Spain: Distress Investors, Covid-19 and a ‘Brave New (Insolvency) World’
Over the months that followed 14 March 2020, Spain set up the basis and justification for a new legal insolvency system that contains exceptional rules and principles that could be described as a ‘new reality’. While new exceptional insolvency law altered the statutory ranking of creditors, the new Spanish Recast Insolvency Act brought some very important changes to the field of refinancing agreements. Finally, the covid-19 pandemic made it evident that some issues affecting monitoring covenants and corporate debt purchases, both existing before 2020, will continue evolving in a way that every distress investor should be aware of.
- Changes to the statutory ranking of creditors within insolvency proceedings
- Monitoring and supervision covenants
- Equitable subordination
- Acquisition of corporate debt and non-eligible lenders
- Changes to Spanish schemes of arrangement: unfair prejudice
Referenced in this article
- Royal Decree Law 16/2020
- Act 3/2020
- Spanish Recast Insolvency Act
- Aifos insolvency proceedings
- Babcock Power España insolvency proceedings
- Benito Urban disclosure proceedings
- Abengoa court sanctioning proceedings
- EU Directive on preventive restructuring frameworks
In 1932, Aldous Huxley placed readers in a new reality: a ‘Brave New World’ in which society had experienced a radical change that made the principles that had guided mankind for centuries no longer valid. Whereas in Huxley’s work the World State’s calendar took 1908 as its starting point (the year the first Ford T was produced), in Spain 14 March 2020 is the key date for the legal calendar.
The date 14 March 2020 is the date of the declaration of a state of emergency in Spain by Royal Decree 463/2020 (the Emergency RD) to contend with the situation created by the covid-19 pandemic. Over the weeks and months that followed, the Emergency RD became the basis and justification for a new legal system that, unarguably for a temporary period (although some rules are in effect for up two years), contains exceptional rules and principles that could well be described as a new reality.
In the domain of insolvency law, while not going to the extremes recounted in the novel of citizens being ranked into five castes, the new exceptional insolvency law altered the categories of senior and subordinated claims (akin to Huxley’s Alpha and Beta classes) in a way that every distressed investor should know about. This change to the statutory ranking of creditors is discussed in the first part of this article.
The similarities with Huxley’s Brave New World do not end with these changes to the statutory ranking of creditors – there are three other elements; for example, whereas the novel recounted how citizens’ lives were controlled through technology and the powerful technique of hypnopaedia to plan society and influence decision-making, in Spain the role that financial creditors exert over debtors’ businesses through contractual covenants is still an influential factor. This subject is discussed in the second part of this article.
In the third part of this article, we discuss an issue that existed before the covid-19 outbreak, which is topical owing to the implications it has for the corporate debt purchases that are now occurring, as a tool for investors to achieve ownership of businesses in a similar way to loan-to-own strategies. As with what happened to Huxley’s protagonist, an Alpha-Plus male faced with a new reality and trying to fight it, it cannot be assumed that, in a scenario of increasing financial difficulty, every debtor with debt traded on the corporate debt market becomes quietly resigned to these transactions. And there are precedents for this, transactions in which debtors have strenuously opposed the transfer of debt, justifying the ‘non-eligible’ nature of the new lender.
In reality, in the restructuring and insolvency arena, exceptional insolvency law has placed itself by the side of classic insolvency law. Paradoxically, and similar to the case of Lenina Crowne, another character in Huxley’s work, classic insolvency law has been unable to avoid being affected by the new reality to the point where it has also experienced a few very important mutations. Since May 2020, Spain has had a consolidated set of insolvency rules: the Spanish Recast Insolvency Act (SRIA). SRIA is a single instrument comprising over 700 articles and that includes the original insolvency rules (from 2003) with all their amendments since then as well as a few new ones called upon to play an important role in the post-covid-19 era.
In the fourth and final part of this article, we highlight the new legislation on the court sanctioning of refinancing agreements.
Financing distressed companies in covid-19 times: roll-ups in insolvency scenarios
New incentives for the injection of fresh money by shareholders were deployed in May 2020 because of the covid-19 pandemic. The incentives for lending and payments by third parties that specifically relate to distressed companies have been applauded across the board by all players.
