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BUSINESS-RELATED BANKRUPTCIES UNDER THE BANKRUPTCY (SCOTLAND) ACT 1985 (AS AMENDED)- PHASE 1: SCOPING STUDY

Summary

1 Introduction

1.1 In 2000, the Scottish Executive commissioned a scoping study to explore the requirements for more detailed research to examine the impact of business-related bankruptcy on business start-up and growth in Scotland. The Scottish Executive's policy focus is on business start-up, growth and survivability. However, it has been acknowledged that Scotland has displayed a lower than expected business birth rate, and that a significant proportion of these new-start businesses fail within a few years. Ministers of the Scottish Parliament expressed a commitment to achieve a higher business birth rate in Scotland, and a reduction in the business failure rate, resulting in an overall increase in business activity. Against this background there has been some concern that the process of sequestration, leading to the bankruptcies of business owners and partners, could be having an inhibiting effect on business start-ups: that entrepreneurs might be dissuaded from taking business risks where they are aware of the potential impact of current bankruptcy law should they fail. Equally, there is concern that those business people who are made bankrupt may be deterred from trying again.

1.2 Part of the problem in Scotland is the "stigma attached to business failure". It has been suggested that the Scottish parliament should "applaud business success and be less critical of business failure", and should encourage "entrepreneurs who have experienced genuine failure to get back into risk-taking". In December 1999 the Entrepreneurial Exchange published a paper proposing that "rather than punish and discourage those who fail [in business] we must encourage them to try again".

1.3 The failure of a small proportion of businesses results in the personal bankruptcy of the entrepreneur, working as a sole trader or partnership, or having given personal guarantees on loans made to a limited company. The Entrepreneurial Exchange views existing bankruptcy law as effectively punishing those who fail in business, and therefore feels that it acts as a barrier to enterprise, and suggests that there should be significant reforms to the law. Meanwhile, in England and Wales, an awareness of the need to reduce the financial and social consequences of those business failures which lead to bankruptcy has also been developing, and in March 2000 the Department of Trade and Industry's Insolvency Service published a consultation document ¹, suggesting possible reforms to the law.

1.4 This current study undertook a variety of research activities to explore how current bankruptcy legislation works in Scotland, what is known about the incidence of business-related bankruptcy, and what the impact is of bankruptcy on those who experience it, as well as on those who may simply see it as a possibility in the future.

2 Approach

2.1 The research approach for the scoping study contained four main elements:

• A literature search - to identify literature relevant to insolvency in general, and to business-related bankruptcy in particular, both in Scotland and in other jurisdictions;
• an analysis of existing data sources that provide information about bankruptcies in Scotland - to evaluate the extent to which they enable the numbers and characteristics of business-related bankruptcies to be identified;
• interviews with people affected by bankruptcy either personally or in a professional capacity - to gather information about the causes, process and impact of bankruptcy, to explore the views and experiences of those interviewed, and to identify potentially relevant issues. The interviews were followed up by two workshops - one for those with personal experience of bankruptcy and one for those who have professional involvement - with a view to feeding back the main findings of the scoping study research, validating these findings, and identifying any gaps;
• an assessment of potential research methodologies and approaches for use in a main study, including examination of their feasibility, and the potential risks and benefits. This has also included analysis of the likely costs of a main study, and of timescales for the study, and has involved the development of a detailed research specification for the study.

3 Bankruptcy

3.1 Current bankruptcy law in Scotland has three main objectives:

• to serve the economy and society as a whole, ensuring a climate in which debts are generally paid, by acting as a deterrent to non-payment;
• to provide for the repayment of debts to creditors: in sequestration the debtor's assets pass to a trustee, whose duty it is to realise them and distribute them equitably to all creditors;
• to provide relief to debtors unable to pay their debts: with sequestration, creditors can no longer exercise debt-recovery procedures against the debtor, whether formal or informal, and the debtor is generally discharged after three years irrespective of whether the debts have been paid ².

3.2 In contrast with some other jurisdictions, Scottish bankruptcy law does not place emphasis on protecting the business, the business's employees or the debtor's family, and may be considered more creditor-orientated than much bankruptcy law in continental Europe and the USA. Bankruptcy law does not currently provide for an independent assessment of the viability of a business, or for attempted business rescue, prior to sequestration. This is an important point to which we return later in the report.

3.3 The process of sequestration, which results in a person being declared bankrupt, is relatively simple and easy to invoke, but largely ineffective in recovering much of the debts owed to creditors. It is also very much more difficult to reverse, where a mistake has been made or a change of circumstances arises. Creditors tend to view sequestration as a last resort, except in specific circumstances - the Inland Revenue and Customs & Excise, for example, will tend to use it to prevent further debts building up. Debtors, however, who can petition the courts for their own sequestration, are tending to use it more frequently as a means of seeking relief from a burden of debt.

