06 Jul Formal Attire (Q3-20)
The number of companies in Canada that have entered formal restructurings and owe their creditors in excess of $5 Million is up over 130% in the last twelve months, according to the Office of the Superintendent of Bankruptcy. Approximately 40% of these companies filed for court protection to reorganize their affairs in Q2-2020 during the height of recent uncertainty surrounding the pandemic. With expectations for further loan defaults and business distress, borrowers and their lenders need to carefully evaluate their restructuring options and objectives.
When a borrower faces financial distress it will first resort to negotiating with its creditors through an informal restructuring. If affected parties engage in good faith negotiations with genuine intentions to achieve an amicable resolution, then the savings in time and expense versus a formal restructuring are enormous. It also avoids the likely loss of confidence from stakeholders in the borrower’s value chain (especially suppliers and customers) and the attendant interruption in operations. The stigma of a formal restructuring, conducted through a statutory insolvency regime,2 may unfairly create the perception of greater risk of failure of the borrower, and result in vendors and customers avoiding credit extensions, preferring upfront cash payments or delivery before payment, respectively. The signal of formal restructuring may also negatively impact the borrower’s brand perception. Where possible, an informal restructuring should be pursued to save resources and preserve value in the distressed business.
Informal restructuring best functions where the creditors are either few in number or share a common goal of seeing the restructuring through. Coordinating the response of lenders to ensure they can reach a consensus towards supporting a borrower out of crisis is difficult. Not all lenders are willing to exercise restraints in the face of default and there is little incentive to share in the benefits and burdens of a business rescue if not all lenders are going to provide additional financing or be willing to cooperate with the borrower to achieve a workout plan.
There was a time when self-enforcing market norms encouraged lenders to cooperate. A lender that was a part of a syndicate, for instance, who was overly-absorbed with maximizing its own utility even at the expense of the other lenders or the successful restructuring of the distressed business would have put itself in a position to be censured by the other lenders through the imposition of informal sanctions. The deviant lender would not be “invited” into future syndications and would be left out of the opportunity to partake in profitable loans. Such moral suasion works when there are only a handful of lenders in a given market (like Canada’s bank oligopoly). However, as the number of non-bank lenders has increased in Canada, self-interest and zero-sum outcomes have become more prevalent. Any informal restructuring depends on the willingness of lenders to alter their pre-distress rights, a condition that introduces game-theoretic arguments for settlement, which are more difficult to resolve if any of the lenders are indifferent to future relations. There is no way to bind a dissenting creditor in an informal restructuring, who can hijack the rehabilitation of a distressed borrower. An informal restructuring saves distressed firm transaction costs and averts interference with operations of a business but does not guarantee coordination and consensus among creditors. The whim of a single creditor can usurp negotiations. Given the rise of non-bank lenders in Canada, in particular credit-focused hedge funds and distressed/special situation private debt funds, which TEC estimates have doubled in the past decade, the willingness of creditors to settle on a restructuring plan without court involvement has become impractical.
Formal restructuring has the advantage of binding all relevant stakeholders, including creditors, to a court-approved restructuring plan. It offers the distressed business the opportunity to not only restructure its debts but emerge and continue to operate as a going concern. At the heart of a formal restructuring is the maximization of value for the creditors of the business and the rehabilitation of the distressed business. In many cases, the expectation that the business can be restored to financial health, continue to provide jobs, and remain a going concern motivates a restructuring over a liquidation. A hastened liquidation of the business may best serve the interests of senior creditors protected by security over the assets of the borrower, especially where asset values are depleting, but courts will scrutinize the consequences of allowing a sale based on its utilitarianism. In TEC’s experience, liquidations are most practical when the business has no prospects of being a going concern and management has conceded to such view (often implicitly by way of abandonment).
The CCAA framework in Canada allows distressed companies to liberate from legacy costs, remove burdensome contracts, and eschew obsolete business models. It gives a debtor “breathing room” through an interim “stay” (or moratorium) on enforcement of actions or claims against its assets, which can be co-opted as a tool to ensure that the debtor is to maintain liquidity necessary for running the distressed business pending negotiation of a restructuring plan. Faced with financial distress, a company should be able to continue in the use of its assets or as much of its assets as is necessary to facilitate the restructuring. It means pre-distress secured lenders may not remove assets that are necessary for the continued operation of the business, until management comes up with a proposal or plan for the restructuring and implements same. The proposal or plan of restructuring lies at the heart of a formal restructuring, even against the objection of some creditors, to the extent that such creditors are not treated unfairly.
A successful formal restructuring requires participation from a broad set of actors including management, directors, creditors, shareholders, investors, regulators, administrators (including monitors, receivers, and trustees), and courts. However, the determination of who manages the distressed business has implications on outcomes. The most common option is to have current management remain in place to run the day-to-day affairs of the business and lead development of an exit plan. At the other extreme is replacing existing management with a new team, which signals to observing constituencies a lack of confidence with previous operators. An in-between option is appointing an external person, such as a “Chief Restructuring Officer” to supervise the management of the distressed business as the restructuring is negotiated, and a restructuring plan is put in place.
