Compromising debts in the COVID-19 era

One of the new tools introduced in a number of jurisdictions is an ability for a corporate creditor to impose a compromise of its debts on dissenting creditors. Some of these new processes have been in the legislative pipeline for some time but have been fast-tracked this year; they come at an important time for borrowers and creditors alike as many businesses will need to reshape their finances in the face of declining 2020 revenues and an uncertain road to recovery in many sectors, combined with escalating debts from deferred liabilities and extra liquidity borrowed to survive the pandemic.

In this article, we look at new compromise proceedings in four different jurisdictions: Australia, Germany, the Netherlands and the UK.

Australia

On 24 September 2020, the Federal Government announced plans to implement a new small business restructuring regime, which will adopt certain key aspects of the US Chapter 11 bankruptcy process. The announcement represents the biggest change to Australia’s insolvency laws since the early 1990s.

The SME sector is of vital importance to the Australian economy, and SMEs have been hit particularly hard by the COVID-19 pandemic. 97.5% of businesses in Australia employ fewer than 20 employees and small businesses in Australia employ approximately 4.7m people (44% of the total number of people employed in the private, non-financial sector).

The proposed regime is intended to be faster, less complex, more efficient, more flexible and more cost-efficient than the current liquidation and voluntary administration regimes, and aims to maximise small businesses’ chances of survival. Critically, and most radically in the context of the existing “creditor in possession” options for external administration in Australia, the new regime will provide a “debtor in possession” framework.

The new regime came into effect on 1 January 2021, following the expiration of the extended COVID-19 insolvency relief measures on 31 December 2020.

Key components of the proposed regime are as follows:

• Directors of debtor companies owing less than AUD 1 million (as currently proposed) will be able to appoint a Small Business Restructuring Practitioner (SBRP) (a registered company liquidator, who must be and remain independent), who will assist the directors with the development of a “restructuring plan”. The SBRP will then report to the company’s creditors on whether to approve the plan.
• A restructuring plan is to be developed within 20 business days of the appointment of the SBRP. If satisfied with the plan, the SBRP will “certify” it and submit it to the creditors for consideration. Any employee entitlements that are due and payable must be paid out before the plan is put to a vote – this may present an obstacle for many small businesses which have made use of the Government’s emergency Jobkeeper support measure since the pandemic started.
• The creditors have 15 business days to vote on the plan electronically.
• The plan may be approved by a majority of creditors in value, with no class voting and with related party creditors being prohibited from voting.
• If a majority of creditors vote for the plan, the plan can commence and the SBRP will oversee it. The plan is binding on all unsecured creditors, and on secured creditors, to the extent, their debt exceeds the realizable value of their security interest.
• If the majority of creditors vote against it, the process ends and the directors may choose to enter another insolvency process, such as voluntary administration or using a new simplified liquidation process to allow a faster and lower cost winding up.
• Directors will remain in control of the management of the company (as opposed to the traditional ‘creditor in possession’ model that applies in other Australian insolvency regimes), except as to transactions which are outside of the ordinary course of business which will require authorisation from the SBRP or a court.
• Once a SBRP is appointed, unsecured and some secured creditors cannot take action against the company, nor can a personal guarantee be enforced against a director, or an ipso facto clause be triggered. Rights of secured creditors and the statutory priority afforded to certain creditors such as employees will remain unaffected.
• Protections will be built into the framework to prevent its potential misuse as a means of “phoenixing”. Related party creditors will be prohibited from voting on the plan, companies and directors will only be permitted to use the scheme once in a given timeframe (seven years is currently being suggested) and powers will exist to stop the process if deliberate misconduct is identified (although it is not yet clear who will conduct this process).

Further details of the new regime are still the subject of submissions and discussion, including the AUD 1 million debt threshold, what debts will be included in that threshold (such as contingent debts or related party debts), the specific procedural obligations, the anti-phoenixing measures described above, and the interaction with other insolvency laws such as voidable transactions and directors’ duties (including their duty to prevent insolvent trading).

Public consultation on the exposure of this new draft legislation and explanatory material has now closed. The Corporations Amendment (Corporate Insolvency Reforms) Bill 2020 was introduced to Parliament on 12 November 2020, and the corresponding Regulations and Rules (in which much of the substance of the new regime will be contained) are expected to be released in the coming days.

