August 7, 1998 [home]

Restructuring in Asia - A Brief Survey of Asian Bankruptcy Law

Part II

Including Hong Kong, Japan, Korea, and Taiwan

In Korea with the Chaebol system, Japan with the keiretsu system, China with the Communist system, Indonesia with the Crony System, there are very close connections between banks, very large businesses and government. This process has been referred to as "Relationship Lending." Each part of the triangle has the opportunity to exert enormous influence on the other parts of the system. As a result, capital is often allocated according to personal relationships, government whim or fear losing a very large customer. Where each enterprise is smaller, as in Taiwan and Hong Kong, no one business has the economic power or political clout to influence either politicians or bankers. Decisions are usually made on a more rational arms length basis.

In adverse economic times, the process works in reverse, stymying the reallocation of capital. When a large connected enterprise in Korea, Japan, China, or Indonesia gets into trouble, the loan cannot be written off without threatening to wipe out the capital of the bank, drastically affecting the group or causing a national currency crisis which requires government intervention. So the opposite of "Relationship Lending"¹ (Yellen, J, "Lesson From The Asian Crises", http://www1.whitehouse.gov/WH/EOP/CEA/html/19980415.html, April 15, 1998) occurs. We might call this "Relationship Protecting." Under this process the bank/creditors, debtors and governments have both an economic and a personal stake in keeping "zombie businesses" alive. So the reallocation of capital slows to a crawl aided by an inefficient, archaic and malleable legal system supported by large infusions of taxpayers money.

In systems with smaller business like Taiwan and Hong Kong neither "Relationship Lending" or "Relationship Protecting" can take place. No bank or government will dance to the tune of Chang's Hardware or Lee's Computers. The exposure of either the bank and the government are limited because small businesses do not have the power to get unlimited amounts of cash. When the system goes into reverse, banks need not fear for their capital nor government's for their currency when Chang or Lee goes belly up. Therefore, there is no interference in the process and no need for taxpayer money. The hapless Chang and Lee will start try again.

HONG KONG

Hongkong shares many of the attributes of its fellow city state, Singapore. As a former U.K. colony, Hong Kong also inherited aspects of U.K. bankruptcy law. The present Hong Kong bankruptcy law can be found in parts V to X of the Hong Kong Companies Ordinance Chapter 32. This law can be traced to U.K. bankruptcy legislation of 1929. It was amended over the years until a substantial revision took place in 1984. Unfortunately, the 1984 revision was based on a U.K. revision of 1948 and does not allow for a formal corporate rescue. The law was amended in 1996 to allow for a voluntary arrangement approved by creditors to avoid bankruptcy proceedings.

Unlike other Asian jurisdictions, the administration of the bankruptcy law in Hong Kong has been accomplished by skilled practitioners, trained in the common law tradition. It is lamentable that many of these practitioners are expatriates. With the return of Hong Kong to the People's Republic of China and the change of administration, it is not certain how many of these practitioners will remain to administer the law in the future.

In addition, the change of administration may increase the amount of corruption in the system. According to the "Corruption Perception Index" published by Transparency International and Gottingen University Hong Kong had a pre take over rating of 7.28 slightly below the U.S. rating of 7.66. The PRC has a rating of 2.88. There is a strong possibility that the new rulers will not be as scrupulous in observing the rule of law as were their predecessors.

The reliance on foreign practitioners points out another significant aspect. The Chinese cultural reliance on trust and avoidance of formal court procedures is still very much a part of the business climate. Although much of the stigma of bankruptcy no longer exists in Hong Kong, the city is still a small community based on family controlled businesses. Since Chinese business practice relies on trust and personal connections, obviously a lapse in the trust caused by insolvency would have of a great effect.

Nevertheless, there have been major changes in outlook, specifically between generations. As many of the Hong Kong family businesses have sent sons abroad for education, it is natural that this younger generation adopts a more Western idea, that bankruptcy is an integral part of the business cycle rather than the stain on the family honor. So within the family units and small businesses, it is the older generation that would be more likely to turn to an informal work out process, while people under 50 would be more likely to turn to the legal system to collect debts or to receive protection from creditors.

In addition to the generational divide, there is a divide between the treatment of larger international companies and smaller local companies. Large foreign companies are more likely to use legal procedures to solve problems, while smaller local companies are more likely to pursue informal workouts.

