Corporate+Restructuring +an+Overview

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Chapter 1 edited / Corporate Restructuring / p. 1

Chapter 1

Corporate Restructuring: An Overview

The financial crises of the late 1990s devastated emerging-market economies and presented

considerable obstacles to achieving a sustainable recovery. The rises in unemployment, sharp

jumps in interest rates, double-digit declines in output, and plummeting exchange rates

engendered considerable suffering, enormous shifts in the profitability of business activities, and

a massive overhang of bankrupt corporations and bad loans on the balance sheets of banks. The

scope of banking and corporate sector difficulties dwarfed the financial and human resources

available to devote to their resolution. In some countries, effective laws, strong institutions, and

decisive government leadership combined to recognize losses quickly, limit the overhang of

impaired bank assets, and make progress in resolving corporate distress. In other countries,

archaic laws and weak institutions and leadership compounded the problems, slowing economic

recovery and increasing the ultimate fiscal costs of the crisis.

The key role of the corporate sector in precipitating the East Asian crises and the

fundamental importance of corporate sector restructuring to the health of the banking system and

the achievement of sustainable recovery have focused attention on the role of public policy

responses in corporate restructuring. Nevertheless, detailed information on the steps that

governments have taken to remedy systemic corporate distress remains limited. Policymakers,

regulators, bankers, restructuring specialists, and corporate managers confronting financial crises

require answers to numerous questions of policy and implementation that may be informed by

past experience. For example, what are the best practices for regulatory measures? Should

governments establish asset management companies to take over impaired loans? How should


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chapter 1 overview edited / corporate restructuring / p. 2

out-of-court workout procedures be structured? What techniques have proven effective in

restructuring distressed firms?

This volume relies on the experience of senior public officials, private businessmen, and

staff of the World Bank and International Monetary Fund (IMF) involved in corporate

restructuring to address these questions. The papers that follow were commissioned as part of a

World Bank seminar on Corporate Restructuring: International Best Practices, held in

Washington, D.C. in March 2004. In this initial chapter, we touch on the major issues raised in

papers and oral presentations given at the conference. The subjects addressed can be grouped

into efforts to monitor corporate sector vulnerability; the legal, regulatory, and policy responses

to systemic corporate crises; and financial restructuring techniques used to deal with insolvent

companies.

[1] Monitoring Systemic Corporate Sector Vulnerability [end]

The conference began with Jack Rodmans overview of progress in reducing banks

nonperforming loans, set out in chapter 2. Asian economies have cut the volume of

nonperforming loans in half over the past two years, mostly through write-offs and transfers to

government agencies rather than through disposition of assets. Rodman discusses the main

requirements for reducing nonperforming loans: strong government leadership and the

willingness to take difficult regulatory actions are essential, and the provision of working capital

to special asset management companies can be an important indicator of government

commitment. Governments can substantially reduce the costs of resolving nonperforming loans

by clarifying the legal structure for transactions such as trusts for securitization, strengthening


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creditor rights and the role of the court system, opening the market to foreign competition, and

encouraging a wide range of instruments for selling nonperforming loans (for example, asset-

backed securitizations and joint ventures). Governments also have to face reality about the need

to use taxpayers money to achieve progress in reducing nonperforming loans. Rodman cites the

example of Japan, where nonperforming loans were held on bank books for a decade until the

government decided to take strong measures and use government funds.

In numerous instances, government asset management companies and banks exhibited

timidity in recognizing the market value of assets and therefore opted to warehouse assets rather

than dispose of them quickly. Sellers of nonperforming loans need to have a realistic

understanding of asset values and the capacity to absorb losses. A bank may retain a

nonperforming loan in the expectation of making a relatively large recovery in the future, but in

the meantime its ability to make other loans is impaired because its troubled balance sheet makes

it difficult to raise new capital. And while time passes, the value of the asset may deteriorate.

Professionals hired to dispose of nonperforming loans cannot be held accountable for losses that

were inherent in the system before they acquired the loan. For example, Malaysias Danaharta

was successful because it acquired nonperforming loans at market prices and disposed of them as

quickly as possible.

Although they are not able to predict accurately the timing of crises, econometric models

can be useful in measuring vulnerability to a crisis. Most research focuses on macroeconomic

variables such as the level of international reserves, the real exchange rate, or credit growth. For

instance, Kaminsky, Lizondo, and Reinhart (1997) distinguish four broad approaches to

empirical work on crisis prediction: (a) qualitative discussions, (b) examination of stylized facts,

(c) individual and multicountry panel studies testing theoretical models, and (d) evaluations of


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the usefulness of leading indicators. Less extensive cross-country work has been done in

identifying corporate sector indicators that are useful predictors of crises in emerging markets.

