Bankruptcy of Large Firms and Exit Mechanisms in Korea

Nam, Il Chong / Soogeun Oh(Author)

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This report deals with two fundamental questions that face the Korean economy: why did so many large firms go bankrupt, and what is wrong with the insolvency mechanisms in Korea? Roughly one third to one half of the medium-sized chaebols went bankrupt or fell into deep financial trouble after the onset of the crisis. In addition, essentially all of the firms belonging to the Daewoo group, one of the top five chaebols, went bankrupt. Some firms affiliated with the other top five chaebols have also fallen into financial difficulties. Massive bankruptcy of chaebol firms led to deep financial difficulties of banks and non-bank financial institutions, which in turn resulted in a massive injection of public funds. Even after the outbreak of the crisis, lack of confidence in the court-supervised bankruptcy proceedings led to the wide use of so-called workouts. The laws on court-supervised bankruptcy proceedings have recently been revised twice, but have not been able to gain full confidence of market participants.

Officially, there are three mechanisms that parties with interests in a bankrupt firm can resort to: bankruptcy (forced liquidation), reorganization, and composition. However, these court-supervised proceedings have not been used much in the past when it comes to large insolvent firms. Before the onset of the crisis, financial difficulty of large firms had traditionally been handled by the administrative branch of the government in an industrial policy context. The focus on such governmentled mechanisms, often called rationalization measures, centered around the survival and continued operation of the firms involved. The rights and interests of the creditors, especially those of banks, had been largely ignored. As a consequence, formal bankruptcy proceedings have not had a chance to develop into well-functioning exit mechanisms.

Two revisions made after the outbreak of the crisis required that the court use an economic criterion in determining whether a firm should be granted reorganization and that the court should not allow composition for large firms. Thus, large firms were limited to reorganization if they chose to remain as goingconcerns. The court also changed its attitude toward the bankrupt firms and nullified most of the shares owned by dominant shareholders of bankrupt firms that applied for reorganization. As a result of these and other reforms, the probability of reorganization being granted to only the firms whose going-concern values exceed the liquidation values increased substantially.

The authors claim that the most important factor behind the malfunctioning of bankruptcy proceedings in Korea is the lack of proper corporate governance in financial institutions and large firms. Banks in Korea have been run as if they were government businesses; and as a consequence, they have not been supervised by a proper governance structure that is profit-oriented. Lack of proper governance was the main reason that banks did not act properly as creditors in bankruptcy proceedings and passively followed initiatives of debtor firms and the government.

This monograph also contains a chapter focusing on a comparative analysis of bankruptcy proceedings of the following six East Asian countries: Singapore, Malaysia, the Philippines, Thailand, Indonesia, and Korea. The comparative analysis generally confirms that Singapore and Malaysia are equipped with superior institutional infrastructures concerning corporate governance of large firms and reallocation of resources from bankrupt firms, compared to the other four countries that have been adversely affected by the economic crisis. The monograph concludes with a set of proposals that the authors believe is needed to improve the efficiency of bankruptcy proceedings in Korea.

Issue Date
Korea Development Institute


Ⅰ. Introduction

Ⅱ. Extent of the Debt Crisis

Ⅲ. Main Issues in the Law and Economics of Insolvency
 Ⅲ-1. The Role of Insolvency Mechanisms
 Ⅲ-2. Three Fundamental Ex-Post Decisions
 Ⅲ-3. Decision-Making Process
  1) Regime 1: Decision by a Single Authority
  2) Regime 2: Formal Bargaining Games
  3) Regime 3: Informal Bargaining Games
  4) Regime 4: Recent Proposals That Do Not Depend on Bargaining

Ⅳ. Formal Bankruptcy Proceedings
 Ⅳ-1. Corporate Reorganization
  1) Basic Procedure
  2) Filing
  3) Commencement
  4) Reorganization Plan
  5) Post-confirmation Procedures
  6) Problems and Analysis
 Ⅳ-2. Composition
  1) Basic Procedure
  2) Filing
  3) Commencement
  4) The Condition of Composition
  5) Problems and Analysis
 Ⅳ-3. Bankruptcy
  1) Basic Procedure
  2) Filing
  3) Commencement
  4) Claims and Distribution
  5) Conclusion
  6) Problems and Analysis
 Ⅳ-4. Comparison and Transferability between Proceedings

 Ⅴ-1. Legal Basis for Workouts
 Ⅴ-2. Process of Workout
  1) Selection of Target Firms and Formation of the Council of Creditors
  2) Investigation of Target Firms
  3) Confirmation of Workout Plans
  4) Conclusion of Memorandum of Understanding (MOU)
  5) Monitoring
 Ⅴ-3. Scope of Workouts
 Ⅴ-4. Problems and Analysis

Ⅵ. Governance of Debtor Firms and Creditors, Markets for Ailing Firms
 Ⅵ-1. Corporate Governance of Large Firms and Chaebol Problems
 Ⅵ-2. Corporate Governance of Financial Institutions
 Ⅵ-3. Markets for Ailing Firms and Their Assets
 Ⅵ-4. Vulture Funds

Ⅶ. Other Measures Taken by the Government or Creditors
 Ⅶ-1. Rationalization Measures of the 1970s and 1980s
 Ⅶ-2. “Big Deals” of 1998
 Ⅶ-3. More Discussion on the Role of the Government

Ⅷ. Comparative Analysis of the Bankruptcy Proceedings of Six Asian Countries
 Ⅷ-1. Creditors, Debtors, and the Government
  1) Financial Markets
  2) Corporate Governance
  3) The Government
 Ⅷ-2. Comparative Analysis of the Insolvency Proceedings of the Six Countries
  1) Overview
  2) Unitary versus Plural System
  3) Expediency
  4) Quantum Requirement
  5) Expertise of the Court
  6) Role of Creditors and Managers of Debtor Firms
  7) Civil and Criminal Penalties for Managers of Insolvent Firms

Ⅸ. Progress Made and Challenges Ahead

Series Title
KDI Research Monograph 2000-01
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