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Encouraging corporate turnarounds: banks helping struggling businesses get back on track

by Macaire Bromley, Partner, DibbsBarker | 01 May 2015

In 2014, the Senate Economics References Committee and the Financial System Inquiry called for law reform to encourage and facilitate corporate turnarounds, and to provide additional flexibility to businesses in financial difficulty.

As the inquiry observed in its final report, Australia’s insolvency framework is broadly considered to be working well. It is a mature and well-regarded regime that benefits Australia not only in domestic trade, but also in attracting offshore capital.

However, there is an emerging view that Australia is capable of delivering more effective debt restructurings and corporate turnarounds. Specifically, the Senate Economics References Committee recommended in June 2014 (in its review of ASIC’s performance) that law reform should be considered to encourage and facilitate corporate turnarounds. In that regard, it was proposed that elements of the USA Chapter 11 framework be considered (recommendation 61). In December 2014, the inquiry recommended in its final report that the government consult on possible amendments to the external administration regime to provide additional flexibility for businesses in financial difficulty (recommendation 36). In particular, the inquiry suggested that a restructuring safe harbour and an ipso facto moratorium during restructuring efforts should be considered.

These recommendations indicate that although Australia provides well for the winding down of insolvent companies, the moving on of businesses and assets and the recycling of capital, more can — and must — be done to assist financially troubled companies and save them from falling over the precipice in the first place. 

Banks and other financial creditors are well placed to participate in this reform, as outlined by Macaire below. For further detail on the proposed reforms, see also Finsia’s feature on challenges in financial services following a recent roundtable co-hosted with law firm DibbsBarker.

The external administration regime

Australia’s external administration provisions are commonly understood in the context of a failed, insolvent company. People tend to shy away from any discussion about insolvency in the expectation that it is not relevant to them. However, open discussions about insolvency will help to ensure that the Australian market is adequately equipped to avoid it, by pursuing early efforts to support and turn around a company experiencing a decline in its financial performance. 

Australia’s external administration framework includes the following:

  • receivership, appointed by a company’s financial creditor(s)
  • voluntary administration, usually instigated by a company’s directors, providing the option of the company’s affairs being dealt with by way of a deed proposal (although subject to the requisite consent being obtained) or otherwise leading to liquidation
  • winding up in insolvent liquidation
  • creditor schemes of arrangement, where classes of creditors’ claims may be rearranged and compromised.

Encouraging corporate turnarounds

In my view, there is a key change that would assist in improving the Australian approach to dealing with companies in financial difficulty. This is a cultural change, and specifically, one that calls for the introduction of a protocol which guides parties’ conduct when a company faces financial decline.  

If the failure of a company is perceived as a negative outcome, it stands to reason that a coordinated and supportive response to the financially troubled enterprise, which is aimed at turning the situation around, is to be encouraged. Ideally, the response should occur outside of formal legal frameworks to preserve the value of the company and so maximise the prospects of it being turned around, and also to retain flexibility.

However, where parties are attempting to manage financial decline (and in worse cases, manage a crisis), certainty and consistency are also critical elements of an effective turnaround process. For these reasons, it is beneficial for there to be a protocol in place which describes the principles that are expected of market participants in responding to a financially troubled company. For the protocol to be effective, there needs to be broad agreement from those market participants that they will adhere to the protocol, so that it becomes market standard conduct.

The most effective example of an informal debt restructuring protocol that I am aware of is the London Approach followed by market participants in the UK. There is also a better-known global protocol, known as the INSOL principles, which is similar to the London Approach. The London Approach evolved in the UK in the 1990s with the support of the British Banking Association and the Bank of England. It provides a set of guiding principles for banks and other financial creditors in dealing with customers in financial difficulty. It is so consistently applied by banks that it has become market standard conduct in the UK.

To preserve the good standing and reputation of the banking industry, and based on the fundamental view that it yields better returns than individual action to enforce rights in insolvency, the tenets of the London Approach include the following:

  • lenders adopt a reasonable and supportive attitude towards companies experiencing financial difficulty, to which they have been willing lenders in the first place
  • lenders stand still to provide the company with a stable platform and time to put in place a sensible restructuring plan
  • where there are multiple lenders to the company, lenders share information and work together to a collective view. 

An Australian protocol

Applying learnings from overseas protocols and successful turnarounds conducted domestically, there are five key principles which, if routinely applied, will maximise the prospects of turning around a financially troubled company. These five principles might therefore form the basis of an Australian informal debt restructuring protocol. The principles are:

  • creditors remaining supportive when they receive bad news
  • creditors agreeing to stand still and not take enforcement action or exercise rights triggered by insolvency
  • the company preparing a plan 
  • the plan being supported by accurate, reliable financial information about the company, which is shared equally with creditors
  • creditors coordinating their response to the plan.

