Financial crises frequently result in considerable financial and corporate sector distress, requiring a broad policy response that includes a corporate debt restructuring strategy. The immediate objectives of this strategy should be to provide an orderly and efficient mechanism for separating viable from non-viable firms while providing equitable burden sharing. In recent years, three broad approaches have been used to meet these objectives. One involves across-the-board, direct government involvement that determines the extent, method, and distribution of burden sharing among relevant parties. An alternative is a market-based, case-by-case approach in which decisions are left to private sector debtors and creditors within the context of a well-regulated legal system that facilitates consensual restructuring agreements. On balance, experience points to the benefits of a hybrid of these two approaches, involving a comprehensive, coordinated restructuring approach based on market incentives while the government works toward an equitable sharing of limited fiscal resources.

Financial crises frequently result in considerable financial and corporate sector distress, requiring a broad policy response that includes a corporate debt restructuring strategy. The immediate objectives of this strategy should be to provide an orderly and efficient mechanism for separating viable from non-viable firms while providing equitable burden sharing. In recent years, three broad approaches have been used to meet these objectives. One involves across-the-board, direct government involvement that determines the extent, method, and distribution of burden sharing among relevant parties. An alternative is a market-based, case-by-case approach in which decisions are left to private sector debtors and creditors within the context of a well-regulated legal system that facilitates consensual restructuring agreements. On balance, experience points to the benefits of a hybrid of these two approaches, involving a comprehensive, coordinated restructuring approach based on market incentives while the government works toward an equitable sharing of limited fiscal resources.

An economic crisis involving major shifts in relative prices, serious disruptions in the availability of financing, and a deep downturn in economic activity will cause widespread damage across the corporate sector. This section1 discusses different approaches to the possible need, in these circumstances, for a restructuring of corporate debt, drawing on a growing body of work in this area. It also reviews relevant country experience, focusing on the underlying factors that led to different country approaches to corporate restructuring, and presents lessons that can be drawn from these experiences. Matters related to banking crises and debt restructuring are covered in Sections V and VIII, respectively.

There is no alternative in a systemic banking crisis to substantial government intervention, even in countries strongly committed to market-oriented policies, owing to the externalities inherent in a breakdown of the banking system.2 Significant country crises will likely result in considerable corporate sector distress because of both the sizable decline in the value of the domestic currency and the collapse of the real economy, requiring that a corporate restructuring strategy be a critical component of any economic program. Further, past experience in Asia and Latin America points to the need for this strategy to be put in place at an early stage—in tandem with financial system restructuring, and in combination with appropriate macroeconomic, financial, and structural policies.

The immediate objectives of a comprehensive corporate restructuring strategy should be to provide an orderly and efficient mechanism for separating viable from nonviable firms, ensuring that the debt and operations of viable firms can be restructured quickly and in a manner that ensures future viability, and that these firms have access to sufficient financing to facilitate an economy-wide recovery.

A threshold issue in designing a restructuring strategy for the corporate sector is determining the manner in which the burden of restructuring is to be allocated among relevant parties. A closely connected issue relates to whether any fiscal support will be provided for corporate restructuring, and the nature and delivery of such support, taking into consideration the incentive structure that will be used to stimulate implementation of the strategy (e.g., direct support to the corporate sector, or indirect support through the financial sector). Three broad approaches can be envisaged to address these considerations:

  • One approach to burden sharing involves across-the-board, direct government involvement that determines the extent, method, and distribution of burden sharing among relevant parties. Possible solutions could range from a legislatively mandated full absorption of costs by the banking sector or other relevant parties, to a predetermined amount of public support to corporations for specified purposes (e.g., to protect against foreign exchange rate risk), to tax and other fiscal-related incentives for parties that engage in restructuring. Under this approach, the relevant solutions are generally applicable across the board to all economic agents in the prespecified category, regardless of individual factors. Any fiscal solution under this approach would be expected to be direct (e.g., universal foreign exchange cover to all companies with foreign currency debt). It is also possible to have an across-the-board strategy without direct fiscal support (e.g., a legislatively imposed strategy that requires burden sharing only by private parties).

  • An alternative approach is a market-based, case-by-case approach in which private sector debtors and creditors are generally left to determine, on a case-by-case basis and using market solutions, the nature, scope, and other aspects of burden sharing. Fiscal support involved in this strategy would normally be provided on an indirect, case-by-case basis (e.g., use of public funds to recapitalize domestic banks that meet certain soundness requirements). Nevertheless, in the absence of fiscal support, the government could still have an important role in the market-based strategy (e.g., implementing legal reforms and regulatory incentives to encourage speedy market-driven restructuring).

  • A third, hybrid approach could be envisioned that incorporates elements of the above two (e.g., a limited across-the-board feature, combined with reliance on market-based, case-by-case negotiations to complete the restructuring process).

