This Selected Issues paper analyzes Spain’s sustainable growth rate. It sheds some light on Spain’s medium-term growth prospects by looking into the key factors driving potential growth, both in the past and likely in the future, and international experience of countries in the aftermath of financial crisis. The paper suggests Spain is likely to face a long period of moderate growth (about 1½–2 percent) and high unemployment, but policy action—especially that directed toward reducing structural unemployment and raising productivity—could lead to much better outcomes.

Abstract

This Selected Issues paper analyzes Spain’s sustainable growth rate. It sheds some light on Spain’s medium-term growth prospects by looking into the key factors driving potential growth, both in the past and likely in the future, and international experience of countries in the aftermath of financial crisis. The paper suggests Spain is likely to face a long period of moderate growth (about 1½–2 percent) and high unemployment, but policy action—especially that directed toward reducing structural unemployment and raising productivity—could lead to much better outcomes.

Strengthening the Insolvency Framework For SMEs1

Spain has recently introduced reforms to its insolvency regime aimed at facilitating out of court workouts for non-financial enterprises, including small and medium size enterprises (SMEs). These reforms represent significant advances in the system. However, further changes are necessary to make the insolvency regime a useful tool for SME deleveraging. Additional reforms could be made to increase effectiveness and incentivize use, including by involving public creditors in collective proceedings and by introducing a framework for personal insolvency with an effective discharge, coupled with measures to strengthen institutional capacity.

A. Overview

1. Spanish SMEs rarely use the insolvency regime in spite of their high levels of debt distress.2 This is largely due to insufficient options for effective restructuring of the business or for the speedy liquidation of assets with the attendant ability to close up shop and start again. Specifically, the regime has the following gaps: (i) opportunities for successful restructurings within court are limited, as composition plans are overly restrictive in their scope and do not bind secured and priority (e.g., public) creditors; (ii) liquidation is not value-maximizing, as it is generally initiated in practice only as last resort and does not adequately facilitate the continued operation and sale of the business as a going concern; (iii) the lack of an effective discharge for natural persons offers scarce hope for individual entrepreneurs to emerge from their debt at the end of the process; and (iv) insolvency proceedings are costly and generally take too long, due to procedural inefficiencies and weaknesses in the institutional framework. While recent reforms attempt to make up for the weaknesses of in court procedures by promoting out of court agreements, changes could be made to make such procedures more attractive and effective for SMEs and to harmonize the insolvency regime as a whole. The authorities have recently announced general plans to address some of these gaps by (i) increasing flexibility and scope of in court restructuring plans; (ii) reviewing the current legal framework for insolvency administrators to incentivize speedy and less costly insolvency procedures; (iii) expanding the options available for SMEs to timely restructure in and out of court; and (iv) facilitating going-concern sales. These are welcome developments.

2. Solving the problem of SME overindebtedness is important due to the structure of the Spanish economy. SMEs represent over 99% of the businesses in Spain, the majority of which are microenterprises.3 Most of these businesses operate as sole entrepreneurs, who have unlimited personal liability. Other small businesses, albeit incorporated, secure business credit with mortgages in their personal assets, or with personal guarantees, of the business owners and directors and their family members. As such, commercial failure in Spain frequently entails household insolvency.

B. The Spanish Insolvency Regime

3. In Spain’s post-crisis environment, an effective insolvency regime must provide adequate tools to assist in deleveraging the real economy, with a particular focus on SMEs. First, the insolvency regime should provide effective means to restructure a business both in and out of court (first section). Second, the regime should also allow for the speedy sale of a business (or business units) out of liquidation to preserve as much value as possible of the going concern and to facilitate changes in market structure and firm size (second section). In either case, speed is of the essence, so procedural efficiency and a strong institutional framework is crucial (third section). Moreover, the insolvency regime should provide for a debt discharge for individual entrepreneurs in order to preserve human capital after a business failure (fourth section). Finally, consistency among in court and out of court options is desirable to avoid moral hazard, forum shopping, and to facilitate transition from out of court to in court procedures.

