Reorganization (February 18th) (1) (2) (1).pptx

reorganisation

1. ‹#› Capital Structure and Corporate Reorganisation February 18, 2025 Dr. Maryam Malakotipour ( [email protected] )

2. Overview of corporate restructuring Restructuring under financial distress M&A Other corporate restructuring methods Recaps, Leverage Buyouts, Spin-offs, Carve- outs Issuing equity in public market ‹#›

3. ‹#› Today’s outline The theory of insolvency law Liquidation vs Reorganisation Benefits of reorganisation over liquidation Critique on reorganisation Reorganisation Framework Rules adopting a plan Key issues within reorganisation Additional rules on creditor democracy and creditor protection Cross-class cram-down APR vs. EU RPR Dutch reorganisation procedure (WHOA) Reorganisation game 🡪 report submission

4. The theory of insolvency law Insolvency law is a collective debt collection law that targets maximisation of the total value that can be distributed to creditors Creditors’ Bargain Theory (Baird & Jackson): lacking any legal rules on insolvency creditors would agree upon a collective procedure (common pool problem) Reasons to agree upon a collective procedure: Higher revenues: Prevention from destructive asset grabbing. Jackson (The Logic and Limits of Bankruptcy Law, p. 14): “This is derived from the commonplace notion that a collection of assets is sometimes more valuable than the same assets would be if spread to the winds. It is often referred to as the surplus of a going-concern value over a liquidation value.” Lower costs: Less litigation amongst creditors Less monitoring costs ‹#›

5. Ocean as a common pool ‹#›

6. Liquidation vs. Reorganisation value ‹#›

7. Liquidation Legal entity does not survive ‹#› Piecemeal liquidation value Going concern liquidation value

8. Alternative way: Reorganisation Formal Reorganisation procedure Reorganisation is meant here only in a legal sense not in a business sense Some kind of arrangement or rearrangement with creditors E.g. Debtor pays all of its creditor’s 70% of the nominal value of their claim. After the reorganization Teldar continues to exist and operate an enterprise Usually a moratorium on debt enforcement to provide a ‘breathing pause’ and the possibility to come to a restructuring Corporate debtor survives ‹#›

9. Benefits of reorganisation over going concern sale Assets are kept together. The best way to preserve going concern value Also possible to benefit from non-transferable ‘soft assets’ such as permits and licences Debtor-in- posession: even when there is an automatic stay, the debtor can continue the business Easier to keep shareholder in place 🡺 Reorganisation allows firms to retain higher going concern value in excess of the liquidation value (aka: surplus value) ‹#›

10. Critique on reorganisation from CBT CBT: Views insolvency as a common pool problem and treats insolvency as a collective debt-collection device. Jackson: “The underlying justification for a reorganisation process, seen as a collective debt-collection device, must be that the assets are worth more to the creditors than they would be to third parties.” Why keep the legal entity in place and reorganise, instead of selling all assets? Clarck: “Reorganisation makes sense when there are no or few potential outside buyers.” ‹#›

11. Assuming that reorganisation is desirable ‹#›

12. Rules on adopting a plan Reorganisation voting rules in different legal systems: What if 95% of the creditors think a reorganisation is to be preferred above a straight forward liquidation? Legal systems usually provide for a possibility to vote A most interesting way to lose your rights. Other people voting over your claim!? Majority vote for creditors: Germany: more than 50% in number representing more than 50% of the amount Preventive restructuring plan (StaRUG, 2021): more than 75% in value UK: English restructuring plan (2020): more than 75% in value English scheme of arrangment: more than 75% in value and 50% in number US Chapter 11: Majority of two-third in amount and a majority in number ‹#›

13. Why a majority vote? To prevent hold out behaviours. Holdout behaviour indicative not of a common pool problem, but of an anticommons problem. What happens when we replace the common pool regime with a collective regime in which everyone has to agree? ‹#›

14. Understanding the problem in narrative form ‹#›

15. Dear creditor, We are contacting you as you are one of our 3 creditors, each having a claim of €100. Our total amount of debt is therefore €300. We have bad news and good news. The bad news is that we cannot pay you. If we liquidate now, proceeds will only be €75 and liquidation costs will be €30. You will therefore each receive only €15 after a few years. Please see the reports of two independent auditors. The good news is, that if we reorganize, and replace management and implement a new business strategy, we can pay all of you €25 within 3 months. Please sign this letter as an agreement that you consent to a reorganisation in which you will receive 25 cents on the Euro. Your ashamed but at the same time optimistic debtor P.S. Please be informed that if you were to be so unreasonable as not to consent, we will sue you for all costs and damages following from a failed reorganization. ‹#›