The conference helped to fill this gap with papers by Jack Glen (chapter 3) and by Michael

Gapen, Dale Gray, Cheng Hoon Lim, and Yingbin Xiao (chapter 4).

Glen proposes the interest coverage ratio (ICRthe ratio of earnings, before interest,

taxes, and depreciation expense, to interest expense) as a measure of firm viability: firms with a

ratio below 1 do not generate adequate cash flow to service their debt. He analyzes the

relationship between the ICR and factors specific to the firm, as well as macroeconomic events,

for a large number of firms in a broad cross section of countries during the period 19942001.

After controlling for firm, sector, and country fixed effects, he demonstrates a strong link

between the macroeconomic environment and a firms ability to service its debt. This is not

surprising. The paper adds an important dimension to our understanding of the dynamics of the

crisis in Thailand by identifying how much deterioration one would expect from any given level

of change in the economic environment. For every 10 percentage point decline in GDP growth,

the ICR drops about 1 percentage point. For example, the 16 percent drop in Thailands GDP

from 1996 to 1998 would, by these estimations, have doubled to about 25 percent the share of

Thai firms with an ICR of less than 1.

An interesting conclusion from the paper is that creditor rights have a large impact on a

countrys average ICR. Creditor rights are defined by an index ranging from 1 to 4, with higher

values indicating stronger creditor rights. Glen finds that a movement of one unit in this index

increases the average ICR in a country by 0.83. Apparently, better creditor rights induce firms to

be more conservative in their capital structure.


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In chapter 4, Gapen and his co-authors estimate corporate sector credit risk using the

contingent claims approach, a concept widely applied by financial market participants to

measure the default probability of a firm. The contingent claims approach uses options theory to

measure the value of the firm in terms of the market price of securities in the capital structure

(because equity can be thought of as a residual claim with limited liability, there is a

correspondence between equity and a call option). The authors compute the distance to distress,

which is the difference between the implied market value of firm assets and an indicator of the

level of debt, scaled by a one standard deviation move in firm assets. This model would have

provided an accurate view of the pending financial difficulties facing the Brazilian corporate

sector in the buildup to the crisis and would have signaled serious problems for many Thai firms

nearly 18 months before the floating of the baht.

The authors also point out that a complete analysis of the risks involved in corporate

sector vulnerabilities must take into account third-party guarantees, such as government

guarantees of the financial system. In Brazil, use of the contingent claims approach to estimate

convertibility risk appears to explain some of the rationale behind capital outflows and corporate

sector behavior during the second half of 2002. In Thailand, the contingent claims methodology

shows that the likely cost to the government of financial sector guarantees rose markedly during

the crisis, reaching between 30 and 40 percent of GDP by October 1997. Subsequent

restructurings in the financial sector indicate that this estimate was relatively accurate.

The final perspective on detecting systemic corporate vulnerability comes from one of the

few government agencies in the developing world devoted specifically to monitoring corporate

sector vulnerability on a permanent basis. In chapter 5, Rodolfo Danies Lacouture discusses the

activities of Colombias Superintendency of Companies, established to monitor and, as


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warranted, intervene in businesses with the goal of preventing crises, ensuring confidence in the

legal system, and generating reliable accounting data. The Superintendency of Companies

reviews companies, on its own initiative or at the request of a minority shareholder, to evaluate

the companys legal, accounting, economic, and administrative status. If a company is subject to

significant problems, the superintendency first provides support by reviewing annual business

plans and monitoring quarterly information to see if progress is being made. For companies

found to be in violation of public orderfor example, officers have committed fraud or the

company is in immediate risk of insolvencythe superintendency may remove management,

impose fines, and, in the extreme case, order liquidation of the company. The superintendency is

also charged with establishing the legal process for restructuring and bankruptcy and may act as

the judge in bankruptcy proceedings.

The superintendency has focused on gathering information on companies and overseeing

insolvency proceedings. Almost 2,500 companies have been subject to special follow-up because

they were in a critical financial situation, and the superintendency is seeking to reach

restructuring agreements for companies that handle 1.1 billion pesos in assets and have 2,000

jobs at risk. The superintendency also has developed a diagnostic index program to evaluate

company operations. The program (available on the Internet) helps companies to benchmark

their performance relative to a peer group and to identify the risks they confront. This preventive

system has reaped significant advantages over the past three years, contributing to a sharp

decline in the number of companies entering into restructuring agreements or mandatory

liquidation.


