Four years since the onset of the financial crisis, Thailand’s economic recovery remains fragile and is now threatened by a sharp slowdown in external demand. Bank and corporate sector restructuring policies have formed a key focus of the Article IV discussions. An important initiative to accelerate bank and corporate restructuring is the recent establishment of the Thai Asset Management Corporation (TAMC). An inadequate legal framework has been a major impediment to corporate debt restructuring. Even with an acceleration of bank and corporate restructuring, questions will remain about medium-term growth prospects.
IV. Improving The Legal Framework for Corporate Rehabilitation1
1. Among the reforms needed to facilitate corporate rehabilitation in Thailand, perhaps none is more pressing than the design and application of the legal framework. Reform in this area was a central component of the Fund-supported reform program, and considerable progress has been achieved. Prior to the financial crisis, Thailand’s bankruptcy law was oriented towards the liquidation, rather than the rehabilitation, of corporations. The introduction of the Reorganization Chapter of the Bankruptcy Law in 1998 represented an important step in addressing this deficiency. The law was further revised in 1999 to enhance the prospects for rehabilitation, among other things, by including provisions to facilitate the availability of new financing to corporations during the period of rehabilitation proceedings. In addition, a specialized bankruptcy court was established in 1999. The establishment of this court was based on a recognition that, given the complexities arising in corporate restructurings, specially trained and dedicated judges would be needed if the newly revised law was to be properly implemented.
2. Notwithstanding the progress that has been made to date, further legal reforms are necessary to accelerate rehabilitation of the corporate sector. This is based on the experience with corporate sector restructuring in Thailand over the past several years. It should be recognized at the outset that it is not unusual for countries to keep their insolvency laws under continuous review, and to make adjustments from time to time as circumstances warrant. This is particularly true for emerging markets that have recently weathered financial crises. Korea, for example, has amended its law twice since 1998 and is contemplating a new set of amendments. Mexico also recently amended its insolvency law.
3. The establishment of the Thai Asset Management Company (TAMC) is not a substitute for general legal reform (see Chapter III). Although TAMC will help accelerate corporate rehabilitation through its special legal powers, the resolution of impaired assets (accounting for no less than ½ of system-wide distressed assets) that are not transferred to the TAMC will continue to be subject to the general framework. Indeed, the ability of the TAMC to maximize recovery of the assets it manages will be adversely affected by weaknesses in the general framework. In particular, to the extent that the TAMC wishes to sell impaired assets on the secondary market, potential purchasers who would have to rely on the general legal framework to resolve these assets would take into account its weaknesses when deciding upon an appropriate purchase price. Further, given the magnitude of corporate distress in Thailand, it is likely that most debtor/creditor negotiations will take place outside formal rehabilitation proceedings. As such, the type of out-of-court framework that is currently administered by Bank of Thailand’s Corporate Debt Restructuring Advisory Committee (CDRAC) will continue to guide this process. Such a framework, however, would be hampered by the absence of a predictable rehabilitation law.
4. This chapter identifies key strengths and weaknesses of the existing legal framework and attempts to provide insights into addressing remaining shortcomings. It also briefly discusses the reform of other economic laws that can increase the availability of credit to corporations by reducing the riskiness of new lending. The chapter draws on the recent experience with insolvency reform in a number of countries and recent studies that attempt to identify international best practices in this area.2
B. Objectives of a Rehabilitation Law
5. The overriding economic objective of a rehabilitation law is to enable financially distressed, but viable, enterprises to become competitive and productive. The goal is to benefit not only the stakeholders of the enterprise (owners, employees and creditors), but also the broader economy in general. For a rehabilitation law to achieve this objective it must create incentives for all stakeholders to participate in the proceedings. Thus, for example, the features of the law must be sufficiently attractive to encourage debtors to commence proceedings sufficiently early in their financial difficulties, thereby increasing the chance of rehabilitation. On the other hand, the law must provide adequate protection to creditors in order to assure them that the proceedings will not be used merely as a device for nonviable enterprise to delay liquidation. To ensure that rehabilitation will provide for long-term competitiveness, rather than a temporary respite, the insolvency law (and other supporting laws) must avoid placing undue constraints on the type of restructuring that can take place. Thus, for example, the insolvency law must provide an effective means by which the indebtedness of the enterprise can be reduced, through, for example, debt-for-equity conversions or, where necessary, debt forgiveness.
