The English High Court has recently delivered judgment in the IMO Car Wash case (In the matter of Bluebrook Ltd and others  EWHC 2114 (Ch)), in which the High Court considered whether to sanction three related schemes of arrangement for restructuring indebtedness proposed by the IMO Car Wash group to the senior lenders of the relevant group companies.
IMO Car Wash (IMO) – the world’s largest carwash company, owned by US private equity firm The Carlyle Group – defaulted on its debt in March 2009 by failing to make an interest payment and breaching its financial covenants. IMO was indebted to two groups of secured lenders owing £313 million to the senior lenders and £119 million to the junior lenders. The security of the mezzanine lenders over the assets of IMO was fully subordinated to the security of the senior lenders pursuant to the terms of an intercreditor agreement. The relevant boards of directors were concerned that IMO could not pay its debts as they fell due and that the group was balance sheet insolvent.
All parties agreed that the assets of IMO were insufficient to satisfy its obligations to both the senior lenders and the mezzanine lenders.
Terms of the Restructuring
IMO (UK) Limited, a sister company and its holding company, proposed three schemes of arrangement with the senior lenders that would involve a prepackaged administration through which the IMO group would transfer its business and assets to a “Newco” and use the sale proceeds to repay part of the debt due to the senior lenders. The senior lenders would then exchange the remaining debt due from IMO for equity in the Newco.
The mezzanine lenders would not receive any repayment of the debt due to them and would be left with claims against the old IMO companies with no assets. This was justified by the scheme companies on the basis that the mezzanine lenders had no economic interest in the group because the value of the group assets was significantly and demonstrably less than the value of the senior debt. Accordingly, the mezzanine lenders were not required to approve the schemes as their claims were not being compromised. However, they challenged the schemes on the basis that the schemes unfairly prejudiced their interests.
The Court was required to decide whether or not to sanction the schemes of arrangement.
The Valuation Evidence
In creating the schemes, IMO and the senior lenders had procured or engaged in the following valuation exercises:
- Commissioning a report from PricewaterhouseCoopers (PWC) to analyse the value of the group for the administrator who was intended to be appointed in the prepackaged administration if the restructuring was to proceed. The report valued the group on a going-concern basis, and not on a liquidation or fire-sale basis, by adopting the following methodologies:
- An income approach, which valued the business on a discounted cash-flow (DCF) basis. In this approach, an “alpha factor” was added to the cost of capital to reflect uncertainty in the market and the impact of the credit crunch on the availability and cost of financing.
- A market approach, which analysed comparable publicly traded companies.
- A leveraged buyout analysis, which looked at the debt capacity to assess the level of equity investment a potential private equity purchaser would be prepared to make.
- Instructing UK merchant bank Rothschild to pursue a third party sales process with a view to seeing if a buyer for the existing group could be found. Only one indicative offer was received.
- Instructing PWC to extrapolate an overall value for the business based on a surveyor’s valuation of a number of the group’s sites.
Based on these valuations, it was estimated that a purchaser would pay no more than £265 million for the business, which fell well short of the £313 million of outstanding debt due to the senior lenders. Even if PWC stripped out the “alpha factor” it used in the income approach, the value still would have been well short of the level of senior debt.
The mezzanine lenders produced alternative valuation evidence in the form of a report from L.E.K. Consulting (L.E.K.) which carried out a DCF analysis of the business. For the report, L.E.K. undertook a “Monte Carlo simulation” which involved repeated calculation of the DCF valuation using random sampling of input and assumptions, followed by the aggregation of the results into a distribution of the probabilities of different valuation outcomes.
The L.E.K. report also carried out a comparable transaction valuation, using five precedent transactions as a basis for valuation, and a comparable multiples valuation, using nine comparable public companies from which various data was extracted and applied to figures for the group. From these exercises, L.E.K. derived a valuation range whose lower end was in excess of £300 million on average, with a median valuation of approximately £385 million.
The mezzanine lenders relied on the L.E.K. report in support of their case, arguing that they had an economic interest as there was a realistic possibility that the scheme companies had intrinsic value in excess of the senior debt and that the companies’ directors were failing to extract proper benefit for the creditors of the companies.
