Table of Contents
Summary
The government has identified entrepreneurship in emerging sectors like life sciences, Artificial Intelligence (AI), and green technologies as key drivers of productivity growth. These new technologies are characterised by a strong positive (right) skew of returns: while most entrepreneurs will fail to develop a pathbreaking innovation, the few that do succeed will reap high rewards and push the technological frontier, spurring follow-up innovation, job creation and economic growth. Although failure is the norm, encouraging more entrepreneurs is key to having breakthrough successes. A system that too heavily penalises failures will disencourage healthy risk-taking and entrepreneurship in these industries.
Company failure is also an important mechanism for competition and innovation, and an important learning process for founders. Policy reforms have focused on making it quick for an entrepreneur to start their first company, but not for them to move quickly onto the second if the first doesn't succeed. Just as startups too often languish in Britain's planning and regulatory regime, unable to scale up, founders themselves languish in lengthy bankruptcy proceedings, with their talent going to waste in the meantime. In the US, the average bankruptcy proceeding takes about four months, compared to more than twelve months in the UK. Reforming bankruptcy is an important step to improving the dynamism of the UK economy.
To allow private entrepreneurs to drive wider economic growth, the government should create an institutional environment that is conducive to entrepreneurship and healthy risk-taking. The current patchwork of personal and corporate bankruptcy regulation presents a major obstacle to entrepreneurship in this country but can – with the right reforms – be turned into an engine of innovation.
Simpler, pro-debtor regulation and an effective stream-lined bankruptcy process are needed to create a dynamic growth-oriented environment for young firms and start-ups to succeed. Faster resolution of legacy bankruptcy cases would encourage more risk-taking and allow serial entrepreneurs – who tend to perform better in subsequent ventures – the opportunity for a fresh start to continue innovating. Such pro-debtor bankruptcy reform is associated with higher levels of patenting, in particular in technologically innovative industries.
We propose the introduction of a new, drastically simplified bankruptcy code modelled on the US bankruptcy code. The guiding principle of the reform should be to prioritise opportunities for business creation by streamlining the bankruptcy process, prioritising out-of-court workouts, and by allowing for fast discharge of existing cases. To facilitate the transition, companies should be given the choice between the new re-modelled framework and the old system.
The Challenge & Opportunity
Frontier technology in the fields of AI, life sciences, and environmental technology promise to be among the key drivers of future growth. In many ways the UK is uniquely placed to become a world leader in all three of these fields: It has a vibrant tech scene, a competitive higher education sector, and London is a global hub that can pull in the world’s best talent.
Converting these excellent fundamentals into successful innovation, firm and job creation requires the right institutional setup. These new growth areas in technology share a particular bottom-up, entrepreneur-driven structure. To be precise:
Frontier innovations, for instance in green technologies, are fundamentally uncertain and risky with a strong right skew in the outcome distribution. That is, the modal outcome is failure; very few ventures will be ultimately successful, but those that do promise extraordinarily high returns.
Innovations in technology-intensive areas are driven by experts with extensive experience in their fields. Some of them are serial entrepreneurs, while others lack an established track record. These entrepreneurs take substantial personal and financial risk, often moving on from corporate jobs into entrepreneurship. Ventures are financed out of pocket – mostly with personal or family assets, for example in the form of mortgages on private property or savings. The high personal risk associated with starting a new business also implies a high opportunity cost, which considerably narrows the pool of prospective founders.
Given the financial and personal risks involved in startup creation, it is particularly important that we provide the right institutional framework to encourage entrepreneurship in new technologies. We must not forget that business failure is the norm: According to the ONS, more than 25% of businesses fail after their first year; after five years 60% of new business will have disappeared. Failure rates are even higher for entrepreneurial founder firms and concentrated in emerging sectors.
To nurture an entrepreneurial economy and capture the growth potential of these new industries, we must develop frameworks that understand and are amenable to failure. An important factor in developing this environment is an agile and modern bankruptcy framework that encourages entrepreneurship, risk taking, and firm creation.
Cross-country evidence suggests that debtor-friendly bankruptcy reforms – both of corporate and personal bankruptcy law – are associated with higher rates of firm creation, self-employment and patenting. Pro-debtor personal bankruptcy reforms are associated with the development of more radical, path-breaking innovation, as measured by subsequent patent citations and patent valuation. This effect has been shown to be particularly large in industries with high large innovation potential, such as artificial intelligence.
The US is a useful comparator for the UK. The US has consistently outperformed its European counterparts when it comes to early-stage entrepreneurial activity (defined as the share of the working age population involved in early-stage business creation). There are invariably many reasons for this, but there is strong evidence that the incentives created by the U.S. bankruptcy code contribute significantly to early start-up activity.
