Regulation of Distressed Debt Investment Funds in the EU: Restructurings and Takeovers  

LL.M Master Thesis

Regulation of Distressed Debt Investment Funds in the

EU: Restructurings and Takeovers

Master’s Program in Law and Finance LL.M.

Name: Antonio Bančić

Email: antonio.bancic@icloud.com

Student Number: 12374237

Supervisor: Edoardo Martino

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This thesis concerns the impact of EU laws on distressed debt investment funds in the context of restructuring proceedings and takeovers. In other words, it aims to analyse whether the current EU legal framework successfully prevents value-destroying takeovers. Distressed debt funds invest are investment funds that invest in financially distressed firms. They acquire distressed debt at significant discounts with the intention to participate in the restructuring of the distressed company and extract the value of underused assets. This allows them exchange distressed debt for equity in the newly restructured firm. By doing so, they take over the firm and become the controlling shareholders. On the one hand, distressed debt funds provide expertise and funding in order to restructure the company to be more efficient and profitable – they generate social welfare benefits by preserving jobs and businesses. On the other hand, they act opportunistically as they frequently sell-off the company’s assets and charge exorbitant fees, ultimately leaving the company ‘hollowed out’. To ensure the former and safeguard against the latter, the thesis examines relevant EU laws for achieving so, namely – ‘Directive on Restructuring and Insolvency’, ‘Alternative Investment Funds Managers Directive’ and ‘Directive Relating to Certain Aspects of Company Law’. The thesis argues that the current EU legal framework is only partially successful in preventing value-destroying takeovers and concludes the following: Firstly, the EU laws insufficiently protect SMEs against value-destroying takeovers; Secondly, distressed debt funds are inadequately regulated under the EU laws; Thirdly, the AIFMD’s definition of ‘acquisition of control’ is obscure and gives rise to regulatory arbitrage; Fourthly, rules on distributions yield limited success in deterring asset stripping.

Key words: distressed debt funds, distressed debt, distressed companies, restructurings, asset stripping, value-destroying takeovers, EU law, SMEs.

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Abstract ... 1

I. Introduction ... 3

II. The phenomenon of distressed debt investing ... 5

II.1. Classification and definition of distressed debt funds ... 5

II.2. Distressed debt markets and rationale behind distressed debt investing ... 6

II.3. Distressed debt investing strategies ... 9

III. Economic effects of distressed debt investing and their impact on pre- and post-restructuring period ... 11

III.1. Acquiring distressed debt (the pre-restructuring period)...11

III.2. Insolvency proceedings and restructuring ...13

III.3. Post-restructuring period ...15

IV. The current EU legal framework ... 18

IV.1. Directive (EU) 2019/1023 on Restructuring and Insolvency ...18

IV.2. Directive 2011/61/EU on Alternative Investment Fund Managers (AIFMD) ...22

IV.3 Directive (EU) 2017/1132 Relating to Certain Aspects of Company Law ...26

V. Inadequacy of current EU legal rules in regulating distressed debt funds ...27

VI. Conclusion ... 33

VII. Bibliography ... 35

VII.1. Primary Sources ...35

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Over the past century, at least in North America and Western Europe, the prevalent political ideology has been that of capitalism. Along with the globalisation, this ideology has been spreading all around the world ever since. The (economic) globalisation process has brought a higher degree of interconnectedness of the national economies, whether through trade, capital investments or migration, and the concept of ‘global economy’ was created. Global economy is a dynamic ecosystem – it expands, peaks, contracts, and troughs – it is of cyclical nature (Billingsley, Gitman and Joehnk, 2013). When the economy is either at the end of a credit cycle, it is contracting as the credit supply decreases, businesses and financial markets become distressed, and companies often start to default. The latter is a consequence of companies becoming over-reliant on debt financing, particularly nowadays, resulting in the ever-growing corporate debt bubble (Saigol and Bucak, 2020; Doherty, 2020). Such financing has its upsides, e.g. tax savings, but also many downsides, of which the greatest is the risk of bankruptcy. Hence, better access to credit, coupled with the cyclicality and the interconnectedness of economies led to a development and growth of ‘distressed debt markets’. Some investors have started to see investment opportunities in these situations; namely, trading securities of distressed companies or ‘distressed debt investing’ (Wassermann, 1993). Consequently, distressed debt investing has seen significant rise in popularity over the past forty years. There is a small-scale group of highly sophisticated investors that, inter alia, thrive on economic contractions and the resulting financial distress of businesses: the so-called ‘distressed debt investors’, ‘distressed debt funds’ or often pejoratively referred to as ‘vulture funds’. The funds are managed by professional money managers and are typically accessible only to cash-rich investors (Jiang, Li and Wang, 2012). They seek investment opportunities in financially distressed companies, which are, for the time being, unable to cover their liabilities (Jiang, Li and Wang, 2012). Distressed debt funds sometimes actively participate in the reorganisation of distressed companies in order to extract additional value from the investment but may also choose to trade securities and earn the profits from the volatility in price. Their participation in restructurings is a ‘double-edged sword’. On the plus side, distressed debt investors provide funding and expertise to distressed companies, organise them more efficiently and restore their financial health. Thus, they help to ensure continuation of business and preserve jobs for the time coming: they generate positive social welfare effects and

potentially yield long-term value-creation. On the minus side, distressed debt funds are frequently criticised for their opportunistic behaviour. Their modus operandi may best be illustrated by the famous quote of English philosopher Francis Bacon, “the folly of one man is the fortune of another”. Particularly, they carry out ‘asset-stripping’1 and charge high fees when

providing (financing) services to distressed companies (Caselli and Negri, 2018; Ligterink, Martin and Boot, 2017). This destroys the company value as valuable assets are often liquidated and cash is extracted, causing the newly restructured company to default again. Therefore, in order to prevent European Union (EU)-wide value-destroying restructurings and ensure otherwise, the EU law is of great importance and shall be addressed in the thesis. Considering the above-mentioned and the economy’s cyclicality, a contraction will eventually occur and economic recession in the (near) future is inevitable. Therefore, the ‘hunting season’ for vulture investors might soon be opened.

In light of the above-mentioned, this thesis will provide an analysis of distressed debt investors, the investment strategies they utilise, the consequent economic effects, as well as the relevant EU legal framework on such investing and the legal lacunae thereof. Ultimately, the thesis will attempt to answer the following research question: Is the current EU legal framework sufficiently effective in preventing value-destroying takeovers by distressed debt funds?

In order to answer the research question, the thesis will include the following four research methods: descriptive, analytical, evaluative and positive. Firstly, the descriptive method will mainly be used to address the first two sections: to define and categorise distressed debt funds, to explain the rationale of such investing and the economic effects arising from it. Secondly, the analytical method shall be applied to sections regarding EU legal frameworks, namely ‘Directive on Restructuring and Insolvency’ (Directive 2019/1023), ‘Alternative Investment Funds Managers Directive’ (Directive 2011/61/EU) and ‘Directive Relating to Certain Aspects of Company Law’ (Directive 2017/1132). Lastly, evaluative and positive methods will provide an assessment of the adequacy of EU legal instruments for attaining the goal, followed by the conclusion. The thesis refrains from any normative considerations but will conclude with some suggestive policy remarks.

