Interest, defined as consideration paid by a debtor for the use of a loan during its term, is generally paid only until the maturity of such a loan. Once the debtor of a loan defaults on repayment under the pertinent loan agreement, interest in its purest sense is no longer paid. Instead, the debtor should pay an additional amount to the creditor as damages for the late payment. Such damages, may be calculated by applying a certain default interest rate to the debt amount for the late payment period. Under Korean law, such default interest rate should be the same as the interest rate set forth in the loan agreement unless otherwise provided thereunder. If a default interest rate is higher than the interest rate stipulated by the loan agreement, then the higher rate will be applicable. A statutory default interest rate ceiling of 25 percent per annum previously obtained, but this has since been abolished under the terms of the IMF restructuring program. Prior to the financial crisis and the advent of high interest rates, the standard interest rate applied by most commercial banks in Korea was approximately 12.5 percent per annum. However, the market interest rate as demanded by alternative sources of financing, and to which borrowers who had exhausted credit with the banks were forced to turn, was considerably higher for various reasons. Consequently, unless the loan agreement set forth a default interest rate for late payments that was considerably higher than the market interest rate, debtors were reluctant to repay their debts in a timely manner because by not repaying such debts, the debtor could derive certain benefits from the difference that existed between the default rate, usually the standard interest rate of 12.5 percent per annum plus a penalty in the order of two percent, and the significantly higher market interest rate. The same phenomenon still applies in instances of breach of contract when a party to a contract who is in breach thereof is obliged to pay damages to the other party. When a debtor defaults on an obligation to pay damages to the other party with a certain period of time as determined by law, the debtor is obligated to make an additional payment to the non-breaching party as damages for late payment. Unless a default interest rate for calculating such damages is provided in the contract, under Korean law, such a rate should be five percent or six percent per annum according to the nature of the transaction. In this context, the breaching party might be willing to delay payment of damages to the other party because the debtor could then enjoy the benefit of the difference between the default interest rate and the market interest rate. Indeed, the longer the debtor delays payment of such damages, the greater the benefits the debtor could derive. In fact, such situations create advantage to most debtor Korean companies in default, and in theory it could be very difficult to collect their debts unless they paid them voluntarily. In view of the fact that most Korean companies have a certain amount of debt to commercial banks or other financing sources at the standard interest rate or higher, they inevitably may suffer some financial loss as a result of paying interest on the loan to the banks at the standard interest rate or higher, but would benefit from paying damages as a defaulting party arising from such default at a lower rate. Even if the creditor commences legal proceedings, the debtor companies could resort to stalling tactics and extend the proceedings as long as possible if the applicable rate in calculating the creditor's damages arising from default to be paid to the creditor is lower than the market interest rate and such debtors could therefore benefit from the difference between the two rates in the manner as explained above. Some debtor companies even request their legal counsel delay the proceedings for as long as possible. However, certain statutory measures exist to prevent such undesirable conduct. For example, once legal proceedings have commenced, the statutory default interest rate with respect to the judgment award is 25 percent per annum, which is applicable from the day after the service of a writ of summons. However, if the debtor's protests during the proceedings are not deemed to be simply delaying tactics, the court, as a practice, would apply such a statutory default interest rate only from the date of judgment, which would be much later than the day after the service of a writ of summons. In practice, the courts have rarely applied such a rate from the commencement of proceedings. Thus, this statute has not completely wiped out the tendency of the debtor to delay the proceedings for the purpose of maximizing the benefit derived from the difference of the applicable default interest rate and the market interest rate. Currently, the market interest rate has increased to 20 percent per annum or more, and even the commercial banks quote around 17 percent per annum as the standard interest rate for loans. It is understood that such high rates cannot be assumed by the bulk of low-productivity Korean companies. Most debtor companies, therefore, are faced with two options: either pay their debts as early as possible to avoid any excessive financial losses arising from such high interest rates on their debts; or, default on their debts to take advantage of the difference between the market interest rate and the applicable interest rate imposed by court proceedings. Although no statistical data are yet available on this issue, most debtor companies are likely to be more inclined to default on their debts than in the past unless, for example, a mortgage on property provided as a security to the bank is to be foreclosed. In particular, they could also default on their debts arising from general commercial transactions as there would be no consequences of the severity of the foreclosure of a mortgage. Small-sized companies or those with less healthy credit ratings could be more vulnerable to such temptation. Such companies may willfully default on their debts while attempting to collect outstanding debts that are owed to them. Since the advent of historically high interest rates, some corporate lawyers expected that they would be besieged by creditors wanting them to collect outstanding debts, and likewise that a equal number of debtor companies would seek assistance in delaying repayment of their debts. Surprisingly, however, there appears to be no indication that such willful defaulting occurs more frequently now than in the past, even though the number of corporate insolvencies has increased dramatically. Considering that more than eight months has passed since the so-called "IMF system" was put in place involving extremely high interest rates, a serious credit crisis may have resulted if a substantial number of debtor companies had defaulted on their debts. Further, the number of pending debt collection cases filed with the courts would also have increased. Such is not the case in Korea at present. It appears that the companies that have become insolvent are not the ones that have willfully defaulted. Indeed, there has been no remarkable change in the "psychology" of the debtor companies notwithstanding the increase in the market interest rate. Needless to say, there are various other factors which debtor companies must consider before deciding to default on their debts and take advantage of the difference between the market interest rate and the applicable default interest rate through court proceedings. For example, they still appear to give more weight to their credit standing on a long-term basis over any short-term financial advantage in this regard. If they are of an optimistic disposition and anticipate the current economic downturn will not be over-long, they may not be willing to sacrifice their reputation in order to hedge against any financial loss related to interest rates. At present, such considerations seem to deter debtor companies from defaulting on their debts, en masse. Under the current framework there is certainly the opportunity for moral hazard created by the existence of a legal loophole which debtors may take advantage of. They may indeed default on their debts to benefit from the difference in the market interest rate and the applicable default interest rate for late payments, particularly when the market interest rate is rapidly increasing. Until now, however, there has been little change in debtors' psychology with regard to payment of their debts occasioned by the attraction of obtaining a more favorable rate of interest. It appears to be other forces beyond the law, such as debtors' innate optimism, which are maintaining stability in the Korean economy. Fortunately, Korean market interest rates have begun to decrease, and any
temptation for debtor companies to default on their debts to take advantage of the
difference in the relevant interest rates will soon become less intense than earlier
this year. To the extent that optimism regarding Korea's economic recovery
exists, it does not appear that debtor companies will attempt to exploit the legal
loophole by defaulting on their debts to benefit from a difference in interest rates. by Jong-Ku KANG For more details, please contact |
