This article is an extract from Restructuring & Insolvency. Click here for the full guide.
At the time of writing in September 2022, we are charting unprecedented times: the effects of covid-19 are far from gone, a war in Ukraine is still raging in Europe with implications around the world, energy prices are through the roof and a global recession is looming.
The reverberations of the covid-19 pandemic continue to be felt, with economies dislocated and faced with rising inflation. Fuel to this fire have been the effects of the war in Ukraine, which has led to materially higher energy prices. The war has also added to ongoing supply chain issues. The worry of central banks is that the resultant inflation, which a year ago was thought to be transitory, becomes embedded.
To counter this, monetary policy is tightening. The years of cheap money appear to be coming to an end. This means that businesses, which have of late been propped up by cheap loose money, may struggle in the coming years when they come to refinance.
However, most mid and large cap companies refinanced their debt during the past couple of years, so the immediate effect of monetary tightening is yet to be felt by a number of companies. Where debt documents are relatively flexible (as most have been of late), issues with short-term liquidity can often be addressed within the terms of these. Therefore, the end of the road for some companies with weak fundamentals may not be until such maturities hit.
At the time of writing, recessions across a number of economies appear imminent. The year 2022 has illustrated the weakness of economic forecasts as what looked like a solid recovery earlier in the year is turning into an inflation-driven recession. The hope is that this does not prove to be the case.
War in Ukraine
Despite the frontlines stagnating, the war in Ukraine shows no signs of abating – peace talks seem far off. The war has been felt most acutely in Europe through the effect it has had on European gas prices. Over the past decade, the price of gas had traded between 20 pence and 75 pence a therm in the United Kingdom; it reached 555 pence a therm this year following Russia’s decision to restrict flows of the Nord Stream 1 pipeline. At the time of writing, the European Union has announced that it is preparing emergency measures to curb the price of electricity by separating it from the cost of gas. Meanwhile, the UK energy regulator has announced that the price cap for households will jump by 80 per cent from October to £3,549. The UK government initially announced a £400 grant to support households, which has been followed by the announcement of an estimated £150 billion ‘energy price guarantee’ plan. The effect of these sharp gas price increases will have wider ramifications for the European economies, in particular in relation to inflation.
Supply chain disruption
The disruption suffered by supply chains during the covid-19 pandemic continues. The pandemic saw bottlenecks arising in supply chains driven by wild swings in supply and demand. While there were hopes that pressures on supply chains would start to ease, this has not been the case owing to ongoing covid-19 restrictions in China and the effects of the war in Ukraine. Lockdowns in China have meant the closure of ports and factories, while the war in Ukraine has impacted the supply of raw materials and transit routes. For example, Ukraine accounts for 50 per cent of the world’s supply of neon, which is a core base material for the production of semiconductors.
Since the start of the pandemic, there has been a shortage of semiconductor chips – a critical component in high-tech goods. Broadly, the shortage was caused by a combination of unprecedented demand, structural issues in the industry and the impact of covid-19 on the inputs required for semiconductors. The shortage has impacted a number of sectors, in particular the automotive industry. However, in some good news, according to JP Morgan Research, more chips are expected to become available in the second half of 2022, and they believe the shortage may be ending.
The second biggest economy in the world, China, is slowing down, which is having ripple effects globally. There are two key reasons for the slowdown: the slump in the Chinese property market and the country’s zero-covid policy.
China’s housing market has been a major driver of growth for the past two decades. Much of the property development was fuelled by debt, with Nomura estimating, based on official statistics, that Chinese developers owed US$5.24 trillion as at June 2021. In August 2020, China implemented the ‘three red lines’ policy, which aimed at placing restrictions on property developers’ ability to access credit. The effect of these restrictions was seen most notably in the case of Evergrande, which defaulted on part of its debt in late 2021.
China’s zero-covid policy has been a key policy of premier Xi Jinping. China’s continued lockdowns and efforts to eradicate the virus are politically difficult to backtrack from, particularly given how much the policy was triumphed earlier in the pandemic. Therefore, lockdowns, as Shanghai experienced for two months in April and May 2022, are likely to continue. Such lockdowns are highly disruptive to the Chinese economy and are key to explaining why China’s economy only expanded by 0.4 per cent year on year in Q2 of 2022 according to the National Bureau of Statistics of China.
