Resolving unsustainable corporate debt

There are a number of ways to resolve unsustainable corporate debt, some better than others. The best response would be for the company to raise new equity and/or undertake “operational restructuring” through the discontinuation of less profitable or loss-making “non-core” businesses, layoffs of excess labor, and other cost reductions to increase the company’s earnings and debt service capacity, as well as sales of non-core businesses and real estate or other assets to retire debt. If it appears that operational restructuring cannot reduce corporate debt to a sustainable level, “financial restructuring” becomes appropriate. For example, creditors could convert debt into equity or into lower-yielding convertible bonds. To avoid moral hazard, creditors should contemplate debt write offs only after having exhausted all other approaches and should retain some instrument, such as equity, options, or warrants to participate in any recovery.¹ Term extensions may be acceptable, so long as these 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.² Grace periods on debt service—especially on interest payments—usually just postpone the day of reckoning for nonviable companies.

The choice of a forum for such operational and financial restructuring of distressed companies will normally depend on the severity of a company’s problems and differences among interested parties. If the company’s underlying business is nonviable, liquidation is appropriate. If the company is viable (albeit over-indebted) as a going concern but the parties are separated by wide differences over the apportionment of loss, corporate restructuring may need to proceed via a court-supervised rehabilitation. Otherwise, restructuring may proceed through an out-of-court “workout.” A systemic crisis involving hundreds or thousands of cases could overwhelm a nation’s courts and create a need for greater reliance on out-of-court workouts.

Link between corporate and financial sector restructuring

Corporate restructuring and financial sector restructuring are two sides of the same problem. The creditor(s) of a corporation under restructuring should provision—and, as necessary, further reduce its capital—to reflect (i) the present value effects of any debt/equity conversions, rate reductions, term extensions, grace periods, and write-offs; and (ii) appropriate provisioning of remaining corporate debt based on international-standard, forward-looking criteria. If a financial institution’s risk-weighted capital adequacy falls below some ratio (for example, 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 re-capitalize the institution and take control. Thus, corporate cash flow is linked both to the amount of sustainable corporate debt and to the cost of re-capitalizing financial institutions for losses in resolving the non-sustainable portion of corporate debt. In any case where financial restructuring of a distressed corporation involves a debt/equity conversion, financial institution shareholders will also need to make arrangements for managing the converted equity and plan for eventually exiting from equity ownership. Unless the financial institution has expertise in management of corporate equity, this task should be outsourced.

Corporate restructuring goals

The debtor and its creditors will naturally seek to minimize their losses. For example, the corporate managers and controlling shareholders will seek to avoid loss of control, dilution of their equity, or divestment of favored assets and lines of business. Managers and controlling shareholders of financial institutions will seek to avoid losses on corporate debt restructuring that could necessitate capital write-downs leading to equity dilution, loss of control, and nationalization or liquidation of the institution.

The government will have to balance a variety of conflicting interests. These may include minimizing the costs of bank re-capitalization; protecting workers, suppliers, and subcontractors of failed companies to minimize ripple effects through the economy; minimizing distortions to market competition through excessive debt-rescheduling concessions; avoiding labor strife; and—last but not least—dampening public criticism enough for the government to remain in office.

From the perspective of the distressed company itself, as distinct from its shareholders, one can identify time-phased restructuring goals.

• In the short term (e.g., 3 months), it will be important to achieve a degree of financial stabilization in order to prevent the liquidation of viable, albeit over-leveraged, companies. Non-viable companies should be allowed to fail and exited, for example, through liquidation. In a systemic crisis, however, “strong swimmers” should not be dragged down along with the weak.

• In the medium term (e.g., 6-24 months), operational restructuring should be undertaken to improve the company’s profitability, solvency, and liquidity. This will involve steps like those mentioned above.

• Over the longer term, it is important to deter imprudent debt-fueled investment so that companies do not launch non-viable ventures or assume unsustainable debt. Deterrence depends on a demonstration of the ability of wronged creditors to foreclose on assets, liquidate non-viable companies, and take viable but distressed companies away from uncooperative shareholders/managers.

It is relatively easy to financially stabilize distressed companies, for example, through creditor standstills or debt restructuring. Operational restructuring in a systemic crisis is more difficult, since hundreds of firms may be attempting to sell non-core assets, while low stock prices will likely discourage new equity financing. Failure to move beyond financial stabilization, however, and pursue operational restructuring to address operational weaknesses, such as high labor costs, low-margin or loss-making business lines, poor working capital management, or capital tied up in low—or negative-return assets—will diminish long-term competitiveness.

Onset of the crisis

The years leading up to the crisis witnessed heavy debt-financed expansion by chaebol into new businesses—often in competitive and cyclical industries—and into emerging markets with distant and uncertain profit prospects. During the run-up to 1997, profitability and returns on investment declined, leverage grew, and interest coverage remained razor thin at best. By end-1997, liabilities/equity for Korea’s 30 largest chaebol, excluding financial affiliates, was just over 5:1 on average; fifteen of the top 30 chaebol were insolvent or had a liabilities/equity ratio in excess of 5:1.

Box 2.

Initial Options for De-Leveraging The Thirty Largest Chaebol, 1997-99

In early 1998, the government directed that chaebol should reduce their liabilities/equity ratios to 200 percent by end-1999. The following table includes assumptions from early 1998 about opportunities for using court-supervised reorganization or liquidation to resolve insolvent chaebol; and expectations about foreign investment relative to GDP, earnings increases, and new equity issues relative to market capitalization.

Sources: Fair Trade Commission for end-1997 balance and SBC Warburg Dillon Read for projections of foreign investment and equity issues.Note: Liabilities and equity in billions of won.

Balances	Liabilities	Equity	Liabilities/Equity	Resolution Method
At 12/31/97	351,703	69,122	509%
	-48,647	-1,947		Court-supervised insolvency
	−12,000			Foreign investment, asset sales
		1,200		“Normal” retained earnings
		2,500		Increased retained earnings
	-8,250	8,250		Domestic equity issues
	-5,250	5,250		Offshore equity issues
Subtotal	277,556	84,375	329%
		0		Asset re-valuations
	-14,890	14,890		Debt/equity conversions, to 15% of total equity
Subtotal	262,666	99,265	265%
	-21,250	21,250		Additional debt/equity conversions, debt write-offs, or other debt rescheduling
12/31/99 goal	241,416	120,515	200%

Sources: Fair Trade Commission for end-1997 balance and SBC Warburg Dillon Read for projections of foreign investment and equity issues.Note: Liabilities and equity in billions of won.

