INSOL International, London: Developing a rescue finance market
Lower costs of enforcement in the US, speedier, specialised courts in Europe with a “proper” cross-border recognition regime, and Asian regulators that understand distress: a panel of investors from around the world shared their wish lists for an ideal environment to encourage the development of a global rescue financing market fit for the future.
Damon Meyer, executive director of New York-based alternative asset management firm Highbridge Capital Management, Federica Pietrogrande, managing director at asset-based lender Gordon Brothers in London, and Pierre Bour, founding partner of the London-based investment firm Fidera, joined BlackOak director and Singaporean lawyer Ashok Kumar, for the panel at INSOL London 2022, titled, “Developing a rescue finance market – straight from the investor’s mouth”.
Moderated by Debra Dandeneau, the chair of Baker McKenzie’s global restructuring & insolvency group, the panel discussed some of the barriers to entry for investors in different jurisdictions and concluded that, while favourable restructuring and insolvency laws are beneficial, it’s the wider corporate law infrastructure that can really make the difference.
Opening the panel, Meyer defined rescue financing as any “financing of last resort” made available to companies short on liquidity that need funds to facilitate or avoid a reorganisation but are unable to access the regular capital markets. The panel explained that rescue financing can happen in and out of court, and before, during or after a restructuring or insolvency process is commenced.
Setting the scene: the current state of play
Dandeneau dived straight in with a series of questions that set out the current state of play of the rescue financing market, asking each investor what they look for when deciding to invest in a distressed situation.
From a fund’s point of view, Bour said it “always comes down to asset quality” and whether there is a cash flow or recovery budget attached to an asset that the fund can analyse. In Europe, he said, understanding the dynamics of the relevant stakeholders in a distressed situation and aligning yourself with them is also key - bringing capital alone is not enough.
For an asset-based lender like Gordon Brothers, Pietrogrande said they were more interested in the net orderly liquidation value of a businesses’ assets – whether inventory, plant machinery, equipment or trademarks. She said the ability to enforce against those assets quickly and effectively was also crucial.
Meyer noted that Highbridge focuses on different considerations depending on whether it is already an existing lender in a distressed company’s capital structure, versus if it is looking at a rescue financing as a third-party investor. While it is not an asset-based lender, he said it is important to evaluate the underlying value of assets to understand recovery in a “true downside scenario” – but where a rescue is on the cards Highbridge is more interested in the going concern value of the businesses it invests in, with the risk-reward ratio being “incredibly important”.
In Asia, Kumar noted, his clients will look at all of the above: the quality and value of the company and its assets, the ease of enforcement and exit, and the predictability of the court system. In this region, he added, it is very important who the investors are dealing with, because knowing the entrepreneur is what gives financiers confidence.
Dandeneau asked about the role of banks, or par senior secured lenders, in restructurings in the respective jurisdictions where the investors operate.
Meyer said it was rare to see par lenders in middle-market rescue financing situations in the US – even with large cap companies they only really get involved when they are existing lenders to a “fallen angel” or in a very significant distress cycle. The reason for that is because the US debt market is so robust, he said, and there’s a lot of opportunity for par lenders to sell their debt to alternative capital providers at a price that makes sense.
In Europe, Bour noted there had been a significant change since 2008 and the European sovereign debt crises of 2012 to 2013, when banks weren’t in great shape from a balance sheet perspective. These days European banks are in a much better place so “house banks” typically still play a significant role as a stabilising force in restructurings where they are stakeholders – and funds like Fidera tend to work quite closely with them.
Bour also noted that European banks’ ability to inject capital into restructurings had improved “significantly” in the last 15 years or so, so long as it’s in the form of debt.
Pietrogrande noted that the regulatory framework for lending activity in different European countries often influences how banks behave in restructurings. For example, central bank capital provision requirements might force some banks to sell more debt, so that in Southern Europe, banks will sell “massively”, while in Northern Europe they might be more conservative.
She added that European banks are very concerned about the reputational risk of selling their positions after the last financial crisis.
In Singapore and Malaysia, Kumar admitted, it was very rare to see banks trading out of their positions meaning that most restructurings are bank-led. He added that the absence of a bank debt trading market in some Asian jurisdictions mainly had to do with how the loans were valued.
