Germany: Distressed M&A: Swap of Debt for Equity in an Insolvent Company to Be Simplified by a New Law on the Facilitation of the Reorganization of Enterprises

Last Updated: 29 November 2010
Article by Jones Day

GERMAN M&A AND PRIVATE EQUITY NEWS - 4TH QUARTER 2010

As part of an intended comprehensive amendment of German insolvency law, the German Federal Ministry of Justice has prepared a draft of a new law to facilitate the reorganization of enterprises ("Reorganization Facilitation Act"). The new law will curtail the rights of shareholders of insolvent companies and allow capital measures and other corporate measures to be taken in the insolvency of a company without the participation of the shareholders. The new regulation is of interest to investors because it will significantly simplify the purchase of the shares of an insolvent company.

Investors usually buy insolvent enterprises by means of an asset deal. The advantage of this approach is that the buyer, in principle, assumes only those liabilities that he actually wants to assume. (Exceptions may apply, as in the case of liabilities stemming from employment agreements.) In addition, unprofitable parts of the enterprise can be left with the insolvency administrator. There are, however, serious shortcomings inherent in an asset deal. Agreements with third parties that may be of fundamental importance to the business cannot be transferred to the buyer without the consent of the other party to the agreement, which may not be obtained at all or only if the buyer is prepared to make substantial concessions to the other party. Furthermore, public permits required for the operation of the business may not be transferable, so they cannot be assigned to the buyer in the course of an asset deal. The buyer will need to apply for a new permit, which may create difficulties. The purchase of the insolvent enterprise by means of a share deal is frequently preferable in these cases, but only after the debt of the insolvent entity has been restructured by means of a plan of restructuring, which will need to cure a (calculatory) overindebtedness and ensure that the company has an appropriate equity ratio going forward.

Cooperation of Existing Shareholders Required Under the Current Law

Creditors are generally not prepared to waive a company's debt or support the reorganization in any other way if the shareholders themselves do not make an appropriate contribution to the continuation of the business. If the shareholders are unwilling or unable to do so, then the creditors may consider taking shares in the company by swapping their debt for equity. The first step of a debt-forequity swap is usually to reduce the registered share capital of the company (to zero, if required) in order to extinguish any losses in the balance sheet. After the capital decrease, the registered share capital is increased, the company's debt is contributed as consideration for the new shares, and any subscription rights of existing shareholders are excluded. The new shares created by the capital increase are allocated to the participating creditors. Opportunities for investors arise if the existing creditors do not want to take equity in the insolvent company but are prepared to sell their claims (below par) and thus enable the investor to participate in the debt-for-equity swap. An investor can, of course, also agree to subscribe to new shares issued by the company and contribute cash funds as consideration for these shares.

Under current law, the issuance of shares to creditors or investors without the cooperation of existing shareholders is only possible, if it is possible at all, if the existing shareholders are required to cooperate because they have fiduciary duties to the company. Whether such fiduciary duties exist in a specific case is frequently unclear. At any rate, it is usually not possible to enforce fiduciary duties with the help of the courts in time for the reorganization. It goes without saying that there is no incentive for the existing shareholders to agree on the necessary capital measures if the outcome is that they will no longer hold a (meaningful) stake in the company. Creditors that intend to reorganize the insolvent company frequently have no choice but to buy the shares of the existing shareholders at a purchase price that exceeds the actual residual value of the shares in the insolvent company.

No Cooperation Required by Existing Shareholders Under the New Law

The draft Reorganization Facilitation Act provides for the rights of shareholders to be curtailed by means of a plan of restructuring without their consent. Under the new law, capital measures in connection with a debt-for-equity swap, the exclusion of existing shareholders' subscription rights, compensation payments to shareholders exiting the company, the continuation of a company that was dissolved as a result of the opening of insolvency proceedings, the transfer of shares in the company, and other corporate measures may be provided for in a plan of restructuring. Appropriate compensation needs to be provided for in the plan if the existing shareholders lose their shares as a result of such measures. If the shares in the insolvent company are no longer worth anything, then no compensation is required.

The plan of restructuring and the regulations contained therein become effective once the plan has been confirmed by the insolvency court and such confirmation is no longer subject to an appeal. A court will not confirm the plan if mandatory provisions on the content of the plan, on the process, or on the adoption of the plan by the creditors and the existing shareholders were not complied with in all essential points. Voting on the plan of restructuring occurs in groups. The plan itself allocates creditors and shareholders to different groups according to the specific legal position of the respective participant. There will usually be more than one creditor group. In general, an insolvency plan is adopted only if all of the groups consent to the plan. In order for a creditor group to consent to the plan, the majority of the creditors in that group (head count and sum of claims) need to have voted in favor of the plan. In the case of a shareholder group, the new law will provide that a majority of the shareholdings is necessary for the group to consent. A group, especially a group of shareholders, that votes against the plan may nevertheless be crammed down if: (i) the members of the dissenting group are not worse off under the provisions of the plan of restructuring than they would be if there was no plan, (ii) they participate in an appropriate manner in the economic value made available to the participants under the plan, and (iii) the majority of the group vote in favor of the plan.

The plan of restructuring may withdraw shares from the existing shareholders without any compensation if the shares are no longer worth anything, which is usually the case if the company is insolvent. If the group of existing shareholders votes against such a plan, then it can be crammed down. Since the members of the group would not receive anything if there was no plan and the company was liquidated, they will not be worse off with the plan than they would be without it. Members of such dissenting group will participate in an appropriate manner in the economic value that is made available under the plan if no creditor obtains funds or other assets in excess of its claim and no other shareholder is better off under the plan than the members of the dissenting shareholder group. In exceptional cases where the shares in the insolvent company still have some (residual) value, the plan of restructuring needs to provide either for the continuing participation of the existing shareholders in the company following the reorganization in a scope determined by the residual value of their shares or for their shares to be withdrawn and appropriate compensation to be paid.

The value of the shares of the current shareholders needs to be determined as soon as the plan of restructuring is drawn up. The potential residual value of the shares determines the provisions that can be made in the plan with respect to such shares. If the majority of a shareholder group are of the view that the provisions in the plan of restructuring are based on a valuation of the shares which is too low and that they would be better off without the plan than they are with it, then they will vote against the plan. If the insolvency court crams down the dissenting shareholder group and confirms the plan nevertheless, the members of such group may appeal the court decision. In order for such appeal to be admissible, the shareholders need to provide prima facie evidence that they would be materially disadvantaged by the plan and that such disadvantage could not be cured by any payments provided for under the plan. This requirement intends to prevent abuse of the right of appeal.

Outlook

The new law will prevent existing shareholders from blocking debt-for-equity swaps and other corporate measures with respect to companies in insolvency. It can be expected that the reorganization of insolvent companies and the participation of investors in such companies by means of either loan-to-own strategies or some other acquisition of shares will be facilitated.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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