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Balances	Liabilities	Equity	Liabilities/Equity	Resolution Method
At 12/31/97	351,703	69,122	509%
	-48,647	-1,947		Court-supervised insolvency
	−12,000			Foreign investment, asset sales
		1,200		“Normal” retained earnings
		2,500		Increased retained earnings
	-8,250	8,250		Domestic equity issues
	-5,250	5,250		Offshore equity issues
Subtotal	277,556	84,375	329%
		0		Asset re-valuations
	-14,890	14,890		Debt/equity conversions, to 15% of total equity
Subtotal	262,666	99,265	265%
	-21,250	21,250		Additional debt/equity conversions, debt write-offs, or other debt rescheduling
12/31/99 goal	241,416	120,515	200%

Sources: Fair Trade Commission for end-1997 balance and SBC Warburg Dillon Read for projections of foreign investment and equity issues.Note: Liabilities and equity in billions of won.

Assuming no asset re-valuations (a practice prohibited since 1999) and 14,890 billion won in debt/equity conversions—which would leave creditors with 15 percent of total equity—the top 30 chaebol would still show liabilities/equity of 265 percent. Thus, an additional 21,250 billion won of debt/equity conversions (or other present value gains to debtors from debt write-offs or other debt restructuring) would be needed to achieve end-1999 liabilities/equity of 200 percent. This analysis is intended not to suggest that 200 percent liabilities/equity was an ideal goal (or better than an interest coverage goal), but rather to illustrate the difficulty of eliminating such a large debt overhang through incremental improvements—instead of a wholesale conversion of debt into equity—within a 2-year period.

Estimates in early 1998 raised questions about the ability of Korean companies to achieve sufficient de-leveraging through incremental enhancements, such as asset sales, foreign investment, new equity issues, or increases in retained earnings; this suggested that wholesale reductions in the stock of debt through debt/equity conversions or debt write-offs would be needed. In Korea, liabilities/equity for the thirty largest chaebol was 509 percent at end-1997. There were not enough asset buyers and equity investors, and not enough of an opportunity for immediate operational restructuring, to reduce corporate leverage to the government’s end-1999 liabilities/equity target of 200 percent just through incremental measures, such as asset or business sales, issuance of new equity, or increases in retained earnings from operational gains. Hundreds of large corporations were simultaneously exploring the possibility of asset or business sales or equity issues to strengthen their financial position—creating the prospect of an asset glut and fire sale prices. Thus, as illustrated in Box 2, the stock of corporate debt had to be reduced through debt/equity conversions or write-offs to stabilize corporate finances on a lasting basis. Other concessionary debt restructuring—rate reductions, term extensions, or grace periods—could provide temporary financial stabilization for distressed chaebols. But unless they used temporary financial stabilization to implement sufficiently deep operational restructuring, companies might be unable to resume normal debt service upon the expiration of these debt concessions.

Recurring pattern in corporate restructuring

A review of corporate restructuring activity in Korea since 1997 reveals a recurring pattern. Creditors periodically act decisively to take problem companies away from existing management and controlling shareholders while agreeing to some financial stabilization either through a workout or court-supervised insolvency. Subsequent operational restructuring, however, is often delayed because of creditor reluctance to take additional losses on the sale of over-valued assets at realistic prices, reluctance to lay off workers, and different views among creditors. For its part, the government has periodically weighed in with sweeping measures to promote long-term corporate reform or re-energize the corporate restructuring process.

In 1997, 13 chaebol—including such giants as Hanbo Steel and Kia—with cumulative debts of KRW 28 trillion entered court-supervised insolvency. Of these, 11 went into receivership, effectively wiping out existing management and controlling shareholders. While Kia was sold to Hyundai, many companies have languished in receivership or enjoyed the competitive benefits of debt service concessions included in debt composition agreements. In some cases, creditors have been reluctant to sell companies in receivership for less than their outstanding debt. For instance, it was reported that creditors owed $4 billion by Hanbo rejected a $2.5 billion offer for the company from Posco/Dongkuk; a subsequent offer by another investor for $400-500 million was withdrawn, leaving creditors with nothing. As of end-2000, 42 affiliates from the sixty largest chaebol were subject to debt composition proceedings while another 61 were in receivership. Of these 103 affiliates, 54 were designated for rehabilitation, 14 for liquidation, and 35 for sale or merger.

By end-1997, according to one investment bank analysis, another eighteen of Korea’s top 30 chaebol (apart from those already under court supervision) were at medium or high risk of insolvency. Simultaneous distress among so many large chaebol was obviously cause for concern, especially since Korea’s insolvency system was not capable of rapidly rehabilitating a large number of distressed chaebol, and neither Korea’s financial system nor the Korean public were prepared for massive financial sector losses. Between October 1997 and May 1998, Korean financial institutions provided at least KRW 1.9 trillion in emergency bankruptcy-avoidance loans to Haitai, New Core, Jindo, Shinho, Hanwha, Hanil, Dong-ah, Kohap, and Woobang. At least six of these companies subsequently entered court-supervised insolvency or went through one or two workouts. Following two unsuccessful workouts, Dong-ah was designated for liquidation in early 2001.

While it searched for an alternative between potentially cumbersome receivership for resolving distressed companies and “bankruptcy avoidance” loans, the government introduced a number of important initiatives in February 1998 and thereafter. Some would promote general corporate reform: improvements in financial disclosure and accounting standards, including requirements for consolidated and combined financial statements; stronger shareholder rights and enhanced corporate governance standards; relaxation of legal constraints on foreign investment; liberalization of merger and acquisition (M&A) rules; greater latitude for employee layoffs during corporate restructuring or reorganization; improved unemployment insurance benefits; and more streamlined rules on court-supervised rehabilitation. Other reforms sought to impose more financial discipline on large chaebol not in immediate distress: elimination of domestic cross guarantees; additional requirements in capital structure improvement programs (CSIPs) to shed non-core affiliates and reduce liabilities/equity ratios to 200 percent by end-1999; tighter exposure limits on financial institutions; and Fair Trade Commission (FTC) action against anti-competitive intra-chaebol transactions. In June 1998, the Financial Supervisory Commission (FSC) encouraged banks to announce a withdrawal of credit, or “exit,” from 55 non-viable companies. Soon thereafter, the government announced its support for eight “Big Deals” to consolidate through merger, acquisition, or joint venture businesses in eight sectors suffering from excess capacity. Over the past year, the FTC has been moving to limit to 25 percent of its equity any chaebol affiliate’s shareholdings in a related affiliate.

