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The theory of restructuring: Are the workouts working?

This paper was given at The Economist Conferences – Thailand Regional Forum: bank and Corporate restructuring

In light of the limited time available today, I would like to make the following brief points which will touch on a number of areas in the hope of stimulating discussion in the question and answer session which will follow.

Law reform is not in itself enough

The Thai legislators reacted well to the Asian economic crisis. The introduction of the new rehabilitation law and other reforms where significant moves to make the insolvency related laws in Thailand more efficient, practical and relevant to the economic reality facing Thailand post crisis. Whilst aspects of the reforms such as the so-called new foreclosure law were illusions promulgated by the legislator and recklessly marketed by the international press, the sense of the legislator was clear in implementing, as the crux of insolvency related reforms, a rescue package (i.e. the rehabilitation law). That said, there remains a failure to attack some of the fundamental deficiencies in Thailand’s law and practice including the inefficiency of the Civil courts.

However, law reform will not of itself necessarily create efficient and effective practice or create a corporate recovery culture. Anyone who has operated in Thailand will know that practice may well differ substantially from the written letter of the law. Moreover, the practice of government departments in ignoring or simply choosing not to apply some difficult or outdated laws, rather than seeking amendments to or abolition of the relevant law, only results in the rule of law declining and thereby limiting the possibility of law reform successfully affecting practice.

Creditors and, in particular, debtors will not utilise an insolvency regime, regardless of how efficient it is or the number of insolvencies at that time, unless there is some incentive to utilise the insolvency system and there is a recovery culture accepted in the market place. This has certainly been the experience in Thailand to date where despite the introduction a new rehabilitation law in April 1998, there have only been a limited number of formal rehabilitations despite the fact that NPLs have only recently dropped below 40% of outstanding credits.

What is needed to ensure that the insolvency regime is utilised are clear incentives or triggers to entice debtors and creditors to utilise the system. In Australia, for example, the voluntary administration procedure introduced on 23 June 1993 (which is broadly similar to Thailand’s rehabilitation law except that the court is not as entrenched in the process), instituted very clear incentives for directors of insolvent companies to have prompt recourse to the voluntary administration system. At the same time as the voluntary administration procedure was implemented, a new regime was introduced imposing civil and criminal personal liability for directors of insolvent companies who continue to trade whilst insolvent. The new insolvent trading liability scheme allowed directors to avoid personal liability by providing them with a defence if they acted promptly to appoint a voluntary administrator. This defence recognised that in handing over an insolvent company to an independent administrator the director was taking the most honourable of steps, acknowledging the position of the company and seeking to protect the interests of the true stakeholders of the company at that time, the creditors.

In addition, the taxation laws in Australia were amended in 1993 to provide for personal liability for directors for unpaid group taxes if the directors failed to appoint a voluntary administrator within a specified of period following receipt of a penalty notice from the taxation authorities. This procedure has, in Australia, been the trigger, in a practical sense, for many voluntary administrations, which have now become, by far, the most commonly used insolvency procedure.

In contrast, the rehabilitation procedure in Thailand has only been utilised in a limited number of cases despite there being a wealth of insolvencies. The reason for this would seem to be the absence of similar incentives or triggers to utilise the procedure coupled with the stigma of admitting insolvency.


The misreporting of the TPI judgment

In one of the first non-consensual rehabilitation petitions filed with the newly established Central Bankruptcy Court, the court’s conclusion that Thai Petrochemical Industry Public Company Limited (“TPI”) was insolvent was seen by many, certainly in the international press, as an indication that the Thai courts had accepted the cash flow test of insolvency and that this test would be applied in future cases. This is, sadly, far from accurate.

Under the Bankruptcy Act it is clear that the relevant test of insolvency in Thailand is, and will remain so following the TPI judgment, the balance sheet test of insolvency (i.e. whether liabilities exceed assets).

Importantly, the TPI judgment does make it clear that the signing by a debtor of a Debtor Accession under the CDRAC process and the issue by the debtor of terms sheet and proposed restructuring plans can be considered as amounting to a proposal by the debtor to compromise its debts with two or more of its creditors. This raises a presumption of insolvency under the Bankruptcy Act. To rebut this presumption the debtor must prove that it is in fact solvent by introducing evidence to show solvency. In the TPI case the court did not accept the debtor’s submission of accounts showing that its assets exceeded its liabilities as the accounts had not been audited by a public certified auditor and thus the court felt that they carried little weight and did not defeat the presumption of insolvency which had been raised.

