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Feature

Distressed debt investing
UK and US markets compared
Artist: Satoshi Kambayashi

Caroline Leeds Ruby and Maura O’Sullivan of Shearman & Sterling LLP consider the issues involved in investing in distressed debt in the UK and US markets.

The term “distressed debt” is commonly used to describe debt which, at the time of determination is, or is perceived to be, in some degree of financial distress so that the prospects of timely and full repayment are impaired. There has been a significant growth in distressed debt investing in both the UK and US markets. Businesses particularly affected by the economic downturn (such as the financial services, retail, automotive, property and construction sectors and businesses affected by high energy and commodity prices) have provided the bulk of distressed debt opportunities.
PLC November 2008 www.practicallaw.com

Many companies that have borrowed loans or issued bonds are now in or near default or face a refinancing challenge in relation to debt that is due to mature shortly. A borrower can no longer rely on refinancing its debt to avoid a default or repay maturing debt, particularly in the case of under-collateralised debt, such as some second lien debt (see Glossary). Banks under pressure from regulators to manage their balance sheets have sold off performing loans at below par.

The crisis in the financial markets has resulted in a significant reduction in the pricing of loan assets in the secondary market. The Loan Syndications and Trading Association (LSTA) recently reported that, at the end of September 2008, 69% of the loans on the US secondary market were priced below 90 cents in the dollar and many were priced much lower. This is encouraging debt buy-backs by borrowers and sponsors.
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An investor who bought debt at 40% of par and can realise 60% quickly through an insolvency process may be unwilling to wait for a lengthy workout to be completed to get 100% back and take the risk the workout fails. This article. the senior debt may be 100% collateralised and distressed debt investors who buy subordinated debt will be most interested in a quick restructuring. Credit events will be chosen depending on the reference entity's jurisdiction and business. hedge funds. • A buy and hold strategy: buying distressed debt to gain a position of influence in a bankruptcy or restructuring process and then selling the investment at a higher value. the US Treasury Department will be authorised to purchase up to $700 billion of distressed mortgage-backed securities and other assets and then resell the mortgages to investors. A lender can also buy a total return swap under which market risk is transferred as a whole. In reality. The variety of investors also means that there will be a variety of strategies and approach. It is as yet unclear what impact these developments in the financial markets will have on distressed debt trading overall. Distressed debt investors may use some of the following strategies to realise value from distressed debt: • A trading strategy: buying distressed debt to sell it at a higher price within days or weeks. • Seller’s liability for misrepresentation.com © Legal and Commercial Publishing Limited 2008. or a credit default option under which credit default risk only is transferred. or • An opportunistic strategy: buying distressed debt (sometimes together with an equity kicker) to gain a position of influence in a bankruptcy or restructuring process. • Cash settlement involves payment of the difference between the notional amount of the CDS and the current market value of the reference obligation. compares the two markets by looking at: • Strategies for investing in distressed debt. Instead. however.practicallaw.8 trillion in bank guarantees and the purchase of stakes in major banks. the seller agrees to pay out agreed sums to the buyer if certain credit events occur in respect of a single or group of reference entities. Subscriptions +44 (0)20 7202 1200 . investors comprise a wide range of players including major investment banks. lenders may have engaged in a workout involving a rescheduling of loans to extend or change the facility’s terms. the US (with its unprecedented Troubled Asset Relief Plan) is about to become a purchaser of troubled assets from financial institutions in the wake of the crisis in the financial markets. many now try to dispose of non-performing or under-performing loans in the secondary market. • Loan to own investments. if the reference entity fails to make a scheduled payment under its debt obligations or becomes subject to insolvency proceedings. • Positions of conflict. loans are traded at a discount to their face value. In the past. Many of the drivers of the distressed markets in the UK and the US are similar. likely that the documents and structuring will be improved to deal with counterparty risk. • Due diligence and confidentiality issues. but there are a number of legal and regulatory differences. In some cases. in evaluating distressed debt opportunities. A lender can buy a CDS in relation to a reference entity’s specific debt obligations to protect it against a loss in market value of the reference obligations on a credit event. KEY STRATEGIES In the distressed debt market. Companies often fear that distressed debt investors are vulture funds which will block a restructuring and provision of interim working capital and force a company into a debt for equity swap. which may lead to equity ownership with others (“loan to own”) and selling the investment following a turnaround (see “Loan to own investments” below). pension funds and private equity funds and there are many investors who will support a quick turnaround and exit. Under a CDS. European lenders have agreed on a similar rescue plan that involves a commitment of ⁄1. The second article in this series will consider the challenges of cross-border bankruptcies in the liquidation or reorganisation of a distressed debtor’s business and a comparison of US and UK bankruptcy and insolvency proceedings 22 Credit default swap A credit default swap (CDS) is a contract between a credit protection seller (seller) and a credit protection buyer (buyer) where. in consideration of the buyer paying the seller an agreed fee. • UK and US standard documents used for secondary trades. It is. the first in a two-part series. as in a layered debt structure. Under the terms of the US plan. PLC November 2008 www. a counterparty may have the right to call for settlement (physical or cash) following a credit event: • Physical settlement involves delivery of securities or loans in exchange for payment of the notional amount of the CDS. market abuse and securities laws issues. • How distressed debt is purchased.Feature In addition. • Insider trading. for example.

