There has been much discussion in the past few years about the impact of US bankruptcy practice on UK and European restructurings. One area of English restructuring law in which there is increasing pressure to adopt the US approach is that of schemes of arrangement, in particular schemes for financially distressed debtors, which are designed to implement a restructuring involving senior and junior, or subordinated, debt.
A lively debate is taking place concerning the ability of the debtor and its senior creditors to proceed with a scheme of arrangement without obtaining the consent of junior creditors, and in particular over the method for valuing the debtor’s assets and business for the purpose of deciding whether the junior creditors have any residual economic interest in the debtor.
Junior creditors have expressed concern at the approach adopted by the English courts, most recently in the first instance judgment of Mr Justice Mann in MyTravel (2005), in which the court, in these types of case, assesses value exclusively by reference to break-up values that would be obtained in the event of the realisation of the debtor’s assets in an insolvent liquidation. They point to the different approach taken by the US Bankruptcy Code in relation to the confirmation of contested Chapter 11 plans, where the value chosen has been the going concern value calculated with reference to the debtor’s future earning capacity.
This debate highlights a number of important issues. But while the English law analysis needs further clarification, the solution is not to incorporate into English schemes law the US approach to enterprise valuation. The US approach to valuation in contested Chapter 11 cases is only one piece in a large and complex jigsaw puzzle and needs to be understood in context – and as part of the careful and detailed balancing of interests among stakeholders in a corporate reorganisation found in the US Bankruptcy Code. Indeed, the English and US bankruptcy systems remain sufficiently different to caution against such an exercise. (Note, for example, how in the English system the legislation regulating schemes is limited to three skeletal sections with detailed doctrine being left to the judges.)
The judgment of Mann J in MyTravel illustrates the English approach. MyTravel sought to negotiate a consensual deal with its junior creditors, whose bonds were subordinated in the event of the liquidation of the debtor (at which point the junior creditors’ claims would be given the same ranking as that of shareholders). No deal could be reached and so MyTravel proceeded to promote a scheme of arrangement under which all of MyTravel’s assets would be transferred to a new company (Newco), which would assume some of MyTravel’s debts, but not those of the junior creditors. The Newco would offer to buy out the bonds in return for 2 per cent of its shares. The junior creditors objected to the scheme. The MyTravel scheme did not include the junior creditors as parties, since their rights were to be unaffected by the schemes.
The junior creditors in MyTravel appeared at the hearing of the application for the court order summoning a creditors’ meeting. They argued that it was wrong for the court, in deciding whether the junior creditors had an economic interest in MyTravel’s assets, to proceed, as MyTravel had proposed, on the assumption that MyTravel was in liquidation, because it appeared to be balance sheet insolvent and the only alternative to the scheme would be an insolvency proceeding culminating in a winding up in which the junior creditors would receive nothing. This, it was argued, was not the right point of comparison. Instead, the correct point of comparison was an alternative restructuring and a valuation of the debtor as a going concern outside an insolvency proceeding.
Mann J was not persuaded. He held (although the Court of Appeal subsequently decided that this holding was unnecessary) that the court is required to look at the real world situation and assess the junior creditors’ real economic interests. On the evidence, the only alternative to the scheme was a winding-up, and even if further negotiations among the debtor, senior and junior creditors might result in a revised arrangement, such a deal did not confer on the junior creditors an economic interest in the debtor.
Absence of economic interest
Mann J’s approach raises a number of issues. One of the most fundamental relates to the status of the economic interest issue: does the absence of an economic interest go to the court’s jurisdiction or just its discretion to approve the scheme? The rule is made by the judge and is best viewed as being relevant only to the question of whether the scheme should be sanctioned – when the court has to consider whether to exercise its discretion to approve the scheme. The court has to decide whether the scheme is reasonable at this point, and so the economic interest issue can be dealt with in that context.
This approach focuses on the value of the debtor if the scheme does not become effective, rather than on the value of the reorganised debtor, as is the case under Chapter 11. The issue in the English context is whether the scheme is a reasonable one for parties to the scheme to approve in the circumstances. A consequence of using a higher valuation may be to give the junior creditors a right to veto the restructuring. The English rules, unlike those in Chapter 11, do not allow for a scheme to be approved over the objections of a dissenting class of creditors (who are party to the scheme).
In Chapter 11, if a plan eliminates any class – so that they receive nothing under it, like the junior creditors in MyTravel – that class is deemed to have rejected the plan. They can still be bound by the plan, but are entitled to a showing that the plan is fair and reasonable as to them, which means that they can force a valuation of the reorganised debtor to show that whoever receives property under the plan – including equity interests in the reorganised debtor – will not be overcompensated.
The US approach to valuations must be seen as part of a wider picture and a tailor-made balancing of the interests of senior and junior creditors within the Chapter 11 system. If the UK wishes to follow the US approach, it will need to think about more extensive changes to the legislation governing schemes, and not just the adoption of Chapter 11 valuation methodologies.
Nick Segal is a partner at Freshfields Bruckhaus Deringer