It has been a good year for those who thrive on bad news. Europe’s restructuring industry has kicked into high gear as the pandemic has taken hold, with high profile restructurings since Covid including Swissport, Matalan, Hema, Selecta, Codere, Virgin Atlantic, Pizza Express, Hertz, Europcar, Norwegian Air Shuttle, and more.
Many of these have been relatively consensual, with all parties placed under pressure by the timeline of the pandemic, making owners and lenders alike less willing to play hardball. What’s the point in fighting over the keys of a business which is limping along under lockdown?
In 2021, however, balance sheet restructurings will move into an even higher gear.
“Peak default rates typically don’t happen at the bottom of a crisis, but six months afterwards as companies start to spend again,” says Joseph Swanson, co-head of the EMEA restructuring group at Houlihan Lokey. “Many companies release working capital as revenues shrink in a recession, but as a recovery takes hold, they need to start investing again. That’s when defaults start to accelerate.”
Earnings foregone in 2020 won’t magically flood back in 2021 — instead, companies will be facing permanently higher leverage multiples, and pressure from lenders to get back to a debt load which their earnings can sustainably support.
“You get the feeling that, in lots of the debt refinancings this year, people were just kicking the can down the road in the hope that things will improve,” says Jennifer Marshall, a partner in the restructuring group at Allen & Overy. “When we come out of lockdown and some of the restrictions on enforcement are lifted, then you’re going to see what I’d call proper restructurings, in other words attempts to get companies into a permanently sustainable capital structure.”
Seismic shake-up
But the busiest ever year will come on top of a seismic shake-up in the laws governing European restructuring. The European Insolvency Directive, passed in 2019, aims to harmonise European insolvency and corporate debt restructuring, and replace the patchwork of separate national regimes, often with antecedents more than a century old.
“Before the current wave of insolvency law reform, deals were often negotiated based on the lowest common denominator given the lack of flexibility to impose a given deal on non-consenting classes of creditors,” says Swanson.
“The new insolvency acts provide companies in distress a blank slate to create new capital structures which will ultimately lead to a reduction in the amount of zombie companies and a deepening of European debt capital markets.”
The new laws draw lessons from the longstanding US Chapter 11 regime and the UK scheme of arrangement, some of the most popular and flexible tools for complex cross-border debt restructurings, and gives restructuring advisors a whole new suite of tools to use.
All the new laws, including that of the UK, passed in 2020, allow a ‘cross class cramdown’, in which a majority of creditors can bind a minority, even if they are not in the same class of debt. This can be a potent weapon for encouraging creditors to strike a deal, and makes it harder to act as a hold-out, blocking a broad deal in return for more beneficial terms. The new Dutch law can also bind a group of legal entities at once, increasingly useful in complex structures with multiple financing vehicles involved.
Although two restructurings so far have theoretically been able to use the cross class cramdown — those of Virgin Atlantic and Pizza Express — neither ended up doing so, and the English judge presiding over the Virgin deal cautioned against excessively aggressive potential interpretations of this feature.
“At this point, it’s not yet clear what type of tool section 26(a) [cross class cramdown] will be — a jackknife or a chainsaw,” says Swanson.
He continues: “As capital structures grow more complex and private capital markets displace banks as providers of non-investment grade finance, it is inevitable that that the law follows suit and evolves to address new challenges presented by the market.”
EU member states have to draft the actual legislation to implement the new EU directive, and the first new laws in the remaining EU countries will go live early in 2021, in Germany, the Netherlands, and the Czech Republic.
At the same time, the UK’s transition period in leaving the European Union is ending, severing the automatic recognition member states must make of each other’s insolvency processes.
“I think there’s going to be a bit of a stock take, and people are going to have to think quite carefully when using the English tools about whether they’re going to get the recognition they need in Europe,” says Marshall.
This matters because English law has become widely used for the largest and most complex restructurings in Europe. Even when a firm’s operations are entirely based outside England, it’s common for facility agreements and other contracts to be governed by English law, and for borrowers and their creditors to seek the rubber stamp of an English court to actually implement a debt restructuring. More than half of the UK schemes agreed by English courts since 2016 were for companies headquartered elsewhere.
If courts in EU countries will no longer recognise English law judgements automatically, this adds a big slug of uncertainty into the restructuring process — just as more companies than ever will want to reach quick and efficient compacts with their creditors.
The UK was the first country to adopt the recommendations of the EU Insolvency Directive, despite having technically left the EU by that point, so the laws ought to be reasonably close. But the politics of Brexit mean mutual recognition is off the table, unless a broader deal can be agreed by year end.
Loss of automatic recognition is not necessarily a disaster, but it makes processes longer and harder. If, for example, an English court rubber stamps an agreement between company and creditors on how to restructure a loan facility, there will be no guarantee that a judge in France will accept that decision, creating another point where unhappy creditors could challenge a deal that’s almost done.
“We’ve relied on private international law and judicial recognition for insolvency proceedings involving Asia, the US and Middle East for a long time, and we’ve still managed to do restructurings involving those jurisdictions, so it’s not that it can’t be done. It’s just that we’ve got very used to it being done in Europe on the basis of a nice framework that everyone respects and understands,” says Marshall.
The other option for companies, however, will be to use the new Dutch or German laws — if they are able to.
“The German and Dutch laws do look phenomenally good on paper, but one of the fundamental problems that you’ve got is that English law continues to govern most financing docs in Europe,” says Marshall. “As the law stands at the moment, you’re not going to be able to use a German scheme or Dutch scheme to vary English law contracts.”
No more tourism?
But some companies and their advisors may not want to turn away from the familiar. Debt restructurings are a matter of corporate life or death, and few firms will want to be the test pilots for a new law in a new jurisdiction, no matter how potentially attractive the toolkit may be.
That could even end up pushing bankruptcy tourism to the US, rather than the UK, if Brexit makes it awkward. While no automatic recognition exists for Chapter 11 in Europe, US court decisions can have extraterritorial effects — no company or creditor will risk being in contempt of US court.
“I think there’s a sort of natural conservatism, which means people will come to processes that they know,” said Marshall. “If we get a series of European judgements where European courts start refusing to recognise the English process, you could even see a push towards Chapter 11.”
Marshall also highlights the role of accumulated experience. London hosts most of Europe’s experienced distressed debt investors, who often buy debt in troubled companies in order to take their seats at the restructuring table. But it also hosts most experienced restructuring lawyers, the largest offices of restructuring advisory firms, and most importantly, a judiciary with deep experience navigating the most complex corporate insolvencies and creditor negotiations.
“The laws are all very similar in many ways,” says Marshall. “What’s different, though, is that England has very experienced judges in courts which have been doing schemes for the last 200 years and the judges know the scheme process inside out. Dutch or German judges do have a bit of a learning curve ahead, which might give the UK an advantage for a while.”
Politics adds a further twist in the tale. Some of the largest companies struggling with the fallout of Covid — airlines, for example — are major employers, with political clout and national prestige at stake.
Domestic politicians might be reluctant to bail these firms out, but equally reluctant to see foreign courts in offshore jurisdictions take decisions that threaten employment or pensions at home. GC