Understanding The Pangs of Corporate Debt Restructuring

8/10/2019 Understanding The Pangs of Corporate Debt Restructuring

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10/15/2014 Understanding

the Pangs of

Corporate

Debt

Restructuring

Corporate Finance Project

(Finance Part)

Submitted by Submitted to

Samyak Jain Sh. Rituparna

LLM Banking & Finance Das

Total Number of Words4,032

Total Length of Project14 Pages

NATIONAL LAW UNIVERSITY, JODHPUR


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UNDERSTANDING THE PANGS OF CORPORATE DEBT RESTRUCTURING

CORPORATE FINANCE PROJECT WORK

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National Law University, Jodhpur

TABLE OF CONTENTS

TABLE OF CONTENTS ________________________________________________________________________ 0

INTRODUCTION _____________________________________________________________________________ 2EVALUATING THE CONCEPT OF CORPORATE DEBT RESTRUCTURING _________________________________ 3

I. UNDERSTANDING THE PROS&CONSOF CORPORATE DEBT RESTRUCTURING______________________________ 3

A. Advantages of Corporate Debt Restructuring ____________________________________________ 3

B. Disadvantages of Corporate Debt Restructuring Mechanism ________________________________ 4

II. EVALUATING THE MODUS OPERANDIOF CORPORATE DEBT RESTRUCTURING_______________________________ 5

A. Commencement of Process ___________________________________________________________ 6

B. Representation of Creditors Interest ____________________________________________________ 6

C. Engaging Independent Advisors _______________________________________________________ 7

D. Stabilization of Business _____________________________________________________________ 7

E. Improvement of Cash Flows _________________________________________________________ 8

F. Securing Access to Complete & Accurate Information ______________________________________ 8

G. Engaging into Negotiation Process _____________________________________________________ 8

H. Admonition through Credible Threats __________________________________________________ 9

I. Inter Creditor Negotiations __________________________________________________________ 9

III. MECHANISMS OF CORPORATE DEBT RESTRUCTURING______________________________________________ 10

CONCLUSION ______________________________________________________________________________ 13

REFERENCES ______________________________________________________________________________ 14


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INTRODUCTION

TheBhagvad Geetastates, The nonpermanent appearance of happiness & distress & their

disappearance in due course, are like the appearance & disappearance of winter & summer

seasons1. Quoting the aforesaid prophecy made little sense had not the vociferous Business

Cycle abjured the phenomenon of Corporate Ascendance. With the advent of Globalisation,

the corporates who were earlier cocooned in the business friendly policies pursued by their

respective nations have been advertently exposed to the cleavers of highly competitive global

conglomerates who have an established reputation of competency and efficiency.

The Term, Corporate Debt Restructuring prima facie signifies a mechanism wherein acorporate entity endeavours to reorganise, recast and refurbish its outstanding debt obligations.

Such mechanism is based upon a consensus between the Lenders and the corporate entity

upon the assessing that the maintenance of status quo shall impair the functioning of the

company as well as it may be disadvantageous for the Lenders to pursue Winding up & other

Debt Recovery procedures as historically such measures have yielded little or no value to the

creditors. The Corporate Debt Restructuring mechanism is in a nature of novation of the

lending agreement wherein the lenders volunteer to ease the stringent clauses in an agreement

and substitute it with more adaptable terms & conditions in lieu of the challenges posed to the

Borrower due to internal & external factors.

The current research endeavour has been stratified into four parts wherein; In the first part, the

meaning & the concept behind the term Corporate Debt Restructuring has been deciphered;

The second part concerns itself with the Laws & Regulations germane to the concept of

Corporate Debt Restructuring under various Indian Laws; The Third part embodies the

conclusion.

1

See Verse 2.14, His Divine Grace A.C. Bhaktivedanta Swami Prabhupada, 1986. Bhagavad - Gita - As it Is. 2nded. s.l.:The Bhaktivedanta Book Trust.


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Minimal Judicial InterferenceWorkouts avoid the intervention of the judiciary,

whose pace may be too slow in the face of the emergency of financial difficulties.

Furthermore, the costs of formal insolvency proceedings are substantially higher,

and the inexperience of judges and their lack of understanding of commercialmatters, in certain jurisdictions, is detrimental to reaching an agreement between

the parties.

Reduction in Cost Formal winding up procedures are costly in terms of time,

money, and reputation. CDRs are less costly, even in cases involving numerous

advisors and numerous creditors to coordinate. Transaction costs and time costs of

workouts are generally lower than those of formal windingup procedures.

Minimalistic Regulatory InterferenceFrom a regulatory point of view, a CDR

does not necessarily imply a risk that the debtor loses a license or any other type of

regulatory authorization to operate its business. However, this may be impossible

to achieve in winding up procedures, as the fact that the company enters into formal

insolvency proceedings may entail the termination of its license or authorization

and a ban on procurement of public administration contracts. Depending on the

nature of the debtors business, the lack of regulatory impact may represent a very

substantial factor in the decision to use CDR instead of formal winding up

proceedings.

