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).

INSOLVENCY SYSTEMS AND RISK MANAGEMENT: CONCEPTUAL ISSUES (Contd)

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 (Contd)

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 (Contd)

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. 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.

GROUND ZERO: WHERE ARE WE??? (Contd)

Non-Performing Loans (NPLs) of the Banking System (Rs. in Billion i.e., in Column 2).
Year NPLs NPLs to Loans Provisions to NPLs

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007(Provisional)

173.0 183.0 230.7 240.1 244.1 231.5 211.3 199.7 177.4 175.5 205.7

23.5% 23.1% 25.9% 23.5% 23.4% 21.8% 17.0% 11.6% 8.3% 6.9% 7.5%

46.6% 58.6% 48.6% 55.0% 54.7% 60.6% 63.9% 70.4% 76.7% 77.8% 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 7 figures for the financial sector are significantly higher, and are not quantified (at present).

GROUND ZERO: WHERE ARE WE??? (Contd)

Trend Non Performing Loans 300 250
PKR(billion)

Effect of SBPs BPD circular No.29 of 2002

200 150 100 50 0

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
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NPL

GROUND ZERO: WHERE ARE WE??? (Contd)

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%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Provisions to NPLs

GROUND ZERO: WHERE ARE WE??? (Contd)

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??? (Contd)

Final (hard) numbers relating to SBPs 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 writeoffs (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??? (Contd)

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 Pakistans 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-offs generated) could have been substantially reduced by using the concept of sustainable debt. The methodology for using this concept was available i.e., HBLs EDR (excess debt recovery) product/ scheme (P+25%) presented to the GoP in 1999.
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GROUND ZERO: WHERE ARE WE??? (Contd)

4. The mechanics of determining FSV: Under SBPs 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??? (Contd)

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

By 2003, it had become clear that the hard approach towards the NPL problem was not working. 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 (Contd)

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 doesnt do its work; if re-organisation provisions are not practicable, then companies are liquidated unnecessarily. Uncertainty results in either case. The merits of creditorin-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 (Contd)

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 GoPs 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. BIFRs 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 (Contd)

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 (Contd)

The key hurdle in adopting this model is Pakistans lack of competent administrators who could perform such functions under the law. 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 (Contd)

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 (Contd)

The American model (Chapter 11) Contd

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 Pakistans 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?? (Contd)

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?? (Contd)

We have recognised the limitations of Pakistans 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 (Contd)

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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