6. An additional objective of some rehabilitation laws is to help foster the development of an entrepreneurial class by providing owners a “second chance”. To achieve this, the law should give the debtor the opportunity to prepare and propose a rehabilitation plan, either directly or through an administrator.
7. Meanwhile, from the perspective of an unsecured creditor, a rehabilitation law is intended to enhance the value of a claim through the continuation of the enterprise. To achieve this objective, the law must provide unsecured creditors with a method to vote on a plan proposed by the debtor. Many countries also allow the creditors to propose their own plan. With respect to secured creditors, while the law must prevent them from undermining the rehabilitation of a viable enterprise, it also should provide for measures that will ensure that their claims or property rights will not be impaired.
8. Finally, and particularly in the context of a systemic financial crisis, an objective of a rehabilitation law is to limit the public sector costs of crisis resolution. This requires maximizing the involvement of the private sector in order to force creditors to bear the costs of the risks they incur. In this context, the law should enable a plan that provides for significant debt reduction and which is supported by a majority of creditors, to be imposed on a minority of dissenting creditors.
9. As some of the above objectives conflict with one another, a critical policy challenge is finding an appropriate balance among them. Individual countries will inevitably strike their own balance in resolving such an issue. Irrespective of the choices that are made, however, the desired rules need to be established clearly in the law and applied consistently by the institutions that are charged with implementing them. A law that is applied effectively and consistently will engender greater confidence in financial markets than an unpredictable law. In this respect, predictability should be seen, in and of itself, as a key objective of an effective rehabilitation law.
10. Thailand’s reorganization chapter is seen to contain a number of positive features, when judged against the above objectives and existing best practices. Among the most significant are:
A comprehensive stay on legal action during the proceedings that apply to both unsecured and secured creditors, thereby providing protection to the debtor during the period when the rehabilitation plan is prepared;
Rules that provide for voting on a rehabilitation plan by different classes of creditors, thereby maximizing the chances that a rehabilitation plan will be approved;
Provisions that encourage new financing to the enterprise during the proceedings, by providing repayment priority to new credits; and
Comprehensive avoidance rules that nullify fraudulent and preferential transactions made by the debtor prior to the commencement of the proceedings, thereby not only maximizing the value of the estate but also ensuring equity among creditors.
Perhaps even more importantly, Thailand’s judiciary and, in particular, the newly established bankruptcy court, have made steady progress in applying the law in an effective and consistent manner.
11. Notwithstanding these strengths, experience with the application of the law over the past several years has revealed a number of shortcomings. The most important of these relate to: (a) the rules relating to debtor control of the enterprise and plan preparation; (b) criteria relating to the commencement of rehabilitation proceedings; and (c) the conversion from reorganization to liquidation. These shortcomings have undermined the law’s predictability and have made both debtors and creditors reluctant to use it. Each of the shortcomings is discussed in turn, with a view to identifying ways to address these problems.
C. Debtor Control and Plan Preparation
12. A key shortcoming of the reorganization chapter relates to the selection of the preparer of the rehabilitation plan (plan preparer). The chapter provides that whoever requests commencement of court proceedings (the “petitioner”) may propose the plan preparer. The court will then appoint the proposed preparer unless other interested parties are able to overrule this choice. For example, in the case where a petition is filed by a creditor, any plan preparer proposed by the petitioner (i.e., creditor) can be rejected in favor of a plan preparer proposed by the debtor. However, the creditors may overrule the debtor’s choice of plan preparer and propose their own, as long as there is an affirmative vote of the creditors holding two-thirds of the outstanding debt. As a result, a debtor that wishes to commence proceedings can only be assured that he will prevail in his choice of plan preparer if he has the support of creditors holding more than one-third of the outstanding debt. Conversely, creditors will only be assured that their choice will prevail if they have the support of a two-thirds majority of the creditors.