1 Asset stripping is a process of selling (non-core assets or non-operating) assets owned by the target company, which can be

easily liquidated in order to pay-off the shareholders with dividends. The consequence of such practice is a ‘hollowed-out’ company that leaves creditors and employees with unpaid claims. See (Caselli and Negri, 2018), pp. 72; (Ligterink, Martin and Boot, 2017), pp. 16, 24.

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The section will briefly define and classify different types of distressed debt funds, as well as provide a rationale behind distressed debt investing and the strategies thereof.

II.1.CLASSIFICATION AND DEFINITION OF DISTRESSED DEBT FUNDS

Distressed debt funds or ‘vulture funds’, are investment funds which specialise in distressed debt investing, i.e. investing in financially distressed companies by acquiring (highly) ‘distressed securities’2, at sub-par market value and expecting for the price to recover

(Stefanini, 2006). The aim is to the purchase debt of a financially troubled company at a significant discount to its intrinsic value, as debt default has already occurred or there is a high risk of non-payment (Harner, 2008a). Distressed debt funds are generally considered to be a sub-type of hedge funds and private equity funds. Unlike institutional investors such as pension funds or investment banks, hedge funds and private equity funds are predominantly active in this niche due to the lack of investment restrictions which allows them to adopt riskier strategies and invest in highly illiquid assets. When interconnected with other systemically important financial institutions, their failure may create instability in the financial markets (Tosetti Dardanelli, 2011). For this reason, under the EU law, the funds are to some extent regulated by AIFMD and are broadly defined as ‘Alternative Investment Funds’ (AIFs). Without making specific legal distinction between hedge funds, private equity and other types, AIFs are defined as close-ended collective investment undertakings which raise capital from investors and invest it in accordance with a defined investment policy for the benefit of those investors.3 They invest

in financial assets other than those of ‘mainstream or conventional categories’ (investment-grade bonds, cash and stocks), such as real estate, hedge funds, venture capital, derivatives contracts, and etc. (Chen and Scott, 2020).

2 “Distressed securities are shares, bonds trade receivables or financial loans on the verge of, in the middle of, or emerging

from bankruptcy or financial stress”. See (Stefanini, 2006), pp. 187-188

Moreover, distressed debt funds can be differentiated based on their investment focus – ‘Distressed Sovereign Debt Funds’ and ‘Distressed Corporate Debt Funds’. The former type specializes in acquiring sovereign governmental debt on the secondary market and aims to enforce the full recovery of these claims (UNCTAD, 2020). An example of such ‘predatory’ practice occurred in 2001 when Elliot Management Corporation, a US hedge fund, acquired a substantial amount of Argentina’s defaulted debt and initiated recovery proceedings, eventually bringing a profit of more than $ 2 billion (Merle, 2020). The latter type is also called ‘event-driven investment funds’ as they “seek to capitalize on opportunities arising during a company’s life cycle, triggered by extraordinary corporate events, such as liquidations or restructurings” (Stefanini, 2006). The next subsection will further analyse distressed debt markets, the investing rationale and different methods and strategies thereof.

II.2.DISTRESSED DEBT MARKETS AND RATIONALE BEHIND DISTRESSED DEBT INVESTING

Albeit often perceived as a novelty, distressed debt investing is a well-known investment practice in the financial world. It dates back to the end of the 19th century UK, more

precisely, the expansion and crash of railway industry which had caused the railway stocks to plummet (Stefanini, 2006). A handful of investors bought the stocks of railway companies at bargain prices, assumed an active role in the reorganisation process, and secured substantial profits as a result (Stefanini, 2006). Fast forward a century, the distressed debt investing of today came into prominence in the 1980s in the US, mainly as a consequence of failed restructurings financed via ‘leveraged buyouts’4 (LBOs) and 1980s recession (Berk and

DeMarzo, 2016; Altman, Hotchkiss and Wang, 2019). Followed by the economic growth in the 1990s, the distressed debt investors who invested in this ‘first wave’ eventually realised their profits (40% excess returns in comparison to other alternative asset investments) which paved the way for the creation of the ‘distressed debt markets’ and ‘specialised’ distressed debt investors (Altman, Hotchkiss and Wang, 2019). The second wave took place in the early 2000s, as a consequence of the ‘Dot-com bubble’ burst. The third wave in late the 2000s and early 2010s was caused by the ‘Global Financial Crisis’ (GFC) (Altman, Hotchkiss and Wang,

4 Leveraged buyout is an acquisition strategy where the acquirer borrows the money through a shell company to obtain target

company's shares, and posts these newly acquired shares as collateral on the loan. If the tender offer succeeds, the bank can be certain to recover the money as the acquirer (debtor) will gain control over the assets of the company (collateral). See (Berk and DeMarzo, 2016), pp. 1016-1019.

2019). In that regard, European distressed debt market is considered to be relatively young and small. Firstly, the EU market only came into existence in late 1990s, after the introduction of the European Monetary union and the single currency – ‘euro’5 (Stefanini, 2006). Secondly,

the capital is usually allocated through banks rather than capital markets, so the volumes of public debt outstanding and investment opportunities are smaller and narrower (Declercq, 2003). Thirdly, distressed securities in the EU are issued by holding companies. As operating companies usually own the assets, it is more difficult for distressed debt investors to enforce default and participate in the restructurings (Stefanini, 2006). Fourthly, EU approaches bankruptcies and reorganisations more from a ‘social fairness’ aspect and aims to preserve businesses by favouring negotiated reorganisations, thus resulting in a lower number of defaults and liquidations (Stefanini, 2006).

Moreover, there are two important characteristics of the distressed debt markets and investing: the relationship of the distressed debt markets and equity markets is interdependent and distressed debt investing requires a ‘trigger event or catalyst’ (Altman, Hotchkiss and Wang, 2019). Firstly, the markets are interconnected and interdependent as a trend change usually represents the change in cycles – there is no actual separation between the markets as the activity thereof depends on the stage of the cycle, hence expansion of one market means the contraction of the other and vice versa. Secondly, there has to be some sort of a trigger event allowing for future growth in order for distressed debt investing to take place, hence the name ‘event-driven’ investing (Travers, 2012). By analysing the three aforementioned waves, it can be said that the catalyst can be firm-specific (LBOs), industry based (‘Dot-com bubble’) or market-wide (GFC). Thus, in order for distressed debt investing to be successful, the market conditions have to be abysmal (e.g. economic stagnation or contraction, industry crisis, credit crunch and etc.) which must negatively impact the target’s balance sheet (e.g. inability to pay-off the debt, lack of demand or general inefficient corporate governance), putting them in a distress and eventually in default. It can be concluded that default rates and credit spreads are highly correlated – in the periods of general economic or industry-specific stress, the volatility of the credit spreads for existing bonds becomes greater, thus causing the lending to be more

5 “…the high-yield bond market stood out as a viable alternative to borrowing from banks. The single currency erased currency

and interest rate trades among EU member states and forced investors to develop new strategies based to a greater extent on credit spreads”. See (Stefanini, 2006), pp.185.

expensive and the company’s debt levels to become unsustainable and distressed (Stefanini, 2006).