On balance—but with important caveats as noted below concerning the critical importance of country-specific factors—the experience with systemic restructurings to date suggests that a hybrid approach is likely to be most relevant for the circumstances of Latin America.3 A properly designed hybrid strategy would be expected to involve more limited fiscal resources than a universal, across-the-board approach, while protecting the interests of corporate shareholders to a greater degree than under a purely market-based approach, but without shifting the burden of restructuring entirely to creditors. Such a hybrid approach could also incorporate across-the-board and market-based incentives to encourage speedy debt restructuring. Depending on the specific country, however, early legal and institutional reforms may well need to be adopted as part of the necessary preconditions for successful implementation of such a strategy.

Linkages Across Sectors and Burden Sharing

Experience suggests that there are great benefits to be gained from corporate debt restructurings that take place within a comprehensive strategy that, to the maximum extent possible, spreads the burden across the domestic public and private sectors: private corporate and financial; public federal and state; as well as domestic and external. Otherwise, domestic burden-sharing issues would be particularly onerous and contentious, further aggravating already negative private sector expectations and social cohesion, damaging economic activity, and depressing fiscal revenue.

The government’s ability to provide fiscal resources will affect the extent and characteristics of its involvement in corporate restructuring. For example, indirect financing of debt restructurings through acquisition of nonperforming loans from banks in exchange for zero-coupon bonds will enable greater government financing of restructurings, but with a negative liquidity impact on banks.

This evident linkage between the restructuring of the corporate and banking sectors makes it vital that a government facing a systemic crisis must expeditiously formulate a strategy for the parallel restructuring of these sectors. Indeed, a close interrelationship exists between progress in corporate restructuring and the process of returning the banking system to health. A lack of progress in resolving problems facing the corporate sector will sap the strength of the banking system to the extent that corporate loans form a significant portion of banking system assets. A troubled corporate sector negatively impacts future profitability of the banking system, reflecting banks’ reliance on new corporate lending for a significant portion of their profits.

Correspondingly, banks will be in a better position to bear losses or impose a lesser burden on corporate shareholders to the extent that the process includes a recapitalization by banks’ shareholders. It would be difficult for a bank to enter into restructuring agreements that require any loss recognition unless the bank has a capital structure that supports the recognition of such losses, or the bank is otherwise required by regulators to recognize losses even in the absence of a restructuring agreement.

Nevertheless, recent experience shows that banking and corporate restructuring strategies have frequently been designed separately and with little coordination, especially in the initial stages of crisis response.

The Framework for Corporate Restructuring

Alternative Approaches to Corporate Restructuring

Three broad approaches can be distinguished based on the manner in which the costs of corporate restructuring are shared among economic agents: direct government involvement, typically applied across the board; the market approach applied case by case; and a hybrid of the two.4

Under direct government involvement, the government establishes in advance certain parameters for corporate restructuring that are broadly available, or applied uniformly, to the corporate sector regardless of individual factors such as the viability of the corporation.

This approach often takes the form of direct financial support to the corporate sector, with the government actively absorbing the related losses. The most common example is foreign exchange insurance or subsidy schemes that are made available to all creditors or debtors. For example, the government could offer foreign exchange at prespecified exchange rates for all companies with foreign debt, in exchange for creditor agreement to restructuring terms that involve specific features (such as lengthening of debt maturities and grace periods, interest rate reductions, and equity injections).

Tax or other direct fiscal-related incentives may also be used to encourage corporate restructuring. Depending on the specific incentives, such inducements may be provided to debtors, creditors, or both. The relevant fiscal costs normally would not be as significant as those associated with foreign exchange insurance schemes.

Mandatory legislative or regulatory transformation of private sector contracts has also been undertaken by countries. This can be done overtly (e.g., through a statute converting all foreign exchange assets and liabilities of banks to local currency at specified conversion rates), or more subtly (e.g., by a statute that takes away creditors’ contractual rights to enforce their claims against defaulting corporate debtors).5

Any fiscal solutions under the direct government approach would be expected to be direct and broadly applied. However, fiscal support is not necessarily required (e.g., a legislative transformation of private sector contracts could allocate costs solely among bank shareholders, depositors, and companies with no fiscal support).

  • A main advantage of direct government involvement is that this approach can be implemented quickly, helping to restore sustainable economic conditions. It also can be less politically and socially disruptive, with the government potentially absorbing the cost of restructuring and therefore cushioning the social impact.

  • The main disadvantages of this approach are that (1) it is not based on market forces and thus is likely to be inefficient and incur higher fiscal costs (e.g., the criteria for fiscal support or legislative solutions will not usually distinguish between viable and nonviable firms); (2) moral hazard is likely to increase owing to the extensive government involvement; (3) recent experience has shown that legislative across-the-board solutions may be susceptible to challenges by sectors of the economy disadvantaged by the scheme (e.g., creditors—including depositors and pension funds—whose funds were converted at unfavorable rates in order to subsidize an across-the-board conversion of corporate loans); and (4) across-the-board schemes that lack fiscal support may jeopardize the soundness of the banking system because it is typically the corporate sector’s main creditor. Eventually the corporate sector is weakened from the lack of available bank financing.

Under the market-based, case-by-case approach, private sector debtors and creditors are generally left to negotiate and determine, on a case-by-case basis and using market solutions, the nature, scope, and other aspects of the burden sharing associated with corporate restructuring.

