The last two years have seen significant developments and unexpected turns in the financial restructuring market. The impact of the Covid pandemic precipitated an immediate and significant uptick in the level of corporates facing underperformance and distress, only to be followed in 2021 by an incredibly ‘hot’ financing market and significant drop-off in corporate default rates – a consequence, among other things, of unprecedented levels of government support provided across the major global economies, an active M&A sector, a low interest rate environment and strong asset valuations.
By the start of 2022, among other challenging macro-economic factors, it was clear that supply-chain difficulties, mounting inflationary pressures and resultant interest rate hikes would start to put pressure on certain corporates, especially those that were exposed to commodity costs and/or already experiencing financial difficulties in the form of liquidity shortages or over-levered balance sheets. Those challenges, exacerbated by the conflict in Ukraine, have intensified throughout 2022, and recent US and UK insolvency data points towards, and the market anticipates, an increase in default rates and restructuring cases over the next year.
Against that backdrop, this article focuses on some of the key legal developments and market trends which are relevant to stakeholders whose interests are or may become subject to the UK restructuring market.
Key legal developments
The Restructuring Plan
Of the measures introduced by the Corporate Insolvency and Governance Act 2000, the Restructuring Plan (RP) has attracted the most attention within the restructuring community. Despite its infancy, it has become a powerful restructuring tool for complex capital structures, and we expect it to become even more prevalent as corporate stress increases. A recent interim Insolvency Services report has branded it a success. More recently, we could see our first RP being used in the SME space so it is not necessarily the province of larger restructurings.
The RP allows a company (which may include a non-UK company) that is facing financial difficulties to enter into a plan with its creditors and/or shareholders to alleviate those financial difficulties. While very similar to the well-established UK scheme of arrangement process, the RP contains a number of key additional features over and above what can be achieved by a scheme of arrangement, which make it an attractive method by which to reach a compromise between a debtor and its creditors. The most notable additional features are:
- Cross-class cram down, by which an RP can be imposed on a class of creditors or shareholders even if it is not approved by the minimum threshold of 75% in value of such class, provided that the dissenting class of creditors or shareholders are ‘no worse off’ under the plan than they would be in the so-called ‘relevant alternative’ and there is a consenting class of creditors or members who would receive a payment, or have a genuine economic interest in the company, in the event of the ‘relevant alternative’; and
- The possibility to disenfranchise entirely a class of creditors or shareholders from voting on the RP if that class has no genuine economic interest in the company.
In the future, companies proposing RPs will need to assess carefully the terms of their proposal in light of how the English court will scrutinise the application of the ‘no worse off’ and ‘relevant alternative’ principles that are relevant to an RP. One of the areas we believe is most likely to be a key focus of any strategy is the strength (or weakness) of the valuation evidence provided to support the RP. Creditors must also tread carefully; the power of the RP means that they need to think about the terms and structural positioning of their debt claims as against the claims of other creditors and whether that puts them at risk of being classified and isolated as a separate class of creditor capable of being crammed down. A weakness in valuation or a misjudged ‘relevant alternative’ will increase the risk of creditor challenge and the court choosing not to exercise its discretion to sanction the RP (even if the RP is approved by the applicable majority(ies)).
In light of the increasing number of cases where regulated entities have used schemes of arrangement to compromise the claims of redress creditors (see Provident Financial and Amigo Loans), the FCA has recently published guidance setting out in detail the approach it intends to take to ensure that consumers are treated fairly when compromise processes, such as schemes, RPs and CVAs, are used by regulated firms. The consumer protections set out in the FCA guidance go above and beyond the typical controls, levels of information (provided to affected creditors) and principles of fairness which the court will assess or apply when considering a scheme, RP or CVA, and regulated firms looking to launch any such process will need to be mindful of:
- The FCA’s guidance;
- Its willingness to challenge these processes if it feels they do not adequately satisfy its regulatory requirements (see Amigo Loans); and
- The competing pressures to which directors may be subject if, in a distressed scenario, they are required to discharge statutory duties to the company’s creditors as a whole, while at the same time having to satisfy the FCA’s requirement that the relevant compromise is the ‘best’ outcome possible for consumers.
Supplementing its existing controls under the Pension Act 2004, the Pension Regulator (tPR) has been granted under the Pension Schemes Act 2021 additional anti-avoidance powers in respect of defined benefit (DB) pension schemes, the most notable being its ability to investigate and prosecute any person for two new criminal offences. Those are:
- Where a person (with intention and without reasonable excuse) acts or engages in a course of conduct that prevents the recovery of whole or part of employer DB pension scheme debt, prevents such debt becoming due, compromises or otherwise settles that debt, or reduces the amount due; and
- Where a person without reasonable excuse acts or engages in a course of conduct that they knew or ought to have known would detrimentally affect in a material way the likelihood of accrued pension scheme benefits being received.
The term ‘person’ is wide in scope and includes companies, directors, trustees, professional advisers and lenders. Each offence carries a penalty of seven years in prison and/or an unlimited fine of up to £1m. However, tPR has stated that the new criminal offences are aimed at ‘the most serious examples of intentional or reckless conduct’ and that they ‘don’t intend to prosecute behaviour which [they] consider to be ordinary commercial activity’.
While restructurings of corporates with DB pension schemes have often required engagement or negotiations with the relevant pension trustee, the introduction of these criminal offences mean that stakeholders and advisers may be even more careful to engage with pension trustees and/or tPR in respect of whole business restructurings/restructurings which may affect the position of a DB pension scheme.