The rationale behind distressed debt investing is the ability to exploit market anomalies, i.e. inefficient pricing due to information asymmetries (Mooradian and Hotchkiss, 1998). The ‘Efficient Capital Market Hypothesis’ (ECMH) assumes that market prices contain ‘all’ publicly available information that reflect expected ‘unbiased future cash flows’ and that any pricing distortions are corrected by arbitrage mechanisms (Moloney, 2014; Miller & Segal, 2017). Therefore, according to the ECMH, when distressed debt is priced substantially low, its price reflects the high defaulting probability of the company. However, this is not always the case as certain investors, e.g. institutional investors, are disallowed by law or their articles of association (AoA) to invest in non-investment grade securities due to their high risk and illiquid nature (Stefanini, 2006).6 Consequently, when (debt) securities becomes distressed and

downgrade in investment quality (i.e. credit rating), they are required to immediately dispose of it or ‘fire sale’ which causes a significant drop in price. The ‘fire sale’ may also signal the market that the payment of distressed debt has become overly uncertain, but it does not necessarily mean that the probability of default is now more likely. While this information asymmetry might discourage other investors, it gives distressed debt investors the opportunity to acquire distressed securities/ businesses at a significant discount as the “market value of distressed securities does not reflect their intrinsic value”7 (Stefanini, 2006; Mooradian and Hotchkiss, 1998). Since distressed debt funds often have fewer regulatory constraints on the risk level of their portfolio and when coupled with substantial cash reserves, they are able to acquire the securities, exploit these market anomalies and earn high returns (Stefanini, 2006). To achieve so, it is important to accurately value distressed or defaulted company and the viability of its business – its ‘financial health’ (Stefanini, 2006)8. This requires sophisticated

investment, corporate governance and valuation knowledge in order to extract hidden value of assets and secure capital gains (Gietzmann, Isidro and Raonic, 2018). In fact, an intricate

6 “Many institutional investors cannot buy distressed securities because their articles of association, their fiduciary

responsibilities or their regulatory authorities forbid them to hold speculative grade securities, even though the issuer can generate profits”. See (Stefanini, 2006), pp. 193.

7 See (Stefanini, 2006), pp. 193.

8 ‘Healthy companies’ represent businesses whose reorganization value is higher than liquidation value. Usually such

companies have sound business models but are temporarily distressed due to over-indebtness or have short-term cash-flow problems. On the other hand, ‘unhealthy companies’ are those whose business models have failed and whose assets can be put to a better use, i.e. companies whose liquidation value is higher than reorganization value. See (Stefanini, 2006), pp. 187.

analysis of both financial and legal aspects will determine the return on the investment (Stefanini, 2006).

On the more critical side, it is precisely this opportunistic investment strategy which earned them the nickname ‘vulture funds’ as they carefully scan for distressed targets, often with a purpose of breaking down the companies and stripping their assets or restructuring them, whilst not necessarily creating any value, all for the purpose of maximising their return on investment (Stefanini, 2006). Likewise, these ‘cash-rich’ investors often provide ‘expensive’ liquidity to distressed companies which have no other viable options, as some sort of ‘lender of last resort’, usually to the company’s detriment. However, when accumulating large debt positions in distressed companies, and when providing additional financing, the investors demand higher returns as compensation for greater idiosyncratic risk, which decreases the diversification of their portfolio (Lewis, 2016). Consequently, the company’s shareholders and (non-adjusting) unsecured creditors, such as suppliers and ‘small and medium-sized enterprises’ (SMEs) suffer financial losses. Nonetheless, the flipside of the aforementioned criticism is that while charging sizeable fees, distressed debt funds are beneficial for the market. Namely, by providing liquidity to the distressed company, they may play a critical role in the preservation of value during a corporate reorganisation and aid the company in successfully weathering the ‘reorganisation storm’. This will be further examined in section III.

All things considered there is a good reason distressed debt investing is still considered to be a ‘niche industry’9, as it requires extensive financial and legal knowledge, sufficient investment

capital and a high-risk appetite – a typical ‘high risk, high reward’ situation (Altman, Hotchkiss and Wang, 2019; SIFMA, 2020; BIS, 2018). Therefore, the next sub-section will briefly illustrate distressed debt investing process and different strategies pursued.

II.3.DISTRESSED DEBT INVESTING STRATEGIES

The choice of distressed debt funds’ investing strategies often depends on the risk appetite and the required level of returns. Altman et. al differentiate between three main types

9 The total value of the distressed debt market in 2017 was estimated at face value of $747 billion and $414 market value. See

(Altman, Hotchkiss and Wang, 2019)., pp. 268; In comparison, global capital markets were estimated at $74.7 trillion, bond markets at $102.8 trillion and OTC derivatives markets at $594.8 trillion respectively. See (SIFMA, 2020) and (BIS, 2018).

of distressed debt investment strategies: active control, active non-control, and passive (Altman, Hotchkiss and Wang, 2019). The first type, active control or a de facto takeover, yields the highest target returns of approximately 15-30% per annum (Altman, Hotchkiss and Wang, 2019). Active control is the riskiest strategy as it requires substantial capital investments since the aim is to gain control over the restructuring proceedings, and eventually over the target company itself. Often, to ensure a successful turnaround, investors will be required to provide additional funds in the process, making this strategy more expensive and hence riskier (Altman, Hotchkiss and Wang, 2019). If the restructuring succeeds, the value of equity will be restored and distressed debt investor will exit the company at a profit, usually in two to three years (Altman, Hotchkiss and Wang, 2019). Therefore, the investors will earn the difference between the sale price of equity and the capital invested (purchase price of a debt plus subsequent investments during or after the restructuring). The second type, active non-control, yields on average 12 to 20% per annum (Altman, Hotchkiss and Wang, 2019). The investors actively engage in the restructuring, albeit without the intention to exert control over the target (Altman, Hotchkiss and Wang, 2019). They usually participate semi-actively through a creditors’ committee and sometimes enter the corporate structure of a reorganised company as members of the board of directors (BoD) (Altman, Hotchkiss and Wang, 2019). The investors only seek to increase the value of their holdings and exit after one to two year, so this strategy requires fewer capital investments and is less risky (Altman, Hotchkiss and Wang, 2019). The third type is passive investing. The investors do not actively participate in restructuring but rather seek to acquire distressed securities at a heavily discounted price, expecting the company to successfully restructure and sell the securities at a higher price – trading strategy (Altman, Hotchkiss and Wang, 2019). On average, it has the shortest holding period of six months to one year and expected annual returns range between 12 and 15% (Altman, Hotchkiss and Wang, 2019). This strategy is the least risky but is risky nevertheless to the extent that if the target goes into liquidation, as there are insufficient assets to satisfy all claims, the distressed debt investor is at risk of not being able to recover the full face value of its investment (Teunissen, Taggart, Arora and Mugabi, 2006). Thus, the investors must in any case be able to estimate whether the firm will go bankrupt (Altman, Hotchkiss and Wang, 2019).

For the purpose of this thesis, the focus will primarily be on the active control strategy as it entails considerable engagement of distressed debt funds and is important for (mis)valuing of company and its assets, both in restructurings and resulting takeovers (Gietzmann, Isidro and Raonic, 2018). One could say that the actual problem with distressed debt funds is their

indifference towards value since they are only concentrated on the returns. Therefore, the focus on active control is essential for making an adequate assessment of their value-creation or destruction. The next section will describe the investing process more in detail, the economic effects thereof and their impact on each phase.

