Originally published August 14, 2009
♫Workin' out the carwash!♫ (Europe)
On Tuesday, 11 August, the English High Court of Justice,
Chancery Division handed down its decision in the widely watched
case Re IMO (UK) Limited1 . The Court
effectively granted control over what is left of IMO Car Wash
("IMO"), the world's largest
dedicated carwash company, to IMO's senior lenders and, in the
process, foreclosed any possible recovery by IMO's mezzanine
lenders and other junior creditors. The central question in the
case, namely how and when IMO should be valued, vividly illustrates
the tension that exists between senior and junior creditors in
deeply distressed situations. Did the mezzanine lenders in IMO
suffer an unfortunate loss? Undoubtedly. Does this case highlight
inherent weaknesses in existing documentation for European
intercreditor arrangements or in the UK insolvency regime? As
discussed more fully below, we don't think so.
The IMO group was purchased by The Carlyle Group in 2006 for £450m. The acquisition was financed through a mixture of senior debt provided by a group of banks led by HBOS and mezzanine debt provided largely by funds. As is typical in European acquisition financings, the intercreditor agreement grants the senior lenders priority for all purposes over the mezzanine. The security agent appointed under the intercreditor agreement is required to act in accordance with the instructions of the majority senior lenders until the senior debt is discharged in full. Hence, in an enforcement scenario, the majority senior lenders are entitled to instruct the security agent to liquidate IMO's assets. The proceeds of any such liquidation are to be applied to repay the senior debt and, only if proceeds remain after the senior debt is fully satisfied, the mezzanine debt.
Unfortunately, IMO underperformed badly following its acquisition and both the senior debt and mezzanine debt fell into default. The outstanding debt, including capitalised and default interest is approximately £313m of senior debt and £90m of mezzanine debt. To address its financial woes, IMO and two related group companies (the "Debtor Companies") each proposed a scheme of arrangement (the "Schemes") to compromise the claims of the senior lenders.
Pursuant to the Schemes:
i. the business of the IMO group as currently structured ("Existing IMO") will be transferred to newly formed entities within a restructured group ("Newco") which will be owned by the senior lenders in proportion to their holding of the existing senior debt;
ii. approximately £252m of the senior debt will be novated to Newco and approximately £67m of that will be capitalised and issued as equity to the senior lenders, leaving Newco with a reduced senior debt of approximately £185m;
iii. approximately £12m of the senior debt will remain at Existing IMO, with the balance being released; and
iv. the claims of the mezzanine lenders against any assets (including subsidiaries) transferred to Newco will be released in accordance with the intercreditor agreement.
The Debtor Companies each convened a meeting of their senior lenders to approve the Schemes. Importantly, the Debtor Companies did not convene meetings of the mezzanine lenders or otherwise seek to bind the mezzanine lenders under the Schemes. The meetings of the senior lenders were duly held in late July 2009, and the Schemes were approved by the requisite majority in number representing more than 75% in value of the senior lenders. Thereafter, the Debtor Companies applied to the English High Court of Justice, Chancery Division for sanction of the Schemes.
The mezzanine lenders opposed the sanction of the Schemes. In essence, the mezzanine lenders argued that:
i. although the valuation methodology utilised by the Debtor Companies and senior lenders showed that the current value of the IMO group was less than the outstanding senior debt, an alternative study commissioned by the mezzanine lenders concluded that it "appears highly likely that the value of IMO 'breaks' in the Mezzanine tranches";
ii. the transfer of assets to Newco as contemplated by the Schemes therefore deprives the mezzanine lenders of the ability to realize any benefit if and to the extent the value of the IMO group in fact (now or in future) exceeds the outstanding senior debt; and
iii. consequently, consummation of the Schemes is unfair to the mezzanine lenders.
In response to these complaints, the senior lenders asserted that the mezzanine lenders lacked standing to oppose the sanction of the Schemes, as the Schemes were not put to them for approval and did not affect their legal rights (as regulated by the intercreditor agreement) as against Existing IMO. Moreover, the senior lenders rejected the valuation proffered by the mezzanine lenders and argued that the mezzanine lenders were without standing to challenge the Schemes because they had no realistic economic interest in the Debtor Companies. In particular, the senior lenders argued that the valuation relied upon by the mezzanine lenders was unrealistic given that:
i. the Debtor Companies are insolvent;
ii. the Debtor Companies have defaulted on interest repayment obligations under both the senior and mezzanine facilities and these breaches cannot be cured;
iii. the business continues as a going concern only because of the forbearance of the senior lenders; and
iv. without the sanction of the Schemes, the operations and/or assets of the business are highly likely to be sold via an administration process (either as a result of enforcement by the senior lenders or appointment of an insolvency practitioner by the board of directors) and the valuation exercises undertaken on behalf of the Debtor Companies demonstrated convincingly that the value remaining for the mezzanine in such a scenario after satisfaction of the senior debt would be nil.
