David Clementi: Debt workouts for corporates, banks and countries: some
common themes
Speech by Mr David Clementi, Deputy Governor of the Bank of England, to the INSOL International
Sixth World Congress held at the Hilton Metropole Hotel in London on 19 July 2001.
* * *
Introduction
I am delighted to have the opportunity to speak at this, the Sixth World Congress of INSOL
International. The Bank has a long-standing interest in insolvency arrangements. As the keepers of
the London Approach, we have a direct, if informal, role in corporate workouts. This is in part
historical, but it is no accident. Development of a satisfactory framework for corporate workouts is
integral to the Bank's core purposes of maintaining financial stability and seeking to ensure the
effectiveness of the UK financial system. The Bank is more commonly associated with the Monetary
Policy Committee and the pursuit of monetary stability. But financial stability is an important corollary
to this; it is difficult to achieve one without the other. The Bank in particular is closely involved with the
design of regulation and financial infrastructure, such as payments and settlement systems, to ensure
that these are robust and the system is, as a result, better able to withstand a crisis. Our interest in
insolvency arrangements is similar. Without a framework that is predictable, equitable and transparent,
designed to maximise value for all interested parties, the costs and wider economic disruption from
unnecessary corporate liquidations may be enormous.
My speech this morning, therefore, provides an opportunity to signal the Bank's support for INSOL's
mission to take a leadership role in international insolvency and credit issues and to bring about
greater international co-operation among the main players. The growing interest by a number of
international organisations in the design of orderly and effective corporate insolvency regimes, and in
the encouragement of greater co-operation in cross-border corporate insolvencies, suggests you have
been successful in that objective. I think this has been greatly assisted by the important work which
the INSOL Lenders Group has been co-ordinating in developing a set of principles governing
corporate workouts at the pre-insolvency stage.
But corporate workouts represent just one strand in financial restructurings more generally. There are
two others I want to cover; and these are, first, restructurings of financial institutions, including banks,
and, second, sovereign debt workouts. Indeed, in many instances, restructurings in the corporate
sector will need to proceed in tandem with those in the financial and sovereign sectors. I would argue
that, in all three cases, a collective approach by the different participants in the private and public
sectors, and effective co-ordination among creditors and debtors, should help to preserve value. So I
would like to consider today the extent to which these differing approaches raise common themes, and
also whether there are distinguishing features which could affect the interactions between the three
strands.
I recognise, of course, that more progress has been made in the corporate context than in the area of
financial institutions or sovereign debts; and I think that reflects great credit on many individuals and
organisations represented at this Congress. So I will start by offering a few thoughts on corporate
workouts, linking these to the Bank of England's long-standing involvement in the London Approach
and our responsibility for the maintenance of financial stability. I will then turn to look at how the
desirable features, incorporated into the agreed principles governing international corporate workouts,
might be applied to financial restructurings; and finally in a similar way look to whether these principles
can be carried across into the field of sovereign workouts. This raises the issue of the role of the
various different parties to debt restructurings, including the official sector. By drawing out some
common themes, I hope to put INSOL's work on the corporate sector into the broader context of
differing approaches to resolving debtor difficulties.
Corporate workouts
Let me start then with corporate workouts; and let me begin by saying a few words about the Bank's
interest in this issue. As I noted a moment ago, it arises mainly from our financial stability
responsibility, although I would argue that our role in promoting the efficiency and effectiveness of the
financial system is also relevant. Episodes of incipient or actual financial instability are often
accompanied by failures in the corporate sector which may lead more generally to losses throughout
the financial system. In some cases, the corporate failures reflect an inability to resolve temporary
liquidity problems affecting a company that remains viable in the longer-term. Creditors may act
without the benefit of all available information on a company's solvency. This imbalance in information
available to company and creditors can be compounded by conflicts of interest between different types
of creditors, or between banks, bondholders and other financial institutions. The end-result is often the
same: the unnecessary liquidation of viable companies, which represents a market failure capable of
amplifying financial instability. That, in a nutshell, explains the Bank's interest and involvement in this
area.
