For a few dollars more. company rescue proposals

June 2009 For a few dollars more. company rescue proposals The Wagons are on the move On 15 June 2009 the Insolvency Service issued a consultation paper "Encouraging Company Rescue" setting out its proposals for getting UK business through the global downturn "to emerge stronger and more successful on the other side." The key proposals are: extending the availability of a moratorium on creditor action to medium and large sized companies so they may seek to agree a rescue by way of Company Voluntary Arrangement (CVA). (See below: What is a CVA?) providing super-priority and security rights to lenders who provide finance in the context of a rescue. What is a Company Voluntary Arrangement? A CVA enables a relevant majority of creditors to implement a rescue plan which binds dissenting unsecured creditors. Key Issues High level proposals for company rescue reforms published 15 June 2009 Focus on granting troubled companies a breathing space, known as a moratorium Focus on making rescue finance available Upsetting priority and security forever? Currently, the legislation entitles small companies to apply for a moratorium of up to three months when its directors propose a CVA. A small company is one which currently satisfies at least two of the following three requirements: turnover of not more than 6.5m; assets of not more than 3.26m and less than 50 employees. During the moratorium, amongst other things, security cannot be enforced and proceedings cannot be commenced or continued against the company or its property except with the consent of the court. Again, the effect of this moratorium is to allow a company time to formulate a proposal so that it can come to an arrangement with its creditors. There are a number of exceptions and certain companies will not be treated as eligible for a moratorium, for example insurance companies, banks and building societies. The CVA proposal cannot affect the rights of secured creditors to enforce their security without the concurrence of the creditors concerned; this effectively gives the secured creditors a veto on an arrangement if it affects their rights. A meeting may also not approve a proposal under which a preferential debt of the company is to be paid otherwise than in priority to non-preferential debts, unless the preferential creditor consents to such a change in priority. In order for the proposal to be approved more than one half majority in value of the shareholders and more than three quarters in value of the creditors must vote in favour of the CVA. This is not the first time that such proposals have been raised as a means of improving the UK insolvency regime (The European High Yield Association made similar suggestions over two years ago). This is however the first time that serious steps have been taken to initiate such changes - and has undoubtedly been prompted by the current economic downturn. But is this the right time to be reacting and reforming the insolvency legislation in this way? Interestingly one of the main proposals is to promote the use of rescue financing - seemingly based closely on the DIP financing available in the US Chapter 11 process. If you would like to know more about the subjects covered in this publication or our services, please contact: Michael Bray +44 (0)20 7006 1291 Adrian Cohen +44 (0)20 7006 1627 Mark Campbell +44 (0)20 7006 2015 Charles Cochrane +44 (0)20 7006 2196 Nicholas Frome +44 (0)20 7006 2762 Philip Hertz +44 (0)20 7006 1666 Mark Hyde +44 (0)20 7006 1616 Alistair McGillivray +44 (0)20 7006 4423 David Steinberg +44 (0)20 7006 1621 Malcolm Sweeting +44 (0)20 7006 2028 To email one of the above, please use firstname.lastname@cliffordchance.com Clifford Chance LLP, 10 Upper Bank Street, London, E14 5JJ, UK www.cliffordchance.com