One of the strongest arguments in support of retaining the distressed management as the business commences restructuring, is the experience and knowledge which the management of the debtor provide. This experience and knowledge may be lost with the immediate replacement of the management of the debtor upon the commencement of formal restructuring. The formal restructuring regimes in Canada and the U.S. support a debtor-in-possession (“DIP”) concept, which keeps existing management in place and the debtor in control of its property and estate as the process of restructuring is underway. In addition to the knowledge and experience which is brought to bear, retaining the management of the distressed business may be a critical step to ensuring that the restructuring of the distressed business starts as early as the signs of distress become evident. This is because retaining at the early stage of its distress, the debtor presumably still has valuable operations and setting restructuring in motion can yield better chances of ensuring that the distressed debtor emerges successfully.
Existing management’s retention of control of a distressed business is not an absolute privilege. A management team that has defrauded, or has been dishonest in its dealings, will not be afforded the room to continue in its fraud, at the expense of the creditors of the business. A DIP must act as a fiduciary and is duty bound to protect the interests of creditors too. That is why the CCAA provides for a mechanism for an independent insolvency professional to monitor the distressed company’s ongoing operations and assist with reporting to the court and stakeholders on viability of the business and progress on the restructuring plan. A monitor’s mandate includes the power to take financing initiatives, such as borrowing money and granting super-priority security to lenders during the period of restructuring (commonly referred to as DIP financing).
Even in light of this, TEC notes that the bar to displace management is very high. Merely evidencing incompetency, mismanagement or imprudent decision making on the part of management is not enough. Fraud and gross negligence have to be proven to compel a restructuring court to oust existing management, although TEC has been successful in motivating untrustworthy management teams to resign by increasing their potential exposure to certain liabilities. The monitor has the power to challenge transactions undertaken by the management of the now distressed business which it considers to be disadvantageous to creditors, and request a court order for them to be clawed back into the estate of the debtor. Such fraudulent conveyance cases tend to be highly contested and are typically not pursued unless the underlying amounts are significant.
The successful restructuring of a distressed business depends vitally on a stay of creditor action and enforcement, a plan and means of enforcing that plan (even against the volition of dissenting creditors), and a management structure to implement the restructuring. Informal restructuring has advantages but its reliance upon cooperation among the parties (primarily the creditors) limits achievement of the foregoing vital components necessary for success. A formal restructuring is the only sure way to ensure legal certainty of a plan and secured lenders must “dress” appropriately before entering such a process.
Virtuous Distress
One of the underlying themes of every restructuring is the existence of defaulted debt. Disagreements between investors, creditors, distressed debtors and other stakeholders largely revolve around what to do about the debt: the desire for immediate repayment, the need to make compromises to facilitate the survival of the business, the desire to be divested from the business, among other considerations. During the period when the company considers commencing a restructuring, some creditors for varying reasons may be unwilling to either remain invested in the distressed business or provide further capital. These pre-distress creditors may seek to sell their debt to a distressed debt investor that expects to reap a profit either by reselling the debt, by liquidating the claim in the process of restructuring, or by taking an equity position in the debtor as it exits restructuring. Banks have a heightened incentive to dispose of their distressed debts.
When a debtor’s financial prospects deteriorate, with the possibility of default, regulators require the lender banks to make provisions (or reserves) for the likelihood of default. Such provisioning by a bank means that it has more capital tied up in respect of a debt, the repayment of which is uncertain. While the imposed regulatory adjustments may better facilitate prudence, for bankers, these adjustments do not make economic sense for bank profitability. In such situations, it makes even less economic sense for banks to provide additional financing to distressed debtors. Distressed debt investors like TEC are active buyers of distressed debts from banks and other traditional lenders.
Banks are inclined to sell their distressed debts at a discount because, compared to the risk of a fire-sale following insolvency or bankruptcy enforcement, they are better off with a predictable loss arising from the trade. Banks also prefer cash to a possible debt for equity exchange which the debtor might propose as part of its restructuring plan. Banks rarely possess the expertise to profit from distress. TEC does not have the regulatory pressure faced by banks and is willing to partake in the process of corporate restructuring, in which it has extensive experience. This benefits the restructuring process but also the economy as a whole: TEC serves as a source of liquidity for the bank and the borrower. Banks can channel that liquidity towards healthier undertakings, thereby improving economic activities.
Investing in distressed businesses is complicated and time consuming. It also requires investors to have proven expertise in operational turnaround, which can only be developed through years of transactional experience. It should not be surprising that the asset-based lending (ABL) industry is associated with providing financing to distressed businesses. Its historical origins in Canada are associated with cash-strapped businesses that view the ABL industry as lenders of last resort. The goal of the borrowers was to obtain interim financing to enable the business to keep its head above water, until when they can obtain credit facilities from banks or other traditional lenders. Although the ABL industry may not be regarded as exclusively providing financing for distressed businesses, it still plays a strong role in the financing of distressed businesses seeking new financing to support their restructuring. ABL providers like TEC focus on the value creation and enhancement of distressed businesses so that profits can be maximized for TEC investors, which incidentally also results in benefits for the distressed debtor and its other stakeholders.
