Emerging Markets and Crisis Applications for Out-of-Court Workouts: Lessons from East Asia, 1998-2001

William MakoWorld Bank23 March 2004

Introduction

Why out-of-court workouts?Different origins of crisesFocus on East Asia case, 1998-2001Importance of corporate-financial sector linkages

Agenda

I. Corporate-financial sector linkagesII. East Asia approaches to out-of-court

workoutsIII. ResultsIV. Easy lessonsV. Difficult lessons (“deal breakers”)

Incentives for debtor cooperation Inducement of financial sector losses Resolution of inter-creditor differences

Corporate cash flows determine sustainable level of corporate debt.

EBITDA: $100

Debt: $1000

$625 sustainable

$375 unsustainable

Assets: $1250

Equity: $250

Assumptions:•Need for 2:1 interest cover•8% market interest rate

Company X

Need to emphasize operational restructuring; Not just financial restructuring

Operational & ”Self Help”

Exit bad business Sales of non-core

assets Layoffs Other cost cuts New equity

Increase earnings/cash Reduce debt

Financial restructuring

Term extensions Rate reductions Grace periods Debt > convertible

bonds Debt > equity

Address moral hazard Avoid cosmetic fixes

Operational & financial restructuring may follow an iterative process

Stabilization, e.g. standstill

Debt rescheduling;Debt/equity swap

Creditor sakes ofConverted equity

Easy asset sales & cost cuts

Sales of major Assets/business

Financial

Operational

Losses from corporate restructuring may erode financial institution capital

Initial costs Present value costs of debt restructuring Temptation to avoid ( e.g, big “balloon”

payment)

Follow-on costs Asset sale prices may reveal over-valuation of

collateral Sale prices for converted equity may exceed

carrying value & crystallize a loss Temptation to neglect follow-on restructuring

Costs from general provisions

Corporate cash flows determine both sustainable corporate debt and costs of re-capitalizing weak financial institutions

Bank Y

Loans 1,000 150 850

Deposits 920

Capital 80 150<70>

Previous assumptions:•$1000 corporate credit•$375 non-sustainableNew assumption:•Bank loses 40% on Restructuring non-sustainable credit

All parties will naturally seek to minimize their own losses

Corporate debtors Outside

interference Sale of favored

assets Loss of business

line(s) Equity dilution Loss of control

Financial Institutions Capital write-

downs Equity dilution Nationalization Forced M&A Liquidation Loss of control

Government Goals

Minimize costs of bank re-capitalizationProtect workers/suppliersMinimize “ripple effects” Minimize distortions to market competitionAvoid labor strifeDampen public criticism enough to stay in office

Suggested Goals: ToPreserve/Promote Healthy Companies

Short-term (e.g., 3 months) Achieve financial stabilization Avoid liquidation of viable companies

Medium-term (e.g., 6-24 months) Operational restructuring Enhance profitability, liquidity, and solvency

Long-term Deter imprudent corporate over-investment

South Korea:Corporate Restructuring Accord

1998 “contract” among 210 domestic lenders 1-3 months standstill; extendable by 1 month Creditors Committee; usually led by Lead Bank 75% threshold for creditor approval Coordination Committee to arbitrate & give

guidelines Possible fines

Other key factorsLed to Corporate Restructuring Promotion Law (2001)

Malaysia:Corporate Debt Restructuring Committee

Under central bank auspicesEither debtor or creditor could initiateMinimum size: RM100 million debt; 5+ creditorsStandstill; creditors committee; etc.High threshold (100%) for CDRC creditor approval; lower thresholds for non-CDRC casesOther key factors

Thailand:Bangkok Rules + CDRAC

Initially, “Bangkok Rules” provided guidelinesReplaced by Debtor-Creditor Agreements 6-8 months schedule to develop/approve workout

plan Standstill, creditors committee, etc. 75% creditor approval to ratify plan 50-75% approval >>> amend and re-submit

3-person panel arbitrated inter-creditor differences Easy escape clause

Other key factors

Indonesia:Jakarta Initiative Task Force

Initial emphasis on consensual proceedings JITF to advise, mediate, facilitate & address

obstacles

JITF upgraded in April 2002 Could impose time-bound mediation Could orchestrate regulatory relief Could refer uncooperative debtor to Attorney

General for bankruptcy petition

Other key factors

East Asia Out-of-Court Workouts:Caseloads & Results

Korea Malaysia Thailand Indonesia

Total debt $88.9 bn

$10.4 bn $65.5 bn $18.9 bn

# of cases 83 54 14,917 n.a.

Complete cases

68 46 6,345 n.a.