From a policy perspective, an effective insolvency framework should balance two trade-offs:
It needs to ensure an effective resolution of insolvent, unviable businesses while keeping illiquid but solvent firms intact. This screening motive is crucial when it comes to the reallocation of capital towards highly productive new firms. On the one hand, keeping these illiquid but solvent firms from shutting down protects jobs and allows firms to realise long-term, risky projects with short-term cash flow risk. On the other hand, it slows down the reallocation of capital to more productive firms.
The insolvency framework should encourage good (entrepreneurial) risk-taking, as it allows for innovation and growth, but discourage bad (excessive) risk-taking with little social benefit. This selection motive shapes the types of new businesses that are created. Strict insolvency laws reduce high-risk-high-reward investment but protect creditors and therefore lead to lower borrowing costs ex-ante.
Status-quo insolvency regimes around the world differ in their emphasis on the two objectives. On one side, continental European jurisdictions, such as Germany, typically prioritise a quick resolution of insolvent businesses as well as limits on entrepreneurial risk taking. On the other side, the US system is tilted towards keeping illiquid firms afloat while encouraging risk taking. Comparatively, the UK system is a patchwork of various pieces of legislation somewhere in-between Germany’s creditor-friendly and America’s debtor-friendly system. The current legal setup fails to deliver on all fronts.
Table 1: Comparison of Insolvency and Bankruptcy Environments: United Kingdom vs. United States
There are five sets of pathologies in the existing legal framework that reform should address:
Fragmented Regulation Across the UK: Insolvency procedures vary between England and Wales, Scotland, and Northern Ireland. For example, Scotland has two sets of insolvency laws (one for voluntary arrangements and one for receiverships). Centralising and simplifying these procedures across the UK would establish a consistent regulatory environment and improve processes for businesses and creditors. The EU is also centralising its insolvency system, acknowledging the challenges posed by fragmented bankruptcy laws and the benefits of a unified approach.
High Professional Fees From the Mandatory Practitioners: The mandatory appointment of a bankruptcy practitioner is a particular drain on existing resources and limits payouts for both creditors and residual claimants (equity holders). Insolvency practitioners are subject to regulation by various professional bodies, which creates another unnecessary layer of complexity, and leads to inconsistent professional standards and limits oversight.
Lack of Incentives for Early Intervention: The complexity of existing procedures in combination with high costs (monetary and time) often leads to delayed action, imposing higher than necessary bankruptcy costs and in some cases leading to avoidable business failure. Delayed resolution generates disproportionately higher costs and economic uncertainty for small and medium sized firms.
Liquidation Bias: Although recent legal changes are aimed at promoting business continuation, in practice, there is a bias towards firm liquidation. SMEs usually struggle to access restructuring options like CVA due to costs and complexity. If we think of small firms driving innovation, the distortions are strongest exactly where it is the most costly.
Limited Use of Debt-Equity Conversions: Economists suggest that allowing creditors to convert debt to equity in insolvency proceedings could enhance incentives for restructuring, reduce information asymmetry, and allow firms to retain value. However, this mechanism is challenging to implement under current UK law, given its focus on creditor rights. Debt-to-equity conversions may open the door to legal challenges by disadvantaged creditors. Major restructuring plans, including debt-to-equity conversions, also often require court approval, which slows down the insolvency process and creates additional uncertainty.
Plan of Action
The UK’s current convoluted legal framework acts as a deterrent to start-up creation in high-risk technologies. A major simplification of the existing legal framework would reduce downside risk for many entrepreneurs and investors, and thus encourage start-up creation and growth.
This proposal advocates for the introduction of a two-tiered insolvency system along the lines of the US bankruptcy code, which, in international comparison, has proven to balance the conflicting motives of bankruptcy law better than other systems.
The prioritisation of the different motives and trade-offs as described above should depend on economic circumstances. In the current environment we should de-prioritise selection and encourage more firm creation. In fields such as AI and green technology, the downside risk is relatively small compared to the rewards. The overarching goal should be the introduction of a new insolvency framework that prioritises preventative restructuring and gives debtors the highest possible freedom to continue operating their companies throughout the process.
In particular, the new system should:
Prioritise fast discharge from bankruptcy to promote economic certainty for creditors and debtors, and to enable a fresh start for serial entrepreneurs whose latest venture has failed. As a guideline, the system should aim to discharge debtors within six months. In the US, the standard time to discharge is about four months, compared to more than twelve months in the UK.
Enable out-of-court workouts and fast restructuring, providing tax incentives for bail-ins and debt-equity conversions rather than insisting on full repayment of outstanding liabilities. Debtors should stay in possession of their enterprise throughout the process and have an option to request an automatic stay against any enforcement action taken by creditors, allowing the smooth functioning of business activity throughout the process. Exceptions should be made for judgments made prior to the bankruptcy filing or in case of criminal proceedings against the debtor. The appointment of a practitioner in the field of restructuring should not be mandatory.
