Are there alternatives to bankruptcy? A study of small business distress in Spain

Business bankruptcy rates (ratio of the number of business bankruptcy filings to the number of business exits) in Spain are among the lowest in the world, which means that Spanish firms rarely enter a formal bankruptcy procedure. The goal of this paper is to explain this empirical observation, which may imply that economic agents regard the system as inefficient and try to deal with financial distress in alternative ways.¹ For that purpose we employ a large sample of Spanish, French and UK firms, finding that small businesses in Spain, unlike their European counterparts, rely on mortgage foreclosures² as the main alternative to bankruptcy proceedings.

According to Table 1 Spain had the second lowest bankruptcy rate out of 26 countries, including both high-income and emerging economies, in 2006. An even more striking observation is the difference in the orders of magnitude between Spain and other developed economies: for instance, while there were around 29 bankruptcies per 100 firm exits in France and 16 in the UK, there were 0.3 in Spain. Only the deep economic crisis that Spain is currently experiencing has modestly increased the number of bankruptcy filings, but the Spanish bankruptcy rate was still one of the lowest in the world in 2010 (see Table 1).

However, the use of bankruptcy procedures by Spanish businesses varies widely depending on the size of the distressed firms, as shown in Fig. 1. While the rates of micro firms (businesses with less than 10 employees) were around 0.15 % in 2006 and they have just reached 1.3 % during the economic crisis, those of non-micro firms were 10.4 % in 2006 and they have increased up to 90 % during the crisis, in line with the aggregate rates of developed countries. Since micro firms account for more than the 95 % of firms in Spain,⁴ they are the key drivers of the low bankruptcy rate of Spanish companies. They are also very important in terms of economic activity: they accounted for 51 % of total employment and 28 % of total value added before the economic crisis and they currently account for 39 and 25 %, respectively.⁵ Finally, although the available evidence is rather limited, Spanish micro firms seem to file for bankruptcy much less than some of their European counterparts: in 2006, the bankruptcy rates for self-employed and micro enterprises were 0.01 and 0.15 %, respectively, in Spain, while those in France were 11.1 and 23 %,⁶ and the bankruptcy rate for self-employed in the UK exceeded 16.2 %.⁷

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Spanish micro firms also have other distinct characteristics. They hold, by far, the largest proportion of mortgage loans over financial debt, as shown in Fig. 2. Filing for bankruptcy is especially unattractive for them because a significant proportion of the bankruptcy costs are fixed (Van Hemmen 2011).⁸ Personal bankruptcy may apply to many of those firms regardless of their legal form, because the distinction between limited and unlimited liability may be blurred for them, partly because lenders require personal guarantees or security in the form of a mortgage on the owner’s home (Berkowitz and White 2004).

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Consistent with those stylized facts, our hypothesis on the low business bankruptcy rates in Spain is the following. Filing for bankruptcy in Spain is very costly for both small firms and their creditors. Due to this, the capital structure of micro firms is biased towards mortgage loans (i.e., loans secured on land and buildings). Having this capital structure allows them to avoid bankruptcy by carrying out debt enforcement via mortgage foreclosures,⁹ which are cheaper procedures than bankruptcy, in case of financial distress.

In order to test this hypothesis the optimal identification strategy would be to analyse the impact of substantial changes in the Spanish bankruptcy law in both bankruptcy rates and firms’ capital structure. The current bankruptcy code entered into force in 2004 after a major legislative reform. But it seems that the de facto insolvency framework barely changed because the performance of bankruptcy proceedings did not seem to substantially improve (Gutiérrez 2005; Van Hemmen 2004), bankruptcy rates did not increase after the introduction of the new code and it seems that firms’ capital and asset structures have not changed either (Celentani et al. 2010).

By contrast, our identification strategy relies on cross-country comparisons. Specifically, we compare the observed choices (choice of capital structure, choice between bankruptcy and mortgage) of Spanish firms with those of firms from countries where their bankruptcy systems are more efficient and their laws do not incentivise them to bias their capital structure towards mortgage loans. France and the UK are chosen as the comparison group because their bankruptcy rates are much higher than the Spanish ones and because of the specific features of their insolvency frameworks.¹⁰

Our findings corroborate the proposed hypothesis. First, there is a positive and strong correlation between the ex-ante probability of default and the ratio of tangible fixed assets (the assets that can be pledged as mortgage collateral) to financial debt in the case of Spanish micro firms, suggesting that firms with risky business models bias their capital structure towards mortgage loans to avoid filing for bankruptcy in the event of default. Second, a higher proportion of tangible fixed assets over financial debt significantly decrease the probability of being in bankruptcy among Spanish micro firms in financial distress. By contrast, these two relations do not hold either for Spanish larger businesses or for firms from the other two countries.

