68469 PAKISTAN STRENGTHENING THE INSOLVENCY REGIME Non-Lending Technical Assistance (NLTA) Final Report June 23, 2011 Finance and Private Sector Development South Asia Region (SASFP) and Finance, Private Sector Development and Infrastructure Legal Vice Presidency (LEGPS) The World Bank CONTENTS I. Introduction ..................................................................................................................................... 1 II. Potential Objectives of a Insolvency Reform ................................................................................... 2 III. The Insolvency Regime in Pakistan .................................................................................................. 3 IV. The Re-Emergence of the Corporate Rehabilitation Act ................................................................. 6 V. Participation by the World Bank ...................................................................................................... 8 VI. Final Analysis of the CRA ................................................................................................................ 10 VII. Next Steps ...................................................................................................................................... 11 Attachments: Attachments 1: Government request for technical assistance (May 7, 2009) Attachment 2: Technical assistance project proposal (July 2009) Attachment 3: Concept Note (September 2009) Attachment 4: Written comments/Agenda for video conferences on CRA (March 2009-March 2010) Attachment 5: Government’s (SECP & MOF) Written Response to World Bank Comments Attachment 6: Presentation to the Secretary of Financing (October 2010) Attachment 7: Final comments on CRA (October 2010) Attachment 8: Annotated law provided to Government (December 2010) PAKISTAN Strengthening the Insolvency Regime NLTA Final Report I. Introduction 1. The importance of a modern, binding and effective insolvency regime is undeniable. Nearly 90 countries around the world have reformed their bankruptcy codes since World War II, and over half of them have done so during the last decade. One of the key aspects in the reform process is the delicate balance addressed by a modern insolvency system which encourages the organization of viable firms and liquidates unviable firms. In doing so, the system should seek to minimize reorganization costs by ensuring quick and efficient procedures, by ensuring that viable firms are better off reorganized than liquidated and by incentivizing a speedy recovery of reorganized firms. 2. The financial and macroeconomic crises, as recently experienced in Pakistan, provide an opportunity for bankruptcy reform, as the potential employment impact often places the issue of insolvent companies high on the policy agenda.1 As such, in the wake of the 2008-09 balance of payments crises, Pakistan like other jurisdictions, gave renewed attention to establishing a modern insolvency regime to effectively and efficiently liquidate non-viable companies while fostering corporate restructuring to address temporary financial distress in otherwise viable enterprises. Chart 1 Non-Performing Loans (NPLs) in the Banking System 2007 - 2010 25 600 35 Public Private Foreign Commercial 500 30 20 NPLs 25 Loans 400 15 20 NPLs 300 15 10 10 200 5 5 100 0 0 0 CY07 CY08 CY09 CY10 Source: State Bank of Pakistan, Quarterly Performance Review of the Banking System, December 2010 3. In Pakistan, the effort at bankruptcy reform was initiated in 2004-06 but lay dormant until late 2008, when rising interest rates, spikes in the commodity prices, creeping inflation and severe 1 For example, in 2009, bankruptcy filings increased by 5 percent in Japan, 6 percent in the UK, 11 percent in Germany and 40 percent in the US. Cirmizi, Klapper, Uttamchandi, The Challenges of Bankruptcy Reform, October 2010. 2 energy shortages pushed many good companies to the brink of bankruptcy. The economic crises also revealed to the market the lack of international competitiveness in many other companies. From Chart 1, it is apparent that the NPLs in the banking system began to tend upward in 2008 and have continued to do each year since. 4. As of December 31, 2010, NPLs in Pakistan had increased to about 14.7 percent of loans (Rs. 548 billion) from a low of 7.6 percent ($218 billion) at the end of 2007. With the continuous growth in NPLs since 2007, credit risk remains the biggest challenge for the banks in Pakistan. There was some slowdown in the beginning of CY10, but the fourth quarter saw a rebound in NPLs as Rs. 54 billion of NPLs were added, raising the NPL ratio from 14 to 14.7 percent in one quarter. These NPLs seem more concentrated in a few local private banks, but Chart 1 shows that all types of banks are experiencing the impact of an increasing number of distressed enterprises. Sector wise breakdown indicates that the vast majority of NPLs lie with the textile sector, which accounts for 31 percent of NPLs but only 19 percent of loans. Electronics also shows a higher share of NPLs than loans, while Chemicals, Agriculture and Energy show lower shares of NPLs than shares of loans. II. Potential Objectives of an Insolvency Reform 5. In many jurisdictions, most of which can be considered more sophisticated and mature markets than in Pakistan, when faced with rising distress levels in the enterprise sector, would ratchet up the insolvency system in order to ensure that, despite the rising level of impaired assets, resolution would be based on the formalized “rules of the game.“ Such rules, would, as a process, ensure that companies in distress go through a painful, but necessary negotiation with creditors to ultimately produce a market based outcome. The outcome would attempt to balance interests of creditors, owners and other stakeholders with the company benefiting individual well-being. 