In July 1998, with encouragement from the FSC, 210 local financial institutions contractually bound themselves to the Corporate Restructuring Agreement (CRA) and embarked on “workouts” as an alternative to receivership and uncontrolled “bankruptcy avoidance” loans. The CRA provided for a 2-5 month standstill to accommodate workout negotiations, designation of a lead creditor, a 75 percent threshold for creditor approval of workout agreements, a 7-person Corporate Restructuring Coordination Committee (CRCC) to provide workout guidelines and arbitrate inter-creditor differences if creditors could not agree on a workout plan after three votes, and FSC imposition of fines on creditors for breaching the CRA. The CRCC provided inter-creditor arbitration decisions in 21 cases prior to July 1999.

Between September 1998 and March 1999, CRA workouts involving KRW 34 trillion of debt restructuring and KRW 10 trillion of corporate “self help” (e.g., business/asset sales, new capital, cost savings) were agreed for 41 affiliates of 16 chaebol and 38 medium or large stand-alone companies. Thus, the emphasis was on financial restructuring rather than corporate selfhelp. Financial restructuring relied mainly on term extensions, rate reductions, and grace periods, along with conversions of KRW 3.6 trillion of debt into equity or convertible bonds. Only KRW 565 billion of debt was to be written off. Controlling shareholders experienced significant dilution as a result of debt/equity conversions and chaebol managements were replaced in some cases. Creditors deployed joint management teams to monitor costs and the disposition of assets. On average, corporate self-help was to be implemented over three years, which was a reasonable goal. It appears that strenuous efforts were made to control costs, but that access to new equity was poor, partly because Hyundai, Samsung, LG, and SK so dominated capital markets, and those sales of non-core businesses and real estate lagged because of unrealistic valuations.

Following an extended period of decline—as evidenced by Daewoo Corporation’s negative KRW 12 trillion in cash from operations for 1998—twelve Daewoo affiliates failed in July 1999. Existing management and controlling shareholders were shunted aside, and some were threatened with criminal prosecution. The ability of creditors to displace existing management and controlling shareholders within Korea’s second or third largest conglomerate provided some warning that no chaebol is “too big to fail.”

By end-1999, CRA workouts had been developed or agreed for the twelve Daewoo affiliates. These had resulted in the restructuring of KRW 59 trillion in debt, mostly through rate reductions and conversions of debt into convertible bonds or equity by early 2001. The CRCC provided inter-creditor arbitration decisions in two Daewoo cases and mediated a proposal—first by Korean creditors, and then by KAMCO—to buy out $4.8 billion in debt owed to foreign creditors by Daewoo Corporation, Daewoo Heavy, Daewoo Motors, and Daewoo Electronics.

Following the financial stabilization of Daewoo companies, momentum for operational restructuring during 2000 was slow to develop. Pre-Ford discussions with General Motors about acquiring Daewoo Motors lapsed. Planned spin-offs of Daewoo Corporation’s construction and trading businesses and Daewoo Heavy’s shipbuilding and heavy machinery businesses were delayed until the fourth quarter of 2000. These delays reflected the time needed to legislate relief from heavy taxation of the spin-offs and to negotiate preferential terms with public shareholders who, taking advantage of the fact that these workouts were out-of-court, resisted the equity write-downs and share allocations in residual “bad companies” proposed by major creditors. The only sales to occur in 2000 were of Daewoo Telecom’s TDX division and of Daewoo Electronic Components. At end-November 2000, Daewoo Motors was put under court receivership. Since then, Daewoo Motors has reportedly laid off 6,400 workers (about 9 percent of its workforce), reduced material costs, and re-negotiated many vendor contracts. Creditors plan to restructure and sell off ten or so units of Daewoo Electronics (DEC), but must first obtain approval from public shareholders, who hold 94 percent of DEC’s shares, for a second debt/equity conversion. Despite the fact that DEC had negative capital of KRW 27 trillion at end-2000, creditors are continuing—incredibly—to attempt to resolve DEC out of court.

In other ways, 2000 represented a hiatus for the operational restructuring of still-distressed corporations. Business projections used to develop some of the early CRA workouts were clearly unrealistic and, not surprisingly, 18 companies were forced into second-round CRA workouts by mid-2000. These workouts involved additional term extensions, rate reductions, and grace periods, and additional conversions of debt into equity and convertible bonds. An examination of cash flows and creditor descriptions of fantastic assumptions underlying some projections, however, raised doubts about the credibility of these second round workouts.

By mid-2000, there were increasing concerns that regulatory forbearance on provisioning for restructured corporate debt was discouraging financial institutions from pursuing post-stabilization “operational restructuring transactions,” such as company sales, transfer to corporate restructuring vehicles (CRVs), asset sales, or liquidation. To encourage financial institutions to agree to CRA workouts, the FSC had provided a special exemption from the general application of forward-looking criteria (FLC). Financial institutions were allowed to provision restructured debt at just 2-20 percent until as late as end-2001. While some financial institutions were more conservatively provisioned in some cases, these may have been the exception. There are also reasons to believe that converted equity was over-valued. A lower-of-cost-or-market rule (instead of, for example, booking converted equity at a nominal KRW 1 per share for illiquid stock) may have allowed banks to carry converted equity at “market prices” that were unrealistically high as a result of thin public floats, legal protections for public shareholders, and agreements among creditor-shareholders not to sell converted equity during the workout implementation period (3 years on average) without unanimous agreement among creditor-shareholders. In cases where sale of a company, transfer of debt/equity instruments to a CRV, asset sales, or liquidation could force a bank to recognize losses on under-provisioned loans or over-valued equity, creditors could be expected to resist such operational restructuring transactions. In mid-2000, the FSC decided to end the special 2-20 percent provisioning for restructured corporate debt and require banks to apply standard FLC to all corporate credits by end-2000.