B. Disadvantages of Corporate Debt Restructuring Mechanism

There are certain inherent lacuna in the scheme of CDR mechanism, despite the

beneficent minimalistic regulatory interference, the CDR mechanism has its own share

of pitfalls which are illustrated as;

Difficulty in Assessing the True Position of Debtor If it is difficult to

assess the real financial and economic situation of the debtor, Analysis is

imperative to determine the viability of the business and in some cases this is

not feasible within the short time-frame of a CDR negotiation. This could also

result in serious controversies regarding creditorsrights.


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Fraudulent BehaviourIn cases where the promoters of the company or the

people in management of the company have defrauded the company and its

investors, in such cases CDR mechanism is perceived to be an escape routewhich does not bode well with the public perception and the wishes of the

investors.

Lack of Unanimity RequirementUnder the CDR mechanism, the approval

of the CDR package is subject to super-majority vote5, which creates

impediments in the form of coordination amongst different stakeholders,

especially the minuscule bondholders (in value terms), thus in such cases the

formal winding up procedures are preferred which enables the major

stakeholders to bind the minor ones.

Lender Liability ActionsThe creditors may face liability if it is found that

through the implementation of the workout they were de facto running the

debtors business (shadow directors). They could also face lender liability for

the concession of abusive credit.

II. EVALUATING THE MODUS OPERANDIOF CORPORATE DEBT

RESTRUCTURING

A CDR implies a contract between the debtor and its creditors, which binds the debtor vis-

-vis the creditors and also binds the creditors inter se6. Therefore, CDR refers to

5It implies holder of 75% of Debt (in value terms) and 60% of debt holders (in numerical terms)6Principally there are two kinds of agreements; DebtorCreditor Agreement (DCA) & InterCreditor

Agreement (ICA)

Inter Creditors Agreement - All banks /financial institutions in the CDR System are required to enter into the

legally binding ICA with necessary enforcement and penal provisions, if 75% of creditors (by value) agree to a

debt restructuring package, the same would be binding on the remaining creditors.

DebtorCreditor Agreement - Debtors are required to execute the DCA. The DCA has a legally binding stand

still agreement binding for 90/180 days whereby both the debtor and creditor(s) agree to stand still and commit

themselves not to take recourse to any legal action during the period.


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multilateral contracts that include covenants governing the conduct of the debtor and the

modification of the creditors rights under their lending relationships with the debtor.

Restructuring implies that the lending relationships cannot go on unmodified, as the debtor

is unable to fully comply with its obligations under the loans. For creditors, it is better tomodify their lending relationships with the debtor than force the debtor into insolvency,

where the prospects of recovery may be significantly lower. Therefore, if the debtor can

survive in a restructured form, all parties to the workout stand to gain.

A. Commencement of Process

The CDR mechanism essentially involves bringing together the debtor and his

creditors. It can be successful only if the creditors that hold most of the financial debt

of the common debtor agree to participate in the process. As the process is purely

informal, it can be initiated in any way and by any of the parties. The debtor has superior

information regarding his own financial state, so it is logical to assume that the debtor

will most likely initiate negotiations with its main creditors. However, in some cases

the debtor may decide to engage in riskier projects with the intention of obtaining the

necessary funds to service the financial debt. In practice, in the case of large corporate

debtors, the inclusion of specific covenants in loan contracts helps this process. A

default under the covenants gives creditors the possibility of initiating a negotiation

with the debtor in order to solve the indebtedness problem, rather than call a default

and enforce their claims. Given the fact that most loans have cross-default clauses, the

enforcement action of a single financial creditor can initiate a creditors race, resulting

in the debtors liquidation and extremely high costs and negative effects for all parties

involved.

B.

Representation of Creditors Interest

The first step in representing the creditors interest is the appointment of lead creditor.

The qualification of the lead creditor being that he should have a large exposure to the

distressed company. The lead creditor provides leadership, coordination, management

and administration, and reports to the creditors committee. The creditor committee

consists of all the stakeholders having an interest in restructuring the company. The

creditors committee cooperates with the lead creditor and provides representative

reactions to the proposals put forward by the debtor and by the lead creditor.


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E. Improvement of CashFlows

Debt restructuring is necessary because the debtor faces illiquidity or insolvency.

Successful restructuring requires that the debtor have access to finance/ adequateworking capital that allows it to continue its operations. This requirement imposes a

need for additional financing (in terms of Working Capital Term Loan) and therefore

is often a serious problem, as it implies throwing good money after bad. In particular,

it may be crucial to find cash to satisfy smaller creditors and thus keep the negotiations

to a manageable number of parties. Obtaining funds during the informal process can be

an acute problem because, even though such initiatives for additional funding are

accorded the status of super priority for a debtors ongoing debts.