Moving on to address the role of alternative capital providers in restructuring, Bour said that in Europe, they tended to cover the gaps in the market that banks could not fill, particularly in complex cross-border situations, where there is limited ability to issue additional secured debt and a capital injection is needed at short notice.
Pietrogrande noted that asset-based lenders can often lend where others can’t and actually work well combined with other lenders in distressed situations, because they can lend a higher loan to value percentage on the same assets.
In the US, Meyer noted that alternative capital providers had largely replaced the banks with respect to the provision of distressed rescue financing and “thus had a very important role”. One of the advantages certain alternative capital providers have is their trading platforms and ability to access public markets that can allow companies to use their equity as currency, he added.
Barriers to entry and stumbling blocks
Dandeneau steered the conversation towards the barriers to entry of investing in certain markets.
Pietrogrande said the European market was very fragmented and it was “very, very interesting” to map the regulatory framework in each country to see which types of loans highly regulated and which ones are not. She explained that sale and leaseback, for example, is not considered a financing in some European countries, and so not regulated at all, where in others it is.
In addition to looking at the existing regulatory framework, she said asset-based lenders would always ask before investing in any market, whether they can enforce quickly and easily and whether there are claw back risks in the jurisdiction, or risks from equity subordination or lenders’ liability.
But the most important factor overall, she said, was the reliability of the courts. Pietrogrande compared European judges to US bankruptcy judges who have “real” offices with accountants, lawyers and staff.
Bour noted that lender liability can be a big issue in countries like Germany where if you make a loan to a distressed company you need a third party to confirm that it’s in the company’s interests. In Italy, he added, it’s actually a criminal offence to lend to a company that’s technically in default. “So lots of barriers to navigate through.”
Kumar said that while Singapore probably had the most advanced insolvency legislation in the region, the cross-border cooperation with its neighbours in Southeast Asia was “not as cohesive as it is in other parts of the world”. But that’s changing, he added, and Singapore is trying to “lead the charge” for a more coordinated approach to encourage new capital to come into distressed situations.
Flying the flag for the US, Meyer said were not a lot of barriers to entry in that market where a predictable court system makes enforcing against collateral more predictable. However, he backed what the rest of the panel said about the importance of understanding the enforcement regime when investing in other jurisdictions.
Dandeneau asked the panel to elaborate on some of the ways that different jurisdictions have stumbled with reforming their insolvency legislation in recent years.
Bour called the EU’s Preventive Frameworks Directive – which mandates that all 27 member states introduce restructuring tools into their local laws – a “game changer”. He told delegates he was “quite sceptical” a few years ago as to whether the EU would actually get there, so the directive coming into force in July (after a year’s extension for most states due to covid-19) was “really huge”.
But Bour also warned that the big issue going forward was how the Directive would be transposed and implemented across different countries, which could invariably lead to differences in application.
As an example, he referenced the EU’s 2014 Bank Resolution and Recovery Directive (BRRD) that followed Europe’s sovereign debt crisis – a system for winding down banks across Europe to deal with non-performing loans, which he said was an integral part of the EU’s attempt, still not quite realised today, to create a Banking and Capital Markets Union across its member states.
While the BRRD was initially “extremely welcomed by the markets” as it was supposed to create certainty for creditors and a level playing field with regards to bank resolutions, he said its first application, for the Portuguese bank Banco Espirito Santo (BES), did the exact opposite, disregarding fundamental legal concepts such as equal treatment of pari passu instruments and non-discrimination of creditors, setting “a very sad precedent from an investor perspective”.
Halfway through BES’s BRRD process, the Portuguese government decided to take its Portuguese law bonds that ranked pari passu with other bonds and move them to a “bad” bank, while all the other bonds were transferred to a “good” bank, Bour said.
Under the BRRD, when debts are moved to a bad bank, creditors are supposed to get a “no worse off” payment to ensure they don’t get worse treatment than they would in a liquidation. Eight years into the process the creditors of BES are still waiting for those payments, which were supposed to be made shortly after the resolution, he noted. A lot of litigation has been filed, he added, but a hearing at first instance has still not taken place.
