The New Incentives of Senior Lenders in Financial Distress

Current Legal Problems lecture The New Incentives of Senior Lenders in Financial Distress Date: 16 November 2023 Understanding the past New Incentives of Senior Lenders  Shareholders have always had an incentive to avoid a restructuring in financia distress... Firm Value: Senior Lenders, Junior Lenders, Shareholders  but senior lenders have had the incentive to monitor the financial condition of the company (through covenants) and push for a restructuring where necessary The more significant change: CLO incentives  Overcollateralization (OC) tests 1) CLO manager's performance fees 2) Incentive to avoid default  Problems of participating in restructuring and exit finance  Problems of participating in debt-for-equity swap Why is this a problem? The alternatives... Problem Divert cash from operations to meet debt  service obligations  Amend and extend  Up tier and dropdown transactions     Is the problem overstated?  Avoiding false positives (Tung (2021)) Alternatives Insufficient cash to invest in operations Business deteriorates further Fees, interest, and increased liquidity pressure No deleveraging May reduce cash debt service requirements and deleverage But cash interest may be converted into PIK interest Impact of buyback depends on discount  Split control rights (Tung (2021); Berlin, Nini and Edison (2020)) 1) Springing covenant 2) Cure rights and deemed cure 3) Avoiding testing/ensuring compliance: pay down borrowings; size of RCF; definitions of EBITDA; use of LCs 4) Only RCF lenders have right to call default  Incentives of senior CLO and other investors What Can and Should Law Do? We need to consider to what extent corporate and corporate insolvency and restructuring law should incentivize early restructuring in light of senior financial creditors' changing incentives. Self-help by suppliers and government agencies  Monitoring capacity  Resources and specialist experts  Legal problems 1) Re Savoy Hotel Ltd [1981] Ch 351; [1981] 3 WLR 441; NGI Systems & Solutions Ltd v The Good Box Co Ltd (in administration) [2023] EWHC 274 (Ch). Directors' duties  Fraudulent and wrongful trading 1) Stopping a company from trading on when the situation is hopeless v earl restructuring 2) Insolvency practitioner incentives  Common law duties 1) Best interests of creditors as a whole 2) The Supreme Court and imminence (although note Hunt v Singh [2023] EWHC 1784 (Ch)) 3) The meaning of insolvency 4) The standard of review • S 212 of IA 1986 - but risk?  Reform of common law duties 1) Elizabeth Warren's 2019 Stop Wall Street Looting Bill (US)? 2) Ireland and duty to have regard to 'the need to take steps to avoid insolvency' (Quinn and Gavin (2023)) a) Problem of claim for failure to act b) No need to introduce European Restructuring Directive in UK  Disqualification 1) State remedy a) Resources? b) Impact of recent disqualification cases? A well-advised director who takes care to document their decision-making process may be able to navigate liability risks without too much difficulty. Lender incentives  US litigation re up tier and dropdown transactions  UK challenges  Broader lender liability? Encouraging raising of exit finance within court-supervised plan Incentivizing the PE firm to seek a restructuring 1. Gifting Firm Value £350  Senior lenders: £500  Junior lenders: £500  Shareholders 2. Incentivizing PE firms to seek a restructuring  Solving the problem of collusion 1) Monetary contribution measured against post-new money value 2) Results in the type of valuation dispute Government wished to avoid (postreorganization enterprise value; discount to plan equity valuation for rescue finance; fees and effective additional discount) Conclusion - Most effective solution to the problem is to provide legal tools that incentivize PE firms to seek a restructuring -  Ease of raising new money  No APR But there must be adequate safeguards for creditors  Implicates the type of valuation dispute we wished to avoid  This is unavoidable