While required regulations on CRVs were in place by end-2000, no CRV has yet been established. Evidence and anecdote suggest that some banks account less conservatively for restructured corporate debt and converted equity and are less willing to convey these financial assets at realistic transfer prices to a CRV for management. There are also reports that differences have arisen among banks over the relative value of converted equity and debt (e.g., secured vs. unsecured) to be conveyed in exchange for ownership interest in a CRV.

In apparent response to a loss of corporate restructuring momentum, the government sought to reinvigorate its corporate restructuring program in the fall of 2000. During October, twenty-one banks conducted credit risk assessments of just 287 potentially non-viable corporations, of which 69 were deemed problematic but viable with creditor support while another 52 were to be exited. The results were greeted with some skepticism. Only 12 new companies were included on the exit list. The others were mostly “downgrades” from workout to receivership, or from receivership to liquidation. The November 2000 exit list included at least one company from the June 1998 list of companies to be exited. Decisions on two “exit” companies—Hyundai Engineering & Construction (HEC) and SSangyong Cement Industries—were deferred. Our analysis of 1999 interest coverage for 496 large corporations (excluding Daewoo affiliates) based on EBITDA, however, found interest coverage of less than 1.5:1 for 156 of the 496 companies; less than 1:1 for 112; and less than zero—negative cash flow—for 64. This raised additional questions about the adequacy of the October credit risk assessments.

Following HEC’s near-default in November 2000, several events raised concerns about a possible bail-out of the company’s controlling shareholders: the November roll-over of bank credits through at least end-2000; HEC’s announcement of a new “self-rescue” plan (its fifth since May 2000) in which KRW 600 billion of KRW 1,300 billion would be raised from a transfer of HEC’s Sosan ranch to state-owned Korea Land Corp; reports that the FSC had asked Hyundai affiliates to end their resistance to supporting HEC’s self-rescue, which was seen to be a reversal of the government’s policy of requiring chaebol affiliates to stand on their own; and Korea Development Bank’s (KDB) “quick underwriting” of KRW 304 billion in HEC re-financing during the first quarter of 2001, with expectations that KDB would underwrite a total of KRW 1.4 trillion of HEC debt during 2001. While it is obviously important to undertake a professional and independent assessment of HEC’s businesses—including the profitability and solvency of large construction projects—and preserve whatever is viable, observers worried that such non-market interventions to protect controlling shareholders and management from receivership would negate the lesson—provided at considerable expense—from Daewoo that no chaebol is “too big to fail” and create long-term moral hazard. These concerns were somewhat alleviated by creditor takeover of a bloc of HEC shares and expectations that a debt/equity conversion would severely dilute or eliminate the founding family’s equity holdings. However, moves to do a debt/equity conversion ran into familiar problems of potential opposition from secured creditors who wanted to be included with unsecured creditors in a debt/equity conversion and from public shareholders who could insist on preferential terms for write-downs of existing equity. In addition, HEC was slow to implement recommendations from its consultants for cost reductions and other operational restructuring.

Recent moves to support and save Hynix from receivership have created similar concerns. Hynix’s end-February 2001 debt was put at KRW 9.1 trillion—KRW 5 trillion with banks and KRW 4.1 trillion with NBFIs. Amounts coming due in 2001 were put at KRW 5.2 trillion. With chips selling for rock-bottom prices, financial institutions—especially the NBFIs—were unwilling to rollover Hynix debt without some emolument. Hynix’s lead bank reportedly warned that court receivership would deal a “crippling blow” to the economy. Apparently accepting the argument that current laws and procedures for receivership would harm rather than rehabilitate Hynix, the state-owned financial institutions organized a KRW 5.1 trillion rescue that included creditor bank purchases of KRW 1 trillion in convertible bonds.³ Under its “quick underwriting” program, KDB has underwritten KRW 840 trillion of Hynix bonds and expects to underwrite a total of KRW 2.9 trillion by end-2001.⁴ This rescue plan and other maneuvers have raised issues and criticism. Final recoveries for creditors and post-conversion shareholdings for family members cannot be predicted, so it is impossible to judge this rescue from either a business or a moral hazard perspective. Claiming that Hynix and other Hyundai firms have not undertaken any layoffs, asset sales, or other painful self-rescue steps, one press report suggested that their “insouciance” toward self-restructuring “has triggered a moral-hazard controversy.” Indeed, the emphasis is on re-scheduling to the apparent neglect of de-leveraging. Other press reports that the FSS had instructed creditor banks to classify Hynix loans as normal further highlight the conflicts of interest that can arise when a financial supervisor is tasked with managing corporate/financial sector restructuring in a systemic crisis.⁵ Reports that Hyundai Heavy, Hyundai Merchant Marine, and Hyundai Corporation had agreed to support Hynix if necessary by purchasing chips from Hyundai Semiconductor of America at cost plus an 18 percent margin raise several issues, including the continued existence of cross guarantees (albeit in more creative formats) and the competitive propriety of intrachaebol transactions.⁶

Perhaps reflecting doubts about the adequacy of the October 2000 credit risk assessments, the Financial Supervisory Service (FSS) recently established a “corporate health checkup system” under which creditor banks have nominated 1,187 domestic firms to undergo credit risk assessments. Those selected had been given “precautionary” or lower credit ratings by creditor banks, recorded an interest coverage ratio of less than 1, or shown other signs of insolvency during the past three years. The number could increase, as it does not include firms under court-supervised composition or receivership. During April 2001 on-site inspections, the FSS reportedly found that most banks had failed to establish detailed and objective criteria for assessing the creditworthiness of companies. Banks were also found to have omitted firms that failed to receive an unqualified audit opinion or that were unprofitable. Firms will be categorized as those to be revived; those suffering from temporary liquidity problems; those suffering from “structural” liquidity problems; and those to be liquidated. Creditor banks are expected to produce results each month and complete this round of credit risk assessments by end-August. The FSS reportedly expects that 200-300 firms will be classified as non-viable.⁷

Results

Looking first at its corporate restructuring performance from a long-term perspective, Korea has done a good job—so far—of establishing precedents to deter companies from making imprudent debt-fueled investments in the future. Through both court-supervised receiverships and out-of-court workouts, the controlling shareholders and managements of many chaebols—including some of Korea’s biggest pre-crisis names—have completely lost out or seen their shareholdings severely diluted and their managerial discretion severely circumscribed. The outcome for Daewoo’s former managers and controlling shareholders is especially stark. If these precedents are preserved, Korea will emerge from the crisis in a much stronger position than some countries such as Thailand and Indonesia, where gaps in local insolvency/foreclosure systems encouraged rampant “strategic defaulting” and extraordinarily high NPLs. Long-term deterrence of imprudent debt-fueled investments, however, will depend on the treatment of Hyundai’s controlling shareholders and managers. If nonmarket interventions are used to protect them from receivership and loss, the hard-won lesson of Daewoo that no chaebol is “too big to fail” will be lost.

