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On this paper concerning bankruptcy laws and entrepreneurfriendliness.
etap_350 517..530
Bankruptcy Laws
and Entrepreneur-
Friendliness
Mike W. Peng
Yasuhiro Yamakawa
Seung-Hyun Lee
Using bankruptcy laws as a case of formal institutions, we show how formal institutions
impact entrepreneurship development. Historically, bankruptcy laws usually have been
harsh. Recently, many governments have realized that entrepreneur-friendly bankruptcy
laws can not only lower exit barriers, but also lower entry barriers for entrepreneurs. Since
bankruptcy laws are not uniform around the world, it is important to understand how they
differ in their friendliness to entrepreneurs. This article focuses on six dimensions of
entrepreneur-friendliness: (1) the availability of a reorganization bankruptcy option, (2) the
time spent on bankruptcy procedures, (3) the cost of bankruptcy procedures, (4) the oppor-
tunity to have a fresh start in liquidation bankruptcy, (5) the opportunity to have an automatic
stay of assets during reorganization bankruptcy, and (6) the opportunity for entrepreneurs
and managers to remain on the job after ?ling for bankruptcy. In an effort to cover both
developed and emerging economies and to draw on geographically diverse examples,
we use data from Australia, Canada, Chile, Finland, Hong Kong, Japan, Norway, Peru,
Singapore, South Korea, Thailand, the United States, and other countries to illustrate these
differences. Overall, this article contributes to the institution-based view of entrepreneurship
by highlighting the important role that formal institutions such as bankruptcy laws play
behind entrepreneurship development around the world.
In entrepreneurship practice and research, institutions matter (Baumol, 1996; North,
1990; Scott, 1995; Yamakawa, Peng, & Deeds, 2008). Market-friendly institutions gen-
erally facilitate more vibrant entrepreneurship development, which, in the aggregate,
Please send correspondence to: Mike W. Peng, tel.: (972) 883-2714; e-mail: [email protected], to
Yasuhiro Yamakawa at [email protected], and to Seung-Hyun Lee at [email protected].
This article was presented at the Entrepreneurship Theory and Practice (ET&P) special issue conference
at Northeastern University (October 2008). It is a portion of a longer manuscript that was presented at the
Babson Conference (Madrid, Spain, June 2007) and the Strategic Management Society (San Diego, October
2007). The longer manuscript received a U.S. Small Business Administration Of?ce of Advocacy Best Paper
Award for a Babson Conference paper “Exploring the Importance of Small Businesses to the U.S. Economy
or a Public Policy Issue of Importance to the Entrepreneurial Community” at the 2008 Babson Conference
(Chapel Hill, NC, June 2008). We thank guest editors (David Ahlstrom and Garry Bruton) and two reviewers
for editorial guidance; Geoffrey Desa, Tatiana Manolova, and Eric Morse for helpful comments; and Jay
Barney for collaboration on related work. We also thank Sheila Puffer and Dan McCarthy for organizing the
ET&P conference and the SBA Award Committee (chaired by Andrew Zacharakis) for its encouragement.
This research has been funded, in part, by the National Science Foundation (NSF) (CAREER SES 0552089).
All views expressed are those of the authors and not necessarily those of the NSF.
P T E
&
1042-2587
© 2009 Baylor University
517 May, 2010
DOI: 10.1111/j.1540-6520.2009.00350.x
would translate into economic development (Baumol; North). Moving from this widely
accepted and thus uncontroversial proposition that institutions matter, the next generation
of research on the institution-based view of entrepreneurship needs to probe into how
institutions matter (Peng, 2003; Peng, Lee, & Wang, 2005; Peng, Wang, & Jiang, 2008).
Following Lee, Peng, and Barney (2007), we argue that whether bankruptcy laws are
entrepreneur-friendly has a direct bearing on the level of entrepreneurship development at
the societal level.
1
Speci?cally, this article focuses on the impact of corporate bankruptcy
laws (hereafter labeled “bankruptcy laws” for compositional simplicity)—a crucial formal
institution governing the insolvency of entrepreneurial ?rms that has been largely
neglected in entrepreneurship research.
2
Starting up an entrepreneurial ?rm is a risky and uncertain endeavor that has very
strong likelihood of ending in bankruptcy. While the small number of successful entre-
preneurs and their ?rms receive disproportionate scholarly and media attention, a sad and
predictable fact is that a majority of entrepreneurial ?rms end up in bankruptcy.
3
Given
that most governments encourage more entrepreneurial start-ups and that most such
start-ups fail, societies that are friendlier and more forgiving to failed entrepreneurs are
likely to attract more individuals to start up new ventures and to have stronger economic
development that comes with vibrant entrepreneurial activities. Conversely, societies that
are harsher to failed entrepreneurs whose start-ups end up in bankruptcy will discourage
entrepreneurship development. Therefore, in the context of bankruptcy laws, we de?ne
“entrepreneur-friendliness” as bankruptcy laws’ disposition to be friendly, helpful, and
forgiving to entrepreneurs whose ?rms are bankrupt.
Historically, entrepreneur friendliness and bankruptcy laws are like an “oxymoron,”
because bankruptcy laws are usually harsh and even cruel. The very term “bankruptcy” is
derived from a harsh practice: In medieval Italy, if bankrupt entrepreneurs did not pay
their debt, debtors would destroy the trading bench of the bankrupt—the Italian word for
broken bench, “banca rotta,” has evolved to become the English word “bankruptcy.” The
pound of ?esh demanded by the creditor in Shakespeare’s The Merchant of Venice is only
a slight exaggeration. The world’s ?rst bankruptcy law, passed in England in 1542,
considered a bankrupt individual a criminal and punishments ranged from incarceration in
prison to death sentence (bankruptcydata.com, 2008).
Around the world, being entrepreneur-friendly is a relatively new concept in bank-
ruptcy lawmaking, which is in radical contrast with traditional bankruptcy laws and
practices that generally favored the creditor and were harsh toward the bankrupt (Halliday
& Carruthers, 2007). Recently, many governments around the world have increasingly
1. Our focus is on productive (not unproductive or destructive) entrepreneurship (Baumol, 1996). While a
majority of unproductive and destructive entrepreneurship is active in the underground economy, we argue
that more lenient bankruptcy laws would provide more incentives to ?rms to use formal bankruptcy laws.
Given that using formal procedures of bankruptcy processes would require ?rms to engage in legal business,
it is likely that unproductive and destructive entrepreneurship would be discouraged should a country make
bankruptcy laws friendlier to entrepreneurs.
2. Although personal bankruptcy laws may also affect entrepreneurship development (Armour & Cumming,
2008; Ayotte, 2007), we do not deal with personal bankruptcy laws in this article.
3. While we acknowledge that “bankruptcy” and “failure” can be two different concepts, we focus speci?-
cally on the former, and not the latter. One can argue that many young and small ?rms just disappear without
going through the formal process of bankruptcy and that many more established and larger ?rms formally
declare bankruptcy. However, studies have shown that, for example, among U.S. ?rms that ?led for bank-
ruptcy, nearly 60% of them were less than ?ve years of age (White, 1990). Nearly 90% of bankrupt U.S. ?rms
employed fewer than 20 employees and had under $1 million in assets (Warren & Westbrook, 1999). Thus,
more younger and smaller ?rms are going through the formal bankruptcy procedures than more established
and larger ?rms, thus justifying our focus on the impact of bankruptcy laws on smaller, entrepreneurial ?rms.
518 ENTREPRENEURSHIP THEORY and PRACTICE
realized that entrepreneur-friendly bankruptcy laws can not only lower exit barriers, but
also lower entry barriers for entrepreneurs. The central question that we address in this
article is: How do bankruptcy laws around the world differ in their friendliness to
entrepreneurs? In an effort to cover both developed and emerging economies and to draw
on geographically diverse examples, we use data from Australia, Canada, Chile, Finland,
Hong Kong, Japan, Norway, Peru, Singapore, South Korea, Thailand, the United States,
and other countries to illustrate these differences. Overall, this article contributes to the
institution-based view of entrepreneurship by highlighting the crucial role that formal
institutions such as bankruptcy laws play behind entrepreneurship development around
the world. In other words, to facilitate entrepreneurship development, formal institutions
not only need to help facilitate more entrepreneurial entries, but also need to reduce the
pain associated with bankruptcies in order to facilitate less painful exits.