13. Given the important role of the plan preparer in a rehabilitation process, the uncertainties in the selection process under the current law undermine its effectiveness. Not only is the preparer responsible for the reorganization plan, he is also given complete control of the enterprise once the proceedings commence. Thus, from the debtor’s perspective, unless he is assured the support from the requisite percentage of creditors, he has no incentive to initiate proceedings and will, in fact, resist their initiation because of the likelihood that he will lose total control of the business during the duration of the rehabilitation. Meanwhile, from the creditors’ perspective, unless they have sufficient support from within their group, the debtor’s plan preparer will assume total control. This may be of concern to creditors in view of the fact that the law does not contain rules regarding conflicts-of-interest or professional qualification. Creditors may legitimately fear debtor’s plan preparer will be an insider, who will permit the owners to continue to operate the company without sufficient oversight, during which time the value of their claims will continue to dissipate.
14. The risks posed for both the debtor and creditors in selecting the plan preparer are key reason why there have been few contested reorganization petitions. Indeed, petitions have generally been filed only once the debtor and creditors have been able to reach a compromise agreement as to the identity of the plan preparer and the nature of his powers. In a number of cases, the agreement has provided for the appointment of an independent professional (e.g., a certified accountant) as the plan preparer who is responsible, inter alia, for the continued operation of the business by incumbent management. As is discussed below, if the law were revised to provide for such a power sharing arrangement, the filing of petitions would not need to be contingent upon reaching an agreement on this issue.
15. International experience suggests that the law must contain inducements for debtors to use the proceedings early on its financial difficulties, thereby maximizing the chances for effective rehabilitation. In some cases (e.g., Chapter 11 of the United States) the debtor is given full control over the enterprise during the proceedings. As a further inducement, the debtor is sometimes also given the first opportunity to prepare a plan (Chapter 11 in the U.S.). Only when the debtor has failed to do so within a specified time frame are creditors given the right to propose their own plan. An advantage of this approach is that it enables the owners of the enterprise, who typically have the best understanding of the underlying business, to maintain operational control, thereby increasing the likelihood of a successful rehabilitation.
16. However, international experiences also suggests that there are disadvantages to giving the debtor unrestricted control over the enterprise during the proceedings. Since, under such an approach, a debtor will often feel that it has nothing to lose by filing a rehabilitation petition, it may do so in circumstances where rehabilitation is not feasible. If the rehabilitation proceedings are used solely as a means of delaying inevitable liquidation, the interests of creditors may be undermined since the value of the assets—and therefore the value of their claims in liquidation—will be reduced. Moreover, even in circumstances where the enterprise is viable, there is the possibility that the debtor’s management may act irresponsibly and, in some cases, fraudulently during the proceedings, to the detriment of creditors.
17. To balance the interests of creditors and debtors, while still providing inducements to use the system, many countries allow for “power sharing” arrangements between the debtor and a court-appointed administrator. While the debtor continues to be responsible for the operation of the day-to-day business of the enterprise, the administrator is responsible for approving all significant transactions. Under the approach followed in the United States, and which could also be used in Thailand, the debtor is given the first opportunity to prepare and propose a plan. To avoid abuse, it is desirable under such an approach that the maximum length of “plan exclusivity” be specified in the law. Moreover, specific rules are needed regarding the qualification and selection of the court-appointed administrator to ensure that he is both independent and competent.
20. In Thailand, changes to the law along these lines would likely be of considerable benefit to debtors, but would also most likely be welcomed by creditors. Creditors would no longer be concerned that, absent support by two-thirds of the creditor group, the debtor would effectively control the plan preparer. Moreover, they would most likely accept the continuation of incumbent management as long as they had the assurance that it was subject to oversight by an independent professional with adequate financial experience.
