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Beyond Harshness versus Leniency:
Corporate Bankruptcy Laws, Entrepreneurial
Aspirations and Risk Aversion
ABSTRACTWe explore how national differences in bankruptcy codes influence the likelihood of an individual starting a high growth aspiration business. We move beyond a linear ordering of bankruptcy codes from pro-debtor to pro-creditor, developing theory to understand how different elements of bankruptcy laws influence entrepreneurial motivation and the supply of credit respectively. We suggest that the former will be moderated by individual attitudes to risk. We test our hypotheses using an inter-temporal cross country dataset developed by merging the Global Entrepreneurship Monitor (GEM) data with country data about bankruptcy arrangements. We find that pro-creditor elements of the bankruptcy code are positively related to high growth aspiration entrepreneurship. However, high aspiration entrepreneurs care about control arrangements post-liquidation: removal of incumbent managers as part of bankruptcy procedures has a negative impact. The demotivating elements of the bankruptcy code from the perspective of entrepreneurs have a greater effect on more risk-averse individuals.
Keywords: Entrepreneurship, High aspiration entrepreneurship, Bankruptcy, Global Entrepreneurship Monitor, Risk aversion.
1. INTRODUCTION
“Holland, the most unpolite country in the world, uses debtors with mildness and malefactors with rigour; England, on the other hand, shows mercy to murderers and robbers, but of poor debtors impossibilities are demanded” Samuel Bryron, Manchester Times 22nd October 1862
The importance of institutions in shaping preferences and incentives, and thereby behaviour is now accepted throughout management studies. In entrepreneurship research, it has also been recognised that the institutional environment is a crucial factor affecting entrepreneurship (e.g. Baumol, 1990; Busenitz et al, 2000; Zahra and Wright, 2011). Zahra and Wright (2011) explain that institutions are “the characteristics of the external environment in which new ventures are established and compete and that explain the birth-rate, magnitude and types of opportunity and how entrepreneurs exploit them for profit.” (Zahra and Wright, 2011: 76). There is no consensus however, on which institutions are the critical ones for entrepreneurs. Previous researchers have stressed the role of both ‘higher order’ institutions (e.g. constitutional protection of property rights), and of government regulations (e.g. Djankov et al., 2002; Klapper et al. 2006; van Stel et al., 2007; McMullen et al., 2008; Bowen and De Clercq, 2008; Sobel, 2008; Aidis et al., 2012; Levie and Autio, 2011; Troilo, 2011; Estrin et al., 2013). However, these institutions tend to be closely associated with the level of development and hence their individual impacts have been hard to identify empirically (Aidis et al., 2012).
Bankruptcy procedures are an element of a nation’s institutional environment at the regulatory level of particular significance for entrepreneurial choices (Dally, 1994; McGrath, 1999; Lee et al., 2007). The nature of bankruptcy codes is not closely associated with the level of development. Indeed, the range is often characterised as running from pro-creditor to
pro-debtor, with for example the UK and France standing at opposite ends of the spectrum (La Porta et al., 1998). However, the implications of this ordering for entrepreneurial activity are ambiguous. “Harsher” (less pro-debtor) bankruptcy laws are normally argued to deter entrepreneurship (Lee et al, 2007; Lee et al., 2011, Lee et al., 2012). However, agency theory suggests that harsher rules would encourage entrepreneurship via its positive influence on the supply of finance (Shleifer and Vishny, 1997; Djankov et al., 2007). We offer a more finely grained analysis distinguishing between those aspects of the law, which affect entrepreneurs and creditors respectively. We also argue that bankruptcy procedures affect entrepreneurs differently depending on their attitude to risk.
Bankruptcy laws have an important influence on entrepreneurial outcomes through both the motivation of individuals to become entrepreneurs and the extent of finance being offered. The theory reflects tensions between entrepreneurship and corporate governance views. For the former, the issue is to secure sufficient independence for entrepreneurs so that they can create value by innovating, taking risks, investing and launching new ventures (e.g. Foss and Klein, 2012). In this context, harsher treatment of entrepreneurs when their firms fail may demotivate entrepreneurial activity, especially when those individuals are more risk averse. Hence debtor-oriented bankruptcy laws are argued to encourage entrepreneurial entry (Lee et al. 2010). For the corporate governance literature, the focus is on the creditor; the concern is of agency and of securing a return for those who finance investment. From this perspective, debtor-oriented bankruptcy laws will limit entrepreneurship by restricting the flow of credit. It is creditor-oriented bankruptcy laws that will enhance entrepreneurial activity by encouraging the provision of finance, reducing financial constraints for entrepreneurs. When these two viewpoints are considered jointly, the predicted impact of the relative harshness of the national bankruptcy code upon entrepreneurial activity becomes ambiguous.
We propose that this dilemma can be resolved by evaluating bankruptcy codes in a more fine grained way. The design of bankruptcy laws has been interpreted as a linear ordering from harsh to lenient, i.e. creditor-friendly to debtor-friendly (La Porta et al., 1998; Djankov et al., 2007; Djankov et al., 2008), but it is this characterisation that generates the ambiguous predictions. If bankruptcy laws are harsher towards debtors, the negative consequences associated with business failure are exacerbated, which distorts entrepreneurial choices away from higher risk options. On the other hand, harsher bankruptcy laws also reduce the risks borne by lenders and help to secure returns across a wider range of outcomes, which may enhance the supply of funds to potential entrepreneurs. We propose that these two aspects need not be ordered in this linear way: bankruptcy laws that are harsh to entrepreneurs and those that offer strong protection to creditors are not necessarily the same. Hence previous studies (Lee et al, 2007; Lee et al., 2011, Lee et al., 2012) have been insufficiently nuanced. We instead focus on separate elements of the legal code, some likely to encourage creditors and others to demotivate debtors. Moreover, we propose a moderating relationship between risk attitudes and the elements of the bankruptcy code operating primarily through entrepreneurial motivation. Potential entrepreneurs who are more risk averse are more likely to be deterred in environments where the elements of bankruptcy laws affecting the control rights of the owner-manager are harsher. Since institutional structures define the incentives for individuals to act on perceived entrepreneurial opportunities, the interaction between institutions and individual attitudes and perceptions is critical in determining entrepreneurial behaviour (Arenius and Minniti, 2005).
