Policy Approaches to Corporate Restructuring Around the World: What Worked, What Failed?

1. Policy Approaches to Corporate Restructuring Around the World: What Worked, What Failed? By Stijn Claessens University of Amsterdam For presentation at the conference Corporate Restructuring: International Best Practice World Bank Washington, D.C. March 22-24

2. Structure of Presentation • Introduction and Initial Conditions • Overview of Approaches Used • The Outcomes in Corporate Restructuring • NPLs and financial measures • Operational restructuring measures • Policy Lessons

3. Introduction • Review lessons from eight financial crises involving corporate distress over past decade • Brazil, Czech Republic, Indonesia, South Korea, Malaysia, Mexico, Thailand, Turkey • Assess which policies were effective/ineffective given country circumstances, and why • Note: do not review the causes or initial conditions • Causes ought to condition responses, however • Initial conditions, e.g., fiscal headroom, foreign exchange exposures, etc., determine scope for actions

4. Initial conditions: pre-crisis corporate sector financial conditions Data one year prior crisis: Asia 1996, Czech Republic 1996, Turkey 2000, Mexico 1994, Brazil 1998.

5. Approaches used for corporate restructuring • Government-sponsored, voluntary workouts schemes • Court-supervised restructuring and bankruptcy • Restructuring by public asset management companies • Voluntary workouts outside government-sponsored and in-court frameworks • Other, supporting policy changes

6. Government-sponsored voluntary workouts schemes • London type schemes adopted by 6 out of 8 countries (Brazil and the Czech Republic not) • Enhanced in various ways: • Did all (or most) financial institutions sign on to the accord under regular contract or commercial law? • Was formal arbitration with deadlines part of the accord? • Could penalties for failure to meet deadlines be imposed under the accord? • Not all countries had these three features in place (immediately): lessons were learned over time

7. Features of out-of-court corporate restructuring processes: Asia

8. Features of out-of-court corporate restructuring processes: Non-Asia

9. Strengths determined restructuring • Korea, Malaysia stronger framework than Thailand initially, Turkey quickly strengthened, Indonesia less, Mexico least • Number of cases and speed of restructuring depended in part on the strength of framework • Much restructuring was still cosmetic, with soft terms, few debt-equity conversions and limited operational restructuring; many cases reverted • And out of court needed well-functioning bankruptcy system as threat and to finalize deals

10. Court-supervised restructuring and bankruptcy/insolvency • Initial weaknesses in bankruptcy regimes made court-supervised restructuring unattractive; exceptions were Korea and Malaysia • Limited use due to pro-debtor bias in legal system aggravated by limited efficacy of judicial system • Some legal deficiencies corrected, more in East Asia and Turkey, less so in Latin America • But effectiveness of insolvency systems remains low, with long periods and high costs

11. Features of in-of-court: creditors rights weighted by judicial efficiency

12. Judicial system remains bottle-neck in many crisis countries

13. Restructuring by public asset management companies • All East Asian countries, Mexico, Turkey and Czech Republic established an AMC or (used) a deposit insurance, for buying NPLs from banks • Purposes of AMCs differed: some were setup largely to support banking system; others also had asset disposal and/or restructuring tasks • Asset disposition was slow in most cases • Difficulty in valuing assets, thin markets for selling assets, fears of selling too cheaply, and social and political pressures slowed down

14. Most AMCs ended up with large role in restructuring • Regardless of purposes, most AMCs ended up restructuring, especially large, difficult firms • With large holdings and some special powers, most AMCs played a large role in restructuring and could set pace and intensity of restructuring • Social impact, political connections or fear to reveal “skeletons” slowed restructuring, however • E.g., in Mexico there were essentially no assets sales when FOBAPROA was AMC

15. Restructuring by AMCs was often poor • As in other countries, AMCs often delayed, rather than sped up operational restructuring • Many concerns throughout whether AMCs facilitated sufficiently deep corporate restructuring • Holdings by AMCs remained large in most countries for several years after crisis, four Asian AMCs still held some $150 billion in mid 2002 • Disposition accelerated, however, over time, and restructuring improved in quality

16. Holdings of NPLs and powers: Asian AMCs

17. Holdings of NPLs and powers: Non-Asia AMCs

18. Other forms of government-directed corporate restructuring • Korea: five plus three program, for 6-64 chaebols • Elimination of cross guarantees, capital structure improvement, lowering of leverage to 200%, tighter exposure limits for financial institutions, streamlining business lines and increased transparency • Still required lead banks to act, which was an issue • Korea: Big Five chaebols, Capital Structural Improvement Plans (CSIPs), with business assets swaps and mergers • For two too large to fail/ignore chaebols did not work, used new funds raised by affiliated Investment Trust Companies to finance their cash-flow needs

19. Voluntary workouts outside government-sponsored and in-court frameworks • In most countries, smaller firms more adversely affected by shocks and credit crunch than larger • Special programs (forced roll-over, trade and working capital financing, SME workouts programs) helped • M&A, triggered by policy changes, helped with financing, less so with restructuring directly • Over time, foreign entry helped with enhancing institutional quality, especially in financial sector

20. Other, supporting policy changes • Many countries did not have or slowly adopted proper loan classification and loan-loss provisioning rules, e.g., no “forward-looking criteria” • Many other tax, legal and accounting rules hindered • E.g., tax losses only allowed with write-offs; treatment of mergers as taxable event; debt to equity conversions only allowed for shareholder loans; etc. • Corporate governance changes important, but slow • Source of vulnerabilities and required for restructuring • But implementation still incomplete

