7
Informal rescue
For most troubled companies, entering into formal insolvency procedures is a course of last resort only to be pursued when informal strategies have been exhausted. Informal procedures, as noted in chapter 6, will often prove more attractive than formal steps and stakeholders will hope that informality may avoid the negative consequences that are often the result of commencing an Insolvency Act process.1 Those consequences may include: the precipitation of contractual breaches across financing arrangements; liquidations of collateral;2 rating agency devaluations; shocks to market confidence; reductions in employee morale; and reputational harms to brands and directors as individuals. Informal processes are likely to offer more flexibility than statutory arrangements and they will be more amenable to the early and proactive involvement of major creditors. They also offer a less confrontational forum for ‘marketplace’ negotiations than many a formal procedure.3
It is understandable, accordingly, that informal strategies of various forms are of increasing importance to companies and their advisers. Different modes of informal action are reviewed in this chapter but, before looking at particular approaches, it is worth considering the different parties that may be interested in an informal rescue and the stages of events that commonly lead up to the selection of an informal rescue strategy.
1See J. Armour, ‘Should We Redistribute in Insolvency?’ in J. Getzler and J. Payne (eds.), Company Charges: Spectrum and Beyond (Oxford University Press, Oxford, 2006) p. 219; G. Meeks and J. G. Meeks, ‘Self-fulfilling Prophecies of Failure’ (Judge Business School Working Paper, Cambridge, 2004).
2On the destructive propensity of asset-based lenders to seek to liquidate collateral when they hear of a company’s difficulties (and the problems of controlling such creditors) see Armour, ‘Should We Redistribute in Insolvency?’, p. 219.
3On advantages of informality see P. Omar, ‘The Convergence of Creditor-Driven and Formal Insolvency Models’ (2005) 2 International Corporate Rescue 251; World Bank Insolvency Initiative, Symposium Paper No. 6, Section 8 ‘Informal Insolvency Practices’ (World Bank, Washington D.C., 1999); European High Yield Association (EHYA),
Submission on Insolvency Law Reform (EHYA, London, 2007) pp. 3–4.
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Who rescues?
When a company encounters problems it has long been the paradigm that informal rescue processes are started when its major creditor, the bank, becomes concerned and starts to take action – either by making enquiries of the directors or by taking a more hands-on approach to overseeing managerial performance. It was noted above, indeed, that the banks have recently taken the ‘rescue culture’ to heart and many of them have established teams of specialists that are dedicated to the provision of turnaround services to debtor companies.4 As discussed in chapter 3, however, the last decade has seen radical changes in the credit market and the arrival of new actors with fresh interests in troubled companies.
Three significant changes are to be highlighted. First, alternative lenders of different kinds have burst onto the market to supplement (and often to supplant) the banks. These include the hedge funds,5 private equity groups, investment banks and distressed debt investors. It is now the case that a troubled company’s fate is increasingly dependent on a hedge fund rather than a traditional bank.6 Second, underperforming companies that seek liquidity can now choose from a huge range of debt financing options including asset-backed lending, subordinated debt products (e.g. mezzanine debt) and debt capital market products (e.g. high-yield bonds). Third, the rate at which debts are sold means that the group of lenders with interests in a rescue may well be fluid during the rescue or restructuring process and that various investors in debt will see their debt in a very different way from traditional bank lenders.7
4 See ch. 6 above. See also J. Franks and O. Sussman, ‘Financial Distress and Bank Restructuring of Small to Medium Size UK Companies’ (2005) 9 Review of Finance 65: the average company in the sample spent seven-and-a-half months with the banks’ Business Support Units (BSUs) and somewhere between half to three-quarters of these companies emerged from the BSU without going into formal insolvency proceedings (pp. 76–7); Armour, ‘Should We Redistribute in Insolvency?’ p. 212.