D. The Commencement Criteria
21. Under Thailand’s Bankruptcy Act, the commencement criteria for the opening of reorganization proceedings are onerous. Specifically, commencement proceeds upon a court determination that: (i) the debtor is insolvent; (ii) the debtor is indebted to one or more creditors for an amount of at least BIO million; and (iii) there are reasonable grounds and prospects for reorganization of the debtor.
22. Although the Bankruptcy Act does not define “insolvency,” it does establish a list of events that create a “presumption” of insolvency. These include, among other things, events that evidence liquidity (i.e., an inability to pay debts as they fall due). However, in a number of decisions to date, the Thai Supreme Court has clarified that the determination of “insolvency” under the Bankruptcy Act is to be based on an assessment of whether the value of the debtor’s liabilities exceed the value of its assets.3 Moreover, the courts have also confirmed that this concept is applicable to the reorganization chapter. While evidence of illiquidity provided by the creditor would create a presumption of insolvency under the law, this presumption can be rebutted by the debtor demonstrating that, notwithstanding its inability to meet debt obligations as they fall due, the value of its assets still exceeds the value of its liabilities.
23. This feature of Thailand’s rehabilitation law stands in contrast to modern rehabilitation laws elsewhere, which do not require, as a condition for commencement, a determination of insolvency based on the value of the debtor’s assets and liabilities. Rather, most laws allow for proceedings to be commenced upon a determination that the debtor is unable to pay its debts as they fall due, i.e., that the debtor is illiquid. A number of tests are used to determine illiquidity, including a debtor’s general cessation of payments.
24. It is preferable for commencement criteria to be based on a determination of illiquidity, rather than insolvency. In particular, two reasons can be cited why reliance on a demonstration of illiquidity is to be preferred over a demonstration that the value of liabilities exceeds assets:
First, since rehabilitation is more likely to be successful if proceedings are commenced at an early stage in a debtor’s difficulties, the test of illiquidity is more appropriate as it will normally, though not necessarily always, precede insolvency.
Second, a determination of insolvency requires valuation of the debtor’s assets and liabilities, which can be a complicated and uncertain process. This is all the more so in cases, such as Thailand, where the underlying value of assets is difficult to determine given the repercussions of the financial crisis. Determination of illiquidity, in contrast, requires no valuation process.
For these reasons, one option to consider is revising the commencement criterion for rehabilitation proceedings to that of illiquidity. Indeed, consistent with the laws of some countries (such as Germany), the law could provide that petitions filed by debtors need only demonstrate a likelihood of illiquidity. This would allow for debtors to seek protection under the law at an even earlier stage of the their financial distress.
Prospects for Reorganization
25. Under the current Reorganization Chapter, proceedings can be commenced only upon determination of a “reasonable ground and prospect” for reorganization. The law provides that the petition for commencement, whether filed by the debtor or the creditor, must clearly set forth the basis for this determination. By establishing a further barrier to commencement, this criterion injects uncertainty into the system. For a debtor seeking protection, he may not be able to demonstrate such “reasonable grounds” at the very outset of the process. With respect to a creditor petition, the creditor will only have adequate information to make such an assessment once a plan preparer has conducted an investigation of the company. Accordingly, the requirement that such an assessment be made at the time of commencement (i.e., before a plan preparer is even appointed) is circular. This barrier is another reason why, to date, most filings for rehabilitation have only occurred once a debtor and the majority of its creditors have reached agreement on the broad parameters of a reorganization plan. It would therefore be desirable to consider eliminating this separate criterion.
E. Conversion to Liquidation
26. It is critical that a bankruptcy law provide a means by which reorganization proceedings can be converted into liquidation proceedings in circumstances where there is no feasible possibility for reorganization. Otherwise, there is a risk that a nonviable debtor will use the reorganization proceedings to delay an inevitable liquidation, during which time the value of creditors’ claims are dissipated. In part, Thailand’s bankruptcy law addresses this issue, as the ability of a debtor to use the reorganization proceedings solely as a means of delaying liquidation is reduced by the time limit imposed by the law (a plan must be submitted for approval within five months of commencement).
