The UK has for some time been considered the jurisdiction of choice for implementing large scale, and often highly complex, cross-border financial restructurings. The pre-eminence of the UK restructuring market going forward, however, is far from certain. The political and legal uncertainties surrounding BREXIT, the increased willingness of companies to pursue restructurings under Chapter 11 and the EU Preventive Restructuring Framework Directive all mean companies may abandon the UK in favour of alternative jurisdictions to restructure their debt.
Whether these factors are sufficient to pose an existential threat to the UK restructuring market remains to be seen, but the government has made clear that it intends to do what is required to retain the UK’s “best in class” status and preserve its position as a global leader in large scale restructurings.
It is against this backdrop that the government issued its response in relation to the proposed changes to the UK’s insolvency and corporate governance framework. The initial market reaction to the proposals has largely been positive with many welcoming the intention behind the proposed reforms. However, if you delve deeper into the response, it is clear that the government still has a lot of work ahead of it before producing draft legislation if it wishes to create truly effective additions to the existing toolkit.
The purpose of this article is to provide a high-level summary of the proposals and to highlight some of the main practical issues that (if left unresolved) may reduce the effectiveness of the proposed reforms.
The pre-insolvency moratorium
In the context of a business in financial distress, prevention is undoubtedly better than cure. However, for directors at the helm of a struggling business, avoiding insolvency can appear a daunting and, at times, overwhelming enterprise. Directors are often tasked with identifying the cause of the financial issues within the business and devising and negotiating a financial restructuring plan. At the same time, they remain responsible for the day-today operations of the business and, often, implementing an operational turnaround strategy. These pressures are compounded by the fact that, absent contractual standstill or waiver arrangements or the rarely used CVA small company moratorium, the only way to obtain protection and prevent hostile creditors from taking action against the struggling business would be to enter into administration, with the associated stigma and contractual triggers this may bring. For listed companies or those subject to sectorspecific regulations, a default under their financing arrangements without a legally binding prohibition on the creditors taking enforcement action could have destabilising implications (even without such action ever being taken).
The absence of a moratorium means the directors have to spend more time engaging with their creditors which, in turn, further stretches the bandwidth of the directors, increases adviser fees that can materially affect short-term liquidity and could, ultimately, jeopardise the chances of implementing a successful restructuring. It is this gap in the existing toolkit that the new moratorium seeks to fill.
The moratorium is designed to be a standalone procedure that will prevent creditors from taking enforcement action (though, as discussed below, precisely what the moratorium will achieve in practice remains open to debate). It will be initiated by filing the necessary papers at the court (similar to the out-of-court administration procedure) but the process itself will be conducted out of court. An insolvency practitioner (referred to as a “monitor”) will be appointed to oversee the moratorium and to protect the interests of the creditors. The monitor embodies a supervisory role and does not assume the directors’ managerial responsibilities. Instead, the monitor is responsible for ensuring the qualifying conditions (discussed below) remain satisfied throughout the moratorium. The monitor will also be responsible for sanctioning asset disposals outside the normal course of business and the granting of new security over the company’s assets.
In an attempt to balance the interests of creditors against those of the company, the moratorium only has a short initial duration (28 days) but can be extended by a further 28 days provided the monitor confirms that the qualifying conditions continue to be met. The moratorium can be further extended provided that 50% of the secured creditors and 50% of the unsecured creditors vote for such extension (the court may grant a further extension without creditor consent in cases where it is impractical to obtain).
Overall, the principle appears sensible as it gives directors respite from hostile creditors and allows them time to devise a restructuring proposal and thereby avoid an impending insolvency. However, the detail of the proposal demonstrates a number of practical problems that need to be addressed. The principal issue relates to the qualifying conditions that need to be satisfied in order to enter, and retain the protection of, the moratorium. The main conditions are as follows:
- the company cannot be insolvent but must be in a state of “prospective insolvency”;
- it must be more likely than not that an arrangement with the creditors can be agreed; and
- the company needs to be able to meet its current obligations and those falling due during the moratorium as and when they fall due.