6. Insolvency is therefore, often misunderstand as a sort of legal mortuary, when in fact it is a hospital where the assets and expertise of a business injured by management mistakes or the vagaries of the free market, are recapitalized or rechanneled to renewed productivity and social benefit. In this way, the insolvency process is uniquiely intertwined with the rights of entrepreneurs, workers and creditors which need to find a proper balance among themselves, if an economy is to reach its maximum potential.2 7. The three fundamental goals of any insolvency law are: (i) transparency, including a system for publicizing and indexing judgments, an accessible method for registering securing interest and an effective notice of insolvency proceedings, (ii) predictability - in terms of being fair, simple and clear, which if not achieved ends up costing more as financial institutions compensate the uncertainty with additional credit costs; and (iii) efficiency, which conceptually is clear but empirically is difficult to measure. In a narrow context, the efficient resolution of insolvency depends on the ability to reorganize viable firms and to liquidate the unviable ones at a low cost.3 2 Edited by Jay Lawrence Westbook, The Global View of business Insolvency Systems. 3 The World Bank, The Challenges of Bankruptcy Reform, E. Cirmizi, L Klaper and M. Uttamchandani, October 2010. 3 8. An insolvency system has significant legislative, institutional and regulatory dimensions. The level of detail of the review, in particular, the institutional and regulatory dimensions requires much greater analysis and time to provide a thorough evaluation. While a sound insolvency system is absolutely dependent on all three components, not the least of which is the effectiveness of the courts and the regulation of insolvency practitioners, the review below focuses on the legal aspects. The institutional and regulatory dimensions require considerable additional analysis and time to provide a thorough evaluation. It is important to reiterate that a sound insolvency system is dependent upon all three components, not the least of which is the effectiveness of the courts and the regulation of insolvency practitioners. III. The Insolvency Regime in Pakistan 9. Corporate insolvency in Pakistan is governed by the 1984 Companies Ordinance – a law which is not for general application but rather covering only the corporate sector. This law deals with incorporation, management, regulation, and winding up and covers all limited liability and foreign companies registered in Pakistan. It provides for a detailed mechanism for the reorganization and winding up of companies and about dealing with the assets of the companies involved in these processes. As it was considered out of date and obsolete, a Corporate Law Review Commission (CLRC) was established to review the 1984 Companies Law, but made little progress. 10. Therefore, one issue is that the provisions only apply to those corporate entities that fall under the jurisdiction of the Ordinance. The trend globally is toward independent legislation with the subject matter of insolvency.4 More fundamentally, the Companies Ordinance goes into great detail with regard to liquidation and winding up - in the case of non-payment to creditors, but is much weaker when it comes to “Chapter 11� type of formalize work-out mechanisms. For example, the liquidation provisions cover 149 of the 514 sections of the Ordinance, while the rehabilitation provisions amount to six in total. 11. In the case of troubled, but viable enterprises, Pakistan’s Insolvency Regime is challenged on both the liquidation side as well as the reorganization side. As a result, the system is vastly underutilized, leading to rising NPLs in the system – both for viable and unviable firms, without the ability of the system to respond effectively. For example, when NPLs rose, the system resorted to a number of ad hoc administrative interventions over the years, including the H.U. Beg Committee in the 1980s, rescheduling of project finance loans in the 1990s, SBPs debt amnesty of 1997 and in 2002 the Committee for Revival of Sick Industrial Units (CRSIU) along with “BPD Circular 29� allowed banks to liberally write off NPLs on the basis of questionable valuation.5 At the same time, efforts 4 “Given the breadth of the topic, it may be fit for independent legislation.� CLRC Concept note, May 16 2006. 5 Rs. 125 billion of NPLs were settled at the cost of Rs. 75 billion of provisions - a very low write-off efficiency ratio. More specifically, banks were settling with borrowers at higher values than provided for under BPD Circular 29 where distressed assets were settled at values as low as 75 percent of principal in part due to the use of Forced Sale Value (FSV) to value the company on a liquidation basis rather than as a going concern. Valuations of distressed assets were also drawn into question. S. Sheikh, & F. Naqvi, Corporate Rehabilitation: A Permanent Solution for the Sick Industries Problem, Paper produced by mimeo, 2007. 4 were made over the past two decades to make the system more functional with the establishment of special banking courts in 1984, followed in 1997 by a complete review of banking court procedures via the Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act. 12. In 1999, the Government shifted the pendulum even further toward creditors by introducing the National Accountability Bureau Ordinance (November 16, 1999). For the first time in the history of Pakistan, failure to service 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 & Industrial Restructuring Corporation Ordinance, 2000 and resulted in the creation of the Corporate and Industrial Restructuring Corporation (CIRC), a new state asset management company with wide- ranging powers to deal with insolvent companies and their debts. Finally, a revised law, the Financial Institutions (Recovery of Finances) Ordinance, was introduced in 2001 for banking companies which featured a provision for banks to foreclose and take possession of secured assets without the hassle and delays of judicial proceedings. This periodic recourse to these on-time incentive schemes is effectively a public admission that in the area of insolvency and corporate reorganization, the legal system has failed.6 13. Despite the law being focused almost entirely on the orderly liquidation of insolvent companies, in practice, voluntary and involuntary methods of liquidation have been underutilized. In part, financial institutions, do not initiate liquidation proceedings as recovery under other methods, such as the Financial Institutions Ordinance, provide them with a relatively quicker recovery method. On the other hand, debtors tend to not initiate voluntary liquidation because control by shareholders is lost and there is no relief to shareholders as a result. The liquidation provisions, though numerous, have been underutilized. For involuntary liquidation, a liquidator appointed by the court is in charge of the proceedings.7 Indeed, already in 2006, the concept paper for development of the corporate sector issues by the Corporate Laws Review Commission (CLRC) indicates that the process of winding up or liquidation provided under the Ordinance was cumbersome, time consuming, duplicative and archaic (para 4.46, page 20). 