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IMPACT ON PRE

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Investors acquire distressed debt with different motives, one of which is to gain control in the company, restructure it efficiently and ‘sell it for a profit’. The active control strategy is also often called ‘loan-to-own’ as the investors purposefully purchase distressed debt with the aim of converting it into new equity whilst in reorganisation (Gompers, Ivashina and Ruback, 2019). By accumulating the debt, they will be able to ‘control’ the firm’s reorganisation proceedings and have an upper hand in debt restructuring negotiations with other creditors. At this point, distressed debt funds are in the position to create or destroy the value of the distressed target – they can reorganize the company more efficiently, or sell-off company’s assets in piecemeal and make organizational restructuring of the company more difficult – for the purpose of realizing a certain return on investment, i.e. to generate profit for the fund and their investors.

The following section will elaborate on the three phases of distressed debt investing: pre-restructuring phase or ‘acquisition of distressed debt’; insolvency proceedings and restructuring; and post-restructuring phase.

III.1.ACQUIRING DISTRESSED DEBT (THE PRE-RESTRUCTURING PERIOD)

Prior to acquiring distressed debt, the investors usually hire an external consultant to determine the going concern (reorganisation) value of the company to draft a ‘turnaround plan’ and determine the viability thereof (Cuny and Talmor, 2007). They also analyse the balance sheet of the company, i.e. the complexity of the company’s capital structure and the number of debtors involved, as well as the relevant bankruptcy laws (Harner, 2008a). Therefore, before making any acquisition decisions, the investors must be knowledgeable of the firm value, its

capital structure and legal rules of the jurisdiction, all of which impacts the probability of a successful turnaround. The valuation includes information on: “the company’s cash flow and liquidity position and interest payment dates; rights of debt holders to call defaults, accelerate debt, waive defaults and take other actions; relative rights of junior and senior creditors under intercreditor agreements; whether current holders are interested in participating in a potential restructuring; nature of collateral and security interests if the debt is secured, amount and nature of pending claims against the company and other parties and etc.”10 (O'Neal, 2008).

When the investors estimate a good prospect of a lucrative turnaround, the next step is to analyse the market for trading claims of distressed companies and acquire the target’s securities. As trading of claims against defaulted companies is generally allowed, the parties can buy and sell claims against bankrupt companies (Harner, 2008a). To finance the acquisition, distressed debt investors establish an investment fund and raise money, usually through their pool of investors and/ or by means of a loan (i.e. leverage) (Mäntysaari, 2010). The types of distressed securities purchased include, inter alia, non-performing bank loans and non-investment grade corporate bonds, such as trade debt claims held by trade creditors, hence the distressed company’s suppliers or customers (Harner, 2008a). The choice of the distressed security will greatly depend on the complexity of the debt structure (Wruck, 1990). According to Hotchkiss and Mooradian, distressed debt investors tend to purchase senior unsecured debt in most cases, e.g. bank loans or senior corporate bonds, but depending on the financial condition of the company and the investing strategy, pari passu debt and junior claims are also often acquired (Hotchkiss and Mooradian, 1997). It is, however, of great importance to correctly determine which securities will be eligible for a debt-to-equity swap, the so-called ‘fulcrum security’ (O'Neal, 2008). Especially, when the aim is to actively control the reorganisation, this will be important for determining the extent of impairment of a certain class and the corresponding recovery in the restructurings (O'Neal, 2008). Buying too junior debt runs a risk of low recovery, whereas of too high senior debt runs a risk of not being converted into equity but rather paid-out in cash (O'Neal, 2008). Therefore, an incorrect assessment will have an impact on the recovery rates and negotiating position, or lack thereof, in the insolvency proceedings.

After identifying the class of debt, investors purchase the impaired class(es) of liabilities through broker dealers and accumulate stakes thereof until a controlling position in the target debt class(es) is reached (Gompers, Ivashina and Ruback, 2019). This controlling position will give distressed investors the ability to influence negotiation of restructuring proceedings, i.e. to block or participate in designing of reorganisation plan (Harner, 2008a). According to Hotchkiss and Mooradian, accumulated claims amounting to at least 33% of the debt outstanding should suffice for attaining the influence or control over the proceedings (Altman, Hotchkiss and Wang, 2019; Hotchkiss and Mooradian, 1997).

III.2.INSOLVENCY PROCEEDINGS AND RESTRUCTURING

Following the accumulation of debt and subsequent controlling position, distressed debt investors (may) file an involuntary petition for bankruptcy against the company, hence file for bankruptcy against the debtor’s will and initiate reorganisation proceedings (Harner, 2008a). Due to the highest proportion of debt relative to other creditors and. having the most leverage vis-à-vis the distressed company, they will be able to set the terms of the reorganisation (Harner, 2008a). Thus, they will also have more negotiating power against other stakeholders such as major contract parties and junior creditors (Harner, 2008a). Additionally, when the company enters into restructuring under the insolvency law, the duty of care initially owed to shareholders will be owed to the creditors as the ‘new owners’ (Harner, 2008a). Therefore, as the distressed debt investors become the largest debtholders, the management is under obligation to do what is best for the investors and the company, which is to actively facilitate negotiations between creditors and implementation of the (investors’) reorganisation plan.

Distressed debt investors can generally influence or control the restructuring proceedings in a twofold manner: through a reorganisation plan (priority and voting scheme) and/or prepetition contract rights (via debt covenants) (Harner, 2008a). Firstly, a reorganisation plan can be seen as a ‘court-enforced agreement’ between the debtor and its creditors which sets out how the company will reorganise its capital and organisational structure, as well as the repayment of the debtor’s prepetition debt (Harner, 2008a). The debtor usually consults with the major creditor groups and has the right to design and propose the plan (Harner, 2008a). Some creditors, typically unsecured ones, can seek appointment to the official creditor’s committee to get a better insight into the debtor’s finances and participate in the negotiations (Schultze

and Lewis, 2012). However, the controlling creditors are not required to do so as they hold the greatest proportion of the company’s debt, which in turn allows them to control the voting on the reorganisation plan (Harner, 2011). For this reason, they may choose to block the initial plan, propose their own plan or design the new plan with the debtor in order to structure the voting classes in a favourable manner (Harner, 2008a). Such power is especially prominent if the distressed debt investors own the majority of claims across multiple creditor classes, allowing them to pressure the classes in supporting their reorganisation plan, especially the lower ranked creditors (Harner, 2008a). Secondly, distressed debt investors can exert influence through a contract, namely by providing ‘rescue financing’ or a ‘Debtor in Possession’ (DIP) loan (Krasoff and O'Neill, 2006). The DIP loan is a capital injection provided to the debtor during the reorganisation proceedings in order to ensure the debtor’s liquidity and the continuation of its business operations during the restructuring (Harner, 2008a). Such loans have a ‘super priority’, meaning that the DIP claim is paid out before other priority claims (Harner, 2008a). Distressed debt investors providing DIP loans are often criticised for charging excessively high interest rates, as well as for including deliberately stringent debt covenants, giving them even greater control of the company upon a default – hence a ‘loan-to-own’ name (Harner, 2008a; Baird and Rasmussen, 2006). The breach of covenants may give the distressed debt investors the ability to control the company’s collateral or assets upon a default, i.e. if the restructuring fails they may exchange the DIP claim for the company’s assets; or, in general, it allows them to exert greater control over management decisions and assume controlling ownership (Harner, 2008a; Teunissen, Taggart, Arora and Mugabi, 2006).

