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It's a frightening world out there: Chinese factories by the thousands lock their doors, and their owners disappear into the night. Russia's once-mighty resource giants scamper to restructure crippling debt and avoid going under. Ukraine and Latvia teeter on Iceland-like insolvency.
Financial institutions just about everywhere seize up and are shut down or nationalized. On just one day late last month, a Danish bank collapsed, a Japanese finance company went bankrupt and two German states were forced to pour almost $4 billion into a crippled lender to keep it afloat.
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With even the most muscular economies staggering, financial failure and corporate crashes are becoming increasingly common in nearly every locale. "The situation is the same everywhere," says Alexander Rymko, the Moscow-based lawyer who heads the Russian banking practice at Lovells LLP. "We expect a lot of bankruptcies."
What's perhaps less obvious is that cross-border components will figure prominently in a huge number of these collapses, whether through investments, creditors, subsidiaries, assets or a combination of all of the above. "Everything we're touching is cross-border," says Peter Spratt, London-based crisis management leader at PricewaterhouseCoopers LLP. "It's an inevitability of globalization."
Legal practitioners and restructuring experts are gearing up for a global onslaught of insolvencies and bankruptcies unprecedented in terms of scope, size and reach. What's more frightening, the worst may be yet to come. "We're at the fairly early stages of actual restructurings, and that's before we even begin to see the quantum of insolvencies," says Spratt. Across Europe, he adds, "I'm personally surprised that the number of restructurings is not higher than they are." But Spratt warns that insolvencies tend to lag the economy by up to two years. Since the recovery is not expected to begin at least until 2010, the insolvency wave will be breaking for years to come. It will inevitably spill across borders.
The biggest response so far has been to put off the reckoning, according to interviews with professionals, coupled with a survey of published bailouts, restructurings and insolvencies. Leave aside for the moment the U.S. and Britain and their multitrillion-dollar efforts. Governments elsewhere have sunk hundreds of billions of dollars into bailouts, most of which are structured as short-term loans.
How much longer that's possible is another question. Governments are becoming harder-pressed to keep writing checks as corporations falter. Private banks will have more and more trouble shuffling bad loans. All the while, the speed of these collapses will accelerate. "Formal proceedings will become more important," says Philipp von Randow, a Frankfurt-based Latham & Watkins LLP restructuring partner. "There's less time for out-of-court restructurings."
Crosscurrents will flow in every conceivable direction. Consider the high-profile bankruptcy of SsangYong Motor Co. in January. This marked the second time the South Korean auto manufacturer has gone bust in the past decade. SsangYong, which has been 51% owned by China's Shanghai Automotive Industry Corp. since 2004, went into an odd kind of court receivership in January. Once it defaulted on its debt, a South Korean court "set aside the rights of the majority shareholder, ejected it from management and appointed alternative managers," in this case some Korean SsangYong employees. They will attempt to "salvage some of the company," says Hank Morris, director of Seoul-based business advisory firm Industrial Research & Consulting Ltd. This isn't liquidation, Morris stresses, but a chance at restructuring, during which time debts are frozen. Shareholders aren't wiped out, just sent packing. Eventually, the court must determine whether a slimmed-down SsangYong can survive. If it doesn't, Morris warns, many of the vehicle maker's suppliers will go down with it.
So from São Paulo to Shanghai, Moscow to Manhattan, lawyers and other restructuring advisers are gearing up for a mammoth insolvency wave. And that raises a second frightening issue: Is the world ready? Are various legal regimes around the world sufficiently well equipped and prepared to handle the rush?
The answer is neither simple nor uniform. Obviously, some countries have systems better enabled than others. But practitioners in 10 different jurisdictions unanimously draw a hard line between the regulations on the books and their application. "Just because laws allow for it doesn't mean it's going to happen," warns Karen Ostad, a New York-based partner at Morrison & Foerster LLP, with long experience in cross-border restructurings.
Of the once-supercharged Bric countries, China, Russia and Brazil all have relatively new bankruptcy or restructuring laws. The fourth, India, is debating one. Other countries have signed on to a model United Nations insolvency code to some degree or other. The Cayman Islands, for example, just enacted an insolvency law that contains substantial cross-border provisions, says Jeremy Walton, a Caymans-based partner and global head of the fund disputes team at the law firm Appleby. "It's going to help people going forward," Walton believes.
