Information sharing is key to the success of an informal workout

Based on my previous thought leadership editorials, you should have basic understanding how informal workouts can be regulated by a set of principles set down by the International Association of Restructuring, Insolvency & Bankruptcy Professionals (INSOL International).

The primary purpose of the principles is to create an environment where value can be generated while protecting all parties in the process of resolving a funding crisis. This week, we will focus on the fifth and sixth principles, which shift the discussion towards information sharing and legal parameters.

Access to information

The fifth Insol Principle states that during the Standstill Period, the debtor should provide and allow relevant creditors and/or their professional advisers reasonable and timely access to all relevant information relating to its assets, liabilities, business, and prospects to enable proper evaluation of its financial position and any proposals to be made to relevant creditors.

Reasonable and timely access to all relevant information: During the Standstill Period, the debtor should allow relevant creditors and/or professional advisers appointed to represent them access to all relevant information regarding its assets, liabilities, business and prospects. This is important not only to enable the relevant creditors to assess the financial position of the debtor at the Standstill Commencement Date and during the Standstill Period but also to enable them to evaluate any proposals which the debtor may wish to make for its rescue, workout or reconstruction.

The principle adds that the relevant creditors will need to receive information that they can rely upon and have evaluated by their advisers. For this reason, the information will have to be obtained, or at least be capable of due diligence, by independent advisers acting for the relevant creditors. The advisers to the appropriate creditors can sometimes work from information provided by the debtor or its advisers. Still, issues of reliance and liability can cause difficulty in this regard. Where asset valuations are needed, it will usually be necessary for the relevant creditors to commission such valuations themselves. The location and nature of assets can necessitate special due diligence techniques.

The role of the independent business review fits into this space. It relies on full disclosure and where fraud is present of the directors and management fear consequences for the losses the process can be undermined. That the advisors may be presented with fanciful information and forecasts requires diligence of the part of the reader. The concept of reasonable scepticism is well advised to those performing this work.

Reviewing accounts

The Insol Principle points out that the debtor should accept that the advisers to the relevant creditors will be expected to review the accuracy of accounts, projections, forecasts and business plans related to any proposals for rescue or reconstruction and also to estimate the consequences of the relevant creditors refusing to agree to the proposals being put to them. The relevant creditors will also wish to gain reassurance that, as between themselves, their relative positions have not and will not be prejudiced by any proposals which are being made.

The advisors should also review both internal audit reports and reports from the external auditors.

Any proposals to be made to relevant creditors: The nature of the proposals which the debtor may wish to make for its rescue, restructuring or workout will, of course, depend on the circumstances. They may only involve the provision of temporary additional liquidity. Still, in other cases, debt write-offs, exchange offers for bonds, debt-to-equity conversions or asset-for-debt exchanges may be necessary to restore balance sheet solvency to the debtor. In some cases, the proposed arrangements can be affected by contractual arrangements between the debtor and the relevant creditors alone. In others, the proposals will need the sanction of the courts (e.g. in the case of schemes of arrangement or Chapter 6 reorganisations). In such cases, it is usual for the debtor and relevant creditors to try to ensure that, so far as practicable, the outcome of any formal procedure is known in advance.

This is quite a critical point Chapter 6 requires the directors to express an opinion that the business is capable of being rescued. That must be based on a reasoned process and due consideration of the facts. When one reads the supporting affidavits to the commencement by directors they are invariable light on detail and when the BR commences often the information required to support the assertion is simply not there.

BRP have developed information checklists and document request precisely because the data often does not support the directors opinion.

Reflecting applicable law

The sixth Insol Principle points out that proposals for resolving the debtor’s financial difficulties and, so far as practicable, arrangements between relevant creditors relating to any standstill should reflect applicable law and the relative positions of relevant creditors at the Standstill Commencement Date.

The objective of the information-gathering, due diligence, and evaluation processes during the Standstill Period is to enable the relevant creditors to evaluate the debtor’s position, assess any proposals the debtor may make, and satisfy themselves that they are receiving equitable treatment relative to the other relevant creditors.

In making their assessments, creditors will need to compare the outcome they could expect from any proposals made against the returns they might expect to achieve in a formal insolvency process or from other available options.

Accountants or other financial advisers acting for the relevant creditors frequently provide advice based on insolvency models for the debtor group. These models reference certain stated legal and accounting assumptions (e.g., the validity of security, guarantees, rights of recourse, rights of set-off etc). These will, in turn, be based on the information generated through the due diligence process. Such insolvency models should take account of all relevant claims and entitlements (e.g. the claims of the relevant creditors and other creditors, inter-company and subrogated claims and dividend entitlements) which would be counted in any insolvency of the debtor and of all relevant insolvency laws.

Chapter 6 requires that whatever plan is presented it must represent an outcome better than a liquidation. The liquidation cascade is a critical part of the first meeting of creditors and the meeting to approve the Business Rescue Plan. This test is the infamous part B of the objectives for business rescue. The model ignore the time value of money and how long a managed wind down will take as opposed to a Liquidation.

The litigation delays and the issues at the master office add to the complexity and confusion is this assessment. The assessment is often based on the time to recover the capital as opposed to the long term value that a properly structured and funded turnaround will take.

The article adds that insolvency models can either be used simply to identify where realisations are likely to go in the event of insolvency (applying usual insolvency principles) or can be more sophisticated and seek to predict the likely return to creditors in insolvency using assumed realisation values and assuming a contemporaneous liquidation and asset realisation by all companies in the debtor group. They only serve as estimates because of the assumptions about the value and time used in these models. Still, they are helpful as a basis for negotiation and evaluation.

When applied to groups of companies, insolvency models will consider the position of each debtor company separately and then aggregate the result on a group basis and by reference to each relevant creditor so that the net expected return to each relevant creditor can be determined.

Insolvency models for larger groups can be extremely complex. They will need to take into account the differences in the various insolvency regimes of the jurisdictions involved.

The Insol principle points out that the output from the insolvency models can, amongst other things, be used to identify the claims that relevant creditors may have against each debtor company; to estimate the likely return to such creditors from their claims and to estimate the proportion of the indebtedness due to relevant creditors which appears to be covered by assets (as opposed to uncovered).

These calculations can, in turn, be used when considering such issues as debt-to-equity conversion or debt write-offs. Because the benchmark for the approach advocated under the Principles tends to be the position as at the Standstill Commencement Date, relevant creditors will also wish the insolvency model and the assumptions upon which it is based to have regard to issues such as the validity of claims of relevant creditors, the validity of any security they may hold, the validity of any exposure reductions which occurred in the period before the Standstill Commencement Date and the advantages which the holders of guarantees may enjoy by virtue of their ability to make claims against both principal debtors and guarantors. For this reason, the due diligence exercise carried out on behalf of relevant creditors quite often applies not only to the debtor but also to the claims and entitlements of the relevant creditors.

Conclusion

The information available and the judgement applied to it often require careful consideration and specialist valuations. Market conditions, as well as the liquidity of the markets for assets and companies, add to the time taken to complete these processes. Informal workouts in these circumstances give rise to real risks for the creditors and debtors in this regard.

The lack of cross border insolvency regimes, even within the Southern African Development Community (SADC) region, have been highlighted by both academics and the South African Restructuring and Insolvency Practitioners Association (SARIPA). Group business rescue provisions need to be developed. Often the cross guarantees in one company can place healthy businesses in distress when they find their productive assets been attached to support inter group guarantees.

There is a lot to do to build a better framework for workouts in complex groups. Chapter 6 of the Companies Act (71 of 2008) is only a start of the required reforms that are needed.