There may also be limits on the sorts of entities which can be lenders under a credit facility and so sellers may only be able to transfer or assign loans to such permitted lenders. • In both jurisdictions. The local bankruptcy and regulatory rules will influence the investor’s strategy. not uncommon for debt to be traded in the UK market using New York law documents and vice versa. Investors will receive the par value of the notes at maturity unless there is a default. although care must be taken that other restrictions (for example. The underlying reference entity can comprise more than one company and the credit risk can be combined with other risk such as interest rates. however. however. The US equivalent of a UK sub-participation typically differs from the UK position in the following ways: • Under an English law sub-participation agreement. In exchange for taking the credit risk on the underlying reference entity.com Credit-linked note A single name credit-linked note is a debt security issued by a third party which gives exposure to an underlying reference entity through an embedded credit derivative. Both the LMA and the LSTA publish detailed guidance on their documents and there are some notable differences between the two sets of documents (see “LMA vs LSTA documents” below). Loan Market Association PLC November 2008 www.) METHODS FOR BUYING There are many ways of buying distressed debt and the method will depend on the type of transaction the investor is seeking. In some cases. a buyer will usually only acquire contractual rights against the seller and this does not result in a change of the lender of record. but of the counterparty. inflation or commodity price fluctuation to create hybrid structures. Under English law.practicallaw.Feature The impact of the current crisis in the financial markets and the economic downturn may incline some investors to view workouts as more risky. see the second article in this series to be published in the December 2008 issue of PLC Magazine. the investor receives coupon payments which are usually higher than the coupon payments that would be payable on a corporate bond issued by the underlying company. by collateral and set-off arrangements. the buyer will not be the lender of record but will usually acquire an undivided interest in the payment stream (see “Secondary market trade documents” below). Distressed debt is often sold synthetically using credit default swaps or total return swaps or through the issue of credit-linked notes (see boxes “Credit default swap” and “Credit-linked note”). the seller) novating the loans and commitment to the participant (usually using a transfer certificate) in return for the participant cancelling the participation. where possible. In general. • Under a New York law participation agreement. the other party may be left with an unsecured claim in the bankruptcy not of the underlying debtor. confidentiality) are not breached (see “Confidentiality” below). The US equivalent of a transfer is an assignment and assumption under which the seller assigns the debt to the buyer who assumes the seller’s obligations to the borrower. US Chapter 11 bankruptcies may produce a more certain outcome than a bankruptcy in Europe due to differences in law and procedure. it may be possible for an economic interest in debt to be transferred through synthetic means or participations or by using trust structures with the effect of avoiding these restrictions. particularly due to liquidity problems. 23 © Legal and Commercial Publishing Limited 2008. the elevation process is similar but an assignment and assumption agreement is used. (LMA) documents provide for this elevation to be done by the grantor (that is. The borrower’s consent is often required for a transfer or assignment unless an event of default is actually continuing. This risk should be covered. It is. a participant may become elevated to become a lender of record. Elevation may be important if the lender of record becomes bankrupt so that none of the payment flows involve an insolvent entity. SECONDARY MARKET TRADE DOCUMENTS The documents used for a secondary market trade of distressed debt depend on the jurisdiction concerned. the basic methods of buying distressed loans are a transfer (either by assignment under an assignment agreement or a transfer by novation under a transfer agreement or transfer certificate) and a sub-participation (under a participation agreement). (For further details. Many UK and US credit agreements contain contractual restrictions on transfers and assignments which may prevent a debt purchase by these methods. The Lehman bankruptcies have highlighted the risks posed by transfers by synthetic means or participations and some hedge funds are now reluctant to accept participations. If a counterparty or buyer or seller of participation becomes bankrupt. Many market participants are now reviewing documentation and collateral structures to reduce counterparty risk. Under New York law LSTA documents. the UK market uses LMA English law documents and the US market uses New York law LSTA documents. in which event the investors will take delivery of debt securities of the underlying reference entity or receive an amount calculated at the recovery rate. In the UK. Subscriptions +44 (0)20 7202 1200 .