F. Securing Access to Complete & Accurate Information

This is an essential condition for reaching a consensual agreement. The creditors

endeavour to seek information about the debtors business activities, current trading

position, general financial position and assets and liabilities. The provision of

information demands key participation of independent professionals, whose

intervention makes the information provided more credible. As stated before,

independent experts should review the economic information provided by the debtor.

G. Engaging into Negotiation Process

A CDR proposal is generally based on an agreement between creditors and the debtor

on the terms and conditions for the restructuring, and the creditors unanimous or

majority acceptance. Negotiation is multilateral, as it involves negotiation between the

creditorsgroup and the debtor as well as negotiation between the different creditors

participating. The debtor is subject to a standard of good faith as the consequence of

contractual obligations vis--vis the creditors. Creditors do not have a contractual

relationship inter seat the very outset, but the good faith standard is required as a pre-

contractual obligation. Good faith requires cooperation in negotiating and finding

feasible solutions to the financial difficulties of the debtor and requires that all parties

to the workout fully disclose their position.


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H. Admonition through Credible Threats

A recalcitrant debtor may be forced to negotiate if creditors have access to swift

enforcement mechanisms. Well-established and widely used creditor remedy and

insolvency law regimes can be used to influence the commencement and progressionof CDR proposal. The invitation to commence a dialogue should rarely be refused. If

the debtor declines the opportunity, it faces the prospect that individual creditor

remedies or formal insolvency proceedings will be pursued. Unwilling creditors face a

similar sanction to their uncooperative behaviour. This threat is generally sufficient to

initiate some type of dialogue. In this way, the courts and formal procedures work as a

last resortfor the negotiation between the debtor and its creditors. The credibility of

the threat of resorting to the court system is the single most important element to push

for a negotiation between the debtor and the creditors. The debtor needs also a credible

threat: that of obtaining a stay against the creditors and affecting their rights through

reorganization or other formal insolvency proceedings.

I. InterCreditor Negotiations

Negotiation among creditors is particularly sensitive, due to the different nature and

characteristics of credits and to the presence of conflicts of interest among a number of

creditors. The CDR proposal must recognize the relative positions of creditors.

Creditors with larger claims must take the lead in the restructuring process and in

negotiations with the debtor. The agreement should recognize and accommodate

creditors with valid security rights and other priorities. It is not necessary to replicate

the ranking of claims in a liquidation procedure, but the restructuring should follow as

closely as possible that ranking. If a secured creditor is not treated in accordance with

its status in such proceedings, it may decide not to respect the standstill and enforce its

security or, even worse, force the debtor into formal insolvency. In CDR proposals, the

most difficult negotiations frequently take place not between the debtor and the

creditors, but among the creditors themselves. The negotiation among financial

creditors faces particular problems: there can be asymmetric information among the

firms creditors and situations where a financial creditor makes concessions conditional

on other financial creditorsactions. Conditional concessions may lead to herding

and to coordination problems among financial creditors. At the same time, there can be

an aggregation problembecause, apart from the differences in the diverse financial


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credits, some of the financial creditors could have instruments that distort or eliminate

their incentives to reach an agreement. For Instance Creditors with credit insurance

or with credit default swaps will find themselves in a very different situation, and this

will undoubtedly affect negotiations among the parties. Creditors who have hedgedtheir credit risk have no incentives to engage in constructive negotiations. In some

cases, they will actually be interested in the failure of the negotiation, as opening formal

insolvency proceedings would trigger insurance payment or payments under the swap

contract.

Enhancing the financial capability of a corporate debtor through CDR enables the

debtor to better service debt owed to non-participants. Hence, numerous small creditors

rationally and opportunistically decline to participate in a workout. If these creditors,

taken together, are substantial enough to dissuade other creditors from agreeing to

workout arrangements, an otherwise efficient workout effort will fail.

III. MECHANISMS OF CORPORATE DEBT RESTRUCTURING

Debt restructuring may include many different components. It is not imperative that all

debts be treated in the same way, even if the workout only affects financial creditors. It

should be possible to adapt the restructuring to different creditor perspectives, and

distinguish between those who prefer to receive a partial payment as soon as possible, and

those with confidence in the future of the debtor, who can elect to recover their credits in

full. Some of the commonly employed mechanisms for CDR include;

Rescheduling of PaymentsA rescheduling of payments constitutes a novation of the

former debts for the creditors that participate in the restructuring agreement. Therefore,

debts with new characteristics substitute the old debts.

Roll-oversThis is one of the less radical changes that a restructuring may entail, and

consists of modifying the maturity dates, providing for the same interest for the

extended period of time granted for payment.


