Introduction

Mr. Hagan explained how designing and implementing a legal institutional framework for resolving corporate debt problems is not something that is typically associated with financial stability. The IMF gets involved in the context of a crisis, in which the priorities are focused on stabilizing the financial sector; adopting adequate fiscal, monetary, and exchange rate policies; and dealing with the financial sector in distress. Once stabilization is achieved, however, another problem arises: the crisis has left a large part of, or sometimes the entire, corporate sector on its knees for a variety of reasons.

This problem is often not addressed ex ante because corporations, unlike commercial banks, are not subject to special regulation and supervision. This is a systemic problem because once stabilization is achieved, the next step is to try to reignite growth. If the entire corporate sector is in distress, and if corporations are not in a position to invest or employ because they are overwhelmed by debt, the problems will manifest in the banks, as levels of nonperforming loans (NPLs) begin to rise. Those NPLs impair banks’ abilities to provide credit to healthy companies—if there are any—precisely when it is most needed. This may even result in the NPLs rising to a level in which a second wave of banking distress brings more financial instability.

A lesson from the financial crises is that the design of a framework for addressing systemic corporate debt distress is crucial at an early stage. Another lesson learned is that shortcomings of the corporate debt resolution framework can be a latent problem in an economy not yet in a crisis, but in which indebtedness of the corporate sector increases over time. It may manifest by rising levels of NPLs; in other cases, because the banks are nervous about the capital implications of NPLs, they disguise them by evergreening the loans. A number of emerging market economies are experiencing significant overindebtedness in the corporate sector. The design of frameworks that address this issue, in India, in China, or elsewhere, is becoming a critical priority.

Relationships Between Systemic Corporate Debt, Financial Stability, and Economic Growth

Mr. Gitlin used the hypothetical example of a country whose companies have high levels of problem loans. The companies fall into two categories: (1) companies that have a future if they can be restructured (that is, companies that will be able to provide economic growth and create jobs if they are reorganized), and (2) companies that have no future (that is, they will never be able to make a profit, irrespective of any measures taken). These companies absorb huge economic assets but cannot invest or create jobs, so they deteriorate very quickly. The responsible course is to redeploy those assets to productive uses. Large amounts of assets are trapped in such companies, and it is important to get those assets back into productivity.

Mr. Gitlin then discussed a systemic situation: Indonesia during the Asian financial crisis. The IMF provided assistance to Indonesian authorities in adjusting the macroeconomic policies. However, because of currency devaluation, the companies were unable to repay their debts, which for the most part were denominated in foreign currency. Almost every major company in Indonesia could not get capital and could not function. Unfortunately, Indonesia did not have a developed formal bankruptcy system with effective courts. Therefore, it was necessary to examine how commercial issues could be resolved in that environment; generally, parties did not use the courts—instead, senior persons, respected by both parties, were brought in to mediate.

A government agency, the Jakarta Initiative, was created for effective mediation between the creditors and the corporate debtors. The approach required the creation of incentives and disincentives (carrots and sticks). To get the parties to make use of the agency, a government entity, the Jakarta Initiative Task Force, was created, including a regulatory vehicle to allow participants to get the necessary approvals and measures to resolve tax issues. A further incentive to use the system was that if a company did not act in good faith, it could be referred to the attorney general’s office, which could file a bankruptcy petition against the firm. Thus, in this systemic situation a practical solution was found to get the economy back on its feet.

Addressing the issue of the problem loans, particularly if they reach systemic levels, is critical. And it cannot be done by the private sector only; this requires the involvement of the central bank, the regulators, the legislature, and full cooperation among all parties to come up with a proper solution.

Mr. de Ranitz analyzed the problem in the context of any economy, in which there are four layers, lowest to highest: (1) natural persons, (2) companies, (3) banks, and (4) the government. With regard to natural persons and companies, if there is a serious corporate debt overhang, companies will not be able to obtain new loans and invest. Employees’ spending behavior will be affected, and they may start saving due to fears of unemployment. The local economy deteriorates too.

Although the number of NPLs will be increasing, banks will recognize these NPLs only if the regulator puts on pressure. Banks tend to avoid addressing problem loans. At the government layer, employees, companies, and banks will generate less income and profits, resulting in a decrease of taxable income across the board.

