Insolvency: A fresh approach

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(Legal Week Via Thomson Dialog NewsEdge) When the Enterprise Act reforms were introduced in September 2003, it was against the background of a government initiative to bring the UK entrepreneurial regime closer to that of the US. The Enterprise Act covered both competition law and insolvency law reform with the objective, as announced by Gordon Brown in June 2001, being to help the UK economy reach US levels of productivity. A key facet of this for the reformers was that bankruptcy in the US did not have the same stigma as it did in Europe, and so the Enterprise Act sought to bring the UK closer to the US approaches to insolvency.



The reality of the Enterprise Act reforms was that they fell far short of the apparent purpose of introducing a Chapter 11-style process in the UK. There was no introduction of a debtor-in-possession (DIP) concept. There was no effort to introduce a framework to allow DIP priority financing, a key aspect of a Chapter 11 (so much so that there is now an established industry of `DIP lenders' who will make funding available to support a company during its restructuring in a Chapter 11). There was no introduction of provisions similar to those that apply in the US to executory contracts. There was no invalidation of insolvency events of default, which enabled counterparties to walk away at a time when the distressed company needed them most.

But where the legislative reforms may have failed to go far enough, the market has quickly adapted to US-style techniques. These have, ultimately, helped form a new environment in which restructuring and the continuance of the company has replaced the prevalent attitude of the 1990s which saw many large and complicated workouts ending up in formal insolvency - seen by most as ultimately destructive of value.

A key element in driving the market in this way has been the emergence of hedge funds and distressed debt trading desks as key players in a restructuring. There is now more than $1.1trn (579bn) worldwide under hedge fund management, with London at the centre of Europe's hedge fund management industry, responsible for approximately two-thirds of the $325bn (171bn) in funds under management in Europe. Many of those London-based hedge funds specialise in - or at least have - a presence in the distressed debt and restruc-turing market. This has represented a significant sea change, particularly when coupled with the fact that many constituencies that traditionally would have held onto their debt and seen through the restructuring, such as private placement noteholders and senior banks, are now willing to sell out to the distressed debt traders. Such debt inevitably ends up in whole, or in part, in the hands of the hedge funds. Add this to the fact that many hedge funds will hold debt positions across several layers of the capital structure, and it is evident that the dynamics have changed hugely from the environment that preceded the Enterprise Act of 2003. In that environment, the senior secured banks tended to be the dominant party in control of the restructuring or, if they deemed it appropriate, the insolvency.

Instead, the usual paradigm for a restructuring in the UK will be the formation of ad hoc committees of various levels in the capital structure, with a view to negotiating each constituency's corner in order to reach a consensual restructuring. Each committee is likely to have its own financial and legal advisers and will be driven towards achieving a successful, consensual restructuring, rather than lining up the administrators to take over the business. Moreover, where administrators and receivers are used, it may often only be as a small part of the process, for example to implement a restructuring through a pre-pack sale of the business to a new company owned by the hedge funds and secondary traders.

Accordingly, many of the restructurings in the UK over the past few years have gone some way towards dispelling the notion that hedge funds are aggressive and destructive in their approach to these complicated situations. Many of the funds are not there to `make a quick buck' - in fact, many of them wish to own the company at the end of the restructuring process, usually via a form of debt-for-equity swap, and that will often be the key motivation behind their strategy. They will then want to hold the company for a sufficient period of time to enable it to have turned the corner so that it may then be capable of being sold or become the subject of an IPO.

A recent example of this has been the Gate Gourmet restructuring. Latham & Watkins and Houlihan Lokey Howard & Zukin acted for the mezzanine creditors which, by the time the restructuring and debt for equity was consummated, were fully constituted by hedge funds (in other words there was not one original mezzanine lender left). This group and their advisers entered into the usual valuation debate with the private equity firm that owned Gate Gourmet prior to its restructuring. Notwithstanding the difficult background (namely, strikes at Heathrow and labour arbitration in the US) no-one (including, notably, the company) panicked and called in the administrators. Everyone held their nerve, agreed a solution in which the hedge funds ended up owning a majority of the company and laid the foundations for the company to be put back on a stable footing. An IPO exit in the next year or two is now highly likely. All of the hedge funds made significant money in the restructuring process, with the promise of more to come if there is a successful IPO exit.

Similarly, in the restructuring of Jarvis, a group of hedge funds led by an investment bank (and represented by Latham & Watkins and Close Brothers) provided bridging finance to the debt-for-equity restruc-turing as well as a post-restructuring working capital facility. This group still continues to hold equity in the listed company and remains very much involved in the company's strategy going forward. It would not be fanciful to suggest that in the climate of, say, five years ago, Jarvis would have been a candidate for administration. Instead, it continues as a listed company and has successfully refinanced its working capital facilities.

However, this is not to say that the lions have become lambs. Hedge fund creditors will not hesitate to litigate if they perceive that their rights are being threatened, insufficient value is being attributed to their debt holdings or they are otherwise being treated unfairly. There have been a string of such cases where hedge funds have either litigated or challenged a restructuring on this basis, for example, MyTravel (hedge funds bought subordinated bonds and challenged the restructuring); British Energy (hedge funds bought equity and challenged the restructuring as being unfair to shareholders); Colt Telecom (hedge fund creditors sought to put the company into administration in order to stop the management burning through its cash reserves) and TXU (hedge fund creditors sought to challenge a series of linked company voluntary arrangements).

But it would be wrong to end on such a note. Many hedge funds have a strategy that combines distressed debt investing with something more akin to a private equity or distressed private equity strategy, looking for positions of control and influence rather than seeking to make a quick buck or litigating to acquire leverage in a restructuring. Such a strategy often involves a medium-term hold of their debt (or the resultant equity in a restructuring) of anything from one to several years. Couple this with the modernisation of bankruptcy law regimes in Germany, France and Italy and it can be seen that there is an increasingly favourable environment for distressed investors seeking a US-style solution - and returns - in a restructuring.

These new legal regimes are now being tested and knowhow and precedents are building up (for example, the new procedure de sauvegarde is being tested in both Global Auto Logistics and Eurotunnel). There is now more confidence in the Italian restructuring regime, given the large returns made by several US hedge funds (and some investment banks' proprietary desks) in the Parmalat restructuring. There have also been more cases where there has been a practical application of the EC Regulation on Insolvency Proceedings 2000 and a useful precedent from the European Court of Justice in relation to the key issue of `centre of main interest' ( Eurofoods [2006]). All this points to an increasingly favourable European environment for hedge funds to seek out arbitrage opportunities and to invest in debt for a longer-term holding and ownership strategy.

John Houghton is a partner specialising in restructuring and insolvency at Latham & Watkins.

Copyright 2006 Legal Week Publications
The opinions and views expressed in comments, blogs, etc. are those of the authors alone and not necessarily those of TMC, TMCnet, or its editors. TMCnet reserves the right to edit, delete, or otherwise make changes to the content that appears on these pages at its own discretion and as it deems necessary.

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