14. In the case of reorganization, a procedure is outlined in section 284, where a compromise or arrangement is proposed between a company and its creditors. The creditors (and in the case of wind-up, the liquidator), convene a meeting to determine the matter, and if three quarters of creditors (in terms of value) agree to the compromise, it is binding on the company. The Court must review, and has the power to make modifications to the proposed reorganizations. However, the process itself is complex, involves a heavy role for the Court, and is particularly cumbersome when a transfer of shares is involved. 15. For a so called “sick industrial unit� in a Company, section 296 of the Companies Ordinance coupled with the 1999 Rules for Rehabilitation of Sick Industrial Units, provides for a different regime when the Federal Government declares a company sick. The Banker’s Committee 6 IBID. 7 Internal LEGPS memorandum to SASFP, November 6, 2008. 5 (including the State Bank of Pakistan and the heads of other banks and financial institutions) makes a determination and a report is submitted to the Task Force constituted by the Federal Government. The Government then authorizes the drawing up of a rehabilitation plan. 16. Three aspects of this legal gap prevent effective reorganization in the face of corporate distress: (i) a legislative gap in the legal framework for bankruptcy (Companies Ordinance, 1984), (ii) the lack of an institutional set up for reorganization, and (iii) the absence of a trained cadre of insolvency experts to steer distressed companies through formal proceedings, to provide legal and business advice during such proceedings, and to provide judicial oversight of the process. 17. In a number of jurisdictions, including Pakistan, the reorganization process has proved ineffective for a variety of reasons. Even on paper, the process is considered of limited utility and is no substitute for an effective reorganization system. In particular,  It is a voluntary process, as opposed to modern reorganization proceedings which can be forced upon a troubled debtor at the application of a creditor, thus precipitating intervention in the debtor's affair, even at the opposition of owners and managers but which nevertheless might be in the interests of the creditors as a group.  The restructuring focuses only on the liabilities side of the debtor's balance sheet (financial restructuring), whereas a proper reorganization would frequently need to provide a framework for operational restructuring which addresses underlying problems in the debtor's business model by downsizing, consolidation of operations, sale of assets, etc.  Restructuring can only operate in relation to the classes of claimant selected by the parties proposing the plan; the plan characteristically does not address in a comprehensive manner all the claims, assets, and affairs of the debtor in the way that a reorganization process can.  The definition of classes is left to the parties and subject to court approval, which provides flexibility, but can be immensely complicated and contentious, subject to extensive and costly litigation. Modern reorganization regimes provide off-the-shelf definitions of classes.  The restructuring process itself has no effective class “cramdown� mechanisms and can bind dissentients within a claimant class. At the same time, the restructuring process cannot deal with all members of a dissenting class by guaranteeing them adequate protection.  The restructuring process has no built-in mechanisms for the procurement of post- commencement funding for the debtor, whereas there would be such a mechanism in developed reorganization processes.  For sick units, section 296 creates a special committee. 18. 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 materialize. The proof of this fact came in the 6 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. 19. Since 1984, there have been 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 (i.e., 16 years after the promulgation of the Ordinance). Subsequently, the committee has dealt with a total of 388 sick units out of which it claims to have revived 196. This committee acted more as an "arbitration window", without developing a capacity to undertake deep (i.e., operational) restructuring. 8 20. Such a lacuna in the law and its application has left many companies to flounder without the possibility to work out temporary liquidity issues, or re-circulate assets to better uses. Such system of insolvency is all the more important in the face of (i) external shocks which hit good companies as well as bad; and (ii) restructuring which requires a quick and unabated exit mechanism. IV. The Re-Emergence of the Corporate Rehabilitation Act 21. The Corporate Rehabilitation Act (CRA) was prepared by the State Bank of Pakistan Banking Laws Review Commission (BLRC) in 2004. While the question of revival of sick companies was looked at by the CLRC, its Concept Paper concluded that “both the revival of sick companies and liquidation of companies may be included in the company law.� Therefore, this CRA was drafted and ratified by the BLRC in 2004. Since that time, however, the effort to address both the general issues of corporate law reform and/or rehabilitation of distressed companies, has been dormant. 22. Following the economic crises of 2008, and faced with a rise in corporate distress for various external and internal reasons, the Government began fast-tracking efforts to provide the missing dimension of the insolvency regime which would facilitate the sorting of cases according to their underlying prospects for recovery. As a result, the SECP and SBP were in 2008, assigned by the Government of Pakistan, to work in parallel to revise the CRA as a standalone piece of legislation and to create a Resolution Trust Corporation (RTC)-like structure that would help restructure and/or sell weak manufacturing units (mostly in the textile sector) to strong investors (mostly local groups). 