Navigating distressed liability management transactions: An English perspective

The new wave of liability management transactions

Higher interest rates, geopolitical uncertainty and other economic headwinds have created significant challenges for some highly leveraged companies in certain industries to obtain new debt and/or refinance upcoming maturities. Companies and their supportive stakeholders are therefore looking for creative (and sometimes aggressive) solutions to manage their capital requirements.

In simple terms, the (relatively) recent wave of distressed liability management transactions (LMTs) fall into three categories, as follows:

1. “Drop down”: the use of unrestricted subsidiaries, investment baskets and/or restricted payment baskets to structurally subordinate existing non-participating creditors by moving (or “dropping down”) valuable assets (such as IP or even an entire business unit) to an unrestricted/excluded subsidiary or otherwise out of the existing creditors' security net so as to allow new debt to be raised in exchange for new security over those (now) unencumbered assets.
2. “Up-tier”: the use of requisite lender consent to facilitate the exchange of existing debt of a company for new super senior instruments (typically coupled with an injection of new money) which subordinates the claims of non-participating creditors to the “up-tiered” claims of participating creditors, often leaving the subordinated debt with weaker covenants and lower recovery prospects. In the US, there has been a noted increase in recent years of lien stripping up-tier transactions. These have been less prevalent in Europe but the recent Hunkemoller up-tier could signal a new dawn for these transactions (although this transaction is subject to legal challenge in the US).
3. “Double dip”: the use of existing debt, lien, and investment baskets to give creditors a direct and an indirect claim against a debtor, thereby benefitting from a higher proportional return in an insolvency scenario. Often this is done by lending new money to an unrestricted subsidiary with the proceeds being on-lent to the restricted group and guarantees and security being granted for the intercompany loan as well as the original new money (as permitted by the relevant baskets).

There are variations on these themes, but at their core these types of LMTs take advantage of the flexibility in documentation to improve the position of participating creditors to the detriment of non-participating creditors. Utilising flexibility in financial documents to obtain new money at the expense of old money is nothing new, but the proliferation of bond-style covenants in loan markets in recent years has contributed to the increasing popularity of these types of LMTs. But compliance with documentation is not the only legal requirement that needs to be satisfied to successfully implement a distressed LMT. This article is focused on LMTs outside of traditional in-court restructuring procedures, such as schemes of arrangement and restructuring plans in the UK and Chapter 11 proceedings in the US, but it may be that an in-court procedure forms a part of the desired solution.

Directors’ duties

Directors of a company owe duties under the law of the company's jurisdiction of incorporation and, potentially, the laws of the jurisdiction in which insolvency proceedings are opened. However, given the relatively low jurisdictional thresholds for opening insolvency proceedings in certain jurisdictions, it can be difficult for directors and creditors of large international companies and groups to know for certain where such proceedings will be commenced.

Under English law, directors must comply with statutory and fiduciary duties owed to their company. This includes the duty to avoid conflicts, and to exercise independent skill and judgement. When a company is in financial difficulties, the most relevant duty is often the duty to act in the best interests of the company and act in the way the director considers, in good faith, would be most likely to promote the success of the company for the benefit of its members (and/or creditors) as a whole. Ordinarily, this duty requires the directors to look to the interests of members (ie shareholders) but if a company is in the zone of insolvency (which is understood to mean bordering on insolvency, where insolvent administration or liquidation is probable, or where a company is insolvent on a cash flow or balance sheet basis) the “creditor duty” is triggered and, from that point, directors are required to consider the interests of creditors, as well as members. The closer a company is to insolvency, the greater weight that should be given to creditors' interests. That balance tips once insolvency is inevitable: at this point the directors' focus should be purely on creditors' interests.

How then should directors act in the context of these distressed LMTs? First, directors need to consider the solvency position of the company. Where the company is solvent (and the creditor duty is not engaged) the duty to promote the success of the company should encourage the directors to pursue a strategy that maximises long term value in the company for the benefit of shareholders, even where that may not be in the interests of the creditors as a whole in the short term. However, if the creditor duty is engaged, the picture becomes more complex. Depending on how likely insolvency is, directors need to weigh the interests of creditors against members, which, in practice, may encourage a more conservative approach on the basis that the directors will want to avoid deepening the insolvency of the company. Directors will need to carefully consider any new money on offer, the terms of that new money and the impact on existing creditors.

Analysis should be carried out as to whether the transaction improves the position of creditors as a whole (and not a subset of creditors) when compared to the alternative of not entering the transaction and/or the company entering into insolvency proceedings (which is likely to leave creditors in a worse position). Offering the benefits of participation in new money to relevant existing creditors (consistent with the approach taken in the context of schemes of arrangement and restructuring plans to ensure compliance with fairness and class requirements) may rebut claims that certain creditors were favoured over others in the same class. Where guarantees are given by subsidiaries for the debts of their parent or sister companies (eg as a part of a double dip transaction) then issues of corporate benefit come to the fore. Directors will also need to be comfortable that there remains a reasonable prospect of avoiding an insolvent administration or liquidation. Directors should ensure that any analysis on the commercial rationale and the reasoning behind their decision making is clearly recorded.

Generally, creditors have no direct cause of action against directors of a debtor for a breach of fiduciary duty. A subsequently appointed administrator or liquidator would have standing to bring a breach of duty claim against the directors (as well as various other actions) but, until their appointment, only the company itself (or potentially shareholders bringing a derivative claim) can bring breach of duty proceedings against board members. If the directors have acted in breach of duty and the benefitting creditor has actual or constructive notice of this fact, the company (eg by a subsequently appointed insolvency practitioner) can avoid the transaction and recover any benefits conferred under it.

