In August 2009, an English court sanctioned the use of a scheme of arrangement to restructure the debt of IMO Car Wash Group, a highly leveraged UK based car wash company. This decision follows the similar use of schemes of arrangements in other restructurings. For example earlier this year an English court sanctioned the use of a scheme in the debt restructuring of McCarthy & Stone. In both of these restructurings, the subordinated creditors were left with no value for their debt claims. In IMO, the secured mezzanine creditors unsuccessfully attempted to persuade the court to withhold its approval of the restructuring. These cases highlight the inherent tension between senior and junior creditors in distressed situations. In light of the use of schemes, we believe both senior and junior creditors should review why the creditors relied on a scheme of arrangement to restructure a heavily indebted company and whether the IMO court decision will alter the way creditors should think about the restructuring of a company which falls under the jurisdiction of England. In this memo, we have analyzed the debt restructuring used in IMO and summarized the structures and legal regimes that operate in the context of an English restructuring.
In 2006 the Carlyle Group acquired the IMO group and funded the acquisition with equity and senior and mezzanine debt. The senior and mezzanine debt were secured by the assets of the company, with the mezzanine debt contractually subordinated through an intercreditor agreement to the senior debt. The intercreditor arrangements between the senior lenders and the mezzanine lenders provided, among other things: (i) the senior debt ranked ahead of the mezzanine debt; (ii) the mezzanine debt could not be paid until the senior debt was fully repaid; (iii) the security agent for the senior and mezzanine debt holders had authority to release the security, guarantees and liabilities in any enforcement action without the consent of the mezzanine lenders, provided all proceeds were applied in accordance with the intercreditor agreement; and (iv) a right for the mezzanine lenders to buy the senior debt at par upon an acceleration of the debt.
IMO began underperforming and breached covenants under its debt agreements, and defaulted on interest payments to the senior and mezzanine lenders. IMO initially entered into standstill agreements with its senior and mezzanine lenders, and began negotiations with its lenders and shareholders with a view to completing a consensual restructuring. This process included an offer of warrants to the mezzanine lenders, which was rejected. When a consensual restructuring could not be achieved with all parties, the company and its senior lenders sought to complete a restructuring without the consent of the mezzanine lenders, using the UK administration process and a scheme of arrangement.
The structure was as follows:
- IMO entered into a conditional asset transfer agreement to sell the assets of the group to a newly formed group of companies to be controlled by the senior lenders.
- The senior lenders agreed to write off approximately £126 million out of the total of £313 million due to them in exchange for substantially all of the equity in the newly formed group of companies. The mezzanine and other creditors’ debts were left in the existing group, which would have no underlying assets.
- The court approved the scheme of arrangement.
- The administrator was then appointed by the security agent, and the existing group of companies were placed into administration.
- The security agent, upon the instructions of all senior lenders, released all liabilities and the security and guarantees over the assets, and requested that the administrator complete the asset transfer agreement.
- The administrator transferred the assets in accordance with the asset transfer agreements. This transfer did not form part of the scheme of arrangement, and was subject to the administrator’s discretion as to whether the transfer was in accordance with the purpose of the administration and in the interest of all creditors.
The overall effect of the arrangements was to transfer the assets of the existing IMO group into a new group, giving the majority of the equity in the new group to the senior lenders, with a smaller interest in favor of management. A large part of the existing debt was novated to the new group, but no assets were available to pay the mezzanine (or any further subordinated) lenders. The senior lenders' justification for this treatment was that the value of the group was such that the mezzanine lenders had no economic interest, because the group's overall value was "significantly and demonstrably" less than the value of the senior debt. The mezzanine lenders argued that the proposed schemes unfairly prejudiced their interests because the value of the group's assets may not be less than the senior debt, and that they should be allowed to participate in the new group by being given an interest after the senior lenders have had their debt repaid and a proper return on equity. A second argument was that there were enough prospects of the mezzanine lenders having an economic interest in the group in the future to justify their inclusion in any restructuring arrangements. Their exclusion from the scheme was, therefore, in their view, unfair.
What is a Scheme of Arrangement?
An English scheme of arrangement is a statutory procedure, provided for under the Companies Act 2006, whereby a company may make a compromise or arrangement with its members or creditors (or any class of them,) provided that a requisite majority of creditors agree (e.g. 75% in value and 50% in number in each class of creditors who vote in favor of the scheme) and the sanction of the court is obtained. A scheme of arrangement is not an insolvency procedure, and is often used by English companies to effect a merger of two companies. Its primary benefit is to undertake a corporate reorganization of some type without the consent of all the parties to the reorganization.