2 In this briefing note, we summarise the key aspects of the present proposals, and comment upon how we think they may impact the current market and the ability to successfully restructure ailing companies. The proposals fall into two main categories (i) extending the option of a moratorium and (ii) promoting rescue finance. Taking each in turn: Hold up at the bank! Out of court moratorium The proposals provide for two types of moratoria. The first involves a 28 day moratorium without the need for any court involvement although papers would be filed at court. This in effect extends to all companies the moratorium already available to small companies. The key to achieving this short term moratorium, is the required statement by a licensed insolvency practitioner (who will act as a nominee) that a CVA has a reasonable prospect of success and of being approved by 75% in value of the creditors. Like the existing small company provisions, it is envisaged that the new moratorium would not be available for certain types of companies and in certain circumstances. Amongst those companies that are excluded are insurance companies, banks, and entities that are subject to capital market arrangements for at least 10m. Equally the moratorium would not be available if the company was already or had recently been subject to a formal insolvency process or had an administrative receiver appointed to it. During the short moratorium the proposals envisage that the CVA could be voted upon by creditors at a formal creditors' meeting and if approved by 75% in value of those creditors, would be binding on all creditors who would have been entitled to vote. It is difficult to see how any CVA, other than one in a very simple form could be put together in such a short space of time. Court-sanctioned moratorium The proposals also include a court-sanctioned moratorium, which has the potential to be extended for a period of up to three months - though the initial moratorium would last for only 42 days. Unlike the shorter form, "out of court moratorium", the court would need to be satisfied that, in addition to there being a reasonable prospect of a successful CVA being achieved, the company is also unable or likely to become unable to pay its debts within three months of the hearing. In addition, it must be established that the moratorium, would be in the best interests of the creditors as a whole. The consultation paper indicates that the onus on satisfying these criteria would rest with the insolvency practitioner and is similar in many ways to the reliance the court places on proposed administrators. The introduction of such a courtsanctioned moratorium would provide a significant benefit to companies where the underlying business is viable, but the company needs a breathing space in which to restructure its affairs. One of the key objectives that the proposals seek to address is to enhance existing legislation and ensure that company rescues (if appropriate) are progressed more efficiently and at a much lower cost. The court-sanctioned moratorium would however, necessarily involve a significant amount of time and costs to satisfy the conditions required to achieve court approval - with no guarantee of success. This compares unfavourably with the existing regime which enables companies to be placed into administration, without any court involvement, and benefit from a 12 month moratorium, during which the administrators could pursue a CVA as an exit route. The current proposals suggest that at least two court hearings would be required to obtain the benefit of a three month moratorium. Mark Hyde, partner in our Restructuring/Insolvency group, expresses his views on the proposals: "The proposals recognise the fact that the UK insolvency regime is already highly regarded. Whilst I can see the benefit in extending the out-of-court pre-cva moratorium to larger companies, usually the complex finance arrangements and security structures of large scale businesses do not naturally lend themselves to this process. Much of what we are seeing in the market at present reflects this, and critically the proposals do not change the fundamental premise that a CVA cannot work unless the secured creditor is on board for the arrangement itself, so even though a moratorium may be imposed upon a secured creditor, that secured creditor must not object to the CVA proposal for it to succeed. However, the suggestion of a three month court-sanctioned moratorium proceeding is intriguing. It would effectively amount to a debtor-in-possession proceeding and would offer the opportunity for the incumbent management to propose a restructuring of the debtor without the need for an insolvency officeholder to be appointed to run the debtor in the meantime. The consultation paper envisages that any restructuring proposal that emerges must be implemented through a CVA - I think this will need to be tweaked, since complex restructurings are usually implemented via schemes of arrangement (which have certain advantages over CVAs)." Rescue or ransom: Rescue finance? The second theme of the proposals is facilitating access to rescue finance in the context of both administration and CVAs. The proposals explore achieving this by offering enhanced security and priority rights as an incentive to lend to troubled companies. In addition to this, the proposals contemplate overriding negative pledge clauses (which limit the granting of security) in certain circumstances. Rescue finance has been available in the context of Chapter 11 proceedings in the US for many years. This plays a critical part in the reorganisation process. The Chapter 11 process is renowned for successfully rehabilitating failing companies. Further, the process has barely any stigma attached to it as a

3 significant number of debtors exit and return to profitability. This is often attributed to the process itself and, to a certain extent, the availability of Debtor-In-Possession Financing (DIP finance). Philip Hertz, partner in our Restructuring/Insolvency group remarks that: "It has long been recognised that one of the key aspects to a successful restructuring, whether it be achieved consensually, through administration, a scheme of arrangement or a CVA, is the provision of future or continued finance. It usually therefore falls to the banks who ultimately hold the keys to encourage a successful rescue." David Steinberg, partner in our Restructuring/Insolvency group, also makes the point that: "Whilst DIP finance works well in the US, this is against a completely different security and priority regime. In the UK the proposals for such financing have the potential to become quite ugly where existing lenders do not agree to the basis upon which the rescue finance is provided. There will be plenty of scope for argument about whether the rights of existing secured creditors are likely to be prejudiced by the creation of new super-priority indebtedness, that said, the US market has to confront the same issue in Chapter 11 cases all the time." Priority ranking - in administration Fixed charge security; Costs and expenses of the administration in accordance with the order stipulated by the enacting legislation; Preferential creditors; Unsecured creditors up to a maximum of 600,000 if the company's net profit is 10,000 or more; Holder of a floating charge; Unsecured creditors Post-administration interest on debts; Deferred creditors; Shareholders (only if there is a surplus after the debts are paid). Prioritising finance costs The proposals seek to encourage rescue finance, in a number of different ways. The first is to allow the finance costs to rank ahead of other expenses in the context of an administration. This would mean that rescue finance costs would be paid before the fees of the administrators, which is a proposal that insolvency practitioners may not find palatable - essentially they would bear the risk that their costs would not be paid in the event of failure. Creating super-priority security The second aspect of the rescue funding, is to permit the creation of new security in an administration which ranks ahead of floating charges and unsecured creditors and, in certain circumstances, ahead of fixed charges (see above for priority ranking in administration). In this respect the proposals seek to upset the established priority upon which lenders base their original analysis of the costs/risks and benefits in extending credit. In cases where fixed charge holders do not agree to sharing their priority status - or are indeed being required to accept a subordinated status, the proposals in the consultation charge the insolvency practitioner who is appointed as administrator to show that the granting of the security is necessary to obtain the finance, that it is also in the best interests of creditors as a whole and that existing lenders are "adequately protected". This safeguard appears to be borrowed directly from the US Chapter 11 model which provides that in the event that the security is diminished - the debtor must provide "adequate protection" to secured creditors by making payments or providing additional security. The proposals do not however articulate what "adequately protected" would mean in the UK context. If the existing security holder considers that his rights have not been protected he may apply to court to challenge the new rescue security. This leaves understandable concerns on the part of lenders, who may be advancing finance on one basis to find that the security they thought they had is no longer available or has been diminished by a new lender in the context of the rescue finance arrangement. This type of finance completely erodes the established hierarchy of priority in the UK (see above: priority ranking - in administration). The proposals envisage that a new market may develop in the provision of rescue finance, and it is entirely possible that the commercial criteria applied by the rescue finance provider may not be aligned with the interests of the existing secured creditors. Of course those existing lenders have the option to provide the rescue finance themselves and could benefit from the same super priorities set out in the proposals. In addition the current proposals do not appear to envisage any controls being imposed on the rescue finance provider so as to ensure their continued commitment to the rescue operation - this may be best dealt with in the detail of the legislation. However, it may simply be left to the parties to negotiate whatever arrangement they can, against the backdrop of the court's ultimate veto and the rights of existing creditors to object to any given arrangement.

