New rules to the game

As the impact of the financial crisis has spread out into the wider Russian economy, the country's current insolvency regime is struggling to cope with the rapid rise in corporate failures. Alexander Yerofeyev argues that one of the best responses would be to adopt a version of the 'London Approach' or International Association of Insolvency Professionals (INSOL) principles to allow temporary support operations in advance of voluntary restructuring. But a number of hurdles still need to be overcome.

The financial crisis came to Russia later than developed Western economies, but struck hard. The country is highly dependent on exports of oil, metals and other commodities. As overseas demand dried up, so did foreign currency inflows. The Russian Rouble has fallen dramatically since October 2008. Many banks have been hit by consumers withdrawing deposits. Interbank lending has effectively ceased. In the real economy, some of the first sectors to be hit were real estate and retail, but the impact quickly spread to other sectors, especially in commodities and natural resources. Many borrowers found it impossible to refinance short-term loans taken for development or acquisition purposes.

The government injected large amounts of liquidity into the banking sector, and this has helped avoid mass bank insolvencies. But the situation in the wider corporate sector proved to be much more complicated. A program of selective state loans was quickly curtailed: the government probably realized that it could not provide financial help to all who needed it; at the same time, many companies declined to take up the option for fear of subsequent nationalization.

The level of defaults on Russian bonds is a good barometer of the overall impact. Bond issuances became very popular in Russia in recent years, allowing reasonable amounts of funds to be raised through an easy and inexpensive process with limited disclosure requirements. The downside in all those issuances, however, was a put option after one year, which was executed by most of the bondholders after the crisis started. As a result, almost 100 companies defaulted on bond redemption and coupon payment between October 2008 and April 2009, to a total of US$5.5 billion. It is likely that many more high profile corporate defaults will follow. Corporate debt to international banks is at least US$500 billion, of which US$200 billion is to be repaid during 2009.

The severity of the impact on troubled businesses' ability to continue as a going concern will depend on how imminent default cases will be dealt with. The natural instinct of many Russian banks in relation to a troubled debtor is to seek to enforce the claim as quickly as possible, preferably seizing the collateral. However, in most cases this collateral is illiquid and does not allow significant monetary recovery. At the same time, many potentially viable businesses could be driven into bankruptcy.

Russian insolvency law is still not very effective in dealing with corporate defaults; it neither offers predictability and protection for creditors, nor does it facilitate rescues of viable parts of the debtors' businesses.

The new package of amendments currently being proposed is aimed first and foremost at creating a new procedure for rehabilitating problem debtor companies, which is somewhat reminiscent of the American Chapter 11. The proposed amendments reflect the idea of restricting the length of the recovery procedure to two years; however, this may be insufficient in the overwhelming majority of cases, as we are seeing debt installment plans under discussion with a minimum of five years. It seems that the bankruptcy system needs extensive reform if it is to work.

The 'London Approach' or 'INSOL principles' type of process - facilitating temporary support operations in advance of voluntary restructuring - may therefore be a viable alternative, especially where multiple banks are involved. A number of such negotiations are already underway. However, a range of practical issues should be resolved to try to make those procedures a success. In particular:

• The above-mentioned weakness of the insolvency regime: currently parties do not know where they will stand in a fall-back scenario.
• There is a very diverse range of creditors and other stakeholders in larger cases. This reflects the rather disordered funding strategies of many corporates in recent years. The creditors often include international and Russian banks (whose approaches to workouts are very different), numerous Russian bondholders (each of whom can 'pull the trigger') etc. This can combine to make achieving any compromise agreement extremely complicated.
• Many borrowers are unfamiliar with collective approaches to debt restructuring. Their responses tend to range from doing nothing or waiting for a bail out by the government, to trying to negotiate with each creditor on a bilateral basis. This inexperience is also reflected in the absence of management information tools (such as reliable short-term cash forecasts).
• Many lenders are often not experienced either, being represented by loan officers who may not have been in workout situations before. Therefore, some banks can find it difficult to organize the process efficiently.
• There is a severe lack of experienced advisors to guide lenders and borrowers through the process. In particular, many borrowers are often approached by the investment banking arms of some creditors, offering to sort out the situation in exchange for a fee, an equity sweetener etc. The response from other creditors and stakeholders is normally rather negative.
• The federal and regional governments are large creditors for tax and other mandatory payments in many cases. By law they have very limited powers to agree to any restructuring of such arrears.
• Last but not least, fresh funding to support restructuring plans is very scarce. State-owned banks (such as VEB, Sberbank, VTB and Gazprombank) and sometimes international financial institutions such as EBRD are normally the only game in town, but those organizations are also very selective.

Nevertheless, there appears to be no constructive alternatives to developing the 'INSOL approach for Russia further. The government and the Central Bank, with the support from business and bankers' associations and professional firms, could play a key role in facilitating the dialogue between different key lenders on developing relevant rules of the game. Among other consequences, successful voluntary restructurings would make state financial assistance to Russian companies more effective and increase the chances of the government getting their money back.

Article author

Alexander Yerofeyev
Partner
KPMG in Russia and the CIS
+7 495 937 4479 Alexander Yerofeyev View all articles by this author