creditor agreement necessary to make rescheduling work will be difficult to secure.

Debt/equity conversions

A further mode of informal rescue, and one that can be implemented through a variety of procedures – following, for instance, a London Approach process or a hedge fund purchase – is the conversion of debt to equity.112 In this procedure, the creditor agrees to exchange a debt for an equity share in the company and hopes that, at some future date, this will produce a greater return than would have been obtained in a liquidation. Recent celebrated cases of such conversions have included Eurotunnel, which had been overwhelmed by huge debts since it was floated in 1987.113 The latest in a long line of restructuring deals was concluded in 2007 and saw the company taken over by a new holding company, Groupe Eurotunnel (GE), creditors left in control of about 87 per cent of the shares in GE, and Eurotunnel’s debts slashed from £6.2bn to £2.84bn. Similar debt for equity conversions have been associated with the names of Saatchi and Saatchi plc (£211 million of debt), Brent Walker Group plc (£250 million of bank debt), Signet (formerly Ratners Jewellers, £460 million of debt) and Queens Moat (£200 million of debt).

From a creditor’s point of view, a conversion may be attractive because it offers the prospect of a future return on investment that is potentially unlimited as the company’s fortunes upturn and potentially far more valuable than the returns available on liquidation. Where banks have loaned without security – as is often the case with lending to larger quoted groups that have borrowed from many banks – there is the prospect of low recovery rates in an insolvency and debt to equity conversion can be more desirable than resort to formal insolvency procedures. In contrast, the creditor that is fully or partially secured has a far weaker incentive to support a troubled company by taking an equity position. Where the creditors, companies and projects involved are high profile, a further advantage of the debt to equity conversion is that it brings public relations returns: the creditor is seen in the public eye

112See K. Kemp and D. Harris, ‘Debt to Equity Conversions: Relieving the Interest Burden’ (1993) PLC 19 (August); Belcher, Corporate Rescue, pp. 120–1; DTI, Encouraging Debt/ Equity Swaps (1996).

113The legacy of construction overrun costs: see A. Osborne, ‘Eurotunnel “Saved” as Debts Cut’, Daily Telegraph, 26 May 2007; R. Wright, ‘Challenge on the Way to Bring Down Eurotunnel’s Debt’, Financial Times, 28 November 2006.

to be committed to industry and loyal to its customers in their hour of need.

From the company’s perspective, a conversion takes away the burden of interest repayment, it eases cash flow and working capital difficulties and it improves the appearance of the balance sheet because managerial workforce efforts will be seen as producing profits rather than as merely servicing interest burdens. The financial profile and gearing of the company will improve as debts and competitive disadvantages are removed. The company will then be better placed to seek new credit lines from creditors, to attract new business and to reassure its current customers. This, in turn, is likely to improve morale within the company and to increase the prospects of turning fortunes around. For directors, particular benefits will occur as the threat of liability for wrongful trading is reduced when debts are taken off the balance sheet in a conversion.

The DTI issued a Consultation Paper in 1996 which stressed the important contribution that debt/equity swaps can make in allowing troubled companies to reorganise their affairs.114 The DTI favoured encouraging such swaps but thought it inappropriate to require creditors by law to participate in compulsory swaps. Instead, the Department sought to raise the profile of swapping; to make involved parties more aware of the potential benefits of swaps; and to encourage the development of model debt/equity swap schemes that could be adapted to particular circumstances.115

Debt to equity conversions do, however, involve a number of difficulties and disadvantages. They can be time-consuming and expensive to negotiate, not least because the consent of the company’s existing shareholders, as well as of the main creditors, will usually be required. The former will have to agree to the issue of new shares, and such shareholders may be inclined to hold out in order to improve their positions. Where there are divergences of approach or position on the part of the creditors, it may again be difficult to come to a prompt, agreed restructuring plan. These divergences may arise because exposure levels

114DTI, Encouraging Debt/Equity Swaps.

115See, for example, Appendix E – The Economics of Bankruptcy Reform – in the DTI/ Insolvency Service’s Consultative Document, Company Voluntary Arrangements and Administration Orders (October 1993); P. Aghion, O. Hart and J. Moore, ‘Insolvency Reform in the UK: A Revised Proposal’, Special Paper No. 65 (LSE Financial Markets Group, January 1995) and in (1995) 11 IL&P 67; A. Campbell, ‘The Equity for Debt Proposal: The Way Forward’ (1996) 12 IL&P 14. See further ch. 9, pp. 422–6 below.

vary, the banks may be based in different jurisdictions or they may work subject to different regulatory constraints and within their own business cultures.116 Where foreign banks are involved, it will be necessary to

consider, for instance, whether these are subject to regulatory restrictions on the holding of equity.117

For creditors, a negative aspect of a conversion is that there will be a loss of priority on a subsequent liquidation in so far as they have become shareholders and as such will be eligible to receive no return until all creditors have been repaid. The financial flexibility of the creditors’ operations will also be reduced by conversion since it will be more difficult to realise their investment afterwards: sale of shares after a conversion may prove difficult or unproductive. Ownership of shares may, moreover, involve a culture shock for UK banks who, unlike their German counterparts, are unused to owning material portions of industry. They may be inclined to sell any accumulated shares once the market becomes liquid but such liquidity may be a long time coming.

For these reasons, there may be alternatives to either formal insolvency proceedings or debt to equity conversions that may be more attractive to creditors and debtors. Debt rescheduling may be appropriate where the number of bank creditors is small and the company’s financial problems can be overcome by changing the progressive interest or principal repayments. What rescheduling will not do is remove balance sheet deficits or improve gearing ratios.

Another alternative is to convert debt to limited recourse or subordinate debt. In such a process, the creditors agree either that their debts will be converted from a general corporate obligation into claims secured against specific assets or that they will rank for repayment behind other debts (but ahead of equity). This will give some protection to directors with regard to wrongful trading liabilities but, again, it will not remove balance sheet deficits or gearing problems.118

In summary, debt to equity conversions can provide an effective and efficient means of allowing troubled companies to continue operations and of avoiding formal insolvency procedures. The main effectiveness and efficiency concerns relate to the time and money that has to be

116See further Kemp and Harris, ‘Debt to Equity Conversions’, pp. 22–3.

117Ibid., p. 25. The US Bank Holding Company Act 1956 with few exceptions generally prohibits US banks from acquiring equity securities.

118Kemp and Harris, ‘Debt to Equity Conversions’, p. 22.