Therefore, as a result of choosing either of the two aforementioned strategies, distressed debt investors will be able to influence the restructuring process and the valuation of assets, and impose the reorganisation plan on both the debtor and other creditors. It will allow them to facilitate a debt-to-equity swap. In addition to debt restructuring, the investors may also secure further financing, dispose non-operating assets, redefine the business strategy, and enhance earnings. The next subsection will analyse the last phase, that of the post-restructuring period when the new company emerges and along with it, distressed debt investors as its new owners.

III.3.POST-RESTRUCTURING PERIOD

After the successful implementation of the reorganisation plan, the investors exchange their claims for the common stock of the newly restructured company and in return its indebtedness (debt-to-equity swap). Where distressed debt investors accumulated the majority stake in debt claims, and depending on the exchange ratio, by means of conversion, they become new controlling shareholders. At this point, the investors are positioned to appoint board members or replace the management in order to execute their initial turnaround plan and resurrect the company successfully (Harner, 2008a). The control over the BoD and the management is of great importance for distressed debt investors because it mitigates potential agency conflicts between managers and shareholders (Harner, 2008a). Thus, by having control over both the BoD and the management, the investors will have better access to private information, a direct link to the company’s decision-making and will ultimately ensure better alignment of incentives of the management (Harner, 2008a). This will in turn minimise any internal obstacles and allow the realisation of a turnaround. Therefore, the key segment of the post-restructuring phase is to implement the new business strategy – to exploit the company’s underused assets and bring about organizational and operational improvements to the company, i.e. the rationalisation process or reduction of inefficient compartments of the firm to improve its operational efficiency (Harner, 2008a; Harner 2011). However, the implementation of the new business strategy may both create and destroy firm value.

As for value creation, firstly, distressed debt investors provide funding to the troubled companies when it is most necessary, that is during the restructuring proceedings. The investors commit additional capital to provide liquidity and preserve the business operations whilst in restructuring, i.e. the DIP loan. Importantly, this helps to maintain employment levels, relationship with customers and suppliers, keeps the company active, on the market and maximizes growth opportunities and profitability (McCormack, 2016). Therefore, distressed debt investors ensure the company’s going-concern surplus over its liquidation value (Harner, 2008a). Secondly, as distressed debt investors accumulate high portions of the company’s distressed debt, they acquire a strong and concentrated negotiating power. This puts them in control of the reorganisation process since they can more effectively influence the content, approval, and implementation of the reorganisation plan. Consequently, by assuming a leading role, the conflict of interests between different classes of creditors, as well as shareholders and

management, is substantially minimised, thus the negotiation process is much smoother. This translates into significantly speedier proceedings and lower dead-weight bankruptcy costs, hence the overall firm value will be higher, and the investor’s returns and value of creditors’ claims will be maximized (Harner, 2008a; Altman, 2014). Therefore, the investors can sometimes achieve more than the state-guided bankruptcy law in terms of maximizing the value for all creditors. Thirdly, before acquiring distressed debt, the investors identify hidden value and inefficiencies of the distressed company. Given their expertise, they actively reorganise the company in a more efficient manner. For instance, better negotiation of debt write-off and higher asset value; enhancement of productivity of assets and personnel; replacement of inefficient/ entrenched management with the new one or better disciplining and aligning of incentives; sale of non-core assets and refocusing the business strategy(Harner, 2011; Gietzmann, Isidro and Raonic, 2018). The company continues to operate and generate value which in turn benefits junior/ unsecured creditors whose claims remain preserved (Hotchkiss, Smith and Strömberg, 2012). Therefore, the end result is a operationally and organisationally more efficient company. The market seems to agree, as Hotchkiss and Mooradian find greater abnormal stock and bond returns when distressed debt investors are actively involved in the restructuring (Hotchkiss and Mooradian, 1997).

With regards to the value destruction, firstly, although distressed debt investors control the restructuring proceedings, a great deal of value is lost nevertheless due to the conflicts between the management, shareholders, and the controlling debtholder (Harner, 2008a). It is a consequence of the shift of the management’s duty of care from shareholders to creditors (Baird and Rasmussen, 2006). Particularly, in cases where the distressed debt investors do not fully control the restructuring proceedings, they still need to negotiate and reach an agreement with the other classes of creditors, which often creates conflicts of interest, the so-called ‘collective action problem’. Namely, as the investors invest substantial efforts and funds, securing the implementation of their restructuring plan is pivotal for maximisation of the returns. Other creditors might not agree with their plan, and thus, this may result in litigation and create delays, which can cause the company to run out of money before the restructuring plan is approved (Harner, 2008a). Overall, this leads to a value destruction as it reduces distributions to (junior) creditors as the pool of assets lessens (Harner, 2008a). Secondly, distressed debt investors providing DIP loans often structure terms and conditions (T&Cs) of the agreements in the excessively restrictive loan covenants. Chiefly, the covenants aim to ensure the repayment of the debt but may also be purposefully made to restrict the distressed company’s

flexibility in manoeuvring through restructuring (Baird and Rasmussen, 2006). Prior to drafting of the DIP agreement, the investors get access to the distressed company’s finances in order to assess the risk, determine the T&Cs, and demand the appropriate interest rate (Baird and Rasmussen, 2006). Hence, at that point, the investors are well aware of the company’s financial needs and assets as a collateral. Arguably, the covenants are therefore intentionally drafted in a dis-favourable manner for the company, as the investors anticipate the breach thereof. Depending on the T&Cs, the breach of covenants can give the distressed debt investors certain rights and control powers over the company and its assets, for example a right to liquidate or fire-sale certain company’s assets posed as a collateral (Harner, 2008a; Baird and Rasmussen, 2006). This may empower the investors to purchase these assets at bargain prices through other corporate entities, thus giving rise to a fraudulent behaviour (e.g. related party transactions and asset tunnelling-out) (Harner, 2008b). Potentially, it could be argued that debt covenants are drafted in a manner to protect the investors from the company’s liquidation and the inability to satisfy its claim. However, given the fact that a DIP loan has a ‘super priority’, this is highly unlikely. In addition, DIP loan rates may also be set opportunistically high, as in the absence of alternative loan providers, the distressed company may have no choice but to accept the loan irrespective of the cost. All of this reduces the value of the estate, makes unsecured creditors less likely to satisfy their claims and puts them in a more vulnerable position. Thirdly, value creation depends on the point of view. Though it can be argued that distressed debt investors play a crucial role in making the company more efficient, it is questionable at what cost. For instance, the investors may refocus the company’s overly diversified business strategy on its core business and therefore dispose of non-operational assets. As with breaching of the DIP loan covenants, this can be also viewed as a disguised asset stripping based on the economic justification of disposing the underused or non-productive assets. Likewise, the organizational and operational restructuring may entail closing down production facilities and reducing excess workforce. It is certainly debatable to what extent such measures are necessary, especially from a social welfare standpoint, given the fact that distressed debt investors are very much profit-oriented, and their primary aim is to secure returns for their pool of investors (Wassermann, 1993). Additionally, distressed debt investing model always includes an exit strategy. The investors are often criticised for their short-termism as they tend to exit the company on average one to three years following the restructuring (Harner, 2008a). They seek to realise gains on their investment by selling the stock acquired through a debt-to-equity swap, either through an initial public offering (IPO) or a private sale of equity (Harner, 2008a). Along with their exits, their managing expertise and personnel also leaves the company, whilst the debt remains, thus

(again) bringing the company’s survival in question. Therefore, it is evident that the distressed debt investors remain committed to the initial aim of profit-making and securing short-term liquidity of their investments, rather than enhancing long-term value creation for the company (Crutchfield George and Vivian Dymally, 2013).