Looking next at short-term financial stabilization to prevent the liquidation of viable albeit over-leveraged companies, Korea has done more than enough for large corporations. Of the 108 companies that had entered the CRA workout process, 36—presumably the “strong swimmers”—had graduated by end-2000. A number of questions can be raised about another 47 companies that remain under workout or which were transferred from workout to receivership or liquidation by March 2001, as well as about the 103 chaebol affiliates that were under court supervision at end-2000.

• Are non-viable companies being identified and liquidated in a timely manner?

• Do creditor stays in court-supervised insolvencies and debt restructuring concessions (e.g., rate reductions and grace periods) in workout MOUs provide market-distorting competitive advantages and preserve “zombie”companies?

• Are viable business assets being allowed to find their highest and best use (e.g., through sale at a realistic market price or transfer to a professionally-managed CRV), or are creditors unreasonably hanging on to workout companies?

It is also worth mentioning that CRA workouts did nothing to financially stabilize Korea’s small and medium-sized enterprises (SMEs), which suffered mightily in the crisis. SME failures climbed to 8,200 in 1997 and 10,500 in 1998. The irony is that although Korea’s SMEs did nothing to precipitate the crisis, they were surely harmed by their powerful, cash-conserving, late-paying chaebol customers. Lastly, it is important to note that the financial stabilization of large corporations—and the demise of many SMEs—in Korea proceeded according to a rule of law. Korea witnessed none of the unilateral debt moratoria and “strategic defaulting” that have plagued Thailand and Indonesia.

Most questionable is the adequacy of medium-term operational restructuring to improve the profitability, solvency, and liquidity of troubled companies. Anecdotal evidence and fragmentary analysis suggest that there has been some progress, but that more remains to be done. Profitability improved between 1996 and 1999 for most non-workout chaebols, but the situation remains dire for the Daewoo companies and chaebols under workout or court-supervision (Table 1). It is worth noting that GDP growth was 10.9 percent in 1999, slowing just to 8.8 percent in 2000. Despite this still-robust growth, the profits of companies listed on the Korea Stock Exchange decreased 26.5 percent in 2000 and profitability sagged to 1.8 percent. If growth further slows to 3.5 percent or lower in 2001, corporate profitability as well as asset values and corporate valuations could further decline. In retrospect, 1999 may come to be seen as representing a lost opportunity for maximizing gains on the sale or liquidation of distressed companies, the sale of non-core assets, new equity issuance, inducement of additional capital investment, and conveyance of holdings in distressed companies to professionally-managed CRVs for turnaround and value enhancement.⁸

Table 1.

Net Profitability of Chaebols

Source: KIS.Note: Profit calculations exclude revaluations of marketable securities and foreign exchange.

Table 1.

Net Profitability of Chaebols

Category	Number	1996	1999
Top 4	4	0.9%	3.0%
Daewoo	1	1.0%	-67.7%
6-30	14	0.1%	2.9%
31-64	23	-0.5%	2.4%
Under court supervision or workout	21	0.1%	-25.3%
	63

Source: KIS.Note: Profit calculations exclude revaluations of marketable securities and foreign exchange.

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Table 1.

Net Profitability of Chaebols

Category	Number	1996	1999
Top 4	4	0.9%	3.0%
Daewoo	1	1.0%	-67.7%
6-30	14	0.1%	2.9%
31-64	23	-0.5%	2.4%
Under court supervision or workout	21	0.1%	-25.3%
	63

Source: KIS.Note: Profit calculations exclude revaluations of marketable securities and foreign exchange.

Changes in liabilities/equity ratios suggest modest progress, but should be viewed with caution. According to the Bank of Korea, liabilities/equity for Korea’s manufacturing sector has declined from about 4:1 at end-1997 to 2.1:1 at end-1999. But there has been virtually no retirement of debt. During 1999, the liabilities of Korean companies decreased just 1 percent while assets increased by 9 percent. The great bulk of the KRW 90 trillion in new equity that Korean companies raised or earned during 1999 went to acquire additional assets rather than to retire debt. While 210 percent liabilities/equity represents an improvement, such leverage is relatively high for companies in highly competitive or cyclical business, that is, for most Korean companies.⁹ Moreover, liabilities/equity ratios have been subject to some manipulation in the past. A few more years of financial reporting according to improved standards will be needed before liabilities/equity ratios can be taken seriously. Even then, liabilities/equity ratios will remain less meaningful than other measures, such as profitability, returns on assets or capital invested, and interest coverage.

Interest coverage (based on earnings before interest and taxes) in Korea has hovered around a razor-thin 1:1 since at least 1997 and Korean companies maintain lower interest coverage ratios than companies in 21 other developed and emerging markets (Figure 1). As indicated earlier, our analysis of 1999 interest coverage for 496 large corporations (excluding Daewoo affiliates) based on EBITDA found interest coverage of less than 1.5:1 for 156 of the 496 companies; less than 1:1 for 112; and less than zero (i.e., negative cash flow) for 64. Without additional equity and/or operational restructuring, such companies run a significant risk of default.

International Comparisons: Liabilities/Equity vs. Interest Coverage

Source: “A Comparative Look of Korea’s Corporate Reform,” LG Economic Research Institute, 9/21/2000; original data taken from WorldScope DB and the World Bank; Asian Development Bank.

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International Comparisons: Liabilities/Equity vs. Interest Coverage

Source: “A Comparative Look of Korea’s Corporate Reform,” LG Economic Research Institute, 9/21/2000; original data taken from WorldScope DB and the World Bank; Asian Development Bank.

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International Comparisons: Liabilities/Equity vs. Interest Coverage

Source: “A Comparative Look of Korea’s Corporate Reform,” LG Economic Research Institute, 9/21/2000; original data taken from WorldScope DB and the World Bank; Asian Development Bank.

