Insolvency Reform in the EU and UK in the Era of Brexit: As Political Systems Diverge, Insolvency Regimes Converge

1. Introduction

In recent years reform of insolvency legislation has been on the agenda in both the UK and in the EU through the EU's flagship Capital Markets Union ("CMU") initiative. Recent publications appear to indicate there will soon be substantial changes in the EU and the UK, which will have far reaching implications for distressed investors. Crucially, the proposed reforms suggest there will be key initiatives introduced, such as a new restructuring procedure including a cross-class cram down, and a moratorium for solvent companies. The changes are particularly significant as they are likely to limit the ability of "out of the money" shareholders and junior creditors to adapt "hold out" strategies.

In November 2016, the European Commission published a draft directive (the "Draft Directive") which had at its root an ethos of early restructuring, second chance frameworks and the avoidance of unnecessary liquidation of viable companies. Two years later, following consultations on a range of potential reforms by the UK Department for Business Energy & Industrial Strategy (the "Government"), including most recently in March 2018, the Government has issued a paper (the "Response") summarising responses received in the aforementioned consultations and setting out the Government's proposed next steps.

The proposed actions in the Response fall generally into two areas: corporate governance and insolvency. Whilst the corporate governance proposals appear to address some of the criticisms of the UK regime emphasised by the liquidation of Carillion in early 2018, this alert will focus on the highly significant reforms to the insolvency legislation. Interestingly it appears that as the UK prepares to leave the European Union, the potential reforms to insolvency legislation may bring the EU and the UK closer than ever in matters of insolvency.

The Response revealed that a number of significant changes will be implemented, with the aim of ensuring that the UK's insolvency regime "retains its world-leading position".

2. New restructuring vehicle

The new "flexible restructuring plan" which the Government intends to implement will allow a company to bind all creditors, including dissenting junior creditors, through a cross-class cram down provision which is comparable to the absolute priority rule^[1] contained in Chapter 11. The cram down can only be imposed provided dissenting creditors are no worse off than in liquidation; and the legislation will also provide that where a cross-class cram down is applied, a dissenting class of creditors must be satisfied in full before a more junior class may receive any distribution or keep any interest under a plan. The proposal varies from the absolute priority rule, however, as it permits a court to overrule certain provisions and confirm a restructuring plan where it is necessary to achieve the aims of the restructuring and it is just and equitable in the circumstances. The voting thresholds under the new plan will be 75% of a class by value, and more than 50% of unconnected creditors (note, however, that it is to be confirmed if the latter will be in each class or taken as a whole).

In terms of procedure, it is intended that the process will resemble a scheme of arrangement, with a restructuring plan proposal being sent to creditors and shareholders and filed at court. There will then be a court hearing at which classes of creditors and shareholders will be examined (with the possibility of challenging class formation), following which there will be a vote on the proposal. Ultimately, however, it will be at the court’s discretion whether to confirm a plan and make it binding on creditors and shareholders.

Whilst there are outstanding points to be confirmed in relation to the new procedure, it seems a useful tool which may soon be at the disposal of a distressed company.

3. Moratorium

As well as the introduction of the new procedure, the Response suggested that additional reforms to insolvency legislation would be forthcoming. One is the introduction of a new moratorium for companies which are not yet insolvent.

The new moratorium is intended to encourage business rescue. It will give financially distressed companies which are ultimately viable time to restructure or seek additional investment, and will last for an initial period of one month with the possibility of further extensions of up to one month by the company and further if approved by creditors. To be eligible for this new moratorium, the company cannot already be insolvent and it must be able to carry on its business and meet its current obligations. Furthermore, the prospect of rescue of the company must be more likely than not. Throughout the moratorium, the company's compliance with the qualifying conditions will be monitored by an authorised supervisor.

