Bond is Back

Opportunities for investors in European HY Debt

• Record amounts of HY issuance in Europe since 2010, much of which has refinanced the LBO bank debt maturity wall
• Potential for significant restructuring activity in relation to such high yield bonds over the next 2-5 years
• Such restructurings will differ from the wave of bond restructurings in the early 2000s due to:

°         litigation in connection with liability management transactions

°         more complex capital structures

°         intercreditor and security arrangements

°         more complex regulatory landscape

°         changes to European insolvency and corporate law regimes

• In distressed situations, bondholders and issuers alike will need to seek legal advice from corporate, finance, and tax experts and cross-border litigation specialists as well as high yield, securities and restructuring lawyers

Introduction

European-based issuers are turning increasingly to the bond markets for their financing requirements. According to analysis done by a leading US investment bank, European-based high yield issuers achieved record supply of $74.8 billion in 2012, surpassing the previous record of $62.9 billion in 2010. Q1 2013 has seen HY issuance in Europe reach epidemic levels with €21.4 billion issued; reflecting the busiest quarter on the books since S&P’s LCD service began tracking this data in 2006, and easily exceeding the prior record of €15.2 billion in the second quarter of 2011. Year-on-year, 2013 leads 2012 by 76%. Much of this HY debt has been issued to refinance the so-called “wall” of LBO bank debt that was due to mature between 2011 and 2014, showing a marked shift away from senior bank debt and towards the high yield bond markets.

Default rates for European HY debt hit lows of around 1% for much of 2011, but climbed steadily over the course of 2012 to above 2%.^[1] Even if the default rate remains static at 2%, this suggests a wall of European bond restructurings on the horizon on a scale not seen for nearly a decade. The difference between then and now is the complexity of capital structures, with super-senior revolving credit facilities, senior secured bonds (sometimes with pari-passu bank term loans) often sitting alongside more traditional senior unsecured bonds and governed by complex intercreditor arrangements. In this bulletin, our partners draw on their experience in European bond restructurings in the early 2000s and long involvement in the high yield space to identify some of the key issues and potential pitfalls for investors in distressed HY assets in Europe over the next five years.

Initial skirmishes

Companies enjoy greater flexibility under high yield incurrence based covenant packages and are likely to examine a number of liability management transactions to deal with impending maturities and liquidity pressures before they consider more significant restructuring alternatives. For example, issuers will look at exchanging current bonds for longer-dated instruments or taking advantage of sub-par trading prices by tendering for bonds or creating special purpose vehicles to acquire bonds in the market. The key issue for issuers will be how to build the necessary levels of consent to make such liability management transactions viable.

There are a number of structures which can be used to incentivise consent to liability management transactions – e.g. “early bird” payments, additional payments where squeeze-out thresholds are reached and covenant strips to devalue retained claims for dissenting creditors. It should be noted in this regard that the English courts have recently ruled that there are limits to the enforceability of covenant strips that are excessively prejudicial to a remaining minority.^[2] Further, these types of tactics have been widely used in US bond restructurings and have lead to much litigation in the US courts – which may give debtors pause for thought before pursuing such strategies.

Forming the committee

Regardless of whether the debt consists of senior bank or high yield bonds, European restructurings tend to be negotiated between the debtor and committees of its creditors (several committees in multiple-layered capital structures). In the case of bond debt, such committees tend to be formed on an ad-hoc basis, usually with no formal agreement between committee members and the debtor or committee members and other bondholders.

Unlike formal creditor committees in a chapter 11 process, an ad-hoc committee is not a separate legal entity and there is no imperative for the debtor to engage with a committee absent commercial necessity. For this reason, it tends to be critical for the committee to represent at the minimum an amount of the bonds which is able to block any transaction proposed by the debtor (i.e., if 75% bondholder consent is required to implement a deal, the debtor will be forced to deal with a bondholder group that represents more than 25% of the bonds, assuming there is no way to implement the deal around them).

Individual bondholders can be very sensitive about disclosing their precise holdings of a given issuance – so it is typical for the legal or financial advisers to hold details of the individual holdings of committee members to enable them to confirm the aggregate holdings of the committee, on the understanding that these will not be disclosed to other members.

