On the 22nd of November, the European Union announced a proposed directive for a framework of reforms to its member states’ restructuring and insolvency laws. The EU proposal reflects a philosophy and approach that U.S. investors will find familiar: a regime that allows distressed companies to restructure often yields greater recoveries for creditors than a regime that relies exclusively upon liquidation. Indeed, the proposal points to a World Bank study, which shows that countries that have restructuring regimes yield average recoveries to creditors of 83%, compared with countries that exclusively have liquidation procedures and which yield average recoveries of 57%. Given the proposal’s expressed goal of promoting restructuring, it is not surprising that the proposed directive also borrows many of its features from chapter 11 of the U.S. Bankruptcy Code.
The following is a quick summary of some provisions of the EU proposal that practitioners and investors familiar with the U.S. Bankruptcy Code might recognize.
Insolvency is not a precondition to restructuring
Outside the U.S., creditors often are puzzled by the absence of any requirement that a debtor (other than a municipal debtor) be insolvent in order to commence a case under the Bankruptcy Code. The EU proposal now follows in that direction. One of the themes of the proposal is that troubled enterprises should be encouraged to consider restructuring discussions at an early stage and not wait until they are insolvent to address their financial difficulties. To facilitate this, the proposal removes the condition that an enterprise be “insolvent” as a condition for entering into negotiations and obtaining a stay of enforcement actions. To balance against potential abuse, though, the proposal requires a showing of a “likelihood” of insolvency to confirm a restructuring plan.
The debtor remains in possession
The proposal incorporates the concept of debtor in possession and permits a debtor to continue to operate its business and remain in control of its assets during the restructuring negotiations. Part of the rationale for this change is to avoid unnecessary costs. Accordingly, the proposal does not require the appointment of a restructuring practitioner in every case, but instead states that EU member states may request such an appointment where, for example, the debtor is granted a stay, or a restructuring plan contemplates a possible “cross-class cram-down” (discussed below).
A form of automatic stay temporarily protects against enforcement actions
The proposal does not necessarily provide for an automatic stay similar to section 362 of the Bankruptcy Code, but it does permit a debtor that is engaged in restructuring negotiations to request the applicable judicial or administrative authority to impose a stay, even before the commencement of a formal proceeding. The stay may be against particular creditor actions or may be a general stay. Among other things, it would apply to prevent termination of contracts by creditors at least to the extent such contracts are necessary for the ongoing operation of the debtor’s business, but the debtor also has an explicit obligation to continue to comply with its obligations under such contracts while the stay is in effect. Moreover, the proposal incorporates the prohibition against enforcing ipso facto clauses in contracts while the stay is in effect.
The automatic stay imposed by section 362 remains in place during the course of a bankruptcy case unless and until the affected creditor demonstrates cause for relief from the stay. In contrast, the initial stay under the EU proposal is limited to four months, and the debtor has the burden of demonstrating progress in its negotiations to obtain an extension. Moreover, the maximum duration of the stay is twelve months. The proposal also incorporates a concept of relief from the stay if a creditor or class of creditors demonstrates that it would be “unfairly prejudiced” by the stay or if creditors demonstrate that they could block confirmation and do not support continuation of the negotiations.
Financing a distressed enterprise, even on a superpriority basis, is encouraged
The proposal notes that, under certain national laws, creditors that extend financing to distressed companies face the risk of avoidance actions or may incur penalties for extending credit to insolvent enterprises. These laws may jeopardize the ability of distressed companies to obtain needed financial support while they attempt to negotiate a restructuring plan. The proposal, therefore, states that such financing should be exempt from the application of avoidance actions or such penalties, but only if the financing is “reasonably and immediately necessary for the continued operation or survival of the debtor’s business or the preservation or enhancement of the value of that business pending confirmation of the company’s restructuring plan” and is not “carried out fraudulently or in bad faith.” Because of its potential impact on creditors, the proposal contemplates that, even during the course of out-of-court restructuring negotiations, the member states may require the debtor to seek the approval of the relevant judicial or administrative authority for such financing. Although the proposal does not go so far as to mandate superpriority treatment for new financing, it encourages member states to consider adopting “further incentives” to encourage new lenders to take the risk of financing companies in financial distress.
Impaired classes of similarly situated creditors vote on the restructuring plan
The proposed directive incorporates the concept of voting on restructuring plans by classes of similarly situated creditors. The proposal relies upon national law to determine class formation criteria, but it notes that secured creditors always should be treated separately from unsecured creditors. A plan proponent may seek advance guidance from the judicial or administrative authority on its proposed classification scheme. As is the case under section 506(a)(1) of the Bankruptcy Code, the proposal recognizes that national law may provide for a secured creditor to have both a secured and an unsecured claim based upon the value of its collateral. In addition, to the extent that the applicable national law also gives affected shareholders the right to vote, the proposal preserves that right. On the other hand, it overrides any requirement that a company convene a meeting of shareholders and offer shares to shareholders on a pre-emptive basis, but only to the extent necessary to ensure that shareholders do not abuse their rights to frustrate restructuring efforts. It also makes clear that unaffected creditors should not have the right to vote. The proposal looks to national law to determine majority voting requirements, but specifically states that voting majorities should be based upon the amount of creditors’ claims or equity holders’ interests and that the voting threshold cannot exceed 75% of the amount of claims in a class.
