BizCLIR

Bankruptcy law and practice play an important role in limiting the risks of credit. In every loan, both borrower and lender face a risk that it cannot be repaid. Bankruptcy limits the risks for lenders by establishing the rights of each type of lender and the obligations of the debtor in the event of default. This permits lenders to calculate the risk and price their credit more accurately. It also sets methods for working with defaulting borrowers in order to better enable the borrower to better meet financial obligations. For the borrower, bankruptcy is an institutionalized form of forgiveness, providing borrowers with relief (whether in whole or in part) from their obligations if a business venture fails.

Bankruptcy consists of two related but distinct possibilities: reorganization and liquidation. In reorganization, creditors will work with a bankrupt debtor in order to make the business viable again, preserving jobs, investments, and repayment capacity. They may forgive some of the debt or simply reschedule it for future repayment in order to improve their chances of obtaining the rest of the debt. When it is clear that the debtor cannot repay the debt, even after reorganization, then liquidation is used. Under liquidation, the defaulting company is closed and its assets are distributed or sold.

The economic impact of bankruptcy law is significant. Proper laws and practice improve access to credit by encouraging lenders to lend with the confidence that they have a reasonable mechanism for dealing effectively with defaulting debtors. At the same time, they encourage entrepreneurs to take on the reasonable risks of investing in new areas or expanding existing investments with the knowledge that there are constructive ways to deal with failure in case their investment predictions do not work out. In healthy economies, bankruptcies are a normal part of the overall business climate.

Ethiopia’s bankruptcy regime is relatively untested. Despite a reasonable framework law based on the Swiss bankruptcy code, other laws and practices have encouraged avoidance of the bankruptcy system. To the extent the bankruptcy law is being used, however, it is being used only for liquidation, not for reorganization. (Should the Government eventually increase privatization of State-owned enterprises, reorganization can be a very effective tool for making them functional and viable in a market economy.) The courts, understandably, are not well versed in bankruptcy practice or procedure, as bankruptcy filings are rare. Surprisingly, however, there seems to be a strong basis for building trustee and reorganization capacity based on existing “private receivership” practices. Current banking collateralization practices and limited commercial credit make it unlikely that much significant change will take place in the near future.