Clawback

Should insolvency proceedings be commenced shortly after the implementation of an LMT, there may be grounds on which the transaction can be set aside on application to court by the subsequently appointed administrator or liquidator. As a matter of English insolvency law, there are three principal grounds on which transactions are capable of being set aside:

1. transactions at an undervalue;
2. voidable preferences; and
3. voidable floating charges.

Transactions defrauding creditors may also be set aside, although this is less likely to apply to LMTs in practice.

By way of example, if a company sold IP to a sister company in return for an intercompany receivable and that company raised debt using the IP as collateral, then (depending on the use of proceeds) that transaction may constitute a transaction at an undervalue if the value of the consideration provided to the company (the intercompany receivable, presumably subordinated to the new secured debt) is significantly less than the value of the consideration provided by the company (the IP). If the transaction took place within two years of the commencement of administration or liquidation and the company was insolvent at the time of the transaction (and a good faith and proper purpose defence does not apply) then the transaction is liable to be set aside.

Further, a transaction entered into by a company within six months of administration or liquidation (or two years in the case of connected persons) can be set aside as a preference if the company has done something which has the effect of putting a creditor into a better position than the creditor would have been in if the thing was not done and the company was insolvent at the time of the transaction. The company must have been influenced in giving the preference by a desire to prefer that creditor. An up-tier transaction that prefers the payment of certain creditors over others and/or prioritises certain claims over others may be susceptible to challenge on this basis.

Where a transaction is liable to be set aside on any of the grounds referred to above, this is likely to also constitute a breach of duty by the directors of the debtor company. Where formal in-court restructuring procedures are tilized the risk of a successful challenge is (considerably) lower than in an out of court restructuring, which could mitigate in favour of formal proceedings where any of the risks identified above are substantial.

Oppression of the minority

English common law has developed a protective principle for minority dissenting members of a class which provides that the power given to the majority assenting members must be exercised in good faith for the purpose of benefiting the class as a whole, and not merely individual members.¹

This principle was further developed in the 2012 case of Assénagon² where the court held that it is not lawful “for the majority to lend its aid to the coercion of a minority by voting for a resolution which expropriates the minority's rights under their bonds for a nominal consideration”.

In Assénagon, the debtor company sought to implement an “exit consent” under which it would invite creditors to swap existing bonds for new bonds while amending the terms of the existing bonds so as to substantially destroy the value of the rights arising from those existing bonds which would remain held by the minority bondholders that did not agree to swap their bonds. Finding for the dissenting minority, Briggs J noted that “oppression of a minority is of the essence of exit consents of this kind, and it is precisely that at which the principles restraining the abusive exercise of powers to bind minorities are aimed”.

Assénagon was a rather egregious example of minority oppression, and it does not follow from that case that all “up-tier” (or other LMTs) that prefer the majority at the expense of the minority are unlawful. In the context of schemes of arrangement and restructuring plans, it is not unusual to offer (relatively modest) inducements to creditors that agree to vote in favour of the debtor company's proposal and for the rights of non-participating old money to be diluted by reference to the rights afforded to participating new money. Assénagon amounted to an effective expropriation of rights, but it is expected that an “up-tier” transaction that leaves some substantial benefit with the dissenting class, is capable of benefitting the class as a whole and is not overly oppressive, will not offend the principles laid down in that case.

Creditor protections: What can creditors do when faced with a potential distressed LMT?

It would be usual for creditors to co-ordinate their response to a distressed debtor by way of traditional co-ordinating (or steering) committees, or more flexible ad hoc committees, usually organised with the consent and support of the debtor. More recently, and in response to risk of the more aggressive LMTs, so called “co-operation agreements” are being used by creditors (independent of the debtor) to seek to avoid the “prisoner's dilemma” inherent in the decision as to whether to accept an LMT proposed by a debtor and take the benefits that come with being a part of the assenting class or hold out for better terms and risk being adversely impacted if the debtor obtains the support of the requisite majority. The aim of these co-operation agreements is to form a blocking stake which means the LMT is not capable of implementation without the support of the co-operating creditors acting together. Creditors may agree between themselves not to trade their debt or negotiate or agree side deals with the debtor or other creditors without the co-operating group and agree to vote in accordance with a specified majority and then only where a transaction treats all signatory creditors equally. Questions have been raised around the efficacy of such agreements, and creditors do need to ensure that any such arrangement is consistent with any duties of confidentiality. Creditors also need to be conscious of any attempts to restrict co-operation in non-disclosure agreements.

Outside of co-operation agreements, if a creditor is not offered a participation in the new money, elevation and/or other benefits (and other legal remedies are not available) they could look to offer the new money to the debtor (eg on more attractive terms). It also remains for non-participating creditors to apply relationship pressure on debtors, sponsors and/or other creditors where possible to seek to avoid the worst consequences of these transactions being imposed on them.

Conclusion

The distressed LMT techniques referred to above are creatures of the US legal market and the English legal risks identified above are not present to the same extent in the US market. The strategies to implement and counter their implementation are therefore likely to play out differently depending on the applicable jurisdictions.

While the risks identified above need to be taken into account, distressed LMT transactions will remain a valuable tool to address financial difficulties of a debtor company with a complex capital structure. Where they are implemented lawfully and in good faith, they can provide the lifeline a company needs to turn its fortunes around and preserve value for the benefit of stakeholders as a whole.

This article was first published in Corporate Rescue and Insolvency journal.