To summarise, distressed debt investing has both its upsides and downsides. In order to prevent the negative effects of distressed debt investing, the next section will analyse the relevant EU legal rules designed for achieving such aim.

IV.

T

EU

In the context of the thesis, the ‘Directive on Restructuring and Insolvency’ (hereinafter “Directive 2019/1023”) is relevant for the insolvency phase as it aims to incite and ease restructurings by providing more harmonised and legally certain rules. It also intends to minimise overall costs incurred during the insolvency proceedings, simplify and accelerate insolvency proceedings, and thus encourage value-creating restructurings. Moreover, the ‘Alternative Investment Fund Managers Directive’ (hereinafter “AIFMD” or “Directive 2011/61/EU”), more precisely, section 2 of Chapter V, governs the obligations of alternative investment fund’s managers (hereinafter “AIFMs”) when acquiring control in companies. Importantly, the primary focus of the AIFMD analysis will be the impact of ‘asset stripping’ rules on distressed debt investors and preventing value-destructive takeovers. Lastly, the ‘Directive Relating to Certain Aspects of Company Law’ (hereinafter “Directive 2017/1132”) shall be analysed in the light of asset stripping, mainly with regards to the prohibition of distributions. Therefore, the AIFMD and Directive 2017/1132 are relevant for ensuring value creation in the post-restructuring period.

IV.1.DIRECTIVE (EU)2019/1023 ON RESTRUCTURING AND INSOLVENCY

Directive 2019/1023 is the EU’s attempt to harmonise and reduce regulatory arbitrage of divergent national rules and procedures of insolvency proceedings and restructurings across

the Union.11 The Directive establishes a preventive restructuring framework to enable viable

enterprises in temporary financial distress to restructure effectively early on and avoid unnecessary liquidations.12 This should minimise losses of jobs, know-how and skills, and

incite restorations of financially sound businesses, hence generate greater social welfare benefits overall.13 More specifically, the harmonisation aims to eliminate legal uncertainties

for investors vis-à-vis the risk of perplexing and lengthy insolvency procedures.14

Consequently, better foreseeability should lower the costs and encourage investors to participate in the restructurings.15 In fact, shorter and more efficient restructurings minimise

delays and preserve higher firm value, thus yielding higher recovery rates for the unsecured (junior) creditors.16 Furthermore, this should allow investors to assess the risk better which

should lower the debtor’s borrowing costs, and ultimately, result in lower restructuring costs and fewer debt covenants.17 The ECB considers that the harmonisation will also promote

further development and deepening of the EU distressed debt markets, thus easing the access to the market and making it more competitive and efficient (ECB, 2017). To sum up, the harmonisation should principally bring about more transparency and legal certainty, drive down the costs of investing and restructuring for distressed debt investors, creditors and debtors, boost cross-border investments, and ultimately maximize the total value of creditors and investors.18

Article 1 defines the subject matter and the scope: enabling an efficient restructuring of viable businesses in temporary financial distress. Though the Directive does not explicitly state so, in the preamble, it mentions entrepreneurs and ‘small and medium-sized enterprises’ (SMEs) as its ‘target audience’ and highlights their importance for the proper functioning of the EU internal market. Nonetheless, subsection 2 prescribes ‘negative’ definition of the scope and

11 Recital 1 and Article 1(1) Directive 2019/1023. 12 Recital 2 Directive 2019/1023.

13 Recital 2, 4 and Article 4(1) Directive 2019/1023. 14 Recital 7 Directive 2019/1023.

15 Recital 7 Directive 2019/1023. 16 Recital 16 and 29 Directive 2019/1023. 17 Recital 16 and 17 Directive 2019/1023. 18 Recital 7 and 15 Directive 2019/1023.

excludes certain categories of debtors. Hence, in addition to SMEs, the Directive does not exclude listed or other non-listed companies and it applies to the case at hand.

Moreover, Article 5 prescribes the ‘debtor in possession’ as the default mode and allows the company to remain in control of its assets and daily business operations whilst undergoing restructuring, without having to sell the assets. Furthermore, Article 8 sets out the content of restructuring plans, a checklist of information to be included in the plan. Namely, the plan must contain, inter alia, the debtor’s list of assets and liabilities at the time of submitting the restructuring plan, as well as its economic situation and causes of the financial distress. Likewise, it must also include the proposed restructuring measures and their duration, their impact on the employment, the debtor’s estimated financial cash flows and, if necessary, for executing the restructuring plan, any new financing and the justification thereof. Lastly, the plan must provide a statement of reasons attesting the viability of the restructuring plan in preventing insolvency and achieving financial restoration of the distressed debtor. The inherently complex nature of distressed debt investing is the difficulty of obtaining information on the target’s financial condition (Jain, 2012). Therefore, to remedy the issue, restructuring plans eases the access to such information to other concerned parties, e.g. creditors and employees.

Article 9 gives both debtors and creditors the right to submit the restructuring plan to the ‘affected parties’19 for the vote on their adoption. Pursuant to Article 9(6), the plan is to be

adopted by the majority of affected parties, either based on the the majority of the amount of claim value or the majority of each creditor class(es). Hence, this allows distressed debt funds to propose the restructuring plan and where they own the majority of claims, also to adopt it. It effectively grants them a full control over the content of the plan. Article 9(2) provides certain safeguards and prescribes that the conditions for the confirmation of the plan must ensure fair and proportional treatment of the creditors of the same classes. Also, it warrants that no dissenting creditors are worse off than in liquidation, and that any requisite new financing does not unfairly prejudice the interest of creditors. Finally, according to Article 10(1), the restructuring plan must be officially confirmed by the judicial or administrative authority and becomes binding on the parties. This is particularly important with respect to new financing

