This week we bring you part II of Esin Attorney Partnership’s report on the newly adopted Provisional Article and the effect on financial restructuring and NPL reform in Turkey. Last week’s post is available here. In this post they provide additional insight into the newly adopted legislation and discuss their recommended actions on the legal front.

1) Financial Restructuring Considerations

Universal Effect on All Creditors: While the Framework Agreements provide for a statutory regime, it is not intended to provide for a properly “collective” insolvency procedure including all creditors of a debtor. As drafted, the Framework Agreements only bind those who have signed it. As such, many parties who commonly operate in the credit markets in Turkey (including many foreign financial institutions) will work outside the Framework Agreements, and compromises struck by and between the parties to the Framework Agreements will not bind non-signatories. The general situation clearly requires a restructuring regime to be instituted that would have collective effect. Otherwise, there will be continuing asymmetry between the treatment of signatory creditors, on the one hand, and non-signatory creditors, on the other, because non-signatory creditors will be able to continue with their enforcement proceedings at a time when the debtor is in the process of restructuring its financial debts and signatory creditors are subject to a moratorium. Such a situation is likely to force debtors to perform all their due obligations owed to non-signatory creditors, but not vis-a-vis signatory creditors. This very effect will discourage non-local creditors from becoming parties to the Framework Agreements, as well as discouraging debtors from investing time and effort in attempting to achieve a financial restructuring through the Framework Agreements process, in particular, where such debtors have a number of non-signatory creditors.

There are numerous examples of insolvency regimes in other countries which deal with all creditors collectively. Indeed, for a process to be properly considered an effective restructuring and insolvency process, many would say that it should include a universal moratorium as an essential element. For example, in the US, Chapter 11 provides for an “automatic stay” where all judgments, collection activities, foreclosures and repossessions of property are suspended and may not be pursued by creditors, similar to what the composition/concordat process offers in Turkey.

Action recommended: The entire financial restructuring regime must be revised so as to have collective effect (with limitations) on creditors, and which would thereby require all banks and financial institutions dealing with Turkish borrowers to be part of the process. Although the effects of a local insolvency procedure in one jurisdiction (for example, to write off claims) may not be effective in another, it should still be possible to legislate towards such a position through international treaties and in particular international recognition of key elements of Turkish insolvency procedures.

Can Konkordato Be An Alternative: Composition (concordat, konkordato) is an alternative to financial restructuring under the Framework Agreements that does have universal application to all creditors, including non-financial creditors. Except for secured receivables, during the initial and definitive grace period of the composition, no debt enforcement proceedings can be initiated or continued and no interim attachment nor injunction decisions can be exercised, including enforcement proceedings for public receivables. Although during the grace period the secured creditors can initiate or continue debt enforcement proceedings, they cannot obtain any protective measure (such as sequester of movables) or liquidate the pledged assets.

Composition has existed in the Enforcement and Bankruptcy Code (the “EBC“) for a long time, but it was only at the beginning of 2018 that the EBC was modified, making it easier for debtors to meet the composition requirements. Since these changes, many distressed companies in Turkey have applied for composition and benefitted from the universal moratorium it provides, granting them the opportunity to overcome liquidity issues mainly caused by their FX exposure.

There are both advantages and disadvantages of the composition process, explained below.

First, the main difference between financial restructuring under the Framework Agreements and the Kondordato is that a Kondordato composition is a court-led process. Following the receipt of the composition application, the court may grant an initial grace period of up to three months (which can be extended for up to another two months) and, later, a definitive grace period of up to one year (which can be extended for up to another six months), and appoint ‘commissars’ (effectively, supervisors) to the debtor. While, in principle, debtors still have the ability to run their businesses as they were, the composition process requires all transactions of the debtor to be performed under the supervision of the commissars.

The rationale is that as the debtor can continue its business during the initial moratorium period under the supervision of the commissars and the court, this protects the interests of creditors while balancing the interests of the debtor and its creditors. It may be expected that since the commissar and the court have extensive powers during the composition process, such as refusing to approve a debtor’s important decisions and transactions, it restricts the debtor’s ability to operate in a flexible manner and may cause bottlenecks, especially where dealing with commissars who may be unfamiliar with the business of the debtor, and the critical urgency of the situation, and where slow-footedness may materially and adversely affect the debtor’s business and prospects. However, in practice, we have experienced that debtors have a great deal of freedom, and the commissars create trust in the creditors, which result in a smooth process for the debtor.