The next portion of the judgment is the portion which has been misreported and its misunderstood by many. It has been suggested that the court then went on to apply a cash flow test of insolvency. It did not. It did not ask if TPI was able to pay its debts as they fall due – this is the cash flow test.

The cashflow test of insolvency is used in many modern economies in the world. It has recently been suggested that Thailand should implement this test as the test of insolvency for bankruptcy cases and perhaps a lower threshold for rehabilitation cases(such as a test requiring only an expectation of an inability to pay debts as they mature as is the case in Indonesia, or the Singaporean test which requires that a company is or will become unable to pay debts as they fall due). I strongly agree with these suggestions.

Whilst I prefer the cash flow test, Thailand’s insolvency system can function without it. The test of insolvency is important because it is used as the door to determine which companies will be able to enter into or be placed into the bankruptcy and rehabilitation procedures. Once one accepts that Thailand has made a policy decision to apply a balance sheet test of insolvency (that is, it has decided to apply a high entry standard), I believe that the system can function adequately within its own limitations providing the test is properly and intelligently applied. However, this may be difficult to achieve. The balance sheet test can be distorted if inadequate accounting standards or misleading or manipulated valuations of assets mean that evidence before the court is not necessarily representative of the true fair market value of a company’s assets or an accurate statement of its liabilities. The balance sheet test can lead to delays in hearings, as detailed and often expensive evidence will need to be lead about asset values with different expert valuers having different views. I am sure that the Bankruptcy Court does not consider itself to be expert in the valuation of assets and therefore it must weigh expert valuation evidence before it – an unenviable task. The balance sheet test also invites corruption and manipulated valuations. This all makes the balance sheet test a rather unpredictable test and a difficult test for the courts to apply in a transparent and fair manner.

In the TPI case the court’s assessment of the evidence before it was proper and intelligent. However, this is no guarantee of similar results in other cases and should not in my view be viewed as an indication of a predictable approach to the application of the balance sheet test in future cases. The nature of the test means that it is difficult to apply in a predictable manner.

In the TPI case the court applied a balance sheet test of insolvency, not a cash flow test. In applying the balance sheet test, it accepted that the assets in question could best be valued by applying the discounted cash flow method of valuing assets. That is, it accepted that the fair market value of assets in the petrochemical business could be assessed by utilizing the discounted cash flow method of valuation in comparison to a forced sale value of the assets, and utilizing net realizable values for other assets. The court was not concerned that the valuer had not visited the site or interviewed management as the valuation utilized cash flow projections prepared by the debtor’s management which the court said are normally prepared in an optimistic manner by the debtor. The court did not accept criticism of the valuation by the debtor’s witnesses because that evidence assumed that the serviceable life of the plant was very long in contrast to other evidence submitted by the debtor which indicated that the plant’s serviceable life was not more than 30 years. Thus, the court concluded that the debtor was insolvent as a presumption of insolvency was raised and the debtor could not introduce credible evidence to rebut the presumption and the valuation evidence produced by the five petitioning creditors.

The TPI judgment appears to be an indication that the Central Bankruptcy Court will apply the balance sheet test sensibly by valuing assets on a discounted cash flow basis if credible valuation evidence is submitted to the court. However, the judgment is not an indication of a shift to a cash flow test of insolvency. It is possible for a company to be solvent on a balance sheet test (even if assets are valued on a discounted future cash flow basis) but insolvent on a cash flow test (i.e. it is unable to pay debts as they fall due from a liquidity perspective).

Despite my support for the introduction of a cash flow test in Thailand (and possibly a lower test for entry into rehabilitation – if the legislation requires that a company wait until it is, without doubt, insolvent before allowing it to enter rehabilitation, the company may be left waiting too long if the goal is to rehabilitate the business), it remains my view that neither the cash flow test or the balance sheet test are in themselves perfect tests of insolvency. In some countries, the courts apply both tests but have also in recent times moved to consider insolvency with an overarching sense of commercial reality. This feature is something that can only work in an economy with a developed insolvency system. Insolvency is in reality a moving picture rather than a snapshot of a company’s position at any one time. It seem to me that the preferable approach, in an ideal world where transparency, independence and integrity are assured, is to apply both tests of insolvency as appropriate with an overarching sense of commercial reality in assessing the company’s true position.

