V Asset Management and Corporate Debt Restructuring
- Marc Quintyn, and David Hoelscher
- Published Date:
- August 2003
Overview of Strategy
The third component of crisis management is asset management and corporate debt restructuring. Corporate and financial sector restructuring are inextricably intertwined, being two sides of the same issue. A key aspect of this process is the orderly transfer of ownership and the management of weak assets. Strengthening this process may include both legal and institutional reforms. For this reason, resolution of the banking system issues must be carried out in conjunction with resolution of corporate sector issues. Banks have three options in dealing with nonperforming assets: they can restructure them, liquidate them, or sell them to a specialized institution for resolution. The objective of this component of crisis management efforts is to seek arrangements that allow banks to maintain positive cash flows and deepen business relations with solvent borrowers.
Experience to date suggests that these activities are the most protracted element of crisis resolution. Despite important advances in asset management, corporate debt levels in most postcrisis countries have not come down, and corporate restructuring has proved to be a long-term process. In Thailand, debt levels have fallen from postcrisis peaks but remain high, while profitability and corporate cash flows have only slowly stabilized. In Korea, progress has been made in corporate restructuring for companies outside the Corporate Restructuring Agreement (see below), but the financial conditions of corporations under workout agreements remain dire. Significant corporate restructuring is just now under way in more recent crisis cases such as Ecuador and Turkey.
Managing Nonperforming Assets
The objective in managing nonperforming loans is to maximize their value and minimize bank losses and capital erosion. This process is complex and requires a supporting legal and institutional environment and specialized skills. Techniques for managing assets may include restructuring of loan terms, disposition through auctions or other sales methods (which transfers management decisions to the purchaser), and liquidations through court or administrative procedures. Asset sales are often at the core of the asset resolution process. Many techniques, traditional and more sophisticated, have been developed for this purpose, but little empirical work has been done to evaluate their relative effectiveness.
There are a number of institutional options for managing impaired assets (Figure 2). Banks may manage them directly or sell them to a specialized asset management company, either privately or publicly owned. Specialized institutions are necessary when the management of nonperforming loans interferes with the daily running of the bank or when specialized skills are needed. While each institutional setup has advantages and disadvantages, experience suggests that, in general, private financial institutions can respond quickly and efficiently whereas government-owned centralized asset management companies may be relatively more efficient when the size of the problem is large, when special powers for asset resolution are needed, or when the required skills are scarce.32
Figure 2.Options for Asset Management
Decentralized arrangements are those for which management responsibility remains with private sector institutions. For open institutions, the choice is between managing within the existing structure and creating a specialized subsidiary or private asset management company. For closed institutions, the authorities may transfer assets to a resolution trust managed by a private financial institution for a fee. Nonperforming loans of borrowers who are likely to honor their loan contracts, perhaps after renegotiation, and small loans should remain in the bank. Banks may transfer other nonperforming loans to their asset management companies for more efficient management and resolution. By involving specialists, the asset management company can focus on rapid loan workouts and more effective corporate restructuring.
While loan workouts are a normal aspect of banking business, setting up separate asset management companies becomes necessary if managing nonperforming loans is becoming a dominant part of the banking business and interfering with the daily running of the bank. The handling of bad assets may require skills that are not normally available to a great extent in a bank: loan workout specialists, real estate experts, liquidation experts, and specialized lawyers. Banks, however, may be reluctant to set up one or more separate asset management companies because it may force earlier loss recognition and pressures on their CARs.
The authorities can facilitate the establishment of asset management companies. Legal obstacles should be removed to allow for clean transfers of titles (and the associated priority) in asset transactions and transfers without requiring prior permission from debtors—an asset management company should be able to legally stand in for the bank.33 Institutional rigidities regarding incorporation can be minimized, and tax neutrality for asset transfers must be assured. The sooner these companies are up and running and contributing to effective corporate restructuring, the sooner the bank, the economy at large, and ultimately the government will benefit.
