The recent spate of corporate restructurings and rescues is testament to the combination of difficult and inter-related conditions currently facing companies. This includes a lack of new bank finance, concern about debt-heavy balance sheets, exposure from insolvency of debtors and, perhaps most critically, lack of liquidity. The likelihood that these conditions will prevail for quite some time has meant that debt-for-equity swaps have re-emerged from their use in the 1990s as a popular form of corporate rescue. Forms of debt-for-equity swaps
The mechanism involves creditors or lenders accepting equity in the debtor company in return for writing off the company’s debt. The equity offered may take the form of shares, warrants and options. A simple swap will involve a lender or creditor exchanging debt for shares in the debtor company. Schemes of arrangement may be useful where unanimous consent of secured creditors is required by the security documents, but is unlikely to be given. A company voluntary arrangement may also provide for a debt-for-equity swap.
How much equity?
For lenders, the requirement to consolidate accounts may have some impact on the size of the stake desired. The company, for its part, will wish to avoid triggering change of control provisions in its contracts. The company may also wish to minimise dilution of its shareholders’ holdings.
Type of equity
The form of equity offered to lenders will depend on the company’s existing capital structure, the nature and extent of indebtedness and the parties’ bargaining positions. If a lender is to take ordinary shares, this will mean it ranks below secured creditors in insolvency. It is therefore likely to demand enhanced voting rights, vetoes, and preference shares to exert as much control over the company as possible. Care should be taken to ensure that preference shares are treated as equity (not as debt) and accordingly auditors should be consulted at an early stage. From the company’s perspective, issuing ordinary shares will dilute the stakes of existing shareholders.
Advantages for the company
The attractions of a debt-for-equity swap are evident. The company will benefit from a reduction in gearing, lower interest payments and improved liquidity. The company will therefore be in a better position to survive the challenging economic times and will appear more attractive to investors. Banks will also be more likely to provide favourable credit terms when facilities come to be renewed.
Advantages for the lender
For the lender, the basic attraction of a debt-for-equity swap is that it has the chance to recover some or even all of the amount of its lendings if it chooses to participate. Taking this chance may be a better prospect than recovery following insolvency procedures, which may see unsecured creditors and under-collateralised secured creditors receiving only a portion of their debt.
Considerations for listed companies
Most debt-for-equity swaps result in the lender(s) becoming significant shareholders in the company. Special consideration is necessary where the company is listed. The UK Listing Authority (UKLA) will seek to ensure that the company remains suitable for listing after the restructuring. It will have particular regard to the requirement for 25% of the listed share capital to be in public hands and the requirement that the company conducts its affairs independently from any shareholder holding a 30% stake.
The lender will want to avoid triggering a mandatory offer, under which it would be forced to offer to purchase all equity shares and certain non-equity shares in the company for a cash price at least equivalent to the highest price paid for shares in the past 12 months. This rule is activated if a party alone or acting in concert acquires shares that carry 30% or more of the voting rights in a company. Lenders in a syndicate may be construed to be acting in concert.
Going forward
The economic downturn has led to a market where more and more companies are grappling to shed costs, maintain credit facilities and generally weather the storm. Debt-for-equity swaps are an appropriate mechanism where a company is in short-term difficulty, but its lenders recognise that the company has inherent value and will ultimately recover. Liquidity, however, is not just a problem for companies and it remains to be seen whether lenders will tend to insist on liquidation as another means to recover their funds.
By Barry McCaig, corporate finance partner, McGrigors LLP. E-mail: barry.mccaig@mcgrigors.com.
