Transcript Slide 1

CORPORATE REHABILITATION ACT (CRA)
– BACKGROUND, CONCEPTS AND LEGAL
ARCHITECTURE
Salman Ali Shaikh
January 2009
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INSOLVENCY SYSTEMS AND RISK
MANAGEMENT: CONCEPTUAL ISSUES

The creation of an effective insolvency regime is a successful
interplay of three key elements: design, legislation and
implementation.

The government needs to understand that it is the ultimate risk
manager (David Ross: Harvard Business School).

The development of a modern insolvency system gives the
government the ability to manage risk by reducing and/ or allocating
risk to different segments of the market and society. The CRA gives
the GoP a very powerful tool in terms of economic policy.

The creation of a transparent system with predictable outcomes
greatly enhances long-term capital formation and promotes FDI (e.g.,
China).
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INSOLVENCY SYSTEMS AND RISK
MANAGEMENT: CONCEPTUAL ISSUES (Cont’d)




Universal “best practices” (e.g., UNICTRAL: Legislative Guide on
Insolvency Law) are never best everywhere – they are “best” only in
specifiable circumstances. However, they do provide a very useful
road map.
Due consideration needs to be given to the structure (present and
desired) of the national economy, legal and “cultural” impediments,
etc.
Economic cycle issues – i.e., when the liquidation values of
companies are greater than the going-concern value, you do not need
an insolvency system. You merely need to tighten your recovery laws,
systems and procedures.
The need for a corporate rehabilitation law in Pakistan. Urgently
needed because corporate debt has been growing (at 10% - 12% p.a.)
and liquidation values have been declining at the same rate for the
past several years.
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INSOLVENCY SYSTEMS AND RISK
MANAGEMENT: CONCEPTUAL ISSUES (Cont’d)

The compound effect of these two simultaneous processes does not
need a graph to visualize. The liquidity gap (going-concern basis)
doubles every 6-7 years.

3 key elements re-stated: design, legislation and implementation. Two
elements (design & implementation) have been lacking in all the legal
enactments since 1997.

The proposed CRA is an attempt to correct all imbalances created by
these enactments.

The fourth key element in insolvency is time. In insolvency the
consequences of a few “mistakes” (errors of judgement) are minor
compared to the costs of delay.

Therefore, a significant part of this presentation will focus on the
design (i.e. the legal architecture) of the proposed CRA.
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INSOLVENCY SYSTEMS AND RISK
MANAGEMENT: CONCEPTUAL ISSUES (Cont’d)

Enacting a law is relatively easy. Making it work (i.e., implementation)
is often very difficult.

Political will is crucial. Specialized laws need a state-of-the-art
enabling environment to deliver results. Capacity-building and
institution-strengthening.

During the designing process we had to ask ourselves three very
basic questions.





Where are we??
Where do we want to be??
How do we get there??
Basically the desired outcome(s) should determine the design of the
law.
“The function must determine the form” (Walter Gropius: Bauhaus
school of architecture).
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GROUND ZERO: WHERE ARE WE???


Since 1997, there have been random mood swings on a national basis
between the desire for “recovery” (of bank debt) and the aspiration to
“revive” (sick industry).
However, in terms of legislation, “recovery” became an obsession.

The (essential) balance between debtors and creditors rights were
sacrificed for this cause.