There were several competing valuation methodologies put forth by the Debtor Companies and the mezzanine lenders in support of their respective positions. These were:
i. A report by PricewaterhouseCoopers (the "PWC Report") commissioned by the Debtor Companies and carried out as at 9 March 2009 and updated as of 3 June. This report valued the IMO group on a going concern (as opposed to a liquidation or fire sale) basis to determine "the amount that the business is expected to realise in a sale at the current time". To calculate this value (termed the "Business Realisation Proceeds"), PWC adopted three methodologies:
a. An Income Approach, which calculated the Business Realisation Proceeds using a discounted cash flow ("DCF") analysis. As part of this approach, PWC added 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.
b. A Market Approach, which determined the Business Realisation Proceeds based on a comparison of IMO to comparable publicly traded companies and an analysis of statistics derived from transactions in the industry.
c. An LBO Approach, which considered how much a private equity purchaser potentially would pay for IMO given expected market debt capacity and typical expected equity rates of return.
The PWC report resulted in possible values ranging from £220m to £275m and concluded based on all the facts that a purchaser would not likely pay in excess of £265m for the business as a going concern.
ii. An auction carried out by Rothschild at the request of the directors of the Debtor Companies in an attempt to sell the business. As part of this process, Rothschild contacted a number of potential financial buyers and received inquiries from an additional 12 parties. The process produced only one indicative bid in the range of £150m to £188m.
iii. A site valuation pursuant to which the Debtor Companies instructed King Sturge LLP to value a subset of the group's locations, based on which PWC extrapolated an overall valuation for all the sites. This exercise resulted in a valuation ranging from £164m on a restricted sale basis (i.e. swift sale without a full marketing campaign) to £208m on a full market value basis.
iv. A report by LEK Consulting (the "LEK Report") commissioned by the mezzanine lenders which criticized the approaches described in clauses i through iii above and instead suggested a discounted cash flow analysis using a "Monte Carlo simulation". Unlike the PWC Report, the LEK Report did not set out LEK's valuation of the business using a DCF analysis based on its own reasoned assumptions. Rather, the Monte Carlo simulation involved repeated calculation of the DCF valuation using a random sampling of input and assumptions, and then an aggregation of the results into a distribution of the probabilities of possible outcomes. Based on this approach, LEK concluded that "in each scenario a significant majority of the outcomes exceeds £320m" and it therefore "appears highly likely that the value of IMO 'breaks' in the Mezzanine". The LEK Report went on to carry out both a comparable transactions valuation and a comparable multiples valuation which resulted in a median valuation (which the Court in Re IMO (UK) Limited described as "unreasoned and unsupported") of circa £385m.
The principal issue before the Court in Re IMO (UK) Limited was whether the Schemes operate unfairly to the mezzanine lenders by depriving them of valuable rights against the IMO group, thereby giving standing to the mezzanine lenders to oppose the Schemes in circumstances where the Schemes were not put to them and their rights as regulated by the intercreditor arrangements were seemingly unaffected.
It is settled law that a company need not include in a scheme any class of creditors whose rights are not altered by the terms of the scheme (In re British & Commonwealth Holdings plc  1 WLR 672), nor consult any class of creditors who have no economic interest in the company (In re Tea Corp Ltd  1 Ch 12, 23-24). In re Telewest Communications plc (No 1)  1 BCLC 752, 763 at , David Richard J elaborated on these principles as follows:
"[T]he relevant rights of creditors to be compared against the terms of the scheme are those which arise in an insolvent liquidation. Strictly speaking, because the company is not in liquidation, the legal rights of the bondholders are defined by the terms of the bonds. However, the reality is that they will not be able to enforce those rights and that in the absence of the scheme or other arrangement their rights against the company will be those arising in an insolvent liquidation."
In terms of the issue as to whom a scheme of arrangement must be put, a company is free to select the creditors provided that the rights of the creditors and the effects of the scheme on those rights are not so dissimilar as to make it impossible for those creditors to consult together with a view to acting in their common interest (Sea Assets Limited v Persahaan Perseroan (Persero) PT Perusahaan Penerbangan Garuda Indonesia  EWCA Civ 1696).
The issue of economic interests was recently discussed at length by Mann J of the Chancery Division in Re myTravel Group plc  2 BCLC 123. In that case, Mann J ruled that in any liquidation of the company, the subordinated bondholders would likely not receive any distribution, and accordingly that their economic interest in the company was "nil". Mann J made such comments notwithstanding that the "economic interest issue" was not before the Court. The question before Mann J was whether the class meetings of those creditors and shareholders with whom the company intended to make a scheme were properly constituted. The Court of Appeal firmly set the recital of Mann J in relation to the issue of economic interests aside "because it was unnecessary and might give rise to problems in the future".
The Decision in IMO
After three days of hearings, Mann J decided that the mezzanine lenders to IMO had no economic interest in the Debtor Companies and accordingly sanctioned the Schemes.