3.4 Most creditors, prior to petitioning for sequestration, will try other means of debt recovery and diligence - the formal processes of seeking the recovery of debts, including such actions as poinding and warrant sales ³. The interaction between informal debt recovery processes, diligence and sequestration is quite complex, and varies markedly between different types of creditor, and according also to the characteristics of the debtor and of the debt. There is no simple or consistent route that creditors follow. Rather decisions about debt recovery methods tend to be based on business considerations - the cost of the process in relation to the expected return.

3.5 As an alternative to sequestration, Scottish law provides for the use of a trust deed. A trust deed is a formal, legally binding contract between a trustee and a debtor, entered into voluntarily, under which a trustee administers the debtor's assets for the benefit of his creditors. A protected trust deed (trust deeds automatically become protected, unless creditors object) is binding on all creditors, and no further debt recovery measures may be undertaken.

3.6 From the debtor's point of view, a protected trust deed provides a way of dealing with intractable debt problems without having to meet the formal criteria of apparent insolvency, and without the social stigma of bankruptcy. However, there is no formal discharge from protected trust deeds after three years (as there is with bankruptcy), and debtors do still lose their assets.

3.7 Although many debtors are still unaware of the possibility of entering into a trust deed, the number of protected trust deeds is currently increasing rapidly in Scotland. In 1994/95 there were just 424 protected trust deeds registered, while in 1999/2000, at 2,353, they surpassed debtor petitions for sequestration for the first time.

4 Practice issues identified

4.1 In the course of the research a number of important issues were identified.

Defining business-related bankruptcy

4.1.1 At present, bankruptcy statistics in Scotland do not distinguish between business-related and consumer bankruptcies even on the most basic level. While the most appropriate definition for business-related bankruptcy in the Scottish context is not immediately obvious, a number of options do exist, as summarised in table 1.

Table 1. Summary of approaches to defining business-related bankruptcy

Effectiveness of sequestration

4.2 From the creditors' perspective, sequestration is not particularly effective; the rate of return is low, and in the majority of cases no payment is made to the creditors.

Impact

4.3 From the debtors' perspective the impact of sequestration can be devastating, even though little or no funds are realised for the creditors. What few assets may exist are often taken up by the costs of the sequestration process itself, and it might be said that the only beneficiaries are the insolvency practitioners who are appointed as trustees. Where the sequestration has been invoked by the debtor him/herself, however, the impact is more one of bringing relief from the pressures of creditors, though there is much evidence to suggest that debtors do not necessarily understand the full implications of sequestration when they enter into it, and that by then it is too late to do anything about it.

Lack of information

4.4 Lack of information and understanding seems to be the norm; debtors report having no-one to turn to for objective advice when they get into financial difficulty; solicitors and accountants generally have only a limited knowledge of bankruptcy law, and those with specialist knowledge tend to charge high up-front fees for their services. Businesses in financial difficulty are unable to afford the advice offered. At the same time, it appears to be a characteristic of failing businesses or of people falling deeper into debt that they do not seek advice, and try to tackle the problem by working harder, or by trying to trade themselves out of difficulty. Ignorance of the process of sequestration and of its likely impact was therefore widespread amongst those interviewed, despite the good efforts of the Accountant in Bankruptcy in providing easy-to-read booklets summarising the sequestration process.

Alternatives to sequestration

4.5 There is no hard information about the number of bankruptcies that could have been avoided if impartial professional advice had been available earlier, but the indications of the scoping study suggest that it could be considerable. A number of factors do prevent such advice being sought, including an unwillingness to admit to oneself or to others that there are financial difficulties, and the lack of suitable sources of advice. It is clear, for example, that while the Local Enterprise Companies throughout Scotland can offer considerable advice and assistance to businesses at start-up and when they want to expand, there is significantly less specialist advice available to offer businesses in difficulty, or even a health-check for those that appear to be trading normally. It is also the case that anyone can start up their own business (and almost anyone can become a director of a limited company) without any training or qualification. This can mean that many business owners are ill-equipped to deal with financial difficulties when they occur.

Different views

4.6 In the process of sequestration, several different people are involved: the creditor(s); debtor; the debtor's family; the trustee; the debtor's advisors (if any). The interviews undertaken during the scoping study indicate a lack of effective communication between the parties: the creditors tend to view the debtors as people who won't, rather than can't, pay; the debtors view the creditors as unreasonable; the debtors view the trustee as working in isolation and not keeping the debtor informed; and both the debtor and creditor view the trustee as taking most of the realisable assets for their own fees. Those Insolvency Practitioners interviewed in the study also tend to have a limited view of the debtors - that they got themselves into the situation they are in and to some extent deserve all they get.

