Bankruptcy laws and other procedures governing financial default are key elements in the functioning of market economies for several reasons: they codify and protect the rights of creditors, thus tending to reduce the cost of credit; they enhance global efficiency by forcing unprofitable firms to exit, allowing the reallocation of their resources into more productive uses; and they provide to company owners an indirect device for controlling and overseeing the management by subjecting poorly-performing managers to the threat of a transfer of control.
In market economies, bankruptcy is one among several mechanisms by which corporate control can be transferred to more efficient owners. Other mechanisms include takeovers or the sale of shares on the stockmarket. But, to be effective, these devices require the existence of well-developed capital markets. However, financial markets are in their infancy in countries undergoing transition from centrally-planned to market economy. Hence, the design and implementation of effective bankruptcy procedures and enforcing them is a critical step in laying the foundations for effective corporate governance in post-communist economies.
The experience so far of Eastern and Central European countries with bankruptcies indicates clearly that this step has not yet been successfully completed. This is not surprising. There are substantial differences between bankruptcy laws in market economies and no consensus on what would be the “optimal” bankruptcy law. As well, bankruptcy law of an established market economy may well not work effectively during the early stages of the transition because of the limited number of creditors; the fact that often both creditors and debtors are still more or less under the control of the government; and the long tradition of government bailout. More importantly, bankruptcy procedures are still largely ineffective in Eastern European countries because judicial systems largely lack the capacity and the expertise required to face the large number of cases.
This article compares the design, operation and outcomes of bankruptcy legislation in Hungary, Poland, the Czech Republic’ and Russia. The first section summarises the analytical foundations of bankruptcy with explicit reference to the situation in Eastern Europe. The second section gives a short overview of the principles guiding bankruptcy legislation in some major OECD countries: The third section describes the process of rehabilitating bankruptcy laws in Eastern Europe and shows how country-specific institutional traditions have shaped their design and implementation. It also illustrates the increased reliance on a variety of out-of-court procedures to resolve insolvency problems of privatised companies. In the fourth section, more systematic comparisons are made of the procedure designs, the specific features which drive the outcome of the bankruptcy decision. The fifth section demonstrates how bankruptcy laws have had little practical effect, so far, in transition economies and tries to identify some of the reasons of this lack of effectiveness. In the final section, we draw some broad guidelines about desirable features of bankruptcy procedures to be implemented during the transition process in other post-communist economies.
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Estabilishing Financial Dcipline
