Also covered in the April 9, 2008 edition of The Globe and Mail
April kicks off loan review and renewal season. Across the country, bank loan officers are reviewing year-end financial statements and assessing corporate prospects. This process is likely to result in a further tightening of lending standards and widening of credit spreads. A recent Federal Reserve study reports that already one third of U.S. banks have tightened loan criteria and that 45 per cent of banks are now charging more for credit.
All signs are that this tightening of credit conditions will lead to an increase in corporate insolvencies and workouts. Weak companies that have avoided cutbacks and restructurings during the recent era of cheap credit will be pushed into insolvency and bankruptcy proceedings. Credit default swap price indices, an early indicator of deteriorating credit quality, have increased six fold in the past year; and both Moody’s Investor Services and Standard & Poor’s are forecasting a fivefold increase in U.S. corporate defaults this year.
In past downturns, restructurings and liquidations were the most common ways of dealing with troubled companies; but traditional debt restructurings are time consuming and expensive. They require engaging in a prolonged process of defining the creditor classes that are entitled to vote on the restructuring plan, followed by tough negotiations among those creditor classes to arrive at a plan that all creditors will support.
In the current reality, "Distressed M&A" - the management led sale of a financially distressed company as a going concern in a pre-plan, court-supervised auction process – will replace the traditional debt restructuring plan as the deal structure of choice for dealing with troubled companies. In this new reality, savvy buyers who understand the complex rules of Distressed M&A will be presented with unique opportunities to purchase distressed businesses at fire sale prices. M&A deal lawyers, who are nuanced in the art of running a thorough and transparent auction process, will have the advantage over insolvency lawyers who lead creditor-driven restructuring plans in prior down turns.
The revolution in credit markets over the past decade is driving this new reality. The typical corporate loan is no longer held on the bank’s books but is quickly sold into a structured investment vehicle. This conduit then securitizes the loan into collateralized loan obligations. Investment grade tranches are sold principally to insurance companies and more speculative tranches are purchased by private equity funds and hedge funds that then insure their investment with credit default swaps.
Traditional insolvency restructurings are designed to give the debtor the ‘breathing space’ to build a new business plan and to effect operational changes. In today’s credit markets, however, where loans are actively traded, troubled debt instruments are quickly traded into the hands of specialized distressed investors as the borrower’s credit condition deteriorates. These vulture investors are not ‘patient money’; they are traders seeking a quick exit from their positions through aggressive ‘loan to own’ strategies culminating in an opportunistic sale of the company as a going concern.
Farris Partner, Al Hudec, features in the April 9, 2008 edition of The Globe and Mail newspaper.
The complex architecture of modern debt structures adds to the difficulty of successfully engineering a traditional debt restructuring. Historically, when debtors had simpler capital structures (often only two classes of debt), the senior lenders with the most collateral backing their notes effectively controlled the restructuring process. Junior lenders with little or no security ranked behind them and were prohibited by so-called blockage provisions in their bond indentures from seeking payments or exercising other remedies until after the senior lenders were paid.
Today’s debt structures are not so simple. A typical capital structure of a large corporate borrower includes numerous tranches or layers of debt, including new types of debt such as second lien, mezzanine and payment-in-kind notes. Dealing with multiple levels of debt, each held by multiple lenders, can make the process of negotiating a debt restructuring plan an almost impossible task. For example, the terms of second lien notes usually give their holders a seat at the bargaining table and significant negotiating leverage. Hedge funds holding distressed debt further complicate the process by continuing to trade the company’s debt throughout the negotiating process, strategically investing in multiple classes of the company’s debt to enhance their bargaining position in the restructuring negotiations.
The popularity of covenant lite loans during the recent period of easy credit adds to the time pressures that make achieving a complex loan restructuring difficult. Bank loan agreements now look more like trust indentures. There has been a drift away from maintenance covenants, which require ongoing compliance with financial covenants, towards laxer incurrence covenants which require compliance only episodically, such as when the borrower wishes to borrow more money. The relaxed terms mean that the first sign of financial stress is often a payment default, at which point there is little time left to commence a successful restructuring.