Sanctions arising from the Ukraine-Russia conflict have had a significant impact on corporates which have business lines in the affected areas or whose shareholders are subject to sanctions. Corporates have generally responded swiftly to these challenges, but some may remain unresolvable for the foreseeable future and continue to create operational and financial difficulties. For example, sanctions on Russian credit institutions will likely cause significant disruption for those businesses seeking to repay loans to those institutions and may limit access to alternative sources of liquidity and/or trigger cross-defaults across other facilities. Obtaining consents or waivers from lenders or approvals from stakeholders may also be difficult if those constituencies comprise sanctioned persons, which may in turn limit or prevent companies from effecting consensual amendments or restructurings to their debt terms without a cramdown process.
The prevalence of ‘cov-lite’ financings across the debt capital markets has led to a situation where highly levered or stressed corporates have been able to navigate periods of difficulty and underperformance without having to turn to lenders or bondholders for consents or waivers. In recent years, liquidity shortfalls and the related need for companies to obtain creditors’ consent to incur new money have often been the most common trigger for restructuring discussions. Even then, in many cases, permissive covenant terms have allowed companies to access new credit lines by relying on the greater flexibility for the provision of new money in leveraged finance documents. As the macro-economic stresses begin to impact businesses, pressures on liquidity will likely become greater, while some highly levered or underperforming companies will find it increasingly difficult to refinance their maturing debt (in particular those who added debt to their balance sheets to overcome the impact of Covid). Some companies may also be forced into refinancing debt ahead of maturity if audit-related pressures require them to do so. In that context, new money will continue to be a key factor in most distressed situations. Those investors ready to provide that new money will be well placed to participate in, if not drive, any restructuring process which is subsequent to or part of that new money injection.
New money terms
The terms of any new money will depend on the circumstances of each deal. If the consent of existing creditors is required for any additional debt financing, that consent is often forthcoming only if such lenders or a group of them provide that financing on a ‘super senior’ basis. Third party providers of new money, on the other hand, will have to find basket availability in the existing debt document to provide funding or, if baskets are used up or restrictions on financial indebtedness are tight, they may have to be more creative, with consideration often given to providing finance at entities outside the restrictions in existing debt documents. One critical and recurring theme is control; having provided capital in stressed circumstances, new lenders will likely expect to have mechanisms in place to protect that investment in a downside scenario, whether through security interests, enhanced governance rights or contractual provisions.
Forbearance – a return to normal behaviour?
Throughout the Covid pandemic, creditors generally provided unusually high levels of forbearance in its various guises. That was driven by a number of factors. Credit institutions, for example, were under regulatory pressure to show leniency to corporates struggling due to impacts arising from Covid, while creditors more generally were reluctant to implement any fundamental balance sheet restructurings or take assertive enforcement action at a time when there may have been no predictable business plan against which they could model a restructuring or enforcement (and recovery) strategy or any certainty that they could recover sufficient value from disposals of secured assets. As the market impact of Covid recedes (albeit other market storms are brewing in its place) and given that the Covid-related regulatory programmes have all but fallen away, it will be interesting to see how willing creditors are to provide forbearance, especially as activity in the secondary market picks up and incumbent creditors begin to comprise a lesser proportion of par investors than in 2020 and 2021.
ESG remains a core focus across all markets, as shown by asset allocations, ESG metrics in bond and loan terms and a renewed scrutiny on ‘greenwashing’. In the refinancing and restructuring context we expect that it will cause capital constraints in the mining, oil and gas and other ESG-challenged sectors, with the pool of investors willing to invest in those industries becoming smaller over time. For the more stressed companies in these sectors, we expect that external capital will become less available and more expensive, and that in turn may increase refinancing risk and precipitate restructurings.
The universe of crypto assets is broad, encompassing digital currencies, stable coins, non-fungible tokens and others. This has given rise to new opportunities in the market but also increased risk, particularly in unregulated activities. The market volatility of certain crypto assets and the drive for investment in often little understood assets may be a cause for concern and may give rise to future economic stress. It is not clear how the traditional market tools for dealing with a collapse (including insolvency and regulatory) would respond to this new technology. The UK government has, for example, started to examine the potential need for a special insolvency regime to deal with the collapse of crypto exchanges.
Preparing as promptly as possible for the downside scenario, even if that feels like a relatively remote outcome or an interim solution is expected to be found, is in our opinion a good housekeeping exercise which will become even more valuable as the rising number of distressed credits places increased pressure on the resources required to manage underperforming investments. Understanding what may occur post-default or how a distressed situation might play out, which stakeholders will be able to control or influence any given situation, and where allegiances can be formed with other interested parties will ensure readiness and may even present opportunities which might not otherwise have been considered. On the other hand, failure to prepare exposes both debtors and creditors to the risk of their counterparties being better organised and able to respond more quickly to defaults or other restructuring triggers when they occur, taking control of the process away from the stakeholders who are late to the party. With that in mind, debtors are beginning to stress test liquidity scenarios, refresh on basket availability/permissions under debt documents and in some cases engage with lenders. Creditors, on the other hand, are starting to assess exposures across portfolios, strategise enforcement, restructuring or even new money options and work out the risks of their debt claims being crammed or compromised by the action of debtors and other competing creditors.
Sam Brodie, Helena Potts and Alexander Wood are all partners in the financial restructuring and insolvency practice at Shearman & Sterling.