William P. Mako
A number of East Asian corporations, saddled with debt, nearly collapsed during the financial crisis of 1997. Many have managed to avoid both repayment and restructuring, however, and remain overly indebted and invested in unprofitable businesses.
During the 1990s, East Asian corporations borrowed heavily and expanded into many low-margin or loss-making businesses and markets. The financial crisis sparked by the fall of the Thai baht in July 1997 made it difficult, if not impossible, for these highly leveraged corporations to service their debt, undermining, in turn, the health of the financial institutions that had extended loans to them.
Although the link between corporate restructuring techniques and financial sector restructuring is reasonably straightforward, too little operational restructuring has occurred, and East Asia’s corporate and financial sectors have yet to recover from the crisis. The failure to shed marginal businesses and resolve unsustainable debt has left corporations, banks, and national economies less competitive, less able to respond to real growth opportunities, and vulnerable to future shocks. Why has restructuring proceeded so slowly, and what can international development institutions such as the World Bank and the Asian Development Bank do to encourage speedier resolution of corporate distress in future crises?
Corporate restructuring and financial sector restructuring are two aspects of the same problem. The amount of debt a company can sustain—and on which lenders can expect reliable debt service—is determined by the company’s cash flow. Indeed, a company cannot sustain interest payments in excess of its cash flow.
There are a number of ways to resolve unsustainable debt, some better than others. The best is for a company to raise new equity and sell noncore businesses and assets to retire debt while restructuring its operations—discontinuing less profitable or loss-making businesses and reducing labor and other costs, for example—to increase its earnings and debt-service capacity. A next-best approach is for creditors to convert debt into equity or lower-yielding convertible bonds. To avoid moral hazard, creditors should not consider debt write-offs until they have exhausted all other possibilities, and they should obtain some instrument (such as equity, options, or warrants) enabling them to participate in any recovery. (Equity ownership by creditors can create other moral hazard issues against which financial supervisors would need to guard.) Term extensions may be acceptable, provided they do not have the practical effect of transforming debt into an equity-like instrument without also giving creditors the rights of equity holders. Reducing interest below the risk-adjusted rate may also be acceptable, so long as principal is repaid (but governments should discourage rate reductions that provide an undeserved competitive advantage and preserve “zombie” companies from liquidation). Grace periods on debt service usually just postpone the day of reckoning for nonviable companies.
Creditors of corporations being restructured should take loan provisions that appropriately reflect the present-value effects of interest rate reductions, term extensions, or other debt rescheduling; debt-to-equity conversions; and any loan write-offs. They should also provision against possible losses on remaining debt, based on international, forward-looking criteria. If a creditor institution’s risk-weighted capital falls below a certain ratio (say, 8 percent), the government may decide to close and liquidate the institution, merge it with a stronger partner, solicit additional capital from current shareholders, or recapitalize it and take ownership and control.
Responses to systemic crisis
Indonesia, Korea, Malaysia, and Thailand all adopted some variant of the “London approach” to out-of-court restructurings of unsustainable corporate debt. (The London approach, promoted by the Bank of England during the U.K. recession of the mid-1970s, encourages creditors and debtors to follow certain principles—for example, minimizing losses to creditors, avoiding liquidation of viable debtors, and continuing financial support to viable debtors—in out-of-court restructuring agreements.) However, the countries varied widely with respect to the amount of protection they provided to creditors and their use of public asset management companies to resolve company loans acquired from distressed financial institutions.
Indonesia is emphasizing two approaches to corporate restructuring. A public asset management company has taken over the corporate loans (amounting to 22 percent of GDP) of numerous failed financial institutions and is attempting to restructure them. As for amounts owed overseas (offshore borrowing having accounted for 50 percent of corporate debt), foreign lenders have been left to negotiate their own deals (some using formal time-bound mediation managed by the Jakarta Initiative Task Force) or sell their credits. Creditors cannot count on the courts to protect their rights.
Korea adopted a multitrack approach to corporate restructuring. In 1997, 10 of the most distressed chaebols—groups of companies, each typically controlled by one family—went into receivership. Subsequently, Korea’s financial supervisor promoted out-of-court restructuring (workouts) for less distressed chaebols. An agreement among local financial institutions allowed two to five months to negotiate workouts, with a standstill on debt service during negotiations; established a 75 percent threshold for creditor approval of workout agreements; and created a committee to arbitrate differences among creditors. Last, the Korean government sought to impose greater financial discipline on large chaebols by requiring that companies implement capital structure improvement programs approved by their lead creditors, eliminating cross guarantees on debt, establishing tighter exposure limits, and imposing fines for improper transactions between related companies. Following the failure of the self-restructuring efforts of Daewoo, one of the largest chaebols, creditors took control of its companies. The public asset management company’s role was limited to providing bank liquidity through purchases of nonperforming loans at substantial discounts on face value.