Finally, we depart from earlier studies on bankruptcy and entrepreneurship (Lee et al., 2011; Lee and Yamakava, 2012) and follow Levie and Autio (2011) and Estrin et al. (2013) in focusing on high growth aspiration entrepreneurs. From a policy perspective, high growth firms, rather than new firms in general, have the significant impact on national growth (Wong
et al., 2005; Henrekson and Johansson, 2010); analysing them allows researchers to relate micro-level outcomes to societal outcomes (Davidsson 2004; Ireland et al, 2005). Furthermore, corporate bankruptcy laws might be expected to more relevant for high growth aspiration entrepreneurs as their firms are more likely to borrow and in case of insolvency to fall under the corporate bankruptcy laws.
2. CORPORATE BANKRUPTCY LAW AND ENTREPRENEURSHIP
“Bankruptcy is precipitated by debt; a firm that never borrowed couldn’t go bankrupt, unless burdened by involuntary debt, such as tort judgment” (Posner, 2007: 431). The institution of bankruptcy forms ‘the rules of the end game’ (Lee et al., 2011: 519): arrangements to address business failure following insolvency. Accordingly, the bankruptcy code sets out the processes for the debtor and creditors to follow when the debtor becomes insolvent and describe how the assets of the debtor are to be distributed amongst relevant stakeholders: creditors, employees, tax authorities and shareholders1. We focus on corporate bankruptcy law, which is particularly relevant for new ventures aiming to achieve a larger scale of operations2. Corporate bankruptcy laws apply to incorporated firms and generally include two types of procedures to deal with insolvent firms: liquidation and reorganisation (La Porta et al., 1998; Armour, 2001). Liquidation occurs when a firm is converted into cash through the sale of its assets (Armour, 2001: 4) and may involve either the firm being sold piece-meal (i.e. being wound-up) or as a going concern (Hart, 2000). Re-organisation is a procedure by which an owner-manager may continue to operate the insolvent debtor company and be given additional time to devise a reorganisation plan. If creditors reject the plan, the court determines the value of the company and the allocation of claims (Posner,
1 If an entrepreneur has incorporated their business, the entrepreneur’s personal assets are not linked to the firm
and are protected from creditors by limited liability. In general, bankruptcy laws provide entrepreneurs with insurance, limiting downside risks in case of failure (Posner, 2007).
2 The relationship between personal bankruptcy law and entrepreneurship, has been studied widely; e.g.
2007: 433). The aim of reorganisation is to aid firms either to become solvent again or to operate for a limited time producing a surplus while the burden of current debt is lifted.
Although these two procedures, liquidation and reorganisation, are generally available in most bankruptcy regimes, there is enormous variation in specific details between countries. This heterogeneity is in part due to the often conflicting objectives which have to be balanced within corporate bankruptcy law: protecting creditor rights and, preventing the liquidation of viable firms (Claessens and Klapper 2005: 254). Once a company becomes insolvent, creditors share an interest with owner-managers’ in maximising the total value of the proceeds because the creditors become residual claimants and their fixed claims are no longer guaranteed.3 Owner-managers may also have superior information on the value-maximising options available to the company. However, owner-managers’ !"#$%&' benefits of control may diverge from maximising the value of the company. This is of no concern for creditors as long as they remain secure, fixed claim stakeholders. Bankruptcy laws in different countries strike different balances between offering guarantees to creditors and creating opportunities for retaining control by owners-managers, who may be either able to provide additional value creation opportunities, or to tunnel out resources. These differences have led to bankruptcy regimes being classified linearly as either creditor-oriented or debtor-oriented (Djankov et al, 2008). For example, UK law prioritises creditors’ rights, whereas French law emphasises the continuation of the insolvent firm to protect jobs. Yet, these differences also reflect different national policy objectives and different weighting of the interests of other stakeholders, including the tax office and the employees.
3 Provided the total value of the proceeds can be expressed in monetary terms and the transaction costs of
2.1 Incentives for Entrepreneurs
How do differences in bankruptcy laws influence the incentives for individuals to start high growth aspiration ventures? Legal arrangements for bankruptcy are critical for entrepreneurship, which is a risky activity with relatively low survival rates (Audretsch 1991; Gimeno et al. 1997; Mata and Portugal 1994). The taking of risks is inherent to entrepreneurship (Kirzner, 1973) and the harshness of bankruptcy arrangements with respect to reorganisation affects the entrepreneur’s evaluation of bad outcomes. A bankruptcy system in which financial distress leads to the removal of management will leave the owner-manager with no opportunity to supervise the reorganisation proceedings. Hence, a failure of the business venture could lead to a highly frustrating outcome for the entrepreneur in which they have superior information about how to rescue the situation which the ailing venture is prevented from exploiting. There could be serious personal financial consequences and potential entrepreneurs may also take into account the personal stigma resulting from loss of business control, following financial distress (Sutton and Callahan, 1987). This suggests that the individual likelihood of entrepreneurial entry will be inversely related to elements of the bankruptcy code that affect the probability of loss of control by owners-managers. This will be especially true for high aspiration entrepreneurs, who may need to take on more risks and will be more likely to take on debt in order to attain their growth targets, and will therefore be more exposed to the possibility of bankruptcy proceeding if the venture fails (Bhide, 2000).
