Freshfields' 'Hot topics' series – liability management

In the US distressed market, liability management has emerged as an effective and widely accepted tool to increase liquidity, restructure debts and extend a borrower’s runway to help it avoid insolvency. However, although not unheard of, it is yet to achieve the same prevalence in Europe, where documents are still catching up to the level of flexibility seen in the US, and different capital structures and legal regimes raise different issues.

In the latest seminar in our restructuring 'Hot topics' series, Lars Westpfahl, Mark Liscio, Scott Talmadge, Andy Hagan and Lindsay Hingston discussed the topic’s US background and considered the potential for its more common use in Europe, particularly in light of the ongoing COVID-19 pandemic.

In summary, the key points included:

• In the US, liability management is the most prevalent way that stressed and distressed borrowers are dealing with their balance sheet obligations today. The restructuring community is increasingly dealing with liquidity issues, over-leveraged balance sheets and upcoming maturity dates by pursuing transactions that raise liquidity, spin out and finance discrete assets and de-leverage and/or restructure various balance sheet obligations utilising flexibility build into the debt documents, rather than filing for Chapter 11.
• Broadly, liability management takes the form of either an 'asset dropdown' or a 'debt up-tiering'. In the former, a transfer of valuable assets or subsidiaries from a restricted to an unrestricted group entity takes place, whose value can then be used to raise debt on a structurally senior basis. In the latter, new tranches of senior debt are created, with this new debt being used to purchase the borrower’s existing debt as a means of deleveraging. In both methods, non-participating parties will typically be subordinated as a result of the transaction.
• The typical stakeholder dynamics are no longer borrowers versus creditors but instead a more complex relationship between borrowers and diverse creditor sub-groups. There is a growing trend in creditor groups proactively proposing liability management exercises to debtors in order to improve their own standing. In some instances, debtors receive rival proposals and are able to play creditor groups off against each other in order to achieve the best terms for the company.
• The emergence of liability management in Europe has been predicted for over a decade, yet we still do not see it being used in quite the same way as in the US. This is mainly because of finance documents lacking the same generous baskets, the generally smaller size of capital structures, and the continued availability of cheap refinancing. Another factor is the ability to access relatively quick and cost effective in-court processes, such as the UK scheme of arrangement or restructuring plan, to achieve a more comprehensive balance sheet reset. However, there have been some examples of liability management tools being used to deliver European restructurings, for example the distressed exchange offer used to deliver Brighthouse's 2018 debt-for-equity swap.
• The COVID-19 pandemic has strained many balance sheets, but thus far the ease of refinancing has cushioned the blow. Should markets cool, it may be that more European debtors turn to liability management exercises to create additional runway to wait for a post-pandemic recovery.
• In US liability management exercises, the main legal issue is typically around the correct interpretation of the debt documents and whether they permit the transaction in contemplation. A significant number of cases have been litigated, with mixed success. There may be additional legal issues to consider in the context of European liability management exercises. For example, in England, the directors’ duties regime will require a focus on the interests of the company and its creditors as a whole, and directors will need to be satisfied that any transaction is being entered into for proper commercial considerations and on the best terms available. The use of majority consents to deliver amendments to the debt documents would also need to be considered in the context of case law against minority oppression.
• Overall, it pays to be prepared. Debtors should be aware of options to improve their balance sheet position via a liability management exercise, and investors should be proactive in considering both offensive and defensive strategies to address them.

If you would like to receive invitations to future events in the 'Hot topics' series, please email katharina.crinson@freshfields.com.