‘The current market is very different to what it was like this time last year. There are many more opportunities for investors to be looking at, and that will only become greater as the year develops.’
As this comment from Sam Brodie, restructuring partner at Shearman & Sterling encapsulates, the restructuring market is in flux. Since the pandemic hit, law firms have braced for a deluge of insolvency and restructuring work. In fact, faced with a unique crisis and a backdrop of large corporates with capital structures more complicated than ever, many firms bolstered their restructuring teams. Brodie was himself part of this trend, having joined Shearman in March 2021 from Akin Gump.
But now, more than two years on from the UK’s first Covid-19 lockdown, a lot has changed. Since then, temporary government support has come and gone, and new economic challenges have emerged. Speaking with Shearman’s Legal 500-ranked corporate restructuring and insolvency team, The In-House Lawyer reflects on the market.
Despite the perfect storm of 2020, the restructuring market in 2021 was notably subdued. While the number of UK company insolvencies snuck up 11% from the previous year, according to government statistics, they remained below pre-pandemic levels and distressed investment opportunities were comparatively sparse. Explains Brodie: ‘2021 was a muted environment for the restructuring community. The cases that were out there were generally legacy cases and involved a few of the issues that flowed from Covid, but new cases were relatively few and far between compared to 2020 and years prior to that.’
Instead, many companies were able to ride out adversity relying on temporary measures introduced by the Corporate Insolvency and Governance Act 2020 (CIGA), government support measures and the ability in favourable financial markets to raise capital through further equity or debt issues. But this is starting to change.
Now, as inflation has reached a 40-year high and interest rates surge, companies grapple with long-term economic issues catalysed by Covid-19. Brodie’s colleague, Alexander Wood, notes: ‘The uncertainty around Covid meant that there was an expectation that there would be a bump in the road, but that things would also recover. We are now out of that and there is a strong expectation among investors that businesses must demonstrate a credible business plan going forward. There’s going to be much more focus on the fundamental issue, and that is: “is there a viable business here worth supporting?”’
The war in Ukraine has created further difficulties for certain businesses, particularly those in industries heavily reliant on large volumes of oil and gas consumption, as well as those dependent on supply chains, agricultural produce and other commodities emanating from the affected areas. Investors are also sensitive to the sanctions arising from Russia’s invasion of Ukraine and to the human impact of the situation, and do not want to find themselves in positions that might have sanctions or reputational implications. ‘They have also been seeking to analyse the impact of sanctions on positions they already hold and there has been a lot of legal advice around which situations people can or cannot be invested in,’ says Brodie.
These reputational concerns chime with a wider trend of the scaling of ESG issues on the corporate agenda, adds Brodie’s fellow partner, Helena Potts. ‘ESG has a bearing on restructuring dynamics, it is not just a new money issue. Some investors are retreating from certain markets where they feel less able to deploy their capital. The most obvious one is the oil and gas markets where we see a contraction in the number of finance parties willing to follow their money, or even amend and extend their historical exposures.’ Though, as Potts notes, this could provide new, more lucrative opportunities for investors who continue to operate in these spaces.
Still, the ripples that are starting to be felt in the SME space will likely soon hit big corporates, says Brodie. ‘Because a lot of the larger corporates used 2020 and 2021 to focus on liquidity and to amend or refinance their capital structures and push out debt maturities, the macro headwinds that we have seen over the last few months haven’t yet pushed a lot of these corporates into restructurings, but they certainly have the potential to, whether that’s a consequence of impending maturities, liquidity shortfalls, covenant breaches, audit pressures or other defaults.’
Going forward, some sectors will inevitably be more vulnerable in the initial wave, but Wood warns that there are few businesses completely immune. ‘There are localised pockets, but the reality is that there are lots of sectors being impacted. We are facing a genuine worldwide economic set of circumstances that are going to put pressure on a lot of businesses and the broader that pressure and the broader the impact, the further reaching the tentacles of recession become.’
These developments come at a time when there has been a shift in the regulatory landscape in the UK. In addition to temporary measures designed to curtail the impacts of Covid-induced lockdowns, CIGA introduced three permanent tools to facilitate easier resolutions.
These include a restructuring plan regime that allows for distressed companies to propose a restructuring arrangement, as an alternative to schemes of arrangement, to compromise the claims of creditors and/or shareholders. The Act also introduced a new standalone moratorium as well as a prohibition on the application of ‘ipso facto’ automatic termination provisions on insolvency, which preserves the insolvent companies’ supply contracts, to aid its rescue plan.
According to Brodie, the restructuring plan is ‘a game-changer in the restructuring world’. ‘It has given debtors a lot more leverage and control in managing their creditors towards a sensible resolution or compromise of liabilities,’ he says. The regime also allows debtors in certain circumstances to cram down or disenfranchise dissenting creditors (or shareholders) to drive a quicker resolution, which, albeit a positive for distressed companies, is an additional risk factor for creditors to consider given that it reduces any power they might otherwise have to ‘hold out’ for a more favourable resolution.
However, the proactivity in the UK to adapt to the market challenges has been received favourably, says Wood. ‘The restructuring plan is a powerful tool both locally and internationally,’ he notes. ‘One of the things that lawyers were concerned about was whether Brexit would affect the UK as a restructuring hub, but this has not been the case at all. The UK has continued to be a hub for European restructuring and provided you have got English law in there or English assets, there’s always going to be a good case for restructuring under a UK restructuring plan.’
Looking forward, the evolution of the regime through judicial interpretation will be closely followed. Despite being a relatively new restructuring tool, a number of restructuring plans have passed through the courts. In one recent example from March 2022, for Smile Telecoms Holdings, the High Court approved the first plan to exclude out-of-the-money stakeholders from voting. ‘The court found that the shareholders of the scheme company could be disenfranchised on the basis that they had no genuine economic interest left in the business. That has been of particular interest to the market generally because it’s the first time the court has sanctioned the use of that power,’ highlights Brodie.
Yet, there are other areas yet to be addressed. ‘We think there will be a significant pressure point when competing parties have different views as to what the “relevant alternative” is, in circumstances where the debtor is seeking to use the cram-down mechanism,’ Brodie notes. The concept of the relevant alternative refers to the hypothetical scenario that is most likely to occur if not for the restructuring plan being sanctioned by court.
‘Creditors’ claims can only be crammed down if they would be no worse off in that alternative outcome,’ explains Brodie. ‘If you have one set of dissenting creditors saying: “we would be better off in the relevant alternative if there were no restructuring plan and so we shouldn’t be crammed down”, and the debtor saying “you would be no worse off in the relevant alternative” such that the restructuring plan and cram-down mechanism should be approved, the court will be asked to adjudicate as to which is the most likely relevant alternative. In that circumstance, there may be a point of difficulty for the court as it will have to assess competing financial models and evidence being presented to it.’
As such, the restructuring and insolvency space is likely to remain in flux as it faces novel and ever more complicated scenarios. And, if market sentiment is to be believed, there are plenty of these expected in the coming years.
As Potts concludes: ‘Capital structures are now more multi-layered and nuanced than they were around the time of the global financial crisis; the providers of capital are more diverse and with varying degrees of risk appetite and willingness to engage in distressed processes. Being able to understand and manage these dynamics to find implementable solutions is a key requirement for advisers operating in this space.’