The court will only sanction a scheme if it passes the “fair and reasonable” test, but once sanction is obtained, it will bind all creditors of a class that are a party to the scheme, irrespective of whether they vote in favor or not. If a creditor within the class feels they are unfairly treated by the terms of a scheme, they can raise objections at the sanction meeting or earlier. 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, and it is not necessary for the company to consult any class of creditors who are not affected, either because their rights are untouched or because they have “no economic interest” in the company.
What is a Pre-pack Administration?
As mentioned earlier, the actual transfer of the assets in the IMO restructuring was effected by an administrator by way of a pre-packaged sale. A pre-pack sale is typically structured as follows: (i) prior to any formal insolvency procedure, the directors of the company instruct an insolvency practitioner to value the assets of the company, and the directors then negotiate with the administrator, senior lenders (as they will ultimately need to release any security over the assets) and the potential buyer; (ii) the administrator is then appointed by either the directors or a qualified floating charge holder; and (iii) immediately following appointment, the administrator will execute the sale of the business on behalf of the company, provided it is satisfied that it has “obtained the best price reasonably obtainable”, and in doing so, he is furthering the primary purpose of the administration to rescue the company as a going concern and has regard for the interest of company’s creditors as a whole. Such sales are usually conducted without the prior approval of junior creditors or the permission of the court.
As stated above, an administrator is under a duty to “obtain the best price reasonably obtainable” when selling assets subject to security, but this is not a statutory duty, and is set out in the statement of insolvency practice, which is a code of best practice. If an administrator breaches this code, it will not necessarily follow that he has breached his duties under UK law. Creditors do have a right to challenge the actions of administrators, but absence of fraud or gross negligence, the English courts are very apprehensive to interfere with their decisions.
Transferring the assets through administration enables the directors of a company to avoid being exposed to liability if the sale transactions were later determined to be undervalued. In IMO, the sale was conditional upon administrators receiving an indemnity from the existing security agent for all liability.
There is no guarantee that an administrator will “rubber stamp” the asset transfer agreements. Before giving effect to those agreements, the administrator must be satisfied that the transfer of the assets is consistent with the purpose of the administration, and will be in the best interests of all creditors (including the mezzanine debt.) However, in practice, the administrator typically relies on the valuation work already prepared by the company and its creditors, and follows the course that has been outlined for him when he was appointed.
The IMO Scheme
The IMO scheme only dealt with the mechanism of release of the scheme claims (e.g. the senior debt) in anticipation of the exchange for the shares in the new group holding company controlled by the senior lenders. The restructuring could have been accomplished without a scheme of arrangement had all the senior lenders consented to the claim release. The scheme was used to circumvent the requirement in the senior loan agreement to receive the consent of all the senior lenders to permit the security agent to release the security interest over the assets to be transferred to the new holding company. The mezzanine lenders were not an affected class under the scheme. If all of the senior lenders were in favor of the restructuring, the restructuring could have been done with use of the administration process solely because the senior lenders would have instructed the security agent to release the security interests, thereby allowing the administrator to sell the assets free of any liens. This would have left the mezzanine lenders with a difficult task of pursuing the administrator for not having obtained the best price reasonably obtainable.
The IMO Court Case
The decision for the IMO court was whether or not to sanction the scheme, which was approved by more than the required majority of the senior creditors at the relevant meetings. The principles outlined by the judge were:
- that a company may choose the creditors with whom it wishes to compromise, and need not include creditors whose rights are unaltered by the scheme;
- in entering into a scheme, the company need not consult unaffected creditors or contributors, either because their rights are untouched or because they have no economic interest in the company. The court can find out whether such an interest exists, and the normal standard of proof applies; and
- the footing on which the mezzanine lenders are entitled to object to the scheme is as creditors on the grounds of unfairness, if the scheme unfairly affects them in ways other than altering their rights.
Even though the mezzanine lenders did not form a class, they opposed the IMO scheme at the court hearing on the following grounds:
- the transfer of the assets to the new group of companies shuts out the mezzanine debt from any prospect of benefiting from the assets, and there are sufficient prospects of their having an economic value (now or in the future);
- as the mezzanine lenders' valuation showed, value “broke” in the mezzanine debt, and therefore they had an economic interest and should constitute a class for the purposes of the scheme; and
- the terms of the scheme were unfair, as they unfairly prejudiced them.
The senior lenders successfully argued that the mezzanine lenders did not have any standing to oppose the Schemes because: (i) the mezzanine lenders did not form a class because their rights were not affected (e.g. their rights were governed under the intercreditor arrangements, and remained unchanged and were in the same position irrespective of the scheme); and (ii) the valuations showed the mezzanine lenders had no economic interest in the scheme companies, given that the scheme companies are insolvent and, without the scheme, the operations and/or assets of IMO would more than likely be sold in the administration process, either as result of enforcement by the senior lenders or appointment of an insolvency practitioner by the directors of IMO, and that the valuation produced by PricewaterhouseCoopers (PwC) clearly illustrated that in such a scenario, there was no value left for the mezzanine lenders.
