Australian banks have historically relied on formal liquidation, voluntary administration and receivership processes available under the under the Corporations Act 2001 (Cth) and under general law where informal restructurings have failed. There has been little appetite for exploring alternative methods to exit distressed situations by debt trading.
Until recently, an immature secondary debt market and general unwillingness to see potential upside returns flow to distressed investors exacerbated the reluctance of lenders to exit distressed situations by trading out of risk positions.
Australian banks now view trading out of distressed loans as a viable option, often assessed at the outset of an informal restructuring and used as a benchmark indicator for assessing other exit strategies.
There are a number of reasons for this shift in focus including:
- an increase in impaired loans and liquidity contraction following the global financial crisis;
- the emergence of special situation funds in the local market;
- Australia being seen as a safe-harbour (both economically and politically) for capital investment;
- revised capital adequacy requirements following the introduction of Basel II (now further enhanced through Basel III); and
- banks' frustration at the sometimes protracted nature and cost of formal insolvency appointments.
There has been renewed focus on the methods to capture enhanced equity values that flow from a successful restructure. Traditionally limited by the formulaic process required to be undertaken by receivers and external administrators, the market is now beginning to see more creative solutions aimed at delivering successful loan to own implementation strategies.
This article considers how an appropriately structured formal external administration process combined with a debt trade may satisfy an external administrator's duties whilst delivering equity control to a distressed investor through strategies more commonly seen in other jurisdictions.
Loan to own strategy
Loan to own strategies generally involve an investor providing or acquiring senior secured debt with the intention of using it as leverage to take control of or own the borrower through implementation of a debt and capital restructuring.
Subject to the terms of the underlying inter-creditor and financing arrangements, while purchasing a controlling stake in senior secured debt gives certain controls over restructuring and enforcement decision-making, the investor is still required to go through a consensual negotiation or enforcement process to take control of the borrower or its assets. This may be achieved through:
- a debt for equity swap; or
- the investor enforcing its security through a pre-packaged appointment of receivers and/or administrators.
A debt for equity swap is able to be achieved where the investor agrees to cancel some or all of its debt (and the rights attached thereto) in exchange for an equity stake in the borrower.
Where a consensual restructure is not possible, control may be able to be achieved through the Voluntary Administration process that allows for the administrator to issue new shares or for the court to compulsorily transfer a member's shares in certain circumstances, or through a Scheme of Arrangement.
The Scheme of Arrangement regime was initially introduced to allow for restructuring insolvent companies but, following the introduction of the Voluntary Administration regime in Australia in 1993, is now more commonly associated with public company takeovers due to the greater level of court involvement. Nevertheless, a members' and creditors' scheme of arrangement can be used to effectively restructure both the debt and capital structure of the borrower.
Recent High Court authority in Lehman Bros Holdings Inc v City of Swan; Lehman Bros Asia Holdings Ltd (in liq) v City of Swan (2010) 240 CLR 509 (which dismissed an appeal against a decision of the Full Court of the Federal Court of Australia) confirmed that a deed of company arrangement cannot extinguish creditors' claims against third parties. Conversely, in the Opes decision (also upheld on appeal in Fowler v Lindholm, in the matter of Opes Prime Stockbroking Limited (2009) 178 FCR 563), it was held that a scheme of arrangement can extinguish creditors' claims against third parties. In reaching this conclusion, the court also highlighted the flexibility of Part 5.1 of the Act (ie. the section dealing with schemes of arrangement).
The advantages of pre-packaging or agreeing to a restructure prior to the commencement of formal external administration are obvious. Unfortunately, the traditional approach of the Australian courts (and therefore practitioners) to focus on ratification of due process through a sales campaign that delivers value (consistent with the statutory obligation imposed on controllers under section 420A of the Act to achieve the "market value" for assets sold by controllers) often threatens loan to own strategies and the ability to pre-package a restructuring or expedite the period a borrower is in external administration.
However, there appears to be growing support for reliance on marketing efforts taken prior to external administration with expert valuations used as evidence to establish where value breaks so as to justify a pre¬packaged restructure that utilises the external administration process as a tool to cram down or compromise creditors and members. The origins of this position were stated in Re Tea Corporation Ltd [1904] 1 Ch 12 (where the members were ignored for the purpose of approving a scheme of arrangement because they had no economic interest in the assets) and applied in Australia in Opes Prime Stockbroking (2009) 179 FCR 20 and also found support in the UK decision in Re Bluebrook Ltd and Ors [2009] EWHC 2114 (Ch) (often referred to as the IMO Car Wash case).
Example of a loan to own transaction
A recent loan to own transaction adopted a number of the strategies outlined above. The company (Purchaser) signed a binding heads of agreement with receivers of Parent and Target (Heads). The Heads gave the Purchaser the option to purchase the assets of Target or Parent's shares in Target with an election to be made within a very tight timeframe. This gave the Purchaser little scope to negotiate with various stakeholders (including trading parties and Parent shareholders) which was required in order to take control of Parent (and therefore control of the consolidated group). In order to overcome this, the Purchaser sought to negotiate with the senior secured lender (Secured Creditor) to purchase its debt and related securities prior to the deadline for the election under the Heads.
By selling its debt for the same amount payable under the Heads, the Secured Creditor was no worse off under the debt trade. The trade was completed under a standard form LMA trade confirmation and accession certificate. It was not subject to extensive negotiations as would have been the case had an election been made under the Heads.
Having stepped into the shoes of the Secured Creditor, the Purchaser took over the appointment of the Receivers. This gave the Purchaser visibility on the day-to-day operations of the business and the ability to participate in the renegotiation of key contractual arrangements with various stakeholders.
The Purchaser now has the option to fall back on the extended Heads and credit bid its secured debt to complete an acquisition under the Heads and negotiate with Parent shareholders to purchase their shares. In the absence of shareholder approval, the Purchaser can put forward a deed of company arrangement and seek to have the deed administrator rely on section 444GA(1) of the Act to compulsorily transfer shares in Parent to it, with leave of the court, as part of a restructure. A court will grant leave if it is satisfied that the transfer would not "unfairly prejudice" the interests of members of the company (section 444GA(3) of the Act). Following the principles enunciated in Tea Corporation shareholders will not be unfairly prejudiced if there is no economic value in their shares.
Obtaining control of the shares in Parent will deliver the consolidated group to the Purchaser enabling it to access significant benefits including potential tax losses as well as continuity of business ensuring there will be no trigger of change of control provisions in various contracts. This outcome also renders the Heads redundant as the Purchaser had indirectly acquired Target. This will be a considerably superior outcome to what would have been achieved through a straightforward asset or share sale under the Heads.
Conclusion
There are many reasons why a loan to own strategy can be a viable restructuring tool. In circumstances where banks are gaining an appetite for trading out of their debt, it is worthy of consideration. It allows banks to remove unwanted distressed loans from their books and can allow flexibility in deal structuring. With banks often seeking out trading opportunities prior to formal insolvency appointments, purchasers should be prepared to move quickly to take advantage of the potential benefits.
This article was first published in INSOL World Fourth Quarter 2011
Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.