In this approach, the cost of the corporate restructuring will often be borne by corporate shareholders. Banks will normally reduce the value of their claims on corporations only after they have acquired substantial equity in the relevant companies. Banks would likely also bear a share of the burden, however, either because corporate equity is insufficient to compensate for loan losses or because corporate owners have sufficient leverage to negotiate retained equity in the restructuring negotiations.

This approach may involve fiscal support for corporate restructuring that is provided indirectly (e.g., through use of public funds to recapitalize the banking system, to compensate for some portion of the losses incurred in the corporate restructuring process). Any such support would normally be provided only to eligible parties (e.g., to domestic banks whose shareholders inject additional equity or meet specified soundness requirements, or both).

The market-based, case-by-case approach may also be designed without fiscal support. Even here, however, the government would still play an important role—for example, by implementing insolvency law reforms, or by effecting regulatory reforms that encourage speedy, market-driven restructuring, or through a combination of such measures. As discussed below, possible regulatory incentives could include revisions to securities or banking regulations that hinder workouts. Additional important governmental involvement may relate to driving the restructuring process (for example, by providing facilitation or mediation services to debtors and creditors) and ensuring that banks have or are required to acquire sufficient capital to engage in commercially reasonable restructuring transactions.

  • The main advantages of the market-based approach are that it limits moral hazard issues associated with inappropriate corporate bailouts, avoids costly government involvement with nonviable firms, and exploits bank expertise and experience, which if sufficient should reduce fiscal costs and facilitate the flow of credit to viable firms.

  • However, this approach also involves significant costs, including: (1) it is time consuming because it requires individual negotiations and tackling of vested interests, with uncertain results concerning the ultimate control over corporations; (2) it may well result in increased bank or government ownership of the corporate sector, at least until they have the opportunity to sell their claims to the private sector after the economy recovers; (3) it requires a strong legal and institutional framework that is not often present, especially in countries undergoing crisis; and (4) there is the potential for political complications under this approach (e.g., desire to prevent better-capitalized, foreign-owned banks from acquiring a large portion of the corporate sector).

    The hybrid approach includes a component with direct government involvement, combined with reliance on market-based, case-by-case negotiations to complete the restructuring process. As with the other two core approaches, fiscal support may or may not be provided and, if provided, may be direct or indirect. If carefully designed, this approach could enable policy-makers to benefit from the core advantages associated with each of the first two approaches, while avoiding some of the more significant disadvantages. (See below, under “International Experience,” for discussion in greater detail about some of the features that could be included in a well-designed hybrid strategy.)

Classification of Corporates

In formulating the details of the hybrid debt strategy, some classification of corporations would be required.

There are those corporates that, except for the impact of a sizable local currency depreciation, are operationally healthy and can function in the new environment if their debt is reduced on the basis of a formula that is linked to the macro picture. For these companies, the problem is merely one of reducing debt within a certain range, which lends itself to a more “across-the-board” approach where the shareholders’ burden is minimized. The question is, Who bears the burden that would normally be borne by these shareholders if one were to apply the market approach?

There is a separate category of corporates that, in the new environment, either requires operational restructuring or can no longer continue in business. In these cases, one could imagine real debt-for-equity conversion combined with operational restructuring or, in some cases, liquidation.

There are small companies for whom—irrespective of whether they need operational restructuring or not—an across-the-board approach is taken primarily as a matter of convenience. This was the strategy used in some Asian countries (e.g., Indonesia) for limited cases. It was justified primarily on the basis of the “de minimum” nature of the claims, and simplicity.

Workout Mechanisms

The workout mechanism is critical, especially under the market-based, case-by-case approach, where there will be a need to put market-based incentives in place to encourage the restructuring of viable companies, and not the weak. A key consideration is whether the management of the restructuring process would be facilitated by the creation of one or more asset management companies (AMCs). If so, the scope of this structure is an important consideration (e.g., centralized AMC or multiple decentralized AMCs; public or private AMCs).

A government-financed agent—the AMC—generally is involved in the case-by-case approach. The AMC’s role is to buy nonperforming loans from banks, ideally at market values, and then sell those loans to the private sector (helping to deepen markets) or collect on them. Some public AMCs also actively seek to restructure the nonperforming loans prior to sale, as a means of maximizing returns.

A strategy of ex ante recapitalization of privately owned banks will often put the banks in charge of managing their own workout units for problem borrowers. Depending on the viability of the borrower and the relative priority of a bank’s claim, the final resolution may well involve a liquidation of the borrower and the sale of its assets separately or as a going concern. In other cases, the negotiations will lead to a restructuring of the debt or operations of the borrower (or both) and a resumption of the borrower’s access to credit.

Legal and Regulatory Systems and the Institutional Infrastructure

The formal insolvency system is especially important where individual debtor-creditor negotiations are contemplated. Corporate workouts would normally be expected to take place on an out-of-court basis, generally using collective restructuring techniques such as those embodied in the London Approach.6 However, out-of-court restructurings occur “in the shadow” of the formal in-court insolvency system, since it is this system that defines the rights, obligations, and leverage of the parties in an out-of-court restructuring. Out-of-court restructurings are likely to be successful in a context where the formal insolvency system defines rights and obligations in a balanced, transparent, and predictable manner. Conversely, if the rules of the formal system are unbalanced or applied unpredictably, out-of-court restructurings can be expected to be limited or in extreme cases even nonexistent. (Appendix 7.1 includes a summary of some of the key issues that need to be addressed in designing an orderly and effective formal insolvency system.)