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An examination of year 2000 financial statements for 391 companies showed that 24 percent still had interest coverage of less than 1.5:1; that 17 percent had interest coverage of less than 1:1; and that 11 percent had negative cash flows. This situation appears to be a slight improvement from 1999, but is still worrisome. Of the KRW 170 trillion in debt (bank loans and bonds) owed by the 391 companies at end-2000, KRW 65.5 trillion (39 percent) was owed by companies with interest coverage of less than 1.5:1. A 1999-2000 comparison of 21 workout companies showed declines in interest coverage from negative 0.78:1 to negative 1.45:1 and in returns on assets from negative 24 percent to negative 47 percent. These most-distressed companies should be resolved quickly, probably through receivership or liquidation.

It stands to reason that the easiest operational restructuring measures have already been implemented. The easiest and fastest dispositions of quality assets (often the Korean half of joint ventures with foreign partners) occurred relatively early in the crisis. Examples cited by local equity analysts as corporate restructuring “success stories,” such as Hanwha, Doosan, and Hyosung took place outside the CRA workout process. The companies under court-supervision or workout are more problematic. While 6-24 months should suffice to implement substantial operational restructuring at a large corporation, as suggested at the outset, a systemic crisis where hundreds of firms are overleveraged (see Box 1) and simultaneously attempting to sell non-core assets and raise equity in depressed market conditions poses special challenges. Failure to move beyond financial stabilization and make substantial additional progress on the operational restructuring of distressed corporations could diminish long-term competitiveness.

Lastly, major recognition is due for the implementation of important measures designed to promote general reforms in corporate behavior and impose greater financial discipline: improvements in financial disclosure and accounting standards; stronger shareholder rights and enhanced corporate governance standards; liberalization of M&A and foreign investment rules; tighter exposure limits; and actions to curb anti-competitive intra-chaebol transactions. Progress has not been uniform: gaps in the regulation of investment trust companies (ITCs) added fuel to the Daewoo conflagration; thinly-disguised cross guarantees periodically pop up; and the FTC has yet to prevail in any of its complaints against improper intra-chaebol transactions, which remain on appeal. Overall, however, Korea’s efforts to reform the legal and regulatory environment governing corporate behavior should contribute significantly to ongoing reforms in its corporate sector and serve as a model for other countries in the region. Especially heartening are reports that some auditors are being severely penalized for some notable audit failures and, as a result, that auditors were significantly stricter in requiring companies to make adjustments to their year 2000 financial statements.

General lessons

The Korean experience offers a number of important lessons for other countries emerging from the 1997 crisis or similar crises in the future.

1. A credible threat of foreclosure/bankruptcy is needed to elicit debtor cooperation with court-supervised rehabilitations or out-of-court workouts. A strong system for insolvency and enforcement of creditor rights can be a powerful tool for rehabilitating viable-but-distressed companies, liquidating non-viable ones, and encouraging debtors to cooperate with out-of-court corporate restructuring efforts. Recent contrasts between Korea and Indonesia and Thailand are instructive. While more remains to be done on the operational restructuring of distressed Korean chaebols, the CRA workouts in 1998-99 did impose significant losses on controlling shareholders and management. The 1997 descent of 11 chaebols into receivership, in which controlling shareholders lost management control and equity rights, provided an incentive for debtors to agree to some losses in CRA workouts. Half a loaf was better than none. In Indonesia, the absence of any credible threat from the country’s legal framework for protecting creditors has severely undermined corporate restructuring efforts and encouraged deals that emphasize debt rescheduling and minimize corporate “self help.” In Thailand, the lack of a credible threat of foreclosure and liquidation has resulted in anomalous cases of debtors seeking to avoid court-supervised rehabilitation. While Thailand has made significant advances in developing an option for court-supervised reorganization (rehabilitation) and implementation capacity—especially its special-purpose bankruptcy court—the continuing lack of coercive alternatives undermined out-of-court workout efforts.

2. While an efficient framework for out-of-court workouts is necessary in a systemic crisis and can resolve some instances of corporate distress, permanent solutions may require a court-supervised process. An efficient framework for out-of-court workouts is needed both to avoid saturation of the courts and to preserve value. Sole reliance on the courts to restructure hundreds of distressed corporations (not to mention potentially tens or hundreds of thousands of SMEs) in a systemic crisis would overwhelm the courts and legal infrastructure. Evidence from the U.S. and the U.K. also indicates that creditors are likely to receive higher recoveries from an out-of-court workout than from a court-supervised rehabilitation or receivership.¹⁰ The problem increasingly apparent in Korean workouts is that disputes over the allocation of losses and risk—between creditors over (i) the treatment of secured vs. unsecured debt, (ii) the provision of new credits, and (iii) over the sale or transfer of converted equity and restructured credits; and between creditor-shareholders and public shareholders over the allocation of equity losses—are difficult and time-consuming to resolve in an out-of-court process. Delays may impose additional losses on the company subject to workout. Ultimately, resort to a court-supervised process may be needed to resolve such disputes in a timely manner.

3. Forbearance on loss recognition, inconsistent application of provisioning standards, and liberal accounting rules for converted equity may discourage follow-on operational restructuring transactions. Loose linkages between corporate and financial sector restructuring may have encouraged a number of “half measures” in corporate restructuring:

• The heavy reliance in workouts on term extensions, grace periods, rate reductions, and conversions of debt into equity or low-yielding convertible bonds, with negligible debt write-offs;

• The reluctance of creditors to insist on (or agree to) business or corporate asset sales that could force loss recognition on associated corporate loans provisioned at as little as 2 percent;¹¹

• The readiness of creditors to agree to second-round workouts in early 2000 for 18 companies of dubious viability who were clear candidates for liquidation;¹²

• The failure of creditors to deal pro-actively with the Daewoo situation, despite signs of increasingly severe corporate distress that were available by end-1998, or Saehan’s unanticipated bankruptcy/emergency workout in May 2000;

• The reluctance of creditor-shareholders to put converted equity under professional management, since a professional manager receiving incentive compensation would insist on a realistic transfer price for the converted equity; and

• October 2000 credit risk assessments by banks which turned up an incredibly few companies to be “exited.”