Resolved debt

95% 77% 48% 56%

Financial:Ops Ratio

5:1 40:1 n.a. 13:1

New Money $3.7 bn n.a. n.a. n.a.

Accomplishments vs. Suggested Goals:Short-Term Financial Stabilization

Many SMEs failed – e.g., 19,000 in Korea 1997/8But not an immediate issue for large corporationsUnlikely that any good corporate failed due to liquidity crunchMore of a credit culture issue: Formal standstill; due diligence; creditor

monitoring (e.g., Korea) versus “Do-it-yourself” standstill; “strategic defaulting;”

no creditor oversight (e.g., Thailand, Indonesia)

Medium-Term Operational RestructuringKorea

More operational restructuring and “self help”But Korea still a mixed pictureThrough 2001, bottom quartile of corporates High debt, increasing losses, more negative cash

flow

Success stories like Daewoo: Workforce reductions of 25-60% Strategic sales and spin-offs, e.g., Motors to GM E&C, Heavy, & Shipbuilding – good profitability,

leverage, and interest cover by 2001

Medium-Term Operational RestructuringOther Countries

Financial restructuring dominated, e.g., Indonesia JITF: 93% of debt rescheduled or

converted Malaysia CDRC: almost no asset sales; zero

coupon bonds

Frequent “balloon payment” arrangementsRelapse risk for operationally flabby companiesCorporate debt recidivism an issue in 2001

Long-Term Deterrence of Debt-Fueled Corporate Over-Investment

Korea – no chaebol “too big to fail” 25 (with $33B debt) into receivership since 1996 Wipeout of Daewoo’s controlling shareholders Creditor control at Hyundai MH Group companies Encouraged cooperation with out-of-court workouts

Thailand & Indonesia No near threat of foreclosure, liquidation,

receivership Un-cooperative debtors may hang on; albeit with

questionable future access to debt financing

Easy Lesson #1:Principles and Processes

Several good examples from East Asia “Bangkok Rules” perfectly fine; just not

enforceable Malaysia CDRC’s August 2001 rules on

workouts Korea: Model commitments by

debtors/creditors

Available; readily replicable

Easy Lesson #2: Need to Address Legal/Regulatory Issues, e.g.

Tax issues (e.g., corporate income, M&A, NOLs)Review period for M&APersonal liability for employees of State banksLimits on bank holdings of corporate equityLegal lending limitsPossible de-listing by local stock exchangesPublic tender requirement in debt/equity swapPublic shareholder resistance to equity dilution

Easy Lesson #3:Need to Address Capacity Constraints

Huge demands: insolvency judges, admin- istrators, professionals, government crisis teamSegmentation of the problem, e.g., Malaysia: Big cases >> courts or out-of-court workout Medium cases >> asset management company

(AMC) Small cases >> bank workout departments

AMC focus on bulk sales of un-restructured NPLsRestructuring joint ventures (e.g, Korea’s KAMCO, CRCs)

Deal-Breaker #1:Incentives for Debtor Cooperation

Serious restructuring usually causes some loss to corporate shareholders/managementAbility to impose losses; encourage cooperation Korea vs. Thailand/Indonesia

Useful “sticks” Creditor access to foreclosure, liquidation,

receivership Simple commencement criteria (performance-

based) Easy conversion to receivership/liquidation

Deal-Breaker #2:Inducement of Financial Sector Losses

Banks may support superficial restructuring >> “zombie” companiesBest response: forced sale of “excess” NPLsAlternative: forbearance should be approached cautiously Banks may use as opportunity to “double their bets” Forbearance on loss recognition may encourage

assets overvaluation; discourage follow-on restructuring

May also impede bank recapitalization (due diligence)

Any forbearance should be strictly limited in scope/duration

Deal-Breaker #3: ResolvingInter-Creditor Differences Out-of-Court

Often stickier than debtor/creditor differencesEx post facto imposition of arbitration could be challengedFinancial supervisor enforcement poses conflictsOther alternatives:

Law (e.g., Korea, 2001) to force sales by holdout creditors, at an independent valuation

Rely on lower thresholds for reorganization in court Facilitate majority creditor recourse (“pre-packaged”

bankruptcy) to ratify/enforce workout agreement

Main Lessons

1. For debtor cooperation, no serious alternative to credible threat of total loss, e.g., from foreclosure, liquidation, or receivership

2. For adequate support from financial institutions, readiness by supervisor to force/induce loss recognition

3. For inter-creditor differences, a reliable & non-problematic resolution mechanism (e.g., “pre-packaged” bankruptcy)

Outstanding Issues

Enhanced monitoring of corporatesFinancial stabilization for SME suppliersRole of forbearance & adequate controlsRelative performance of public, private, and public-private restructuring/resolution efforts