One aim is to increase and encourage the provision of funding to distressed companies to deal with their momentary liquidity needs by classifying as post-petition claims, in the event of liquidation, any claims stemming from funds or guarantees committed by third parties, including parties that have a special relationship with the debtor. This upgrade to a post-petition claim (the highest category obtainable in a Spanish insolvency proceeding) will only be allowed where the funds or guarantees have been granted to the company in a proposal for an arrangement or an amendment of an earlier arrangement with creditors.
Furthermore, the government has sought to encourage shareholders to provide their struggling (but not yet insolvent) companies with cash or support, with an incentive related to a certain upgrade of the ranking of their claims within insolvency scenarios in respect of the ranking they would normally have. Those claims may have been given a senior ranking that is considerably higher than the ranking they would normally be given as a pre-petition, subordinated claim (junior to other claims for collection, without collateral and without any voting rights).
According to the terms of the roll-up measures, any financing that a specially related party (ie, shareholders beyond certain stakes, directors, parent companies or any company within the same corporate group) provides to the distressed company after 14 March 2020 will give rise to an unsecured claim in any subsequent insolvency proceeding opened until 14 May 2022. In the wording of Royal Decree-Law 16/2020 (RDL 16/2020), in that two-year period, the same ranking will be granted to any claim for which a specially related party becomes the creditor because of having paid on behalf of the distressed debtor an unsecured, senior or secured claim.
The urgency with which these measures had to be published, combined with the absence of any precedents in Spain on temporary and exceptional upgrades of certain claims in the event of a subsequent insolvency proceeding, meant that some features of this upgrade are not completely clear. It has been questioned, for example, whether a provider of funds that delivered cash to the distressed company and secured the repayment of that cash with a security interest in the company’s assets would have anything more than a pre-petition unsecured claim in the subsequent insolvency proceeding.
There are some who argue on this subject that classification as a pre-petition, unsecured claim is the highest category that this type of claim could attain, because outside this exceptional and temporary rule created by RDL 16/2020, it would always be a subordinated claim. Those holding this opinion consider that strengthening the funding provided as a result of the covid-19 pandemic has an unbreakable boundary in the letter of RDL 16/2020 itself, and the Law, in particular, does not grant the creditor a higher or different ranking than that of an unsecured claim. Therefore, those of that opinion have concluded that the claim in respect of funds provided by a specially related party, even if it has security, should be classified as a pre-petition unsecured claim in subsequent insolvency proceedings and have the security cancelled.
On the other side of the fence are those who believe things should be different if the aim is to encourage funding to distressed companies, because practically the only ones prepared to provide funding or to agree to assume the payments of those companies in troubled times are usually their shareholders, directors or other group companies. With this in mind, they have stated categorically that, in the event of a later insolvency proceeding on the funded company, the security gained by the specially related person who provided funds and secured them with collateral should not be ordered to be cancelled.
For now, at least, doubts over the cancellation of the security gained for funds provided to companies by specially related parties between March 2020 and March 2022 appear to have been dispelled.
Furthermore, in the technical enhancement process on RDL 16/2020, carried out in the lower house of the Spanish parliament between June and September 2020, groups from the various political parties reached an agreement ensuring that specially related parties holding secured claims for cash paid out between March 2020 and March 2022 will retain the security in the event of later insolvency proceedings.
The same protection has been afforded to specially related parties that, rather than provide funds directly, had paid in that period on behalf of the company one or more claims with security. Also in that case, and in the event of later insolvency proceedings, anyone who had been subrogated in respect of that claim as a result of the payment made for the company’s benefit will be treated as pre-petition unsecured creditors but ‘without prejudice to any preferred rights they may hold’.
Loan subordination risk: monitoring and supervision covenants
In distress transaction, lenders are regularly vested with a series of common information rights, such as obtaining the financed party’s annual and interim financial statements, ability to appoint a third party to examine these statements, or even a specific item included in the accounts, as occurs with cash surpluses, as a preliminary step when carrying out a cash sweep, regular valuations of collateral, etc.