2.2 Incentives for Creditors
However, the bankruptcy code will also affect the incentives to provide credit and therefore the supply of finance for entrepreneurs. A large finance literature has emerged which models the supply of finance as being related to national institutional arrangements, for example with respect to stock exchange versus bank funding of enterprises (Franks and
Mayer, 1995); governance arrangements (Djankov et al., 2007); and venture capital structures (Gompers and Lerner, 1998). When bankruptcy arrangements are creditor-oriented, they incentivise debtors to repay their debts and give the creditors greater power to recover the cost of their loans in case of default. This acts to reduce the cost of debt-financing and therefore to increase its supply. Empirical evidence links the size of the credit market (La Porta et al., 1997; Djankov et al., 2007), and credit provision to small firms (Berkowitz and White, 2004), to the degree to which creditor rights are protected through stricter bankruptcy laws. If, as argued by Evans and Jovanovic (1989) among others, entrepreneurial activity is credit constrained, then creditor-friendly bankruptcy arrangements in a country will enhance entrepreneurial activity by relaxing the constraints on the supply of funds. This suggests that the individual likelihood of entrepreneurial entry will be positively related to elements of the bankruptcy code that relate to the security of the return of debt in the case of business failure. The impact of increased supply of funds is likely to be especially important for high aspiration entrepreneurs, since their demand for funds is likely to be greater in order to meet their higher growth objectives.
2.3 Bankruptcy laws and risk aversion
Individuals’ perceptions and attitudes have been hypothesised to play an important moderating role between the institutional context and entrepreneurship activity (Acs et al., 2008; Arenius and Minniti, 2005; Rauch and Frese, 2007). Bankruptcy law affects entrepreneurial entry decisions via expectations of possible scenarios following financial distress, which is relatively more likely for new firms (Geroski, 1995). Entrepreneurs’ attitudes towards risk will influence how they evaluate the prospect of financial distress. Bankruptcy codes influence the financial outcome for entrepreneurs in the case of business failure and more risk-averse individuals will weigh bad outcomes more heavily in their
expected value calculations of returns. Hence, we expect the impact of bankruptcy codes on high growth aspiration entrepreneurship to be moderated by individual risk attitudes.
If entrepreneurs are not able to calculate all the possible outcomes of their decisions and their probabilities in advance, their subjective valuation of alternative risks will differ (Arenius and Minniti, 2005; Koellinger et al., 2007). Consequently, individuals who are less risk averse are more likely to become entrepreneurs (Arenius and Minniti, 2005; Caliendo et al., 2009; Kihlstrom and Laffont, 1979). Debtor-oriented bankruptcy laws are argued to produce a partial insurance effect against the costs of failure, thus reducing the level of risk tolerance necessary for an individual to become an entrepreneur (White, 2001; Lee et al., 2007; Armour and Cumming, 2008). This should encourage more risk-averse individuals to become entrepreneurs (Lee et al., 2007).
2.4 Entrepreneurs, the supply of finance and attitudes to risk
In the finance literature, creditor rights have been conceived as heterogeneous across countries (e.g. La Porta et al., 1998; Djankov et al., 2007; Djankov et al., 2008)4. La Porta et al (1998) identify four elements in bankruptcy proceedings that can be compared across countries and which taken together shift the balance of power from debtors to secured creditors. The more of these rules are present in a country, the more the bankruptcy laws are regarded as creditor-oriented. However, while some of these rules clearly impact primarily creditors, others affect mainly debtors. Our approach is instead to consider each component separately, distinguishing between pro-creditor and anti-debtor effects; the former may encourage entrepreneurship by enhancing the supply of finance while the latter may demotivate entrepreneurs. Moreover, the impact of the latter elements is likely to be moderated by the individual entrepreneur’s attitude to risk.
3. HYPOTHESES
The four elements that the literature has identified as characterising the bankruptcy regime are: restrictions on reorganisation; the absence of stays on secured assets; mandatory removal of incumbent management during reorganisation proceedings; and the priority given to secured creditors in distribution of the proceeds resulting from the disposition of the assets (La Porta et al., 1998). We propose five hypotheses; the first four concern the impact of each element of the bankruptcy code on the likelihood of high growth aspiration entrepreneurial entry. The fifth considers the moderating impact of attitudes to risk on the way that the relevant elements of the bankruptcy code affect high aspiration entrepreneurship.
First, we consider the impact of whether there are restrictions on filing for reorganisation such as requiring creditors’ consent, or minimum dividends. This element of the code is potentially both demotivating for entrepreneurs and positively motivating for
suppliers of credit. Thus, such restrictions may be entrepreneur-unfriendly if they reduce the probability that the firm will survive bankruptcy proceedings. But by strengthening the position of creditors, such restrictions may enhance the supply of credit. This is because secured creditors are able to recover the value of their loans through liquidation rather than going through the uncertain and often lengthy reorganisation process, as long as the securities they hold cover the value of the debts owed to them (Prentice et al., 2003). More generally, creditor protection may be enhanced as these rules prevent debtors who cannot hope to reorganise their firms successfully from delaying liquidation. Thus, if there are restrictions for going into reorganisation such as requiring the creditors’ approval, this reduces the likelihood of reorganisation being even attempted let alone successful. Our first set of hypotheses takes account of both possibilities:
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Even if a firm does enter into reorganisation proceedings, bankruptcy laws’ favourability towards debtors can vary enormously. In some countries, such as the USA, the legal provisions for reorganisation completely shift the balance of power from creditors to debtors (Pochet, 2002: 344). In others, such as the UK, this shift of power does not occur and as a result this may limit the use of reorganisation as against outright liquidation. There are two commonly used indicators of whether a bankruptcy code engenders this shift in power: if there is no automatic stay on secured assets and if the removal of the incumbent management
is required by the bankruptcy laws. We argue however, that these two elements will have different impact from the perspective of entrepreneurs.
