The impact of the new proposal for an EU restructuring directive on Loan-to-Own strategies

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Master Thesis

European Private Law (LL.M.)

Amsterdam Law School

The impact of the new proposal for an EU

restructuring directive on Loan-to-Own strategies

by Johannes Mönch, LL.B.

Supervisor: Prof. dr. Rolef de Weijs

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Windscheid, Bernhard Lehrbuch des Pandektenrechts, Second Volume, First Part,

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1. Introduction

When a company is in serious financial trouble, the last thing on the mind of most people will probably be how they can become the owners of that company. Yet that is exactly what some distressed debt investors are considering in that situation. If the company has a viable business and the problems are principally limited to the financing of the company, it might even be worthwhile to acquire the company. To that end, these investors can benefit from the distressed status of the company, since it is often possible to acquire the company’s debt at a significant discount. The acquired debt can then be used in a second step to acquire the company and thus become the owner. This approach to taking over a company is known as Loan-to-Own (LTO). The goal of this paper is to answer the question, how the proposed Directive for a preventative restructuring framework1_{will impact LTO strategies in the European Union.}

To answer this question, it is necessary to first of all understand how LTO strategies work. After chapters 2 and 3 provide a general introduction to the topic and a look into US law, chapter 4 will examine the current state of affairs concerning relevant legislation in Europe. With all of this in mind, chapter 5 will attempt to anticipate the impact of the proposed Directive (Proposal) on LTO strategies in Europe. Chapter 6 will then analyse the findings of the previous chapters and chapter 7 will provide a summarized conclusion.

Any research into LTO strategies warrants a look at the current situation in the United States, where, due to the ubiquity of such activities,2_{quantitative research provides us with insights}

into the dynamics associated with such endeavors. This is why chapter 3 extends the general introduction to LTO of chapter 2 to focus specifically on developments in the United States. The findings of this chapter will then contribute to the overall estimation of the impact of the Proposal on LTO in Europe.

To illustrate the status quo in Europe, it would be ill-advised to consider only EU legislation. Rather it makes sense to also include Member State law into the thought process as it plays a significant role in determining the legal environment for LTO strategies. As the Proposal comes 1 Directive of the European Parliament and of the Council on preventive restructuring

frameworks, second chance and measures to increase the efficiency of restructuring, insolvency and discharge procedures, COM/2016/0723 final - 2016/0359 (COD), published 22.11.2016

2 Harner/ Griffin/ Ivey-Crickenberger, p. 182: LTO strategies are pursued in appr. 25-30%

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in the form of a Directive in need of national implementation, it is important to realize that the European conceptions will have to be integrated into Member State law.

While it would be desirable and worthwhile to extend deliberations to all Member States, this would go beyond the possibilities of this thesis. Because of the author’s familiarity with it, this paper will therefore be limited to German law. Though it can only serve as an exemplary illus-tration of the impact at Member State level, it can help to illustrate the multi-level complexity of regulating a commonly cross-border commercial phenomenon in a multi-layered system of governance.

The research question is by its very nature speculative. The overall approach of this paper is therefore not the more common strict deduction, which most legal analysis is based on, but rather to gather information, in order to make an informed speculation on the likely impact of the Proposal.

Finally, while the introduction of a harmonized pre-insolvency restructuring regime will also have a much more fundamental effect on the commercial and insolvency law systems of the Member States, the assessment of chapter 5 will focus mainly on those aspects of the Proposal that will have an impact on LTO strategies and mostly ignore the general debate surrounding the pros and cons of pre-insolvency proceedings.

The author of this paper hopes to contribute to a much-needed discussion on LTO in Europe, as well as on the intricacies regarding the introduction of a common European pre-insolvency restructuring regime.

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2. Brief overview of Loan-to-Own strategies

The following chapter provides a brief introduction to LTO in general. The first part offers some historic context of this phenomenon and the second part is concerned with the different strate-gies of LTO investing. The third part subsequently explores the important question, which debt positions will be targeted respectively with these different strategies. Finally, the last part will explore points of concern regarding LTO.

a. Historic background

Investors who seek to gain active control over a company through purchasing its debt did not emerge overnight. Even before the latest financial crisis there were developments in the finan-cial markets which facilitated the activities of such investors. For example, since the mid 1990s there has been a trend to securitize debt and to further turn it into collateralized loan obligations, which significantly increased the liquidity and tradability of debt.3

LTO strategies are usually employed by so-called “alternative investors”. These include private equity and hedge funds, as well as investment banks. They are alternative investors as opposed to banks as traditional sources of financing.

As these classic suppliers of debt financing disengaged more and more from distressed debtors, the 2000s saw the rise of specialized distressed debt investors (DDIs).4_{When the Enron}

Corporation filed for chapter 11 protection on the December 2nd_{, 2001, two of their three largest}

corporate bondholders were Angelo, Gordon & Co. and the Baupost Group.5_{With both of them}

being alternative investors and both following a distressed investment approach, they started buying up corporate bonds as Enron was headed for insolvency.

The unfolding of the latest financial crisis made for a difficult M&A market, as banks stayed clear of the financing necessary to execute such deals. They did so in an effort to reduce the amount of sub- and non-performing loans (NPLs) in their portfolio.6_{The ensuing tightening of}

banking regulations furthered the banks’ need to shed substantial amounts of their NPL load,

3 Altman, p. 76

4 Bücker/ Petersen, p. 804

5 Goldschmid, p. 201

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meaning that distressed debt was sold at significant discounts. Therefore the inclined investor could find plenty of opportunities to acquire distressed debt.

Ironically, the distressed debt was itself sometimes the result of prior deals by alternative investors. Leveraged buyouts for example in their typical form result in a heavily indebted target company, which in turn could then prove to be the target for LTO strategies.7

As the heydays of leveraged buyouts came crashing into the financial crisis, there was a significant number of overleveraged companies carrying enormous amounts of distressed debt. Additionally, the ensuing low-yield environment, pushed investors to riskier investment strategies.8_{This included the acquisition of distressed companies via LTO strategies, which}

potentially offered significantly higher profits than average market returns at the time.