23. The SECP/SBP review looked at the principals embodied in three cases: the Indian, English and American models and concluded that for a comprehensive insolvency regime for Pakistan, the American insolvency system seemed the most viable for the following reasons:  The Indian model has 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 revitalizing a sick 8 S. Sheikh, & F. Naqvi, IBID. 7 company does not profit from its effort, it does not make much of an effort. 9 The end result of a committee-centered 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.  The English model was deemed unsuitable for Pakistan since it is first necessary for the management of the insolvent company to petition the court to appoint somebody to take over all management powers in order to obtain relief under a judicial administrator. It was considered that the vast majority of even large corporations in Pakistan are run by their owners and the chances of these owners/shareholders voluntarily giving up management control in Pakistan are minimal.  The American version embodies a guiding philosophy that society's best interest lies in giving the maximum possible opportunity for businesses to survive as viable entities. A distressed company is allowed to retain its management during bankruptcy proceedings. Entry into bankruptcy is effectively uncontested and once bankruptcy proceedings commence, all pending litigation is automatically stayed. In addition, the debtor company can access fresh funding and is provided with a minimum period of 120 days to come up with a plan of reorganization - normally required to be approved by a majority of creditors.10  Given the particular aspects of the Pakistan situation, particularly the low level of capacity among insolvency professionals, several jurisdictions (including from emerging economies) were studied in detail. In this respect, the Mexican insolvency law of 2000 was particularly useful as it addresses issues that deal with low technical expertise in the judiciary.  Drafting considerations take on additional aspects particular to the Pakistani situation: (i) retaining the language of the U.S. Code to the extent possible rather than trying to rewrite into simpler language in order to replicate the Code’s consistency and provide a century of case law at the judges disposal, (ii) lower the time for a bankruptcy proceeding by forcing debtors to file a plan at the same time as seeking relief and requiring the process be completed in 90 days,11 (iii) providing for a technical committee to advise judges on complex financial issues and (iv) treating government dues at par with unsecured debt to facilitate rehabilitation without contending with decades of accumulated government obligations and (v) discharging personal guarantees upon acceptance of a reorganization plan. 24. Finally, the CRA contains a chapter enabling the establishment of a Resolution Trust Corporation (RTC) and includes in the main text, provisions that allow for banks and creditors wishing to exit early from the rehabilitation process to sell their rights to "vulture investors� (i.e., 9 BIFR has a backlog of more than 8 years of cases. Its dissolution (and replacement) has been recommended. 10 The American model requires a very high level of judicial expertise as well as a body of trained and experienced lawyers. There is also the danger that the process of rehabilitation can be dragged out at the expense of creditors. Finally, there is a moral hazard risk when companies use the law to avoid the consequence of their own mistakes. 11 Furthermore, to encourage debtors to be reasonable, the CRA provides that if a plan of rehabilitation is not approved within the specified period, the company shall automatically be wound up. 8 investors specializing in purchasing and managing distressed assets). This provision, it was thought, would help to create a vibrant secondary market in the sale and purchase of distressed debt, but was confused by the fact that the RTC was viewed as a public corporation by many in the Government with funding for paid in capital included in the 2009-2010 Federal budget. V. Participation by the World Bank 25. Against the background of an urgent need to build a part of the insolvency regime which has heretofore not existed in Pakistan, the Securities and Exchange Commission of Pakistan (SECP), in a letter dated May 7, 2009 to the World Bank, officially requested assistance in: (i) bringing to bear the Bank’s global knowledge on insolvency regimes around the world, and (ii) suggesting a package of technical assistance (TA) to implement a new regime (Attachment 1). The SECP suggested a TA package to develop the rules, regulations, codes of conduct, and procedures, in order to put the CRA into immediate practice, and capacity building for institutions involved in corporate restructuring, including the Corporate Rehabilitation Board, judicial insolvency bench, insolvency practitioners, etc. (Attachment 2). Based on the SECP request a concept note was prepared for a Non-Lending Technical Assistance (NLTA) which envisioned the preparation of a TA activity in support of the CRA implementation (Attachment 3). 26. At the same time, the Bank carried out reviews of three versions of the draft CRA as it went through changes resulting from stakeholder consultations and provided its views in written form and through video conference meetings with the SECP and the Ministry of Finance (Attachment 4). The IFC also provided guidance on legal, institutional and operational dimensions of the RTC with plans of being a co-investor. BOX 1 NLTA Activities (In Reverse Chronological Order)  Discussion on Insolvency Reform Planning Ministry as part of Growth Strategy: June 2011  Final comments and Annotated Law Provided to GoP: December 2010  High Level Mission (Director, PREM) Presented Issues to Secretary Finance: October 2010  Final Report Issued to Secretary Finance: October 2010  Presentation of Mission Findings to Secretary Finance: July 2010  Fact Finding Mission: July 2010  Government Written Responses: April 2010, June 2010  Written Comments on CRA : March 2009, June 2009, March, 2009, October 2010  Video Conferences with SECP & MOF: March 2009, December 2009, January 2010  Concept Note: September 2009  Request for Technical Assistance to Implement CRA: May 2009  Draft CRA Provided to the World Bank for Comments: November 2008 9 27. During the stakeholder consultation, however, the Bank team noted a significant deterioration in the application of good insolvency principals in the final draft. The third review revealed significant deficiencies in the principals underpinning the law and communicated