SECTION 8 - CORPORATE FINANCIAL DIFFICULTY

8.1 Introduction

In this section the matter for consideration is not what causes financial difficulty but the effect of it and the relationship, if it can be described as such, which then eventuates between the debtor corporation and its creditors, particularly its bank creditors.

8.2 Attitude

Earlier in this report attention was drawn to the issue of culture, both societal and commercial, as an important influence or factor on attitudes to insolvency generally. In particular, it was suggested that cultural influences might pose a considerable barrier toward the application of both informal and formal insolvency processes, notwithstanding that a law or a set of informal "rules" provides convenient access to those processes.

In the section on insolvency law it was observed that, in the modern context, insolvency processes, particularly the formal rescue process and the informal work-out process, rely for their effectiveness on early initiation, before the financial position of a debtor corporation has so deteriorated that no attempt at rescue or a work-out might be contemplated.

The majority of the local studies clearly evidence that the financial difficulty of a corporation is, more often than not, accompanied by an attitude of concealment and denial on the part of owners and managers. The local consultants were asked to identify attitudes of both corporate debtors and lenders to financial difficulty. The following selection of excerpts from the local studies are instructive:

• Philippines: A corporate debtor in financial difficulty generally has an attitude of "concealment" or "denial" toward the admission or exposure of that financial difficulty. The corporate debtor fears that by admitting their financial difficulty, credit will be harder to get. Also, it fears that the creditors will immediately enforce on their security.

  The reason may be based on their experience with the creditors. If they feel that they can turn to a particular creditor who is sympathetic to their plight and is willing to help them then they might disclose their financial difficulties. Otherwise, if they are not close with the creditors or do not have a long standing relationship with their creditors, they will be reluctant to disclose their financial difficulties for fear that they are not sure how these creditors will react".

• Taipei,China: Yes, there is an attitude of "concealment" or "denial". This is based on cultural factors, e.g. the owner being not willing to face the reality that the company is poorly managed and has thus become insolvent, or the owner lacking the concept of abiding by the law.
• Indonesia: "Corporate debtors will generally try to conceal or deny financial difficulties from their creditors and governmental authorities. If lenders discover a debtor's financial difficulties, they may be quick to react and declare the corporate debtor in default. The reason for this is the unpredictability of the Indonesian judicial system and substantial questions whether creditors can effectively use the judicial system to recover outstanding debt."
• Hong Kong, China: "There usually is an attitude of both concealment and denial by corporate debtors toward the admission or exposure of the financial difficulty. But, it must also be noted, corporate lenders are also frequently in denial."

  "Chinese family-controlled companies in Hong Kong, China prefer to disclose as little information as necessary to their bankers. The complex organisation of many of the family-controlled groups in Hong Kong, China lack transparency and make it easier to conceal developing difficulties."

  "In Hong Kong, China, there is much less accountability to shareholders. Some bankers feel that local companies are often run more to favour the interests of the controlling tycoons' family than the interests of shareholders."

  "Many local companies do not have independent managers - or if they do, have brought in managers to raise money rather than to impose financial controls - so the controlling family often does not hear contrary views being voiced by senior members within the company."

  The Hong Kong, China local study further observes that if companies have sought the advice of professional advisers or independently thinking managers, they are often able to avoid difficulties and, if not, would be more willing to volunteer the facts relating to the company's financial difficulty. Companies which are reluctant to get the advice of professional advisors or to hire independently thinking managers (which, it is suggested, comprise seventy per cent of corporations in Hong Kong, China) often remain reluctant to disclose any adverse information.

• Thailand: "The loss of face involved in admitting difficulties is also a factor."
• Singapore: "There is a perceptible tendency for entrepreneurs who have established a business enterprise and still manage it to be pro-active in seeking independent financial assistance to structure debt, refinancing and rescheduling scheme[s]."
• Pakistan: There is normally an attitude of concealment or denial toward the admission or exposure of financial difficulty. The reason is based on "cultural factors to the extent that a social stigma is attached to such difficulty. The desire to put off the attending and consequential problems that occur once the issue of financial difficulty gets publicly known also play a part. Also in a large number of cases there is mala fide in that the projects for which loans are taken are unviable right from their inception and therefore there is a continued effort to cover up."
• India: "The attitude of "denial" towards the admission or exposure of financial difficulty [is] extremely common in India.... most Corporate Debtors dispute the debt due when.... insolvency action is commenced."

There appears, therefore, to be an overwhelming tendency toward concealment and denial of financial difficulty. It is not, of course, suggested that this is peculiar to some or all of the RETA economies. It is not much different from attitudes found in most countries. To that extent, therefore, efforts in the RETA economies to encourage greater transparency and a greater willingness to deal with financial difficulties at an early stage are no different from those faced in most other countries.

