The responsibilities of the directors of troubled companies have become increasingly difficult to reconcile. It is well known that once a company’s solvency is in doubt, the primary duty begins to shift from being owed to the company’s owners and ultimately it is the creditors’ interests that must prevail. Once it is unequivocally insolvent, the duties are owed clearly to creditors. But which creditors? Or, more correctly, how can you ensure fairness to all classes of creditors?
There are specific statutory duties to employees. In a sense, once a company’s equity has lost its value, the directors could let the creditors decide what they want. If only it were so easy. The directors still have the delicate task of making sure that the interests of creditors are being protected and that any losses are minimised. This means they must avoid any one particular creditor group having an unwarranted influence. Clearly, creditors with security will have their own special position.
Current troubled companies in the UK are different from the cases seen in the downturn of the early 1990s. The companies and their businesses are much more global than ever before, so the need to find solutions acceptable throughout the world has increased. The asset profile is also different. In many of the troubled sectors, a lot of the value is in intangible assets, including contract rights, which may be lost in a formal insolvency. The telecom and energy sectors are good examples. Perhaps most importantly, the debt profile of these groups is much more diverse, both in terms of geographical spread and in terms of the legal nature and standing of the debt claims.
Influence of the Chapter 11 model
The one insolvency regime everyone has heard about is the US Chapter 11. Other regimes tend to be assessed by comparison with it.
From a distance, Chapter 11 can be seen as a useful tool to restructure companies. The UK Government has evidently been impressed by advocates of the Chapter 11 model. Whatever the actual merits of Chapter 11, the fact is that it has huge influence for a number of reasons: it is being used in many of the current high-profile cases; it is not parochial – the system sets a very low threshold for overseas companies to enter it so it is ‘available’to non-US companies; and at least as a matter of US law, it applies across the globe.
Just as importantly, major creditors constituencies are used to Chapter 11 and may expect it, or an equivalent, to apply outside the US. They certainly expect to have as much of a view as they would in a Chapter 11 proceeding.
This introduces the concept of ‘debtor in possession’. Given the number of cases where accounting irregularities or worse have been detected, it may seem remarkable for this to continue to be considered a wise principle. Perhaps the reason is that Chapter 11 is actually a structured mediation/negotiation between interested parties.
Another element that greater creditor control introduces is the strong influence of the creditors’ committee with the attendant costs. In some cases it seems that it is a case of debtor in possession and creditor in possession at the same time.
A further introduction from Chapter 11 is the concept of ‘the estate bears all the costs’.
Some creditor groups have actively worked to ensure that some of these practices, and certainly the influence of informal groups of creditors, should apply in UK, as well as Asian and Continental Euro-pean, restructurings. This leads to the debtor and its directors negotiating with a bank group and one or more bondholder groups, making what used to be bilateral negotiations more of a triangular process.
The Enterprise Act
Rehabilitation will be even more marked when the Enterprise Act begins to make its influence felt. This stresses the importance of a solution that is in the interests of all stakeholders, not just, for example, secured creditors.
One of the policy changes introduced by the Enterprise Act is the idea that the objective should be to rescue the company itself, not just its business.
With hindsight, the restructurings of the late 1980s and early 1990s look like very simple structures, although they seemed complex enough at the time. An important reason why things are so much more difficult now is the multiplicity of different creditor groups involved. It is not just a question of a group of multiple banks with different perspectives.
Bondholder debt introduces a number of new dynamics, particularly when that debt gets traded. There will be investors buying in for the debt/equity swap opportunity. One only has to look at the Energis result to see the extent to which interests can diverge.
The original shareholders are left on the sidelines. One way or another, any veto right they have will be lost and, at best, they will end up with a nominal stake in the resulting entity.
This can come as a rude shock to investors who think they enjoy the protection allowed by legislation such as the Financial Services and Markets Act and by Stock Exchange rules.
So where does this leave the directors? If a UK company wants to complete a debtor in possession restructuring, it will have to carry it out outside administration, as administration is likely to involve some displacement of the incumbent management.
The legal environment for directors of a troubled UK company is very different from that in the US. In particular, the spectre of personal liability for wrongful trading makes it a much more challenging task. At the same time, we are seeing the directors and officers insurance market shrinking, while stringent requirements are increasingly being imposed, not to mention higher premiums.
Peter Bloxham is head of restructuring and insolvency at Freshfields Bruckhaus Deringer