Where a borrower is in financial difficulty, it is likely that there will be simultaneous triggering of default clauses across facilities with most or all of its lenders. Even if the borrower has not ceased payments on a facility, the default under one facility is usually a default under other facilities, thereby accelerating the obligation to pay (automatically or on demand) and allowing each creditor to enforce its security. This may lead to a race of creditors to enforce. As an alternative to insolvency proceedings, the creditors may restructure.
Restructuring may offer the opportunity of an eventual sale at a better price and may involve lower costs. Restructuring assumes that the borrower (usually a company) has value, that it can be turned around and that the consent of the borrower and its principal creditors are available.
In this and the following chapters, the borrower is assumed to be a company. Companies can be owned and classes of shares can be created so as to structure this ownership in any way that the parties agree, subject only to some legal constraints. Although it is possible to enter standstill arrangements with individuals, restructuring in the sense set out in this chapter in relation to companies is not feasible. Also, it is assumed that there may be other creditors, whose participation in the arrangement is critical.
A standstill agreement is usually the first step in a possible rescue. The standstill agreement may be sought by the borrower itself. Standstill agreements are sometimes called “moratoriums” or “forbearance” agreements. It is usually put in place while the position is investigated and a possible rescue plan is be considered. It will include an agreement by creditors not to enforce their debts or commence insolvency proceedings. It will generally will be necessary that the arrangements are kept confidential, given the possible damage to reputation, risk of panic and resort to litigation.
A standstill agreement is designed to allow time for a longer term solution, such as by a restructuring agreement. The borrower will usually agree to co-operate with the creditors and work towards a restructuring plan. It will agree to provide all necessary information, access to accounts and to the borrower itself. It will agree not to undertake further borrowing or grant further security or do anything which might jeopardise the borrower. It will agree not to seek to place the borrower in liquidation or to dispose of any assets.
Investigation and Disclosure
It is critical that the creditors get full and frank disclosure from the borrower of its financial situation. It is common that an accountant is put in place to investigate the position. A surveyor may be involved in relation to an investment property or development property security.
There may be a legal, accounting and survey due diligence. The legal due diligence will seek information about the borrower, its assets, the likely impact of enforcement, insolvency and other liabilities. The accounting due diligence will usually verify the accuracy of information furnished, critically assess projections and the proposed business plans.
A core principle of restructuring is that creditors share the risks and rewards equally. Generally, creditors will seek fairness and equality in the context of their existing positions. A creditor should not improve its position nor be prejudiced relative to others. Creditors may agree arrangements during the standstill period whereby monies received on a particular security may be placed for the benefit of all creditors in trust.
There are likely to be different types of creditors. It is a matter for negotiation how the respective rights of creditors are dealt with, in the restructuring agreement. All creditors should ideally be included in a standstill agreement. The entry of a standstill agreement may itself be a ground for an insolvency order. A non-participating creditor may therefore commence insolvency proceedings. Trade creditors will not generally be included. They may need to be paid as part of the plan in order to keep the business trading.
The standstill agreement may require each creditor to give up its rights against the borrower under its loan agreement in favour of a decision of the majority under a decision making procedure in the standstill agreement. The following may be given up to majority decision:-
- reducing or withdrawing facilities;
- declaring an event of default and accelerating payments;
- amending the agreement;
- exercising set-off;
- waiving breaches of covenant;
- commencing legal proceedings;
- appointing an insolvency practitioner over the borrower;
- charging interest.
The standstill agreement may provide that certain key matters must be agreed by all creditors. Other matters may be decided by a majority. The agreement might provide that decisions are delegated to a smaller group of creditors such as a steering committee. This can facilitate the process.
There are likely to be different types of creditors. It is a matter for negotiation how the respective rights of creditors are dealt with in the restructuring agreement.
The standstill agreement may provide for an injection of new cash in order to allow the company to trade or to provide for employees. Trading needs and working capital needs may be met by a lender agreeing to provide additional finance. If this is done, there may be agreement between a number of lenders in relation to the priority of the additional money to be injected. The lenders may agree that if there is a default there will be a proportionate sharing in the losses.
The agreement may require the company to implement a cost cutting plan. It may be required to sell assets. Dividends and payments to creditors will be prohibited.
A standstill agreement may seek to insulate directors against the risk of incurring liability for wrongful, reckless or fraudulent trading. In return for a standstill agreement, the borrower’s promoters or shareholders may themselves agree to make some additional provision such as additional security or cash. In the absence of this, the directors may risk liability and be effectively obliged to wind up.