An alternative is the establishment of centralized asset management companies. These arrangements have both advantages and disadvantages, the weight of each depending on specific country circumstances. In general, centralized companies have been set up when asset management within the private sector is not a feasible option (for instance, because the required skills are lacking), or when there is evidence that the problem may be too large in terms of share of failed banks or nonperforming loans to be dealt with effectively in a decentralized manner.
There are two broad categories of centralized asset management companies: those with narrow mandates and those with expanded mandates. The former take over and liquidate assets from closed institutions and are typically focused on rapid asset disposition. The latter purchase assets from ongoing concerns with a view to expediting corporate restructuring.34 Sunset clauses are often introduced in both cases to reduce concerns about asset warehousing. There are trade-offs, however, when determining the exact lifespan of the institution. A centralized asset management company with a short lifespan will seek to sell assets immediately, thereby possibly accepting very low “fire sale” prices. A longer lifespan may enable the company to manage and package the assets to increase their value, seek suitable investors, and sell the assets gradually into the market. It may wait for prices to bottom out and the economy to recover. Sale alternatives abound, including competitive bidding, securitization of asset portfolios, sales with put-back clauses, or seizure and sale of collateral.
Box 10.Appropriate Design Features of a Centralized Asset Management Company
If it is decided that a centralized asset management company will be set up, a number of design features need to be put in place to enhance the effectiveness of its operations.1 These include operational and budgetary independence, legal protection of its staff, governance and internal controls, and clear operational rules.
Independence: These companies are prone to strong political pressures on behalf of borrowers. To ensure effectiveness and efficiency, the company should be established as an autonomous entity, perhaps under a special law, with the flexibility to hire the best available professionals and advisory firms, both domestically and abroad and to make independent decision on purchases, restructuring and disposition of assets. Moreover, to support resolution efforts, the staff should be legally protected from litigation for actions undertaken in good faith.
Funding: There should be independence from the budget appropriations process to limit political interference by inhibiting the company in terms of staffing and other resources. At the same time, these companies should be sufficiently funded to perform their intended functions. The operating budget should be separate from funding allocated for asset takeover. Funding could either come from the proceeds of government bond issues or raised by the company’s own bond issues backed by the government, with the proviso that whenever a company realizes losses these be directly absorbed by the budget. If the company issues its own bonds, it is important, in countries where the government bond market is small, that these bonds do not lead to segmentation in the secondary markets for government and government-backed bonds. So bonds issued by the these companies should carry the same characteristics as existing government bonds, and any issues should be closely coordinated with other government bond issues.
Legal basis: The legal basis of a centralized asset management company is critical to its success. One issue of particular importance concerns the transfer of assets. The legal basis of the company should provide for clear transfers of titles and priority in the transactions of assets. Similarly, legal obstacles for the transfer of assets, such as requiring the permission of the debtors before the transfer of loans can be effected, should be removed. If need be, these companies could benefit from special legal and administrative powers for loan recovery and resolution when either the existing legal system is not equipped to deal with the magnitude of the nonperforming assets and endeavors to reform the system are overly time consuming, or when the authorities want to restrict certain legal powers of creditors to just these companies. Such powers were instituted and successfully applied in Malaysia but have not been feasible in many other countries due to resistance from vested borrower interests.
Accountability, transparency, and governance:2 A centralized asset management company must be accountable for its performance, be required to report regularly to the parliament and the public, and be subject to strict audits by external professional auditors on behalf of its stakeholders. The specific nature of such companies—making themselves redundant—requires specific governance incentives, such as providing employee outplacement assistance and compensation incentive programs for rewarding timely and final resolution of assets.1 Woo (2002).2Das and Quintyn (2002).
If it is decided that a centralized asset management company will be set up, a number of design features need to be put in place to enhance the effectiveness of its operations.35 These include operational and budgetary independence, legal protection of staff, governance and internal controls, and clear legal and operational rules (Box 10).
