The restructuring of middle market companies is increasingly more global for a number of reasons. Faced with slowing growth in their domestic markets, companies look abroad to meet more aggressive growth forecasts. In addition, as their customers expand their geographies, so must suppliers. With improvements in technology, more receptive business environments abroad, and the development of low-cost joint ventures, even lower middle market companies are regularly expanding into additional markets.
With this global expansion, companies are finding local financing is now readily available in many jurisdictions, enabling them to expand international operations without lending limitations. This additional leverage is frequently at the level of the local operating company, creating complex multilevel balance sheets that were once the province of large multinational businesses.
These structures are increasingly common, even for smaller companies with an eye toward growth rather than a restructuring. A borrower’s balance sheet may be laden with bank debt, second lien debt, mezzanine debt, and high yield bonds held by a variety of institutions, including traditional banks, distressed debt funds, credit funds, collateralized loan obligation (CLO) managers, and private-equity funds, each with a different agenda.
In general, corporate financing has become increasingly complex as banks continue to experience disintermediation by a variety of lending sources. These sources may have conflicting approaches when confronted with a troubled company, however. Varied risk appetites, abilities to add additional capital, and regulatory structures may complicate motivations. The credit-default swap (CDS) market has made it possible for some lenders to hedge their exposure, thereby changing their incentives and creating scenarios in which even lenders in the same securities have misaligned interests.
Despite increasing globalization of credit markets, the world’s insolvency processes remain stubbornly territorial. Even the European Union, which has managed a common currency, has widely varying insolvency rules among its member nations. Despite the ability of EU companies to issue bonds in a common currency, the underlying credit risk in an insolvency differs considerably across otherwise similar companies, depending on the relevant regime controlling the processes across each company’s operations.
It is frequently impossible to accurately predict how an insolvency will play out; therefore, the credit investor must assess risk based on limited information and a general feel for how a variety of factors, including management actions, the perspective of regulators, and the preferences of other creditors, might affect the outcome.
For a company with multinational operations that is beginning to see difficulties on the balance sheet, there may be steps it can take to avail itself of the most advantageous jurisdiction in which to seek relief. Selecting the proper jurisdiction may increase the likelihood of achieving an effective restructuring and avoiding liquidation. While the United States — with its established law favoring rehabilitation over liquidation — is often favored when it is an option, the United Kingdom and Germany also offer benefits to troubled companies.
Within the European Union, the practice of jurisdiction shopping is referred to as center of main interest (COMI) shifting. Under the COMI concept, companies may be able to move their administration functions to the United Kingdom and claim jurisdiction. For example, such a shift allows some companies to restructure their obligations in an organized and expeditious manner, providing a path to return to a healthy state.
As countries look for ways to save jobs and create globally competitive companies, the continuing evolution of laws across jurisdictions can offer more resolution options for troubled companies beyond the death sentence of liquidation. The competition to find deals has increasingly driven special situations investment firms to look for opportunities more broadly, including in markets outside the United States. As a result, the number of funds and their service providers that have opened offices abroad has surged.
Despite the enthusiasm for potential investment opportunities abroad, it remains challenging for many funds accustomed to the Chapter 11 process to find compelling investment opportunities. There are a number of stark differences between the U.S. bankruptcy regime and restructuring powers and the regimes in other countries that make it difficult for investors accustomed to the relative certainty and clarity of Chapter 11 to achieve similar comfort levels abroad.
After venturing abroad for potential opportunities, investors may find that the increased amounts of work and uncertainty do not lead to an acceptable transaction. This greater uncertainty limits interest from outside investors, particularly in middle market companies.
One of the strongest features of the U.S. regime is the ability of more-senior creditors whose claims are impaired to effect a restructuring over the objections of junior creditors. This is commonly referred to as a “cram down.” In many jurisdictions outside the United States, a cram down is not easily accomplished and may not be available at all. Without such a tool, all of the constituent parties must agree on the exact terms of a restructuring, which is simply impossible to achieve in many situations.
For example, in addition to impaired junior lenders at the primary company, other senior lenders at subsidiary companies also may object. In cases in which local lenders are critical, either because of the size of their claims or because they are essential to the ongoing performance of the business in terms of cash management, their inability or unwillingness to engage in a process that is unfamiliar and may not be as favorable to them can lead to insurmountable barriers to agreement.
Other common objectors are workers’ organizations and government labor representatives. These organizations may fear setting precedents that could be more widely applied and may tend to revert to prior experiences. Other creditors may simply be able to exercise hold up value and receive recoveries, even when they otherwise would be out of the money.
For many small and midsized companies, these difficulties present barriers that are too formidable to effectively restructure around. The critical determinate of value in many cases is the ability to work through a process and gain consensus from all constituencies. This can be very difficult for potential investors to gauge in advance, especially foreign investors who may be treated differently than local banks.
Another helpful feature in a U.S. bankruptcy is the automatic stay, which prevents certain lenders from acting immediately to exercise their remedies and provides a company filing Chapter 11 with time to formulate an organized plan. Jurisdictions in other countries may not offer such protections and may not recognize stays issued by U.S. courts when local lenders take actions against local assets.
This can lead to significant diminution of value to investors, even when investing in domestic companies that file bankruptcy in the United States. The absence of a stay can create a feeding frenzy among creditors and push a company that otherwise could be restructured into a quick liquidation.
The ability to create post-filing superpriority liens enhances a company’s ability to have sufficient liquidity to fund both the costs of bankruptcy and ongoing operations during the pendency of a case. In the U.S. process, such liens are granted with debtor-in-possession (DIP) loans. Without such a source of funding, many companies are forced into liquidation because they lack operating funds.
The ability to sell assets free and clear of liens and encumberances is very helpful in maximizing recoveries to lenders in a timely manner. In the U.S., this is effectuated through a 363 sale, which is overseen by a bankruptcy court. In other jurisdictions, however, assets can be subject to secondary proceedings, making a sale of a going concern prohibitively expensive and time-consuming.
Even the rules determining when and under what conditions a company must declare itself insolvent vary widely. In the United States, a company’s management and board of directors are tasked with determining when their company has entered the zone of insolvency, and they are required to take actions in a timely manner to protect creditors when such a determination has been made. Once a company has entered bankruptcy, U.S. courts typically allow at least six months to develop a plan.
In other countries, companies may have much less time to make such a determination and address their problems, and failure to comply can carry both financial and criminal liabilities. The shorter time frame and stiff penalties may convince management that it is safer simply to liquidate the company quickly rather to attempt to maximize creditor recovery.
In many jurisdictions an insolvency filing results in the appointment of a trustee or receiver, along with the removal of senior management. Depriving a company of a motivated management team endeavoring to maintain business during the delicate period of restructuring further pushes many companies toward liquidation.
For some companies, a multinational restructuring can be effective and result in a healthy company and attractive recoveries for participating investors. For many others, the stark reality will be difficult. The push to rehabilitate rather than liquidate companies remains a uniquely U.S. concept. While other jurisdictions are beginning to embrace rehabilitation as a path to the preservation of jobs and global competitiveness, liquidation remains generally easier and safer for many of those facing distressed situations in those countries.
Middle market companies, therefore, may find political and financial support to fight to stay alive elusive indeed. For a company based in the United States, these challenges can mean the loss of a significant sales market or an important operation at a particularly sensitive time. For a company based abroad, it can mean a lack of capital to provide a bridge to a successful outcome.