However, in Thailand today, my view is that predictability is what is really needed. If creditors and debtors are able to accurately predict how the court will assess the question of solvency this will have a significant impact on the progress and quality of restructurings as parties will understand with greater certainty their bargaining positions. Predictability can be an illusion in a civil law country where courts are not bound by earlier decisions; however, significant comfort should now be able to be drawn from the existence of a specialized bankruptcy court to consider bankruptcy and rehabilitation cases and it is hoped that there will a consistency of approach from the court in similar cases.


Are the reschedulings all that bad?

It is regretful that:

  1. Many restructurings in Thailand are nothing more that reschedulings of debts. Many restructuring plans do not truly focus on the viability of the business; rather, they are simply a rescheduling of debts with no real expectation that the debtor will be able to comply with the rescheduled debt reduction program in particular the significant balloon payment which is a common feature of many restructurings.
  2. Many rehabilitations under the Bankruptcy Act do not result in the debtor’s business being rehabilitated and it continuing in existence with a fresh start, free and clear of unsustainable debt.
  3. Debt to equity swaps are being used as a mechanism for creditors to avoid having to write off their lost investment. There is justification for a debt to equity swap if there is perceived to be some possibility that the shares in the insolvent company will, one day, have value. However, in some restructurings, this is not the case – the debt for equity swap can be simply a mechanism to hide the lost investment for a few years as there is no real expectation that the company will be able to comply with its restructuring plan.
  4. Creditors use restructuring negotiations as means of extracting additional security, equity or fees when they are not truly committed to the long term restructuring contained in the restructuring plan in which they extracted that additional leverage or profit and do not expect that the debtor will be able to comply with the plan.
  5. Many planners appointed under the rehabilitation procedure are not independent of the debtor. The phenomenon of the debtor nominating a related party, a subsidiary or even itself as the planner brings into question the integrity of the rehabilitation procedure. It entirely ignores an underlying philosophy or objective of any respectable rescue package which is to allow an independent party to take control of the business for a limited time, investigate its affairs and design a reorganisation plan that has regard to the interest of all relevant stakeholders. The role of an independent party is even essential in prepackaged plans (i.e. where the rehabilitation is used a mechanism to implement a plan preagreed by a majority of creditors) in order to protect the interests of minority creditors. I am not opposed to special purpose vehicles or joint planners so long as the role of an independent party in those arrangements is entrenched and the arrangement is structured so that the independent party’s independence is preserved and it retains ultimate control of the debtor, at least during the plan preparation stage.
  6. The Bank of Thailand has only recently begun to speak loudly about the quality of restructurings when many of us were calling the spade a spade (the spade being a rescheduling) from the middle of 1998, if not earlier.
  7. The FRA has still not been able to distribute proceeds to most creditors from its internationally publicised auctions and is now pushing many of the suspended finance companies into bankruptcy, which will probably prolong the creditors wait for their money.
  8. There has not been a coherent strategy to restructuring in the banking industry. The fact that many important Thai banks have different approaches to restructurings, different goals in the short and medium term and are at materially different positions in relation to their own restructuring, has meant that they come to the restructuring negotiating table with very different perspectives. Add to this some AMC which struggle to communicate and/or act consistently with their own objectives and the restructuring negotiating table can be a messy one.

Having regard to the above and a number of other regrettable aspects of the way restructurings have developed in the last few years, the question becomes whether the restructurings have been a success or failure. This can only be assessed by reference to what the objective, from a macro perspective, has been over this time. On this issue I would be delighted to hear the thoughts of those in the audience today.

For my part I can say this. Often in restructuring, there is an initial period called a moratorium where things are frozen or stayed. The reschedulings might be viewed as an extension or adaptation of the moratorium. As one banker said to me, “we will do the rescheduling now and then do the restructuring next time they default”. If the macro objective since 1997 has been to achieve stability, at least in the short term, as well as satisfying stated requirements of the international agencies that assisted Thailand following the crisis, then restructuring has been a success.

Grudgingly, I am now coming to accept that the reschedulings may serve a useful purpose. The sad aspect is that many of them are drafted and agreed by stakeholders, knowingly or ignorantly, as fictions (i.e. drafted and agreed as if the parties expect the debtor to comply, for example, by paying the interest deferred in the first few years in later years and being able to make the 85% bullet payment in the last year of the term).

If what is really intended is an extended moratorium, with additional security and fees being paid by the debtor during the moratorium period, then this is how the deals should be framed.

The nonsense is when any restructuring regardless of its quality (i.e. even if it is an unachievable rescheduling), is allowed to permit the loans to be reclassified as performing. This, rather than the rescheduling itself, is what will haunt Thailand in the years to come.