The importance of China as an engine of global growth means that the difficulties being faced by the Chinese economy are of global concern. The situation is not helped by an increasingly aggressive China and a hawkish United States (eg, clashing over Taiwan), which is likely to further exacerbate trade tensions and accelerate efforts to decouple their economies.
A range of factors are combining to drive inflation upwards across economies globally. As economies began to reopen in 2021, pent-up consumer demand in developed economics combined with supply chain issues, labour shortages and huge quantitative easing kick-started inflationary pressures. For Europe (the United States being largely shielded), the war in Ukraine further exacerbated this through the impact it had on gas prices. In July 2022, the annual rate of inflation hit 8.5 per cent in the United Stares, while the United Kingdom hit 10.1 per cent and Germany hit 7.5 per cent.
In an effort to combat inflation, central banks have reacted by increasing interest rates. At the time of writing, the Federal Reserve funds rate stands at 2.25–2.5 per cent, the European Central Bank deposit rate stands at zero per cent and the Bank of England’s bank rate stands at 1.75 per cent. Fitch predicts that at the end of 2022, the Federal Reserve funds rate will be at 3.25 per cent, the European Central Bank’s deposit rate will be at 0.25 per cent and the Bank of England’s bank rate will be at 2 per cent – some analysts predict even sharper increases. The years of historically low interest rates appear to be over.
Higher borrowing costs will be a further drag on economic activity and could tip a number of economies into a recession. The Bank of England has warned that the economic outlook for the United Kingdom and the rest of the world has ‘deteriorated materially’. Indeed, the Bank of England has warned that it expects the United Kingdom to fall into a recession by the end of 2022.
Market conditions are more challenging now given rising interest rates and slowing issuance volumes. Corporate bond issuances fell by 17 per cent in the first half of 2022 compared with 2021, while high-yield issuances dropped 78 per cent, according to Refinitiv. A large proportion of companies refinanced their debt in 2021 to take advantage of historically low interest rates. This means that near-term refinancing demands have reduced. Of the US$22.6 trillion in corporate debt (including bonds, loans, and revolving credit facilities from financial and nonfinancial corporate issuers) rated by S&P Global, only 12 per cent of such debt is due to mature over the next 18 months, while 48 per cent is due to mature over the next five years.
Despite the slowdown in broader debt capital markets, private credit funds have shown themselves ready to step into the gap to a certain extent. We have seen a massive increase in private debt markets, with S&P Global estimating that the global private debt market grew tenfold in a decade to US$412 billion at the end of 2020. We expect to see private credit funds play an increased role as traditional debt markets slow down and traditional lenders shy away from lending to riskier companies.
Last year, there was confidence in the strength of the retail sector owing to large household savings accumulated during covid, despite the fact that retail sales in 2021 remained lower than in 2019. This year, the outlook is much different.
With inflation at recent highs and consumer confidence at historic lows, household budgets are increasingly being allocated to essential items. As a result, in the United States, retail companies declined roughly twice as much as the broader US stock market index in the first half of this year, and the CBI reported in July 2022 that retail volumes in the United Kingdom are expected to continue to decline. Retailers are caught between significant rising costs and disruptions in their supply chains and the need to reign in price rises to avoid the loss of customers. Retailers will not all be affected equally, with smaller companies less likely to have access to increasingly selective debt and capital markets.
It is no news that airlines suffered massively during the pandemic, and a number of airlines have entered or exited insolvency over the past two years as many countries shut down international travel and are only now lifting restrictions. Asia is lagging, with China and Hong Kong continuing to impose travel restrictions and quarantine rules.
Airlines and airports in the United States and Europe struggled to deal with the rebound in demand. This was primarily because of staff shortages, with the industry unable to rehire sufficient employees to cope with the rebound. This caused a slowdown in bookings from July and August 2022 for airlines coupled with the need for a number of airlines to cancel existing flights. After a less successful summer than hoped for, the overall rebound in the airline industry may be short-lived as consumers look to cut discretionary spending while rising costs constrain profitability and limit deleveraging.
Government responses and policies during the pandemic, including quantitative easing and stimulus programmes, supercharged the crypto markets and caused a large increase in blockchain projects and boost in crypto valuations (eg, bitcoin grew more than 1,700 per cent from its 2020 low to its November 2021 high). Once inflation rose rapidly and the markets turned, volatility and rising interest rates followed. These factors caused a crisis of confidence and heavily impacted the crypto market because (being a newer, more volatile and less regulated asset class) it thrives on risk-taking behaviour by bullish investors.