As the aftermaths of the ‘largest financial shock since the Great Depression’9_{drag into}

the late 2010s it is therefore no coincidence that investors are still keeping a close eye on insolvency legislation.10_{The issue is however by no means a new one. Although the technical and}

economic environment may have changed drastically since antiquity, ancient Romans were far from oblivious to the topic.

The issue of acquiring debt at a significant discount, while still being able to benefit in full from the rights granted by the debtor, was brought to the attention of the legal advisors to Emperor Anastasius, who saw themselves confronted with an early form of ‘financial raiders’ buying up distressed debt at a discount in order to claim the full outstanding amount later on.11_This

resulted in the so-called lex Anastasiana, a rule which capped the amount of money any acquirer of debt would be able to claim by the price he or she paid to assume the debt.

7 Florstedt, p. 2346

8 ibd.

9 International Monetary Fund: World Economic Outlook, April 2008, p. 4. Available at https://www.imf.org/external/pubs/ft/weo/2008/01/~/media/Websites/IMF/import ed-flagship-issues/external/pubs/ft/weo/2008/01/pdf/_textpdf.ashx.

Retrieved 23.05.2017.

10 According to a survey in the European Distressed Debt Market Outlook 2017 by Debtwire, 78% of those surveyed seek equity control of companies via LTO, p. 3 (http://mergermarketgroup.com/wp-content/uploads/2017/01/DW-Distressed- Debt-2017_Final-LR.pdf)

11 Corpus Iuris Civilis C 4, 35, 22: “[…] quosdam alienis rebus fortunisque inhiantes, cessiones aliis competentium actionum in semet exponi properare, hocque modo di versis personas litigatorum vexationibus afficere […]”, ca. 506 A.D.;

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While most modern legal systems do not employ such a general provision, there still seems to be a certain feeling of unease when it comes to people exerting rights derived from debt they have acquired against a distressed debtor. 12

As we will see in this paper, investors can currently benefit from the dissimilar treatment of debt versus equity investing by way of restructuring and insolvency instruments under current investment regulation. This makes it worthwhile to take a closer look at LTO strategies on the dawn of a harmonised European pre-insolvency restructuring regime.

b. Deal strategies

As the name suggests, the goal of any LTO strategy is to eventually own a target company. There are two ways to acquire ownership of a company through debt. The first one is to acquire debt with the intention of later converting this debt into equity through a debt for equity swap.13

The ultimate goal of this transaction is therefore to acquire the majority of the shares.

Secondly, debt can also be used to attain an advantageous position in an eventual bidding pro-cess for the assets of a company. In this scenario, by acquiring the bulk of a company’s assets the business of the company has de facto also been overtaken by the bidder. Although the com-pany is still owned by the original shareholders, it is now stripped of its business. The options for executing an asset deal vary slightly, but one method under US law is to credit bid with secured debt that was previously acquired for that purpose.14_{Potentially, this allows the investor}

to ‘cherry pick’ assets from a company,15_{while leaving the undesirable obligations behind.}

The reasons for M&A activity in general are manifold. Classic goals are an increase in market control, synergy effects, reducing the overhead, market access, reducing risk through diversification and many more.16

All these motivations can also apply to active-control distressed investing. However in essence, LTO investing is a form of value investing, since the DDIs will target companies, which they 12 Landers, p. 3: [Agreeing with this, but…] “Mere opportunistic behaviour by the LTO

investor does not provide grounds for legal sanctions.”

13 Harner, p. 157

14 ibd.

15 Aleth/ Böhle, p. 1187

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regard as being undervalued in the market.17_{The investors therefore seek to profit from the}

market’s faulty evaluation regarding specifically the future potential of the distressed company. If the investors are correct and the market did undervalue the company, they stand to profit from the gap between their internal estimation and the market prices. Chances for finding such op-portunities are available as approximately 60% of the debt issued unrated or with a CCC rating is expected to default eventually, while about 25% will not even last one year.18_{Distressed debt}

investing includes not only LTO strategies, but also the possibility of short-term trade. This means that the investor aims to flip the acquired debt for a quick profit.19_{Unless the goal is pure}

securities trading, taking a controlling interest in a company is viewed as the preferable path in distressed investing.20

This is also the kind of distressed debt investing this paper is concerned with. It should however be noted that an investor following an LTO strategy can for example simultaneously provide DIP financing for the company during restructuring or insolvency.

Since the actual process of auctioning off assets under insolvency law is not a primary subject of the Proposal, this paper will mostly concentrate on the debt for equity approach. Credit bid-ding can however be part of LTO strategies, which is why chapter 3 will take a look at recent developments in the US in this regard, without which the picture of LTO strategies would be incomplete.

c. Targeted debt position

Companies usually finance themselves not only in one, but multiple ways. Aside from the equity, which shareholders contribute to the company’s capital this also includes various types of debt. This debt can for example be composed of outstanding claims from trade creditors and classic secured bank loans, but can also include corporate bonds and more complex securities. The type of debt which is targeted will depend chiefly on the deal strategy employed by the DDI. It is a direct result of what position the DDI is aiming for at the end of the process. When the goal is to acquire the assets of a company in an auction, the investor will try to procure

17 Moyer/ Martin/ Martin, p. 59

18 Nevins, p. 50

19 Gray/ Greenway/ Bibeault/ Metzger, p. 129

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senior secured debt, which can be used to acquire the secured assets later on. This kind of debt means that the investor is now in the group of the highest ranking creditors in any insolvency proceedings, which gives him a priority status when it comes to the distribution of the insol-vency estate. Depending on the jurisdiction, claims from secured debt are also largely protected from being depleted through restructuring plans and are subject to extraordinary satisfaction during insolvency. The US Bankruptcy law also allows for secured debt to be used as means of payment during insolvency. Further details in the following chapter.

The importance of that particular strategy at least for the United States was demonstrated by

Gilson et al., who found a positive relationship between the level of secured debt in a company

and the likeliness of it being the subject of an acquisition during insolvency.21_{Regarding the}

bargaining position during negotiations over a restructuring plan, it is also noteworthy, that the number of secured claims is typically limited. This makes it relatively easy to gain control over this class of creditors.22

When the DDI is trying to acquire the majority of a company through a debt for equity swap, things are not quite so straightforward. To understand why it is important for the investor to purchase the right kind of debt, it is helpful to consider, how an insolvency will typically play out for the creditors involved in the proceedings.

