolvency laws offer legal protection to viable businesses by allowing them to negotiate arrangements with their creditors. Therefore, as the European Commission (EC) recommendation of March 20148 also stresses, having clear, simple and non-rigid insolvency laws are crucial for improving the business environment and supporting businesses’ long-term survival.

Since 2016, the WBT economies have made a number of amendments to their insolvency laws (Table 2.5). Kosovo has made significant changes to its insolvency regime. In 2016, the government simplified the process of insolvency by introducing a legal framework for corporate insolvency. It also allowed debtors and creditors to benefit from liquidation and reorganisation procedures (World Bank, 2017[2]). Another exemplary development occurred in North Macedonia, where the government has reformed the voting procedures for reorganisation plans and allowed more participation by creditors in insolvency proceedings (World Bank, 2017[2]).

Overall, the reforms have improved the economies’ legal frameworks to protect the interests of both debtors and creditors, as the Montenegrin case shows (Box 2.4).

Legal frameworks on secured transactions are in place, but some lack time limits for automatic stay

While a clear legal framework on secured transactions9 is necessary to protect all parties involved in a transaction and to make transactions more efficient, the law should strike a balance between creditors’ rights and debtors’ interests when regulating the automatic stay10 on debt collection. While an automatic stay helps the debtor to recover and allows creditors to collect their claim during the reorganisation process, the EC recommends there should be a time limit (EC, 2014[25]).

Although all the assessed economies have established frameworks to support SMEs and creditors if a company becomes insolvent, the approaches in their regulatory frameworks differ and not all of them fix a time limit for automatic stays.

The legislation covers all aspects of secured transactions in Bosnia and Herzegovina, Serbia, and Turkey. These economies regulate secured creditors’ ability to satisfy their secured claim in reorganisation, as well as their right to be paid first out of proceeds from the sale of assets on which they have lien11 or collateral. The bankruptcy legal framework for secured transactions in these economies also includes restrictions, such as the requirement for creditors’ consent to conduct the reorganisation of a debtor’s bankruptcy case opened in court, and the appointment of a bankruptcy administrator to replace the company management until the approval of a reorganisation plan. However, none of them has defined a time limit for the automatic stay during the process.

In Albania, the legal framework regulates restrictions such as the requirement for creditor’s consent when a borrower files for bankruptcy, or that secured creditors are to be paid first from the liquidation proceeds of a bankrupt firm – it provides a contractual stay of 90 days, binding only on the parties that have agreed to it. However, the regulations do not cover areas such as the seizure of collateral by the secured creditors (after reorganisation) nor on the management of administration of the property awaiting the resolution of the organisation.

In North Macedonia, the regulation specifies several aspects of dealing with secured transactions, but does not legislate on the stay. Secured creditors have the right of a separate settlement out of the bankruptcy proceedings. The judge grants this right if the asset is not subject to a reorganisation plan. With the secured creditors’ consent, the collateral on assets subject to reorganisation may be transferred on assets from the estate that are not vital to the debtor’s reorganisation. In any event the secured creditors have a right to be paid first from the sale proceeds of the assets over which they have secured right (collateral). The bankrupt debtor’s reorganisation plan must be approved by vote by a majority of the creditors.

Monitoring and evaluation of bankruptcy proceedings remain weak in the region

It is crucial for economies to have a well-developed set of performance indicators to better monitor the efficiency of insolvency regimes. The OECD has developed insolvency indicators (see Box 2.5 and also Annex 2.B) to obtain policy indicators that evaluate the differences between countries, to facilitate further research on exit policies and productivity growth.

Despite some examples of positive changes, the monitoring and evaluation of bankruptcy and insolvency procedures are still very weak in the assessed economies. Most of the WBT economies do not collect basic indicators, such as the average time it takes to receive a full discharge from bankruptcy, the number of backlogged court cases related to bankruptcy or the number of years a bankrupt entrepreneur has a negative score after discharge.

Only Albania collects information on the average time taken for an entrepreneur to get a full discharge and the average number of years afterwards that the entrepreneur has a negative score. The ministries of justice in both Serbia and Turkey monitor the size of their court case backlogs every year.

The assessed economies also sporadically monitor the implementation of bankruptcy and insolvency regulation. For example, the Albanian Bankruptcy Supervision Agency monitors bankruptcy administrators’ implementation of the bankruptcy laws and procedures. Montenegro conducts monitoring via the Judicial Council, which publishes yearly reports on its activities and results, including information on insolvency procedures.

