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Distressed Investing in Australia

A guide for buyers and sellers

About Blake Dawson


Our focus is getting to the heart of your legal needs and delivering you commercially astute and practical
solutions. We have a proud history, long standing client relationships, a passion for challenging conventions
and thrive on cutting edge work.
We provide legal services to Australias leading companies and institutions as well as global corporations and
government. We are privileged to work with many of the organisations that are shaping tomorrows industries.
Blake Dawson delivers more than just the law. We value our relationships with our clients and look forward
to working with you.
Our Distressed Investing Practice
Our Distressed Investing practice has an established track record of assisting clients to successfully execute
the restructuring, sale or purchase of distressed assets, companies and non-performing loan portfolios.
Our expertise spans all sectors including real estate, energy and resources, manufacturing and financial
services and we cover all geographic areas. We bring together a multi-disciplinary team of leading advisers
from our banking, restructuring and insolvency, corporate, property and tax teams to best structure your
distressed deals. For further information, please visit our website at www.blakedawson.com

About PricewaterhouseCoopers
PricewaterhouseCoopers provides industry-focused Assurance, Tax & Legal and Advisory services
forpublicandprivate clients in four areas:
corporate accountability
risk management
structuring and mergers and acquisitions
performance and process improvement
We use our network, experience, industry knowledge and business understanding to build trust
andcreatevaluefor our clients.
Distressed Debt Group
Over the past decade, PricewaterhouseCoopers Distressed Debt Group has managed more than
150sell-side and buy-side engagements in over 25 countries. Overall the group has acted for more
than30internationalclients, 60 local buyers and various government agencies.
With dedicated staff located in Australia as well as Asia, Europe and Latin America we bring together
global experience with local capability, no matter where the deal is, to ensure a smooth and seamless
experience. Weare also uniquely positioned through our extensive relationships with the pool of global
investors,toensureany deal is marketed to the widest possible audience of buyers.
The Distressed Debt group is an integral part of PricewaterhouseCoopers Corporate Advisory
andRestructuringpractice which has a local presence in over 60 countries in the world.

2010. Blake Dawson and PricewaterhouseCoopers. All rights reserved.


This work is copyright. Reproduction of any part is welcome with prior permission from Blake Dawson and
PricewaterhouseCoopers. Requests and enquiries may be emailed to sarah.wilson@blakedawson.com and
duncan.mcgilligan@au.pwc.com.
Australian laws and regulations are constantly changing. This publication is intended only to provide a summary of
the subject matter covered. It does not purport to be comprehensive or to render legal advice. No reader should act
on the basis of any matter contained in this publication without first obtaining specific professional advice. We invite
you to contact us for any further information or assistance.
PricewaterhouseCoopers refers to PricewaterhouseCoopers, a Partnership formed in Australia or, as the context
requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a
separate and independent legal entity.

Table of contents
Foreword Blake Dawson

Foreword PricewaterhouseCoopers

Overview Distressed investing in Australia

1. The who, the how and the why of buying distressed debt/assets

12

Who buys and sells distressed assets, and why? How big is the global market? What is Australias
place in this market, and what do potential investors think of Australia? What is the secondary debt
market, and how does it operate in Australia and offshore?

2. Portfolio debt sales the key considerations in value


18

What determines the value of a portfolio of an individual credit or a portfolio of distressed debt?
What are the key steps in the administration of distressed assets? How do debtholders recover
assets in Australia?

3. Using secured debt to control outcomes and obtain ownership of the assets

28

What are the legal boundaries within which distressed asset investors must move? What are the
rights and responsibilities of secured debtholders? How can debtholders best protect the value
oftheir assets?

4. Recapitalising distressed listed/unlisted companies


32

How can distressed asset investors recapitalise their assets? What are the differences between
listed and unlisted firms? How does the administration regime in Australia provide for companies
tobe reorganised?

5. Why should an Australian bank sell debt?


36

If Australian banks have felt no need to sell distressed assets until now, why should they consider
it? Reasons include an increased number of buyers of distressed assets, the increasing drain
on management time and focus on workout, the constraints on capital created by Basel II,
andliquidityconstraints brought on by the global financial crisis.

6. How does a non-performing loan portfolio sale work?


40

What are the steps in selling a non-performing loan, or a portfolio of loans? How are they priced
and how do sellers achieve the best price. What are the mechanics of servicing the portfolio
duringand after the sale process? How can sellers best protect their interests?

7. Structuring options for sellers of debt/assets


46

How should banks and other sellers of debt structure their transactions? Options include outright
sale, a joint venture arrangement, or securitisation.

8. Tax implications of selling and buying debt


Tax issues are complex both for the buy side and sell side. What features of the Australian tax system
are relevant for distressed asset investment? What tax issues should sellers and buyers take into
account at the planning stage?

50

Appendix A Economic outlook

62

Appendix B Summary of Australian Big 4 Banks Basel II disclosures

64

Useful websites

66

Contributing authors

68

Contact information

Back cover

Foreword Blake Dawson


The emergence and continued growth of a secondary market in Australia for
distressed debts and assets is a sign of the increasing depth and sophistication
ofAustraliasfinancial markets.
Such a market is beneficial to the Australian economy for at least two key reasons.
Firstly, it adds much needed liquidity into the system, permitting parties with existing
positions to trade out those positions. Secondly, it creates a floor for distressed assets,
meaning that any business that is capable of being restructured is restructured.
Ultimately, by providing opportunities for new investors, the chances of preserving
stakeholder value and continuity of employment in Australian businesses aremaximised.
For lenders and investors with existing positions, there is the option of selling
down their positions into the market. For potential investors with a knowledge
ofdistressedinvesting techniques, there is the opportunity to invest.
Australia is an attractive place to invest. The rule of law prevails and the legislative and
judicial processes are justifiably held in high regard. A number of the historical legal
impediments to secondary market trading have now been removed and the Australian
market is becoming more comfortable with the distressed investing techniques that are
common features of other markets; these include loan to own strategies; pre-pack
formal appointments; and convertible note investing. By utilising these techniques,
an investor can look to minimise the risks associated with investing in distressed
companies or their assets.
Of course there still remain issues that lenders and investors must confront. The
Sons of Gwalia decision, for example, has not done much for Australias reputation
inother financial markets where shareholders are expressly excluded from competing
with creditors upon insolvency. These issues aside however, distressed debt and
asset trading is a market not to be ignored. In a time of uncertainty, it presents
significantopportunity for those who have the appetite.
As market leaders in restructuring and distressed investing, we are committed
to shaping this emerging market. For this reason we have partnered with
PricewaterhouseCoopers to produce this guide. Covering the key legal and
accounting issues, we hope this guide will arm you with the requisite knowledge
andunderstandingto participate in and take advantage of this exciting market.

James Marshall
Partner, Blake Dawson

Foreword PricewaterhouseCoopers
When one door closes another door opens; but we so often look so long and so
regretfully upon the closed door, that we do not see the ones which open for us
When Alexander Graham Bell wrote this world famous quote it is doubtful that he
hadinmind the financial crisis of 2008/09.
The Australian market is today facing a period of uncertainty like it has not faced
sincethe early 90s. Like then, globally banks today are facing a rapid build up
in nonperforming loans and companies are facing unprecedented pressure on
their top and bottom lines. However the market is also a very different one today
to thoseuncertain days. In todays market there are so many more options open
tobothdistressed companies as well as lenders.
There exists a very real opportunity for banks to unlock the hidden value tied up in
nonperforming loans. From freeing up management time to focus on newer more
pressing problems to releasing capital that needs to be set aside against all NPLs,
debt sales have a very real place in todays market as has been highlighted by the
American,European and Asian markets experience.
This is why, together with Blake Dawson, we have invested in this publication to further
develop the Australian market and to highlight some of the issues around the buying
and selling of distressed debt and assets and thereby encouraging the evolution
ofthisfledglingmarket in Australia.
Please read this with the open mind that Alexander Graham Bell advocates and
help us to help you realise this opportunity and in the end maximise recovery
duringtheseuncertain times.

Michael McCreadie
Partner, PricewaterhouseCoopers

Overview Distressed
investing in Australia
Australia is really attractive to us...
...says the manager of a billion dollar global fund dedicated
to investing in distressed assets, who was interviewed for
thepurposesof this publication.
Worldwide, distressed investment is a
US$50 US$100 billion industry. As the
consequences ofthe global financial crisis work
their way through the global economy, it is one
of the few areas that is set to grow significantly
in the years to come, as increasing numbers of
companies find themselves in difficult financial
circumstances and are unable to meet their
debt commitments. Distressed M&A in the
USaloneis set to grow by 93% this year.

The business operating environment is well


regulated and stable, with good infrastructure
and well developed services

There is a large base of sophisticated


investors looking for alternative investment
opportunities in this new and exciting market.

Australia will follow. The boom years have


been good to the lucky country, but the
global downturn has significant implications
for Australian companies. Export markets
are stressed and the domestic economic
situation has darkened. Companies are laying
off large numbers of workers, are restructuring
to avoid insolvency, and in some cases
arefallingintoadministration.

Between December 2008 and January 2009,


PricewaterhouseCoopers and Blake Dawson
interviewed a number of high profile market
participants, including representatives from
Australias major banks, foreign banks active
in the market, fund managers with experience
in distressed asset investing offshore,
and domestic private equity managers
consideringdistressed deals.

For distressed asset specialists, Australia is


anextremely attractive market. Heres why:

This overview outlines our conclusions from


those interviews together with research into
the opportunity for the creation of a secondary
or distressed investing market in Australia.
Thispublication outlines the mechanics of
such a market, from the basics of distressed
asset transfer to the structure of such deals,
itslegalframework and tax implications.

Opportunities will proliferate as the economic


situation unfolds. The countrys banks are
managing a larger number of underperforming
loans than they have seen in 15 years.
Theirworkout teams are overwhelmed. In all
likelihood, the supply of non-performing loans
from Australian banks will multiply as banks
struggle with the new business conditions
and become increasingly comfortable with
the idea of bundling and selling poorly
performingassets to third parties
The legal and accounting frameworks are
clear and comprehensible, unlike a number
ofmarkets in the Asian region

The distressed investing market in Australia


has historically been very quiet. But this is
likelytochange, and change rapidly.

Understanding how to participate in distressed


investing will be vital in the coming months
and years for those organisations that wish
toflourishthrough the downturn.

Australian banks have never


really thought about debt sales.
They have never really had to.
Senior manager, major Australian bank

Background
Australia has had little need for a distressed asset market
until today. A strong economy for well over a decade
has meant there have been relatively few bankruptcies,
non-performing loans on banks books have been well
withinmanageable limits, and investors have had a wealth
ofpositive, growth oriented opportunities to focus on.
Now, we are on the verge of a new market.
A market created by the rapid change in
economic circumstances, byinvestment
capital looking for opportunities in an
extremely difficult environment, and by
the need for Australian banks and other
financial institutions to find solutions
tonew problems.

well structured financial markets, rigorous


legal frameworks and clear regulatory
environment give it a competitive
advantage over its regional neighbours,
and a clearly imminent increase in
financial distress is attracting attention
from those who seek to extract value
fromfinanciallytroubled companies.

Through a period of 15 years of


uninterrupted growth, Australian lenders
have experienced only modest levels of
financial distress amongst their customers.
Financiers in other parts of the world have
developed efficient markets for transferring
distressed assets off their balance sheets
to specialist investment funds and other
investors dedicated to the sector. But
their Australian counterparts have been
underno pressure to do so.

Global funds with experience in distressed


markets are cashed up and poised on
the sidelines. Over the next few years,
Australia may well see the birth of a
vibrant market for these assets, but it
will take a change in approach on behalf
of the major financial institutions, and a
fewbreakthrough deals to kick start it.

With the global financial crisis rolling


through the Australian economy, financial
institutions are likely to see a sharp
increase in non-performing loans and
other distressed assets. At the same time,
banks revenues are reducing because of
lower demand for credit, and there will be
greater pressure from both shareholders
and regulators to hold increased amounts
of capital against impaired assets.
Meanwhile, distressed asset funds
operating across international markets
areeyeing Australia carefully. The countrys

Bad news rising


At the tail end of a 15-year boom, the
Australian economy is facing numerous
challenges. Seemingly overnight, the
credit crunch and the global financial
crisis have brought the countrys longest
unbrokenperiod of growth to a halt.
The years of relatively easy credit that
fuelled the countrys optimism and its
investment in the future have ended.
In 2006, companies were offered
unprecedented amounts of leverage
to finance their futures and maintain
smooth cash flows. Much of that

activity came to astop in the middle


of2007 as banks faced serious liquidity
challenges in the flow on from the subprime crisis in the US. The early stages
of the credit crunch saw the collapse
of many Australian companies whose
rise had been emblematic of the boom:
Allco Finance Group, ABC Learning,
Centro and Babcock & Brown being
thehighest profile casualties to date.
The spread of bad news through the
financial markets has infected broader
sentiment throughout the economy.
Companies, for many years unable
to recruit enough good people fast
enough, have been laying workers
off in their thousands. Consumers,
amainstay of Australian prosperity for
over a decade, have stopped shopping.
Despite fast and deep cuts in official
interest rates bythe Reserve Bank of
Australia, industryhas stopped investing
andthehousingmarkethas stalled.
China, whose economic health has been
crucial for Australia, has also faltered in
recent months, its export-led GDP growth
stumbling from over 10% over the last
decade to less than 7% at the end of
2008. Chinas unprecedented demand
for commodities placed a floor under
prices for much of Australias inventory
of natural resources, and underwrote
soaring share prices for the countrys
blue chip mining companies and a flurry
of investment in small and medium
sizedcommodityenterprises.
China also directly invested tens of
billions of dollars in Australian resource
enterprises. Much of this investment is
under pressure to continue to perform.
The collapse in Chinas export markets
israpidly flowing through to the Australian

mining community, and that sector, just


12 months ago the source of a great
deal of economic strength, is undergoing
swiftand unpleasant adjustment.
In short, the credit crisis is having a
significant impact on Australias industries
and enterprises. Many companies with
previously sound business models
havemet with unexpected difficulty
when attempting to roll over their shortterm loans, causing sudden and severe
cash flow issues. Many have had to
quickly and radically adapt their business
operations. Others have simply failed.
According to the Australian Securities
andInvestments Commission, the number
of companies entering administration in
Australia jumped 10.3% between 2007
and 2008 to 8,300, and the number
of insolvency appointments jumped by
over6%to12,770.

Bad loans in the system


With the economy in freefall, banks and
other financial institutions are bracing
themselves for a major increase in
distressed assets as companies and
consumers find themselves unable to
service the loans taken on in the good
times. By the end of the last fiscal year,
the major banks had already seen a rise
in bad debt charges, up some 174% over
the year to end June 2008. The first half of
calendar 2008 was 54% higher than the
second half of 2007. By some measures
the increase in bad debt charges in fiscal
2008 was up 183%, representing 0.41%
of total loans. The Australian banking
industry hasnt seen this level of bad
debt charges since 1994, the tail end
ofthelastdownturn.

Our conversations with the major banks


indicate that many workout desks are
already feeling the pressure.
Michael McCreadie, PricewaterhouseCoopers

impaired assetS and BAD debt expense


7.0%

2.5%
Impaired assets / gross loans & acceptances (left axis)
Bad debt charge / gross loans & acceptances (right axis)

6.0%

2.0%
5.0%
1.5%

4.0%
3.0%

1.0%

2.0%
0.5%
1.0%
0.0%

0.0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Notes: 2006 onwards based on AIFRS

Source: PricewaterhouseCoopers Perspectives: Major Banks Analysis, October 2008

Domestic Credit Growth


(Annual % growth)
30%
25%
20%
15%
10%
5%
0%
1997

1998

1999

Total

2000

2001

Housing

2002

2003

2004

Personal

2005

2006

2007

2008

Business

Source: PricewaterhouseCoopers Perspectives: Major Banks Analysis, October 2008

At the same time, the banks have


witnessed a marked increase in
impairedassets, up by 137% in fiscal
2008, or 0.43% total loans. While this
isstill significantly below levels experienced
during the 1990s, the banks are also
seeing significant increases in past-due
loans. During fiscal 2008, loans that were
past due 90 days or more with adequate
security increased 29% in aggregate.
Our discussions with a number of
workout professionals in the major
banks indicate that many are facing
unprecedented workloads. In many banks,
workout desks are perhaps the only
growing part of operations, with many
experiencing such growth in demand
theyfearbeingoverwhelmed.
While impaired assets and debt charges
are likely to increase significantly, bank
margins will be under pressure from
slowing credit growth on both the
consumer and business lending sides.
Total credit growth slowed in 2008 to
10.5% from 16% in 2007, with growth
in business lending slowing to 13.7%
in the year to September 2008 from
over22%the previous year.

