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European Restructurings This Time Round

posted by John Armour

The private equity buyout boom of the past few years, followed by the credit crunch of the past couple of months, have been just as strong phenomena in Europe as they have been in the US. Buyouts took on greater and greater levels of leverage, fuelled by debt that was increasingly ending up in the hands of non-bank financial institutions-- hedge funds, insurance companies and pension funds-- rather than banks. Now it looks like these types of investors have, for the time being at least, lost much of their appetite for credit risk. Not only have the deals dried up, but the medium-term prospects for the more optimistically leveraged buyouts -- facing risks of covenant blowout and refinancing imperatives -- are not looking so great. So far, this is a familiar story for US readers. However, in the European context, the restructurings in this round are likely to take place against a background that is quite different in many ways, a few of which I'll try to explain after the break.

European firms have, until recently, tended to have much more concentrated holder of their debt than has been the case in the US. That is, debt has tended primarily to take the form of syndicated loans granted by a relatively small number of banks, and bond-type finance, parcelled up and traded freely amongst many different investors, has tended to comprise less of firms' outstanding finance than in the US. This tendency to concentrated, or bank-oriented, debt finance, was associated with two key distinguishing features-- (i) corporate bankruptcy laws that have traditionally been geared more towards liquidation than reorganisation; and (ii) a strong culture amongst the principal creditors-- the banks-- of seeking to achieve a (confidential) workout without invoking formal bankruptcy proceedings. (Of course, workouts happen in the US, but the Trust Indenture Act and the use of bond finance means that to be effective, there needs in most cases at least to be a prepack Chapter 11, which is a publicly notifiable event).

Where there are relatively few lenders, a consensual workout is relatively straightforward to achieve.To start with, it's easier to identify the participants, and there's less risk of simple disagreement over valuations. At the same time, a small(ish) community of banks who are regularly involved in syndicated lending and subsequent restructurings are able to develop norms concerning their behaviour in a restructuring environment. Overly aggressive hold-out tactics can cause an informal restructuring to fail, with disastrous consequences in a world without an effective reorganisation law. An awareness of this collective action problem leads lenders to sanction such hold-outs by threatening them with exclusion from future syndications. Central banks and regulators also play an important role in knocking heads together. In the UK, this crystallised in a set of market norms known as the 'London Approach', under which lenders would work together to achieve a restructuring. It's my understanding that similar sorts of restructurings, in which banks would effect a work out in private, were the norm in continental Europe as well.

The advent of more dispersed debt-- in the form of bonds (which have been issued in record amounts by continental European companies since the introduction of the Euro) and OTC securitisations of other loans -- has changed this picture for restructurings. Gone is the ready list of 'likely suspects' for holders of debt, with many new players entering the restructuring world. Simply identifying who actually holds the debt is a major challenge. Gone, too, is the consensus-building approach that used to prevail. Some distressed debt investors are testing the limits of hold-out strategies. Worse still, some debt holders who have bought protection via credit default swaps may actually stand to get a higher payoff (from their CDS counterparty) if a restructuring fails than if it succeeds.

Much of this picture of the new restructuring environment will sound familiar to US readers. The difference in Europe lies in the impact of th formal bankruptcy laws. In a number of EU jurisdictions, directors may face personal liability if they fail to put a firm into bankruptcy proceedings within a fixed time-- often a matter of weeks--once they discover their firm is balance sheet insolvent. This can impose a "guillotine" on the time available for a workout. At the same time, few European bankruptcy codes contain robust, tried-and-tested reorganisation laws, the impact of which is fully understood by parties bargaining "in its shadow" in trying to achieve a workout-- making it difficult for them to know when they might overplay their hands.

