By Mitchell Mengden (Law Clerk, Delaware Court of Chancery)
In the past decade, private equity sponsors have taken a more aggressive stance against creditors of their portfolio companies, the most recent iteration of which has come in the form of collateral stripping. Sponsors have been using creative lawyering to transfer valuable collateral out of the reach of creditors. This Article delves deeper into the issue by examining the contract terms and litigation claims raised by these transactions.
The lack of protective covenants and ease of manipulating EBITDA and asset valuations are key conditions that permit collateral stripping. Each of these conditions were present in the past decade, primarily due to the protracted expansionary stage of the credit cycle. Lenders, however, can protect themselves from collateral stripping by negotiating stricter covenants and tighter EBITDA definitions, as well as pursuing ex post litigation for fraudulent transfers, illegal distributions, and claims for breach of fiduciary duty.
Contractual opportunism and creative lawyering will almost certainly continue to pervade credit markets. This Article provides a roadmap of ways that lenders can protect themselves from opportunism during contracting and throughout the course of the loan. As this Article concludes, ex post litigation claims are often an inadequate remedy, so lenders should seek to tighten EBITDA definitions and broaden protective covenants—even if to do so requires other concessions—to avoid litigation.
By Steven T. Kargman (Kargman Associates/International Restructuring Advisors)
Argentina’s new government under President Alberto Fernández recently completed a bond exchange which was approved overwhelmingly by its foreign bondholders. The final restructuring deal that Argentina reached with its foreign bondholders in early August was the product of a fraught and tortuous negotiating process that lasted several months and came after Argentina had defaulted on its sovereign debt in late May for the ninth time in its history.
A recent four-part article published in Global Restructuring Review examines the negotiating dynamics in the restructuring negotiations between Argentina and its foreign bondholders. The article focuses in particular on what I call the “three P’s”—namely, the pandemic, the professoriate, and the Pope—that I argue underpinned Argentina’s strategy in those negotiations.
Argentina sought to use each of the “three P’s” to its advantage. First, the pandemic likely made Argentina’s foreign creditors more accommodating in their stance vis-à-vis Argentina in light of the strains the pandemic placed on Argentina’s sovereign balance sheet. Second, Argentina benefited from the support of prominent professors from around the world who expressed their strong support for Argentina’s negotiating position. The professors weighed in on various matters such as whether Argentina’s debt sustainability would or would not be restored by debt restructuring proposals then under consideration and what type of collective action clauses (CACs) for binding dissenting creditors through a supermajority vote should be used in the new bonds issued pursuant to the restructuring. Third, Argentina sought to benefit from the Pope’s moral authority as reflected in a meeting the Pope held in late January with President Fernández as well as in the Pope’s participation a few days later in a Vatican conference on issues of debt and development.
In its final section, the article discusses the economic prospects for Argentina post-restructuring in view of the major economic challenges that Argentina will continue to face notwithstanding the outcome of the recently concluded sovereign debt restructuring. The article also provides an overview of certain factors that may be relevant to Argentina’s upcoming discussions with the International Monetary Fund (IMF) concerning the IMF’s outstanding loan of $44 billion to Argentina.
The full article can be found here. This four-part article was first published in Global Restructuring Review (GRR) and is reposted with the permission of the GRR.
On January 12, 2019, a new ‘Code of enterprise crisis and of insolvency’ was adopted in Italy.
The qualifying aspect of the new law is its emphasis on early intervention. The early warning system is based on enhanced internal monitoring and a ‘duty to scream’ imposed on public creditors, if the company is delinquent on VAT or social security contributions. All business entities must set up adequate ‘organisational, management and accounting’ systems that allow early detection of a crisis and timely dealing with it. The law also creates a public office that should help debtors to find an agreement with creditors or induce them to file for a proper reorganisation procedure.
There are incentives for debtors and directors who tackle the crisis early (and for auditors who take the appropriate steps). On the other hand, undue delay is addressed in various ways. Among them, a new presumption regarding the quantification of damages in case of directors’ trading after the moment when the company is deemed dissolved, that will make it easier for trustees to hold directors liable.
The reform also brings in updates on international jurisdiction, now entirely based on centre of main interest (COMI) (however, there is no general cooperation obligation with regard to cross-border insolvency), and a comprehensive set of rules on group crisis (seemingly compliant with the UNCITRAL principles).