Finally, we must stress the importance of the research question. The model of García-Posada (2013) predicts that, in the context of the Spanish insolvency framework, there is a positive relation between bankruptcy rates and welfare. The intuition is that low bankruptcy rates and low welfare are the outcome of an institutional design characterised by the low efficiency and low creditor protection of the bankruptcy system relative to those of an alternative insolvency institution, the mortgage system. In that context, firms and their creditors avoid filing for bankruptcy by heavily relying on mortgage collateral, which can be repossessed and liquidated in the event of default. The problem is that the mortgage system is not well suited for some firms, which need to bias their asset structure to have enough collateral, with the ensuing productive inefficiencies. Those firms would be better off if they had access to a bankruptcy system that worked relatively well. In other words, as the bankruptcy and mortgage systems are imperfect substitutes, the equilibrium in which only mortgage is widely used (reflected in low bankruptcy rates) is Pareto dominated by the equilibrium in which agents can choose between the two insolvency institutions (reflected in higher bankruptcy rates). His analysis also predicts that bankruptcy will be unfeasible for the smallest firms in the economy as long as some of the bankruptcy costs are fixed. As some of those firms will have to overinvest in capital assets to sign their contracts under mortgage, they will incur in productive inefficiencies. If the absence of a well-functioning bankruptcy system for those firms also reduces their growth opportunities—e.g., by hampering access to unsecured lending such as venture capital—then the current insolvency framework may help explain the firm size distribution and the low aggregate productivity of the Spanish economy. This is consistent with the evidence of Fabbri (2010) in Spain, who finds that lengthy bankruptcy procedures decrease firm size and raise funding costs and with that of Ponticelli (2012) in Brazil, who shows that congestion in bankruptcy courts substantially reduces firm-level investment and productivity.

The rest of the paper is structured as follows. Section 2 provides a brief literature overview and discusses the paper’s main contributions. Section 3 discusses some key features of the insolvency framework of Spain, France and the UK Sect. 4 focuses on data sources and sample selection criteria. Section 5 explains the empirical testing of the hypothesis. Section 6 concludes. Appendix A provides a description of the main legal concepts used in this paper and Appendix B contains some robustness analyses.

This paper is mainly related to the works of Morrison (2008, 2009), and Celentani et al. (2010, 2012). Morrison (2008, 2009) studied why US small distressed firms—defined as those with 500 or fewer employees—rarely file for bankruptcy. He argued that there are cheaper procedures for these firms, such as assignments for the benefit of creditors,¹¹ bulk sales,¹² foreclosures and private workouts. Their implementation, however, require that neither the debtor firm nor the creditors’ file for bankruptcy. They also face, unlike the bankruptcy system, major coordination and asymmetric information problems that may hamper their use. Thus he identified the conditions under which these problems are not very important so those procedures can be implemented: small firms, with simple capital structures (i.e., low number of secured creditors) and with close and trustworthy relationships with their creditors are likely to avoid filing for bankruptcy. This paper applies a similar reasoning to the Spanish, British and French case: wherever there are cheaper alternatives to bankruptcy, the latter will only be used when parties don’t reach an agreement, becoming the residual option.

Celentani et al. (2010, 2012) were the first that studied the low bankruptcy rates in Spain. They proposed an explanation that was not immediately contradicted by a number of aggregate stylized facts. Specifically, they used the theoretical prediction of Ayotte and Yun (2009), according to which low creditor protection and low judicial ability imply low bankruptcy rates, to conjecture a wide set of activities (leverage reduction, lenders’ screening and monitoring, choice of projects that trade off return for lower risk and/or lower liquidation costs, use of mortgage collateral) in which firms and their creditors could engage to reduce the probability of bankruptcy. This paper focuses on one of their ideas, the use of mortgage foreclosures as an alternative to formal bankruptcy procedures. To the best of our knowledge, this is the first study that addresses the research question with firm-level data, which allows testing the hypothesis by means of econometric analyses.