its views during Video Conferences on March 26, 2010, to confirm and fully understand the policy issues behind the CRA. The Bank’s comments were provided informally to the technical team at SECP and MOF during the March 26 video conference. Each provided written replies on April 27 2010, and June 15 2010, respectively (Attachment 5). In summary, the Bank’s view was that policy choices embodied in the final drafting of the CRA seemed to favor a system which allowed bailing out of debtors, without restructuring and without protection of creditor rights. BOX 2 CITATION IN IMF THIRD REVIEW: Consultations on the new bankruptcy law (Corporate Rehabilitation Act) have reached a final stage. The new law will help both the corporate and financial sectors by strengthening the legal basis for rehabilitation of viable but struggling corporate borrowers and speeding up the process of liquidation of unviable entities. Submission of the draft law to parliament has been delayed in order to allay concerns raised by financial institutions regarding creditor protection. The revised law was submitted to the Minister of Finance on November 16, 2009. 28. The policy issues were strategically important enough to be taken up with the Government in the context of the new series of budget support operations, the Poverty Reduction and Support Credit (PRSC) discussions. Formulations of an acceptable CRA were entrenched as a prior action in either the PRSC I or II (depending on progress.) As the analysis by the Bank revealed fundamental divergences between the CRA as drafted and the policy goals expressed by the Government of Pakistan, as well as departures in important areas from international best practice, the Bank’s views were taken seriously by the Ministry of Finance as represented by the Finance Secretary. At the same time, the IMF in its review of its three year program, took note of activity to revise the CRA which helped bring high level attention to the dialogue on this issue. Box 2 provides the wording in the third review (Box 2). 29. As a result, during the April 2010 Annual Meetings, the Finance Secretary requested that the Bank team visit Islamabad to carry out a brief due diligence and analysis. The analysis took place in July 2010 and the report was provided to the Finance Secretary himself, during the wrap up meeting on July 23 (Attachment 6) and then in a more detailed form through correspondence transmitted on October 17, 2010 (Attachment 7). At the Finance Secretary’s explicit request, an annotated version of the law was provided (Attachment 8). 10 VI. Final Analysis of the CRA 30. The Bank’s review of the final version of the CRA revealed significant issues, which if sustained into law, would represent a unique approach to insolvency reform in the world. Moreover, the balance and approach embodied in the CRA appeared to the Bank team to be inconsistent with the expressed policy goals of the Government, including the goal of creating a viable and economically sustainable mechanism for corporate restructuring. 31. In sum, the CRA appeared to propose a centralized mechanism for the protection of existing shareholders for a small percentage of the largest Pakistani business enterprises. The CRA also appeared to allow the possibility of entrenching existing management at the expense of the interests of other stakeholders, without regard to the viability of the enterprise and without necessary checks and balances. Taken together, the provisions -- many of them highly unusual in their own right, and unique as a set – seemed to create a serious risk that the CRA framework would be a vehicle for abuse, to defeat creditor rights and allow either the continuation of non-viable entities, or more likely, the continuing ownership and management of distressed businesses by incompetent people who no longer retained the confidence of creditors: the very group whose money (and not any longer the shareholders') would be directly at stake in the enterprise. 32. The Bank team viewed the very weak creditor rights regime as likely to cause the banks to bear heavy losses in relation to loans made to companies invoking the CRA, which could have systemic effects on lending and risk taking. On the other hand, the operations of the partly state-funded RTC may encourage banks to rid themselves of their bad loans, but would be highly likely to result in net losses to the public purse for little or no social welfare gain. Most importantly it would represent a hindrance to the Government goal of building fiscal and financial discipline into the system. 33. The specific comments provided to the Government, include the following:  At the heart is what appears to be a framework to restructure -- or indeed, simply to write down or write off -- the existing liabilities of a handful of the largest companies in the economy. 12  The proposed procedure would allow this to be done through a restructuring plan even if each and every creditor of a company had voted against this plan, through court order (possibly at the advice of a proposed Technical Assistance Committee, a quasi non-governmental organization appointed by the Chairman of the SECP and the Governor of the SBP.  There need not be a proper market-referenced valuation of the collateral to determine whether the debtor was indeed insolvent; whether it had a going concern surplus and thus ought to be rescued rather than liquidated; or how badly insolvent it was, with a view to determining which claimant classes are underwater. 12 Companies are eligible to invoke the CRA process only if they have debts (nb. not turnover) of more than Rs 50m i.e. approximately US$ 0.6m. By contrast, the median (nb. not minimum) debt of companies in US Bankruptcy Code Chapter 11 proceedings is around US$1.2m.) It is estimated that the Total number of Pakistani corporate enterprises is 64,559 with 216 Pakistani companies with sales revenue (nb. not debt) over Rs 30m and 32 Pakistani companies employing more than 1,000 people. Therefore the law covers only a handful of large debtors. . 11  The benefit of the enforcement moratorium would extend to the debtor's guarantors, which would usually be its owners. In policy terms, it is difficult to identify a legitimate rationale for this provision, since the enforcement moratorium is intended to protect the company's going concern, not the financial interests of third parties like shareholders.  