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LOAN WORKOUTS AND DEBT FOREQUITY SWAPS

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LOAN WORKOUTS ANDDEBT FOR EQUITY

SWAPSA Framework for Successful Corporate Rescues

By

Subhrendu Chatterji and Paul Hedges

JOHN WILEY & SONS, LTDChichester • New York • Weinheim • Brisbane • Singapore • Toronto

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Subhrendu Chatterji and Paul Hedges have asserted their right under the Copyright, Designsand Patents Act 1988, to be identified as the author of this work.

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Library of Congress Cataloging-in-Publication Data

Chatterji, Subhrendu.Loan workouts and debt for equity swaps: a framework for successful corporate

rescues/by Subhrendu Chatterji and Paul Hedges.p.cm.—(Wiley finance)

Includes index.ISBN 0-471-89339-01. Corporate turnarounds. 2. Corporations-Finance. 3. Corporate debt. 4- Corporate

reorganizations. I. Hedges, Paul. II. Title. III. Wiley finance series.

HG4028.R4 C46 2001658.15—dc21

00-068517British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN 0-471-893390

Typeset in 10/12pt by Laser Words, Chennai, IndiaPrinted and bound in Great Britain by Biddies Ltd, Guildford and King's LynnThis book is printed on acid-free paper responsibly manufactured from sustainableforestation, for which at least two trees are planted for each one used for paper production.

To a banker, his wife, their daughter-in-law and her son

—SC

To Coelho

—PJH

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CONTENTS

Foreword by David Wilson Havelock xiii

PART I: INTRODUCTION AND BACKGROUND 1

1 Introduction 3The environment for loan workouts 4Objectives of this book 6Intended audience 7Structure of the book 7Terminology used 10Acknowledgements 10

2 Loan workouts: what they are and why they are needed 13Introduction 13Background to statutory insolvency frameworks and loan workouts 13The need for corporate recovery and rescue frameworks 14Statutory and voluntary frameworks for corporate distress 15Statutory insolvency frameworks 16Voluntary rescue frameworks 20The nature of loan workouts 21The benefits and disadvantages of loan workouts 21Factors affecting the effectiveness of loan workouts 23

PART II: STRATEGY, PARTIES AND THE PROCESS 27SECTION A: LOAN WORKOUT STRATEGIES AND 29STRUCTURES

3 A framework for managing non-performing loans 31Introduction 31Elements of a non-performing loan strategy 32The role of credit risk strategy 33Prevention and control 33Timely identification 34Protective steps and remedial actions 35

viii CONTENTS

The role of specialist teams 35Communication channels and feedback loops 36Impact of the bank's wider strategy 37

4 Organisation and systems relating to non-performing loans 39Introduction 39Positioning the loan workout unit 39Responsibility and authority 42Transfer of responsibility for cases 43Loan workout unit structure and resources 44Early warning systems 46Problem loan classification 48Asset management companies 49

5 Managing loan workout transactions 51Introduction 51Business philosophy and integrity 51Transaction management 55Controlling transaction-related costs 57

SECTION B: THE PARTICIPANTS 61

6 The company 63Introduction 63Company features conducive to loan workouts 63Key stakeholders involved in a loan workout 65Directors and management 65Shareholders 68Employees and trade unions 70

7 The banks 71Introduction 71The bank group 71The co-ordinator 72The steering committee 76Facility agents and security trustees 78Position of individual banks 79

8 Other key participants in loan workouts 81Introduction 81Factors limiting participation in loan workouts 81Non-bank financial creditors 82Debt traders and investors in distressed debt 84Suppliers and other creditors 86Preferential creditors 87Customers 87Governmental and other agencies 88

Contents ix

9 External advisors 89Introduction 89Reasons for engaging external advisors 89Independent advisors 91Reporting accountants 92The company's external auditors 95Legal advisors 96Investment banking advisors 97Other advisors and experts 98

SECTION C: THE LOAN WORKOUT PROCESS 99

10 A framework for executing loan workouts 101Introduction 101Loan workouts in context 101Anatomy of a financial restructuring transaction 102Implementing the framework 107The moratorium, restructuring and refinancing 108

11 Turning around a business 109Introduction 109Internal causes of corporate decline 109Operational control failures and fraud 112External causes of corporate decline 112Symptoms of corporate decline 112Achieving short-term operational stability 114Components of enterprise restructuring 115Sequencing restructuring activities 117Interaction between business restructuring and loan workouts 118

12 The information gathering and review process 119Introduction 119Initial internal appraisal 119Obtaining information externally 121Reports of reporting accountants 122Other advisors' reports 126

13 Exploring loan workout options 127Introduction 127Review of debt workout options from the lenders' perspective 127Short-term 'exit' strategies 128Medium-term 'controlled exit' strategies 130Long-term 'financial restructuring' strategies 132

14 Evaluating restructuring options and developing proposals 135Introduction 135Types of risk in a loan workout 136

X CONTENTS

Assessing the risk of a financial restructuring proposal 139Returns from loan workouts 140Liquidation value 142Evaluation 142Developing financial restructuring proposals 144

