General Practice, Solo & Small Firm DivisionMagazine

Volume 17, Number 6
September 2000



Edward S. Knight

Legal infrastructure is the system of rules, procedures and institutions that undergirds global financial activity. It encompasses national laws in major financial jurisdictions, as well as in the emerging markets worldwide. It covers international law and institutions from bilateral and multilateral debt restructuring initiatives to new financing mechanisms.

Through much of the nineteenth and early twentieth century, governments financed themselves externally by issuing bonds. Governments frequently defaulted on those bonds, or unilaterally rescheduled them. In the 1970s, commercial banks in major industrial countries all but discarded risk analysis in a race for yields on loans to developing country governments, which in turn were eager to finance state-run infrastructure projects. The lending boom ended in 1982, when Mexico informed its creditors it could no longer service its debts. Other borrowers followed suit.

The securitized financing patterns born of the resolution of the 1980s debt crisis, and the privatization and liberalization trend that swept industrialized and developing worlds alike, contributed to the unprecedented pattern of flows that characterize today’s capital markets. Complementing these trends is an increasing flow of private savings into the markets, where investment funds compete for investor dollars by seeking high yields abroad as interest rates remain low in major industrialized economies. The ease with which even bank debt is traded, and the shift to bond financing among sovereign and other emerging markets borrowers, stand in stark contrast to the insulated environment of commercial bank lending among a limited number of institutions and their sovereign clients that prevailed before the crisis.

Radically diverse kinds of borrowers, many with no prior borrowing history or familiarity with the work of the capital markets, raise funds from a diverse group of creditors in the form of obligations that are easy to trade and even harder to trace, with the help of a diverse group of intermediaries and advisors. The role of governments has become more complex—they are borrowers, external creditors, restructuring agents, insurers, lenders of last resort, and facilitators of private investment, not to mention regulators and economic policy makers. Law and its institutions frame the relationships among this diverse group of market participants.

The Legal Infrastructure Agenda. The goals of a legal infrastructure effort should be to enhance transparency and predictability in financial transactions, limit the spread and mitigate the impact of financial crises on different sectors within the affected economy and on other economies, and encourage the speedy and orderly resolution of financial crises. Transparency involves improvements in the making of necessary information available to market participants, and in the functioning of institutions on which the markets rely. Key among such institutions are regulatory authorities and the courts. Containing failures to prevent a broader crisis addresses legal mechanisms, such as insolvency regimes and debt restructuring frameworks. Encouraging the speedy resolution of financial crises focuses on facilitating voluntary, contractual solutions negotiated between debtors and creditors.

Effective measures must consider the complex institutional and cultural frameworks in which financial transactions are en-meshed. Working for transparency and predictability in financial markets may require a close look at the composition and function of the local bar in emerging markets economies. Independent, knowledgeable regulators also are an integral part of today’s financial markets. Yet the role, authority, and training of regulators vary widely among different countries. In addition, systems for training lawyers and judges are critical to the overall reform effort, yet many law schools and bar associations in emerging market countries have no resources to prepare their constituents for the world of cross-border finance. Corporate governance, shareholder rights, and creditor rights are also high on the reform agenda. Corporate organization in different countries is driven not only by the laws on the books, but reflects peculiarities of cultural heritage, economic history, and decades of government economic policies.

Indonesia: A Case Study The profile of Indonesia’s financial crisis reflects the recent change in the composition of capital flows. Fully half of Indonesia’s external debt to private creditors at the end of 1997 represented direct, largely unhedged cross-border borrowing by private nonbank corporations, mostly from banks offshore. Much of that borrowing was backed by export credit agencies in industrial countries.

Given the significant portion of the country’s indebtedness attributable to private corporations, corporate workouts had to be a major part of Indonesia’s crisis response strategy. However, it was believed that Indonesian debtors were not constrained by fear of bankruptcy liquidation in their dealings with creditors, and that creditors stood no chance of predictable or equitable treatment if liquidation were ever to happen. Insolvency reform was viewed as critical to Indonesia’s recovery.

An internationally supported bankruptcy reform effort was underway in Indonesia when the crisis struck. Indonesian authorities committed to make amendments to the existing bankruptcy law that tightened deadlines; rationalized the treatment of secured debt; provided for the appointment of ad hoc judges and receivers from the private sector; gave the government the power to bring insolvency proceedings "in the public interest"; and provided for the establishment of a new commercial chamber in the court system, staffed with selected judges specially trained in commercial matters.

The court’s record has been mixed at best. Foreign and Indonesian creditors alike, as well as many in Jakarta’s legal community, have suggested that the commercial court’s decisions betray inadequate command of corporate finance. The courts are ruling against creditors on what appear to be suspect legal grounds, in a manner that lacks predictability in the conventional legal sense, and raises concerns about transparency.

In the meantime, the Indonesian government established the Indonesian Debt Restructuring Agency (INDRA) and implemented the "Jakarta Initiative." INDRA offered a measure of protection from further depreciation of the exchange rate to companies that restructure their debts to fit a specified profile. The second initiative was a voluntary negotiation framework, including standards for disclosure, combined with initiatives to remove legal, tax, and regulatory impediments to common restructuring techniques; a streamlined process for obtaining regulatory approvals; facilitation services; and power to bring insolvency cases before the new tribunal on behalf of the government to further the public interest.

What Are the Lessons of This Experience? First, institutional reform must accompany substantive law reform in such vital areas as bankruptcy. Second, institutional reform is slow and requires the building of trust and legitimacy in the legal and business community. The local judiciary and the bar must be a part of the process. Third, law and judicial reform are best complemented by a strong, government-driven, out-of-court workout scheme that provides a ready alternative to litigation. Fourth, it is important to examine existing legal, regulatory, and tax measures that may act as obstacles to restructuring. Fifth, there is a trade-off between executive/administrative and legislatively approved measures taken in crisis. Governments fighting crises by executive decree may suffer a backlash against reform on the part of the legislature. Finally, measures that governments and others in creditor countries can take to facilitate speedy and orderly debt restructuring when crisis hits are: contract clauses, cross-border insolvency reform, and reviewing legal impediments to restructuring in creditor countries.

Edward S. Knight is Chief Legal Officer of the National Association of Securities Dealers, Inc., and was formerly general counsel, United States Department of the Treasury.

This article is an abridged and edited version of one that originally appeared on page 211 of The International Lawyer, Spring 2000 (34:1).

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