The creditors may agree to provide new loan facilities. They may negotiate different rates of interest that may require additional security or guarantees.
The standstill agreement may allow for a new creditor to advance new monies which will have priority for repayment. The new money provider may require security and a guarantee. The provider of the new monies may require a priority agreement. Creditors might be obliged to accept that their security ranks behind that of the provider of the new money.
The standstill agreement should be flexible to allow for various possibilities. The agreement will normally be, for a one to three month period, depending on the circumstances.
Generally, the standstill agreement will be deemed terminated if any of the following occur, application for insolvency, breach of material legal agreements or failures of compliance by the borrower. A majority of the creditors will usually be required to terminate the agreement. If there are different types of creditors, each class might have its own vote. If all goes to plan the Agreement will be terminated on conclusion of the restructure with adequate protections. The restructure should provide a basis for proceeding without the moratorium.
A restructuring agreement refers to a range of agreement types and does not have a fixed meaning. It may refer to a variation of the loan agreement itself. In the company context, it usually refers to a variation of the loan agreement in conjunction with a fundamental reorganisation of the company’s business and / or its share capital. The restructuring usually refers to the company itself.
The restructuring agreement may involve several or most creditors. It may involve the repackaging of the “good” parts of a company business and / or a debt for equity swap. These types of arrangement are discussed in the next chapter. It may involve the use of insolvency procedures or may be undertaken outside of insolvency
A “standstill” agreement is more short term in nature, while the restructuring agreement is a longer term solution. A restructuring agreement may contain some of the same terms as a standstill agreement. It will often follow after a standstill agreement and be the longer term resolution of the problems. The labelling of the agreements is descriptive only and is not important.
In so far as a restructuring agreement involves a variation of the loan agreement, the provisions set out in our chapter on variation agreements may be incorporated to varying extents, as the circumstances require. Therefore, the agreement may contain one or more of following types of clause, which are considered in more detail in that chapter;
- preconditions and immediate obligations;
- warranties and representations;
- varied commercial terms;
- tighter covenants;
- additional security;
- other provisions.
A restructuring agreement may be implemented in the context of a development loan. See our chapters on development workouts.
There may be an interbank arrangement between the various lenders. This would be like a syndicated lending facility, by which there is a lead lender or agent acting on behalf of the groups. There may be an agreed sharing of total security. The lenders may appoint the lead banker as agent to coordinates the arrangement.
Restructuring in one sense involves reorganising the business so as to return it to profitability. This may follow from a business plan. This may involve improving organizational structure or making operations more efficient. This may involve identifying operational inefficiencies, saving costs and reducing overheads. It may involve downsizing or winding down unprofitable business segments, divisions or affiliates and removing any weaknesses in systems, procedures and controls.
The restructuring may involve implementing a business turnaround plan. It may also involve avoiding future risk situations rectifying the causes of the company’s past shortfalls, seeking business partners and mergers or acquisition opportunities. It should assure the businesses short-term and long-term viability on the basis of sustainable, short and long-term financial cash flows and projections.
A particular feature of companies is that shareholders’ rights are similar to those of creditors, to some extent. Creditors’ rights depend on the net income and net capital of the company. They take the upside and downside of the company’s fortunes. They are entitled to what is left (if anything) after payment of creditors in a winding up.
Corporate restructuring in the strict sense involves a fundamental reorganisation of the way in which company’s debt and share capital is held. Company law facilitates the exchange of shares for debt. It also facilitates the repackaging of the “good” parts of a company’s business into another company in exchange for shares in that new company (which are then sold).
Restructuring may be formal or informal. Where it is informal, it operates outside of the insolvency rules. Informal arrangements are more flexible and not subject to time limits, court procedures, additional costs and expenses. However, there is a risk that creditors who do not become party to the agreement or who are not wholly provided for in the agreement may seek liquidation or enforcement of their debt against the company’s assets. Certain types of reconstructions cannot take place in the case of an insolvent company without court sanction. The insolvency procedures can be essential in that they provide a moratorium against enforcement.
Formal Company Restructuring
A company arrangement may involve transfers of assets to another company in return for shares in that company. Generally an insolvent company cannot transfer its assets. However there are company law procedures for reconstruction which allow arrangements for reconstruction of the company and subsidiaries with court approval. These procedures also facilitate debt for equity swaps.
The above procedures are cumbersome and have not been used often in recent years. The more general process of examination has been used instead for the reconstruction of insolvent companies. The proposal must be approved by three fifths of each relevant affected class and approved by the court.