As soon as the number of NPLs increases, something should be done because the longer the wait, the more serious the problem will be. If something changes in one layer, it will have a direct effect on all the others. For example, if an insolvency law was created to allow natural persons to obtain a fresh start after one or two years, it could have a direct effect on the banks unless legislation includes measures to avoid fraud and abuse.

Mr. Méjan discussed the cost of not dealing with these issues proactively. In the 1990s, the insolvency regime in Mexico was not performing well and did not help the corporations deal with their NPLs. The government decided to create new legislation to address the issue that insolvency is not only a problem of the debtor with their creditors but also an issue that involves the debtor, creditors, employees, and the government. The debtors as entrepreneurs invest their money in the business and want to recover their money to be able to reinvest; creditors are in a similar position. Because a bank or several banks are usually among the creditors, financial authorities need to consider the problems of the insolvent company. Suppliers and clients of the company also suffer the impact of insolvency, as does the government, through lost tax revenue. Insolvency is a holistic problem: When there is a crisis, insolvency problems often arise two or three years later when the firms suffer the consequences. Thus it is important to create a regime that deals with this particular outcome.

Mr. Unnikrishnan explained that the problem arises when lenders have to lend to unviable companies, the money is tied down, and lenders cannot use their funds for productive uses. Borrowers suffer if they do not receive timely assistance to rehabilitate or improve their businesses. With an absence of certainty in the legal regime leading to an insolvency regime, and in the actions to be taken, there has to be legal certainty and clarity regarding the outcome in case the borrower fails to repay. For example, India has a fragmented and antiquated insolvency legislation. A new bankruptcy code is being discussed in Parliament, addressing both personal and corporate insolvency, and there is a bill regulating the insolvency of financial institutions.

Mr. Hagan summarized that systemic corporate indebtedness, before, during, or after a crisis—or without a crisis—can have knock-on effects unless it is properly addressed.

Convergence in Insolvency Laws and Design of Out-of-Court Procedures

Mr. Hagan discussed the convergence of insolvency laws across the world and of the role the government should play in out-of-court procedures in the context of corporate restructuring.

Mr. Gitlin explained that with an effective insolvency system, companies can be swiftly liquidated or restructured, as in the United States. The more efficient the insolvency system, the quicker the economic recovery will be. For example, some US oil fracking companies have filed for Chapter 11 proceedings and are restructuring their debt to become more competitive. They will emerge stronger after this crisis. Thus, with an insolvency system that can address troubled companies quickly, some companies will be liquidated and some will be restructured, but those companies that are effectively restructured will be ready to compete.

There are four reasons for developing an out-of-court system: (1) it is faster, and speed is essential; (2) it is less costly; (3) there is less publicity, and publicity is harmful to companies in distress; and (4) it may be essential to use out-of-court procedures if the formal system does not work well. There are general principles for out-of-court restructuring, such as the ones adopted by the International Association of Restructuring, Insolvency and Bankruptcy Professionals, which are based on common sense: a stay of proceedings, provision of information, and creditor engagement in negotiations.

The problem with an out-of-court approach is that without special legislation, creditors must achieve 100 percent consensus, which makes it very difficult to reach an agreement. Therefore, in some cases, special statutes have been passed to avoid this requirement. These hybrid systems allow most of the restructuring work to be completed out of court, with minimal court intervention. Every out-of-court restructuring law is different and must address the characteristics of each country. Mr. Gitlin cited examples in Australia, France, the United Kingdom, and the United States. There is no one-size-fits-all formula, but the marrying of an out-of-court negotiation with a court procedure to keep it efficient is a valuable option.

Mr. de Ranitz stated that there is not much convergence in formal insolvency laws because insolvency systems reflect political choices. Certain countries want to protect employees at any price, whereas other countries want to protect the financial sector by granting security rights and quick ways of foreclosure. Thus harmonization focuses more on procedural aspects than on the substantive insolvency law.

Insolvency laws are necessary, but an institutional framework is also required, that is, courts that understand insolvency, and efficient and reliable insolvency practitioners. Out-of-court restructuring is an attractive option not only when the insolvency law is deficient, but also when the courts are deficient. If the outcome under insolvency law is clear, there is no point in spending resources on legal advisors and court fees to arrive at the predicted result. A predictable insolvency system may take the burden away from the overburdened courts.

Mr. Hagan explained that the predictability of the insolvency system is critical to an out-of-court framework because it defines parties’ leverage. If the outcomes are not clear, parties will be less willing to negotiate.

