Latham & Watkins Restructuring and Insolvency Group

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1 Number August 2009 Client Alert Latham & Watkins Restructuring and Insolvency Group The IMO Car Wash Decision Latham & Watkins Advises IMO Car Wash in the Leading UK Restructuring Case this Year The Company s Advisers Team The following are advisers for the company who were responsible for the restructuring negotiations, drawing up and then successfully implementing the scheme of arrangement in the face of heavy opposition from the mezzanine creditors: Latham & Watkins: Mike Bond John Houghton Dominic Newcomb and others NM Rothschild & Sons Ltd: Andrew Merrett Dacre Barrett-Lennard Marco Van Oord and others Leading Counsel: Robin Dicker QC Richard Fisher Introduction Mr Justice Mann s judgment in the recently contested scheme of arrangement in the IMO Car Wash restructuring 1 is an important case for the restructuring, finance and private equity communities and their advisers. It clarified crucial issues which will be key in many future restructurings of over-leveraged companies struggling under the burden of multiple classes of debt, including: valuations and their role in deciding who is in and who is out of a scheme of arrangement; fairness considerations in the scheme sanction process; directors duties; the terms of intercreditor agreements; the mezzanine creditors rights to acquire the senior debt at par; and credit bidding. Background Schemes of arrangement have undergone a recent resurgence as the implementation tool of choice in large restructurings such as McCarthy & Stone, British Vita, Countrywide and Crest Nicholson. In all but Vita (where Latham & Watkins acted for the mezzanine creditors committee), the subordinated creditors (or, in the case of Countrywide, the equity holders) have been crammed down by the scheme, or left out of it altogether, on the basis that they are out of the money. A critical question for all the parties in such restructurings is therefore exactly how to determine who is and is not in the money. Valuation is key and goes to the heart of every English multi-creditor-class restructuring (including cases brought into England by reason of a COMI shift ). But ever since the MyTravel case in 2005, questions have remained as to what basis of valuation should be employed by a company when drawing up the creditor classes for the purposes of a scheme of arrangement. Valuation also determines the scope of the directors duties; it helps the company to determine who the stakeholders are in the business and its underlying assets and therefore to whom the directors owe their primary fiduciary duty in the restructuring negotiations. But, perhaps remarkably, the debate on valuation has rarely been heard in the English courts. Aside from MyTravel, one has to go back to 1904 and the case of In re Tea Corporation for further guidance of substance. This is of course in stark contrast to the process in the United States where valuation is debated in all Chapter 11 cases and it is therefore not surprising that the UK restructuring world was focussed on the IMO schemes of arrangement. Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy and an affiliated partnership conducting the practice in Hong Kong. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2009 Latham & Watkins. All Rights Reserved.