recurring fees or other fees paid on or after the trade date. the buyer is entitled to payments of interest and ordinary course fees made by the borrower on or after the trade date. If any seller goes into bankruptcy. The buyer will need to undertake diligence on prior transfer agreements to ensure that these did not restrict the assignment of claims against predecessors in title. The seller remains lender of record and maintains the relationship with the borrower. If an upstream seller goes into a US bankruptcy proceeding. the closing date. although the trade confirmation sets out the terms of a binding trade (that is. This can raise confidentiality issues. The buyer still takes credit risk on the seller since. will have an obligation to pay the funds to the buyer and such payment should be made shortly following the receipt of funds by the seller. although a delay will result in a delay in receipt of compensation. • Assignment to the buyer of the seller’s rights against prior sellers under the transfer agreements. if a loan is traded: • “Settled Without Accrued Interest”. • “Trades Flat”. IAS 39 requires an assessment of whether the seller has transferred the risks and rewards of ownership. such a participation should achieve offbalance sheet treatment as the LMAfunded participation agreement is drafted to reflect the requirements for derecognition of International Accounting Standard (IAS) 39 “Financial instruments: recognition and measurement”. the seller is entitled to interest and recurring fees (fees expressed to accrue by reference to time) accrued up to.com © Legal and Commercial Publishing Limited 2008. if a loan is traded: • “Settled Without Accrued Interest”. In an LSTA sale. CONFIDENTIALITY A distressed debt investor is more likely to require confidential. but excluding. Settlement. therefore. Interest and fees. The parties have no incentive. payments from the borrower will be paid to the seller (and not directly to the buyer) and will. the buyer should consider filing a protective proof of claim against the seller asserting contingent. The seller will be liable for its own breaches under the transfer agreement and its representations in relation to prior sellers but will continue to have a claim against prior sellers and to take a credit risk on those prior sellers. • “Trades Flat”. if the loan is traded “Settled Without Accrued Interest” and the buyer has the advantage if the loan is traded “Trades Flat”. it is superseded at closing by the terms of the operative transfer document contemplated by the Form of Purchase section of the trade confirmation. in respect of interest and fees. and the buyer owns a beneficial interest in the loan and the commitment rather than just a contractual right. to delay closing after T+20 in an LSTA sale. therefore. If a seller who reports under US GAAP grants a participation using an LSTAfunded participation agreement.Feature LMA documents may not be suitable if the seller of the debt reports under US generally accepted accounting principles ( GAAP) and does not want the loan asset to stay on its balance sheet following the transfer. The position can be complicated if the buyer or seller enters into an insolvency proceeding before a trade has closed. the buyer is entitled to interest. if there is a delay. will be exposed to credit risk on the seller. the buyer will only acquire contractual rights against the seller. unliquidated claims in the event that damages arise in the future before the bar date. the buyer will acquire rights against the seller and prior sellers in relation to the traded debt and the seller will only be liable for its own breaches. flow through the bankruptcy estate. a seller has the advantage. The buyer will acquire rights against the seller only. Sales of distressed debt in the secondary market on LSTA documents (LSTA sales) usually settle on delivery of: • Transfer agreements (“upstreams”) under which the seller and prior sellers acquired the traded debt. the trade is a confirmed trade). however.practicallaw. LMA vs LSTA documents Some key differences between trading on LMA and LSTA documents include the following: 24 Basis of settlement. In addition. In an LSTA sale. In an LSTA sale. Sales of distressed debt in the secondary market on LMA documents (LMA sales) usually settle on the basis of the seller’s representations about itself and any prior sellers of the traded debt. If the seller reports under International Financial Reporting Standards (IFRS). the participation transfers an undivided interest in the loans and commitment. The seller. the seller is entitled to all interest and accruing ordinary course fee accruals up to T+20 (where “T” is the trade date). In an LMA sale. if the seller goes into a bankruptcy proceeding. the buyer will only have an unsecured claim against the seller’s bankruptcy estate. Under English law. the trade confirmation forms part of the operative transfer documents. Trade confirmation. a banker owes a duty of confidentiality to his customer alPLC November 2008 www. The buyer becomes entitled to interest and fees from either the trade date or the closing date in an LMA sale and from either the trade date or T+20 in an LSTA sale. in respect of interest and fees. non-public information to put a price on a loan asset than an investor buying performing debt. the buyer will need to evaluate the credit risk it takes on the seller and the upstream sellers in the chain of title. If a seller reports under US GAAP. Subscriptions +44 (0)20 7202 1200 . a loan asset will remain on the seller’s balance sheet if the buyer remains exposed to credit risk on the seller in the event of the seller’s insolvency. The buyer. Under an LMA-funded participation agreement. In an LMA sale. In an LMA sale.