If, at any stage during the moratorium, these qualifying conditions are no longer met, the monitor must terminate the procedure. In the government response and guidance, all three qualifying conditions lack detail. Questions such as “what does prospective insolvency actually mean” and “what evidence will be needed to show that an arrangement is more likely than not” will need to be fully fleshed out (though case law interpreting comparable tests in relation to existing procedures may provide some guidance). It is clear the government will have to carefully define these concepts for the moratorium to work as intended. The more concerning issue, however, is not the lack of detail (which we assume will take shape as the proposals develop) but rather that a company must be able to meet its obligations throughout the moratorium as they fall due.
If the company is solvent – and is able to meet its debts as they fall due on a go-forward basis – then it begs the question as to why the company needs the benefit of the moratorium in the first place? If the company becomes unable to meet its debts then the moratorium will fall away and the company (providing it does not immediately enter an insolvency process) will be left to fend for itself against potentially hostile creditors, leaving it in the exact position the moratorium seeks to protect against. It is unclear why a company would enter into the procedure (thereby signalling to its creditors and the wider market that it is in a state of prospective insolvency) if the protection were to fall away so easily. Obviously, a balance needs to be struck between protecting the company from an avoidable insolvency while at the same time not unfairly restricting creditor rights; however, the proposal as it stands appears to remove the moratorium protection just as soon as it becomes urgently required.
Therefore, it is questionable how useful such a tool will be in practice unless the final qualifying condition is amended.
Supplier termination Clauses
Another proposed legislative introduction is a prohibition on so called ipso facto clauses (ie clauses which permit one party to a contract to terminate solely on account of the insolvency or financial condition of another party). The inspiration for this appears to have been drawn, at least in part, from Chapter 11, which generally prohibits the termination or modification of contractual rights or obligations as the result of the commencement of bankruptcy procedures. However, comparable concepts exist in other jurisdictions including Australia and the Netherlands (where a similar restriction was introduced as part of the recent Dutch insolvency reforms).
The prohibition may not seem immediately relevant to large financial restructurings effected at holding company level, but its introduction is another step designed at promoting rescue culture. Indeed, where the indebtedness of a group sits (even partially or contingently) at operating company level, the prospect of continued revenue generation – and, by extension, any realistic chance of rescue – can be hampered by a right for suppliers to terminate contracts for the supply of vital goods and services upon the detrition of the business’s financial condition. Even if suppliers do not opt to terminate, their right to do so, often on short or immediate notice, can lead to renegotiations of payment terms that affect the debtor group’s liquidity when headroom is most needed.
The ban on ipso facto clauses therefore seeks to preserve businesses’ operational capabilities in the context of financial distress. To achieve this, the government has proposed that the prohibition will apply to all contracts for the supply of goods or services (as yet undefined) and contractual licences (subject to certain exceptions, such as regulatory licences and specific financial contracts yet to be identified). There is some ambiguity as to the precise grounds on which counterparties will be prohibited from terminating; the response itself refers to formal insolvency procedures (including the new moratorium and Restructuring Plan) but the prohibition may also apply to grounds connected with the debtor’s financial condition. Though the latter has not been confirmed, the legislation may extend the prohibition to a state of cashflow or balance sheet insolvency without the need for formal insolvency proceedings to be commenced.
Putting aside the question of whether it is “right” to fetter freedom of contract in this manner, the main issue that requires clarity is the intended scope of the prohibition (both with regard to the contracts to which it applies and the nature of the prohibitions that will be imposed).
The proposed application of the prohibition, to all suppliers of goods and services, is far broader than the existing statutory regime (which is limited to preserving continuity of supply of essential services such as electricity and IT). The practicality of the proposal will depend, in many respects, on the “goods and services” within its scope and, as importantly, those which are to be excluded. In addition to regulatory licences, the proposals refer to certain types of financial instruments that will be excepted from the prohibition (though no further details are provided in this regard). If these exemptions are limited to specified derivative products and netting arrangements, will creditors be obliged to continue making available overdraft, letter of credit and revolving credit facilities?