Bankruptcy Laws as Formal Rules of the Game
As “rules of the game,” institutions have two broad categories: formal and informal
institutions (North, 1990).
4
Of course, entrepreneurship is driven by a combination of
formal and informal rules of the game. A substantial body of research has focused on the
informal norms and cognitions exhibited by entrepreneurs, such as the urge for action,
the fuel to take risk, and the drive to succeed (Mitchell et al., 2002; Yamakawa, Peng, &
Deeds, 2009). Arelatively smaller body of entrepreneurship research has dealt with formal
rules of the game, by concentrating mostly on the impact of lowering entry barriers such
as providing more loans (Le, Venkatesh, & Nguyen, 2006) and reducing tax rates (Bruce
& Moshin, 2006). Little research in the entrepreneurship literature has examined exit
barriers such as bankruptcy laws.
As a formal institution governing corporate insolvency, bankruptcy laws represent
“rules of the end game.” By lowering exit barriers, entrepreneur-friendly bankruptcy laws
can curtail downside losses of entrepreneurial failures. Moreover, by imposing relatively
less painful and less costly procedures, entrepreneur-friendly bankruptcy laws also lower
entry barriers. This is because more would-be entrepreneurs may be attracted to join the
start-up game if they feel the cost of bankruptcy is not prohibitive (Lee et al., 2007).
Governments interested in economic development need to encourage more entrepre-
neurial start-ups, each of which can be viewed as an experiment or a real option for the
society (Lee et al., 2007). While it is long known that some start-ups will succeed and a
majority will fail, it is virtually impossible to predict a priori which ones will succeed and
which ones will fail. Therefore, it is imperative to encourage more entrepreneurs to
experiment with their ideas in a friendlier institutional framework (North, 1990). While
efforts to make the environment more entrepreneur-friendly can be undertaken along
informal and formal dimensions, it is relatively more dif?cult, challenging, and time-
consuming to change the informal aspects affecting entrepreneurship. For example, it is
dif?cult to transform a culture known to be risk averse and avoid uncertainty to generate
a large number of entrepreneurial start-ups in a short span of time (Hofstede, 2007;
North). Therefore, countries seeking to encourage more entrepreneurship may see a
more immediate impact by adjusting their bankruptcy laws to reduce the cost and pain
4. There are two schools of thought on institutional theory—a more economic angle starting from North
(1990) and a more sociological one stemming from Scott (1995). In this article, we follow the economic angle
and focus more on formal institutions represented by bankruptcy laws. For a more integrative approach, see
Peng et al. (2009).
519 May, 2010
associated with bankruptcy (Halliday & Carruthers, 2007). For example, Lim and Hahn
(2003) show that bankruptcy reforms in South Korea after the 1997 economic crisis
quickly contributed to productivity growth by allowing inef?cient ?rms to exit, encour-
aging new entries, and stimulating surviving ?rms to become more ef?cient.
Dimensions of Bankruptcy Laws’ Entrepreneur-Friendliness
The purpose of bankruptcy laws is to resolve con?icts among a ?rm’s
stakeholders—in particular, creditors, owners (entrepreneurs in the case of entrepreneurial
start-ups), managers, employees, and tax authorities—when a ?rm is ?nancially insolvent
(Jackson, 1986; Longhofer & Peters, 2004). Literally “stakeholders,” all these parties have
signi?cant economic interests at stake. Bankruptcy laws ensure an orderly process in
terms of who gets what of the remaining assets (Halliday & Carruthers, 2007). Whether
the process is fair or equitable is a point of contention, depending on one’s point of view.
For example, bankruptcy laws more forgiving to bankrupt entrepreneurs may be viewed
as “unfair” by creditors. From an entrepreneur’s viewpoint, we suggest in Figure 1 that
bankruptcy laws differ along six dimensions in terms of their entrepreneur-friendliness.
These six dimensions are drawn from Lee et al. (2007) as well as from Claessens and
Klapper (2005), Doing Business Report 2008 (2008), La Porta, Lopez-De-Silanes,
Shleifer, and Vishny (1998), and Lee, Yamakawa, Peng, and Barney (2008). They are (1)
the availability of a reorganization bankruptcy option, (2) the time spent on bankruptcy
procedures, (3) the cost of bankruptcy procedures, (4) the opportunity to have a fresh start
in liquidation bankruptcy, (5) the opportunity to have an automatic stay of assets during
reorganization bankruptcy, and (6) the opportunity for entrepreneurs and managers to
remain on the job after ?ling for bankruptcy.
Extending previous work, we have amassed a database that enables us to draw
examples from around the world to illustrate the differences along these six dimensions
(Table 1). The country examples in this article are chosen (1) to highlight the variances
along a single dimension, and (2) to be geographically diverse around the world. We have
endeavored to include both developed and emerging economies, and to cover major
continents (Asia, Australasia, Europe, North America, and South America). Each pair of
Figure 1
Components of Bankruptcy Laws and Entrepreneur-Friendliness
A fast bankruptcy procedure
A fresh start in liquidation
A low cost for bankruptcy filing
An automatic stay of assets
Managers stay on the job
Entrepreneur-
friendliness of
bankruptcy laws
Availability of reorganization
520 ENTREPRENEURSHIP THEORY and PRACTICE
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521 May, 2010
two countries chosen for one dimension represents the maximum and minimal levels for
that dimension. Numerous other country examples can certainly be chosen. However, a
practical constraint is that we prefer to cover countries with no missing data on any of the
six dimensions. Because Table 1 also reports new ?rm formation (the ratio of new ?rms
to the total number of ?rms in one country) as an admittedly crude but informative
measure of entrepreneurship development at the country level (Lee et al., 2008), we only
include countries where we can obtain data on new ?rm formation.
Availability of a Reorganization Bankruptcy Option: The United States
versus Finland
Bankruptcy laws traditionally focus on liquidation, by dismembering the ?rm and
selling its assets to repay creditors—in the same spirit of breaking bankrupt merchants’
trading benches in medieval Italy. More entrepreneur-friendly bankruptcy laws in some
countries allow for a second option: reorganization, which gives a ?rm certain legal
protection while it sheds some debt and reorganizes in order to compete more effectively.
Known as Chapter 11 in the United States, such reorganization may enable some ?rms,
which are in temporary ?nancial distress, to eventually become successful. Not all coun-
tries have reorganization as a bankruptcy option. For instance, bankruptcy laws in Finland
do not have an option for reorganization bankruptcy, and bankrupt entrepreneurial ?rms
are thus forced to liquidate immediately.
Clearly, providing an opportunity for bankrupt ?rms to reorganize is more
entrepreneur-friendly than forcing them to liquidate. Note that providing this option
deviates from the norms of traditional bankruptcy laws that were typically harsh on the
bankrupt. In the United States, the Bankruptcy Act of 1898 was the ?rst to give ?rms in
distress some protection from creditors (bankruptcydata.com, 2008). The widely used
Chapter 11 reorganization was enacted by the Bankruptcy Reform Act of 1978 that took
effect on October 1, 1979.
The post-1979 entrepreneurship development in the United States has been enviable.
That is why there is a recent global trend to add the U.S. Chapter 11-type reorganization
bankruptcy as one of the choices for bankrupt ?rms in many countries such as Argentina,
Australia, Great Britain, Indonesia, South Korea, and Thailand (Halliday & Carruthers,
2007). Most recently, as of June 2007, China reformed its bankruptcy laws to allow for the
reorganization option that had not existed before (Kargman, 2007).
Time Spent on Bankruptcy Procedures: Singapore versus Chile
The cost of bankruptcy is positively related to the length of time spent on bankruptcy
procedures (Bebchuk, 2000). In a liquidation bankruptcy, a fast procedure allows the
quick reallocation of assets of failed ?rms to better uses. At the same time, a fast procedure
can provide entrepreneurs the opportunities to start up a new business.