Restructuring

In court

4. The Spanish insolvency regime provides debtors and creditors the ability to reach restructuring agreements within court. Formal insolvency proceedings are primarily regulated by the Insolvency Act of 2003 (Ley Concursal), which establishes a procedure allowing for the restructuring or the liquidation of corporates and other legal entities as well as individuals (entrepreneurs and consumers). Insolvency proceedings can be initiated by both the debtor and its creditors and can be either simplified or regular. SMEs typically use the simplified proceedings, which generally apply when the debtor has fewer than 50 creditors and the debtor’s assets and liabilities do not exceed €5 million. Insolvency plans (convenio concursal ordinario) may be proposed by the debtor or by creditors. Once approved by the relevant majority of unsecured and non-priority creditors, the plan must be submitted to the court for approval, and once approved it binds all ordinary and subordinated creditors.4

5. The in court restructuring process does not sufficiently involve secured or priority (e.g., public) creditors. Priority and secured creditors cannot be bound by majority acceptance of a restructuring plan. As the majority of SME debt is owed to secured and public creditors, the inability to mandate their involvement as classes with majority voting and a possible “cram-down” in the process makes the restructuring procedure within the insolvency system largely ineffective. In addition, the law generally restricts the content of the plan to debt reductions up to 50 percent of unsecured debt and rescheduling of only five years, which unduly limits the freedom of creditors and may be insufficient to resolve the debt overhang of many SMEs. The limitations are also inconsistent with the scope of out of court refinancing agreements, which have no limitations on write downs or rescheduling. An additional problem with insolvency plans is their procedural rigidity. It is not possible to negotiate and make amendments to the initial plan once it has been proposed, which thwarts negotiations and causes the rejection of plans that could have been approved with some changes. In addition, the classification of claims of counterparties of terminated executory contracts as administrative expenses (credito contra la masa), hinders the ability to restructure business activity.5

6. Consideration could be given to redesigning the restructuring procedure to include secured and public creditors and to abolish the limits on content. Secured and public creditors should be bound by a plan accepted by the requisite majorities. The latter could be achieved by forming separate classes for voting purposes, which would be bound by a majority vote of their members, as long as the minority receives at least as much under the plan as they would receive in a liquidation (i.e., the “best-interests” test). A dissenting class could be subject to “cram-down,” provided that it is treated “fairly and adequately,” meaning that it can be impaired without its majority consent as a class only if any junior class receives no value at all, and no senior class receives more than 100 percent.6 Subordinated creditors should be wiped out when ordinary creditors take a haircut. Such a system could be designed to allow secured creditors to participate in the financial upside of reorganization, which would engage them in proceedings, and prompt them to file more often for insolvency and forego individual enforcement by foreclosure or repossession. In addition, to increase chances that a plan will be approved, the initial proposal for a reorganization plan should also be open to renegotiation and amendments. The ability for the parties to modify a restructuring plan during the plan execution phase following judicial approval would also maximize the chances of a successful restructuring. Finally, in line with international best practice, claims of counterparties of terminated executory contracts should be classified as ordinary insolvency claims.

Out of court

7. Substantial changes were recently made to the insolvency regime to expand the options available to enterprises, including SMEs, to reach agreements out of court (see Box 1). These include the following:

  • Refinancing Agreements: Substantially expanded with the Royal Decree 4/2014 (the “RDL”) of March 2014, refinancing agreements now include partial refinancing agreements, which allow an enterprise to reach an agreement with any one or more of its financial creditors, and collective refinancing agreements including all financial debt. Refinancing agreements may include, subject to majority creditor approval, write downs and rescheduling of debts, as well as debt for equity swaps, which also require shareholder approval (which may not be unreasonably withheld). Judicial confirmation of agreements meeting the requisite majorities binds non-participating and dissenting creditors, including, under certain circumstances and to a limited degree, secured creditors.