In some countries an automatic stay is placed on secured assets during reorganisation proceedings. This prevents secured creditors from unilaterally seizing the firm’s assets that they hold as security, thus allowing time for the reorganisation plan. In some cases the assets used for security will be important to the running of the business, and thus if this option is executed the firm may be unable to continue in business. Furthermore, the threat of other creditors unilaterally seizing assets may encourage creditors in a ‘race to collect’ the debts owed to them (Armour, 2001). Thus, if no automatic stay is placed on assets, the chances of a firm surviving bankruptcy as a going concern will probably be reduced. This is likely to have something of a disincentive effect on potential entrepreneurs. However, the main effect of having no automatic stay on secured assets is for creditors. Such arrangements give them significantly greater power to recover their loans under a wide variety of circumstances. Thus, bankruptcy codes with such characteristics provide much greater security to creditors, which seem likely to engender stronger supplies of finance to entrepreneurial ventures. The positive pro-creditor effect on high aspiration entrepreneurship seems likely to outweigh the negative anti-debtor factor. Hence:
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&+'"'-#,-%8-%;&*7%-,&%)=-Some bankruptcy regimes "'?;#"' the removal of the incumbent management during reorganisation. For example, in the UK, the management must be replaced by an official administrator appointed by the secured creditors. The administrator will then run the business and prepare the reorganisation plan. In other countries the incumbent management remains in control of the firm, for example in the US under Chapter 11. Brouwer (2006) argues that
ousting of management during bankruptcy is a crucial factor in explaining why fewer firms survive bankruptcy intact through reorganisation in Europe than in the US.5 In addition, required removal may have a strong negative impact on entrepreneurship because entrepreneurs strongly value control of their companies (Parker, 2009); they are often motivated as much by the desire for independence and to change the business model or even the society more generally as by the profit motive per se (Schumpeter, 1934). On the other hand, automatic removal of the incumbent manager can have at best modest implications for return to creditors and, these are likely to be strongly outweighed by the disincentive effects on entrepreneurs. The negative implications will be even more serious if entrepreneurs fear the stigma of failure (Sutton and Callahan, 1987). Hence we formulate our third hypothesis:
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"'?;#"'3=--The fourth component of creditor rights indicates whether secured creditors are ranked first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm. This is important for creditors as it increases the likelihood that they will be repaid in full whether the firm is successful or not. France for example, does not give priority to secured creditors, requiring that the employee wages and bankruptcy fees are paid first. Hence, French secured lenders in default may expect to recover less of the value of their collateral than secured lenders in Britain or Germany, where secured creditor priority is observed; this has a knock-on effect with French firms needing to provide more collateral per dollar of debt than German or British firms (Davydenko and Franks, 2008). However, it is
5 In Europe other bankruptcy methods exist which keeps bankrupt firms intact such as acquisition in liquidation
proceedings in England (Brouwer 2006). However, unlike reorganisation, these do not allow the entrepreneur to remain in charge of the firm.
hard to identify any disincentive effects from such regulations on entrepreneurs; the priority is being taken from other creditors and stakeholders but not from the entrepreneurs themselves. Thus, priority being given to secured creditors should unambiguously encourage the extension of credit and reduce the cost of credit to entrepreneurs. This leads us to:
()!*&+',#,-B/-0+'-1#2'1#+**3-*4-5'6*7#89-%-+#9+-9"*:&+-%,!#"%&#*8-'8&"'!"'8';"-#,-
+#9+'"-#8-6*;8&"#',-:+'"'-!"#*"#&)-#,-9#$'8-&*-,'6;"'3-6"'3#&*",-&+%8-:+'"'-#&-#,-8*&=-The impact of rules concerning bankruptcy on the individual choice to become an entrepreneur may be moderated by individual risk aversion. If individuals are risk taking, or tend to discount the likelihood of bad outcomes, then their choices will not be much affected by bankruptcy codes which favour creditors over debtors. However, if potential entrepreneurs are relatively more risk averse, their personal evaluation of bad outcomes will be more negative in jurisdictions in which the consequences of bankruptcy are relatively harsher. Consequently, they will be less likely to choose to become an entrepreneur. Moreover, high growth aspiration entrepreneurs are likely to take on more debt and the downside risks are greater with larger debts. Note that these moderating factors influence the (negative) incentives for individuals to become entrepreneurs in countries where the elements of bankruptcy codes are harsher concerning business failure, but do not influence the impact on creditors, and therefore on the supply of finance. We have noted potential negative incentive effects on entrepreneurship from rules concerning entering into reorganisation, automatic stays on secured assets and especially the required removal of management, but not from priority being given to secured creditors. Hence we propose:
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=-Figure 1 below summarizes our hypotheses ---
{Figure 1}
---4. METHODS
4.1 Data
Our data on entrepreneurial aspirations and individual characteristics derives from the Global Entrepreneurship Monitor (GEM) adult population surveys6. We use data from 39 countries covering 251,235 individuals over the years 2002-2004 which forms a pooled, cross-sectional, time-series dataset. This time period was chosen due to data availability, see next section (4.3.1). Each year the survey comes from a different sample of respondents.
6 With very few exceptions, the data consist of representative samples of at least 2,000 individuals in each
country. GEM surveys were completed through phone calls, and through face-to-face interviews in countries where low density of the telephone network could create a bias. National datasets are harmonised across all
countries included in the survey.The dataset is unbalanced as information is not available for all countries in all
The samples are drawn from the working age population which avoids the potential selectivity bias that could affect studies which focus on existing entrepreneurs.
Our data on the bankruptcy code in each country derives from Djankov et al., 2007 (see also La Porta et al., 1998). They provide a cross-country comparison of the rights of creditors to extract a return through corporate bankruptcy proceedings. For each of the four indicators countries scoring zero have bankruptcy regimes which in this respect are favourable to the debtor whereas countries scoring one have a pro-creditor policy in this particular respect.