The CRA has been designed to achieve both objectives while
maintaining a balance between debtors and creditors rights.
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Successive waves of creditor-friendly laws were enacted – e.g., the
Recovery Act 1997, NAB Ordinance 1999, CIRC Act 2000 and the
Recovery Act 2001.
Inspite of this onslaught, NPL continued to remain at high levels.
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GROUND ZERO: WHERE ARE WE??? (Cont’d)
Non-Performing Loans (NPL’s) of the Banking System (Rs. in Billion – i.e.,
in Column 2).
Year
NPL’s
NPL’s to Loans
Provisions to NPL’s
1997
173.0
23.5%
46.6%
1998
183.0
23.1%
58.6%
1999
230.7
25.9%
48.6%
2000
240.1
23.5%
55.0%
2001
244.1
23.4%
54.7%
2002
231.5
21.8%
60.6%
2003
211.3
17.0%
63.9%
2004
199.7
11.6%
70.4%
2005
177.4
8.3%
76.7%
2006
175.5
6.9%
77.8%
2007(Provisional)
205.7
7.5%
79.2%
Source: State Bank of Pakistan
NOTE: There are concerns about data integrity owing to conceptual and methodology – related issues – e.g.,
two regulators, NPL at CIRC, facility-based classification, accounting implications of Recovery Act 1997/
Recovery Act 2001, etc. While the figures of NPL in the banking sector are probably reliable, the overall
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figures for the “financial sector” are significantly higher, and are not quantified (at present).
GROUND ZERO: WHERE ARE WE??? (Cont’d)
Trend Non Performing Loans
Effect of SBPs BPD circular
No.29 of 2002
300
200
150
NPL
100
50
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
0
1997
PKR(billion)
250
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GROUND ZERO: WHERE ARE WE??? (Cont’d)
Provisions and NPL's Over Years
NPLs to Loans
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
Provisions to
NPLs
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GROUND ZERO: WHERE ARE WE??? (Cont’d)
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In 2002, in recognition of the failure of CIRC, NAB and CIRSU to make
a significant contribution on the NPL front an “administrative” (i.e., an
amnesty scheme) insolvency solution was resorted to.
The SBP issued “guidelines” (effectively a directive) whereby banks
were “actively encouraged” to settle NPL with borrowers at the FSV
(forced sale value) of the under-lying collateral.
This step (taken out of desperation/ frustration) has had the desired
results – obviously!!!.
Administrative insolvency and similar “one size fits all” solutions have
the advantage of being fast-track.
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GROUND ZERO: WHERE ARE WE??? (Cont’d)
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
Final (“hard”) numbers relating to SBP’s FSV scheme have been
requested. However, as per preliminary figures, around Rs. 125 billion
of NPL had been settled at the cost of Rs. 75 billion in terms of writeoff’s (provisions used) – a very low write-off efficiency ratio.
The costs (quantitative and qualitative) of these positive outcomes are
high. Some of these “costs” are as follows:1. Admission of failure:
Periodic recourse to these “one-time amnesty” and “incentive”
schemes is a de facto public admission that in the areas of
insolvency, corporate rescue, etc., the legal system has effectively
collapsed.
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GROUND ZERO: WHERE ARE WE??? (Cont’d)
2. Heavy guzzler of provisions:
In the late 1990s, smart banks/ bankers were making aggressive
one-shot settlements with borrowers at values ranging from P+25%
to P+50% - at a time when Pakistan’s economy was very weak. It
is a pity that now (with high GNP growth rates) distressed assets
are being settled at values as low as P-75% to P-25%!!!.
3. The problem with the FSV concept:
It is an arbitrary figure which assumes that all NPL is on a
liquidation basis (i.e. not a going concern). The amount of
provisions used (i.e., write-off’s generated) could have been
substantially reduced by using the concept of sustainable debt. The
methodology for using this concept was available – i.e., HBL’s EDR
(excess debt recovery) product/ scheme (P+25%) – presented to the
GoP in 1999.
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GROUND ZERO: WHERE ARE WE??? (Cont’d)
4. The mechanics of determining FSV:
Under SBP’s guidelines, FSV is determined by evaluators, an
“unregulated profession” (capacity building issue). Enormous
power has been granted to evaluators. Anecdotal evidence
suggests that these powers have been abused/ misused.
5. “Sickness worthy of revival”:
Not all companies are worth reviving – e.g., inefficient, obsolete
technology, etc. In fact, owing to competitive disadvantages,
sometimes entire industries can be considered to be “unworthy” –
e.g., textile products in North Asia, sugar in Pakistan, etc. Amnesty
schemes (that are not based on financial data) cannot make such
distinctions.
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GROUND ZERO: WHERE ARE WE??? (Cont’d)
6. Amnesty schemes protect inefficient managements:
Very often the root cause of sickness is the management. In such
cases, a change of management can convert sick entities into
healthy companies.
7. Moral hazard:
Such schemes promote the “default culture” and have a cumulative
effect that can last for decades.
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CORPORATE REHABILITATION ACT: THE
OPERATING ENVIRONMENT
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By 2003, it had become clear that the “hard” approach towards the
NPL problem was not working.
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The two recovery laws were being administered by incompetent
“specialized” banking courts. Both these laws are conceptually
unsound as they permit accrual on NPL (non-accrual loans).

