CHAPTER 1
The restructuring and workout environment in Europe
Martin Gudgeon Shirish Joshi PJT Partners
1. Introduction
The current restructuring and workout environment in Europe is characterised by diversity and complexity, and has witnessed several transformative trends. Steps continue to be taken to make workouts easier and to limit value destruction from financial distress, particularly in the form of revisions to local insolvency laws to make them more reorganisation-friendly within each jurisdiction, and attempts to coordinate and harmonise laws and processes across various jurisdictions. Several characteristics of corporate and financing structures and innovation in financing markets mean that financial restructurings in Europe continue to be complex.
These characteristics include:
• increased complexity in debt instruments, security packages and corporate capital structures;
• a secondary market in loans and other credit instruments that continues to grow;
• credit markets willing to refinance stressed credits with limited levers that creditors can rely on in a downside scenario;
• continued uncertainty and challenged prospects on a macro-economic level in several industries, particularly in terms of timing of recovery on an industry-wide level; and
• an increasing number and variety of credit investors.
In general, the course and outcome of any restructuring process will principally depend on:
• the prevalent insolvency regime, not just in the debtor's jurisdiction of incorporation or where its financial liabilities exist, but also in every jurisdiction where the debtor has material business operations;
• the size and complexity of a debtor's capital structure;
• the number of stakeholders in the company;
• the composition of the company's creditor/lender base;
• the degree of effectiveness of the contractual rights that creditors have against the company, as negotiated in the credit documentation; and
• the availability of alternative financing sources and general health of capital markets and, in particular, the banking system in the relevant jurisdiction.
The European markets have seen a transformation in each of these factors that will have a long-lasting impact on the restructuring environment going forward.
2. Legal environment
Relative to the United States, where Chapter 11 of the Bankruptcy Code is more debtor-friendly, European jurisdictions tend to be creditor-focused, with the exception of certain jurisdictions such as France and Italy. Often, control is ceded to creditors or the courts, either directly or through an appointee. Over the past several years many jurisdictions have made tangible efforts to move away from regimes that almost seemed to encourage liquidation in any bankruptcy and towards regimes that encourage business rehabilitation (where justified), which may be viewed as an attempt to emulate the Chapter 11 framework that has prevailed in the United States. The intent has been to make restructurings and workouts easier to execute by facilitating elements such as super-priority new money financings, binding/cram-down mechanisms and debt-for-equity swaps via legal, rather than solely contractual, means.
Germany was one of the first European countries to implement a new insolvency regime, the Insolvenzordung, in January 1999. Italy has had the Prodi Bis since 1999 and the Marzano Decree, which was highlighted during the Parmalat restructuring, since December 2003. The United Kingdom reformed its insolvency law with the Enterprise Act that came into effect in September 2004. Incremental revisions to local insolvency and restructuring laws continue to take place, including the German Bondholder Act of 2009 (Schuldverschreibungsgesetz) and modifications to the Italian regime in 2010 and the German regime in 2012. France has implemented the procedure de sauvegarde. French restructuring and insolvency law remains debtor-friendly; however, certain amendments (which came into force in 2012 and 2014) and the CGG transaction precedent (where, relative to previous French-based company restructurings, pre-restructuring shareholders were provided a much smaller percentage of the post-transaction equity and more limited new money participation rights, and the vast majority of the post-restructured company was owned by creditors) may suggest a change, slightly rebalancing the bargaining power in favour of creditors. While many of these new regimes have been used on an ad hoc basis, few of them have been tested to the extent where they are sufficiently well understood to cater to the wide range of specific situations and outcomes that are typically seen in restructurings. The European Union in 2015 implemented a new regulation which made amendments to the existing 2002 EU Insolvency Regulation and which was aimed at making the pan-European restructuring and insolvency environment more coordinated and transparent (the 'Recast Regulation').
