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29Finance & Development / June 1997

Creditors’ Crucial Role in Corporate Governance

C H E R Y L W . G R AY

Effective debt monitoring and collection play a crucial role in corporate governance in market economies and re- quire adequate information, creditor incentives, and an appropriate legal framework.

OTH FINANCIAL sector reform and private sector development have received considerable atten- tion in developing and transition

economies in recent years. But the critical nexus between banks and firms—not only for financing but also for efficiency and ultimate survival—has been underempha- sized. Banks and other creditors have an extremely important role to play in foster- ing efficiency in medium and large private or state-owned firms. Creditors, in turn, rely for their survival on debt repayment

by their borrowers. Without dependable debt collection, no amount of supervision or competition can make banks run efficiently.

Debt appears to be slowly emerging as a device for exerting control over medium and large enterprises in some transition economies. The powers and incentives of creditors in these countries are still weak, however, compared with their counterparts in more mature market economies. Strong creditors are as critical to the efficient func- tioning of enterprises as are strong owners. External financing for private firms comes essentially from two sources: debt and equity. While control by equity holders is appropriate in profitable times (when entrepreneurial risk taking is needed), cred- itor monitoring and control become binding in times of financial distress, particularly when tight controls on spending and investment are needed. Indeed, foreclosure and bankruptcy laws typically shift control of firms to creditors at such times. Thus, the development of effective creditor con- trols is a crucial element in successful eco- nomic transition.

The requirements for good control, or “corporate governance,” by owners have been extensively analyzed. The legal and institutional requirements for effective debt monitoring have not been as thoroughly analyzed but are no less important. Like equity holders, creditors can monitor firms either actively or passively. The active mode involves hands-on evaluation of a firm’s operations, investment decisions, and capacity and willingness to repay. The pas- sive mode depends on collateral for secu- rity. To the extent analysis is carried out before a lending decision is made, the value of the firm’s collateral is what is analyzed rather than the operations of the firm.

There are three crucial underpinnings to creditor monitoring and control in market economies: adequate information, market- oriented creditor incentives, and an appro- priate legal framework for debt collection. The experiences of Hungary and Poland in the first half of the 1990s provide fascinat- ing lessons about how—and how not—to strengthen creditors as agents of gover- nance and restructuring for medium and

Cheryl W. Gray, a US national, is a Lead Economist in the Finance and Private Sector Development Division of the World Bank’s Policy Research Department.

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large enterprises. Although this article focuses on these two countries, their prob- lems have much in common with those faced not only by other countries in Eastern Europe but also by many develop- ing countries in Africa, Asia, and Latin America.

Information The first requirement is information.

Lenders need information on the creditwor- thiness of potential borrowers, and de- positors and bank supervisors need information on bank portfolios. While this may seem obvious, the constraints imposed by the poor quality and asymmet- ric distribution of information in developing and transition economies should not be underes- timated. Inadequate financial and cost accounting can hide the true value of firms’ assets, and dra- matic changes in the structure of input prices, demand, competi- tion, and distribution channels reduce the value of prior information. Reputation, the basis for much lending in stable market economies, is less binding, owing to the phenomenal pace of change. In sum, every firm currently operating in a transition economy is to some extent a new firm, even if it has been operating for 50 years.

Even if information on firms is available from potential borrowers, bank employees are often not trained in techniques of mar- ket analysis and loan appraisal, and thus have difficulty using that information. Similarly, bank supervisors often lack not only the technical ability but also the politi- cal will to carry out tough supervision. Furthermore, the “watchdog” professions —including accounting, law, securities, and credit rating services—are still in their infancy, making it difficult for outside investors to monitor firms and prevent fraud or misuse of their investments.

When information asymmetries are sig- nificant, adverse selection may make it costly, if not impossible, for outside in- vestors to fund the growth of a firm with either debt or equity. If formal lending occurs, it will typically be based on collat- eral (or perhaps reputation) rather than on active monitoring of the firm’s operations.

Creditor incentives The second requirement for debt to serve

a control function is the existence of appro- priate market-based incentives for credi- tors, whether banks, trade creditors, or government.

Bank credits. Banks should play a pivotal role among creditors in maintaining borrower discipline and financing new activities. By 1992, many of the state-owned commercial banks in Hungary and Poland were in serious financial difficulty when evaluated using internationally accepted accounting principles. This difficulty was the result of several factors, including bad loans inherited from the socialist era, tran- sition-induced defaults on existing loans, and defaults on new loans extended after the onset of relative price reform.