CIRC had failed to develop any appetite and/ or capacity for debt restructuring and chose to act purely as an auction house. “CIRC has
had a very limited success in clearing up balance sheets of the
financial institutions” (World Bank Report – 2003). Fortunately, CIRC
has a mandated “expiry date”. Any extension granted would defy logic
and common sense.

NAB had effectively abdicated the NPL field owing to its initial failures,
inappropriate staffing and inherent defects in its law.
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CORPORATE REHABILITATION ACT: THE
OPERATING ENVIRONMENT (Cont’d)

CIRSU (Committee for the Rehabilitation of Sick Industrial Units) was
created through a notification by the MoF in 2000. It has chosen to act
as an “arbitration window”, and has not developed any capacity to
undertake deep (i.e., operational) restructuring. Typically a debt is rescheduled (often cosmetically) and “revival” is declared. The MoF
should actively consider its closure.
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CORPORATE REHABILITATION ACT: LEGAL
ARCHITECTURE

We considered three alternative models, while drafting the CRA,
namely:


An empowered administrative body (the Indian model).
Judicial administration (the English model).
Chapter 11 (the American model).

The need to have a system with elements of both re-organisation and
liquidation was a key concern. Re-organisation without effective
liquidation creates a very unbalanced insolvency system. “If
liquidation provisions are not credible, then bankruptcy law doesn’t do
its work; if re-organisation provisions are not practicable, then
companies are liquidated unnecessarily. Uncertainty results in either
case”.

The merits of creditor–in-possession models versus debtor-inpossession models were also debated. We opted for the latter, for
value-maximization reasons.
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CORPORATE REHABILITATION ACT: LEGAL
ARCHITECTURE (Cont’d)

The lack of judicial expertise, the total absence of relevant
professional bodies (e.g., administrators, receivers, liquidators,
evaluators, etc.,), and “insolvency desires” created by the GoP’s
amnesty schemes were viewed as key risks by us. Appropriate risk
management measures have been built into the CRA. Several
innovative ideas were developed by us after examining 10-12 nonOECD jurisdictions. The Mexican insolvency law (and related
institutions/ structures) were particularly useful.

Administrative models. We have been down this road before (i.e., the
H.U. Beg Committee) – it does not work.

In India, under the SICA (Sick Industrial Companies Act) of 1984, a
Board of Industrial and Financial Restructuring (BIFR) was created.
BIFR’s decision-making processes proved to be more cumbersome
(and slower) than the courts. SICA, BIFR and all related structures are
being disbanded.
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CORPORATE REHABILITATION ACT: LEGAL
ARCHITECTURE (Cont’d)

To be effective, an insolvency process requires the pro-active
participation of both the “interested” parties – i.e., debtors and
creditors.

In the administrative model, this key feature is missing. A group of
“disinterested” bureaucrats cannot be considered to be credible
stake-holders in an insolvency process.

The English model:

A widespread suspicion about the underlying motives of debtors led
to consideration of the English Model, involving “debtor-eviction”. The
perceived advantage was “contested entry”, which was seen as a
method to remove the possibility of countless frivolous insolvency
petitions. A further advantage was management by a judicial
administrator who would also prepare the rehabilitation plan for the
court.
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CORPORATE REHABILITATION ACT: LEGAL
ARCHITECTURE (Cont’d)

The key hurdle in adopting this model is Pakistan’s lack of competent
administrators who could perform such functions under the law.
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Another hurdle was that a contested entry system would add an extra
layer of litigation, causing unnecessary delays to the process.

The Australian CVA (Corporate Voluntary Administration) was also
looked at. CVA also has the same implementation issues as stated
above.
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CORPORATE REHABILITATION ACT: LEGAL
ARCHITECTURE (Cont’d)

The American model (Chapter 11).

We have adopted the American model with significant modifications.
Our CRA has the following salient features:-

Entry into rehabilitation proceedings is a right. However, debtors must
consider such a step carefully because of the provision for automatic
conversion into liquidation in the event that no rehabilitation plan is
approved. Various quantitative tests for entry were considered, but
were discarded owing to the widespread use of “cooked” financial
statements.