27. Thailand’s law, however, falls short of fully ensuring certainty with respect to liquidation. In particular, if this time limit for submitting a plan expires and no reorganization plan has been approved, all insolvency proceedings terminate, with the effect that the debtor merely resumes its activities. Unlike most other insolvency laws, a failed reorganization attempt will not automatically result in liquidation proceedings. The existing rule in Thailand would not be as problematic if, upon the failure of a rehabilitation plan, creditors could initiate liquidation proceedings on the basis of illiquidity. However, as in the case of the reorganization chapter, the test for liquidation is that of insolvency, which requires the application of an uncertain valuation process.
28. To address this problem, consideration should be given to allowing liquidation proceedings to commence automatically once the time period for reorganization lapses, consistent with best practices. This time period may need to be lengthened if a debtor “exclusivity” period is to be introduced (i.e., when only the debtor may propose a plan), which would then be followed by a period (perhaps an additional 3 months) during which time creditors could propose their own plan. But following the termination of this latter period, liquidation would become automatic unless a plan had been approved. If this rule is not introduced, then as a minimum, consideration could be given to establishing the criterion for commencing liquidation as illiquidity so that, following the failure of rehabilitation, the barrier to liquidation would be minimized.
F. Other Measures to Increasing the Availability of Credit
18. An effective corporate restructuring strategy needs to include measures to enhance the availability of credit. Beyond reform to the Bankruptcy Law, legal reform in two other areas could be of considerable assistance. First, a modern legal framework that supports the granting and enforcement of a wide variety of security interests would serve to reduce the risk of lending. Consideration is currently being given to reforming Thailand’s laws in this area (a draft secured lending law has been submitted to the Council of State). Second, experience to date demonstrates that the weakness of the general credit enforcement mechanism in Thailand will continue to curtail the flow of credit, particularly in circumstances where banks, already hampered by nonperforming loans, are understandably risk adverse. The experience of other emerging markets clearly demonstrates that improvements in this area can be of great benefit for borrowers.
19. Although progress has been made over the past several years in improving the enforcement mechanism, there is considerable scope for further reform. In particular, reform is needed both with respect to the procedures applicable to the granting of a judgment and those that relate to judgment execution. With respect to obtaining a judgment, part of the problem relates to the chronic overcrowding of the civil courts. However, the absence of continuous civil proceedings also exacerbates delays that are encountered by creditors wishing to enforce both secured or unsecured claims. With respect to the execution of judgments, reforms introduced over the past several years have reduced the opportunity for the execution process to be delayed by appeals through the court system. However, the auction process continues to be problematic. For example, the establishment of a “reserve” price, above which the asset in question must be sold, often gives rise to multiple auctions.
20. This chapter has identified weaknesses in the existing insolvency framework and, in that context, has made specific recommendations for reform. Drawing from international best practice, it identifies key areas for improvement, including greater certainty with respect to the selection and responsibilities of the rehabilitation plan preparer, an enhanced role for incumbent management during the proceedings, simplification of the criteria relating to the commencement of rehabilitation proceedings, and providing for automatic conversion to liquidation in the event that rehabilitation fails. In addition, as a means to enhance the availability of credit in the economy, it is critical that steps be taken to strengthen the legal framework for secured lending and, more generally, credit enforcement.
Prepared by Sean Hagan and Seng Chee Ho.
The United Nations Commission on International Trade Law (UNCITRAL) is currently preparing a legislative guide that distills and elaborates upon a number of recent insolvency studies, including those prepared by the Fund, the World Bank and the Asian Development Bank. See, Orderly and Effective Insolvency Procedures - Key Issues (IMF 1999).
See, e.g., Krung Thep Metal Works Co. Ltd. vs. Somchai Holding International.