Germany

Germany’s new restructuring regime came into force on 1 January 2021. At the heart of the new regulation is the introduction of a so-called stabilization and restructuring framework (“SRF”) for companies. In a sea change to the traditional approach, the SRF enables a company to be restructured before insolvency proceedings have to be initiated. It is therefore expected that this new regime will have a major impact on German restructuring practice.

The core element of SRF is the submission of a restructuring plan (the “plan”) by the company and its acceptance by affected creditors.

• The plan allows far-reaching arrangements to be made affecting not only the debts of the distressed company but also its shareholder structure. The decision as to which creditors will be affected by the plan and whether the plan should affect shareholders remains with the company.
• The plan can be used to restructure the debts owing to affected creditors (for example by imposing a haircut or a deferral), intervene in the rights of shareholders, alter creditors’ claims under security provided by other entities within the group and/or implement a new financing.
• Claims of employees must not be changed under the plan.
• The creditors affected by the plan must be divided into groups according to appropriate characteristics and treated equally within their groups. If the plan intervenes in the rights of shareholders, the shareholders must form a separate group.
• In order to become effective, the plan must be accepted by each creditor group by a majority within that group of at least 75 % by value, whereby the voting right depends on the amount of the claim held by each creditor. Dissenting creditor groups can be crammed down under certain conditions.
• It is possible to implement the plan without the involvement of the court. The new restructuring law thus gives the debtor a comparatively discreet opportunity for restructuring both its debts and its capital on a confidential basis. A successful restructuring, though, requires a structured and precisely planned preparation.
• Involving the restructuring court may, however, be advantageous. The plan will only bind dissenting creditors if it is approved by the court. Under certain conditions, the court may also terminate mutual contracts and order stabilization measures (such as a cessation of enforcement measures), neither of which can be done under a plan without court involvement.

If the court is involved, the following limitations of liability will also apply:

• Relaxation of the general prohibition on payments pursuant to section 15b of the Insolvency Code (previously section 64 of the Limited Liability Company Code) if the company has notified the court of its subsequently occurred illiquidity and/or over-indebtedness.
• Provisions of a legally binding plan and legal actions taken in the implementation of the plan are generally not contestable in a subsequent insolvency.

In certain cases, a restructuring officer must be appointed, to whom the court can transfer various rights of control. Alternatively, it is also possible to enter into a consensual settlement with different creditors with the support of a restructuring moderator.

The Netherlands

Due to the effects of the COVID-19 pandemic on businesses the Dutch government is accelerating the introduction of a new piece of legislation, the Confirmation of Extrajudicial Restructuring Plans (Wet Homologatie Onderhands Akkoord) (“WHOA”), that provides for both public and private pre-insolvency restructuring proceedings which in essence allows debtors (or their creditors) to compromise certain debts. This new piece of legislation has been passed by both the House of Representatives and the Senate. This act has been published in the Bulletin of Acts and Decrees on 3 November 2020 and will change to “entered into force on 1 January 2021". 

The new process, sometimes known as the “Dutch Scheme”, is inspired by and based upon the experience of composition plans in the UK and the US. As soon as the legislative proposal enters into force, it will enable debtors to force dissenting creditors within the scope of the composition plan to comply with the plan, provided that the majority of the creditors have approved the composition plan. More detail is set out below:

• In essence, the WHOA introduces an efficient debtor-in-possession (“DIP”) procedure which allows legal entities and individuals which conduct an enterprise or an independent profession and which believe they are likely to be unable to pay their debts in the future to present a debt restructuring plan to their creditors and/or shareholders. The plan can then be submitted to the court for approval. Although creditors, shareholders or works council representatives cannot themselves propose a restructuring plan, they can petition the court to appoint a restructuring expert who may propose such plan on their behalf. The debtor can propose an alternative plan to the restructuring expert’s plan. However, the debtor’s consent is not required for the restructuring expert’s restructuring plan, unless the debtor is a small or medium-sized enterprise (“SME”). 1 Regulation (EU) 2015/848 of the European Parliament and of the Council of 20 May 2015 on insolvency proceedings
• The restructuring plan can be either a public or a non-public procedure. Non-public procedures are confidential to the parties, will not be covered by the Recast Insolvency Regulation1 and can be entered into by any debtor with sufficient nexus to the Netherlands. Public procedures are – as the name suggests – public so all hearings and judgments are public, will be listed in and so recognized under the Recast Insolvency Regulation, are registered in the Dutch trade register and the Dutch Central Insolvency Register and are open to entities whose COMI is in the Netherlands.
• Once the plan has been drafted, those creditors and/or shareholders affected must vote on it (although the debtor can go to court before the voting takes place to ask for a ruling on matters such as valuation, class formation and sufficiency of information). Creditors will be placed into classes, depending on their respective legal positions. As a minimum, each creditor must be placed in a class which under the plan has the same ranking vis-a-vis other creditors as the creditor would have had in the insolvency of the debtor. Secured creditors will generally be classed together but only for that part of their claim which is “in the money”, based on a liquidation valuation. The remainder of the claim will be treated as unsecured.
• The plan will be treated as approved by a class if more than two-thirds in value of the creditors voting in that class vote in favor. For shareholder classes, the threshold is twothirds of the issued capital of those that voted within that class.
• Once the class votes have taken place, the plan is submitted to the court for approval. Where all classes have voted in favor of the plan, the plan will bind all creditors/shareholders in each class, regardless of whether they voted in favor (a horizontal cram down). Provided the plan has been approved by at least one “in the money” class, the court can also approve the plan at which point the plan will be binding not only on those classes which voted in favor but also those which did not (a “cross-class cram down”).

However, the court can refuse to approve the plan in certain circumstances:

• If procedural requirements have not been met or if the classes have not been properly constituted, the court can refuse to confirm the plan either of its own volition or at the request of a creditor or shareholder;
• Creditors who voted against the plan can ask the court to refuse to confirm the plan on the grounds that the plan does not meet the best interests of creditors test, which requires that creditors or shareholders would receive no less under the plan than they would on the liquidation of the debtor.
• Where a creditor has voted against the plan and is part of a class which has voted against the plan, the creditor can ask the court to refuse confirmation of the plan if:
  • the value distribution under the restructuring plans deviates from statutory or contractual arrangements and, as such, impairs the opposing creditors;
  • the relevant creditor is a SME creditor and has not been offered an amount representing a value of at least 20% of its outstanding claims (subject to certain exceptions); or
  • the creditor is a secured creditor and has only been offered shares in the restructuring plan. • If an unsecured creditor class has not approved the restructuring plan, the creditors in that class are entitled to receive a cash distribution equal to the amount they would have received in a liquidation of the debtor.
• If the court approves the restructuring plan, the relevant creditors have the option to opt for the cash distribution or to stick with the plan.

The court can also make other orders as part of the WHOA process:

• The debtor (or, if appointed, the restructuring expert) can ask for a moratorium of up to eight months during which time it will remain entitled to conduct its business as usual, as long as the interests of the creditors are safeguarded. This also results in creditor enforcement action being stayed during this period. A moratorium can be granted in two situations: (i) the debtor files a restructuring statement with the court and offers or intends to offer a restructuring plan within two months, or (ii) a restructuring expert is appointed.
• If the plan entails the amendment or termination of long-term contracts such as leases or supplier contracts, the court can approve such steps where counterparties refuse to cooperate.
• The debtor (or, if appointed, the restructuring expert) can also ask the court to grant a stipulation or preliminary injunction to safeguard the interest of the creditors and shareholders, after it has filed a statement in which it declares that the negotiation has commenced. For example, the court can impose a condition that the restructuring plan must be voted on within a specified period or that the debtor must regularly inform the creditors, shareholders and the court about how the process is progressing.
• The debtor can ask the court to preapprove the contractual arrangements it intends to enter into after it has launched its restructuring efforts pursuant to the WHOA. If the court grants this pre-approval, the debtor is protected from clawback and challenge actions if the debtor were to become insolvent. Such pre-approval would enable the debtor to grant security and attract (bridge) financings without the risk of clawback and challenge actions.

The WHOA, unlike similar schemes in other jurisdictions, has an advantage when it comes to the restructuring of a multinational group of companies. Not only does the WHOA provide a platform for the restructuring of group liabilities through a single procedure (regardless of the guarantors’ home jurisdiction), the court-approved restructuring plan will be automatically recognized within the EU under the Recast Insolvency Regulation (applying to the public procedure). A group of companies may combine the public procedure and the nonpublic procedure. All this means that the WHOA is a state-of-the-art law that allows for global restructurings with the flexibility of a UK Scheme, combined with the moratorium and certainty of the US Chapter 11, but at a lower cost and within a short time frame.