8.3 Taking advice, submitting to investigation

The local consultants were also asked about attitudes and practices once the financial difficulty of a corporate debtor had been admitted or exposed. In particular, they were asked whether there might be negotiation; whether corporate debtors and/or lenders might employ or agree on the employment of professional expert assistance; to what extent one might contemplate full access and disclosure of the financial position and business activities of the debtor corporation; whether lenders might act in combination or act independently and secretly from one another; and whether there would be sufficient knowledge, experience and expertise within domestic banks to endeavor to analyse and try and find some solution to the financial problems.

The response in the local studies reveals that there is a general reluctance on the part of corporate debtors to seek outside professional assistance and some reluctance on their part to accept the imposition of experts and advisers employed or retained by lenders. However, in the majority of cases, it appears that debtor corporations would ultimately accept the need for some type of "outside" assessment, although both corporate debtors and lenders preferred that this assessment be conducted by the lenders themselves.

From some observations in the local studies (for example, Japan, Hong Kong, China and Singapore) it seems clear that if the relationship between corporate debtor and lender has been close, particularly if the lender has had a good understanding and knowledge of the business and finances of the corporate debtor, it is far easier to initiate a constructive joint effort between corporate debtor and lender toward endeavoring to solve the problem than in a situation where such a relationship, knowledge and understanding does not exist. This tends to support some earlier observations in this report regarding the desirability of lenders, in particular, initiating and maintaining close and informative links with borrowers. The practice of lenders might, as a result, be greatly improved.

8.4 Lender attitudes

It cannot be expected that the lenders of a corporate debtor will necessarily, or at all, engage themselves in any attempt to rescue or assist the corporate debtor. Probably, in the majority of cases, the reaction of a lender to the financial difficulty of a corporate debtor will be to take action to recover the outstanding debt. This leads to the issue of enforcement, particularly the enforcement of securities.

As mentioned earlier in this report, it is a common banking practice throughout the RETA economies to engage in the practice of secured lending, particularly on the security of land and shares. In Hong Kong, China, Singapore, Malaysia, India and Pakistan, lenders also have the facility of the "floating charge" (or something similar) as security over all the assets of a corporate borrower. In some of these latter jurisdictions the common method of enforcement is to appoint a receiver (which can normally be done without recourse to the courts) who becomes the manager of the debtor corporation and is empowered to collect and otherwise sell all the assets of the corporation for the benefit of the secured creditor. Enforcement by way of a receiver is a popular method, particularly in Hong Kong, China, Singapore and Malaysia. Except in Malaysia, the appointment of such a receiver will normally rule out any possibility of a rescue process for the corporate debtor. None of the rescue processes of Hong Kong, China and Singapore restrict the rights of the appointment of a receiver by a secured creditor. In the case of Singapore, judicial management would be declined to a corporate debtor if a receiver has been appointed or if there is a likelihood that a receiver will be appointed. Thus in those countries, the enforcement of the security by the appointment of a receiver can forestall and prevent any type of corporate rescue.

In Malaysia, however, there has been some significant incursions into the right to appoint or continue with the appointment of a receiver. If a creditor who holds a floating charge over all the assets of a corporate debtor threatens to or appoints a receiver, the corporate debtor responds by commencing proceedings for a scheme of arrangement or compromise and then seeks, and usually obtains, interim orders from a court which restrain the secured lender from enforcing the security. This development of case law in Malaysia runs contrary to English and Commonwealth precedents. It provides a good example of the tensions that are created between, on the one hand, legislative attempts to provide for a rescue process and, on the other, commercial practices which suggest that there should be no restraint on the rights of secured creditors to pursue their independent remedies.

In the other RETA economies (where most attention focuses on the ability of secured creditors to realise or enforce their security, particularly, as mentioned, over land and shares), the local studies reveal a quite varied position.

First, on enforcement processes generally. If one takes, as an example, enforcement of a security over land, the position appears to be as follows:

• Philippines: A security over land can be enforced without recourse to the courts provided the security documentation permits this. If enforcement was sought through the courts, it may take many years for the enforcement to be complete. However, both judicial and extra judicial enforcement will be restrained if the debtor corporation applies for rescue under PD902A.
• Korea: Enforcement is through the courts which is normally a quick and efficient process. However, if the commencement of a reorganisation is ordered, enforcement of the security will be suspended.
• Pakistan: To the extent that enforcement is required to be taken through either the civil courts or the banking tribunals, the process is considered to be effective (in that time frames for final adjudication are prescribed). However, in practice, "the system is very slow and also corrupt." If a corporate debtor seeks a scheme of arrangement or compromise, applications for enforcement of securities over land may be transferred to the court hearing the application and may be suspended.
• Taipei,China: Enforcement is through a court which orders an auction of the property. This is normally a swift and efficient process. The reorganisation of a corporate debtor is likely to result in a suspension of the enforcement of secured property rights.
• Indonesia: Enforcement is through a court which is described as ".... ineffective...." The process is "time consuming, expensive and unpredictable". Enforcement of security rights will be suspended once an application for bankruptcy has been filed.
• Thailand: Enforcement is through a court. The Thailand country study comments that: "The foreclosure laws have come under much criticism recently. They do not allow for expeditious enforcement. The debtor or interested parties may easily raise certain objections and delay the process."
• Japan: Enforcement is through a court and the court system is regarded as effective. However, enforcement will be suspended if the Debtor Corporation applies for corporate reorganisation.
• India: "Suits involving enforcement of security... get blocked by the ingenious and often fraudulent defenses propagated with substantial degree of success by the borrowers and their lawyers¡­. The effectiveness of the suits is severely dented by the time frame involved¡­. A trial.... usually takes 8 to 12 years to come up for hearing."