posed on the buyer are consistent with any duties of confidentiality that the seller owes to the debtor. “related investments”. The LSTA model credit agreement permits confidential non-public information to be disclosed to assignees. The civil offence of market abuse can lead to an unlimited fine (section 123. Subscriptions +44 (0)20 7202 1200 . The market abuse restrictions apply to conduct inside and outside the UK relating to UK markets and to conduct in the UK relating to EEA markets. carrying out false or misleading transactions or employing fictitious devices to effect transactions. An investment grade borrower with stronger bargaining power may require its creditors to agree to confidentiality restrictions in return for the disclosure to its creditors of information in a restructuring.practicallaw. • Persons appointed to receive information on behalf of lenders. • For the purposes of sections118 (1) and (3) of FSMA. This therefore covers securities and related derivatives traded on a prescribed market but it does not include loans. transferees and sub-participants who have signed a confidentiality agreement. under sections 118 and 118A of the Financial Services and Markets Act 2000 (FSMA). however. • Persons providing administration or settlement services. The buyer may also be unable to on-sell the relevant debt as it will be unable to disclose the relevant information to a potential buyer. If a seller discloses information to a potential buyer in breach of this duty or any contractual confidentiality restrictions (including confidentiality letters containing third party rights clauses). Alternatively. assignees or subparticipants. FSMA).Feature though disclosure can be made if the customer consents. These changes will make distressed debt trades easier. participants or prospective assignees and participants so long as there is an agreement imposing substantially similar confidentiality provisions on those persons. such as those relating to information walls (see Glossary). tipping off and insider dealing. In any lending transaction. being instruments admitted to trading (or to be admitted to trading) on a “prescribed market” (such as the London Stock Exchange or AIM or another EU regulated market). The permission does not usually allow disclosure by sub-participants who wish to sell their sub-participation to third parties so any such information passed on to them by a lender must be treated as confidential unless the borrower otherwise agrees. where proper information walls are put in place. behaviour in accordance with certain other specified rules. which would be potentially damaging for the reputation of the individual or organisation involved. A typical LMA-style English law credit agreement usually contains the borrower’s permission for the lenders to disclose confidential information to potential assignees. the customer could apply for an injunction or sue for damages. The LMA standard terms and conditions and confidentiality letters provide that sellers may disclose the terms of transactions to potential buyers (other than pricing) if they comply with confidentiality restrictions in the applicable confidentiality agreement. The LMA has recently revised the confidentiality provisions in its precedent leveraged credit agreement and standard confidentiality letters. behaviour can only be market abuse if it occurs in relation to: • “Qualifying investments”. • Behaviour likely to distort the market. The LMA forms of confidentiality agreement permit disclosure to the extent permitted under the credit documents or by law or regulation. The changes allow lenders to disclose to: • Third parties to whom lenders sell debt by synthetic means or with whom they enter into direct or indirect sub-participations. the FSA could publish a statement revealing the incident of market abuse. 25 © Legal and Commercial Publishing Limited 2008. is permitted. New York law does not impose on bankers a duty of confidentiality to their customers. improper disclosure. Sellers of distressed debt need to ensure that the confidentiality provisions imPLC November 2008 www. there is a contractual duty of confidentiality (either through a separate confidentiality agreement or confidentiality provisions in the applicable credit agreement). • Behaviour or dissemination of information likely to give a false or misleading impression. being investments whose subject matter is the qualifying investment or whose value or price depends on that of such qualifying investments. The Financial Services Authority’s (FSA) Code of Market Conduct provides guidance on the market abuse offences and contains a number of safe harbours including those in relation to a public takeover bid. The behaviour must fall into specified types of behaviour which can constitute market abuse.com Market abuse In the UK. In addition. The model confidentiality provisions do not expressly permit a participant to disclose confidential information to third party purchasers. This includes: • Misuse of information.