Separately, the formal insolvency system is also important because it enables a court to make an outof-court agreement that is accepted by a qualified majority of creditors binding on dissenting creditors. With the growth of capital markets and the significant increase in the number and diversity of investors holding corporate debt, the ability to expeditiously bind-in holdout creditors has become critically important to the success of restructuring efforts.

Finally, other laws must also be designed (or revised) to be supportive of corporate restructuring. These include tax provisions (e.g., ensuring that there are no negative tax consequences for corporate restructuring transactions) and securities regulations (e.g., ensuring that the securities laws do not limit transactions like debt-to-equity conversions or issuance of new equity instruments).

International Experience

The following summary of international experience of corporate restructurings is based on nine episodes of systemic corporate crisis that occurred during the past two decades in middle-income emerging market countries (see Tables 7.1 and 7.2).

Table 7.1.

Corporate and Household Distress-Resolution Schemes: Main Features

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Table 7.2.

Corporate and Household-Debt Resolution:Key Features

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The Direct-Government, Across-the-Board Approach Was Used in Two of the Cases Studied

Mexico (1983—FICORCA). The government provided foreign exchange cover to help the corporate sector settle external arrears to foreign suppliers and to provide refinancing and foreign exchange cover for private sector external debt, and a capital injection to nationalized banks. This scheme took place in the context of a comprehensive rescheduling of public sector debt-servicing obligations that provided Mexico with cash flow relief of $30 billion over the period 1983–86.7

Chile (1982). Direct government involvement saw the government and the central bank provide direct subsidies to corporations and households and to some solvent banks through the exchange of foreign currency debt-service payments at a preferential exchange rate, limited purchases of nonperforming loans from banks, and interest rate subsidies for household mortgages. The government financed these transactions mainly by issuing zero-coupon bonds. In addition, the rescue of the banks in Chile and the purchase of nonperforming loans were also significant.

Common Characteristics

  • The corporate debt was mainly held by foreign creditors or denominated in U.S. dollars (or both).

  • No major legal or regulatory reform was undertaken.

  • There was no use of market-based restructuring by recapitalized banks or a government AMC (or both).

The Market-Based, Case-by-Case Approach Has Been Used in Five Countries Studied

Hungary and Poland in the early 1990s, and Thailand, Malaysia, and Korea in the late 1990s. Following bank restructurings, countries gave a variety of incentives to banks to address and expedite corporate debt restructurings.8 All of the Asian countries created government AMCs to take over bad bank debts, and in some cases take a lead role in corporate restructuring. Most countries utilized some sort of AMC aimed at the rapid “workout” of viable firms by providing coordination and information. These organizations were bank-led (Poland), government-led (Malaysia), or bank-and government-led (Korea).

Common Characteristics

  • Virtually all corporate and household debt was held by domestic banks. In Hungary, Poland, and Malaysia, corporate obligations were almost exclusively in domestic currency. Korean corporations had some foreign currency bond obligations. In Thailand, 70 percent of corporate debt was denominated in domestic currency.

  • Legal reforms, which were crucial in every case, focused on improving insolvency procedures and in identifying and removing country-specific impediments to corporate restructuring. They usually involved a strengthening of the rights of majority creditors vis-à-vis debtors and minority creditors.

  • The immediate fiscal costs (present value) ranged from 6 percent of GDP (Poland) to 20 percent of GDP (Korea) and 44 percent (Thailand), financed mainly by issuance of government bonds.

The Hybrid Approach Has Been Used in Two of the Cases Studied

Mexico (1995). FOBAPROA (later IPAB) and other quasi-governmental financial entities were established to encourage increased bank capitalization and to restructure corporate loans. Direct support to banks was given through the purchase of non-performing loans at pre-crisis book values (well above market values). Blanket restructuring of loans took place, accompanied by direct debtor support. The government established a number of support programs to deal with banking sector and corporate debt problems, including subsidies to small and mediumsize firms (with the cost shared by the banks and the government), the restructuring of existing loans, the purchase of banks’ loan portfolios, and programs to assist specific sectors. Banks’ nonperforming loans were exchanged for bonds that only accrued interest (to manage the fiscal cost), resulting in inadequate liquidity and low lending activity by banks.9

Indonesia (1998). The market-based approach was an important feature in Indonesia, with a state corporate restructuring agency (the Jakarta Initiative Task Force) and the Indonesian Bank Restructuring Agency (IBRA) leading corporate restructuring. This followed a comprehensive restructuring and re-capitalization of the banking system. In addition, the government provided a number of general subsidies, in the form of exchange rate guarantees and tax incentives for firms that negotiated qualifying restructuring agreements, and implemented an across-the-board policy for the restructuring of small and medium-size enterprise debt held by IBRA.10

Common Characteristics

  • The corporate sector of all countries carried high levels of both domestic and foreign debt, with the direct government involvement aimed mainly at the foreign debt. The complexities of the balance sheets led to the creation of several government-led mediation entities, as well as schemes for direct corporate debt relief.