In response to the feared pullout of foreign


banks, in January 2009 the Australian
government launched a A$4 billion fund to
support commercial property development
projects that lose their international
financial backing due to the financial
crisis. Domestic banks will provide half
thefundscapital.
Many second tier banks and other
smaller financial organisations are
seeking consolidation or other forms
of partnership with larger institutions.
Non-bank financial institutions have been
significantly weakened by the increase in
the cost of funding, as well as the collapse
in demand for housing finance with the
fallinhouseprices.
Each of these issues creates new
pressures on Australias financial system
whose most marked characteristic over
the past decade has been swift growth
and fast innovation.

This points to a challenging environment


for the major banks, to say the least.

Distressed assets

Things are likely to be worse for other


players in the financial services arena.
The foreign banks, second tier financial
institutions, such as smaller banks, credit
unions and building societies, as well
as other non-bank financial institutions
are each facing their own issues
andfinancialstrains.

A significant volume of distressed debt


is an unfamiliar problem for Australian
lenders. Australian financial institutions
have generally adopted a much simpler
business model than their counterparts
offshore. While banks and other financiers
in the US, Europe and Asia have actively
managed their balance sheets by selling
individual loans or portfolios of nonperforming loans (NPLs) and other
distressed assets to realise value and
transfer them off their books, Australian
banks have not done so, resolutely
keeping bad loans on their own books and
focusing on working them out themselves.

A fear exists that foreign banks, under


pressure to withdraw capital to support
their home markets, will pull out of the
Australian market, transferring their
Australian loan portfolios, in aggregate
totalling some A$50 billion to A$80 billion,
to other counterparties or reducing

funding lines. At the time of publication,


reports were emerging of the first of
such activity, with a major foreign bank
offering a portfolio of leveraged loans
ofuptoA$100 million.

The full impact of Basel II is really unknown


as yet as we have not lived through a cycle
with it. If the full impact is applied, then there
is no way banks can afford to carry NPLs on
thebalance sheets during the tough times.
Senior manager, major Australian bank

Australian bankers, when interviewed about the lack of a local


market for distressed assets cite several reasons, the most
persistent of which is that there has been no real need for one.
Australian banks have never really thought about debt sales,
said one senior manager at a major Australian bank. There may
be a number of reasons for this. It may be that the structure of
Australian loans the documentation has precluded trading
them. Secondly, banks may have had the view that they would
be foregoing too much profit were they to transfer their assets.
Andthirdly, because of their position in the community, banks
would be reluctant to hand their customers over to a distressed
asset firm that may not have the same relationship imperative.
Other reasons given include a cultural reluctance to admit
mistakes, as well as a focus on workouts as a core banking
competence that precludes the sale of NPLs.
None of these reasons would seem strong enough to dissuade
banks from entering into an active distressed debt market if the
volume of NPLs reached critical mass. As workout desks become
increasingly overwhelmed, as investors begin to offer prices that
reflect the fair value of the loans, banks will be forced to consider
the alternative to keeping all NPLs on their balance sheets.

Capital questions
Over and above the pressure banks are likely to feel from
increasing volumes of distressed assets, regulators will have a
keen eye on banks management of capital. The introduction of
the Basel II regulations this year will increase scrutiny of banks
NPL portfolios. There is growing concern among the banking
community that both the banks and the regulators do not
yet appreciate the full impact of the new regulations as levels
ofNPLsincrease significantly.
Basel II requires banks to set aside up to 25% of the gross
loan value of NPLs as Tier 1 Capital, capital that could be freed
up to generate income for the bank in other ways if the NPLs
weresoldto another party.

We see a market waiting


to come to life.
Michael Sloan, Blake Dawson

According to one senior banker: If the full impact of Basel II


is applied, there is no way banks can afford to carry NPLs on
their balance sheets during the tough times. Hepoints out
thatthe Basel II regulations, if fully imposed, are extremely
procyclical, discouraging banks from lending during
downturns,andfreeingup capital during boom times.

Distressed corporates
The distressed market is not just
confined to the impaired loans of
Australian banks. Many listed and private
Australiancompanies and trusts are
experiencing severe liquidity problems
associated with looming refinancing dates
and a lack of replacement debt capital.
To date, some larger listed corporates
have managed to reduce gearing and raise
liquidity through cut price raisings on the
equity market which, whilst dilutive, is a
better option than the other alternatives.
However, for private companies and listed
companies with weak share prices, this
option is generally not available. Anumber
of off-shore and domestic funds and
lenders are now targeting distressed
corporates and offering them relatively
highly priced debt (usually with a right to
convert to equity upon agreed terms) to
fund liquidity gaps. Such funds will also
consider investing equity but will seek
assurances around the balance sheet
andmatters such as class action risk.

Demand for distress


Banks are indeed likely to consider selling
their distressed assets in the near future.
At the same time, there is significant
demand for them from both global players
based in Asia and local private equity
players looking to deploy their funds in
the distressed asset arena. The market in
Asia has been active since the late 1990s,
when the number of distressed companies
shot up in the Asian financial crisis. Across
the globe, there are hundreds of entities
that invest in distressed assets, from
the major international players out of the

10

US, such as Cerberus and Lonestar, to


smaller specialist funds, many of which
have pan-Asian funds that would consider
Australia and New Zealand part of
theirinvestmentuniverse.
A survey of 100 hedge funds across Asia
by Debtwire in October 2008 found that,
after China and Indonesia, Australia is
the market where most distressed debt
opportunities are expected to arise over the
coming year. At the same time, Australias
strong legal framework and regulatory
environment give potential distressed asset
investors security in their property rights,
an advantage over the less predictable
Chinese and Indonesian markets.
There are a number of things we like
about Australia, says one manager at
an international alternative investment
fund. Firstly as a global fund we like
the language, the law and the corporate
governance framework. At the same
time, because we deal with distressed
assets we can see there are some real
problems brewing in the underlying
economy so we are likely to see
someopportunitiesarise there.
The country also has a greater level
of sophistication in terms of asset
management networks. We are a capital
provider, and cant service individual loans
from a pool of them. Rather, we need to
tap into an existing infrastructure to help
us manage our assets, and that exists in
Australia, whereas it doesnt in some of
theless developed markets in Asia.
A point made by many asset managers
was that, because many funds operate
on a global basis, any investments in
Australia would have to offer risk-adjusted
rates that were competitive with those

There are a number of things we like about


Australia. Firstly as a global fund we like the
language, the law and the corporate governance
framework. At the same time, because we deal
with distressed assets we can see there are
some real problems brewing in the underlying
economy so we are likely to see some
opportunities arise there.
Manager, international alternative investment fund

attained in other parts of the world. At the


moment, there is an impression that there
is something of a large spread between
what sellers of distressed debt might
offer,andwhat buyers might pay.
My feeling, says another distressed
asset specialist operating across Asia,
isthat the market in Australia is still in
price discovery mode. There is a fairly
largebid-ask differential.
At the same time, asset prices across
the globe have been falling steadily since
mid-2008, and many investors are sitting
on the sidelines waiting to see when
abottommight be found.
The picture is one of a market waiting to
come to life. On the supply side sit the
banks, with a growing pool of distressed
assets that will need to be managed for
value, but constrained in their ability to

expand workout operations by supply of


experience. They are also limited in their
capacity to hold NPLs by the need to set
aside significant amounts of regulatory
capital against them. On the demand side,
there are a large number of funds with
considerable amounts of capital available
ready and willing to invest in these assets.
With a change in approach from Australias
major banks, an adjustment in price
expectations from both sellers and buyers,
and a detailed understanding of the legal
and business issues discussed in the
rest of this publication, we anticipate the
creation and growth of a real market for
distressed investing in Australia over the
next few years. This growth will benefit
banks, investment funds, and, in the end,
companies experiencing financial distress
to have an efficient market focused on the
ownership and management of their debt.

11

1. The who, the how


and the why of
buying distressed
debt/assets
The distressed debt market in Asia matured during the late
1990s as numerous countries in the region went through a
period of economic turmoil. The Asian financial crisis threw
up many distressed opportunities offering alternative
investors above average returns. Theseopportunities,
combined with a flattening of returns in the US/Latin
American distressed markets focused investors
attentiononthe Asian markets.
The initial influx of buyers came primarily
out of the US and included larger players/
funds such as Cerberus and Lonestar,
and finance houses such as GE. Target
acquisitions included large secured NPL
portfolios, real estate and large corporate
debt. As the economic crisis worsened
more opportunities arose across Asia and
especially in countries such as Taiwan,
Japan, Korea, Thailand, Philippines,
India, China and Malaysia. With early
deals reportedly generating significant
returns, the market for distressed
debt quickly grew and the number
ofplayersexpanded exponentially.
While statistics vary, in todays market
there is estimated to be hundreds
ofinvestors involved in the distressed
debt market. The major distressed debt
investors have been around since the
early 1980s and have developed unique
skills and expertise in valuing, buying and
managing distressed debt acquisitions.
Initially the majority of distressed debt
investors originated in the US and
Europe, but the growth of opportunities
in Asian markets in the last 10 years
has seen the emergence of numerous
Asian-based buyers focusing solely
onAsianopportunities.

12

The current global economic turmoil has


seen a number of funds pull out of the
market and others take a very cautious
approach to investing. To quote a common
phrase, no one wants to catch a falling
knife. Our discussions with investors
have indicated that while this was the
general consensus in 2008, most expect
to revisit these views in 2009. Also it
would seem that established buyers are
looking to raise new funds and capitalise
on the movement of capital away from
traditional areas to distressed investing.
The chart on page 36 indicates the extent
of raisings by distressed funds over the
pastcoupleofyears.
A unique characteristic of the current
economic turmoil is the true global nature
of the downturn. Previous downturns have
focused on particular regions and hence
distressed investors focused on particular
markets. An issue for Asia Pacific sellers
is that due to the state of markets in the
US and Europe, the big global distressed
investors who work with a global pool of
capital will focus their attention wherever
the best returns can be achieved.
Currently this is in Europe and the US.
Forthe market in distressed debt to grow
in Australia, pricing and returns will have
tobe comparable with global valuations.

Established buyers are looking to


raise new funds and capitalise on
the movement of capital away from
traditional areas to distressed investing.

How are investors classified?


Distressed investors can generally be classified
intothe following three categories:

1. Distressed debt funds


(Hedge funds, private equity funds)
This category is made up of those buyers that have a
primary focus on distressed debt or assets. Many of
the early players in the distressed market were funds
established by ex-investment bankers with wealthy
clientele looking for above average returns. Historically
these funds have been subject to minimal regulatory
control and have therefore been able to preserve high
levels of confidentiality. In Asia at present there is a
large number of these types of funds ranging in size
from the small with more than US$50 million to invest
to the large with over US$1 billion available to invest.
In the current climate these funds are typically looking
for opportunities where they can bring to bear their
financial skills, such as restructuring a company to
maximise their returns. Typical investment size across
Asia is US$10 to 25 million while some of the larger
funds will look at US$100 million plus opportunities.
Return requirements are generally in the 25% plus
Internal Rate of Return (IRR) range. While usually
distressed funds prefer to invest on their own rather
than in a joint venture structure, in the current climate
structuring deals including joint ventures are becoming
more popular as a means to mitigate exposure and
enhance value to both the buyer and the seller.
New entrants into the market have been the
traditional Private Equity firms. As the number of
traditional private equity deals have slowed or the
risks and rewards have become relatively unattractive,
alternative forms of investment are being investigated.
Traditionally private equity has purchased equity as
a means to assume control; however the distressed
investing model of using the debt structure to secure
control with added security is becoming increasingly
attractive for those funds that still have cash.

2. Financial institutions
(including investment banks,
commercial banks and financial houses)
Many financial institutions have special situation
groups focusing on distressed debt investing.
Typically these operations form part of the bank
andoften focus both internally and externally.
For example, a special situations group can helptheir
parent institution with their own nonperforming loans,
can help expand customer bases by purchasing nonperforming loans from other financialinstitutionsor
can invest their own funds.
Some of the more consistent investors here include
Morgan Stanley, JP Morgan, UBS, Goldman Sachs,
Merrill Lynch, Standard Chartered, Standard Bank,
Deutsche Bank, HSBC, Citibank and GE.
These investors tend to have higher investment size
preferences in the range of US$15 to 20 million plus.

3. Local buyers
Both categories 1. and 2. are generally foreign
investors, as typically their focus is cross border,
i.e.they will look to invest in multiple countries
withinaregion.
Given the growth in distressed debt opportunities
in Asia over the last 10 years, a number of local
operators have been established to focus on specific
country based opportunities. A good example of
these are government supported entities established
to resolve local bank non-performing loan problems
such as the Asset Management Companies (AMCs)
established in China, Thailand, India and Vietnam.
In Australia a number of local servicing companies
have also looked to purchase NPLs mainly focused
on the consumer credit card space and generally
onaforward flow basis.

The majority of these funds are offshore, but a number


of new funds are setting up in Australia.

13

Countries rated on their distressed debt opportunities in 2009


China 65

17

Indonesia 49

23

Australia 38

22

South Korea 36
India 25

25

Vietnam 21
Japan 12
Malaysia 14
Taiwan 9
Hong Kong 12
New Zealand 3 14
Singapore 8
0%

29

15

13

5
7

18

32

34

54

10%

19

47
20

19

43

21

17

43

17

16

37

21

2
4

17

41

24

13

36
18

Philippines 17

16

31

27

4
11

22

16

Thailand 16

8
15

2
26

36

20%

28

30%

40%

50%

15

60%

70%

80%

90%

100%

Percentage of respondents
Significant

Very High

High

Low

None

Source Debtwire: Asia-Pacific Distressed Debt Outlook 2009, December 2008. Survey canvassed 100 hedge fund
managers and proprietary trading bankers.

Investors focus on Australia Types of investments

14

The attractiveness of the Australian market


to distressed investors is highlighted by the
chart above 60% of the 100 investors
surveyed throughout Asia had significant
or very high potential for distressed debt
opportunities in 2009. The same survey
found China and Indonesia (the only two
countries rated more highly for distressed
opportunities than Australia) to be the
countries where it is most difficult for
creditors to exercise or enforce their rights
over security or to enforce their rights in
court. As a result, Australia is very much
on investors radars.

Deal types

The added attraction of the Australian


market is the strength of the regulatory,
legal and governance environments.
Asone investor mentioned, when we
walk into an Australian court the chances
of us getting subjugated to a lower asset
class is pretty unlikely. In comparison to
other Asian markets, Australias strong
legal and regulatory framework provides
a relatively high level of comfort and
securityforinvestors.

Most distressed debt investors


will look at a range of deal types
includingthefollowing:

NPL portfolios sold by banks (either


secured or unsecured, although secured
portfolios tend to attract more interest)

High yield lending

Equity investments, often coupled


with high yield lending, particularly
intherealestate sector

Equity investments and/or high


yield lending, in private companies
or State Owned Enterprises (SOEs)
often combined with management
influence(e.g. seats on the board)

Distressed real estate or real estate


seized by financial institutions and
subsequently offered for sale

Single credits of distressed debtors

Credit card portfolios or other


types of receivable portfolios
(suchasutilitydebts)

NPLs or NPL portfolios on


thesecondary market.

Assessment approaches

Key elements

While each of the above investment


types will require a different assessment
approach, typically investors will consider
the following issues in relation to each
potential transaction:

While each investor has a specific


investment decision matrix and
a preferred investment type, the
key elements that they all look for
inanytransaction include:

Determining an exit strategy


depending on the nature of the
investment, exit strategies may
range from regular debt repayments,
foreclosure actions, sale of assets or
realisation of equity holdings

Estimating future cashflow what are


the timings and total expected gross
cashflow amounts generated by the
proposed exit strategy, for example
the timing and amount of forecast debt
repayments or the realisation of assets

Estimating costs to be incurred


inrelation to the adopted exit strategy
such as outsourced collection costs or
the cost of establishing a local presence

Reasonable transaction size relative to


the fund size, i.e. the effort to be put
into a deal needs to be justified through
a meaningful investment amount.
Typically the average investor is looking
at deal sizes (across Asia) of between
US$10 to 25 million with larger investors
looking to allocate up US$100 million
ona deal bydeal basis

Access to reliable and current data with


which to make the investment decision

Certainty of a transaction taking place,


especially in the case of a NPL sale
byabank

A clear exit strategy including a relatively


predictable timeframe. In this regard
some investors look for a relatively short
turn around such as less than 1 year
while others prefer longer timeframes.
It is not uncommon for distressed debt
investments to have an average life
of2 to 4 years

Above average return requirements


while return requirements vary between
investors and for each investment type,
all distressed investors are looking
forabove average returns.

Agreeing on the desired required return


factoring in the cost of debt/equity and
estimated risk to the investment.