Mr. Méjan discussed critical features of insolvency law in Mexico. There have been very few insolvency cases under the new Mexican regime, only about 700 cases, which is low considering the high number of companies in the nation. Out of those cases, 35 percent were solved through reorganization, including some large, cross-border cases, which are cited as precedent in international insolvency law.

Key features of the new Mexican insolvency law focus on maximizing the value of the enterprise, either through reorganization or liquidation. This shift in focus is important for financial and judicial authorities. Other key features are the reduction in time of the proceedings, transparency, and predictability. The law incorporated the prepackaged reorganization plan at a later date, and it has been a success. Since the introduction of these amendments, almost all insolvency cases have used the prepack system: the debtor and most of the creditors decide on the reorganization plan and bring it through the insolvency system. It is a hybrid system, rather than an out-of-court procedure, which reduces litigation and procedural complexities.

Mr. Unnikrishnan discussed regulation of the financial sector during general corporate distress. In a systemic corporate distress situation, there may be a market failure affecting restructuring. Debtors do not necessarily want to restructure their debt because they hope that there will be future concessions. Creditors adopt a similar attitude: banks avoid restructuring in the hope of an economic turnaround and because it may imply writing down their claims, with the corresponding impact on their capital.

The primary role of the state is to provide a legal framework that enables a settlement and mediation and incentives for out-of-court settlements. However, Mr. Unnikrishnan indicated that out-of-court arbitration can be more expensive than judicial processes. Another problem of out-of-court restructuring is that bankers’ concessions can lead to liability, which is a serious concern.

Mr. Hagan pointed out that one basic principle for both bank resolution and corporate insolvency is the “no creditor worse off than in liquidation” principle: in a reorganization, no creditor should be in a worse position than in a liquidation. Even with that principle in mind, there are jurisdictions in which certain creditors, especially state-owned banks, prefer to liquidate rather than reach a settlement, because of the concerns about potential liability.

Mr. Gitlin mentioned the problem of officials who provide favorable treatment to politically connected borrowers. The issue of liability, however, was a powerful deterrent to efficient debt restructuring agreements, particularly in India, and may require a special legislative intervention. Another strategy is to move the bad loans to an asset management company, subject to a special legal regime. In Mr. Gitlin’s view, this is a good vehicle to involve professionals to deal with debt restructuring, under the protection provided by the special law.

Mr. de Ranitz discussed how to involve banks in the negotiation process. Financial creditors are generally in a strong position and are willing to negotiate, whereas suppliers do not play a significant role. Suppliers are more interested in keeping the borrower as a client than in the full recovery of their past claims—but banks need to recover their loans. It is important to protect secured creditors in insolvency and their rights to enforce on their collateral after a specified stay period in insolvency. The protection of secured credit is fundamental to promote access to finance and economic growth.

Mr. Hagan pointed out the need to ensure an efficient credit enforcement mechanism, because this increases the availability of credit for the benefit of society. There is a strong correlation between efficient credit enforcement mechanisms and the price of credit.

Mr. Méjan discussed the correlation between the cost of credit, efficiency, and debt enforcement, and the issue of regulatory forbearance. The banking sector supports the development of a strong insolvency regime because it makes it possible to lend money with the confidence that it may be recovered if problems arise. From the regulatory perspective, Mr. Méjan cited postpetition financing of companies under reorganization in Mexico, in which the regulatory framework was modified to promote these transactions.

Mr. Unnikrishnan explained the motivation and the key features of the new Indian law in connection with the position of financial regulators. India did not have a comprehensive bankruptcy law; individual and partnership bankruptcies were covered by antiquated legislation. Companies are regulated by the Company Act of 2013, which does not include insolvency provisions. Special legislation exists for industrial companies, but this law is not general. Legal procedures are complemented by Reserve Bank guidelines on corporate debt restructuring (Corporate Debt Restructuring Guidelines and Strategic Debt Restructuring). The situation is far from satisfactory, because there is no certainty, clarity, or single applicable law. The new bankruptcy law will provide a comprehensive regime for corporate insolvency, with important influence from US bankruptcy law. Insolvency professionals’ participation in all processes, and the key role of financial creditors in taking a decision on companies’ viability, are defining the new law’s characteristics. The new law also introduces specialized courts to deal with corporate and household insolvency.