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[1] Legal, Regulatory, and Policy Responses to Systemic Corporate Crises [end]

A strong bankruptcy framework is critical to the investment climate and the efficiency of capital

markets. If, in the event of adversity, creditors lack assurance of being able to recover collateral

or salvage a portion of their loan, they will reduce the volume of their lending, restrict lending to

borrowers who hold collateral that can be repossessed easily, or raise the interest rate. Thus the

allocation of capital will be less efficient, and the volume of investment lower, than would be

possible with an effective bankruptcy framework. This framework has several aspects, including

the administrative efficiency of courts (for example, whether cases are considered expeditiously),

the impartiality and expertise of judges (whether judges are honest and knowledgeable about

commercial law and business realities), the consistency of court decisions (whether the outcome

of disputes is predictable), the supply of competent accountants and the use of acceptable

accountancy principles, and the appropriateness of the laws and regulations governing

bankruptcy (for example, whether they are balanced and not overly weighted to either debtor or

creditor interests or are consistent with efforts to maintain bankrupt firms as a going concern,

where feasible). While several countries took steps following systemic crises to improve the laws

governing bankruptcy, reforms to enhance the capacity and expertise of the bankruptcy process

proved more elusive.

The appropriate structure of bankruptcy law in industrial economies is evolving with the

level of economic development. As James Zukin writes in chapter 9, earlier bankruptcy regimes

emphasized tangible property rights, the rights of secured creditors, and the realization of assets

to discharge debts. However, in modern economies, the value of the firm as a going concern


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often exceeds the value of tangible assets, due to advantages such as human resources,

organization, and brand-name recognition. Thus modern bankruptcy regimes, as exemplified by

the U.S. Chapter 11 system, emphasize maintaining firms as going concerns, with provisions for

stays on litigation, standstill agreements, debtor-in-possession financing, negotiations to achieve

workable reorganizations, and cram-down of majority-approved agreements on minority

holdouts. Restructuring regimes in industrial countries are moving toward the Chapter 11 system,

and some limited progress has been made in emerging markets, although the balance between

creditor and debtor interests varies considerably. Although there are clear advantages to a

Chapter 11style reorganization framework, it can provide scope for delays and requires a highly

specialized judiciary. In Thailand, the process gave debtors scope for delay. Therefore, emerging

markets have to calibrate the Chapter 11 process to the realities of the specific country and build

in adequate checks and balances, such as time-bound resolutions.

Weaknesses in the bankruptcy regimes of emerging markets are detailed in chapter 6.

Gordon Johnson reports on a joint World BankIMF initiative to set standards for the assessment

of bankruptcy regimes (as part of a broader effort to assess financial systems). Standards were

developed for each step in the credit process, including access to credit (systems for credit

information, collateral systems, and registries), companies in financial distress (risk management

practices, resolution devices, legal frameworks for corporate workouts, and the broader

environment that would promote and enhance corporate workouts), and formal systems for

resolution and recovery. If one considers the choices made in insolvency systems along a scale,

where one extreme is pro-debtor and the other is pro-creditor, these standards fall at about the

midpoint of systems adopted in the industrial countries.


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The assessments of the transition economies in Europe, several countries in Latin

America, and a few emerging markets in Asia provide a mixed picture. For creditor rights, about

half of the countries are operating more or less at a functional level, while the rest fail to meet

standards in most areas. Most systems involved in the legal frameworks for insolvency are not

working effectively, even in countries that have updated their laws in recent years. The

rehabilitation procedures for companies undergoing restructuring in emerging markets are not

much better, and the assessment of institutional and regulatory frameworks is worse. There is

enormous need for greater capacity to oversee corporate restructuring in the court systems and

regulatory bodies of emerging markets. Johnson emphasizes the weak treatment of employee

rights and social protection of labor, the lack of access to financing, and tax provisions that

penalize restructuring as major obstacles to successful corporate workouts.

In chapter 10, this broad overview of the state of bankruptcy regimes is complemented by

the perspective of a practitioner in emerging-market bankruptcy cases. Ray Davis cites the lack

of predictability in the process for recovering on defaulted debt in many emerging markets. The

lack of an effective legal framework for insolvent companies means that successful restructuring

negotiations are more dependent on intervention by government or the organization and skill of

the negotiating parties.