Furthermore, the extent of creditors’ involvement (in terms of dialogue and influence) in a Kondordato composition is not as great as in financial restructurings under the Framework Agreements process. As the Konkordato composition is a court-led process, creditors’ input is much less than in a financial restructuring process, which is ultimately a contractual matter as the law currently stands. In particular, during the Konkordato moratorium period, which can last up to 18 months from the time of application for the composition, i.e., until the point where the composition plan requires to be approved by creditors, the creditors’ involvement is very limited including in relation to what the composition plan proposal provides for or recommend. In addition, unsecured receivables cease to accrue interest from the beginning of the initial Konkordato moratorium period until the composition plan is approved by the creditors. Therefore, a Konkordato composition may also result in a loss of interest income for unsecured creditors. This may cause an imbalance between the interests of unsecured creditors and the debtor.

Lastly, applying for a Kondordato composition usually results in reputational damage for the debtor because it is perceived in the market as being bankrupt or on the verge of bankruptcy. The financial restructuring process pursuant to the Restructuring Agreement process, however, is a confidential and out-of-court process and, hence, does not attract the same stigma.

Available Restructuring tools: Restructuring processes, if properly conceived, generally contain certain “tools” i.e. have features and tools which facilitate timely and effective restructuring. The tools for financial restructuring provided for under the Framework Agreements are, however, limited compared to other international restructuring regimes (such as Schemes of Arrangement in the UK and Chapter 11 in the US).

Under Schemes of Arrangement and Chapter 11, the restructuring of both secured and unsecured claims is possible whereas, in financial restructurings under the Framework Agreements, the principle is to protect existing securities and, therefore, security rights cannot be impaired without individual secured creditor consent.

Chapter 11 and Schemes of Arrangement seem to require higher thresholds for restructuring (i.e., 2/3 in amount and majority in number; 75% in amount and majority in number, respectively). However, both provide for the ability to “cram down,” whereby the dissenting minority creditors can be forced to restructure, including by writing-down debt (on a pari passu basis with consenting creditors). The Large Scale FA, however, does not include a “cram down” feature but instead states that a write-down requires the unanimous consent of all creditor institutions. In addition to a write-down, an extension for an additional loan requires the consent of 90% by volume and two by number. On the other hand, write-down will not be possible under Small Scale FA and creditor institutions cannot be forced to extend additional loans but they may decide individually therefor. Furthermore, a debt-for-equity swap is used as a restructuring tool under Chapter 11 and Schemes of Arrangement. However, the Framework Agreements do not contemplate debt-for-equity swaps without shareholder consent. These features make it difficult to achieve a fruitful restructuring agreement between the debtor and creditors because, essentially, it requires all involved parties’ interests to be aligned.

Action recommended: The Framework Agreements should be updated to provide additional restructuring tools (in particular, a “cram down”), as in other international restructuring regimes, to facilitate the process of reaching an agreement on restructuring.

Embezzlement risk: The crime of embezzlement is regulated under Article 160 of the Banking Law, which states that “[an officer’s] damaging [of a] credit institution by any means whatsoever by using the credit institution’s resources to their or others’ benefit is deemed embezzlement.”

The pre-existing Article 160/4 of the Banking Law states that making available additional loans, extending terms of existing loans, or making an instalment plan, receiving additional securities or using other tools for restructuring in accordance with the banking legislation and principles and procedures do not constitute “embezzlement.” However, this general wording does not create enough security and, given the risk of criminal liability, bankers are reluctant to use financial restructuring tools, such as write-downs or debt-to-equity swaps.

The new Provisional Article clarified that the actions to be taken to restructure loans, including write-downs, made in accordance with the Provisional Article do not constitute an “embezzlement.” However, this provision is limited to financial restructurings conducted under the umbrella of the Framework Agreements. This means that the embezzlement risk is no longer a major concern for those restructurings. On the other hand, the risk remains the same for the financial restructurings carried out by financial institutions that are not parties to the Framework Agreements, as well as for financial restructurings implemented through processes other than the Framework Agreements construct. Considering that there are many ongoing financial restructurings being pursued other than under the Framework Agreements, lawmakers must also take action to mitigate the embezzlement risk in relation to those other types of financial restructurings.

Action recommended: We recommend removing the reference to the Framework Agreements in the Provisional Article.

2) Considerations Regarding NPLs

Trading NPLs: Banks have a real need to sell their NPLs to repair their balance sheets and to increase their liquidity in light of the strict capital maintenance requirements in Turkey. This is particularly important for the Turkish economy as Burak Dalgın and Güven Sak also pointed out: “an inability to clean bank balance sheets and restore credit flows in a timely and competent manner would risk triggering a negative feedback loop (credit starvation, economic contraction, loss of corporate sector capacity to operate and service debt, impaired bank balance sheets, further credit starvation).”

