9 minute read 28 Aug 2020
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How new restructuring frameworks could help companies in distress

9 minute read 28 Aug 2020

The European Preventive Restructuring Framework offers different ways to help companies impacted by COVID-19. Here’s what you need to know.

In brief
  • The COVID-19 pandemic has led to four groups of companies emerging, each with different needs for restructuring.
  • The new European framework may prove helpful for those companies who cannot currently cover debts, but who don’t have an acute liquidity problem.
  • Financial restructuring may be the best option to allow companies with valid business models to return to profitability.

Today, when a company is facing distress, three basic instruments for restructuring in and out of court are available. Depending on the degree of pressure for financial and operational restructuring, the following instruments are deployed by various European jurisdictions:

  • Consensual solutions with all stakeholders outside of insolvency (e.g., based on an independent business review or restructuring concept)
  • Early insolvency instruments (e.g., protective shield procedure, insolvency under self-administration) based on an insolvency plan and approved by the insolvency court
  • Regular insolvency proceedings executed by the insolvency administrator and approved by the insolvency court

A fourth restructuring option, which only comprises minor “in court” elements, has recently been developed by the EU. After lengthy negotiations, the EU Directive 2019/1023 on “Preventive Restructuring Frameworks, on discharge of debt and disqualifications, and on measures to increase the efficiency of procedures concerning restructuring, insolvency and discharge of debt” was published in the Official Journal of the European Union on 26 June 2019.

The European Preventive Restructuring Framework aims at effective preventive restructuring of viable companies in financial distress by reducing the length of restructuring procedures. As such, higher recovery rates for creditors are achieved as, normally, the passing of time only results in a further loss of value for a company in distress.1

In this context, the EU Directive explicitly focuses on small- and medium-sized enterprises (SMEs), which includes the vast majority of businesses in the EU, as these companies are more likely to be liquidated than restructured. SMEs are often unable to carry the higher restructuring costs that come with the more efficient restructuring procedures of some member states, such as the early insolvency instruments2 previously mentioned.

Member states have until the middle of 2021 to transition the EU Directive on preventive restructuring frameworks into national law. The national legislators are currently working on a "system-oriented" integration of the pre-insolvency restructuring plan, since a legal framework outside of the insolvency proceedings is planned in various jurisdictions.

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Chapter 1

The effects of COVID-19 on different groups of companies

Four groups of companies have emerged during the crisis with differing needs for restructuring.

The COVID-19 pandemic is having an immense effect on our economic ecosystem and is an unprecedented shock that will significantly impact future economic development.

As the first wave of the COVID-19 pandemic spread across the globe, lockdown and social distancing measures led to a plunge in demand and supply. Supply chains have been massively disrupted from the outset of the pandemic and continue to struggle even as regional clusters start to reopen. As the crisis has developed, four groups of companies in different sectors have emerged. There are companies that had a healthy and functioning business model before COVID-19 and companies with business models that were already under pressure going into the crisis. These groups can be divided further into those that are likely to be temporarily negatively affected and those for which the negative changes may be permanent.

Healthy business models

Depending on industry and company, shocks from COVID-19 may be temporary. We are already starting to see demand returning in some sectors. In many cases, however, companies are struggling with ongoing disruption. This is expected to continue for the remainder of this year, and any solution will depend largely on the availability of a cure or vaccine for COVID-19. Many sectors will see a return to a “new normal,” and will not need to change their existing business model. Such sectors may include hospitality (e.g., hotels and restaurants), advanced manufacturing, oil and gas, or technology, media and telecoms (TMT), which has seen some success in the COVID-19 crisis.

Other sectors are experiencing a different impact. Shocks due to COVID-19 have been disruptive and may lead to permanent change due to changes in customer behavior, due to fear, regulation or a shift in values. Their previously healthy business models will therefore need to adapt; for example, airlines are not only experiencing a drop in demand of more than 90% but also fear longer-lasting effects. Ongoing travel restrictions impacting personal travel, plus new ways of working, and the economic downturn causing businesses to defer travel, have the potential to reduce overall demand for air travel permanently.

Stressed business models

Other companies in various sectors, were already under pressure before COVID-19. These companies have been impacted by the current crisis in a different way. The pandemic has served as more of a catalyst for existing problems and in some cases revealed the true extent of their problems. The crisis has led to an immediate need for action, shortening the time available to react to underlying issues and to prepare a structured response. It may be a chance for many to address the need for structural change, but with a significantly more negative impact in the shorter term due to COVID-19.