More specific mechanisms may also be agreed, including the possibility of overseeing compliance with the viability plan supporting the financing, the option of guiding the financed party on how to allocate certain funds, the power to appoint an independent third party that, as a chief restructuring officer, will ensure the proper implementation of the restructuring plan and the option of expressly refusing a drawdown request where the lender believes that the funds are not being used according to the terms of the financing agreement.
This range of powers, or more specifically the strictness with which these types of covenants (either affirmative or negative) are enforced, has led some lenders to ask how far they should go in monitoring and verifying how the financing is used, and how far they are engaging in de facto directorship of the financed company when influencing the borrower’s management decisions with instructions and limitations.
As is often the case, this concern did not emerge spontaneously; it surfaced after several legal setbacks revealed this to be yet another risk to be analysed when dealing with distress financing. Frequently cited is the subordination of loans (equitable subordination) from certain financial institutions ordered back in 2011 within the insolvency of real estate company Aifos.
Aside from the legal grounds of that case, the truth is that de facto directorship of a distressed company by lenders is alien to the normal financing of distressed business. Using a financing agreement to become a ‘tyrannical creditor’ (an effective business manager with broad powers to manage and administer the borrower) makes for a major alteration of the activities that lenders are expected to engage in. However, there is no shortage of examples in which struggling companies (or their insolvency administrators) have complained about undue interference in their management. In most cases, those complaints are aimed at obtaining the subordination of claims, the release of collateral and, in fewer cases, at seeking additional liability on the part of the lender for causing or aggravating the borrower’s state of insolvency.
Until now, lenders have tended to win these cases. The courts’ reasoning is that there are no grounds for de facto directorship since all the lenders did was oversee that certain costs did not impact the repayment of the loan, ‘in defence of their legitimate interests’. Although lenders are used to monitoring strictly and actively the cash flows on a project, these processes normally differ from de facto directorship if the lender does not supplant the company’s management or impose its will on them, and the latest reforms in the area of loan subordination point in this direction. As an example, the most recent wording of article 283.2 II of the SRIA rules out attributing prima facie the status of de facto director to lenders that enter into financing agreements that include covenants imposing obligations on borrowers in relation to the viability plan.
By the same token, Chamber I at the Spanish Supreme Court concluded that the lender’s role in relation to the borrower is far from that of a de facto director if the duties involved in overseeing and controlling funds do not become commingled with those of managing or administering corporate interests.
Loan transfers: acquisition of corporate debt and ‘eligible lenders’
In the realm of corporate debt, there is a distinction between small businesses’ debt and all other borrowers’ debt. Most corporate debt transfers have taken the form of the sale of non-performing loan (NPL) portfolios (and have sometimes been mixed with debt owed by consumers) rather than the transfer of individual loans. For larger borrowers, sales of single names (of one or more positions held against a single debtor) have taken precedence over loan portfolio sales.
Anyone interested in buying up debt must first find out whether its transfer requires the debtor’s consent or whether the debt is restricted to lenders that meet the specifications listed in the financing documents for eligible lenders. Debtor’s consent had not been a requirement previously although it has become increasingly necessary. If required, it should be indicated whether it is necessary in all cases or whether the need disappears once there is a breach by the debtor (or the financing is accelerated). In some cases, it is necessary for the debt purchaser to be a regulated financial institution (bank, insurance company, pension fund, investment services firm, etc), although traditionally the focus has been on it being tax resident in a ‘friendly’ territory (not requiring the debtor to withhold non-resident income tax that would normally have to be assumed as an expense).
It is increasingly common to find debt that cannot be transferred to institutions whose names are on a blacklist included in the facility agreement because of prior disagreements with the debtor or its shareholders or a track record of not being willing to play the ‘amend-and-extend’ game in previous debt restructurings.
In recent years, some corporate debt transfer agreements have been questioned by the courts precisely because the banks transferred the debt to investment vehicles possessing some connection with competitors of the distressed company. This led to debt transfer transactions that, in principle, did not seem to be prohibited by the financing agreements becoming a highly disputable issue owing to the addition of another cost for the distressed company on top of and in view of its circumstances. Financing agreements often have clauses giving lenders (in this case the new creditor who acquired the debt and is connected with the competitor) access to the company’s critical information on the market, products, prices, clients and margins.