  • The implementation of legal reforms was a necessary condition for addressing corporate distress, with mixed results.

  • There was a sizable fiscal cost (net present value) of these operations (20 percent for Mexico and 55 percent for Indonesia). In the case of Mexico, the financing was through zero-coupon and back-loaded government bonds, while in Indonesia roughly 70 percent of bonds carried market-related coupons (the remainder were index bonds issued to the central bank).

Implications of the International Experience for Latin American Countries

Country-specific factors are critical to the choice of approaches summarized above. The market-based approach requires a relatively robust and predictable legal and institutional framework for its success and may not be optimal for a country with very weak laws and institutions. By contrast, a country with strong constitutional protection of property rights is likely to be unable to effectively implement a legislative across-the-board solution that deprives parties of contractual rights, since such solutions would be subject to constitutional challenge. Even more difficult considerations relate to the relative strength and political power of vested interests that are likely to influence how the restructuring strategy is implemented in practice.

A country with fiscal difficulties would lack resources to implement any approach that contemplates a significant amount of direct fiscal support to the corporate sector. The most frequent examples of the across-the-board approach have involved direct government financial support through various foreign exchange insurance and subsidy schemes. Such schemes would have little relevance for countries that do not have a large portion of corporate debt denominated in foreign currency. Moreover, the ability to provide fiscal support would of course be highly dependent on available fiscal resources in the short and medium term, which would limit the extent to which this approach could be used in Latin American countries already facing significant fiscal constraints.

The likely damage caused by a crisis to both the corporate and banking sectors and the associated complexities of corporate balance sheets point to the need for a coordinated, comprehensive approach that restructures both sectors simultaneously with direct government involvement. The risks appear too great to rely solely on a market-based, case-by-case approach, which is not well suited to the likely immediacy of needed action, and will have limited scope to take into account political and social considerations. At the same time, appropriate case-by-case mechanisms and incentives will need to be put in place to ensure that viable firms continue operation and that costs are minimized.

In this context, the experience with systemic restructurings suggests that a hybrid of the direct governmental involvement and case-by-case approaches may be most relevant for the circumstances of Latin America. A properly designed hybrid strategy should economize on fiscal resources relative to an across-the-board approach. This strategy would need to impose viability requirements, thereby ensuring that significant efforts are not put into propping up companies that should be liquidated. A hybrid strategy would also be expected to protect the interests of corporate shareholders to a greater degree than under a purely market-based approach, thereby tempering some of the political and social complexities that otherwise could result. Depending on the specific country, however, early legal and institutional reforms may well need to be adopted as part of the necessary preconditions for successful implementation of a hybrid strategy.

The form and extent of fiscal involvement must key off a country’s fiscal circumstances, and in many cases there will in fact be little room for fiscal maneuver. Assuming that there is a corporate sector need and sufficient fiscal flexibility, one could envisage a FICORCA-like foreign exchange cover scheme or other forms of direct debtor support such as those used by Mexico following the 1995 debt crisis. The methods used by Chile (1982) should also be explored, particularly in light of the wide range of direct subsidies and the form of finance that reduced up-front costs.

A potentially less costly means of direct governmental involvement would be through the provision of tax breaks and other fiscal incentives to parties that engage in restructuring. To encourage early workouts, such incentives could be linked to the speed of restructuring (e.g., a 100 percent tax break for transactions completed by a fixed date, with gradually decreasing tax incentives for transactions completed after that date, up to a cutoff point). Depending on the country-specific circumstances, various kinds of other direct fiscal incentives could be envisioned to encourage restructuring.11

Great care will also need to be placed on the form of the complementary case-by-case workout and incentive mechanisms. The government should appoint rapidly a government director to take charge of bank and corporate restructuring. Country experience suggests that the first task of such a director should be to help collect corporate debt data to inform policies, and to identify and seek removal of other impediments to corporate restructuring.

A centralized AMC approach could be used to facilitate restructuring, especially if the size of the corporate sector problem is huge and there is to be indirect governmental support through the purchase of banking sector nonperforming loans. As an alternative, consideration could be given to establishing private AMCs to service, restructure, and collect on nonperforming loans that have been purchased by the government. To encourage aggressive restructuring, the arrangement could provide increased compensation to the servicing AMC where recovery on a nonperforming loan exceeds specified parameters.

A hybrid approach will involve creditors and debtors entering into collective case-by-case negotiations. The government could assume a mediating or facilitating role of providing information and coordinating these negotiations with a view to ensuring that they serve the public good. As a means of accelerating the restructuring process, banks could be asked to restructure nonperforming corporate loans within a specific time frame (e.g., six months) and with debt relief in a specified net present value range (based on some measure of the currency depreciation). If necessary, banks that comply with these guidelines within the specified time frame could be given some explicit regulatory forbearance (for a set limit of time), favorable regulatory treatment for those write-downs, or receive additional capital from the public sector. To the extent that net present value reduction within the range identified is not enough to make the debt sustainable, there would be a presumption that more extensive restructuring would be undertaken (i.e., possible restructuring of operations and debt-for-equity conversions).