2 The Key Terms of the IMO Schemes The senior creditors set up a newco which would bid for the company s assets following the appointment of administrators The senior creditors effectively bid their debt by releasing (or novating to newco) substantially all of their claims against the group Under the terms of the scheme, newco agrees to issue shares to the senior creditors and to become indebted under new senior and second lien facilities, in each case pro rata to the senior creditors prerestructuring senior debt holdings The mezzanine creditors are left out of the scheme and receive no consideration under the restructuring terms Where necessary, existing security and guarantees (including those granted to the mezzanine lenders) would be released by the security trustee pursuant to the terms of the intercreditor agreement The oldco companies not transferred to newco would be liquidated or dissolved post-closing of the restructuring The IMO Car Wash Restructuring Terms The IMO group required financial restructuring following payment defaults, financial covenant breaches and an unsustainable capital structure. The proposal ultimately put forward by the IMO group involved three schemes of arrangement, with compromises being agreed between the company and its senior creditors conditional upon the assets of the group (following the appointment of administrators) being transferred to a newco which would be owned by the senior creditors (subject to dilution for a management incentive plan). The mezzanine debt would be left behind in the oldco structure rendering the mezzanine debt effectively worthless. Accordingly, the mezzanine creditors were left out of the scheme altogether.this structure is described in more detail in the chart contained in the Appendix at the end of this Client Alert. With the mezzanine lenders therefore left out of the restructuring and left holding claims against worthless entities, the issue at the heart of the dispute was whether or not they could be rightly excluded? Valuation The company s valuation approach The company and its advisers were focussed on the determination of valuation from the outset of the restructuring in order to ascertain whether or not the mezzanine lenders were in the money. In this respect, the company commissioned a desktop valuation, but also tested the market through a third-party sales process which was overseen by the company s financial advisers, Rothschilds. Against the background of a senior debt level of approximately 315 million, those exercises indicated the following valuation ranges: the market testing process produced an indicative offer which placed an enterprise value on the IMO group of between million on a cash and debt-free basis, including a normalised level of working capital. In this context it is important to note that the senior lenders indicated that staple financing might be available to provide acquisition finance to bidders in order to maximise offers; and the desktop valuation estimated the value of the group to be between 235 million and 265 million on a going concern basis. A third valuation exercise was also undertaken by the company to sense check the above analyses. This involved an assessment of the value of certain of the IMO group s sites on a market value and restricted sales basis. An extrapolation exercise was then carried out to produce a valuation of the entire group portfolio, resulting in valuations of 164 million and 208 million respectively. It is important to understand that in the circumstances of a scheme and subsequent transfer of the IMO business which was to survive as a going concern, none of the parties in the IMO Car Wash case attempted to argue that a liquidation value of the group was the appropriate benchmark, in contrast to the arguments raised in MyTravel. All agreed that a going concern valuation was correct. The critical point in the IMO Car Wash case was whether or not the company s valuation approach was the correct basis for proposing the restructuring? It should be further explained that in undertaking the desktop valuation exercise, the company s valuers had taken into account three different approaches to reach the above value range: an income approach which is based on the cashflows the business could generate in the future. This was essentially a discounted cashflow analysis ( DCF ), subject to adjustments to reflect the realities of the current market; a market approach which was assessed by reference to comparisons with other publicly traded companies and transactions; and a leveraged buyout analysis aimed at assessing how a potential private equity purchaser would look to pay given its typical expectation of rates of return in the current market. 2 Number August 2009

3 As previously noted, these approaches produced a high value peak of 265 million, significantly below the level of the senior debt and, most importantly, significantly above the evidence from the Rothschild sale process which indicated an enterprise value of between only million. The mezzanine s valuation approach The mezzanine lenders conceded that if the group was sold immediately, all proceeds would flow to the senior creditors. However, they argued that this was unfair as this valuation took into account the current, harsh market conditions. It was further argued that the IMO group had an intrinsic value that was greater than this and that this was properly reflected in a DCF analysis which they had commissioned. This purported to show that the future enterprise value of the group would break in the mezzanine debt. The mezzanine s DCF valuation was predicated on the basis that without the constraints of the existing financial covenants, and with the revised debt structure which was envisaged by the scheme of arrangement or alternatively the mezzanine s creditors own proposal, it was highly likely that the senior lenders would at some time in the future make a full recovery, leaving a surplus for the mezzanine creditors. Accordingly, they argued that they were adversely affected by the scheme of arrangement; it was unfair that they were not included in the scheme as they were (they said) economically interested in the future outcome of the company s assets. Conclusion re valuation Against this background, Mr Justice Mann held that: The company s advisers had produced expert evidence which was both comprehensible and which related to the key point how much would a purchaser pay for the group now? Importantly for the restructuring community, it was this test to which Mr Justice Mann gave significant weight when assessing the strength of the valuation evidence. In the circumstances of a scheme of arrangement in which the business of the group was to continue, a going concern basis of valuation was appropriate. Any valuation exercise should use real world judgements as to the assumptions to be made when valuing the group it should not be a sterile statistical exercise. Although no single method of valuing a business was automatically favoured over another, the DCF method used by the mezzanine lenders valuer, which used a Monte-Carlo statistical analysis producing a wide range of potential values dependent on a range of inputs, was not favoured by the Judge. He described it as producing not so much a range of values, professionally assessed, but a range of possibilities. Directors Duties A further key part of the debate centred around the mezzanine creditors argument that because their valuation showed that they were interested in the assets, it was incumbent on the directors to implement a restructuring which would leave the mezzanine creditors with some future interest. They argued that the directors were under a duty to agree to a deal with the mezzanine, for example, that the interest could be subject to a PIK instrument, or by promoting a scheme of arrangement involving the mezzanine creditors or some other compromise which would allow the company to continue to pay senior interest whilst not writing off the mezzanine debt. The mezzanine ran this argument even though the mezzanine creditors committee, which had been formed in late 2008, had been involved in active (but ultimately fruitless) discussions with both the senior creditors and the company s financial advisers, Rothschilds. Moreover, the mezzanine committee had itself rejected an offer of warrants as part of the restructuring terms. Tellingly, the mezzanine creditors valuation report had not been received by the company (notwithstanding 3 Number August 2009

