Recent draft-legislation in the European Union may significantly impact investors in distressed European credits. In order to promote investment in the European market, the European Commission issued a proposed directive on November 22, 2016 (COM(2016) 723), which is intended to harmonize the restructuring and insolvency regimes of EU member states by implementing regulations for pre-insolvency proceedings. The proposed legislation is currently being reviewed by the European Parliament and European Council. This review process could take up to two years. If approved, all EU member states would have an additional two years after adoption to bring their legal systems into compliance with the directive.
All EU member states currently have laws governing formal insolvency proceedings. However, many states lack regulations that govern the restructuring process at the pre-insolvency stage. In those states, attempts to effect out-of-court restructuring plans are often obstructed by holdout creditors seeking to obtain preferential treatment. Under current laws in many states, a creditor may block adoption of an out-of-court restructuring plan, even where a majority of other creditors support the plan. In those instances, the only way to effectuate the restructuring plan is to pay off the holdout creditor or apply for a formal insolvency proceeding in which an opposing minority can be overruled. Both options are often unpalatable because the debtor is usually short on cash and prefers to avoid a formal insolvency proceeding, including the potentially negative effects on the debtor’s reputation and business. Additionally, a formal insolvency proceeding must involve all of the debtor’s creditors, even if only certain of the debtor’s financial liabilities require restructuring. The draft legislation seeks to resolve the issue of holdout creditors in pre-insolvency negotiations, thereby creating a more sensible and efficient path for debtors to restructure their debts.
Key elements of the proposed law
The proposed law is designed to ensure that a harmonized system exists at the pre-insolvency level for EU member states. The goal is for debtors to apply for fewer formal insolvency proceedings, thereby reducing the negative impact of such proceedings on the financial sector and, by extension, protecting jobs in the EU. The legislation would make pre-insolvency proceedings available to distressed debtors facing a “likelihood of insolvency.” The term “likelihood of insolvency” is necessarily vague as to what level and types of distress constitute “insolvency,” and when such outcomes are “likely.” Based on that term’s use in certain EU member states’ current insolvency laws, it would likely be interpreted to describe debtors whose liabilities exceed their assets, or who will likely become unable to pay their debts in the long term. Beyond that construction, it is unclear how the EU legislature might further define the parameters of the law, or if it will be left to judicial interpretation.
The core element of the proposed law is the restructuring plan. The law does not set forth any specific guidelines to which the plan must adhere. However, the law permits a debtor to exclude unaffected creditors from the plan, and provides that only those creditors affected by the plan may vote on its adoption. This is intended to allow the debtor to restructure those aspects of its business that are distressed, while maintaining the status quo in those aspects of its business that are performing. Indeed, unaffected creditors maynot even receive notice of the pre-insolvency proceeding or the restructuring plan.
Although the proposed law facilitates out-of-court restructurings, there are two events in a pre-insolvency proceeding that require a court’s involvement. First, the debtor may request a court to stay individual enforcement actions while it negotiates a restructuring plan with its creditors. The scope of the stay, and the number of creditors that it covers, may be tailored to fit the debtor’s needs. The duration of the stay is limited to four months, but may be extended by the court on a case-by-case basis. However, the stay cannot apply to outstanding claims of the debtor’s employees. A stay issued during the pre-insolvency period suspends any obligation the debtor may have (under the relevant EU member state’s insolvency laws) to file a formal insolvency proceeding. Member states may limit or lift the stay only if the company becomes unable to pay its debts that are already due or about to become due, or if continued negotiations are opposed by a sufficient number of creditors who could ultimately block adoption of the restructuring plan. Creditors to which the stay applies may not withhold performance or terminate executory contracts on account of debts that arose prior to the stay, or as a result of an ipso facto clause in a contract. The stay is designed to incentivize debtors to take advantage of pre-insolvency proceedings by ensuring that debtors will retain possession of their assets while they reorganize. Furthermore, court involvement at this stage allows the debtor to seek appointment of a mediator to promote negotiation with its creditors, and allows creditors to seek appointment of a supervisor who, like a trustee, is tasked with overseeing management of the debtor’s business.
The second scenario in which a court may become involved in a pre-insolvency proceeding is if the debtor wants to “cram down” a dissenting creditor. Cram down is a significant power granted to the debtor in a pre-insolvency proceeding, and is an important departure from many EU member countries’ current pre-insolvency regimes. To effect a pre-insolvency plan under the proposed law without court approval, every class of affected creditors must support the plan. However, opposing classes can be overruled if a court determines that such treatment complies with the best interest of creditors test, and has a reasonable prospect of preventing the debtor’s insolvency. The cram down provision prevents minority creditors from obstructing reasonable restructuring plans during the pre-insolvency period and preserves the debtor’s ability to reach consensus with other creditors. The proposed cram down provision is similar to the US cram down provision under chapter 11 of the US Bankruptcy Code in that it requires adherence to the absolute priority rule, which requires that no creditor with an interest junior to the dissenting class will receive any distribution before the dissenting class is paid in full.
Impact on investors
The proposed law may provide new opportunities (and risks) for investors in distressed European credits. The law promotes early restructuring, facilitates continuation of the debtor’s business during the restructuring, affords the debtor time for negotiations by staying enforcement actions, and prevents dissenting minority creditors from obstructing plan approval. These benefits will likely enable debtors to reorganize faster and without the burdens of a formal insolvency proceeding, thereby preserving value for creditors and improving their future prospects. On the other hand, minority creditors will lose important leverage in negotiating with a debtor unwilling or unable to pay its debts. The proposed law allows for significant interference in creditors’ rights at an early stage of a corporate crisis, and may be misused by recalcitrant debtors to rid themselves of disfavored creditors. Additionally, the lack of notice to unaffected creditors before a pre-insolvency plan is confirmed raises potential due process concerns.
It remains to be seen whether the proposed law will be an overall benefit or disadvantage to investors in distressed European credits. Although the law is clearly advantageous to debtors and those creditors who consent to a plan, other creditors are likely better served under the current laws of the relevant EU member states. Ultimately, the answer will likely depend on which side of this divide an investor falls on.