Davis cites several ingredients for successful restructuring outcomes. Strong leadership

by creditors is essential to impose discipline on the company and to prevent dissident creditors

from using the legal system to obstruct negotiations. Lengthy negotiations should be avoided due

to the potential for destruction of value, particularly in countries where the law enforcement

system is too weak to impose effective sanctions on destructive workers. Cash controls are

needed to protect creditors interests, because they prevent owners and managers from siphoning


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funds from the business during negotiations. The presence of at least some local creditors can be

helpful in gaining favorable treatment by regulators and the courts, and local creditors may be

better placed than foreigners to gain acceptance of draconian measures. In Daviss experience,

government intervention has been useful in achieving successful restructurings in Malaysia and

Mexico, but less so in Indonesia, where the Jakarta Initiative has been relatively ineffective in

larger, more complex cases.

Tax policy has an enormous impact on the success of corporate restructuring. In chapter

8, Vassilou Lampros and Gordon Johnson review case studies of how the tax system affected the

ability of firms to restructure successfully. In principle, the tax system should be neutral with

regard to operational and financial restructuring during stable economic situations and should

encourage solutions that preserve companies as ongoing concerns. During periods of systemic

corporate distress, policymakers should consider targeted promotion of rapid restructuring such

as time-bound tax incentives and amnesty of debt restructuring. In practice, tax rules are not

restructuring friendly and pose significant obstacles to financial and operational restructuring in

numerous countries. Restructuring transactions may be subject to various kinds of transfer taxes

or may trigger taxable events at a time when distressed companies lack the resources to cover tax

liabilities. Lampros covers issues such as the importance of allowing carryforward of losses to

facilitate bank mergers, steps taken to exempt corporate restructuring transactions from taxes in

Malaysia and the Philippines, tax exemptions for mutual funds set up for corporate restructuring

in Thailand, and the impact of the tax system on transactions by asset management companies in

China and Taiwan (China).

Out-of-court workoutprocedures, generally based on the London approach developed by the


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Bank of England, have played an important role in corporate restructuring following systemic

crises. Such workouts can avoid lengthy, potentially more expensive court cases. Moreover,

following systemic crises, courts often are unable to handle the large number of restructuring

cases. Thus several countries hit by systemic crises established procedures and provided

government support for out-of-court workouts. As Stijn Claessens emphasizes in chapter 11, out-

of-court workouts were more successful in countries where effective bankruptcy regimes

established appropriate incentives for parties to reach agreementfor example, in Korea and

Malaysia (and, to some extent, Turkey)than in countries with weaker legal systemsfor

example, in Indonesia, Mexico, and Thailand.

Out-of-court procedures differ by country, but they typically have the following

elements: a standstill period during negotiations, designation of a lead creditor and a creditor

committee, some higher authority that can resolve cases and arbitrate disputes, reliance on

professional due diligence (audit firm or insolvency experts), agreement by majority that is

binding on all creditors, provision for rescheduling of obligations coupled with operational

restructuring, imposition of losses on both creditors and debtors, and access to new working

capital.

In chapter 12, Ira Lieberman, Mario Gobbo, William Mako, and Ruth Neyens draw

several lessons from the experience with out-of-court workouts. One key aspect is to address the

needs of different kinds of firms. The widespread failure of small businesses may be addressed

through blanket rollovers and injection of liquidity for working capital. Mid-size firms require

rollovers and extensions of bank credits to help them ride out the crisis. And the largest firms

must be dealt with on a case-by-case basis, with deep corporate restructuring and avoidance of

simple bailouts. It is important to impose losses on all stakeholders, including managers,


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creditors, and owners. The authors also cite improvements to prevent and cope with future crises,

including stronger transparency to limit the problems with insider lending, greater capacity to

manage corporate restructuring, and the availability of a menu of tools to deal with crisis-

induced insolvencies (including restructuring funds or special-purpose vehicles, formal

bankruptcy systems, prepackaged bankruptcies, asset management companies to provide relief to

banks, market solutions to divest asset management company assets, and voluntary workout

schemes). Finally, procedures for out-of-court workouts must recognize that coping with

systemic crises can take years and should provide for a second round of modifications once

economic conditions have stabilized.