4 Mark Campbell, partner in our Restructuring/ Finance group comments: "Prioritising rescue finance in this way appears to be designed with the interests of the borrower in mind. In practice, in many cases already, existing lenders actively encourage business rescue by providing continued or new financing, and already as a matter of English law they can seek on a consensual basis to negotiate security and priority that properly reflects their risks in the context of a restructuring. The new proposals which seek to formalise the priority and, in some cases, override existing security, will no doubt give greater protection to those who have provided rescue financing but this appears to be at the expense of the existing lenders whose priority rights and security may be eroded. This may drive lenders generally to increase their pricing and adjust their risk models accordingly, which would be in no one's best interests. I would like to hear more about the protections that are envisaged to ensure that these proposals don't drive up the cost of finance in the good and not so good times." The proposals set out similar options to create new security in a CVA as a means to access finance. It is suggested that any risk of a shortfall to the existing lender brought about by the granting of the super-priority security, could be protected against by the debtor taking out insurance. How realistic it would be to obtain such insurance is one of the specific queries raised in the consultation. The final limb of the proposal of rescue finance extends to the release of certain assets subject to asset based lending arrangements (ABLs) upon the commencement of an administration or CVA. The proposals contain a specific reference to floating charges and whether they, and ABLs, should be limited to assets or book debts arising before the insolvency occurs, to enable the administrator to enter into new agreements and obtain further rescue finance. This again seems to present a fundamental attack on the priority ranking, although it is made clear that long term contracts where the company has had the benefit of the contracts already in its cash flow would be preserved. Riding into the sun set or shoot out! The proposals are described as refining the current law to make company and business rescue more successful and easier. However, some of the proposals do appear to challenge fundamental principles relating to security and priority which could potentially affect secured transactions that are already in existence. It appears inevitable that the changes (if introduced) will have a retrospective effect, although the consultation is not explicit in this regard. It should also be borne in mind that the consultation is very high level, and it may be that some of the preliminary concerns set out in this briefing may not be quite as radical if the adequate safeguards are implemented in any detailed legislative amendments that ensue. Charles Cochrane partner in our Restructuring/Finance group says: "I have been approached to comment on the proposals as part of a panel formed by the CLLS Financial Law Committee and I think that it is right that the Insolvency Service are seeking to consult on the proposals at this early stage especially when, at first blush, notwithstanding the fact that the proposals are presented as legislative enhancements rather then full scale reforms, they do seem to challenge some of the fundamental principles of security and priority laws". One thing that remains a certainty is that upon a total meltdown of a company, all stakeholders stand to lose out. Attempts to ensure that the UK insolvency regime promotes rescue and rehabilitation for the purpose of maximising value can, if approached in a balanced way, only have a positive effect on the economy at large. The proposals perhaps signal a growing trend towards creating an insolvency regime in the UK which is destined to be more debtor friendly. It is interesting that the proposals for rescue finance are based upon the US model. Whether these will encourage a rescue culture, will be debated in the months to come. What all stakeholders will wish to avoid is creating a Wild West scenario where existing lenders are held to ransom and opportunistic "rescue finance" is advanced to ailing debtors, regardless of whether it's likely to leave them "Dead" rather than "Alive!" The consultation is available via the attached link: http://www.insolvency.gov.uk/insolvencyprofessionandlegislation/con_doc_register /compresc/compresc09.pdf Clifford Chance's market leading Restructuring team brings together a large dedicated team of top ranked lawyers who can draw upon a broad range of expertise in areas such as finance, M&A, tax, pensions, capital markets, regulation and real estate, to deliver practical and commercially sound solutions for our clients. Our Restructuring team frequently partner with clients through all stages of the transaction - strategic planning, negotiation and implementation - and, where required, use our cross border expertise to give practical guidance on jurisdictional variances and issues. Our overall depth, scope, experience and detailed understanding means we are well placed to provide proactive legal and technical advice of a consistently high quality, irrespective of the scale and complexity of the transaction.

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