Vol 5 (2008) - Issue 6

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The Changing Role of Shareholders in Restructuring

Introduction

One can scarcely open a financial journal without reading about the roles that holders of derivatives and other financial instruments may have in the demise of major institutions and speculation about their rights as potential creditors. All of this uncertainty makes quantification of the ‘black-hole’ problematical and makes rescue less certain. In addition to these problems is the need to consider the claims that shareholders may have as possible creditors in insolvency proceedings. For those who advance credit confident that creditors will always be paid before shareholders, this requires the ability to think the unthinkable.

The role of shareholders in the reorganisation of the debtor

Domestic legislation determines those issues where shareholders are given the right to vote in liquidation or reorganisation proceedings. By the time either of these proceedings is proposed, shareholders are usually ‘out of the money’ as potential beneficiaries of the process, in that the equity is worthless. However, there are other dimensions to consider, especially if restructuring is on the cards and the debtor is a listed company.

The law relating to restructuring is a balancing game, permitting the debtor to reorganise its affairs in the ‘greater good’, while modifying the rights of the creditors and the shareholders to receive their pound of flesh without delay (albeit that all liquidations involve considerable delay). Typically, only the creditors will be required to vote on the acceptance of any proposal.

Although the shareholders are probably already out of the money, it is important to remember that some of them, especially founder shareholders, may also be very significant creditors, either as lenders, bondholders or in some other capacity. Where the debtor is unquoted, these shareholders may be instrumental in any refinancing and in particular, the provision of DIP finances at affordable interest rates.

Financing complexity

The market has offered an infinitely variable range of financing options in the last decade – typically the debtor may be financed by traditional ‘first lien’ secured bank lending, mezzanine debt in one or more tranches, and more leveraged products including second lien debts and PIK notes. Some of these may be useful to the refinancing. The extent of creditor claims may go far beyond commercial banks and supply creditors and there may well be agreements between these parties with respect to their rights as creditors, to security, voting rights, the right to sue etc.

Derivatives may come into play for very substantial claims but the amount of their claims may not be capable of being determined until an insolvency event occurs. Indeed, prior to a formal insolvency event, the state of decline of the company will determine who is at the table to approve any proposed restructuring.

As a result of a substantial increase in distressed debt trading, it is probable that some, possibly all, of the parties will change during the restructuring process. Debt trading was regarded as the bogey man of financing a decade ago but is now regarded as advantageous in that it offers reluctant lenders an escape route, enabling their place to be taken by lenders who may be interested in funding the restructuring albeit with agendas and motivation that may differ from those of the initial lenders.

Priority of creditors

Now it is a generally accepted proposition that in any insolvency or restructuring process, creditors should be paid in full before the shareholders participate.