Recently, I described academic studies suggesting that corporate innovation is fostered by labor laws that limit firms’ ability to discharge employees at will. These studies provide support to the idea that the best way to encourage risk-taking and experimentation is not to “celebrate failures,” but to remove the proverbial Sword of Damocles of punishment for them, something that any organization can do by modifying its termination policies.

It turns out that corporate innovation is encouraged not only by protecting individual employees but the firms themselves. In a paper published in 2009, “Bankruptcy Codes and Innovation,” Viral Acharya and Krishnamurthy Subramanian show that firm-friendly bankruptcy laws have a positive effect on corporate innovation.

Acharya & Subramanian have analyzed changes in bankruptcy codes that took part in 12 countries in 1978-2002. Over this period, seven countries (Canada, Finland, Indonesia, Ireland, India, Israel, and Sweden) have made their bankruptcy codes more debtor-friendly, i.e., favoring firms filing for bankruptcy. Five countries (Denmark, UK, Lithuania, Romania, and the Russian Federation) have made their country codes creditor-friendly, i.e., giving more rights to firms’ creditors.

Compared to a “control” group of counties—those that did not undergo a creditor rights change–the “treatment” group of five countries that underwent a firm’s rights decrease demonstrated a 9.7% decrease in the number of patents issued to these countries and a 13.3% decrease in their quality. In contrast, in seven countries where firm’s rights were increased, the number of patents rose by 10.7% and their quality by 15.4%.

There are two major factors contributing to creditor-friendly bankruptcy codes’ negative effect on innovation. First, they lead to the excessive liquidation of firms’ assets, which results in the reduction of funds available for innovation activities. Second, in countries with stronger creditor rights, innovative firms take smaller quantities of debt and keep more cash reserves, which again limits their ability to invest in innovative projects.

The major conclusion from the data presented by Acharya & Subramanian is that debtor-friendly bankruptcy codes encourage firm-level innovation by promoting the continuation of innovative activities even following the firm’s bankruptcy. Saying the same thing differently, very much like their employees, firms, too, need protection from failure.

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The image credit: http://ampthemag.com/the-real/days-fbi-bust-national-event-co-files-bankruptcy/