Cramdown and the absolute priority rule come to Europe
The EU proposal incorporates the basic U.S. principles of cramdown of a plan over a dissenting class of creditors or shareholders (assuming shareholders are permitted to vote under the national law), which it calls “cross-class cram-down.” As with section 1129(a)(10) of the Bankruptcy Code, at least one affected creditor class1 must have accepted the plan for cramdown to occur, other than a class that, based upon a valuation of the debtor, would not be entitled to receive any payment under the normal ranking of claim priorities. The only other specific requirement2 imposed for cross-class cram-down is the absolute priority rule, which prohibits a class of claims or interests junior to a dissenting class from receiving or retaining anything under the plan. In applying the absolute priority rule, the proposal expressly provides that the judicial or administrative authority should look to the debtor’s “enterprise valuation,” which is focused on the longer term value of the debtor’s business and, as a rule, should be higher than a going-concern liquidation value. Even if cross-class cram-down does not apply, approval of a plan also requires a finding that any new financing is necessary to implement the plan and does not unfairly prejudice the interests of creditors.
Reorganization must be better than liquidation under the “best interest of creditors” test
The proposal expressly incorporates (and uses the term) the “best interest of creditors” test to protect dissenting creditors and dissenting classes of creditors. Therefore, a plan proponent must demonstrate that the dissenting creditor or creditor class would not be worse off under the restructuring plan than it would fare in a liquidation of the debtor. The proposal states, though, that the valuation should be conducted both as a piecemeal liquidation and as a sale of the debtor as a going concern.
The plan must be feasible
The proposal also includes a requirement that the plan proponent demonstrate that the plan is feasible. Under section 1129(a)(11) of the Bankruptcy Code, the test for feasibility is that the plan is not likely to be followed by a liquidation or a need for further financial reorganization of the debtor (unless the plan contemplates such liquidation or reorganization). In the language of the EU proposal, the plan proponent must demonstrate that the plan has a “reasonable prospect of preventing the insolvency of the debtor and ensuring the viability of the business.”
The proposal attempts to clarify duties of directors of distressed companies
The EU proposal attempts to strike a balance between inhibiting directors of a distressed enterprise from taking actions in furtherance of a restructuring and protecting creditors from management decisions that may further diminish the value of the debtor’s estate. While urging that directors not be “dissuaded” from pursuing the restructuring path and encouraging directors to seek the advice of restructuring professionals, the proposal does state that directors should “avoid any deliberate or grossly negligent actions that result in personal gain at the expense of the stakeholders, agreeing to transactions at under value, or taking actions leading to unfair preference of one or more stakeholders over others.” The proposal, however, fails to draw any bright lines on these standards.
Trained insolvency courts will expedite the process and bring transparency and predictability
The proposal notes the difference in the length of insolvency procedures among the member states and attributes some of the delay to the lack of a trained group of judicial and administrative professionals. It also emphasizes the need for transparency and predictability of outcomes. To this end, it proposes that member states have specially trained judicial or administrative bodies to oversee insolvency proceedings and suggests the creation of specialized courts or chambers in accordance with national law. To expedite the process, the judicial or administrative body must rule on a request for confirmation within 30 days after the request is made (a feat not always achieved in complex U.S. restructurings).
What does the proposal fail to address?
The proposal does not address certain aspects of individual countries’ laws, such as the conditions to commencing an insolvency proceeding (except for the prohibition of creditors commencing an insolvency case during the operation of the stay), what constitutes “insolvency,” and claim priorities. Avoidance actions also are not addressed in general, but the proposal provides that certain actions in connection with the proposed restructuring will be exempt from avoidance. The proposal notes that, given the link between a country’s insolvency laws and other laws, attempting to impose uniform insolvency laws in certain areas could affect a country’s commercial law in other areas. While not addressing priority of claims, the proposal does encourage member countries to adopt regulations that give new and interim financing priority over pre-restructuring debt.
The proposed directive also does not make any changes to insolvency laws affecting consumers. It notes that, in contrast to businesses (which often obtain financing on a cross-border basis), consumers are more likely to obtain loans from local banks. On the other hand, it also notes that a recent study showed that the lack of consistent insolvency laws applying to consumers has served as a barrier to selling retail financial products on the cross-border basis.
The EU proposal is just that – a proposed directive that will have to be examined by the member states and the European Parliament. Once the directive is adopted, the member states will have two years to implement the changes required by the directive.
1 EU member states may increase the number of affected classes required to accept the plan for cross-class cram-down to apply.
2 Note that paragraph 28 of the commentary accompanying the proposal states that cross-class cram-down requires that “dissenting classes are not unfairly prejudiced under the proposed plan,” but Article 11 of the proposal does not impose the requirement.
For a summary of the proposed directive from a German perspective, please read New EU proposal for a preventive restructuring framework.