In this section we will focus on the features of the insolvency frameworks of Spain, France and the UK related to our hypothesis, namely, the choice between bankruptcy procedures and mortgage foreclosures and the choice of firms’ capital and asset structures. We will examine the incentives to file for bankruptcy of both the debtor firm and its creditors, as alternative procedures such as mortgage foreclosures can only take place if both parties refrain from filing. For a more thorough analysis of the insolvency frameworks see Celentani et al. (2010, 2012) and Davydenko and Franks (2008).

The firm-level data come from the OECD-Orbis database, which is the result of the treatment of the commercial database Orbis by the OECD (Ribeiro et al. 2010; Ragoussis and Gonnard 2011). Orbis contains financial information on both private and publicly held companies around the world although coverage, especially of small firms, greatly varies across countries. Orbis also provides other non-financial information, such as year of incorporation, industry, legal form and status. Status is a variable that tells the legal and economic condition of the firm: for instance, if the company is active or it has ceased its operations and if it is undergoing a bankruptcy procedure or not. The data have, however, some important limitations. First, if a business shut down without filing for bankruptcy, the records do not indicate which alternative procedure the firm used.²³ Second, the status is only observed at the moment in which the data are extracted from the database, i.e., no historical records are kept. Since the data from Orbis were extracted in 2010 (December 31, 2010), we have the status of each company at that time. Finally, as Orbis is a commercial database, our sample may not be representative of the whole population. We address this potential criticism in Appendix B.

Regarding the sample selection, we use data on firms from three countries: Spain, France and the UK We only keep their financial data for 2008 because of two reasons. First, the main variable in all our analyses will be constructed using the information on status, which is only available for 2010. This makes panel data an unfeasible structure for the sample, since the variation in the main variable will happen across sections, but not across time. Second, because of the time lag in the submission of financial statements by firms, the Orbis database is characterised by a typical time lag of 2 years (Ribeiro et al. 2010), which implies that coverage (in number of companies with complete records) for 2009 and 2010 is very poor, leaving 2008 as the best choice. While this time gap could be problematic, it alleviates a simultaneity bias that may arise if the bankruptcy process or the alternative insolvency procedure affects the company’s financials (e.g. a foreclosure on some of the firm assets or a debt haircut), as our regressors will be lagged twice. We also apply some filters to clean the data. We exclude state-owned companies, non-profit organisations and membership organisations. To avoid double-counting of information we eliminate all consolidated accounts for which unconsolidated information exists. Finally, we remove inconsistent observations²⁴ and extreme values. Our final sample has more than 560,000 firm-level observations.

For the empirical analyses of this paper it is crucial to distinguish between financially distressed firms and non-distressed ones. While it is probably safe to assume that all firms under bankruptcy proceedings are distressed (rarely will a healthy business file a bankruptcy petition), for the rest of observations we proxy distressed businesses as those whose interest coverage ratio (EBITDA²⁵ over interest expenses) is lower than 1.

We then construct several variables. Bankruptcy is a dummy variable that equals 1 if the firm was bankrupt when the data were extracted (2010). To measure the probability of default we use the Altman’s Z-Score (Altman 2000).²⁶ As the Orbis database does not contain specific information on mortgage loans, we need to construct a proxy for the proportion of those loans on total debt. The proposed proxy is “Tangibility”, which is computed as the ratio between tangible fixed assets (land, buildings, plant and machinery)²⁷ to financial debt, in percentage terms. Since tangible fixed assets are the only assets that can be used as mortgage collateral in Spain, we relate those assets with the debts they may secure. For robustness, we have carried out all this paper’s analyses with an alternative proxy that includes trade credit, namely the ratio between tangible fixed assets to total debt, reaching very similar conclusions, which is not surprising given the high correlation between the two proxies.²⁸

As controls, we use a dummy that equals 1 if the firm has limited liability, the firm’s age, the firm’s size—computed as the number of employees²⁹—and industry dummies. According to Berger and Udell (1995) and Petersen and Rajan (1994), firm’s age captures the public reputation of the firm, since they find a negative relationship between firms’ age and interest rate premium charged by banks. Davydenko and Franks (2008) interpret age as a proxy for information asymmetries between a firm and its lenders, since they find negative impact of age on the probability of filing for bankruptcy (vis-à-vis using out-court procedures). Age may also capture coordination costs, as older firms are more likely to maintain multiple bank relationships (Hernández-Cánovas and Köeter-Kant 2008). With respect to firm’s size, small firms may file less for bankruptcy if a substantial proportion of the bankruptcy costs are fixed (Morrison 2008) or if personal insolvency laws are very severe, although the relationship between size and bankruptcy need not be linear because very large firms may prefer to avoid the adverse publicity of a bankruptcy filing. To correct for right skewness we will take logs of age and size in our statistical analyses.

