British Accounting Review (1996) 28, 121–137

ECONOMIC CONSEQUENCES OF DEBTCOVENANT VIOLATION: THE CASE OF

INNO-PACIFIC HOLDINGS LIMITED

TREVOR WILKINSNational University of Singapore

IAN ZIMMERUniversity of Queensland

This paper describes a case involving default on public (loan stock) debt by the listedSingaporean company, Inno-Pacific Holdings Limited. The case demonstrates throughthe chronology of events how technical default on public debt can be costly. Thepaper also documents the reactions of the trustee and bank creditors, illustrates howan independent third-party adviser to the loan stockholders can minimize the costs ofdefault, and describes a practical solution to a claim dilution issue involved in adivestment and repayment plan which aligns the interests of the various claimholders.

1996 Academic Press Limited

INTRODUCTION

The accounting choice literature assumes explicitly that the avoidance ofaccounting-based debt covenants is a determinant of accounting policychoice. For example, researchers frequently propose that managers of firmsthat are close to leverage constraints in trust deeds prefer to select income-increasing accounting procedures to avoid or defer technical default1 (see,for example, Watts & Zimmerman, 1986, 1990; Chen & Wei, 1993; DeFond& Jiambalvo 1994; Sweeney, 1994). This assumption, in turn, implies thattechnical default cannot be resolved at low cost by negotiation with lenders.Beneish & Press (1993), for example, conduct a cross-sectional study on asample of United States firms which shows that technical violation ofaccounting-based covenants is costly. In this paper, we use a case involving

The authors acknowledge the helpful comments received from Andrew Chen, Andrew Khoo and LuhLuh Lan. We also benefited from the helpful comments of an anonymous reviewer.

Correspondence should be addressed to: Trevor Wilkins, Associate Professor, Department of Financeand Banking, Faculty of Business Administration, National University of Singapore, 10 Kent RidgeCrescent, Singapore 0511.

Received 8 September 1994; revised 15 May 1995; accepted 5 July 1995

0890–8389/96/020121+17 $18.00 1996 Academic Press Limited

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default on public debt by the listed Singaporean company, Inno-PacificHoldings Limited (Inno-Pac), to illustrate the detailed procedures usedwhere technical violation is costly.

The use of case studies to provide further insights into issues in theaccounting and financial economics literature is now relatively morefrequent in different journals across different countries (see, for example,Kaplan, 1989, 1994; Brown & Dunlop, 1991; Buchan, Peasnell &Yaansah, 1992; Flanagan & Whittred, 1992; Van Nuys, 1993; Whittred,1994). However, this case is of particular significance as it focuses ondefault on public debt.2 Unlike private debt for which the informationconcerning defaults is difficult, if not impossible to obtain, this publicdebt is subject to additional monitoring through the Stock Exchange ofSingapore reporting rules as well as by the trustee. Therefore, theinformation on the chronology of events associated with the defaults wasmade publicly available on a timely basis through the various circularsissued by the company and approved by the Stock Exchange of Singapore,and through the Singapore financial press.

The default on a public debt is also significant for other reasons. First,because contract negotiation is less costly in private debt issues,3 UnitedStates research shows that virtually all the technical defaults occur inprivate rather than in public debt issues (Smith, 1993, p. 292; Sweeney,1994, p. 290; Gopalakrishnan & Parkash, 1995)4. Furthermore, researchindicates that financial distress is less likely to be resolved through privaterenegotiation when there are more classes of debt outstanding; althoughit is more likely when relatively more debt is owed to banks (Gilson,John & Lang, 1990). This case demonstrates through the chronology ofevents involving the default on public debt by Inno-Pac how default canimpose severe costs on a firm. The case documents the materialcosts of covenant violations involving debt restructuring, divestitures,appointment of an independent third-party adviser, and suspension ofsecurity trading. The case also illustrates how the interpretation oftechnical default on a financing constraint defined over an accounting-based leverage ratio can subsequently be difficult. In addition, it documentsthe reactions of the trustee and bank creditors, and illustrates the valuablerole of an independent third-party adviser to the company’s loanshareholders in minimizing the costs of the default and adjudicating theterms of the restructured claims that promised to leave the respectiveclaimholders better off. The events also describe a practical solution toa claim dilution issue involved in the divestment and repayment planproposed by the company to its debtholders. Finally, the paper documentschanges in Inno-Pac’s management and organizational strategy andstructure subsequent to the default and financial restructuring. This lastsection provides some anecdotal evidence on the benefits of financialdistress to the firm’s claimholders. Amounts referred to are all inSingapore dollars unless denoted otherwise.

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THE TECHNICAL DEFAULT

During 1992, Inno-Pac had two outstanding unsecured loan stocks withtransferable subscription rights for shares in the company.5 On 18 August1992, the trustee for both these notes, British and Malayan Trustee Ltd(BMT), served notice to Inno-Pac requiring it to rectify a breach in thelimitation on borrowing covenant that was written around the leverage ratiowithin 30 days (The Straits Times, 24 August 1992, p. 39). More specifically,the covenant required the borrowings of the group to be not more thanfour times the ‘adjusted’ total of capital and reserves as defined in the trustdeeds. The audited consolidated accounts of the group as at the 31 December1991 reported total liabilities that were 4·65 times the adjusted total capitaland reserves of $27·5 million.