Concluding Remarks

Experience clearly suggests that there are great benefits from corporate debt restructuring that takes place within a comprehensive overall strategy. In the face of a widespread economic crisis, spreading the restructuring burden across the domestic public and private sectors (public federal and state, and private corporate and financial) can help to reduce the impact of restructuring on already weak social cohesion and private sector activity.

The linkage between the financial health of the banking and corporate sectors makes it vital that a government that faces a systemic crisis should formulate a strategy for a parallel restructuring of these sectors. Correspondingly, banks will be in a better position to bear losses or impose a lesser burden on corporate shareholders to the extent that the process includes a recapitalization by banks’ shareholders. Although these linkages may seem self-evident, recent experience shows that banking and corporate restructuring strategies have frequently been designed separately and with little coordination, especially in the initial stages.

Experience also shows that an optimal restructuring strategy will include elements of direct government involvement combined with a case-by-case market approach. Direct government involvement will generally be required to develop and coordinate the restructuring strategy for the corporate and financial sectors within a set of principles to guide the scheme. This needs to be undertaken within a framework that encourages a voluntary, private, and decentralized decision-making process. In guiding the process, the first tasks of the government team are to help collect corporate debt data and analyze the impact of potential debt relief on banks’ balance sheets, to assess whether there is room to extend regulatory forbearance to banks that provide debt relief to private firms, and to identify and seek removal of other impediments to corporate restructuring.

It is critical that, if needed, early legal and institutional reforms take place. These will include a flexible out-of-court workout mechanism as well as modern formal bankruptcy proceedings to be applied if the private, decentralized decision-making procedures fail to produce mutually agreeable results.

Appendix 7.1. Summary of Key Issues in Designing Orderly and Effective Corporate Insolvency Procedures12

An orderly and efficient insolvency system should accomplish at least two broad overall objectives: the allocation of risk among market participants in a predictable, equitable, and transparent manner; and the protection and maximization of value for the benefit of all interested parties and the economy in general. Such a system can also play a role in other, more specific areas of importance for financial system stability and soundness. It imposes discipline on debtors and creditors, which increases competitiveness of the enterprise sector and facilitates the provision of credit. Insolvency systems also provide a means for financial institutions to curtail deterioration in the value of their assets, which is of direct benefit to the domestic banking system. In the event of a financial crisis in which the entire enterprise sector is in distress, an effective insolvency system can also provide a useful means of ensuring that private creditors contribute to resolution of the crisis and bear the costs of the risks they have incurred (for example, through insolvency law mechanisms that allow for approval of restructuring agreements over the objections of minority dissenting creditors).

The approaches adopted by countries in designing their insolvency laws reflect a number of factors, including not only the underlying legal traditions, but also divergent choices related to political, social, and other noneconomic factors. Nonetheless, advantages and disadvantages are associated with each choice in key areas, and greater benefits are to be derived from pursuing some policy choices over others. Drawing on the experience in this area, the following is a summary of some of the broad considerations that arise in designing an orderly and efficient insolvency law.

Liquidation Procedures

The law should provide for comprehensive and predictable collective liquidation procedures that seek to maximize the value of the debtor’s assets and ensure equitable treatment of similarly situated creditors, while protecting to the maximum extent possible the bargained-for contractual rights of creditors.

All entities within a market economy, including state-owned enterprises, should be subject to coverage of the insolvency law. However, countries may wish to establish special regimes outside the general insolvency law for highly regulated entities such as financial institutions.

Commencement of Liquidation

  • The law should allow liquidation proceedings to be commenced on the basis of a petition filed by either a creditor or the debtor, generally using a cessation-of-payments criterion rather than a balance sheet insolvency test.

  • Upon commencement of liquidation proceedings, all assets in which the debtor has an ownership interest should be transferred to an independent, court-appointed liquidator.

  • Upon commencement of liquidation proceedings, the debtor should be required to disclose all assets and questionable transactions.

  • During liquidation proceedings, all assets over which the liquidator exercises control should be protected by a “stay” on the ability of unsecured creditors to enforce legal remedies against the assets. A stay of more limited duration should also be imposed on secured creditors, subject to appropriate exceptions (e.g., for assets that are not necessary for sale of the business as a going concern), and to mechanisms that ensure adequate protection of secured creditor interests.

  • The court should have power to order interim protective measures concerning the debtor’s assets, pending a determination on whether the proceedings should be commenced.

Other Specific Issues in Liquidation Proceedings

  • The law should include a mechanism that enables the liquidator to recapture assets transferred by the debtor prior to commencement of liquidation, where such transfers prejudice creditors generally, and with stricter rules applying to transactions with “insiders.”

  • The law should give the liquidator the authority either to terminate or continue performance under contracts that have not been fully performed by both parties.

  • The law should allow the exercise of any pre-commencement right of set-off, as well as the exercise of post-commencement set-off at least if the mutual claims arise under the same transaction. Consideration should also be given to allowing post-commencement set-off in other circumstances, particularly with respect to mutual financial obligations.

