The landmark decision in Design Studio1 introduces the US rescue financing concept of "roll-ups" to Singapore. This is the first case to consider the appropriateness of the roll-up feature in Singapore and is a pragmatic decision that is guided by a careful balance between the protection of creditors' interests and the rehabilitation of the debtor. This case also clarifies that super priority is not solely for new money financings.
The Design Studio case and the super priority regime
In respect of a rescue financing of a debtor subject to a scheme of arrangement or judicial management proceedings, the debtor can apply to court to obtain super priority status for such rescue financing. There are various threshold tests to be passed before a financing is granted super priority status and there are different levels of super priority that may be granted. These different levels of priority include:2
a) that if the debtor is wound up, the rescue financing is to be treated as if it were part of the costs and expenses of the winding up;
b) the rescue financing is to have priority over all unsecured debts and preferential debts (note that this paragraph (b) and paragraph (a) above were the alternative super priorities requested in Design Studio – the court was satisfied that super priority should be granted to the rescue financing pursuant to this paragraph (b));
c) the rescue financing is to be secured by a security interest on property of the debtor that is not otherwise subject to any security interest or a subordinate security interest on property of the debtor that is subject to an existing security interest; and
d) the rescue financing is to be secured by a security interest, on property of the debtor that is subject to an existing security interest, of the same priority as or a higher priority than that existing security interest, if the debtor would not have been able to obtain the rescue financing from any person unless the debt arising from the rescue financing is secured and there is adequate protection for the interests of the holder of that existing security interest.
In Design Studio, the Singapore High Court approved a S$62 million super priority rescue financing package to Design Studio Group Ltd and its subsidiaries ("DSG Group"). This is only the second reported rescue financing case since the enactment of the Companies (Amendment) Act 2017, which introduced the rescue financing regime in Singapore. The first reported case was Attilan3 where the court rejected super priority status for the proposed rescue financing on the basis that the debtor had not taken reasonable efforts to secure normal financing. Following Attilan, there have been two unreported rescue financing cases where the courts granted super priority.4
In Design Studio, the court granted super priority status to a rescue financing from DSG Group's sole secured lender, HSBC, and a major shareholder of the group ("DEPA"). The rescue financing package notably included a roll-up of pre-existing debt. A roll-up entails applying all or a portion of the rescue financing proceeds towards paying off debt owed to the rescue lender, thereby upgrading the pre-existing debt into super priority debt.
The controversy of roll-ups
In the US, roll-ups increased in popularity during the global financial crisis. In tight credit markets, less credit was available to distressed debtors. As a result, distressed debtors typically turned to their existing pre-petition lenders to obtain financing necessary to continue operations. Such pre-petition lenders often conditioned the provision of new debt on the roll-up of pre-petition debt. During the crisis, US bankruptcy courts were more willing to approve roll-ups to ensure that debtors obtained post-petition financing to avoid liquidation. In fact, one of the largest commercial rescue financings made in the history of US rescue financing was during that period: a US$8 billion super priority rescue financing undertaken by Lyondell Chemical Company5 which featured a dollar-for-dollar roll-up of its pre-petition debt. In Lyondell, it was undisputed that the debtor would not have been able to obtain the financing needed to prevent its liquidation without the roll-up feature. The Design Studio court highlighted that the economic difficulties faced during Lyondell are "similar to the present economic climate in the wake of COVID-19"6.
Roll-ups are the subject of much controversy in the US bankruptcy courts as they disrupt the principal of equal treatment of creditors. As noted by the Design Studio court, roll-ups "not only raise the priority of the pre-petition loan, but they raise it to the highest possible level: paid in full".7 The court in Design Studio considered the controversy and ultimately decided that the language in section 211E of the Companies Act 2006 (now section 67 of the Insolvency, Restructuring and Dissolution Act 2018) is "sufficiently broad" to allow for roll-ups. Nonetheless, the court emphasised that the use of roll-ups is not without limits and the rescue financing must create "new value":
"In the case of roll-ups, only roll-ups which ultimately create some value for the company should be regarded as rescue financing. The terms and conditions of each roll-up have to be scrutinised on a case by case basis. New funds which are almost entirely used to repay old debts create little new value, and are not roll-ups which should be regarded as rescue financing…. The amount of new funds that must be pumped in cannot be stated with any meaningful precision in the abstract, but would need to be considered against the circumstances of the specific case. In essence, there must be real benefit by the provision of the roll-up financing, and not a mere trifle or something fanciful."8
In Design Studio, the majority of the rescue financing comprised "new money": S$39.3 million of the S$50 million provided by HSBC, and S$8.38 million of the S$12 million provided by DEPA. This is key as the court made it clear that new money needs to be present in rescue financing to "create new value"9 for the debtor.