In the absence of strong institutions or an adequate legal framework, there may be scope for providing centralized asset management companies with legal and administrative powers to overcome limitations in the rules that otherwise might hamper the company’s ability to manage the assets. When the legal framework limits the ability to resolve banks or distorts the balance between creditors and borrowers, special legislation could give the company the necessary powers to overcome such limitations. Any special powers would have to be clearly outlined in law and should be in place only for a limited period while the legal and institutional base of the country is being strengthened.
The most important disadvantages of a centralized asset management company are the potential for poor quality management and staff, and for political interference. Managing and liquidating nonperforming loans is a complex process involving extensive bilateral negotiations that open a wide scope for corruption. The objective of applying uniform rules and criteria could be jeopardized by political pressures on behalf of borrowers. These pressures can be countered by establishing an independent agency, perhaps under a special law, and giving management and staff legal protection. At the same time, the company must be accountable for its performance, be required to report regularly, and be subject to strict audits by external professional auditors on behalf of the government.
Empirical assessments of the effectiveness of centralized asset management companies have suggested that the most successful ones have had narrow mandates.36 These companies have had only limited success in corporate restructuring. Political pressures, limitations of market discipline, and conflicting objectives have hampered their expanded role. Moreover, those with expanded mandates have often been used to recapitalize financial institutions by buying nonperforming assets at above market value. This recapitalization option is less transparent than more direct methods, it converts the asset management company into a loss-making operation to be covered by additional fiscal expenses, and it provides the government with less leverage in the recapitalized institutions.37
The key issue in the operation of all asset management companies—but most notably those that are centralized—is asset pricing. As long as the ownership of the bank and the company is the same, nonperforming loans can be transferred relatively rapidly because the transfer of assets is only an internal transaction. When ownership of banks and companies is different, pricing often becomes difficult because investors may be unwilling to share risk and potential losses. If an independent centralized asset management company is set up to purchase assets from ongoing concerns, nonperforming loans should be purchased at a price as close to fair market value as possible. While it is difficult to price nonperforming assets, especially in the midst of financial crises, an approximation of their value based on estimated recovery, cash flow projection, and appraisal of collateral should be used for the purpose of the transfer. When timing is an issue and there is a great number of assets involved, the transfer can take place at an initial price, with the explicit agreement that the final price of the transaction be established after the value of the assets has been estimated or the assets have been sold.
Corporate Debt Restructuring
Banks and corporations must seek the timely and orderly transformation and reduction of corporate debt so that they can return to profitability and viability. In systemic crises, however, banks often are at a disadvantage in negotiating with borrowers. Legal actions that may be effective in normal times may not be effective in systemic crisis because the judicial system typically becomes overwhelmed.
Corporate debt restructuring should proceed in the context of operational restructuring of companies. Operational restructuring is a prerequisite for renewed corporate profitability, new investment, access to bank credit, and economic growth. Operational restructuring of nonperforming corporations must affect their businesses in the form of closures and reorganization of productive capacity, with a view to removing obsolete or excessive capacity and restoring profitability. This topic, which is not addressed in this paper, must be carefully planned and coordinated with efforts for corporate debt restructuring.
When a corporate crisis is systemic, the government may have to play a role in mediating between corporations and banks. Excess negotiating power by either debtor or creditor can obstruct the process, prolonging or impeding the resolution process. The government may opt to mediate either informally by providing common guidelines or formally by establishing an institutional framework for negotiations. Government intervention is generally not needed when the number of troubled corporations is small and their macroeconomic importance is limited. When corporate debt problems are widespread, market failures inhibit the debt restructuring process; or when banks are unable to work out debt on a large scale, a comprehensive debt restructuring framework involving the government may be needed.