The European Union is buoyed by both 2002 regulations establishing a blueprint for multinational bankruptcies and a European Court of Justice decision in 2006 involving a subsidiary of failed Italian food giant Parmalat Finanziaria SpA. They make cross-border cases easier to be filed and heard in a single jurisdiction, the so-called center of main interests.
Actual practice, however, can be another story. Practitioners warn that coordinated insolvencies may be more the exception. "For every [Comi] used, probably 100 can't make the case," says Simon Granger, the London-based senior managing director of corporate finance and a restructuring specialist at FTI Consulting Inc.
Even within national borders, everything from culture and domestic politics to the state of judicial expertise and local government pressure can create a laborious bankruptcy process. Often, the situation on the ground can be at best messy and at worst an unworkable environment for insolvencies. Add multiple jurisdictions to this mix and it begins to look a lot less settled.
"Everyone anticipates more jockeying," says Katherine Ashton, a London-based partner at Debevoise & Plimpton LLP who specializes in restructuring.
Finally, the complexity and scope of today's insolvency can be mind-boggling. Take the Madoff scandal and other Ponzi schemes. Walton believes that "massive insolvencies with zero assets will be causing real problems in the future," in which liquidators must train their sights primarily on those responsible for the fraud.
All that said, legislators have shown they can react quickly and rewrite laws to make them more responsive -- if the crisis is serious enough. "The United States isn't alone at looking at extraordinary measures for dealing with the situation," says von Randow.
Ostad cites Iceland, which had to nationalize its insolvent banks in the early days of the crisis. "They created laws, where before they didn't have them or need them," she says.
With its major banks failed and its national coffers depleted, Iceland was a situation in extremis. Yet other measures have occurred as well under less dramatic circumstances. Two weeks before the meltdown, Italy passed changes to its bankruptcy law tailored to the bailout of Alitalia Cia. Aeree Italiana SpA but useful in separating bad assets from good.
As the financial world imploded, both Germany and France rushed out legislation that makes restructuring less hidebound. In France, "the government wants to facilitate pre-insolvency restructuring," says Antoine d'Ornano, Paris-based international counsel for Debevoise. Paris enhanced 2005 legislation that created mechanisms for restructuring debt. These regulations, in effect since Feb. 15, make it easier for management to obtain a kind of court-ordered time-out. "When the debtor goes to court, it forces creditors to come to the table," says d'Ornano, who explains the process:
The regulations provide for a court-blessed arrangement, commonly called safeguards. These enable management to stay in place, something akin to a debtor-in-possession but without formal bankruptcy. Debtor and creditors can draft a workout with the help of a court-approved administrator who monitors and assists the process. Banks can extend repayments or make new loans with superpriority over existing debt, all new concepts in France. Safeguards are available for six months, with two six-month extensions possible. At the end of the process, the court decides whether to approve the new arrangement.
Germany has already eased the strict conditions under which directors must declare insolvency. It is poised to modernize its antiquated bondholder law. And it may enact even more sweeping measures.
According to local press reports, the government is considering a law that would enable an official administrator to step in, assume on behalf of the government the liabilities of a corporation or bank and try to restructure. During this period, equity holders would have no say in the operations. But if the turnaround is successful, the government would hand back the company to its previous owners, minus restructuring costs. "It's breathtaking what thoughts are pondered," von Randow says.
This is a global crisis in every sense of the word. Financial woes in one country can have severe and unexpected repercussions in another. According to Austria's finance minister, Austrian banks alone have loaned €230 billion ($290 billion) to Eastern Europe, equal to 70% of the country's GDP. (Austrian and Swiss banks flooded the region with money. Thanks to these banks, more than half of Poland's mortgages alone are in Swiss francs, a bout of cross-border insanity that defies imagination.) Moody's Investors Service is finally getting around to at least threatening to downgrade these banks.
The belief that Western European banks will withdraw lending in Eastern Europe in turn leads to a fear that not only Eastern European corporations will be squeezed, but nations themselves will experience even worse current account deficits. That puts even more pressure on lending, both corporate and sovereign. Already, there is widespread belief that unless the International Monetary Fund bails it out, Ukraine could default on its sovereign debt as early as this month. Latvia's debt is already rated as junk. Bulgaria's current account deficit is a staggering 21.5%.
This kind of negative feedback loop can wreak havoc on borrowers, no matter how solid they appear. "If sovereign debt defaults, any company within that country has enormous problems," Ashton says.