Nevertheless, as per banking laws and market practice, NPLs can only be sold to Turkish asset management companies while Group I loans (i.e., standard loans and other receivables) and Group II loans (loans under close monitoring) can be sold to other third parties as well. Asset management companies are established solely for the purposes of purchasing and trading NPLs. Therefore, in practice, sale of NPLs to a third party other than asset management companies is believed to be problematic from the perspective of the crime of embezzlement since such a sale will result in reduction of bank’s assets in a way not expressly permitted under applicable law. Therefore, to clear their balance sheets of NPLs, only option for banks seems to sell them to asset management companies. For instance, following in the footsteps of Yapı ve Kredi Bankası A.Ş. and Türkiye Garanti Bankası A.Ş., Türkiye İş Bankası A.Ş. recently announced its sale of receivables amounting to TRY 1.1 billion to asset management companies for TRY 32.4 million.

Asset management companies are licensed companies supervised by the BRSA, whose operations include acquiring bank loans, making collections, restructuring and reselling debts. Despite large scopes of operation, in practice, they are inclined to acquire loans and hold said loans until they collect receivables via enforcement procedures. They are not designed to trade loans and, thereby, create financing or restructuring opportunities for the debtors, or to restructure the loans themselves and, thereby, enable debtors to continue their operations. Therefore, the option to sell NPLs to asset management companies does not serve one of the main aims of financial restructuring, which is protecting and enhancing the viability of financially distressed but viable companies in a sustainable way.

Furthermore, while Turkish asset management companies have two decades of experience in purchasing, managing and collecting large consumer loan portfolios, they are not very much experienced in dealing with big-ticket large corporate loan portfolios, nor do they have the financial resources to buy these assets.

Considering that there is a high number of big-ticket corporate NPLs in Turkey and that this number is constantly increasing, it would be unfair to expect those Turkish asset management companies to carry the major NPL burden alone. Therefore, it is essential for the Turkish economy to attract international funds focused on NPLs to buy Turkish NPLs.

In addition to the foregoing, the BRSA has expressed that a Turkish entity cannot sell the receivables that a Turkish debtor owes it to a non-Turkish party. This is a major obstacle for Turkish banks selling their NPLs to non-resident investors.

Action recommended: The sale of NPLs to third parties other than Turkish asset management companies (including international distressed asset funds) must be permitted.

Disclosure of Information: Disclosure of information about loans and borrowers to purchasers is another issue in the sale of NPLs. As a general rule, the Banking Law prohibits banks from disclosing client-related information to third parties.

However, Article 73 of the Banking Law permits the disclosure of client information as part of a valuation carried for the sale of bank assets, including loans. Furthermore, Article 190 of the Turkish Code of Obligations sets forth that the assignor must provide all documents substantiating the assigned receivables and other documents that would be necessary for the assignee to claim the assigned receivables.

While these two provisions provide a certain level of comfort to Turkish financial institutions in indirectly enabling them to provide client information to third parties, Turkish banks are hesitant to rely on the provisions when disclosing client information to potential buyers.

Action recommended: Article 73 of the Banking Law must be clarified to ensure that Turkish banks are able to disclose client information to third parties for NPL sales purposes (auctions and bilateral basis), even before entering into definitive sale and purchase agreements with them.

Securitization of NPLs: Securitization can be summarized as the collection of illiquid assets, such as long-term receivables, into a pool and the transformation of the pool into a security, which is tradable and, therefore, more liquid than the underlying loan or receivable. Under the Capital Markets Board of Turkey’s regulations, asset-backed securities and covered bonds can only be issued in respect of Group I loans (i.e., standard loans and other receivables: loans where the credit risk has not risen significantly), and not NPLs.

Action recommended: In order to help banks clear their balance sheet and increase liquidity, banks must be allowed to issue these securities in respect of their NPLs as well.

3) Other Considerations

Information Requirements: Under the Framework Agreements, the debtor is required to provide various documents and information in order to apply to enter into the Framework Agreements financial restructuring process, that information relating both to itself and its associates, including shareholders. While there are material disclosure obligations under similar international restructuring regimes, they do not require all such information to be provided at the outset. It seems that this requirement is a material deterrent for Turkish debtors (in particular, where a foreign entity, such as a shareholder, is involved in the process) who might otherwise wish to invoke the regime and the protection (and flexibility) that it affords.