Addressing the question whether the mezzanine lenders had standing to oppose the Schemes, Mann J stated the following:
The schemes do not involve the Mezzanine Lenders in the sense of engaging them as parties. They will not bind them, and their legal rights are unaffected. The Mezzanine Lenders therefore cannot, and do not, complain as persons whose legal rights are being altered by the schemes in some unfair way. However, they are still entitled to object as creditors on grounds of unfairness if the schemes unfairly affect them in ways other than altering their strict rights. The court is exercising a discretion, and as a matter of principle can consider unfairness in that sense, if it is made out. That is the essence of the case of the Mezzanine Lenders.
The Court and each of the parties agreed that a going concern valuation, not a liquidation valuation in the sense of a break-up valuation, was the appropriate point of reference to determine whether the mezzanine lenders had a sufficient (or in fact any) economic interest in the Debtor Companies to justify their objections to the Schemes. All of the valuations before the Court sought to answer the question of what a purchaser would likely to pay for the Business. It was clear that the Court was unimpressed with the LEK Report and was swayed instead by the conclusions set out in the PWC Report and other evidence offered by the senior lenders. For example, Mann J commented that he had "misgivings as to the ultimate soundness" of the DCF valuation relied upon by the mezzanine lenders (i.e. the so-called "Monte Carlo simulation") and that he preferred the "real world judgments" in the valuations relied upon by the senior lenders.
In terms of resolving disputes as to valuations, Mann J referred to his decision in myTravel Group plc and commented as follows:
"If there is a dispute about this, then the court is entitled to ascertain whether a purported class actually has an economic interest in a real, as opposed to a theoretical or merely fanciful, sense, and act accordingly - see the reasoning in In re MyTravel Group plc  2 BCLC 123 at first instance. Where things have to be proved, the normal civil standard applies. The same case indicates that the mere fact that the possibility of establishing a negotiating position and extracting a benefit from a deal is not the same as having a real economic interest (though obversely a real economic interest may establish, or enhance, a negotiating position). The basis on which the assessment of that interest is to be carried out will vary from case to case."
At the end of the day, Mann J was not prepared to give the valuation of the mezzanine lenders "as much weight" as the other valuation exercises and he came to the conclusion that the evidence was "not good enough" to establish that the mezzanine lenders had an economic interest in the Debtor Companies.
The Court was also seemingly swayed by the decision of the mezzanine lenders not to exercise their rights under the intercreditor arrangements to compel a sale to them of the rights and obligations of the senior lenders for the amount of the outstanding senior debt. If the mezzanine lenders were truly convinced that the value of IMO broke in the mezzanine, they could avoid any deprivation of benefit occasioned by the proposed Schemes by exercising the purchase option. Their failure to do so appears to have lead the Court to conclude that even they did not have faith in the LEK Report.
The decision in IMO is important because it represents the first
time that the Court has been asked to consider the issue of
valuation of a distressed company. This decision will clearly not
be the last word on valuations, rather it is likely to be just the
beginning of a new and developing area of jurisprudence. We would
be surprised if some of the sophisticated principles developed by
the US courts in the area of business valuation do not eventually
find their way into English Common Law.
In our view, IMO was largely decided on its particular facts. Had the mezzanine lenders tendered more compelling evidence demonstrating a reasonable possibility that the value of the Debtor Companies exceeded the senior debt, the outcome could well have been different. Accordingly, whilst the decision in IMO is likely to embolden senior lenders or other interested parties to attempt to take control of other companies through similar schemes of arrangement, this case should not be seen as the death knell for junior lenders.
Junior lenders wishing to avoid the same fate as the IMO mezzanine lenders would be well advised to present strong and compelling valuations to the relevant company and its directors early on in the process, and throughout, the restructuring process; and also to raise any concerns with the directors about potential breaches of their duties early in the process, not on the doorstep of the Court.
Furthermore, we believe careful attention should be paid in future to purchase rights contained in intercreditor agreements. While the specifics of the purchase mechanics in the IMO intercreditor agreement were not described in the decision, it is interesting to note that the default position contained in the form intercreditor creditor agreement recently published by the LMA requires that any mezzanine purchase right be exercised by the mezzanine lenders acting as a whole. In many situations, we believe this would render the purchase right worthless, as the inability or unwillingness of a single mezzanine lender to exercise the option would effectively prevent any exercise of the right. It would be incorrect in such circumstances for the court to interpret this (as it did in IMO) as evidence that the mezzanine lenders as a group do not believe the value of the company exceeds the senior debt sufficiently to justify the risk involved in the purchase. We believe junior creditors should consider insisting that any purchase rights benefiting them be exercisable by any or some subset of the junior lenders in order to ensure that it can still be exercised where one or more junior lenders fails for whatever reason to go along with the purchase.
1  EWHC 2114 (Ch).
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