If a ?rm ?les reorganization bankruptcy (such as Chapter 11 in the United States), a
fast procedure may protect the value of the assets of the ?rm and improve its chance for
an eventually successful turnaround (Bebchuk, 2000). A lengthy process characterized
by an uncertain outcome, however, may make business partners (such as buyers and
sellers) reluctant to maintain their business relationships. This in turn may reduce earnings
and the value of ?rm assets (LoPucki & Doherty, 2002). One recent study drawing on
data from 88 countries ?nds that on average, 48% of the ?rm value is lost during the
typically lengthy bankruptcy process (Djankov, Hart, McLiesch, & Shleifer, 2008).
522 ENTREPRENEURSHIP THEORY and PRACTICE
Managers are likely to become frustrated with the long bankruptcy procedure, which
distracts them from focusing on more important operations. An inef?cient, time-
consuming procedure may end up forcing a ?rm to liquidate by increasing ?nancial
distress while a fast procedure could have saved the ?rm. In Singapore, it only takes about
10 months to go through bankruptcy. In contrast, in Chile, it takes 4.5 years to go through
the process. A longer time spent in the liquidation bankruptcy also means that the
resources will not be put to better use in a timely manner, which in turn will slow
entrepreneurship development at the societal level.
In Japan, even when ?nancially insolvent ?rms decide to ?le for bankruptcy, courts
will scrutinize the case and decide whether to allow certain ?rms to declare themselves
bankrupt. In other words, some insolvent ?rms are not allowed to go bankrupt. This
procedure alone takes more than three months (Alexander, 1999). It is, therefore, not
surprising that in Japan, half of all liquidations took more than three years and more than
75% of reorganizations exceeded ?ve years from application to conclusion (Alexander).
Obviously, failed entrepreneurs stuck with existing ?rms going through a lengthy bank-
ruptcy procedure are not in a position to start new ?rms (Harada, 2005). Overall, a more
ef?cient bankruptcy procedure may encourage more entry of new ?rms—in Silicon
Valley, this is known as the motto of “fail fast, fail cheap, and move on” (Saxenian, 1994).
In this spirit, Mexico reformed its bankruptcy laws since 2000, signi?cantly shortening the
average bankruptcy process from 7.8 to 2.3 years (Gamboa-Cavazos & Schneider, 2007).
Cost of Bankruptcy Procedures: Norway versus Thailand
The actual cost involved in ?ling bankruptcy can also be intimidating. One may think
that the direct cost of bankruptcy is not very high. This indeed is the case for Norway,
where the direct cost of bankruptcy is only 1% of the value of the assets of the ?rm.
However, around the world, this is clearly not the norm. In Thailand, bankruptcy costs
36% of the value of the assets of the ?rm. In comparison, the United States is in the
midrange between these two extremes. The direct cost is approximately 7% of the assets
of the average U.S. ?rm.
These data underscore Mason’s (2005, p. 1523) argument that costly bankruptcy “can
cause sluggish economic growth.” In other words, high bankruptcy cost may provide
incentives for ?rms to delay ?ling bankruptcies even when, at the societal level, it may be
more valuable for them to go bankrupt so that resources and employees can be channeled
to more productive use. Also, when the cost associated with bankruptcy is high, some
entrepreneurs may be discouraged to start businesses in the ?rst place.
Fresh Start in Liquidation Bankruptcy: Peru versus Japan
Bankruptcy laws can either discharge bankrupt individuals from debt or allow the
pursuit of the bankrupt entrepreneurs for years. By discharging bankrupt entrepreneurs,
bankruptcy laws can allow creditors to claim residual assets, but would not allow them to
pursue any remaining claims. Since an entrepreneur’s future earnings are exempt from the
obligations to repay past debt from bankruptcy, the entrepreneur is given a “fresh start”
(Ayotte, 2007). In the absence of a legally protected “fresh start,” creditors can pursue any
remaining claims, at least for some de?ned period of time. In Germany, until the recent
bankruptcy law reforms (Armour & Cumming, 2008), the debtor would remain liable for
unpaid debt for up to 30 years and creditors could go beyond claiming residual assets
(Ziechmann, 1997, pp. 12–25). German managers at bankrupt ?rms could also be per-
sonally liable for criminal penalties. It is not surprising that such differences in limiting
523 May, 2010
downside losses can make a huge difference in the risk-taking propensity between Ameri-
can and German entrepreneurs.
5
Internationally, Peru stands out as one of the most entrepreneur-friendly countries on
this dimension, because entrepreneurs can walk away with 75% of their debt. In contrast,
Japan only allows its bankrupt entrepreneurs to discharge less than one tenth of their debt
and allows creditors to recover more than 90% of the debt.
Automatic Stay of Assets in Reorganization Bankruptcy:
Canada versus Hong Kong
In some countries, bankruptcy laws may come with an automatic stay of assets and
discharge some portion of debt. An automatic stay upon the start of bankruptcy proceed-
ings means that creditors must cease debt collection efforts and move claims to the court.
The ?rm would continue to operate while creditors and ?rms negotiate. Before deciding
whether the ?rm should be liquidated or not, an automatic stay of assets allows time for
mangers to communicate with creditors (Franks, Nyborg, & Torous, 1996). La Porta et al.
(1998) ?nd that nearly half of the 49 countries they study do not have an automatic stay
of assets. While an automatic stay is allowed in Canada, the United States, and other
countries in the case of reorganization bankruptcy, it is not guaranteed in countries such
as Hong Kong and South Korea.
In an economy where secured creditors are allowed to repossess their assets when a
?rm ?les reorganization bankruptcy, it can end up in premature liquidations. Given
uncertainty over the future potential of the ?rm, even when the value of the ongoing
concern is higher than liquidation value, some creditors may have a greater interest in
liquidating the ?rm. In Hong Kong, for example, an automatic stay of assets does not
extend to secured creditors and these secured creditors thus have incentives to pursue
liquidation bankruptcy. Therefore, when an automatic stay is not in place, many ?rms do
not have the opportunity to ?le a reorganization bankruptcy even when this option is
legally allowed. When entrepreneurs know that they would not be given a second chance
when their ?rms are undergoing dif?culty, some of them would be discouraged to start
new businesses in the ?rst place.
The Fate of Entrepreneurs and Managers: Australia versus South Korea
Entrepreneurs and managers make ?rm-speci?c investments. This ?rm-speci?c
knowledge would be most required when a ?rm is in ?nancial distress. However, if
entrepreneurs and managers are going to be driven out when a ?rm ?les reorganization
bankruptcy, they may lack incentives to make ?rm-speci?c investments in the ?rst place.
If entrepreneurs and managers know ex ante that they will not be automatically replaced
in the case of bankruptcy ?ling, however, the opportunity to stay with the ?rm thus works
as a “bonding device” (Gaston, 1997). Therefore, when a ?rm ?les bankruptcy, offering
an opportunity for entrepreneurs and managers to stay may provide them with a better
?ghting chance to revive the ?rm. For example, bankrupt entrepreneurs and managers in
Australia are automatically granted rights to stay on the job.
5. In 2003, the European Commission recommended the ready availability of a “fresh start” through personal
bankruptcy laws to foster entrepreneurship (Armour & Cumming, 2008). Moreover, a number of European
countries (e.g., Germany, the Netherlands, and the UK) have recently increased the forgiveness of their
bankruptcy laws centered on the notion of fresh start.
524 ENTREPRENEURSHIP THEORY and PRACTICE
Conversely, in South Korea, bankrupt entrepreneurs and managers are ?red and
replaced. However, in a manager-replacement system such as a trustee-appointment
system, appointing outsiders without ?rm-speci?c knowledge for reorganization may end
up with improper reorganization (Alexander, 1999). For example, Chapter 11 in the
United States allows entrepreneurs and managers to retain control of the ?rm and provides
them the exclusive right to propose reorganization plans. In contrast, in Japan, control
rights are rendered to secured creditors (Franks et al., 1996). It is not surprising that the
practice of allowing secured creditors to take over has been criticized for causing prema-
ture liquidation. Thus, in turn, when entrepreneurs and managers know that they would
not be given a second chance to revive their ?rms under dif?culty, some of them may be
discouraged to start new businesses in the ?rst place. On the other hand, when entrepre-
neurs are given opportunities to stay on the job and work on the revival of their troubled
?rms, they may be more willing to take risks and start businesses.