So far, the default response from both governments and private institutions is to avoid formal bankruptcy whenever possible. However, that implies the ability of banks and other financial institutions to lend more or on better terms. That in turn presupposes liquidity, which remains in short supply. Ashton explains the dilemma: "Two different elements are at war with each other. No one wants to go into bankruptcy, and creditors want the highest return. On the other hand, creditors don't have a lot of leeway. There's no more credit."
Confusion and misstep bedevil both government and private-sector efforts. No country is immune. Witness Washington's stumbling, ad hoc approach to wounded U.S. banks, its dramatic shifts on the bailout terms of insurance giant American International Group Inc. and the widespread condemnation of the Bush administration's refusal to bail out Lehman Brothers Holdings Inc., which stands, by far, as the biggest bankruptcy of this cycle. "In good economies, nations have time to think about laws and social politics. In bad times, they just react," Ostad says.
It would also be a mistake to view cross-border bankruptcy as anywhere near unitary or even convergent. The world doesn't operate under the fundamentals of Chapter 11, despite what Americans may want to believe. DIP financing in Europe is unheard of. Equitable subordination differs from country to country. Insolvency committees have different standings.
Among insolvency regimes, fundamental differences remain in approach, priority and desired outcome. In Brazil formal bankruptcy is a long, slow death sentence to be avoided at all costs. Yet, as Eduardo Salomão Neto, the São Paulo-based senior partner at Levy & Salomão Advogados, explains, nonliquidation reorganization became an option in Brazil only about three years ago. "The last option is to put a company into bankruptcy," he says. "A bankruptcy procedure, properly litigated in Brazil, may take 10 years or more."
So far, at least, Brazil has escaped relatively unscathed in the global meltdown, although Salomão reports several midsized companies have filed for reorganization since the end of last year. But with such severe bankruptcy regulations, only those companies with absolutely no alternative take the plunge. In August, the large agribusiness Agrenco Ltd., formally declared bankruptcy. But that came after its chairman and COO were arrested on money-laundering charges. Agrenco parent Agrenco Holding BV is based in Bermuda, but most operations are in Brazil.
The differences of approach to the institution of bankruptcy are evident even within the European Union, whose regulations supposedly demand mutual recognition of laws and authority. "On one end of the spectrum, there's a coordinated pan-European process," says Granger. "At the same time, there's a lot more scope for a process that's fragmented and adversarial."
Debevoise's Paris-based d'Ornano cites conflicts between where he sits and where his colleague Ashton resides across the English Channel: In the U.K., he says, insolvency administrations tilt toward creditors and liquidation of assets, whereas in France, the end game focuses on "maintaining employment levels."
Or take another neighbor, Germany. It continues to have strict rules governing when a company is forced to declare insolvency, with directors criminally liable for lapses in judgment. At the other end of the process, equity holders must approve any debt-for-equity swap, giving them the rights to scuttle a restructuring.
Western European jurisdictions have refined their insolvency regimes in the past decade and made great progress, von Randow says. But there remains "a very interesting divergence among these jurisdictions."
In normal times, the whole process of cross-border insolvencies could play out over years of court hearings and be measured, methodical and sometimes excruciatingly boring. (The European Court of Justice decision involving Parmalat subsidiary Eurofood IFSC Ltd. came more than two years after the bankruptcy itself.) Likewise, company executives, directors and their restructuring advisers might have months to plot strategy before deciding what route to take.
But these are not normal times. Von Randow frames the issue in medical terms. In the past, "patients were sick, but we had ample time. Now the patients come in and they're about to die. Time is running out much faster."
Return for a moment to Lehman, the bankruptcy widely held responsible for triggering the current financial meltdown. Lehman filed for Chapter 11 on Sept. 15, 2008. Almost simultaneously, the U.K. subsidiary went into receivership and a U.K. receiver assumed control. Other administrators seized operations in Hong Kong and Japan.
With hundreds of thousands of clients at risk and with billions of dollars of business evaporating by the day, a U.S. bankruptcy court judge approved the sale of Lehman's North American investment bank operations and real estate to Barclays plc a scant four days later.
At the time, Judge James Peck and others in that packed downtown Manhattan courtroom praised the speed and collaboration among authorities, not only within the U.S. but overseas as well. Six months later, some revisionist history may be in order. While U.S. operations were kept open for the week, receivers by law had to immediately shut down U.K. operations. The U.S. has separate bankruptcy provisions for a broker-dealer; Britain doesn't.
Billions of dollars got stuck. Jurisdictional disputes remain. "Local creditors have competing interests," says Granger, whose firm represents unsecured creditors. Lehman's empire stretched around the globe. Asset sales elsewhere are nowhere near resolution.