Both countries moved to reinvigorate existing banks through recapitalization. On

the one hand, a one-time recapitalization early in the transition process may be nec- essary (but not sufficient) to establish viable institutions, given the under- capitalized state of most commercial banks when they were initially created. Undercapitalized banks cannot operate for long without government support and may face perverse incentives to continue dis- tress lending and engage in ever riskier behavior to avoid bankruptcy. On the other hand, growing experience from around the world shows that recapitalization is risky, particularly if undertaken repeatedly.

Until mid-1994, Hungary’s efforts to reform its banks paid little attention to the dangers of recapitalization. Hungarian banks were effectively recapitalized four times during 1991–94. Yet little else was done to create strong incentives for bank restructuring. No independent, in- depth portfolio audits were undertaken. Performance-oriented management con- tracts were not implemented, nor were bank managers given strong and clear incentives to increase the value of the banks they managed. The government did not formulate a clear plan for privatizing state banks, although two of them under- took privatization programs largely on their own initiative. Most observers agree that banking supervision was weak.

Poland, after a rocky start, made stronger efforts than Hungary in the four years ending in mid-1994 to deal with the perverse incentives faced by the managers of a group of state-owned banks. Like

Hungary, it opted to recapitalize its com- mercial state banks, but, unlike Hungary, it carried out only one round of recapitaliza- tion. Furthermore, this recapitalization was embedded in a much larger program, the Enterprise and Bank Restructuring Program (EBRP), designed to change incen- tives and promote privatization. Among other actions, it prohibited new lending to problem borrowers and required banks to set up workout departments and take actions to resolve those loans that had been classified as nonperforming at the end of 1991. It also required banks to undergo repeated, in-depth portfolio audits by out-

side auditors. The program was made credible by the strong and consistent leadership of the Polish Ministry of Finance from 1990 through early 1994.

In sum, during 1991–94, Poland’s banking reforms were far more comprehensive than Hungary’s. Because the Polish reforms forced greater trans-

parency and were tougher and more credi- ble, they were more successful in slowing any further deterioration of the state- owned commercial banks and—most important for this discussion—in strength- ening banks’ resolve to pursue debt collec- tion vigorously.

Trade credit. Suppliers were also weak creditors in the early years of transi- tion. In 1993 and 1994, a significant portion of the debt to trade creditors in Hungary and Poland consisted of overdue payables, many of which had resulted from the tran- sition-induced demand and liquidity shocks of 1991 and 1992. This stock of interenter- prise arrears undercut discipline, owing to the fear of “domino” bankruptcies occur- ring if any creditor attempted to collect debts. Yet the incentives of trade creditors to monitor debtors are growing steadily stronger as the private sector continues to grow. Trade creditors, particularly pri- vately owned ones subject to their own hard budget constraints, have increasingly prevented the emergence of new overdue receivables by requiring payment in advance—that is, before they ship goods to problem firms.

Government credit. Debt owed to the government—including arrears to the tax office, the social security service, and the customs office—became a substantial por- tion of the debt on the books of problem firms in Hungary and Poland in the early 1990s. Yet these agencies were weak credi- tors, not known for active law enforcement and collection of arrears. In contrast, their

Finance & Development / June 199730

“Banks and other creditors have an extremely important role to play in fostering efficiency in medium and large private or

state-owned firms.”

legacy from the years before 1990 was one of pervasive bargaining and redistribution from profitable firms to loss-making ones. Habits are not easy to change overnight, and tax and social security arrears continue to be a major source of “financing” for firms in financial distress. There is, how- ever, some evidence that budget pressures are beginning to make government credi- tors more vigilant in both countries.

Debt collection The third requirement for creditor moni-

toring and control in a market economy is an appropriate legal framework and effec- tive procedures for debt collection. Without an effective system of debt collection, debtors lose repayment discipline, the flow of credit is constrained, and creditors may be forced to turn to the state to cover their losses if they are to survive. In informal credit markets, the effectiveness of debt col- lection depends on nonlegal or extralegal sanctions—such as the threat of a debtor’s ostracism by the business community or, in extreme cases, self-help (sometimes violent) on the part of creditors or their agents. Formal credit markets depend more on legal procedures involving collateral (secured lending), workouts (creditor-man- dated reorganization of the debtor firm), and bankruptcy (liquidation). Well- designed and implemented rules facilitate rapid and low-cost debt recovery in cases of default, thereby lowering the risks of lend- ing and increasing the availability of credit (particularly bank credit) to potential bor- rowers. Poorly designed and implemented rules make lending more costly and stifle the flow of credit. The recent experiences of Hungary and Poland provide interesting illustrations of both flaws in the debt-collec- tion processes and attempts to address them.