15

Secondary debt trading terms


Traded distressed debt includes secured and
unsecured bank debt, trade debts, liquidated
and unliquidated damages claims and other
chosesinaction.
The transfer of economic risk associated with a debt
may be achieved either by transferring the debt itself
so that the purchaser of the debt enters into a direct
relationship with the debtor or by sub-participation
of the debt in which case the purchaser assumes
the economic risk associated with the debt pursuant
toacontractual relationship with the seller only.
Debt transfers are normally carried out by legal
novation or assignment and the mechanism for
transfer is likely to be set out in the relevant loan
documentation. Any such transfer must be carried
out in accordance with the terms of the loan
documentation which may include restrictions on
the minimum amount of debt that can be transferred
or the nature of transferees. For instance, it is
common for loan agreements to include provisions
providing that the debt may only be transferred
toanotherfinancial institution.
Sub-participation is more flexible because the
debtor is not party to the arrangement and
has noinfluence on the terms. For this reason,
portfolio sales are likely to be carried out by
sub-participation. Sub-participations can be funded
(the purchaser makes payment upfront) or unfunded
(the purchaser indemnifies the vendor in the
eventofapaymentdefault).
A funded sub-participant assumes a credit risk
on the seller whereas in the case of an unfunded
sub-participation the seller assumes a credit risk
onthepurchaser.
Sub-participants are also exposed to increased
cost risk and withholding tax risk as they do not
receive the benefit of the protections under the loan
agreement. Similarly a sub-participant will not be able
to accessmarketdisruptionprovisions.

16

Where only part of a particular debt is sub-participated


a key issue will be how voting rights under the relevant
loan are executed. Generally, the lender of record
will not be able to split its vote so voting rights will
generally go to the institution with the largest exposure
subject to consultation. However, in some instances
where the lender of record is keen to protect a client
relationship it may be reluctant to cede voting control
even to a sub-participant of the majority of its debt.
Other important considerations in distressed debt
trades are whether the sub-participant has the ability
to force a transfer of the debt to it and whether it
receives an interest in ancillary rights to the debt
(e.g. claims against advisors in respect of reports
providedto the vendor).
In distressed debt trading a central issue of focus is
whether the purchaser is taking the risk only on the
level of return or on the risk of the validity of the claim.
Often the vendor will retain the risk that the claim
isrejected by a liquidator.
The Asian secondary debt markets (including
Australia) have not yet developed their own
standard documentation or terms for distressed
debt trading, but the Asia Pacific Loan Markets
Association is seeking to progress standardised
documentation for Australia. For most trades within
these markets, parties typically adapt local par debt
trading documents using distressed debt terms
from the US market (Loan Syndication and Trading
Association (LSTA) terms) or the European market
(the Loan Marketing Association (LMA) distressed
debt trading terms). Standard documentation
available includes risk transfer documentation and
associated documents for carrying out a debt
tradesuchasconfidentialityarrangements.

Perspective

The unique characteristic of the current economic turmoil is the global


nature of the downturn. Major global distressed investors will focus
their attention wherever the best returns can be achieved. Australias
advantage is the strength of our regulatory, legal and governance
environments, which offer security for investors.
Sellers of distressed debt need to know about likely buyers (who
generally fall into three main categories: foreign distressed debt
funds, foreign financial institutions and local buyers), their return
requirements, their preferred investment types and approaches,
how they make their investment decisions and the key elements
ofwhatthey look for in a transaction.
Important considerations for both buyers and sellers are the
secondary debt trading terms and the transfer of economic
risk associated with a debt. Any transfer must be carried out
withtheterms of the relevant loan documentation.
The Asia Pacific Loan Markets Association is seeking to
progress standardised documentation or terms for distressed
debt trading for Australia. Currently parties typically adapt local
debt trading documents from the US or the European standard
terms. Standarddocumentation available includes risk transfer
documentation and associated documents for carrying out a
debttrade suchasconfidentiality arrangements.

In comparison to other Asian markets,


Australias strong legal and regulatory
framework provides a relatively high level
of comfort and security for investors.

17

2. Portfolio debt sales


the key considerations
invalue
There are many interlocking factors that will determine
thevalue for the transfer of a loan portfolio.
The factors that will impact pricing include:

The credit approval process

The quality of the portfolio

The type of sale

The quality of information

The timing of the sale.

How much of the individual


debt will be recovered?
The key determinant of value will be
the proportion of the outstanding debt
that can be realistically recovered
fromtheborrower.

The risks posed by each of these factors


can be minimised by ensuring a robust
and transparent process.
The main variables that will be considered
by the buyers include the following:

How much of the individual debt


willberecovered?

How long will it take to collect?

How much will it cost to collect?

What is the risk associated with the


debtrecovery process?

The key considerations are summarised


inthe diagram below.

Corporate loans
For corporate loans the first question
is whether or not the loan is secured,
and if so, what is the realisable value
ofthe underlying security. The key issue
hereishow current is the appraisal.
Once a floor has been set on the loan
value the next question to be addressed
is whether the borrower is likely to seek
to restructure the loan. Issues that need
tobetaken in to account include:

Are there personal guarantees?

Are there director liability issues?

Who has provided the guarantees?

Is the company still trading?

A buyer's key considerations


How much
will I collect
and from
what sources?

18

When will
I collect?

Servicing
and
Management
Costs

Discounted
for return
requirements
(incorporating
leverage)

Valuation

The emergence and continued growth of a


secondary market for distressed debts and
assets is a sign of the increasing depth and
sophistication of Australian financial markets.
James Marshall, Blake Dawson

Addressing each of these questions will


assist in determining if a restructuring
or renegotiation of the debt will be
possible. Ifa restructuring or discounted
pay out is not possible then how
much of the loan over and above the
security is recoverable? Some of the
issues here include whether there are
guarantees in place, what assets are
behind the guarantors and where are
theguarantorslocated?

Consumer loans
For consumer loans the questions
aresimilar:

Are the loans secured, and if so,


what is the realisable value of the
underlyingsecurity?
What are the chances of renegotiating
the loans?

How long will it take to collect?


Any purchaser of debt will factor in the
time value of the investment, and discount
the future payment stream back to present
value. Assumptions regarding the time
it is likely to take to recover the debt will
have significant influence on the overall
valuation. There are a number of factors
that will be key, including:

What restructuring or discounted


payoff is to be put in place,
andoverwhatperiod?

How long will it take to foreclose


onaproperty?

What are the potential impediments


toenforcing security?

How long is the typical bankruptcy


process for corporates or individuals?

How long does it take to sell assets?

How far through the recovery process


isthe seller?

What are the chances of recovering


any of the shortfall after realising
thesecurity?

For unsecured loans what are the


chances of recovering any amount
fromthe borrower?

Australian
insolvencyprocedures

What is the likely timing of any


liquidationdividend?

The main steps in each of the major


formal recovery procedures in Australia
areoutlined below.

To determine the likelihood of recovery,


borrower characteristics such as age,
sex, location and employment status
must be assessed. Other factors
influencing recoverability will be the
type of loan and what it was used for
and what sort of recovery process has
theloanbeenthrough?

Administration
Voluntary administration is the most
common formal corporate rescue process
used in Australia. It is most often initiated
by the directors of the company because
the appointment of an administrator
will relieve the directors from any risk
of personal liability for insolvent trading
in relation to debts incurred following
the appointment of an administrator.
An administrator can be appointed by
the directors (by resolution), a liquidator
of the company, or the holder of a fully
securedcharge over the company.

19

Administrators are given wide powers


to control and manage the company,
and the directors are not permitted
to exercise any powers except with
theconsentoftheadministrator.

The appointment of an administrator gives


an independent insolvency practitioner
the power to administer and conduct the
companys business. Administrators are
given wide powers to control and manage
the company, and the directors are not
permitted to exercise any powers except
with the consent of the administrator.
The administration process under
Australian law is driven by the votes of
unsecured creditors at creditor meetings.
Courts do not supervise the process
but can adjudicate on issues that arise
upon the application of interested parties,
including the administrators. Whilst
in administration, statutory moratoria
prevent proceedings against the company
being commenced, charges being
enforced against the company (subject
to a 13 day decision period for holders
offullsecurity) or property being recovered
from the possession of the company,
exceptincertain circumstances.

20

However, there is no moratorium


preventing contractors from terminating
their contracts on the basis of an
insolvency event clause. In many cases
contracts will contain default provisions
which allow for termination upon the
appointment of an administrator.
The administrator must generally
report to the creditors, in writing,
within30 business days of appointment
specifying the options for the companys
future. The options are either a deed
of company arrangement, liquidation
or return of the company to the control
of the directors. The report will contain
the administrators recommendation
as to which option is in the
creditorsbestinterests.

The key steps and timelines for voluntary administration


Action

Timeframe

Notice of appointment sent to creditors

5 business days from appointment

First meeting of creditors

8 business days from appointment (omit the first day)

Second meeting of creditors

Up to 30 business days from appointment

Adjournment of second meeting of creditors

Permitted for up to 45 business days with creditor approval;


further extensions possible with court approval

Given the extensions which may be made


to the timing of the second meeting of
creditors, in complex administrations
it may take between 3 and 12 months
before the companys fate is voted upon.
At the second meeting of creditors, the
creditors vote on whether the company
should enter into a deed of company
arrangement, be liquidated, or returned to
the control of the directors (a majority vote
is counted in terms of numbers and value).
Significantly, no court approval is required.
If a deed of company arrangement
is entered into, the limited statutory
requirements allow tremendous flexibility.
Deeds can be used to implement almost
whatever type of arrangement the situation
requires from a simple compromise of
debts to a complete corporate restructure,
a capital raising or a continuation of the
business. Recent reforms have also
enhanced this flexibility by facilitating
post-restructuring equity raising
anddebtfinancing.

Where the creditors accept a proposal


that the company is to continue to trade,
the execution of the deed of company
arrangement marks the end of the
administration. The terms of the deed
replace the statutory moratorium on
company debts and the arrangement
binds all of the companys creditors,
shareholders, directors, the company
andthe deed administrator.

Administration and
Chapter 11 compared
Overseas investors are often interested
to compare Australias voluntary
administration regime with the
UnitedStates Chapter 11 procedure.
The table on page 22 highlights the key
similarities and differences between
Australias voluntary administration
and the United States Chapter 11
regimes, based on the Australian
Governments, Corporations and Markets
Advisory Committee, Discussion Paper,
Rehabilitating large and complex
enterprises in financial difficulties,
September 2003.

21

AUSTRALIAS VOLUNTARY ADMINISTRATION VS US CHAPTER 11 PROCEDURE


Australia Voluntary administration

US Chapter 11 procedure

Prerequisites

Insolvency or likely insolvency.

Good faith only.

Who can commence


theprocedure?

The directors, a liquidator or provisional


liquidator or a substantial chargee.

The directors.

Benefits in appointing

Directors can avoid incurring liability


forinsolvent trading.

To avoid some contracts, avoid some past


transactions and restructure balance sheet.

Recent amendments enhance flexibility


inbalance sheet restructuring.
Role of the court
in commencing
the procedure and
approvingthe plan

No mandatory role in either situation, though


the court has various ancillary powers
exercisable on application.

Procedure initiated by petition to the court.

Who controls the


company during the
rehabilitationprocedure

The administrator, who must be a


registeredliquidator.

The directors (unless the court orders their


replacement by an independent trustee).

Committees or creditors

Limited functions, namely to consult with


administrator in relation to the administration
and consider reports by the administrator.

Major role. Can employ professional advisers at


the companys expense.

Information to creditors

Report by the administrator about the


companys business, property, affairs
and financial circumstances and a
recommendation about what is to be done.

Court-approved disclosure statement.

Moratorium on claims
against the company

Automatic moratorium, with significant


exceptions for some secured creditors
andproperty owners.

Automatic moratorium, which applies to all


secured and unsecured creditors.

Ability of contract
counterparties to
enforceipso facto clauses

Yes.

No.

Ability of creditors to
exercise set-off rights

Yes.

No.

Liability for
goodsandservices

Administrator personally liable, with a right to


an indemnity out of the companys assets.

Company liable as debtor in possession, with


debts having priority over pre-commencement
unsecured debts.

Ability to
disclaimcontracts

Company can generally repudiate


contracts, with counterparty ranking
asunsecuredcreditor.

Company can disclaim executory contracts, with


counterparty ranking as an unsecured creditor.

Avoiding prior transactions

Administrator cannot avoid


pre-administration transactions.

Company can avoid selected classes


oftransactions.

Loan financing during


rehabilitation procedure

Lender is an ordinary unsecured creditor


of the company, but recent legislative
amendments allow for priority to be
adjustedwith secured creditors consent.

The court can give a lender a priority over all


existing unsecured creditors and, if necessary,
over existing secured creditors.

Who devises
rehabilitationplan

The administrator, although other parties


canput forward proposals.

The directors, usually in consultation with


professional advisers, during the exclusivity
period(see below).

Continuing close court involvement in the


rehabilitation procedure, including final
approvalofplan.

After the exclusivity period, any interested party,


including the creditors.
Duration of
exclusivityperiod

Approximately 1 month, subject to


thecourtextending the period.

Typically at least 120 days.

Approval of
rehabilitationplan

One meeting of all creditors.

Meetings of each class of creditors.

Majority required to
approve the plan

50% majority by number and by value of all


the creditors who vote.

Two-thirds in amount, and more than one-half by


number, of creditors who vote, class by class.
A dissenting class can be overridden by the
cramdown rules.

Rehabilitation plan binding


secured creditors

Yes, if the secured creditors agree or the


courtso orders.

Yes, provided:

Unimpaired creditors deemed to


haveapprovedplan.

if impaired class of secured creditors, at least


one impaired class assents; and
the plan is fair and equitable.

Rehabilitation plan
discriminating between
creditors

22

The creditors can approve a deed that


discriminates against particular creditors, but
cannot alter employees priority rights.

Under the absolute priority rule, senior creditors


are paid before junior creditors. All creditors are
paid before shareholders. One class cannot
receive less than another class with identical
priority without the consent of its members.

Receivership
Financers typically require a debtor
company to provide security, usually a
mortgage debenture, containing a fixed
and floating charge. The debenture usually
allows the financier to appoint a receiver
to the debtor upon default under the
instrument. A receiver is appointed to
thecompany for the purposes of realising
company assets to discharge the debt
owing to the secured creditor. Receivers
enjoy sweeping powers under both the
debenture and statute, including the power
to take possession of the companys
assets, realise those assets or carry
onthebusiness of the company.
The terms of the security govern the
appointment. The secured creditor decides
the identity of the receiver and, in doing
so, is under no obligation to consult with
the debtor company. Usually the receiver
isaprofessional insolvency practitioner.
A receiver owes duties principally to the
secured creditor, not to the debtor or its
unsecured creditors. However, a receiver
is subject to statutory duties in exercising
his or her powers, including a duty of care
in exercising a power of sale to achieve a
market price. The receiver is also subject
to the supervision of the court and the
corporate regulator, Australian Securities
and Investments Commission (ASIC).
The appointment of a receiver offers
considerable advantages in terms
of immediate control (particularly of
commencement, which may take only
1to 2 days), cost and flexibility. However,
it does not create a moratorium on
the initiation or commencement of
proceedings against the debtor.
In a very limited number of cases
acourt is given the statutory power
toappointareceiver.
Usually a deed of indemnity is provided
bythe secured creditor to the receiver.

The timeframe required for a receivership


to be completed depends on the
complexity of the receivership and the
receivers ability to recover the secured
creditors security. A company can
concurrently be under both administration
and receivership. Creditors with a
charge over all or substantially all of
a companys assets can choose to
appoint a receiver over the top of an
administrator. Thereceiver can then deal
with the secured assets unfettered by the
administration. Accordingly a prospective
purchaser of assets would usually deal
with the receiver, and not the administrator.
Such concurrent appointments (especially
to large companies) are common.
However, concurrent appointments
can make balance sheet restructuring
very difficult, given that the focus of
secured creditors is usually the sale
ofsecuredassets.

Liquidation
Winding up may be initiated by court
order (winding up in insolvency) usually
upon a creditors petition, or by the
creditors (creditors voluntary winding up).
A simple creditors voluntary winding up
takes between 6 to 8 weeks and entails
various notices and meetings. A complex
winding up, which may involve recovery
actions being pursued through the courts,
couldtake considerably longer.
The liquidator winds up the company
and applies the assets to satisfy the
liabilities and distributes any surplus to the
shareholders. The directors powers cease
upon the appointment of the liquidator.
There is a stay on proceedings against
the company. Liquidators have extensive
forensic recovery powers, can recover
voidable transactions and bring
claimsagainst directors.
Set out on page 24 is a table that
outlines the liquidation priority regime
for secured creditors for both fixed
andfloatingchargeassets.

23

LIQUIDATION PRIORITY REGIME


Realisation of fixed charge assets
(e.g. property, plant, equipment
andgoodwill)

Realisation of floating charge assets


(e.g. stock, work in progress and debtors)

Priority waterfall

Priority waterfall

Costs of realising fixed charge assets

Costs of realising floating charge assets

Secured creditor debts

Employee entitlements

Employee entitlements

Secured creditor debts

Unsecured creditors

Unsecured creditors

Shareholders

Shareholders

Recovering debts from


individuals: Bankruptcy
and sale under a
mortgage/foreclosure
An issue that frequently arises for portfolio
sales of non-performing loans concerns
the ability to enforce against individuals
real property. The relevant timeframes
and operation of personal foreclosure
and bankruptcy laws can be relevant
toconsiderations.
A lenders power of sale is heavily
regulated. Generally, a lender can enforce
its power of sale over mortgaged property
1 month after the borrowers default. The
timeframe and procedures are lengthy and
complex and they vary from State to State.