Currently, Australian companies tend not to prepare a plan based on accurate information which will deliver a lasting turnaround. There may be no plan at all, or one that is based on poor quality financial information and overly optimistic forecasts. Additionally, plans can be superficial and incapable of delivering anything more than a short-term, band-aid solution. To be viable, a company’s plan must outline the financial and operational changes that will be made to return the company to sustained improved performance over the medium term.

Likewise, creditors in Australia are less familiar with the concept of coordination outside of a financial syndicate or where they share rights and obligations pursuant to a like framework. By coordination, I refer to ‘working together to a collective view’, led by a coordinating team if the size and complexity of the matter warrants it. The creditors who stand still and coordinate their response to the troubled company’s plan will necessarily be those who are asked to compromise or vary their claims. These will ordinarily be financial creditors although key suppliers, alternate providers of debt capital and other stakeholders might also be involved.

There are a number of benefits to coordination. As described by Chris Howard and Bob Hedger in their text Restructuring Law & Practice (LexisNexis, 2nd ed (revised), 2014 at 1.34), coordinated collective action between a group of creditors helps to avoid duplication of cost. Additionally, if parties work together to create the same pool of information, this should help the collective decision making process and can ensure that the implications of certain actions, if taken, are fully explored and understood.  

Coordination does not mean agreement on every term. Disparate creditors can coordinate a response to a company’s plan to deliver a holistic solution. That response will almost certainly involve a degree of compromise across the board, but that is not to suggest that it is unreasonable for an individual creditor to insist on certain terms. Depending on the circumstances, such terms might be applied to all creditors to ensure fairness, or alternatively to the individual creditor to respect pre-existing rights.  

An effective protocol need not be significantly more detailed than the five points outlined above, although other key principles, such as the super priority of new money, warrant consideration. A more detailed explanation of the principles as they are intended to operate is also likely to be desirable. The critical point, however, is that parties must begin adhering to the relevant principles with a sufficient degree of consistency and frequency to create a market standard practice.

The immediately obvious benefit of such a protocol is the incredible flexibility that it affords relevant parties. For example, the terms and timeframe of the standstill are a matter for the affected parties to agree in the relevant circumstances, though it remains important to recognise the fundamental tenet of remaining supportive and the fundamental objective of providing the company with a stable platform, affording it an opportunity to be turned around.

The effectiveness of the UK protocol, the London Approach, is said to be strongly influenced by the fact that the banks and the regulators support it.  

In Australia, banks, regulators, government creditors, corporate industry bodies and other market participants who are adversely affected by failing companies might take the lead in confirming the principles of an Australian protocol and routinely applying them on deal. Government or relevant regulators might take the lead in articulating those principles clearly, not through rule of law but rather as a helpful set of guidelines that codify the conduct that Australia expects of its participants when companies face financial difficulties.

Key learnings for effective debt restructurings

Banks and other financial creditors have vast experience in assessing and monitoring customer risk, and usually have rights under loan documentation to request additional information where there is a concern about the customer’s financial position.  Banks and other financial creditors are therefore in an invaluable position to assist a customer experiencing financial difficulties, particularly where the customer is relatively unsophisticated. Below I provide a short list of actions which, if taken, are likely to increase the prospect of a struggling customer getting back on track: 

