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Cross-border restructuring know-how

by contributor Deryck Palmer, Pillsbury | Published April 25, 2012 at 1:49 PM

Right now, the global economy is under threat from two directions. On the one hand, the crisis still being played out in Greece and other nations could expand into a broader European sovereign debt crisis, which would threaten the stability of banks in Europe, the U.S. and elsewhere. At the same time, the U.S. real estate market remains moribund: Residential real estate is still hobbled by foreclosures, and the commercial market will not be in a position to expand until the economy and consumer spending recover.

These fault lines are of a historic geographic scale and magnitude. Is there a way for the global market to right itself? The answer, in part, may be found in the U.S. When businesses here face challenges, powerful laws are available that permit both operational and financial restructuring. By contrast, European and other global businesses are largely stuck with a model based on business cessation and asset liquidation. What we've found here in the U.S., albeit with attendant pain, is that a recession provides the opportunity to establish future economic sustainability. Can our U.S.-style restructuring practices be used to help right the global economy?

U.S.-style restructurings could be our next big export. Although it may not be apparent to many Americans, our economy is in fact in recovery, however weak, with improvements in manufacturing activity, business spending, capital flows and unemployment. But if European contagion causes an epidemic of bank failures, how will the inevitable cross-border insolvencies be handled? U.S.-style restructuring practices could become a highly sought-after area of expertise.

The U.S. restructuring model has a number of distinct, attractive features. U.S. bankruptcy law focuses on reorganization to achieve sustainable solutions that allow businesses to continue, even in a somewhat different form, as opposed to a short-term resolution in which assets are liquidated to appease creditors. This focus relies on the debtor-in-possession concept, where a reorganizing company continues its operations under current management but with court and creditor supervision. DIP status confers expansive powers to set aside prior transactions and obtain so-called DIP financing, which receives priority over existing creditors.

By contrast, many other countries' (notably European) legal systems focus on immediate recovery by the creditors. The debtor company will often be liquidated even if reorganization and continued operation would provide higher returns to creditors over time.

Chapter 15 of the U.S. Bankruptcy Code contains provisions to promote cooperation among insolvency regimes in different countries, in recognition of the increasingly global nature of businesses today. However, it does not change local law, so distressed European companies may still face liquidation even if their U.S.-based operations and assets enable access to Chapter 15 for some purposes.

The two stressors of sovereign debt and the stalled real estate market converge in banks. Each alone would be a significant problem for banks, and together they magnify each other's effects. The level of real estate dealmaking slowed after concerns deepened that the European debt crisis might spread, and uncertainty about associated bank losses has been sapping confidence and halting real estate transactions dependent on collateralized mortgage-backed securities. Experts predict continued choppiness in real estate capital markets even if the situation does not worsen, and if Greece leaves the euro zone, the effect could spark a global financial crisis.

The U.S. commercial and residential real estate markets represent a roller coaster of factors. For example, although foreign direct investment is helping revitalize U.S. markets, emerging markets divert attention with attractive growth trends. Meanwhile, the $4 trillion commercial real estate market faces a huge amount of debt in coming years, which may only be mitigated by new financing sources.

At the same time, nascent recoveries in manufacturing, spending and capital flows are driving a partial rebound in commercial real estate globally, with the total dollar value of transactions rising for the past seven consecutive quarters. However, robust apartment and office markets are offset by slack retail markets, with no end in sight until 2016. Gross domestic product growth in 2012 is likely to be below the projected 2.9%, which will result in lower consumer confidence, higher unemployment and consequently lower housing demand.

In residential real estate, the recovery Catch-22 continues with the need to clear inventory, including many foreclosures, before any sustainable recovery can begin. In order for home prices to rise, improvements in employment are needed to spark sales and reduce delinquencies and foreclosures. Some lenders are even paying cash to homeowners to incentivize short sales; although every bit helps, meaningfully addressing the overhang of houses headed for foreclosure will take time and a broader economic recovery. Lending has also stalled, with new issuances of nonagency mortgage securitizations remaining at record lows. Delinquencies are at historic highs, despite government and bank efforts to modify mortgages or refinance homeowners into more affordable loans.