Factors to consider
In determining whether to exercise its discretion to grant super priority status to the rescue financing, the court in Design Studio considered the legislative intent, committee reports and US bankruptcy court cases for guidance. In its analysis, the court emphasised that the legislative intent was for the super priority scheme to "facilitate rescue financing, to allow viable companies to be able to restructure".10 It also noted that committee reports intended that the courts act as a gatekeeper to deal with the risk of abuse and determine the appropriateness of granting super priority.11 To this end, any decision to grant or deny super priority requires the court to carefully balance various factors, which the Design Studio court grouped into the four categories described below.12 These are broadly similar to the factors which guide US bankruptcy courts in similar cases.
a) Creditors' interests: whether other creditors would be unfairly prejudiced from the arrangement, whether the rescue financing is in their best interests, and whether creditors are adequately protected.
b) Viability of restructuring: whether there is a good probability that the restructuring will succeed, whether the rescue financing proposed would create new value for the debtor, whether stable returns are expected or whether the financing will be used for risky investments.
c) Alternative financing: whether better financing proposals are available, especially proposals which do not require super priority. The court will assess if the applicant has made reasonable efforts to procure such offers, and evidence of reasonable attempts can include failed negotiations with other potential lenders. However, it is not necessary to show that financing was sought from every possible source.
d) Terms of proposed financing: whether the terms were reasonable and in exercise of sound business judgment, whether the terms and conditions were made in good faith, for proper purpose and are fair, reasonable and adequate.
The court noted that Design Studio was not contested and future contested cases will further refine the factors. Moreover, the facts of the case lent itself to a relatively straight-forward analysis. First as to creditors' interests, HSBC was the sole secured creditor, meaning super priority would not prejudice other secured creditors. As for unsecured creditors,13 the court noted that absent this rescue financing, DSG Group would possibly be faced with liquidation and nil return to the unsecured creditors. Second as to viability of the restructuring, the rescue financing was necessary to make the scheme of arrangement viable and avoid liquidation. Third as to alternative financing, the debtor had engaged an independent global financing services firm to seek potential lenders, out of which, HSBC and DEPA offered the most favourable terms. Fourth as to terms of the proposed financing, the court found the terms to be fair, reasonable and adequate in light of the difficult and tight financial markets.
Of note, the ongoing COVID pandemic weighed heavily on many of the factors as the court acknowledged that in light of the current market, the proposed rescue financing was the most pragmatic solution for all parties involved.
What does this mean for market participants?
Design Studio has opened the possibility of including roll-ups as a feature in the Singapore rescue financing regime and is welcomed as an incentivisation for existing lenders to extend rescue financings. However, it should be noted that in Design Studio, the facts were relatively straight-forward, and the application was not contested. Future cases involving more complex fact patterns, such as a request for the rescue financing to be granted super priority by way of security with a higher ranking priority and a more complicated creditor structure, will require the court to engage in a delicate balancing act. In particular, security with a higher ranking priority will lead to considerations of "adequate protection" given to existing security holders. In addition, if new financiers are fully secured, they may have little incentive to closely monitor debtors and may permit debtors to take greater risks and result in other creditors suffering greater losses if the rescue financing fails. This harm may be particularly pronounced in schemes of arrangement, where the management of the debtor remains in control of the insolvent company and there are greater incentives for "out of money" equity holders to advocate shifting into riskier investments as a potential route back to being "in the money". Further, the claims of other creditors who continue to deal with the debtor will be subordinated to the super priority claim by the rescue finance lenders. Accordingly, these other creditors may become more wary of entering into dealings with the debtor.
The Design Studio court has established that its role is that of a pragmatic gatekeeper, evaluating the appropriateness of granting super priority status through a careful balance of factors including creditors' interests and the survival of the debtor. However, future cases will illustrate the difficult balance between encouraging rescue financings in order to aid distressed debtors and the concerns of creditors that do not benefit from super priority.