As the economy continues to contract and increasing numbers of companies are forced to confront cash flow shortages and the spectre of insolvency, a debt-for-equity swap may be one of the restructuring tools debtors and creditors will use to avoid a formal insolvency. This article provides an overview of debt-for-equity swaps and also considers the legal and commercial issues that may impact on the implementation of, and possibly determine the ultimate success of, the equitisation. Although the analysis is principally focused on larger corporate borrowers with various debt tranches, most of the principles are equally applicable to all debt-for-equity swaps. Background
A debt-for-equity swap involves the exchange of debt owed to (almost invariably financial) creditors for share capital of the borrower. Like any restructuring, the form and complexity of debt-for-equity swaps varies widely depending on the nature and size of the borrower and its capital structure, the attitude of its creditors and any additional legal constraints to which all, but in particular listed companies, are subject. In recent years notable names such as Eurotunnel, Schefenacker, Metrovacesca and Crest Nicholson have all restructured their balance sheets via debt-for-equity conversions, but the procedure also features within smaller private restructurings. Recognising this, on 14 January 2009 the government announced a Capital for Enterprise Fund of £75m to be used to exchange debt for equity in qualifying small companies. The fund will provide equity and quasi-equity (explained below) of between £250,000 and £2m for companies with turnover of up to €50m that have viable business models and growth potential but are in need of long-term capital.
Benefits to the borrower
After a decade of cheap credit fuelling highly leveraged acquisitions and rapid corporate growth, many borrowers now face the ominous prospect of servicing high-interest payments with dwindling cash flows. By deleveraging, the borrower will be commercially more competitive and could seek extended payment terms from trade creditors (some of whom may have started to demand payment on delivery) creating greater cash flow headroom. Furthermore, an injection of fresh equity by banks or other financial institutions is likely to enhance the borrower’s prospects of being able to raise additional debt finance on the back of a perceived improvement in its covenant strength. Borrowers should be aware, however, that agreeing and implementing a debt-for-equity conversion can be an expensive and time-consuming process.
Directors of the borrower
Once a company is in danger of not being able to pay its debts as they fall due, the duty of the directors to promote the success of the company includes a duty to consider the interests of its creditors, now recognised in statute by s172(3) of the Companies Act 2006. In addition to this fiduciary duty, the directors must also be aware of the personal liability they could incur if they are found to be guilty of wrongful trading under s214 of the Insolvency Act 1986. It is in the directors’ personal interests to ensure the survival of the company as a going concern and a debt-for-equity conversion may be the only means of avoiding insolvency.
Where the borrower is likely to trigger a default under the terms of its debt, it is advisable that as part of their contingency planning the directors initiate discussions with creditors as early as possible. Yet in situations where the directors own some or all of the equity of the borrower (as is often the case in private companies) and/or where management is incentivised by potential equity rewards under a share incentive plan, the directors may be reluctant to take steps to dilute the value of that interest. Nevertheless a delay in instigating discussions with creditors will usually diminish the restructuring options available to the borrower as time moves on. In turn this could further undermine the borrower’s negotiating position, as well as potentially exposing the directors to criticism and, in serious cases, to personal liability. Ultimately, directors should realise that a restructured balance sheet may again enable the borrower to generate profits available for distribution and, where the directors are also shareholders, return some value to their own equity in the borrower.
Considerations for creditors
1) Position of other creditors
Security held by a creditor that converts its debt into equity will obviously become obsolete, since the secured debt will be extinguished. A secured creditor (almost invariably a bank holding senior debt) whose claims can be met out of the secured assets will therefore have less interest in a debt-for-equity proposal since it does not face taking a write-down on its investment in the event of the insolvent liquidation of the borrower. Provided the restructuring proposal will allow the borrower to meet its senior debt repayments going forward and does not effect the value of their security, the senior lenders may not even participate in the conversion and simply keep their debt facilities in place to finance the borrower’s working capital needs.
One of the most crucial and contentious areas of any restructuring is the value placed on the business as, among other things, this will determine where the value breaks: the class of debt that will suffer a partial or complete loss of investment on formal insolvency. Since creditors in this debt tranche will expect to receive the greatest share of equity on conversion, the model used to calculate business value can be intensely negotiated.
Unsecured financial creditors who purchased their debt at face value and who are facing a significant loss on their investment are likely to be happy with any proposal that enables them to realise a close-to-par return. These ‘out of the money’ creditors are likely to hold bonds, often issued on an unsecured basis and subordinated to the senior and mezzanine debt. By contrast, borrowers may be faced with creditors, sometimes known as ‘vulture funds’ that purposefully acquire sub-performing debt with a view to acquiring control of a borrower on a conversion (known as a ‘loan to own’ strategy). Because these distressed debt investors purchase their debt on the secondary market at deep discount they can afford to accept a substantial write-off on its face value. Consequently, such funds may actively engineer a restructuring to acquire an equity interest that could ultimately yield far higher returns than would have accrued to them from their initial debt investment.
2) Nature of equity
To preserve priority over existing shareholders, the converting creditors will require shares that are as similar as possible to debt. This is usually accomplished by the issue of redeemable preference shares carrying a fixed dividend entitlement and priority on any return of capital (sometimes referred to as ‘quasi-debt’). Creditors will also usually look for a participating right to share in any additional dividend declared by the borrower and/or a right to convert their preference shares into ordinary share capital to benefit from any increase in future equity value. Irrespective of the enhanced rights attached to the shares, however, any return on the shares is dependent either on distributable reserves being available or the shares having some value on a future sale or return of capital.