4. Governments must be ready to impose losses on the shareholders of local financial institutions and force the resolution of over-valued assets. A government’s failure to force local financial institutions to pursue financial and operational structuring of their distressed clients will leave companies in a “zombie” state with uncompetitive cost structures, capital tied up in loss-making or low-return assets, and unable to obtain financing.¹³

5. There must be the flexibility and the readiness to lay off excess workers and to accept foreign control over additional companies. Foreign investment an improve the operations of distressed companies and their market access. By providing additional sources of capital, foreign investment can also lessen the losses creditors would otherwise suffer in a systemic crisis. Labor reductions and foreign investment, however, can be the mostly politically contentious—and exploitable—aspect of corporate restructuring. It may be relatively easy for debtors and creditors, seeking to avoid the mutual losses inherent in corporate restructuring, to mobilize workers and the public to oppose layoffs and sales of “national assets” at “fire sale prices” to foreign “vulture investors.” In the interests of promoting company rehabilitation and lessening losses to the financial sector, however, it is important to address regulatory and attitudinal impediments to workforce reductions and foreign investment. Development of adequate safety nets and a greater appreciation of the links between foreign investment and sustainable growth should make it easier for governments to address these potentially contentious issues.

6. All significant tax, legal, and regulatory impediments to corporate restructuring must be eliminated, barring some other overriding public policy purpose. Experience from throughout east Asia shows that impediments may include taxation of debtor gains from debt restructuring; the inability of creditors to deduct debt restructuring losses to reduce taxes; immediate taxation of mergers, spin-offs, and other non-cash corporate reorganizations; excessive transfer taxes; unreasonable waiting periods for creditor-review of proposed mergers; legal lending limits; constraints on the ability of state-owned financial institutions to take losses on corporate restructuring; and various protections for public shareholders. Recent experience demonstrates that any one of these impediments can delay a corporate restructuring transaction. Some impediments—such as controls on tax deductions for credit right offs, bank exposure limits, and protections for public shareholders—serve broader public policy interests and cannot be simply swept away. In some cases, waivers may be appropriate (e.g., on legal lending limits). Public shareholder rights to oppose dilutive equity restructuring can be particularly difficult or impossible to override in an out-of-court workout—as seen in recent cases involving Daewoo affiliates. Thus, it may be necessary to rely more on court-supervised processes, such as “pre-packaged” reorganizations, to effect equity restructuring of companies.

7. Some central body should be responsible for driving financial sector restructuring and making adequate corporate restructuring a condition for bank re-capitalization. The government should consider forming a special-purpose, temporary, crisis-management team to consolidate responsibility, ensure consistency of work and decisions, provide the necessary specialized skills, and insulate crisis resolution from other official duties and related conflicts of interest. The crisis-management team should report to a governing body that would balance political interests and resolve differences of opinion among the permanent government agencies represented on the team. Since a country’s ministry of finance would be the one to issue bank re-capitalization bonds, it should play a leading role on any crisis management team. To avoid conflicts of interest between minimizing costs and safeguarding the nation’s financial system, the financial supervisor should normally keep out of financial sector restructuring and focus on supervising financial institutions. The finance ministry and financial supervisor would need to coordinate, however, on questions of regulatory forbearance. To achieve a strong link between corporate restructuring and financial sector restructuring, it would be desirable for the finance ministry to require a professional and independent assessment and certification of the “adequacy” of major corporate restructuring agreements as a pre-condition for making up financial institution losses on the implementation of these corporate restructuring agreements.

Corporate and financial sector restructuring will involve a variety of considerations and costs—including knock-on effects through the economy. The government should seek to minimize the present value of the multi-year costs of corporate and financial sector restructuring. But this is easier said than done. Governments often succumb to the temptation to focus only on Year 1 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. A government’s crisis management team would likely benefit from an independent assessment of the net present value costs and effects of alternative strategies for resolving corporate and financial sector distress. Particular attention should be paid to projections of corporate cash flows, unsustainable corporate debt, and bank re-capitalization requirements; alternatives for protecting the workers, suppliers, and subcontractors of failed companies; and the potential effects of below-market interest rates and other debt-restructuring concessions on market competition. To the extent that a government can develop credible cost projections and educate the public on the likely costs of available alternatives, it may be easier for the government to act decisively to resolve corporate and financial sector distress at least cost to the taxpaying public.

8. There must be sufficient implementation capacity to conduct due diligence, structure and negotiate workouts, conclude asset sales, and manage converted equity. Leaving aside thousands of SMEs, the restructuring of hundreds of distressed corporations could absorb every accountant, lawyer, investment banker, workout professional, and receiver in a crisis-stricken country and run up enormous professional fees. Professional support will have to be brought in from outside the country and acclimated to local legal/financial systems. As debtor companies may be unwilling or unable to retain and pay for such professionals, it may be necessary for creditors or the national treasury to pay at least some of these costs. Banks and public asset management companies (AMCs) will lack professionals with requisite experience in corporate workouts and turnarounds. Efforts to develop in-house workout capacity can take time and the results may not be completely satisfactory. Thus, banks and public AMCs would be well advised to retain outside professionals—on some incentive compensation basis, whenever possible—to conduct due diligence, structure and negotiate corporate workouts, and manage asset sales. Lastly, reason suggests and recent experience indicates that corporate restructuring deals in a systemic crisis will leave financial institutions with masses of converted corporate equity. Banks will have enough difficulty in managing themselves in a crisis and will have no experience in managing corporate shareholdings or exercising corporate governance. Thus, the management of converted equity should be outsourced to asset management/corporate turnaround professionals—perhaps through equity partnerships such as those used by KAMCO or proposed CRVs.

9. Crisis efforts to resolve immediate corporate distress should be supplemented with other measures to promote long-term corporate reform. Improvements in financial disclosure and audit standards, corporate governance practices, exposure limits and limits on related-party lending or cross guarantees, and regulation of anti-competitive transactions among related parties can benefit short-term corporate restructuring as well as long-term corporate reform.