Further data on macroeconomic conditions and institutional contexts control variables comes from a variety of sources which will be identified below.
4.2 Dependent Variable
Our dependent variable is based on a subset of the nascent entrepreneur (start-up) category. Nascent entrepreneurs are defined by GEM as individuals between the ages of 16 and 64 who in the past year have taken action towards setting up a business that they expect to own, but who are yet to have paid anyone wages for more than three months (Bosma and Levie, 2009).7 We follow the approach of Estrin and Mickiewicz (2011) to identify high growth aspiration entrepreneurs. A coding of 1 indicates an individual who is currently a nascent entrepreneur starting a high growth aspiration business, defined as aspiring to create more than ten jobs over a period of five years (12% of all start-ups). It is coded 0 for individuals who are not involved in starting up a business or who are starting a business but
7 Nascent entrepreneurial activity, which is characterised by a high risk of being interrupted without being
transformed into a successful business venture, may be seen as a poor measure of entrepreneurship. Yet it has been popular in empirical research for two reasons. First, the element of newness that is represented by a start-up may capture the idea of entrepreneurial entry well. Second, in the context of building a formal estimable model, the focus on nascent entrepreneurial activity alleviates endogeneity problems that are difficult to overcome in the context of cross-sectional data.
have low growth ambitions. Mean values of the dependent variable for each country are presented in Table 1.8
4.3 Explanatory Variables 4.3.1 Bankruptcy law We use four variables:
Ͳ restrictive reorganisation = 1 if there are restrictions for filing for reorganisation such as requiring creditors’ consent or minimum dividends;
Ͳ no automatic stay = 1 if there is no automatic stay on secured assets during reorganisation;
Ͳ management removed = 1 if there is mandatory removal of the incumbent management from control of the firm during reorganisation proceedings.
Ͳ secured creditors first = 1 if priority is given to secured creditors in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm.
Individual country scores on creditor rights index and its components can be seen in Table 1. These variables are available until 2003 (Djankov et al., 2007). We lag all our macro level explanatory variables by one year to address potential issues of endogeneity, so we can only use data until 2004. Since an important control variable (experience of previous business exit) is missing for 2001, we run regressions on the period from 2002 to 2004.
--- Table 1 ---
8 Estrin and Mickiewicz (2011) explain the advantages of using a categorical dependent variable as compared
4.3.2 Risk aversion and perception
We follow previous studies (Arenius and Minniti, 2005; Koellinger et al., 2007) in using “fear of failure” from GEM as a proxy for an individual’s risk aversion9. This can be understood as a measuring a combination of risk aversion and subjective perception of the risks involved in starting a new business. We also include the country-year mean of fear of failure to account for different societal attitudes to risk taking. This captures country-level factors affecting attitudes towards risk including possible common effects of bankruptcy regimes (Levie and Hart, 2010); by controlling for these effects we are able to identify the individual, personal, within-country heterogeneity in fear of failure, which is our primary interest.
4.3.3 Interaction effects
The interaction terms are created by multiplying each of the creditor rights variables and fear of failure dummy.
4.4 Control Variables
4.4.1 Individual level: Socio-demographic characteristics
The standard individual level controls for socio-demographic characteristics such as gender, age and education are included in all models as they have been shown to be significantly related to entrepreneurial entry and aspirations (Parker, 2009; Aidis et al., 2012; Reynolds, 2010; Estrin and Mickiewicz, 2011). Gender (female) is coded 0 for females. Age is included with age2 as an inverted-U shaped relationship with entrepreneurial entry has
been previously identified (Lévesque and Minniti, 2006). Education is controlled for by two dummy variables: secondary education indicates whether an individual has completed
9 The variable derives from the question ‘Would fear of failure prevent you from starting a business?”, coded as
0 for no and 1 for yes. It does not provide a pure measure of risk aversion, because it may also stem from the
respondent’s perception that they lack the skills, knowledge and experience necessary to start a new business (Caliendo et al., 2009).
secondary education (coded as 1) and higher education, which indicates whether an individual has completed higher education (also coded as 1). Finally, to control for previous business experience we include business exit, a dummy variable coded 1 for individuals who have shut down or discontinued a business in the previous 12 months.
4.4.2 Country level: Macroeconomic & institutional environment
In cross country equations it is important to control for the level of country development as this affects both the likelihood of starting a business and the institutional environment (Wennekers et al., 2005). We control for level of development by including lagged log GDP per capita taken from the World Bank’s World Development Indicators (e.g. Acs et al., 2008). We follow Estrin et al. (2013) in entering the variable in logs to take account of non-linearities. We include the size of domestic credit to the private sector as a percentage GDP (private credit/GDP) to control for the level of financial development and in particular of banking sector development (e.g. Djankov et al., 2007) as this will affect the provision of credit. These data also come from the World Bank World Development Indicators and are again lagged by one year to alleviate possible endogeneity.10
The potential effects of bankruptcy law may be confounded with a more fundamental omitted dimension characterising the legal order. To address this, we follow Estrin et al. (2013) in controlling for the security of property rights by using “constraints on the arbitrary power by the executive branch of government” from the Polity IV database, lagged by one year and called executive constraints.11 Tables 2-4 report the correlation coefficients for the independent variables. While there is some collinearity between some of the aggregate
10 Lee and Yamakawa (2012) use the real interest lending rate, testing for moderating effects. For our sample,
we verified that the use of real interest rate made no difference to other results, while the size of credit (over GDP) performs better as a control variable.