  • Where post-commencement set-off is not permitted for mutual financial obligations or where the liquidator is able to interfere with contract termination provisions, the law should allow an exception from these rules for application of the “close-out netting” provisions in financial contracts between the debtor and a third party.

Liquidation and Distribution

  • The procedure for liquidating assets should be transparent, timely, and efficient and should allow for both public auctions and private sales as necessary to ensure maximization of the value of the assets.

  • The laws governing distribution of the proceeds from sale of a debtor’s assets should pay due regard to contractual terms that provide for security or subordination of creditors’ claims. Priority rules should be designed to facilitate the effective functioning of the insolvency procedure by according administrative expenses a priority over unsecured claims. The inclusion of other statutory priorities for political or social reasons should be limited, since they generally undermine the effectiveness of insolvency proceedings.

  • The discharge of individual debtors (sole proprietorships or partnerships) following liquidation of their enterprise provides an appropriate means of giving entrepreneurs a fresh start. However, this option should not be available to those who have engaged in fraudulent behavior or failed to disclose material information during the proceedings.

Rehabilitation Procedures

The law should provide for rehabilitation procedures that enable a financially distressed company to become a competitive and productive participant in the economy, thereby benefiting not only the company’s stakeholders, but also the economy more generally.

Commencement of Rehabilitation Proceedings

  • The law should provide for the commencement of rehabilitation proceedings by the debtor or creditors, including by means of conversion from liquidation proceedings. A general cessation-of-payments criterion may be imposed in connection with creditor petitions. However, to encourage early debtor filings, there should be no requirement for such a showing in the case of debtor petitions.

  • The rehabilitation procedure should provide for a “stay” on the ability of all creditors to enforce legal remedies against assets of a debtor once rehabilitation proceedings are commenced.

  • The stay in rehabilitation should restrict the ability of secured creditors to exercise their rights against collateral during the entire period of the proceedings, subject to provisions to ensure the adequate protection of such creditors (e.g., allowing relief from the stay when the value of collateral cannot be protected, or imposing time limits on the duration of the proceedings).

  • Consideration should be giving to arrangements under which the debtor is allowed to operate the enterprise on a day-to-day basis following commencement of rehabilitation proceedings, but under close supervision of an independent, court-appointed administrator. The court should retain authority to displace the debtor’s management when there is evidence of gross mismanagement or misappropriation of assets.

  • To ensure that rehabilitation proceedings are not abused by debtors, the law should contain provisions that allow for the conversion of rehabilitation proceedings to liquidation proceedings.

The Restructuring Plan

  • To encourage debtors to utilize rehabilitation procedures, the law should normally provide the debtor with an opportunity to prepare a restructuring plan for approval of creditors. The administrator or creditors (or both) should also be given the opportunity to prepare a plan, after expiration of an initial debtor “exclusivity” period.

  • The law should not limit the proposals that may be included in restructuring plans, except for provisions necessary to protect creditors who may be bound without their consent to a plan that impairs their rights.

  • It is critical that the law provide a means by which a plan can be imposed upon a minority of dissenting unsecured creditors. However, mechanisms should be incorporated that protect the interests of such creditors, including a minimum requirement that dissenting creditors not be bound to a plan unless it provides at least what they would have received in a liquidation of the company.

  • To enhance the chances of rehabilitation, consideration should be given to allowing secured creditors and priority creditors to vote on the plan, but only as separate classes. The court should also be able to divide unsecured creditors with different economic interests into different classes for voting purposes.

  • Where the requisite majority of creditors has approved a plan that is also endorsed by the administrator, the law should give the court power to reject the plan only in very limited circumstances (e.g., unfair treatment of dissenting creditors, or voting fraud).

  • To enhance the efficiency of the rehabilitation process, the law should allow for expedited approval by a court of “prepackaged” rehabilitation plans that have been voted on or negotiated before commencement of the rehabilitation proceedings.

Other Specific Issues in Rehabilitation Proceedings

  • The law should include a mechanism for the avoidance, under appropriate circumstances, of transfers and transactions effected by the debtor prior to commencement of the rehabilitation procedure, with stricter rules applying to transactions with “insiders.”

  • If the administrator is given the authority to nullify termination provisions or the law does not provide for set-off of independent monetary claims (or both), exceptions should be made to allow for the post-commencement netting of financial contracts.

  • The law should give the administrator adequate powers to secure new financing for a company that is in rehabilitation proceedings, including the power to give administrative expenses priority to a post-petition creditor or to grant a security interest in unencumbered assets of the debtor, or both. Where necessary, consideration should also be given to granting a new creditor priority over other administrative creditors.

Institutions and Participants (Liquidation or Rehabilitation)


  • The law should facilitate the ability of creditors to play an active role in insolvency proceedings, inter alia, by allowing for the formation of creditors’ committees. The costs of running such committees should be treated as an administrative expense.

Liquidators and Administrators

  • Liquidators and administrators should be required to have a sound knowledge of the applicable insolvency law and expertise in commercial and financial matters.