A country's insolvency regime should seek to limit the costs arising from potential market failure, for
example by supporting effective private sector mechanisms for reorganising viable companies. I would
say it should do so partly by providing incentives for debtors and creditors to negotiate workouts at the
pre-insolvency stage. This will hopefully reduce the risk of unnecessary corporate liquidations and
avoid benefiting one group of creditors at the expense of others.
Most of you, of course, will know that, guided by these principles, the Bank took the lead in developing
a framework governing corporate workouts in the 1980s and early 1990s - the "London Approach" or
"London Rules". We are not jingoistic about this; we are equally supportive of variants whether Hong
Kong Guidelines or Jakarta Initiatives. We draw the line, however, at Aussie Rules; references to
Australian sports jangle a few nerves at the Bank! In any case, "rules" is definitely the wrong word,
since the London Approach has no legal or statutory backing - it is merely an informal codification of a
set of practices that had come to be widely accepted in the vast majority of large corporate workouts
undertaken in the UK in recent years. This includes arrangements for an informal standstill while an
independent review of the company's long-term viability and financing needs is carried out. But what is
perhaps less well-known is that, in developing the London Approach, the Bank built on a tradition of
involvement in industrial restructuring dating back to the 1920s. Indeed, a cursory glance at
R S Sayers' excellent history of the Bank from 1891-1944 reveals that Montagu Norman's involvement
in corporate restructuring in the inter-war period probably took up more of his time than any of his
other duties, often to the consternation of some of his more conventional colleagues!
Since the recession of the early 1990s, and reflecting the more stable macroeconomic conditions in
recent years, the Bank's direct participation as a mediator in corporate workouts has declined. We do,
however, remain willing to take on that role again if invited to do so and where this appears necessary
to help resolve the potentially conflicting problems of a company's creditors. Where we have tried to
add value in recent years has been in promulgating the London Approach abroad and in working to
develop the framework in the light of recent innovations and developments in global financial markets.
Several issues have loomed large. One is the applicability of the unanimity requirement given the
proliferation in the number and type of creditors in any large international workout. Another is the lack
of a formal moratorium over all or part of the period of resolution of a company's problems, as distinct
from the informal standstill of the London Approach during the initial period of collecting all available
information and evaluating the company's long-term prospects. More broadly, the extent to which the
Approach is affected by developments such as securitisation, loan trading and credit derivatives is
exercising our minds and those of others closely involved in corporate workouts.
These issues raise potentially very tricky questions. For example, loan trading arguably makes the
creditor co-ordination problem more challenging, but at the same time provides an exit route for those
unwilling to be involved in the restructuring and an entry for specialist turnaround investors.
Credit derivatives raise a different set of issues, because they need not involve transfers of the
company's debt until, in the case of physical settlement, a credit event occurs. The knowledge that
debt will change hands following a credit event might, however, affect the incentives facing the
company, its "pre-credit event" creditors and its potential "post-credit event" creditors in unpredictable
ways. One possibility is that a bank which has purchased credit protection via a credit derivative may
have an incentive to put an ailing company into liquidation in order to obtain a payment from its
counterparty rather than participate in a restructuring, the results of which are uncertain. For many
banks, such an approach would be incompatible with building banking relationships, but the recent
debate as to whether restructuring, rather than failure, constitutes a credit event for the purposes of a
credit derivative contract shows the matter is highly topical. At the very least, active markets in credit
derivatives and secondary loans might make it more difficult to identify and organise creditors in order
to negotiate any debt workout.
These are, as I have noted, awkward issues. But I am encouraged to see that the INSOL Lenders
Group has attempted to address some of them in the course of drawing up its Statement of Principles
for a Global Approach to Multi-Creditor Workouts. I am also encouraged that discussions on the
Principles involved not only the largest global banks, but also a range of other finance providers,
including insurance companies, institutional investors, hedge funds and secondary market debt
providers. As the Governor noted in providing the Bank's endorsement of the ILG's initiative in
October 2000, past experience suggests that a collective approach by the major creditors to a debtor
company in financial difficulties can help to preserve value, to the benefit of the creditors as a whole
and of others with an interest in the company. Although I know there have been tricky issues to
resolve in the negotiations - notably those relating to the standstill, debt trading and the provision of
new money - in the end, the Principles seem broadly consistent with the London Approach, based as
they are on the enlightened self-interest of all the creditors. Ultimately, although some debt providers
may be able to gain in individual cases by striking out on their own, in the long run a co-operative
approach will ensure greater recoveries for creditors, including bondholders, in aggregate.