While pari passu may be one of the phrases most frequently cited, when it comes to insolvency, its meaning is very much limited to the equal treatment of similar creditors. What actually makes all the difference in insolvency is the ranking of groups of similar creditors. A higher ranking class of creditors will always be paid out first, before the next in line will be con-sidered. There is virtually never enough money to pay all the creditors, otherwise the company would probably not have declared insolvency in the first place.

Most commonly in a real world liquidation scenario this means that the secured creditors will get all their money, unless they were unwise enough to be undersecured. The lowest ranking creditors and the shareholders will receive nothing. Finally, there is the group of creditors, who still receive some small amount. They get partial satisfaction out of the remaining insolvency estate according to a quota, which distributes the funds equally over the group. The debt which they hold will be referred to as the fulcrum debt, because it is the critical point in the financing,

21 Gilson/ Hotchkiss/ Osborn, p. 26

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where the investor needs to place its lever to break into the company.

If someone proposes to settle the insolvency through negotiating a restructuring plan instead of simple liquidation, the pay-out under the, for the time being, hypothetical liquidation scenario will play an important role. The restructuring plan can include a debt for equity swap, but this only makes sense for certain creditors. The secured creditors, who already receive 100% of their claim are already completely satisfied and have no debt left, which they can swap. The out-of-the-money lowest ranking creditors would of course like to receive something, but their bargaining power is next to zero. If they were to propose a plan which includes a debt for equity swap for them, while simultaneously not fully paying a class of creditors, which is above them in the ranking and is partially in-the-money under liquidation, the plan could be stopped by these fulcrum creditors. As long as a senior dissenting class of creditors is not fully satisfied, no junior class may receive any kind of consideration. This so-called absolute priority rule will be further explored in chapter 5.

It is therefore up to the fulcrum creditors to negotiate the swapping of at least part of their debt into shares. What exactly constitutes this fulcrum debt depends of course firstly on the funds available for distribution and secondly on the different classes of debt and their ranking. If there are no subordinated and preferred creditors the fulcrum debt might consist of the entire unsecured debt, including the trade debtors. The trick from the investor’s perspective is to an-ticipate which class of creditors will be just in-the-money. The holders of the fulcrum debt can be compared to the equity holders in normal times, as they are arguably also the company’s residual owners.23_{At times it can of course be difficult to identify where the fulcrum security is}

in a company, the argument over which can prolong restructuring efforts.24

All of this also demonstrates the importance of the debt structure of a company for the fea-sibility and success of different LTO strategies. While banks may be willing to sell off their distressed debt even if it is in the form of ‘plain vanilla’ bank loans and traditional loan facili-ties, the possibilities for assigning such instruments are typically more restricted than those of bonds, which as securities were after all created to be traded in the first place. In addition, the specific terms of the different debt instruments and the percentages they make up in relation to the overall debt of a company will have an impact on the potential for success of LTO strategies.

23 Harner, p. 161

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d. Points of concern

As with any contested takeover strategy, LTO investing is regularly met with a certain degree of antagonism. This paper will not go into a general discussion of the pros and cons of hostile takeovers,25_{a debate which includes the ideas of efficiency through a market for company}

control26_{on the one side and the stakeholder approach}27_{on the other side. There are however}

certain issues specific to LTO strategies from the shareholders’ and the creditors’ point of view as well as regarding the efficiency of such behavior in general.

i. From the shareholders’ point of view

Since LTO investing means that the original shareholders of the company will eventually either lose their shares or alternatively the business controlled by the shares, you would expect to find the most fervent opposition against any LTO coming from this group. However, this does not automatically mean that the law should leap to the aid of the shareholders to defend them against the outside investor.

Although there is evidence to suggest that while the shareholders of the acquirer benefit from above-average returns, the shareholders of the target company appear to pay the price, ac-cording to a study by Meier/ Servaes,28_{it must be said that the shareholders of the insolvent}

company are not the primary concern of insolvency law. In a liquidation scenario they would presumably receive nothing at all, so the fact that they are losing out cannot provide a sound argument to prohibit all LTO activity. They are also obviously unable or even unwilling to pro-vide additional financing and have therefore forfeited their stake in the company.

ii. From the creditors’ point of view

The threat by LTO takeovers can have a similar effect on a company’s management as 25 cf. ibd., p. 174: Benefitial effect depends on the viability oft he proposed turnaround concept.

26 For this debate see for example Fortier

27 See for example Hanly, p. 904: The idea of implicit contracts with stakeholders, such as employees.

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leveraged buyouts (LBOs). In the same way LBOs can be thought to serve the alignment of the interest of management and those of the shareholders, LTOs can serve to prevent a lack by the management to pay attention to the interests of creditors. Treating the company’s creditors well will presumably deter them from selling their debt to someone else.

At the same time it is at least questionable whether the original debtholders are very well suited to deal with distressed debt, especially in terms of their respective motivation. DDIs offer an exit opportunity for the holders of distressed debt,29_{especially smaller creditors,}30_{who may be}

unfit to deal with distressed debt. This may prove especially necessary in smaller companies, since banks are more likely to help big respectable businesses with many employees, as they do not want to be publicly associated with such a business failing.31_{It might also be one reason to}

explain why the likelihood for the involvement of LTO investors seems to rise the smaller the company.32

Put in positive terms, distressed investing replaces the original creditors, who were typically anticipating a relatively low-risk investment with new creditors who voluntarily engage in a high-risk investment and are presumably also equipped with the necessary level of sophistica-tion and tolerance for risk.33

Lastly, if the goal of the investors is the continuation of the business, they might also want to keep the trade creditors happy, who would otherwise be unlikely to recover anything from their outstanding claims.

iii. Efficiency concerns

From a more neutral perspective the mere risk of LTO can potentially discourage companies from taking on too much debt in the first place. This might keep companies from the dangers of overleveraging, which include the possibility of suddenly becoming insolvent, because of a relatively minor decrease in the company’s assets, thereby avoiding LTO activity altogether.Alternative investors, such as hedge or private equity funds and investment banks, which

