The enacted Corporate Insolvency and Governance Act (the Act) introduces three permanent reforms to the existing insolvency legislation and certain temporary measures designed to address the immediate impact of COVID-19 on UK businesses. Among other things, the Act looks to maximise the potential for struggling companies to be maintained as a going concern. As market participants and the courts get to grips with the new legislation, it is clear that there will be some impact on the special situations landscape and the business of stressed and distressed investment.
Reduced opportunity for hold-out investors?
While many stressed and distressed or special situations investors continue to invest in capital structures with a view to maximising the economic return of an undervalued investment, many investors have historically looked to buy hold-out stakes, taking very low-cost positions in order to frustrate a consensual process or to take ownership for asset-stripping. The Act includes measures that reduce the scope for these investment drivers, such as the new moratorium and the new ability to institute a cross-class cram-down under the new Restructuring Plan.
The advent of a moratorium (initially for 20 business days, but potentially longer) makes it more difficult for an existing lender to seek to take enforcement action in relation to existing debts. As a result, buying into a capital structure to try to force an insolvency filing no longer acts as a powerful threat. In addition, a dissenting junior creditor that would previously have tried to hold up a scheme of arrangement despite having no realisable economic value may have its hold-out value vastly reduced now that the courts can cram-down creditors across classes.
Whilst every outcome will be determined by the specific facts of that situation and the merits of arguments for each creditor class, it is clear that the Act is designed to protect the going concern value of companies, and that hold-out value will be reduced accordingly.
Increased opportunity for liquidity investors?
During times of distress, many portfolio companies look to increase liquidity to support their business back into productive economic performance. Whilst there is a sensible balance to be struck between ‘weathering the storm’ and overburdening a group with leverage, liquidity is a common tool in helping companies trade out of difficult situations or provide sufficient breathing space for a company to implement a broader restructuring. The continued availability of credit and, particularly, the ability of credit funds and other flexible capital providers to deploy funds quickly and without regard to capital adequacy issues means that there is an abundance of ‘dry powder’ available to help with the right credit situation. It is here where perhaps we will see more distressed investors seek to invest.
Having seen instances such as Matalan, where the existing scheme of arrangement regime can be used to modify consent levels in debt documentation to allow for super-senior rescue financing, the Restructuring Plan introduced by the Act brings an added dimension to this dynamic. Using the Restructuring Plan, it will be possible to impose additional liquidity financing even where an entire class is dissenting, subject to the requirements of the Act. This could lead to an increased use of liquidity financing by companies to help them trade through difficult times where the business and credit fundamentals remain solid but unforeseen macro events have precipitated market degradation.
Whilst some market participants may be wary of over-leveraging existing facilities, the Restructuring Plan can also allow cross-class cram-down, thereby potentially equitizing some of the existing junior debt where servicing such debt would be unsustainable (assuming such junior creditors would be no worse off under the Plan than the likely alternative). In fact, the Restructuring Plan may offer a useful alternative route through the intercreditor ‘value protections’, which have limited access to the pre-pack administration in recent times given that the Restructuring Plan can act as an alternative to a more traditional share pledge enforcement. Importantly, liquidity financing also often imposes more strict terms on operational flexibility from which lenders through the entire capital structure can benefit, as those terms act as a lowest common denominator for compliance by the group companies. As a result, the Restructuring Plan may also indirectly encourage business efficiency.
Legislative eligibility and access for companies
The English courts’ adoption of the ‘significant connection’ test to avail eligibility for certain features of the Act means that the test is not overly restrictive and overseas companies may be able to benefit from the Act. With Brexit’s timetable looming over the British economy, it will be important to see how the UK framework under the Act fits within the existing European insolvency regime and, in particular, the ‘centre of main interests’, which has formed the chassis for many European restructurings since 2009. That said, whilst COMI shifts were the traditional method of establishing jurisdiction for schemes, there has been an increased reliance on introducing UK co-obligors into the structures (e.g., Hema and Nyrstar), which may be seen as preferable, particularly given the potential tax and timing implications surrounding COMI shifts.
Coupled with the restrictions on termination and supply contracts upon an insolvency process, there is a strong desire to enhance rescue opportunities for companies facing distress. Whilst there are questions to be asked about the ultimate freedom to contract, it is clear that the provisions (and their exceptions) are trying to determine the right balance between freedom to contract and longevity of contractual freedom.
Limitations and valuations
There are a number of initial areas where the Act and its protections are considered by market participants to be lacking. For example, there is no designated moratorium in place to give effect to a Restructuring Plan, but it is to be seen where the two will be used together in practice. Differently from the sister legislation on which perhaps the Act has been modelled, it is not clear whether the new moratorium will mimic a Chapter 11 automatic stay with worldwide effect or whether it will be confined only to the UK. It is possible also that the involvement of the court in creditors’ voluntary arrangements will add unnecessary complexity in driving distinctions between unsecured creditor classes and increasing uncertainty between, for example, landlords who are often compromised only to a limited extent and other creditors who may be compromised more heavily.
It is clear that valuation will remain a key driver to special situations transactions and restructurings more generally. Proving to the court that there is or is not any value will likely be the area most susceptible to challenge, particularly given the varying metrics of valuations and their respective alternatives. However, court sanction for any Restructuring Plan will reduce the likelihood of subsequent litigation and allow the company in question to focus on operational rebuilding.
Whilst the Act will undoubtedly be subject to rigorous testing in court, we can see indications from certain cases, like that of Virgin Atlantic, that the modernisation of the UK’s legislative regime around insolvency and governance will add stability and aim to work in tandem with public policy to protect companies as a going concern, particularly against stakeholders with no viable economic interest seeing to generate holdout value. This clarity may force certain types of distressed and special situations investors to re-evaluate their investment theses and strategies, enabling such firms to remain well-positioned and well-capitalised to drive significant returns in this new era.