4. Termination clauses

Additionally, the new reforms will prohibit the enforcement by a supplier of termination clauses in contracts for the supply of goods and services on the grounds of a party entering into a formal insolvency procedure. "Insolvency procedure" for this purpose will include liquidation, administration, company voluntary arrangements, the new moratorium and the restructuring plan mentioned above. The Response also notes that the Government acknowledges there are certain specific types of financial product and service which may be exempt; however, it has not provided any further detail on this. Whilst the reform does not prohibit these clauses in general as is the case under Chapter 11, it is an interesting step towards the jurisprudence of the United States and an encouragement of a "rescue mentality".

5. The insolvency framework in general

As well as the specific procedures outlined above, the Government has considered the responses to its various consultations and has noted it will: (a) take measures to ensure greater accountability of directors when selling subsidiaries in distress (noting, however, that any measures which are implemented should not dis-incentivise rescues or hold directors liable where they have no control), (b) legislate to enhance existing recovery powers of insolvency practitioners in relation to value extraction schemes, and (c) legislate to give the UK's Insolvency Service the necessary powers to investigate directors of dissolved companies.

6. Unclear timetable for reform

Whilst the details of the reforms are still to be finalised and the potential timeline is unknown, it appears these reforms will have a significant effect on the landscape of insolvency legislation in the UK. Attention will now turn to the European Commission to see the next steps in the European Union insolvency reforms. Whilst the Draft Directive was published in 2016, there does not appear to be a clear timeline on implementation of this; however, the EU has explained it is committed to putting in place the foundations of the CMU by mid-2019 and, following recent developments, discussions will now be taking place between the European Commission, European Parliament and Council of the European Union. In any event, once the Draft Directive comes into force, there will be a delay before individual countries implement the relevant provisions.

7. Current EU insolvency approach – the European Insolvency Regulation

Any attempt to harmonise insolvency systems within the EU was, until quite recently, seen as a "bridge too far" for EU policy makers. Insolvency systems are highly reflective of a country's tradition, culture and priorities. The simple question of how creditors are treated in an insolvency speaks to each Member State's approach to capitalism, property rights and employment rights. Some countries are seen as "debtor friendly" and focussed on employee rights (such as France); others are far more "creditor friendly" (such as the UK), focussing on maximising the insolvency estate for creditors and particularly secured creditors. All countries have for some generations tried to move away from a culture of insolvency being a thing of shame which must be punished, to a more permissive and rehabilitative approach; some countries have moved further on the continuum than others.

In 2003 a tentative harmonisation measure, the European Insolvency Regulation^[2] (the "EIR") was implemented. The EIR, which was revamped in light of experience in 2015 in the form of the recast EIR^[3] was, at its core, designed to address where a company in a Member State^[4] should file for insolvency, and ensure that once an insolvency process had been filed, the laws of the country of filing would govern the administration of the insolvency for all Member States. It was a limited and arguably brilliant reform. Consequently it led to competition amongst Member States to improve insolvency systems as states looked over their shoulders at reforms taking place in other Member States. Insolvency professionals in the UK in particular began to use the EIR to shift the location of certain big insolvencies taking place in Europe into the UK. Competition created the conditions for improvement and, to an extent, convergence. We have discussed how the UK is planning to reform insolvency law and, as outlined below, it appears the UK and EU are heading in a similar direction. The EU has clearly decided to push forward with more substantive harmonisation measures and, Brexit or no Brexit, the UK is following, or perhaps leading, it's hard to tell.

8. Comparing and contrasting the Draft EU Directive and the UK's Response

The similarities between the Draft Directive and the potential reforms outlined in the Response are clear, despite there being some difference in respect of the intricacies and procedures. Both documents contain a number of similar concepts, such as access by a solvent company to an optional moratorium and a restructuring process which separates creditors and shareholders into separate classes. A summary of the similarities is seen below:

Generally, we see the intention behind both reforms as leading to the saving of distressed corporate entities. As it stands, most UK restructurings don’t lead to the saving of the entity. In the UK, "pre-pack" sales where the business and assets of the failing company are sold by an administrator are a well-trodden path for financially stressed companies. Pre-existing contracts need to be transferred to a new owner with the original "shell" being left with the liabilities – the process can be disruptive for the business. Quick pre-packs without court involvement are not a feature of the insolvency systems in the rest of the EU. Notwithstanding years of insolvency reforms on the continent, insolvencies often lead to fire-sale insolvencies where the corporate shell fails to survive and, crucially, often the underlying business fails to survive.

