Investing in distressed assets across the Euro zone is widely perceived as a key opportunity on the private equity landscape. Significant amounts of money have been raised for distressed investments, and the number of potential investors has grown substantially.
Distressed investing in Europe has traditionally been perceived as riskier and more challenging than U.S. distressed investing due to a number of features of the Euro zone legal systems. For one thing, many insolvency regimes in Europe are predisposed toward liquidation of troubled companies rather than restructuring them and preserving going-concern values. Therefore, a distressed investment in a European troubled entity has traditionally posed significantly more risk of value loss than in a reorganization-focused regime such as the U.S. Whereas Chapter 11 reorganization in the U.S. and administration in the UK have become relatively well-tested and predictable methods of balance sheet restructuring, the relative dearth of successful, high-profile financial restructurings in continental Europe leads to greater uncertainty for investors in this zone. This in turn increases risk of investment loss should a formal insolvency proceeding be required, and raises the level of difficulty for achieving a consensual out-of-court workout.
In the last year or so, perhaps in anticipation of a greater need for balance-sheet restructurings, some Euro zone countries have updated or amended their insolvency regimes. The amendments to the German insolvency code, which went into effect on March 1, 2012, are among the most recent and interesting such changes.
The German statutory amendments streamline and add predictability to the treatment of distressed investments by, among other things, allowing debt-for-equity swaps in restructuring plans without requiring approval of existing shareholders and by giving a preliminary creditors’ committee broader influence over the direction of insolvency proceedings and the insolvent company in a way that is protective of going-concern value. While the new rules are not a comprehensive overhaul of the German system, they do add new tools for distressed investing in German domestic companies and multinationals with a significant German presence.
Distressed Investment Background and Fundamentals
“Distressed investing” can refer to several different kinds of investment:
- Debt trading, in which an investor purchases debt at a discount with the intent to sell it at a more favorable price;
- Debt restructuring, in which an investor purchases some or all of a tranche of debt at a discount with the hope of realizing a profit by paying off the debt or restructuring it on favorable terms; and/or
- Control investing, in which an investor hopes to gain control of an entity either through purchasing its debt or making a new-money loan, with the expectation that the debt will later be converted into equity if and when the company becomes insolvent.
As described more fully below, the new German laws provide added control and participation for all three types of investors in the event of an insolvency, but have the most impact in the context of control investing.
Updates to the German Insolvency Laws
Facilitation of Debt-Equity-Swaps
The recent reforms significantly improve the mechanisms by which creditors can convert their debt claims into equity. This should increase flexibility for designing restructuring plans and provide greater predictability and a reduced timeframe for converting a distressed investment into a control position in a target company.
While in the past the German insolvency law provided no mechanism for any changes to shareholders’ rights without their formal consent (leading to delay and unpredictability, as shareholders understandably would be reluctant to approve a significant dilution or, essentially, elimination of their position), such swaps can now be accomplished via an insolvency plan. While shareholders, along with other affected classes, would have the right to vote on such a plan under past practice, a new mechanism (akin to a U.S. “cram down” restructuring) would allow the plan to be implemented without consent in certain circumstances. Similarly, an insolvency plan can now be used to implement a dilutive investment, whether from an existing or a new investor, without shareholder approval.
While the exact impact of the new law will depend on how it is implemented through the court process, the possibility of allowing debt-for-equity conversion or highly-dilutive new equity investments with a streamlined and predictable process that reduces the ability of existing equity to hold up the process will increase the attractiveness of control investing in German companies.
Court may appoint a Preliminary Creditors’ Committee in the early stages of insolvency filing
Historically, creditors in a German insolvency proceeding have not had a meaningful mechanism to influence restructuring matters in the period between the insolvency filing and the initial creditors’ meeting, which may be a few months later. The reform act addresses this problem by allowing creditors to establish a “Preliminary Creditors’ Committee” (vorläufiger Gläubigerausschuss) at an early stage of the proceedings in major cases. (Under past law, insolvency administrators sometimes appointed a creditors’ committee, but the committee had no formal say in the proceedings).
After an insolvency filing, the debtor, its preliminary administrator or a creditor may request that a Preliminary Creditors’ Committee be established. Such requests will be granted where (1) there are eligible creditors willing to serve on the committee; and (2) where a debtor has ongoing business operations of a certain magnitude in terms of balance sheet total, revenue and employees.
