Salman Akram Raja

A draft Corporate Rehabilitation Act (draft CRA), based on Chapter 11 of the US Bankruptcy Code, has been in circulation in Pakistan for over a decade. Why the US model that requires a judicial system more sophisticated and swift than what most countries can presume to possess, chosen has remained a mystery. Not a single concept or options paper justifying the suitability of the model adopted in the draft is available with either the State Bank or the Securities and Exchange Commission. Quite likely when someone, under donor pressure, called out for a rehab law Chapter 11 was the most readily available download.

Methods of corporate rehabilitation, available worldwide, follow two generic models. The first model consists of rehabilitation arrangements that seek the consent of clearly delineated broad classes of creditors and the debtor with minimal recourse to the courts. Existing security priorities are preserved and the parties are encouraged to arrive at a mediated resolution out of court. The courts help in the supervision of creditors’ and debtors’ meetings and in ensuring overall fairness of the outcome to all. This approach to corporate rehabilitation is exemplified by the Company Voluntary Arrangements (CVA) envisaged by the UK Insolvency Act. This broad approach is also followed in other common law jurisdictions such as Canada and Australia.

The other approach to corporate rehabilitation is that of Chapter 11 of the US Bankruptcy Code. This approach, as adopted in the draft CRA, relies on faithful financial reporting as well as the commercial savvy of the judicial system in permitting the courts to enforce a rehabilitation plan even on an unwilling majority of creditors in a given class.

A key feature of the US Chapter 11 is the automatic stay of all recovery proceedings against the debtor merely upon the debtor filing a petition for rehabilitation before the court. The stay applies to the recovery of taxes as well as utility bills owed to electricity and gas suppliers.

The debtor-driven, court-centric approach to corporate rehabilitation peculiar to the United States and a handful of other countries is the result of 80 years of experimentation and accretion in the US.

While the draft CRA is clear about the release of existing personal guarantees it is not clear about the fate of the shareholding of the existing shareholders. If their shareholding is to stand extinguished along with the vacation of their personal guarantees a set of highly perverse incentives is created by the draft CRA for the existing shareholders who are also guarantors of the company’s liabilities.

On the other hand, if existing shareholders/ guarantors are to retain their equity interest in the company while being relieved of their personal guarantees, it would make sense for them to propose a rehabilitation plan based on an overly pessimistic view of the future cash flows of the company. In the event of the creditors not accepting such a plan, which invariably would require a significant write off, the debtors would be able to use the inordinate delay inherent in the Pakistani judicial system to keep the creditors hanging while their debt recovery efforts, including decreed cases, remain stayed on account of the automatic stay provided by the draft CRA.

Given the realities of the Pakistani judicial system, and the fact that over the years various creditor steering committees have tackled the resolution of large defaults out of court, what is needed is a streamlining of the rehabilitation framework along the lines of the UK Company Voluntary Arrangements. Existing realities, that include a judicial system not attuned to the swift dispute resolution needs of the modern economy and less than stellar financial reporting standards, should be built upon incrementally rather than adopting the US Chapter 11 that emerged in the context of the vastly differently US corporate and judicial environment.

By increasing the systemic risk involved in lending the draft law will add to the intermediation costs of financial institutions, making access to credit harder for the less than the bluest chip borrowers.