Recent Developments in the Insolvency Proceedings in Korea

1. Recent Developments in the Insolvency Proceedings in Korea Feb. 2001 Il Chong Nam Korea Development Institute

2. < Contents > 1. Problems in the old system 3 2.Changes in insolvency proceedings in recent years 8 3. Workouts 14 4. Future challenges 15

3. Workout Daewoo(2), Ssangyoung(7), Donga Construction(10), Anam(22), Saehan(23), Kohap(26), Byucksan(30), Shinho(36), Woobang(51), Kabool(53), Jindo(57), Shinwon(60), Shindongbang(62), Hwasung ind.(64) Bailout Hanhwa(8), Donga Construction(10), Kohap(26), Shinho(36), Hanil(45), Woobang(51), Jindo(57), Shinwon(60) Corporate Reorganization Hanbo(14), Halla(20), Haitai(21), Jinro(24), Shinho(36), Woosung Constrution(39), Hanil(45), Kia(56), Kunyoung(59), Kukdong E&C(68), Chunggu(69), Hanshin Construction(70) Composition Halla(20), Jinro(24), Shinho(36), Kia(56), Kukdong E&C(68) • 1. Problems in the old system • Two fundamental questions • What’s wrong with the insolvency proceedings in Korea? • Why do so many large firms fall in deep financial trouble in Korea? <Table 1> Bankrupt Chaebols Note : ( ) is the rank of a chaebol according to its size

4. 1995 1996 1997 1998 1999 Corporate Reorganization 79 52 132 148 37 Composition 13 9 322 728 140 Bankruptcy 12 18 38 467 733 Total 104 79 492 407 910 <Table 2 >The number of bankruptcy cases in the last 5 years • Criticisms directed at the insolvency proceedings before 1998 • Creditors keep lending money to large debtor firms which are essentially bankrupt. • Creditors rarely initiate formal insolvency proceedings. • Government interferes with insolvency cases too heavily. • Managers of bankrupt firms often divert money from their firms. • Reorganization proceeding is too slow and takes too much time. • Reorganization proceeding is too lenient to debtor firms • Reorganization plans are unrealistically optimistic.

5. “Bankruptcy” (forced liquidation) proceeding is rarely used for large firms. • Reform of the insolvency proceedings • Revision of the reorganization act, the composition act, and the “bankruptcy” act in early 1998 • Revisions of the 3 acts in April, 2000 • Further revision planned in 2001 Hyundai Samsung LG SK Total Debt 1998 61.5 44.7 36.4 22.5 165.1 1999 52.6 38.4 26.3 22.3 139.6 Equity 1998 13.7 16.2 10.7 6.4 46.9 1999 29.1 23.1 14.3 13.9 80.3 Debt/Equity 1998 449.3 (312.0) 275.9 (258.0) 341.0 (315.6) 354.9 (249.9) 352.0 (286.8) 1999 181.0 (152.1) 166.3 (147.8) 184.2 (153.3) 161.0 (131.5) 173.9 (147.4) <Table 3> Result of top 4 chaebols’ financial structure reform (Unit: Trillion Won) Note : The numbers in the parentheses are the D/E ratios when the effects of revaluation of assets are included.

6. debt adjustment New credits Delay of debt repayment Debt equity swaps Others Total Cut in interests Normal interests DAEWOO (12 firms) 53,333 (53,153) 1,189 (1,189) 8,617 (160) 3,439 (3,204) 66,577 (57,706) 5,913 (3,472) Non-DAEWOO (64 firms) 20,144 (19,495) 4,648 (4,388) 7,103 (2,626) 1,655 (2,243) 33,550 (28,751) 1,205 (1,040) Total (76 firms) 73,477 (72,648) 5,837 (5,576) 15,719 (2,785) 5,094 (5,447) 100,127 (86,457) 7,118 (4,513) • Wide use of “Workouts” • A total of 76 firms became targets of workouts • 27 of the top 70 chaebols (including 12 Daewoo firms) <Table 4> Debt adjustment plan and result of workout firm (Unit: Billion Won) Note : ( ) is the result of the workout plans Source : Financial Supervisory Commission

7. Book value (as of June. 1999) After First Investigation (as of August. 1999) After Last Investigation (as of December. 1999) Asset (A) Debt (B) Net asset (A-B) Asset (A) Debt (B) Net asset (A-B) Asset (A) Debt (B) Net asset (A-B) 91,893 77,768 14,126 61,231 86,818 -25,587 59,747 88,991 -29,244 <Table 5> Financial State of the DAEWOO Group (Unit: Billion Won) • New criticisms that came up recently • It is hard to trust the accounting books of bankrupt firms • It is hard to figure out the true financial state of bankrupt firms even after several months’ study by professional accounting or consulting firms. • Composition is used by dominant shareholders of large debtor firms mainly as a way to maintain control of the firms.