4.7 There is certainly considerable scope for better communication between the participants, and for better understanding of their respective views.

Impact of sequestration

4.8 Although it certainly provides relief to many debtors, sequestration often has a devastating effect on the debtor and his/her family. Few are prepared for the seriousness of the effects and most are ignorant of even the basics, such as what will happen to their house. More than this, many of the worst psychological effects of sequestration come not from the effects of the legislation but from other factors - the feeling of having control taken out of their hands, the association in people's minds that bankruptcy equates to dishonesty (a significant number of contracts of employment, for example, make bankruptcy grounds for dismissal, along with criminal activity), and the very clear message that bankruptcy equates to failure. Many of these negative feelings are fuelled by the trustees and by the creditors, and much could be done to make the experience of sequestration much less negative than it is.

Impact on business start-up

4.9 No evidence could be identified in the scoping study to suggest that the possibility of bankruptcy, or the procedures surrounding sequestration, have any impact on business start-up or growth. Only in the case of people who have been bankrupt was there any suggestion that the experience would deter them from taking risks in the future - again, largely because of the associations that go with bankruptcy, or of the experience of failing in business, rather than the process of sequestration itself.

5 Issues for a main study

5.1 The scoping study examined the potential content of a main study, the research methods which could be adopted and the feasibility of undertaking a study, in terms of costs, the benefits it would bring and the potential risks.

5.2 Overall, there is a clear need for a systematic study of business-related bankruptcy in Scotland, both to identify the numbers and characteristics of such bankruptcies each year (currently no reliable statistics are collected), and to examine how current legislation and practice works and how these might be changed to the overall benefit of business and the economy.

5.3 However, the scoping study has also highlighted the very considerable potential to help people in business avoid sequestration, by providing suitable help and advice at an early stage and by encouraging the use of other, less formal, methods of debt recovery and management. These would offer higher rates of return for creditors whilst permitting, at least in some cases, the debtors' businesses to continue trading, and would potentially be of lower cost than the formal processes of sequestration. For this reason, the recommendations from the scoping study include significant reference to the need for action research - pilot-scale projects to investigate and trial approaches aimed at preventing business-related bankruptcies. At present, the Scottish Executive continues to monitor and learn from pilot studies underway elsewhere in the UK.

5.4 The main issues identified in the scoping study, and which would impact on the design of a main study, include:

• the difficulty of defining business-related bankruptcy and distinguishing between business-related and consumer bankruptcies;
• the potential importance of personal responsibility in business-related bankruptcies;
• the impact of bankruptcy on the businesses affected, and how this could have been changed;
• examining the relative effectiveness of sequestration against its objectives, and identifying potential alternatives;
• examining the potential for preventing business-related bankruptcies, through the provision to businesses of better information, and through informal methods of debt recovery.

5.5 The driving force behind a main study would be to identify ways of helping the business start-up and survival rates in Scotland, and to encourage entrepreneurial activity in the business community:

• by reducing the likelihood of business failure and bankruptcy occurring;
• by encouraging (genuine) business people who have gone bankrupt to recover quickly and to use their experience of failure to help build successful businesses;
• by reducing the negative impact that the fear of bankruptcy may have on entrepreneurial activity.

5.6 In order to address these objectives and aims, a main study needs to focus on a range of issues. A study would need to:

• develop an understanding of the incidence and characteristics of all bankruptcies, and of how to distinguish between business-related and consumer-related bankruptcies;
• identify how support could be provided more effectively at an early stage to businesses in difficulty, in order to reduce the incidence of business failure and the need for sequestration;
• analyse business-related bankruptcies according to the causes that led to them;
• establish baseline figures on the incidence of business-related bankruptcy, to enable monitoring of trends in the future;
• develop a better understanding of the pathways to bankruptcy in the business situation;
• examine the effectiveness of sequestration against its key objectives;
• identify whether there are alternatives to bankruptcy which could achieve the same overall objectives more effectively, perhaps for specific case types;
• assess the impact of bankruptcy on the individuals involved - the bankrupts themselves, their families, their creditors, professional practitioners, and the wider business community;
• identify ways in which bankruptcy law and practice could be altered, in order to result in better business sustainability, higher business start-up rates and a reduced negative impact on genuine business people;
• learn from the best practices in other jurisdictions, and identify the extent to which they could work in Scotland.

5.7 In order to focus on these issues, the research in a main study should gather a range of information about:

• sources of business support and advice;
• the incidence and characteristics of business-related bankruptcies;
• the effectiveness of sequestration and of alternatives to sequestration;
• the impact and effects of business-related bankruptcy;
• how current bankruptcy legislation works in practice, and potential changes to existing bankruptcy law.