Contain an option to fast-track cases for small and medium-sized businesses, similar to Subchapter V of Chapter 11 of the US bankruptcy code, and allow for the resolution of these cases entirely out-of-court.
Provide an option to convert any restructuring plan into a business liquidation upon the debtor’s request.
FAQs
What is the current insolvency procedure in the UK, and how does it work?
In the UK, insolvency procedures are designed to handle cases where businesses cannot meet their financial obligations. The process varies by region due to devolution, with specific rules for England and Wales, Scotland, and Northern Ireland. Generally, there are five main types of corporate insolvency procedures:
Administration: This aims to rescue a company that still has potential. An administrator temporarily takes over the business, shielding its assets from creditors, and tries to restructure or sell parts to keep it afloat. If saving the business isn’t feasible, it may be converted to a liquidation.
Liquidation: This winds down the company and sells off assets to pay creditors. The company closes, and any leftover funds go to shareholders. Liquidation can be compulsory, led by a court, or voluntary, decided by shareholders.
Company Voluntary Arrangement (CVA): Here, the business proposes a restructuring plan, often with the guidance of an insolvency practitioner. Creditors vote on this plan, and if 75% approve, the business can continue operating under the supervision of the practitioner.
Receivership: If a company defaults on secured debts, a receiver may be appointed to recover assets linked to those debts. This focuses on repayment for specific creditors rather than saving the business.
Pre-Pack Administration: A prearranged deal between creditors and the company is approved by the court, enabling a quick sale or restructuring that often preserves more value.
The procedure applied depends on the company’s financial health, asset structure, and goals—whether it's rescue, debt recovery, or an orderly closure. In most cases, these steps aim to balance the interests of creditors, employees, and the company’s survival potential, though the UK’s framework often favours liquidation over restructuring. Proposed reforms suggest simplifying the system to encourage entrepreneurs to take risks and help viable companies survive financial distress.
Will pro-debtor bankruptcy reform lead to higher borrowing costs for prospective entrepreneurs?
More debtor friendly bankruptcy law and readier discharge of individuals’ debts could affect entrepreneurial investment in innovation. On one hand, readier discharge leaves creditors with more nonperforming loans, which will be passed on in the form of ex-ante higher borrowing rates. This reduces entrepreneurs’ access to credit in the future and may deter prospective entrepreneurs from starting a firm. On the other hand, pro-debtor reform reduces entrepreneurs’ personal costs of failure, encourages repeated investment and skews investment towards riskier innovation. The empirical evidence suggests that the latter channel dominates and the effects on borrowing costs are relatively small when financial markets are sufficiently competitive, as is the case in the UK.
How big can we expect the effects of the reform to be?
The effects can vary on a case-by-case basis. In the cross section of industrialised countries, pro-debtor bankruptcy reform is typically associated with an increase in patenting activity at the industry level of about 25% and an overall increase in the number of patenting firms by 24%. Industries with higher growth potential typically benefit more from these reforms, which is why we would expect the effects to be significantly larger in areas such as life science, artificial intelligence and green technology. Based on the empirical evidence in the academic literature, we would expect these effects to be worth between 0.2 and 0.4 percentage points of additional annual growth.
Are there any international comparisons or precedents that we can build on?
The European Union has initiated a comprehensive overhaul of its existing bankruptcy framework in 2019. EU Directive 2019/1023 sets out a series of harmonisations and reforms aimed at introducing an EU-wide preventative restructuring framework, facilitating the discharge of debt, as well as other measures to increase the efficiency of insolvency processes. The reform in effect brings EU law closer to the US benchmark as described in this briefing.
Are there any other anticipated consequences for the financial sector should this reform be implemented?
The empirical evidence suggests that pro-debtor bankruptcy reform can lead to short-term increases in lending rates as banks adjust to higher downside risk from business insolvency. We expect these adjustments to be short-term, and more than offset in the long run through the crowding-in of new, innovative start-ups that offer high returns to entrepreneurs and financiers alike.
An efficient insolvency system can also unlock long-run benefits for lenders, in particular banks. Preventative restructuring can reduce the build-up of non-performing loans on bank balance sheets and therefore lead to an improvement in banks capitalisation rates and boost the long-term stability of the banking system.
Johannes Matt is an economist at the Centre for Macroeconomics (CFM) and a PhD Candidate in Economics at the London School of Economics at Political Science (LSE). He is also a Fellow at the LSE’s School of Public Policy where he teaches International Finance. His research focuses on how financial institutions shape innovation, business dynamism, and economic growth.