  It may be observed from this survey that some considerable tensions can arise between a corporate debtor which is insolvent or in financial difficulty and its secured creditors. In Indonesia, for example, it could be argued that a debtor corporation, despite the fact that it is insolvent, is in a relatively strong position. It appears that such a debtor corporation might easily obstruct and delay enforcement of security rights; equally obstruct or delay any attempt of a creditor to apply for the debtor corporation to be liquidated (as to which see the next section); and, if all else fails, apply for suspension of payments under the revised bankruptcy law and obtain the benefit of a suspension of secured enforcement rights.

  By utilizing slightly different processes, a similar position might be said to prevail in Malaysia. A corporate debtor can commence proceedings for the possibility of a scheme of arrangement or compromise and obtain orders suspending the enforcement of security rights and any liquidation proceedings against it. At least, however, in that instance, the debtor is forced into the possibility of a rescue process.

  The issue of suspending or restraining the rights of secured creditors in the context of the development of a modern rescue process does present a number of difficulties. Ideally, an insolvency law should relate to and support the usual commercial processes of the community. There is little sense in promoting a law that it is decidedly at odds with accepted, entrenched and commercially justified processes. However, support for the principle of an ordered and fair form of insolvency administration has normally dictated the necessity to apply some restraints on rights arising from commercial transaction. Notable in this regard are restraints (limited in both nature and time) in regard to the enforcement of security rights over assets of an insolvent debtor corporation which has applied for rescue.

8.5 Unsecured debt recovery

In many of the RETA economies the process of debt recovery through the court system is long and tedious. The following are relevant extracts from some of the country studies:

• Thailand: "Currently, delay (in the courts) is probably the biggest impediment toward justice".
• India: "The recovery procedure for debt collection is slow and tardy".
• Pakistan: The process is "very slow".
• Philippines: "The judicial and court system for the purpose of debt collection is not so effective".
• Indonesia: In general, the Indonesian judicial system has not been an effective tool for the purposes of debt collection or bankruptcy proceedings. "Judicial remedies are time consuming and expensive. Even more importantly, the Indonesian judicial system's decisions have been inconsistent and unpredictable and are subject to a variety of extra-judicial influences".
• Taipei,China: "In comparison to the foreclosure of collateral by secured creditors, the debt collection by unsecured creditors is much more time consuming".

This puts unsecured creditors at a considerable disadvantage. Their main bargaining strength may be to refuse further supply unless past indebtedness is paid and/or unless further supply is paid for in cash. That, however, is only relevant if continued supply is important to the corporate debtor.

Unsecured creditors are also disadvantaged if, as appears to be the case in some of the RETA economies, their attempts to bring liquidation proceedings against a corporate debtor are frustrated. Liquidation proceedings can be long drawn out and the result is difficult to predict. (see next section).

8.6 Lease finance creditors

The usual "enforcement" which follows from a failure to meet lease payments is to recover the leased equipment. In a number of the RETA economies this presents a problem. If, for example, entry is refused to the place where the leased property is located (despite the terms of the contract which would normally create a positive obligation to permit such access and recovery) enforcement has to be by court order. That process can be long and tedious. Note, for example, these observations from some of the country reports:

• Taipei,China: "Formal court proceedings will have to be proceeded with for the recovery in case the lessee rejects the owner's access to the place where the equipment is located .... A final court judgment could possibly take about a year."
• Malaysia: "In practice the process is fraught with difficulties of a practical nature ...."
• Indonesia: The exercise of recovery rights requires court process ".... since the leased property is under the control of the lessee, the lessor must file a (request for seizure upon the lessee's property) with the Court.... In actual practice, it is difficult to recover leased equipment.... This difficulty is primarily due to inefficiencies in the Indonesian judicial system."
• Thailand: The exercise of repossession rights requires court process.

8.7 Conclusion

There is nothing much that an insolvency law can do about deficiencies concerning the exercise of individual creditor rights. But there is a real problem when, at the same time, there are deficiencies in both that area and in the rights of creditors to seek the application of insolvency processes against a debtor corporation. If a creditor cannot, in a practical and effective sense, seek either individual or insolvency remedies against a debtor, a considerable bias is created for the benefit of the debtor. This does not make commercial sense.

Although the issue of enforcement of individual creditor rights is relevant to this study (at least for background and information purposes) it is beyond the province of the study to make detailed recommendations in that area. Perhaps, however, a convenient "model" approach might follow these suggestions: