Restructuring:In-court or out-of-court!
Introduction
The following discussion paper is meant to highlight the key choice of options in a successful restructuring of an ailing business. It is also meant to initiate a discussion overdue for years:“In-court restructuring is a valuable option for a business in trouble to achieve the operational and the financial turnaround.”
The principle options open to stakeholders are either an out-of-court restructuring or an in-court solution through an insolvency regime. Those are superimposed on the process of restructuring. This process principally encompasses operational restructuring – increasing the efficiency of assets of the business - and financial restructuring – addressing the inadequacy of a firm’s capital structure. For the purpose of this paper, financial restructuring also includes short term crisis stabilisation. The drivers behind those two dimensions are markedly different yet both dimensions influence each other in an often complex way.
The experience of the authors of this discussion paper is that practitioners specialising in either out-of-court (consensual) restructurings or in-court-restructurings are often reluctant to take a holistic view and draw upon the most appropriate course of action. Instead, they favour a suboptimal route for a variety of reasons. Those include (lack of) familiarity with the alternative process, fee and cost considerations, or loss of control. Whilst those reasons are understandable from the point of view of an individual player, the overall outcome is usually compromised. This discussion paper therefore attempts to formulate a series of pointers and questions in order to improve decision making and help the parties involved in a restructuring process identify the optimal course of action regardless of power considerations.
Process of restructuring
Whether or not a business has to undergo both financial and operational restructuring in order to be saved from dissolution is ultimately based on a number of key facts and financial indicators:
- Is the business profitable on the operationing (EBIT) level?
- Does it generate positive cash flow before interest and redemption?
- Does it generate sufficient risk-adjusted return on capital?
- Does it possess a sustainable market position in the market segments it is competing in that will enable it to remain viable in the future?
If the answer to all of the above questions is “Yes”, it appears likely that an operational restructuring or a strategic redirection is not the solution to its decline and crisis and the business can be saved by re-adjusting its capital structure through financial restructuring.
This is not to say that every business benefits from a process of continuous operational improvement. This, however, should be left to operational management as part of their daily routine or embedded as such.
Clearly, if the above questions remain unanswered or the answer is “No”, a full programme of operational restructuring initiative must be developed and implemented. This may be supplemented by a review of its business strategies or, indeed, a review of its corporate strategy. Stakeholders must then decide on the basis of an operational restructuring plan and its financial ramifications, respectively, the extent of a re-adjustment of the capital structure of the business.
Key questions in the course of its financial restructuring will then be
- How much interest payment and redemption can the restructured business bear in terms of both cash flow and income. In other words, what is its debt capacity purely on financial and economic grounds?
- Are there further legal considerations or limits re the shape of the restructured balance sheets with a further effect on its financial debt capacity, e.g. is a balance sheet solvency test applicable in its jurisdiction?
- Are there additional restrictions re the deductibility of interest payments (e.g. thin capitalisation rules)?
- How much fresh money does the business need and what is the degree of urgency? Will the lenders require an equitable subordination report or the like before injecting new money into the distressed business?
In the course of the process of financial restructuring, the emphasis from facts and figures to power considerations starts shifting when addressing issues such as
- Who is going to participate in the new money and who wants to exit altogether?
- What is the valuation for the restructured business in order to determine debt-to-equity exchange ratios?
- What is the impact of a financial restructuring agreement on the business of the debt and equity holders? Can they afford (additional) write-offs, whose bonus payment would become affected, would the agreement contradict already publicly announced commitments etc?
- What is the threshold majority among senior lenders for the acceptance of waivers, release of security etc?
- Does an agreement in one distressed situation sets precedence for another distressed situation, where similar players are at the table?
It is at this junction, when the process of financial restructuring turns into an often sophisticated political game of forming coalitions, behind-the-door bilateral negotiations, tactical threats, parallel agendas, and horse trading. And it is at this junction when the two options are always on the table – tacitly or overtly. But which option is better suited to achieve both an equilibrium in the interest of the stakeholders and to address the actual operational and financial problems the business is facing?
Out-of-court restructuring or in-court restructuring?
Whilst this question is difficult to answer in absolute terms, a number of factors favour one or the other option:
Out-of-court restructuring or consensual restructuring
- Relatively simple stakeholder structure
- Few or a single shareholder
- Limited number of banks or a few dominant lenders only
- Easier-to-handle debt structure
- Syndicated loans with similar risk exposure of lenders across the different parts of the business (including domestic and foreign subsidiaries)
- Overlap of debt and equity holders (such that stakeholders in their role of debt holders may face subordination risks)
- Unsecured or largely unsecured debt or voidance risks for debt holders
- Operational restructuring measures resulting in an “affordable” cash out flow
- Severe “shot gun” clauses in client or supplier contracts in case of insolvency • Inability to win long term orders if business is in state of insolvency
- Prospect of long-drawn out legal battles with administrator once in insolvency, e.g. due to voidance risks
- Risk of a major exodus of competent management once in insolvency
In contrast, an in-court solution may become the favoured solution if the following factors prevail
- Large, fragmented shareholder structure
- Fragmented debt holders structure; holders of debt have different agendas such that it is difficult to coral a sufficient number of votes to reach voting thresholds. As result, inability to agree on terms of necessary new money
- Complicated debt structure with contentious uncertainties re their ranking
- Operational restructuring that is prohibitively expensive if carried out as a going concern, e.g. large scale retrenchment or cessation of long-term (unprofitable) contracts or cessation of long term leases
- Strong market position, clients are strongly dependent on deliveries of business, at least in the short term
- Strong brand, surviving the temporary set-back of an insolvency
- Labour Law issues: better adaption possibilities under an insolvency umbrella
In any case, stakeholders of the business and their advisors must explore the ramifications of each path. That, in practice, means that both equity and debt holders and the company itself, whilst still a going concern, develop detailed contingency plans of an in-court-solution, which may be an outright insolvency or a Chapter 11 style process as, for example, Germany and France adopted with its insolvency plan or the Sauvegarde procedure. Stakeholders must then evaluate those plans in respect of both the likely financial outcome and their own power position having implemented such contingency plan. Drawing up such plans require from the stakeholders and their advisors in-depth knowledge of the insolvency or in-court-process not only in order to produce a workable solution but also to portrait this option as a credible option. It is here, where the authors of this paper believe much more work has to be done in order to bring about this competence and knowledge, which will ultimately help the stakeholders to opt for the right course of action.
National egoism has to be overcome in truly international restructuring cases!
In this context it is also extremely important that the appointed insolvency administrator(s) to communicate from the first moment with the restructuring specialists involved pre-court on a fair basis. It will regularly be beneficial to make use of their indepth knowledge of the companies problems and possible solutions.
This regularly speeds up the process of getting an overall picture of the business in trouble and allows the insolvency administrator to take the decisions necessary quicker as time is always of the essence in the first days of the in-court restructuring.
And of course the out-of-court specialists may also -and regularly should- serve the company in-court as long as they add value to the restructuring process, execute the new options available in the in-court-restructuring and can be financed out of the estate.
It is still a long way to go, but the authors are convinced, that combining the expertise of in-court and out-of-court specialists will improve the results for all stakeholders significantly in distressed situations.
So let us use the Turnaround Wing of INSOL Europe as the platform to exchange our perspectives and thoughts in order to learn from each other for the sake of the business in trouble!
Let us, together, make this vision come true!