  • Out of Court Agreements on Payments: Introduced in 2013 by the Law to Support Entrepreneurs, the out of court agreement on payments or “OCAP” (acuerdo extrajudicial de pagos) is designed to address the financial stress of small businesses, facilitated by a professional mediator. The agreement, which must be approved by creditors holding at least 60% of the total general unsecured claims (claims of secured and public creditors are excluded)7, must allow for the continuation of the business, and may include a moratorium of no more than three years, and a write down of no more than 25%.

8. These new out-of-court agreements do not stay public creditors or include them in collective creditor decision-making at the negotiation table. While public creditors are permitted by law to negotiate bilaterally with debtors to reach rescheduling of tax debts, these processes are separate from the formal out of court agreements that debtors may reach with other creditors, which limits their effectiveness for SMEs. This is because failure to bring public creditors to the negotiating table with other creditors hinders collective decision making. Involving public creditors would enable a more effective debt restructuring of the business, induce other, including secured, creditors to consent to a restructuring of their claims, and ultimately leave more working capital for the restructured enterprise. It would also allow public creditors to keep the debtor business afloat as a future taxpayer without disrupting employment and supplier and customer relationships, which benefits tax revenue in the longer run. In addition, leaving public creditors outside the restructuring process, even while secured creditors are included, is inconsistent with the status of public creditors in the insolvency law, who rank below secured creditors in a liquidation.

9. There are several options for involving public creditors in out of court agreements. In the parliamentary procedure to approve the RDL as a law, public creditors could be introduced as a third class, in addition to the current two classes of ordinary and secured creditors. Under the OCAP, public creditors could be required to participate in the mediated creditor decision making process. At the very least, the start of the either of these two procedures should require the tax authorities to engage in a discussion with the debtor to restructure debt. Alternatively, as a temporary measure to “jump start” the restructuring of firms, the tax authority could announce that it would agree to participate in out of court refinancing agreements during a limited period of time. Such involvement could entail a design (subject to compliance with state aid rules) whereby public creditors (i) would agree to a stay on individual enforcement of their claims to the same extent as other creditors and (ii) agree to contribute actively to the financial restructuring of the debtor enterprise by accepting an impairment of their owed debt at a level in between those creditors of higher rank (e.g., secured creditors), but above those of more junior general unsecured creditors. In light of current limitations in the law with respect to the tools available to public authorities to restructure debt, in any event changes would need to be made to attendant legislation to permit more significant public creditor involvement.

10. In addition to the inclusion of public creditors, other amendments could be made to make the RDL process more attractive for restructuring SME debt. First, the four month period of stay is generally too long for renegotiating SME debt. More flexibility to allow creditors to vote to reduce the length of the period or to vote to revoke their consent would provide useful incentives to SME creditors to use the process and limit moral hazard. In addition, the provisions in the RDL with respect to liability for those debtors who refuse “unreasonable” debt for equity terms are unsuitable for SMEs and will discourage their use. As SMEs are generally closely, and often family, held, SMEs may refuse to enter in the RDL process for fear they will be forced to accept a debt to equity swap and lose control of their business or be held personally liable if they fail to consent.

11. The OCAP procedure for SMEs offers insufficient incentives for use. The inclusion of a mechanism to specifically tackle the financial distress of SME was a welcome development. However, improvements are likely needed for it to be truly effective. Public and secured creditors, who hold the majority of SME debt, are neither affected by the stay of execution nor are they included in the restructuring agreement.8 In addition, the limits on the content of the plan—25 percent debt-forgiveness and extension of maturities of no more than three years—are too rigid to be useful. Additionally, the law currently provides that upon a failed OCAP procedure, a liquidation proceeding within the insolvency proceeding is automatically opened. Limiting the subsequent insolvency to liquidation unduly restricts the possible exits to financial distress and constitutes a clear disincentive to use the OCAP for fear that upon failure to reach agreement with creditors, the debtor will be liquidated and the liability and disqualification section (sección de calificación) opened.

12. The OCAP should be amended to provide adequate options for SMEs and to eliminate disincentives to use, as follows:

  • No limits should be placed on the extent of debt forgiveness or extension allowed under the plan.

  • Public creditors (addressed above) and secured creditors should be bound by the agreements and called authoritatively by the mediator to negotiations and involved in the process.