Furthermore, as the scheme did not affect the mezzanine lenders’ legal rights, they could not complain as persons whose legal rights are being altered by the scheme in some unfair way. That said, the mezzanine lenders were still entitled to object as creditors on grounds of unfairness if the scheme unfairly affected them in ways other than altering their rights. The court has discretion, as a matter of principle, to consider unfairness.
In sanctioning the scheme and rejecting the mezzanine lenders' claims, the court pointed out that by putting forward the scheme, the senior lenders are running a real risk that if the business at par fails to prosper, they will end up in a worse position in the future. Equally, the mezzanine lenders have a safeguard in the terms of the intercreditor agreement under which they could buy out a senior lender and carry out the refinancing themselves, but they have chosen not to take this option. The court said that the option of refusing the sanction of the scheme by the court would also leave the parties in the position of having to renegotiate the financing with the mezzanine lenders, and that throwing the parties into further negotiation was not regarded as a legitimate or sensible use of the court’s powers in the circumstances.
IMO appointed PwC to carry out a valuation of the existing group of companies. The objective was to come up with a value which represented the amount that the business would be expected to realize in a sale at the current time. The following three approaches were followed: (i) an income approach/discounted cashflow projections, which included an “alpha factor” to the cost of capital, to reflect uncertainty in the market and the impact of the present credit crunch on the availability and cost of financing; (ii) a market approach, by way of comparison with other companies and statistics derived from transactions in the industry; and (iii) a leveraged buy-out analysis (e.g., what finance would be available to a private investor to acquire the assets and the expected equity rate of return). Attempts to find a buyer were not successful. All valuations by PwC and through the sale process were significantly below the £313 million level of senior debt.
The valuation put forth by the mezzanine lenders was on an “intrinsic value” basis, using a discounted cashflow analysis referred to as the so-called Monte Carlo simulation. This simulation involved repeated calculation of the discounted cashflow valuation using a random sampling of input and assumptions and then an aggregation of results into a distribution of probabilities of possible outcomes. The conclusion produced a value in excess of £320 million, which meant that it was highly likely that the value “breaks” in the mezzanine debt. The report also went on to carry out both comparable transaction valuations and a comparable multiples valuation, which resulted in a median valuation in the region of £385 million.
The court drew a distinction between the valuation exercises carried out by IMO and by the mezzanine lenders. The former was intended to derive a present value in terms of what a potential purchaser might be prepared to pay. The result of the mezzanine lenders' valuation was a computer-based statistical analysis, which produced something closer to a range of possibilities than a range of values, the latter being where professional judgment was needed. In the court's view, a proper approach to valuation in the group's case needed "some real world judgments as to what is likely to happen…rather than a range to which other ranges are applied in a series of random calculations to come up with some mechanistic probability calculation." For this reason, the court gave less weight to the mezzanine lenders' valuation, and decided that it was not enough to allow the mezzanine lenders to establish their case. It was also not sufficient to establish that the value of the group was greater than the value of the senior debt.
The Argument on Breach of Duty of the Boards of the Group Companies
At a late stage in the case, the mezzanine lenders raised a new issue on a possible breach of duty by the boards of the group companies. The allegation considered by the court was that the directors of the group companies should have bargained for something to be provided for the mezzanine lenders as part of the re-financing process, and that what they were, instead, doing was to give effect to the wishes of the senior lenders. The court noted that at the relevant times the group was technically insolvent, and there were on-going events of default under major credit agreements, and mezzanine lenders had no economic interest in the group. The court found that the directors properly consulted the senior lenders, and noted that to suggest that the directors had bargaining power with the senior lenders, when the group was in difficulties with its financial covenants and a capital restructuring was certainly required, was held to be unreal.
While much of the discussion of the IMO court case has been about the standards of valuation, the case more importantly highlights, as in McCarthy & Stone, the use of schemes of arrangement and pre-packaged administrations as effective tools to transfer corporate assets away from a debt laden company to the advantage of senior lenders. The successful use of this form of restructuring, and the inability of mezzanine lenders to thwart its implementation, means that senior lenders to companies under the English law jurisdiction that are in financial difficulty may increasingly turn to this form of restructuring. The case highlights the need to carefully consider the intercreditor arrangements between the different lender groups with focus on:
- who has the right to direct the release of any security and guarantees held by a lender group; and
- what process is required before security interests are released as part of enforcement proceedings.
The case does clarify the valuation issue by reinforcing the view of the English courts that a company’s value is its “current” value, rather that some “future” value based on an improvement in market conditions, asset prices or financial performance. It also becomes clear the growing weight which judges will put on valuations, and that in order for any junior creditor to argue it is being unfairly prejudiced, either by the terms of a scheme of arrangement or a pre-packaged administration sale, it should obtain a rigorous valuation.