A key function of the government in corporate debt restructuring is to provide an orderly and effective insolvency framework. A framework for debtors and creditors that is predictable, equitable, and transparent can contribute to financial stability. Moreover, such a system ensures the protection and maximization of value for the benefit of debtors, creditors, and other interested parties. An orderly and effective insolvency system imposes discipline on debtors and allows banks to limit deterioration in the value of their assets. Such a framework should include laws and regulations for bankruptcy, reorganization, and liquidation. It should also provide for protection of secured and unsecured creditors. In this way, the insolvency law provides a means of ensuring that private creditors contribute to the resolution of the crisis (Box 11 summarizes a set of best practices for corporate restructuring).38
Box 11.Good Practices for Corporate Debt Restructuring
- A court-supervised reorganization framework that protects debtors from asset seizures; provides priority for new lending; gives a debtor and its creditors an opportunity to work out a mutually satisfactory restructuring plan; allows a majority of creditors to “cram down” a reorganization plan on a holdout minority of creditors; and converts the case into a court-supervised liquidation if interim milestones and reasonable deadlines are not met.
- A legal presumption, which may be altered in negotiation, that the equity interests of all shareholders—including minority shareholders—are wiped out in the case of corporate insolvency.
- Substantial institutional capacity, in terms of experienced judges, receivers, and insolvency professionals.
- Agreed standards among financial institutions for out-of-court workouts, including appointment of a lead creditor and steering committee; development and sharing of information; priority for new lending; apportionment of losses among creditor classes; thresholds for creditor approval of proposed workouts; and means for the resolution of differences among creditors.
- Reliance on market participants to structure and negotiate out-of-court workouts based on available information and the participants’ commercial interests.
- A strong financial regulator able and willing to force banks to take immediate losses on corporate restructuring and to take over insolvent or nonviable banks.
Institutional reforms may have to accompany legal reforms during a crisis. The government may need to establish fast-track procedures, dedicated courts, and specialized judges. A special budgetary allocation may be required to facilitate the hiring and training of judges. Establishment of special procedures outside of the formal bankruptcy framework may expedite debt restructuring. In a systemic crisis involving the restructuring of hundreds or thousands of corporations, exclusive reliance on court-supervised processes will overwhelm the capacity of courts and insolvency professionals and bring the process to a halt. An out-of-court process can include guidelines and official mediators.
An example of the out-of-court system is the London Approach. That approach—which has been duplicated in a number of cases including the Bangkok Approach, the Istanbul Approach, and the Jakarta Approach—seeks to establish a framework for negotiations between creditors and debtors (Box 12). While the authorities play only a facilitator role in the London Approach, they have a more active role in some recent variants. This government-led approach was applied aggressively in Korea, where several mediumsize corporate groups were restructured through debt rescheduling under the Corporate Restructuring Accord. This accord consisted of a steering committee with representatives from participating financial institutions and was responsible for assessing the viability of corporate candidates for restructuring, arbitrating differences among creditors, enforcing decisions, and modifying when necessary workout plans proposed by creditors. In Thailand, the Corporate Debt Restructuring Advisory Committee, formed by the Bank of Thailand and representatives of debtor and creditor groups, was established in 1998 as an independent intermediary in the restructuring process to facilitate negotiation among all parties concerned.
Such out-of-court procedures for corporate restructuring need to be backed up by credible court-supervised processes for seizure of assets, foreclo-sure, liquidation, and reorganization. Without the threat of court-imposed loss, there is not enough incentive for corporate debtors to agree to asset sales, equity dilution, and diminution of management control that may be part of a fair restructuring deal. While some debtors might cooperate voluntarily, more often the success of out-of-court efforts ultimately depends on the ability of creditors to impose losses on debtors.
Governments may encourage banks to apply summary terms and conditions for the restructuring of certain asset pools and thus permit greater focus on large borrowers. Such rules can best be used for large pools of homogenous small loans, such as mortgages or credit card portfolios. Applying summary solutions reduces an enormous logistical problem for banks and provides a sense of fairness to borrowers. Such schemes remove a potential political problem from the debt restructuring process and allow banks to concentrate on their largest problem loans, which should be dealt with on a case-by-case basis. Given the burden-sharing issues involved, such schemes must be balanced. Private banks may agree to assume the cost of any concessions, but these costs could be absorbed by the government in part or in full.