  • In a subsequent insolvency proceeding, all options should be available, not just liquidation. OCAP agreements should survive and not be challengeable under avoidance rules absent intent to defraud (other) creditors. The OCAP period of good faith negotiations should be counted towards the period of “best efforts” behavior for a debt discharge (see below).

Liquidation

13. Sales of a going concern out of liquidation may offer the speediest and most complete method of deleveraging a business while preserving value. Under the Spanish regime, if the debtor files for liquidation or if no plan is proposed or approved, the proceeding enters into the liquidation phase. While the Spanish regime aims at liquidation of going concern sales wherever possible, the vast majority of proceedings still end in piecemeal liquidation largely because (i) liquidation is generally not available in practice before other rescue techniques have been exhausted and (ii) the law is unclear as to whether essential contracts, licenses and permits may be transferred without the need for a previous authorization of the contractual counterpart. In addition, the law does not allow for the direct market sale/auction of the debtor entity, free and clear of debts and liens. Stakeholders have also indicated that social security claims often survive liquidation, inhibiting speedy and efficient going concern sales.

14. Liquidation should be made more conducive to going concern sales. To speed up transition to liquidation, the judge, upon a hearing of the administrator or a creditors’ committee, could be empowered to convert the case to liquidation when lengthy attempts at restructuring endanger value. Clarification to the law should be made to specifically allow the transfer of contracts, licenses and permits (without the consent of contractual counterparties) in the case of asset sales of a going concern. The transfer of favorable tax attributes, such as loss carry-forwards, could also be considered. Consideration could also be given to allow for the sale of debtor entity, free of debt and liens, with subsequent distribution of proceeds to creditors. Such sales can be particularly quick, allow the simple maintenance of necessary contracts, and lead to the continuation of the debtor enterprise together with eventual subsidiaries. In addition, it should be clarified that social security debts do not remain after a going concern sale.

Procedural and institutional aspects

15. Insolvency procedures take too long. In 2012, insolvency proceedings on average lasted approximately 650 days or more. While partially a reflection of weaknesses in the institutional framework, problems also exist with the procedural rules. First, proceedings may be held up subject to resolution of challenges and appeals against the list of creditors and inventory. Although the 2011 reform improved efficiency by providing that the suspension of the procedure would only occur when the claims challenged amount to 20% of the total claims, the measure has proven insufficient. Second, the procedures do not facilitate rapid entrance and exit of smaller debtors, despite the existence of a simplified procedure for SMEs. Third, creditors do not have enough say in the insolvency process in order to facilitate the progression of the procedure and alleviate the burden on the judge.

16. To facilitate the insolvency procedures, the following changes could be made:

  • Streamline the appeals procedure against the insolvency administrator’s list of claims and creditors by either ‘expediting the procedures’ for resolving challenges to the insolvency administrator’s list or allowing for closing the common phase and moving to the next stage despite the challenges.

  • Consider the development of standardized forms for use by SME filers (to be used, e.g., in the simplified proceedings) to speed up the process.

  • For larger cases, provide a “creditors committee” to enhance creditors’ role and control and oversight of the proceedings (including over the insolvency administrators) and alleviate the current burden on the judge.

17. The institutional framework could also be improved to expedite proceedings and foster business rescue. Although insolvency cases are decided by specialized commercial judges, there are not enough judges, judges do not have assistance (e.g., in the form of clerks), infrastructures are obsolete and inefficient, and case management and the organization of courts could be improved. This—together with a sharp increase in cases caused by the crisis—has generated a backlog of cases that causes excessive delays. Much value is put at risk by months—even years—undergoing formal insolvency proceedings. Measures to improve capacity could include creating a body of clerks to assist judges, increasing the number of judges, and improving case management by speeding the process of digitalization of files. In the area of insolvency administrators, changes should be made as follows: (i) creditors should have significant influence over selection and compensation of insolvency administrators and (ii) compensation structures should be changed to incentivize restructuring and going concern preservation.