“That’s where it really comes down to the credibility of the courts, and it comes down to the stakeholder interferences and it comes down to really having that certainty that you need, that the judge will actually be impartial and give you, within a reasonable amount of time, the right answer – rather than giving you a big Directive, which is really great and ticks many boxes, but actually, that in practice doesn’t work,” he said.
Dandeneau acknowledged that Singapore had done a “great job” at bringing in sophisticated judges and a specialised courts system, but she questioned whether it had stumbled in any way too?
Kumar explained that Singapore’s new laws only came in in 2017 and had been evolving. Comparing the city-state to the US in the 1970s when Chapter 11 was first introduced and it took a while for the jurisprudence to develop, he said Singapore had seen “slow and steady progress”.
He noted that Singapore’s next project was to develop the Singapore International Commercial Court (SICC), a tribunal staffed by international judges, to try to attract cross-border restructurings to the city-state and give the investing community more confidence. The SICC has already hired former US bankruptcy judge Christopher Sontchi and Mr Justice Arjan Sikri, a former justice of the Supreme Court of India, he said – and that was just the beginning.
Kumar emphasised that Singapore’s big task is to encourage cooperation with its neighbours like Malaysia and Indonesia, which are not UNCITRAL Model Law countries. That had already begun with a court-to-court cooperation protocol entered into between Singaporean and Malaysian courts in October 2021. “We have all the tools,” he told the panel, “we have ambitions to become a centre for restructuring for the region, but that can only happen if we develop a regional framework with our neighbours to attract regional restructuring into Singapore, to raise capital and work together.”
Dandeneau said she didn’t want to “let the US off the hook” so quizzed Meyer on what he thought was the biggest problem with restructurings in United States.
“My answer is probably not going to be popular for this audience,” Meyer laughed, “but I think the biggest problem is the cost of an insolvency process.” He said it was hard for a middle market investor to run an in-court insolvnecy process in the US at the moment for less than US$20 million, which could be prohibitive.
Meyer explained that “a core tenet” of the US’s system was the ability for creditors to come into the bankruptcy court and represent their rights – but as that added to the cost of restructurings, there has been an increased focus on rescue financings that avoid an insolvency process or facilitate an out of court restructuring. “You need capital providers and a company who are willing to be creative to do that,” he added.
Pietrogrande suggested the high cost of a Chapter 11 was actually the reason for some debtors to forum shop and pursue a scheme of arrangement in the UK instead, to which Dandeneau protested there were “really not that many” examples of that happening.
Pietrogrande also accepted that cost was an issue in European liquidations, where the lower the recovery, “the higher the cost of your credit”. She lamented the “patchwork” legislation applicable to liquidations around Europe and said insolvency administrators and liquidators were “almost all powerful” across the continent, with no governance rights given to creditors.
Moving on from the barriers to entry, Dandeneau asked each of the investors to describe their ideal legal system for investing in distressed entities.
Pietrogrande commented that enforcement is not just dependent on the local restructuring and insolvency law, but on things like how security interests are dealt with and the ranking of creditors.
She said she welcomed super-priority for debtor-in-possession financings, including for shareholders providing new money, and also break-up frees for stalking horse bidders that can “really set the rules of the process and benefit all the other bidders”.
Introducing electronic filing everywhere, and permitting filings in English like The Netherlands does, would really speed up the process for an effective and reliable court system, she added.
Bour echoed that new money has to be free from challenge from other stakeholders, with the ability to take valid security without claw back. He said the new EU Directive “very much goes in that direction”, but warned it depends on implementation again.
He also said his “controversial” hope was to move towards more centralised bankruptcy courts in Europe, because the quality of rulings and the degree of stakeholder interference varies depending on which court you end up in.
“If you're very unlucky and the headquarters of a company is in a tiny town, and you file there, then you get a judge who does divorces for a living… it’s not a reflection on the quality of the judge, but he just doesn’t have the relevant experience to deal with a large case, and by definition, the quality of the rulings you get is less certain,” he noted.