The year 2022 has been characterised by a steep decline in major cryptocurrencies (termed the ‘crypto winter’) and the collapse of the Terra stablecoin and Luna cryptocurrency. When market confidence fell and investors sold their holdings, Luna saw a substantial collapse in its price. The Terra stablecoin, with its dollar peg algorithmically supported by Luna, lost its peg and plummeted in value following a significant loss of confidence. The result of the subsequent implosion was a cascade of selling across broader cryptocurrency markets and wider contagion. Since the collapse of Terra and Luna, crypto hedge fund Three Arrows and crypto lenders Voyager Capital and Celsius have all filed for US Chapter 11 relief.
European industrials have been hard hit by the Ukraine war and the prospect of a halt of gas supply from Russia to Europe. Manufacturers’ need for heat, electricity generation and steam for production makes them particularly susceptible to any disruption to gas supply and increased energy costs.
The UK restructuring plan, Dutch WHOA scheme, German StaRUG – and many more!
Implemented in June 2020, the United Kingdom's restructuring plan, which introduces cross-class cram down, is one of the biggest changes to the English insolvency and restructuring landscape in recent decades. Previously untested elements such as how cross-class cram down works and the possibility to exclude a class of creditors or shareholders from voting on the plan entirely have now been tested (with 11 cases at the time of writing), and the legislation and practice is starting to bed down. We have also seen the UK judiciary’s keen interest to compare and contrast the new English system with Chapter 11 in the United States (eg, in the Houst restructuring plan where the court stated, for the avoidance of doubt, that the UK regime does not incorporate an absolute priority rule – unlike Chapter 11).
The United Kingdom has, for the past decade, dominated Europe’s restructuring and insolvency market. However, that may be changing as other European countries – notably Germany and the Netherlands but now also Spain, France and Italy – introduce their own mechanisms to comply with Directive (EU) 2019/1023 (preventive restructuring frameworks) and, to a degree at least, the impact of Brexit is felt.
While the Dutch (court confirmation of extrajudicial restructuring plans (WHOA)) and German (Stabilisation and Restructuring Framework for Businesses (StaRUG)) regimes have now been in force for almost two years, restructuring activity in both countries remains – at the time of writing – still relatively low. With considerably more restructuring activity expected in the autumn and winter, it is too early to say whether corporates will resort to the new domestic tools or whether London remains Europe’s centre of gravity for restructurings.
Tensions in offshore?
It has been fascinating to see the discussions between the Hong Kong courts and the US Bankruptcy Court in relation to the effect of a foreign restructuring coupled with a successful Chapter 15 application on US-governed debt. You can read more on this in 'Transatlantic restructuring' in this book.
Model laws – some news!
The UN adopted the first model law in relation to insolvency back in 1997 with the UNCITRAL Model Law on Cross-Border Insolvency (the Cross-Border Model Law) but then went quiet. Fifty-five jurisdictions proceeded to adopt the Cross-Border Model Law between 2000 and 2020 with Brazil being the latest country to do so. Then the UNCITRAL Model Law on Recognition and Enforcement of Insolvency-Related Judgments (the Judgments Model Law) was adopted as well as, in short order, the UNCITRAL Model Law on Enterprise Group Insolvency with Guide to Enactment (2019) (the Enterprise Group Model Law).
In July 2022, the UK Insolvency Service issued a consultation proposing to implement the Judgments Model Law and the Enterprise Group Model Law. The United Kingdom is one of the first countries considering the implementation of both these model laws, which the UK Insolvency Service states is indicative of its ongoing commitment to cooperation and international best practice.
The global economic outlook is gloomy, with central banks struggling to curtail inflation. The hope will be that inflationary pressures will ease in 2023 as the effect of monetary tightening is felt, consumer demand levels decrease and supply chain disruptions ease.
Governments have already incurred unprecedented levels of debt in the efforts to support businesses and individuals during the covid-19 pandemic. It remains to be seen how far they will be prepared to go this time in supporting individuals.
Recession is the ever-growing buzz word around markets at present. A challenging time lies ahead for many businesses across a variety of sectors. Fortunately, recent legal developments across restructuring markets mean practitioners are better placed than ever to help businesses manage such challenges.
This guide, as a way of keeping track of global legal developments, will continue to be an important reference tool, especially in these volatile times. As ever, we hope that you enjoy reading and using it.
The authors would like to thank Richard Layther for his contribution to this chapter.