Finally, the law makes relevant changes regarding two of the three available restructuring instruments, while there is nothing new with regard to the very peculiar reading of the absolute priority rule (APR) according to Italian insolvency law.
The law broadens the scope of the cramming down on dissenting creditors (subject to a 75% supermajority in the relevant class) in out-of-court, but court-confirmed debt restructuring agreements: once restricted to financial creditors only, they are now available with respect to all creditors. The confirmation of the plan, which envisages only intra-class cram down, is possible irrespective of compliance with any priority rule (absolute or relative), with the only backstop of a ‘best-interest test’, now based on a comparison with a liquidation scenario. This makes the Italian ‘scheme of arrangement’ a very flexible and effective tool (confirmation rates are also very high, in practice).
Regarding judicial composition with creditors (concordato preventivo), the law confirms the controversial requirement (introduced in 2015) that a minimum 20% payment of unsecured creditors is ensured when a liquidation plan is proposed, and adds the requirement of some form of ‘external’ financial input. By contrast, there is no such a threshold when the business is due to continue under the plan: however, ‘business continuation’ is now defined more narrowly than in the past – it is such only if creditors are paid mainly out of proceeds of the ongoing business, rather than from asset sales, or, under a statutory definition, if the continued business employs at least one-half of the previous workforce. This requirement may exceedingly restrict access to reorganisation or transfer wealth from creditors to employees.
As mentioned, the APR conundrum – the matter is domain of case law – is not solved by the new law. While the discussion regarding APR among creditors is confined mainly to what constitutes ‘new value’ (thus evading the APR waterfall), APR still seems not to apply to equity holders, in case of business continuation.
Finally, the new law introduces very minor tweaks to ‘plain’ insolvent liquidation proceedings, solving some interpretive issues but without an innovative approach, and makes the ‘certified reorganisation plan’, an out-of-court restructuring framework, somewhat more stable in case things don’t work out and the debtor ends up insolvent.
Certain new measures are already in force, but the whole new Code will come into force on 15 August 2020. It should be noted that the new law fully applies – as the law it supersedes – only to enterprises with less than 200 employees. Enterprises exceeding that threshold are deemed ‘large’ and, while being able to access ordinary restructuring tools, if insolvent they are subject to ‘extraordinary administration’, a special going-concern liquidation regime that provides for broad discretion for governmental authorities and the pursuit of business continuity even at the expenses of creditors’ rights.
The paper offers a comprehensive review of the main features of the new law, setting it in the context of the current Italian insolvency law framework.
By Jay Rao (University of California, Berkeley, School of Law)
This Article examines the application of equitable subordination under Title 11 of the United States Code to bankruptcy claims purchasing transactions that transpire after the occurrence of inequitable conduct by a third party. Although a significant issue with practical consequences, it has drawn relatively scant commentary. To the author’s knowledge, no scholarship to date has attempted to comprehensively discuss the issue or describe the indirect cleansing and washing of tainted claims resulting therefrom. While analyzing and criticizing the current state of the law, this Article introduces the concepts of the “subordination benefit,” “subordination benefit elimination theory,” and “limited subordination benefit theory” to facilitate and further conversations related to the intersection of equitable subordination and bankruptcy claims trading.
This Article primarily aims to promote an active, fluid bankruptcy claims trading market to, on an ex post basis, benefit creditors and, on an ex ante basis, reduce the cost, and induce the extension, of credit in the primary capital markets, thereby supporting the broader economy. Additionally, this Article seeks to reduce indirect cleansing of tainted claims and indirect claims washing through the bankruptcy claims market.
The subject matter is particularly timely and relevant, given the recent publication of the Final Report and Recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, the significant growth of the claims trading market and increasing activity and sophistication of distressed investors, and the recent formation of the American Bankruptcy Institute’s Claims Trading Committee.
This Article argues that subordination benefit elimination theory, which represents the dominant theory propagated by courts and commentators, finds support in a misguided reading of caselaw and conflicts with sound economic policy and logic. Further, while acknowledging limited subordination benefit theory is a superior approach to subordination benefit elimination theory, this Article argues that limited subordination benefit theory also runs contrary to sound economic policy and logic. This Article requests commentators and courts halt and reverse the propagation of subordination benefit elimination theory and avoid disseminating limited subordination benefit theory. Instead, this Article proposes post-misconduct discounted claims purchasers be entitled to participate in the subordination benefit to the same extent as pre-misconduct claimholders.