There are various defences available. from an inside source (such as through being a bondholder. The offence applies only to individuals (and not companies) but by arranging for a company to deal on the basis of inside information. • If it were made public would be likely to have a significant effect on the price of any securities (section 56(1). a defence to the three offences to show that the dealing would not result in a profit attributable to the price sensitive information. w w w. if the information would be likely to have a significant effect on their price if made public). see feature article. if it concerns the existence of any defaults or breaches of financial covenants. for example. to another person. office or profession. information which: and the market abuse rules but the market abuse rules apply to a wider range of markets and behaviours. There is an overlap between the UK insider dealing offences • To encourage or procure another person to deal in securities that are price-affected. (For further details on market abuse. which are similar to those available for market abuse offences. Financial Services and Markets Act 2000) (FSMA) (see box “Market abuse”). to seven years’ imprisonment (section 61. for example. SECURITIES LAWS ISSUES Distressed debt buyers will be keen to obtain as much information as possible on the underlying distressed assets. It is also a defence to the dealing and encouragement offences to show that a market maker was acting in good faith in the course of his or his employer’s approved market making business. CJA). Criminal Justice Act 1993) (see box “Insider dealing”). • Breach of EU.practicallaw.Feature Insider dealing Under the UK Criminal Justice Act 1993 (CJA). otherwise than in the proper performance of his employment. c o m / 4 . it is a criminal offence of “insider dealing” for a person who has information as an insider: • Has not been made public. • Breach of the UK Disclosure and Transparency Rules in relation to disclosure of inside information. Subscriptions +44 (0)20 7202 1200 . and he knows that it is.3 8 2 9325). The penalties for insider dealing are an unlimited fine and/or up • Relates to particular securities or to a particular issuer of securities or to particular issuers of securities and not to securities generally or to issuers of securities generally. • To disclose the inside information. market abuse and securities laws. • To deal in securities that are price-affected in relation to the information (that is. p ra c t i c a l l a w. but securities and insider trading laws generally restrict a seller’s ability to disclose such information. The definition of inside information for the purposes of the CJA is similar to that for the Financial Services and Markets Act 2000. availability or utilisation of PLC November 2008 www. a company may be guilty of conspiracy or aiding and abetting an offence under the CJA. • Commission of a UK insider dealing offence (section 52.com © Legal and Commercial Publishing Limited 2008. compliance will be required with the applicable rules relating to insider trading. Holders of distressed debt in a company whose securities or other “qualifying investments” are admitted to trading (or to be admitted to trading) on a “pre26 scribed market” (such as the London Stock Exchange or AIM or another EU regulated market) or holders who acquire such investments on a debt for equity swap or become members of a creditors’ committee or bondholders’ committee may acquire inside information and must ensure that this does not lead to: • Breach of the UK market abuse rules (section 118. • The information is. inside information. US or any other applicable securities laws. • Is specific or precise. Even if the borrower agrees to disclosure of confidential information. Although insider dealing offences apply to a wide range of securities such as bonds listed in the EEA or admitted to trading on certain other regulated markets. an individual may commit the offence of encouraging the company to deal and directors of companies and indiA person with information is an “insider” if: vidual advisers could be charged. “Market abuse: what’s new?”. that is. and he knows he has it. Information concerning a loan to a borrower which has issued listed securities may constitute inside information for the market abuse or insider dealing tests. • He has the information. In addition. director or professional adviser). It is. CJA). it would not apply to transactions involving loan sales without any link to any other form of “securities” as defined in the CJA.

Feature funds or the existence of restructuring talks. influenced the decision to engage in dealing. (Confidentiality agreements need not be in writing. Members of a creditors’ committee or bondholders’ committee may be unable to trade their bonds as a result of receiving inside information through their participation in the committee and knowledge of the status of restructuring negotiations and other inside information.3. fairly and professionally in accordance with the best interests of the client (Conduct of Business Sourcebook 2. In the US. The existence of the loan itself may be inside information.5E). or creates a false or misleading impression by his conduct which induces a person to agree to buy (or refrain from buying) qualifying investments or related investments or rights in such securities (even if the rights are not traded or listed). the Securities and Exchange Commission adopted Regulation Fair Disclosure (Regulation FD). will constitute market abuse.) • To disclosures to rating agencies so long as the ratings are publicly available. • Require a firm to implement measures to manage positions of conflict (further guidance on conflicts of interest is provided in Chapter 10 of Senior Management Arrangements. Under Regulation FD. They are required to employ policies restricting disclosure and regularly review their procedures to ensure that they remain effective to avoid unlawful disclosure of. if an issuer or senior official discloses material. Sellers should also consider the identity of potential buyers to determine if those buyers are likely to give rise to insider trading issues. in 2000. Systems and Controls). 27 © Legal and Commercial Publishing Limited 2008. within 24 hours after the disclosure becomes known to a senior official or before the start of the next trading day. or access to. FSMA). A crucial factor in determining whether market abuse has occurred is the proper segregation from “dealing decisions” of employees with access to information. but must be express. Financial Services Authority (FSA) rules may: • Restrict FSA-regulated firms from using non-public information to enter into distressed debt transactions (even where the use does not amount to insider trading or market abuse) as part of their more general obligation to act honestly. promise or forecast.3. it was false or misleading or deceptive.3E). They may look to have the inside information made public so they can start trading again (although the information may impact the bonds’ price). if the inside information is held behind an effective information wall. or could reasonably have been expected to know. the issuer must publicly disclose the information: • In the case of intentional disclosures. • In the case of non-intentional selective disclosure. The treatment of inside information is a major issue in debt trading. Regulation FD does not apply: • If the person to whom the disclosure is made is either someone who owes the company a duty of trust or confidence