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

3 Key Issues in the Study of Business-related Bankruptcy

3.1 Introduction

3.1.1 The purpose behind the scoping study was to prepare recommendations for a larger, more detailed study of business-related bankruptcy in 2001. The scoping study was therefore aimed at developing an understanding of the issues involved in business-related bankruptcy, and in defining possible research approaches.

3.1.2 The main issues identified in the scoping study, and which 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.

3.2 Distinguishing between business-related and consumer bankruptcy

3.2.1 At present, bankruptcy statistics in Scotland do not distinguish between business-related and consumer bankruptcies at even the most basic level. This is clearly an important omission, since it severely limits the extent to which the impact of government policies regarding business start-up, growth and long-term development can be measured in terms of the long-term sustainability of businesses.

3.2.2 Thus while business growth is encouraged, maintaining the status quo is not given significant attention and management of decline or recovery is neglected by most business support agencies. This imbalance in the support offered to businesses appears to contribute to the incidence of business-related bankruptcies, but the lack of statistical data on the numbers of business-related sequestrations and protected trust deeds makes it impossible to examine inter-relationships such as these in any detail. The primary task for a main study would therefore be to derive an appropriate means of monitoring business-related bankruptcies in a meaningful, reliable and reproducible way.

3.2.3 The most appropriate definition for business-related bankruptcy in the Scottish context is not immediately obvious, although a number of options do exist.

3.2.4 At a simple level, it is possible to define business-related bankruptcy entirely on the basis of whether or not the debtor has any involvement in running a business. However, experience in other jurisdictions, and experience from the scoping study, suggest that such an approach is too simplistic to be useful.

3.2.5 Various examples of statistics of business-related bankruptcies can be found in other jurisdictions ¹⁹. Different jurisdictions use different definitions, and in some the adopted definitions do not appear to be applied consistently. An important element in some of these definitions is whether all outstanding debts, or a certain proportion of them, are business debts, as compared with consumer debts. One option for identifying business-related bankruptcies in Scotland would be to follow this approach, and to use simple information provided by debtors about their debts, to categorise cases according to the nature of the debt.

3.2.6 However, there are problems with employing this approach. Some debts can quite easily be categorised as business-related (for instance, debts to commercial suppliers, Inland Revenue or Customs & Excise, or debts for professional fees), while others are obviously consumer debts (for instance, debts on store cards, for catalogue purchases or, less clearly, for council tax). In other cases, however, it may be difficult, or impossible, to tell at first glance whether a particular debt is business- or consumer-related, without obtaining additional information from either the debtor or the creditor. Debts owed to banks and utilities companies are examples - since they could relate to either consumer spending, or to business spending.

3.2.7 In addition, however, even if the nature of the debt itself could be accurately established, this would not provide evidence about how the debts had arisen. Even those debts which are clearly business debts - such as arrears owed to the Inland Revenue or Customs & Excise - may have in fact been incurred due to excessive drawings having been taken from the business in order to support consumer spending. Similarly, debts such as credit card debts, which may appear to constitute consumer spending, may in fact have been incurred through the credit card being used to provide working capital for the business; and personal loans may have been taken out to support the business.

Table 4. Approaches to defining business-related bankruptcy

3.2.8 A further option is therefore for a bankruptcy to be defined as business-related only when the debts leading to bankruptcy have been incurred in the course of running the business, rather than as a result of consumer spending. This approach is concerned with the root cause of the debt, rather than the nature of the debt, or whether there is simply an association between the debtor and trading as a business. It is intended to distinguish between bankruptcies that occurred as a result of business difficulties, and those caused by personal excess. However, a superficial examination of the debts would not be sufficient clearly to establish this root cause. Rather it would be necessary for an investigation to be made, including an examination of the business's books, and analysis of drawings taken, in order that the root cause could be established.

3.2.9 In practice, examination of individual bankruptcies will undoubtedly result not in two clear-cut categories of business-related bankruptcy and consumer bankruptcy, but in a continuum, with some clear-cut cases at each extreme and the majority including both business and consumer elements.

Figure 1 - the continuum of bankruptcies

3.2.10 Details provided by a trustee about one particular bankruptcy illustrate the type of case belonging somewhere in the middle of this continuum:

"Around 4 or 5 years ago, if the debtor was insolvent then he was only marginally so - 2-3k. Over the past two or three years he has suffered bad debts of around 5000. The business was making 15k - 25k but turnover and profits have declined. Work referred by manufacturers has declined. His wife lost her baby and stopped working for 2 or 3 years which added pressure to household finances. Profitability has fallen from 10k to 15k but expenditure has continued unabated. Moved to a bigger house with a larger mortgage in 1998. This is acknowledged as a serious mistake as the timing could not have been worse!"

3.2.11 While it is clear that personal expenditure played a part in this particular bankruptcy, the debtor's main debts are owed to Customs and Excise and various trade suppliers. The relative failure of the business over recent years clearly contributed to the bankruptcy. However, this was oHoweHcombined with the "personal excess" of moving to a larger house with a bigger mortgage, despite household finances being under pressure due to the reduced profitability of the business and to the loss of a second income.

3.2.12 For the purposes of a main study into business-related bankruptcies it is proposed that sufficient information be gathered about each bankruptcy for both the nature of the debts, and their root cause to be identified. Having gathered this information it will be possible to identify the characteristics of the continuum, how to position individual examples of bankruptcy within the continuum, and how to identify meaningful groupings of bankruptcies. As a result of this process it will be possible to develop a simple and repeatable basis for distinguishing business-related and consumer-related bankruptcies, which could then be used for permanent statistical monitoring purposes.

