Analysis of the Cost and Distribution of Commercial Insolvencyby Benoit-Mario Papillon
Note: While abstracts are available in both English and French, some research papers are only available in their original language. This document is only available in French.
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Each year in Canada, thousands of companies find themselves insolvent, no longer able to meet their obligations. As opposed to previous optimistic scenarios that allowed for their financing, the state of insolvency is a harbinger of significant losses. Reported liabilities suggest an order of magnitude for these losses. For 2010, total liabilities declared by companies entering insolvency proceedings under the Bankruptcy and Insolvency Act (BIA) or the Companies’ Creditors Arrangement Act (CCAA) were about $40 billion. Numerous adjustments are required, among them four major ones, in order to arrive at an estimated financial loss.
First, we must deduct dividends paid to creditors. In many situations, there are no dividends at all; the total amount as a percentage of declared liabilities will be less than 10 percent.1 Second, there are the losses of shareholders and other stakeholders, including the contingent liabilities of employee pension funds. Addition of shareholders’ losses, assuming a debt/equity ratio of about one, has the effect of almost doubling the $40 billion reported for 2010. Third, there are the liabilities of commercial insolvencies handled outside the BIA or the CCAA. While these two laws are general in scope, both in the financial sector and in some non-financial sectors, such as agriculture, commercial insolvency situations are often governed by sectoral laws or government programs.2 Lastly, for the financial sector, we must add only those financial losses that have not already been counted as losses in non-financial sectors.
The effect of the adjustments is difficult to predict. However, it is reasonable to argue that the total financial loss is likely to be at least in the tens of billions of dollars, and could be around $100 billion. This is a considerable amount as a percentage of Canada’s gross domestic product (GDP), and is even significant as a percentage of the earnings of the primary input, “capital,” in the GDP. These earnings are an important component of the earnings of savings in the economy. This makes commercial insolvency an important aspect of the organization of economic activity in Canada, which juxtaposes large independent companies and supports the emergence of new businesses.
Unlike the situation in former socialist economies, where the phenomenon of commercial insolvency was not seen, economic activity in Canada, and in other comparable countries that are highly integrated into the international economy, takes place in the context of specialization of labour and exchange, and in a decentralized organization with a multitude of companies competing for sales and access to resources. However, the comparison of Canada with other countries with similar principles of organization reveals wide variations in the scope of the phenomenon of commercial insolvency. In countries such as Germany or Japan, for instance, commercial insolvency is relatively less common; in other countries like Canada, it is more common. These differences among otherwise comparable economies raise the question of the cost of commercial insolvency and its supervision by the law governing businesses in difficulty.
For the creditor of a company that has become insolvent, financial losses are a cost associated with that company’s insolvency. These losses are sometimes offset by gains at other, more productive, companies. Therefore, the cost of commercial insolvency in Canada, from a collective or legal standpoint, cannot be measured simply through the sum of the financial losses associated with all cases of commercial insolvency. The cost of using legal procedures for businesses in difficulty is an element of the cost of commercial insolvency.
Given that CCAA data has only recently become available, measurement of these costs was limited to BIA data. We can see that for the entire period 1995–2009, the total amount of these costs came to just over $4.7 billion. Apart from 1994 and 2006, when annual costs exceeded a billion dollars due to insolvencies of some very large companies, the annual amount during the period varied between $95 million and $304 million. The costs are distributed between bankruptcies (75 percent) and proposals (25 percent). By excluding outliers, the dispersion of the cost per file remains significant. It is useful, therefore, to use the median to track changes in these costs over the period.
There is an upward trend with a median value, which rose from $2260 in 1994 to $2952 in 2008, representing an average annual increase of almost 2 percent over the period. There is wide variation among provinces. Relative to the value of the national median for the entire period, which is $2558, the four provinces with the largest volume of files have median values of $2191 for Alberta, $2257 for Ontario, $2301 for British Columbia and $4069 for Quebec. This variation among provinces for all files decreases significantly when looking at subsets of files grouped by type of proceeding (voluntary bankruptcy, involuntary bankruptcy or proposal) and type of business (sole proprietorship or incorporated business). Since the median varies significantly among the type of proceeding and the type of business, from a minimum of $1878 for voluntary bankruptcies of sole proprietorships to a maximum of $18 859 for Division I proposals of incorporated businesses, the significant variation among provinces reported above should be viewed, at least partially, in light of different circumstances of using insolvency proceedings based on the province.
A better way to compare the costs of using procedures is to express them as a function of two of the main goals of the law governing businesses in difficulty: managing excessive debt levels and reducing creditors’ losses. In the first instance, the cost index corresponds to the ratio of costs to the insolvent company’s level of debt. In the second instance, the cost index corresponds to the ratio of costs to dividends generated by the use of insolvency proceedings. For the entire period and for all files at the national level, the cost of procedures per dollar of debt is six cents. At this level of aggregation, there is not much difference between the costs for bankruptcy files (five cents per dollar of debt) and the costs for proposal files (six cents per dollar of debt). However, behind these national averages, there are significant variations among provinces.
Again limited to the four provinces mentioned above, the cost of procedures per dollar of debt runs from a minimum of two cents for British Columbia and Alberta to a maximum of seven cents for Ontario and Quebec for bankruptcies. For proposals, the cost ranges from a minimum of three cents for Alberta and Ontario to a maximum of eight cents for Quebec. The second index or ratio indicates, for the entire period and for all files at the national level, that the cost of the procedure per dollar of dividend paid to creditors is $1.76. Research results indicate that this ratio tends to be higher for bankruptcies than for proposals. Interpretation of these results will require further analysis. For example, is the bankruptcy procedure actually more expensive per dollar of dividend, or is it often used too late when there are no assets left?