TEC takes direct steps to see to the success of the businesses in which it is invested. This in effect means that TEC is bound to seek the highest possible returns on the investments made in distressed situations. TEC believes the control of a firm in distress should be in the hands of creditors whose interests align with the interest of the firm as a whole. The process of financial restructuring often goes hand in hand with organizational restructuring. Reorganizing a financially distressed debtor encourages the distressed debtor to look more closely at its assets, and to determine the most appropriate combination of assets that will allow the business to operate efficiently going forward. With this restructuring, the distressed debtor is able to make operational changes where needed. For instance, it can do away with non-core assets with negative synergies and focus financial and managerial resources on its core business. The participation of distressed debt investors can drive the process of restructuring as investors come with characteristic qualities that can translate to value for the distressed debtor. TEC will typically require control so that it can drive the process and add value.
Distressed debt investors have been shown to not only cooperate with other stakeholders, but also generally support the restructuring of the debtor.3 But, to be clear, their motives are not altruistic – they are self-interested, profit maximizing market participants. However, involvement by investors like TEC do have salutary impacts on other stakeholders of distressed businesses. TEC never sets out with a “loan to own” strategy but realizes that, at the extreme, it must be prepared to own and operate a distressed business until it can be turned around and sold. TEC can use its secured debt position in the capital structure of a debtor to influence business strategy and effect the change in management of distressed companies, usually by the threat or actual invocation of enforcement rights. When TEC provides new money to a distressed business, it has, through the loan covenants, immense latitude to monitor the progress of the business, and exert pressure on the management to make certain decisions that may drive value. TEC can also orchestrate a change in management especially where the company failure is attributable to poor leadership or the lack of entrepreneurial creativity on the part of the extant management team. Through our activism we are able to unlock value which had been previously unharnessed or ignored by the distressed business.
Distressed debt investors typically possess and exploit the necessary know-how about their target companies, which is important for engaging with the debtor and other stakeholders in order to unlock the underlying value of the distressed business. In the context of restructuring, value can be created through the effective recapitalization of the assets of the debtor, a process that does require new money, whether as debt or equity. The new money, in the form of DIP financing, may be particularly needed to help the company remain open and to continue to carry on its business. It is important to clarify that any rescue efforts must depend on the possibility that the distressed firm is viable but only financially distressed. Making this determination is not always an easy call but TEC, as a sophisticated and experienced distressed debt investor, is better placed to determine which firms are and worthy of a rescue endeavor. Distressed debt investors not only provide financing to the distressed business, but also provide the intelligence to guide the restructuring in a way that increases returns to the investor and other stakeholders of the company. Distressed debt investors play a critical role in ensuring managerial accountability and efficiency in the conduct of a distressed business.
Given the interests of the distressed debt investor in the business, there is an increased likelihood that the intervention of such investors can prevent a liquidation of the business. For some lenders, absent any legal basis for constraining their desire to quickly liquidate the borrower, that option is the first recourse, taking advantage of the financial pressures of the debtors, to extract value for themselves. This was the case in one contentious formal restructuring in which TEC was involved whereby another secured lender vehemently opposed a restructuring plan, instead preferring a speedier liquidation of the indebtedness to them. TEC’s involvement and its larger debt position, as well as its reorganization strategy, was critical in driving a restructuring-focused negotiation. With the cooperation of several other stakeholders, TEC was able to drive the negotiations in the direction of a successful restructuring of the business, providing initial new financing, and preserving thousands of jobs and taxes for the local government.
The reputation of distressed debt investors as “vultures” has been coloured by the emotions of losing management teams and sensationalized by the media. In the current crisis environment, distressed debt investors are increasingly present at the negotiating table in formal restructurings. Empirical evidence shows that participation of such investors in a formal restructuring help distressed companies successfully emerge as going concerns.4 In that respect, firms like TEC are the “phoenix” for the reorganization process contributing, among other things, substantial resources in the form of capital, business and financial acumen, and expertise.
[2] In Canada, the two primary pieces of bankruptcy legislation are the Bankruptcy and Insolvency Act (the “BIA”) and the Companies’ Creditors Arrangement Act (the “CCAA”). The BIA is the principal federal legislation in Canada applicable to insolvencies. It governs both voluntary and involuntary bankruptcy liquidations as well as debtor reorganizations. The CCAA is specialized companion legis- lation designed to assist larger corporations to reorganize their affairs and is similar to Chapter 11 of the United States Bankruptcy Code. The CCAA provides a restructuring corporation with greater flexibility and greater creativity in conducting its reorganization.
[3] Fuller M (2006). The distressed debt market – a major force that’s here to stay. Recovery, 15. The paper suggests that contrary to acting in a self-serving manner, distressed debt investors in the UK have worked with other lenders to drive the value proposition of the group.
[4] Wei Jiang et al., Hedge Funds and Chapter 11, 67 J. FIN. 513, 513 (2012)