Webinar summary: spotlight on the practice of debt enhancement in financial restructuring proceedings
Jean-François Adelle
Jeantet, Paris
The IBA Banking Law Committee held a webinar on 11 July 2022 to discuss the practice of the enhancement of debt in financial restructurings from an international perspective.
The panel, moderated by Jean-François Adelle, Co-Chair of the IBA Banking Law Committee, from Jeantet (Paris, France), comprised of four lawyers combining leading expertise on financing and restructuring, from key jurisdictions: Ferdinand Hengst from De Brauw Blackstone Westbroek (Amsterdam, the Netherlands), Jacqueline Ingram from Milbank (London, England), Andreas Naujoks from Noerr (Frankfurt, Germany) and Eric M Rosof, Liaison Officer for the IBA Banking Law Committee, from Wachtell Lipton Rosen & Katz (New York, US).
Enhancement essentially refers to the practice of granting security interests, or additional security interests, or improving the ranking of a security, involving a new credit aimed at refinancing an existing unsecured or undersecured debt. Financial restructuring, whether occurring in or out of court, generally favours the providers of new money who are taking on risks associated with loans.
The enhanced debt benefits from more robust recovery expectations and protection against subsequent debt-to-equity swaps and/or liquidation scenarios. This, however, could be the source of potential conflict between up-tiered creditors and other creditors when the restructuring, in which the enhancement is granted, is unsuccessful.
The webinar debate was held in light of the large, publicised and contentious French restructuring case involving Orpea, which illustrates the issue. Orpea SA, the French listed holding company of the European group in the business of providing serviced care homes in Europe, which had €9bn of debt, was hit by financial difficulties after revelations concerning fraudulent practices. It, subsequently, conducted a fully confidential and court approved restructuring with several French banks in mid-2022, in which they provided €1.7bn in new money and were allowed to roll-up, with interest, existing unsecured debt for €1.5bn. Four months later, it was made public that the plan, which had not yet been implemented, was insufficient, and the company then commenced a second in-court restructuring, which also involved its foreign creditors, with a view to obtaining €2bn of additional money and the erasure of all of its €4bn in unsecured debt through a debt-to-equity swap to be conducted on the basis of a 30 per cent conversion rate. The security interests related to the enhanced debt in the first attempt at restructuring were protected. This situation creates a divide between the up-tiered banks who have a 100 per cent recovery expectation, and the unsecured creditors participating only in the second restructuring, who have a 30 per cent recovery expectation in relation to their debt on the plan’s completion date. While it is too soon to draw all the lessons from this case in France, the purpose of the panel was to shed light on the stakes, trends and disputes relating to enhancement in four key jurisdictions.
The panel considered three aspects: (1) how has enhancement developed and how is it applied; (2) how can it be challenged; and (3) what are the recommended best practices?
How has enhancement developed and how is it applied?
It was revealed that enhancement has developed in all four markets, probably starting in the US, as a tool that allows for the incentivisation of existing or new lenders to provide new money in exchange for some advantages. There are many examples of old debt that has been enhanced, which represents a material part of the new injected money. However, differences were identified. For example, old debt being elevated through a roll-up is common in the United States, but the practice has not yet spread to the United Kingdom and Germany.
An important distinction was made between enhancement happening in, and out of, court.
The four speakers agreed that in in-court restructurings, the enhancement matrix is governed by contract and determined by the negotiating position among the parties and potential management liability.
The most important contractual constraint comes from existing intercreditor agreements: within one syndicate, trying to elevate certain creditors above others does not work. Ingram noted that there is perhaps less flexibility in the UK than the US, because intercreditor arrangements tend to be slightly tighter.
Another key contractual limitation relates to negative pledge covenants. Naujoks stressed that this is quite important in the Schuldschein market, where the debt is structured as a bilateral promissory note, there are no intercreditor agreements and, accordingly, negative pledge clauses and, generally, termination stipulations limit enhancement, provided they are respected.
When it comes to in-court restructuring, the legal framework is more diverse. In the US, the typical court proceeding concern Chapter 11 of the US Bankruptcy Code. New money is given to the debtor under debtor-in-possession (DIP) financing, where a roll-up of pre-petition unsecured debt, or an enhancement of already secured debt, can take place.