The Lehman bankruptcy gives some idea of just how difficult cross-border insolvency can be today. Ashton describes typical financial complexities: Imagine a German company, she begins. Its syndicated loans are formulated under English law, its high-yield debt under U.S. law. "A German court could be asked to apply U.S. law and British laws," with creditors. "God knows where," she says.
Then, there are issues involving joint ventures. Andrew Bolton, who heads Appleby's restructuring practice, describes a hypothetical scenario: Russian and Brazilian companies come together to form a joint venture, incorporated in the Caymans, to own a pipeline in Kazakhstan.
Or take your average multinational concern. The very concept of a center of main interests assumes a strict hierarchy between an all-powerful head office and its dependent subsidiaries. Instead, what Granger terms a "matrix" of cross-border relationships is often at work, with everything from shared production plants to global stakeholders. He cites the hypothetical case of a British holding company with subsidiaries in Germany, France and Italy. "If the German subsidiary is independently run, has a German lender, German suppliers and German business, it's going to be very hard to convince the German court that the insolvency shouldn't be in Germany," he says.
European insolvency regulations have so far "failed to provide a way a group could be brought under control," adds Neil Cooper, a London-based corporate recovery group partner at restructuring advisory group Zolfo Cooper. He suggests the EU will eventually tackle the notion of substantive consolidation of groups when insolvent, possibly crafting some kind of "huge pot of assets and liabilities that can then be separated."
But even principles enshrined in laws common from one jurisdiction to another aren't necessarily guaranteed. In a landmark September 2007 case, U.S. Bankruptcy Judge Burton Lifland blocked an effort by two Bear Stearns Cos. hedge funds to file for insolvency in the Cayman Islands, where they were incorporated, and have the U.S. courts recognize the insolvency. Lifland denied the so-called Chapter 15 filing. He ruled that despite their Cayman registration, the center of main interests was in the U.S., which is where their operations, management and customers were. "We never envisioned a case that wouldn't be recognized in the country of incorporation," says Cooper, who helped draft the United Nations model law on cross-border insolvency.
That decision and what it represents leaves legal advisers scrambling for alternatives.
Walton and Bolton describe efforts in the Caymans and other offshore domiciles favored by hedge funds and other investment vehicles, many in serious trouble: a U.S. Chapter 7 filing alongside a Caymans filing and administrator; a Chapter 11 filing immediately preceded by a Caymans filing; preparation for an insolvency filing in the Caymans by asset transfer; or the appointment of a chief restructuring officer.
Walton calls the typical hedge fund "a paradigm of cross-border" relationships, with investors, investments and operations spread every which way. "If you can't have a unitary cross-border proceeding for a hedge fund, you really are in difficulties," he says.
While Walton and Bolton say the Caymans are well equipped to handle cross-border insolvencies, other jurisdictions appear far less prepared. Take Russia. Flush with sky-high natural resource prices, major Russian corporations went on spending sprees in mid-decade, buying domestic competitors and foreign trophies. These companies owe a total of $400 billion in foreign debt, according to the head of Russia's Regional Bank Association. Although the loans may have been used to fund offshore acquisitions, much of this debt is held by the Russian operating and production companies themselves, and the debt is secured by shares.
Russian corporate defaults are so far just a trickle; Debtwire estimated between 20 and 30. Most are relatively modest. Russia's largest baby food manufacturer, Nutritek Group, defaulted on a $50 million bond in December and has an additional $100 million payment due in two bonds by June. The company said it would hold a rights issue to pay down its debt.
Why these numbers are small is obvious: By some estimates, Russian banks loaned more than $15 billion to Russian corporations to avoid default and repay foreign debt. One Russian state bank, Vnesheconombank, or VEB, alone has provided almost $11 billion, according to Reuters.
The biggest single bailout came in November, when VEB gave UC Rusal a $4.5 billion, one-year loan, which the company used to retire syndicated foreign debt in danger of default. The money had been used to acquire a 25% stake of Russia's mining giant, OJSC MMC Norilsk Nickel.
Rusal, controlled by Russian oligarch Oleg Deripaska, is the world's largest aluminum company. Deripaska is desperately trying to restructure more than $14 billion in debt, much of it used to acquire offshore assets in countries from Australia to Nigeria. Aluminum, meanwhile, has plummeted from a high of $33,000 a ton in February 2008 to $9,400. Foreign banks holding about half that debt are now negotiating with Deripaska, who wants an extension on repayment, with rates tied to aluminum prices.