William Mako, in chapter 7, cites lessons from the East Asian workout regimes,

beginning with those that are relatively easy to implement. The identification of the appropriate

principles and processes to guide workouts can be based on best practice examples, such as the

model memorandum of understanding for Korean workouts. Legal and regulatory impediments

to restructuring can be eliminated quickly, assuming sufficient political consensus. Governments

can and should invest in capacity to deal with future workouts and should use existing capacity

efficiently by segmenting firms by size (as in Malaysia). More difficult obstacles to successful

restructuring involve the ability of creditors to impose losses on a debtor (given weak legal

frameworks and political pressures), the governments readiness to force creditors to recognize

losses from corporate restructuring, and the resolution of inter-creditor differences regarding the

allocation of losses and risk.

Establishing the appropriate incentives for both corporates and banks, while limiting the

economic collapse from financial crisis, is a major theme of Stijn Claessenss paper in chapter

11. Governments are often driven to intervene to support the banking system during systemic


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crises, but they should do so in ways that maintain appropriate incentives for resolving

nonperforming loansfor example, by linking the extension of government financial assistance

for recapitalization of banks directly to the pace of financial corporate restructuring undertaken

by banks. While forbearance on the imposition of prudential requirements is often necessary

during systemic crises, it should be done without condoning excessive risk taking and cosmetic

corporate restructuring. For example, forbearance on the capital adequacy ratio is preferable to

forbearance on provisioning for nonperforming and classified loans. While both methods of

forbearance reduce the absolute amount of capital required during periods of distress,

forbearance on the provisioning of nonperforming and classified loans masks the extent of losses

and creates adverse incentives to addressing classified loans. Similarly, forbearance should be

uniform across all financial institutions rather than on an ad hoc basis, should disclose the level

of nonperforming loans, and should have explicit time limits for expiration. Incentives for

appropriate banking and corporate behavior can also be improved by limiting ownership links

between banks and corporations, by requiring disclosure of nonperforming loans and (perhaps

phased-in) adequate loan-loss provisioning, and by amending tax, accounting, and other legal

rules to avoid discriminating against corporate restructuring. Claessens also explores the

importance of corporate governance reforms, as investment and financing behavior of the

corporate sector was often one of the major vulnerabilities that led to financial crisis.

The experience of countries in crisis indicates that a lack of expertise and experience in

managing corporate activities, political pressures, and the massive number of insolvent

corporations limited the success of banks and asset management companies in achieving

corporate turnarounds and underlined the need to dispose of assets rapidly with limited

consideration for price. Rapid asset sales can attract outside investors to the management of


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operational restructuring. However, large-scale disposal of assets can be difficult because of

depressed asset prices and political pressures. One alternative is for ownership to remain with the

state for some period, but to outsource the restructuring to private sector professionals. Greater

differentiation by the type of assets is also usefulfor example, between ongoing businesses and

real estate, which is relatively homogeneous and has less potential for loss of value (and can

therefore be held by asset management companies).

The conference heard the views of policymakers who had gained considerable experience

in managing the governments response to systemic crises, as shown in chapter 13. According to

Hogen Oh, former executive chairman of Koreas Corporate Restructuring Coordination

Committee, the governments first step in confronting the crisis was to unify supervision of the

financial system and wrest control from the old boys network that had managed the

supervision of banks, insurance, and securities companies. The Financial Supervisory

Commission required banks and, by extension, corporations to adopt international accounting

standards and made the extent of losses transparent. The recognition of losses and the

elimination of cross-guarantees within corporate groups forced chaebols to restructure. The

Financial Supervisory Commission issued guidance to banks to aim for a reduction in the

leverage of the chaebols from 400 to 200 percent, a goal that was hard to achieve but did force

business leaders to take steps to rationalize their balance sheets.

The governments approach to out-of-court workouts provided for binding decisions on

restructuring if a sufficient majority of creditors could not be reached. Workouts for some 102

corporations, including Daewoo companies, were managed, with almost all reaching a successful

conclusion. The demise of Daewoo was a watershed event that dispelled the notion of implicit

government guarantees for too-big-to-fail chaebols in Korea. Following Daewoos breakout,


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other large chaebols such as Hyundai started to restructure. Oh notes that the greatest factor in

Koreas successful corporate restructuring was that the government created an appropriate

environment and provided fiscal resources to support restructuring but, with the exception of the

Big Deals, did not meddle in the details of which industry or company would survive.