While the Large Scale FA may solve this problem somewhat, by giving creditors the option to accept the application without all required documents being provided to them, this is a major issue for debtors because their application might be rejected if they are unable to provide all the required information. Additionally, occasional protection is required urgently and there may simply be insufficient time available to assemble the required information especially as it is also required for third parties whom the debtor may not be able to compel to make disclosure to it. In addition, the information requirement is still applicable under the Small Scale FA.

Action recommended: The Framework Agreements must be changed so as to require less information to be provided by a debtor wishing to enter into the process sand that the information requirements are replaced with disclosures by the debtors over the course of the process but subsequent to commencement.

Turkish Enforcement Laws: Creditors’ ability to enforce rights, including security rights, is very important in terms of tidying up overstretched financial markets. Where it is desirable that outside parties relieve incumbent holders of distressed debt, potential purchasers will wish to know that the path to enforcement is as smooth and efficient as possible, that proper recourse is available against debtors and their assets and that enforcement procedures will allow realization of assets within a reasonable time period and achieve value.

As per Article 45 of the EBC, a creditor may initiate enforcement proceedings by way of either (i) an enforcement proceeding based on a judgment (ilamlı icra), or (ii) an ordinary enforcement proceeding (ilamsız icra). While the faster way would be initiating an ordinary enforcement proceeding rather than completing a litigation process to receive a judgment, that route may also be inefficient because the debtor is entitled to object to the payment order without having to justify the objection. If the debtor files an objection, the creditor must file either an “action for lifting the objection” or an “action for the cancellation of the objection” before the competent court to be able to continue the enforcement proceedings, which means that the enforcement process becomes lengthy and cumbersome if the debtor refuses to cooperate and even if it does so entirely without showing justification.

The enforcement process is also lengthy given the procedure and time period prescribed for the sale of goods. Sale by auction, for instance, must be announced one month prior to the sale. An asset cannot be sold in the first auction if a particular value (equal to the aggregate of (i) 50% of the estimated value of the asset and (ii) the amount of enforcement costs) is not obtained. Thereafter, the enforcement office must proceed with the second auction, which cannot be earlier than twenty days after the first auction. Although this is mainly to ensure value is achieved for the asset, it makes the process lengthy and cumbersome.

There are other methods which ensure both that value is obtained and which do not lengthen the process. There are examples under international regimes where independent valuations by properly qualified valuers of assets (which can be obtained without any undue delay) can serve to ensure that value is achieved, without holding up enforcement or realization.

The cleaner the enforcement processes, the greater the attraction local loans will have to international investors and the quicker they will enter the market to acquire them, and the quicker local banks’ balance sheet issues will be resolved. This is particularly important for international funds that may not be familiar with the Turkish enforcement regime, which is quite debtor-friendly due to the lengthy and cumbersome enforcement process. Ironically, though, as much as that feature might favour debtors wishing to defer enforcement, it also acts as a major deterrent to international investors who would otherwise be willing to acquire exposures (at a discount to face value) and to restructure them to allow viable businesses to carry on in business with their balance sheet repaired, enhancing equity value, employee prospects and the general economy.

Action recommended: The Turkish enforcement regime should be revisited in its entirety to ensure that creditors are subject to an expedited enforcement process. In particular, the fact that debtors have an objection right at almost every stage of enforcement without any justification is a tool that can be used by debtors to make it difficult for creditors to recover their receivables and is a discouraging factor for foreign financial institutions lending to Turkish companies who would otherwise bring restructuring skills and liquidity to the market.

Dispute Resolution: The Regulation sets forth that the disputes arising from restructuring agreements will be settled by an arbitral tribunal established according to the Framework Agreements. The BAT determined the principles for the formation of the arbitral tribunal: the arbitral tribunal will not be composed of professional arbitrators who are legal experts and arbitrators will not receive monetary compensation for their duties. Further, there is no requirement for all of the arbitral tribunal to be composed of legal experts.

This particular arbitral tribunal composition creates the possibility that disputes cannot be settled quickly and efficiently. An arbitral tribunal composed of finance law experts and that operates according to international arbitration standards is crucial to quickly and effectively settle disputes arising from such complex and multilateral legal relations as financial restructuring.

Action recommended: Authorizing the Istanbul Arbitration Centre, which is the domestic institutional arbitration institution of the Republic of Turkey, to hear financial restructuring disputes will allow them to be settled quickly and efficiently.