11 Claessens and Klapper (2005) found that countries with more efficient judicial systems have a higher use of
bankruptcy procedures. In other specifications (not reported) the Law and Order indicator from Country Risk was used as a more narrow measure of judicial efficiency. However, this variable was not found to be significant and did not alter the coefficients of other variables.
control variables, i.e. between GDP/capita, secondary education and business failure, the correlation coefficient is always below 0.6. There is no evidence of collinearity problems between the individual level variables. One may also notice relatively low correlations between the four elements of bankruptcy law, with an important exception of high correlation between the two dimensions we identified as most related to the issue of entrepreneurial control (management removed and no automatic stay on assets). The same conclusion can be reached via applying Cronbach’s Alpha measure which is low at 0.48. Nonetheless, our estimation strategy takes this potential collinearity into account, via separating the estimation of the four elements of the code.
--- Tables 2, 3 & 4 ---
4.5 Model Specification
The regressions are estimated using multilevel logistic regression because of the hierarchical nature of the data: individuals (level 1) are clustered in country-years samples (level 2). This means that an individual in the same country-year cluster has more similar characteristics to other individuals within the same cluster than to individuals in a different cluster. This poses a problem for traditional regression techniques as the errors cannot be assumed to be independent in clustered data (Bliese, 2002). All models are estimated using the same sample of 251,235 individuals. Logistic regression estimates the probability that an individual will be a high aspiration nascent entrepreneur. Logit coefficients were obtained by STATA’s xtlogit command via maximum likelihood estimation using adaptive Gauss-Hermite quadrature with means and variances. Estimation by logit is our preferred choice because we face a small proportion of observations in high aspiration entry compared to the
rest of the working age population and it can be proved analytically that logit coefficients are not affected by such a skewed distribution (e.g. Maddala, 2001). All models include random country-year effects to account for dependency of observations within 88 country-year clusters.12 The general equation for the models presented below is as follows, where ߨ
represents the probability of an individual starting a business, ȕ relates to coefficients, ī and ǽ to vectors of coefficients, #-indicates individuals,- D indicates countries and- & years so
D&-indicates country-years, ݑ௧is the country-year level residual and ݁௧ is the individual level residual: ൬ గೕ ଵିగೕ൰ ൌ ߚߚଵܾܽ݊݇ݎݑݐܿݕܿ݀݁݅݊݀݅ܿܽݐݎ௧ߚଶ݂݁ܽݎ݂݂݈ܽ݅ݑݎ݁௧ ߚଷሺܾܽ݊݇ݎݑݐܿݕܿ݀݁݅݊݀݅ܿܽݐݎ כ ݂݁ܽݎ݂݂݈ܽ݅ݑݎ݁ሻ௧ ሺ݅݊݀݅ݒ݅݀ݑ݈݈ܽ݁ݒ݈݁ܿ݊ݐݎ݈ݏሻ߁௧ሺ݉ܽܿݎ݈݁ݒ݈݁ܿ݊ݐݎ݈ݏሻ߄௧ݑ௧݁௧ (1)
Table 5 presents our specifications of equation (1), which includes only the control variables. Model (2) additionally contains the four creditor rights indicators. We go on to include each of the creditor rights indicators singly to address potential collinearity issues, corresponding to models (3), (5), (7) and (9). Each of these models is then followed by a model including the component’s interaction with fear of failure (i.e. models: (4), (6) and (8)).
12 Such dependency could also be dealt with by using country-year fixed effects but this would make the
inclusion of corporate bankruptcy law variables problematic, as they are characterised by very little variation over time, especially over our short time period.
5. RESULTS
For ease of interpretation, the coefficients reported in Table 5 have been exponentiated. For logit models that implies the reported values now correspond to the factors by which the odds of an individual being a nascent entrepreneur change for a unit change in the explanatory variable, holding all other variables constant.
We tested the suitability of using a multilevel random intercept model on our data. We estimated a null model with no coefficients and carried out likelihood ratio tests which confirm that a multilevel random intercept model is a more suitable model than a single level one (p<0.001). The residual interclass correlation (IC) – the degree of unexplained variance at the country-year level – was 17.0% for high aspiration nascent entrepreneurs.13 We then included year dummies, all the individual level controls and their country-year level means into the regression model (not reported). This reduced the residual interclass correlation to 8.5%. Next, we added our macro-level control variables: GDP per capita, private credit to GDP and executive constraints (model 1). But the reduction in residual interclass correlation was quite small; as a result, 8.1% of country-year variance was left unexplained.
--- Table 5 ---
Considering Hypothesis 1, we do not find support for either 1a or 1b. We note in columns 2 and 3 of Table 5 that the presence of restrictions on reorganisation has no significant effect on high aspiration entrepreneurship. We also fail to identify the predicted moderating effect through attitude to risk; the interactive effect between restrictions on reorganisation and fear of failure in column 4 is weakly significant and has an unexpected sign.
13 It was higher than for a comparator model we run using all nascent entrepreneurship (both high and low
aspirations) as dependent. This indicates that country-year characteristics are more important for high aspiration nascent entrepreneurs than for nascent entrepreneurs in general.
Hypothesis 2 concerned the impact of no automatic stays on secured assets, with the moderated effect through attitude to risk in Hypothesis 5b. The relevant coefficients reported in column 2, 4 and 6. We do not find support for the direct effect predicted in Hypothesis 2; the coefficients on automatic stays are insignificant in columns 2 and 4. However, we find strong support for Hypothesis 5b: no automatic stays on secured assets is strongly moderated by individual tolerance of failure. Thus, we observe in column 5 the interaction between no automatic stay and fear of failure is negative and significant at the 1% level. In Hypothesis 3, we predicted that the forced removal of management would have a negative effect on high aspiration entrepreneurs, and we find significant support for this in column 2. However, while the direction of the effect is also negative in columns 7 and 8, the estimated coefficients are not statistically significant. But the effect comes through very strongly when we consider the relationship moderated through individual attitudes to risk, in Hypothesis 5c. Thus, in column 8 the interaction of management removed with fear of failure is found to be negatively and highly significantly related (at 1% level) to high aspiration entrepreneurship. We also illustrate the scale of these effects by comparing the marginal change in odds ratio for individuals with high and low fear of failure in Figure 2. While for both categories, the removal of management has a negative effect (hence negative slope of both lines), the impact of this effect is more pronounced for individuals with high fear of failure (the slope is steeper). For individuals characterised by fear of failure, the odds ratio of being engaged in high aspiration entrepreneurship are reduced by 30%.