16. Balance sheet of the company Assets: Machine of €75 Debts: 3x€100 = €300 Costs of insolvency €30. Available for creditors €45. Creditors receive: 15% Shareholders receive: 0 Assets Debt & Equity Machines 75 Equity -/- 225 Debts 300 Total 75 Total 75

17. Is this the relevant analysis? If we are rescuing the company, why should liquidation value be the dominant scenario? ‹#›

18. Why restructure the company? Capture the going concern value What is the going concern value? Let’s say the going concern value is € 140. Higher than liquidation value, for example because of licenses and permits granted to the company. Difference of €75 to €140 is not extreme. ‹#›

19. Going concern value Assets: Going concern €140 Debts post reorganization: 3x€25=€75 Scenario proposed: Old equity has a windfall and its shares are worth 65 Alternative scenario: Creditors receive all or most of the shares Remember: every ‘hair cut’ increases equity Assets Debt & Equity Machines 140 Equity 65 Debts 75 Total 140 Total 140 ‹#›

20. ‘The better letter’ Dear creditor, We are contacting you as you are one of our 3 creditors, each having a claim of €100. Our total amount of debt is therefore €300. We have bad news and good news. The bad news is that we cannot pay you. If we liquidate, you will probably receive only €15. The liquidation value is estimated at €75 and liquidation expenses are estimated at €30. The good news is, that if we reorganize, we can capture the going concern value estimated to be €140. See for both the going concern valuation and the liquidation valuation the auditor’s report. We of course need to attract new money to pay for wages and restructuring costs. In case of reorganization, we can pay all of you €25 within 3 months. Also, you will receive 25 cents on the Euro and [1%] – [33%] of the shares in the company. Your ashamed but at the same time optimistic debtor P.S. Please be informed that if you were to be so unreasonable as not to consent, we will sue you for all costs and damages following from a failed reorganization. ‹#›

21. How to draft legal rules that: Allow to capture the going concern value & Ensure that creditors receive ‘the better letter’? ‹#›

22. Debt for equity swap Easiest way to deal with insolvency would be a debt for equity swap. Creditors do not get paid, but instead get shares in the company. The debts are used to make payments on shares. ‹#›

23. EU Directive Directive of June 2019 forces MS to implement preventive restructuring procedure outside bankruptcy To enable viable enterprises that are in financial difficulty to rescue. With aim of ‘higher degree of harmonization’. But leaves many choices to MS, for example APR or EU RPR (art. 11) Definition of ‘likelihood of insolvency’ Implementation of best interest test, art. 2(1)(6) Debtor control/veto over: entering, art. 4; plan, art. 9; cram down, art. 11 Board or shareholders represent ‘debtor’? preamble 53 Design of protection for interim finance, art. 17 Employee protection, art. 1(5)(a); art. 6(5); art. 13 Conformance with and application of EIR Who chooses practitioner? debtor, creditors or court? preamble 88 Public or confidential? Court oversight? art. 4(5-6) ‹#›

24. Features of the Directive Preventive restructuring framework for debtors when likelihood of insolvency (art.4) Available on application by debtors Also available at the request of creditors and employees’ representatives subject to the agreement of the debtor, MS may limit requirement to SMEs Debtor in Possession (DIP) (art. 5) Debtors remain in control of their assets and day-to-day operation of their operations Stay of individual enforcement actions (art. 6) Ultimate goal: creditors & shareholders bound by restructuring plan Either by majority vote or by cross-class cram-down ‹#›

25. Rules on adopting a reorganisation under Directive Step 1: Offer a plan (Dir. art. 9) Step 2: Creditor majority rule (Dir. art. 9) Step 3: Court confirmation and protection by means of ‘best interest of creditors test’ (Dir. art. 10) Do we want more? What if an entire class holds out? Step 4: Court cross-class cram-down (Dir. art. 11) Step 5: Check on court cross-class cram-down by means of EU RPR or APR (Dir. art. 11) ‹#›

26. ‹#› Procedure

27. ‹#› Example Based on the no creditor worse off test: The minimum value that the bank is entitled to receive is 350 The total minimum value that suppliers are entitled to receive is 50

28. ‹#› Example Reorganized Balance Sheet with 26.7% Pay out (based on a proposed plan)