24

If a lender fails to recover all of its funds


from the sale of property, the lender
has recourse to the borrower for the
outstanding amount. This is the most
important distinction between Australian
real property mortgages and those of
theUnited States.
To realise this amount, the lender can use
the bankruptcy procedure. This canbe
quick and effective if the borrower, anxious
to avoid bankruptcy, finds funds to pay
the outstanding amount within 21 days
(seepage 25). However, the process
can take months if the bankruptcy runs
its course, especially if the borrower
conteststhe bankruptcy notice.

Recapitalising a distressed company


can be achieved either informally or
through a formal insolvency procedure.
Bankruptcy
BANKRUPTCY TIMEFRAME
Action

Timeframe

Creditor issues bankruptcy notice,


demanding payment

First step

If person ignores notice a creditors


petition for bankruptcy can be made

At least 21 days after the bankruptcy


notice

In all cases there is an application


to court for a creditors petition
forbankruptcy

Within 7-14 days of the expiry of


the bankruptcy notice, but not more
than6 months

Court determines application (if


successful, court sequesters bankrupts
assets and appoints a Trustee)

Within 4 to 8 weeks of application

Trustee notifies creditors of


thebankruptcy

After 42 days of Trustees appointment

Trustees report to creditors on likelihood


of receiving dividends

After 3 months of Trustees appointment

Trustee may pay dividends, interim


andfinal

Usually after 3 months


ofTrusteesappointment

How much will it cost to collect?


The costs of collecting the debts can
include a wide range of costs which will
need to be factored in to any valuation
calculation. Investors will typically factor
inany of the following costs:

The cost of servicing the portfolio.


Thiswill usually be provided by a third
party servicing company. There are
a number of such organisations in
Australia, primarily set up to service the
consumer debt market, however some
also havecorporate capabilities

Administration costs of the purchaser

Tax costs which will typically need to


take into account corporate profits
tax and withholding tax on repatriating
profits if the investor is offshore.
Corporate profits tax is generally around
30%, whereas interest withholding tax
inAustralia is generally around 10%

Other specific costs such as legal


costs, auction costs, commission
costsandstamp duty costs.

25

What is the risk associated with the purchase?


There are many factors that may be taken into
account when determining the discount rate to be
applied to the net present value of the future cash
flow. One approach is to apply a formula and calculate
the weighted average cost of capital. This takes into
account such variables as the risk free rate, country
risk premium, debt to equity ratio, cost of debt
andtheeffective tax rate.

Any calculation however will need to be compared


to the investors desired internal rate of return for
distressed investments, whether they be portfolios
or single credits. A common theme that many of
the larger investors have expressed is that they are
working in a global environment and they are therefore
competing against returns in deals in Europe and
the US. If they can get similar or better returns on
deals in other markets, then it is hard to get these
past credit committees. As such most investors have
indicated they are working on internal rates of returns
in excess of 20 25%. For more information on
usingsecuredconvertible notes see page 34.

Sons of Gwalia risk shareholders as unsecured creditors


The Australian High Court case of Sons of Gwalia v Margaretic (Sons of Gwalia decision) confirmed
that shareholders in publicly listed companies may prove as unsecured creditors in the administration
or liquidation of the company in respect of a successfully established claim for misleading and
deceptive conduct or non-compliance with the continuous disclosure regime by the company
prior to its insolvency. Such claims are generally founded on a companys failure to disclose
itstruefinancialstatetothe market.
The circumstances in which a shareholder will be able to establish a claim are limited, both in relation
to the factual and legal circumstances. For example, there will usually be practical difficulties in
establishing such claims, particularly in proving the elements of reliance on the alleged misleading
anddeceptiveconduct and causation (there is no fraud on the market in Australia).
While these shareholder claims may be difficult to establish, the existence of such potential claims must
be considered in valuing distressed debt since such claims may dilute the value of the unsecured debt.
Following the Sons of Gwalia decision the Australian Federal Government commissioned
the Corporations and Markets Advisory Committee (CAMAC) to examine whether the law
shouldbechanged. CAMAC released its report on 29 January 2009.
While its members were not in complete agreement, CAMAC recommended that legislative reform
was not required to overturn the Sons of Gwalia decision or to postpone, cap or prohibit aggrieved
shareholder claims. CAMAC considered that any move to limit the rights of recourse of aggrieved
shareholders where a company is financially distressed could be seen as undermining apparent
legislative aims to provide shareholders with direct rights of action in respect of corporate misconduct.
The Australian Federal Government is considering CAMACs recommendations. Legislative reform
would be required to reverse or limit the effect of the Sons of Gwalia decision and it is unlikely that the
Australian Federal Government will make any decision on this issue for quite awhile. Until there is any
legislative reform, shareholders will be able to make claims against an insolvent company based on the
fact that they were misled into buying shares in the company and will be treated as unsecured creditors
in respect of those claims.
If investors acquire secured debt or invest in distressed companies using secured convertible notes,
thisrisk can be avoided.

26

Perspective

The first step is assessing the value of the distressed debt.


Sellers of distressed debt need to be aware of the factors which determine
the value of the loan portfolio and the buyers key considerations. Pricing
depends on various factors including the credit approval process, the
quality of the portfolio, the type of sale, the timing of the sale, and the risks.
Buyers will consider the type of loans, whether they are corporate or
consumer, how much of the individual debt can be recovered, whether
thedebt is secured or unsecured, how long it will take to collect, how
muchthiswill cost and the risks associated with the debt recovery process.
Buyers need to be aware of Australian corporate insolvency procedures,
the differences between voluntary administration, receivership and
liquidation, as well as bankruptcy procedures for individuals. The key
steps, timeframes, costs of each process, as well as the extent of power
toadminister andconduct a companys business are crucial considerations.
Assessing the risks associated with the purchase is a major consideration.
To determine the discount rate to be applied to the net present value of
future cash flow, one approach is to calculate the weighted average cost
of capital taking into account variables such as risk free rate, country risk
premium, debt to equity ratio, cost of debt and the effective tax rate.
In valuing distressed debt of a company, buyers also need to be aware of
the effect of the Australian High Court case of Sons of Gwalia v Margaretic,
discussed on page 26.

Large foreign investors have


indicated they are working
on internal rates of returns
in excess of 20 25%.

27

3. Using secured debt


to control outcomes
and obtain ownership
oftheassets
A secured creditor who is entitled to enforce a charge over the
whole, or substantially the whole of a companys property has
wide powers of enforcement especially in relation to companies
that may also be in administration. Such a secured creditor
can elect to appoint a receiver over the secured property
evenduring the first 13 days of an administration.

Thus, a secured creditor can opt out


of the voluntary administration process
and enforce its security. If the secured
creditor fails to take this step within the
13 days it will be unable to enforce its
security during the period of the voluntary
administration; however a practice has
developed whereby administrators extend
this period in order to encourage secured
creditorstosupport their appointment.

28

In the case of a secured creditor whose


entitlement does not extend to the whole
or substantially the whole of the companys
property, then that secured creditor will
be unable to appoint a receiver without
the administrators or the courts consent.
In these circumstances, the secured
creditor becomes subject to the actions
of the voluntary administrator during the
course of the administration. An exception
to this rule arises if the secured creditor
takes steps to enforce its charge before
the appointment of an administrator.
Thisenforcement power may, however,
berestricted by the court on an
applicationbythe administrator.

A receiver exercising a financiers power


of sale over secured property must take
reasonable care to sell the property
atnoless than its market value.

Voting ability
In a receivership, the receiver realises
assets for the benefit of the secured
creditor and there is no process for
unsecured creditors to vote. Therefore
unsecured creditors have limited formal
input into or influence over a receivership.
In a voluntary administration, the future
of the company is decided by a vote of
creditors. Resolutions are passed by a
majority in number and value. Ifthere
is a deadlock, the chairman of the
meeting (the administrator) has a casting
vote. Thecasting vote may (but will
notalways) be exercised in accordance
with the vote of the majority of the value
of the creditor pool. Thus, a party that
controls more than 50% of the liabilities
of a company inadministration, both
in valueand number, may have control
of the outcome of voting and thereby
control thecompanys destiny. Employees
typically form the majority of creditors in
number and thus are an influential voting
block. Secured creditors can vote in full
withoutvaluing their security.

Duties affecting the power


of sale section 420A
A receiver exercising a financiers power
of sale over secured property must take
reasonable care to sell the property at
no less than its market value, or if no
market value can be ascertained, at the
best price available in the circumstances.
Thisduty arises under section 420A of
the Corporations Act 2001 (Cth). A similar
dutyarises under common law.
These duties of care aim to ensure that
receivers do not sell assets at a discount
simply to recover secured debt quickly
and cheaply at the expense of both the
secured creditor and other creditors.
Generally, in order to fulfil these obligations
a receiver will pursue a structured and
public sales process, including:

advertising the assets and requesting


expressions of interest

undertaking due diligence

organising tender bids

deciding on preferred bidder

selling to preferred bidder.

There is no equivalent to section 420A


for voluntary administrators, however,
theadministrator has a duty to act in
the best interests of creditors and this
includes realising market value for assets
sold. Incertain circumstances it may be
necessary to sell a business very quickly
during an administration to preserve
goodwill and avoid the termination of
contracts. While an administrator in selling
assets does not need formal creditors'
approval, usually creditors' views are
consideredbefore asale is effected.

29

Pre-pack appointments
A pre-pack appointment occurs in
areceivership or an administration when
the sale of an insolvent company, or its
assets, is negotiated by stakeholders
(including creditors, shareholders, key
customers and key trade suppliers)
andagreed beforetheformal
procedureiscommenced.
The key advantage of a pre-pack is to
maximise the chances of a rescue for
the company while it remains a going
concern without the loss of goodwill
usually associated with an unplanned
insolvency announcement. Pre-packs
are commonly used on companies with
contractorservice based businesses.
The process begins with negotiating the
pre-pack arrangement. Once agreement
is reached, an administrator (or receiver)
is appointed, and the pre-ordained sale
of the company or its assets is executed
expeditiously. Because the pre-pack
sale occurs without the business or
its assets being offered on the open
market, the sale could be impugned as a
breach of the administrators or receivers
duty of care inselling the company or
assets (discussed above). To avoid this,
administrators are required to show
that due enquiries were made regarding
the real value of the asset or business
during the pre-pack process before the
administration, and that the sale continues
to be reasonable and in the best interests
of creditors afteradministrationbegins.

30

There have been few pre-pack


administrations and receiverships to date
in Australia. This is due to the difficulties of
managing stakeholders and the concerns
about the duty of the administrator or
receiver in the sales processes. Although
this concern is legitimate, the pre-pack
sales exist to maximise the value of the
business and its assets and avoid the
loss of goodwill often associated with
unplanned insolvencies.

Control strategies
A party looking to invest in a distressed
company or its assets will often seek to
acquire secured debt in the company as
a first step to gain control and then drive
through a sale or recapitalisation.

Perspective

An important consideration for buyers when assessing a distressed asset is


to assess how much debt is secured because secured debt can be used to
control outcomes and obtain ownership of assets.

A secured creditor who is entitled to enforce a charge over the whole,


or substantially the whole, of a companys property has wide powers
of enforcement especially in relation to companies which may also be
inadministration.

A control strategy for buyers is to acquire the secured debt and


drivethroughthe sale or recapitalisation.

Buyers need to be aware of the duties placed on a receiver by the


Corporations Act 2001 and common law when exercising a financiers power
of sale over secured property to take reasonable care to sell the property
atno less than its market value, or the best price in the circumstances.

If a buyers strategy is to preserve value in a distressed company such as a


contract or service based business, one strategy is to enter into a pre-pack
arrangement, to maximise the value of the business and its assets and avoid
loss of goodwill, associated with unplanned insolvencies.

A party looking to invest in a distressed


company or its assets will often seek to
acquire secured debt in the company as
a first step to gain control and then drive
through a sale or recapitalisation.

31

4. Recapitalising distressed
listed/unlisted companies

In some cases, recapitalising a distressed company can


have significant advantages over an asset sale.
These advantages include:

Tax advantages Asset sales can attract


significant stamp duty (although stamp
duties on business assets other than
land are progressively being phased
outin Australia)

Investors can retain company


specific benefits such as the existing
infrastructure of a companys operations,
including contracts and employees.

Recapitalising a distressed company can


be achieved either informally or through a
formal insolvency procedure. Adistressed,
though solvent, company and its
lenders may decide that the company
can return to health despite its current
difficultieswithdebt.
Privately-held companies can be
recapitalised with relative ease. With
supportive lenders and shareholders,
substantial new equity can be injected
quickly and with minimal publicity.
Itmay even be possible to recapitalise
a distressed company without the
supportofits existing shareholders.
Publicly listed companies face more
complex challenges, although it is equally
possible to recapitalise a distressed
listedcompany quickly.

32

The ASX Listing Rules generally limit the


amount of equity that can be placed
to an investor without shareholder
approval to 15% in any 12-month period.
Australian takeover laws prevent an
investor from subscribing more than
20%of voting shares in a company
without shareholder approval. A significant
feature of shareholder approvals of this
nature is that an experts report as to the
proposals fairness and reasonableness
is generally required, adding to the
cost and complexity of the proposal.
Obtaining shareholder approval (and
an experts report if one is required)
can result in considerable delay in the
distressed company getting access to new
funds,which it may not be able to afford.
However, there are various exceptions
to the shareholder approval requirement
that can be used to facilitate a
recapitalisation quickly. In particular,
exceptions to both the 15% Listing
Rule limit and the 20% takeovers law
restriction are available for pro-rata rights
issues (including underwritten rights
issues) toshareholders.In addition,
waivers from the general 15% rule can
be sought from ASX to facilitate rights
issues on an accelerated basis, which
combine advantages to the company
ofan accelerated institutional offer (quick
access to funds) with the advantages
to retail shareholders of a rights issue
(minimisingdilution through participation
inthe recapitalisation).

Recent reforms to the voluntary


administration regime certainly
encourage recapitalisations.
Raising equity is now much easier.

By way of example, suppose an investor


wishes to participate in a recapitalisation
of a listed company in desperate need
of funds. The company could make a
placement to the investor of up to 15%
of the companys capital. The company
could then announce an accelerated
rights issue, underwritten by the investor.
Properly structured, the proposal would
enable the company to access the funds
from the placement and the institutional
component of the rights issue almost
immediately, and enable the investor to
acquire a significant stake in the company
through the placement and by taking up
its entitlements and any shortfall under the
rights issue without the timing constraints,
cost and uncertainty associated with
seeking shareholder approval for the
recapitalisation proposal.
In general, the techniques available to
listed companies are also available to
managed investment schemes, such
as real estate investment trusts and
infrastructure vehicles, although additional
considerations arise due to their unique
structure. In particular, amendments
to the entitys constitution may be
requiredtofacilitate a recapitalisation.
Listed companies are also subject to
continuous disclosure obligations under
the Corporations Act and the ASX Listing
Rules, which in broad terms require them
to immediately disclose information that
would be expected to have a material
effect on price or value to the market as
soon as the company becomes aware
ofthat information.

Anyrecapitalisation proposal will become


public as soon as it is agreed (or perhaps
even during negotiation). This can
increase the likelihood of a competing
proposal emerging, thereby placing the
investors proposal at risk, particularly
where the proposal remains conditional
on announcement (for example, it is
conditional on shareholder approval).
Tomanage this risk, investors should
agree appropriate deal protection
measures such as break fees and
arrangements restricting the company
from negotiatingcompetingoffers.
Recent reforms to the voluntary
administration regime certainly encourage
recapitalisations. Raising equity is now
much easier. Administrators have a
specific power to transfer shares with
the courts or shareholders permission,
whereas previously, administrators had
no right todo so without shareholder
consent. Additionally, administrators can
beexempted from the detailed and costly
disclosure obligations associated with
issuing new equity where this is issued in
exchange for debt. It is also now possible
to change a companys name without
shareholders consent. This is a significant
advantage where changing the name
might ease a sale, for example, a potential
buyer might want to apply its own brand
to the company. Similarly, the administrator
can now apply to the court for permission
for the company to operate without
setting out the words Subject to Deed
ofCompany Arrangement with its name in
advertising or documents. This benefit can
be significant where those ominous words
might alienate customers or suppliers.

33

Secured convertible notes


Secured convertible notes offer investors
a way to combine potential equity upside
and control, while protecting themselves
against the risk of having to compete
against a multitude of unanticipated claims
if the recapitalisation should fail. In light
of the decision in Sons of Gwalia, which
allows shareholders who believe they
have been misled into buying shares in
a company to make a claim against an
insolvent company and be treated as an
unsecured creditor, secured convertible
notes have become an increasingly
important instrument for investors
in distressed entities. For a detailed
discussion of Sons of Gwalia see page 26.