A committee representing a blocking stake will also be better positioned to negotiate the payment of its advisors’ fees. Unlike LMA form banking documents, bond documents do not tend to provide for the costs and expenses of creditors to be paid – the committee will need to negotiate this with the debtor. Advisors should be aware of this and will often need to be prepared to align themselves economically with the committee members (i.e. by back-ending some part of fees on the condition of a successful transaction).

Non-disclosure and diligence

There is a natural tension in any bond restructuring between the bondholders’ desire to preserve their ability to trade the paper, the need for committee members to have sufficient information to consider restructuring proposals put forward by the debtor and the debtor’s desire to preserve the privacy of its information.

There may be some limited ability to preserve the interests of all parties if the debtor discloses certain information to the committee’s advisers only, on the understanding it will not be circulated to the committee members themselves unless and until they sign confidentiality agreements. At some point, however, the committee members will need to come “inside” in order to properly engage in negotiations.

In such circumstances, an NDA is critically important as a way to balance the competing interests of the parties. From the committee’s perspective an NDA will allow committee members to receive confidential information with the certainty that they ultimately can be cleansed of it. Cleansing is achieved by the debtor’s disclosure of all non-public information that is still material on completion of the restructuring or earlier termination of negotiations. It is usual for the NDA to include an obligation on the debtor to confirm that all such information has been disclosed following cleansing and for it to permit committee members to disclose information if the debtor fails to comply with the cleansing obligation.

The form and extent of the transactional due diligence will depend on the nature of the transaction being contemplated, but bondholders should be aware that it is unlikely to be full acquisition-style diligence, even where a debt for equity swap is being considered. At a minimum, the committee will need to complete legal due diligence on all finance and security documents to establish the respective rights of all financial creditors. It will also be necessary to establish the corporate structure of the group, ownership of key assets and exposure to key liabilities. There is no reason why senior creditors should not be pressured to permit disclosure of confidential senior debt documents to junior creditors, as a restructuring of distressed junior debt should be in their interests, unless senior creditors are seeking to drive a restructuring that disenfranchises holders of junior debt.

Tax due diligence can be vital in determining the preferred means of implementation and valuing hold out consents.

Some types of due diligence that might trigger investors to walk away in a solvent deal (e.g. material litigation, insurance, property) will be irrelevant in a restructuring context other than for determining the value of the business and, therefore, the viability of the restructuring as parties to negotiations are all stakeholders already.

Implementation

The first step for the committee and its advisers will be to identify the shape of a likely restructuring – e.g. an amendment and restatement of existing terms, an exchange or tender offer, a full debt for equity swap – and analyse the consent thresholds required to implement that transaction. As well as consent levels under the debt documents, a transaction may also require the consent of equity (in order to effect a debt for equity swap) and other classes of creditor (as a result of cross defaults, restrictive covenants, etc.).

Changes to English company law in 2009 mean that it may now be easier to effect debt-for equity swaps for private English companies, because pre-emption rights can be disapplied and there is no longer a requirement to seek shareholder consent for the allotment of shares. However, consents may still be required for public companies, or companies incorporated before October 2009.

Unlike the early 2000s, much of the recent issuance of high yield debt has been by private rather than public companies. Because of this, and in contrast to the previous wave of bond restructurings, any debt-for-equity swap is likely to require a shareholders agreement to regulate the post restructuring governance of the company. The greater the number of potential equity holders, the more complex this document will be. Further, much of the recent bond debt has crept up the capital structure to benefit from and share in security. This will, in turn, change the role of bondholders in future restructurings: there will no longer be an automatic assumption that bond debt is junior and can be disenfranchised, nor that it forms such a large part of the capital structure that value will definitely break in that debt.

It is also important to identify any relevant regulatory consents or clearances which would be required prior to completion (it will not be in any stakeholders’ interest for a restructuring to be delayed by several months whilst competition clearance is obtained, for example).

