Corporate insolvency and rehabilitation
In the recent past, one has witnessed random mood swings between the desire for “recovery” of bank debt and the aspiration to “revive” sick industry. Thus the balance between the rights of debtors and creditors has been disturbed. This can only be redressed through a modern insolvency regime.
The need for a corporate rehabilitation act arises because the financial and social value of a going concern is normally greater than its liquidation. A company has a value far greater than the sum of its assets. Businesses should continue to function even at the expense of some creditors.
However, leaning too far in favour of defaulting businesses, will force banks either to stop lending or start charging higher interest rates. It is the job of a good bankruptcy law to balance these competing interests. And it is from this angle, of balancing the competing demands of creditors and debtors, that the consistent failure of the existing insolvency and recovery laws is most clearly visible. Insolvency laws: The existing corporate insolvency law provides for both liquidation and rehabilitation of bankrupt companies. The liquidation provisions are elaborate, accounting for 149 out of the 514 sections in the Ordinance. By comparison, not only are the rehabilitation provisions very limited in number (accounting for a total of six sections), but the provisions themselves are also very limited in scope.
The ordinance contains two distinct provisions on company rehabilitation. The first option, under Section 284, allows a company to present a scheme and make it binding on all creditors if that scheme is approved by a majority of the creditors accounting for 75 per cent or more in value of the company’s liabilities. In addition, Section 296 creates a special committee to deal with sick industrial units.
Both of these provisions have failed to deal with corporate insolvency. Since 1984, there are only 12 reported cases in which insolvent companies have used the provisions of Section 284 to deal with their creditors. So far as Section 296 is concerned, the committee has dealt with a total of 388 sick units, out of which it claims to have revived 196. According to a World Bank report, this committee has chosen to act as an “arbitration window”, and has not developed any capacity to undertake deep (operational) restructuring.
By comparison, the past two decades have seen repeated attempts to make the law more creditor-friendly, with the setting up of special banking courts in 1984. This was followed in 1997 with a comprehensive review of banking court procedures via the Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act, 1997.
Under this Act, companies which owed amounts to banks and other financial institutions were barred from contesting the claim of the bank unless the court gave permission to them on certain restricted grounds. This law allowed interest to be accrued on non-performing loans, which are, by definition (and international accounting standards) on a non-accrual status!!! The military takeover in 1999 then resulted in another push of the pendulum towards the protection of creditors’ rights.
The Musharraf government introduced the National Accountability Bureau Ordinance on November 16, 1999, in which, for the first time, the failure to pay back a bank loan was defined as a criminal act, punishable by up to 14 years in jail. This was then followed in 2000 by a new law which resulted in the creation of the Corporate and Industrial Restructuring Corporation (CIRC), a new state entity with wide-ranging powers to deal with insolvent companies and their debts.
Finally, 2001 saw the introduction of a revised law, the Financial Institutions (Recovery of Finances) Ordinance, 2001 for banking companies which featured a new provision whereby banks could foreclose and take possession of secured assets without enduring the hassle and delays of judicial proceedings.
It has become easier for banks and financial institutions to recover loaned amounts. And despite one of the most creditor-friendly legal regimes, the economic benefits failed to materialise. This is evident from the very generous debt forgiveness scheme introduced by the State Bank of Pakistan via BPD Circular 29 of 2002 which allowed debtors to settle their outstanding liabilities through payment of the forced sale value of their secured assets.
The levels of corporate debt are increasing rapidly (at 10-12 per cent per annum) while liquidation values have been declining at the same rate for the past several years. The fiscal space created through BPD Circular 29 has now run its course and non-performing loans (NPLs) are increasing once again. Thus the question before the regulators and the legislature is: does the problem merit a permanent solution or should the government continue to resort to ad hoc solutions?
The corporate insolvency, is one which will always be there and there is a home-grown permanent solution available in the form of the draft Corporate Rehabilitation Act (CRA). This law was drafted by the authors of this article and ratified by the Banking Law Review Commission (BLRC) in 2004. It has been with the government for the past four years.
Under BPD Circular 29, preliminary figures indicate that approximately Rs125 billion of NPLs was settled at the cost of Rs75 billion of provisions, a very low write-off efficiency ratio by any standard. In the late 1990s, smart banks were reaching settlements with their borrowers at values ranging from principal plus 25 per cent to principal plus 50 per cent. Under BPD Circular 29, distressed assets were settled at values as low as principal – 75 per cent. A part of this problem arose from the emphasis placed under BPD Circular 29 on the concept of Forced Sale Value (FSV). The first reason for the problem was that FSV was determined on a liquidation basis as opposed to on a going concern basis. Second, the evaluation of the distressed assets was determined by the valuer whose integrity, in many cases, was apparently not beyond reproach.
The question which then needs to be examined is, what is the CRA and how would it be beneficial?
Corporate rehabilitation law: While there is certainly an international body of best practices which can be referred to for guidance, such practices only provide a general overview. In order for any legislation to be fully effective, it must be tailored to fit the needs of the particular legal landscape and not just adopted without additional consideration.