If commentators and courts are unready to abandon both theories and if required to make a suboptimal binary choice, this Article suggests limited subordination benefit theory be propagated and utilized in lieu of subordination benefit elimination theory.
Vasile Rotaru (Droit & Croissance / The Rules for Growth Institute)
From a functional law and economics perspective, the recent European restructuring directive (the ‘Directive’) brings both welcome innovations and multiple pitfalls. Its final text bears the traces of the divergent objectives and inspirations of its drafters. In a recent paper, I attempt to provide a thorough analysis of the different hidden ‘models’ and important measures of the Directive, as well as its unfortunate oversights.
The first part of the paper lays the theoretical foundations of the subsequent analysis. It has long been argued that insolvency law should pursue two objectives: (i) facilitating debtor’s ex ante access to finance; and (ii) ensuring an efficient ex post distribution of resources in the economy, by restructuring economically viable companies with bad capital structures and swiftly liquidating companies with an unsustainable business. Together, the two should result in wealth maximization, the default (but by no means only) criterion for assessing business law’s merits.
The paper takes a ‘functional’ approach, which is fueled by a deep skepticism towards any extensive cost-benefit analysis. It suggests that the ex ante focus should be on ensuring that a suitable epistemic framework is in place when the decision as to the redistribution of resources has to be taken. This implies incentivizing decision-makers to reliably reveal their preferences and bear the costs of their actions while diminishing coordination failures and potential conflicts of interests. Starting with this intuition, I attempt to reformulate the classical creditors’ bargain theory, underlining that so called ‘preventive’ proceedings are no exception.
In the second part of the paper, I rely on this theoretical framework to provide a critical analysis of the main measures of the Directive. I show that the apparent complexity of its final text (the contemplated proceedings could potentially take more than 70 forms) is owed to its drafters pursuing divergent objectives: economic efficiency or short-term preservation of businesses and jobs at all costs, with an unfortunate bias in favor of the latter (especially concerning SMEs).
Moreover, two coherent formal ‘models’ of proceedings are offered. The first is a unitary, public proceeding, with a potential general moratorium for up to four months. The second is a two-step proceeding—partially inspired by the current French model—that would start with an amicable phase devoid of wide publicity and would be accompanied by individual moratoria granted on a casuistic basis where they seem justified. The second, short and public ‘closing’ phase would be triggered in the specific circumstances where the restructuring plan has to be forced upon dissenting stakeholders. Once a decision has been made as to the objectives and formal model, most of the subsequent transposition options follow.
The Directive implies a devolution of decision-making powers to classes of affected stakeholders, although the court preserves a far too important role. Indeed, stakeholders are in the best position to identify and exploit any restructuring gain. It remains to be seen which criteria will be used to ensure that the interests of members of a class are aligned and no abusive behavior takes place. Where a plan is not approved by all classes of stakeholders, the Directive provides for a cross-class cram-down, where a majority of classes or at least one class of stakeholders who are ‘in the money’ must approve the plan. The latter option could potentially lead to abuses and uncertainties, given the meagre experience of European practitioners with valuations as a going concern. The cram-down can involve a debt-equity swap imposed both on shareholders, who should be treated as any other class of stakeholders and dissenting creditors. This possibility is not trivial, as it forces creditors to continue financing the business, and should be duly justified.
Unfortunately, the contemplated protections of stakeholders’ interests are somewhat underwhelming. For instance, instead of ensuring that all stakeholders share the restructuring gain in accordance with their respective ranks in the capital structure, the Directive provides for a confusing and dangerous ‘relative’ priority rule, which will likely render the negotiations unpredictable, or, alternatively, for an incomplete ‘absolute’ priority rule. Moreover, no protection is provided against debtor’s potentially abusive behavior before the opening of proceedings.
Finally, the paper offers some insights into the expected impact of its transposition into French law. In particular, its last part suggests that any transposition needs to aim at increasing the transparency and predictability of restructuring proceedings in order to foster secondary debt markets, and therefore to ensure that impatient creditors can easily be replaced by those interested in the restructuring gain.