Malaysia was perhaps the most successful among the crisis countries in limiting the costs

of the crisis and spurring economic recovery. Dato Zainal A. Putih, chairman of Danaharta (the

Malaysian asset management company), reviews the restructuring of Malaysias banking and

corporate sectors. Danaharta, Danamodal (which was involved in bank recapitalization), and the

Corporate Debt Restructuring Committee (which assisted voluntary corporate restructuring)

worked in tandem to address both corporate and banking sector problems. Danahartas success in

speeding the disposition of nonperforming loans was assisted by special powers to facilitate the

disposition of assets, including the acquisition of nonperforming loans from banks via statutory

vesting (which sped up the transfer process), foreclosure on property collateral bypassing the

court process, and appointment of a special administrator with full control and responsibility

over a company that cannot settle its debts with Danaharta. Danamodal worked to maintain

appropriate incentives by requiring banks receiving capital injections to write down

shareholders capital, submit recapitalization plans, and meet monthly reporting of performance

against a list of identified targets. The Corporate Debt Restructuring Committee, or CDRC, was

established in July 1998 to help mediate voluntary out-of-court restructuring of large debt cases

involving viable borrowers with multiple major creditors. By the time CDRC closed down in

end-July 2002, it had resolved all 48 cases accepted for mediation, involving a total debt

outstanding of RM 52.5 billion.


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Although the three agencies were established with the objective of maintaining financial

market stability, they worked in perfect unison, contributing directly or indirectly toward

corporate restructuring. Danaharta encouraged viable borrowers to restructure their loans,

Danamodal played a crucial role in restoring confidence in the safety and soundness of the

banking sector (thus preventing systemic failure and setting the foundation for stronger

recovery), and CDRC paved the way for operational restructuring, such as through the disposal

of assets or the sale of non-core business. Putih notes that all three agencies were created as

finite-life agencies in order to minimize moral hazard. It is notable that Malaysias policymakers

viewed the agencies role as limited to a period of systemic turbulence and elected to disband

them and rely on market discipline once the crisis had passed.

Shinjiro Takagi, chairman of the Industrial Revitalization Corporation of Japan (IRCJ),

discusses the Japanese experience with the resolution of nonperforming loans. Since 1999, Japan

has made progress in improving the bankruptcy framework and adopted guidelines for out-of-

court workouts. Takagi notes two areas where further improvements are necessary: (a) the new

reorganization procedures treat the right of unsecured trade creditors and other unsecured

creditors equally, thus reducing incentives for the provision of trade credit, which is essential for

maintaining a business as a going concern, and (b) the guideline for out-of-court workouts

requires the consent of all affected financial creditors, so that no compulsory power exists to

induce creditors to accept the plan. Along with reform of the law, almost all the courts in Japan

are opening their gates wider to reorganization cases, and the cases are being handled more

expeditiously.

IRCJ was established to purchase loans owed by distressed debtor companies that can be

rehabilitated. Companies and staff from the companys main bank submit restructuring


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proposals to IRCJ, and after extensive review and revisions to the plan, the company and bank

submit a formal request for assistance. On approval, IRCJ purchases the debt when the non-

main banks apply for debt purchase or agree to the reorganization plan and then sells the

purchased debt within three years. Banks were reluctant to bring large, influential cases to IRCJ,

because they were concerned about losing control during the valuation process and their

financial strength deteriorated during the prolonged economic recession. However, with the

recent recovery and restored profitability, the main banks are bringing more cases this year.

[1] Restructuring Techniques [end]

Progress in corporate restructuring requires more than ensuring that regulators and private sector

agents face the appropriate incentives. The size of banks nonperforming loans, coupled with the

governments commitment to support the financial sector (and indeed the governments

responsibility for economic stability and growth), has required specific financial interventions to

resolve corporate distress. Governments that have achieved some success in corporate

restructuring have established new institutions, provided the legal basis for new forms of

transactions, and adopted innovative financial strategies to facilitate the disposal of distressed

assets.

In chapter 15, Richard Daniel reviews the prerequisites for resolving a large overhang of

nonperforming loans, based on his experience heading the Grant Street National Bank (set up to

liquidate low-quality assets from Mellon Bank). First, it is necessary to take the portfolio of bad

loans away from the lenders who made them. The initial lenders are likely to be unwilling to

acknowledge, or even recognize, their own mistakes. Moreover, collecting on bad loans, or


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restructuring companies, requires a different set of skills than making new loans. The collector

needs to know when a loan is bad and how to extract the most out of the situation as fast as

possible. And the loan collector needs to have the unqualified determination to collect, which

may be difficult for loan officers who originated the bad portfolio. But more than the appropriate

personnel, banks dealing with an excessive problem loan portfolio need effective credit quality

control and asset classification, access to a well-functioning legal system to help force collection,

sufficient reserves, and the will to stop making, or renewing, bad loans. This latter quality can be

a major problem in countries trying to move from a state-managed to a free-market economy.