Personal insolvency regime

18. For the smallest Spanish enterprises, the principal hindrance to effective deleveraging through insolvency is the inability of financially responsible and cooperative individual debtors to receive a fresh start.9 The lack of an effective discharge of the debts remaining after liquidation operates as a powerful disincentive for the debtor to file for insolvency, as they will still face full personal liability even after a bankruptcy proceeding. It also gives only limited incentive to creditors to reach an agreement with the debtor to restructure their loans pursuant to a plan, as creditors know they always remain entitled to full payment no matter how small chances of recovery may be, even in the event of total liquidation of the debtor’s non-exempt assets. The lack of a fresh start hinders entrepreneurship, as individuals fear they will be held personally liable indefinitely upon business failure. It also fosters activity in the grey economy, as individuals who are indebted for life will try to keep most of their future earnings concealed from creditors (and the tax authorities), in order to prevent the benefits from being pursued by previous creditors. The lack of a discharge is particularly problematic due to the fabric of the SME economy, where the majority of businesses are sole proprietorships subject to full personal liability for business debts, and a substantial majority of the remainder, albeit incorporated, has taken personal guarantees by owners and their family in order to secure business credit.

19. Spain could amend its insolvency system to include a framework for natural persons that affords a discharge of unresolved personal debt after liquidation.10 In line with modern legislation, and with other EU countries (e.g., Germany, Ireland, Italy, Latvia), Spain would substantially benefit from a system that provided the opportunity for a full discharge of residual debts not paid off in a liquidation of all non-exempt assets, including one’s residence, after a specified number of years of subsequent good faith efforts. The period of years after which discharge would be granted, while recommended by the European Commission at no more than three years11, could be initially set in Spain based on the “indifference point.” This would be the point at which creditors would have no overall negative impact on their finances and cash position, and at which debtors would still be incentivized to use the insolvency process and use their earning capacity following liquidation of existing assets. The period of best efforts could be reduced over time as stakeholders adapt to the process12. The insolvency framework for individuals should be a simplified and accelerated process with minimal professional and judicial involvement, standardized petition forms, and strong institutional support. It could also facilitate the joint resolution of business-related household debt, given the large number of family loans and guarantees, by staying enforcement actions against household members. In the case of incorporated SMEs, personal guarantees and third party security rights (mortgages, pledges) given by owners and family members for business debt should be addressed and settled by appropriate rules within the insolvency of the company. Experience shows that countries with high payment discipline introduced a personal bankruptcy regime that was eventually welcomed by banks and the consumer credit sector, without undermining payment culture, or negatively affecting the supply or cost of credit. Such a regime would help to clean the balance sheets of banks of credits that are irrecoverable and would relieve the courts from useless enforcement actions that offer no or little return to creditors. On the societal and macro-economic level, such a regime would encourage entrepreneurship and foster modernization, social cohesion, and growth.

Recent Changes to the Spanish Insolvency Regime

In 2013 and 2014, Spain introduced major changes to its insolvency regime, governed by the Ley Concursal of 2003, as amended. These changes, put in place by the Law to Support Entrepreneurs (September 2013) and the Royal Decree on Urgent Matters in Relation to Refinancing Agreements and Debt Restructuring (March 2014), are summarized below.

Law to Support Entrepreneurs and their Internationalization (effective September 29, 2013) (the “LSEI”)

  • Expedited out-of-court restructuring mechanism for SMEs: The LSEI created a new out-of-court procedure – the “out-of-court agreement on payments” or OCAP (acuerdo extrajudicial de pagos) designed to solve the financial crises of small businesses, facilitated by a professional mediator. The process puts in place a stay on executions (up to 3 months max); secured and public creditors are not affected. The proposed plan must be approved by creditors representing at least 60% of liabilities (again, secured and public claims not included). The plan must provide for the continuation of the business, the stay or moratorium set forth in the plan may not exceed three years, and the haircut must be no more than 25%. A parallel procedure is put in place for debtor with tax and social security debt which allows only for a postponement of payments (rescheduling of arrears) but no write downs.