By Horst Eidenmüller (University of Oxford; European Corporate Governance Institute – ECGI)
In a recent paper, I discuss the rise and fall of regulatory competition in corporate insolvency law in the European Union. The rise is closely associated with the European Insolvency Regulation (EIR, 2002), and it is well-documented. The United Kingdom (UK) has emerged as the ‘market leader’, especially for corporate restructurings. The fall is about to happen, triggered by a combination of factors: the recasting of the EIR (2017), the European Restructuring Directive (ERD, 2019) and, most importantly, Brexit (2019). The UK will lose its dominant market position. I present evidence to support this hypothesis.
Regulatory competition in European corporate insolvency law happened by accident: it was the unwelcome consequence of the entering into force of the EIR in 2002. The EIR was designed to eliminate forum shopping and to harmonize Member States’ jurisdiction and conflicts rules for international insolvencies. However, in practice, it did not achieve this end. The Regulation’s test for main insolvency proceedings, a company’s ‘Centre of Main Interests’, can be manipulated. Forum shopping became almost a signature feature of the EIR, and the UK emerged as the ‘market leader’ for corporate restructurings in the European Union (EU). The available data clearly confirms this assessment. The popularity of the UK as a restructuring venue also stems from the attractiveness of the Scheme of Arrangement—a procedure that is not within the scope of the EIR. Under the applicable European rules, restructuring decisions taken by courts in one Member State must be automatically recognized in all other Member States.
The regulatory landscape for corporate insolvency law in the EU is changing. The EIR was recast in 2017, the EU passed the ERD in 2019, seeking to harmonize Member States’ pre-insolvency restructuring regimes so that local businesses get local access to restructuring processes, and the UK will probably leave the EU in 2019.
I argue that the recast EIR will not significantly affect forum shopping and regulatory competition in corporate restructurings. However, the ERD will have such an effect, i.e. it will significantly reduce forum shopping and regulatory competition in corporate restructurings. This is because the ERD mandates that Member States implement certain key features of pre-insolvency restructuring regimes by 2021, effectively ruling out radical legal innovations departing from the new European standard. Unfortunately, the ERD is a ‘defective product’: it mandates inefficient procedures and should be repealed.
Most importantly, Brexit will eliminate the dominant competitor in the European restructuring market, i.e. the UK. This is because Member States will no longer be forced to automatically recognize decisions taken in UK restructuring proceedings. It appears that the restructuring market already anticipates this effect: one can observe a decline of the popularity of the Scheme of Arrangement in cross-border cases from 2016 onwards. I present evidence in the form of hand-collected data on cross-border Schemes of Arrangement to support this hypothesis.
By Andrea E. Kropp (Duke University School of Law)
Little attention has been paid to Italy’s bonds issued under New York law in discussions of Italy’s debt stock and how it will be restructured should the need arise. Because these New York law bonds have no collective action clauses and had been presumed to contain very creditor-friendly pari passu language, they appeared to be too difficult to restructure. As a result, it has been assumed that they would remain untouched, with an Italian debt restructuring impacting only local law bonds. No proposals had previously addressed how to restructure the New York law bonds because of this assumption. This article fills that gap by creating an actionable strategy to restructure the bonds and by demonstrating how the long-held presumption about the creditor-friendly pari passu language is flawed.
The article advocates for the use a set of exit amendments in an exchange offer effectuating the restructuring of the New York law bonds. These exit amendments will be used to secure execution and attachment immunity and to extend the period before creditors holding the non-exchanged bonds can accelerate. This set of exit amendments act to make the bonds quite unattractive to would-be holdout creditors. In addition, these creditors’ motivation to hold out is decreased even further because of the pari passu language in the indentures for the issuances. While the pari passu language in the bonds appeared to pose an insurmountable challenge to a restructuring, this presumption is grounded in a reading of the sales documents rather than the underlying Fiscal Agency Agreements that actually control the issuances. In contrast to the sales documents, the Fiscal Agency Agreements contain language that is much less creditor-friendly. Consequently, a recalcitrant creditor’s calculus in determining whether to hold out in a restructuring has changed significantly, making the exit amendment strategy a truly viable option.