While liquidity support facilities are often as important for companies in financial distress as the continued supply of goods and services, enforced continuity of a supply of cash may be a bridge too far.
In the government’s response, the scope of the restriction only expressly extends to preventing contractual terminations. By contrast, Chapter 11 also prevents the modification of contractual rights as a result of the commencement of a bankruptcy case. Limiting the restriction to a right to terminate could provide scope for supply contracts to be structured so as to provide unilateral rights for the supplier to modify key terms on insolvency triggers. A contract continuing for the supply of goods may be of little benefit to a company needing to preserve liquidity if same-day payment terms are immediately imposed.
Unlike in Chapter 11 proceedings, the government proposes that suppliers will retain the ability to terminate contracts on grounds other than the insolvency of the counterparty. These include: (i) nonpayment of liabilities; (ii) by giving notice in the manner prescribed by the contract; and (iii) for other reasons unconnected with the company’s financial condition or entry into an insolvency procedure (eg for breach of other obligations under the relevant contract). These exceptions provide a layer of protection for suppliers but may limit the usefulness of the prohibition in practice. If suppliers are able to terminate on account of “other reasons” it may be straightforward for suppliers to circumvent the restrictions through creative drafting and a market shift towards pre-insolvency termination triggers could swiftly defeat the regime’s purpose.
The conceptual step of prohibiting ipso facto clauses feels like one in the right direction. The continuity of operations is, very often, an integral means of preserving value for the benefit of stakeholders and, for most businesses, continuing to trade requires far more than the preservation of the limited services which are currently afforded statutory protection. However, the scope of the regime must be carefully delineated to ensure it works in practice as intended in concept.
The Restructuring Plan
The UK scheme of arrangement has, for some time, been considered the proverbial jewel of the UK restructuring crown. This flexible statutory procedure is a powerful restructuring tool enabling either an English or foreign incorporated company (in certain situations) to cram-down dissenting creditors in order to implement its restructuring proposal. The scheme strikes a careful balance between the freedom of the parties (containing almost no restrictions on the nature of the arrangement that can be reached between the parties) while at the same providing court oversight and a number of creditor protections. All this is made even more impressive when you consider that the scheme is a creature of company law and not a specific restructuring tool.
Nevertheless, the scheme, though internationally renowned, is not perfect. The most notable issue is that schemes lack the ability to implement a cross class cram-down, meaning that minority out-of-the-money creditors (or shareholders) could potentially block a restructuring if they were in a class separate to the pro-restructuring majority.
The absence of a cross class cram-down is certainly not a fatal flaw and there are many practical methods to work around this issue. For example, in situations where there are out-of-the-money shareholders, the company can first be put into administration, allowing the administrator to commence a “pre-pack” and subsequently implement the restructuring without the dissenting class blocking the proposed arrangements.
Notwithstanding the methods used to mitigate this issue in practice, the absence of a cross class cram-down is notable and it is unsurprising (especially when you consider that a cross class cram-down is a commonlypraised feature of Chapter 11 and a key part of the EU Preventive Restructuring Framework Directive) that the UK is looking to incorporate this into the new restructuring toolkit.
When deciding to incorporate a cross class cram-down mechanic the government could have easily tweaked the existing legislation in relation to schemes. However, with the international familiarity of the scheme in its current form, doing so could have created uncertainty around the procedure and therefore risked the position of the scheme as a leading international restructuring tool. The government therefore decided instead to create a whole new procedure, referred to in the response as the Restructuring Plan.
The procedural similarities between the Restructuring Plan and the existing scheme are notable, which reflects the government’s intention to preserve both the procedural familiarity of the scheme and existing scheme related jurisprudence already established by the courts. Both procedures follow broadly the same process, from the company’s initial proposal and the formation of distinct creditor classes to sanctioning by the court.
However, the Restructuring Plan differs from the scheme in certain instances, including the voting procedure, which is, in essence, the same as that used in CVAs and the eligibility criteria/jurisdictional test (discussed below).