or who expressly agrees to maintain the disclosed information in confidence. or dishonestly conceals mate- rial facts. a trader who knowingly or recklessly makes a misleading or deceptive statement. • To communications made in connection with most registered primary offerings. non-public information (oral or written) that an enumerated company official discloses to the financial community and shareholders. There will be an inevitable conflict between the borrower’s concern for confidentiality and the bondholders’ desire to trade their bonds in this situation. from the individuals who are involved in or who influence the decision to deal. inside information.practicallaw.3. In addition. non-public information to market professionals or shareholders. The FSA’s Code of Market Conduct (CMC) provides further guidance on the market abuse regime and is designed to help determine whether or not behaviour amounts to market abuse. Buyers can be asked to sign restrictions on dealing. or • Who are required to file reports under section 15(d) of that Act. or similarly effective arrangements. The FSA’s view is that.2E states that dealing on the basis of inside information which is not “trading information” constitutes market abuse. Foreign private issuers of debt and foreign governments are specifically excluded from its application. Distressed debt traders in the UK or who sell to persons in the UK must be careful not to send out incorrect information or to make misrepresentations in relation to qualifying investments or related investments. CMC 1. Financial institutions usually erect information walls between their debt trading desks and other departments to take advantage of the defences available to insider dealing and market abuse offences and to comply with the CMC. For instance.1.1R) (COBS). Subscriptions +44 (0)20 7202 1200 . The dissemination of false or misleading information by a trader who knew. Regulation FD applies to issuers: • Whose securities are registered under section 12 of the Securities Exchange Act of 1934. This requires certain issuers of debt to make public any material. that indicates that the decision to deal by an organisation is not “on the basis of” inside information (CMC 1. simultaneously. or had contact with those who decided to deal (CMC 1.com of the individuals at the organisation in question that had access to the relevant information had any involvement in the decisions to deal. but this would not provide an “insider dealing” defence to a seller. will be committing a criminal offence (section 397. the FSA is not likely to determine that a person is acting “on the basis of” inside information where none PLC November 2008 www.

• Shares the same security package as the senior debt. A type of secured debt which generally: • Ranks equally with other senior debt as to payment but is subject to restrictions on payment following an event of default under other senior debt. and not to be used for. liabilities and financial condition of the debtor and investigates the debtor's business. A warrant or an option to buy equity. under the Insolvency Rules 1986. • A bank providing corporate finance advice to a debtor also trades in his debt. but the rights and obligations are owed by and to the lender. In the UK. to be withheld from. For the purposes of section 118C of the Financial and Services Markets Act 2000. Capital reorganisation of a company in which a creditor converts indebtedness owed to it by a company into one or more classes of that company's share capital (which may not be equity share capital in the strict sense). to one or more issuers of a qualifying investment or one or more qualifying investments. Either way. who should consider the content carefully. • A shareholder and a board member. MISREPRESENTATION A seller of distressed debt must manage his exposure to liability for misrepresentation under the general law. • Ranks behind senior debt (but ahead of junior debt and unseDebt for equity swap. a creditors' committee is appointed by the US Trustee on the filing of a Chapter 11 bankruptcy case. if generally available. A committee of bondholders may be formed to represent bondholders' interests. be likely to have a significant effect on the price of the qualifying investments or the price of related investment. after a company has been placed into administration. In the US. Arrangements within a business that require information. The creditors' committee assists the administrator in the discharge of his functions and determines the administrator's remuneration. enquires into the acts. or an interest in. consults with management on the administration of the case. • An agent for a senior syndicate and agent for a mezzanine syndicate. In the UK. Inside information. directly or indirectly. The creditors' committee is generally composed of seven creditors who are chosen from the holders of the largest unsecured claims against the debtors. a breach of the representation and warranty may lead to liability for the seller. a meeting of the company's creditors can resolve to set up a creditors' committee consisting of at least three and no more than five elected creditors of the company. Conflicts may arise. a buyer may sue a seller for any untrue statement of fact or law which induced the buyer to purchase the distressed debt.Feature Glossary Bondholders' committee. Equity kicker.com © Legal and Commercial Publishing Limited 2008.practicallaw. conduct. Under the FSA Conduct of Business Sourcebook. for example. • Relates. if an investor is: • A bond trustee and also an investor in senior debt. One of the biggest challenges on a restructuring or bankruptcy is to identify bondholders. not the borrower as the sub-participant does not become a party to the loan agreement. Where a lender contracts with the sub-participant to grant rights over. The administrator will call the creditors' committee's first meeting within three months of its establishment and thereafter it will meet regularly. The creditors' committee mentors management’s activities. cess. the benefit of other persons within the business or for whom it acts in the course of carrying on another part of its business. a buyer could also sue a seller for misrepresentation of fact. rather than the transfer of existing rights. an FSA-regulated firm PLC November 2008 www. Information wall. as most will not hold bonds directly in the clearing system but through accountholders and brokers. assets. • Would. Sub-participation. POSITIONS OF CONFLICT Distressed debt investors need to ensure they do not hold positions which may cause a conflict of interest. It involves the creation of new rights and obligations. If debt is traded on the terms of standard form documents (see “Secondary market trade documents” above) then the 28 seller may choose to give standard representations and warranties or to negotiate tailored representations and warranties. to which certain people in the business have accured debt) with regard to the proceeds of enforcement of the security package. Second lien debt. The committee plays an important role in enabling the issuer to gather enough votes from bondholders to approve a restructuring or reorganisation plan. information relating to qualifying investment or related investments (see box "Market abuse") of a precise nature which: • Is not generally available. and in the US. Subscriptions +44 (0)20 7202 1200 . Creditors' committee. the lender's interest in a loan. in terms of the assets over which security is granted but is subject to "standstills" on enforcement.