The way forward for survival and bankruptcy procedures

In order to enhance their legal framework on insolvency regimes, all WBT economies should:

• Conduct entrepreneurial awareness campaigns about alternative forms of liquidation. Most of the economies have established out-of-court settlement options as a less expensive and faster way to liquidate than filing for bankruptcy. Settlements through mediation or concordats are less expensive for the state and impose a smaller burden on the judiciary system. However, according to private sector interviews, entrepreneurs know little about the options offered by alternative settlement procedures such as mediation or concordats – and sometimes are not even aware of their existence. Consequently, their use by enterprises remains limited. Promotion campaigns should highlight the benefits of the alternative liquidation methods in terms of cost, time and administrative procedures for enterprises. This could reduce the number of bankruptcy procedures, lessening the administrative burden on courts, and help to overcome the fear of failure among entrepreneurs.

• Link out-of-court settlement systems to formal bankruptcy proceedings. The outcomes of out-of-court settlement procedures should automatically trigger formal bankruptcy proceedings if a full agreement between debtor and creditors is not reached. Put differently, if the majority of the creditors are strictly against the debtor’s proposed reorganisation plan, then this case should automatically go for liquidation, with an option for debt discharge and restart. In cases where there is partial support for the debtor’s proposed reorganisation plan (e.g. more than 50% of creditors), then the company should automatically proceed to reorganisation, with the chance of shortening the formal approval procedures.

• Reduce the time and cost of bankruptcy by simplifying formal bankruptcy proceedings. The experiences of high-income OECD economies show that those with simple streamlined procedures have fewer appeals on court verdicts, the average proceedings are quicker, the average cost as a percentage of the bankrupt estate is less than 10% and the overall recovery rate is greater than 60% (OECD, 2018[27]; World Bank, 2018[28]). The frameworks in Finland, the United Kingdom and the United States have separate formal proceedings for liquidation and reorganisation, as well as a variety of preventive measures in place. Slovenia has developed a good process for simplifying the link between out-of-court settlements and formal bankruptcy proceedings (Box 2.6).

• Maintain the administrative capacities of the bodies implementing the insolvency framework to keep up with framework changes in all WBT economies. For bankruptcy administrators, bankruptcy judges, appraisers and creditors’ associations, governments could consider formal training and limited-duration licensing of implementation bodies to ensure high-quality services. Constant monitoring and audits of their work should provide for higher professional standards and ensure that the quality of their services is maintained.

• Step up efforts on monitoring and evaluation. Proper monitoring and evaluation leads to well-informed evidence-based policy making, helping to improve national credit registries. By enhancing co-ordination between the various public institutions, such as the ministry of justice and national statistical offices, governments could increase the number of relevant indicators collected and better evaluate the impact of insolvency policies.

Formal bankruptcy discharge procedures exist in most economies

Bankruptcy discharge procedures are extremely important as they allow entrepreneurs to reintegrate into the economy. A discharge is a court order that releases the debtor from personal liabilities for certain specific debts covered by the legal framework. According to EU recommendations, discharge processes should be as quick as possible, ideally automatic and take no more than a year, in order to preserve the failed entrepreneur’s resources for a possible restart. Nevertheless, it should be noted that while all the EU Member States allow discharges, it is still not possible to complete legal bankruptcy proceedings within a year in most of them, or to be discharged from bankruptcy within three years. Similarly, most of the EU Member States offer honest entrepreneurs no possibility of an automatic discharge after liquidation (EC, 2018[33]).

In the WBT region, Albania, Bosnia and Herzegovina, Kosovo, Montenegro and Turkey have established formal discharge procedures for entrepreneurs. In Montenegro the law sets a maximum limit of three years to obtain a discharge. However, in North Macedonia there is no discharge from debt rules for natural persons13 and in Serbia entrepreneurs are liable for all obligations incurred in connection with the pursuit of the business.

Programmes to promote second chance among failed entrepreneurs are still lacking

In the WBT there is a region-wide lack of government-supported programmes both to promote a second chance among entrepreneurs who have gone bankrupt and to fight against the cultural stigma associated with bankruptcy. Information campaigns to raise awareness about second-chance opportunities are almost non-existent in the region, failing to promote second chances. Turkey is the only economy that mentions second chances clearly in its Turkish Entrepreneurship Strategy and Action Plan. The action plan aims to facilitate a second chance for bankrupt entrepreneurs; however, the strategy does not provide details on the specific measures to realise this target.