Discussion
Contributions and Policy Implications
This article has contributed to the institution-based view of entrepreneurship by using
bankruptcy laws as a case of formal institutions to demonstrate how institutions matter.
Given that entrepreneurs rationally respond to the incentives and constraints provided by
an institutional framework (Baumol, 1996; Lee et al., 2007, 2008; North, 1990; Peng &
Khoury, 2008; Peng, Sun, Pinkham, & Chen, 2009; Peng et al., 2008; Yamakawa et al.,
2008), it seems that making bankruptcy laws more entrepreneur-friendly may stimulate
more entrepreneurial activity—as shown by data on new ?rm formation in Table 1.
Although management and entrepreneurship research rarely engages in public policy
issues (a tendency critiqued by Barney, 2005; Peng et al., 2009), the public policy impli-
cations of our research are clear.
6
Our central policy advice is that to the extent that
governments are interested in attracting more entrepreneurs to start-up ?rms, they are
advised to make bankruptcy laws more entrepreneur-friendly, along the six dimensions we
have discussed. For example, Armour and Cumming (2006) ?nd that entrepreneur-
friendly bankruptcy laws stimulate entrepreneurial demand for venture capital that funds
risky ventures. Using data from 33 countries, Lee et al. (2008) report that in a typical
country, (1) reducing the time spent on bankruptcy from 1.9 years to 0.4 year leads to a
13% increase in new start-ups, and (2) allowing incumbent managers to stay on the job (as
opposed to ?ring them and replacing them with outside trustees) is associated with an 11%
increase in new start-ups.
Overall, these are nontrivial policy instruments that governments can implement and
manipulate to stimulate more entrepreneurship. In emerging economies in particular,
more modern and more entrepreneur-friendly bankruptcy laws can give parties greater
con?dence in the legal framework that underlies lending and investment decisions, includ-
ing decisions by foreign venture capitalists to invest in entrepreneurial start-ups in a
particular country (Ahlstrom, Bruton, &Yeh, 2007; Kargman, 2007; Le et al., 2006; Lu &
Hwang, 2009; Wright, 2007; Yamakawa et al., 2008; Yang & Li, 2008).
6. This point is underscored by the fact that a longer manuscript of this research, upon which the present
article is derived, received the U.S. Small Business Administration Of?ce of Advocacy Best Paper Award for
a Babson Conference paper “Exploring the Importance of Small Businesses to the U.S. Economy and Public
Policy Issues of Importance to the Entrepreneurial Community” at the 2008 Babson Conference.
525 May, 2010
In addition, it is important to note that we are advocating more entrepreneur-friendly
bankruptcy laws, but we are not calling for totally painless bankruptcy laws. More
entrepreneur-friendly bankruptcy laws are simply less painful bankruptcy laws, and bank-
rupt entrepreneurs still have to painfully endure a signi?cant amount of ?nancial and
reputation losses, as well as a high degree of stigma (Shepherd, 2003). Given the inevi-
table risk and uncertainty associated with entrepreneurship, reasonable reduction of such
risk, in this case through more entrepreneur-friendly bankruptcy laws, is likely to be
bene?cial.
A Future Research Agenda
For entrepreneurship researchers, this article merely scratches the surface of a prom-
ising research agenda that may yield large dividends in future work. Focusing on and
testing the impact of each of the six dimensions longitudinally and across a large number
of countries will be an obvious ?rst step (Lee et al., 2007, 2008). More detailed, clinical
studies focusing on the bankruptcy process and its evolution in one country (such as the
study by Gamboa-Cavazos & Schneider, 2007, on Mexico) will shed additional light
beyond what can be obtained by more global, cross-sectional studies that, of necessity,
will be unable to investigate country-speci?c nuances. Not necessarily limited to the six
dimensions discussed in this article, future research can also investigate the impact of
other dimensions as speci?ed by various bankruptcy laws.
While scholars interested in advancing the institution-based view of entrepreneurship
are naturally interested in isolating the impact of speci?c mechanisms of formal as well as
informal institutions on entrepreneurial behavior and performance (Peng et al., 2009), De
Soto (2003) reminds us that it is not just piece-meal development of speci?c institutions
that make entrepreneurs take risks and start up new businesses. Rather, it is well-rounded
overall development of the institutions that stimulates entrepreneurship. There are signi?-
cant problems associated with piece-meal development of institutions in many emerging
economies (Puffer & McCarthy, 2007). But the same problem was the source of pain for
many developed countries in the past. In his own words, De Soto (p. 9) argues:
But it is not only former communist and Third World countries that have suffered all
of these problems. The same was true of the United States in 1783, President George
Washington complained about “banditti . . . skimming and disposing of the cream of
the country at the expense of the many.” These “banditti” were squatters and small
illegal entrepreneurs occupying lands they did not own. For the next hundred years,
such squatters battled for legal rights to their land and miners warred over their claims
because ownership laws differed from town to town and camp to camp. Enforcing
property rights created such a quagmire of social unrest and antagonism throughout
the young United States that the Chief Justice of the Supreme Court, Joseph Story,
wondered in 1820, whether lawyers would even be able to settle them.
For this reason, we will have to exercise caution in judging the impact of improving
bankruptcy laws in different countries. While it is advised to make bankruptcy laws more
lenient to encourage entrepreneurship development, if other institutions that help entre-
preneurial success were not in place, the effect of the improvement of bankruptcy laws
may not be meaningful. For example, even when an entrepreneur sees starting a new
business as a lucrative option due to more lenient bankruptcy laws, should ?nancial
institutions in the country be underdeveloped, it is not going to be easy for the entrepre-
neur to fully appreciate the bene?ts of lenient bankruptcy laws. Thus, from the standpoint
526 ENTREPRENEURSHIP THEORY and PRACTICE
of an entrepreneur contemplating starting a new business, a lenient bankruptcy law not
accompanied by sound ?nancial institutions may not look as lucrative as it should be.
Therefore, future studies will need to examine how other formal and informal
institutions—individually and in combination—affect the effectiveness of entrepreneur-
friendly bankruptcy laws in promoting entrepreneurship development.
Conclusion
From the age of imposing entrepreneur-hostile bankruptcy laws, countries and gov-
ernments around the world have come a long way to reform their bankruptcy laws to make
them more entrepreneur-friendly. Strengthening market-supporting institutions to stimu-
late more entrepreneurship development is at the heart of the institution-based view of
entrepreneurship (Lee et al., 2007; Peng et al., 2008, 2009; Yamakawa et al., 2008).
Sadly but predictably, most entrepreneurial start-ups fail. If failure may cost the
bankrupt entrepreneurs a pound of ?esh (as in The Merchant of Venice), how many of
them will want to dive into entrepreneurship? Since entrepreneurs are inherently risk
taking, some may still want to do it. However, what we do not know is how many
would-be entrepreneurs are deterred by harsh bankruptcy laws and how many potentially
signi?cant entrepreneurial ideas and opportunities are lost. Similar to the saying “No pain,
no gain,” an economy unwilling to shoulder the costs of certain entrepreneurial failures
is not likely to reap the bene?ts of a strong entrepreneurial sector and the economic
growth it may bring (Hoetker &Agarwal, 2007; Knott & Posen, 2005). In conclusion, we
advocate more entrepreneur-friendly bankruptcy laws designed to make the “pain” less
painful for failed entrepreneurs and their ?rms, and to “gain” from more vibrant entre-
preneurship development around the world.