it will need to consider various issues depending on the transaction structure. If an investor. At least 25% of a company’s listed share capital must be in public hands to satisfy the UK Listing Authority’s Listing Rules (LR 6. • The lender generally will not want to consolidate the results of the entity whose shares it will hold as this may affect its capital adequacy requirements and its financial statements. • The loan to own process may take some time and the debtor will need working capital during this period. Takeover Code). the change of control or other aspects of a restructuring may lead to the requirement for a substantial payment into the pension fund to get the pension trustees on side and avoid action by the UK Pensions Regulator or the US Pension Benefit Guaranty Corporation or their equivalent in other jurisdictions. The Panel will usually waive the requirement if the independent shareholders pass an ordinary resolution approving the waiver and the Takeover Code “whitewash” procedure is followed. • Shares cannot be issued at a discount to their nominal value under the laws of many jurisdictions (for example. this level of minority interest may prove problematic if a further restructuring is required. Loan to own strategies can be carried out in a number of ways: • An investor may just swap debt for shares in a consensual restructuring (often convertible redeemable preference shares). which may be difficult to raise in the financial markets. Anti-trust issues can be a particular problem for financial institutions. A brief overview of some of the US and UK issues involved are outlined below. in February 2008. either alone or acting in concert with other investors. If the distressed debt investor is a regulated bank. the investor must launch a mandatory offer unless the Takeover Panel (the Panel) waives the requirement (Rule 9. PLC November 2008 www. there may be limits on the percentage of both the debtor’s total equity and voting equity which it can hold. . EC Merger Regulation (139/2004) or Competition Commission clearance may be required. • Generally.19R). remuneration and information walls.the restructuring may mean that the company no longer satisfies the applicable listing rules.practicallaw. • In the UK. in a consensual restructuring or on an enforcement of pledges over the shares. • The proposed transaction must be structured to avoid concerns that the directors’ actions will breach their duties.Feature must manage conflicts of interest so its clients are treated fairly in accordance with proper standards of business (COBS 2. • It may be difficult to value the equity stake if there are valuation issues to resolve and this may delay a UK restructuring. For US companies. Hart Scott Rodino approval may be required. There are a number of exceptions to the general rule that consolidation is required under IAS 27 “Consolidated and Separate Financial Statements”.com • The transaction may have an adverse effect on suppliers or other trade creditors or lenders to the group. if the debt for equity swap involves bondholders from the retail market. the investor and others (including management) may form a new company funded by debt and equity and acquire shares in the debtors’ subsidiaries. The CMC provides more detail on how to manage conflicts of interest for financial institutions which are subject to the CMC rules (common platform firms) including the separation of business. an investor could agree to convert debt into a subordinated obligation ranking just above equity which is convertible or carries warrants to give the investor a 29 © Legal and Commercial Publishing Limited 2008.if it remains listed following the restructuring. the bondholders cannot accept unregistered securities in a debt for equity swap and a cash tender will be required. • A restructuring may substantially crystallise tax liabilities. The debtor may be put into receivership or administration before the sale.1. . As part of its updated proposals for reform of UK insolvency laws.1R). As shareholders together holding more than 25% may block a special resolution. under section 100 of the Companies Act 1985). • There may be issues to resolve in moving the debt to the level of the company which will be issuing shares. the investor may find that it is subject to onerous disclosure requirements.the acquisition of an equity stake may trigger a requirement to make a mandatory offer for the remaining equity. LOAN TO OWN INVESTMENTS Loan to own strategies involve an investor buying distressed debt with a view to potentially converting this to an equity stake in the borrower. including those listed below: • Anti-trust clearance may be required if there is to be a change of control. the European High Yield Association proposed that a judicial valuation procedure be introduced for administrations. which a lender may be able to take advantage of. Subscriptions +44 (0)20 7202 1200 . If a distressed debt investor is proposing to convert debt into an equity stake. acquires voting interests exceeding 30% in a company listed in the UK. • If the debtor is listed: .1. • If the target’s pension scheme is in deficit. • A change of control may lead to termination of any material contracts. For UK companies. To avoid the issues raised by having a direct or indirect shareholding in a debtor.