21. Regulatory and loan restructuring frameworks, as of early 1997 and 2003

22. Corporate governance changes

23. Other tax, accounting, legal and regulatory changes • Need a broad set of options, not only debt rescheduling and principal and interest reductions, but also debt-for-equity swaps, assets sales, securitization, asset spin-offs • Relative importance varies over time and with demand base of investors and type of assets to be restructured • But tools often missing. Lack of Corporate Restructuring Vehicles (CRVs) and venture funds, equity partnerships, and other tools especially hindered restructuring • Korea assigned only in 2000 CRVs a formal role in out-of-court restructuring, no CRVs established until 2002

24. Outcomes in corporate restructuring • Financial restructuring measures: NPLs and financial indicators • NPLs rose initially sharp, with lag depending on reporting standards; slow decline after that • NPL share fell only in East Asia after 1999; only in 2001 Korea and Malaysia NPLs in single digits • In other countries, NPLs were already high due to high interest rates: also foreign exchange effects • In Mexico took long time for NPLs to come down

25. Share of NPLs, including NPLs transferred to AMCs (percent)

26. Financial indicators: leverage and interest coverage • Leverage initially saw a sharp increase, in part due to foreign exchange shock and rescheduling • Only a slow decline afterwards, showing financial restructuring can take many years • Structure of financing lengthened, for good and bad reasons (reschedulings, bonds) • Interest coverage was worse in East Asia, but had been declining in other countries before crises • Interest coverage still low in many countries years after crisis and many distressed corporations

27. Leverage

28. Interest coverage

29. Financially distressed corporations(percent with IC < 1)

30. Operational restructuring measures • Financial restructuring only a means to achieving improved operational performance • Financial structure can create incentives for deeper, more sustainable operational restructuring • Can be through changing management, bringing in new owners, changing financial structures • Much financial restructuring was response to systemic crisis, and while it achieved temporary financial stabilization, was not always sustainable or promoted real, operational restructuring

31. Return on assets • Longer-run decline in ROAs in many countries • After sharp decline following crisis, some quick rebound, followed by varying pattern to more “normal” ROAs: East Asia strongest recovery helped by global conditions (except Malaysia to lag) • But profitability and cash flow of corporations in many of the crisis-affected countries remained low, even negative in Brazil, Turkey • Large corporate restructuring deals continued to emphasize financial over operational restructuring

32. Return on assets

33. Policy Lessons • An efficient insolvency system • Loss absorption capacity • A proper framework for financial institutions • Limits on the role of banks and the state • A menu of approaches • Corporate governance and other reforms • Broader lessons on corporate restructuring

34. An efficient insolvency system • An efficient court-supervised process is a necessity • The effectiveness of out-of-court system depends on formal court system • In-court more generally needs to be a credible threat • While formal bankruptcy regimes can be more quickly improved, and have been in many countries, legal enforcement remains often limited • In the meantime, London-type approaches, can be useful, but regime needs to be tight

35. Loss absorption capacity • Loss-absorption capacity is necessary, with private sector incentives and no perverse links • To restore bank capital adequacy, recapitalization by private sector is preferred, but rarely sufficient • Government resources linked to actual restructuring, as was done in some countries, can strengthen incentives • Proper incentives also means limited ownership links and limits on borrowing from related financial institutions • More broadly, need to consider links between financial and corporate sectors, by political system and otherwise

36. A proper framework for financial institutions • To facilitate restructuring, need to have a proper incentive framework at the level of individual loans • Includes proper accounting, classification, and provisioning rules, and tight exposure limits • Other barriers such as tax and accounting rules and certain legal rules to be addressed • And a proper incentive framework for institutions • Prudential and legal systems need to limit forbearance and ensure that undercapitalized financial institutions are properly disciplined while giving incentives for banks to come to grips with their problem loans

37. Limits on the role of banks and the state • Consider upfront how to limit role of banks and state, while inevitable, in restructuring • Banks, state-owned or under extensive safety net, and AMCs played a large role, but slow to divest assets • At best commercial banks and AMCs are used for financial restructuring, not for operational restructuring • More and earlier involvement of outside investors is necessary to achieve deep operational restructuring • Encourage quick divestiture by LCC/LLP, with full disclosure • AMCs to divest within set time limits

38. A menu of approaches • To dispose of assets, a menu of approaches should be available to banks, AMCs, investors • When large-scale disposal of assets is difficult, if asset prices are depressed or because of political sensitivities, solutions can be mixed public-private arrangements and other ways to effectively reprivatize assets. • More differentiation by the type of assets • Type of assetslarge corporations, small firms, consumer credit, real estate requires different approaches in terms of speed/forms of asset disposition and restructuring

39. Corporate governance and other reforms • Corporate governance reforms to accompany • Strengthen corporate governance, especially enhanced rights for public (minority) shareholders • Many other reforms are necessary as well • Liberalization of rules governing FDI and investments • Foreign participation in financial system especially • Mergers and acquisitions to be facilitated • Adoption of international accounting standards and enhanced disclosure (of NPLs especially) • Prohibitions on anti-competitive business practices

40. Broader lessons on corporate restructuring • Preserve private sector incentives to restructure weak financial institutions and NPLs • A consistent framework with sufficient loss-absorption • Private agents to face right sticks and carrots • Use crisis to start deeper structural reforms • Be not only cognizant of political economy factors, but adjust pro-actively and up-front • Be aware of political economy factors behind the causes of a crisis and its resolution • Change ownership structures so that recovery is expedited and more sustainable outcome results