Malaysia, like Korea, took a multitrack approach. A debt-restructuring committee led by the central bank facilitated some out-of-court workouts, while Danaharta, a public asset management company—with powers to appoint administrators to run companies and seize collateral—had resolved 32 billion ringgit ($8.4 billion) of its 47 billion ringgit ($14.7 billion) corporate debt portfolio as of mid-2000. About 200 companies are being rehabilitated under court supervision, and at least another 10,000 are being “wound up” (liquidated) under Malaysia’s Companies Act.
Thailand initially emphasized “Bangkok rules” modeled on the London approach. After a slow start, creditors were induced by the country’s financial supervisor to adopt a time-bound process for negotiating corporate workouts. Two years later, a large volume of unresolved cases are being forwarded to the bankruptcy courts. Thailand still lacks an effective foreclosure and insolvency regime (although it is trying to develop one), which is hampering voluntary restructuring efforts. Thailand’s public asset management companies have focused on the sale or management of loans, not on corporate restructuring.
Corporate restructuring results should be measured along three dimensions: (1) long-term deterrence of imprudent debt-fueled investment, (2) financial stabilization in the short term (3 months) to prevent the liquidation of viable albeit overleveraged companies, and (3) medium-term (6–18 month) operational restructuring to improve profitability, solvency, and liquidity.
Deterrence. Korea initially achieved a commendable record on long-term deterrence. The ability of Korean creditors to force many chaebols into receivership and seize Daewoo signaled that no chaebol was “too big to fail.” (This lesson is being undermined by recent support for Korea’s largest chaebol.) By contrast, the weakness of Thailand’s foreclosure and insolvency system encouraged “strategic defaulting” and nonperforming loans, which at their peak represented 48 percent of all loans. Following delays in some high-profile cases, Thailand is beginning to make progress in court-supervised reorganizations. In Indonesia, recent proposed restructuring deals pose serious moral hazard issues. In several cases, if corporate debtors can repay the principal owed to the public asset management company within 12 years (including an 8-year grace period), the former controlling shareholders can regain 100 percent equity ownership, despite the large present-value cost to the public asset management company. Such deals, which could encourage other corporations to “go for broke” in borrowing funds to finance expansion, create moral hazard.
“Three years after the crisis, relatively little operational restructuring has occurred.”
Stabilization. Short-term financial stabilization was not an issue for large corporations in the recent crisis. In Indonesia and Thailand, which had debtor-friendly legal environments, debtors achieved financial stabilization on a do-it-yourself basis, simply by unilaterally imposing a moratorium on debt servicing. In Korea’s more rigorous legal environment, companies that cooperated with creditors enough to avoid receivership were stabilized through debt standstills and financial restructurings that featured interest rate reductions, term extensions, grace periods, and debt-to-equity conversions. In other, earlier crises, the concern was that the “strong swimmers” would be dragged down along with the weaker ones. In this crisis, thousands of small and medium-sized enterprises have failed, but few large companies—either strong or weak—have had to close.
Operational restructuring. Three years after the crisis, relatively little operational restructuring has occurred. Even in Korea, which has seen the most restructuring—especially by less distressed chaebols acting outside the formal workout program—data from the central bank show that company liabilities decreased just 1 percent, while assets grew 9 percent between the end of 1998 and the end of 1999. Clearly, the 90 trillion won ($82 billion) in new equity raised or earned by Korean companies went toward acquiring additional assets rather than retiring debt. In the out-of-court workouts, the ratio of corporate “self-help” (for example, sales of noncore businesses and assets, issuance of new equity, and cost-cutting measures) to debt restructuring was 1:4, at best. Given Korea’s initial debt overhang, it is no surprise that 1999 data show a cash flow/interest-expense ratio of less than 1.5:1 for 32 percent of 496 companies, less than 1:1 for 23 percent, and less than zero (that is, negative cash flow) for 13 percent.
Differences among the four countries in the amount of financial and operational restructuring that has taken place mainly reflect differences in the ability of creditors to impose losses on debtors, the readiness of governments to impose losses on the shareholders of local banks and on taxpayers, and the public’s tolerance for worker layoffs and foreign takeovers.
In Korea and Malaysia, debtors cooperated with out-of-court restructuring efforts, sometimes accepting debt-to-equity conversions that diluted ownership and diminished shareholder control because creditors had the power (through receivership or special administrators) to oust controlling shareholders and management. The absence of such “sticks” stymied corporate restructuring—even of the modest financial-stabilization variety—in Indonesia and Thailand until negotiation fatigue and macroeconomic recovery encouraged debtors and creditors to normalize their relationships.
In Thailand, the government was unwilling to nationalize the entire financial sector. It took over more than 50 finance companies and some mid-sized banks. For the remaining private banks, it offered up to 300 billion baht in public funds for recapitalization in return for corporate restructuring and new business lending. Only one-fifth of this amount was used, however, because the controlling shareholders of the remaining private banks were unwilling to have their ownership diluted or to risk loss of control. The Thai government did not impose this program or nationalize remaining large banks, despite nonperforming loan rates of about 40 percent. To have nationalized the remaining banks in the context of weak insolvency and foreclosure laws would have shown corporate debtors that they could drive creditors out of business and—unless repayment was effectively pursued by a public asset management company with super-administrative powers—taught the worst possible lesson. The financial supervisor provided no forbearance on capital adequacy (that is, it did not allow a temporary reduction in required capital-adequacy ratios), but it allowed banks to recognize corporate restructuring losses over a 2½-year period. Liberal rules allowing provisions to be calculated net of collateral, on mostly overvalued property, provided additional implicit forbearance. This approach to forbearance probably discouraged private investment in Thai banks and may have further slowed progress on corporate restructuring.