The procedure would allow for the subordination - to the point of de facto extinguishment -- of pre-existing claims by new loans. De facto extinguishment would occur when the new loans exceeded the value of the company's assets and/or the present value of its future cash-flows.  The approval of a plan would prima facie discharge the debtor's natural-person guarantors. Again, this is a highly unusual provision, showing extraordinary concern not for the continuation of the company's going concern, the position of its employees, or indeed the rights of creditors, but with the interests of its owners, who would usually be the guarantors of its liabilities.  A state supported Resolution Trust Corporation could distort the operations of the markets for NPLs and for distressed assets, and could also retard their development. Even more problematically, it could -- indeed, would be designed to -- buy claims from financial institutions in circumstances where the debtor had invoked or was likely to invoke the CRA procedure and the claims were at risk of being reduced or extinguished in the way described above. 34. The conclusion is that the CRA as written has a high potential for abuse by both debtor and its owners. Specifically, a CRA procedure can be initiated by the company itself while the company continues to operate.13 The company’s guarantors (i.e., its owners) get the benefit of the enforcement moratorium and the claims against the company cannot even be “assessed.�14 The company can then defeat pre-existing creditors by obtaining new secured or unsecured loans enjoying priority over pre- existing claims.15 Pre-existing secured creditors are accorded only notional protection which does not relate to on any actual market valuation of the collateral.16 Finally, the confirmation of enforcement against assets may break up the going concern, but assessment of creditor claims does not. The intention here appears to be to hamper all creditor efforts. VII. Next Steps 35. While the TA for implementation of the CRA was not deployed due to the lengthy discussions on policy issues around the law, there has been a strong receptivity on the part of the Government to the Bank’s intervention in this matter. In March 2011, the Ministry of Finance was reviewing the specific provisions in the law where issues were raised in the context of the Bank’s interventions described above. The review, has led to some redrafting by the drafting committee and resubmission to the Cabinet for review.17 The Bank team continues to remains ready to help the Government (i) finalize the specific provisions in the CRA, (ii) formulate rules and procedures for implementation of the law, and (iii) design, and fund and help implement capacity building for insolvency professionals and regulators. 13 Article 12, Article 13(4), and Article 22, dealing with both types of cases. Article 37(2). 14 Article 37(1)(f). Enforcement against assets may break up a going concern, but assessment of claims does not. 15 Articles 40, read together with Article 22. 16 Articles 40(4)(b) and 45(2), and point 2, above. 17 The Planning Ministry in the context of its Growth Strategy has placed insolvency reform as one its four focus areas for implementation PAKISTAN DRAFT CORPORATE REHABILITATION ACT DRAFT COMMENTS FROM THE WORLD BANK (transmitted informally, in preparation for March 3, VC discussion I. Background 1. In the context of the policy discussions between the World Bank and the Government of Pakistan on strengthening of policy and institutional frameworks for private sector-led growth and responsible access to finance arising out of the current PRSP and CAS meetings, and in connection with a recent request for assistance in modernizing legal frameworks in Pakistan for addressing corporate distress and insolvency, we have had the opportunity to review the current draft (provided to us on 24 November 2009) of the proposed Corporate Rehabilitation Act („CRA‟). The current draft of the CRA introduces a number of changes that, taken together, give rise to several policy concerns. Our reading suggests that the CRA as now structured appears unlikely to provide a mechanism designed to enable the preservation and rehabilitation of economically viable enterprises while strengthening the incentives for responsible access to credit. The degree of discretion left to courts (subject to the advice of a Technical Assistance Committee („TAC‟) of experts over whose appointment and operations the government may be expected to exercise influence), without built-in checks and balances to ensure market-based valuation and other mechanisms to ensure objective and independent assessments of asset value and enterprise sustainability, is not consistent with the international „best practice‟ guidance as reflected in the United Nations International Trade Commission’s Legislative Guide on Insolvency („Guide‟) and the World Bank Principles on Effective Insolvency Systems („Principles‟). 2. This note identifies the mechanisms in the draft CRA that give rise to concern, and sketches out the likely cumulative effects of the operation of those mechanisms. It then expands upon the main issues created by the CRA and highlights the specific provisions underlying these issues. II. Summary of Concerns A. Mechanisms 3. For a small group of the largest distressed companies in the economy, the CRA would create a mechanism that could allow the write down, write off or subordination of creditor claims; the suspension and subsequent discharge of third party guarantees held by such creditors; the maintenance of existing shareholders as the company‟s owners even though their equity had been extinguished by the company‟s financial state; and the retention of a management team that may have lost the creditors‟ confidence. Each of these mechanisms could operate without reference to any market-based test for the viability of the affected company and without an adequate valuation mechanism, and could override even the unanimous objections of the company‟s creditors, who by virtue of the company‟s financial state would have a direct economic stake in the company‟s assets and business. These mechanisms would operate by decision of the courts on the advice of a TAC, a quasi non-governmental organisation over the appointment and operations of which, absent appropriate checks and balances, state authorities could exercise significant influence. Further, the CRA would provide a framework within which a Corporate Restructuring Company („CRC‟) with