By and large it is normal practice to allow corporate debt to be transferred without restraint because there are no specific contractual or legal restrictions. At other times, however, the circumstances surrounding the debt purchase transaction signal that the particular transaction is highly likely to be disputed by the debtor or even by the supervisory authorities. Those circumstances may relate to the personal features of the purchaser (eg, its own identity, or the identity of its owners or those in control) or of the transaction itself (eg, because purchase of the debt will blow up a restructuring that had almost been agreed with the former lenders, because the debtor is placed in a worse position or because there are regulatory limits on the purchaser’s investment in this type of debt).
If the risk of the transaction being disputed by the debtor is compounded by the increasing likelihood that the Spanish courts will ultimately order the new lender to disclose the documents by which it purchased the debt, it is understandable that certain corporate debt purchase agreements will require a prior study to avoid thorny situations. Disclosing the transaction documents by court order means revealing the transfer price, the terms and conditions for purchasing the debt, the purpose of the transaction or, for example, whether the parties acknowledged that the transfer might be disputed, and even stipulated remedies if relevant.
An example of an order to disclose a corporate debt transfer agreement is the decision by Barcelona Court of First Instance Number 23 delivered on 27 November 2018 (Benito Urban), which ordered disclosure of the transfer agreement to enable the debtor to bring a claim against the former lenders and the new purchaser because the debt purchase transaction breached contractual clauses and statutory rules.
Spanish scheme of arrangements under the SRIA
The 7 May 2020 edition of the Official State Gazette published Royal Legislative Decree 1/2020 of 5 May 2020, approving the SRIA. The SRIA came into force on 1 September 2020 and, among other rules, it repealed the Spanish Insolvency Law 22/2003 of 9 July 2003 along with some of, but not all, its additional and final provisions.
The SRIA does not repeal urgent exceptional measures such as RDL 16/2020 or Act 3/2020, so there will be a period where those laws will exist side by side. Some of the most noticeable elements of the SRIA are those related to the court sanctioning of debt refinancing agreements.
- For calculating a majority of the financial liabilities, creditors with collateral are identified as creditors with secured claims.
- The jurisdiction to sanction a refinancing agreement for a group or subgroup lies with the judge that has jurisdiction to issue an insolvency order on the parent company or, if the parent company had not signed the agreement, jurisdiction over the group company holding the largest financial claim that participates in the agreement.
- The sanctioned refinancing agreement may contain the transfer of assets or rights to creditors (either secured or unsecured) for or in payment of their claims.
- The sanctioned refinancing agreement is immune to clawback actions, and acts, transactions, payments made and securities granted or created in execution of the agreement are clawback protected.
- Applications for sanctioning in relation to the same debtor are prohibited until a year has passed since the first one was filed, regardless of who submitted the previous request.
- Specific tests are introduced for determining whether there has been unfair prejudice for dissenting creditors. These tests are based on court practice, such as the judgment of Seville Commercial Court Number 2 delivered on 25 September 2017 (Abengoa). To determine whether an unfair prejudice has occurred, the judge considers all the particular circumstances. In any case, unfair prejudice means dissimilar treatment for equal or similar creditors, or where an unsecured creditor would be able to obtain greater satisfaction of his or her claim in liquidation rather than under the refinancing agreement.
- The existence of unfair prejudice for one or more creditors cannot prevent the agreement from being sanctioned in respect of the other creditors.
- In the final decision to sanction the refinancing decision, the judge must decide to lift any attachments decreed in enforcements of claims falling under the sanction and to end any separate enforcement action that may have been halted.
- A decision confirming a breach of the refinancing agreement will give rise to termination of that agreement and the disappearance of its effects on claims.
Certain groundbreaking developments at the EU level (eg, those envisaged in the EU Directive of the European Parliament and of the Council on preventive restructuring frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures) have led us to conclude that the Spanish insolvency sphere will continue evolving. The book is still being written, so a firm eye should be kept on future developments in Spain’s ‘brave new (insolvency) world’.
The authors of this article would like to pay tribute to Antonio Fernandez, former head of Garrigues’ restructuring and insolvency practice, who passed away in April 2020 from covid-19.