In England, there are two instruments available: one such scheme of arrangement is a narrow tool used to arrange for a compromise between a company and a group of its creditors where the plan approved 75 per cent by value and 50 per cent by the number of those creditors is binding on the minorities. The restructuring plan, recently introduced, is essentially an enhanced scheme, where the cross-class cram-down mechanism is available, but there is no absolute priority rule. In both cases, it is common for new money injected as part of the restructuring to have super-senior status and we are starting to see cases where existing debt is enhanced by improved security or terms.
In the Netherlands and Germany, which have both implemented Directive 2019/1023 (EU) on restructuring and insolvency, in-court enhancement is happening. In the Netherlands, the court can reshuffle the debt and, for example, put the proceeds of the collateral into waterfall provisions, or allow existing financiers to extend the proceeds of their collateral over a wider debt. But, contrary to the US, the court does not have the ability to take existing collateral that has been granted for the first lien and move it up towards new money financiers.
How can enhancement be challenged?
Out-of-court enhancement is combatted by contractual litigation, where every case is fact specific. In the US, it is to be noted that there is no good faith and fair dealing concept, at least not in New York law, which governs many of these agreements, and the black and white letter of the law typically prevails in litigation.
As regards in-court enhancement, many protections come into play:
In the US, an essential point is that the uptiering is not confidential contrary to the French conciliation proceeding in Orpea. There is a hearing and a judge reviews the arrangement. There is a court proceeding, a notice of the hearing and a right of any other creditor to be heard and complain about the enhancement.
If the restructuring plan fails, the out-of-court enhancement can then be challenged as a preference within 90 days, as well as a breach of contract if the enhancement is not permitted under the financing agreements.
In England, the key point is that there is no court process that can be used to ‘bless’ an out-of-court transaction, as in Orpea. A challenge would be conducted under the law on clawback, which requires that the company who granted the enhancement and preferred or treated a certain creditor more favourably, or gave away value and did not receive equivalent value, to have subsequently entered into an insolvency process, unless the action is based on fraud. English courts have accepted that if a creditor is not being directly compromised, but is otherwise affected by the arrangement that is being put in place, they may have standing to challenge it.
In Germany, a challenge will be possible if the enhancement was granted in a situation where the benefitting creditors were aware of the liquidity crisis or the over-indebtedness of the company. Hengst noted that the courts’ review of enhancement in a prior restructuring will now also be exercised within the framework of the EU directive test: if the debtor proposes a restructuring plan with the enhancement of old money and new money, then the judge must compare the creditors' treatment with how they would have been treated in an insolvency scenario.
What are the recommended best practices?
In out-of-court restructurings, all the panellists agreed that with enhancement being a matter of contract, creditors should pay careful attention to what their financing documentation says. Leaving terms ambiguous can sometimes be advantageous, but in other cases it can be very harmful. In civil law jurisdictions however, Hengst noted, courts will look not only at the black letter of the contract, but also at contextual elements; however in a heavily negotiated deal between professional parties, the black letter will lead.
With respect to in-court enhancement, four best practices for the domestic and international arenas were put forward:
- Transparency on the enhancement process vis-à-vis other creditors: The need for transparency is likely to go up with the increased use of the cross-class cram-down mechanism. Such transparency should also cover the alternatives that might have been on the table and who the stakeholders are that voted in favour of such alternatives;
- Equal treatment among creditors: Creditors in a similar situation should generally be treated in the same way, however there may be reasons to treat pari passu creditors differently. In the UK, for example, there have been a number of cases where pari ranking creditors have been treated differently. Each has used a different justification for doing so – eg, commercial necessity (key suppliers etc), the same eventual par outcome (Adler case, AGPS Bondco Plc [2023] EWHC 916 (Ch), and the surplus going to specific creditors coming from new money rather than debtor assets;
- Sophisticated judiciary and court review: Courts are expected to implement a principle of some sort of equity. Courts should increasingly turn their attention to whether it is just and equitable to impose a cross-class cram-down, in particular where there is a dissenting group, and exercise a kind of check and balance. In England, Ingram noted that best practices have come from the courts; and
- Show-up with a better alternative: In restructurings with enhancement or roll-up situations, the judge is generally under pressure to get a plan approved. It is recommended that the competing group act fast, form a lead creditors group, build an alternate plan to finance the debtor, try to be offered at least some portion of the new facility with related roll-up and fees, and try to overcome the objections to the plan in court. Rosof noted that this is possible in the US because, contrary to in the Orpea case, there is a transparency requirement.