3.3 Assessing debtor responsibility for bankruptcy

3.3.1 The research undertaken in the scoping study suggests that both professional people, and debtors themselves, would like to see a distinction being made between honest people who go through bankruptcy and those who are dishonest or guilty of fraud. Within the literature on bankruptcy, proposals also exist for bankruptcy law discriminating between bankrupts on the basis of their honesty or dishonesty.

3.3.2 At present, if a trustee suspects fraud, or that an offence has been committed under bankruptcy legislation, the case will be referred to the Crown Office and may eventually lead to prosecution. In practice, it would appear that relatively few cases are pursued, and that the number of successful prosecutions is low, though statistics are not currently available. Clearly, if bankruptcy legislation were to discriminate between the honest and the dishonest, the latter category would include those who had been successfully prosecuted. Attempting to include bankrupts in the "dishonest" category without such evidence would appear to be a project fraught with difficulties and dangers, and would certainly raise human rights issues.

3.3.3 Nevertheless, an assessment of the extent of the debtor's own responsibility, or even culpability, may be seen as making an important contribution to understanding business-related bankruptcy, and the different pathways to bankruptcy.

• At one extreme there may be cases of business failure which arise for reasons entirely outwith the businessperson's control - a downturn in the market, strong competition, suddenly increased costs - for which there may be little remedy, other than perhaps a clear change of business direction.
• Personal problems commonly play a role in bankruptcy, and in some cases business failure may have been precipitated by problems such as ill health, family breakdown, bereavement or alcoholism. Such problems may distract the person running a business, resulting in a fall-off in work undertaken, or inattention to some aspects of the business, perhaps resulting in loss of financial control.
• There are also cases of business failure which have more predictable causes and which early business advice might be able to prevent. Such causes include under-capitalisation of the business venture, unrealistic cash projections, ineffective management, over-trading, lack of financial control and over-staffing.
• At the far end of the spectrum are the instances of recklessness or dishonesty. Perhaps a business owner tries to trade him/herself out of trouble, knowing that the odds are stacked against success, or even deliberately engineers a business failure in order to avoid mounting debt and as a step towards re-starting under a new trading name.

3.3.4 Even in some of these last cases, however, the apparent recklessness may have been caused by panic, or a desperate desire to save the business, rather than deliberate dishonesty. Where the business owner employs staff, he/she may attempt to continue trading, against the odds of success, in order to protect the jobs and security of the staff, and may incur debts in order to do so. To the debtor, their actions may appear responsible and in the best interests of the business and the staff. To an outsider, such actions may appear irresponsible, ill-judged, or even bordering on the dishonest.

3.3.5 In the absence of a prosecution, it may be inappropriate to distinguish bankruptcies on the basis of the dishonesty of the debtor. However, as part of the investigation into individual bankruptcies for a main study, it is proposed that an assessment be made of the extent of the debtor's responsibility. This element could then be built into the understanding of business-related bankruptcy developed during the course of a main study, and used to help determine the placing of individual bankruptcies within the continuum.

3.3.6 In addition, it may be appropriate for this main study to undertake some specific investigation of bankruptcy cases in which dishonesty has either been alleged or proven, through submission of suspected offences reports and/or prosecutions. As well as providing statistics about the numbers of such cases, and their outcome, this investigation should help to clarify the characteristics of cases where culpability is clear, and the ways in which these differ from the majority of cases.

3.4 Outcome of bankruptcy for the business

3.4.1 The research undertaken during the scoping study suggests that there is a range of possible outcomes for businesses involved in bankruptcy. In some cases the business has already been closed down prior to sequestration taking place, while in others the business is closed down at the time of the sequestration. Yet there are also cases in which the trustee continues to run the business, for varying lengths of time, in order to sell it on as a going concern, and some sole traders simply continue trading throughout, apparently unaffected by the sequestration. As part of the investigation into individual bankruptcies for a main study, it is therefore proposed that an examination be undertaken of what happened to the business at the time of sequestration, the circumstances of each individual case, and the factors contributing to this outcome.

3.4.2 The findings of the scoping study also suggest that if business people were to seek assistance, and were able to obtain the specialist advice and support needed, then in a proportion of cases sequestration might be averted. As an additional element in the investigation into individual bankruptcies for a main study, it would therefore be useful to undertake an objective assessment of the underlying viability of the business, and whether appropriate intervention could have turned the business around. Included in this assessment would be questions of whether the business was only apparently insolvent, or whether it was also practically insolvent and/or absolutely insolvent, and whether the business was essentially profitable though experiencing cash flow problems, or clearly unprofitable.

3.5 Relative effectiveness of sequestration

3.5.1 It is clear from the research in the scoping study that the process of sequestration is of limited benefit. For the creditor it offers a very low return in comparison to other means of debt recovery and for the debtor, in cases resulting from creditor petitions, the process can seem, and often is, draconian in its impact and difficult to escape from. The only area where it is perceived as offering significant benefit is in cases where the debtor petitions for his/her own sequestration - in which cases it can offer welcome relief to the debtors from the burden of debt they carry. Even in these cases, however, debtors often appear unaware of the true impact of the process, and only learn of these after the event, by which time it is difficult or impossible to reverse the process.

3.5.2 A full study should therefore address the extent to which the current options offered by legislation meet their objectives: what they offer the creditor, the debtor, and those involved in the administration of the process.

3.5.3 As part of this, an assessment of whether the sequestration is likely to result in a dividend being paid out to the creditors should be included in the investigation undertaken into individual bankruptcies. This would help identify how those business-related bankruptcies resulting in payment of a dividend differ from the rest. From the point of view of the creditors these would appear to be the most "successful" bankruptcies, but it will be important to establish in what circumstances, and at what cost to others (such as employees, the business community), this success is achieved.

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