In reaching his decision on the issues before him, the judge, Mr Justice Mann, confirmed key established principles from cases which had been previously decided as follows:
- A company is free to select the creditors with whom it wishes to enter into an arrangement and need not include creditors whose rights are not altered by the scheme.
- It is not necessary for the company to consult any class of creditors that is not affected, either because the creditors’ rights are untouched or because they have no economic interest in the scheme.
- Creditors could still object on the grounds of unfairness if the schemes unfairly affected them in ways other than altering their strict legal rights.
All of the valuations produced by the senior and mezzanine lenders were conducted on a going-concern basis, and the judge agreed that “in order to assess the fairness of the schemes a going concern valuation is appropriate”.
The judge considered the valuation evidence submitted on behalf of the senior and mezzanine lenders and was highly critical of the L.E.K. report on which the mezzanine lenders relied. He expressed concern about the manner in which the L.E.K. report was provided and the lack of assumptions contained within the report. He contrasted the L.E.K. report with the PWC report, which he acknowledged contained meaningful assumptions.
The judge dismissed the Monte Carlo simulation analysis as a “robotic exercise…not often used in valuation exercises”. He went on to say that “a proper approach to valuation in a case such as this requires some real world judgments as to what is likely to happen (such as a judgment as to the correct weighted average cost of capital, which is a very important element in a DCF calculation), rather than a range to which other ranges are applied in a series of random calculations to come up with some mechanistic probability calculation. I find the former approach much more helpful and much more relevant”. He concluded that the Monte Carlo model failed to demonstrate that there was a realistic chance that the value of the IMO group was in excess of the value of the senior debt.
The IMO case also addressed the extent of directors’ duties in negotiating a restructuring. Under statutory provisions in the Companies Act 2006 and the Insolvency Act 1986, when a company is insolvent (or is unlikely to avoid becoming insolvent) the duties of directors switch from acting in the best interests of the company to acting in the best interests of the creditors of the company. The mezzanine lenders alleged that the directors should have used their bargaining position with the senior lenders to secure a deal for something to be provided to the mezzanine lenders.
As the IMO group was technically insolvent, it was questionable whether the directors really had bargaining power due to the need to agree on a restructuring and the personal risks for the directors of wrongful trading if they continued to trade the business without a compromise with the creditors. The judge acknowledged that the initial restructuring discussions involved both the senior and the mezzanine lenders, but when these discussions failed the directors agreed the schemes with the senior lenders who they saw as being the only parties that had an economic interest in the IMO group. He concluded that the boards had acted independently due to the presence of independent directors, the unanimity of board decisions and the fact that the board received independent advice.
The Court found that the mezzanine lenders did not have a relevant economic interest in the scheme companies and decided that the schemes should be sanctioned.
What does the decision mean for junior creditors?
The IMO case is of great interest to the restructuring community as it is the first time that the English Courts have been asked to consider the issue of valuation. A similar dispute between creditors in relation to the restructuring of the holiday company MyTravel left the issue of valuation unresolved. The IMO restructuring plan is similar to that of the retirement home builder McCarthy & Stone which was implemented by way of a scheme. The scheme gave a majority of the company’s equity to senior lenders in exchange for a debt write-off but left junior lenders with nothing as they were considered to have no economic interest. However, in that case there was no argument over valuation.
The decision of the High Court provides confirmation that only the interests of those creditors with a genuine economic interest in a distressed company need to be taken into account in the planning of a restructuring of that company’s debt. The question of which creditors have an economic interest in the distressed company is determined by reference to the present market value of the company, tested on a going-concern basis. If the value is less than the senior debt, a restructuring excluding the junior lenders will merely implement the subordination provisions envisaged in the loan documents.
The IMO case could have implications, not just for UK companies but also for distressed Continental Europe-based companies which could be restructured under English law.
This judgment is clearly very specific to the facts of the case and can be considered to be based on the quality of the valuation evidence provided by the parties. A judge will remain open to refusing to sanction a scheme if the valuation evidence of the senior lenders can be challenged by evidence indicating the value might be sufficient to include some of the subordinated debt.
It is unclear whether the mezzanine lenders will appeal the decision. In the meantime, mezzanine lenders will, no doubt, continue to challenge restructurings in which they stand to lose a lot of money. However, they would be well advised to use a sensible, robust, going-concern valuation in support of their position.