While drafting the CRA, three different types of models were considered-- the English, the Indian and the American models.
Indian model: In India, the job of rescuing sick companies has been entrusted to the Board of Industrial and Financial Restructuring (BIFR). This is a model which has already been tried in the form of the H. U. Beg Committee.
The end-result of a committee-centred approach, in both India and Pakistan, has been an institution where sick companies go to die and where cases linger on for years before finally expiring. This approach has failed repeatedly and even in India, it is being discarded in favour of a modern insolvency law.
English model: The fundamental reason why the English model is not suitable is cultural: in order for a company to obtain relief under judicial administrator proceedings as precsribed under the English law, it is first necessary for the management of that company to petition the court to appoint somebody else to take over all management powers. That may be conceivable in a culture where corporations are professionally run and professionally managed but that is hardly the case in Pakistan. Instead, the vast majority of even large corporations are run by their owners. The chances of such owners/shareholders voluntarily giving up management control are minimal.
American model: The American model of bankruptcy law is the most successful and the most debtor-friendly regime of corporate solvency. The overall guiding philosophy behind the US Bankruptcy Code is the assumption that society’s best interest lies in giving the maximum possible opportunity for businesses to survive as viable entities. This is one of the main reason why America remains the most entrepreneurial and commercially successful nation.
Under the Code, a distressed company is allowed to retain its management during bankruptcy proceedings. Entry into bankruptcy is effectively uncontested and once bankruptcy proceedings commence, all pending litigation is automatically stayed. In addition, the debtor company can access fresh funds through what is called a “super-priority” loan, i.e. one which ranks higher in priority even than secured creditors, and is provided with a minimum period of 120 days to come up with a plan of reorganisation. That plan is normally required to be approved by a majority of creditors (holding at least two-thirds in value of the outstanding debts). In exceptional circumstances, the court may allow the plan even without the approval of the creditors (what is sometimes referred to as a “cram down” provision).
Corporate Rehabilitation Act: The most practical basis for developing a comprehensive solvency regime is the American insolvency system. On the other hand, no matter how well designed, the laws of another country cannot simply be picked up and transplanted into another legal environment without some attempt to take into account the particular requirements of that environment. The CRA therefore tries to tread a delicate line between adoption and adaptation of the Code.
The first decision that was made in the drafting of the CRA was to try and retain the language of the Code to the maximum extent possible rather than trying to rewrite the Code in simpler language. The reason for this was that an insolvency law is a complex document. If it is to be written from scratch, then there is a tremendous burden on the author to make sure that all the different bits and pieces match up together. Furthermore, starting from scratch would leave the judges implementing the law with little or no guidance in terms of case law. By contrast, retaining the language of the Code makes the burden of drafting very simple and more importantly, allow judges and lawyers access to more than a hundred years of jurisprudence in which practically every aspect of bankruptcy law has already been examined.
The second design choice made during the drafting of the CRA was to try and speed up the entire process of rehabilitation. The CRA therefore requires debtors to file a plan at the same time as seeking relief, gets rid of the exclusivity period (i.e., during which only the debtor can propose a plan) and requires the entire process to be completed within 90 days with extensions being allowed only under very limited circumstances. Furthermore, to encourage debtors to be reasonable, the CRA provides that if a plan of rehabilitation is not approved within the specified period, the company shall automatically be wound up.
Finally, the entire CRA was examined with a view to making it more successful. Because of the lack of both judicial and legal familiarity with proper insolvency regimes, the CRA provides for an advisory committee to which judges can turn if confronted with complex or unfamiliar financial issues. Furthermore, in order to encourage debtors and creditors to find common ground, the CRA provides for mandatory mediation before mediators who are also required to file a report before the court summarising the issues in dispute and giving their opinion for the consideration of the court regarding the validity of any plan proposed by the debtor.
In addition, the CRA contains an express provision allowing for banks and creditors wishing to exit early from the rehabilitation process to sell their rights to “vulture investors”, which is to say, investors specialising in purchasing and managing distressed assets. This would help to create a vibrant secondary market in the sale and purchase of distressed debt.
The CRA also specifically provides that government dues shall be treated at par with unsecured debt. This would facilitate revival of companies without having decades of accumulated government obligations to contend with. It also provides that those debts that are discharged through rehabilitation proceedings shall also discharge personal guarantees as well as liability under the wilful default provisions of the National Accountability Bureau Ordinance, 1999.
The CRA does not, by any means, represent the perfect solution to insolvency issues. However, it is a fully thought out and considered response which at present represents the best possible alternative to the current situation.
In the current scenario, time is of the essence. The government should immediately review and enact the CRA as part of the financial and economic reform measures being undertaken during the current budget debate.
Mr Salman Ali Shaikh (salmanshaikhpk@yahoo.co.uk), a commissioner at the Securities and Exchange Commission drafted the CRA with Mr Feisal Naqvi),an advocate of the High Courts (fhnaqvi@gmail.com. This article represents the personal views of Mr Shaikh.