Company restructuring can take place in the context of examinership. See our chapter in relation to the examinership process. Any proposal that is consented to by creditors and shareholders meetings and confirmed by the court is binding on all parties, including those who did not consent to it.
Apart from examinership, there is an older procedure which enables an arrangement or compromise to be put into effect for insolvent companies. It involves the following steps;
- the company, the creditors, members, or the liquidator in the course of winding-up, apply to the court;
- the court may order a meeting of the creditors or class of creditors, or of the members or class of members as the case may be, to be summoned in such manner as the court directs;
- at the relevant meeting(s) a majority in number representing three-fourths in value of the creditors or class of creditors, present and voting in person or by proxy must agree to the compromise or arrangement;
- if subsequently sanctioned by the court it is binding on all the creditors or members or the classes as the case may be, and on the company (or in a winding-up, on the liquidator and contributories);
- before the scheme can have effect, an office copy of the court order sanctioning the scheme must be filed with the Registrar of Companies.
The court has discretion at two stages. First of all the court has discretion as to the calling of meetings; secondly, it has discretion whether or not to sanction the scheme following the holding of the statutory meetings. Where a member or creditor receives full information about the scheme and is given sufficient time to consider his position, the court will not generally interfere. The objections to the scheme by dissenting members or creditors are important factors in the exercise of the court’s discretion.
Each class of members or creditors should be accurately identified for the purpose of the various meetings which the court has power to call. The class meetings must represent the divergent interests.
The restructuring agreement will set out the terms on which the creditors agree to continue to lend. There may be a consolidation of existing facilities into one overriding agreement. The financial terms of the restructuring agreement may involve a combination of any one or more of the following:-
- new monies;
- partial write offs;
- increased margin;
- deferment or rescheduling of payments;
- extension of loan term;
- capitalisation of interest;
- debt to equity conversions.
New monies may come from a new lender, an investor or by the disposal of assets. It may be that some lenders will require to have their debt refinanced within a limited period. Lenders might also seek equity or options to take equity by way of incentive.
The new financial covenants will reflect the proposed business plan for recovery. The covenants in relation to expenditure, management, dividends, disposals, liquidity, profitability, solvency and capital adequacy will be carefully reviewed and are likely to be tightened.
There is likely to be tight control by way of covenants on what the borrower can do. These are sometimes called “short lease” covenants. This will include restrictions on substantial expenditure, dividends, disposals and on the creation of further security. Comprehensive cash flow information will be required. The agreement may require disposals of assets in a timely and structured way.
The company may have positive financial covenant targets to attain. For example, it may be obliged to attain certain targets in certain time frames. These targets may be defined in terms of net worth and financial ratios to be achieved. Default will entitle the lender to terminate the arrangement.
The creditors may require further fees, front ended or rear ended. Increased commitment fees, restructuring costs and expenses fees may be required on account.
Restructuring agreements are likely to have tax implications. It will generally be necessary to obtain specialist taxation advice. The tax rules facilitate reconstructions and re-organisations. Capital taxes that would normally arise on transferring shares and assets do not apply provided certain conditions are met.
Debt for equity swap
A debt for equity swap is where a creditor, often together with other creditors or holders of other debt security, converts its debt into shares in the debtor company. There may be an associated cash raising exercise. The swap may address issues of potential liability for directors for wrongful, reckless or fraudulent trading.
A debt for equity swap may occur where the debtor company is in difficulties but the situation is not sufficiently acute to require the appointment of an examiner or liquidator. The principal creditors accept that they are likely to receive a lower rate return, but take the view that the substitution of equity for debt is likely to lead to a more satisfactory result, provided the company returns to profitability.
A restructuring may be for the purpose of making the company more attractive for the injection of new capital by new investors. A debt for equity swap may be simply an exchange of the debt for shares. In more complex cases, there may be a new company which is funded by debt and equity provided by the bank and other investors which is established to acquire the business from a liquidator or examiner.
The main commercial issues for agreement will be as follows:-
- how much debt is to be substituted for equity;
- what overall proportion should be held by the bank;
- what type of shares should be held by the bank;
- disposal of shares.
The bank may take several different classes of shares at once. This may include redeemable preference shares which carry a particular rate of return and which may be redeemed by the company. By substituting debt for equity, the bank will be subordinating its substituted debt to other creditors. It will therefore want a return for any upside in future value. This may be achieved by making the bank’s shares convertible into equity shares. There may also be a participating dividend. This is a dividend related to profit as well as a fixed dividend.
