While privatization has attracted substantial attention in the transforming economies, the development of their bankruptcy procedures has been largely overlooked. In Discussion Paper No. 878, Research Associate István bel and Research Fellow Konstantine Gatsios review the costs and regulations governing firms' liquidation and reorganization and compare the practices of market economies with those that currently apply in Hungary. Reorganizations entail the costs of developing a plan legal costs, the wages of those involved, etc. and also the costs faced by creditors on account of rescheduling and deferments. Society benefits if the resulting profit exceeds the earnings from dissolving the firm by at least the total cost of its reorganization. The firm should go into liquidation, however, if the remaining burden after debt forgiveness and the cost of reorganization exceeds these expected profits.

The Hungarian government introduced a draconian bankruptcy law in 1992 to end the growth of inter-enterprise debt: managers must file for bankruptcy within eight days if their firms' payment arrears exceed 90 days, failing which they are personally liable for any damages incurred by creditors on account of further delay. bel and Gatsios maintain that this law is an important step towards a functioning market economy but cannot provide a bridge from the very underdeveloped financial system to a well-functioning capital market. Hungary's new bankruptcy laws and regulations are stringent even by Western standards and therefore quite unsuitable for an economy in transition. The absence of domestic capital markets and the world-wide recession have virtually eliminated demand for firms' assets, so their liquidation values are artificially low, while banks are unable to forgive loans, so firms' debt obligations typically exceed the net surpluses from their reorganization. They may therefore be forced into liquidation in cases where reorganization would be more efficient for both the firm and the economy as a whole.

The Economics of Bankruptcy and the Transition to a Market Economy
István bel and Konstantine Gatsios

Discussion Paper No. 878, December 1993 (AM)