In the face of all these debt innovations, any hope of salvaging a company through a traditional debt restructuring process is slight. The new reality is that the bankruptcy process will be dominated by aggressive debt investors with a trading mentality seeking a fast exit from the bankruptcy process. As a result, the workout structure of choice in this down turn will be the management led sale of the business through a court supervised auction process.
The key to success in this new reality will be an understanding of the intricacies of Distressed M&A. In a Distressed M&A transaction, management, together with their financial advisors, lead a process of actively auctioning the troubled company. If pre-insolvency efforts to sell the company are unsuccessful, the company files for protection under the Company Creditors Arrangement Act. This filing provides an automatic stay order which prevents creditors from realizing on their security. It also allows the company to seek court approval of a debtor-in-possession or DIP financing in which a new lender willing to provide fresh working capital receives a court-ordered ‘super priority’ security interest in assets of the debtor. With these protections, management of the debtor company has the breathing space necessary to continue in its effort to sell the company. At the end of the sale process, the court issues a vesting order confirming the transfer of the sold assets to the buyer free and clear of encumbrances. This court certification of title is a major benefit to buyers of distressed assets.
Canadian bankruptcy courts, in various cross border restructurings, have imported into Canada U.S. ‘stalking horse’ bid procedures developed under Section 363 of the U.S. Bankruptcy Code to sell troubled businesses in Canada. A recent example is the court supervised auction of its forestry assets by Pope & Talbot. Provided that the court is comfortable that proper and sufficient efforts are made to get the best price for the business, it will approve a Distressed M&A transaction without the normal shareholder approvals and without the need to obtain approval of a formal restructuring plan by the various creditor classes of the debtor company (a process that can be complex and expensive, and often extremely frustrating).
In a Section 363 stalking horse bid process, the distressed company engages in a sale process, selects a preferred bidder and enters into a fully negotiated asset purchase agreement. The company and the stalking horse bidder present the deal to a court for approval in a hearing where the court also approves a further 21-30 day competitive auction process to market test the initial bid. Subsequent bidders must base their offers substantially on the documentation negotiated by the first bidder and must overbid the original bid by a defined amount. If there is a higher bid, which is not matched by the stalking horse, the stalking horse bidder receives a break fee and expense reimbursement as compensation for the lost deal.
Recent amendments to the Company Creditors Arrangement Act will give additional momentum to the growth in popularity of Distressed M&A. Late last year, this depression era statute was expanded from 22 to 63 sections. These changes, which are scheduled for implementation this year, give statutory recognition in Canada to a Distressed M&A process very similar to the U.S. stalking horse bid process. They also codify the full toolbox of modern restructuring tools which have been developed by bankruptcy judges over the years. These tools include the right of the insolvent debtor to seek court approval permitting it to reject or disclaim unwanted contracts and to transfer to a buyer the benefit of contracts that would otherwise terminate as a result of the insolvency. The amendments also confirm the power of a bankruptcy court to require critical suppliers (including landlords and utilities) to continue to supply the failing business during the time it is under court protection.
Distressed M&A is not for the faint of heart. The dire straits of the target company, the time urgency of the situation, the complex interplay with various creditor classes and the unfamiliarity of potential buyers with the court supervised process make Distressed M&A a risky endeavor. Buyers who understand the unique opportunities and risks presented by Distressed M&A, and who can work quickly and decisively to manage these risks, will reap the substantial rewards of Distressed M&A.
About Al Hudec
Al Hudec is a senior securities practitioner with 25 years of experience in all legal aspects of securities and corporate finance, including mergers and acquisitions, public and private financings of equity and debt, corporate governance and related party transactions, regulation of listed companies, income trusts, banking and restructurings; with emphasis on the North American resource and technology industries.
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