In response, Inno-Pac released a public statement. This statement saidthat proceeds of the group’s divestment of its investment in five companieswould be used to reduce its borrowings.6 The statement said that the $36·5million expected to be raised from this major divestment programme wouldreduce Inno-Pac’s borrowings by $34 million, after providing $2·5 millionfor working capital. This would bring its debt ratio back within the fourtimes stipulated in Clause 7 of the trust deed. However, the statement didnot satisfy the trustees, and on 2 September 1992 Inno-Pac requested atemporary suspension of trading in its shares, loan stocks, and warrantspending an announcement. A company spokesman for Inno-Pac also stressedthat the breach was ‘made only on “technical grounds”,’ claiming thatarrangements were already under way to remedy it, and appealed to investorsnot to press for early repayment of its loan stocks because ‘it was illiquidand needed time to conduct an orderly disposal of assets’7 (The Straits Times,3 September 1992, p. 39).

BACKGROUND TO THE PROBLEM

Inno-Pac was initially a single business company operating the KentuckyFried Chicken restaurants as a franchisee in Singapore since 1976 underthe name of Kentucky Fried Chicken (S) Ltd. It was listed on the StockExchange of Singapore in 1983, and in September 1985 Innovest Berhadof Malaysia became the (51%) controlling shareholder (and ultimate holdingcompany) of a loss-making operation. The company returned to profitabilityin 1986 under a new management and a corporate restructuring. Underthis scheme of reconstruction, Kentucky Fried Chicken International Cor-poration became a 50% joint venture partner in a new subsidiary company,Kentucky Fried Chicken Management Pte Ltd, to operate the KFC res-taurants in Singapore, and the company became principally a holdingmanagement and investment company.

The company subsequently adopted its present name and expanded,

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through equity participation, in the operation of KFC restaurants in WestMalaysia through the associated company, KFC Holdings (Malaysia) Be-rhad, the KFC franchise operator in that country (the joint venture agree-ment with Kentucky Fried Chicken International Corporation wassubsequently terminated in November 1992 upon the sale of the KentuckyFried Chicken Management Pte Ltd subsidiary to Pepsico Holdings). Smallprofits were then recorded in 1987 and 1988. Between 1989 and 1990Innovest Berhad of Malaysia also reduced its controlling shareholding from51 to 42%, and then subsequently ceased to be a substantial shareholderin Inno-Pac following the sale of its respective shareholdings in KFCHoldings (Malaysia) Berhad in December 1992 and in Inno-Pac in March1993 (The Straits Times, 12 May 1993, p. 39).

In the late 1980’s and early 1990’s Inno-Pac embarked on an ‘acquisitionspree’ which saw it expand and diversify into businesses that had little incommon with one another; including aluminium fabrication, electroniccomponent plant, and chemical operations (The Straits Times, 1 October1992, p. 48). In February 1989, it also acquired Shakey’s Inc. USA, andset up a chain of Shakey’s restaurants in the Asia Pacific region throughsubsidiaries in Singapore, Thailand, Hong Kong, and Taipei. By 1991, theInno-Pac group had expanded and diversified to comprise 51 subsidiariesand sub-subsidiaries and 16 associated companies, principally engaged infast-food franchising (including owning and operating Kentucky FriedChicken and Shakey’s pizza restaurants), paper and other product trading,8

and chicken farming and processing. Besides Singapore, Malaysia andthe United States, Inno-Pac had also spread its operations to Indonesia,Philippines, Thailand, Hong Kong, Taiwan, China, the Middle East, Malta,Hungary, Poland, Mexico and Jamaica.

To finance its acquisitions and diversification, Inno-Pac issued new shares(including a rights issue for $27 million in April 1989), and substantiallyincreased its borrowings and leverage. The borrowings included raising a$60 million short-term multi-note issuance guarantee facility (NIF) inOctober 1989, new secured and unsecured bank loans, and the $36 millionpublic debt loan stock on which it was in default in August 1992. Thus, bythe end of 1991 the company owed a total of $90 million to bankers inaddition to the $36 million to its loan stockholders, against a total capitaland reserves of only $55 million.

By 1992, Inno-Pac was also facing severe liquidity problems.9 At 31December 1991, the consolidated asset of $237 million (fixed and current$152 million and $85 million respectively) had to carry $182 million ofliabilities, of which $152 million were current and the remaining $30 millionlong-term. In addition, the company incurred increasing after-tax losses(before extraordinary items) of $3·1 million, $9·2 million, and $14·4 millionrespectively in 1989, 1990 and 1991. Consequently, its net tangible assetbacking fell from $1·19 per share in 1989 to 0·47 cents per share in 1991,and its share price declined from a high (low) of $2·46 ($1·10) in 1989 to

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$1·20 (80 cents) in 1991. The market prices of both the 1992 Loan Stockand 1994 Loan Stock and detachable warrants were similarly marked downseverely by investors. To compound further the company’s profitability andliquidity problems, the company’s auditors (Ernst & Young) qualified theDecember 1991 accounts to indicate that the group’s ability to repay totaldue borrowings of $76 million in 1992 was dependent on realization ofsome assets as well as restructuring of loan arrangements with bankers.Nevertheless, the Inno-Pac Board expressed the view that the group ‘hasenough on-going businesses and assets to be able to resolve these issuessatisfactorily’ (Chairman’s Statement, Annual Report, 1991).

REACTION OF THE TRUSTEE

Given the severe profitability and liquidity situation, technical default onthe leverage constraint and debt service default10 on the $17·8 million worthof 1992 Loan Stock repayable on 25 November 1992 was not entirelyunexpected; even though the company had already realized $27 million indivestments by September and had ‘plans’ for further divestitures (TheStraits Times, 3 September 1992, p. 39). Accordingly, beginning 1 Augustthe trustees wrote approximately 60 letters to Inno-Pac in August andSeptember 1992 ‘seeking clarification and information’ over the issue ofborrowing limits and repayment, including the letter of 18 August whichserved notice on the company to rectify the breach in the limitation inborrowing ratio within 30 days. Indeed, Inno-Pac received 37 letters inSeptember alone.

However, Inno-Pac subsequently committed further defaults on loans bysubsidiaries in August. These further defaults involved the demand by abank for early repayment of a US$1·5 million loan owed to Shakey’s US,and failure to discharge guarantee obligations granted to Shakey’s Singaporeof $1·4 million bank facilities. The company’s inability to perform on thesevarious obligations resulted in further events of default pursuant to the trustdeeds. Accordingly, the trustee then wrote to Inno-Pac on 1 Septemberadvising the company that it had committed a further default, and demandedimmediate repayment of both loan stocks together with accrued interest fora total of $35·89 million11 (The Straits Times, 3 September 1992, p. 39).

Similar to United States institutional arrangements, failure to cure adefault on debt service or breach of a covenant within a grace period (usually30 days) gives lenders or their trustees the option to seek remedies. PriorUnited States research (Chen & Wei, 1993) shows that lenders react toviolations of accounting-based debt covenants in two distinct ways: theyeither grant a waiver of the violation, or demand certain conditions, suchas early repayment, increase of interest rate, asset divestitures, restrictionof further borrowing, and so forth. Chen & Wei (1993) also show that awaiver is less likely to be granted to a firm with a higher estimated probability

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of bankruptcy and a higher leverage ratio, and that the consequences fornon-waiver firms are very different and much more severe for some (suchas payment demanded) than for others (such as tightening terms).

Beneish & Press (1993) attempt to measure the monetary costs of thoseconsequences by providing evidence of refinancing and restructuring costsand changes in investing and financing decisions. In addition to showingthat technical violation is costly, they provide evidence that the costs facingfirms that violate accounting-based covenants in debt agreements are greaterfor firms that cannot obtain a waiver than for those that can, and thatlenders increase their control of firm activities through the adding ofnumerous new restrictions on investing and financing to prevent furtherdissipation of assets. Within this theoretical context, the reactions of thetrustees to serve the respective notices on Inno-Pac for technical default on18 August and for failure to discharge guarantee obligations granted tosubsidiaries on 1 September, rather than to grant a waiver, are consistentand understandable. The costs imposed on Inno-Pac subsequent to thesedefaults and the increased lender control of Inno-Pac’s activities post-defaultare also consistent with this United States evidence.

However, notwithstanding these actions, the trustee allowed Inno-Pac aconcession in response to the company’s appeal not to press for earlyrepayment of its loan stocks. The trustee agreed to allow the company tohold separate meetings with each of the two groups of loan stockholders toexplain their position and to ask for more time to carry out and completeits proposed divestment and repayment plan. This appeal followed a partialrepayment of $7·89 million to the trustee in September following thesale of an associated company’s (KFC Holding [Malaysia]) shares andconvertible unsecured loan stock which were held by Inno-Pac and its 90%owned Malaysian subsidiary Top Text Sdn Bhd (The Straits Times, 1 October1992, p. 48). In a letter of 30 September to the trustee, that was madepublic upon the instructions of the Stock Exchange of Singapore, Inno-Pacalso assured all creditors that it had firm intentions to repay its loans within‘a reasonable period of time’, and stated that it was preparing the variouscirculars to shareholders to convene the necessary extraordinary generalmeetings to obtain approval for the divestments already announced.

INTERPRETATION OF LEVERAGE CONSTRAINT

DeFond & Jiambalvo (1994, p. 152) point out that a frequent response toa technical default is to have it ‘cured’ subsequently before accounts arefiled. In other words, by retroactively rewriting the covenant or by otheractions such that the borrowing firm was retroactively not in violation atthe balance sheet date, the firm may avoid costs of such a violation.12

An interesting variation of such a response to ‘cure’ their breach appearsto have been attempted by Inno-Pac. The accounting-based limitation on

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borrowing constraint in the trust deeds for the Inno-Pac loan stocks isdefined in terms of the borrowings of the Inno-Pac group being not morethan four times the ‘adjusted’ total of capital and reserves. Correspondencewith Inno-Pac reveals that this ‘adjusted’ capital and reserves is defined astotal group (consolidated) net assets less liabilities (of $55·37 million), less‘deferred expenditure’ [$13·13 million of which approximately $9·60 millionrepresented (intangible) trademarks for Shakey’s], less minority interests (of$14·70 million). Based on the audited year-end consolidated accounts ofthe group at 31 December 1991, the borrowings of Inno-Pac of 4·65 timesthe adjusted capital and reserves of $27·54 million are in breach of thisleverage constraint. However, in a letter dated 30 September in responseto the trustee’s notice to rectify the breach in the leverage constraint, Inno-Pac showed auditor’s computations of its leverage ratio which was belowthe specified four times as at 30 June 1992.13 Consequently, the companyclaimed that the breach based on the audited year-end financial statementswas only a technical one which had subsequently been ‘cured’ by the timeof the half-yearly (30 June) accounts.