What does this domestic situation mean when projected out to the global economy? In each downturn, there has been a steady push in the U.S. to understand and improve business practices. This is why we are seeing relatively strong corporate performance despite the overall economic environment. To survive, companies have faced the painful restructuring process (both operationally and financially) and gotten it done.

In Europe, the situation with Greece has showcased a fragile balance of economic and banking systems. European banks currently own bonds issued by the governments of Greece, Ireland, Italy, Portugal and Spain, which carry particular risk of default. Should this occur, banks holding those bonds would experience substantial losses. French and German banks are most vulnerable, with an estimated $80 billion in exposure to Greece and more than $500 billion to Italy.

However, this crisis would not be limited to Europe. For example, U.S. banks hold $641 billion in sovereign debt from Greece, Ireland, Italy, Portugal and Spain, and they have loan exposure to German and French banks estimated in excess of $1.2 trillion. A default in one of these countries would hit U.S. banks directly and indirectly.

A sovereign debt failure would also have broader economic implications. A default would likely lead to political changes in the European Union and lower consumer confidence globally, depressing both EU and U.S. growth. This in turn would hurt Asian economies, which remain largely driven by Western purchases.

Of course, a sovereign debt crisis does not only affect government bonds. Ratings agencies traditionally link bank ratings to the ratings of their respective sovereigns, and in turn markets link banks' funding costs to their sovereigns' funding costs. This effect is illustrated daily. For example, on Dec. 13, European and U.S. markets fell sharply after two ratings agencies, Moody's Investors Service and Fitch Ratings, issued a warning that measures to protect the euro had not resolved the danger of immediate and significant economic downturn, which would in turn affect the banking system.

Basel III is an accord designed to protect against bank crises by limiting the risk of undercapitalization. However, it is not clear how well these rules can work in the current environment, and whether they truly protect against a rash of bank collapses.

But weren't reforms enacted after recent crises to prevent such meltdowns? In 1974, the Basel Committee on Banking Supervision was formed to advise regulators on common capital requirements for internationally active banks. In 1988, the first set of standards (Basel I) was released to address the perceived failings of deregulation, under which banks were engaging in particularly risky behavior. Basel II was released in 2004, offering a comprehensive framework for risk-sensitive capital regulation. Finally, in response to the Great Recession, Basel III was released in 2010, instituting increased capital and liquidity requirements, as well as other procedures for limiting vulnerability to future bubbles.

The problem is that this focus on withstanding future losses does not address the cross-exposure issues presented by the current euro-zone crisis. The very assets that a bank may have acquired during a lending boom to help bolster capital ratios may themselves be at risk during a sovereign debt crisis. Further, while banks generally depend on deposits in individual retail accounts to fund their lending, during a lending boom deposits do not grow nearly as fast as the demand for credit.

Therefore, while future regulations may better protect banks from overexposure, presently we cannot rule out the possibility of another global recession as a result of a euro-zone debt crisis.

If there were to be a wave of global restructurings, we anticipate a greater need and desire for U.S.-style restructurings. This may happen through multinationals finding ways to file in the U.S. and avoid the problem of foreign jurisdiction altogether. But another possibility is that other countries will themselves move toward such laws, as some already have. China, in particular, has already seen the potential value of such changes and has modeled its new Enterprise Bankruptcy Law after U.S. restructuring law, though with some changes reflecting different national priorities. In the near future, we may see increased pressure on foreign jurisdictions to adopt the kinds of restructuring mechanisms that have repeatedly proved successful in the U.S. In a new global recession, some of our great exports may be our bankruptcy law and restructuring expertise.

Deryck Palmer is a partner at Pillsbury Winthrop Shaw Pittman LLP.

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