Restructurings vs Liquidations รป is it better to sink or swim?

Given the challenging economic circumstances currently facing Hong Kong and many other parts of the world, it should be no surprise that insolvencies both large and small are a hot topic of debate.

In any economy, especially during downturns, business failures are a reality - Enron, HIH, Ansett, Global Crossing, APP - the list goes on. According to Standard & Poor's, a record number of companies defaulted on their debt in 2001, and that trend appears to be continuing. As companies defaulting on their debt are generally in financial difficulty, an event of default will often force lenders to make a difficult decision - do they support the company through a restructuring or workout process or do they cut their losses and put in a receiver or liquidator.

In Hong Kong there is no statutory form of workout. That is, a formal, court driven process under which a debtor can get relief from its creditors and breathing space to reorganise its affairs. The US has such a process - Chapter 11 - where the debtor obtains such relief whilst remaining in control of the company. There is no appointment of an independent external administrator to run or otherwise oversee the company's affairs.

The UK, Canada, Australia and Singapore all have statutory workouts that require an independent external administrator and provide relief to struggling companies from creditor actions whilst they formulate workout proposals. Hong Kong has no form of statutory work out, but has (for the last six years!) been debating the so called "provisional supervision" legislation.

Thus, in Hong Kong non-statutory or out-of-court workouts are prevalent. This means that lenders, typically banks, act by negotiation to arrive at a consensual debt restructuring from failing enterprises. Under joint HKMA/Hong Kong Association of Banks' guidelines, (The Hong Kong Approach to Corporate Difficulties) banks are asked to act as one body and collectively make decisions as to whether to support the debtor or pursue recovery.

The rules are not enforceable (they are described as "formal but non-statutory") and individual banks, particularly foreign banks, have been known to act more 'independently' when they disagree with the strategy of the majority or they want to force larger lenders to buy their debt at a premium to the market value of the debt. The HKMA is a strong supporter of the Hong Kong Approach, and is prepared to act as a mediator if differences of views threaten the successful conclusion of a workout. Generally, the guidelines have been accepted and adhered to in the local market place.

Most debt restructurings will undoubtedly produce a greater return for unsecured creditors than a liquidation scenario. Restructurings such as Guangdong Enterprises Limited ("GDE"), in which PricewaterhouseCoopers acted as financial advisor to the banking group, enabled the Guangdong Government to 'inject' a valuable asset to entice lenders to accept a restructuring plan. Such a 'gift' would not have been obtained by the GDE creditors in a liquidation scenario, and greatly enhanced the value of the restructuring package to creditors.

Restructurings have other advantages. Employees benefit from keeping their jobs with a (hopefully) stable restructured entity; and when a company is restructured and survives, employees are generally paid amounts owing to them in full, although they may be forced to take pay cuts as part of the restructuring effort. Creditors, whether they be banks or trade creditors, benefit as their debtor will survive and (hopefully) continue to buy goods or services from them. Restructured entities are often very loyal to lenders and suppliers that have helped them during difficult times.

But not every troubled company situation is a workout situation. For example, whether or not a company can be restructured depends largely on where it is on the insolvency curve. As the chart below shows, the earlier the intervention, the more likely a workout can be implemented.

Take the topical cases of Kmart (the second biggest US discount retailer) and Daiei (Japan's biggest supermarket chain). Kmart filed for bankruptcy (Chapter 11) protection at a very early stage. According to its bankruptcy filings, Kmart has assets of US$17 billion against liabilities of US$11 billion - on a balance sheet test it is not technically insolvent. Kmart filed for Chapter 11 because its cash flow was strained, largely due to unprofitable stores.

Media reports say that Kmart is looking to shut 25-30% of stores and management turnaround specialists have been brought in by management to assist them through this process. This early, controlled reorganisation process mazimises Kmart's options and should enhance recovery on assets.

Daiei, on the other hand, has assets of US$24 billion against liabilities of US$23. 7 billion - a very low margin for error. Daiei looks set to struggle on after its main creditor banks approved a lifeline by agreeing to further funding and to convert some debt to equity. History in Japan tells us that Daiei, with around 90,000 employees, is considered too big to fail. Kmart, with 250,000 employees, is apparently not too big. Only time will tell whether Daiei's strategy is sound. .

But sometimes the liquidation of a company is unavoidable, especially when it offers the best option to creditors to extract value. Where fraud is involved, where existing management cannot be trusted or where lenders have just lost faith in the business plan, liquidation will often be the only option.

In Australia recently there was a huge outcry when the second largest insurer, HIH, went into liquidation. Allegations have been made in the press about regulation of the industry by the Australian Prudential Regulatory Authority, the actions of HIH directors and auditors. To its credit, the Australian government has appointed a Royal Commissioner to examine "whether decisions, or actions of Directors, officers or associated advisers contributed to the failure or were involved in any undesirable corporate governance practices. It will also examine the adequacy and appropriateness of arrangements for the regulation and prudential supervision of general insurance at Commonwealth, State and Territory level".

The Royal Commission has its own website (www. hihroyalcom.gov.au) which features, amongst other things, transcripts of proceedings, reference material and reasons for rulings.

The amount of information available to the general public in the HIH case makes the process both useful and transparent. The Australian Securities and Investment Commission has also acted quickly on wrong doings found, having already secured one successful court judgement against three directors - less than a year after the HIH collapse.

This is to be contrasted with the Enron hearings in the U. S. , where there is perhaps too much information available with about a dozen separate congressional committees and a criminal investigation by the US Department of Justice currently being conducted. Former directors of Enron claim that the investigators have already made up their minds. You probably can't blame them, especially with one committee chairman announcing "those responsible for the Enron collapse deserve prison sentences" when presumably the investigation hasn't finished and he certainly hasn't heard the directors' side of the story.

Probably the time for choosing liquidation over restructuring is when it looks to be the most efficient way of realising assets. Often by the time a company has recognised that it has a problem, its business is losing money. Recoveries on assets will generally be higher if a business can be sold as a going concern, rather than sale on a piecemeal basis.

Unless the company can be sold as a going concern or bleeding business lines shut down, immediate closure of the business can be the best option, as the losses can be immediately stemmed and assets preserved. Whether or not you support the Ansett Administrators controversial decision to trade on pending a possible (but ultimately unsuccessful) sale, there is no denying that was expensive. Trading losses incurred by the Administrators are said to be around AU$1 million (HK$4 million) per day.

The decision to trade on appears to have been made to save some of the jobs of Ansett employees (about 2,500 out of 15,000 jobs prior to administration). Whilst this might be an admirable aim, employees are paid first in an administration. Trading losses come directly from the pockets of the unsecured creditors and in this case the pockets of the Australian taxpayer via a government guarantee of workers entitlements. The challenge for liquidators is to contain the trading and deal costs to ensure those recoveries filter through to creditors.

Another situation ripe for liquidation is when creditors have lost faith in management - either their vision and business plan, or simply their ability to repair an ailing company - either way there is reason enough for liquidation. Two or three years ago, many lenders were told "don't worry about the money we owe you, we are starting a dot com". It is unsurprising to see why some lenders quickly lost faith in management.

Insolvency and restructuring principles often come back to the old saying "a bird in the hand is worth two in the bush". So whilst superior returns over long time frames might look good on paper, often lenders have to make hard decisions early. The quality of loans can deteriorate over time unless carefully monitored and managed.