COSTS OF VIOLATION AND SUBSEQUENT REFINANCINGAND RESTRUCTURING

Many of the costs of default are unobservable and consequently difficult toquantify or measure (see, for example, Gilson et al., 1990, p. 319; Sweeney,1994, p. 292). However, recent evidence by Beneish & Press (1993)shows that technical violation of accounting-based covenants is costly. Theyconclude that the average cost of violation is between 1·2 and 2% of themarket value of equity for the sample of United States firms that violatedtechnical constraints between 1983 and 1987. However, the costs imposedon Inno-Pac appear to be more severe. The 1992 Annual Report of Inno-Pac reports that 1992 was a ‘difficult and traumatic year’, during which‘the Group’s problems reached such proportions that its very existence wasthreatened’. Consequently, ‘the Company implemented a major divestmentprogramme to raise funds to repay its debt obligations in respect of itsoutstanding loan stocks, the notes and advances under a Multi-OptionIssuance Facility, and demands by various banks on the Company’s guar-antees issued for facilities granted to the Shakey’s businesses’.

The details of this major divestment programme are as follows. In acircular to its loan stockholders on 15 October, Inno-Pac advised of itsintentions to sell its 50% stake in its major Singapore subsidiary, KentuckyFried Chicken Management Pte Ltd. The circular also detailed four otherproposed divestments, and outlined its debt and capital repayment andrestructuring plan. According to the plan, total borrowings would be reducedby $39·1 million by 25 November 1992, and the loan stockholders wouldbe fully repaid by November 1993 (from the proceeds of five orderly

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disposals that would raise $26·5 million, and from $40 million to be raisedeither through new borrowings, or through new share or rights issues). Thiscircular also ‘warned’ the loan stockholders that rejection of the company’splan might place the company under judicial management and risk li-quidation. In such circumstances, the loan stockholders could allegedlyexpect to receive less than what they would receive under the proposal(Business Times, 16 October 1992).

Smith (1993) argues that as the number of lenders to a loan syndicateincreases, the renegotiation costs associated with a technical default arehigher. Gilson et al. (1990) also find that the more classes of debt outstanding,the less likely private renegotiation of financial distress is to be successful.In the Inno-Pac case such costs of renegotiation were minimized by theappointment of an independent adviser. Subsequent to the restructuringand refinancing plan outlined in the circular to loan stockholders on 15October, the accounting firm Coopers & Lybrand (C & L) were appointedas an independent adviser to the loan stockholders. C & L’s letter of adviceon 2 November to the loan stockholders recommended that they seek threealterations to the proposed plan for it to be ‘fair and reasonable’ (The StraitsTimes, 5 November 1992). These three recommended alterations are:

1. Loan stockholders be allowed to take action if Inno-Pac incurs furtherdefaults under the trust deeds.

2. The 30-day grace period for Inno-Pac to make the second instalmentrepayment (of 33 cents for every dollar on 25 November 1992) bewithdrawn.

3. A committee comprising major creditors to be set up to monitor Inno-Pac’s divestment plan and its debt and capital restructuring.14

In response, Inno-Pac’s executive director disagreed generally withC & L’s recommended alterations. He maintained that loan stockholdersshould only have the right to take action for further defaults that would havean ‘adverse material affect’ on the company’s ability to pay. Furthermore, hemaintained that the grace period to make repayment was essential as therewas a ‘possible delay’ in the completion of the proposed sale of four of thefive planned divestments, and withdrawal of the grace period was therefore‘not in the best interest of the loan stockholders’.

However, the executive director did agree to the third C & L’s re-commendation of a committee being set up to monitor the divestment planand its debt and capital restructuring exercise; with the caveat that thecommittee ‘should not stand in the way of Inno-Pac’s efforts to makerepayments or to run the company’ (The Straits Times, 5 November 1992).Acceptance of this recommendation is consistent with evidence of Beneish& Press (1993) showing that increased lender control of firm activities, inaddition to refinancing and restructuring costs, is an important effect oftechnical violation.

In their response to Inno-Pac, C & L reiterated its view that the company’s

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response was still unfair to the loan stockholders. Accordingly, they releasedan amended list of eight recommended changes to their previous letter ofadvice on 2 November (The Straits Times, 6 November 1992). These newrecommendations were aimed at further safeguarding the loan stockholders’interests and minimizing the costs of Inno-Pac’s financial distress by (a)effectively making all debt rank equally [or, in other words, mitigating theclaim dilution problem (see, for example, Smith & Warner 1979)], (b)strengthening the monitoring, and (c) giving the loan stockholders andmajor creditor banks some form of participation in the divestment plan andthe restructuring and refinancing of the company.

Financial distress increases conflicts of interest among claimholders (see,for example, Wruck, 1990). It heightens incentives for claimants to jockeyfor advantage in the event of distress. However, three of the new re-commendations proposed by C & L align the interests of the variousclaimholders. The first major recommendation mitigates claim dilutionthrough the proposing of a fixed charge so that loan stockholders rank equalwith Note Issuance Facility (NIF) banks and other creditor banks on Inno-Pac’s remaining principal investments. C & L emphasized that ‘all classesof creditors are bound by the same terms of repayment and nobody isplaced in a position which is more advantageous than the other’. Theirsecond proposed amendment in order for the loan stockholders to be onpar with others is to allow them to take any action in the event that anyother creditor commences bona fide proceedings to enforce payment orpresents a petition for the appointment of a judicial manager or liquidatoror receiver and manager. In return, the loan stockholders are to agree torefrain from taking action against Inno-Pac until the due date of 25November 1992, and to change the period and basis for Inno-Pac to makethe proposed payments after the due date. The third new recommendationof a promise to provide security to all creditor banks and loan stockholders onproperties not included under the originally proposed divestment programmealso helps to align the interests of these various claimants.