Numerous studies on financial theory and financial management of businesses have focused on the cost of commercial insolvency. Our research identified the principal works of this financial literature, whose founding text is the 1958 article by Modigliani and Miller (The Cost of Capital, Corporation Finance and the Theory of Investment). The existence of an optimal financial structure, i.e., a debt/equity ratio maximizing the value of a company, has long been touted as the result of two opposing forces — deductions for interest payments on debt in a system that taxes corporate profits, and the costs associated with bankruptcy. A classification of bankruptcy costs has been developed, and several empirical studies have measured these costs for businesses from various sectors. The cost of procedures is treated as a direct cost that includes the value of managers’ time consumed using the procedure. The other category of costs relates to the financial losses of the insolvent company.
In the financial literature, commercial insolvency is caused by debt, and results in a transfer of ownership of the company from the shareholders to the creditors. In an article that is very complementary to the classic 1976 Jensen and Meckling paper (Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure) and that uses agency theory to explain the financial structure of the company,3 two authors, Haugen and Senbet, (The Insignificance of Bankruptcy Costs to the Theory of Optimal Capital Structure) show that from the financial theory perspective, the costs of commercial insolvency are limited to the costs of the transfer of ownership of the company from shareholders to creditors, and that these costs are minimal. These authors also point out that the other cost elements included in the estimate of direct and indirect costs confuse the cost of commercial insolvency with the cost of reallocating a company’s resources and assets to other uses. The value of the Haugen and Senbet article in the context of this research is to reiterate that an analysis of the costs of a phenomenon is closely related to an analysis of the causes of that phenomenon and the perspective of that analysis.
In financial analysis research, the phenomenon of commercial insolvency is dealt with at the level of the sole proprietorship, and its cost is an exogenous variable in a model explaining the importance of debt relative to equity in the business’ financing. The law of businesses in difficulty is in the background. This research adopts the opposite perspective: the phenomenon of commercial insolvency is dealt with from a global perspective and can be treated as the measurement of its cost. In this measurement, the research distinguishes between total cost and social cost. Total cost includes the costs of procedures and other direct costs, as defined in the financial literature, as well as the total amount of financial losses of the parties involved with insolvent businesses.
The estimate of the total cost flows from the desire to establish an upper limit of the social cost of commercial insolvency, i.e., excluding transfers between economic agents. Some of these transfers raise few or no issues of fairness in terms of the law governing businesses in difficulty, as is the case with financial losses offset by gains for competing businesses. Performance incentives created by competition are not enough to ensure the competence and honesty of business managers, however, particularly when the company ceases to be profitable and is heading towards an increasingly probable state of insolvency. Financial losses of some stakeholders in the company may then increase exponentially, with no offsetting gain for the stakeholders of competitors. Moreover, these losses do not rule out financial transfers to certain parties that are more internal than others, such as controlling shareholders. Such transfers can raise issues of fairness and increase the social cost of commercial insolvency
In the financial literature, the cause of commercial insolvency is cited as debt. The organizational change professional will look for causes of insolvency among factors that could slow the company’s progress as an organization; the engineer will look at cost savings that could be realized in physical processes. These observations illustrate partial visions of the phenomenon of commercial insolvency. The scope of the law governing insolvency, including its public dimension and its potentially coercive side, does not fit with either of these visions. A vision is required that encompasses every factor, direct and indirect.
In the taxonomy of the causes of the insolvency of a particular company, chance or bad luck, i.e., what is beyond the control of managers, will refer to the determinants of commercial insolvency at the global level. Among the causes related to the behaviour of managers and entrepreneurs, dishonesty and incompetence tend to stand out. The law governing businesses in difficulty, with its statutes, regulations and professional practices, operates somewhat on the border between global determinants and the causes of the insolvency of a particular company. This research views the law governing businesses in difficulty as a way of resolving the state of commercial insolvency. It also sees the law as one of the determinants of the scope of the phenomenon of commercial insolvency, affecting the behaviour of economic agents either directly through its rules, or by default due to the absence of rules. In more analytical terms, the social cost of commercial insolvency is an endogenous variable in an economic analysis model of the law governing businesses in difficulty. This social cost can be interpreted as an order of magnitude of the maximum gain in efficiency in terms of resource savings that can result from a particular evolution in the law governing businesses in difficulty, following specific changes in one or another of its components.
Distribution of the cost of commercial insolvency has important implications in terms of incentives and, by extension, in terms of the total cost of commercial insolvency. The report alludes to this in a few places. Reference to a model introduced by White in 1983, for example, demonstrates that certain elements in the cost of commercial insolvency are proportional to the relative importance of unsecured claims in the company’s total debt, the amount of these claims representing the flexibility available to managers in the restructuring procedure used to avoid or postpone a desirable liquidation. Use of a database that allows for measuring the distribution of the cost of commercial insolvency will provide for a more in-depth look at the elements of commercial insolvency relating to its distribution among stakeholders in the company.
1 This percentage is based mainly on application of the BIA and a few CCAA cases as statistics on application of the CCAA are available only since 2009. Return to footnote 1
2 Despite sectoral laws and programs, application of the BIA or the CCAA is not excluded. It would be reasonable to argue that the case of ABCPs falls under the financial sector; the CCAA was nevertheless, used as a framework for negotiations to spread stakeholders’ financial losses over time and, ideally, reduce them. Return to footnote 2
3 This same agency theory inspired Law and Finance authors, who are very concerned with the legal protection of external sources of business financing, institutional lenders and minority shareholders, in their analysis of the law governing businesses in difficulty. Return to footnote 3
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