While adept at financial restructuring, nationalized banks in Korea and public asset management companies in Indonesia and Thailand have been slow to pursue operational restructuring. Governments are reluctant to see nationalized banks or public asset management companies take losses, which must be borne by taxpayers and explained to parliament, from the follow-on operational restructuring of distressed corporations.
Governments are also reluctant to see nationalized banks or public asset management companies fire excess workers and shutter nonviable businesses because such actions could incite protests and affect the entire economy. Indeed, state-controlled financial institutions can be convenient vehicles for propping up distressed companies—for example, through debt rollovers; new credits; or term extensions, below-market interest rates, and grace periods—and postponing the day of reckoning. Companies and their creditors may also be reluctant to accept losses on sales of assets whose values have plunged since their acquisition. This reluctance is often coupled with widespread resentment of foreign “vulture” investors. It is relatively easy for debtors and creditors to mobilize workers and the public to oppose foreign takeovers and “fire sales” to foreigners.
Clearly, governments should minimize the present-value multiyear costs of corporate and financial sector restructuring. But this is easier said than done. Governments often succumb to the temptation to focus only on first-year costs, “kick the can down the road,” and hope for some macroeconomic deus ex machina in subsequent years to lessen the ultimate cost of resolving corporate and financial sector distress.
William P. Mako is a Senior Specialist in the Private Sector Development Unit of the World Bank’s East Asia and Pacific Region.
Role of international institutions
Numerous issues in corporate and financial sector restructuring arise during crises, including eliminating tax, legal, and regulatory impediments; strengthening prudential regulation; improving supervision of financial institutions; establishing procedures for out-of-court workouts; resolving intercreditor differences; improving financial disclosure and corporate governance; choosing between bank-led and public asset management company–led restructuring; and making other institutional arrangements. The international development institutions can offer practical advice on these issues based on experience in dealing with past crises.
As important as the aforementioned issues are, however, the most critical issues are the ability of creditors to impose losses on debtors; the readiness of governments to impose losses on the shareholders of local financial institutions and on taxpayers; and sensitivity to worker layoffs and foreign takeovers. Giving due recognition to such sensitivities, the international development institutions should encourage governments to develop adequate safety nets and recognize the link between foreign investment and sustainable growth. If the international development institutions cannot provide support on the most critical issues, progress in addressing other issues is unlikely to advance the timing or quality of corporate and financial sector restructuring.
The international development institutions should encourage countries to put in place adequate legal protection for creditors. Recent experience also shows that the negotiation and implementation of out-of-court workouts can be derailed by opposition from minority creditors and public shareholders. Thus, options for court-supervised reorganization need to be strengthened. A host of policy issues and varying legal traditions need to be considered, but key goals include adequate incentives for viable but distressed companies to pursue court-supervised rehabilitation and reliable criteria for commencing a reorganization or deciding that a company should go into bankruptcy instead. Such reforms are best implemented before a crisis occurs.
Recent experience also shows that banks are reluctant to take measures such as selling off company debt or converted equity or forcing companies to restructure (for example, closing nonviable businesses and selling overvalued assets) that may require banks to reduce their capital and thereby expose themselves to possible dilution of ownership, diminution of control, or takeover. Some regulatory forbearance is usually allowed during a crisis, perhaps in the form of looser supervision. Or, as happened in Thailand, the financial supervisor may give banks more time to reflect losses from corporate restructuring in their balance sheets. Such measures, however, may discourage banks from resolving problem loans and potential investors from investing in banks with murky balance sheets. A more transparent alternative would be to require prompt and full recognition of losses on corporate restructuring while providing closely supervised forbearance on capital adequacy. For example, the supervisor might allow risk-weighted capital to drop below 8 percent for a limited time. Especially in situations where the government has guaranteed all depositors, capital-adequacy standards to protect depositors from risk taking by banks lose some relevance. The international development institutions could usefully highlight this issue for international standard-setting bodies.
Last, and perhaps most important, the international development institutions could provide an independent assessment of the present-value costs and effects of alternative strategies for resolving corporate and financial sector distress. Particular attention should be paid to projections of cash flow and bank recapitalization requirements; alternatives for protecting the workers, suppliers, and subcontractors of failed companies; and the effects of below-market interest rates and other debt-restructuring concessions on market competition. The ministry of finance, with technical support from the financial supervisor, should drive the costly process of corporate and financial sector restructuring. To the extent that the international development institutions can provide independent assessments to the ministry of finance and help educate the public on the likely costs of available alternatives, they may make it easier for the ministry of finance to act decisively to resolve corporate and financial sector distress at least cost to the tax-paying public.