Box 12.Best Practices in Corporate Workouts
The London Approach to multicreditor workouts is based on nonjudicial proceedings where creditors, recognizing that their self-interest is best served by collective negotiations rather than unilateral action, agree to a comprehensive restructuring of the debtor. The Jakarta Initiative Task Force, established in Indonesia in 1998 to encourage voluntary restructurings, is an example of government attempting to encourage the use of the London Approach to facilitate widespread corporate restructuring in response to a crisis.
The International Federation of Insolvency Practitioners (INSOL International), after five years of development by workout practitioners, published in 2000 the Statement of Principles for a Global Approach to Multicreditor Workouts, codifying the London Approach. INSOL International regards the eight principles as best practices for all multicreditor work-outs, which are applicable in all jurisdictions having insolvency laws.
First principle: Where a debtor is found to be in financial difficulties, all relevant creditors should be prepared to cooperate with each other to give sufficient—though limited—time (standstill period) to the debtor to allow for information about the debtor to be obtained and evaluated and for proposals to resolve the debtor’s financial difficulties to be formulated and assessed, unless such a course is inappropriate in a particular case.
Second principle: During the standstill period, all relevant creditors should agree to refrain from taking any steps to enforce their claims against or (otherwise than by disposal of their debt to a third party) to reduce their exposure to the debtor but are entitled to expect that during the standstill period their position relative to other creditors will not be prejudiced.
Third principle: During the standstill period, the debtor should not take any action that might adversely affect the prospective return to relevant creditors (either collectively or individually), as compared with the position at the standstill commencement date.
Fourth principle: The interests of relevant creditors are best served by coordinating their response to a debtor in financial difficulty. Such coordination will be facilitated by the selection of one or more representative coordination committees and by the appointment of professional advisers to advise and assist such committees and, where appropriate, the relevant creditors participating in the process as a whole.
Fifth principle: During the standstill period, the debtor should provide, and allow relevant creditors and/or their professional advisers’ reasonable and timely access to, all relevant information relating to its assets, liabilities, business, and prospects, in order to enable proper evaluation of its financial position and any proposals to be made to relevant creditors.
Sixth principle: Proposals for resolving the financial difficulties of the debtor and, so far as practicable, arrangements between relevant creditors relating to any standstill should reflect applicable law and the relative positions of relevant creditors at the standstill commencement date.
Seventh principle: Information obtained for the purposes of the process concerning the assets, liabilities, and business of the debtor and any proposals for resolving its difficulties should be made available to all relevant creditors and should, unless already publicly available, be treated as confidential.
Eighth principle: If additional funding is provided during the standstill period or under any rescue or restructuring proposals, the repayment of such additional funding should, so far as practicable, be accorded priority status as compared to other indebtedness or claims of relevant creditors.Source: International Federation of Insolvency Practitioners.
Prudential rules must guide the restructuring of loans. Grace and maturity periods may be lengthened, but a renegotiated loan contract must require that interest be paid on a monthly or quarterly basis and not just accrued. The interest rate used should be a realistic, forward-looking market rate related to banks’ funding costs. Prudential rules also must define the conditions under which a restructured loan can be returned to performing status. This should require that the restructured loan contract has been regularly serviced for some time. Such a rule is an important safeguard to prevent banks from using fictitious loan restructuring to reverse loan loss provisions and artificially inflate their CARs.
The restructuring of loans or recovery of collateral should be achieved as speedily as possible but cannot be subject to a formal timetable. Banks should seek to restructure or sell loans or collateral assets as soon as possible. But at the same time, this must be done in a process of negotiations that conforms with the law and properly defends the legitimate interests of bank owners and borrowers, all of which reflect loss-sharing issues between private sector agents.