Debt for equity swaps:
Summary and implications
Companies are often looking for ways to strengthen their balance sheet and reduce their debt. This is particularly the case for companies in financial difficulty. Similarly, where a company is having difficulties meeting its financial commitments, creditors are concerned with ensuring that that they obtain as much value as possible from that company.
Increasingly debt for equity swaps are being used to achieve these objectives.
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Whether or not a debt for equity swap is appropriate will depend on various factors including:
• whether the key commercial objectives of the company can be achieved by a debt for equity swap;
• whether the debt for equity swap has the requisite support of participating creditors and shareholders; and
• whether are there any regulatory issues which may impact on the ability of the company to undertake a debt for equity swap.
Debt for equity swaps
Converting debt into equity can be a key component of restructuring a company is financial difficulty.
A debt for equity swap involves a creditor converting debt owed to it by a company into equity in that company. A debt for equity swap may or may not be completed within the framework of a statutory procedure and often forms part of a corporate rescue.
A debt for equity swap may be appropriate where a company: • is having solvency issues but is still ultimately viable; • is over geared; or
The key commercial issues for creditors, shareholders and the company will be:
• valuation of the company;
• how much of the debt owed is to be substituted for equity; and • what type of equity interest the creditor will acquire.
Parties will also need to consider what structure best delivers the debt for equity conversion, keeping in mind that different structures require different levels of support from creditors and
shareholders (see table 2).
Table 1: Reasons for doing a debt for equity swap
Benefits to the company Companies will also need to consider the
impact of applicable laws, rules and regulations such as those relating to public companies, regulated companies such as banks, competition, tax, accounting and pensions (discussed further in this briefing).
Nature of an equity interest
Any “equity” interest may be used, such as ordinary shares, fixed coupon ordinary shares, preference shares or equity warrants.
• strengthen the balance sheet
• possibly assist directors avoid personal liability for wrongful trading
Benefits to participating creditors
• possible greater return than if an administrator is appointed
• participation in any further growth of the company
• may be used opportunistically to acquire sub-performing debt (often at a discount) with a view to converting to equity and, in some instances, gaining control of the company
In many cases the equity interest will try to
replicate the terms of the debt facility (e.g. with respect to payment of interest/dividends and repayment date/redemption date) and it is common to create a new class of shares, such as preference shares (often described as “quasi debt”).
Preference shares generally have some or all of the following features: • priority over all other classes of shares as to income and capital return,
such as fixed preferential dividends and a fixed date for redemption; • right to convert to ordinary shares in certain conditions (often seen as
the “reward” element of the debt for equity swap);
• veto rights over certain matters (such as variation of class rights or actions that may result in dilution);
• rights to appoint directors; • restrictions on transferability; and • limited voting rights.
As dividends and redemption payments must be funded out of the company’s distributable reserves, consideration needs to be given to whether the company can service the preference share dividend and/or redemption obligations and whether there are there any dividend blocks within the group which need to be addressed (for example, by a capital reduction).
Table 2: Possible structures
Subordination of debt
Debt converted into a subordinated obligation convertible into shares, such as an equity warrant or convertible bond
• ranks behind other debts but ahead of equity
• consent of all participating creditors required
• binds only those creditors who agree to participate
• simple and flexible
• does not address balance sheet issues Contractual debt for equity restructuring
Debt is converted into shares • consent of all participating creditors required
• binds only those creditors who agree to participate
• simple and flexible
• balance sheet issues addressed Scheme of arrangement
Company makes an arrangement or compromise with its creditors or classes of its creditors
• can be used to effect almost any internal reorganisation, including a debt for equity swap
• approval of 75% in value, and 50% in number, of those voting within each class of affected creditor required
• must be sanctioned by the court (must be fair and reasonable)
• binds all creditors (can be used to “cram down” objecting or more junior creditors)
• more costly and complex procedure
• balance sheet issues addressed Company voluntary arrangement
A compromise or other arrangement with creditors in accordance with a statutory procedure
• implemented under the supervision of an insolvency practitioner
• approval of more than 75% in value of creditors, and more than 50% in value of members, required
• binding on all creditors (can be used to “cram down” objecting or more junior creditors)
• does not affect rights of secured or priority of preferential creditors unless they agree to the proposals
• more costly and complex procedure
• balance sheet issues addressed
Entity which will issue the equity interest
Parties need to consider which entity will issue the equity interest. This may be the debtor entity, a parent of the debtor entity or a clean entity (such as a new holding or intermediate holding company requiring a more complex structure).
Which creditors can/will participate in the debt for equity swap?
The proposed structure of the debt for equity swap will often depend on whether it is intended for all, or only certain, creditors to participate.(i.e., senior and/or mezzanine and/or junior creditors). The parties will need to
• it is possible for any junior creditors to exert disproportionate influence; • there is scope to “cram-down” certain creditors' interests;
• the participating creditors have the capacity / authority to hold the new equity interest, the internal infrastructure to manage the investment and (if required) individuals to represent it on the board of the company.
Shareholder approval is often required to approve matters necessary to effect a debt for equity swap, such as creation of a new class of shares; directors’ authority to allot shares; amendments to the articles of association; and disapplication by shareholders of their pre-emptive rights.
The implementation of a debt for equity swap must not be unfairly prejudicial to minority shareholders (when measured against the majority shareholders).
Issues for public companies
Certain implications arise if a creditor (alone or acting in concert with others) reaches a certain threshold of ownership interest in the company. For example:
• in the case of companies admitted to the Official List, 25% of shares must remain in public hands; and
• where the creditor(s) hold a substantial holding (i.e., 10% or more) there are more onerous disclosure and compliance requirements under the related party rules in the Listing Rules or AIM Rules.
Further, for both public companies and private companies whose securities are or have been traded on a public market at any time during the last 10 years where the creditor(s)/ concert parties reach 30% or more, a mandatory offer for all the issued shares of the company may be required.
Certain companies may require regulatory approval before a new significant shareholder can be introduced. These include:
• FSA regulated businesses; and
• businesses subject to cross-media ownership rules.
If the creditors’ acquisition of shares amounts to a ‘change in control’ of the company, or a change in the degree of control, this could constitute a merger. It will be necessary to assess:
• whether there is a merger; and
• if there is any requirement to notify the transaction to the relevant merger control authorities to obtain the necessary consents or clearances.
If the European merger control regime’s jurisdictional thresholds are met, notification to the European Commission is compulsory. If the merger falls under the jurisdiction of the UK, the Office of Fair Trading has the power to review the qualifying merger - but the decision on whether or not to notify is a risk assessment. Different countries will have their own merger regimes, which may apply if the merger has an international dimension.
A debt for equity swap can result in favourable tax treatment for both the creditor and the company.
Where both parties are subject to corporation tax, the release of a debt is generally deemed to be income in the hands of the company (other than as part of insolvency proceedings). However, where the release is in consideration of the issue of ordinary shares, the company will not be deemed to receive income.
The creditor will get a deduction equal to the difference between the carrying value and the market value of the loan and, going forward, the creditor’s base cost in the shares in the company will be equal to the market value of the released debt.
If a creditor acquires 20% or more in the company: • a presumption of participating interest arises;
• the company may be a deemed a subsidiary of the creditor if the creditor exercises a dominant influence; and
• consolidated accounts may be required.
If there is a final salary pension scheme in the group, further consideration will be needed of:
• the impact of the debt for equity swap on the covenant of the employers participating in the scheme; and
• whether or not to seek clearance from the Pensions Regulator. In a corporate rescue situation, the Pension Protection Fund may also be involved.
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