3) Existing shareholders and minority creditors
Any debt-for-equity conversion will require the support of the borrower’s existing shareholders, for example in giving the directors authority to allot new shares and/or to agree to the disapplication of pre-emption rights on issue. In most equitisations these shareholders will see their equity massively diluted, often down to less than 5%. The debt-for-equity swap proposal must be able to convince unhappy shareholders that retaining a minority interest in an ongoing business offers a better potential return than they would receive in an insolvency. Frustrated at seeing the value of their equity written down, certain shareholders may seek to hold out for an improved deal by withholding their consent to the restructuring proposals.
Minority creditors may also consider that insufficient value has been attributed to their interest and may (depending on the terms of any intercreditor agreement) instead seek recovery by having an administrator or liquidator appointed to the borrower. Such opposition may require that the proposals be amended or else implemented by way of scheme of arrangement or company voluntary arrangement (CVA) in order to ‘cram down’ the dissenting creditors. A scheme of arrangement is likely to significantly increase costs due to the required involvement of the court in the process. Furthermore the requisite approval thresholds (majority in number plus 75% in value of the classes voting for a scheme and a simple majority in value of members and 75% by value of the creditors voting on a CVA) may be difficult to achieve if there is significant opposition to the proposals.
An alternative means of overcoming dissenting creditors and shareholders may be to use a pre-pack structure whereby a new vehicle (newco) is set up to purchase the business and assets of the borrower out of administration. Existing creditors of the borrower would become shareholders of the newco, and would fund newco to buy the borrower’s assets.
4) Control issues
Once restructuring negotiations have commenced and particularly where the borrower is already in default, creditors will require some form of control as a condition of their continued support. As in any form of restructuring, creditors should be wary of being too active in directing the actions of the borrower. Particularly in circumstances where creditors are seeking to force resignations of directors or put their own appointees on the board they need to be careful not to attract liability as shadow directors.
Section 251(1) of the Companies Act 2006 defines a shadow director as someone ‘in accordance with whose directions or instructions the directors of the company are accustomed to act’. Although courts will be very reluctant to find a creditor, acting to protect its own interests, to be a shadow director (for example see Kuwait Asia Bank EC v Mutual Life Nominees Ltd [1990]), in Re a Company (No 005009 of 1987) [1989] a clearing bank failed to strike out an allegation made by the liquidator of an insolvent company (although the allegation was not ultimately pursued) that it had acted as a shadow director and could therefore be liable for wrongful trading.
5) Negotiation and implementation
As noted above, debt-for-equity conversions can be time-consuming and expensive. Since time and money are invariably in short supply for struggling businesses, certain steps are usually required to enable negotiations to get off the ground. For highly syndicated facilities and/or where there are a large number of bondholders, it will be necessary to create steering committees of the various creditor classes to streamline the negotiations. A standstill agreement may also be required so that all parties can negotiate without the threat of action being taken by creditors (for example acceleration of debt or enforcement of security) that would scupper any prospect of a restructuring.
Some form of interim financing is likely to be needed to support the business during the standstill. Since some facilities may be used more than others during this period, an intercreditor agreement should ensure that should a repayment default occur, the sale proceeds of any assets sold on subsequent enforcement are distributed pro-rata to each creditor’s exposure at the date the restructuring commenced, as opposed to the position at the time of enforcement.
6) Impact of conversion
Converting creditors also need to consider the possible legal, accounting and tax implications of taking equity. An in-depth analysis of these matters is beyond the scope of this article but certain issues should be noted:
- Shareholder rights and obligations: a new set of articles and/or shareholder agreement will usually be required to regulate shareholder rights in the borrower (or the newco used to purchase its business).
- Takeover Code: where the Takeover Code applies to the borrower particular consideration should be given to rule 9 that requires a purchaser (including any parties acting in concert) of an interest in shares carrying 30% or more of voting rights to make a mandatory offer for the entire equity share capital and any transferable securities carrying voting rights. To avoid triggering the rule 9 obligation, the conversion will need to be ‘whitewashed’, ie approved by an ordinary resolution of the independent shareholders.
- Consolidated accounts and capital adequacy: subject to certain exemptions, taking a controlling equity stake will require the converting creditor to factor the borrower into its consolidated accounts, which may have a negative impact on group financial results. Banks also need to consider the potential impact of exchanging debt for a higher risk-weighted asset on their capital adequacy requirements.
- Disclosure: some debt investors may be uncomfortable with the disclosure and reporting requirements of the Listing Rules and/or Disclosure and Transparency Rules, where applicable.
Conclusions
A debt-for-equity swap is a significant corporate rescue tool, and can be used to ease the financial burden on borrowers and potentially improve recovery for lenders by transferring short-term debt obligations into rights to receive a return on shares in the future. Yet striking the right balance in a debt-for-equity swap can be difficult, particularly under the time pressure applied to many restructurings. The headline terms of any agreement will reflect the bargaining position and attitude of the creditors, shareholders and directors involved in negotiations. Nevertheless it is the detail that will knit any equitisation together and potentially determine the success or otherwise of the restructuring for each party.
Tom McKay, associate in the business restructuring and reorganisation practice group, Jones Day.
E-mail: tmckay@jonesday.com.