Typically, as in at least the US, Australia, and the UK, bondholders andmajor creditors do not have representation on the board of directors andcannot potentially participate in the management of the firm within thecorporate governance framework in Singapore. The intent of covenants andfinancial contracting is to allow participation only to the extent necessaryto constrain speculative inclinations of shareholders (see, for example, Smith& Warner 1979, p. 147; Krainer, ch. 5). However, this case illustrates how,following the breach in a key covenant of the trust deeds, a number of otherpost-violation recommendations by C & L strengthen the monitoring andallow modest participation in the operating and financial decisions of Inno-Pac. For example, the recommendation that a representative of the trusteebe a member of the committee set up to monitor Inno-Pac’s divestmentplan and its debt and capital restructuring gives the loan stockholders theoption to be directly involved in the operating and financial decision-making

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with the management of Inno-Pac (the other members of this proposedcommittee were to be major creditor banks and Inno-Pac). Other re-commendations, which include requiring special accountants as co-sig-natories on all payments and withdrawals (The Straits Times, 10 November,1992), also strengthen the monitoring and increase the degree of par-ticipation provided.

Inno-Pac subsequently succeeded in obtaining agreement from the loanstockholders and banks to accept the proposals and rescheduling of debts.The repayment schedule provided for 55 cents on each dollar of debt to berepaid by 30 January 1993 from the proceeds of the divestment programme,and the balance to be secured and repaid by 25 November 1993. The twonecessary extraordinary general meetings (EGM) were both held on 9November. The quorum of 50·94% of the 1994 loan stockholders inattendance voted unanimously in favour of the divestment and repaymentscheme proposed by Inno-Pac. However the EGM of the 1992 loan stock-holders was postponed for 2 weeks as the meeting could not convene aquorum needing 51%.15 Subsequently, the requisite quorum of 1992 loanstockholders also gave approval to the company’s proposal on 24 November,and on 25 November Inno-Pac completed the sale of its Kentucky FriedChicken Management Pte Ltd subsidiary to Pepsico Holdings (for $19·5million) (The Straits Times, 26 November 1992).16

As the company was unable to redeem fully the 1992 loan stocks amount-ing to $17·8 million on 25 November, in accordance with the original termsof the trust deed, the approvals given by both groups of loan stockholdersfor the subsequent divestment and repayment plan was a reprieve forInno-Pac. The company now had approval from both these groups ofloanstockholders to delay full repayment for 1 year, and the loan stockholdersand creditor banks all ranked equally and were on par in the event of anyfuture actions being taken by any group of creditors to enforce payment.17

Thus, Inno-Pac was now able to proceed with its orderly divestment andrestructuring programme. In turn, the proceeds from the divestments realizedmost of the cash necessary to repay the promised 55 cents on each dollarof the principal amount of the loan stocks, advances outstanding underthe NIF, and the debt obligations under its guarantees according to therescheduled repayment scheme that had been agreed to.18

The foregoing procedures also illustrate how the trustee’s decision toagree to the appointment of an independent adviser and allow the EGMsin which the loan stockholders could themselves vote on Inno-Pac’s proposeddivestment and repayment plan, instead of placing the company underjudicial management and risk liquidation, reduces the costs of the default.The acceptance of the proposals to give the loan stockholders and majorcreditor banks some participation in the divestment plan and in the re-structuring and refinancing of the company strengthen the monitoring andconstrain some of the risks attached to their debts. Furthermore, giving theloan stockholders and creditors the right to take action in the event of any

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future payment defaults having a material adverse affect on Inno-Pac’sability to pay gives these creditors an option, if exercised, to have a moretimely adjudication of the claims of the different stockholders. This option,in turn, could contribute to a reduction in bankruptcy costs and reduce thepossibility of the firm being liquidated (see, for example, Gilson et al., 1990,p. 319).

It was reported after the first meeting that it was ‘evident that thethree parties—Inno-Pac, British and Malayan Trustees, and Coopers &Lybrand—were satisfied with the proposal’ (The Straits Times, 10 November1992). The company got the 30 days’ grace period for its repayments, andcreditors could only take action if the committee monitoring the divestmentexercise felt that any payment default had ‘a material adverse effect’ on thecompany’s ability to pay. The company also (successfully) applied to theStock Exchange of Singapore for a re-listing of its 1992 loan stock that hadexpired on 25 November 1992 (The Straits Times, 24 November 1992).

Prior financial economics research on the costs and benefits of financialdistress shows how financial distress triggers a process of organizationalchange and corporate revitalization that has the potential to create valuefor the firm’s claimholders (see, for example, Gilson 1989, 1990; Wruck,1990). Besides changes in a firm’s financial structure, financial distressprovides a mechanism to remove incumbent managers and bring aboutchanges in governance that discipline insiders for poor performance. Forexample, Gilson (1989, 1990) documents a high turnover of top managementand directors following financial distress. Wruck (1990, pp. 433–5) alsoprovides evidence from clinical studies and case studies documentingchanges in organizational structure and strategy, which suggests that financialdistress provides the impetus for value-increasing organizational changes.For example, actions such as selling assets, refocusing strategy and under-taking restructurings of operations, often create value for the firm’s claim-holders.