  • Courts should have the final authority for appointment of a liquidator or administrator. Liquidators and administrators should be subject to removal by either the court (for cause) or by a majority of un-secured creditors (with or without cause, but in the latter case only for a specified period after commencement of the proceedings).

  • The method to be used to determine the remuneration for a liquidator or administrator should be transparent and should be made known to creditors at the beginning of the proceedings.

  • Liquidators and administrators should not be subject to a legal liability standard that is stricter than negligence.

The Court

  • The law should provide adequate guidance on how the court should exercise its discretion, particularly on matters that involve an assessment of economic and commercial issues.

  • Procedures should be put in place to ensure that court hearings are held quickly and that all decisions are rendered soon thereafter. The lower court’s decision should remain binding pending an appeal.

  • Judges that handle insolvency cases should be required to have adequate training and experience in commercial and financial matters.

Cross-Border Insolvency

Measures should be introduced to facilitate the recognition of foreign proceedings, as well as to improve cooperation and coordination among courts and administrators in different countries. Adoption of the Model Law on Cross-Border Insolvency prepared by the United Nations Commission on International Trade Law (UNCITRAL, 1999) would provide an effective means of achieving this objective.


  • Claessens, Stijn, Daniela Klingebiel, and Luc Laeven, 2000, “Financial Restructuring in Banking and Corporate Sector Crises: What Policies to Pursue?” NBER Working Paper 8386 (Cambridge, Massachusetts: National Bureau of Economic Research, April).

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  • El-Erian, Mohamed A., 1992, “Mexico’s External Debt Policies, 1982–90,” in Mexico: The Strategy to Achieve Sustained Economic Growth, edited Claudio Loser Eliot Kalter, Occasional Paper 99 (Washington: International Monetary Fund).

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  • INSOL International (International Federation of Insolvency Professionals), 2000, Statement of Principles for a Global Approach to Multi-Creditor Workouts (London).

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  • International Monetary Fund, 1999, Orderly and EffectiveInsolvency Procedures: Key Issues (Washington: IMF Legal Department).

  • Krueger, Anne O., and Aaron Tornell, 1999, “The Role of Bank Restructuring in Recovering from Crisis: Mexico 1995–98,” NBER Working Paper 7042 (Cambridge, Massachusetts: National Bureau of Economic Research, March).

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  • Lindgren, Carl-Johan, 1999, Financial Sector Crisis and Restructuring—Lessons from Asia, Occasional Paper 188 (Washington: International Monetary Fund).

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  • Stone, Mark, 2000, “Large-Scale Post-Crisis Corporate Sector Restructuring,IMF Policy Discussion Paper 00/07 (Washington: International Monetary Fund, July).

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  • United Nations Commission on International Trade Law (UNCITRAL), 1999, UNCITRAL Model Law on Cross-Border Insolvency with Guide to Enactment (New York: United Nations).

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Peter Hayward, Ketil Hviding, Carlos Muñiz, and Mark Stone also contributed to this section.


The country-specific data to be considered includes the scale and nature of the existing corporate distress and details on the structure and level of corporate indebtedness, overall debt-to-equity ratios, and interest coverage ratios. Current information on average leverage ratios and foreign exchange exposure is important, especially if there is sizable corporate debt that is denominated in foreign currency. However, a lack of relevant information and the need for rapid crisis response often require making choices without full information.


These issues are also discussed in greater detail in Stone (2000) and Claessens, Klingebiel, and Laeven (2000).


One alternative involves a legal requirement for the automatic reduction of all corporate foreign currency debt in the event of certain external shocks affecting a country (e.g., automatic debt reduction of x percent in all foreign currency debt where a country’s currency depreciates by more than y percent during any z-month period).


The “London Approach” refers to principles and techniques for collective, out-of-court negotiations between a troubled debtor and its creditors that were promoted by the Bank of England in the 1980s. The London Approach generally involves voluntary creditor and debtor adherence to a set of orderly negotiation principles that are designed to assist the parties in reaching a consensual restructuring agreement that is beneficial to all concerned. The Bank of England played an active role in debtor-creditor negotiations at the time the London Approach was first promoted. Today, the degree of governmental nonfiscal involvement in out-of-court negotiations varies from country to country, and is itself an important aspect of designing a corporate restructuring strategy. A more recent international variant of the London Approach can be found in INSOL International (2000).


For more detail on the Asian cases, see Lindgren and others (1999), pp. 41–42.


The limitations and lessons learned from the Mexican approach are discussed in Krueger and Tornell (1999).


INDRA, the exchange rate scheme, was never widely used (reportedly only one firm took advantage of it), in part because of the relative stability of the rupiah after the worst of the crisis; the scheme was eventually allowed to expire.


Some variations of the direct-government-involvement approach are unlikely to be appropriate for a hybrid strategy that contemplates support of market-driven transactions. In particular, across-the-board schemes that seek to reallocate losses through (continued) mandatory legislative changes in contractual terms are so destructive of bargained-for rights and market confidence that they should probably have no place in a well-designed hybrid strategy.


The issues summarized herein are derived from and discussed in greater detail in IMF (1999).

Recent Experience and Lessons for Latin America