The establishment of centralized agencies to take over and dispose of banks distressed

assets was a common feature of countries hit by systemic corporate crises. After an introduction

by Ruth Neyens of the World Bank, chapter 14 gives presentations by managers in some of the

more successful asset management companies, including Dat Zukri Samat from Danaharta,

Beom Choi of the Korea Asset Management Company, and Yang Kaisheng, president of Chinas

Huarong. Taking nonperforming loans off of the banks books enabled them to focus on the core

activities of financial intermediation, minimized the incentive for banks with dwindling (or

negative) capital to take large risks, severed the ties between banks and corporates that impeded

asset resolution, and enabled banks to clean up their balance sheets, a prerequisite for raising

further capital. Setting up new agencies with special powers also allowed governments to

eliminate some of the legal obstacles to restructuring, while maintaining control over the process.

And centralizing extremely scarce restructuring expertise in one or a few agencies helped to

achieve economies of scale in restructuring.

But not all asset management companies achieved a substantial, rapid restructuring of

nonperforming loans. The landscape is full of failed agencies, such as Mexicos FOBAPROA


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(Spanish acronym for Bank Fund to Protect Savings) and the Indonesian Bank Restructuring

Agency. The relatively successful agencies presented here are the exceptions. First and foremost,

each agency emphasized transparency as a key principle of operations, to maintain public

confidence in the process, facilitate acceptance of asset management company decisions by

ensuring fairness, and enable potential buyers to evaluate assets for sale. For example, Danaharta

took particular care to ensure transparency by requiring disclosure of business plans, public

notices, and regular reports on progress. Governance structures that ensured efficient

administration, open transactions, and checks and balances on management were equally critical

to success. Danaharta provided for the review of restructuring plans by an independent adviser

and for approval by secured creditors. And KAMCO emphasized transparent procedures and fair

transactions. Each company had only one opportunity to restructure, which minimized strategies

that maintained company operations while delaying resolution of the underlying problem.

Malaysia also mandated that Danaharta be short-lived, so that the agency could not perpetuate

itself and banks would realize that they, not the government, were responsible for future

nonperforming loans.

The asset management companies also benefited from special powers that were not

available to other institutions, principally the banks. The act establishing Danaharta facilitated

the acquisition and disposal of assetsfor example, by enabling Danaharta to foreclose on

collateral and bypass court auction processes. In China, the asset management companies have a

critical advantage over the state-owned commercial banks, as the banks cannot grant debt

forgiveness, while the asset management companies are allowed to resolve assets at less than

their book value. Some of the innovative financial structures established by KAMCO to dispose

of distressed assets benefited from tax incentives.


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Engaging private sector cooperation and ensuring competitive markets were critical.

Successful asset management companies adopted a menu of asset disposition strategies, so that

flexibility and the ability to innovate were important to progress:

[begin list]

In Malaysia, the asset disposition process was market driven, with competitive

bidding through a transparent process and, to the extent possible, enhancement of the

value of business or collateral. Danaharta took over approximately 3,000 accounts with a

value (determined by professional appraisers) of RM 52 billion and is expected to recover

58 percent.

Chinas Huarong uses various resolution strategies, including agreement on

revised repayment plans, discounted borrower payoffs, debt-to-equity swaps, collateral

sales, litigation, and the sale of nonperforming loan assets to third-party investors. Over

the past four years, Huarong has resolved more than $16.6 billion in nonperforming

loans, with an average asset recovery rate of 32 percent.

KAMCO employs a range of financial techniques, including portfolio sales,

securitization, public sales, foreclosure sales, individual loan sales, and rescheduling. One

innovative aspect of KAMCOs operations is the use of a variety of financial structures to

encourage private equity participation, including joint ventures, corporate restructuring

companies that managed a wide variety of companies undergoing restructuring, asset

management companies established under the Asset Securitization Law, and corporate

restructuring vehicles that focused on restructuring single companies.