In contrast to the implied extraterritoriality of the US Chapter 11 process, individual jurisdictional analysis is an important part of European restructurings. For instance, a company may be headquartered in one jurisdiction, with the parent company incorporated in another; conduct business operations, own key assets and owe financial debt in a further half-dozen jurisdictions; and have its primary credit documentation governed by English law. While the overall relationship between the company and its creditors and among creditors themselves will be governed by English law, the efficacy and economic rationality of any enforcement of security or court procedure will be a function of each individual jurisdiction in which the company operates. For instance, certain jurisdictions allow a lender to take security and derive benefit from guarantees granted by other members of the corporate group, but the quantum of any such guarantee is limited to the amount of direct corporate benefit derived by that particular entity as a result of the provision of credit by the lenders.
Further, the test of insolvency or prospective insolvency differs from jurisdiction to jurisdiction, ranging from solely a mechanical balance sheet test to a cash flow test, either in isolation or in conjunction with a balance sheet test. Further, the cost and speed of enforcement action in certain European jurisdictions are quite high, making the threat of enforcement less effective in forcing a borrower or other creditors to negotiate a consensual transaction.
The approach and mindset of the relevant courts and the various participants, particularly banks and other creditors, in a workout process have changed to a large extent to make the European workout process through insolvency more efficient, from both a time and value perspective, but it still remains less efficient than in the United States. Advances continue to be made in terms of recognising restructuring and insolvency procedures across EU jurisdictions through the Recast Regulation, and steps are being taken to harmonise and coordinate local insolvency processes across the EU which, once implemented, should go a long way to addressing this issue. However, the lack of a fully fledged pan-European insolvency protocol remains an impediment to achieving a European multi-jurisdictional restructuring within a formal coordinated legal framework.
This inflexibility and uncertainty has resulted in the majority of European restructurings being accomplished on an out-of-court basis. These consensual restructurings add several layers of complexity to the restructuring process. In general, they require the unanimous consent of all stakeholders to be successfully implemented. The absence of court-imposed binding decisions or an alternative means to cram down dissenting creditors means that individual stakeholders may have disproportionate levels of influence in the negotiating process. The holdout value extracted by out-of-the-money creditors and existing shareholders, who in theory hold investments of no value and should have no voice in the restructuring process, can be significant in practice.
A compromise between the flexibility offered by out-of-court commercial restructuring negotiations and the legal power of insolvency law has resulted in many transactions being negotiated, structured and agreed on an out-of-court basis, but formally implemented through a formal court process. This is particularly evident when there are a very large number of constituent creditors (eg, widely held public bonds) or there is a particular risk of a small number of holdouts. For instance, in France, an Accelerated Financial Safeguard (AFS) procedure is available to implement a pre-pack plan with only a two-thirds majority by value of those voting (in both committees – bank and bond). The AFS procedure has rarely been implemented but is often used as a threat to incentivise holdouts to agree to a consensual deal. Similarly, an English law scheme of arrangement is a corporate process, not an insolvency process, and allows for the entire class of similarly situated creditors to be bound by a particular commercial proposal so long as a simple majority in number and 75% by value of creditors in that class support it.
The differences in insolvency laws across Europe have led to an increase in jurisdiction shopping, where companies in distress relocate either their jurisdiction of incorporation or their 'centre of main interests' (COMI) to more favourable jurisdictions solely to implement restructurings via a legal process that may not be available in their home jurisdictions. For example, the English law scheme of arrangement procedure has been used by a number of non-UK companies. Many have transferred their COMI to the UK, relying on EU regulations, or alternatively have established sufficient connection to the English courts, based on the governing law of the underlying credit documentation, to access the scheme of arrangement procedure.
3. Financial innovation
The European credit markets have seen an unprecedented level of financial innovation over the past several years. Credit markets have been characterised by the increasing complexity of capital structures and new classes of lenders and investors.
3.1 Complexity of corporate, capital and financial structures
Historically, European companies were funded by loans from traditional commercial banks. These loans were generally senior in nature and in some cases secured by all of the borrower's assets (especially in leveraged transactions). Large, well-established corporations had access to the public bond markets. Leveraged buyout activity in Europe has led to innovative financing structures and instruments such as second lien and mezzanine debt structures and payment-in-kind loans. Second lien and mezzanine instruments may be structured as either loans or tradable notes, similar to bonds. These are junior instruments that are usually held not by traditional banks, but by alternative investors such as hedge funds, dedicated mezzanine funds, collateralised loan obligation (CLO) and collateralised debt obligation (CDO) funds and other 'special situations' investors.