Out of court restructuring is a popular and, according to many, optimal way of resolving the circumstances of insolvent companies in the UK, and probably more so since the advent in the UK of the Enterprises Act 2002. One concern that some commentators have raised is the fact that the opportunities to engage in such restructuring are likely to be reduced given the way that the courts have approached claims that directors who have initiated restructuring strategies are liable for breach of duty in failing to take into account the interests of company creditors when their company is insolvent or near to it (as applied by section 172(3) of the Companies Act 2006 in the UK). Allied to this is the concern that if directors are not granted freedom to use their discretion in entering into a restructuring process companies might be placed into administration or liquidation when they have some prospect of continuing to trade and to do so profitably, because directors may choose to be risk averse in placing a company into administration or liquidation rather than take the risk of being held liable for breach of the duty if they attempt restructuring. This paper examines whether the aforementioned concerns are realistic, given the law, and, if they are, what directors should be doing to ensure that they do not breach the obligation in relation to creditors. These are important issues as little consideration has been given in the UK to the issue of liability of directors for breach of duty in the wake of a restructuring. The issues are considered in light of section 172(3) of the Companies Act 2006 which makes the director’s duty to promote the success of the company for the benefit of the shareholders (as under section 172(1) and providing for what is known as ‘enlightened shareholder value’) subject to any rule of law that requires directors to consider the interests of creditors. It is a rule of law in the UK (and in many Commonwealth countries and Ireland) that when their company is insolvent or in dire financial distress directors must take into account the interests of creditors.
The paper finds that while directors might be subject to liability in entering into restructuring attempts, this is only going to occur in limited cases and so there should not be particular concern over liability. This is because first of all courts will not hold directors liable if they acted in good faith and took into account the interests of creditors, and regarded these interests as paramount in their considerations. Even if the directors failed to take into account the interests of creditors or failed to make them paramount, they will not be liable where the court finds that the honest and intelligent director, taking into account creditors’ interests, would have entered into the restructuring in any event on the basis that it would benefit creditors. Obviously if directors restructure in such a way as to benefit themselves or specific creditors, or they have improper motives, then liability is more likely to ensue. But, where the directors have acted reasonably then they should be safe from challenge.
By Richard Levin (Jenner & Block LLP) and Roland Pettersson (LEC Abogados).
This Working Paper analysis the hypothetical transfer and conveyance of Petróleos de Venezuela, S.A.’s assets to a new state-owned entity by the Venezuelan Government, and the possible creditor responses to such action, on account of the Venezuela’s NOC current financial-distress situation. The study is conducted from the perspective of Venezuelan law, which might provide certain legal remedies under Civil, Commercial and Administrative law—although with somehow little practical success expectations, given other factors and externalities—as well as from the perspective of U.S. law, which is of particular relevance, given (i) significant asset exposure in the U.S., where PDVSA—through CITGO—maintains an important operation, (ii) the contractual terms in the bulk of Venezuela and PDVSA’s financial indebtedness relies on U.S. law and provides for submission to the jurisdiction of NY courts, and (iii) many creditors are actually U.S. persons. Thus, this Working Paper examines the above situation, given the multiple issues and complexities on the case, starting from the very nature of PDVSA as an state-owned entity under Venezuelan law, but with particular emphasis on the creditors’ side of the equation and the theory of fraudulent transfer, which is analyzed both from the standpoint of Venezuelan law, as well as from U.S. insolvency framework and international law in general.
By Lee C. Buchheit (Cleary Gottlieb Steen & Hamilton LLP) & G. Mitu Gulati (Duke University School of Law).
There is a growing consensus that Venezuela will not be able to persist for much longer with its policy of full external debt service. The social costs are just too great. This implies a debt restructuring of some kind. Venezuela, principally through its state-owned oil company, Petróleos de Venezuela, S.A. (“PDVSA”), has extensive commercial contacts with the United States. Not since Mexico in the 1980s has an emerging market country with this level of commercial contacts attempted to restructure its New York law-governed sovereign debt. Holdout creditors in a restructuring of Venezuelan sovereign debt will therefore present a serious, potentially a debilitating, legal risk. The prime directive for the architects of a restructuring of Venezuelan debt will be to neutralize this risk.