The Covid-19 pandemic, first and foremost a global health crisis, has had severe economic and social impacts around the world. One of its many negative impacts has been adverse effects on firms’ earnings, which have worsened the ability of firms to service debt.
Although economic downturns are often followed by increases in the number of insolvency filings and in NPL levels, research suggests that insolvency filings remained stable during the Covid-19 crisis and in some countries declined. This is attributable, in part, to the swift action of numerous governments — injecting trillions of dollars in stimulus measures early in the crisis — and rapid adjustment by firms.
Within this framework, the role of corporate workouts become more important. Jobs need to be preserved as far as possible and financially distressed companies are increasingly looking towards informal restructuring mechanisms to salvage value.
There are important drivers that have moulded the industry into what it is today. These, and more are discussed in a toolkit which was recently released by the World Bank.
Clear and present danger
While there is government support to address the worst impacts of the Covid-19 Pandemic, this does not mean that the risk of a wave of insolvencies has been fully averted. Studies from the World Bank Group and other sources report that global financial vulnerabilities have risen since the start of the pandemic, partly because firms have borrowed to tackle liquidity shortfalls experienced during the crisis. In addition, shifts in consumer preferences brought about or accelerated by the crisis may mean that the business models of certain firms will be unsustainable after the pandemic subsides. There has been, and remains, a markedly increased risk that micro-, small-, and medium-sized enterprises (MSMEs) — significant providers of employment — will be forced to close, particularly in countries where vaccines are still not widespread and lockdowns (and their resulting effects on businesses) are continuing.
The toolkit points out that, even when a crisis is not ongoing, corporate distress and firm closure are unavoidable. To a certain extent, it is a desired outcome of strong market economies. It can be seen as a process of self-cleansing and market efficiency that promotes the survival of the most competitive firms. Nonviable firms that remain in business (so-called zombies) should leave the market to make resources available for other firms; their continued existence can lead to credit misallocation and a drop in economic productivity.
Where a business is viable, however, its closure is value-destructive and often leads to unnecessary job losses. In addition, where a large number of businesses are unable to meet their debt obligations, this may lead to high levels of NPLs and other nonperforming assets on banks’ books, limiting credit availability, jeopardizing financial stability, and impeding economic growth. It is critically important that the rescue of viable but financially distressed enterprises be facilitated, in both crisis and noncrisis times. Specifically in the context of the Covid-19 pandemic, the Group of Thirty has noted the need for a nuanced policy response to a corporate solvency crisis.
The toolkit adds that, this means, in particular, ensuring that restructuring mechanisms are tailored to individual economies and that they function effectively. These restructuring mechanisms may be formal and involve the courts, or they may be less formal and conducted with minor or no institutional involvement. The workout procedures described in the Toolkit sit at a point below judicial reorganization on this formality continuum. The World Bank Group has recently observed that although such procedures cannot fully replace more formal procedures, they can in principle be implemented relatively quickly and their use can reduce pressure on the court system. This can be of particular value in jurisdictions where courts are at risk of being overwhelmed by numerous insolvency cases and where institutional capacity to undertake significant reforms of the insolvency system in a short period of time is limited.
The toolkit points out that corporate workouts tend to generate great interest from policy makers during financial or economic crises. This has been evident during the past financial crises, including the Asian financial crisis of the 1990s, the global financial crisis of 2008–2009, and, currently, the Covid-19 pandemic. To avert unnecessary business liquidations and asset fire sales arising from the effects of the health pandemic, policy makers and the private sector are seeking fast, flexible, and cost effective solutions to address firms’ liquidity issues without overburdening the court systems.
That said, the many economic benefits of having corporate workout frameworks are also present in non-crisis times. Generally, flexible and less formal corporate workout tools complement the formal insolvency systems, facilitating faster restructurings while reducing the burden on courts.
The toolkit adds that effective corporate rescue frameworks are positively associated with increased returns to creditors, better access to credit, job preservation, and the promotion of entrepreneurship and venture capital — fundamentals that are all positive for private sector development and economic growth. Corporate workout frameworks, being key to the effective management of credit risks and insolvency risks, also play an important role in protecting the health of the financial sector. This is particularly the case in emerging markets and developing economies (EMDEs) where finance of nonfinancial corporations is predominantly provided by the banking sector.
Of course, corporate workouts do not function in a vacuum. They must be tailored to address the specific needs and challenges of the market and must be supported by an adequate and enabling legal and regulatory environment. It is therefore vital that all legal processes and protocols are followed.
A road travelled before
The toolkit points out that Governments reacted quickly to blunt the effects of the Covid-19 pandemic on businesses, enacting a series of emergency measures to slow down and even prevent debt enforcement and insolvency proceedings and to ensure ongoing firm liquidity during the crisis. As these temporary measures come to an end in many economies around the world, the focus is shifting to ensuring that insolvency systems are equipped to address significant levels of corporate distress that may arise, and that supporting institutions (such as courts) do not become overwhelmed by a possible influx of increased insolvency filings.
Following the Asian financial crisis of the late 1990s and the global financial crisis of 2008–2009, policy makers have increasingly understood that there is no single, “silver-bullet” policy response to address high levels of corporate distress and related nonperforming loans (NPLs).
The toolkit adds that, instead, corporate restructuring, or business restructuring, can take many forms, offering a “toolkit” of informal to formal procedures that can be used to address differing levels of financial distress. For instance, while tools may take the form of centralized responses through government involvement and sector wide coordination (typically during a financial crisis), more informal, flexible processes may be more appropriate to work out individual NPL portfolios with minimal government or court support. These “workout” frameworks, when structured appropriately and implemented in an enabling environment, can facilitate the resolution of both high-value portfolios concentrated in a few borrowers and large-volume portfolios of low-value NPLs.
Many elements must be present to effectively restructure businesses. Firms will need to be viable, related laws must facilitate both financial and operational restructuring, and participation of stakeholders is critical. Most importantly, an economy needs a transparent legal framework and regulatory principles that provide an enabling environment for fair, good faith restructuring negotiations. Once these are in place, they must be applied consistently to ensure that the economic benefits of the workout procedures are achieved. Efficient workout tools play a vital role in allowing insolvency regimes to facilitate market stability and, by extension, crisis recovery. It is therefore important that stakeholders learn how to use such tools effectively.
An increase in risk
In the context of the Covid-19 crisis, the risk has significantly increased that when government stimulus and forbearance measures end, fundamentally viable businesses will be forced to close, with associated job losses. Even in noncrisis times, corporate distress is unavoidable. However, systemic corporate distress can lead to high levels of nonperforming assets.
This can have adverse effects across both the financial sector and the real economy, such as increased inflation and reduced GDP growth. Preventing and resolving nonperforming assets, through sound insolvency and debt resolution regimes, goes a long way toward ensuring the stability of the financial sector. Such regimes also promote access to credit and in turn facilitate economic growth by ensuring that nonviable businesses are liquidated efficiently, unproductive zombie firms can exit the market, and viable businesses are restructured.
The toolkit adds that, while ensuring efficient and orderly liquidation has always been a challenge for policy makers, for most jurisdictions the larger challenge has been on the restructuring front. International experience tells us that there is no one-size-fits-all solution to the challenge of developing effective restructuring frameworks.
Best practices require that a restructuring system provide debtors and creditors with a range of tools to restructure troubled companies. Formal reorganization proceedings must be supplemented with other options. This is what makes frameworks for workouts particularly important.