4 repeated requests for it) until after it had launched the scheme of arrangement and had participated in the initial directions and class hearing. Accordingly, at the time of entering into a lock up agreement for the restructuring with the senior creditors and launching the subsequent scheme of arrangement, the valuation evidence available to the directors indicated (as set out previously) that the mezzanine lenders did not have any economic interest in the restructuring, with no evidence at all from the mezzanine lenders to contradict this. In this regard Mr Justice Mann concluded that the mezzanine creditors case was not a realistic summary of the directors duties and in particular: the mezzanine co-ordination committee was expressly formed for the purpose of protecting the mezzanine lenders interests; the mezzanine lenders had at all material times been fighting their own corner and had never indicated to the directors that they expected them to fight their corner for them, nor did the directors have the authority to do so; coupled with the valuation evidence before it, the board was entitled to conclude that if the mezzanine lenders could not have achieved anything in their negotiations with the senior lenders, the company was in no better position to start negotiating something else; and the lock-up to and promotion of the scheme by the company was in substance acknowledging economic and business realities. It could not impact the interests of anyone other than the senior lenders given the level of debt and the value of the group s assets. The Judge also recognised that the directors options were limited in practice. In discharging their duties to creditors it was quite proper for them to take into account the risks of wrongful trading and the idea, proposed by the mezzanine lenders, that the board challenge the senior creditors by refusing to implement the scheme until a better deal had been negotiated for the subordinated creditors, was firmly rejected by Mr Justice Mann. The Company was Insolvent but should the Directors have Carried on Trading Regardless? The mezzanine creditors further argued that the IMO business was cash generative, it had not suffered a collapse in EBITDA (unlike most other distressed LBOs) and therefore the group could survive on its existing cashflows. Accordingly, the mezzanine argued that the company should have continued to trade within its existing capital structure, even though it was in breach of the finance documents and not paying senior interest. The company considered that this was wholly unrealistic. The evidence provided to the court showed that the group was balance sheet insolvent and whilst it was meeting its trading debts, it was unable to pay all of its debts as they fell due, as demonstrated by the failure to pay the senior and mezzanine interest at the end of March Moreover, the evidence clearly showed that if the scheme was not sanctioned by the court, the senior creditors were highly likely to enforce their security or the company may itself have to apply for an administration order. So the prospects of trading in the existing capital structure seemed remote as far as the company was concerned. Against this background, Mr Justice Mann held that the group was on any footing technically insolvent and was suffering from real creditor pressure. There were events of default outstanding under the company s major credit agreements and the valuations showed that the mezzanine creditors were clearly out of the money. It was therefore unrealistic to expect the directors to continue to trade in the face of all of this in the vague hope that the mezzanine creditors might be able to get back around the table with the senior lenders and cut a new deal. 4 Number August 2009