significant state ownership is envisaged as drawing on public (and other) funds to buy non- performing loans from banks and distressed assets from companies. B. Cumulative Effect 4. In the result, the mechanisms that would become available under the draft CRA may call into question the governance and integrity of the corporate insolvency mechanism as a whole. By eliminating fundamental checks and balances and by centralising decision-making powers in state (or quasi non-state) bodies, it may hamper rather than assist stakeholders in finding sustainable, economically effective solutions for corporate distress. Further, the operation of the CRA could raise critical issues of financial stability (because banks would be forcibly required to absorb the loss of significant levels of non-performing loans), and/or could give rise to significant concern about fiscal discipline (because of the contemplated use of public funds to purchase claims but also assets with no clear market value). C. Centralised Restructuring 5. By virtue of the role of the TAC and the elimination of any requirement for creditor consent in the confirmation of a plan, the CRA establishes a system for centralised restructuring. The members of the TAC would be appointed jointly by the Chair of the Securities and Exchange Commission of Pakistan and the Governor of the State Bank of Pakistan.1 The Court would be required to seek the TAC‟s advice on all key questions concerning the plan, including whether a secured creditor had “adequate protection�; whether a proposed plan or an amendment thereto was “fair and equitable�; which creditor classes were underwater; and it seems, even the overall acceptability of the plan.2 6. The Court could “forcibly confirm� a plan at the TAC‟s advice3 even if all creditors had rejected it.4 While an aggrieved party could object before the Court,5 the Court would be able to decide against it – indeed, would possess jurisdiction to accept the entire plan – without any reference to the market value of the debtor‟s assets.6 The overall result of the law would be an insolvency system based on centralized decisions, isolated from market forces, and possibly influenced by non-economic factors. D. Wealth Effects of the Proposed Legislation 7. The operation of the CRA could result in a substantial transfer of wealth from creditors – notably, financial institutions – to large corporate debtors, and even more so, to their controlling shareholders. The primary mechanism for this is the CRA provision allowing for “forcible confirmation� of expropriatory plans even in the face of unanimous creditor opposition. 7 There is no restriction on any such plan seeking to maintain the company in the ownership of shareholders whose equity stake in it had been entirely extinguished by virtue of the company‟s financial state. 8 8. The second mechanism for potential wealth transfers from creditors to debtors and shareholders is the extension of the benefit of the „automatic stay‟ to the third-party guarantors of the company‟s liabilities.9 This is a highly unusual provision, since the stay in insolvency proceedings is generally intended to protect the going concern of the debtor company, not the financial position of 1 CRA, Article 10(2). 2 “The Court shall refer all plans…� (CRA, Article 10(9), emphasis added). 3 CRA, Article 10(9). 4 CRA, Article 57. By way of contrast and as an indication of international best practice, see Guide, Chapter IV, Recommendation 150; and Principles, Principle C.14.3. 5 CRA, Article 10(12). 6 CRA, Article 57, for example, paragraph 2(a). 7 CRA, Article 57. 8 By way of contrast and as an indication of international best practice, see Principles, Principle C.12.5. 9 CRA, Article 37(2). owners or other third-party guarantors. In a restructuring system in which the consent of at least some affected creditors was required, such extension of the stay would be regarded as objectionable because it would make the proposed plan less likely to attract creditor consent. 9. Third, even a “forcible� confirmation of a plan would prima facie result in the extinguishment of all relevant natural-person third-party guarantees.10 Again, this provision is highly unusual, disincentivises creditor acceptance of the proposed plan, and may be constitutionally suspect, since it purports to affect the position of persons not party to the proceedings before the court, and correspondingly, also to affect the rights against such persons of the debtor company‟s creditors. 10. In any case, the net result of these provisions would be a loss for creditors and a corresponding gain for large corporate debtors and shareholders, an outcome rendered particularly problematic since financial institutions would presumably have granted credit in reliance on the enforceability and (where appropriate) the priority of their claims and guarantees. E. Management Entrenchment and Claim Subordination 11. The CRA potentially enables managers to retain control of the insolvent company even if they had lost the confidence of the creditors, whose money would actually be at stake in the company‟s undertaking. A CRA procedure could be initiated by the company itself, 11 which could then continue to operate substantially as before.12 The draft CRA would enable the company to defeat pre-existing creditors by obtaining new secured or unsecured loans enjoying priority over pre- existing claims.13 Pre-existing secured creditors would be accorded only notional protection that would not relate to any actual market valuation of the collateral. 14 There is no requirement in the draft CRA that the new loans be necessary for the continued operation of the company or for the preservation of the value of its business.15 12. A crucial role of restructuring proceedings is to move productive assets out of the control of a failing management into the hands of a new, perhaps more competent one. Under the draft CRA, this need not happen, and indeed, the old management would be able to continue to operate the company even if it reduced (or extinguished) the value of legitimate claims of pre-existing creditors without bringing any corresponding benefit to the company‟s business (as opposed to the position of its shareholders). F. Risks to Financial Stability and/or to Fiscal Discipline 13. The CRA significantly impacts the position of banks as creditors. From the perspective of financial stability, given the relatively weak protection of creditor rights under the CRA and the potential for large loans to be written down, written off, or de facto extinguished by subordination, banks in Pakistan may find themselves saddled with significant NPLs that may weaken their balance sheets as a result of CRA-driven restructurings. Although the law would only apply to a minimal number of Pakistani companies16 (approximately, less than 0.33% of the corporate enterprise 10 CRA, Article 58(3). 