Collateral. In the early 1990s, Hungarian and Polish laws on collateral dated from the prewar period and failed to provide an adequate foundation for a strong financial system. First, the definition of property that could be used as collateral was narrow, and movable property had to be in the possession of the lender (thereby making it useless to the debtor firm) to serve as security. Second, there was essen- tially no way to register liens on movable property in either country; it was common for several liens to be secured by the same property, and banks often took liens on property worth much more than the value of the corresponding loans. Third, priorities among creditors favored the government over secured creditors. In Poland, for

example, the government had an automatic lien (whether or not formalized in any way) over all property of any party in arrears to it for taxes, social security payments, or customs duties. Fourth, executing liens was extremely difficult and time-consuming, requiring a court decision and then action by a bailiff (to whom a large fee had to be paid up front). Finally, even if a creditor succeeded in executing a lien, it was often difficult to sell the collateral and thus col- lect on the loan. For residential properties on which the mortgagors had defaulted, for example, it was virtually impossible to evict tenants and sell the properties unen- cumbered by tenants’ liens.

Poland provides the first test case in comprehensive collateral law reform. In late 1996, it adopted a new and modern collat- eral law that reforms creditor priority rules, provides for a central registry for liens on movable property, and simplifies foreclo- sure procedures. Hungary has also recently taken steps to improve its collateral system.

Debt workouts. A second critical com- ponent of the legal framework for debt col- lection is the procedure for informal workouts and formal reorganizations, the mechanisms a problem debtor may use in an effort to negotiate a reduction in its immediate debt-service costs in order to stay in business. In return for agreeing to such procedures, creditors may insist on partial debt payments and/or on fundamen- tal changes in the firm’s size or functioning in order to increase the creditors’ chances of recouping the remaining debt. From a pub- lic policy perspective, these procedures are intended to promote reorganization of firms whose value as going concerns (after their reorganization) exceeds their liquidation value. Firms seeking reorganization may, for example, have assets, such as special- ized machinery or unique trademarks, that have little value in alternative settings.

Since 1991, both Poland and Hungary have taken far-reaching steps to adopt mar- ket-based workout processes. Poland had both a judicial procedure and an extrajudi- cial one. Judicial debt workouts occur under the law on “arrangement proceedings,” whose main disadvantage is its inflexibility. To overcome its deficiencies, Poland adopted a new temporary procedure for working out bad loans—the bank concilia- tion agreement—as part of the 1993 EBRP. Under this procedure, which could be used until February 1996, power shifted from the courts and the borrowers to the banks. Banks were empowered to negotiate, and required to monitor, workout agreements on behalf of all creditors, providing they

received approval of creditors representing more than 50 percent of the value of a defaulting borrower’s outstanding debt. The conciliation process was used quite extensively, along with other options for handling problem debts. This temporary process has expired, but the shortcomings of Poland’s permanent judicial process have not yet been addressed.

In 1991, the Hungarian parliament adopted a tough new bankruptcy/liquida- tion law, which took effect on January 1, 1992. It required managers of firms with any arrears of 90 days or more to file for reorganization or liquidation. On their face, the reorganization provisions of the law are similar to those of bankruptcy laws in advanced market economies, including Chapter 11 of the US Bankruptcy Code. Managers of a bankrupt firm retain their jobs after filing and have the first opportu- nity to present a reorganization plan. Creditors may then vote on the managers’ plan and present alternative plans. If an agreement cannot be reached between a firm and its creditors, the procedure reverts to liquidation. From the first filing until the final agreement is reached, the courts have relatively little substantive involvement.

The 1991 law led to a wave of filings for both reorganization and liquidation. Some 5,000 reorganization cases and 17,000 liqui- dation cases were filed during 1992 and 1993. The law was widely criticized as overly ambitious, and amendments made in September 1993 removed both the filing requirement (the “stick”) and the debtor firm’s assured protection from creditors (the “carrot”). The number of reorganiza- tion filings under the bankruptcy law declined dramatically in 1994.

Liquidation. Liquidation is the final stage of the debt-collection process. Creditors’ control rights over defaulting debtor firms derive ultimately from the for- mer’s power to force liquidation, yet in many transition economies the laws gov- erning liquidation give little power to creditors.

In Poland, the liquidation of financially distressed firms may occur under the 1934 bankruptcy law or under Article 19 of the law on state enterprises (a legacy of social- ism). Creditors or the debtor may file for bankruptcy or liquidation, and the laws provide standard rules for appointing liq- uidators, winding up estates, and satisfy- ing claims in order of priority. But the priority list for creditors discourages active creditor involvement by favoring almost everyone else. If the government and proce- dural costs do not consume the debtor’s

31Finance & Development / June 1997

%

% entire estate, employees’ claims may well do so.