Whether the Kremlin can continue to rescue Rusal and others isn't certain. Dependent on oil and gas revenue, the country's reserve fund is plummeting. Meanwhile, the central bank is hemorrhaging dollars as it desperately tries to prop up the value of the ruble. "The government has already indicated it is not going to bail out any more companies," says Rymko, the Lovells lawyer. He predicts bigger Russian banks will merge while small and medium-sized banks will be allowed to fail. "I believe the government is wise enough not to spend all its reserve funds to support commercial companies," adds Dmitri Nikiforov, a Moscow-based Debevoise partner. "I think there will be major insolvencies in the near future, probably this year."
Nikiforov, however, warns that debt structures can be "chaotic." Russian banks are notoriously reluctant to share information with others and would rather negotiate "sweetheart deals behind the backs" of their competitors. "There's a huge behavioral aspect to Russian restructurings," he says. "It's an entirely different world."
What happens when the current trickle becomes a flood? History indicates the Russian bankruptcy system won't be capable of handling cases or acting as an impartial arbiter. In the 1990s, bankruptcy became a favored tool to seize control of companies, with late payments and minuscule debts used as leverage to put even healthy companies into insolvency and assets sold to favored buyers at a fraction of their cost.
The Russian Duma changed the insolvency law in 2002. On paper, at least, it promised a more structured, orderly process. That was strengthened in January, when amendments to the law took effect. Most importantly, they increased a secured creditor's ability to gain pledged assets.
No one, however, suggests Russia has a working bankruptcy system. The one major company to go bankrupt since the 2002 law was OAO NK Yukos, the oil and gas giant whose controlling shareholder, Mikhail Khodorkovsky, ran afoul of then-President Vladimir Putin. Khodorkovsky has been locked up for the past six years on fraud and tax evasion charges. The 2006 Yukos bankruptcy itself was a sham, with no mechanism for the company to discharge debts. It really harked back to the days of forced control change. "The entire legal regime was manipulated," says Nikiforov. "It was entirely artificial."
Last October, a Dutch court validated that view in a case that revolved around the Russian bankruptcy administrator's attempts to seize offshore assets held by Yukos subsidiaries based in the Netherlands. The court ruled that the Russian bankruptcy lacked due process. The administrator has appealed.
Robert van Galen, Amsterdam-based head of restructuring and insolvency for Dutch law firm NautaDutilh NV, represented the old Yukos shareholders in the case. He believes it's the first time in Europe a bankruptcy wasn't recognized because of due process or human rights violations. According to van Galen, the case is an important precedent, because judgments in one European Union country tend to be recognized in others.
Just as big a gap is visible in China, whose new bankruptcy law is barely 18 months old. It followed years of preparation and generated good reviews when it was enacted. Actual bankruptcy cases, however, are few and far between and will likely stay that way, says Steven Dickinson, a Shanghai-based lawyer for Harris & Moure PLLC. "At first, the code looks OK and includes a very American-style reorganization," he says. However, "on closer reading, everything has to be done by the courts," which lack the manpower and the experience to carry out the supervision. "I've gone into court and asked, 'Where is the staff to do this?' The answer is, 'We're not going to do any.' "
The obstacles facing China in implementing its new bankruptcy code are formidable. Judges aren't trained; many are recent university graduates. Support staff is nonexistent. "It's still a very slow process," says Helena Huang, a Hong Kong-based restructuring group partner at Kirkland & Ellis International LLP, who is generally more upbeat than Dickinson. "It's not going to happen overnight."
Since the crisis began, China's biggest bankruptcy is Sanlu Group, responsible for the tainted milk that killed at least six infants and sickened thousands of others. The bankruptcy followed the convictions of top executives, including two who were ordered executed. "This was political, not a business decision," Dickinson says.
Instead, China's approach to bankruptcy is akin to that of Japan in the 1990s: Let the banks handle it.
So far, Chinese banks haven't foreclosed on the companies. Neither do they seize assets and attempt to auction them off. Instead, much as did their Japanese counterparts, they quietly arrange for a change in ownership, sometimes assuming control themselves.
"Cross-border insolvencies can be really complicated," says Timothy DeSieno, a New York-based restructuring partner at Bingham McCutchen LLP with wide experience in insolvencies around the world. "It's really a case-by-case exercise." Now we're about to find out what that means. |
