Director: ReVive Advisory & Turnaround
In my last thought leadership article, we began to look at the principals that underlie informal workouts.
This process is guided by principles set out by the International Association of Restructuring, Insolvency & Bankruptcy Professionals (INSOL International).
The Second Principal requires creditors to refrain from enforcement action during the standstill period, the quid pro quo is that during the Standstill Period their position relative to other creditors and each other will not be prejudiced. Conflicts of interest in the creditor group should be identified early and dealt with appropriately.
Refrain from taking any steps
The INSOL Principle points out that the initial objective of any attempted rescue or workout is to achieve stability. To attempt a rescue or restructuring against a backdrop of instability (e.g. political, general economic or creditor instability) is extremely difficult.
While certain jurisdictions provide for a statutory moratorium which allows breathing space to a debtor before the onset of formal insolvency, in many jurisdictions, a statutory moratorium on creditors’ claims is available only as part of a formal insolvency process.
The confirmation of a standstill provides some reassurance to the debtor’s management that their attempts to achieve a rescue or orderly workout through the provision of information about the debtor to its creditors and interactions with them will not be immediately undermined by enforcement actions by those creditors; and also to the relevant creditors to the effect that the others of them are prepared to proceed on a co-ordinated basis while the evaluation process occurs.
Only the enforcement actions are placed on hold. Perfection of securities and litigation of disputes are not caught in the informal workouts, but the understanding is that the standstill will not be used to improve the outlook for the security holders.
In Chapter 6 of the Companies Act (71 of 2008), the legal actions are suspended unless the business rescue practitioner (BRP) allows such action. This includes onerous contracts and general litigation.
The INSOL Principle adds that, in many jurisdictions, the standstill of the relevant creditors will be the subject of an agreement (my emphasis. It is not an informal understanding that may be required) between the relevant creditors and the debtor. Typically, such standstill agreements will include undertakings by the relevant creditors:
- Not to press for repayment of the amounts due to them or issue or pursue proceedings against the debtor during the Standstill Period.
- Not to try to improve their individual positions relative to other creditors by obtaining or enforcing security or seeking additional financial rewards or preferential treatment during the Standstill Period; and
- To continue during the Standstill Period to allow utilisation of existing credit lines and facilities, at least at the exposure levels existing at the Standstill Commencement Date. (Banks will not limit or withdraw facilities)
While the continuation of facilities by relevant creditors is usually an essential feature of standstill arrangements, in some cases, the termination of certain open derivative contracts may assist the rescue process by removing the volatility associated with such contracts. In other cases, the continuation of swaps or hedges may be necessary to preserve value in the business concerned. Each case will need to be considered on its merits in this regard.
The INSOL Principle points out that, in certain jurisdictions, an agreement by the debtor with all or some of its creditors which provides for a moratorium on the payment of debts will itself trigger formal insolvency. This is the case in South Africa as it can be seen as a prima facie act of insolvency in and of itself. The Agreement between creditors is essential and would include provisions relating to acts of insolvency.
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In such cases, it may still be possible for creditors to agree between themselves (rather than with the debtor) to operate a moratorium on their claims against the debtor and for the debtor separately to agree not to take steps which might prejudice the relevant creditors during an agreed period.
Their position relative to other creditors and each other will not be prejudiced
One of the main objectives of standstill arrangements is to try to ensure that, during the standstill period, the relevant creditors are not prejudiced relative to each other or relative to their position at the commencement of the process. While the issue of the eventual outcome for creditors may be uncertain at this stage, the standstill arrangement (again my emphasis) will usually contain a number of covenants and warranties which are designed to ensure that the position of the relevant creditors does not deteriorate, at least due to any deliberate acts or omissions on the part of the debtor during the Standstill Period.
The INSOL Principle adds that, of more complexity and subtlety tend to be the arrangements between the relevant creditors themselves, which are designed to try to ensure that their relative exposures do not change during the standstill period. To this end, the more sophisticated standstill agreements (or separate linked inter-creditor agreements) will contain provisions which seek to address fluctuations in exposure that often occur during the standstill period where loan facilities provided by one or more relevant creditors are revolving or fluctuating in nature. In relation to such loan facilities, the relevant creditors may agree (under so-called loss-sharing or equalization provisions) to make balancing payments to each other in the event of a collapse, such as are necessary to redress any relative gain or loss to relevant creditors resulting from such fluctuations as compared to the position at the standstill commencement date. These would include hedges and foreign exchange exposures or variable interest rates.
