The bust boom

In the brave new world of bondholder restructurings, the US model is gaining ground. David Frauman gives the lowdown

Economists may continue to examine data to determine whether a recession has occurred, but lawyers who specialise in financial restructurings have little doubt that the market is seeing the most significant increase in the level of large corporate restructurings and insolvencies since the early 1990s. The most obvious differences between this economic downturn and the last, as far as lawyers are concerned, are the relative absence of property company failures and the dramatic increase in the number of troubled companies that are issuers of public debt.
Recent press reports quoting various financial experts suggest that a crash in both the residential and commercial property markets is imminent. If so, one suspects the restructuring and insolvency work that would result from such a collapse would be similar to that of the last economic downturn.
However, the consequences of public debt issuers' suffering are several, not the least of which is the presence of a new creditor constituency that has brought with it a particular perspective about corporate restructuring. The challenge for lawyers involved in this area is to understand and, to some extent, adjust to this perspective.
There were large bondholder groups in a number of the restructurings completed during the 1990s. Heron, for example, had millions in public debt. But the bond issues involved in deals such as that were traditional eurobond offerings and the trustees played the major role in the restructurings, as opposed to bondholder committees, which have represented bondholder interests in restructurings in the US.
The change in the current restructuring environment is a direct result of the dramatic increase in the amount of high-yield debt sold by UK and Continental issuers during the past five years. The market got into full swing in 1997, when there was a total of 40 issues that raised approximately e5.5bn (£3.46bn). The market more than doubled in 1998 to more than e13bn (£8.17bn). Rating agency figures currently place the market at more than e30bn (£18.86bn), but despite the rapid growth in the European high-yield debt market, it remains significantly smaller than the US market, which is estimated to total approximately $637bn (£405.53bn).
As the economy has cooled, the default rates on high-yield bonds have increased dramatically. The rating agencies have reported that European high-yield defaults were running at more than 12 per cent during the first half of 2002, which is double the long-term average and higher than the default rate in the US. Bankruptcy filings by companies such as Enron, WorldCom and Global Crossing have led to record defaults on high-yield debt in the US as well.
The consequences of these increased default rates are readily apparent. Some of the leading European issuers of public debt – the likes of NTL Communications, KPNQwest, UPC, Energis and Marconi – have all been the subjects of restructuring negotiations during the past year, and there are clearly more to come. Standard & Poor's has forecasted that European high-yield defaults will not peak until the end of the third quarter.
A related, but different, phenomena has also made its way across the Atlantic – distressed debt investors. These investors are becoming important players in European restructurings, as they have been in the US for years. However, to date they have primarily been purchasers of public debt. In the US, the distressed investors have been major purchasers of all types of claims and are often the largest holders of bank debt for companies going through restructurings. Trading in distressed bank debt in the US was estimated to be more than $42bn (£26.7bn) during 2001.
Much has been written in the US press about the problems arising from managing a case with an ever changing creditor constituency. One practitioner recently noted that every lender in the Dow Corning case sold its claim. To date, banks in the UK and on the Continent have been far less likely to sell than their US counterparts. Nevertheless, US-based distressed debt investors are playing an increasingly important role in European restructurings.
Problems can arise when there is a wholesale change in creditor confidence. It can be difficult to complete a restructuring if the parties with which a company has negotiated a deal sell their claims. With each change in players the motives and interest also change. It has been argued that distressed investors do not have the same relationship with a company as the original lenders or investors had; therefore, they will be more likely to push for liquidation. This is not necessarily the case, but distressed investors are clearly looking for the best possible return on their investment, which may come from a breakup of the company; but in many cases the best course is to reduce debt and permit the company to take advantage of market opportunities. In all events, distressed investors will bring a new and potentially very different perspective to a restructuring than that of the original lenders and investors.
It has been suggested that restructurings in Europe will, of necessity, be different from those in the US because of the differing legal systems. This is less true than one might think. In fact, the distinguishing characteristic of the high-yield restructurings that have been taking place in the UK and on the Continent to date is how much they look like US restructurings. The US Chapter 11 procedure, which is now a relatively predictable tool for effectuating a restructuring, is for the most part not generally available to European issuers.
Nevertheless, bond investors, both original holders and distressed debt purchasers, are primarily American, and they have brought the US restructuring model with them, for better or worse. For the lawyer the challenge is to reproduce a result that is similar to what would be expected in the US, notwithstanding the different legal systems.
Given the relatively small number of companies with high-yield debt that have undergone restructurings in Europe, the practice is very much in the developmental stage. However, based on US precedent and the deals that have been handled and thhose that are currently being negotiated, there are a number of things worth noting.
First, unlike conventional European restructurings, bond trustees are playing limited roles in the latest round of restructurings. As is typical in the US, large holders of bonds will form an ad hoc committee, either at the issuer's request or because a default has occurred or is imminent. The committee will then choose financial and legal advisers. The issuer is expected to execute an engagement letter pursuant to which it agrees to pay the fees of both sets of advisers. It is this committee that negotiates the terms of the proposed restructuring with the issuer and with other creditors.
Second, the deals are being negotiated, in substantial part, outside of formal insolvency proceedings, with legal proceedings being used to complete the transactions. This process is not unlike the prepackaged Chapter 11 proceedings in the US. In the UK, companies have used a scheme of arrangement under the 1985 Companies Act, together with an ancillary proceeding under Section 304 of the US Bankruptcy Code to make the scheme binding on US creditors. Other companies have been able to use Chapter 11 proceedings, although some have had little basis for establishing jurisdiction in the US courts.
For those companies that can take advantage of Chapter 11, there can be significant advantages. In a prepackaged proceeding, creditors negotiate the terms of this restructuring with the company before the case is filed and all creditors are bound by the plan once it is confirmed. Consequently, a company can emerge from a Chapter 11 with a clean balance sheet, having dealt with contingent and even unknown creditors. Prepackaged cases can be completed in approximately three months from the date of filing.
Third, companies that are arguably operationally sound are able to reduce their debt burden by converting substantial portions of their debt to equity. Generally, it is the public debt that is converted. For structural reasons, the bank debt is usually not impaired in the restructuring in the UK. The result of the equitization is that existing shareholders are massively diluted and the bondholders become the owners of the enterprise. A debt/equity conversion permits creditors to preserve the going concern value of the enterprise, which may be far superior to liquidation or a forced sale.
Finally, as a corollary of the debt/equity conversion process, potential acquirers of distressed companies are buying the bonds with the expectation that they will be able to force an equitization and ultimately obtain control of the company. This is a highly developed practice in the US market, where acquirers can buy both bank debt and bonds at distressed levels and effectively control the outcome of a Chapter 11 proceeding.
Given the lack of uniformity among European insolvency regimes, the US model cannot be imported in totality. While there has been discussion in the UK and, to some extent, in other countries about the desirability of adopting a rehabilitation procedure such as Chapter 11, little progress has been made in that direction. Consequently, it is likely that investors will continue to pursue out-of-court restructurings to the extent possible. But given the experience to date, it is likely that US investors will adapt their expectations to the relevant markets and that lawyers will find ways to achieve their clients' goals. n
David Frauman is a partner at Allen & Overy