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.
Background
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.
The Restructuring
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.
Court Sanction
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.
The Valuations
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 Issue
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.
The Law
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 [1992] 1
WLR 672), nor consult any class of creditors who have no
economic interest in the company (In re Tea Corp Ltd [1904] 1
Ch 12, 23-24). In re Telewest Communications plc (No 1)
[2005] 1 BCLC 752, 763 at [29], 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 [2001] 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 [2005]
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 [2005] 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 [2009] EWHC 2114 (Ch).
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
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