The process is entirely stakeholder driven. Both the debtor and the
creditor(s) can file plans.

The entire process has been compressed with finite time-frames. For
example, the debtor has a maximum of one month after entry into
rehabilitation proceedings to file a plan. In fact, there are fairly
stringent time-frames throughout the whole process.
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CORPORATE REHABILITATION ACT: LEGAL
ARCHITECTURE (Cont’d)

The American model (Chapter 11) – Cont’d

In Pakistan, taxes, levies and government dues enjoy substantial legal
protection. Income tax, sales tax, and customs officers can “re-open”
cases several fiscal years later. In fact, bankers have often engineered
rehabilitation via a change of management or the induction of a new
entrepreneur only to be thwarted by extortionist claims for back taxes. In
the CRA, all such taxes and levies are classified as unsecured debts.
The idea is to move some of the costs of the inevitable losses away from
the banking system.

Treatment of stakeholder rights and priorities. The current system of
giving priority to un-secured creditors (e.g., state dues, taxes, wages,
provincial levies, utility bills, etc.) is archaic and not sustainable and will
have to be removed (IBRD/ UNICTRAL Insolvency Principle 16).

In the United States, the cram-down feature is a threat designed to force
consensus on a rehabilitation plan. In Pakistan’s context, we expect
fairly active use of this provision – at least, in the first few years before
case law emerges and the whole system develops maturity.
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NON-SPECIALISED JUDGES WILL DELIVER
POOR QUALITY JUDGEMENTS: HOW TO PLUG
THE KNOWLEDGE GAP??
“War is too important a subject to be left to the
generals.”
Winston Churchill, 1943
“Insolvency is too complex a subject to be left to the
judges.”
Salman, 1999
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NON-SPECIALISED JUDGES WILL DELIVER
POOR QUALITY JUDGEMENTS: HOW TO PLUG
THE KNOWLEDGE GAP?? (Cont’d)

The ideal legal structure would be specialized judges. Not possible in
Pakistan.

Likewise, a federal court structure would be preferable (e.g., Korea) as
corporate groups operate in 2-3 different legal jurisdictions. Not
possible.

We had to ensure that two key ingredients are present (i,e., speed and
predictability) inspite of the above limitations.

We have achieved this by building into the CRA a multi-disciplinary
vision - the judiciary is only one component.
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NON-SPECIALISED JUDGES WILL DELIVER
POOR QUALITY JUDGEMENTS: HOW TO PLUG
THE KNOWLEDGE GAP?? (Cont’d)

We have recognised the limitations of Pakistan’s “weak judicial capacity”
(where no specialised judges sit in the superior courts) by inserting a
provision, which establishes a three-man Advisory Committee
(comprising bankers, corporate finance specialists, etc.) to assist the
insolvency judge/ court. This committee should be an excellent resource
for judges that are unsure about the correct treatment of complex
financial issues. Furthermore, they should be able to offer lucid advice in
the likely event of several competing plans being submitted – particularly
when the new cram-down feature is being exercised.

In reality, the Advisory Committee will be the tail that wags the dog.

If appropriately selected, they will be the real decision-makers with the
judge ratifying and “sanctifying” the decision. This concept is called “prepackaged” insolvency – it has been used in several jurisdictions to fasttrack legal proceedings.

On capacity-building issues, we have drawn extensively from Mexico
(Insolvency Law of 2000) where several “ground realities” are similar to
Pakistan.
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THE RISK MANAGER MUST GET OFF THE
FENCE

As stated earlier, the government is the ultimate risk manager.

The vast majority of the comments received from MoF relate to costs.

It is unfair to pose these questions to the author(s) of the CRA.

I have tried to demonstrate that the current system and structures are
not workable. They cannot be tweaked.

The GoP must choose between two divergent paths.
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THE RISK MANAGER MUST GET OFF THE
FENCE (Cont’d)

Choice 1: to invest in a modern insolvency system by adopting the
CRA and closing all other “insolvency windows” – i.e., CIRC, CIRSU,
NAB, etc.

The cost is several billion rupees.

Choice 2: no change.

The cost is un-predictability plus billions of rupees spent on ad-hoc
measures – i.e., periodic financial sector re-capitalisation and
corporate bail-out schemes.

Whichever path is adopted, getting off the fence would be a useful
starting point.
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