The exception to the rule is that a court may refuse to appoint a committee if, in the court’s view, such an appointment would negatively affect the debtor’s financial situation. Although this provision is clear on paper, it remains to be seen how the courts will interpret the exception, and whether the exception will, in effect, swallow the rule.
When a Preliminary Creditor’s Committee is appointed, the committee will have the power (described further below) to consult with the insolvency court in selecting the preliminary insolvency administrators ((vorläufiger) Insolvenzverwalter) and to opt for self administration (Eigenverwaltung), both of which will let creditors have a substantial impact on restructuring proceedings. This power is analogous to a receivership in the U.K., in which creditors may select a receiver and influence other key aspects of the restructuring or administration process.
Strengthening of Self-administration (Eigenverwaltung)
The new laws should invert the existing presumption that favors the appointment of outside insolvency administrators over permitting self-administration (Eigenverwaltung) by the insolvent entity.
Historically, when an insolvency proceeding was initiated, the court would typically appoint a preliminary insolvency administrator to take control of all the company’s business and would only permit the existing management team to remain in place where, in the court’s opinion, it would not delay the insolvency process or otherwise adversely affect creditors. In practice, instances of self-administration – in which the company’s management retained control of the business under the supervision of a court-appointed trustee – were relatively rare, even though in a crisis situation such as an insolvency filing, it is often critically important to have an experienced management team with industry knowledge and relationships with key players working to stabilize a debtor’s business operations. Under the previous insolvency regime, where management was typically fully replaced by a less experienced administrator, business reorganizations became quite risky, with liquidation a typical result.
The new law, similar to U.S. Chapter 11, establishes a presumption in favor of self-administration: the court can only reject the application for self-administration if it concludes that creditors would be negatively affected. In reaching its conclusion the court will be required to hear submissions from the Preliminary Creditors’ Committee, if one has been appointed, thus affording significant creditors a much greater ability to influence the restructuring outcome. If the Preliminary Creditors’ Committee unanimously supports self-administration, the court will follow that recommendation.
The new law further adopts principles roughly comparable to U.S. Chapter 11 proceedings by permitting a debtor to seek a “protective shield” period of up to three months in which the debtor may negotiate with key constituents in an effort to prepare a pre-packaged insolvency plan. Such a procedure is only permitted where the debtor is not illiquid, the debtor has elected self-administration, and the intended restructuring does not appear to be obviously futile. During a protective shield period, the court may ensure that (1) enforcement measures (Zwangsvollstreckungen) of creditors are suspended and (2) obligations incurred after the filing constitute preferential debt in any subsequent insolvency proceedings. This procedure should benefit investors by allowing the debtor’s business to operate free of enforcement proceedings and by providing trade creditors comfort in doing business with the debtor, thereby minimizing the negative impact of the restructuring on the business while the creditors and debtor negotiate the terms of a restructuring.
Creditors May Influence Appointment of Insolvency Administrators
In cases where self-administration is not chosen, the new law permits the Preliminary Creditors’ Committee to comment regarding the court’s appointment of the insolvency administrator, before the court makes its appointment. The committee can set out requirements or qualifications the insolvency administrator has to meet, or the committee can propose a specific individual for the position. If the committee makes a unanimous recommendation of an administrator, the court is bound to appoint that individual unless the candidate is not eligible for some extrinsic reason (e.g., for conflict reasons or clearly insufficient experience).
This mechanism is in marked contrast to the prior law, in which a court had sole discretion to appoint a preliminary administrator and often did so from an unofficial or court-approved list without creditor input; with the possibility that the administrator would have little or no experience in the debtor’s area of business. Although creditors had a chance to change the administrator at their creditors’ meeting, this might occur several months after the initial appointment, when it would be too late to effectively change course and when critical decisions about the restructuring may already have been made.
The full impact of the new German insolvency law will not be known until the courts actually implement the new provisions. In principle, however, the new law presents very intriguing possibilities for distressed investors, because it allows for flexibility in designing a restructuring that can “cram down” existing equity by granting new equity to creditors or new-money investors without old equity’s consent. The new law also appears to be a strong message to investors that the German insolvency regime will no longer favor liquidation, but rather will permit creditors a significant voice in a process that (albeit less flexibly than a U.S. Chapter 11) permits management to continue business operations while a restructuring plan is negotiated.