Our hypothesis on the low business bankruptcy rates in Spain leads to two testable hypotheses regarding firms’ behaviour ex-ante (i.e., prior default) and ex-post. From the ex-ante perspective, as filing for bankruptcy is very costly, small firms with risky business models will bias their capital structure towards mortgage loans to avoid filing for bankruptcy in the event of default. From the ex-post perspective, holding mortgage debt will reduce the probability of filing for bankruptcy by a small financially distressed firm. These two implications should not occur in the case of either Spanish larger businesses or firms from the other two countries.

Spain had, before the current economic crisis, one of the world’s lowest business bankruptcy rates, i.e., the number of business bankruptcy filings divided by the number of business exits. Only the crisis has modestly increased the number of bankruptcies, but the Spanish bankruptcy rate is still one of the lowest in the world. This fact is driven by the behaviour of micro firms—the majority of Spanish firms—which rarely file for bankruptcy when dealing with financial distress.

This paper presents and tests a hypothesis that attempts to explain this empirical finding. According to this hypothesis, filing for bankruptcy in Spain is very costly for both small firms and their creditors. Due to this, the capital structure of micro firms is biased towards mortgage loans (i.e., loans secured on land and buildings). Having this capital structure allows them to avoid bankruptcy by carrying out debt enforcement via mortgage foreclosures, which are cheaper procedures than bankruptcy, in case of financial distress.

To test this hypothesis our identification strategy relies on cross-country comparisons. Specifically, we compare the observed choices (choice of capital structure, choice between bankruptcy and mortgage) of Spanish firms with those of firms from countries where their bankruptcy systems are more efficient and their laws do not incentivise them to bias their capital structure towards mortgage loans. France and the UK are chosen as the comparison group because their bankruptcy rates are much higher than the Spanish ones and because of the specific features of their insolvency frameworks.

Our findings corroborate the proposed hypothesis. First, there is a positive and strong correlation between the ex-ante probability of default and the ratio of tangible fixed assets (the assets that can be pledged as mortgage collateral) to financial debt in the case of Spanish micro firms, suggesting that firms with risky business models bias their capital structure towards mortgage loans to avoid filing for bankruptcy in the event of default. Second, a higher proportion of tangible fixed assets over financial debt significantly decrease the probability of being in bankruptcy among Spanish micro firms in financial distress. By contrast, these two relations do not hold either for Spanish larger businesses or for firms from the other two countries.

We must stress the importance of the research question. Bankruptcy procedures and mortgage foreclosures are not perfect substitutes, and the underutilization of one of them—reflected in low bankruptcy rates—may lead to efficiency losses and lower welfare (García-Posada 2013). The reason is that the mortgage system is not well suited for some firms, which need to bias their asset structure to have enough collateral, with the ensuing productive inefficiencies. Those firms would be better off if they had access to a bankruptcy system that worked relatively well. If the absence of a well-functioning bankruptcy system for those firms also reduces their growth opportunities—e.g., by hampering access to unsecured lending such as venture capital—then the current insolvency framework may help explain the firm size distribution and the low aggregate productivity of the Spanish economy. This is consistent with the evidence of Fabbri (2010) in Spain, who finds that lengthy bankruptcy procedures decrease firm size and raise funding costs and with that of Ponticelli (2012) in Brazil, who shows that congestion in bankruptcy courts substantially reduces firm-level investment and productivity.

This paper is a first step towards understanding how agents respond to the Spanish insolvency framework and their implications for the real economy. Further work is required in two directions. First, better data without the limitations of our sample, especially regarding information on mortgage loans and the alternative procedures to formal bankruptcy, could be collected. Second, the impact of the low efficiency of the bankruptcy system vis-à-vis mortgage foreclosures on the performance of Spanish firms should be empirically analyzed.