19 Article 2 Directive 2019/1023. Affected parties may include creditors, workers, classes of creditors and shareholders of the

and when the plan envisages more than 25% reduction of the workforce.20 Alternatively, when

the restructuring plan is not approved by the affected parties in accordance with Article 9(6), Article 11 nonetheless allows the authorities to enforce the plan and its subsequent adoption, upon the proposal of the debtor or with debtor’s agreement. The plan thus becomes binding on dissenting creditors. This mechanism is called ‘cross-class cram-down’ and a Member State (MS) may choose to implement either an ‘absolute priority rule’ (APR) or a ‘relative priority rule’ (RPR).21 According to the APR, the priority of payments is based on the strict priority of

debt claims – senior debt holders must get fully paid off before those of more junior status, often leaving the shareholders with nothing as there are no funds left at that point. The RPR does not entail full pay-off of senior class but only a better treatment than those of more junior class. This gives junior creditors and shareholders more bargaining power, hence allowing them to retain more value at the expense of a more senior class. It gives the shareholders the possibility to exchange old shares for those of the newly restructured company, as “it is no longer required that creditors are paid in full before shareholders” (de Weijs, Jonkers and Malakotipour, 2019). The MS’s choice between APR or RPR could potentially impact the distressed debt fund’s strategy and the subsequent returns. The APR incentivises accumulation of more expensive senior debt to ensure the adoption of the plan, due to its higher priority. Conversely, the RPR encourages the purchase of less costly junior debt and even cheaper distressed equity. This should in theory allow for “saving businesses and thereby jobs and... also strengthen the position of SMEs”, but might also generate incentives for opportunistic behaviour (de Weijs, Jonkers and Malakotipour, 2019). Namely, it allows for easier cram-down of the plan on higher ranking creditors, thus assuring the investors to make less concessions to other creditors, without risking the hold-out. Nevertheless, Article 12 prevents shareholders from unreasonably frustrating the adoption, confirmation, and implementation of a restructuring plan.

Lastly, Article 17 ensures the adequate protection of interim and new financing upon the insolvency of the debtor and allows for the ‘super priority’ of payments over other claims. The ‘super priority’ and protection of financing lower the risk of non-payment and incentivise distressed debt investors to provide extra liquidity to the firm. Additionally, Article 18 provides

20 Article 10(1) and Article 15 Directive 2019/1023. 21 Article 11(1)(c) and 2(a) Directive 2019/1023.

for the protection of other transactions related to restructuring, such as the payment of fees relating to the negotiations and the adopting of a restructuring plan, provided that such transactions are “reasonable and immediately necessary for the negotiation of a restructuring plan”.22 This bars distressed debt funds from opportunistically charging exorbitant fees and

helps to preserve the value of the estate.

IV.2.DIRECTIVE 2011/61/EU ON ALTERNATIVE INVESTMENT FUND MANAGERS

(AIFMD)

The Directive defines managers of alternative investment funds (AIFMs) as “legal persons whose regular business is managing one or more AIFs”23. AIFMs are considered to

have a significant influence on the companies (and the stability of financial markets) due to the significant amount of assets they manage.24 According to Article 1, the Directive establishes

an authorisation, ongoing operation and transparency framework of the AIFMs which operate or market an AIF in the EU. Likewise, Article 2 limits the scope of the Directive to AIFMs, whereas the regulation of AIFs is left to the MSs.25 However, Article 3 exempts certain AIFMs

from AIFMD, namely AIFMs whose assets do not exceed EUR 100 million or AIFMs of ‘partially close-ended’26 unleveraged AIFs whose aggregate assets do not exceed EUR 500

million. This ‘lighter regime’ allows these ‘smaller’ AIFM to opt-in to enjoy the rights granted under the AIFMD, but also to be excluded from obligations imposed by it, based on their ‘unlikelihood’ to create the systemic risk.27

Furthermore, section 2 of Chapter V, the so-called ‘private equity provisions’, prescribes ‘obligations for AIFMs managing AIFs which acquire control of non-listed companies and

22 Article 18(1) Directive 2019/1023.

23 Management of AIFs includes both portfolio management and risk management. See Article 4(1)(b) and Recital 21 Directive

2011/61/EU.

24 Recital 1-3 Directive 2011/61/EU.

25 Article 2, Recitals 6 and 10 Directive 2011/61/EU.

26 AIFs that disallow the investors to exercise redemption rights in the first five years of the initial investment. See Recital 34

Directive 2011/61/EU.

issuers’, albeit the focus is more on non-listed companies (Hodge, 2013).28 Notably, this is

because private equity companies (i.e. distressed debt investors) often de-list the publicly traded companies from the stock exchanges and ‘take the company private’ when restructuring it. Therefore, the section is directly applicable to the problem at stake – distressed debt funds’ acquisitions of control and (value-destroying) takeovers. In fact, the Directive specifically aims to protect employees of firms in which the AIF(M)s acquired control. It does so by imposing limitations on asset stripping (Art.30) and detailed disclosure obligations towards employees regarding the company’s ultimate owners (Art. 27-29), beyond what is readily available in public records, to allow the employees to determine the impact of control on their employment – e.g. whether the acquisition of control will result in job losses (Hodge, 2013).29 However,

disclosure obligations are limited not to endanger the AIF’s business operations and reveal confidential information.30

To begin with, the scope of the section is defined in Article 26 and it encompasses (1)(a) “AIFMs managing one or more AIFs which either individually” and/or (1)(b) “jointly with one or more other AIFMs on the basis of an agreement, acquire control of a non-listed company”. A ‘non-listed’ company is defined as a legal entity with EU-registered office, whose securities are not traded on a regulated market, whereas an ‘issuer’ is a legal entity whose securities are traded on a regulated market.31 Importantly, Article 26(2) excludes non-listed companies that

are characterised as SMEs and ‘special purpose vehicles’ (SPVs) related to real estate. Moreover, Article 26(5) defines the acquisition of control of non-listed companies as “more than 50% of the voting rights of the companies” where the voting rights are held directly by the relevant AIF that entail the control of (a) “an undertaking controlled by the AIF” and (b) “a natural person acting in its own name but on behalf of the AIF or on behalf of an undertaking controlled by the AIF”. The rationale for a narrower definition is because the ownership of non-listed companies tends to be more concentrated, as the capital is raised by a smaller number of shareholders rather than publicly on the stock market, and therefore, a higher voting thresholder in comparison to issuers is required.

28 Recital 53 2011/61/EU.

29 Recital 52-54Directive 2011/61/EU. 30_{Recital 58 Directive 2011/61/EU.}

Moreover, Article 27 and 28 require the AIFMs to notify and disclose the acquisition of major holdings and control of listed/ non-listed companies, namely to the company concerned and its shareholders, as well as the AIFM’s home ‘MS competent authorities’32. Articles 27(1) and (2)

concern only non-listed companies and require such notification upon the acquisition, disposal of or holding of a prescribed threshold of shareholdings of a non-listed company. Likewise, Article 27(4) mandates the AIFM to request the BoD to inform the employees’ representative and use best efforts to ensure that employees are properly informed. Additionally, pursuant to subsection 3, such notification ought to contain information about voting rights, the conditions subject to which control was acquired, the identity of the controlling shareholder and the date of the acquisition of control. The provision is prima facie not of pivotal importance for acquisition of control resulting from the restructuring, but it rather serves to keep employees informed regarding the activities of the controlling AIF(M), particularly when the latter is exiting the company and there is a change of ownership. Furthermore, Article 28 prescribes similar obligations to that of Article 27, although with regards to disclosure and applies also to issuers. Specifically, Article 28(2) requires the AIFM to disclose its identity, the policy for preventing and managing conflicts concerning the safeguards for ensuring arm's length agreements between the AIFM/AIF and the company, and communication policy with employees. In effect, this might curb the distressed debt investors to engage in RPTs and asset-tunnelling out. Likewise, pursuant to Article 28(4), the AIFM ought to disclose its intentions concerning the company’s future business plans to the company itself and its shareholders but must also use best efforts to ensure that the company’s employees are adequately informed. Thus, to keep the employees informed of the AIFM’s intentions and possible changes that might (negatively) impact the former, e.g. the decision to relocate production facilities overseas. Additionally, Article 29 concerns specific transparency obligations regarding the annual report of AIFs exercising control of non-listed companies. The AIFM is required to use best efforts to draft the annual report of the non-listed company and ensure that the report is made available to the employees. Article 29(2) prescribes the information to be included in the annual report concerning the company and it must contain “at least a fair review of the development of the company’s business representing the situation at the end of the period

