A DRAFT Corporate Rehabilitation Act (‘draft CRA’), based on Chapter 11 of the US Bankruptcy Code, has been in circulation in Pakistan for over a decade.

Methods of corporate rehabilitation, available worldwide, follow two generic models. The first model consists of rehabilitation arrangements that seek the consent of clearly delineated broad classes of creditors and the debtor with minimal recourse to the courts. Existing security priorities are preserved and the parties are encouraged to arrive at a mediated resolution out of court.

The courts help in the supervision of creditors’ and debtors’ meetings and in ensuring overall fairness of the outcome to all. This approach to corporate rehabilitation is reflected in the Company Voluntary Arrangements (CVA) envisaged by the UK Insolvency Act. This broad approach is also followed in other common law jurisdictions such as Canada and Australia.

The other model of corporate rehabilitation is that of Chapter 11 of the US Bankruptcy Code. This approach, as adopted in the draft CRA, relies on faithful financial reporting as well as the commercial savvy of the judicial system in permitting the courts to enforce a rehabilitation plan even on an unwilling majority of creditors in a given class.

The process is debtor-driven with judicially enforceable entitlements created in favour of the defaulting debtor that override the debtor’s contractual obligations to creditors. These entitlements include downgrading of the security priorities of existing creditors, release of personal guarantees and the debtor’s right to have a part of debt written-off as unsustainable on the basis of projected cash flows.

A key feature of the US Chapter 11, adopted by the draft CRA, is the automatic stay of all recovery proceedings against the debtor merely upon the debtor filing a petition for rehabilitation before the court. The stay applies to the recovery of taxes as well as utility bills owed to electricity and gas suppliers. Also stayed are claims of trade creditors who might have unpaid invoices for raw materials provided by them to the debtor.

The corporate and judicial contexts in which the debtor-driven, court-centric US Chapter 11 functions are vastly different from those in other developed countries where moves to adopt the US model have been consistently rejected. A recent UK white paper on resolution of corporate distress as well as a comprehensive study commissioned by the Australian corporate regulator came to the conclusion that successful application of a law based on the US Chapter 11 requires a degree of judicial sophistication not available in the United Kingdom or Australia. Several World Bank reports have reached the same conclusion.

In the US itself, Chapter 11 proceedings are frequently criticised for their average time span of four to five years. The CRA proposed for Pakistan provides for certain timelines that are never likely to be met in practice. Pakistani courts have repeatedly held that time limits on judicial proceedings are only directory in nature and not mandatory.

Given the multiple appeals allowed by the draft CRA, the average length of any proceeding before the courts is likely to easily exceed five years. In the US context, the recourse to Chapter 11 proceedings is a painful decision for the management in that the shareholders are likely to seek a rolling of heads. The shareholders in turn lose their equity in the company.

In Pakistan the majority shareholders, the board and the management effectively consist of a common set of individuals. Consequently, the management and the board have nothing to fear from the shareholders. The shareholders stand to gain, at the expense of the company and its creditors, from a successful proceeding in terms of the draft CRA. Consider.

While the draft CRA is clear about the release of existing personal guarantees it is not clear about the fate of the shareholding of existing shareholders. If their shareholding is to stand extinguished along with vacation of their personal guarantees a set of highly perverse incentives is created by the draft CRA for the existing shareholders who are also guarantors of the company’s liabilities.

Once these shareholders/guarantors know that they can simply walk away from the company with no lingering liability enforceable against their personal assets it makes sense for them to propose an optimistic rehabilitation plan that the creditors will accept whether or not such a plan would ultimately be sustainable given the future realistic cash flows of the company.

On the other hand, if existing shareholders/guarantors are to retain their equity interest in the company while being relieved of their personal guarantees, it would make sense for them to propose a rehabilitation plan based on an overly pessimistic view of the future cash flows of the company.

In the event of the creditors not accepting such a plan, which invariably would require a significant write-off, the debtors would be able to use the inordinate delay inherent in the Pakistani judicial system to keep the creditors hanging while their debt recovery efforts, including decreed cases, remain stayed on account of the automatic stay provided by the draft CRA.

Given the realities of Pakistan, and the fact that over the years various creditor steering committees have tackled the resolution of large defaults out of court, what is needed is a streamlining of the emerging rehabilitation framework, not a plunge into the unknown.

The writer is a Supreme Court advocate