Even a reasonably reliable legal system is no guarantee of efficient operation of bankruptcy laws. The very nature of Hong Kong as a center of international trade works against the time required by any legal process. The main problem for creditors is the transient nature of finance in the city. The ability to easily move assets out of the jurisdiction before creditors have a chance to attach, would challenge even the most efficient system.

JAPAN

Japan perhaps his more than other Asian countries has gone to great lengths to institutionalize informal insolvency proceeding. The need for consensus so central in Japanese culture and manifested in the keiretsu system requires in both informal and formal court room proceedings that all parties are consulted and eventually that eventually a consensus plan for restructuring is worked out.

The problems with the system manifest themselves when the leadership of the system breaks down. In the past, most reorganizations were led by an informal process started and controlled by the debtor's main bank or main creditor. The main bank would also occasionally be the debtor's main shareholder and often, it had ties to the debtor's other creditors as well. As both a creditor and shareholder with ties to other major creditors, the bank had all of the information, contacts and power necessary to restructure a troubled company without the resort to creditor committees or court proceedings. Since so much of the process depended on the main bank, the system cannot function efficiently when the main bank is itself in trouble. Without the informal process, the parties must turn to formal proceedings that require similar degrees of consensus and can be very inefficient.

The formal bankruptcy system in Japan relies on their Corporate Reorganization Law of 1952. This law is based loosely on pre1978 chapter 11 of the United States Bankruptcy Act. The procedure is voluntary and is usually initiated by the company itself. It can be, but is rarely invoked by either shareholders or creditors. The procedure is initiated by a court filing, but the usual practice is to have informal of discussions with the court prior to filing. Informal contact is made with creditors to see if there's a possibility of a reorganization or other informal restructuring.

Once the application filed is filed, the proceedings are controlled by the judge. He becomes the finder of fact. He collects information by holding interviews directly with the debtor's CEO, employees and creditors. He goes out and visits the debtor's main operations and investigates all aspects of the debtor's business. The resulting process can take as long as six months before the court even decides whether to accept or reject the application. The adoption of a proposed plan can take much longer.

In theory, a new Bankruptcy law will come out of the next session of the Diet. Regardless of how efficient the law is, its practice will lack two things. First, the strong cultural bias toward consensus and against liquidation will make it extremely rare for creditors or shareholders to choose the liquidation. Second, like other Asian countries, the lack of the use of insolvency processes has resulted in the lack of the people trained in the insolvency process. Setting up Resolution Trust Clones and passing new bankruptcy laws may be the easy part. Finding people to administer them may take much longer.

SOUTH KOREA

The problem with South Korea's insolvency system is not so much a problem of law, but the misuse of the law. Like most other jurisdictions, a formal bankruptcy is begun by filing in the district court with jurisdiction. The filing can be both voluntary and involuntary. If the debtor is adjudicated bankrupt, a receiver is appointed. Once the receiver ascertains the creditors, the creditors have the option of continuing the business of the debtor. However, if they do decide to continue the business, the debtor is still immediately deprived of control over the property.

The law does provide for a formal rescue system. The debtor can stop the bankruptcy proceeding by presenting the court with a plan that is acceptable to the majority of creditors holding three fourths of the total obligations of the debtor.

The problem with the system has to do with the process of mediation. Court supervised mediation is a process that was originally designed to help small companies settle debts without initiating the full bankruptcy process. The process allows companies in trouble some significant advantages. They can postpone debts. Old management continues in control. They can also to receive new money by way of the low interest loans. For example, under the system troubled companies can get loans with an interest rate of 20 percent a full ten percentage points lower than the present going rate.

The system would be a very helpful alternative to bankruptcy for the smaller companies it was designed to help. Unfortunately the system has been misused by large companies including the Chaebols. Last year 201 companies registered for mediation. This represented an eightfold increase.

In order to qualify for mediation the debtor must get the creditor's consent. Often banks will give the required consent to avoid placing the troubled company into a receivership. Once the company is in receivership the bank is required to immediately write off any outstanding debt. Often the loans are to very large customers, writing them off could wipe out the bank's capital. Therefore, the banks go along with the process in order to keep non performing loans on their balance sheet and themselves in business. Most mediation processes are only successful in buying time but the result is often receivership.