The series of changes occurring in the Inno-Pac top management andboard of directors, together with the changes in organizational structureand strategy through 1993 and 1994, are consistent with this process oforganizational change which is potentially value-maximizing for its claim-holders. For example, in August 1993 Inno-Pac announced a number ofchanges in its top management and board of directors aimed at giving ‘afresh direction to the group’ (The Straits Times, 6 August 1993, p. 47).These changes included the appointment of a new non-executive directorand chairman from KFC Holdings (Malaysia), (a company holding an11·7% investment on Inno-Pac), and the appointment of another new non-executive director (who is also the executive deputy chairman of KFCHoldings [Malaysia]), following the departure of another Inno-Pac director.The current executive director of Inno-Pac was also promoted to managingdirector, and it was announced subsequently in February 1994 that twoformer directors, (the former managing director and executive director),

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had been charged by the authorities in Singapore with criminal breach oftrust concerned with conspiring to misappropriate over $8 million of Inno-Pac’s funds between 1989 and 1990 (The Straits Times, 4 February 1994,p. 1). In June 1994, Inno-Pac also announced a restructuring of themanagement of Shakey’s International with the incumbent director andpresident stepping down (The Straits Times, 3 June 1994, p. 47).

Along with these changes in top management, Inno-Pac also announceda number of changes aimed at refocusing its strategy on its core businessesof paper trading and merchanting, and franchising and operating the Shakey’spizza restaurants. These announcements were made following the successfuldivestment of a number of its other assets and businesses in differentindustries in different countries including Singapore, Hong Kong, Chinaand Taiwan. The newly-appointed chairman also announced in May 1994that Inno-Pac would be ‘looking at new opportunities to widen its earningsbase while building on its existing businesses’ (The Straits Times, 31 May1994, p. 40). In this respect, following its successful emergence from itsfinancial restructuring in 1993, Inno-Pac proposed raising new finance, (ofapproximately US$11 million), through a renounceable rights issue of bondswith warrants in April 1994. The company also announced in May 1994that it had signed a memorandum of understanding with four other firmsto form a venture firm to develop and manage a multi-purpose warehouseand container freight station project in India (The Straits Times, 13 April1994, p. 39). Inno-Pac also revealed plans for a similar warehousing projectin Malaysia, and began the merging of the international and United Statesoperations of Shakey’s in June in a move to cut costs and strengthen Shakey’ssystem worldwide (The Straits Times, 5 May 1994, p. 40; 3 June 1994, p.47). Recently, in August 1994, Inno-Pac also announced the company’splans to launch a fast-food pizza chain in India through Shakey’s RestaurantsIndia, a joint venture between Inno-Pacific subsidiary Shakey’s International(60%) and Pamnani Foods (40%) (The Straits Times, 25 August 1994 p.40).

CONCLUSIONS

This case illustrates six points that are alluded to in the financial economicsand positive accounting literature. First, it describes the nature of the costsof violating a covenant of a public trust deed. Second, it illustrates how theinterpretation of a ‘technical’ breach of a borrowing constraint defined overan accounting-based leverage ratio can, retroactively, be difficult. Wherethe costs of such a breach are material, the events illustrate how the companywas able to provide an auditor’s computation based on subsequent half-yearly 30 June accounts showing a ‘cured’ leverage ratio below the fourtimes specified in the trust deeds. In response, this difference in interpretationof whether the company was in breach or not of its trust deeds resulted in

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a series of exchanges of letters between trustee and company that led tothe appointment of the independent third-party adviser and the eventualdevelopment of a mutually satisfactory divestment and repayment plan.

Third, the case illustrates the reactions of the trustee and shows how thethree involved parties—the company, the trustee, and the bank creditors—were able to benefit mutually by agreeing to the independent advisers’proposals which minimized the costs of the breaches of the trust deeds.The anecdotal evidence in the case illustrates that the orderly, monitoreddivestment plan, with debt payment rescheduling accompanied by a debt-and-capital restructuring programme, was a less costly alternative for bothgroups of loan stockholders and all bank creditors than judicial managementand possible liquidation.

Fourth, given that the financial economics literature articulates the con-flicting interests of different claimants, it is surprising that in this case thesame trustee (BMT) acts for two separate groups of loan stockholders.While the values of the conversion option and the detachable warrantsattached to the respective 1992 and 1994 loan stocks are both dependentupon the future viability and value of the overall company, the returns (6%for the 1987/92 versus 3·5% for the 1989/94 loan stocks), duration, andrisks attached to the respective debts outstanding in August–September1992 at the time of the breaches of the respective trust deeds are different.However, the trustee and the independent adviser appear to treat bothgroups of loan stockholders homogeneously in their dealings with thecompany following the breaches. However, notwithstanding this apparent‘concern for equity’ in treatment of both groups of loan stockholders (andindeed all other bank creditors), the case illustrates the procedures availableto affected loan stockholders to protect their interests. Indeed, both groupsdid vote and agree upon the divestment and repayment plan proposed bythe company and amended by the independent advisers at separate meetings,albeit if one meeting was initially postponed because a quorum could notbe reached.