Liability management
through deeds of
company arrangement/
schemesofarrangement
The voluntary administration regime in
Australia provides a way for companies
in financial distress to be reorganised.
A deed of company arrangement is
a mechanismincorporated within
the voluntary administration regime
and allowsa company to enter into
compromise arrangements with its
creditors toavoid goingintoliquidation.
The law provides for extensive flexibility
when dealing with a deed of company
arrangement so the deed can be drafted
to meet the particular circumstances
of the company and its creditors. The
passing of a resolution to implement a
deed binds all of the companys unsecured

34

creditors irrespective of whether or not


they voted in favour of the resolution.
Conversely, only those secured creditors,
lessors of property and owners that voted
in favour of the resolution of a deed will
beboundby it.
The liabilities management of the
insolvent company is enhanced by a
deed of company arrangement because,
depending upon the terms of the deed,
all or some of the companys pre-existing
debts and claims may be extinguished
after the deed obligations are met.
Having creditors reduce the size of their
claims enhances a companys ability to
recommence trading. Unsecured creditors
agree to a reduced return on the basis that
they will receive a greater return from a
deed of company arrangement than they
would if the company went into liquidation.
Creditors may also contemplate receiving
increased returns from the future trading of
the company operating under a deed.
Deeds of company arrangement
have been traditionally used to
restructure a companys debt capital,
but are now increasingly being used
to effect a whole of balance sheet
(includingequity)restructuring.
A scheme of arrangement is an alternative
way for a company to come to a financial
agreement with its members and creditors.
The liability management advantages of
a deed of company arrangement can
also be achieved throughschemes of
arrangement. Schemes of arrangement
can be useful to manage class action risk.

Perspective

A buyer needs to consider whether revitalising a distressed company


may have advantages over a sale of assets. Advantages include
avoiding stamp duty on asset sales and retaining company specific
benefits such as the legal infrastructure of the companys operations,
forexamplecontracts and employees.

Key considerations for this strategy include whether the company


isstillsolvent, and whether it is a private or publicly listed company.

Revitalising a listed company can be complex, because of ASX Listing


Rules and Corporations Act regulatory requirements. The public
disclosure requirements also mean that any recapitalisation proposal
can become public and deal protection measures need to be put
inplacetomanage the risk of competing proposals.

Restructuring a companys debt capital or to effect a whole of


balance sheet restructuring can also be managed through deeds
ofcompanyarrangement or schemes of arrangement.

The taxation consequences of conducting a business in Australia


needtobe considered.

35

5. Why should an Australian


bank sell debt?

Historically Australian banks have not participated in the


debt sales market other than on some large deals such
asthe Sons of Gwalia administration in 2003/04 and sales
ofpast due credit card debts on a forward flow basis.

Why is this period of increased impairments likely to


differ from the early 1990s in terms of Australian banks
attitudestodebt sales? There are several reasons:

Increased number of buyers


The distressed debt market has expanded significantly
in Asia since the Asian banking crisis in the late 1990s.
The number of funds and amount of capital dedicated
to this sector has increased considerably, with the 2007
year on track to be a record for raisings as highlighted
bythegraphon the right.

Management time and focus on workout


Workouts are time consuming, generally complex and can
be costly. As one Australian banker indicated, lending to
distressed entities is credit intensive. In times when there
are so many workout opportunities for banks, the ability to
manage them with limited or scarce resources becomes
an issue. This scarcity of resources is exacerbated by the
strong economic growth over the last 15 years, which
means that sourcing enough skilled staff with good
workout experience has become problematic.

36

2.0%
1.5%
1.0%
0.5%

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

0.0%
1989

As highlighted in the chart, Bad Debt Expenses, the


level of bad debt expenses for the 4 Big Banks began
to rise significantly in 2008 and are forecast to increase
further in 2009 and 2010. Significantly, in dollar terms
bad debt expenses have increased from A$2.2 billion
in1997 to A$6.3 billion in 2008 and forecast to increase
toA$14.3 billion in 2010.

Bad debt expenses


Bad Debt Expenses
(average across
anz,
nab
and
(Average
acrosscba,
ANZ, CBA,
NAB and
WBC) wbc)

BDE % of Assets

The reason given for this general level of inactivity is simply


that they have not had to. Until recently, the Australian
economy had been on an unbroken growth trajectory
since the early 1990s. Levels of defaults and hence nonperforming loans on banks balance sheets have been
low, as highlighted in the chart, Bad Debt Expenses.
Howeverallthismay soon change.

Source: Company reports and ABN AMRO

distress debt and special


situations fundraising
2000-2007
Distressed Debt and Special Situations Fundraising 2000 - 2007
30
25
20
15
10
5
0

2000

2001

2002

No. of Funds

2003

2004

2005

2006

AUG YTD
2007

Aggregated Commitments (US$B)

Source: Preqin Special Research Report: Distressed Debt and Special Situations Aug 07

This is the first year in which the full


implications of Basel II will be felt
and there is a real concern that banks
and regulators have not appreciated
the full impact of Basel II as levels
ofNPLsincrease significantly.

The major change from the early 1990s


has been the introduction of Basel II.
This is the first year in which the full
implications of Basel II will be felt and
there is a real concern that banks
and regulators have not appreciated
the full impact of Basel II as levels of
NPLs increase significantly. In essence,
banks now have to set aside Tier 1
capital to cover the possibility of losses
against loans. In the case of NPLs the
percentage of Tier 1 capital required
can be 20% to 25% of the gross loan
value. Therefore if a bank in Australia
has a A$100 million loan to a customer
who has defaulted on repayments, then
where the bank has made a provision
of 45% against the loan, it may be
required to set aside up toA$23 million
in Tier 1 capital (essentially cash or other
similarly liquid securities). The levels of
specific or general provisions held against
loans are not taken into account when
determining the required level of capital
under the Advanced Basel II rules. So in
the above example the sale of the loan
would free up A$23 million in cash to be
otherwise applied to generating income
for thebank.
From an opportunity cost perspective,
A$23 million in Tier 1 capital could
support A$460 million of performing
corporate loans. This would equate to
approximately A$37 million of interest
perannum at an 8% interest rate.

capital adequacy ratios. While Australian


banks are not likely to fall below the
minimum levels set by the Australian
regulators, the banks cost of funding
could well increase if their capital ratios
fallbelow acceptable thresholds.

Basel II implications of carrying NPLs

Liquidity constraints brought


onbytheglobal financial crisis
Access to liquidity has become a very
real concern for all businesses including
banks. The issue of liquidity for banks
is twofold, firstly to have funds available
to lend in to the Australian economy.
Secondly, in line with the point above,
banks are required to maintain minimum

As a result many Australian banks have


recently raised capital to improve their
Tier 1 capital adequacy ratio. At some
point however, a tipping point will be
reached when it is no longer efficient from
a shareholder return perspective toraise
further capital. At this point therefore
the bank will need to weigh up if debt
sales represent a more efficient way to
managethe level of Tier 1 capital required.
There is a number of other considerations
that may need to be taken in to account by
a bank when considering selling its NPLs.
These may include:

Realising a tax benefit from writing


offa NPL
Under Australian tax law Australian banks
cannot realise a benefit from a NPL
until it is fully written off or the bank has
recovered the net loan proceeds and
crystallised the loss. Therefore, when
banks take general or specific provisions
against loans their accounting profit is
reduced, however they continue to pay
tax on the profit before these provisions.
It is only when the loss is crystallised that
the banks get the tax benefit.

Opportunity cost of redeploying


capitaltied up in a NPL
For the period of a workout or recovery
the bank has the net loan proceeds
effectively tied up and not earning any
revenue. If the debt were to be sold
the funds could then be on lent to
other borrowers that are generating
thebanksrequired rate of return.

37

Managing the banks reputation


orbrand in the market
One of the key assets of each
Australian bank is its brand.
Brandrecognition and awareness are
generally very high. Therefore anything
that may potentially damage the brand
should be avoided. Brand damage is
likely to come from two main sources,
with the first centred on the banks
financial health. Growing levels of
provisions or NPLs may contribute
to ageneral level of unease as to a
banks overall financial security. The
second source is from association
withloan foreclosure. There have been
a number of high profile administrations
where the banks have had their
nameslinkedtocompany closures.

The graph below is an example of the


above description from an economic
point of view. In summary if a bank has
a A$100 million loan impaired by 45%
then from an economic point of view
iftheloan can be sold for anything greater
than A$32 million, the bank comes out
ahead. However the example does not
take in account indirect costs such as
management costs, reputation costs or
the opportunity costs associated with
the interest earned from applying the
Tier1capital to performing loans.
The example below assumes an
8% interest rate on performing loans,
11% cost of capital, a 3 year recovery/
workout period of the loan and an
annualtax rate of 30%.

WHAT IS THE ECONOMIC COST OF CARRYING A NPL?


Ecomomic Cost of Carrying a NPL

120
100
$m

80
60
40

-45.0
-11.3
100

-2.8

-8.5

55

20

32

Source: PricewaterhouseCoopers

38

Net Loan Value


(if debt sale is deferred)

Cost of Capital (interest cost


on capital reqd)

Cost of deferring
the tax benefit

Cost of deferring
the recovery

Net Loan Value (if debt is


sold immediately)

Specific Provision (Financial


reporting provision)

Loan value

Perspective
The main reasons for Australian banks to consider selling debt are:

Increased number of buyers

Increased costs and complexity of managing workouts in-house

Basel II implications of carrying NPLs setting aside Tier 1 capital


tocover the possibility of losses against loans

Improving liquidity position

Realising a tax benefit from writing off a NPL

Redeploying capital tied up in a NPL

Managing the banks reputation or brand in the market

Managing market perception.

In dollar terms bad debt expenses have


increased from $2.2 billion in 1997 to
$6.3 billion in 2008 and are forecast
toincrease to $14.3 billion in 2010.

39

6. How does a
nonperforming loan
portfolio sale work?
For the sale of a portfolio of NPLs to be viable,
financialinstitutions will need to examine their objectives,
understand the nature of the product they are selling,
andbecome familiar with the way the market operates.
Determining what to sell, the method of
sale, the information about the portfolio
and how to present it are all key aspects
that need to be considered to ensure that
the seller maximises return. Establishing

the key driver for the sale at the beginning


of the process is a crucial step.
Financial institutions principally have two
options for dealing with NPLs internal
orexternal workout, as illustrated below.

Options for dealing with NPLs


Internal workout

External workout

Loans remain on
the balance sheet

Workout by in-house
collection department

Outsourcing of the
servicing/workout

Loans leave the


balance sheet

Sale; and continued


servicing of the
commitment on
the basis of a
service agreement

Sale; and takeover


of servicing/workout
by an external
service provider

The outsourcing of NPLs to an external


servicer still involves the continued
involvement of the bank in monitoring
and overseeing portfolio management,
which in turn diverts time and focus
from more profitable banking activities.
An outright sale removes NPLs from
the banks balance sheet, favourably
impacting the banks overall NPL levels
and capital adequacy, and may allow the
bank to redeploy staff resources to less
time consuming, higher return customers
intheearly stages of delinquency.

40

Aside from the above general benefits,


banks that intend to conduct a NPL sale
will often have an overriding objective
for the sale (such as timing or profit
generation) and this will determine
the sizeand composition of the NPL
portfolio to betaken to market and
thesaleprocess.

Determining what to sell, the method of


sale, the information about the portfolio
and how to present it are all key aspects
that need to be considered to ensure
thatthe seller maximises return.

Benefits of distressed asset sales relative to bank objectives


Bank objectives

Improved liquidity position of the


institution, freeing up funds for
newlending and investment

Better capital & debt market


perception, thus reducing funding
costs and raising share price

Improved ratings (S&P, Moodys),


again reducing funding costs and
raising share price

Improved capital adequacy position


particularly in light of Basel II
requirements for weighting on NPLs

Immediate and future positive impact


on profit and loss via possible
provision write backs, utilisation of tax
assets, accelerated recoveries and
savings on human resources costs

Overcome an inability to manage


problem loans in-house effectively

Freeing up management time and


focus resources on more profitable
activities/collections

Release/redeploy staff resources,


thus improving cost to income ratios

Asset class

Reason

Secured corporate

Sale of secured loans is likely to


generate higher values.

Reducing the balance sheet doubtful


debt provision and improving
capital adequacy ratios is generally
viewed favourably by capital and
debt markets and rating agencies.
However this may need to be traded
off against the potential profit and loss
(P&L) impact caused by the differing
valuation methodologies used by
sellers and buyers.

Basel II requires Tier 1 capital


requirements to be based on the
gross value of loans rather than the
net value hence selling higher gross
value NPLs will have a greater impact
on capital adequacy calculations.

Generally limited or no underlying


collateral and therefore larger
provisions can be raised against
these debts making it easier to
resultin a profit on sale.

Substantial number of customers/


loans with relatively low average
balances outstanding. Requires
a similar amount of contact
and monitoring as a secured
debt but generally has a lower
yield. A reasonable size portfolio
(approximately A$300 million)
couldremove up to 60,000 loans

Secured consumer
Real estate
ownedassets

Unsecured corporate
Unsecured retail
Delinquent
receivables portfolios
(telco and utility
debts, store cards,
etc.)

41

Determination of the sale structure


The determination of the sale structure is also fundamental to the sale process and often
involves consideration of the following three strategies:

1. Private placement

deal structuring

no competition; price reduced

speed of sale

information supplied specifically


tailored to investor

may not reach highest


potentialbidders

limited widening of general


investorbase

less certainty for investors

information needs are wide


butremaincontrollable

will not reach all potential investors

process requires more management

requires rating; extensive


informationrequirements

ongoing management required

higher initial costs

subject to current market uncertainty

confidentiality easier to maintain

2. Auction (limited or open public)

reasonably quick process

price maximised

wide base of professional


investorsreached

one-off process

3. Securitisation

42

reaches widest potential investor base

maximum profile

debtor relationship retained

issues can be topped up


withlaterportfolios

SALE PROCESS
Notwithstanding the sale type, the sale process often involves the following four work phases, with each phase
being interconnected:

Project
Planning

Phase 1
Portfolio
Identification
& Valuation

Phase 2
Strategy
Development

Phase 3
Sale
Preparation

Phase 4
Execution

Development of bid
documents and SPA

Investor and
sale management

Due diligence
review and validation

Establish due
diligence and data
room procedures

Negotiation
support

Valuation

Marketing of the
sale transaction

Closing

Confirm your overall


goals and objectives

Portfolio identification
and classification

Finalise
work program

Develop overall
sale strategy

Project Management

The three sale processes on page 42


should not be considered mutually
exclusive. One strategy may apply to
the whole portfolio or to different pools
or each of the three strategies could be
applied to different asset pools depending
on an assessment of how value will
be maximised and the sellers exact
priorities. For example, if maximising
the net proceeds is paramount, then
an auction or securitisation process
would be preferable. If speed of sale or
confidentiality of information is paramount,
then a private placement is likely to provide
the quickestexit route.
Given the recent increase in the supply
ofNPLs in the global market created
by the recent global financial crisis,
coupled with competition for investor
resources, theNPL market appears to
have moved from what was considered
a sellers market pre 2007 to a more
buyer centric market. This may impact
the sale structures going forward as
generally buyers will show apreference
forbilateraldeals.
Distressed asset loan portfolios have
become an established asset class
for many international distressed debt
investors. The major distressed debt
investors have developed unique skills
and expertise in buying and working
out NPL portfolios throughout the
US, Asia and Europe and can often
negotiate deals with borrowers that

are unfeasible for the originator due to


political or market perception reasons.
Unlike banks, unlocking value in NPLs is
the core business of a distressed debt
investor and they use proven collection
methodologies in order to achieve this.
Forthis reason such investors are willing
topay competitive prices to gain access
tosuchassets/markets.
To diversify their exposures, distressed
debt investors are beginning to look
outside the traditional and established NPL
markets. However, these investors have
come to expect sale processes and legal
documents to be reasonably consistent
from country to country. Combine this
expectation with the fact thatone of
the key determinants of value for an
investor is the speed with which they
can start working the portfolio and itis
clear that the information prepared and
presented to investors as part of the due
diligence process is critical to the success
ofanysale.
Investors have very specific information
requirements when bidding for distressed
assets and some of this information can
take time to collect. Contacting investors
and commencing a sale process without
the required information will most probably
result in a long drawn out sale process,
which in turn will both increase the cost
of participating in the sale and decrease
theoverall value of the portfolio.

43

To maximise value for investors and, ultimately through


higher prices provide more value for the bank, it is
considered market best practice to consider the
following (in conjunction with appointing a qualified
sell-side advisor):

Consistent sales process Investors are looking


for a professional sales process and confidence that
the seller will proceed with the transaction closing
ata realistic market-based price.