The other problem with the system is the lack of qualified personnel. At present there are only four bankruptcy judges in the Seoul District Court. Unlike the U.S., Korea is also not "blessed" with an abundance of lawyers. As a result the process is exceptionally slow or almost nonexistent. In addition the law could result in criminal liability for the owner if they declare bankruptcy. The result is that many companies including Hanbro, Kia, New Core, Haitai and Halla continue in operation even though they are totally insolvent. As a comparison, the bankruptcy rate in Korea in 1996 was .4%. In Taiwan it was 4.7%.

Finally, although Korea is not as corrupt as some of its neighbors, a rating on the Corruption index of 4.29 is hardly helpful for a system that is trying to encourage more foreign investment and trust in the legal system. The rating puts South Korea at a level with Malaysia (5.01), South Africa (4.95) and Taiwan (5.02)

TAIWAN

Taiwan is in some ways the most interesting example of Asian Bankruptcy law. First, the law itself has roots that are peculiarly Chinese. Second, the process is more successful than in other Asian countries in reallocating capital.

The original law dates back to the final days of the Qing Dynasty. As part of a legal reform movement, the government drafted a law based in part on the German insolvency code. This draft was largely incorporated into the law when it was finally adopted by the Nationalist government in 1935. When the Kumentang fled to Taiwan after the communist victory in 1949 they took the law with them. Despite amendments in 1937, 1989 and 1993, the basic law remains the same.

The law itself has two aspects. The first part is a classic bankruptcy proceeding. The second aspect is something uniquely Chinese. At the time of the law's draft and at the time of its adoption China was a country of many different customs and usages. It was necessary that the law adapt to the needs of its environment and to local practice.

Under the law a debtor, who is a merchant can apply to the court or to the local Chamber of Commerce for a procedure, which is similar to the Western legal procedure of composition. Under this procedure the local Chamber of Commerce mediates an agreement between the debtor and his creditors under which debtor can remain in business and remain in control of his property.

If the court to or the Chamber of Commerce rejects the composition proposal or if they failed to reach agreement on whom the applications for bankruptcy can be filed by the data or his creditor. A bankruptcy proceeding divests the debtor of control of his personal property.

Since the law includes much of the 1935 law, it is considered archaic. The procedures are considered slow and unclear. Bankruptcy professionals are rare and subject to personal attacks, because they are not considered neutral.

From a cultural perspective, the attitude toward insolvency in Taiwan is similar to the attitude of the older generation in Hong Kong. The Chinese culture in Taiwan puts great emphasis on the repayment of debt. In addition, one of the most valuable assets of a firm or an individual is its reputation, reliability, and connections. It is commonly believed that in Taiwan business people will go to great lengths to avoid bankruptcy in order to protect the reputation.

Despite the perceptions and antidotal evidence, the system seems to do a reasonably good job of reallocating capital. According to a Foreign Banker bankruptcy "doesn't mean a thing. There is no damage done to reputation at all. A lot of small businesses close down and start up again. It is entrepreneurial nature, In had a try and will try again. There is no stigma attached."² (AJCL, v.6, Jul 1996, Tomasic, Roman, Insolvency and Law Administration in Six Asian Legal Systems, at p.59)

The Far Eastern Economic Review ³ (Editorial, "Going for Broke", Far Eastern Economic Review, June 11, 1998) states that in 1996 some 25, 272 Taiwan companies went out of business or about to 4. 7 percent of the total. In the same article, they cite of the work of Bee Yan Aw, Xiaomin Chen and Mark Roberts who found that the ease of entry and exit in Taiwan helped boost productivity. For example in 1991, 38% of textiles and 54% percent of the fabricated metals in Taiwan were produced by companies that didn't even exist five years before.

What appears to be the reason for Taiwan's success in reallocating capital is more a matter of some size than law. Smaller companies have two advantages in reallocating capital. First they can be far more flexible in adapting to changed circumstances. Second and more importantly, smaller companies limit both of the exposure and relationship between the debtor and the creditor.

Submitted by: William Gamble

Emerging Market Strategies

1990 Pawtucket Avenues, Suite 1D
East Providence Rhode Island, United States 02914

Tel. 401-272-8906
Fax 401-272-8139
EMail: william@emergingmarketstrategies.com

This article can also be found on the University of Virginia Darden School of Business Administration Alumni Forum and in the EMS Newsletter. Some of these articles are referenced in Professor Roubini of New York University Stern School of Business Administration Asia Crises Home Page and in the Providence Journal - Commentary Section

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