The ongoing financial crisis has given rise to an increase in financial restructurings for many German companies, as a way of avoiding possible insolvencies. German companies have taken various approaches towards the painful process of restructuring. For instance, they have streamlined their operations, cut costs and raised capital.
Among several restructuring measures, many companies have chosen to improve their financial position through a debt-equity swap. This measure is an out- of-court restructuring procedure and involves the short-term reorganisation of a company through the conversion of existing liabilities into equity.
The mechanism
To be more precise, the term debt-equity swap (also known as “debt-to-equity swap” or “debt-for-equity swap”) does not relate to one particular measure. Instead, the term defines various restructuring methods – all of which aim to convert debt into equity.
The essential aspect of the procedure involves the restructuring of the balance sheet of an indebted company. Through this manoeuvre, relevant creditors who are engaged in the company, agree to reduce their debt claims in exchange for equity interests in a reorganised capital structure of the company. This procedure gives creditors, as shareholders of the company, more control over future restructurings of the company.
A debt-equity swap gives direct positive results. The company’s balance sheet will show a reduction in the burden of debts whilst simultaneously showing a corresponding increase in equity. Such an increase of equity leads to better prospects of opening up new credit lines; it allows the firm to gain more financial flexibility; and enables the firm to compete more effectively in the market.
In Germany, the legal framework sets out two possible structures for debt-equity swaps:
- Capital reduction, followed by the capital increase through the contribution of receivables (non-cash contribution) – the “Standard Structure”. However, under German law, a capital increase requires the approval of 75% of the shareholders, attending and having voting rights at the shareholder meeting.
- Direct shares acquisition (share deal), followed by the waiver of receivables – the “Alternative Structure”. This allows the company to avoid capital measures but it is often time-consuming and especially difficult to execute in times of a financial crisis.
Both of these structures, however, create substantial tax and other consequences. Firstly, because the debt-equity swap procedure generates an extraordinary income, this income will be subject to taxation in the usual way. Secondly, like the risk of creditors’ liability for the shortfall in the value of the contributed receivables (Differenzhaftung).
The Conergy case
The recent case of Europe’s biggest solar company, Conergy, is an example of how the Standard Structure has been applied in practice. The company fell into financial difficulty by focusing on too many business areas in the renewable energy sector. The growing competition in Asia compounded the company’s financial difficulties.
At the end of 2010, Conergy decided to restructure its balance sheet by executing a debt-equity swap. The company reduced its capital stock by 88 percent in order to increase it again up to 188 million Euros, subsidizing the company with fresh equity. Numerous creditors of the indebted firm agreed to participate in the capital increase by subscribing their claims in the amount of 188 million Euros as a contribution-in-kind.
The debt-equity sway allowed Conergy to reduce its debt burden from 323 million to only 135 million Euros. With a reduced debt level, the Company has been able to pursue strategic options such as joint ventures or cooperation and there have been increased opportunities for new lending.
The Pfleiderer case
Another recent interesting case in Germany was the Pfleiderer AG restructuring. The building material company had been almost illiquid because of the latest financial crisis. At the beginning of 2011, the company proposed a restructuring plan, which, after gaining the creditors’ approval, led to a large-scale financial restructuring.
The structure of the debt-equity swap was similar to the one presented in the Conergy case. However, the company also decided to make use of new German bond law (Gesetz über Schuldverschreibungen aus Gesamtemissionen). Pfleiderer had received a considerable credit line in the form of a first-lien secured loan from the participating banks and funds. The banks and other creditors agreed to the contribution in the form of a waiver of a substantial proportion of owned credit receivables. The holders of previously issued Pfleiderer hybrid bonds, identified as equity, agreed to swap their bonds for the right to acquire shares. These were then exchanged after being cut for a minority equity interest in the firm.
Additionally, the procedure included a decrease in capital, followed by its increase – the participation of creditors was anticipated. This procedure led to the substantial cash injection for the company that permitted Pfleiderer to continue its operations. Furthermore, the company issued an option bond (the assumed subscription involved the creditors participating in the debt waiver, but not in the capital increase).
Conclusion – the future of debt-equity swap in Germany
Companies should carefully consider the consequences of a debt-equity swap before conducting this type of restructuring arrangement. However, notwithstanding this, it is clear that the debt-equity swap has attracted considerable attention from German investors.
Especially appealing is that every party involved in the debt-equity swap is often satisfied with its results – the creditor receives shares in the company’s capital and the burdening debt ceases to exist. The company gains credit potential and the creditors are in control of the restructuring procedure, not losing their already invested capital.
Due to the existing regulations, including recently passed laws, such as the Gesetz über Schuldverschreibungen aus Gesamtemissionen, and also to the newly prepared, although not yet enacted, German law governing the restructuring of companies (Gesetz zur weiteren Erleichterung der Sanierung von Unternehmen “ESUG”), the debt-equity swap is a good alternative to the other out-of-court restructuring procedures and its usage will certainly increase over time.
Moreover, according to the regulations of ESUG the procedure of a debt-equity swap can be used as part of an insolvency plan without the historical need for shareholder approval. Therefore, ESUG will strengthen this instrument and limit the rights of shareholders trying to block the restructuring of a company.
Finally, ESUG will diminish the existing risk of creditors’ liability for the difference between the real value of the contribution-in-kind and the contractual agreed contribution.
Although the debt-equity swap is a short-term reorganization procedure and does not solve all the company’s problems, its advantages as a basis for a successful reorganization are widely recognized and its usage is likely to become more popular in the restructuring process of a company.