Mr. Gitlin discussed two ways in which the government could intervene. First, it can develop a secondary market in distressed debt. This would allow banks to receive a payment for their loans right away—without having to go through a long restructuring process—so they can use the funds for new lending. The entities buying distressed debt at a discount have more flexibility in finding restructuring solutions. In Japan, a public fund was created to acquire distressed debt.

The second example refers to companies that are extremely important for the national economy, such as Chrysler and General Motors. If there is a lack of private funding, the state may have to provide funding to support the restructuring of critical industries. The playbook needs to be adapted to changing circumstances to find creative solutions to address new problems.

Mr. de Ranitz stated that in exceptional circumstances, governments sometimes have to act, even if these acts are not basically in line with the laws. For example, the government of the Netherlands bought ABN Amro overnight—without a shareholders’ meeting and without involvement of the supervisory board. Governments should consider their tax laws when they discuss corporate restructuring, because in some countries debt forgiveness will be taxed as profit by the company and will result in a disincentive for the restructuring process.

Questions from Audience

Questions were taken from the audience, covering the following: (1) determination of viability of a company; (2) influence of corporate insolvency over financial resolution frameworks; (3) role of professional creditors in enabling successful restructuring, including the use of a code of conduct for debt restructuring; (4) regime for the liability of directors and managers; (5) tax implications of debt restructuring; and (6) dividing line between restructuring and liquidation. Panelists answered in no particular order.

Mr. Gitlin indicated that the use of explicit financial ratios to determine the viability of companies is not recommended, since these ratios fail to capture the circumstances of each company. He favored the use of detailed professional reports to analyze viability. Regarding the liability of managers, he noted a traditional approach, exemplified by the traditional English system, which seeks to punish managers and displace them in the event of the insolvency of the company, and a second approach, which is less destructive of value, based on taking advantage of the potential for rehabilitation provided by the skills of the incumbent managers, which in turn fosters entrepreneurship. This is the approach in the United States, and it is influencing other countries, including the United Kingdom. This approach does imply that fraudulent managers are not punished, and managers who were simply unsuccessful in business should not be punished for that reason in insolvency proceedings.

Mr. de Ranitz also commented on corruption and fraud. In his view, insolvency law is not the best instrument to fight fraud. This should be done through criminal law, maybe punishing directors for stealing assets or engaging in wrongful trading, but this should not become a dominant feature of insolvency law. Regarding the participation of tax authorities in restructuring, the law should define conditions under which the tax authority will accept a debt restructuring proposal. On the position of managers, he agreed that bringing in outside professionals to manage the business has disadvantages, and the professionals may be reluctant to accept these engagements for fear of liability, despite the availability of insurance coverage. On the question of whether to restructure or liquidate, he recommended looking carefully at the company and deciding whether it is better to preserve the existing organization or to sell the business as a going concern, as in English prepackaged administrations.

Mr. Méjan supported the idea that insolvency law is not criminal law. Although criminal law elements are in the origins of insolvency law, it has proven to be a strong deterrent in using the insolvency system. He addressed the question of the dividing line between restructuring and insolvency: insolvency is defined by the debtor’s inability to pay its debts, and the question about whether to reorganize or liquidate the enterprise is subsequent to the determination of insolvency. The decision about the viability of the business is a key question in the insolvency proceeding, and the assistance of insolvency professionals helps the creditors, debtor, and court in taking that decision. An additional question is the treatment of shareholders in the reorganization of companies; country systems adopt different approaches in this area. The US approach of treating shareholders as residual claimants under the absolute priority rule is an interesting approach to determine the value of shareholders’ rights.

Regarding the criteria for defining insolvency, Mr. Unnikrishnan considered that they must be easy to assess. On the question about whether to restructure or liquidate, financial creditors should have the final decision. Regarding the liability of managers, almost all legal systems have provisions to tackle fraudulent behavior, but he warned against the risk of applying these provisions to actions taken in good faith, because they may deter managers from taking decisions.

In his closing remarks, Mr. Hagan mentioned the importance of tackling corporate debt issues early for the adjustment process to be less severe. One of the consequences of strict liability is that company directors and managers will wait because of the concern that if they file, they will be liable. Thus, one of the consequences is delayed filings. The decision on viability must be taken in the context of a creditor-driven process. If liabilities exceed the value of the assets, shareholders are effectively wiped out, and creditors are left to determine whether to liquidate or to rehabilitate, according to their assessment of the returns of the liquidation versus the reorganization of the company. After that, he thanked the panel and the audience for the discussion.