  • Fresh Start: For the first time, the insolvency regime in Spain includes the possibility for a “fresh start” or “discharge” for individual debtors. To receive a discharge the following claims must be fully paid: (i) all claims against the estate, (ii) all “privileged claims,” and (iii) 25% of all ordinary claims. After a failed OCAP procedure, rules are slightly different (only claims against the estate and privileged claims must be fully paid).

Royal Decree (“Real Decreto”) on Urgent Matters in Relation to Refinancing Agreements and Debt Restructuring (effective March 8, 2014)

  • Refinancing Agreements: The reform makes a number of changes with respect to judicially approved and non-judicially approved refinancing agreements. Primarily, the following:

  • Individual Scheme of Arrangement: allows a company to reach a pre-insolvency agreement with any one or more of its creditors, subject to strict criteria on content, that are not subject to avoidance action (or “claw back”) in an insolvency proceeding.

  • Collective Refinancing Agreements: strengthened to protect against avoidance actions and expanded scope of agreements to explicitly include reference to cancellation of debt (i.e., debt write offs) and other restructuring measures such as debt to equity swaps.

  • Collective Refinancing Agreements, with judicial approval: can be imposed on dissenting creditors upon reaching approval of requisite majorities, depending on the creditors involved and the type of agreement. Secured creditors can be included, subject to higher majority requirements.

  • Priority for Fresh Money: all new money granted in the context of the refinancing agreements are given priority for a period of two years from the entry of force of the reform.

  • Stay on Enforcement: the decree allows for a stay of execution (subject to certain limitations) during the “pre-insolvency” period; public creditors are not included in the stay.

  • Tax Incentives: including (i) in the case of debt write-offs/time extensions, debtor is taxed according to a new system of apportionment of tax income but has ability to use unlimited carried-forward tax losses to offset such income; (ii) in debt-to-equity swaps debtor is not taxed; and (iii) public deeds documenting debt write-offs or reductions of loans, credits or other obligations are now exempted from transfer tax and stamp duty.

1

Prepared by Chanda DeLong (LEG), Manfred Balz (LEG external consultant), and Ignacio Tirado (LEG external consultant).

2

Despite the overall increase in insolvencies of medium and large firms since the financial crisis, use of the insolvency process by many of Spain’s small enterprises is still rare, averaging only 12 bankruptcy filings per 10,000 firms in 2012. See Garcia-Posada M. and J. Mora-Sanguinetti, 2013, “Are There Alternatives to Bankruptcy? A Study of Small Business Distress in Spain,” Bank of Spain Working Paper No. 1315.

3

See Central Business Register, National Statistics Institute of Spain.

4

While the regime also includes a type of pre-packaged plan (convenio anticipado), which may be presented at the time of the debtor’s petition to open an insolvency proceeding or immediately after procedure is declared, together with the written consent of creditors holding at least 20% of total claims to the accelerated and simplified proceedings, this procedure is rarely used.

5

This limitation would also affect the ability to restructure business activity within a liquidation proceeding.

6

See the UNCITRAL Legislative Guide on Insolvency Law, pp. 224–226, 235–236, available in the Internet: http://www.uncitral.org/pdf/english/texts/insolven/05-80722_Ebook.pdf

7

Secured creditors may be bound by the plan if they voluntarily vote in favor and the plan is approved.

8

While the opening of an OCAP procedure provides the debtor the option of going through a parallel process to reschedule public debt, no write-downs of debt are permitted.

9

While the Law to Support Entrepreneurs did introduce a very limited discharge, its requirements for full payment of secured claims, all (administrative) claims against the estate and the long list of privileged claims, as well as 25% of ordinary claims in certain cases, make it unlikely that it will benefit many SME debtors, particularly those with the largest amount of debt.

10

While this note focuses on SMEs, including individual entrepreneurs, a discharge would also be recommended for individual consumers.

11

See European Commission Recommendation of 12.3.2014 on a new approach to business failure and insolvency.

12

In Germany, for example, the discharge period was initially seven years, and was subsequently reduced to five and then three.