The net result of this is that, in my opinion at least, we're going to see a number of the highly leveraged buyouts that run into difficulty winding up in formal bankruptcy proceedings, after a workout has been attempted and failed. This is, I expect, going to lead to political pressure for the reform of some European bankruptcy codes. At the same time, I also expect we're going to see an uptick in a phenomenon that's just emerging in Europe at the moment-- the possibility of relocating a distressed company so as to apply a different governing law. Jurisdiction and choice of law in cross-border insolvencies within the EU are governed by the European Insolvency Regulation according to the debtor's "centre of main interests" (COMI). There's a presumption that a corporate debtor's COMI is the same as its registered office (jurisdiction of incorporation), which may be rebutted by showing it has no real attachment to that jurisdiction. So a company's COMI can be changed by shifting its registered office (and/or its head office) to another country. Former barriers to changing a company's jurisdiction of incorporation are gradually being dismantled in the EU (leading to the possibility of regulatory competition). And for a large restructuring, this sort of technique may be worthwhile.

A recent example was the restructuring of Schefenacker, a German auto parts manufacturer. The state of the company's balance sheet was such that, under German law, the board faced the prospect of personal liability if they did not either achieve an out of court restructuring or put the company into bankruptcy within a few weeks. However it wasn't feasible to achieve a restructuring in this time. So instead they solicited creditor consents to relocate the company's COMI to the UK, thereby avoiding the "guillotine" provision. UK law also facilitates a cram down of dissenting creditors more readily than does German law, increasing the chances of a restructuring succeeding. My expectation is that, as some European firms that over-leveraged themselves during the past couple of years run into difficulties with covenants or refinancings, we will see a lot more of this sort of jurisdictional arbitrage within Europe. It will be a very interesting time, I think, for bankruptcy law and lawyers in Europe.

Comments

John, Very interesting post on thickening of credit market, esp. COMI movement ideas at the end. On that specific case, are you aware how COMI moved? You can't just "consent" to move it. Perhaps this was a case with multiple assets in UK and in Germany and so they simply re-paperworked the artificial corporate entities?

J. PS: If answer too long/boring to readers, just email me on pottow@umich.edu (but their geekiness on all matters insolvent would surprise you!).

John

Schefenacker's COMI was moved by (as John A suggests) shifting its registered and head office from Germany to the UK.

Following the Eurofood decision of the European Court of Justice, COMI is determined by objective factors ascertainable by third parties.

In this case, not only did Schefenacker AG move its headquarters (in the language of para 13 of the preamble to the European Insolvency Regulation No 1346/2000 "the place where the debtor conducts the administration of his interests on a regular basis") to the UK, but it converted to a limited partnership and transferred its business, assets and liabilities to the new general partner, a UK-registered entity, Schefenacker PLC, by universal succession.

Such migrations will continue to occur.

Chris (or John) -- This is getting even more interesting! If HQ were moved to UK, then that implies to me one of (at least) two thing: (1) that substantial activities were already underfoot in UK, and so the HQ moved to "catch up" to the rest of the company (and hence, at least arguably, the COMI already was); or (2) nothing on the ground changed, but the HQ moved from Germany (where all the operations truly are) to the UK, in which case the COMI's migration seems at least somewhat precarious, no?

Thanks for getting some international perspective for our U.S. readers!

The European Insolvency Regulation (see my post for a link to the text) says in Article 3(1) that for a corporate debtor, COMI is presumed to be the place of the registered office. However, this presumption is rebuttable. Recital 13 in the Regulation’s preamble states (as Chris says) that COMI should “correspond to the place where the debtor conducts his interests on a regular basis and is therefore ascertainable to third parties”. This scheme reflects a drafting compromise between Member States whose conflicts rules treat companies as domiciled where they are incorporated, and those whose rules follow the location of the actual seat of business. Unfortunately, its inherent ambiguity leaves the application of COMI shrouded in some uncertainty.The ECJ in Eurofoods explained that the Article 3(1) presumption would be rebutted only by “factors which are both objective and ascertainable by third parties,” reflecting the importance attached to certainty for those extending credit. At the same time, it took the view that the presumption would be rebutted in the case of a “letterbox” company carrying on no business at all in the jurisdiction of its registered office. It is possible to read this as implying that in cases where some business is carried on in the place of the registered office, the Court would be slow to find the presumption rebutted. Precisely which sorts of “objective and ascertainable” factors might be relevant remains uncertain, but it is worth noting that in the era of internet searches, the registered office may be just as readily discoverable than the location of physical premises, especially for a large organisation with premises in multiple jurisdictions.