5 In the USA the hedge funds now dominate trading in US distressed debt: see J. Drummond and C. Batchelor, ‘Hedge Funds See Influence Grow’, Financial Times, 18 November 2005. On UK companies being a growing target for hedge fund activism see Thomson Financial Survey (November 2007), cited in C. Hughes, ‘Hedge Funds Home In on UK Targets’, Financial Times, 5 November 2007.
6See L. Verrill, ‘ILA President’s Column’ (2007) Insolvency Intelligence 112 (on how ‘the market is now dominated by hedge, vulture or “opportunity” funds and private equity houses’).
7See D. Madoc-Jones and N. Smith, ‘Brave New World’ (2007) Recovery (Summer) 18.
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It has been the commodification of credit that has driven changes in the body of rescue-interested actors. Banks have increasingly sold their loans to outside investors, such as hedge funds, and non-bank investors have joined lending syndicates. In the case of riskier European companies, non-banks can now account for up to 80 per cent of the loan finance in private equity deals.8 The growth of the European bond market in the 1990s introduced a new group of unsecured creditors to large-scale insolvencies and rescues. Unlike the traditional dispersed unsecured creditors, bondholders are now willing and able to participate in rescues of troubled companies.9 Until recently, corporate bonds were generally held by long-term investors such as pension funds and life assurance companies but now such papers are traded and often used by hedge funds and banks’ proprietary trading desks who are exploiting trades that combine bonds and credit derivatives.
Hedge funds and private equity groups10 have, by such processes, become increasingly important players in the rescue game.11 Such funds and groups can bring positive qualities to potential rescue scenarios. They tend to be driven by rational profit-directed motives and are able to act quickly (notably to raise funds) in order to institute remedial steps such as restructurings. They tend to be faster moving than the more heavily regulated and more bureaucratic banks. They would also claim to be more flexible in approach, less constrained regarding allowable types of investment and more creative concerning rescues and restructuring than banks.12 Overall, their proponents would say that they increase general liquidity and improve rescue prospects.13 The critics of hedge
8See G. Tett and C. Hughes, ‘When Time Runs Out’, Financial Times, 7 December 2006.
9See J. Roome, ‘The Unwelcome Guest’ (2004) Recovery (Summer) 30.
10‘Hedge fund’ is not a legally defined term but most hedge funds tend to have the following characteristics: they are investment funds in which managers deploy investors’ capital; they are subject to little regulation; they may leverage their investments; they invest more freely than regulated mutual funds; and managers share in the fund returns. See T. Hurst, ‘Hedge Funds in the 21st Century’ (2007) 28 Co. Law. 228. On the likelihood of private equity firms ‘with a stomach for risk’ making ‘a killing’ in restructurings and subsequent sales if the debt of companies in distress falls below its fair value see P. Davies, H. Sender and C. Hughes, ‘Restructuring Enters a Brave New World’, Financial Times, 5 February 2008.
11Hedge funds are said to represent 35 per cent of the primary leveraged European loan market: see STP, ‘Corporate Restructuring in Europe’ (STP, London, 2 March 2006).
12Tett and Hughes, ‘When Time Runs Out’.
13See M. Prangley, ‘Providing Support to Management in a Highly Leveraged Market’ (2007) Recovery (Summer) 26. The supplanting of the banks in US rescues has been said to have increased rates of rescue: see Tett and Hughes, ‘When Time Runs Out’.