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530 ENTREPRENEURSHIP THEORY and PRACTICE
doc_656985225.pdf
On this paper concerning bankruptcy laws and entrepreneurfriendliness.
etap_350 517..530
Bankruptcy Laws
and Entrepreneur-
Friendliness
Mike W. Peng
Yasuhiro Yamakawa
Seung-Hyun Lee
Using bankruptcy laws as a case of formal institutions, we show how formal institutions
impact entrepreneurship development. Historically, bankruptcy laws usually have been
harsh. Recently, many governments have realized that entrepreneur-friendly bankruptcy
laws can not only lower exit barriers, but also lower entry barriers for entrepreneurs. Since
bankruptcy laws are not uniform around the world, it is important to understand how they
differ in their friendliness to entrepreneurs. This article focuses on six dimensions of
entrepreneur-friendliness: (1) the availability of a reorganization bankruptcy option, (2) the
time spent on bankruptcy procedures, (3) the cost of bankruptcy procedures, (4) the oppor-
tunity to have a fresh start in liquidation bankruptcy, (5) the opportunity to have an automatic
stay of assets during reorganization bankruptcy, and (6) the opportunity for entrepreneurs
and managers to remain on the job after ?ling for bankruptcy. In an effort to cover both
developed and emerging economies and to draw on geographically diverse examples,
we use data from Australia, Canada, Chile, Finland, Hong Kong, Japan, Norway, Peru,
Singapore, South Korea, Thailand, the United States, and other countries to illustrate these
differences. Overall, this article contributes to the institution-based view of entrepreneurship
by highlighting the important role that formal institutions such as bankruptcy laws play
behind entrepreneurship development around the world.
In entrepreneurship practice and research, institutions matter (Baumol, 1996; North,
1990; Scott, 1995; Yamakawa, Peng, & Deeds, 2008). Market-friendly institutions gen-
erally facilitate more vibrant entrepreneurship development, which, in the aggregate,
Please send correspondence to: Mike W. Peng, tel.: (972) 883-2714; e-mail: [email protected], to
Yasuhiro Yamakawa at [email protected], and to Seung-Hyun Lee at [email protected].
This article was presented at the Entrepreneurship Theory and Practice (ET&P) special issue conference
at Northeastern University (October 2008). It is a portion of a longer manuscript that was presented at the
Babson Conference (Madrid, Spain, June 2007) and the Strategic Management Society (San Diego, October
2007). The longer manuscript received a U.S. Small Business Administration Of?ce of Advocacy Best Paper
Award for a Babson Conference paper “Exploring the Importance of Small Businesses to the U.S. Economy
or a Public Policy Issue of Importance to the Entrepreneurial Community” at the 2008 Babson Conference
(Chapel Hill, NC, June 2008). We thank guest editors (David Ahlstrom and Garry Bruton) and two reviewers
for editorial guidance; Geoffrey Desa, Tatiana Manolova, and Eric Morse for helpful comments; and Jay
Barney for collaboration on related work. We also thank Sheila Puffer and Dan McCarthy for organizing the
ET&P conference and the SBA Award Committee (chaired by Andrew Zacharakis) for its encouragement.
This research has been funded, in part, by the National Science Foundation (NSF) (CAREER SES 0552089).
All views expressed are those of the authors and not necessarily those of the NSF.
P T E
&
1042-2587
© 2009 Baylor University
517 May, 2010
DOI: 10.1111/j.1540-6520.2009.00350.x
would translate into economic development (Baumol; North). Moving from this widely
accepted and thus uncontroversial proposition that institutions matter, the next generation
of research on the institution-based view of entrepreneurship needs to probe into how
institutions matter (Peng, 2003; Peng, Lee, & Wang, 2005; Peng, Wang, & Jiang, 2008).
Following Lee, Peng, and Barney (2007), we argue that whether bankruptcy laws are
entrepreneur-friendly has a direct bearing on the level of entrepreneurship development at
the societal level.
1
Speci?cally, this article focuses on the impact of corporate bankruptcy
laws (hereafter labeled “bankruptcy laws” for compositional simplicity)—a crucial formal
institution governing the insolvency of entrepreneurial ?rms that has been largely
neglected in entrepreneurship research.
2
Starting up an entrepreneurial ?rm is a risky and uncertain endeavor that has very
strong likelihood of ending in bankruptcy. While the small number of successful entre-
preneurs and their ?rms receive disproportionate scholarly and media attention, a sad and
predictable fact is that a majority of entrepreneurial ?rms end up in bankruptcy.
3
Given
that most governments encourage more entrepreneurial start-ups and that most such
start-ups fail, societies that are friendlier and more forgiving to failed entrepreneurs are
likely to attract more individuals to start up new ventures and to have stronger economic
development that comes with vibrant entrepreneurial activities. Conversely, societies that
are harsher to failed entrepreneurs whose start-ups end up in bankruptcy will discourage
entrepreneurship development. Therefore, in the context of bankruptcy laws, we de?ne
“entrepreneur-friendliness” as bankruptcy laws’ disposition to be friendly, helpful, and
forgiving to entrepreneurs whose ?rms are bankrupt.
Historically, entrepreneur friendliness and bankruptcy laws are like an “oxymoron,”
because bankruptcy laws are usually harsh and even cruel. The very term “bankruptcy” is
derived from a harsh practice: In medieval Italy, if bankrupt entrepreneurs did not pay
their debt, debtors would destroy the trading bench of the bankrupt—the Italian word for
broken bench, “banca rotta,” has evolved to become the English word “bankruptcy.” The
pound of ?esh demanded by the creditor in Shakespeare’s The Merchant of Venice is only
a slight exaggeration. The world’s ?rst bankruptcy law, passed in England in 1542,
considered a bankrupt individual a criminal and punishments ranged from incarceration in
prison to death sentence (bankruptcydata.com, 2008).
Around the world, being entrepreneur-friendly is a relatively new concept in bank-
ruptcy lawmaking, which is in radical contrast with traditional bankruptcy laws and
practices that generally favored the creditor and were harsh toward the bankrupt (Halliday
& Carruthers, 2007). Recently, many governments around the world have increasingly
1. Our focus is on productive (not unproductive or destructive) entrepreneurship (Baumol, 1996). While a
majority of unproductive and destructive entrepreneurship is active in the underground economy, we argue
that more lenient bankruptcy laws would provide more incentives to ?rms to use formal bankruptcy laws.
Given that using formal procedures of bankruptcy processes would require ?rms to engage in legal business,
it is likely that unproductive and destructive entrepreneurship would be discouraged should a country make
bankruptcy laws friendlier to entrepreneurs.
2. Although personal bankruptcy laws may also affect entrepreneurship development (Armour & Cumming,
2008; Ayotte, 2007), we do not deal with personal bankruptcy laws in this article.
3. While we acknowledge that “bankruptcy” and “failure” can be two different concepts, we focus speci?-
cally on the former, and not the latter. One can argue that many young and small ?rms just disappear without
going through the formal process of bankruptcy and that many more established and larger ?rms formally
declare bankruptcy. However, studies have shown that, for example, among U.S. ?rms that ?led for bank-
ruptcy, nearly 60% of them were less than ?ve years of age (White, 1990). Nearly 90% of bankrupt U.S. ?rms
employed fewer than 20 employees and had under $1 million in assets (Warren & Westbrook, 1999). Thus,
more younger and smaller ?rms are going through the formal bankruptcy procedures than more established
and larger ?rms, thus justifying our focus on the impact of bankruptcy laws on smaller, entrepreneurial ?rms.
518 ENTREPRENEURSHIP THEORY and PRACTICE
realized that entrepreneur-friendly bankruptcy laws can not only lower exit barriers, but
also lower entry barriers for entrepreneurs. The central question that we address in this
article is: How do bankruptcy laws around the world differ in their friendliness to
entrepreneurs? In an effort to cover both developed and emerging economies and to draw
on geographically diverse examples, we use data from Australia, Canada, Chile, Finland,
Hong Kong, Japan, Norway, Peru, Singapore, South Korea, Thailand, the United States,
and other countries to illustrate these differences. Overall, this article contributes to the
institution-based view of entrepreneurship by highlighting the crucial role that formal
institutions such as bankruptcy laws play behind entrepreneurship development around
the world. In other words, to facilitate entrepreneurship development, formal institutions
not only need to help facilitate more entrepreneurial entries, but also need to reduce the
pain associated with bankruptcies in order to facilitate less painful exits.