Just as greater international co-operation can produce net gains at the workout stage, so that needs to
be backed up by greater co-ordination in cross-border corporate insolvencies. That is why we
welcome the UNCITRAL Model Law on cross-border insolvencies, which, as most of you will know,
has been implemented into UK insolvency law. The Model Law is consistent with the UK insolvency
regime and contains many helpful provisions relating to co-operation between insolvency courts in
different jurisdictions, and to the granting of recognition to foreign insolvency practitioners. We would
therefore urge other countries to enact the UML.
In this context, we also welcome the ongoing work by international organisations, including the IMF
and World Bank, on the design of efficient and effective insolvency regimes worldwide. It is, of course,
difficult to establish international standards in this area, because the approaches adopted by different
countries reflect not only different legal traditions but also different policy choices, most especially on
the extent to which the system should favour debtors or creditors. Indeed, this is a debate that is live in
several countries, including the UK where new measures were announced last month in the Queen's
Speech, and I am sure is occupying minds at this Congress. But the IMF work argues, rightly in my
view, that any insolvency regime, whether debtor- or creditor-oriented, will enhance financial stability
effectively only if it protects value for the benefit of all interested parties and the economy in general;
and this requires the allocation of risk among market participants to be done in a way that is
predictable, equitable and transparent.
Financial sector restructurings
Let me turn now to my second area: financial sector restructurings, and I would like to start by noting
the importance of confidence in the smooth running of a financial system. Confidence is important in
most industries, but it is at the heart of the financial industry. It is confidence that permits banks to
operate, as a matter of course, with gearing many times capital, and with a maturity mismatch
between their assets and liabilities, often concentrated in short-term or sight deposits. They are thus
peculiarly vulnerable to a loss of confidence, individually and as a group. The potential for
contagion - the threat that trouble in one bank will result in a run on others that might endanger the
system as a whole - makes monitoring banks' solvency and liquidity a core activity for central banks.
Whether responsible day-to-day for supervision or not, central banks still need to stand ready to act as
lender of last resort. However, any such operation must be carefully considered. Any decision to
support an institution, particularly in circumstances of underlying insolvency, creates a moral hazard
that undermines market discipline. Designing effective arrangements for restructuring financial
institutions is thus a particular challenge - there is a need to act quickly and finally; intermediate
arrangements are much more difficult to sustain.
The challenge is complicated by the degree to which financial markets are now global and financial
groups operate in a number of different jurisdictions. The G30 report on international financial
insolvencies, published in March 1998, raised several themes that are rather similar to those relating
to cross-border corporate insolvencies. In particular, it emphasised that a close degree of international
co-operation was necessary to prevent the disorderly failure of a bank or insurance company.
Effective co-operation would help to bring about a reorganisation or if necessary an orderly disposal of
assets, and avoid the delays, uncertainties and loss of value often associated with formal legal
proceedings. If the financial institution does fail, in my view some of the provisions of the Model Law,
especially those relating to judicial cross-border co-operation, are potentially helpful in providing a
starting point for negotiations.
There used to be a clear distinction between banks and securities houses, fund management and
insurance, and financial institutions of different nationalities. Restructuring could be to some extent
contained within one market or one jurisdiction. Now the distinctions between different markets and
types of firm have become blurred and the increasing consolidation of financial groups has given rise
to a range of large complex financial institutions or LCFIs. Restructuring one of these groups would be
far from straightforward. The steps involved with winding up an LCFI have been the subject of recent
discussion among central banks. This has involved not only co-ordination and information sharing
arrangements but also how the wider risk to the system would be assessed in these circumstances.
Winding up a firm on this scale could be a large undertaking in itself. But the wider repercussions in
terms of dislocation of markets could be enormous.
Thankfully, as yet, we have had little if any experience of restructuring or winding down an LCFI. As
with corporates, however, the first step would be an assessment of the long-run viability of the
institution prior to the restructuring. This will determine whether liquidity support to the LCFI may be
justified, or whether it should be closed, in much the same way as the independent review in a
corporate restructuring will determine whether the company should be reorganised or liquidated. With
financial institutions, the time available to make an assessment and reach a decision on providing
support may be limited.
Other common themes in the two strands are the need for co-operation between all the relevant
parties, based on full exchanges of information, and the need for equitable treatment of similar classes
of creditors, investors and depositors. It may also be possible to envisage, in the winding down or
restructuring of an LCFI, the authorities playing a facilitating role in a private sector solution, raising
parallels with the Bank's role in the London Approach.
There has, as yet, been little in-depth exploration of the linkages between corporate sector and
financial sector restructurings. I believe that efforts to explore the complementarities between the two
approaches would reap dividends. A well-designed corporate restructuring framework, by
rehabilitating viable companies facing short-term problems, should maximise the value of creditors'
claims if it preserves the going concern value of the companies. By providing for an orderly recognition
and allocation of losses, it should also improve banks' ability to assess the value of impaired assets
and determine the appropriate level of loan loss provisions. As the IMF has noted, this should
encourage more accurate and predictable pricing of distressed claims, assisting the development of a
deeper secondary market in which financial institutions can trade distressed claims and thereby
transfer loans to specialist turnaround investors.
Of course, some of these complementarities may be difficult to exploit in countries, especially
emerging market economies, in which banks are facing major problems arising from their corporate
loan books. Banks with inadequate loan loss provisions and low capital ratios may be reluctant to
participate in corporate workouts, because they may then be forced to recognise actual losses. The
role of the public authorities is often crucial in such cases. In practice, bank restructuring programmes
have often transferred distressed corporate sector debt to separate government agencies. Indeed, this
has happened in recent years in some G10 countries, notably the US, Japan and Sweden. This can
lead to tensions between maximising short-term debt recoveries to limit the public costs of bank
recapitalisation and preserving longer-term corporate value. Effectively, the public authorities may
liquidate companies prematurely, in an effort to secure immediate cash recoveries, when a
longer-term restructuring of these companies might be a more effective way to preserve value in both
the corporate sector and the wider economy, including the banking sector. To avoid this conflict,
corporate and banking sector restructurings need to be more effectively co-ordinated. I would argue
that this can lead to synergies by facilitating the rehabilitation of viable companies in a manner
benefiting all the creditors - including the public authorities - in the longer term.
Having said all that, there is no doubt that financial restructurings and insolvencies do contain several
distinguishing features compared with corporate reorganisations, besides the importance of
confidence with which I started. Indeed, that probably explains why much of the debate on the Model
Law is on whether its principles can be applied to the insolvencies of banks and other financial
institutions. Different views on this meant that the Law had to contain an effective opt-out for banks
and insurance companies. I would certainly agree that depositors or policyholders are in a different
position from ordinary creditors. They are likely to have less information, be greater in number, and be
less well organised to recover their assets than professional creditors. So any application of corporate
workout and insolvency principles to international financial insolvencies would have to allow for
depositor and policyholder protection schemes.
The role of supervisors would also, of course, need to be recognised explicitly. In particular, the
principles underlying corporate workouts and insolvencies would have to be consistent with
internationally recognised principles of banking and insurance regulation. In the EU framework, that
requires consistency between cross-border corporate sector initiatives such as the Model Law and ILG
Principles and the EU passport system and principle of home state responsibility for banking and
insurance supervision. Relevant EU directives would also need to be taken into account.
All this strengthens my view that although synergies should be realised through consistency in the
approaches to corporate and financial sector workouts, we need to recognise that banks (and
insurance companies) are different. I have noted that, in corporate insolvencies, countries may differ in
the extent to which their legal and statutory arrangements favour the debtor or the creditor. But they
will also differ in the extent to which their insolvency laws embody a universal or territorial approach to
cross-border insolvencies. Exactly the same distinction is relevant in an international financial
insolvency. In the "single-entity" approach, a bank with branches in several jurisdictions will be wound
up according to universal principles, so that creditors and depositors worldwide are entitled to an equal
claim on the bank's worldwide assets. By contrast, a "separate-entity" (or "ring-fencing") approach to
liquidating an LCFI proceeds according to territorial principles, so that creditors and depositors of an
individual bank branch in a particular jurisdiction take precedence in the distribution of all the LCFI's
assets within that jurisdiction, before the local liquidator is authorised to turn over any excess assets to
the home country liquidator.
This implies that, in both corporate sector and financial sector insolvencies, banking supervisors and
insolvency practitioners will be subject to varying legal responsibilities that may make the co-ordination
problem more difficult. I would argue that initiatives such as those of the ILG and UNCITRAL are more
consistent with the spirit of a universal approach. In fact, I would go further and suggest that the
application of these initiatives to international financial restructurings and insolvencies is only possible,
in all respects, if a country adopts a single entity approach to the liquidation of international banks.
Continued adherence to separate entity approaches could therefore make it more difficult to achieve
greater consensus on the principles governing cross-border corporate workouts and international
financial insolvencies.
Sovereign debt workouts
I would now like to stray into even more uncharted territory and turn to my third area, sovereign debt
workouts. I hope I have already said enough to clarify that the establishment of an effective framework
governing the relationships between non-sovereign debtors and their creditors provides a means of
involving the private sector in the resolution of financial crises. But how does this relate to the current
very live debate about private sector involvement (PSI) in sovereign debt workouts? The potential
linkages between the three strands of financial restructurings are amply illustrated by the Asian crisis
of 1997-98, which involved widespread defaults by the corporate sector on both its domestic liabilities
and its obligations to foreign creditors. This impacted not only on the banking sector's balance sheets
and capital positions, with further feedback effects on the corporate sector, but also on the sovereign
sector, through its need to involve itself in bank recapitalisation and corporate sector restructuring. On
top of that, there were contagion effects on public and private sector holdings of sovereign debt at a
time when public finances in many countries were themselves deteriorating independently.
I think it is important to appreciate that the existing framework governing sovereign debt workouts in
emerging market economies (EMEs) evolved in a world where official financing dominated and private
financing was provided by a relatively small number of developed country banks. But private claims
now outweigh official claims on the major EMEs - by a ratio of 70:30 in recent years. And these
private claims are increasingly to bond investors rather than banks - direct and portfolio investment
flows now dwarf bank lending as a source of finance for EMEs. Bondholders are dispersed and often
anonymous, so there are potentially greater creditor co-ordination problems. To contain the potential
systemic consequences of future crises, both the public and private sectors have an incentive to
devise a new framework that can deal more effectively with sovereign debt workouts, and most
especially with the role of PSI, when private claims, particularly bondholdings, are substantial.
This is very similar in kind to the challenge of adapting the London Approach, whose original principles
were most relevant where the creditor group largely consisted of a fairly small group of relatively
homogeneous banks, to a world where creditor groups had become much more disparate and
international, involving large numbers of bondholders and other financial creditors. It seems sensible,
therefore, to consider to what extent the sovereign sector can borrow from the ideas11 discussed by
the ILG and others in developing principles governing multi-creditor global corporate workouts that are
more appropriate to modern financial markets.
I take considerable encouragement from the fact that, in recent months, a number of different private
sector groups have published views on "best practice" principles that might underlie sovereign debt
workouts. Although there are inevitably differences between the various groups, in all cases a
collaborative framework to facilitate negotiations and co-operation between a sovereign debtor and its
creditors, and also to overcome possible co-ordination problems between different creditor groups,
seems to be envisaged. These general principles seem to me to have much in common with the
themes underlying the ILG's corporate workout principles. They also include several other suggestions
to enhance creditor co-ordination, such as the inclusion of collective action clauses in bond contracts
and, more widely, the use of "creditor country clubs" as a conduit for information exchanges.