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Alteration of Interest RatesThe reduction of interest rate (fixed or variable) also

entails a novation of the debtors original obligations. Debt with high interest rates is

one of the common causes of financial distress. These difficulties may derive from the

fact that the interest rates were excessively high for the cash flow generated by thedebtors business or from the fact that the evolution of interest rates, as opposed to a

fixed rate, has resulted in the company receiving finance at an exorbitant cost, compared

with prevailing market conditions.

Forbearance of Penalty in Loan ArrangementsA CDR proposal may include a

waiver (temporary or permanent) of violations of covenants, and may cancel all of the

responsibilities of the debtor derived from violation of the covenants in the loan

agreements.

Alteration of covenantsThe covenants included in the loans may be unnecessarily

restrictive and may impose a considerable burden on the debtor. It should be possible

to reduce the obligations of the debtor under this heading, and, at the same time, monitor

adequately its activities and its financial soundness.

Debt/equity swaps; Debt/debt swaps; equity/equity swaps All of these

combinations are possible and allow creditors to obtain new debt or equity instruments.

It is also possible to grant classes of creditors and even shareholders options to purchase

other securities. For instance, shareholders should have the opportunity of buying out

creditors to avoid seeing their shares wiped out, and to retain control of the debtor

company; similarly, junior creditors should be able to buy out senior creditors.

Additional FinanceProviding new financing arrangements may be crucial for the

recovery of the distressed company. Therefore, new loan facilities are one of the typical

terms in a restructuring agreement, and normally there is additional security or

provisions in inter-creditor arrangements to compensate for the additional risk

incurred by those who provide new financing to a distressed company. In the case of

the provision of new money, no lender can be forced to extend new financing against

its will. This is an implied assumption in every restructuring, and it can be made explicit

in a general agreement among creditors. Normally, creditors with larger exposure to the


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debtor are expected to be contributors of new money, but there is no strict obligation in

that respect.

Restructuring Debt Security Creditors may demand that the pre-existing debtsagainst the debtor be covered by security interests, in compensation for the reduction

in the amounts to be recovered or in the interest rates for their loans. The law should

allow for the creation of new security interests where this priority is balanced with the

advantages that the debtor receives because of the restructuring. A correct analysis

should prove that the debtor and the other creditors benefited from the new financing

and that, therefore, the security interest should not be avoided, as it was instrumental in

providing new finance.

Waiver of InterestFinancial creditors will typically prefer to forgive past interest

and obtain payment for the principal and future interest. This arrangement is normally

favored for regulatory reasons. Future interest payments can also be reduced.

Waiver of Debt Debt forgiveness should be a last resort since the possibility of

forgiveness can give rise to moral hazard. Clearly, knowing that debt forgiveness is a

distinct possibility of a restructuring may induce debtors to engage in riskier projects

and to behave irresponsibly. The creditors may agree to reduce the outstanding debt of

the distressed company (the so-called haircuts). The effect of a write-off is to novate

the original obligations, substituting new obligations for a smaller amount, or

cancelling debts altogether.


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CONCLUSION

Viability is an implicit element of restructuring. In any case, the element of viability of the

business must not be overlooked. An efficient system does not restructure all debtors, butallows the debtor and the creditors to analyse possible solutions to the financial difficulties,

and take, as soon as possible, the decision that is better suited for the debtors business and for

the creditorsinterests. The objective must not be to keep companies alive for as much time as

possible, because that can be a waste of resources and efforts. Therefore, it is imperative to

gather exact information on the debtor and to decide quickly on its viability. Restructuring must

be effective, and must therefore take into account the viability of the business and cover the

reshaping of the debtors business, if necessary, apart from the restructuring of the debt.

Solutions to financial difficulties of debtor do not exist in an isolated or separate form. The

treatment of insolvency occupies a continuum, and there is overlap in some of the techniques

used. A combination of informal and formal elements can perform complementary functions.

Policy makers must understand the existence of different procedures in the continuum, and the

way in which these procedures can interact to cover the needs of a particular economic system.


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REFERENCES

Bolton, P., 2003. Towards a Statutory Approach Towards Sovereign Debt Restructuring: Lessons from

Corporate Bankruptcy Practice Around the Globe. IMF Staff Paper.

Dsilva, D. B., 2013. A Study on Implications of Corporate Restructuring. Prestige International

Journal of Management & IT, Volume 2(1), pp. 39-48.

John, S. G. K., 1990. Troubled Debt Restructurings.Journal of Financial Economics, Volume 27, pp.

315-353.

Rae, F. & Grigorian, D., 2013. Government Invlovement in Corporate Debt Restructuring: A Case

Study from the Great Recession. Modern Economy, Volume 4, pp. 171-186.

World Bank Group, 2009. Corporate Debt Restructuring: Missing Link in Financial Stabilization, s.l.:

s.n.

Understanding The Pangs of Corporate Debt Restructuring

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