Bankruptcy Laws as Formal Rules of the Game
As “rules of the game,” institutions have two broad categories: formal and informal
institutions (North, 1990).
4
Of course, entrepreneurship is driven by a combination of
formal and informal rules of the game. A substantial body of research has focused on the
informal norms and cognitions exhibited by entrepreneurs, such as the urge for action,
the fuel to take risk, and the drive to succeed (Mitchell et al., 2002; Yamakawa, Peng, &
Deeds, 2009). Arelatively smaller body of entrepreneurship research has dealt with formal
rules of the game, by concentrating mostly on the impact of lowering entry barriers such
as providing more loans (Le, Venkatesh, & Nguyen, 2006) and reducing tax rates (Bruce
& Moshin, 2006). Little research in the entrepreneurship literature has examined exit
barriers such as bankruptcy laws.
As a formal institution governing corporate insolvency, bankruptcy laws represent
“rules of the end game.” By lowering exit barriers, entrepreneur-friendly bankruptcy laws
can curtail downside losses of entrepreneurial failures. Moreover, by imposing relatively
less painful and less costly procedures, entrepreneur-friendly bankruptcy laws also lower
entry barriers. This is because more would-be entrepreneurs may be attracted to join the
start-up game if they feel the cost of bankruptcy is not prohibitive (Lee et al., 2007).
Governments interested in economic development need to encourage more entrepre-
neurial start-ups, each of which can be viewed as an experiment or a real option for the
society (Lee et al., 2007). While it is long known that some start-ups will succeed and a
majority will fail, it is virtually impossible to predict a priori which ones will succeed and
which ones will fail. Therefore, it is imperative to encourage more entrepreneurs to
experiment with their ideas in a friendlier institutional framework (North, 1990). While
efforts to make the environment more entrepreneur-friendly can be undertaken along
informal and formal dimensions, it is relatively more dif?cult, challenging, and time-
consuming to change the informal aspects affecting entrepreneurship. For example, it is
dif?cult to transform a culture known to be risk averse and avoid uncertainty to generate
a large number of entrepreneurial start-ups in a short span of time (Hofstede, 2007;
North). Therefore, countries seeking to encourage more entrepreneurship may see a
more immediate impact by adjusting their bankruptcy laws to reduce the cost and pain
4. There are two schools of thought on institutional theory—a more economic angle starting from North
(1990) and a more sociological one stemming from Scott (1995). In this article, we follow the economic angle
and focus more on formal institutions represented by bankruptcy laws. For a more integrative approach, see
Peng et al. (2009).
519 May, 2010
associated with bankruptcy (Halliday & Carruthers, 2007). For example, Lim and Hahn
(2003) show that bankruptcy reforms in South Korea after the 1997 economic crisis
quickly contributed to productivity growth by allowing inef?cient ?rms to exit, encour-
aging new entries, and stimulating surviving ?rms to become more ef?cient.
Dimensions of Bankruptcy Laws’ Entrepreneur-Friendliness
The purpose of bankruptcy laws is to resolve con?icts among a ?rm’s
stakeholders—in particular, creditors, owners (entrepreneurs in the case of entrepreneurial
start-ups), managers, employees, and tax authorities—when a ?rm is ?nancially insolvent
(Jackson, 1986; Longhofer & Peters, 2004). Literally “stakeholders,” all these parties have
signi?cant economic interests at stake. Bankruptcy laws ensure an orderly process in
terms of who gets what of the remaining assets (Halliday & Carruthers, 2007). Whether
the process is fair or equitable is a point of contention, depending on one’s point of view.
For example, bankruptcy laws more forgiving to bankrupt entrepreneurs may be viewed
as “unfair” by creditors. From an entrepreneur’s viewpoint, we suggest in Figure 1 that
bankruptcy laws differ along six dimensions in terms of their entrepreneur-friendliness.
These six dimensions are drawn from Lee et al. (2007) as well as from Claessens and
Klapper (2005), Doing Business Report 2008 (2008), La Porta, Lopez-De-Silanes,
Shleifer, and Vishny (1998), and Lee, Yamakawa, Peng, and Barney (2008). They are (1)
the availability of a reorganization bankruptcy option, (2) the time spent on bankruptcy
procedures, (3) the cost of bankruptcy procedures, (4) the opportunity to have a fresh start
in liquidation bankruptcy, (5) the opportunity to have an automatic stay of assets during
reorganization bankruptcy, and (6) the opportunity for entrepreneurs and managers to
remain on the job after ?ling for bankruptcy.
Extending previous work, we have amassed a database that enables us to draw
examples from around the world to illustrate the differences along these six dimensions
(Table 1). The country examples in this article are chosen (1) to highlight the variances
along a single dimension, and (2) to be geographically diverse around the world. We have
endeavored to include both developed and emerging economies, and to cover major
continents (Asia, Australasia, Europe, North America, and South America). Each pair of
Figure 1
Components of Bankruptcy Laws and Entrepreneur-Friendliness
A fast bankruptcy procedure
A fresh start in liquidation
A low cost for bankruptcy filing
An automatic stay of assets
Managers stay on the job
Entrepreneur-
friendliness of
bankruptcy laws
Availability of reorganization
520 ENTREPRENEURSHIP THEORY and PRACTICE
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521 May, 2010
two countries chosen for one dimension represents the maximum and minimal levels for
that dimension. Numerous other country examples can certainly be chosen. However, a
practical constraint is that we prefer to cover countries with no missing data on any of the
six dimensions. Because Table 1 also reports new ?rm formation (the ratio of new ?rms
to the total number of ?rms in one country) as an admittedly crude but informative
measure of entrepreneurship development at the country level (Lee et al., 2008), we only
include countries where we can obtain data on new ?rm formation.
Availability of a Reorganization Bankruptcy Option: The United States
versus Finland
Bankruptcy laws traditionally focus on liquidation, by dismembering the ?rm and
selling its assets to repay creditors—in the same spirit of breaking bankrupt merchants’
trading benches in medieval Italy. More entrepreneur-friendly bankruptcy laws in some
countries allow for a second option: reorganization, which gives a ?rm certain legal
protection while it sheds some debt and reorganizes in order to compete more effectively.
Known as Chapter 11 in the United States, such reorganization may enable some ?rms,
which are in temporary ?nancial distress, to eventually become successful. Not all coun-
tries have reorganization as a bankruptcy option. For instance, bankruptcy laws in Finland
do not have an option for reorganization bankruptcy, and bankrupt entrepreneurial ?rms
are thus forced to liquidate immediately.
Clearly, providing an opportunity for bankrupt ?rms to reorganize is more
entrepreneur-friendly than forcing them to liquidate. Note that providing this option
deviates from the norms of traditional bankruptcy laws that were typically harsh on the
bankrupt. In the United States, the Bankruptcy Act of 1898 was the ?rst to give ?rms in
distress some protection from creditors (bankruptcydata.com, 2008). The widely used
Chapter 11 reorganization was enacted by the Bankruptcy Reform Act of 1978 that took
effect on October 1, 1979.
The post-1979 entrepreneurship development in the United States has been enviable.
That is why there is a recent global trend to add the U.S. Chapter 11-type reorganization
bankruptcy as one of the choices for bankrupt ?rms in many countries such as Argentina,
Australia, Great Britain, Indonesia, South Korea, and Thailand (Halliday & Carruthers,
2007). Most recently, as of June 2007, China reformed its bankruptcy laws to allow for the
reorganization option that had not existed before (Kargman, 2007).
Time Spent on Bankruptcy Procedures: Singapore versus Chile
The cost of bankruptcy is positively related to the length of time spent on bankruptcy
procedures (Bebchuk, 2000). In a liquidation bankruptcy, a fast procedure allows the
quick reallocation of assets of failed ?rms to better uses. At the same time, a fast procedure
can provide entrepreneurs the opportunities to start up a new business.