[end]


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Two innovative approaches to asset disposition are worthy of further comment. In order

to increase the speed of asset resolution, Huarong sold portfolios of nonperforming loans, in part

to foreign investors. This involved resolving a host of regulatory and policy issues concerning

the participation of foreign investors. The first international auction was held in 2001, and the

second in 2003, with a nonperforming loan portfolio totaling $3 billion. Huarong also piloted a

quasinonperforming loan securitization program, under which assets with relatively high future

cash flows are transferred through a trust to private investors, similar to a securitization deal

(legal, accounting, and supervisory obstacles prevent a true securitization deal in China).

KAMCOs corporate restructuring vehicle is a financial structure that focuses on

restructuring viable companies of medium or large size. The corporate restructuring vehicle also

enjoys tax benefits, which helped banks to dispose of equities received in debt-equity swaps.

Despite its promise, only a few transactions have occurred. The new legal structure and the

valuation of large companies are complicated, and, without the threat of court-imposed losses,

corporate debtors lack incentives to agree to draconian restructuring measures required in

transferring a corporation to a corporate restructuring vehicle. Some creditors also balk at the

transfer to a corporate restructuring vehicle: underprovisioned banks are unwilling to give up

control over their larger properties (which could mean having to recognize large losses), senior

creditors are reluctant to be treated equally with other rights holders, and loan guarantors are

unwilling to recognize losses immediately. Thus holdout creditors often request a cash exit,

undermining the ability to use the structure of a corporate restructuring vehicle.

Christopher Vale provides a managers perspective on the Korean corporate restructuring

funds in chapter 16. Corporate restructuring funds were established with the dual objectives of

improving performance and achieving policy goalsfor example, support for the small and


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medium enterprise sector devastated by the crisis, encouragement of new investments and

technological development, and achievement of stronger corporate governance. The multiple

mandates at times led to difficult tradeoffs. For example, there was little international appetite for

funds with policy objectives, so funding had to be mobilized from domestic banks. The funds

could only invest in newly issued debt or equity, which hindered some transactions (for example,

a fund could not buy old debt at a distressed price). The funds were subject to guidance from the

Ministry of Finance (for example, when they were asked to get involved in restructuring in

addition to making new investments), although the government did not interfere in individual

investment decisions. The funds were limited to 50 percent in the equity of the chaebol and 10

percent in any one company and were required to make at least 25 investments. Given the

relatively small size of the funds ($250 million), the largest investment was $25 million and the

average was $10 million. This was difficult to achieve with any reasonable administrative cost.

The fee structure was poorly designed and generated inadequate profits. And the management

contract was for two years, which was insufficient to allow investments to mature.

The investment funds had some positive impact on the Korean economy. Many small and

medium enterprises were provided equity financing, and merchant banks were motivated to get

involved in the restructuring process. Interest by the foreign-managed funds increased the

interest of other investors in targeted companies. Improvements in the structure of the funds for

the future could include setting up funds offshore to avoid some constraints of the mutual fund

law in Korea, avoiding annual distributions that limited flexibility and exposed the fund to tax

liability, achieving better support from an active board (the boards of the funds were composed

largely of banks that had been forced to contribute and were concerned mostly with getting their

money out rather than with improving operations), and limiting the range of investments.


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The development of distressed debt markets would assist banks and governments in

finding market solutions to dealing with bankrupt corporations. However, as John Butler Jr., Bill

Derrough, and Lynn Hiestand describe in chapter 17, the secondary markets for distressed

corporate debt are relatively underdeveloped in most emerging markets. While progress has been

made in creating markets for distressed debt in some countries of Asia and Latin America, little

has been done in Africa and the Middle East. Efforts to sell distressed debt are subject to lengthy

due diligence and lack of standard documentation, leading to variable and sometimes protracted

settlement periods, creating the potential for failed trades and substantial legal costs. In order to

build effective markets for distressed debt, countries need a high level of transparency and

reasonable certainty of how the laws dealing with troubled situations will be enforced. Measures

to increase the transparency and efficiency of distressed debt markets include standardization and

simplification of loan agreements, standards for settlement procedures, codes of practice for

market activity (such as a protocol for due diligence), and transparent mechanisms for loan

valuation. Butler, Derrough, and Hiestand cite efforts by the Asia Pacific Loan Market

Association to develop a secondary market in corporate debt in Asia.

[1] Reference [end]

Kaminsky, Graciela, Saul Lizondo, and Carmen Reinhart. 1997. Leading Indicators of Currency

Crises. Policy Research Working Paper 1852. World Bank, Latin America and

Caribbean, Office of the Chief Economist. Washington, D.C.

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