11 CRA, Article 12. 12 CRA, Article 13(4), dealing with involuntary cases; and Article 22, dealing with both types of cases. 13 CRA, Articles 40, read together with Article 22. 14 CRA, Articles 40(4)(b) and 45(2), and point 2, above. By way of contrast and as an indication of international best practice, see Guide, Chapter IV, paragraph 38, and Recommendations 66-67; and Principles, Principle C.12.2. 15 By way of contrast and as an indication of international best practice, see Guide, Recommendation 63. 16 CRA, Article 7(2)(c). population17), these may represent a disproportionately important part of the Pakistani economy, and banks‟ inability to obtain repayment from these companies could have systemic effects. 14. The envisaged operation of a (partly) state-funded CRC18 poses risks of another kind. Such an entity could bid for and take into the public sector assets that would more effectively have been utilised in the private one. Its operations could distort nascent distressed asset markets in the private sector by confounding price signals and by impeding private sector players‟ ability to learn to price assets properly and to develop skills to turn around distressed businesses. And even more problematically, it could buy claims from financial institutions in circumstances where the debtor had invoked or was likely to invoke the CRA procedure and the claims were at risk of being reduced or extinguished in the way described above. This could create a net loss to the public purse and pose a risk to fiscal discipline. G. The Position of Employees and of Non-viable Distressed Companies 15. It is important to consider two roles that the CRA does not appear to be designed to play. Take first the position of employees. The CRA does not provide a framework for employment preservation in the context of corporate distress. Comparative restructuring law provides, as examples of employment preservation mechanisms, the obligation on those managing restructuring proceedings to consult with employee (or state) representatives before making redundancies; and the obligation on buyers of certain of the distressed company‟s assets to assume the burden of relevant employment contracts. The CRA contains no such mechanism. Further, restructuring laws often accord distributive priority to accrued wage and other employee claims. The CRA does not provide any such priority. Indeed, if a company were to be made subject to a CRA proceeding before being removed into winding-up, the employee claims given statutory priority in winding-up19 would apparently be subordinated to all CRA administrative costs and claims. 20 The absence from the CRA of any mechanism for the protection of employee interests provides a strong contrast with the unusually comprehensive protection it accords to the interests of the company‟s shareholders. 16. Second, the CRA is not a suitable vehicle for the pursuit of any social policy favoring the preservation of non-viable distressed enterprises.21 A government might be minded to pursue such a policy, for example, because some such enterprises were regarded as systemically significant, or for some other reason as possessing a value exceeding that of their economic product. It would be important, however, for any such policy to be pursued openly, with appropriate public scrutiny of its underlying rationale and justifications, and with due consideration of any alternatives. It would also be crucial openly to determine which public or private group ought to bear the costs of keeping distressed non-viable companies in operation. The CRA does not currently contain any of these safeguards. Firstly, it appears designed not so much to preserve distressed businesses as going concerns as it is to protect the position of the company‟s shareholders (see in particular paragraphs 8 and 9, above). Second, the effect of its distinctive features is to shift the primary costs of corporate distress from shareholders – the parties usually regarded as having responsibility for these costs – to creditors (see paragraphs 7 to 13, above). And third, these costs may then be shifted through the CRC mechanism to another group, perhaps including the taxpayer (see paragraph 14, above). The CRA 17 Compare the figures at http://www.statpak.gov.pk/depts/fbs/publications/ec_2005/appendix-x.pdf and http://www.statpak.gov.pk/depts/fbs/publications/ec_2005/appendix-xv.pdf . The figure in the text may be an underestimate: http://www.statpak.gov.pk/depts/fbs/publications/ec_2005/summary_findings.pdf ; http://www.statpak.gov.pk/depts/fbs/publications/ec_2005/ch2.pdf, at page 7. 18 CRA, Chapter 6. 19 Pursuant to Section 405 of the Companies Ordinance 1984. 20 CRA, Article 21(5). 21 In this context, a non-viable enterprise is defined as one the present value of the sum of whose current and future cash-flows is exceeded by the market value of its constituent assets; such an enterprise is distressed when it is unable to fully meet its obligations as they come due. procedures serve to obscure rather than illuminate the rationale and justifications for each of these steps, and provide no guidance either on why the shareholders are not the appropriate cost-bearers, or on whether in any case the creditors, taxpayers, or some other group would be best placed to bear these costs. H. Limited Scope of Proposed Legislation 17. As noted, the current draft of the law restricts it application to a very small number of corporate debtors; however, the scope may be expanded by administrative action. If the possible risks of the law enumerated above were not mitigated by changes to the CRA as currently drafted, strictly limiting the applicability of this proposed legislation would be important. Clearly, however, consideration should be given to the development of a different, comprehensive corporate rehabilitation statute, such that the resulting law would offer a balanced system allowing for the restructuring of all distressed companies in a sustainable, economically sound manner. Attachment 6 Attachment 7 Attachment 8