UK: How To Use Non-Contractual Rights To Influence A Restructuring Process

Last Updated: 13 August 2018
Article by Paul Durban

Co-authored by Milko Pavlov, Director, Houlihan Lokey

Depending on what type of restructuring is contemplated and the facts and circumstances of the case, there may be rights and remedies available to Junior Creditors in addition to contractual rights which arise from the credit documents. Instead of a "wait & see approach", these tactics will allow the minority Junior Creditors to proactively approach the company in order to be included in any restructuring negotiations.

The Pari Passu Principle

One of the fundamental principles of insolvency law is that all unsecured creditors in an insolvency process should share equally in any available assets of the company or any proceeds from the sale of any of those assets, in proportion to the debts due to each creditor.

However, recent cases have shown that the principle can also benefit sidelined or minority creditors.

In order to allow a business to address a liquidity problem and continue trading in the short to medium term, financing is frequently provided by existing creditors. It is an extension of the pari passu principle that creditors should be able to participate in that financing on an equal basis and for the debtor not to favour certain creditors to the detriment of others. But this does not always happen, in practice.

By way of recent example, a group of bondholders in the offshore deepwater drilling company Seadrill organised to push back on a proposed restructuring plan.

It was reported that disgruntled creditors representing over 30% of Seadrill's $2.3bn unsecured bonds were arguing that the new money financing had not been offered widely to all bondholders and that the participation rights granted to those outside the larger ad hoc bondholder group were insufficient. They held the view that the terms of the plan were unfairly lucrative to the "committed" creditors and the pari passu principle was not reflected in the economic terms of the deal in that they should be included in the financing arrangements.

The case illustrates how seriously the courts take any threat to the principle of pari passu.

Issues Relating to Directors' Duties

Directors are bound by statutory and fiduciary duties to the company. The Companies Act 2006 (sections 171 to 177) sets out the general duties of directors and officers. These include the following:

  • To act within the constitution of the company.
  • To promote the success of the company.
  • To exercise independent judgment.
  • To exercise reasonable care, skill and diligence.

However, when a company is facing financial difficulties, the directors' duty to promote the success of the company is replaced by a duty to act in the best interests of the company's creditors (section 172, paragraph 331, Companies Act Explanatory Notes). In this situation, directors must protect the value of the company assets and minimise losses to creditors as far as possible. In an insolvency situation, a Junior Creditor may therefore be able to exert significant pressure through an argument that a debtor's directors have breached the duties they owe to their creditors.

Insolvency Act Offences

The duty to have regard to the interests of creditors is reinforced by provisions contained in the Insolvency Act 1986 ("IA 1986") which can often be used as a 'stick' in Junior Creditors' initial interaction with a distressed corporate.

Under section 213 of the IA 1986, directors are liable if they knowingly carried on business with the intent to defraud creditors or for any other fraudulent purpose. If a director is found guilty of fraudulent trading, the court can order him or her to pay a fine and may even impose a custodial sentence.

Section 214 of the IA 1986 states that, if the directors of a company allow it to continue trading when they knew or ought to have known that there was "no reasonable prospect" of the company avoiding insolvent liquidation, the directors can be made personally liable to make a contribution to the company's assets.

The misappropriation of corporate assets by a director, in violation of the company's interest and for the director's own personal benefit, is a criminal offence. Also, directors misapplying money or other company property may result in a breach of section 212 of the IA 1986 (the summary remedy against delinquent directors), and the directors may be ordered to repay any amount the court thinks just.

Depending on the circumstances, the law on wrongful trading, possibly in combination with the threat of a disqualification order being made against a director under the Company Directors Disqualification Act 1986, may be used by minority Junior Creditors to assert leverage and gain a seat at the negotiating table.

But a word of caution, here: the law on wrongful trading also applies to shadow directors. In reality, the likelihood of a lender qualifying as a shadow director is low. The court's attitude is that a creditor of a company is entitled to protect his own interests as a creditor without necessarily becoming a shadow director. However, undoubtedly there is a line which must not be crossed beyond which there is a risk that a creditor who ends up assuming responsibility for the company's affairs may become a shadow director.

Fairness Opinions

As described earlier, financial restructuring transactions often involve fresh capital and modifications or exchanges to existing securities held by debt and equity investors. In distressed situations it is therefore not uncommon to see new money being provided on terms which may be challenged by existing creditors. To help overcome these issues, a fairness opinion can therefore be rendered to the Board of Directors indicating that from a financial point of view, based on a defined set of assumptions as of a specific date, the transaction is fair to the Company.

Fairness opinions are typically used when expressly required by the terms of the finance documents or other security documentation, in scenarios where there is a significant level of cross ownership among various participants across the capital structure or where a conflict of interest may arise. Fairness opinions generally support boards of directors in exercising their fiduciary duties and provide documentary evidence that these are acting in the best interests of shareholders and creditors in restructuring situations where debt holders are unlikely to get back the full amount of their principal. As a result, fairness opinions can help protect board members, the controlling shareholders and creditors alike against possible claims from other transaction participants who argue that transaction consideration is unfair and they are being treated unfairly. In "high stakes" restructuring processes, a fairness opinion can also significantly minimize the risk of disruption or delay triggered by litigation.

Creditors - Getting a Seat at the Negotiating Table can be downloaded at

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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