The number of layers in a company's financial structure makes workouts particularly problematic, as it increases the number of stakeholders that need to consent to a restructuring. For instance, as the term suggests, 'second lien' loans are debt instruments that share the same security package as a first lien loan, but are second in priority of payment from any value realised through the disposal of collateral. Conflicts often arise between the senior and junior lien holders with respect to the collateral, especially in the event that the immediate disposal of the collateral is value maximising for the first lien claim, but not for all the claims on the security package. In such an instance, the first lien lenders would be incentivised to dispose of the collateral, to the extent that the value generated at least covers their claim, as quickly as possible. However, junior lien holders would be incentivised to maximise the value of the entire security package, and that might imply adopting a wait-and-see approach or a more extensive disposal process that may take more time and resources. This difference in approach would bring the two lien holders in conflict with one another. Furthermore, certain transactions have featured instruments that have third and fourth liens on the same security package, which makes inter-creditor negotiations significantly more complex.
In addition to traditional corporate restructurings, Europe has seen a number of financial restructurings of non-corporate vehicles, such as securitisations, and the growth of highly structured transactions as a financing tool, such as mortgage-backed securities (both residential and commercial) and opco-propco financing structures. Many of these structures are long term in nature and have correspondingly long-term hedging instruments such as interest rate, inflation and currency swaps. Coupled with the current low interest rate environment, the associated hedging swaps have become a substantial part of the total liabilities of the borrower, which was hitherto not the case. These vehicles are complex, not well understood amongst the wider investment community, set up very differently from traditional corporate entities, and saddled with original governing documentation that did not contemplate a refinancing or restructuring involving existing stakeholders and investors. Accordingly, existing corporate-type restructuring constructs have had to be modified or new techniques created to deal with such situations.
There are two additional trends impacting the European restructuring scene. First, bond markets have become a much greater source of corporate capital. Bonds have fewer covenants, involve considerably more constituent creditors relative to bank loans, have public–private information issues, and are subject to trading much more than bank loans. Secondly, in response to the withdrawal of several traditional banking institutions, alternative credit funds have filled the void. Financing from credit funds is more expensive but also more flexible (eg, covenant-lite) and bespoke. Such borrower- or situation-specific solutions are becoming more evident.
3.2 Loan trading and alternative investors
Traditionally, corporate loans were syndicated to a limited number of commercial banks that generally held the debt on their balance sheets until final maturity (the 'originate and hold' model). The borrower had a close relationship with the lead banks and the lead banks, by virtue of their largest holdings, were heavily incentivised to monitor the borrower closely. Over the past several years, banks have begun to syndicate the loans they originate much more widely, even to the extent that the originating bank may not keep any of the loan on its books.
Under the traditional model, in the event of financial distress the banks would have been made aware at an early juncture and the borrower would have had to negotiate with a limited number of banks, which made it easier to execute the workout process and to maintain a relatively high level of confidentiality. During the negotiation process, the banks would act in close coordination with each other and would agree to provide the debtor with the liquidity and financial support necessary as it completed an agreed restructuring programme, which usually involved a disciplined sale of individual assets or entire divisions by the debtor or, in certain cases, the sale of the debtor in its entirety. Banks did not want to be active shareholders in the business. During this time the debtor could operate free from the stresses and distractions imposed by any formal insolvency procedure.
This consensual approach to the workout process has been more or less rendered obsolete by the rise of loan trading and the number of non-bank institutions in the credit markets. Traditional lending banks have shown an increasing appetite to sell their exposure in the secondary markets immediately upon the onset of financial distress rather than endure a protracted workout process. The pro-cyclical nature of the Basel capital adequacy requirements, where banks have to commit increasing levels of reserve capital against stressed or non-performing loans, has accelerated loan sales.
