Deleveraging to control

As the restructuring landscape in Australia continues to develop we are seeing new and innovative structures being utilised to delever distressed Australian companies. In particular, a deleveraging of debt coupled with an issue or transfer of equity continues to be a favoured and useful path for investors seeking to gain control. Whether you refer to it as “loan to own”, a “debt for equity swap” or something else, there are a number of structures being used to implement these transactions.

These conversion structures are being promoted in a variety of restructuring scenarios in both a consensual and a non-consensual context. In particular, we are noticing a pronounced increase in the application of these structures to borrowers listed on the Australian Securities Exchange (ASX), with the necessary adaptations to accommodate the ASX Listing Rules and various restrictions under the Corporations Act 2001 (Cth). These examples demonstrate a willingness on the part of investors to push the boundaries of the Australian statutory framework in an effort to obtain control of a corporation with the intention of generating a viable return from a newly restructured company or group.

As the innovation continues, there are a number of issues arising that investors need to keep in mind when implementing a transaction of this type. This article seeks to draw together a number of the examples encountered in the Australian market to date to highlight some key considerations relevant to an investor with a focus on value and control — that is, what should the restructured equity look like in a transaction of this nature?

Where does the value break?

The first consideration that is key to the pursuit of these transactions is a clear understanding of where the “value breaks”. Put another way, investors will want to satisfy themselves that they understand (as best they can) the true value of the relevant company and its assets, such that if the restructuring fails and the assets are liquidated, their initial investment can be recouped.

In a consensual context, understanding value is important in managing stakeholder interests as not all stakeholders will be able to recover their investment. If it is clear on the valuation evidence that a group of creditors would receive nil on an insolvency, offering a small return to these creditors can sometimes be sufficient incentive to secure their agreement to the restructuring. On the other hand, in a non-consensual context, valuation evidence has become an integral part of any necessary court application to demonstrate that the creditors as a whole would receive a better return if the transaction is implemented than they would on a liquidation (which is invariably the only alternative). We explore below how the Australian courts have relied on valuation evidence when determining whether to approve a non-consensual control transaction.

Valuation evidence in section 444GA applications

Investors are more frequently seeking to utilise section 444GA of the Corporations Act, pursuant to which a deed administrator under a deed of company arrangement (DOCA) can seek leave of the court to compulsorily transfer the shares in a distressed borrower. The court will grant leave if the deed administrators can demonstrate that the transfer would not “unfairly prejudice” the interests of the shareholders. In considering whether unfair prejudice would result from the transfer, the court has made it clear that prejudice can only be sustained if the shares hold some “residual value”.^[1]

Some shareholders have argued that the simple fact that the deed proponent is seeking to acquire the shares indicates that there must be some residual value in them — why else would the proponent seek to acquire them?^[2] This was the case in Weaver in their capacity as Joint and Several Deed Administrators of Midwest Vanadium Pty Ltd v Nobel Resources Ltd^[3] (Weaver) where the objecting shareholder argued that the mere existence of the recapitalisation proposal in that case inferred that the shares held some value. However, in determining whether there is residual value in the equity, the courts^[4] have consistently held that if liquidation is the only alternative to the proposal and on a liquidation the company’s assets would be insufficient to discharge the whole of its debts (meaning that equity will receive no return), the shares will have no residual value. Accordingly, the courts have to date solely had regard to liquidation scenario valuations. However, there are clearly a number of ways in which a business can be valued which can influence the conclusion as to where the value breaks.

For example, in Re Nexus Energy Ltd (Subject to Deed of Company Arrangement)^[5] (Nexus), both the deed administrators and the opposing shareholders brought substantial valuation evidence to support their arguments on value — the deed administrators arguing that a liquidation valuation was necessary and the shareholders arguing that a non-distressed, arm's-length, going concern valuation was more appropriate. Unsurprisingly, the deed administrators’ valuation indicated that the company’s assets were insufficient to satisfy its liabilities and the shareholders’ valuation showed that there were sufficient assets to discharge the debt and make a distribution to equity. The court ultimately found in favour of the deed administrators on the basis that a going concern valuation did not take into account the specific circumstances Nexus was in, including that it had no funding in place, was in administration and was unable to meet its capital commitments at that time. