One of my partners at Restructur Advisors, Karim Lalani, has recently provided excellent articles detailing two court supervised corporate restructuring processes, one using Canada's Companies Creditors Arrangement Act and one using Canada's Bankruptcy and Insolvency Act. Also for a great summary of some of the legal options available to cannabis companies in the United States (which are excluded from seeking federal bankruptcy protection there), see a recent repost of a great article by JDSupra. But these are not the only options as far as restructuring a troubled company goes.
The Corporate Workout
The alternative to a court supervised restructuring process is, of course, one which is completed out of court, generally known as ‘workouts’ in industry parlance. Restructur Advisors believes that workouts may become much more appealing and relevant over the next 6-12 months, primarily because the financial distress created by COVID-19 may also create a new, and previously unseen, focus on cooperation between debtors and creditors. A resort to more collaborative resolutions may also be motivated by the inability of both debtors and creditor to access courts given their pandemic-induced closures and access restrictions.
Before discussing the mechanisms at play in a corporate workout, let’s take a moment to define what a corporate workout is not (at least for the purposes of this analysis). We will exclude “rescue financing” mechanisms like rights offerings or simple debt refinancing and concentrate our attention on workouts that involve creditors compromising their positions in some way. We will discuss the related but separate decision to sell assets or the majority of the company in a subsequent article.
The Workout Tools
The main tool for a company to execute a corporate workout is a consensual debt restructuring. Here, a debtor company will negotiate with creditors (usually just secured and financial unsecured creditors rather than trade creditors) to come to one of two arrangements. First, the creditors may agree to compromise their ability to enforce the contractual terms of their contract, agreeing to extend the term of the debt or let interest accrue for longer than originally agreed. This is colloquially called “extend and pretend” and is usually used when a borrower is facing an issue which is genuinely temporary (i.e., a temporary supplier interruption or customer delay). This strategy helps address immediate cash flow concerns but does not address the “good company – bad balance sheet/management” issue that is often the underlying cause of distress.
The more common and, in these times, much more effective process is the reorganization of existing debt – in effect, re-cutting the capital structure to recognize the impact that over-leverage has had on a borrower. This usually involves a creditor agreeing to turn all or some of their debt position into a subordinate instrument(s) such as equity, preferred equity or a subordinate note. This has two significant advantages. First, overall leverage decreases, with the calculation focused on bringing the borrower back into covenant compliance; and second, cash interest payments are usually reduced, giving the borrower new business runway. In my experience, the creditor making the heaviest compromise is usually the “fulcrum security” - that instrument which sits above equity (which is pure option value at this point) and below senior secured debt where recovery is largely guaranteed. The fulcrum security is often a high yield bond, convertible bond or structurally subordinated debt with either a second lien or merely negative covenants to bargain with. They are also the creditor with the most to lose if a compromise is not struck – senior secured is often covered, and equity is but a hope for recovery, so the fulcrum security has strong incentive to create option value for themselves by giving the company time to rebuild.
The Workout Needs a Plan
The success of such a redistribution of the capital structure is highly dependent on a revised business plan, often an injection of new capital (often from the same fulcrum security) and the technicalities of the covenant package. The challenge for the fulcrum security will be to strike an acceptable trade-off of their existing rights for future option value – this usually leads to a “step down” of contractual rights in exchange for increased equity ownership, either direct or via warrants. For example, a high yield creditor may roll into straight equity, or convert into a new note which accrues interest (rather than having it current pay) plus a warrant package. The possibilities are limited only by creative structuring and the situation at hand.
Note that to execute a workout, a revised business plan (often with a new management team) will need to show how the company will de-lever over time, and senior debt may be asked to make concessions around covenants and interest/principal repayments, if only for a time.
Why Workout? Given the established processes available in both the CCAA and BIA, why would any debtor or creditor wish to embark on this process? There are actually several important advantages to a corporate workout: first, it can be much cheaper and quicker than a court-supervised process; second, because there is not a defined process to follow, it can be much more flexible – the parties can agree to whatever solutions are legal; third, it is much less visible than a public process via a court – critically, this preserves asset values from a creditors’ perspective (the theory being that an announcement of creditor protection immediately focuses people on the minimum value for assets); fourth, the business impact on suppliers, trade creditors and employees is greatly reduced; and finally (but not least), it does not require access to a court (which can carry considerable uncertainty as to timing and outcome).
Of course, the approach also has some disadvantages: first, all classes of key creditors must agree that a corporate workout is the best way to proceed (without this, there can be no workout, as one creditor or class of creditors can hijack the process); second, there are no procedural hammers to use to motivate recalcitrant stakeholders to agree a workout, as there would be in CCAA or BIA; and third, there is no stay mechanism, so even if a corporate workout is agreed, a single creditor taking legal action can unwind the entire effort at any time prior to resolution.
The Plan Needs Action
We at Restructur Advisors believe corporate workouts deserve a great deal more attention in this difficult time. The value of being quick, flexible, cheap and not reliant on court availability is substantial in this time of exceptional distress. Additionally, we believe creditors should be more flexible in their approach to debtors right now – this may be the best way to preserve asset value and create long term option value for all parties. Finally, the tremendous structural creativity made possible by a corporate workout should allow stakeholders to realign their returns with perceived risk in a relatively precise way, and also take advantage of some very useful accounting tools to affect these restructurings (call us for details!).