As for the rest of the assessed economies, although it is usually claimed by governments that their relevant insolvency laws are in line with the Small Business Act principles, their strategies or action plans do not make any direct or clear reference to promoting a second chance. For example, second chance policies in Serbia are briefly mentioned in the SME Development Strategy and Action Plan 2015-2020 in the section on “Relationship between the Strategy and the Act on small-sized enterprises” (Ministry of Economy, 2015[34]). Linked with the second principle of the Small Business Act,14 the strategy foresees the “improvement of the legal framework for the establishing, the operating and the closing of business entities” without providing any further details. The action plan planned one activity (a promotional campaign) for 2016, but it did not happen. The situation is similar in Montenegro, where the recently adapted Strategy for the Development of Micro, Small and Medium-Sized Enterprises in Montenegro 2018-2020 does not include the second principle of the Small Business Act in its strategic goals. The strategy highlights the importance of second chance policies, which are currently lacking. However, no concrete measures have so far been included in the strategy’s action plan.

The lack of specific programmes to promote second chance policies means that entrepreneurs are left alone to interpret insolvency laws and figure out their rights. In some cases, failed business owners can count on technical and emotional support provided by some sporadic initiatives organised by non-government organisations. Box 2.7 illustrates how sharing information and knowledge among entrepreneurs can give them a better chance to restart and use their entrepreneurial potential.

The lack of initiatives promoting second chances among previously bankrupt entrepreneurs is, however, not unique for the Western Balkans and Turkey. Even most EU Member States do not offer tailored support programmes for entrepreneurs looking to start afresh. Instead, governments often direct restarters to general support programmes, although these are less targeted. Annex 2.C summarises the second chance promotion programmes available in selected EU Member States.

Entrepreneurs still have obstacles to overcome before starting afresh

A second chance for entrepreneurs depends not only on cultural aspects of the economy, but also on the laws regulating the time needed to obtain a discharge (as explained in the previous section), as well as supporting legislation allowing honest entrepreneurs to make a new start. In other words, honest entrepreneurs who have failed need supportive regulations to allow them to make a fresh start.

All the economies have a forgiving approach towards entrepreneurs who have failed: none impose any civic consequences such as the loss of the right to vote or to hold elected office. However, the situation is different when it comes to economic consequences. As discussed in the previous section, in North Macedonia and Serbia the legal framework does not allow an automatic discharge from debt rules, forcing entrepreneurs to open a court case to obtain a discharge, and consequently creating obstacles to a fresh start. In the entity of the Republika Srpska in Bosnia and Herzegovina, natural or legal persons cannot establish a company or participate in the share of another company until they have settled their debts (e.g. social security contributions) in the register of fines, a measure primarily aimed at protecting workers’ rights. These regulatory obstacles and legislative gaps can harm failed entrepreneurs who wish to start again, and prevent them from using the expertise gained through their previous business endeavours.

The way forward for promoting second chance

In order to enhance second chance policies, governments in the region should:

• Introduce policy measures granting a second chance for honest entrepreneurs. Governments need to clear the way for entrepreneurs who wish to restart. Introducing automatic debt discharge rules and setting a maximum time limit for the discharge process in the legal framework is essential to build effective second chance policies.

• Make efforts to reduce the cultural stigma of failure. Despite the fact that there are no civic consequences for filing for bankruptcy in the WBT region, failed entrepreneurs still suffer from social stigma. To achieve a healthy entrepreneurial culture, the economies should recognise honest bankrupt entrepreneurs as a source of new enterprises and jobs. Therefore, a clear distinction has to be made between measures or regulations that apply to fraudulent bankruptcies and those that apply to honest ones. Such a distinction can be instrumental in changing society’s attitude towards debtors. However, amendments in the legal framework alone will not be enough: they should be complemented with initiatives promoting fresh starts and a culture that is receptive and tolerant of failures. To that end, workshops and seminars aimed at sharing the lessons learned from previously bankrupt entrepreneurs can break the stigma surrounding bankruptcy and failure. A notable example is the work of the French organisation, 60 000 Rebonds (Box 2.8).