A permanent solution for the sick industries: Corporate Rehabilitation - I
Salman Ali Shaikh and Feisal Naqvi
ARTICLE (June 19 2008): Companies, like people, are normally worth more alive than dead. That is a simple, undisputable fact. But it is also one whose consequences have yet to be appreciated by Pakistan. Currently, we remain a country in which the only cure for a sick company is execution. Given the approaching financial storm, Pakistan can no longer afford to ignore the lessons learnt by the rest of the world.
Instead, the time has come for Pakistan to embrace a comprehensive and modern corporate rehabilitation act. During the recent past, we have witnessed random mood swings on a national basis between the desire for "recovery" (of bank debt) and the aspiration to "revive" (sick industry). The balance between debtors and creditors rights has been very badly disturbed and this can only be redressed through the adoption of a modern insolvency regime.
To understand the necessity of a corporate rehabilitation act, it needs to be understood that the financial and social value of a going concern is normally far greater than the liquidation value of that concern. A company, in other words, has a value far greater than the sum of its assets. Society therefore has an interest in making sure that businesses continue to function even if their continued existence comes at the expense of some creditors.
On the other hand, if a society leans too far in favour of defaulting businesses, banks will either stop lending or start charging higher interest rates. It is the job of a good bankruptcy law to balance these competing considerations and ensure that societal benefit is maximised.
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 in Pakistan is most clearly visible. Out of frustration, we have had to adopt ad hoc (administrative) insolvency solutions like the H.U. Beg Committee (of the early 1980's), "cosmetic" rescheduling of project financing loans in the 1990's, SBP's debt amnesty scheme of 1997 and SBP's BPD Circular No 29 of 2002. Periodic recourse to these "one-time" incentive schemes is effectively a public admission that in the areas of insolvency and corporate rescue, the legal system has failed.
INSOLVENCY LAWS IN PAKISTAN: THE CURRENT STRUCTURE: The basic law which deals with corporate insolvency in Pakistan is the Companies Ordinance, 1984. It 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 6 sections), but the provisions themselves are also very limited in scope.
The Ordinance thus contains two distinct provisions relating to the rehabilitation of companies. 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% 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 comprehensively 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 Federal Government did not even establish this committee until 2000 (ie 16 years after the promulgation of the Ordinance!). Subsequently, the committee has dealt with a grand 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 (ie, operational) restructuring.
By comparison, the past two decades have seen repeated attempts to make the law more creditor-friendly. The first step in this regard came with the establishment of special banking courts in 1984. This was then followed up 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. Furthermore, this law had the absurd provision of allowing interest to be accrued on non-performing loans, which are, by definition (and international accounting standards) on a non-accrual status! The military take-over in 1999 then resulted in another push of the pendulum towards the protection of creditors' rights.
The government of General Musharraf introduced the National Accountability Bureau Ordinance on November 16, 1999, in which, for the first time in the history of Pakistan, 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, the Corporate and Industrial Restructuring Corporation Ordinance, 2000 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.
Given all of these efforts, it should have become increasingly easier for banks and financial institutions to recover loaned amounts. And yet, despite one of the most creditor-friendly legal regimes in the world, the economic benefits failed to materialise.
The proof of this fact came in the form of 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 SITUATION TODAY: The situation today is once again that Pakistan is faced with a situation in which levels of corporate debt are increasing rapidly (at 10% - 12% p.a.) while liquidation values have been declining at the same rate for the past several years.
Furthermore, the fiscal space created through BPD Circular 29 has now run its course and non-performing loans (NPLs) are increasing once again. The question then before the regulators as well as the legislature is then this: does the current situation merit a permanent solution or should the government resort to ad hoc solutions like those that were adopted in the past?
The short answer to this question is that not only does Pakistan deserve better than another BPD Circular 29 but it makes no sense to go for a temporary solution when the fundamental problem, ie, corporate insolvency, is one which will always be there and when 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 of Pakistan for the past four years. It is a much needed law for downturn management, which is sadly a situation we find ourselves in at the moment.
So far as the effectiveness of BPD Circular 29 is concerned, preliminary figures indicate that approximately Rs 125 billion of NPLs was settled at the cost of Rs 75 billion of provisions, a very low write-off efficiency ratio by any standard.
More specifically, during the late 1990s, smart banks were reaching settlements with their borrowers at values ranging from principal plus 25 % to principal plus 50%. On the other hand, under BPD Circular 29, distressed assets were settled at values as low as principal - 75%!
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 ongoing 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 for Pakistan?
THE MECHANICS OF A CORPORATE REHABILITATION LAW: The decision to opt for a permanent solution to the problem of corporate insolvency does not necessarily answer all questions. Thus 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 model, the Indian model and the American model.
THE INDIAN MODEL: The easiest model to reject is the Indian model. In India, the job of rescuing sick companies has been entrusted to the Board of Industrial and Financial Restructuring (BIFR) created under the Sick Industries Companies Act, 1984.
This is a model which has already been tried in Pakistan in the form of the H. U. Beg Committee and which continues to linger on in the form of the committee created under Section 296 of the Companies Ordinance, 1984. The fundamental problem with this approach is that the process of rehabilitation is driven not by the stakeholders but by an ostensibly (and actually) disinterested party.
Since the government committee charged with revitalising a sick company does not profit from its effort, it does not make much of an effort. BIFR had a backlog of more than 8 years worth of cases and its dissolution (and replacement) had been recommended by a commission set-up to examine its working.
Thus, 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 for years before finally expiring. It makes no sense for Pakistan to adopt this approach when it has been tried repeatedly and has failed repeatedly. Even India, we understand, is in the process of discarding this approach in favour of a modern insolvency law.
THE ENGLISH MODEL: By comparison with the Indian model, the English model has not only been successful within England but has been adopted by a large number of other common law corporate jurisdictions such as Australia, Singapore and Hong Kong. Given that the laws of Pakistan have traditionally drawn upon English laws for inspiration, and also given the relative familiarity of the Pakistani legal community with English statutes and case law, the English model would appear to be the logical choice. However, any assumption to that effect would be incorrect.
(To be concluded)
Business Recorder [Pakistan's First Financial Daily]