Bour put his idea in the context of the EU’s Single Market “which was a huge success” and the pros of creating and Banking and Capital Markets Union”. A centralised bankruptcy court system would respond to those two aims, he said.
Meyer echoed that the most important thing for investors was the predictability of the general corporate law. “If I'm lending money to a company, I need to know where I sit in the capital structure, I need to understand what a lien means,” he noted.
He also highlighted directors’ duties as a critical area of law and said he liked the US system, where you know the directors owe a duty largely to the company and its shareholders, and then other stakeholders in certain situations.
Directors facing potential criminal liability for investment decisions they take can act as a real hindrance for the financing market, he said. “That makes it really, really difficult to invest when you don't know how a board is going to act, or the board is just going to throw up their hands and say, ‘I really want nothing to do with this situation because I'm so concerned’,” he noted.
Kumar said Singapore had tried to find a balance on directors’ duties so that directors don’t get “paralysed” by fear. He added that the city-state’s courts are “quite alive to what is commercial” that the decisions taken in this arena so far had been the correct ones.
Otherwise, Kumar said the big thing on his wish list for Singapore was a new regulatory system that understands distress. “Because most of our regulatory framework is for originations, raising new capital, stuff like that, when it gets to distress, there's a big hole, so there's a fair amount of lobbying going on trying to get our regulators to understand this,” he noted. The regulators for listed companies in particular were just not designed to deal with distress, he pointed out.
Turning to specific examples of areas for improvement, Dandeneau asked the panel about in-court asset sales.
Bour explained that some European jurisdictions do not allow credit bids from investors, which was “a real issue”. He advocated for greater harmonisation of European laws so that there aren’t jurisdictions where you can do a bilateral sale and others where you need to hold a public auction.
He also pointed out that the new EU Directive falls short of creating a workable framework for valuations dispute and said he was “dreading” going to court and confronting inexperienced judges who had never dealt with these things before, with discounted cash flow analyses and EBITDA figures, and all sorts of multiples. “This is going to create a lot of issues,” he predicted.
Finally, Bour said, it would be great to have something similar to the US Bankruptcy Code’s section 363 sales in Europe.
Meyer agreed and noted that 363 sales have become “so prevalent” in the US because they allow debtors to exit a restructuring fairly quickly – before it could harm the business: “Take it away from that restructuring, let it operate, whether it's an asset sale or going concern sale, and put that value back in the estate for the creditors to fight over.”
If you’re a DIP lender, Meyer added, section 363 is a really important tool because you need to know there is a way out of bankruptcy so you’re not “just sitting there unnecessarily” waiting for a consensual restructuring of a Chapter 11 plan to be confirmed.
Meyer also noted that US bankruptcy judges are really good at looking at a debtor’s capital structure seeing where the gives and takes are, then making decisions and encouraging mediation or settlement, which he said “candidly” he hadn’t seen elsewhere.
Pietrogrande picked up on Bour’s comments on the lack of coordination for group insolvencies across Europe, despite the issue being addressed by the recast European Insolvency Regulation. She reminded delegates that delay and inefficiencies kill the value in a business. In Europe, sometimes even within the same country, you might have different procedures with different courts and court-appointed professionals, and coordination just takes “so much time”, she said.
Bour echoed that having a forum for cross-border insolvencies in Europe and an effective tool for cross-border recognition, particularly for restructuring and insolvency processes in third countries, were high on his “wish list”. “Post Brexit, even the UK scheme is technically not accepted in Europe anymore,” he noted.
Good cross-border recognition would also encourage competition between countries, he added, with companies shifting their centre of main interests to the jurisdiction most favourable and least costly for their specific situation. “There’s nothing better than competition, right? By changing a few of the smaller things you can actually get your costs down quite a bit,” Bour said.
As the panel closed, a member of the audience asked whether rescue financiers ever lose money, to which the resounding response was “yes!”
“I can reassure you there is significant scope for money destruction,” Bour joked.
“We're all paid to take risks with that risk comes reward – but not always,” added Meyer.
“If you think about the crazy times we are living in and the volatility of the assets and price of raw materials and energy, you can guess that this is not an easy job,” Pietrogrande nodded.