Quality and timely information Investors


requirequality information to minimise additional
risk discounting and maximise value. Key
information includes historical data, virtual data
rooms, representative sample information of
scanned documentation, updated real estate
appraisals for collateralised assets, past
collection policies, repayment plans, recent
borrower correspondence, financial information
on large corporate borrowers, and standardised
marketbasedlegalsaledocumentation.

Simple sale process From an investors


perspective the less complex the sale process the
better. A process with too many bid stages or that is
unstructured can be time consuming and confusing
for investors. It can also make it difficult for the seller
to compare bids at the end of the process.
Reliable and realistic sale timetable A timetable
that is adhered to by the bank and investors
limits the resource commitment from the bank
andtheinvestor.

A key area of concern for sellers of debt revolves


around the confidentiality of the borrowers
information. The ability of a lender to trade a
borrowers debt in circumstances where they
have confidential information may be restricted
by obligations of confidence and insider trading
laws. It may also be impacted if the lender has
arepresentative on a creditors committee.
Lenders will typically be provided with access to
financial and other sensitive information about a
borrower which is subject to express or implied
obligations to keep the information confidential or
to use it only for certain specific purposes (such as
monitoring performance of the company). The lender
may breach its duty of confidentiality to the borrower
if it discloses information to a prospective buyer
ofthedebt without the borrowers consent.

44

Confidential information received from a borrower or


information about the status of the debt (e.g. potential
default or a proposed restructure of the terms) may
be price sensitive and therefore inside information
for the purpose of the insider trading laws. If the debt
is a financial product to which the insider trading laws
apply (e.g. notes, bonds or debentures issued by the
borrower) possession of inside information prevents
the lender from dealing in the debt until the inside
information becomes generally available or ceases
tobe price sensitive.
Some strategies to limit the risk of liability include
the use of Chinese walls to manage receipt of
confidential information and to ensure the lenders
flexibility in trading the debt, and only trading under
information symmetry between counterparties, such
as between other creditor committee members or
other investors with the same degree of knowledge.
Lenders can also include specific provisions in
their lending documentation to facilitate distressed
debt trades. This may extend to a requirement
that the borrower confirms the accuracy and
currency of financial information if the lender
intendsadebttransfer.
In addition, publicly listed borrowers are subject to
continuous disclosure obligations, which in broad
terms require them to immediately disclose information
that would be expected to have a material effect
on price or value to ASX as soon as the company
becomes aware of that information.
In its Companies Update 02/08 issued last year,
ASX made it clear that listed entities that have
in place (or have put in place or altered) material
financing arrangements which contain covenants
that may be triggered on certain events occurring,
may need to disclose details of the arrangements
at the time the covenants are (or are likely to
be) activated. Disclosure may need to include
details of the covenants in question, as well as
other information such as any impact that the
triggering ofthe covenant may have on the entitys
relationshipwithits bankers, its financial position
and its financial performance (to the extent that
information is material). In practice, market disclosure
of this nature may overcome the lenders inability
to deal with the debt by reason of confidentiality
constraintsorpossessinginsideinformation.

Perspective

As a seller, a bank or financial institution needs to make sure the sale


of a portfolio of NPLs is viable, by examining their business objectives,
understanding the nature of the product, and becoming familiar
withbuyers needs and the way the market operates.

Sellers need to determine their sale strategies, including whether


to sell by private placement, auction (limited or open to the public)
orbysecuritisation, depending on their objectives.

To ensure successful sales banks need to be aware that the buyers


are sophisticated and have expectations of consistent sale processes
and legal documentation, quality and timely information, and a reliable
andrealistic sale timetable.

A seller also needs to be careful not to breach its duty of confidentiality


to the borrower and put strategies in place to limit the risk of liability
forthe purpose of insider trading laws.

Given the recent increase in the supply


of NPLs in the global market, the NPL
market appears to have moved from
a sellers market pre 2007 to a more
buyer centric market.

45

7. Structuring options for


sellers of debt/assets

In the current economic climate the biggest obstacle


to getting a deal closed is the difference between the
bidpriceand the asking price for any deal.
From the buyers view the sellers have not adjusted their price expectations given the
state of the economy, and from the sellers perspective the buyers are over emphasising
the risk. One potential step to try and bridge the gap between the bid and asking prices
is to structure a deal that shares risk and rewards. From single credits to portfolios,
returns may be improved by considering various alternative structures.
Any intended structure will need to take into consideration the sellers objective
forthedebt sale.
Typically most sellers of debt, especially financial institutions, are motivated by
boththequantitative and qualitative benefits of selling problem loans:
Depending on the goals of the seller, and the regulatory environment in which the
seller operates, typically three types of sales structures are considered to maximise
thesellersobjectives, as outlined below.

selling loans
Quantitative benefits

Immediate reduction of NPLs in a timely


manner improve NPL position

Possible gain on disposal for the NPLs


(depending on provision levels)

Improve liquidity position of the bank


and capital adequacy position
possible release of capital and resources
which can be used for other purposes

46

Reduction in other holding costs


relating to NPLs e.g. ongoing legal fees,
payment of maintenance on collateral
Minimise and/or better manage future
provisioning requirements

Qualitative benefits

Free up resources of recovery teams


account officers can be re-assigned
to other areas in the bank

Recovery teams can focus on remaining


NPLs that have a better chance of
recovery and maximise recovery potential

Speed up timing of recoveries as a


large number of NPL loans can be sold
at one time via a portfolio sale

Positive market perception


proactive management of NPLs
may lead to improved ratings

Sales structures maximising sellers objectives


Option 1: Outright sale
typically for cash

Option 2: JV arrangement

Buyer
Buyer
[Investor]
[Investor]

Debt
DebtSeller
Seller
[Bank]
[Bank]

Buyer
Buyer
[Investor]
[Investor]

Debt
DebtSeller
Seller
[Bank]
[Bank]
NPL
NPL

NPL
NPL

Cash
Cash
Equity
Equity

Cash
Cash

SPV
SPV

Option 1: Outright sale


typically for cash
The first option involves the outright sale
of the debt. Most buyers of debt in this
scenario will establish an on-shore entity
or special purpose vehicle (SPV) in which
to warehouse the transaction. In fact,
many jurisdictions in Asia require an entity
which meets local regulatory requirements,
typically local majority ownership, to be
established for these types of transactions.
In this instance, all economic interest in the
credit/portfolio would pass to the SPV and
its ultimate owners. The selling bank would
not retain any interest in the credit/portfolio
although in some instances the selling
bank may be contracted to continue
servicing the credit or portfolio.
At present, this is generally the preferred
option of most selling banks in Asia,
particularly for portfolios, as it achieves
thefollowing aims:

A reasonably quick process

Immediate release of resources

Immediate de-recognition from


thebalance sheet

Perceived to be transparent transaction.

Investors are also generally in favour of


this structure as it provides complete
control over the transaction and allows
for a relatively free hand in structuring
theownership of the SPV.

Cash
Cash

Cash
Cash
Equity
Equity

SPV
SPV

Equity
Equity

alongside the buyer. Under this option, the


SPV would acquire the credit/portfolio from
the bank for a combination of cash (from
the buyer) and non-cash contribution
(the NPLs) from the bank. The economic
interest in the portfolio would then be
shared by the equity holders pro rata to
their equity stakes or another method
(e.g. profit sharing) asagreed between the
parties.
Generally the main reason for choosing this
option is price, especially if a value cannot
be determined or the value depends upon
some future event. JVarrangements
are often adopted for realestate finance
projects or where there may be some
perceived sensitivity in relation to the
portfolio, for example the bank wishes
toremain involved and minimise any
negative publicity that may result in the
event of an outright sale. Alternatively it
is also a mechanism to give the bank the
ability to increase its return if actual returns
are greater than a buyers expectations.
The form of the JV arrangement is at the
absolute discretion of the parties involved
but typically sees certain buyer costs and
return requirements being met in priority to
any return back to the selling bank. Other
advantages of a JV arrangement include:

Ability to engage expert asset managers


to maximise value (whether these
are provided by the bank or the
thirdpartybuyer)

Option 2: JV arrangement
The second option involves forming a joint
venture (JV) between the selling bank and
the buyer. In this scenario the selling bank
typically holds an equity stake in the SPV

47

Sales structures maximising sellers objectives


Option 3: Securitisation
Investors
Investor
servicing
Cash

Trustee

SPV
Asset
transfer
Cash

Servicer
(could be selling bank)

Ability to retain the seller's knowledge,


i.e. the people who have been
managing the portfolio typically
remain involved and transfer
theirknowledgeto the buyer

Flexibility in the deal structuring options

Potential higher returns to the


selling bank (although these
arenotguaranteed).

The main downside of a JV arrangement


is that it may not achieve derecognition
of the loans in the sellers books, which
isoften a key driver of the sale.

Option 3: Securitisation
Securitisation is the process by which
assets with generally predictable cash
flow and similar features are packaged
into interest-bearing securities with
marketableinvestment characteristics.
The key to securitisation is the
predictability of cashflows and supporting
loan documentation, and history to
verifythese cashflows.
Unlike other bulk sales, the focus of the
investor group in this instance is usually
on the rating of the special purpose
vehicleand the coupon payable.

Selling bank

Advantages of securitisation include new


sources of funds for the seller and possible
enhancement of the selling banks ratios.
However the information needs are high
as underwriting costs can be significant
andtransactions can be time consuming.

Other structuring considerations


While the above description primarily
focuses on sale structures that are typically
adopted by selling banks, all buyers should
consider the following during their own
structuring planning for any acquisition:

Flexibility to accommodate current


and future business objectives (i.e.an
investment platform that allows for
various types of investments and,
if necessary can accommodate
severaljoint venture partners)

Ability to enable a tax efficient exit

Minimise any potential permanent


establishment risk, if desired, for the
investment vehicle in the local country
where the investments are made

Analysis of tax efficient structuring for


any management company activities in
foreign jurisdictions (i.e. representative
office or branch)

Minimise withholding tax costs


andcapital gains taxes.

Loans that typically lend themselves


tosecuritisation include:

48

Loans with dependable cashflow


streams (e.g. performing loans,
particularly mortgage/housing loans)

Real estate portfolios with


clearcashflowstreams

Loans where loan documentation


is complete and in electronic form
allowingeasier verification.

Perspective

When choosing structuring options, sellers need to ensure that their


business objectives are facilitated. Transactions involve complex
judgements about business needs, tax and accounting rules,
corporatestructures and a variety of legal issues.

Three types of sales structures which can maximise the sellers


objectives are: outright sale typically for cash; a joint venture
agreement; or a securitisation.

Buyers also need to consider issues such as the structure of their


investment vehicle and the regulatory and tax considerations
ofconducting the business in Australia.

Negotiating and agreeing on the price is the key to closing the


deal in todays economic climate. One potential step to try and
bridge the gap between the bid and asking prices is to structure
a deal that shares risk and rewards. This may mean considering
alternativeinnovativestructures.

A structured deal has the ability


to bridge the pricing differential
between buyers and sellers.
Michael McCreadie, PricewaterhouseCoopers
49

8. Tax implications of selling


and buying debt

This section explains the features of the Australian tax


system that are likely to be relevant to a seller or buyer
of distressed assets. However, the following points
maybehelpful to consider at the initial planning stage:

Australia taxes resident taxpayers on


their worldwide income and capital
gains, but non-residents only on their
Australian-sourced income and in
respect of capital gains, from Australian
land and branch assets

That said, Australian resident companies


are often exempt from tax on dividends,
and capital gains in respect of 10%
or greater shareholdings in foreign
companies. Much of a companies'
foreign branch income is also
exemptfrom tax

The company tax rate is a flat


30% but progressive tax rates for
individuals reach 46.5% (including
a"MedicareLevy" at the standard rate)

Australia imposes 30% withholding tax


on "unfranked" dividends paid to nonresidents (although most tax treaties
reduce this rate to 15% or less). There
is no tax on the remittance of branch
profits to a foreign head office

50

The Australian "dividend imputation"


system addresses multiple taxation of
company profits by granting resident
shareholders a credit for any Australian
company tax on the profits from
whichdividends are paid

Non-resident shareholders do not fully


participate in the "dividend imputation"
system. Instead, dividends they
receive out of taxed profits are exempt
from withholding tax. A separate
withholding tax exemption applies
to"conduit foreign income"

Australia imposes a 10% Goods and


Services Tax (GST), similar to the
Value-Added Tax (VAT) imposed in
many European and other jurisdictions.
Exports are usually zero-rated. Financial
supplies are usually input-taxed

The Australian States and Territories


impose duty on transfers of Australian
land, and some interests in entities that
are Australian land-rich. Depending on
the jurisdiction, the duty will be 4% to
6.75% of the value of the land

The Australian Capital Territory,


New South Wales and South Australia
still impose 0.6% duty on transfers
of unlisted shares and units (from
1 July 2009, 0.3% duty in NSW)

NSW and SA also still impose duty on


most non-residential mortgages at rates
of 0.4% and 0.15% respectively.

The taxation consequences from


the acquisition of debt will depend
on a number of factors, including
whether the debt is acquired directly
or through an acquisition of shares
in a company holding the debt.

The Buy Side


The taxation consequences from the
acquisition of debt will depend on a
number of factors, including whether
thedebt is acquired directly or through an
acquisition of shares in a company holding
the debt. In the latter case, the taxation
consequences will depend on a number
of additional factors. These taxation
consequences are summarised below
in respect of various forms of acquisition
andholding of the debt after it is acquired.
It should be noted that the comments
below are based on an assumption that
the acquired debt is a debt interest
for tax purposes and is not an equity
interest. The taxation consequences
will be different for a holder of a debt
instrument which is classified as an
equityinterest for tax purposes.
Forexample, distributions on an
equityinterest will be treated in a similar
way to dividends from shares, that is they
will be frankable and imputation credits
willbeavailable to theinvestor.
Briefly, a debt interest is a financing
arrangement under which one party has
an effectively non-contingent obligation to
pay back financial benefits of at least the
same value as the amount advanced to
it. This test is complex and its application
will depend on the specific facts
ofeacharrangement.

Acquisition of debt
An acquisition of debt may be effected by
way of a purchase, transfer, assignment,
novation or a similar transaction. This
guide does not cover acquisitions which
are conditional and part of a larger
arrangement (e.g. securities lending).

Briefly, an acquisition of debt is similar to


an acquisition of any other asset the
amount paid for it becomes its cost
for tax purposes. If a debt is acquired
cum interest, that is between the coupon
dates, any amount paid to the seller in
compensation for the accrued interest
isalso included in the cost amount.
The tax cost is important, for example,
if the debt is subsequently sold,
thedifference between the proceeds
received from the sale and the cost
will be included in assessable income
of the seller or allowed as a deduction
astaxableincome or a tax loss.
Where a particular debt is acquired
together with other assets, the
purchase price is allocated between
the assets in proportion to their market
values, as determined by the parties
oranindependent valuer.
Any expenses incurred by the investor
in making the acquisition will be subject
to the ordinary deductibility rules.
Forexample, ongoing expenses of
a revenue character will normally be
deductible, whereas capital expenditure
may be included in the cost of the acquired
asset (e.g. shares in the company holding
the debt) or deductedover5years.

Acquisition of shares of a
company holding the debt
Instead of acquiring debt directly, the
investor may acquire shares in a company
that holds the debt. In this case, the
taxation consequences will depend
on whether the acquired company
experiences a more than 50% change in
its shareholders and whether the company
joins the investors tax consolidated group.

51

More than 50% change in shareholders


Broadly, where the acquisition of shares results in an
at least a 50% change of the companys shareholders,
the availability of bad debt deductions in respect of
the debt held by the acquired company will depend
onanumber of factors.
The change in shareholders is determined for the
period starting from the date the debt was incurred by
the company and ends on the last day of the income
year during which the company seeks to claim a bad
debt deduction in respect of the debt. If there was a
more than 50% change in the ultimate shareholders of
the company, in order to claim a bad debt deduction
in respect of the debt, the company must carry on
the same business as it was immediately before
the ownership change during the income year in
whichthebad debt deduction is claimed.

Example
On 1/7/01, an investor acquires all shares in
Company A holding debt acquired on 1/3/01.
Company A has income year ending on 30 June.
On 1/9/03, Company A ascertains the debt as
non-recoverable and writes it offforaccounts.
Company A did not maintain the same
shareholders during the period from 1/3/01
(when the debt was acquired) to 30/6/04 (the
end of the income year in which the bad debt
deduction is claimed). This is because all shares
in the company were acquired by the investor on
1/7/01, resulting in a 100% shareholder change.
Unless Company A carries on the same
business during the entire 02/04 income year
(i.e. from 1/7/03 to 30/6/04) as it was carried
on 30/6/01 (immediately before the ownership
test was failed), no deduction will be available
toCompanyA for the debt write-off.