Even greater difficulties arise in relation to facilities which are contingent in nature. There is a growing trend amongst financiers to seek to value their exposures under contingent facilities (e.g. foreign exchange facilities, interest rate and currency swaps and other forms of derivatives) by means of marking them to market, often on a daily basis. (this is an approach also endorsed in the IFRS (International Financial Reporting Statements). Standstill agreements quite often seek to address the issue of fluctuations in exposure based on marked to market calculations under these types of facilities in a similar way to those on revolving loan facilities, although the potential volatility in exposures can require very sophisticated arrangements in order to limit the effect of such volatility on arrangements amongst the creditor group. Such loss-sharing provisions also seek to rectify variations in comparative exposure, although in many cases, this issue will not be covered until a formal restructuring proposal is agreed and only limited adjustment mechanisms (if any) will be agreed upon at the standstill stage of the process.
The INSOL Principle points out that additional difficulties may arise because of the nature of the debt obligations subject to such loss-sharing arrangements. For example, where an issue of widely held public debt is involved, it may not be practical to obtain the agreement of the requisite number of holders. All parties should recognise that efforts should be made by those parties involved in the negotiations to devise arrangements, to the extent possible, to give all holders of debt the benefit of such loss-sharing arrangements to facilitate ultimate agreement on a consensual restructuring.
In certain cases, one or more of the creditors may enjoy an existing advantage compared to other participating creditors, either in the form of security or by virtue of the comparative number of companies in the debtor group against which it has recourse (whether by way of direct claims, guarantees or indemnities).
Once again, the inter-creditor arrangements entered at the standstill stage will often allow for the retention of these advantages. (Other forms of advantage which individual creditors may enjoy including set-off rights, liens, the benefit of documents of title associated with trade finance or bill purchase facilities, guarantees and insurance from third parties). The ultimate treatment of these advantages will typically be addressed in an intercreditor agreement forming part of a contractual restructuring and is often the subject of extensive negotiation among the creditors.
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When the claims of relevant creditors are denominated in a number of different currencies, movements in exchange rates during the Standstill Period can affect the relative position of creditors. Standstill arrangements often use assumed fixed exchange rates to determine certain inter-creditor issues (e.g. voting and risk sharing), although realisations may still be shared by reference to actual exchange rates, and end-of-day balancing adjustments may be required to cover exchange rate fluctuations.
The complexity of the standstill arrangements can limit the usefulness of the informal workouts. Chapter 6 enforces a hard lock on the positions and the flexibility one then seeks on financial instruments would be separately negotiated and included in the BR Plan. (once again enforcing the now accepted view that the BR Plan is in fact a contract between the parties.
Conflicts of interest
The Insol Principle points out that actual or perceived conflicts of interest can damage confidence in the restructuring process and can arise in a number of situations. It is expected that such conflicts will be identified by the relevant institution and appropriate steps taken to address any actual or perceived conflict of interest.
These conflicts can arise if the Company makes use of a Bank or other advisors to oversee the process. A creditors committee would be hard pressed not to secure it own position first. These independence requirements are paramount. In a Business Rescue process the BRP is precluded from any prior association with the Company. (Note there is a dangerous practice of lawyers, accountants and auditors extending their services to clients in financial stress and then acting as a friendly BR.)
Conclusion
The standstill impartiality, confidentiality and independence of the individuals performing advisory work to distressed companies undergoing an informal workout are onerous. There is no protection, as there is in Chapter 6, if an error is made due to the compressed timelines of the process.
The complexity of the standstill arrangements in multi-party workouts and cross border distress are not easily dealt with in informal workouts. Chapter 6 provides little answer to these challenges and cross border insolvency is its own special hell of complexity.
Many in the legal profession have been calling for an overhaul of the Insolvency framework and laws in South Africa for a number of years and the standstill requirements in an informal workout highlight some of these challenges.
The need for an overhaul and modernisation of the management of distressed companies and the Insolvency regime needs to be a priority for the Department of Trade and Industry (DTI) and the Department of Justice (DOJ). As can be seen from the above informal workouts, Chapter 6 and the Insolvency act do not create an easy regime and do not add to South Africa’s attractiveness to Capital Markets and foreign investors.
