This article first appeared in Forum, The Edge Malaysia Weekly on April 27, 2020 - May 3, 2020

Covid-19 has permanently reshaped our economic landscape. For the first time in our modern globalised history, an object no larger than 125 nanometres has brought human productivity to a standstill across the globe, collapsing market supply. This is the reverse of the economic crises of the last few decades (for example, the 1997 Asian financial crisis or the 2008 subprime mortgage crisis), which were spurred by valuation bubbles and erupted when markets realised that supply grossly outweighed demand.

For this reason, it is becoming the global economic consensus that, unless the appropriate measures are put in place, what is now a recession may very well become a depression. To that end, we propose that Malaysia must undertake immediate insolvency law reform to create an environment that will both allow and better encourage private rescue financing initiatives to support and sustain the business sector.

Why we need rescue financing

As we begin to “flatten the curve”, we can legitimately hope for the gradual restoration of economic activity, but we must not delude ourselves into thinking that all businesses can return to the same commercial model they had prior to the lockdown. The challenges for businesses go beyond short-term cash flow problems and a temporary shortfall in supply. The pandemic is likely to bring about a new market order that disincentivises economic activity that relies too much on physical interaction and travel. Businesses will need to adapt to these new market conditions and, to that end, will need new capital.

What we propose with private rescue financing does not supplant the unequivocally critical public policy and stimulus plans that the Malaysian government has already put in place. The government’s policy focus is on alleviating the temporary liquidity challenge and it has rightly done so, as this is the most pressing concern. Soon, loan repayment moratoriums must be lifted and, for financial prudence, bank capital reserves must be rebuilt.  Our proposal is that, moving forward, the businesses community needs opportunity and support to survive in the new competitive environment. As we look to the future, we foresee an important role for private capital to play in rebuilding the economy.

Advantages of private capital

Markets and revenues for businesses are expected to be volatile as businesses begin to adapt to new conditions. Unlike traditional financial institution debt, which ordinarily requires a predictable and consistent repayment schedule and return, private capital can be employed to sustain businesses through such volatile markets, as their repayment and returns can be deferred wholesale to a much later period in time.

Private rescue initiatives also introduce additional accountability on management and provide critical business advisory to assist rescued businesses to adapt to the post-Covid-19 market. We believe that not only must a business survive a shortfall of cash or supply, they must also gain a sustainable competitive advantage on the global scene to be viable in the long term. Private equity, in particular, has proven itself to be efficient in bringing about this advantage.

As it so happens, private-equity firms began 2020 with a record US$1.5 trillion (RM6.54 trillion) in “dry-powder” cash. We anticipate there will be global competition for these funds in merger and acquisition (M&A) and rescue deals. Jurisdictions that offer rescue mechanisms that allow investors to appropriately manage their risk of loss and incentivise employment of private capital into rescue schemes will obtain a competitive advantage in attracting this large reserve of funds.

Inaptitude of current infrastructure

In Malaysia, our existing insolvency framework is unfavourable to private rescue financing. Despite recent reforms in 2016, our insolvency laws are too heavily focused on the fair distribution of the assets of failed businesses and do not provide commercially practical options to businesses that are viable, but face a temporary liquidity challenge because of an unforeseen crisis and, in our circumstance today, the potential onset of a new economic environment. These businesses, which form the bulk of the victims of the novel coronavirus, need an avenue by which they can negotiate a fair restructuring of debts and attract investors (white knights) or new lenders.

Briefly:

Furthermore, the moratoriums afforded in the existing regime focuses on the prevention of legal action by creditors when a company seeks to negotiate but fail to address the need for maintaining supply chains in ensuring business continuity. Also, in the case of schemes of arrangement, a moratorium against legal action is not automatically granted, further adding to an already intricate and costly process.

Proposed reforms

So, what do we recommend that Malaysia do?

Reform agenda

SAFE HAVEN

Establish a “safe haven” to give viable businesses breathing

room from creditor insolvency action and legal assurance to

businesses and their suppliers so they can continue to maintain

their supply chain

CROSS-CLASS CRAMDOWN RESTRUCTURING PLAN

Introduce power of courts to enforce settlement on dissenting

class of creditors where proposal is fair and equitable

SUPER PRIORITY RESCUE FINANCING

Allow companies to attract white knights with court application

to grant priority to the rescue money over existing debt,

equity and  other securities.

EXPAND ACCESS

•  Expand access to existing regimes and introduce virtual settlement procedures

•  Encourage direction of private capital into rescue financing with double deduction tax incentive for impairment and loss.

First, following the lead of many governments in the global community, we should begin with establishing a “safe haven” to give viable businesses some breathing room and assure suppliers that their transactions with such businesses will not be avoided by law. We do this by imposing a conditional moratorium on creditor action and suspending the operation of certain facets of  our “undue preference” and “wrongful trading” laws.

The general legal position in Malaysia is that suppliers who supply to insolvent companies risk their transactions being voided by the courts if they have knowledge of the insolvency. Equally, directors who allow a company to continue trading while insolvent face penalties. This is no longer tenable if we wish to maintain supplier confidence and the integrity of our supply chain in the light of the liquidity crunch that has affected almost everyone. The “safe haven” should also include the suspension of ipso facto clauses in contracts, that is, those provisions that allow suppliers to terminate their supply in the event of insolvency or restructuring by the customer company.

Second, we should introduce two new rescue mechanisms into our insolvency laws that are critical to enabling rescue financing:

These mechanisms are not entirely novel; they are found in the US’ Chapter 11 bankruptcy laws and have already been implemented in Singapore. The UK is now pursuing implementation of a cross-class cram-down restructuring mechanism as part of its response to Covid-19.

Third, we need to amend our existing insolvency infrastructure to expand access to its mechanisms to companies while balancing the rights of creditors. The corporate voluntary arrangement regime should be expanded to allow companies with secured borrowings to negotiate voluntary arrangements binding all unsecured creditors (and binding secured creditors only if they consent).

The right to veto an appointment of a judicial manager by a secured creditor should be removed unless the secured creditor can show that the appointment will cause disproportionately greater prejudice. Also, companies should not be insolvent or beyond rescue before they can apply for these measures. Company law should be amended to allow companies that are likely to become insolvent to already seek them before it is too late. Further, to ensure that these mechanisms can be practically effective in the era of social distancing, amendments should be made to allow creditor meetings to be hosted virtually.

Finally, an infrastructure is complete only with an incentive to use it. To encourage participation of private capital in rescue financing, we propose the creation of a double deduction tax incentive for losses incurred by white knights arising from impairment or total loss of their debt or equity in the rescued company, should the rescue operation fail. Safeguards can be included to prevent abuse and ensure that this deduction is available only to genuine rescue deals carried out in good faith.

Conclusion

Even amid this harsh crisis, we can have hope. Taking law reform and active participation of the business community together, we can be optimistic for a significant turnaround. The experience with the Danaharta legislation and measures by the Malaysian government have shown that swift and proper action may be appropriate to deal with the extraordinary fallout from Covid-19.

Chew Seng Kok is the managing director of ZICO Holdings Inc. In his previous role as the managing partner of Zaid Ibrahim & Co, he was involved in advising on and drafting the Danaharta Act. Ang Siak Keng is a partner in Zaid Ibrahim & Co who advises on mergers and acquisitions, foreign direct investments and regulatory compliance. Judson Lim is a senior associate at Zaid Ibrahim & Co who conducts special research for Chew and Ang.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.