In addition, the law provides few means for a receiver or judge to void fraudulent transactions made by a debtor firm’s man- agers or owners, at the expense of credi- tors, prior to filing. Such transactions are thought to be common, and Poland’s legal system must find a way to identify and punish them if the bankruptcy process (or, indeed, any debt-collection process) is to be credible. Although only companies that are still solvent are legally eligible for state enterprise liquidation, many companies in liquidation are actually insolvent. In practice, creditors recover even less under Article 19 liquidations than under bank- ruptcy proceedings.

In Hungary, liquidation procedures are contained in the same law as the reorgani- zation process already discussed. As in Poland, the process is a fairly standard one, at least on paper. Either creditors or the debtor petition for liquidation, a liquidator is appointed, a list of assets is drawn up, and the assets are then supposedly sold to

satisfy claims in the order of creditor priority. While the Hungarian law does not include the counterproductive prior- ity rules incorporated in the Polish law, the compensation formula for liquida- tors leads them to keep firms in opera- tion for as long as possible and to act more as restructurers and privatizers than as agents of creditors. Fur- thermore, the process is thought to offer many opportunities for fraud, both by managers (who may remove valuable assets before filing for liquidation) and by liquidators (who may find many ways to profit from their near-monopoly control over the process). In Hungary, the problem is not so much the existing legal framework as the difficulty of administering it properly in an environ- ment characterized by poor informa- tion, little accountability, and confused incentives.

Debt’s emerging role Surveys of Polish firms involved in

the EBRP and Hungarian firms in- volved in bankruptcy show that the out- comes of these processes have been mixed (see references). The EBRP forced Polish banks to confront their problems, and both countries’ processes furthered the difficult task of weeding out and closing unviable firms and helped build institutional capacity in banks (Poland) and in courts and the trustee profession (Hungary). Loans

were written down in both cases without creating an environment of general debt forgiveness. Better-off firms entered reorga- nization, while weaker ones tended to go into liquidation. Size also mattered, particu- larly in Poland (see chart). Larger firms were more likely to enter reorganization regardless of their profitability. This should not be surprising, since these firms are politically more difficult to close.

The workout and liquidation processes did not, however, impose strong restructur- ing mandates on problem debtors or effi- ciently close insolvent firms. The first two years of implementation of the bank concili- ation agreements in Poland, for example, saw a slowdown (over earlier years) in the rate of layoffs, a decline in average operat- ing profitability, and very little real privati- zation. In both Poland and Hungary, liquidations have been slow and have returned very little to creditors. Continued reforms of laws, court procedures, and creditor incentives are needed to build strong banks and effective legal processes that allow debt to serve as a device to exert

control over firms in times of financial distress.

Conclusion The facts regarding firm financing, bank

incentives, and the mechanisms for debt collection may differ from one country or continent to another. Some underlying themes are constants, however, and apply as much to Africa, Asia, and Latin America as to Central Europe. First, strong, market- oriented creditors are good for an economy. They can afford to provide financing to a wide range of clients at reasonable rates and play an important role in corporate governance, particularly in the restructur- ing of firms in financial distress. Second, creditors must have strong legal rights under contract, collateral, workout, and bankruptcy laws if they are to play this governance role. Giving them those rights may require extensive legal reform in some developing and transition economies. Third, creditors must also have information on their borrowers if they are to play this role. Credit information or credit-rating services can be extremely valuable in facili- tating firms’ access to financing, and gov- ernments should encourage their formation and growth. Accounting services, cham- bers of commerce, the business press, and other parts of civil society also provide much-needed information in well-function- ing market economies. Finally, creditors must have strong incentives to ensure that debts are repaid, and this means they must depend on the market to survive. This implies competitive markets, financial dis- cipline, predominantly private ownership, and a true risk of failure for both banks and firms.

Finance & Development / June 199732

References Herbert L. Baer and Cheryl W. Gray, 1996,

“Debt as a Control Device in Transitional Economies: The Experiences of Hungary and Poland,” in Corporate Governance in Central Europe and Russia, Roman Frydman, Cheryl W. Gray, and Andrzej Rapaczynski, eds.,Vol. 1 (Budapest: Central European University Press).

Cheryl Gray and Arnold Holle, 1996, “Bank- led restructuring in Poland: The conciliation process in action,” Economics of Transition, Vol. 4, Fall, pp. 349–70.

Cheryl Gray and Arnold Holle, 1997, “Bank- led restructuring in Poland (2): Bankruptcy and its alternatives,” Economics of Transition, forthcoming.

Cheryl Gray, Sabine Schlorke, and Miklos Szanyi, 1996, “Hungary’s Bankruptcy Experience, 1992–93,” World Bank Economic Review, Vol. 10, September, pp. 425–50.

Characteristics of Polish firms, by resolution path, 1991/92

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Source: Cheryl Gray and Arnold Holle, 1996, “Bank-led restructuring in Poland: The conciliation process in action,” Economics of Transition, Fall, pp. 349–70.

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