8. 2.Changes in insolvency proceedings in recent years • Introduction of the Economic Criterion Test in the reorganization proceeding • If the liquidation value exceeds the going-concern value, the court must dismiss the petition for commencing the corporate reorganization proceeding. • The court may order drawing up a reorganization plan designed for eventual liquidation of the firm if it finds that the liquidation value exceeds the going-concern value after the commencement of the proceeding. • Expedited the reorganization process • The court should render a decision on whether to allow provisional protection order within 14 days • The court should render the decision on whether to commence a reorganization proceeding within one month (It used to take more than 5 months before.)

9. The court is required to discontinue the case in case no reorganization plan has been drawn up and granted by the court within one year of the day the commencement decision was rendered. • The period during which rescheduled debts are paid in a reorganization plan should not exceed 10 years. (It was 20 years before) • Expedited the composition process • The court is required to make the decision on whether to commence the proceeding within 3 months. • Shorten the period needed for the commencement from 3 months to 1. • Eased the conditions for commencement.

10. Creation of the Management Committee within the court • The committee advises and aides the court on various matters in both reorganization and composition proceedings. • The committee consists of experts in finance, business, or economics • Mandatory sentencing of “bankruptcy” when reorganization fails under certain circumstances • The court is required to sentence the firm to be “bankrupt” in case a reorganization plan fails to acquire the approval of the court. • The court is required to sentence the firm to be “bankrupt” in case it orders the discontinuance of the reorganization proceeding. • Allow split of a firm in reorganization to induce efficient reallocation of the resources • Merger of one of the entities created by such split with another firm is also allowed. • Mergers were allowed, but not splits in the past.

11. Switch between the proceedings made easier • Some of the information collected at the previous proceedings can be legally utilized by the judge presiding over the “bankruptcy” case, when mandatory sentencing of “bankruptcy” occurs during reorganization or composition. • The court is taking a more stringent approach to reorganization and composition • The court applies the Economic Criterion Test more strictly. • The court requires reorganization plans to be feasible. • The court generally does not allow composition to large firms.

12. File for Commencement Dismissal Court may sentence “Bankruptcy” Commencement Mandatory sentencing of “Bankruptcy” by Court Discontinuance Reorganization designed for eventual liquidation <Flowchart for Reorganization Proceeding, focusing on the Economic Criterion Test> If l.v. > g.c.v. If l.v. ≤g.c.v. Report by the Trustee If l.v. > g.c.v. If l.v. ≤g.c.v.

13. Drawing up of a Reorganization Plan Mandatory sentencing of “Bankruptcy” by Court If l.v. > g.c.v. Discontinuance If l.v. ≤g.c.v. Disapproval Discontinuance Mandatory sentencing of “Bankruptcy” by Court Approval If the Plan is found to be infeasible Mandatory sentencing of “Bankruptcy” by Court Discontinuance otherwise Conclusion * l.v. : Liquidation value, g.c.v. : going-concern value

14. 3. Workouts • Mixed results • Massive bankruptcies of large firms have been avoided, and systemic risks reduced. • Heavy costs to major creditors and to taxpayers. • Inefficient corporate governance persisted and aggravated the situation. • Large scale asset-stripping activities occurred in some cases. • Daewoo Motors • Dong-A Construction

15. 4. Future challenges • What’s wrong with the current system of insolvency proceedings? • The 3 acts do not seem to have serious defects. • The court is quite competent although it needs more judges with expertise in bankruptcy cases. • The biggest problem is the inability of the banks to play a proper role as the main creditors in bankruptcy cases. • Distorted corporate governance of large debtor firms is also a serious problem. • Workouts suffer from the weak legal framework. • Why do so many large firms go bankrupt? • Chaebol system and the industrial policies that depended on the chaebol system • High leverage, low profitability

16. Distorted corporate governance of the chaebol firms • Weak governance of banks and the other creditor institutions • Weak financial supervision • Reform in the corporate governance of creditor institutions is the key • Making creditors act as creditors, maximizing their economic goals. • Prudential supervision needs to be strengthened. • Reform in the corporate governance of large firms is also crucial • Need to make large firms behave in ways that are consistent with the maximization of the shareholders’ values in choosing their financial structures, in pursuing risky projects requiring large investments. • Need to make them reveal their financial troubles early.

17. Reform in the corporate governance of the firm in reorganization is important • Need to let the firm maximize the economic value • Large-scale debt equity swaps are necessary • The court should try to sell the firm to a third party and get out. • If the sales take time, the court is the only corporate governance agent that can be trusted and relied upon during the transition period.