5.8 In order to gather the information required by a main study, and to address its objectives, it is envisaged that such a study would comprise seven main strands:

• a literature review, based on, but not limited to, the list of relevant references provided in the scoping study's Second Strand Working Paper (LR);
• a statistical data collection exercise to collect objective data on the incidence and causes of business-related bankruptcy, and alternatives to it (SD);
• questionnaire-based surveys, involving entrepreneurs and key groups of individuals affected by, and working with, bankruptcy, trust deeds or diligence, to collect both qualitative and quantitative information on the causes, processes and implications of sequestration and associated measures (QS);
• interview-based research with a selection of questionnaire respondents, to provide more in-depth information (IR);
• case study-based research, following through a number of selected bankruptcies, involving interviews with all the key players involved - to provide a greater understanding of the processes involved in bankruptcy, of the differences of perception between different key players, and of the interactions between them (CS);
• review of sources of advice and support to businesses, and their applicability to businesses experiencing difficulty; assessment of their current services in relation to business needs and identification of potential development areas to serve business needs better (AS);
• an action research study, to examine potential alternatives to or diversions from the sequestration process (AR).

5.9 Table 2 illustrates how each of the suggested methodologies would contribute towards providing the information required by a main study.

Table 2. Contribution of different methodologies towards required information

5.10 Suggestions for possible action research projects have emerged from the scoping study, including:

• well business clinic - a source of information and advice to be offered to businesses trading normally, or those in some trouble at an early stage - often before the business itself knows it is in trouble. Such a clinic could offer a free check-up and diagnostic information on businesses, and sound professional advice for those in, or heading for, trouble.
• key performance indicators - publication of a set of key performance indicators which might help to highlight to businesses that they may be heading for trouble;
• debtline - an anonymous telephone helpline to provide information and advice to businesses in difficulty, to offer professional advice, and encourage management action to be taken on debt before the burden becomes insuperable;
• intensive care unit - aimed at rescuing businesses that are in severe difficulty and where the owner, partner or director is heading for sequestration. This service could offer an independent assessment of the viability of a business and - if considered to be worth rescuing - provision of the support and resources required to attempt rescue;
• recovery and rehabilitation - aimed at assisting bankrupt people return to business. This service would include finding practical ways of tackling the barriers bankrupt people encounter, as well as providing the advice and support they need.

5.11 All of the research methods proposed for a main study present some practical difficulties, but analysis of these suggests they are not insurmountable.

6 Conclusions and Recommendations

6.1 The scoping study has failed to find any clear evidence that bankruptcy law itself is responsible for deterring potential entrepreneurs from starting up in business, though it may act to dissuade or prevent people from going back into business following sequestration. However, it does seem clear that a real issue exists around the provision of support to business people who are running into difficulties. Scottish Executive policy is to focus on business creation, survivability and growth but there appears to be limited public assistance available to businesses in difficulty. The support which is available is frequently inappropriate, incompetent, or too expensive to be accessible. Consequently, many business people do not receive the information and advice that might enable them to turn their business around, overcome their debt problems, and avoid sequestration.

6.2 While the experience of sequestration may serve to deter people from setting up another business, there is little doubt that the experience of failing in business, and building up intractable debt problems, is also a very significant deterrent to further enterprise in many cases. The impact of providing effective business support would therefore go beyond avoiding bankruptcy itself, and would include reducing or preventing the negative impact of business failure itself.

6.3 Against this background, a study of business-related bankruptcy is clearly needed, firstly to provide the baseline statistics required, secondly to provide a better understanding of its causes, and thirdly to establish how the negative impact of business-related bankruptcy could best be ameliorated, or bankruptcy itself avoided.

6.4 Table 3 below provides a summary of the feasibility issues for a main study.

Table 3. Summary of feasibility issues

6.5 Specific recommendations are:

• A statistical analysis of the Register of Insolvencies should be undertaken.
• Statistical data collection on business-related bankruptcies should commence, through additions being made to the Supplementary Questionnaire. The amended version should then be issued to all insolvency practitioners, along with a letter of introduction and guidelines.
• A pilot should be started for undertaking additional research with recently bankrupt people, including an investigation of their business books. Initially, insolvency practitioners, and others, should be approached with a view to forming a working party to produce defining criteria for the investigation and data collection. With additional regard to other aspects of the research with recently bankrupt people, it is recommended that some of these bankruptcies be used as the basis of case studies, involving interviews with their creditors, trustees, and other relevant professionals, as well as the debtor.
• A systematic review of services to businesses in difficulty should be undertaken, including an evaluation of how relevant they are to the needs of businesses.
• The possibility of developing one or more action research projects providing support to businesses in difficulty should be examined, these discussions to take place with policy makers, the enterprise network, business-related organisations and potential funders.

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