Fifth, this case illustrates the apparent feasibility of appointing an in-dependent third-party adviser in circumstances where lenders are alreadytoo deeply indebted to be able to cost-effectively bail out of their claims inthe short-run. The independent adviser’s major recommendations of forminga committee to monitor the company’s proposed divestment and repaymentplan, allowing some participation by the loan stockholders and major bankcreditors in the subsequent restructuring and refinancing of Inno-Pac, andeffectively making all loan stock and bank debt rank equally, provide benefitsto all the parties concerned. Potential dilution of any one group of creditor’sclaim against all the company’s major assets and properties is minimized,the monitoring and lender control is strengthened, and the loan stockholdersand creditor banks are given the option of a more timely adjudication oftheir claims in the event of future material defaults. Furthermore, thereprieve given to Inno-Pac to delay repayment of its debt obligations reduced

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potential bankruptcy and other costs associated with the default. It allowedthe company to continue to operate viably whilst pursuing its divestmentplan and its restructuring and refinancing exercise, and thus subsequentlyrealize some of the benefits of financial distress (see, for example, Gilson,1989, 1990; Wruck 1990).

The last point this case illustrates is consistent with the financial economicsliterature on the costs and benefits of financial distress. It is likely that thechanges in top management and organizational strategy and structure ofInno-Pac in 1993 and 1994, subsequent to the defaults and financialrestructuring, create value for the firm’s claimholders. The changes ingovernance and financial structure following the recontracting with Inno-Pac’s claimholders appear to be aimed at creating efficiencies in aligningthe interests of the various claimholders. The revised strategy of focusingon core businesses and diversifying into new joint venture projects to befinanced by a rights issue of bonds with warrants, where the debtholdershave the option to hold future equity, also appears to be acceptable to itsclaimholders and the Stock Exchange of Singapore.

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1. ‘Technical default’ occurs when a borrower fails to comply with a covenant other thana debt service covenant in a debt agreement. This ‘event of default’ constitutes a breachof the debt agreement which gives the lenders and/or their trustee the right to takeactions such as demanding immediate repayment of principal and accrued interest,seizing collateral, or renegotiating the terms of the debt.

2. The literature generally assumes that accounting modifications and other variationsto private debt agreements are more frequent and elaborate than in public debtcontracts; primarily because of lower renegotiation costs (e.g., Smith & Warner,1979; Leftwich, 1981). The costs of renegotiation are assumed to be lower becausean amendment of requirements under a public deed has to be agreed to by a specialresolution at a meeting of debtholders, which may be difficult/costly to achieve. Thiscase documents the proceedings of separate extraordinary general meetings of twogroups of public loan stockholders of Inno-Pac that were held soon after the breachof the borrowing limitation of the trust deeds of the respective loan stocks. At thesemeetings, the loan stockholders voted in favour of a divestment plan proposed bythe company to raise cash in order to repay loans owing to them, and on otherrelated matters concerning the monitoring of the plan and possible claim dilutionthat the three involved parties—the company, the trustee, and the independent third-party adviser to the trustees—could not agree upon.

3. We would like to thank an anonymous reviewer for pointing out that the costs for privatedebt may also be very high in certain cases. For example, the case of Laura Ashley plcas reported by the company’s treasurer, A. Fyffe, in the United Kingdom financial pressillustrates how a potential technical default was reported to bankers in advance of itsoccurrence at an eventual very heavy cost.

4. For example, Sweeney (1994, p. 290) documents that 98% of the sample of 130 USfirms report violations of covenants in private lending agreements, and that 90% ofthese are violations of covenants in bank lending agreements.

5. The two outstanding unsecured loan stocks are (a) 6% unsecured loan stock 1987/92 for $17·76 million (1992 Loan Stock) due for repayment on 25 November 1992;

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and (b) 3·5% unsecured Loan Stock 1989/94 for $18·12 million (1994 Loan Stock)due on 22 April 1994. The transferable subscription rights (detachable warrants)were quoted on the Singapore Stock Exchange. Holders of the respective outstandingsubscription rights had the right to subscribe for shares of $1 each in the company,in cash or by surrendering loan stock or partly in cash and partly loan stock, atrespective subscription prices of $1·50 and $1·30 between February 1988 to November1992 (4 years 9 months) and April 1989 to April 1994 (5 years) respectively.

6. Besides the $36 million in loan stocks at the time of the breach of the clause in the trustdeeds of the loan stocks, Inno-Pac owed another $36 million multi-currency noteissuance facility (NIF) to banks and a further $4 million bank loan, bringing its totalborrowings to $76 million (The Straits Times, 3 September 1992, p. 39).

7. For example, the company spokesman said that if the company is forced intojudicial management, it would be unable to sell its fast food franchise, Shakey’s,currently worth $16 million, and would lose another US$4·5 million in royaltyrevenues from the franchise as a result (judicial management is a company voluntaryarrangement form of corporate rescue similar to the United States Chapter 11petition. A judicial manager is an approved company auditor who is not the auditorof the company in question and who is appointed by the company to take chargeof the affairs, business and property of the company in circumstances where thecompany is unable to pay its debts but rehabilitation is considered to have areasonable probability).

