UNCLC Seminar on credit guarantee schemes and SME insolvency - Blog by Hannah Leathem, UNCLC research assistant
On 8 March 2023, the University of Nottingham Commercial Law Centre had the honour of hearing from Professor Juan L Goldenberg, a UNCLC visiting scholar from The Pontifical Catholic University of Chile. This seminar was chaired by Professor Irit Mevorach and Dr Sandra Frisby was the discussant.
Public credit guarantee schemes facilitate access to finance, but they also impact on the likely effect of insolvency proceedings. The interplay between Small and Medium Enterprises (SMEs) being financed and the way they are dealt with when in distress, is not discussed. Professor Goldenberg wanted to prove that when a public policy enhances SME access to credit, it is important to think about what would happen if the company failed.
SMEs are the backbone of economies. In Chile they comprise 98.6% of Chile’s business population and provide 65.3% of employment. Globally more than 90% of enterprises qualify as SMEs.
In emergent economies it is more difficult to access credit, with 68% of SMEs not being able to access the credit they need. The exogenous reasons for this include the administrative costs to develop a banking area for SME’s and under-developed financial markets. Endogenous reasons include non-formalised companies, undercapitalisation and agency problems. Furthermore, there is an issue with information asymmetry. Many small enterprises do not have business, finance and tax records as there are low levels of financial literacy. This makes it difficult to carry out creditworthiness tests and assess credit risk. In addition, there can be issues with a lack of collateral for the loan. It can be difficult to distinguish between the assets of the enterprise and the entrepreneur, which often results in secured finance taking the form of a mortgage over the family home and a personal guarantee from the entrepreneur or their family members. This involves high levels of risk for the entrepreneur to secure a loan.
Public guarantee schemes aim to shift the risk from the entrepreneur. These schemes reduce the financial gap and create a better credit history of the SME for future financial requirements. In addition, this creates a business area focussed on SMEs in the financial institution. However, there are many associated problems. If these schemes pass all the risk to the state, they create a moral hazard. If only a portion of the risk is passed, the financial institutions may not see the guarantee as a strong security. Furthermore, a robust guarantee may result in adverse selection by the financial institution as it may finance unviable or risky projects using this state guarantee and leave its general loan facilities for the more viable ones.
A number of remedies can be introduced to mitigate; however, problems persist. Targeting SME’s who are strong and viable through screening processes prevents adverse selection, however, reintroduces the issue of opacity. SMEs may not be able to prove they are credit worthy. Moreover, maximum coverage of the guarantee ensures part of the risk remains with the financial institution. However, it can be difficult to find a suitable limit and decide whether the liability of the financial institution should be high or low. The level of liability will inform the adversity of the selection process.
Professor Goldenberg then moved the discussion to the Chilean Amendment to its Insolvency Act 2023. This introduces two new types of insolvency proceedings: simplified liquidation and reorganisation proceedings. The simplified liquidation introduces templates for voluntary proceedings and the sale of assets through E platforms. In addition, creditor meetings are not required unless necessary. Simplified reorganisation would introduce templates and simplification of initial documents and provide assistance by an insolvency practitioner. As with simplified liquidation, no creditor meeting is required.
These proceedings would enable more businesses to go through insolvency proceedings. Currently, proceedings are very expensive, leading to a preference for liquidation rather than a rescue attempt.
However, these legal amendments do not consider the way SMEs are being financed, including the public guarantee schemes discussed above. For example, there is an issue with obtaining fresh money, as it is not possible to obtain credit guaranteed by the state where a business has entered liquidation or reorganisation proceedings. This legal restriction does not consider that fresh money may receive special treatment to reduce the lender’s risk, such as a super-priority, and that it will follow from viability scrutiny by the creditors and the insolvency practitioner.
Also, the Chilean financial institutions must ask for the government’s approval to amend the terms of their agreements. Reorganisation proceedings change the conditions of the credit guarantee; therefore, government approval is required. This is a lengthy process which renders it impossible to go through reorganisation whilst under a credit guarantee scheme. This leaves the business with two options: liquidate or guarantee loans which maintain the terms of the agreement.
To conclude, a complete legal regime of the SMEs life cycle must consider a potential insolvency scenario. A regulatory design that neglects the particularities of SMEs makes the access to credit more difficult and limits its ability to project its business in the long term. Guarantee schemes should consider their effects in an insolvency scenario mainly regarding the possibility of effectively promoting the reorganisation of viable SME’s.