There may be ways to reduce the consent thresholds for implementation of the deal – for example, if a transaction would require 90 or 100% consent of bondholders under the documents, it may be possible to implement the same deal with a lower level of consent using an English law scheme of arrangement or CVA, or alternatives in other jurisdictions.

Consideration should also be given to alternative implementation structures (which may provide for reduced recoveries for dissenting stakeholders or classes of stakeholder, including shareholders) through enforcement or commencement of formal insolvency proceedings. Unlike the early 2000s, many European structures now have bondholders sharing security rights pari passu with the senior bank debt, subject to detailed English law intercreditor arrangements which have complex provisions governing which debt tranches controls enforcement at different points in the life cycle of the capital structure. Analysis of control following default will be a key ingredient of fall-back strategy planning.

The English law scheme of arrangement

Where supported by a majority in number and at least 75% by value of bondholders voting, a scheme of arrangement under the English Companies Act 2006 can be used support a transaction to bind all bondholders in to a transaction (including those governed by New York law). Schemes have been used to alter the fundamental terms of a bond or facilitate debt for equity swaps, both of which would usually require:

• unanimous consent under a US TIA-governed indenture (though these are less present in Europe);
• 90% consent under European NY law-governed high yield bonds; or
• 66.66 – 75% consent under English law-governed notes.

Whether a scheme can be used in a given situation will depend on the facts and, in particular, jurisdictional considerations. An English issuer or issuer with substantial operations in the UK is likely have a “sufficient connection” to give rise to jurisdiction for a scheme.

A non-English issuer can be more problematic. An English court will generally exercise jurisdiction to sanction a scheme of arrangement in respect of English-law governed debt,^[3] but high yield bonds will usually be governed by New York law and have a clause granting jurisdiction to the courts of New York. In these circumstances, an English judge would need to be satisfied that (i) there would be some reasonable prospect of benefit to the issuer if a scheme of arrangement were to be sanctioned; and (ii) that one or more persons interested in the assets of the issuer are persons over whom the English court can exercise jurisdiction.^[4] In relation to the first limb of this test, it may be helpful if it can be demonstrated that recognition will be sought and granted in relation to the scheme in the US under chapter 15 of the Bankruptcy Code (although that will depend on the debtor’s ability to demonstrate to the bankruptcy court that it has an establishment in England).

A scheme of arrangement can be preferable to formal insolvency proceedings such as a CVA or chapter 11 because it is not a “debtor in possession” process, and the debtor is free to select those creditors with whom it wants to effect a compromise (i.e. it can be used to effect a transaction with bondholders only, not the debtor’s general body of creditors). The flipside of this is that careful consideration will need to be given to whether a scheme would be recognised in the necessary jurisdictions (because it is not an insolvency process, a scheme will not receive automatic recognition in other EU Member States under the EC Regulation on Insolvency Proceedings, although it is likely to obtain recognition under chapter 15 of the U.S. Bankruptcy Code). There are also certain limits on what can be achieved using a scheme in isolation: it cannot consummate an equitisation of debt without shareholder consent, nor can it effect the transfer of substantially all of the assets of an issuer to allow “equitisation” into the equity of a Newco (the transfer of the assets will have to be undertaken by the directors, an insolvency appointee or, if applicable, a security trustee).

It should also be noted that a number of other European jurisdictions have made changes to their insolvency laws over the last ten years specifically designed to deal with the restructuring of bond debt. It is important that advisers have good contacts with legal experts in such jurisdictions who understand the impact of these changes from a corporate, litigation and tax perspective, as well as from the restructuring and finance side. It will also be important to have contacts in such jurisdictions where there are no regimes which can be usefully used to restructure bond debt.

Conclusion

Bond capital structures have become significantly more complex since the last wave of bond restructurings and legal and regulatory landscape for cross-border European restructurings today looks very different than in the prior wave. Many investors in distressed HY assets in Europe are starting to look at possible restructuring scenarios at an early stage in their investment planning.

Whilst the technology for implementing bond restructuring transactions in the early 2000s remains relevant today, committee advisers will require a wider breadth of expertise than pure transactional restructuring, including expertise in the current high yield and bank/bond market, securities law and transactional tax.

 

Ropes & Gray International LLP