How to Handle Distressed Trade Debt of Customers in Emerging Markets
From the August 2000 edition of Managing International Credit and Collections
Even the most diligent international credit professional eventually encounter one or more customers who either can't pay or won't pay. After a certain period of time, depending on the size of the debt, many either throw up their hands in disgust and write the receivable off or turn the account over to a collection agency.
Before taking either of these steps, international credit and collection professionals should seriously consider some other options. Omni Whittington Emerging Markets' managing director, Jan Mekenkamp, suggests debt rescheduling, debt conversion, and the sale of the debt into the secondary market. He also has a highly effective collection technique. These options should be considered not only when the debt has gone bad but also when structuring new transactions.
Preliminary Considerations Before investigating the last-resort options mentioned above, Mekenkamp suggests evaluating the following issues:
- Is this a case of "won't pay" because your goods are not critical to the debtor's operations?
- If not, is it a case of "can't pay"? If this is the situation, it will be necessary to ascertain whether the situation is a temporary liquidity problem or a structural insolvency.
- Is the predicament a debtor problem or a country difficulty?
- Was or is risk insurance attached to the deal and if so what type?
- Are the financial obligations of the debtor backed by a bank guarantee or similar security?
With the answers to these questions, the international credit professional will have the necessary information to evaluate other collection options.
"The most probable cause of a cross-border default involving an emerging market debtor is that the debtor has a mismatch between its foreign exchange earnings and its corresponding repayment obligations," says Mekenkamp. The simple solution is to resolve the mismatch by restructuring the debt. Unfortunately, this is usually easier said than done.
Mekenkamp says practical experience shows these rescheduling exercises to be lengthy and cumbersome. Additionally, if the payment terms are extended, as they usually are, the likelihood of another default in the future increases. He suggests that in addition to the debt rescheduling programs from the London Club, the Paris Club, and various private creditors clubs, individual creditors and their insurers can bilaterally negotiate rescheduling. See the accompanying sidebar for more information about the London Club and the Paris Club.
Sometimes it is obvious to all parties involved that simply rescheduling the debt will not alleviate the problems, especially when there is a structural foreign exchange problem. In those cases, sometimes converting the debt to one payable in the local currency should be considered, says Mekenkamp. This methodology provides flexibility permitting repayment in any of the following ways:
- cash in local currency;
- equity in the debtor; and
- government debt instruments.
Mekenkamp recognizes that these options may not be attractive to most international credit professionals. "The original creditor," he says, "could do a debt conversion but an investor that buys the defaulted debt from the original holder can derive more benefit." Investors such as Omni Whittington typically purchase this debt from the creditor at a discount and then negotiate the terms of a conversion with the government of the debtor.
Mekenkamp says that this usually results in a win-win situation for everyone involved because:
- The original creditor recovers some of the value of a debt that would probably otherwise have been written off.
- The central bank in the debtor's country sees its foreign exchange debt reduced in return for payment of a local currency amount that is lower than the hard currency countervalue of the debt.
- The purchaser of the obligation has the possibility of acquiring an interest in the local economy under more favorable terms than would have been possible through the foreign exchange markets.
As might be expected, these deals can be cumbersome, and Mekenkamp says price concessions are always required.
Making Debt a Tradable Commodity
Financial engineers have developed secondary markets for virtually every imaginable instrument. Distressed debt is no exception. During the 1980s banks began trading their nonperforming debt among themselves in order to either reduce unfavorable country exposures or accomplish a better spread of risk. That market continues today. Mekenkamp warns credit managers of the need to distinguish between the market for medium-term and short-term exposures. While the medium-term market is extremely large and liquid, the short-term market is much smaller and less liquid.
Major investment banks dominate the medium- term market, while the short-term market comprises primarily private investors and investment funds. The attraction of the secondary market is that, once a buyer is found, the transaction can be completed expeditiously, albeit at a price. The paper will be sold at a discount, and the assignment of the debt usually requires elaborate legal paperwork.
The Last Resort
When all alternative strategies mentioned above are exhausted, there is still one last option. It is what Mekenkamp calls "debt collection plus." He recommends using this strategy, for instance, when the debtor has decided to solve a liquidity problem by selectively not paying your company because the product in question is not critical to the operation. This might happen to a creditor supplying a product offered by many other companies. "If what you supply is not high enough in the debtor's priority list to produce payments," says Mekenkamp, "you should consider altering his perspective by creating a priority position by means of legal remedies."
The advantage provided by the legal route, he says, usually proves to be a much more efficient means of collecting nonperforming debts than by relying on local contacts or a debtor's good will. He suggests that the request for payment can be accompanied by an attachment of the debtor's assets-in either the creditor's country or a third country-followed by legal action if required. This approach often results in full payment, although concessions will sometimes have to be made by the creditor. If the debtor is offering new obligations rather than payment, Mekenkamp recommends having a bank acceptable to the creditor guarantee the new obligation.
Tools Needed When Attaching Assets
The successful use of the debt-collection-plus approach requires knowledge of certain techniques that the international credit and collection professional does not typically use. At the beginning of this article, it was stated that these collection approaches should be considered before a transaction is consummated. Tough collection procedures should be planned for in the beginning even though the international credit professional hopes to never have to use the information. Mekenkamp recommends:
- Asset tracing-"If you want to attach assets, for instance to enforce a judgment against the debtor," he says, " you will first have to know where to find them."
- International legal systems and jurisdictions-" It may take as many as three or four attachments," he says, "in different countries to satisfy the entire claim." Thus thorough knowledge of legal systems in different jurisdictions is imperative.
- Choice of forum-Procedural law in certain jurisdictions, he explains, can optimize your chances of bringing your case before a court in a friendly jurisdiction.
- State immunity issues-In certain countries, such as the UK, he says, governments are immune to prosecution and attachment of their assets Other countries do not protect government entity debtors when they enter into commercial contracts.
Omni Whittington Emerging Markets is a leading player in this specialized field. It invests in distressed emerging markets' debt but also offers a comprehensive debt collection service on a contingency or "no cure, no pay" basis. Mekenkamp can be reached at 011-31-70- 352-1104 or at jhmekenkamp@omniwhittington.
London Club and Paris Club
London Club: The London Club is a forum where international commercial banks negotiate the restructuring of nonperforming debt with governments of debtor countries (typical recent examples are restructuring the foreign debt of Russia and Ecuador).
Paris Club: The Paris Club is a forum where official creditors (export credit agencies and aid organizations) negotiate the restructuring of nonperforming debt with governments of debtor countries. The Paris Club lends its name to the fact that its secretariat is provided by the French Treasury.