29 Sharfman/ Warner, p. 61

30 Kamensky, p. 238

31 Finch, p. 320

32 Li/ Wang, p. 130

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typically engage in LTO are sophisticated financial investors, who possess high analytic abilities, management know-how and the necessary capital.34_{They may consequently come up}

with more creative solutions, because of their proficiency regarding M&A, and may streamline the restructuring process by consolidating debt into the hands of a single party.35_Alternative

investors are also more willing to actually take an equity stake in a company compared to banks.36

It is even possible that in certain situations LTO investors are going to be the only source for financing restructuring efforts37_{and fending off liquidation. They will simultaneously offer}

DIP financing38_{based on their interest in a successful turnaround. Thus they might be the only}

chance to actually achieve a restructuring of the company as envisioned by the Proposal. Overall, LTO investors typically distinguish themselves from short-term DDIs by their longer investment horizons, as their primary interest is to achieve a successful turnaround. Especially for public companies this could even mean that they carry an interest much more focused on the long-term development of the company than the average shareholder, who may buy and sell shares based on their shot-term trade value.

LTO does however also carry the potential for negative effects regarding efficiency. One issue which frequently comes up in connection with bidding on assets in an auction with acquired debt, is referred to as the chilling effect. This relates to the idea that the mere presence of bidders in an auction, who can bid using the value of their secured claim, can discourage others from even entering a bid. There might also be a kind of chilling effect when it comes to the debt for equity swap strategy. In this context, the presence of the investor and simultaneously the majority creditor may push aside more viable restructuring ideas.

Another concern is the increase in complexity and confusion, which can be the result especially of the involvement of multiple rivalling debt investors. The ensuing conflict can prolong the restructuring process and even lead to less than optimal results, while simultaneously draining resources and focus from the target company’s management.39

34 Nevins, p. 50

35 Kamensky, pp. 237 et seq.; also Sharfman/ Warner, p. 61

36 ibd., p. 238

37 Altman, p. 85

38 Harner, p. 162

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The highly dynamic nature of distressed investing and the need to adapt and switch strategies may result in a constant change of creditors,40_{which further hinders consistent negotiations.}

The resulting delay is also likely to decrease the value of the estate.41_{This leads to the more}

general question of whether there should be a restriction on the possibilities to change the identity of a creditor during restructuring negotiations to ensure consistent partners for the negotiations.

It should also be noted that DDIs through their participation in restructuring or insolvency proceedings gain access to non-public, privileged information,42_{which is potentially at odds}

with the idea of price efficiency in an ideal market. The market ideal is based on well-informed participants determining the correct price, because they are aware of all the relevant factors. The evaluation of distressed investor activity may then very well differ from case to case and also depend to a large extend on who you ask:43_{senior creditors, shareholders,}

management, junior creditors, trade creditors and other stakeholders, such as people continuing in the company’s employ. In fact many of the more economic issues regarding LTO might not be substantially different from those found in other M&A or restructuring and insolvency scenarios.44_{As we will see in the following chapters, the interesting issues arise when we look}

at how LTO activity is regulated.

40 Thomas, p. 215

41 ibd.

42 Sharfman/ Warner, p. 61

43 Harner/ Griffin/ Ivey-Crickenberger, p. 169

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3. LTO in the United States

By virtue of its constitution, bankruptcy law in the United States is governed by federal law and is largely codified in Title 11 of the United States Code, referred to as the Bankruptcy Code (BC). While chapter 7 of the BC governs the liquidation of businesses, this chapter will mostly concentrate on the rules of chapter 11, which is concerned with reorganization.

a. Debt for equity swap in the US

Within chapter 11, sec. 1123(a)(5)(J) permits debt to equity swaps as part of the reorganization plan. This provision principally facilitates LTO strategies, which aim to eventually gain the majority of the shares. Chapter 11 also provides a cram-down mechanism, which can be found in sec. 1129(b) BC that can be instrumental in pushing through an LTO agenda against the will of other parties involved.

US law does however put in place some obstacles concerning the purchase of claims. Although courts consistently hold that it is perfectly legal to purchase claims, even if the purpose is just to create standing in insolvency proceedings45_{, this can be a different story for the transfer of}

claims during proceedings, where courts might for example grant an injunction against the transfer of unsecured debt.46

The classification of claims is another matter, which can have tremendous influence on the chances for success of LTO strategies. Courts have also prohibited putting substantially similar claims in different classes, if the purpose of such a classification was purely to influence voting.47

45 e.g. Hall Fin. Group, Inc. v. DP Partners, Ltd. Partnership, 106 F.3d 667, 670 (5th_Cir.

1997)

46 Pan Am Corp. v. All Unsecured Creditors, Adv. No. 91-6175A (Bankr. S.D.N.Y. Oct. 3, 1991)

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b. Credit bidding in the US

The most interesting developments pertaining to LTO in the United States can be observed when LTO investors wanted to make use of the possibility to credit bid under sec. 363(k) BC. This has resulted in a number of cases, which will be the subject of part c of this chapter. The provision allows holders of secured claims to offset the price they have to pay for an asset during the auctioning off of the estate by the amount of the secured claim they hold on the asset. This credit bidding enables secured creditors to effectively use their claims as cash in an auction.

One problem that arises is linked to the uncertainty over the level of security rights on the debt held for example by large banking syndicates48_{and the fact that these creditors do not have}

to actually put up money during the auction, all of which may discourage other bidders and lead to a suboptimal price. In the context of distressed investing, this chilling effect is very pronounced, because DDIs are able to purchase the distressed debt at a discount, but are able to use it at face value for credit bidding.

c. Recent developments regarding credit bidding in the US

There have been a number of cases in the United States, which have been going back and forth between explicitly permitting and curbing credit bidding in certain constellations, including the involvement of investors following a LTO strategy. The most important ones were Philadelphia Newspapers49_{(2010), RadLAX}50_{(2012), Fisker}51_{(2014) and Aéropostale}52_(2016).