The bank will usually require that its preference shares rank ahead of all present and future share in relation to repayment of income and capital. It will prohibit further shares of the same type or having prior rights being issued.
The shares will usually have a fixed preferential dividend equivalent, at least, to the return on the loan. However, the payment will only be made if there are distributable profits available. If there are no distributable profits, the dividend would usually be rolled up so that a notional dividend is paid and is available against the next distributable profits. The bank will wish ideally to take preference shares. Preference classes of shares are only likely to be granted, where the company is likely to be able service the preferred dividend and redeem the preference shares. If this is not the case, bank may take ordinary shares.
Dividends and Redemptions
It might be agreed that no dividends are to be paid for a period while the cash flow forecast assume this. If the existing company has accumulated losses, it will not be possible to pay a dividend until they have been extinguished by distributable profits. This may be avoided by Court approved reduction of share capital or by the establishment of a new company to acquire the debtor’s business.
The bank may require the amount of dividend to which it is entitled to be increased, if certain targets are not complied with. If, for example, the company fails to redeem shares at the agreed date, the interest rate may increase to encourage early redemption. There may also be provision for a participating dividend, in addition to the fixed dividend.
The bank is likely to seek to provide for redemption of the preference shares in line with the original loan redemption. As with the payment of dividends, redemption is only possible from distributable profits. Distributable profits may be from new funds which will be introduced at a point in time or from asset disposals.
In order to maximise the certainty of redemption, the preference shares could provide for certain control rights to kick in to prevent actions which deplete distributable profits. The right to convert may not be immediate and may be provided for, within a particular time horizon.
Preference Share Rights
The preference shares may have voting or non-voting rights. Voting rights may kick in if the preference dividends are in arrears or if redemption dates are missed. The preference shareholders rights’ can be useful in exerting control over the company’s affairs. They can be drafted in whatever way is appropriate.
Preference shares generally have rights to preclude the company from undertaking certain action, without the preference shareholders’ approval. It is possible to write these rights into the company rules. There may be prohibitions rights of veto on the following type of action:-
- issue of further shares ranking equal to or above the preference shares;
- restrictions in relation to the dividends and redemption e.g. prevent dividends or excessive dividends;
- no dilution, to protect the rights to convert into equity.
The bank may seek that the preference shares are freely transferrable notwithstanding the usual restrictions on transfer of shares. There may be some form of pre-emption agreement or right of first refusal in favour of other shareholders, in return.
A shareholders’ agreement may be appropriate in relation to the exercise of rights, following on the re-organisation of the company. There may be an amendment of an existing agreement with shareholders.
The bank may require the following rights to be enshrined in the documents:-
- right to appoint directors or observers on the board;
- rights to financial information;
- veto or voting rights on key issues;
- restrictions on directors’ activities.
A debt for equity swap will normally involve prior legal and financial due diligence. Time constraints may require a selective and pragmatic approach.
A restructuring agreement may have tax consequences which need to be carefully considered.
A restructured company may have a pension deficit. The pension scheme is an unsecured creditor but enjoys certain preferential rights. The swap could mean that the pension fund ranks ahead of the debt converted to equity.
In the case of a defined benefit pension scheme, the Pension Board has certain powers. It can require contributions to be made. This issue needs to be carefully considered.
A bank may agree a company voluntary arrangement which is binding on all creditors on the basis of a 75% vote. This could be used to (so called) “cram down” unsecured creditors.
Liability can arise for those who cause or allow environmental contamination. There is a risk that if a creditor becomes significantly involved in the day to day affairs of a business, that it could become responsible for those liabilities by virtue of involvement in the business.
There may be a requirement for new money. It may be a pre-condition of the restructuring and substitution of the swap that new money is provided for.
Where subsidiaries are involved, it may be necessary to secure that the indebtedness of subsidiary is swapped for shares in a holding company. There are a number of methods to achieve this result.
A key aspect of the swap is the proportion of equity control represented by the new shares. The bank will wish to ensure that its stake in the company does not require it to consolidate its holding into its accounts as a “subsidiary”. There are certain definitions of subsidiary in the relevant companies legislation.
Accounting standards provide for exemptions from the need to consolidate in certain interests where a subsidiary undertaking is held with a view to subsequent resale and has not been previously consolidated or where the undertakings activities are so different that its inclusion would be incompatible with the obligation to give a true and fair view of the group.