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The Walking Dead

With credit conditions tighter, more companies will be pursued by their creditors. But restructuring is becoming increasingly complex, contentious, and costly.
Economist Staff, The Economist
December 14, 2007

Mention the name Schefenacker to the London bankers, lawyers and advisers who specialize in turning around insolvent companies, and you are likely to be greeted with knowing smiles. Schefenacker, which makes mirrors for carmakers such as BMW and Mercedes, almost went bust late last year. In April it emerged from a tortuous restructuring, during which it moved its headquarters from Germany to Britain to take advantage of the flexible insolvency laws there. Along the way, its debt burden was cut by 47% and its founder had to give up three-quarters of his shares to creditors.

These things happen in business. But the reason for the gleam in the eyes of the London specialists is Schefenacker's bill for legal and advisory work: well over €40m ($59m). Compared with the £121m ($242m) that British Energy paid between 2003 and 2005 to its advisers when it got into trouble, this might seem small change. But Schefenacker, with total debts of €429m, was a tiddler next to British Energy. The nuclear-power company's restructuring involved £16.2 billion-worth of liabilities (£1.2 billion of debt and £15 billion for storing, reprocessing and disposing of spent nuclear fuel and for decommissioning power stations).

Expect more Schefenackers, courtesy of the credit crunch. As America's subprime-mortgage crisis has taken hold, credit conditions have suddenly tightened. In addition, rich economies look set to slow down — perhaps uncomfortably abruptly. The rate of corporate bankruptcies therefore looks sure to rise; and to stave off insolvency, many companies will have to reach agreement with their creditors on a restructuring of their debts.

Since mid-September an index of the cost of protection against defaults by low-rated American companies has soared. Moody's, a rating agency, predicts that the proportion of low-rated companies that default on their borrowing will rise from 1% to 4.2% within a year. And BDO Stoy Hayward, an accounting firm, thinks that in 2008 the number of British businesses becoming insolvent will go up by 9%, to a five-year high.

However, not all firms that go bust will be as lucky as Schefenacker, which at least kept its business more or less intact. Many firms undergoing restructuring could end up like corporate zombies, unable either to revive or to die while their creditors haggle over what should be done.

Changes to bankruptcy laws in both America and Europe in recent years ought to have made it easier to revitalise or kill off ailing companies. But companies' finances have become much harder to unravel. Offered cheap money on easy terms, companies — just like consumers and homeowners — have borrowed far more than they used to. The type and complexity of debt have grown too, as have the range and number of creditors.

All this has increased the potential for conflict when a company becomes insolvent. A high level of debt, relative to a company's assets, means that a good proportion of creditors will be left with nothing. Because any restructuring plan has to be approved by a majority of creditors, the ability of a group of lenders to hold out for a better deal has grown. Some institutions will have taken bets that a company will go bust, and so stand to make money if a restructuring fails. This sets the stage for long, fierce battles between different classes of creditor.

The Best Bankruptcy
Chapter 11 of America's bankruptcy code is widely regarded as the global gold standard for bankruptcy law. It protects a company from its creditors and allows its managers to stay in control until they can come up with a plan to reorganise the business (in contrast to Chapter 7, which deals with liquidating companies outright and selling their assets to repay lenders). After a Chapter 11 filing, a firm can continue borrowing money to keep going. Suppliers or customers cannot terminate contracts with it simply because of the filing. "Corporate bankruptcy in America has now lost any stigma it might have once had," says David Heller, a Chicago-based partner in Latham & Watkins, a law firm.

Since its introduction in 1978, the law (and the bankruptcy code in general) has spawned a huge industry of lawyers, advisers and even trade journals. Creditors argued that it was too soft on managers, pointing out that executives could take years to draw up a reorganisation plan while creditors could not put forward plans of their own. Inefficient companies could gain a substantial advantage in Chapter 11, because they could continue in business without having to service their debts. A classic example is the American airline industry: in 2005 four of the six big carriers were operating under Chapter 11.

Changes made in 2005 were intended to speed up reorganisation by in effect handing more power to creditors. Companies now have only 18 months to file a restructuring plan of their own, and the process of bankruptcy has become more expensive. Bosses also have less scope to award themselves large pay rises during bankruptcy.

If Chapter 11 has been thought of as too lenient, insolvency law in Europe has been notoriously severe. Companies with only short-term cash problems often ended up being liquidated. Directors were required by law in some countries to file for insolvency mere weeks after their companies became unable to pay their debts.