If a ?rm ?les reorganization bankruptcy (such as Chapter 11 in the United States), a
fast procedure may protect the value of the assets of the ?rm and improve its chance for
an eventually successful turnaround (Bebchuk, 2000). A lengthy process characterized
by an uncertain outcome, however, may make business partners (such as buyers and
sellers) reluctant to maintain their business relationships. This in turn may reduce earnings
and the value of ?rm assets (LoPucki & Doherty, 2002). One recent study drawing on
data from 88 countries ?nds that on average, 48% of the ?rm value is lost during the
typically lengthy bankruptcy process (Djankov, Hart, McLiesch, & Shleifer, 2008).
522 ENTREPRENEURSHIP THEORY and PRACTICE
Managers are likely to become frustrated with the long bankruptcy procedure, which
distracts them from focusing on more important operations. An inef?cient, time-
consuming procedure may end up forcing a ?rm to liquidate by increasing ?nancial
distress while a fast procedure could have saved the ?rm. In Singapore, it only takes about
10 months to go through bankruptcy. In contrast, in Chile, it takes 4.5 years to go through
the process. A longer time spent in the liquidation bankruptcy also means that the
resources will not be put to better use in a timely manner, which in turn will slow
entrepreneurship development at the societal level.
In Japan, even when ?nancially insolvent ?rms decide to ?le for bankruptcy, courts
will scrutinize the case and decide whether to allow certain ?rms to declare themselves
bankrupt. In other words, some insolvent ?rms are not allowed to go bankrupt. This
procedure alone takes more than three months (Alexander, 1999). It is, therefore, not
surprising that in Japan, half of all liquidations took more than three years and more than
75% of reorganizations exceeded ?ve years from application to conclusion (Alexander).
Obviously, failed entrepreneurs stuck with existing ?rms going through a lengthy bank-
ruptcy procedure are not in a position to start new ?rms (Harada, 2005). Overall, a more
ef?cient bankruptcy procedure may encourage more entry of new ?rms—in Silicon
Valley, this is known as the motto of “fail fast, fail cheap, and move on” (Saxenian, 1994).
In this spirit, Mexico reformed its bankruptcy laws since 2000, signi?cantly shortening the
average bankruptcy process from 7.8 to 2.3 years (Gamboa-Cavazos & Schneider, 2007).
Cost of Bankruptcy Procedures: Norway versus Thailand
The actual cost involved in ?ling bankruptcy can also be intimidating. One may think
that the direct cost of bankruptcy is not very high. This indeed is the case for Norway,
where the direct cost of bankruptcy is only 1% of the value of the assets of the ?rm.
However, around the world, this is clearly not the norm. In Thailand, bankruptcy costs
36% of the value of the assets of the ?rm. In comparison, the United States is in the
midrange between these two extremes. The direct cost is approximately 7% of the assets
of the average U.S. ?rm.
These data underscore Mason’s (2005, p. 1523) argument that costly bankruptcy “can
cause sluggish economic growth.” In other words, high bankruptcy cost may provide
incentives for ?rms to delay ?ling bankruptcies even when, at the societal level, it may be
more valuable for them to go bankrupt so that resources and employees can be channeled
to more productive use. Also, when the cost associated with bankruptcy is high, some
entrepreneurs may be discouraged to start businesses in the ?rst place.
Fresh Start in Liquidation Bankruptcy: Peru versus Japan
Bankruptcy laws can either discharge bankrupt individuals from debt or allow the
pursuit of the bankrupt entrepreneurs for years. By discharging bankrupt entrepreneurs,
bankruptcy laws can allow creditors to claim residual assets, but would not allow them to
pursue any remaining claims. Since an entrepreneur’s future earnings are exempt from the
obligations to repay past debt from bankruptcy, the entrepreneur is given a “fresh start”
(Ayotte, 2007). In the absence of a legally protected “fresh start,” creditors can pursue any
remaining claims, at least for some de?ned period of time. In Germany, until the recent
bankruptcy law reforms (Armour & Cumming, 2008), the debtor would remain liable for
unpaid debt for up to 30 years and creditors could go beyond claiming residual assets
(Ziechmann, 1997, pp. 12–25). German managers at bankrupt ?rms could also be per-
sonally liable for criminal penalties. It is not surprising that such differences in limiting
523 May, 2010
downside losses can make a huge difference in the risk-taking propensity between Ameri-
can and German entrepreneurs.
5
Internationally, Peru stands out as one of the most entrepreneur-friendly countries on
this dimension, because entrepreneurs can walk away with 75% of their debt. In contrast,
Japan only allows its bankrupt entrepreneurs to discharge less than one tenth of their debt
and allows creditors to recover more than 90% of the debt.
Automatic Stay of Assets in Reorganization Bankruptcy:
Canada versus Hong Kong
In some countries, bankruptcy laws may come with an automatic stay of assets and
discharge some portion of debt. An automatic stay upon the start of bankruptcy proceed-
ings means that creditors must cease debt collection efforts and move claims to the court.
The ?rm would continue to operate while creditors and ?rms negotiate. Before deciding
whether the ?rm should be liquidated or not, an automatic stay of assets allows time for
mangers to communicate with creditors (Franks, Nyborg, & Torous, 1996). La Porta et al.
(1998) ?nd that nearly half of the 49 countries they study do not have an automatic stay
of assets. While an automatic stay is allowed in Canada, the United States, and other
countries in the case of reorganization bankruptcy, it is not guaranteed in countries such
as Hong Kong and South Korea.
In an economy where secured creditors are allowed to repossess their assets when a
?rm ?les reorganization bankruptcy, it can end up in premature liquidations. Given
uncertainty over the future potential of the ?rm, even when the value of the ongoing
concern is higher than liquidation value, some creditors may have a greater interest in
liquidating the ?rm. In Hong Kong, for example, an automatic stay of assets does not
extend to secured creditors and these secured creditors thus have incentives to pursue
liquidation bankruptcy. Therefore, when an automatic stay is not in place, many ?rms do
not have the opportunity to ?le a reorganization bankruptcy even when this option is
legally allowed. When entrepreneurs know that they would not be given a second chance
when their ?rms are undergoing dif?culty, some of them would be discouraged to start
new businesses in the ?rst place.
The Fate of Entrepreneurs and Managers: Australia versus South Korea
Entrepreneurs and managers make ?rm-speci?c investments. This ?rm-speci?c
knowledge would be most required when a ?rm is in ?nancial distress. However, if
entrepreneurs and managers are going to be driven out when a ?rm ?les reorganization
bankruptcy, they may lack incentives to make ?rm-speci?c investments in the ?rst place.
If entrepreneurs and managers know ex ante that they will not be automatically replaced
in the case of bankruptcy ?ling, however, the opportunity to stay with the ?rm thus works
as a “bonding device” (Gaston, 1997). Therefore, when a ?rm ?les bankruptcy, offering
an opportunity for entrepreneurs and managers to stay may provide them with a better
?ghting chance to revive the ?rm. For example, bankrupt entrepreneurs and managers in
Australia are automatically granted rights to stay on the job.
5. In 2003, the European Commission recommended the ready availability of a “fresh start” through personal
bankruptcy laws to foster entrepreneurship (Armour & Cumming, 2008). Moreover, a number of European
countries (e.g., Germany, the Netherlands, and the UK) have recently increased the forgiveness of their
bankruptcy laws centered on the notion of fresh start.
524 ENTREPRENEURSHIP THEORY and PRACTICE
Conversely, in South Korea, bankrupt entrepreneurs and managers are ?red and
replaced. However, in a manager-replacement system such as a trustee-appointment
system, appointing outsiders without ?rm-speci?c knowledge for reorganization may end
up with improper reorganization (Alexander, 1999). For example, Chapter 11 in the
United States allows entrepreneurs and managers to retain control of the ?rm and provides
them the exclusive right to propose reorganization plans. In contrast, in Japan, control
rights are rendered to secured creditors (Franks et al., 1996). It is not surprising that the
practice of allowing secured creditors to take over has been criticized for causing prema-
ture liquidation. Thus, in turn, when entrepreneurs and managers know that they would
not be given a second chance to revive their ?rms under dif?culty, some of them may be
discouraged to start new businesses in the ?rst place. On the other hand, when entrepre-
neurs are given opportunities to stay on the job and work on the revival of their troubled
?rms, they may be more willing to take risks and start businesses.