Korea-specific recommendations

It is possible to identify five initiatives likely to accelerate the operational restructuring of distressed corporations.¹⁴

1. Overhaul Korea’s insolvency system to facilitate the timely rehabilitation of viable companies and the liquidation of non-viable ones. A host of evidence indicates (i) that out-of-court workout MOUs are an inadequate basis for the post-financial stabilization operational restructuring of distressed companies; and (ii) that greater reliance should be placed on court-supervised insolvency; but (iii) that the current insolvency framework is ponderous and dissuasive to companies seeking rehabilitation. For example, agreement on out-of-court debt/equity conversions is subject to delays due to differences between secured and unsecured creditors. Implementation of out-of-court debt/equity conversions is subject to delay by public shareholders seeking preferential treatment on equity restructurings. It is reported in the press that the FSS—in contravention of its duty to safeguard the soundness of Korea’s financial sector—has been pressuring financial institutions reluctant to extend credits to distressed companies as promised in workout MOUs. Under-provisioned or unrealistic creditors are preventing the sale of workout companies or workout company assets, or the conveyance of workout company debt or equity to CRVs for management by turnaround professionals. Composition is too easy on debtors, while receivership/bankruptcy is too stringent. Court-supervised insolvency is too time consuming and uncertain to be useful for rehabilitating companies. Despite incremental reforms adopted since 1997, Korea’s insolvency system is still unsuitable. Reluctance to use an unsuitable insolvency system has encouraged excessive reliance on inefficient out-of-court workouts and market interventions as an alternative to receivership.

To develop an insolvency system suitable for the timely turnaround of distressed but viable companies, the Ministry of Finance and Economy (MOFE) working with the Ministry of Justice should give serious consideration to the following:

• Unify current laws on composition (rehabilitation), reorganization (receivership), and bankruptcy (liquidation), and provide clear criteria for commencing each type of case or converting one type of case to another (e.g, from reorganization or receivership to bankruptcy);

• Allow current management—so long as there is no evidence of fraud or gross incompetence—to remain in place in rehabilitation cases under the close supervision of a court-appointed trustee and creditors’ committee;

• In rehabilitation cases, give the debtor an exclusive right to file a rehabilitation plan within six months;

• Make trustees (receivers) more responsible to creditors and provide more institutional and professional support to trustees;

• Improve standards for the disclosure of business and financial information about the debtor company to all creditors;

• Adopt an “absolute priority rule” governing distributions of the insolvency estate among senior creditors, junior creditors, and shareholders and a “cram down” rule to make it possible to override dissident creditors or shareholders;

• With improved disclosure standards and an absolute priority rule as prerequisites, adopt procedures to allow court approval of “pre-packaged reorganizations” on an expedited basis, for example, within 45 days;¹⁵

• Provide for an automatic stay on creditors upon the commencement of insolvency proceedings; and

• Give additional priority to new financing for a company under rehabilitation or receivership.

The emphasis should be on preserving and rehabilitating viable companies. In cases where company managers have engaged in preferential transfers, made fraudulent conveyances, bounced checks, or committed other misdeeds, it should be possible to reverse misdeeds and punish those responsible after the imposition of an automatic stay.

Relatively few large corporations have emerged from court-supervised reorganization or been sold or liquidated since 1997. In pending cases, including new court-supervised cases from among the November 2000 list of 52, reorganizations and liquidations should be implemented as quickly as possible.

2. The Financial Supervisory Service (FSS) should (i) provide guidelines for the latest round of credit risk assessments; (ii) monitor the use of these guidelines to ensure that non-viable companies and companies in need of operational restructuring are identified; and (Hi) follow up to ensure that liquidation or restructuring promptly commences, preferably under improved court-supervised insolvency procedures. Guidelines should consider current and projected profitability, interest coverage, and financing needs under more-and less-favorable economic conditions, and provide breakouts by business segment for multi-division corporations. There should be some penalty, such as more stringent on-site reviews, for a bank’s failure to use these guidelines or to identify emerging corporate distress. The FSS may protest that it should be the responsibility of the banks to do a professional job of conducting credit risk assessments. The record of Korean banks in identifying and responding to emerging corporate distress, however, is not reassuring.¹⁶ The goals now should be to improve the quality of the August 2001 credit risk assessments and to avoid additional surprises.

3. In the interests of concluding some significant “operational restructuring transactions” of workout corporations, the FSS should work to eliminate over-valuation of assets (corporate credits and converted equity) held by financial institutions. Operational restructuring transactions could include sales of workout companies to strategic or financial investors, sales of non-core businesses or assets of workout companies, or conveyance of workout company debt and/or equity for management by a CRV. Such operational restructuring transactions are needed to create some momentum and move corporate assets into higher and better use. Such transactions could require creditors to recognize losses on over-valued corporate credits or converted equity. Recent discussions indicate that financial institutions may classify the same debt differently, and may provision differently for debt with the same classification. Financial institutions may also differ in how they account for converted equity, with some using a lower-of-cost-or-market rule and others applying more conservative principles to essentially illiquid shares. By investigating discrepancies among financial institutions in how they classify and provision for restructured corporate debt and account for converted corporate equity, and by encouraging less-conservative financial institutions to adopt more conservative practices, the FSS could help create favorable conditions for “operational restructuring transactions.” At this point, four years into the crisis and having seen such a macroeconomic rebound in 1999, the time for extended price negotiations and holding out for full recovery on credits or asset purchase prices is past. In those cases where state-controlled financial institutions represent a majority on the workout company’s creditor committee, it would seem reasonable for the MOFE to act as a principal in encouraging state-controlled financial institutions to conclude some operational restructuring transactions over the next few months.

4. Government agencies should not protect controlling shareholders from loss. It is important to distinguish between the distressed company and its management and controlling shareholders. Reasonable steps to preserve the distressed-but-viable company are appropriate. But government agencies can take no action to protect the insiders in any large corporation from loss without negating the lesson from Daewoo that no chaebol is “too big to fail” and giving rise to long-lived moral hazard.

5. While working through remaining pockets of corporate distress, the government should continue to promote measures that encourage general corporate reform and a shift in corporate emphasis from low-return debt-financed expansion toward greater profitability and financial resilience. Key measures to promote general corporate reform include improvements in financial disclosure and accounting standards; stronger shareholder rights and enhanced corporate governance standards; and liberalization of rules on M&A and foreign direct investment. Key measures to encourage better financial management at large Korean corporations include loan exposure limits, limits on cross-shareholdings, limits on financing by related non-bank financial institutions, controls on cross guarantees, limited interest expense deductibility on “excessive” debt, and enforcement of Fair Trade Commission fines for unfair business practices. Limits on cross-guarantees and cross-shareholdings may be considered somewhat unusual for a market economy. The current need for such limits reflects the weakness of Korea’s financial sector vis-à-vis the chaebols. A privatized and revitalized financial sector should be able to stand up to the chaebol on its own.