Some countries (Germany in 1999; France and Italy in 2005) have since introduced Chapter 11-style reforms. A European Union law introduced in 2002 has in effect made it easier for creditors and firms to seek insolvency in countries other than a company's official home.

Often, as with Schefenacker, this has meant Britain. British insolvency law has long been supportive of creditors whose debts are secured by companies' assets. Amendments in 2002, intended to give all creditors (not just secured ones) a fair hearing, have made little difference. One reason is simply that insolvent companies still need money to function; usually, they can borrow only from secured creditors, who will inevitably dictate the terms of such loans. The lack of separate sources of finance for insolvent firms remains a weakness of the system in continental Europe too. In America firms in Chapter 11 can borrow far more easily.

Chancery
All these legal changes could be rendered meaningless by the financial excesses of the past few years. As central banks around the world cut interest rates in the aftermath of the dotcom collapse and flooded the world with cheap money, companies found lenders queuing to offer them loans at very low interest rates. They were delighted to accept — and to play off one lender against another to get the easiest terms and lowest rates.

Not surprisingly, debt levels rose sharply in both America and Europe. According to Standard & Poor's Leveraged Commentary & Data (S&P LCD), a research unit that tracks lending to low-grade companies, the total debt issued by American companies of that class as a share of their gross earnings rose from 4% in 2001 to 5.1% in the first nine months of this year. In Europe the ratio increased from 4% to 5.9% in the same period.

The character of lenders has changed too. Until the late 1990s the biggest creditors, especially in Europe, were banks, which had first claim on a defaulter's assets. The others were usually bondholders, who had to be satisfied with what was left after the banks had been paid.

With the enormous expansion in the number of institutional investors (those other than banks, such as hedge funds), all that has changed. Even when banks made loans, they tended to repackage them and sell them, as bonds, to institutions, freeing up scarce capital. According to S&P LCD, in America the share of non-investment-grade loans held by institutional investors rose by 40 percentage points to 82% between 1999 and the year to September 2007. In Europe that share climbed from 4% to 55%.

Even smallish companies can now have dozens of debt holders. Several years ago, says Bob Hedger, of the Royal Bank of Scotland's restructuring department, the investors in any single deal used to be recognisable or small enough in number that he would know exactly whom to call in the relevant bank or fund. "When I look at the number of hedge funds who have entered the distressed market for debt in the past few years and now regularly hold the debt of distressed companies, many of the names are completely unfamiliar."

With the new investors has come a bewildering variety of loans. Instead of a short chain — secured creditors, unsecured creditors and shareholders — now there are senior or first-lien creditors (who have first dibs on a company's assets), second-lien creditors (who also have claims over the assets of a company, but who get paid only after first-lien creditors), mezzanine creditors, senior subordinated debt holders and subordinated debt holders. At the bottom of this caste system, as before, are the shareholders, who get any leftovers.

In the years of easy, plentiful credit, companies were able to demand looser conditions on their loans. Such conditions, known as covenants, typically specify limits on certain financial ratios, such as that of a company's earnings to its interest payments. If they are breached, creditors can force the company to fix its finances. Recently covenants have become so weak as to be ineffective. "There is a real risk that a company will default on payment obligations before it actually breaches its covenants," according to Ian Field, a partner of Allen & Overy, a law firm, in London.

When the main "sponsor" or the biggest shareholder happens to be a private-equity fund, the terms of a loan sometimes allow the fund to repair breaches in a covenant by putting more money into the company. More often than not, however, this merely delays the inevitable. "When the company finally comes to the table [to implement a restructuring], the level of financial distress is likely to be more severe and there will be less time to implement a successful restructuring," says Mr Field. Even in America financing for bankrupt companies may become more difficult to obtain, simply because companies are laden with so much debt. Lenders might well avoid companies with few assets not already mortgaged to others.

Games People Play
Diverse though they may be, almost all investors in a restructuring are of just two types. Many hedge funds are pure traders who buy debt cheaply and try to sell it as the price inches up, looking to make a quick buck. But there are often larger investors whose ultimate aim is to convert their debt to equity. These used to be mainly "vulture" funds, but now include a wide range of hedge funds and even specialised distressed-debt traders in large investment banks. When a company revives and its share price starts rising, such investors can sell their holdings for a handsome profit.


The problem for other investors round the table is in telling which is which. To compound the problem, as news of a company's troubles spreads, the price of its bonds tends to jump because investors are trading in and out of them. "When I notice a fund buying up the debt of a company for 93 cents on the dollar I can be pretty sure that they want to convert their debt to equity at some point in the future," says a banker. "It rarely makes sense to buy at that high a price for them to be satisfied with being paid off only at par [the full value of the bond]." So when talks start, several of those at the table probably want to end up owning some or all of the firm.

That is when the games begin. In both Europe and America insolvencies are increasingly "pre-packaged": creditors agree on a plan of restructuring before a formal insolvency. This can speed matters along. "Secondary investors, such as hedge funds, usually prefer a consensual out-of-court restructuring but will also have a 'Plan B' if this cannot be achieved. Some form of pre-packaged insolvency has become increasingly popular as a Plan B over the last year or so," says John Houghton, a partner at Latham & Watkins in London. In a "prepack" creditors have more control over the final outcome and run less risk of a fire sale of assets.

However, prepacks are quick only if creditors can agree on them. The creditors who will be paid only part of what they are owed are the most important in any deal because they can hold out for more. Those lower down, who stand to get nothing, can be forced to accept a restructuring plan. But it may be hard even to work out what the company is worth — and that is what determines which creditors get paid.

In December 2006, a couple of months after Schefenacker began its restructuring journey, another car-parts company had ended its own, even longer insolvency adventure. Meridian Automotive System, a Michigan-based company with 4,700 employees, had filed for protection from its creditors under Chapter 11 in early 2005. As well as issuing unsecured bonds, Meridian had borrowed around $485m in first- and second-lien loans.

For a restructuring deal to go through, it has to be approved by a majority (defined differently in different countries) of each "class" of creditor. Some of Meridian's biggest creditors were hedge funds which held a lot of first- and second-lien debt and in effect had a blocking vote in both classes. Contentious negotiations ensued over, among other things, the financing of the company through bankruptcy. In the end, a deal was struck which essentially handed more to second-lien lenders than they might otherwise have been entitled to. The entire bankruptcy took 20 months.

Meridian is hardly unique. As David Resnick, an investment banker with Rothschild in New York, points out: "Many hedge funds now invest 'strategically', often buying up large chunks of different parts of a company's capital structure, so as to be well positioned when that company needs to restructure or files for bankruptcy." To complicate matters even more, some creditors, having bought insurance against default, may make more if the restructuring fails than if it succeeds. Since the debt of such companies is easily traded, those around the table can often change, even as a plan is being debated.

When a deal cannot be struck, creditors may simply attempt to snatch control of the company. This happened in the battle over a European consumer-goods company earlier this year, according to a lawyer who knows the case. When the company ran into trouble, talks broke down between the hedge funds that owned a lot of its debt and the big private-equity firm that owned its shares, which refused to buy out the lenders. The hedge funds threatened to use the courts to take control of the firm's assets and sell them to a shell company wholly owned by them, leaving the private-equity firm with nothing. The private-equity firm retaliated by warning investment banks that they would be blacklisted if they funded the creditors. Faced with the risk of losing the company (an American bank was willing to take the risk), the private-equity firm agreed to a buy-out of creditors anyway. This drama took nine months.

Disagreements among creditors can be costlier still. Talks among creditors of American Remanufacturers, a third car-parts firm, broke down when second-lien lenders claimed that first-lien lenders could not finance the company through bankruptcy without their permission. The court agreed with them. Since the price for such permission would almost certainly have been equal treatment of both classes, the first-lien lot walked away, leaving the company with no money. It was shut down and its assets were sold. Neither set of lenders was paid more than a pittance.

The demise of American Remanufacturers was swift. Just 11 days after its Chapter 11 filing, it became clear that the company would have to be liquidated. But this example, like that of the European consumer-goods company, illustrates both the tactics creditors use and the consequences when they misfire. In an analysis for the American Bankruptcy Institute, Mark Berman of Nixon Peabody, a law firm, remarks: "An observer has opined that the first- and second lien-holders took out their guns and shot each other. From any perspective, it is hard to understand who won or who benefited by the result achieved in this case."


Amid all the threats and tactics, the health of the company is often forgotten. "With so many parties, a lot of time goes in just managing differences and arguing over how to cut the cake rather than figuring out how to increase the size of it," says Stephen Taylor, of AlixPartners, a restructuring firm, who managed Schefenacker through its bankruptcy.

The big restructurings of a few years ago — WorldCom and Eurotunnel, for instance — tended to be those of companies with billions of dollars in debt and assets. Only rarely did businesses of Schefenacker's or Meridian's size have to endure long insolvencies. Many such firms cannot afford to. They may end up among the walking dead.




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