32 By ‘MS competent authorities’ it is meant financial market authorities, such as ‘Commissione Nazionale per le Società e la

covered by the annual report” and more importantly, an indication of the company’s “likely future development”, as well as important events that have occurred in the financial year. As Articles 27-28, Article 29 also aims to protect employees from uncertain future developments by prescribing the AIFM to provide more frequent and detailed information on the current company’s business situation (‘fair review’), any events that might have (had) an impact on it and the possible consequences thereof on future developments. Thus, Articles 27-29 highlight one of the burning issues concerning takeovers by the distressed debt funds – employment layoffs. The funds are often criticised for a (relatively high) number of job destruction in the targets, especially in the first two years following the acquisition of control (Davis et al., 2011). Nevertheless, the statement is in line with the argument that distressed debt investors are experts on corporate reorganisation, and as such, layoffs are a part of the rationalisation process (Davis et al., 2014).

Finally, the key AIFMD provision for ensuring value creating takeovers is Article 30 on ‘asset stripping’. The Article is directed towards AIFMs who manage AIF and applies to the acquisition of control over both listed and non-listed companies. The Article forbids the AIFMs from asset stripping for a period of 24 months following the acquisition of control. More precisely, Article 30(1) disallows AIFMs to “facilitate, support or instruct any distribution, capital reduction, share redemption and/or acquisition of own shares by the company”, obliges them not to vote in favour of such propositions and requires them to use best efforts in achieving so. However, subsection 2 provides derogations from subsection 1 vis-à-vis the ‘capital maintenance rule’. Namely, AIMFs are obliged to restrict or prevent any distributions to shareholders or acquisition of own shares, to the extent that they result in net assets falling short of the subscribed capital and the mandatory reserves. In relation to subsection 2, subsection 3 defines ‘distribution’ as dividend payments or interests relating to shares and ‘restriction on acquisition of own shares’33 with the effect of reducing capital, enabling transfer

of assets or reducing net assets in general, unless the purpose of capital reductions is to counterbalance non-distributable reserves, up to a 10% of the reduced subscribed capital.34

Thus, the exemption allows for distributions and acquisition of own shares to the extent that it is not illegal and detrimental to the company’s finances, i.e. reduction of the company’s

33 Article 20(1)(b) and (h) Directive 77/91/EEC. 34 Article 30(3) Directive 2011/61/EU.

subscribed capital plus reserves, net assets and profits of the previous financial year (Hodge, 2013). In effect, this should ensure sufficient assets for creditors.

IV.3DIRECTIVE (EU)2017/1132RELATING TO CERTAIN ASPECTS OF COMPANY LAW

Even though under EU law distressed debt funds are predominantly regulated by the AIFMD under EU law, Directive 2017/1132 may have an important role in preventing value-destroying takeovers. Inter alia, it imposes certain restrictions on distributions and share buybacks, two forms of asset stripping, beyond the 24 month-period envisaged by the AIFMD. The Directive applies exclusively to public limited liability companies – issuers.35 More

importantly, section 3 of Chapter IV governs the rules on distributions and the focus will be on distributions vis-à-vis distressed debt funds as the controlling shareholders in the restructured public companies.

Article 56 sets out the general rules on distribution, i.e. dividend payments and interest relating to shares, correspondingly to Article 30(2) and (3) AIFMD. Therefore, Article 56(1) prescribes virtually identical restrictions to that of Article 30(2) AIFMD. Thus, the provision limits distributions with the effect of preventing shareholders (i.e. distressed debt investors) from extracting funds from the company via excessive dividend pay-outs resulting in reduction of subscribed capital. According to Article 57, where distributions were knowingly and unlawfully made contrary to Article 56, they ought to be returned to the company. The desired effect of these provisions is to maintain the company’s subscribed capital, hence to lock-in the (excess) capital and prevent the premature pull out thereof (Blair, 2004).36 In addition to

general rules on distributions, there are further restrictions on the subscription of own shares (Article 59), acquisition of own shares (Article 60), financial assistance by a company for acquisition of its shares by a third party (Article 64), and additional safeguards in case of related party transactions (Article 65). Importantly, Article 67 provides additional restrictions on share buybacks to benefit the controlling shareholders of public companies who exercise their dominant influence directly, or indirectly via controlling another company. Hence, it prevents distressed debt funds as controlling shareholders from bypassing the restrictions on share

35 Article 2 and Annex I Directive 2017/1132. 36 Recital 40 Directive 2017/1132.

buybacks by using another entity which they control, e.g. a shell company formed solely for the purpose thereof.

V.INADEQUACY OF CURRENT EU LEGAL RULES IN REGULATING DISTRESSED DEBT FUNDS

Following the analyses of the previous section, it is evident that distressed debt fund takeovers are, to some extent, directly regulated under AIFMD and indirectly through Directive 2019/1023 and Directive 2017/1132. Though these rules provide protection against the opportunistic behaviour of distressed debt funds, the rules are to some extent incomplete, inadequate, and arguably inefficient in safeguarding against value-destroying takeovers. The Directive 2019/1023 might not be sufficiently effective in preventing asset stripping as it primarily applies to SMEs, which are excluded from the scope of AIFMD, and provides weak safeguards to compensate this. Moreover, the AIFMD encompasses multiple types of AIFs under a single ‘one-size-fits-all’ definition, thus risking over-regulation of some and under-regulation of other AIFs. In effect, it may have negative repercussions on distressed debt funds, such as excessive limits on leverage, asset stripping, excessive transparency and reporting obligation which may hamper their business models. Similarly, it is questionable whether the AIFMD’s definition of acquisition of control is adequate to mitigate the negative effects of asset stripping by the distressed debt funds. Lastly, Directive 2017/1132 provides restrictions on distributions and acquisition of own shares only, it is thus limited to only two methods of asset stripping. Therefore, this subsection will identify the inadequacies of the current EU legal rules in preventing value-destroying takeovers by the distressed debt funds.

Firstly, Directive 2019/1023 should create more efficient restructurings and insolvency procedures, and this is important for distressed debt investors as it stimulates distressed companies to restructure preventively, rather than going into insolvency and risking liquidation. The Directive aims to rescue viable enterprises and honestly over-indebted entrepreneurs, hence the emphasis added on SMEs, under the justification that they often do not have sufficient resources to successfully weather through the insolvency proceedings. In effect, easier restructuring means that the preventive restructurings will foster a further development of EU distressed debt markets and increase market participation. Consequently, this should generate greater competition among distressed debt funds and decrease costs of