however.ehya. For example.com and the web This article is at www.com/5-383-6325 Topics Lending general www. A receiver appointed under an appropriately drafted share charge can accept a release of indebtedness as consideration for a transfer of shares.com For subscription enquiries to PLC web materials please call +44 207 202 1200 UK administration or company voluntary arrangement (CVA). In the case of In re Radnor Holdings Corp. • The right to vote a larger proportion of votes on an exit or insolvency.loan-market-assoc. equitable subordination (where the courts subordinate the creditor’s claim because of improper actions or conduct to the prejudice of other creditors) or similar claims.practicallaw.practicallaw.practicallaw. improve the balance sheet in most cases. In reaching its finding. are at a price determined by an independent valuation and sale process and the secured creditor will use the sale proceeds to partially discharge the secured debt. a creditor can buy assets if the requisite consents and court approval are obtained. although stamp duty will generally be payable on the amount of the credit bid. the court placed emphasis on the evidence showing that the investors could not have known of the borrower’s imminent collapse: the evidence included the investors’ due diligence on the historic financial projections. agree to buy the debtor’s assets in Chapter 11 in the amount of the debt owed to them).com www. enforcement sales are often to special purpose vehicles (SPV) in which the secured creditor is one of the shareholders.practicallaw. This structure will not.practicallaw. investors engaging in a loan to own strategy have to undertake detailed due diligence and will need to commit significant time and resources and possibly tie up significant capital to such a strategy. no formal procedure for credit bidding in a UK insolvency. the shares in a company are sold for a nominal amount but remain subject to the company’s existing guarantees and borrowings to reduce both stamp duty payable on the transfer and insolvency challenge risks.com/9-101-6859 www.lsta.practicallaw. If an investor wishes to avoid a controlling shareholder interest then various other options are available under which the investor holds less than 50% of the voting rights but can protect his interests. Subscriptions +44 (0)20 7202 1200 www. 30 PLC November 2008 © Legal and Commercial Publishing Limited 2008. Lenders who provide credit to a distressed US company and subsequently seek to convert the debt into a controlling equity stake when the company goes into a Chapter 11 proceeding may face challenges on the grounds of breach of fiduciary duty. 2006).com/1-103-2033 Restructuring and corporate rescue procedures www. If a company goes into a Related information Links from www. an investor may hold: • Weighted voting rights or veto rights on reserved matters. D.com/6-377-7387 www. although the returns can be substantial and the current economic downturn is throwing up significant opportunities. There will always be a degree of risk involved.com/9-103-1256 Practice notes Corporate loan facilities Credit derivatives Market abuse and insider dealing Understanding the syndicated loan market www. The SPV may borrow from the secured creditors to fund the acquisition.practicallaw. Del. unsuccessful claims were made against distressed debt investors for equitable subordination and aiding and abetting a breach of fiduciary duty in relation to secured loans made to the borrower before its bankruptcy. The US Chapter 11 bankruptcy procedure allows creditors to “credit bid” (that is. As will be clear from the examples of the issues above.com/5-204-3000 Previous articles Private equity: hedge funds’ impact (2007) Corporate debt restructuring: preliminary issues (2002) www. There is. 820 (Bankr.R.com . 353 B. Often.practicallaw.com/4-107-4007 www.practicallaw.com/1-107-4985 www.org www.practicallaw.Feature share of any increase in equity value. unless they can show they lent the money in good faith and not to force the company into bankruptcy and acquire control of it at a cheap price. Due to the rules on self-dealing and fair dealing under English common law.practicallaw. Caroline Leeds Ruby is a finance partner in the London office and Maura O’Sullivan is a finance partner in the New York office of Shearman & Sterling LLP . the review of the company’s projections and receipt of solvency opinions. however.com/4-218-6018 Weblinks Loan Market Association The Loan Syndications and Trading Association European High Yield Association www.