15 Negotiating and completing transactions 147Introduction 147Ingredients of an effective negotiating process 147Negotiating strategy 149Bank lenders 150Holders of bonds 151Shareholders 152Completing the transaction 152Documentation and agreements 153Loan workout information memorandum 154

PART III: THE MORATORIUM AND FINANCIALRESTRUCTURING 157SECTION A: THE MORATORIUM 159

16 Establishing a moratorium 161Introduction 161Causes of a moratorium 161Principal features of a moratorium 162Advantages and disadvantages of moratoriums 164Underlying principles 165Key provisions of moratorium agreements 166Documentation structure 169

17 Financial creditors affected by a moratorium 171Introduction 171Determining who to include in a moratorium 171The position of different financial creditors in a moratorium 173

18 The operation of facilities in a moratorium 179Introduction 179Determining commitment levels 179Issues relating to different types of facility 180On-going operation of facilities 182

19 The concept of loss-sharing 191Introduction 191The importance of loss-sharing 191Definition and framework 192Why is a loss-sharing arrangement necessary? 193Loss-sharing provisions and documentation 194Loss-sharing and different types of facilities 196

Contents xi

Sharing the reward as well as the risk 196Loss-sharing provisions in a restructuring agreement 197

20 Multi-Currency considerations 199Introduction 199Causes of currency-related complications 199Limits and utilisation 200Distributions and loss-sharing 202Hedging 207

SECTION B: FINANCIAL RESTRUCTURING 209

21 Financial restructuring 211Introduction 211Objectives of a financial restructuring 211Developing financial restructuring proposals 212Key information needs 213Entity priority and ringfence structures 215New financ ing 216Security-related issues 219

22 Inter-creditor provisions in a financial restructuring 223Introduction 223Priority rankings 223Pre-enforcement distributions 226Post-enforcement loss-sharing and indemnities 231Decision-making and voting 231

23 Other terms and conditions 233Introduction 233Undertakings 233Financial covenants 235Term and commitment 239Restrictions on assignment and transfer 240Remuneration 240

SECTION C: DEBT FOR EQUITY SWAPS 243

24 Introduction to debt for equity swaps 245Introduction 245Definition 246Advantages of debt for equity swaps 247Disadvantages of debt for equity swaps 248When is it appropriate? 249Principal transaction parameters 250

25 Transaction approach 253Introduction 253The need for specialist advisors 253

xii CONTENTS

Transaction-related considerations 254Impact on information gathering and assessment 255Assessing the appropriateness of debt for equity swaps 256Evaluating debt for equity swap proposals 256Negotiations 258Exit-related considerations 261

26 Equity instruments 263Introduction 263Ordinary shares 264Preference shares 266Convertible debt instruments 270Warrants 270Other equity instruments 271Structuring principles 272Inter-creditor issues 276Valuing equity instruments 276

27 Other transaction parameters 279Introduction 279Proportion of debt converted into equity 279Proportion of equity for lenders 285

28 Other technical issues 289Introduction 289Accounting-related matters 289Taxation 291Selected legal and regulatory issues 291Transaction mechanics 292Swap of debts in subsidiaries 293

PART IV: CASE STUDY 295

29 Project Gloucester 297Introduction 297Background 297Moratorium 298Causes and impact of the financial crisis 300Business restructuring 301Financial restructuring 302Debt restructuring 303Debt for equity swap 305Evaluation 307

Index 309

FOREWORD

When I was approached to provide a foreword to this book I was enthusiastic for tworeasons.

Firstly, I have known the authors personally for many years, having worked with themon major cross-border reconstructions which of necessity involved working into theearly hours of the morning in crisis situations. Such was the desire and commitment toachieve a beneficial outcome for all stakeholders outside insolvency. The authors haveextensive knowledge of the strategies and techniques required to achieve equitable andsuccessful workouts, and these are shared in this book.

Secondly, although workouts cannot be too prescriptive, I have long believed thata book of this nature was needed in the market place, outlining the principles ofvoluntary problem debt standstills and associated restructurings and documenting themethodologies which have been established by experienced practitioners over the years.

Although the recessions of the 1970s and early 1980s saw instances where corporatesentered insolvency proceedings or were involved in rescue operations mounted by theirbankers, subsequent UK recessions have seen an unprecedented level of problems interms of the number of cases, the magnitude of debt and the degree of complexityinvolved. Despite high profile collapses, in the vast majority of cases a successfulrecovery has been engineered to the benefit of all the stakeholders involved in eachbusiness.

Many lessons have been learned and re-learned during this period. At the same time,whilst standard procedures have arisen to deal with most cases, the level of generalexpertise required and flexibility necessary to produce solutions has, of necessity,increased to a considerable degree.

The rescue or 'workout' process will in most instances broadly encompass the variousphases outlined below. It has been consistently proven that the earlier a problem isidentified/predicted, particularly if this can happen whilst relative stability still exists,then the quicker and, in all likelihood, the more successful the turnaround will be.

These steps effectively cover a three-way process:

• The identification/early warning of distress and an initial assessment of viability.• The support operation encompassing standstill principles and including, as necessary,

a full financial restructuring.• The recovery process and the commercial measures needed to achieve a turnaround/

rescue.