52

The same business test is a strict test and requires


the company to carry on exactly the same business.
The test may be satisfied for immaterial or organic
changesin the business.
If the debt is forgiven instead of being written off,
more complex provisions dealing with unrealised
losses will apply to determine whether a deduction
inrespect of a debt is allowed. These provisions
mayallow a deduction or capital loss notwithstanding
the company failing to carry on the same business
(e.g.where a company does not have a net unrealised
loss at the acquisition time) or disallow a capital loss
or deduction even where the same business test has
been satisfied after the acquisition (in some cases
where the company leaves a tax consolidated group).
The investors expenses in respect of the acquisition
should be included in the cost of the shares for
tax purposes, unless the investor is in the share
trading business and the shares are acquired
aspartofthatbusiness.

Acquisition of shares into


ataxconsolidated group
Where the investor is a member of a tax consolidated
group and acquires all shares in a company holding
the debt, the acquired company will join the
investorstax consolidated group.
The tax consolidation provisions are highly technical
and it is strongly recommended to seek advice on
the taxation consequences related to consolidation.
Brieflythe following matters should be considered:

Tax costs of certain assets of the acquired company


will be reset, but tax costs of debts are likely
tobetheir face values

If the acquired company has already claimed a bad


debt deduction in respect of a debt, no bad debt
deduction will be available after the acquisition,
even where the share price includes an amount
inrespectof the written off debt

It is expected that the TOFA legislation


will be enacted in 2009 which will require
that most large taxpayers recognise interest
income on an accrual basis for tax purposes.

If the acquisition results in a change


in more than 50% of shareholders of
the acquired company between the
date thedebt was incurred and the
acquisition date, the company must
test whether it was carrying on the
same business during that time (i.e.
prior to the acquisition). If it did not,
post-acquisition bad debt deductions in
respect of thisdebt may not be available
If the debt is forgiven instead of being
written off, more complex provisions
dealing with unrealised losses will
apply,as noted above.

Holding the debt


Once debt is acquired, the investor will
become entitled to a return from the
debt (e.g. interest), the investor may sell
or convert the debt, the debt may be
collected or written off as bad. Taxation
consequences from these scenarios
aresummarised below.

Interest income
Generally, interest paid by the issuer
of the debt is included in assessable
income of the holder on a due and
receivable basis (but see the comment
onthe Taxation of Financial Arrangements
(TOFA)rulesbelow).
There are two main exceptions to this rule:

The holder is a financial institution,


inwhich case it is required to account
forinterest on an accrual basis

Some debt, if originally issued at a


discount or premium, may require

theholder to account for an amortisation


of the discount or premium on an
accruals basis. Accordingly, if the
purchased debt was originally issued
ata discount or premium, advice should
be sought on the taxation treatment
ofthe remaining discount or premium.
If the debtor is not able to pay interest
and one of these exceptions applies,
theinterest will continue to be included
in the holders assessable income even
ifno payments are made, unless the
holder and debtor agree to suspend
anaccrualoftheinterest.
If interest is paid by a non-resident,
itmaybe subject to a foreign withholding
tax. The investor may be able to apply that
withholding tax to reduce its Australian
tax liability for the year in which the tax
was paid. In some cases, the debtor may
request from the investor a certificate
of residency which confirms that the
investor is a tax resident in Australia.
These certificates are requested by
some foreign tax authorities to allow
the debtor to apply a lower rate of
withholding tax and are issued by
theAustralian Taxation Office (ATO).
It is expected that the TOFA legislation
will be enacted in 2009 which will require
that most large taxpayers recognise
interest income on an accrual basis for tax
purposes. The legislation is expected to
commence on 1 July 2010, but relevant
taxpayers will be able to elect to apply
it to income years (including substituted
accounting periods) commencing
onorafter 1 July 2009.

53

The TOFA rules are complex and change the current


taxation treatment of financial arrangements, including
debts, by prescribing a number of methods, some of
which are elective, to recognise income or losses from
financialarrangementsfor tax purposes.

debt agreement will require detailed consideration


ofthetaxationconsequences.

Converting debt
The holder may choose to convert the debt to another
instrument, normally equity in the issue of the debt,
ifthe debt agreement allows such a conversion.
Briefly, the tax cost of shares received from the
conversion will be equal to the cost of the debt
and incidental expenses related to the conversion
andnogain orlosswill generally arise.

The debt exists at the time of the writing off


(i.e.ithas not been extinguished, etc)

The debt has actually gone bad, that is,


for example, reasonable recovery attempts
have failed, the debtor is in liquidation,
etc. Amere expectation of a default
isnotsufficientforadeduction

Alternatively, a deduction for the difference between


the value of the received shares and the debt amount
may be allowed to the creditor if the creditor bought
the debt in the course of its business of lending
money. In this case, the tax cost of shares will
beequal to their market value.

The holder bought the debt in the ordinary


course of the holders business of lending money.
Thededuction is limited by the amount the debt
wasbought for

Forgiveness of accrued interest incurred after


the purchase will give rise to a deduction
only if the interest has been included in the
holders assessable income or if interest can
beclassified as debt in respect of money lent by
the holder in the course of the holders business
oflendingmoney

Outcomes for creditor if debtor has


difficulties in servicing the debt
If the debtor has difficulties in servicing the debt,
thefollowing outcomes may be possible:

54

Payments are below the required payments


unless the debt agreement and a subsequent
agreement between the debtor and creditor
specifies otherwise, the creditor will be deemed
to receive interest before principal. For example,
where the required payment is A$100 interest
and A$10 principal, but only A$90 payment
is made, the creditor will be required to deem
thispaymentasinterest only.
Changes to the debt agreement the parties
may choose to renegotiate the debt agreement
to provide for a change in the payment schedule,
etc. These changes may result in a debt for
tax purposes being converted into an equity
interest, return from which will be deemed to
be a frankable distribution. Renegotiation of the

Writing off all or part of the debt the holder


may re-assess the recoverability of the debt and
choose to write-off all or part of the debt in its
accounts. However, a corresponding deduction
willonlybeavailable where:

See comments above regarding when the debt


isheld by a company purchased by the investor

Future recoupments of a debt written


off for tax purposes will be included in
theholdersassessable income.

Legally forgiving the debt the creditor may


choose to legally forgive all or part of the debt,
therefore fully or partially discharging the debtor.
A discharge is likely to give rise to a deduction
or a capital loss for the holder; however, the
exact amount of the deduction will depend on
the specific facts of each case. Further, the
forgiveness may also result in taxation implications
for the debtor and/or debtors group entities
underthecommercial debt forgiveness rules.

Lore veliquatem irit pratie te magna at.


Met laore feugue consequi elissim dolendi
onsequat feugue ratie te magna at met
laore feugue consequi elissim dolendions.
Incidental expenditures of the holder

Broadly, the purchaser and holder of the debt


should be entitled to a deduction for incidental
expenditures incurred in acquiring and holding
the debt as those expenditures are incurred.
Thiswillinclude legal fees, factoring fees, etc.

However, where an expenditure is of a capital


nature, for example, due diligence fees in respect
of an acquisition of a business together with debt,
the deductibility may be restricted by including
the expenses in the tax cost of certain assets
orallowingadeduction over 5 years.

Overseas matters
Generally, the above rules apply to debts where a
debtor or creditor is a non-resident. However, the
following considerations should be kept in mind:

Where the debtor is a non-resident, interest


payments and payments in the nature of
interest (e.g. discounts) may be subject to
a foreign withholding tax. The creditor may
reduce its Australian tax by the foreign tax
withheldfrominterest

Where the debt is held by a foreign branch of the


Australian holder and income of the branch is
exempt from Australian tax, no bad debt deduction
in respect of the debt will be available, even
though legally the debt is held by an Australian
taxpayer and other conditions for the bad debt
deductionaresatisfied

Any transfers of the debt between international


related parties must be on arms length terms

If the debt is held by an Australian branch of a


non-resident, the rules above will generally apply
to the branch. However, if the debt is held by a
non-resident not through a branch in Australia,
the acquisition, holding and disposal of the debt
should not have Australian taxation consequences
forthenon-residents

Debt may also be acquired by a trustee of a trust.


If a trust is a fixed trust, that is its beneficiaries
are entitled to a fixed share of the trusts income
(e.g. a unit trust), it is the beneficiaries and not the
trustee who should generally be assessed for tax
inrespectof their entitlement.

Where all or some of the beneficiaries are nonresidents, and the trust qualifies as a managed
investment scheme, income from collection and
disposal of Australian debts (but not interest) to which
foreign beneficiaries are entitled to, may be subject
toa reduced rate of final Australian withholding tax.

Australian stamp duty


Australian stamp duty is a State-based tax
imposed on transactions and legal documents.
There are eight different sets of rules governing
stampdutyinAustralia.
There is no logic or uniformity to the various regimes.
However, outlined below are some of the broad stamp
duty issues which will need to be considered by the
buyer of distressed assets, as the obligations to pay
duty generally fall on the buyer. Given the complexity
and differences in the rules for each jurisdiction,
the actual stamp duty exposure will depend on
thecircumstances of the particular transaction.

Transfer duty is imposed on the acquisition


ofassets located in Australia. Assets which
are subject to duty, in some or all jurisdictions,
includeland and buildings, business assets
(e.g. plant and equipment, goodwill, intellectual
property, trade debts etc.). The rates of duty
vary in each jurisdiction and among jurisdictions
but can be as high as 6.75%. Duty is calculated
on thegreater of the market value of the asset
and theconsideration paid (inclusive of GST).
Accordingly, the stamp duty exposure on the
acquisition ofdistressed assets will depend on the
nature ofthedistressedassetsandtheir location.

55

Transfer duty may also apply to any subsequent


transfer of the assets between entities of the buyers
own corporate group. However, any intra-group
transfer may qualify for corporate reconstruction
relief but formal application for relief is required
tobemade.

Where the distressed assets include shares


orunits, marketable securities duty is payable
inNew South Wales, the Australian Capital Territory
and South Australia on the transfer of shares
inunlisted companies and unit trusts connected
with those jurisdictions. Marketable securities
dutyisimposed at 0.6% (or 0.3% in South Australia
from 1 July 2009) on the higher of the market value
oftheshares/units and the consideration paid.

56

The acquisition of interests in entities which hold


any land assets located in Australia, either directly
or indirectly or on a consolidated basis, could
also attract land rich or land holder duty. Land
rich or landholder duty is imposed at transfer duty
rates (i.e. up to 6.75%) on the market value of the
underlying land assets (although in one jurisdiction,
duty is imposed on both land and chattels). Broadly,
these provisions effectively deem an acquisition
of an interest in the entity as a direct acquisition
of an interest in the land assets held by the entity
oritsassociated entities.

In Queensland and South Australia, there are


trust look-through provisions that need to be
considered if units in unlisted unit trusts are part of
the distressed assets. These trust look-through
provisions operate to treat dealings in the units as
dealings in the underlying assets of the trust located
in South Australia or Queensland and duty is
imposed at transfer duty rates on those assets that
are dutiable property located in those jurisdictions.

If a buyer borrows or finances the acquisition


of distressed assets through secured lending
arrangements, mortgage duty is payable in
New South Wales and South Australia on any
mortgages and charges relating to assets
located in these jurisdictions. Mortgage duty is
imposed at the rate of 0.4% (in NSW) and 0.15%
(in South Australia) on the amount secured
bythemortgages.

If any leases of real property are entered into where


a premium is paid for the granting of the lease,
transfer duty may be payable.

GST
The GST treatment of the supply of distressed assets
will be determined by the seller. In general, the supply
of distressed assets by a GST-registered seller
will be a taxable supply subject to GST unless the
supply is a GST-free supply (e.g. a going concern)
oraninputtaxed supply (e.g. financial supplies).

The disposal of distressed assets can have


a number of income tax consequences
for the seller. Any gain or loss from a
financial asset (e.g. loan) will generally
be assessable or deductible.

GST on the assets


Where the buyer incurs GST on the acquisition
of distressed assets, the buyer will be entitled
torecoverthe GST incurred provided:

it is registered for GST

the assets will not be used to make input taxed


supplies or are not for private use

it holds a valid tax invoice.

In circumstances where the buyer incurs GST on


distressed assets and the assets are subsequently
used to make input taxed supplies, the buyer
will not be entitled to recover the GST incurred
ontheacquisition.
Where the distressed assets are used to make both
input taxed supplies and either taxable or GST-free
supplies, the GST incurred may be apportioned on a
fair and reasonable basis and the proportion of the
GST incurred on the assets relating to the subsequent
taxable or GST-free supplies may be recovered.

Where the distressed assets are acquired as a


GST-free supply of a going concern and the buyer
subsequently uses the assets to make input taxed
supplies, the buyer will be required to make an
adjustment in relation to GST. The amount of the
adjustment payable to the ATO will be 10% of
the proportion of the purchase price that relates
tomakinginput taxed supplies.
Please note that where the buyer acquires property
under the margin scheme, it will not be entitled
to claim any GST incurred on the acquisition
oftheproperty as an input tax credit.

GST on transaction costs


Where the distressed assets are input taxed financial
supplies or the distressed assets are used for input
taxed supplies, any GST incurred on professional
costs relating to the acquisition of the distressed
assets will generally not be recoverable in full. In these
circumstances, the buyer should determine whether
it exceeds the financial acquisition threshold and
whether it will be entitled to reduced input tax credits.

The Sell Side


Special rules for financial arrangements
The disposal of distressed assets can have a number
of income tax consequences for the seller. Any gain
or loss from a financial asset (e.g. loan) will generally
be assessable or deductible. If the asset carries a
deferred return, the disposal of the security may
trigger a balancing adjustment to take into account
any part of the deferred return which has previously
been included in the sellers assessable income.
A deduction for a loss made on a financial asset may
be denied in certain circumstances where the loss is
capital in nature and the financial asset is disposed of
because of the possibility of the issuer defaulting.
In the case of assets other than financial assets
(e.g. ownership interests in an entity that owns
distressed assets), losses made on assets held on
revenue account will generally be deductible, whereas

losses on assets held on capital account will only be


deductible against capital gains or can be carried
forward to be offset against future capital gains.
Where the ownership interest is an equity interest in
an Australian company, care will need to be taken
that the disposal does not result in the denial of the
benefit of any franking credits attached to dividends
whichmay be paid to the seller.

Assets denominated in foreign currency


Where the distressed asset or ownership interest is
denominated in foreign currency, gains or losses which
arise as a result of fluctuating exchange rates between
the date of disposal and the date of payment are
generally assessable or deductible, respectively.

57

New tax-timing rules


New TOFA tax-timing rules will apply to income
years commencing on or after 1 July 2010
(or1 July 2009, if a taxpayer elects). The new rules
will effectively remove the capital/revenue distinction
for eligible taxpayers and allow them to rely on
their financial accounts in determining their tax
liabilityiftheysoelect.

If the new rules apply to the seller of a distressed


asset, the disposal of the distressed asset will
generally result in a balancing adjustment which
willrequire the seller to recognise an assessable
gainor a deductible loss. The new rules will
not applyto the disposal of an equity interest
(e.g.ordinaryshares) if the seller has not elected
torely on their financialaccounts for tax purposes.

Debt restructuring
In general, the sale of distressed assets by an entity,
likely to be undertaken to raise funds to enable
debts to be repaid, will give rise to either gains or
losses for income tax purposes. Any gains made
on the sale of distressed assets will be assessable.
Losses made on the sale of distressed assets will
generally be deductible. Losses made on the sale
of non-depreciating assets held on capital account
canonlybe deducted against capital gains.
Entities should be aware, however, that in certain
circumstances amounts may be included in
assessable income where assets have been acquired
under limited recourse financing arrangements
and, upon termination of that debt (which may be
expected to occur in conjunction with the sale of
the asset), theamount owing is not fully repaid.
Broadly, assessable amounts may arise where
capital allowance deductions (such as depreciation)
are considered to have been claimed excessively
overthelife oftheasset.
Further, amounts may also be included in
assessable income in respect of the sale of leased
plant by anentity, again in circumstances where
depreciation has been deducted in respect of the
asset. Broadly,this may occur where a liability of the
entity is reduced as a result of the sale of the asset,
forexample, onthe entity receiving a benefit in the
formofbeing relievedof a debt.
It is important to consider the tax impact of these
recoupment type provisions when determining how
best to deal with distressed assets, as their application
may result in an entity receiving significantly less
value than first anticipated on the sale of an asset,
therefore potentially affecting the entitys course
ofdealingwiththat asset.

58

Entities with distressed assets may also look to


restructure their debt through debt defeasance
arrangements. Such arrangements allow a debtor,
with a liability to repay a loan at some future date,
topay a third party a reduced amount (e.g, the current
present value of the future liability) in consideration
of the third party assuming the liability to repay the
amount owed by the debtor when it becomes due.
This may include situations where the distressed
assets are sold to finance the up-front payment
tothethird party.
With the exception of finance entities, savings made
by an entity under debt defeasance arrangements
will typically not be treated as ordinary income,
but are likely to fall for consideration and give rise
toconsequences under the CGT provisions.
In circumstances where distressed assets
aretransferred directly by an entity to discharge
adebt, tax implications under the commercial debt
forgiveness provisions may also arise, depending
onthe market value of the assets and the market
value ofthe debt at the time the debt is extinguished.
Debt may also be restructured via the dealing
with distressed assets under sale and leaseback
or hire purchase type arrangements but entities
should also seek to confirm the tax implications
in advance of entering into such arrangements.
Forexample, in broad terms, the ability of a lessee
or hirer to obtain depreciation deductions in respect
of the assets is likely to depend on the existence
of a right, or obligation, to purchase the asset at
theendoftheterm of the arrangement.