Looking at the UK, the makeshift solution of a "pre-pack", which isn't a term used in the Insolvency Act 1986, being more of a process arrived at by practitioners and permitted by judges in the absence of statutory guidance to the contrary, has saved many businesses. It is a highly successful procedure which has arguably led to better returns to the estate and has saved more jobs than the alternative of a slow, unplanned liquidation. However, there are times where the company possesses a contract or a licence so valuable (and for some reason either not transferable, or transferable at great cost), that a pre–pack is not a viable solution. In situations where the company needs to be saved to maximise value, the new reforms should give directors a new tool. This doesn't mean that the pre-pack will be eliminated, more that another tool is being added to restructure a company prior to the implementation of more draconian solutions involving an administration or liquidation.

Both the EU and UK proposals allow for the binding of creditors under a cross-class cram down mechanism. Crucially, however, the reforms at the very least leave open the possibility that shareholders could also be bound under the cross-class cram down. As currently drafted, the Directive provides Member States with the freedom to decide whether equity holders will have the right to vote on a restructuring plan; however, where they do have the right to vote, they can be included in the cram down. The Response (dealing with the UK consultation), on the other hand, does not explicitly state that shareholders can be included; however, it seems to be implied.

9. Elimination of the negotiation leverage of out of the money creditors and shareholders?

Historically, in the UK and in other EU jurisdictions, we have seen battles in which out of the money shareholders or creditors have sought to leverage their position to prevent a restructuring via a debt for equity swap or where stakeholders look to "sell" their consent for a return in excess of what they would have received if a liquidation procedure had been used. In the case of MyTravel in the UK for example, subordinated bondholders had opposed a restructuring plan which, in the subordinated bondholders' view, proposed to give shareholders a disproportionately sized stake in a restructured business in comparison to the returns they would have received in a liquidation. MyTravel owned a travel licence which meant that the corporate vehicle would be far more valuable if MyTravel remained in existence. The corporate vehicle (and the licence) would only be preserved if the shareholders agreed to vote in favour of a restructuring which included a debt/equity swap. Accordingly a proposal needed to be made which was attractive to shareholders. The "shareholder premium" where shareholders enjoy a disproportionate return in order to secure a shareholder vote is, if anything, a greater feature of European restructuring compared to the UK given the absence of a pre-pack alternative. Under the proposed legislation, the leverage of dissenting parties who are "out of the money" will be reduced. This reduction of leverage will be even more significant if the final wording of the respective pieces of legislation confirm that shareholders can be subject to the cram down. Given that a shareholder cram down was dismissed at a late stage in discussions relating to recent French insolvency reforms relating to the sauvegarde procedure, it will be interesting to see how France, as well as other countries in the EU, decide to implement the Directive. There have been a number of very prominent shareholder activist campaigns in France aiming to increase the return to shareholders on a restructuring, the Eurotunnel and SoLocal restructurings being two key examples, which would not have been possible if these cram tools were available^[5].

The introduction of the new moratorium in both proposals is also a key factor as it provides stressed companies with a shield, the absence of which is a key weakness in the current UK regime^[6]. It will, however, be of interest to see the final drafting of the legislation around this new moratorium and whether there will be the potential for abuse by companies.

Whilst the Response is yet to take the form of any legislation and the Draft Directive is in the process of being discussed and negotiated, it certainly appears that the outcome will, at the very least, bring some degree of harmony to the insolvency regimes of the EU and UK. As we move towards the UK's departure from the EU, interested parties will be keeping a close eye on the drafting of the final legislation to see the extent to which this potential harmony becomes binding.