  • Accurate financial information is critical. If a customer is not equipped to deliver such information, they ought to be encouraged to engage a suitably qualified person to assist. Where the accuracy of information is a concern, a carefully prepared suspension, deferral or request in connection with a review event will not only incorporate the key information requirements, but will also be conditioned on the process requirements to ensure that the information delivered is accurate (for example, to evidence the existence of adequate systems and personnel, or advise what steps will be taken and when, to deliver accurate information).
  • Financial information that is delivered to support an early stage waiver tends to be superficial and optimistic. The customer should be encouraged to sensitise such financial information and remove the hope (’the market will turn’), to ensure that any new financial terms which might be agreed are realistic, and to avoid a breach occurring again in the very near term. If the customer lacks the skills in-house, again, they should be encouraged to engage a suitably qualified person to assist, and ideally one who has experience in turnaround situations.
  • A customer may not see the need for — and may not wish to incur the cost associated with — preparation of a turnaround plan, particularly where the customer indicates that the financial issues are a ’short-term hiccup’ and it is simply requesting a short extension of time. Both lenders and customers need to understand that the process need not be overly complex or costly at this point in time, but the benefits are potentially significant. Critically, by seeking out accurate financial information and a plan, the lender and the customer can test the very proposition that the issues are short-term. The information will also assist to assess what new financial terms are realistic. Again, if the customer is not equipped to prepare a plan, it should be encouraged to engage a turnaround practitioner and in appropriate cases, any deferral or suspension may be conditioned on such an appointment. There is no question that if the parties wait, then the undertaking will be more complex and costly down the track, and in the worst-case scenario, an investigative accountant will almost certainly be more costly with less favourable outcomes for both parties on offer.
  • Any new funding need should be clearly identified and explained. A customer should satisfy its lender that it will exhaust all existing sources of working capital, taking into account proposed cost-cutting and streamlining, and that the new funding need is realistic and critical. If existing stakeholders are not willing to provide any new funding, think strategically about who might contribute such funding and the conditions on which any permission to that funding might be agreed. For example, new private equity or debt capital with a strong turnaround plan, including to bring strong management to the table, could be desirable, so long as any inter-creditor matrix works.
  • There are increased capital costs and profit-and-loss considerations associated with distress. These economics, coupled with a lender’s business model and governance relating to the lender’s risk management framework, will impact how the lender is able to respond to the distress. In considering the economics of a turnaround, there is no question that the earlier the customer can be turned around, and ideally ahead of any default, the lower the costs and so the more affordable the restructuring for the customer. This itself increases the prospects of the turnaround being successful. Review events are invaluable triggers which enable early (proactive and supportive) intervention by banks. Where the lender is exposed to a capital cost, it may be possible to offset the cost by a variety of restructuring techniques incorporated into the amended financing arrangements. The lender benefits from the incremental recovery on the loan over time, coupled with the improving risk profile (in turn, decreasing the holding cost of the loan). The potential write-up in the event that the turnaround is successful (assuming an earlier write-down) might also be factored in. The prospects of success can be de-risked by involving practitioners experienced in delivering turnarounds. 
  • Lenders are properly concerned during the restructuring efforts, not to be so involved as to be directing their customers. A customer should take control of its own future and lead its own turnaround. If it lacks the sophistication or expertise to do this, lenders can outline both the benefits to the customer of engaging in an effective debt restructuring early, and the detriments of not doing so. Lenders can condition any waiver on the delivery of certain information, the engagement of a reputable turnaround practitioner and the delivery of a turnaround plan. Ultimately, however, a lender should not see its role as persuading a customer to do things and make changes at an operational level that the customer is not prepared to do and, in those cases, the lender should not mandate them. In my experience, such mandates leave the lender exposed or the customer inevitably defaults on the obligation. It is such customers that, unfortunately, readily move from being viable to non-viable and find themselves in formal workout. Lenders and their advisers want to be sure, ahead of that outcome, that they are satisfied they did all that they could to avoid it.
  • Finally, a common question asked in the context of a more severely distressed customer is: how do you know whether or not the company is viable and therefore, whether or not to support it through a turnaround strategy? Viability is a complex issue in the context of a financially troubled firm. In my view, viability depends on a key question: is the firm able to attract sufficient capital to continue as a going concern both in the short term and the medium to longer term? This in turn depends on whether:

— there is a core business that generates positive cash flow or is able to generate positive cash flow at some future point in time, and 

— the firm’s creditors and other key stakeholders, existing or new, are willing to support the firm on terms that enable the business to generate that cash either now or in the future.

That is, a firm might be able to generate sufficient cash in the future and be viable in the meantime, because of the support of certain creditors on certain terms. In that regard, a financially troubled firm is not dissimilar to a start-up. Ultimately, viability depends very much on creditor and other key stakeholder support and the terms required to obtain that support. If a creditor is not willing to support a firm on certain terms, but the firm is able to garner such support on terms acceptable to others, then the firm is viable, so long as the firm is also able to agree the terms on which the existing creditor remains or exits. When the issues are understood in this way, the significance of the role of stakeholder coordination, communication and the sharing of accurate information becomes clear. A firm can fall into external administration if just one stakeholder takes an individualistic stance that, from the perspective of the other stakeholders, is unreasonable. 

By applying practices consistent with an informal debt restructuring protocol as outlined above and by following the suggested approaches to dealing with a struggling customer, irrespective of any law reform which may also be implemented, banks and other financial creditors will be playing a critical and invaluable role in encouraging and facilitating corporate turnarounds in Australia.

About the author

Macaire Bromley is a restructuring partner at DibbsBarker. Macaire has prepared this article based on her experience in the restructuring and insolvency industry since 1995, including three years in Europe and the Middle East with Allen & Overy LLP, London. Macaire’s long list of credentials includes acting in London for bank co-ordinating committees including the restructure of US$5 billion owed by a Middle Eastern construction company. She acted on the reorganisation of the Bank of Cyprus and the Co-operative Bank’s recapitalisation plan. Such matters have allowed her to develop a strong foundation in advising clients on a broad range of restructuring solutions. Macaire is an active advocate of encouraging and facilitating corporate turnarounds, having made a submission to the Inquiry in relation to its Interim Report and submissions to government in relation to the Senate Economics References Committee’s recommendation 61 in its report on the performance of ASIC of June 2014, and the Inquiry’s Final Report.  

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