--- Figure 2 ---
The impact of secured creditor’s priority in claiming the assets of a bankrupt firm are summarised in Hypothesis 4. Since this element of the code applies primarily to creditors, we do not have a hypothesis of the effect moderated through entrepreneur’s attitude to risk. The
hypothesis is strongly supported by the data. Thus, looking at Models 2 and 9, we find that the coefficient on giving first priority to secured creditors is positive and consistently significant at 1% level. When we compared these results for high aspiration entrepreneurs with the results for all start-ups, priority given to secured creditors is consistently associated with about a 79% increase in the odds ratio for an individual being a high aspiration entrepreneur. Thus, we find that assuring secured creditor priority in claiming assets is an important aspect of creditor protection and facilitates the greater provision of credit which has a significant positive effect on high aspiration entrepreneurship.14
The models in Table 5 are consistent with the empirical literature on entrepreneurship with respect to the standard control variables. Thus we confirm that at the country level high aspiration entrepreneurship is more likely as property rights become more secure. At the individual level, male, educated and middle aged individuals are more likely to be high aspiration entrepreneurs. Individual fear of failure reduces the likelihood of being a high aspiration entrepreneur and experience of business exit increases it.
5. DISCUSSION
Bankruptcy codes influence the likelihood of individuals to become high aspiration entrepreneurs via effects on the motives of individuals to choose an entrepreneurial path and as a result of the amount of finance being made available for entrepreneurial ventures. The literature has until now treated bankruptcy codes as a linear ordering from harsh to lenient. We have argued that while the one dimensional continuum is a sensible way to characterise bankruptcy regimes from the perspective of creditors, it is less appropriate when considering the effects on entrepreneurs. This is because creditors and entrepreneurs care about slightly different aspects of bankruptcy laws, implying that the optimum design of the bankruptcy law
14 Estimates available on request of the interaction term of secured creditors first with fear of failure prove as
can partially reconcile the tensions between encouraging both entrepreneurship and the provision of credit. Importantly, once we distinguish the elements of the bankruptcy code affecting entrepreneurial incentives from those influencing creditors and the supply of finance, we can also investigate how the former may be moderated by the individual entrepreneur’s attitude to risk.
Thus we have analysed for the first time the varying effects of four aspects of bankruptcy laws – restrictions for reorganisations, stays on secured assets, mandatory removal of management, priority given to secured creditors – on high growth aspiration entrepreneurs, as well as the moderating effects of individual attitudes to risk on the impact of three of these regulatory aspects. The impact of any element of the bankruptcy code on entrepreneurship is argued to be composed of two effects. The first is that some pro-creditor elements of the code act to reduce the likelihood of an individual choosing to become an entrepreneur because of the effects on the expected outcomes following financial distress. These negative effects may be enhanced for risk-averse individuals. However, the direction of the effect may be reversed if entrepreneurs are financially constrained and increases in the supply of funds result from a more pro-creditor financial environment. Our results confirm that the bankruptcy code is indeed an important determinant of high aspiration entrepreneurial activity. However, as predicted its impact is differentiated depending on whether the relevant aspect of the code primarily influences perceived entrepreneurial or creditor returns. Thus different elements of the bankruptcy code have differential effects on high aspiration entrepreneurs, and these are particularly affected by individual attitudes to risk.
We commence by considering the element of the bankruptcy code most sharply focused to affect creditors but not entrepreneurs; whether secured creditors rank first in the distribution of the proceeds that result from the disposition of the assets of a bankrupt firm.
We find that this provision has a positive and significant effect on the likelihood of high aspiration entrepreneurship in a country. The importance of this guarantee from the perspective of creditors is that it increases the likelihood that they will be repaid in full whether the firm is successful or not. Moreover, the positive effects via the supply of finance are especially strong because the disincentive effects of such rules on potential entrepreneurs are extremely limited. When choosing whether or not to exploit an entrepreneurial opportunity, the individual is not likely to be concerned about the order in which his or her assets will be distributed in the event that the proposed business venture fails.
Turning next to the provisions which are primarily likely to de-motivate entrepreneurs, but unlikely greatly to influence creditors, namely the aspect of bankruptcy law related to retaining control by owner managers: no automatic stay on assets and management removed. Entrepreneurs have idiosyncratic knowledge (e.g. Hayek, 1945; Kirzner, 1973), which cannot be contracted out or sold. Therefore, they value control. Their new ventures are risky and financial distress is likely. Thus, for entrepreneurs, it is important they retain control during financial distress and aim to steer their companies forward based on what they know. Accordingly, aspects of bankruptcy laws that are harsh in terms of taking control away from entrepreneurs might be expected to have negative impact on their willingness to engage, especially in high aspiration, risky ventures.
Interestingly, the support for this argument as a general proposition was quite weak; there is no direct significant effect of no automatic stay on high aspiration entrepreneurship and only a weak effect from the removal of management. However, the results are thrown in sharper relief when we distinguish between individuals with high and low fear of failure. We identify a negative significant effect of both no automatic stays and mandatory removal of management on risk-averse entrepreneurs. Thus, risk-averse individuals are less likely to become high aspiration entrepreneurs in countries where there are no automatic stays
preventing creditors from unilaterally seizing the firm’s assets. This is probably because potential entrepreneurs judge that automatic stays will increase the chances that an ailing business will survive by allow time for a reorganisation plan to be developed. Moreover, in many cases the assets used for security to creditors will be vital to the running of the business, so if the creditors can obtain access to them during the reorganisation, the firm will be less likely to be able to continue in business. Similarly, we argued in the hypothesis section that whether or not management is required to leave the organisation when firms enter bankruptcy was likely to have a serious disincentive effect on potential entrepreneurs, especially for risk-averse entrepreneurs. We find that bankruptcy codes which require the removal of management reduce high aspiration entrepreneurship significantly more for individuals who are risk averse, than for those who have no risk of failure.