Discussion
Contributions and Policy Implications
This article has contributed to the institution-based view of entrepreneurship by using
bankruptcy laws as a case of formal institutions to demonstrate how institutions matter.
Given that entrepreneurs rationally respond to the incentives and constraints provided by
an institutional framework (Baumol, 1996; Lee et al., 2007, 2008; North, 1990; Peng &
Khoury, 2008; Peng, Sun, Pinkham, & Chen, 2009; Peng et al., 2008; Yamakawa et al.,
2008), it seems that making bankruptcy laws more entrepreneur-friendly may stimulate
more entrepreneurial activity—as shown by data on new ?rm formation in Table 1.
Although management and entrepreneurship research rarely engages in public policy
issues (a tendency critiqued by Barney, 2005; Peng et al., 2009), the public policy impli-
cations of our research are clear.
6
Our central policy advice is that to the extent that
governments are interested in attracting more entrepreneurs to start-up ?rms, they are
advised to make bankruptcy laws more entrepreneur-friendly, along the six dimensions we
have discussed. For example, Armour and Cumming (2006) ?nd that entrepreneur-
friendly bankruptcy laws stimulate entrepreneurial demand for venture capital that funds
risky ventures. Using data from 33 countries, Lee et al. (2008) report that in a typical
country, (1) reducing the time spent on bankruptcy from 1.9 years to 0.4 year leads to a
13% increase in new start-ups, and (2) allowing incumbent managers to stay on the job (as
opposed to ?ring them and replacing them with outside trustees) is associated with an 11%
increase in new start-ups.
Overall, these are nontrivial policy instruments that governments can implement and
manipulate to stimulate more entrepreneurship. In emerging economies in particular,
more modern and more entrepreneur-friendly bankruptcy laws can give parties greater
con?dence in the legal framework that underlies lending and investment decisions, includ-
ing decisions by foreign venture capitalists to invest in entrepreneurial start-ups in a
particular country (Ahlstrom, Bruton, &Yeh, 2007; Kargman, 2007; Le et al., 2006; Lu &
Hwang, 2009; Wright, 2007; Yamakawa et al., 2008; Yang & Li, 2008).
6. This point is underscored by the fact that a longer manuscript of this research, upon which the present
article is derived, received the U.S. Small Business Administration Of?ce of Advocacy Best Paper Award for
a Babson Conference paper “Exploring the Importance of Small Businesses to the U.S. Economy and Public
Policy Issues of Importance to the Entrepreneurial Community” at the 2008 Babson Conference.
525 May, 2010
In addition, it is important to note that we are advocating more entrepreneur-friendly
bankruptcy laws, but we are not calling for totally painless bankruptcy laws. More
entrepreneur-friendly bankruptcy laws are simply less painful bankruptcy laws, and bank-
rupt entrepreneurs still have to painfully endure a signi?cant amount of ?nancial and
reputation losses, as well as a high degree of stigma (Shepherd, 2003). Given the inevi-
table risk and uncertainty associated with entrepreneurship, reasonable reduction of such
risk, in this case through more entrepreneur-friendly bankruptcy laws, is likely to be
bene?cial.
A Future Research Agenda
For entrepreneurship researchers, this article merely scratches the surface of a prom-
ising research agenda that may yield large dividends in future work. Focusing on and
testing the impact of each of the six dimensions longitudinally and across a large number
of countries will be an obvious ?rst step (Lee et al., 2007, 2008). More detailed, clinical
studies focusing on the bankruptcy process and its evolution in one country (such as the
study by Gamboa-Cavazos & Schneider, 2007, on Mexico) will shed additional light
beyond what can be obtained by more global, cross-sectional studies that, of necessity,
will be unable to investigate country-speci?c nuances. Not necessarily limited to the six
dimensions discussed in this article, future research can also investigate the impact of
other dimensions as speci?ed by various bankruptcy laws.
While scholars interested in advancing the institution-based view of entrepreneurship
are naturally interested in isolating the impact of speci?c mechanisms of formal as well as
informal institutions on entrepreneurial behavior and performance (Peng et al., 2009), De
Soto (2003) reminds us that it is not just piece-meal development of speci?c institutions
that make entrepreneurs take risks and start up new businesses. Rather, it is well-rounded
overall development of the institutions that stimulates entrepreneurship. There are signi?-
cant problems associated with piece-meal development of institutions in many emerging
economies (Puffer & McCarthy, 2007). But the same problem was the source of pain for
many developed countries in the past. In his own words, De Soto (p. 9) argues:
But it is not only former communist and Third World countries that have suffered all
of these problems. The same was true of the United States in 1783, President George
Washington complained about “banditti . . . skimming and disposing of the cream of
the country at the expense of the many.” These “banditti” were squatters and small
illegal entrepreneurs occupying lands they did not own. For the next hundred years,
such squatters battled for legal rights to their land and miners warred over their claims
because ownership laws differed from town to town and camp to camp. Enforcing
property rights created such a quagmire of social unrest and antagonism throughout
the young United States that the Chief Justice of the Supreme Court, Joseph Story,
wondered in 1820, whether lawyers would even be able to settle them.
For this reason, we will have to exercise caution in judging the impact of improving
bankruptcy laws in different countries. While it is advised to make bankruptcy laws more
lenient to encourage entrepreneurship development, if other institutions that help entre-
preneurial success were not in place, the effect of the improvement of bankruptcy laws
may not be meaningful. For example, even when an entrepreneur sees starting a new
business as a lucrative option due to more lenient bankruptcy laws, should ?nancial
institutions in the country be underdeveloped, it is not going to be easy for the entrepre-
neur to fully appreciate the bene?ts of lenient bankruptcy laws. Thus, from the standpoint
526 ENTREPRENEURSHIP THEORY and PRACTICE
of an entrepreneur contemplating starting a new business, a lenient bankruptcy law not
accompanied by sound ?nancial institutions may not look as lucrative as it should be.
Therefore, future studies will need to examine how other formal and informal
institutions—individually and in combination—affect the effectiveness of entrepreneur-
friendly bankruptcy laws in promoting entrepreneurship development.
Conclusion
From the age of imposing entrepreneur-hostile bankruptcy laws, countries and gov-
ernments around the world have come a long way to reform their bankruptcy laws to make
them more entrepreneur-friendly. Strengthening market-supporting institutions to stimu-
late more entrepreneurship development is at the heart of the institution-based view of
entrepreneurship (Lee et al., 2007; Peng et al., 2008, 2009; Yamakawa et al., 2008).
Sadly but predictably, most entrepreneurial start-ups fail. If failure may cost the
bankrupt entrepreneurs a pound of ?esh (as in The Merchant of Venice), how many of
them will want to dive into entrepreneurship? Since entrepreneurs are inherently risk
taking, some may still want to do it. However, what we do not know is how many
would-be entrepreneurs are deterred by harsh bankruptcy laws and how many potentially
signi?cant entrepreneurial ideas and opportunities are lost. Similar to the saying “No pain,
no gain,” an economy unwilling to shoulder the costs of certain entrepreneurial failures
is not likely to reap the bene?ts of a strong entrepreneurial sector and the economic
growth it may bring (Hoetker &Agarwal, 2007; Knott & Posen, 2005). In conclusion, we
advocate more entrepreneur-friendly bankruptcy laws designed to make the “pain” less
painful for failed entrepreneurs and their ?rms, and to “gain” from more vibrant entre-
preneurship development around the world.
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Mike W. Peng is the Provost’s Distinguished Professor of Global Strategy at the University of Texas at Dallas,
School of Management, P.O. Box 830688, SM 43, Richardson, TX 75083, USA.
YasuhiroYamakawa is an assistant professor of entrepreneurship at Babson College, Babson Park, MA, USA.
Seung-Hyun Lee is an associate professor of management at the University of Texas at Dallas, School of
Management, Richardson, TX, USA.
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