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funds would counter that the long-term effects of such funds’ highly leveraged and short-term approaches may be uncertain and may include the generation of high levels of systemic risk within financial markets.14 On the accusation of short-termism, private equity firms would say that they differ from hedge funds in so far as the latter take a short-term, or trader’s, view of the company whereas private equity looks for a longer relationship with the company (typically three to seven years before resale).15 Private equity firms also claim to differ from hedge funds by bringing to the table not only cash but the skills required to restructure the business successfully.16
Such developments may be welcomed for bringing liquidity and creativity to the rescue process but the involvement of a host of new parties in rescue processes may have a downside. The buyers and sellers of credit – as discussed above – are joined, within turnarounds, by a number of other types of organisation with various rescue interests and roles. Noteworthy here are credit insurers and turnaround advisory firms. Co-ordinating a rescue when such numbers of organisations are involved may present challenges – especially when the group of interested parties is not constant but is subject to change.17 In such a fragmented world of competitive credit (and often high leveraging) the power of the lenders to impose traditional banking covenants on deals is weakened as is the ability of key lenders to step in early and insist that the company takes certain steps to deal with its troubles.18 The challenges of co-ordinating different types of creditors may, furthermore, be compounded because such holders of debt may have very different objectives in mind when looking at the troubled company. They may have different operating methods, values and assumptions and they may operate to different timescales.19 Thus, a hedge fund with a second-lien loan and a share of equity may have different motives and modes of operating from a bank or holder of bond derivatives. Similarly, banks may be concerned to
14See Hurst, ‘Hedge Funds’.
15For a counter-view, arguing that some hedge funds do take the longer view and are managerially active, see R. Tett and B. Jones, ‘Hedge Funds – A Fad or Here to Stay?’ (2007) Recovery (Summer) 22.
16See C. Bodie, ‘How Private Equity Can Help to Rescue Companies’ (2007) Recovery (Summer) 28; J. Bickle, ‘Private Equity Investors and the Transformation of Troubled Businesses’ (2006) Recovery (Summer) 28.
17See J. Wilman, ‘Rescuers Armed with New Ideas’, Financial Times, 19 March 2007; Prangley, ‘Providing Support to Management’.
18Prangley, ‘Providing Support to Management’.
19See EHYA, Submission on Insolvency Law Reform.
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restructure in a controlled manner so as to leave debts on balance sheets rather than to take equity, whereas bondholders may look to reduce debt levels and maximise creditor recoveries through their equity holdings in businesses with lowered gearings.20 As Chris Laughton has said of the purchasers of distressed debt: ‘Some of them will be prepared to take a medium (or occasionally long) term view … but many look for a quick gain. For these investors, operational turnaround is much less valuable than their deal gain on balance sheet restructuring.’21
Credit trading may also induce the banks to depart markedly from their traditional stances – and in a manner that, again, may reduce rescue options because of divergent interests. As noted in chapter 6, a reported complexity that emerged in the 2002 Marconi rescue effort was that some banks had used credit derivatives to lay off risk so that they could potentially gain more from Marconi defaulting than from agreeing to a restructuring.22 Hu and Black have said, indeed, that the ‘uncoupling’ of creditor and company interests may routinely occur when there is trading in credit default swaps (CDSs) and that, as a result of such trading, creditors may possess incentives to vote against a rescue plan.23 In such situations, derivative trading by some banks but not others may mean not only that the banks have different interests from other groups of creditors but also that not all banks will have consistent interests.24
Co-ordination difficulties may also be exacerbated because, as noted in chapter 3, the modern credit derivatives market does not render interests transparent. Various parties (who may be difficult to identify) may hold hugely complex combinations of interests (in, for instance, intricate mixtures of bonds, equity shares and other forms of paper). This may mean that such parties’ positions are difficult to assess and that deals and compromises have to be devised by expert intermediaries who may find it difficult to locate all the interested parties and to persuade them that the proposed deal is the
20Roome, ‘Unwelcome Guest’.
21C. Laughton, ‘Editorial’ (2007) Recovery (Summer) 2.
22See J. Gapper, ‘The Winners and Losers of the Restructure’, Financial Times, 2 November 2004.
23See H. Hu and B. Black, ‘Equity and Debt Decoupling and Empty Voting 11: Importance and Extensions’ (2008) 156 University of Pennsylvania Law Review 625; and the discussion in ch. 6 above.
24See N. Frome and C. Brown, Lessons from the Marconi Restructuring (IFLR, September 2003) p. 19.