We were undecided in our hypotheses about whether restrictions on reorganisation when a firm enters bankruptcy would have a positive or a negative effect on high aspiration entrepreneurship. This was because such restrictions affect the incentives for both entrepreneurs and creditors. For entrepreneurs, they reduce the probability that the firm will survive bankruptcy proceedings. However, for creditors they may be more likely to be able to recover their loans rather than wait for the duration of a long corporate reorganisation. Hence we offered two versions of Hypothesis 1, with either a positive or negative impact on high aspiration entrepreneurship. In practice, we failed to identify any significant effect, which would suggest that the two forces might be approximately compensating. Unsurprisingly, we were also unable to identify a moderating effect depending on entrepreneur’s attitude to risk. Since the demotivating effects on entrepreneurs appear to have been approximately counter-balanced by an enhanced supply of finance in countries where there are restrictions on reorganisation, the enhanced negative impact on risk averse individuals could not be identified. This may also be because restrictions on the form of reorganisation is a fairly
general element of the bankruptcy rules, unlike securing creditors first or the absence of automatic stays, with which individual entrepreneurs cannot identify when evaluating the downside risks of business failure.
Thus we conclude that the element of national bankruptcy codes that act to secure creditors funds (priority given to secured creditors in distribution of assets) are associated with higher levels of high aspiration entrepreneurship. We would argue that this is through the mechanism of increasing the expected return on assets and therefore enhancing the supply of funds. The result also indicates that entrepreneurial activities, and especially those most likely to enhance growth and employment, may be constrained by the supply of funds. However, other aspects of bankruptcy laws act to deter entrepreneurs. For restrictive reorganisation, we would suggest that the effect of harsher bankruptcy laws on the supply of finance is offset by the disincentive effects on entrepreneurs, so the net effect is zero. At the same time, the two aspects which relate most directly to retention of control by owners managers (no automatic stay on assets; removal of management) have an unambiguous negative effect on individuals with higher fear of failure.
6. CONCLUSIONS
We argue that neither a creditor- nor debtor-oriented bankruptcy systems in of themselves are more encouraging for entrepreneurship; rather some elements of bankruptcy law matter more to creditors and other aspects matter more to entrepreneurs. This indicates that the optimum design of bankruptcy law may not imply just weighing out the advantages of encouraging entrepreneurship directly versus encouraging credit supply.
Our results support the view that some aspects of the harshness of bankruptcy code are in fact associated with an increase in the likelihood of high aspiration entrepreneurship. This is consistent with the view that the disincentive effects of a more penal bankruptcy system
that are less directly associated with the issue of managerial control, are more than offset by the impact of the increase in the supply of finance resulting from a more creditor friendly financial environment.
On the other hand, there are indications that potential entrepreneurs who are risk averse are discouraged by other elements of bankruptcy laws which are unfriendly towards entrepreneurs: replacement of management during bankruptcy proceedings and no automatic stay on assets in particular. For entrepreneurs it seems that the opportunity for a second chance in exercising once their firm is insolvent is the most significant part of bankruptcy laws.
There are a number of limitations of our study. Many of these relate to the data which we have at our disposal. Thus while the measures of creditor rights represent a major advance in terms of cross country measurement of the harshness of the bankruptcy code, our results support the arguments of Claessens and Klapper (2005) that the measures do not adequately capture the complexities of corporate bankruptcy law. Moreover, the variation of the indicators over time period for which GEM data matching the creditor rights indices are available is very limited. Future research would doubtless benefit from the development of more sophisticated and complex measures of bankruptcy codes, and from analysis over a longer period of time in order to resolve more effectively possible issues of causality and endogeneity.
A second important limitation is our focus on corporate bankruptcy law. This means that we restrict our attention largely to the effects of bankruptcy codes on registered firms. To some extent we can address this weakness by contextualising our hypotheses according to the objectives of the organisation, arguing that the harshness of the corporate code will impact disproportionately on high aspiration entrepreneurs. This is perhaps not too restrictive given the confines of the GEM dataset which refers primarily to high and middle income countries.
However, in developing economies, the bulk of new firm entry is in the informal sector, and is not registered. Hence, in countries with large levels of informal production, bankruptcy law will have less impact on entrepreneurial behaviour. There is a need for further research to explore the effects of the relevant bankruptcy arrangements on entrepreneurship in developing economies.
Our analysis has some important policy implications. The results suggest that financial institutions, in particular the harshness of the bankruptcy code, play a complex role in encouraging entrepreneurship. While there is some evidence to indicate that some elements of a harsh bankruptcy regime do deter some individuals from becoming entrepreneurs, especially those with a higher fear of failure, this impact may be offset for other elements of the code by a positive effect via the supply of finance. This strongly suggests that the limitation of the supply of credit is one of the principal constraints on entrepreneurship, and especially on high aspiration entrepreneurship which is likely most strongly to affect economic growth and jobs. Therefore, somewhat counter-intuitively, the policy conclusion is that the bankruptcy regimes which are more strongly pro-creditor with respect to securing priority for creditors are the ones more likely to raise the national prevalence rates of entrepreneurship. This conclusion however comes with an important caveat. While protecting creditors is a good policy, taking away entrepreneurial control of companies when there is financial distress may not be.
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