Les Nemethy's  Instablog

From time to time, one hears or reads statements in the news to the effect that the first signs of an economic recovery are likely to be felt in the US, or that the US economy has more power to regenerate itself than the European economy. This is undoubtedly true.  Much of this regenerative power comes from the superior environment in the US with respect to corporate restructuring, particularly in comparison to Central Europe.

Broadly speaking, there are two ways in which reorganizations may be handled. First, there are in-court reorganizations, where companies file a plan for restructuring with a competent court, which in-turn grants a stay against creditors, effectively freezing creditor demands for a defined period. Second, there are out-of-court reorganizations, where a company and its advisors negotiate with banks and other creditors in order to agree to a reduction in credit, often in exchange for equity (known as debt-equity swaps).

In a debt-equity swap, resistance may come from both creditors who stand to lose their guaranteed interest payments and security interests in exchange for shares, as well as from shareholders of the company who might not wish to see their ownership in the company diluted.

The problem is that both in-court reorganizations and out-of-court reorganizations have much less chance of succeeding in Central Europe than in the US. Once a reorganization reaches the courts in Central Europe, the case is usually fatal. There is very little chance that the company will reemerge from the experience and survive. This is in contrast with the US, where the so-called Chapter 11 system gives companies an excellent chance of reemerging in a considerably stronger state. One of the factors contributing to the success of Chapter 11 in the US is a large body of case law which provides guidance to parties.  

When a company files a Chapter 11 proceeding in the US, this has a certain shock value which may encourage all parties to moderate their demands upon the company. Creditors may be more willing to accept debt-equity swaps; unions may become more amenable to shutting plants; staff may better understand the necessity for layoffs. Everyone realizes that this is a last chance, and that it is better to end up with a lesser interest in an ongoing concern than pennies on the dollar from a liquidation. 

Of course the big news item in the last few weeks has been General Motors filing for Chapter 11. With over $170 billion in liabilities, even the $20 billion of government funding already invested into GM (with $30 billion more to come) was insufficient to put the company back onto a solid footing without a Chapter 11 restructuring. Without closure of insufficient plants and dealerships, reducing debt load, and diminishing pension liabilities, additional funding would have gone to waste-plugging losses. Yes, there is life after death: there is every chance that GM will emerge from Chapter 11 in a leaner and meaner form.

It is sad that similar restructurings are unlikely to be successful in Central Europe in the current legal environment. Courts are not adept at handling filings, and legislation is not as supportive. Banks are seldom willing to even consider debt-equity swaps, wanting to preserve their capital ratios. This does not bode well for the ability of Central European economies to restructure during a financial crisis. 

The charts below provide an overview of recent restructuring activity in Europe compared to the US and emphasize the growing number of Chapter 11-type restructurings in the US.

Exhibit 1: Top 10 live European restructurings since 2008, ranked by pre-filing gross financial debt (GFD)

Source: htp://debtwire.com

Exhibit 2: Top 10 live North American restructurings since 2008, ranked by pre-filing GFD

Source: htp://debtwire.com

On the microeconomic level, this means that many Central European companies will slide into liquidation when they might otherwise have been saved. Companies will have every incentive to settle out of court, rather than resort to a court-administered system that virtually guarantees liquidation. But creditors in Europe have a huge amount of power to drive defaulting debtor companies into liquidation.

On the macroeconomic level, the current value-destructive bankruptcy regime in Central Europe will mean that the drop in GDP, employment shrinkage and recessionary pain will be considerably more pronounced than necessary. Governments and legislators should take note.