The UK

On 26 June 2020, the Corporate Insolvency and Governance Act 2020 (“CIGA”) came into force, a mere 37 days after the first draft was published. One of the permanent measures introduced as Part 26A of the Companies Act 2006 (CA06) is the restructuring plan (plan). The plan process is similar in many respects to the current scheme of arrangement (scheme) process under Part 26 CA06 (which will remain in place and remains an option for companies seeking to compromise their debts). This is intentional – the explanatory notes to CIGA states that the overall commonality between Part 26 and Part 26A will enable the courts to draw on the existing body of Part 26 case law where appropriate. This has certainly proved to be the case in the two plans which have so far gone through the courts2. In summary:

• The plan process is open to UK companies and unregistered companies liable to be wound up under Part V of the Insolvency Act 1986 (IA86) and so will be open to overseas companies provided certain conditions are met, including that they have a sufficient connection to this jurisdiction. In the last decade, a significant number of overseas companies have used an English scheme to effect a restructuring and it is likely that the plan will also prove popular, given its additional features.
• Unlike the scheme requirements, to be eligible a company must show that it has encountered or is likely to encounter financial difficulties that are affecting or will or may affect its ability to carry on business as a going concern and there must be a compromise or arrangement proposed between the company and any of its creditors or members which is intended to eliminate, mitigate or prevent the financial difficulties.
• As with a scheme, the court will convene creditor and member class meetings to vote on the plan provided it is satisfied that the classes have been properly constituted and that there are no jurisdiction issues. However, unlike a scheme, the company can apply to the court to exclude any class of creditor or member from participating in the meetings where it can be shown that the class has no genuine economic interest in the company. This creates the possibility for the rights of creditors who are out of the money to be altered (or even eliminated) without them being allowed to vote on the plan. The ability to exclude out of the money creditors together with the cross-class cram down (on which see below) are two of the key features of the plan that are not available in the scheme process. Excluding creditors will no doubt give rise to disputes as to the nature and value of excluded creditors’ interests and it will be interesting to see whether companies use this ability to exclude - yet bind - out of the money classes or whether they will rely on the court’s ability to cram down dissenting classes.
• The plan will be treated as having been approved by a class if at least 75% of that class present and voting votes in favor. In an important difference from the scheme of arrangement, there is no 50% numerosity test which may make it easier for large debt holders to push through a restructuring using a plan rather than a scheme. • Once the class meetings have been held, the plan must be presented to the court for sanction. As with a scheme, where all classes have voted in favor of the plan, the court will sanction the plan provided procedural requirements have been met, each class was fairly represented at the class meetings and the court is satisfied that the scheme will have effect in relevant jurisdictions and is “fair”.
• However, in the much-advertised “cross-class cram-down” process, the court can still sanction a plan if not all classes have voted in favor of it if:
  •  The court is satisfied that none of the creditors or members of the class would be any worse off under the plan than they would have been under the relevant alternative, and
  • the plan has been approved by at least one class of creditors or members which would receive a payment, or have a “genuine economic interest in the company”, in the event of the relevant alternative.
• The “relevant alternative” is whatever the court considers would be most likely to occur if the plan were not sanctioned. This will be fact-dependent – it could be a sale, an administration, a liquidation or even a different restructuring proposal. This is likely to be a key battleground as different creditors may want to argue different relevant alternatives to suit their commercial objectives. Valuation evidence to determine whether creditors are worse off or not in the relevant alternative will be essential where a company is seeking to use the cross-class cram-down in a disputed plan process.
• Unlike certain other jurisdictions, such as the U.S., there is no absolute priority rule and so it is possible for junior creditors to impose a plan on dissenting senior creditors, provided the court is satisfied that the senior creditors are no worse off under the plan than they would have been in the relevant alternative. This is what some people are calling the “cram up” as opposed to the “cram down”.

The absence of a “cross-class cram-down” mechanism has long been seen as a weakness in the scheme process. Having a new process that allows a company to cram down not only a minority of dissenting creditors in a class but also entire creditor classes, both secured and unsecured, should open up many more possibilities for a company to effect a deep and lasting restructuring of its capital and balance sheet.

Authored by Dylan Goedgebuure, Scott Harris, Christian Herweg, James Hewer, Wouter Jongen, Margaret Kemp and James Maltby.