8. Besides being a major paper trader through its International Forest Products subsidiary,Inno-Pac had major diversified trading activities in food and related commodities (itwas one of the larger rice importers), steel, yarn, plastic/chemicals, building materials,garments, and bulk commodities (such as bitumen, salt, coal/coke and fertilizers) throughits Poon Guan, Inno-Pac Trading and Windmill subsidiaries. The company is also ashipowner and operator (owning three vessels), and is involved in creative designs,media advertisements and publications through its Hagley & Hoyle and Head & Handsubsidiaries.

9. The 1992 Annual Report of Inno-Pac reports that the company ‘faced a cash crunchin the second half of 1992 due mainly to the continuing losses incurred by Shakey’s inSingapore, Taiwan, Thailand, Hong Kong and the US’.

10. ‘Debt service default’ occurs when a borrower fails to make an interest or principalrepayment (see, for example, Sweeney, 1994). As Inno-Pac was unable to redeem fullythe $17·8 million worth of 1992 Loan Stock on 25 November 1992, the company alsocommitted debt service default.

11. The 1992 Annual Report of Inno-Pac clearly explains how the default on loans bysubsidiaries of the company resulted in the trustee subsequently declaring both loanstocks immediately due and repayable in its letter of 1 September to Inno-Pac. Thereport states that ‘one event which triggered off a chain of events culminating in thedemand on the Company for immediate payment of its two loan stocks amounting toS$34 million was the aborting of the sale of the Poon Guan Pte Ltd Group of Companiesfor S$5·02 million. The proceeds of the sale were to have been used to meet the loanobligations of certain Shakey’s businesses. When this sale was aborted at the last minute,the loans could not be repaid and the banks concerned called an event of default. Thisconstituted a breach under the loan stocks trust deeds and the trustees of the Company’sloan stocks served notice in September 1992 demanding the immediate repayment ofboth the loan stocks’.

12. Under Singaporean company law in cases where a trustee for debenture holders hasbeen appointed, there are a number of points of time at which trustees can be alertedto a breach of covenants. First, the directors of the borrowing company have statutoryrequirements to lodge quarterly reports with the Singapore Registrar of Companies andwith the trustee which, inter alia, contain statements such as whether the company hascomplied with all the covenants and provisions of the trust deed, and whether or not

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the limitations on the amount of borrowings have been exceeded. Second, directors arealso required to lodge half-yearly profit and loss statements and balance sheets, withinthree months of the end of the respective periods, with the Registrar of Companies andwith the trustee. Following the notice from the trustees to Inno-Pac on 18 August torectify the breach in the leverage constraint within 30 days, the trustee subsequentlyrequested figures for the computation of the company’s leverage ratio as at 30 June1992 in one of the approximately 60 letters that they sent to Inno-Pac during Augustand September 1992 (The Straits Times, 1 October 1992, p. 48). However, it was notuntil 30 September that Inno-Pac responded by supplying the relevant figures. In thatletter of 30 September (that was made public upon instructions of the Stock Exchangeof Singapore), Inno-Pac also responded to the many earlier letters received from thetrustee. They state: ‘Whilst we appreciate that the trustee has an obligation to carry outyour duties, you must also appreciate the Company is making its best efforts to pursuevarious divestment plans to raise resources . . . Accordingly, it would not be possiblealways to respond to your queries immediately’. Correspondence with Inno-Pac alsoreveals that this company had additional monthly obligations to present managementaccounts to their board of directors and to state whether any of the covenants had beenbreached.

13. The auditor’s computations were based on Inno-Pac’s total borrowings of $90·53 millionagainst adjusted capital and reserves of $23·8 million as at 30 June 1991. (The StraitsTimes, 1 October 1992, p. 48).

14. Similar to United Kingdom company law, these major creditors would be placed in therole of ‘shadow directors’. However, Singaporean company law is different from UnitedKingdom company law in this respect in that only individual persons and not companiesmay be directors of Singaporean companies. We would like to thank an anonymousreviewer for pointing out that placing creditors in the role of ‘shadow directors’ raisessignificant legal issues for creditors in the United Kingdom and colours their attitudeto certain potential covenants and default reactions.

15. Only 48·2% of the loan stockholders turned up for the meeting. A company spokesmansaid the quorum could not be reached because one major loan stockholder failed toreturn with his corporate representation documents. (The Straits Times, 10 November1992).

16. This amount of $19·5 million, plus a further $7·5 million expected from theproceeds of the other four planned divestments, was proposed to go towardspaying the loan stockholders and creditor banks the 55 cents for every outstandingdollar of debt according to the rescheduled repayment of the respective debtobligations that was accepted by the loan stockholders and creditor banks inNovember 1992.

17. The 1992 Annual Report of Inno-Pac reports that, ‘although initially certainlenders had felt that the divestment programme would best be undertaken by aJudicial Manager, it was soon obvious to them that the Management was securingthe best terms possible for the divestments in an orderly fashion. It is alsonoteworthy that at no time did the Company, in its negotiations with the banksand the loan stockholders, attempt to obtain a discount on the Company’s debtobligations’.

18. During 1992 and 1993 Inno-Pac sold a number of its major assets, reduced itslosses in 1993 (to $4 million from $22 million in 1992), repaid most of its debtobligations for which it had secured agreement to reschedule repayment, reducedits capital under a capital reduction scheme that wrote off a substantial part of theaccumulated losses, and relisted its 1992 loan stock on the Stock Exchange ofSingapore. These actions enabled it to reduce its high leverage ratio and redeemthe entire principal amount of the two outstanding loan stocks, plus the respectiveaccrued interests, by the end of 1993.

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