29. ‹#› Example Reorganized Balance Sheet with 26.7% Pay out (based on a proposed plan)

30. Who would have a claim on the surplus reorganization value? ‹#›

31. Cross-class cram-down What if creditors hold out as a class? In some legal systems courts can make a restructuring plan binding upon dissenting voting classes through a cross-class cram-down mechanism As a safegurad, there are conditions to apply cross-class cram-down; such as: Compliance with a priority rule, which can be in different forms: Absolute Priority Rule: The US Chapter 11; EU Directive (as an alternative to the EU RPR) Relative Priority Rule (EU RPR) WHOA-prioirty rule ‹#›

32. The APR in the Directive The claims of dissenting voting classes are paid in full where a more junior class is to receive any payment or keep any interest under the restructuring plan Simple and principled: upholds pre-bankruptcy priority rules. Prevents collusion between senior creditors and shareholders. Rigid and clear rule that forces debtor (shareholders) to propose plan that majority in each class likes. See extensively also Seymour and Schwarcz 2019 . ‹#›

33. The APR in the Directive Inspired from the US Ch. 11, the APR was the benchmark in the initial draft Directive There can be possible deviations from the APR: essential suppliers some equity holders that contribute to the enterprise through their specific skills BUT…………As of September/October 2018 a revised political draft introduced a Relative Priority Rule (RPR) as “preferred rule”. ‹#›

34. Perceived issues of the APR Proposal for relative priority Some Member States considered that these requirements (the APR) would make the procedure more burdensome and costly and would render the preventive restructuring more restrictive if not impossible. !!! Discourages shareholders to file for reorganization in a timely manner. Cross-class cram-down new and raised concerns to number of MS’. Requires costly and time-consuming valuation With APR, it is essential to determine the precise distribution to each party. ‹#›

35. The EU RPR Dissenting voting classes are treated at least as favourably as any other class of the same rank and more favourably than any junior class. ‹#›

36. ‹#›

37. Shortcomings of EU RPR Less incentive for shareholder to facilitate a consensual plan Subsidizes overleveraging of firms Flexibility at the cost of certainty Unfairness No harmonization, leads to abusive COMI-migration See extensively also de Weijs et al (2019) and Ballerini (2020). ‹#›

38. EU RPR Problems: Less incentive for shareholder to facilitate a consensual plan Shareholders want to avoid cross-class cram-down with APR because they cannot keep any value. Therefore, they have incentive to propose good consensual plan and win majority vote. - optional: for more discussion on this see Schwarcz & Seymour (2019 ) Consensual plan has less direct and indirect costs Expert costs Cross-class cram-down entails “ battlefield of experts” Valuation uncertainty Especially problematic if debtor has substantial control over the procedure Directive gives SME’s (99% of companies under proposed definition) control over plan procedure. ‹#›

39. EU RPR problems: Subsidy of overleverage Under EU RPR, shareholders can keep an interest against will of creditors, whilst not paying creditors This subsidizes highly leveraged structures Such as risky LBO structures, which are already over-subsidized by adverse tax incentives - Creates systemic risk Makes reorganisation attractive for shareholder: pull effect Incentivizes to orchestrate insolvency and engage in valuation discussions that are in itself value-destroying. ‹#›

40. EU RPR problems: Flexibility at the cost of certainty The concept of relativity of treatment of different classes is inherently imprecise Ex ante: Negative impact on bargaining power. Ex post: Unsatisfied creditors may be under the assumption that the plan is not fair to them and seek for a higher pay-out through judicial intervention; thus, they may vote against the plan hoping to achieve a fair result. ‹#›

41. EU RPR problems: Unfairness Shareholders are residual claim holders They enjoy upside of company In case of liquidation shareholders they receive nothing unless creditors fully paid. EU RPR enables shareholders to shed debt without losing control and taking value from creditors without their consent. ‹#›

42. ‘more favourably’ also fair? ‹#› EQUITY 30 30 -70 TRADE 100 30 EQUITY 30 30 10 20 30 TRADE 20% ?% % EQUITY 30 30 -80 TRADE 100 30 10 SUBOR. EQUITY 30 30 4 20 30 6 SUBOR. TRADE ?% 20% 60% %

43. EU RPR problems: COMI Migration Choice for Member States for either APR or RPR means strong differences between MS. Creditors may push for a jurisdiction in which their absolute priority rights will be respected. Shareholders of financially distressed companies will press for a jurisdiction which applies EU RPR. ‹#›