My view is that in many cases, moving the registered office would suffice, provided that it is not just a "letterbox". Hence it makes sense to hold board meetings, etc, in the jurisdiction to which the registered office has migrated. To be on the safe side, it is desirable also to move the head office. Moving just the head office, and not the registered office would, however, run into problems because the presumption under Art 3(1) would then count against you.

This in turn begs the question of how the registered office is to be moved. My understanding of Shefenacker is that German law provides for a successor liability doctrine, which means that selling all Co A's assets from Co B means Co A's liabilities carry across too. This was used to "move" the company from a German entity to a UK plc. Not all Member States' legal systems have such a doctrine. Another technique is to merge the initial company into another entity in the "target" jurisdiction, which has been made possible both under the 10th EC Company Law Directive and the ECJ's recent decision in SEVIC. The proposed 14th Company Law Directive will permit companies in the EU to change their registered office directly. I have a paper discussing these issues in more detail here: http://ssrn.com/abstract=860444 which may be of interest.

John, I'm still wondering about what counts for movement. You say hold meetings, etc., but as I recall that was expressly NOT enough in Eurofood. In fact, one of the directors was Irish, wasn't he? Yet they used Recital 13 (from Virgos-Schmit originally as I recall) to say, no, that's not good enough. REAL COMI is in Italy. So I understand how one moves registered office (as that term is used as a synonym with place of incorporation). But just moving that, on its own, IS a letterbox situation and hence not enough to shift COMI. So we have to move "letterbox-plus," And mere holding of board meetings, and even the physical presence of a director or two, isn't enough: the presumption still gets rebutted. See Eurofood. So we don't have maximal clarity on what the "plus" will be to move a COMI, but we know that it's going to be non-trivial. Schefenacker moved not just its registered office, but its actual real head office(!). So that's enough (as it should be, if we take the legal fiction that the objective and ascertainable language means where the head office actually is, esp. in cases where it accords with its registered office). Thus the open question, if I've got it right, is what level of "plus" that's less than Schefenacker and more than Eurofood.

John: you're absolutely right that there is an open question over how much more than "bare" registered office will suffice to ensure that the Art 3(1) presumption (that a company's jurisdiction of registered office is also its COMI) does not get rebutted. The open question is how much more than "just" registered office, but less than registered *and* head office, is necessary to ensure COMI stays with registered office.

However in Eurofood the ECJ did not say that the "real" COMI was in Italy. Rather, they said that (i) rebutting the presumption requires "factors which are both objective and ascertainable by third parties" which "enable it to be established that an actual situation exists which is different from that which locating it at that registered office is deemed to reflect" and that (para 34)(ii) such factors might exist in the case of a 'letterbox' company not carrying out any business in the jurisdiction of incorporation (para 35). Applied to the facts of Eurofood, the COMI was Ireland. (You can see the judgment here: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:62004J0341:EN:HTML )

For what it's worth, the Court's choice of such an extreme example in (ii) makes me infer that the presumption in favour of jurisdiction of registered office is quite a strong one-- that is, that carrying on *some* business there might be enough to ensure it wasn't rebutted.

John/Chris:

To be more precise - Schefenacker did not exactly "move" its registered office in the traditional understanding. A transfer of the registered office into another jurisdiction is not (yet) permitted under German law.

Instead, the German rules of universal succession were used to effect a migration to the UK. First, the German stock corporation was converted into a "limited partnership" (KG) under the German Transformation Act. As a result of the conversion, you have a German limited partnership with one or more general partners and one or more limited partners. The general partner has to be a company registered in the UK. Second, all limited partners of the limited partnership either sell their partnership interests to the English partner or agree to withdraw from the limited partnership.
By its nature, the limited partnership automatically ceases to exist with only one remaining partner and, under German principles of succession, the remaining English partner becomes the full legal successor to all assets and liabilities of the partnership. As a result, the German company ends up as a UK company.

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