The new tax-timing rules will effectively


remove the capital/revenue distinction for
eligible taxpayers and allow them to rely
on their financial accounts in determining
their tax liability if they so elect.

Equity restructuring
Selling a subsidiary member
ofaconsolidated group
Where the shares of a subsidiary member of a
consolidated group are sold, the subsidiary member
will leave the consolidated group (leaving subsidiary).
This will trigger a number of tax consequences for the
head company of the consolidated group as follows.

The head company will be required to recalculate


the cost base of the shares of the leaving subsidiary.
The cost base is broadly equal to the cost base of
the assets that the leaving subsidiary takes with it
minus the value of the leaving subsidiary's liabilities.

Using this recalculated cost base, the head


company will be required to determine whether
it has made a capital gain or a capital loss
fromtheshare sale.

Where the leaving subsidiary's liabilities exceed


the cost base of its assets, the head company will
make a capital gain under CGT event L5 equal
tothatexcess.

For the leaving subsidiary, leaving a consolidated


group may trigger an obligation to make a
payment to the head company under a tax sharing
agreement to enable the subsidiary member
toleave the consolidated group clear of any joint
andseveral liability to pay the group's tax liabilities.
Inaddition, any tax losses, franking credits or other
tax attributes of the consolidated group will remain
with the head company and will not be passed
totheleaving subsidiary.

Selling a foreign subsidiary


Where the shares of a foreign subsidiary are sold, a
capital gain or capital loss will be triggered. However,
where the shares were held by an Australian resident
company that held a direct voting percentage of at
least 10% in the foreign company for a continuous
period of at least 12 months in the 2 years before the
sale, the capital gain or capital loss can be reduced.
The capital gain or capital loss is reduced by
the foreign companys active foreign business
percentage. The active foreign business
percentage is the value of the foreign companys
active business assets as a percentage of the
valueoftheforeigncompanys total assets.
The Australian resident company can choose to value
the foreign companys assets at either book value or
market value, but if either of those methods cannot
be used, or if no choice is made, a default method
applies under which capital gains are fully taxable and
capital losses are reduced to nil. If the active foreign
business percentage is less than 10%, it is rounded
down to zero (so that a capital gain becomes fully
taxable) and if it is greater than 90%, it is rounded
upto 100% (so that a capital gain is reduced to zero).

59

Paying for others mistakes


The disposal of distressed assets can have income
tax consequences for parties beyond the seller where
there is a certain type of fiduciary relationship between
the seller and a third party in particular circumstances.
Such third parties include agents, trustees, liquidators,
receivers and directors of the seller.
Under special rules which can apply, such a third
party may become personally liable to discharge
certain tax liabilities of the seller (in the case of agents,

trustees, liquidators and receivers), be jointly and


severally liable to pay administrative penalties (in the
case of company directors where a selling company
has failed to comply with a tax law) or be deemed to
have committed a taxation offence in relation to an
act or omission done by the company (in the case of
company directors where a company has committed
a taxation offence).

Indirect tax
The GST treatment of supplies of distressed assets
will depend on a number of factors including:

The legal capacity of the seller

The character of the distressed asset being supplied

The entity responsible for the GST consequences


ofthe supply

Whether the assets being supplied would otherwise


be GST-free or input taxed under the GST Law.

In general, the supply of a distressed asset by a


GST-registered seller will be a taxable supply subject
to GST unless the supply is a GST-free supply
(e.g. a "going concern") or an input taxed supply
(e.g.financial supplies). For each supply, the seller
will also need to consider whether an adjustment
is required for GST input tax credits claimed at the
timethe asset was acquired.
Difficulties can and do arise for GST purposes where
the seller is a representative (e.g. administrator,
receiver, liquidator) of an "incapacitated entity"
(e.g.an entity that is in liquidation or receivership).

60

The ATO takes the view that a representative of an


incapacitated entity will be liable for GST, entitled to
GST input tax credits, and has adjustments, in respect
of supplies and acquisitions it makes from the date
it is appointed as representative of the incapacitated
entity. The incapacitated entity will continue to be liable
for GST on supplies and entitled to GST input tax
credits on acquisitions made prior to the appointment
of the representative, subject to an exception
relatingtoadjustments.
Further, where a mortgagee in possession sells
property in satisfaction of a debt owed by a debtor,
the mortgagee in possession will be responsible
forthe GST consequences of the supply.
Where the asset being supplied is real property,
the characteristics of the property will determine
whether it is a taxable, GST-free or input taxed
supply of real property. If the real property being
supplied is taxable, the seller should consider
whetherthe"marginscheme" will apply to the supply.

Perspective

Selling or buying distressed assets in Australia involves


complying with a complex range of taxation requirements
andrecordkeepingresponsibilities.

Both buyers or sellers need to consider the tax implications of


the investment vehicle and the structure of the transaction at an
early stage to minimise the risk of unanticipated tax exposures
andtohelp maximise taxation opportunities.

All aspects of taxation need to be considered including


incometax,capital gains tax, withholding tax, GST and stamp duty.

Foreign investors also need to consider their international


taxarrangements.

61

Appendix A
Economic outlook
Global economic outlook
The current global economic landscape bears little
resemblance to this time last year. With in excess of
US$1 trillion lost in write-downs to date, and the IMF
revising forecasts of total losses upwards to US$2.2 trillion,
it appears that a return to normality is still a way off. What
we are currently witnessing is a massive adjustment in the
global economy, from an environment of cheap and plentiful
debt to one of debt scarcity. The impact of this adjustment
has now flowed from Wall Street to the main street economy.
The IMF has subsequently slashed its
average global growth forecasts, down
from 1.75% in November 2008 to 0.5%
by January 2009. But averages hide the
sizable diversity in growth rates between
countries. The economies of developed
nations are forecast to contract by
an average 2.0% during 2009. Much
therefore hinges on China and India, the
worlds 3rd and 12th largest economies
respectively. The IMF forecasts 6.7%and
5.1% respective annual growth for
these economies, hence the positive
global average. However even these
forecasts have been revised downwards
over the course of the last four months,
withmuch now resting on their ability to
show agility in developing new export
markets and growing their massive,
butunderdeveloped, domestic economies.

62

Australian
economicoutlook
The outlook for the Australian economy
has deteriorated in line with global trends
and now faces the prospect of entering
a recession in the first half of 2009.
Consensus has moved away from a soft
landing to a rockier landing and periods
ofsustained distress for certain industries.
Our Australian Economic Outlook sees
GDP growth slowing from the 2.1%
during 2008 to between 0 - 0.5%
during 2009. Therefore, Australias
position is relatively bright in relation to
other developed countries. Theprime
reason for this is a stronger financial
sector that has resulted from superior
credit policies and risk management
strategies. The recent Government
move to guarantee bank deposits
has further strengthened the sector
andensuredthatconfidenceremains.

However, the fortunes of the Australian


economy are still deeply entwined
withinternational factors including:

The negative financial contagion effect


where assets and industries in Australia
become negatively affected by declines
in asset values which originated
intheUS

A softening in commodity prices,


accompanied by a sharp slowing in
demand has seen Australian resources
facing both a contraction in the value
and volumes of exports. The results
have been mine closures, deferment
ofinfrastructure and asset sales

Health of top export markets, Japan,


China and South Korea which together
account for 39% of total exports.
The Japanese and South Korean
economies have been two of the
hardest hit, while the performance
of the Chinese economy is being
keenly watched from around the
world. Sustained contractions in
these markets, implying reduced
demand for Australian commodities,
will hurt Australian businesses and
strain Australias terms of trade

On the domestic front, a number


of factors influencing our outlook
forthecomingperiod include:

A slow rise in unemployment towards


6 7% (currently 4.5%), affecting
allsectors and States

A weakening Australian property


market with more suburbs and market
segments experiencing declines.
However, our property prices are
traditionally sticky on the downside,

most cities have housing demand


exceeding new supply, and the recent
Federal stimulus package contained
an increase in new home owner grants
thatcould buoy demand

Falling levels of inflation as petrol prices


soften and consumer confidence
levelsremain low

Increases in household savings rates,


as spooked consumers choose to pay
down debt and lock away wealth as
the short-medium term outlook remains
uncertain. This has the important side
effect of blunting the effectiveness
offiscal stimulus packages designed
toboost consumer spending.

However considerable attention will also


be paid to the impact of rapid monetary
and fiscal responses. While these
responses will not counter the structural
adjustment currently taking place in the
global economy, it has signalled policy
makers willingness to cushion the blow
to the Australian economy. Australia was
fortunate to have a strong fiscal position
prior to the onset of the crisis. The second
fiscal package recently announced
shows a willingness to fully exploit this
position and even put the budget into
deficit in order to prop up spending. The
announced package also coincided with
afurther 100pb cut to official interest rates,
bringing them to a record low of 3.25%.
These actions mirror the policies of other
G-20 nations in a coordinated attempt to
stave off a prolonged global recession.
Combined, these actions should moderate
the recent rapid growth in non-performing
loans, however the extent to which they
reaffirm confidence and stabilise the
economy remains to be seen.

63

Appendix B
Summary of Australian
Big4Banks Basel II disclosures
The following provides a summary of the ANZ, CBA, NAB and Westpacs Basel II disclosures (also known
as Pillar 3 or APS330 disclosures). The figures for ANZ, NAB and Westpac are as of 30 September 2008,
whilstCBA is as of 30 June 2008.
The table below provides a summary of the carrying value of defaulted assets which is defined as being 90 days
past due or unlikely to pay.
Exposure

Risk-Weighted
Assets

Exposure

Risk-Weighted
Assets

A$m

A$m

porportion of

porportion of

2,131,013

655,947

99.5%

95.9%

Defaulted assets - Corporate

6,741

16,891

0.3%

2.5%

Defaulted assets - Consumer/Personal

4,382

11,407

0.2%

1.7%

2,142,136

684,244

100.0%

100.0%

Non-defaulted assets

Total
Source PricewaterhouseCoopers

Based on the above the big 4 banks in Australia are carrying a total of A$6.7 billion in corporate loans that
areatleast 90 days past due and A$4.3 billion of consumer related loans.
The following table provides a summary of the total lending, defaulted loans, impaired loans and specific provisions
on the balance sheets by industry for the Big 4. The total write-offs represent loans written off to the profit and loss
for the respective year ends collectively for the big 4 banks. These write-offs are typically taken as either a charge
to the specific provisions or a charge to the collective provisions for credit losses. The big 4 banks have written
offatotal of A$1.4 billion in consumer and A$1.0 billion in corporate loans for the 12 month period.
As can be seen in the table below Specific Provisions are considerably lower than the value of Impaired Loans. In many
cases a bank may not be able to accurately estimate the Individual/Specific Provision, in which case it will estimate the
credit risk provision on a collective basis. The collective provisions for the Big 4 banks were approximately A$8.0 billion.
By far the largest exposure for defaulted loans is the Personal sector, which includes a considerable volume
of residential mortgages. On the Corporate side the largest exposure is in the property and business services
sector with total of A$2.1 billion in defaulted loans.

64

Exposure

Defaulted
Loans

Impaired
Provisions

Specific

Write-Offs

A$m

A$m

A$m

A$m

A$m

24,975

177

120

33

16

111,223

434

320

91

46

30,996

453

365

83

40

377,898

1,100

939

290

209

98,263

666

608

305

150

Personal *

983,996

4,382

1,411

614

1,442

Property and business services

230,363

2,113

1,659

249

192

Trade

93,771

815

488

211

196

Transport and storage

46,146

145

112

46

37

Energy

17,611

-6

Sovereign

22,897

Other

103,997

836

600

300

103

Total

2,142,136

11,123

6,682

2,222

2,425

Industry

Accommodation, cafes, pubs and restaurants


Agriculture, forestry, fishing and mining
Construction
Finance and surance
Manufacturing

Source PricewaterhouseCoopers

65

Useful websites
BLAKE DAWSON
www.blakedawson.com
The Blake Dawson website includes information about the firm, updates on recent legal developments,
partnerprofiles and contact details.

PRICEWATERHOUSECOOPERS
www.pwc.com/au/car
PwCs Corporate Advisory & Restructuring division is a dedicated team of specialists with extensive
skills in diagnosing, advising on and deploying commercial solutions for underperforming, inefficient
ordistressedorganisations and thoseconfrontedwithunexpectedevents.

ASIA-PACIFIC LOAN MARKET ASSOCIATION


www.aplma.com
The Asia-Pacific Loan Market Association is the trade association for the syndicated loan trading
marketintheregion.

AUSTRADE
www.austrade.gov.au
The Australian Trade Commission (Austrade) is the Australian Governments trade and investment
developmentagency.

AUSTRALIAN BUREAU OF STATISTICS (ABS)


www.abs.gov.au
The ABS website provides statistics for a wide rangeof economic and social indicators.

AUSTRALIAN LEGAL MATERIALS (LEGISLATION AND CASE LAW)


www.law.gov.au
An online resource providing information about the Australian legal system and relevant
governmentorganisations.
www.austlii.edu.au
This website provides access to Australianlegalmaterials.

AUSTRALIAN SECURITIES EXCHANGE (ASX)


www.asx.com.au
ASX operates Australias primary nationalstockexchange.

CORPORATE REGULATION
www.asic.gov.au
The Australian Securities and Investments Commission regulates Australias companies.

66

DEBTWIRE
www.debtwire.com
Debtwire is a commercial information provider to the fixed income markets. It publishes regional surveys
ofdistressed debt markets.

FOREIGN INVESTMENT
www.firb.gov.au
The Foreign Investment Review Board examines proposals by foreign interests to undertake direct
investmentinAustralia.

GOVERNMENT INFORMATION
www.gov.au
The Government Entry Point provides access to Australian Federal, State, Territory and Local
Governmentwebsites.
www.business.gov.au
The Business Entry Point is a government resourceforbusiness.

INSOLVENCY PRACTITIONERS ASSOCIATIONOF AUSTRALIA


www.ipaa.com.au
The trade association for Australianinsolvencyprofessionals.

LOAN MARKETING ASSOCIATION


www.lma.eu.com
The European trade association for the syndicatedloan trading market.

LOAN SYNDICATION AND TRADINGASSOCIATION


www.lsta.org
The Loan Syndications and Trading Association is the US association for the syndicated loan trading market.

PROPERTY
www.propertyoz.com.au
The Property Council of Australia is the peak industry body for the Australian commercial real estate sector.

TAXATION
www.ato.gov.au
The Australian Taxation Offices website includes information for business, largecorporatesandmultinationals.

TMA
www.turnaround.org.au
The Turnaround Management Association is the only international non-profit association dedicated
tocorporaterenewal and turnaround management.

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Contributing authors
Blake Dawson
Michael Sloan
Partner, Restructuring & Insolvency
Duncan Baxter
Partner, Tax
Carl Della-Bosca
Partner, Corporate
Jemaya Barlow
Senior Associate, Restructuring & Insolvency
James Marshall
Partner, Restructuring & Insolvency
Matthew May
Partner, Restructuring & Insolvency
Stephen Menzies
Partner, Corporate
Paul ODonnell
Partner, Tax
Paul Pyanic
Senior Associate, Tax
David Ryan
Partner, Corporate
Marcus Ryan
Senior Associate, Tax
Steve Smith
Partner, Banking & Finance
Natasha McHattan
Senior Associate, Restructuring & Insolvency
Sanjay Wavde
Senior Associate, Tax

68

PricewaterhouseCoopers
Michael Codling
Partner, Financial Assurance
Nick Colman
Manager, Distressed Debt Group
Melissa Humman
Director, Corporate Advisory and
Restructuring
Frank Janik
Director, Distressed Debt Group
Paul Kirk
Partner, Corporate Advisory and Restructuring
Scott Lennon
Partner, Economics and Strategy
Steven Lim
Partner, Actuarial Services
Michael McCreadie
Partner, Distressed Debt Group
Rob Spring
Partner, Financial Assurance
Tom Toryanik
Senior Manager, Tax and Legal Services
Rob Tyson
Manager, Economics and Strategy

69

Contact information

For further information, please contact:


Blake Dawson
James Marshall
Partner, Sydney
Restructuring & Insolvency
T 61 2 9258 6508
james.marshall@blakedawson.com

PricewaterhouseCoopers
Michael McCreadie
Partner, Melbourne
Distressed Debt Group
T 61 3 8603 3083
michael.mccreadie@au.pwc.com

www.blakedawson.com

www.pwc.com.au