However, the most significant difference is, of course, the introduction of a cross class cramdown mechanic. The cross-class cram-down mechanic means that at least one (but potentially more than one) class of dissenting creditors or, though the government guidance has not expressly confirmed this yet, shareholders can have the Restructuring Plan “forced upon them”. It is undoubtedly a powerful tool that will afford a level of flexibility lacking in the existing scheme. Given the ability to force creditors with different economic rights to accept the same restructuring proposal, the government has proposed a number of counterbalances (again, inspired by foreign insolvency regimes). The first of these protections is that the crossclass cram-down can only be used if at least one class of impaired creditor (ie a creditor that will not receive payment in full under the restructuring proposal) votes in favour of the proposals. In theory, this prevents senior creditors using the procedure to write down (or even wipe out) the junior creditors unless they themselves also suffer an impairment.
The second notable counterbalance is that a dissenting class of creditors must (unless the court specifically allows otherwise) be satisfied in full before a more junior class may receive any consideration, or keep any existing interest, under the restructuring proposal.
This rule is already a feature of Chapter 11 and is commonly referred to as the “absolute priority rule”.
Notwithstanding the potential of the Restructuring Plan, there are practical issues with the proposal in its current form that need to be considered. The first issue is that the government response does not state what the jurisdictional test for a company to use the Restructuring Plan will be. The scheme has achieved its international acclaim, at least in part, because almost any company can use it.
Unlike formal insolvency proceedings, which typically require a company to have its COMI in England, a scheme can be commenced provided the company proposing the scheme is able to demonstrate that there is a “sufficient connection” to England. Sufficient connection is not a rigid statutory definition but rather it is a flexible and expansive concept which has been carefully fine-tuned by the judiciary. What amounts to a sufficient connection is praised by some (and heavily criticised by others) for being a relatively low bar, with English law-governed finance documents generally considered adequate, even in the case of a foreign entity that has no other connection to the jurisdiction. Allowing a large pool of global companies to use the tool is undeniably key to ensuring it becomes an effective restructuring tool and, while we understand the decision not to clarify the jurisdictional test at this stage was intentional due to the uncertainties surrounding BREXIT, it is clearly an item that needs to be addressed in order to determine how effective this new tool will be.
Another practical issue with the proposed Restructuring Plan is the heavy reliance the procedure places on the English judiciary.
Unfortunately, there is not space within this article to address this point in detail; however, per the government response, the court may be required to rule on a number of matters, including: (i) in situations where there is a cross class cram-down, the valuation methodology for determining the alternative to the Restructuring Plan (valuations being something the judiciary has historically shied away from opining on); (ii) whether it is just and equitable, and necessary to achieve the aims of the restructuring, to depart from the absolute priority rule; and (iii) what constitutes an “impairment”, with such determination needed to prevent a senior class from manufacturing “impairments” that are economically immaterial (such as a minor extension to the tenor of a loan) in order for them to cram down dissenting junior classes.
The English judiciary are renowned the world over and would no doubt rise to the challenge; however, it would be preferable to have sufficient certainty in the legislation so as to avoid, wherever possible, matters being determined by the court, with the associated cost and time burdens this may place on many restructuring processes.
Conceptually, the proposals referred in the government response represent a step in the right direction for the UK restructuring market and are centred on promoting rescue culture and ensuring continuity of operations while adding a new level of flexibility to the implementation of financial restructurings.
In particular, the introduction of the new Restructuring Plan, with its ability to cram down dissenting classes of creditors and (it is hoped) shareholders, should bridge this significant gap between the UK and its main competitors in the global restructuring space.
Given draft legislation will be tabled “when parliamentary time permits”, it could be some time before the application of the new tools can be tested in practice. However, before that time comes, the practical application of certain elements of the proposals require further consideration and clarification, in particular around: (i) the solvency status of companies eligible to benefit from the new moratorium; (ii) the scope of contracts to which the restrictions on ipso facto clauses will apply and the extent of these restrictions; and (iii) perhaps most importantly, the jurisdictional scope of the Restructuring Plan.