44. More flexible APR New Value Exception Requiring equity holders to make a substantial and essential quid pro quo contribution in exchange for their continued (partly) ownership of the debtor Equity retention when there are instrumental shareholders Confine the scope to equity holders of small SME’s (compare new US Small Business Reorganisation Act: small company = max 2,7 million USD debt Encourage family businesses to implement restructuring solutions See also Recital 56 Directive Essential Suppliers If there is a dissenting class of creditors senior to the essential suppliers, provide the possibility that the latter be paid before the senior class is paid in full ‹#›

45. Conclusion Reorganisation is increasingly popular Upon insolvency, creditors (should) become the owners of the company. Why do we want to reorganise instead of liquidating? Properly distinguish between maintaining value (going concern) and distribution: who gets what. If we want to protect workers and jobs, do we need insolvency law for that? If we want to protect the company itself, what are we protecting? Insolvency law is debt collection law. Value should go to the creditors and not to shareholders. ‹#›

46. Dutch Reorganization Scheme (WHOA) ‹#›

47. Features of WHOA Available to debtors that are reasonably assumed will be unable to continue paying debts (Art. 370) Who can initiate the proceeding? Debtor; or A plan expert, who is appointed by court upon request of any creditor, shareholder, work council or other employee representative body Who can draft a restructuring plan? Debtor; or A plan expert: so long as the plan expert is in charge of drafting a plan, the debtor cannot offer a restructuring plan, but can request the plan expert to put the debtor’s plan to vote. If two plans, the court first considers the plan prepared by debtor Debtor in possession (DIP) Debtor remains in full control of the ordinary course of business ‹#›

48. Features of WHOA (cnt’d) Unilateral termination of contract (Art. 373) Cooling-off period (Art. 376) 3 conditions: The stay is necessary for the continuation of the business Reasonably assumed that it serves the interests of the joint creditors Does not substantially harm the interests of the third parties (creditors). During this period, court authorisation is required to take an action against the debtor Normally, maximum period of four months The stay can be extended to maximum four more months (eight months in total) is: Important progress has been made wrt creation of plan The elements under para 6 does not apply to the case Right to use, consume and dispose of property and collect claims (Art. 377) Using the power in line with the normal continuation of the business Interests of third parties concerned are sufficiently safeguarded ‹#›

49. Features of WHOA (cnt’d) Interim financing (DIP financing) (Art. 42) To finance day-to-day operation of business during the proceeding NB: under Dutch law, priming is not possible: cannot create security rights with higher ranks above existing security rights The role of observer (Art. 380) Appointment of an observer by court to supervise the realization of a plan If the observer realises that the interests of the general body of creditors will be adversely affected, she/he will inform the court (Art.380(2)) ‹#›

50. ‹#› Overview of WHOA Procedure

51. ‹#› Class division Art. 374 Allocated to different classes if do they do not have a comparable position in case of liquidation or based on the plan As a minimum, creditors and shareholders should be separated Ordinary SME creditors should be separated from other unsecured creditors if - they fulfil the conditions under Art. 374 (2)(a) and - they are proposed to receive a payment or another right < 20% of the value of their claim 4. Mandatory Claim bifurcation: Distinction between secured and unsecured claims of secured creditors Valuation of secured claim: the value expected to to have been obtained by secured creditors in a bankruptcy “faillissement” case

52. ‹#› No creditor worse off test 384 (3) Will be assessed at the request of one or more creditors or shareholders eligible to vote The court will refuse confirmation if it summarily appears that those creditors or shareholders are worse off than in the event of liquidation of debtor in liquidation NB: it is a minimum protection

53. ‹#› Overview of WHOA Procedure

54. ‹#› Cross-class cram-down (Art. 384 (4)) Distribution of reorganisation surplus value: 1. Distribution of the surplus value in accordance with statutory law. Deviation is possible if there are reasonable grounds and the interests of creditors or shareholders concerned are not harmed; 2. Ordinary SME classes are entitled to a payment or value of at least 20% of the amount of their claim; 3. Unsecured creditors are entitled to opt for a cash payment equal to the value they expect to receive in liquidation; 4. Secured creditors, who receive shares or depository receipts, for the secured part of their claim should be provided with the possibility to choose another non-cash form of distribution.

55. Reorganisation game! Reorganization game: 20 February 2025 Submission of reorganization plan (group report): 6 March WGA (8h50 am), WGB (10h50 am) ‹#›