The key to all this is, in my view, the creditor co-ordination issue. A failure of creditor co-ordination in
the sovereign context can lead to cancellation of longer-term investment projects and protracted
exclusion from international capital markets. The private sector groups argue that, when a sovereign
encounters financial difficulties likely to trigger a debt default, it should encourage a process of
dialogue between the affected creditors and the sovereign. That should involve co-operation to
facilitate a full exchange of information and analysis relating to the current financial situation and
prospects of the sovereign. This will be easier if the country has already taken the necessary action to
improve data availability and transparency and to meet relevant IMF data standards and codes. There
is a close parallel with the way in which corporate and financial sector restructurings are governed by
independent reviews based on full exchanges of information on the corporate's or bank's financial
position. In both cases, it is essential that those analysing the debtor's financial position (the IMF in the
sovereign context and the independent accountants in a corporate case) are able to distinguish
between different types of default. More effective monitoring should improve the discipline on the
debtor and facilitate the extension of more lending by the private creditors in both cases.
Another area where sovereign debt workouts could borrow from corporate and financial restructurings
is in possible recourse to a neutral mediator, charged with facilitating a co-operative creditor solution.
In the sovereign context, one possible facilitator might be the IMF. It would certainly have the
resources and expertise to do the job, although one possible drawback is that the IMF, unlike an
arbiter in a corporate workout, will sometimes itself have claims on the debtor, in this case the
sovereign. And this raises a separate issue of whether, or in what circumstances, the IMF might
provide financial support during a sovereign debt workout - so-called lending into arrears. Such an
approach would have to be designed to limit the moral hazard implications, incorporating strict
conditionality. But it can be useful as a means of supporting a country as it takes remedial policy
action through bridging finance.
The issue of the standstill is, as many of you will know, controversial in the sovereign context,
notwithstanding the fact that an informal standstill plays a crucial role in corporate workouts. Voluntary
debt rollover agreements with creditors or bond restructurings are, I believe, useful aspects of effective
PSI. But historical experience of involuntary sovereign debt standstills, in the form of payments
suspensions, has not exactly been encouraging - the process has often been inefficient and
inequitable. Nevertheless, there are circumstances in a sovereign debt crisis where the immediate
payments relief provided by a standstill may make an important contribution. An example would be
where capital flight is pervasive because immediate policy adjustment is insufficient to bring about
adequate voluntary private sector refinancing.
In these circumstances, a standstill may realise the same advantages as in a corporate workout if it
provides breathing space for remedial policy measures to be evaluated and put in place; if it promotes
creditor co-ordination and avoids unjustified creditor preference by treating creditors of the same type
equitably; and if it provides incentives to both creditors and debtors to reach a voluntary arrangement
sooner rather than later. That is a lot of ifs and, as I have noted, a further provision is that if the
standstill is supported by IMF lending into arrears, it would need to be subject to strict conditionality.
But again these conditions could usefully borrow from the corresponding provisions attached to
corporate workout standstills. In both cases, the standstill should be subject to a strict time limit; it
should allow for a full release of all relevant information from debtor to creditors on a timely basis; it
should facilitate equitable treatment of similar types of creditors (for example through the formation of
bank creditor and bondholder committees); it should provide for the seniority of any new money; and
above all it should deliver the rapid presentation of a restructuring plan to creditors.
What this means is that any sovereign debt standstill would need to be orderly, efficient, equitable and
expeditious. Easier said than done, of course, especially given the fact that generally no single
organisation represents the disparate group of private creditors. But, as with corporate workout
standstills, the key is to reduce the incentives for creditors to rush for the exits.
Of course, some have argued that attempts to negotiate a standstill could have the opposite effect, in
other words they could prompt a rush for the exits. But longer-term investors benefit from country runs
being forestalled, so the net effect might be a beneficial switch from short-run to long-run investors.
Others have suggested that standstills create moral hazard and alter debtor incentives in the process
by undermining the primacy of debt contracts. But, as I have noted before, a well-designed framework
for sovereign debt workouts, involving a voluntary standstill where that is thought to be helpful, might
be no more