The entire discussion revolves around a tiny word in sec. 363(k) BC: “[credit bidding is permissible] […] unless the court for cause orders otherwise […]”. What exactly constitutes such cause is up for debate. For a long time, courts held that only egregious behaviour by the creditor could be regarded as sufficient cause. Then, in Philadelphia Newspapers, the court ruled, based on their interpretation of sec. 1129(b)(2)(A) BC, that the right to credit bid could be

48 Belton, p. 116

49 In re Philadelphia Newspapers, LLC. 599 F. 3d 229, 247 (5h Cir. 2010)

50 RadLAX Gateway Hotel, LLC, v. Amalgamated Bank, United States Supreme Court 132 Ct. 2065 (2012)

51 In re Fisker Auto. Holdings, Inc., Case No. 13-13087(KG) (Bankr. D. Del. Jan. 17, 2014)

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excluded, when the encumbered asset is sold as part of a reorganization plan, so long as the secured creditor still receives the ‘indubitable equivalent’. This lead to uncertainty over the question, whether credit bidding as a concept was generally incompatible with reorganization. The ruling in Philadelphia Newspapers was not upheld by the Supreme Court in RadLAX, where other creditors wanted to keep a stalking-horse bidder from exercising his right to credit bid by referring to Philadelphia Newspapers and other cases. The court denied affirmation of a plan including a cram-down, which would have excluded credit bidding. This seemed like an overall strengthening for credit bidding and maybe even a final word on the subject.

However, only two years later in Fisker53_{the court curbed the ability of Hybrid Tech Holdings,}

LLC, who was looking for an asset deal, to credit bid with its debt in the face amount of $ 168.5 mn, which they had purchased for $ 25 mn, by limiting it to the purchase price. The court ex-pressly relied on the idea of the chilling effect of credit bidding in their arguments.

Recently, in Aéropostale the Bankruptcy court raised the bar again for capping the amount secured creditors can credit bid, stating that ‘cause’ is not given until there is impermissible conduct.54_{It also noted that the court in Fisker was concerned about other aspects of the case}

besides the chilling effect and that in any case the chilling effect alone could not be sufficient ‘cause’ under sec. 363(k) BC.55

The entire discussion can be viewed as the conflict between the right of secured creditors to foreclose on collateral and the right of the debtor to restructure under Bankruptcy law.56_{In that}

sense, guaranteeing the right to credit bid also preserves the bargain the secured creditor made outside bankruptcy.57_{In the context of LTO strategies, it is however questionable, whether the}

debt is correctly priced as the investor wants to exercise his financial leverage and not preserve any prepetition investment decisions.

53 Also the same year In re Free Lance-Star Publishing Co. Case No. 14-30315-KRH (Bankr. E.D. Va Apr. 14, 2014)

54 In re Aéropostale, Inc., Case No. 16-11275 (Bankr. S.D.N.Y. Aug. 26, 2016), p. 63

55 ibd., pp. 76 – 77 56 Keating, pp. 466 et seq.

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It remains to be seen, if the Aéropostale judgment was the last word in this matter. This debate should perhaps motivate lawmakers on the other side of the Atlantic58_{to address the issue of}

credit bidding preventatively. Otherwise the scattered system of insolvency and restructuring proceedings throughout the Member States may lead to a similarly chaotic situation under a unified restructuring regime.

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4. Status quo in the European Union and its Member

States

a. European Union law

i. Takeover Bids Directive

The first piece of EU legislation we will consider is the Takeover Bids Directive of 200459_{. As}

early as 1977 the European authorities realized the importance of regulating the takeover mar-ket. However, it would take all of 27 years and a dedicated High Level Group for these efforts to result in legislation.

It makes a lot of sense not only to regulate, but more importantly to harmonize the rules on takeovers within a single market. Otherwise, Member States could unilaterally put in place rules which ease the requirements for domestic companies to take over a target company in an-other Member State, while simultaneously putting up defensive provisions against takeovers of domestic companies by foreign entities. This contravenes the idea of a level playing field, which necessitates symmetrical takeover conditions.

The Takeover Bids Directive managed to implement some important rules, such as making offers mandatory (art. 5) and stopping the board from interfering with potentially lucrative offers (art. 9). Yet the opt-in-opt-out-mechanism in art. 12 curbed a lot of its theoretical punch, particularly regarding the creation of a uniform framework in all the Member States.

Even more importantly though, art. 2 par. 1 (e) defines securities for the purposes of the Directive as transferable securities with voting rights. That means that LTO strategies, which are after all based on the acquisition of debt, even if it is in the form of securities, are principally not within the scope of the Directive.

In this context, takeovers by way of debt acquisition can even by viewed as a potential tool for circumventing takeover regulation. Barring cases of abusive use of preventative restructuring to force a change in control before the company is in critical distress,60_{the situation of a}

take-over during restructuring or insolvency is fundamentally different from a normal taketake-over. In a normal takeover protection of the shareholders against the loss of their rights without any 59 2004/25/EC

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justification, should be one of the goals of takeover regulation.

This is different for distressed takeovers. There is a potential reason for shareholders to lose their rights. It is the fact that the company has run out of money, with the original shareholders being unwilling or unable to provide further financing. Additionally, their shares at this point have very little value, which means that they have very little economic interest left in the com-pany.

Therefore, the primary goals of distressed takeover regulation are concerns of inter-creditor rights and fairness. This means that although the issue might seem far from classic insolvency law at times, insolvency law is still the appropriate legal discipline to deal with those kinds of transactions.

ii. European Insolvency Regulation

The European Insolvency Regulation (recast) of 201561_{aims to resolve questions of}

interna-tional jurisdiction, recognition and applicable law for the field of insolvency law. This includes proceedings which aim to restructure debt and rescue the debtor (art. 1 par. 1). For example, art. 47 addresses issues arising out of the juxtaposition of main and secondary proceedings for restructuring efforts, in an effort to preserve the effectiveness of such undertakings.62

The Regulation does however not provide substantive rules on insolvency or rescue procedures, but is an instrument of private international law. As such it bears no direct impact on the feasibility of LTO strategies, though the rules regarding recognition and enforcement will help to ensure that the national results of restructuring under the Proposal can unleash their power throughout the European Union.

In this context it is noteworthy that the disapplication of the Regulation63_{to the territory of the}

United Kingdom would call into question the attractiveness of England as a location for the 61 2015/848, for proceedings opened after 26th June 2017 (art. 84). Formerly: 1346/2000 62 Also see: CJEU Handlowy C-116/11: National courts should take into account,

whether restructuring efforts in main proceedings could be disturbed by secondary proceedings.

63 The European Insolvency Regualtion is also not a Text of importance for the European Economic Area and therfore continued application would not be mandated in case the United Kingdom decides to continue as an EEA EFTA member.

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restructuring of companies from other Member States. This would give even more relevance to the preventative restructuring framework of the Proposal as European companies seek restruc-turing in their domestic legal systems.

iii. Lack of harmonized substantive insolvency law

As briefly mentioned in the context of the European Insolvency Regulation, there is as of yet no harmonized substantive insolvency law on a European level. The tapestry of restructuring law is still very much ‘European’. That is to say, not only spread out over 28 Member States, but also, owing to historical developments and the larger legal context, very diverse. There are significant differences between the English scheme of arrangement, the French procédure de

sauvegarde and the Italian concordato preventivo, to name but a few.

It remains to be seen how high the degree of harmonization will be that the Proposal brings to this tapestry. Many issues pertaining to restructuring are highly integrated within the general civil and insolvency law context of national law. Also, the steps of escalation between informal restructuring and full-blown liquidation are often crafted as a logical chain of events, which provide a prescribed procedure. This poses the danger of disruption, when broken by the improper insertion of alien elements. As a result, national legislators will have their work cut out for them, when transforming the European Directive into 28 Member State preventative restructuring regimes.

Regarding LTO strategies, this does mean that the national legislator is well-advised to con-sider the totality of the legal rules applicable when evaluating whether the right incentives and cautionary measures are in place. This is why the following part will give a brief introduction to relevant German law to stress the fact that the dynamics of LTO strategies will in future be determined by a combined system of European and national law.

b. German law concerning debt for equity swaps

i. ‘Insolvenzplanverfahren’

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into the formal proceedings under the Insolvenzordnung (InsO). Currently, there is no pre- insolvency restructuring regime under German insolvency law. That of course does not mean that informal restructuring by means of agreements between the parties do not occur. As in any other country around the world, debt arrangements are commonly and constantly renegotiated. It does however mean that those parties cannot rely on any legal mechanisms beyond general rules of civil law to facilitate a successful debt restructuring. An important and exceptional example of these instruments, provided by securities law, will be explored in part ii.

The insolvency proceedings under the InsO recognize that liquidation is sometimes not the ideal way of dealing with an insolvent company. That is why sec. 1 InsO proposes to reach an arrangement in an insolvency plan as an alternative to liquidation. The

Insolvenzplanver-fahren64_{supports plans to restructure a debtor as long as they seem promising at the time. It}

does so by offering the possibility to act as debtor in possession65_{and even grants a temporary}

stay of 3 months.66_{Crucial for LTO, a debt for equity swap can be part of the plan.}67

Since the authorized capital of a company, especially in an insolvency scenario, will usually not be sufficient to execute such a plan, a debt for equity swap would theoretically also require the cooperation of the members of the general meeting.68_{However for the purposes of an}

insol-vency plan the decisions of the creditors’ committee effectively substitute those of the general meeting69_{and the court can even substitute the approval of the plan by the shareholders, if the}

conditions of sec. 245 InsO are satisfied. These conditions aim to guarantee, that the dissenting class gets at least what they would have gotten in case of liquidation and that no other class takes advantage of them. Therefore, even though the shareholders are part of the vote on the insolvency plan,70_{they can be overruled by a majority of the other classes.}71

There are a number of points which are of particular interest, when it comes to LTO strategies. The InsO, in sec. 162, shows a certain amount of distrust against purchasers of a company that 64 sec. 217 et seq. InsO

65 sec. 270 et seq. InsO

66 sec. 270b (1), (2) icw. sec. 21 (2) no. 3 InsO

67 sec. 225a InsO. For details cf. e.g. Servatius in Spindler/ Stilz, par. 72

68 For details on how this works outside insolvency under German law, see part ii. 69 sec. 245 InsO

70 sec. 222 (1) no. 4 InsO

71 Even when they do not receive anything, if that would have been the case in liquidation as well: insolvency of the Pfleiderer AG, Amtsgericht Düsseldorf, Az.: 501 IN 84/12 et al.

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are simultaneously creditors, if their claims make up more than one fifth of all claims. The legislator presumes that those constellations lack transparency and might not result in fair prices72_{and therefore mandates the consent of the larger creditors’ assembly, instead of the}

smaller creditors’ committee. This might be particularly important for small creditors not represented in the creditors’ committee, whose only other line of defense is to prove a ‘serious statutory violation’ according to sec. 253 par. 4 InsO.73

Another issue with LTO strategies can arises, if a party establishes, that the debt for equity swap under the insolvency plan constitutes excessive compensation (Überbefriedigung), which can potentially preclude the application of the cram-down mechanism of sec. 245 InsO.74_{This could}

be a problem for LTO investors, particularly if they bought the debt at a significant discount and managed to swap it for the majority of the shares. On the other hand, sec. 254 (4) InsO explicitly bars the debtor from claiming compensation from a former creditor based on the over-valuation of the relevant claims. This is an issue which may need to be settled by courts in the future. Finally, on a side note, owing to some recent reforms, loan agreements between banks and companies can now contain a clause excluding the possibility to transfer the loan,75_{if they were}

entered into after 2008.76_{This is certainly one way to make it harder for any LTO deal to take}

place.

ii. Debt to equity swaps under the SchVG

Although no pre-insolvency restructuring mechanism exists under German insolvency law, there is a second way to execute a debt for equity swap. Outside of insolvency the Schuld-verschreibungsgesetz (SchVG) contains rules regarding corporate bonds. This act reflects the problems faced by a company which has financed itself by way of bonds, when it runs into financial difficulties. In that situation, any efforts to restructure the debt might be hampered by the sheer number and anonymity of the company’s creditors.

The SchVG therefore establishes mechanisms to resolve conflicts regarding the modification of 72 Bork, Einführung in das Insolvenzrecht, p. 234 et seq., par. 439

73 cf. Florstedt, p. 2352 74 Spliedt, § 245, par. 20

75 sec. 354a HGB 76 sec. 64 EGHGB

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the terms of the bond etc. If those terms allow for majority votes77_{, the measures which can be}

voted upon explicitly include swapping debt into shares of the company.78_{As a modification of}

the essential terms of the bond, this requires a 75% majority in terms of the number of votes.79

In practice a debt for equity swap will regularly require the consent of the general meeting of the shareholders.80_{Under German corporate law for public companies, the swap will}

typical-ly be executed in two steps, both of which require the approval by the general meeting. First there will be a reduction in capital,81_{followed by a raise in capital with the bondholders using}

the release of their debt as contribution in kind to acquire the newly issued shares.82_Critically

this last step involves an exclusion of the right of the original shareholders to acquire the new shares, in which case they would have a chance to preserve their respective voting power. The exclusion of this so-called subscription right83_{requires the approval by the general meeting with}

a majority vote representing at least 75% of the share capital.84

This of course reflects the difference the German legislator assigns to the situation of a debt for equity swap outside versus inside insolvency. Cram-down mechanisms inherently carry the risk of depriving someone of their rights, which they are entitled to by virtue of their position as shareholder.85_{While it is generally accepted that insolvency makes it necessary to forego some}

of those rights, the same cannot be said for a liquidity crisis outside insolvency.

Specifically, this results in higher thresholds for voting and the level of involvement of the shareholders. This is of course critical to LTO investors, since their usually contested takeover attempt typically revolves around the cram-down mechanism, if they cannot persuade the original shareholders through pressure to make way for the new investors.

At this time German law puts up significant hurdles for the LTO investor when it comes to pre-insolvency takeover attempts. Acquisitions of distressed companies under German law outside insolvency currently have to rely on general civil law. This has also led to some 77 sec. 5 (1) SchVG

78 sec. 5 (3) no. 5 SchVG

79 sec. 5 (4) SchVG. Option to require a higher (not lower) threshold in the terms. 80 cf. Wegerich/ Gittermann, p. 71 or Bücker/ Petersen, p. 804

81 sec. 229 et seq. Aktiengesetz (AktG) 82 sec. 182 et seq. AktG

83 sec. 186 (1) AktG 84 sec. 186 (3) AktG

85 Guaranteed a spart of the right to private property by the German constitution in art. 14 GG.

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interesting contractual solutions, such as the double-sided trust, where a contractual trustee is put in a roughly similar position to an insolvency trustee.86_{Once in formal insolvency however,}

German law does readily permit debt for equity swaps within certain limits, while especially sec. 245 InsO facilitates efficient takeover strategies.

c. German rules on the satisfaction of secured creditors

German law also includes rules which may become relevant for any LTO investor following a credit bidding approach. In its rules on the separate satisfaction of secured creditors the German Insolvency Statute (InsO) institutes rules which subtract the costs of the associated transactions from the proceeds distributed to the secured creditor.87_{The costs are principally rated as a lump}

sum and consist of the costs for the determination of the object and the connected rights (4%), the costs for the disposition of the asset (5%) and, if applicable, turnover tax (19%).

The common reaction by the creditors, when they create the security right on the asset, will be to factor in those costs.88_{This in turn creates a gap between the assumed market value}

of the underlying asset versus the principal of the credit agreement. The result is a kind of taxation effect on the potential profit achievable in an auction, as the difference between the credit bidding value and the purchase price of the debt is reduced. The gap can also be regarded as an unsecured portion of the value of the asset and if large enough, could convince other bidders to bid over the value secured by the security right and up to the market value of the asset, thus negating the advantage held by any credit bidder.

Mandatory fees such as the ones found in sec. 170 and 171 of the InsO can therefore be considered to potentially discourage LTO strategies based on credit bidding.

86 e.g. Wildberger/ Reuter 87 sec. 170, 171 InsO

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5. The impact of the proposed Directive

The following paragraph will reflect on general issues regarding restructuring outside formal insolvency in connection with LTO strategies. The rest of this chapter will then cover specific issues concerning the impact of more technical aspects of the Proposal.

a. Pre-insolvency restructuring

The entire point of the Proposal is to introduce into the Member States an instrument which allows companies to restructure before they enter formal insolvency proceedings. If distressed investing would be limited to just swapping the identity of the creditors without any other consequences the discussion could probably stop at this point. As it stands, LTO investors seek to push out the original shareholders to acquire ownership of the company. When they then use restructuring and insolvency rules to bring about this change in control against the will of the majority of creditors, questions of legitimacy can arise.

As also described in the previous chapter, the idea of curtailing and even discarding claims is well within the international acquis of insolvency law. In fact, it can be said to lie at the heart of any insolvency proceedings, as the law tries to solve the problem of there being too little money for too many people. It is also typical to introduce a ranking, which puts the shareholders of a company at the very bottom of the list when it comes to pay-outs. Since the entire proceeding is generally executed to ensure the creditors receive as much as possible on their outstanding claims,89_{it makes sense to introduce rules which keep the shareholders from jeopardizing a}

restructuring plan, if it could lead to higher pay-outs for the creditors.90

The idea is also that at this point, the shares have no more economic value anyway and the shareholders therefore no longer any stake in the company. This is obviously somewhat untrue in an LTO scenario, because the DDI would not seek ownership of the shares, if they were economically worthless.

The rule of law includes the concept, that property rights cannot be rescinded unless there is a very important reason for such measures. While the future of a business involves 89 cf. Bork, Principles of Cross-Border Insolvency Law, p. 129 et seq.

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stakeholders beyond the shareholders of the company, it is problematic to deny those shareholders the right to determine the future of their company, when the financial difficulties have not yet led to a complete standstill. While it is certainly a good idea to prevent unnecessary insolvencies, the law should also tread lightly when it comes to curtailing shareholders’ rights just because there is a financial crisis. The company is run for the benefit and also for the risk of the shareholders and they cannot deny their responsibility for the financial difficulties. Addressing those difficulties before insolvency should mandate a more cautious approach than that within insolvency proceedings.

The potential of losing the company to a distressed debt investor should be factored into the concept of rights for application, voting and cram-downs. Whether or not contested takeovers in the form of LTO investing are overall beneficial or not, there is a danger of interested parties abusing preventative restructuring for a takeover at a time, when the company was not unavoidably heading for demise.

To that end, the implementation of art. 4 par. 4 of the Proposal should be handled with care. Even if the creditors can only apply for the opening of proceedings with the agreement of debt-ors, the economic situation might very well enable large creditors to “persuade” debtors to file an application anyway. This might open up a lane for investors to extend the potential range of companies, with which they can successfully use LTO strategies, since they are no longer necessarily restricted to those companies in the direst financial situations.

Generally speaking, there is a danger of the pre-invsolvency resturcuring framework envisioned by the Proposal to act as an instrument, which displaces the mechanisms and effects of formal insolvency forward into the pre-insolvency phase. Even if the final Directive would introduce provisions which discourage LTO strategies, pre-insolvency restructuring might still be viewed as a mere procedural precursor to formal insolvency. If there is then already a robust possibility for an LTO investor to achieve a debt for equity swap under national insolvency law, the orig-inal shareholders might regularly see themselves in no position to engage in a fruitless battle they will lose eventually. Thus they might agree to a debt for equity swap in a pre-insolvency restructuring under the mere pressure of future formal insolvency.

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b. The cram-down mechanism

To efficiently and effectively represent the different interests of all the parties involved under the proposed restructuring framework, art. 9 par. 2 of the Proposal adopts the popular idea of putting affected parties into different classes according to similar interests. At the least, secured and unsecured creditors shall be separated into different classes.

The Proposal includes a cross-class cram-down mechanism in art. 11. This means that the ju-dicial or administrative authority conducting the proceedings can confirm a restructuring plan, which has not received the approval of all the classes. Crucially for LTO strategies, art. 12 also suggests putting shareholders into a separate class, so that they may not ‘unreasonably prevent’ a viable restructuring plan. If adopted in the suggested form, this would mean that shareholders are completely open to the cross-class cram-down of art. 11 of the Proposal.

For the purposes of LTO strategies it could prove relatively easy under those circumstances to attain the necessary majority of classes which agree with the plan, even against the will of the shareholders, so long as the plan is attractive enough for the members of the majority of the other classes.

c. Best-interest test

The best-interest test91_{ensures that no dissenting class shall be worse off under a restructuring}

plan than they would be if the company were liquidated. This test should however generally not provide any significant obstacle for the LTO investor.

First of all, regarding the shareholders, it is important to notice that the Proposal refers to the test as the ‘best interest of creditors test’, which excludes shareholders from the protected group by definition. Even if the shareholders were included as part of an extensive interpretation of the rule, the test can only be negative for the shareholders, if it can be demonstrated that there is palpable residual value left in the shares. This will typically not be the case for the companies targeted by LTO investors.

The best-interest test is also designed to address a different problem. The idea behind 91 artt. 11 par. 1 (a), 10 par. 2 (b); art. 2 (7)

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the test is to prevent shareholders and/or large creditors from putting smaller creditors at a disadvantage through striking deals which favour only the former at the expense of the latter. It is not supposed to address the issue of shareholders coming under pressure from major creditors. Secondly, LTO takeover attempts should also not be derailed by the test when it comes to the other creditors. The presumption would generally be that under liquidation most unsecured creditors would face a zero pay-out quota, which makes them irrelevant for the best-interest test. Moreover, trade creditors may in fact benefit from the interest of the LTO investor in the continuation of the business.92_{This could even include paying any outstanding claims they have}

against the company to ensure their future cooperation.

d. Absolute priority rule

Another prerequisite for the cross-class cram-down is that no class junior in the insolvency ranking to a dissenting class may receive anything, if the dissenting class is not fully satisfied.93_{This rule was primarily designed to specifically prevent the shareholders from using the}

restructuring plan to shed all of the company’s liabilities through a debt cut, while retaining some form of capital, which they own through their shares.

The basic idea is that all types of capital have an assigned ranking in insolvency, which is part of their value and therefore their pricing even outside of insolvency. This does not only include the different levels of security rights and subordination regarding debt, but also explicitly in-cludes shares, which in this context, can be seen as the riskiest investment tranche available. When things go well for the company, the shareholders can benefit in full from the accumulated profits. If things do not go well however, they have to accept the risk of losing the money they invested in its entirety. To uphold the correct price and risk attributions, it is therefore necessary to prevent them from using a restructuring plan to circumvent the insolvency ranking.

The only situation where the absolute priority rule could become relevant for LTO investors is if they would attempt to squeeze out senior creditors in a debt for equity swap scenario. The dis-tressed debt investor has for example acquired the fulcrum debt position of asset backed bonds, while there are also other senior creditors that hold claims which are secured by mortgages

92 Landers, p. 2

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senior to that of the asset backed bonds. If the LTO investor than tries to get a plan approved which would include not paying the senior secured creditors in full, the court would not grant approval based on a violation of the absolute priority rule.

The absolute priority rule has no bearing on the asset based takeover scenario, as the LTO investor will operate based on senior secured debt and is therefore entitled to the first position in the pay-out ranking.

One thing which is a bit peculiar about LTO strategies in this context is the fact that the LTO creditors will themselves become the shareholders after a successful transaction. However, this does not constitute a circumvention of the absolute priority rule by means of a kind of time shift. This rule wants to prevent the shareholders from turning the insolvency ranking upside down, it does not want to prevent the replacement of the original shareholders by the creditors. Coming from the opposite side of the company’s financial structure, shareholder loans can be of concern to the LTO investor. As de Weijs points out,94_{shareholder loans could be used as}

means to circumvent the APR, since they give the capital in question a sort of double quality as equity and debt. The shareholders become creditors could now jeopardize the execution of an unfavourable deal by the LTO investor, if this deal relies on a cram-down regarding the share-holders.

The rules on shareholder loans are not part of European insolvency law. It is therefore another example of the observation already made, that the actual functioning and performance of the Proposal will depend critically on its interaction with pre-existing national legislation in the individual Member States.

e. Lack of corresponding transparency rules

One of the biggest concerns regarding LTO strategies is the dissimilar treatment of debt investing versus equity investing. Active-control distressed debt investors seek to benefit from the fact that, from their point of view, the target company is undervalued. That is the same basic idea as with the equity counterpart. While the market thinks that a company is beyond saving, these investors want to use their potentially superior insight and means to turn around the