5 Intercreditor Agreement and the Right to Purchase the Senior Debt One further hurdle that the mezzanine lenders faced was the intercreditor agreement entered into with the senior creditors at the time of the original finance facilities. The intercreditor agreement contained the usual mezzanine subordination provisions and this fact was repeatedly alluded to in argument by the company and the senior creditors. In addition, the rights of the senior lenders to require the mezzanine security and guarantee interests over the opco entities to be released in accordance with the provisions of that agreement were not challenged by the mezzanine or the Judge. Finally, the intercreditor agreement contained the customary right in favour of the mezzanine lenders to purchase the senior debt at par in enforcement circumstances. This has always been viewed as being of benefit to subordinated creditors, but in these circumstances it worked against the mezzanine lenders in practice. The Judge drew a negative inference from the fact that they were unwilling to exercise the purchase option (despite having had that suggestion made to them in correspondence) and the mezzanine lenders had put forward no reasons for this hesitancy. Credit Bidding is it Good Consideration? The consideration for the transfer of the IMO group to the senior owned newco was a credit bid of circa 300 million of senior debt. This was, in essence, a mixture of debt release and debt novation to the newco structure, but the net effect was a reduction in the company s balance sheet (including the guarantor companies in the IMO group) of circa 300 million of liabilities. The mezzanine took exception to this and argued that as the oldco companies were insolvent and given that post-restructuring those companies would have no residual assets available to the remaining creditors (i.e., the mezzanine), there was no real benefit or valid consideration at all to the companies in the credit bid mechanism. If that was right, it would cast serious doubt over any UK restructuring involving a pre-pack sale with a credit bid element. Mr Justice Mann upheld the company s arguments that the debt releases by the senior creditors were sufficient consideration and that he was entitled to look at the fact that the scheme was itself part of a wider arrangement, all of which conferred benefits on the company. Accordingly, the commonly used mechanism of credit bidding in a restructuring or pre-pack context did not attract any adverse comment or controversy. Conclusions The IMO Car Wash case has established some key points of principle for the restructuring community and also provides a number of important lessons in the context of successful implementation of a restructuring. Valuation in these circumstances should be based on how much a purchaser would pay today for the relevant assets whether or not this is best evidenced by a sales process or a marketing exercise, or both, is open for further argument but intrinsic value is certainly not the right benchmark. Directors of companies undergoing restructurings can take comfort from the clarification as to the limited extent of their duties to junior creditors if the evidence demonstrates those creditors to be out of the money. Intercreditor arrangements were respected, in particular regarding the release of the mezzanine claims and security. The buy-out right for the mezzanine lenders was ultimately held against them. 5 Number August 2009

6 Credit bidding remains a valid restructuring tool. Finally, but importantly the IMO case emphasised the importance to the parties in a restructuring of careful planning and a thorough, carefullydocumented, execution of the process. However, whilst clearly important, the debate is not yet over. The case concerned a tiered capital structure with layers of subordinated debt; there may still be fights to be had in restructurings where there is no security/related intercreditor arrangements and the dispute as to who owns the company is between pari passu unsecured creditors and the shareholders. Endnotes 1 For ease, this Client Alert refers to just one scheme of arrangement although there were in fact three schemes, all however on similar terms and inter-conditional upon each other for their effectiveness If you would like further advice with respect to the matters discussed above, please speak to your usual contacts in the Latham & Watkins Restructuring Group or any of the IMO Car Wash deal team: Michael Bond michael.bond@lw.com John Houghton john.houghton@lw.com Rory Negus rory.negus@lw.com Dominic Newcomb dominic.newcomb@lw.com 6 Number August 2009

7 APPENDIX 7 Number August 2009

8 Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you wish to update your contact details or customise the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. Abu Dhabi Barcelona Brussels Chicago Doha Dubai Frankfurt Hamburg Hong Kong Los Angeles Madrid Milan Moscow Munich New Jersey New York Orange County Paris Rome San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Washington, D.C. 8 Number August 2009