Distressed preferred shares are an important weapon in the arsenal of a restructuring lawyer. They allow distressed companies to reduce their borrowing costs by restructuring their debt in a way that gives a taxable Canadian resident corporate lender a tax-free return. This means that the lender can accept a dividend rate that is less than the interest rate on the debt it holds and receive the same economic return without losing the priority that came with holding secured debt. Given the current economic conditions and the state of the credit markets, we have been talking with corporations facing financial difficulty about restructuring alternatives and distressed preferred shares are often considered. Set out below is a brief overview of how they work and the best circumstances for their use.
The Income Tax Act (Canada) (the Act) permits a corporation that is resident in Canada and unable to pay its debts because of financial difficulty to issue financial difficulty preferred shares (referred to as “distressed preferred shares”) as a method of refinancing its existing debt. The Act provides favourable tax treatment for the dividends paid on the distressed preferred shares, thereby permitting the financially troubled corporation to access a lower financing cost. The tax treatment on the dividends provides the lender with the same higher rate of return it would have received if it were paid as interest on debt, giving the distressed issuer a lower borrowing cost. Provided the appropriate tax integration is achieved, dividend rates can be approximately two-thirds of the rate of interest on debt, so the savings can be significant.
In most instances, the transaction which creates the distressed preferred shares consists of the formation of a new subsidiary of the distressed corporation. The common shares of the subsidiary are thus owned by the distressed corporation, and a series of preferred shares are created and made available to be issued by the subsidiary to the distressed corporation's lender. The terms of the distressed preferred shares may vary, but typical terms might include the following:
(a) a term of not more than five years from the date of issue; (b) redeemable annually before the end of the term to the extent that there is any “excess cash flow”; (c) retractable by the holder at any time if default occurs; and (d) the holder will be entitled to annual, cumulative preferential cash dividends to be paid at the rate negotiated.
The subsidiary borrows, on a demand loan basis from the lender, an amount equal to the aggregate of the principal amount owed to the lender by the distressed corporation. The subsidiary then uses those funds to purchase from the lender the debts owed to the lender. This, in turn, returns the money borrowed by the subsidiary in the demand loan to the lender.
The lender then subscribes for the distressed preferred shares in the subsidiary in the same amount as the demand loan. The subsidiary uses the subscription proceeds to pay off the demand loan. The lender thus owns distressed preferred shares having subscribed for them in the same amount as the original loan and the original loan is now owned by the subsidiary.
A series of put call agreements and guarantees are then arranged. If the distressed preferred share dividends are not paid, the transaction is unwound and the lender is put back in the position occupied prior to the undertaking of the transaction including maintaining its priority. In the event of unwinding, the subsidiary returns the original debt obligation to the lender, reduced only by any repayments, and security in the same priority.
This preferred share arrangement effectively results in a lender trading a secured loan arrangement for a preferred share, with a distressed borrower operating as if it had a preferred shareholder. This, however, is a temporary parking of the loan, such that the loan will be put back in place in the event of any default in payment or on the maturity of the arrangement. Other lenders dealing with the borrower will be subject to the continuation, generally in priority, of the loan and security arrangements.
Due to the uncertainty of determining whether the preferred shares will qualify as distressed preferred shares, and in light of the significant tax that would be payable if they did not qualify, an advance ruling from the Canada Revenue Agency is generally requested by the parties involved in the refinancing.
As mentioned above, distress preferred shares give the best return when issued to a taxable Canadian corporate lender. If the debt is not currently held by a taxable Canadian corporate lender, there are structures (which will require an advance tax ruling) through which the distress preferred shares can be warehoused with a taxable Canadian corporate lender.
Distressed preferred shares are most effectively used in restructurings when the cost of borrowing is high and the savings can be substantial. With an increasing number of corporations facing financial difficulty and the prospect for an increase in the cost of borrowing as a result of the current turbulence in the credit markets, it is possible that we will see the use of distressed preferred shares in corporate restructurings in the coming months.