For example, the automotive sector has been struggling with overcapacity and the need for structural change for some time. Non-essential stationary retail has also been heavily impacted by an immediate drop in demand due to lockdown. Changes in consumer behavior and the increasing shift to online channels presented challenges to this sector before the crisis. Companies need to more urgently take action to make the necessary changes in their business models to be able to compete during the crisis and to remain relevant in the future.

Some companies will experience a similar acceleration of challenges as a result of the COVID-19 disruption but will not be able to restructure or turn their business around. They will find that the sustained changes caused by COVID-19 have rendered their business model obsolete, and it will remain so once the crisis has passed.

The following graph illustrates these four groups of companies with a categorization of sectors as described above, indicating their potential need for restructuring:

EU Preventive Restructuring impact of COVID-19

Regardless of the robustness or relevance of business models before COVID-19, the immediate impact of the crisis has created financial stress for affected companies. Short-term liquidity problems can be seen across almost all sectors, with operational cash requirements often remaining very high, while turnover is drastically reduced. Short-term financing instruments, often in the form of state aid, are being widely deployed to help companies survive the crisis.

This short-term financing “solution” leads to a significant change in debt levels, putting a burden on the financial stability of companies in the future. The ability of companies to generate a sustainable Earnings before Interest as Taxes (EBIT) for interest payments and repayment of debt will depend heavily on the underlying business models and their relevance throughout the crisis and beyond. This may lead to a significantly increased need for financial and operational restructuring, and requires a case by case view on the most appropriate instrument available.

As indicated earlier, the instruments currently available represent a valid basis for restructuring and addressing distress prior to default. However, identifying the appropriate instrument needs to be approached case by case. In these uncertain times, with a buildup of non-performing loans looming, the European Preventative Restructuring Framework could be a helpful instrument to complement those already available.

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Chapter 2

The relevance of the European Preventive Restructuring Framework

The new EU directive may prove a suitable restructuring option for companies impacted by COVID-19.

The European Preventive Restructuring Framework focuses on financial restructuring measures, particularly capital measures, even though the definition of “restructuring” in the EU Directive also explicitly includes performance-related restructuring measures ("operational changes," cp. Art. 2, 1. (2) of the EU Directive). The need for financial restructuring is especially valid for companies with healthy business models that have had to increase debt levels due to COVID-19 and are facing temporary problems, rather than companies whose business models were under pressure before COVID-19 and that require operational restructuring measures.

The new framework could therefore be particularly suitable for companies whose increased level of debt is no longer covered by sustainable EBIT, but who do not have an acute liquidity problem and therefore do not qualify for an in-court restructuring procedure.

A pre-insolvency restructuring procedure under the framework could be appropriate for fundamentally viable companies in cases where a complete consensus cannot be reached, but where the vast majority of creditors prefer a restructuring over a formal insolvency procedure.

Where minority stakeholders are obstructing a solution, the possibility of a “cross-class cram-down” may be a valid argument for introducing the preventive restructuring framework.

It remains to be seen whether the new EU Directive can meet the official aim of creating a suitable restructuring instrument – especially for SMEs – with lower restructuring costs as compared to early insolvency instruments that are available in only a few Member States. To make restructuring a better option than liquidation in the eyes of the various stakeholders in SMEs, the rules of the European Preventive Restructuring Framework need to be easy to understand and follow.

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Chapter 3

Conclusion

Financial restructuring may enable companies with valid business models to return to profitability.

Our appraisal of business models and the effect of COVID-19 show that the four groups of companies we’ve outlined in this article will involve restructuring via one of the available instruments. In many cases, financial restructuring measures will suffice to enable these companies with valid business models, in affected sectors such as hospitality, TMT or advanced manufacturing, to return to profitability. In other cases, more operational restructuring measures will be necessary to turn around business models, e.g., in the retail and automotive sectors, and the higher level of distress will require more formal restructuring procedures, including the involvement of the insolvency court.

In view of the expected significant increase in companies facing financial difficulties, the rapid enactment of the European Preventive Restructuring Framework into national law is necessary in order to compete against the UK Scheme of Arrangement and the US Chapter 11 as alternative restructuring locations. As a result, the implementation of the EU Directive would provide safeguards against abusive relocation of the debtor's center of main interests during cross-border insolvency proceedings.

Summary

The COVID-19 pandemic is causing huge levels of disruption. As a result, for the four groups of companies outlined in this article there is a likelihood of restructuring using one of the available instruments. In many cases, financial restructuring measures will suffice to enable those companies with valid business models to return to profitability. In other cases, more operational restructuring measures will be necessary to turn around business models. However, those with higher levels of distress will require more formal restructuring procedures, including the involvement of the insolvency court.

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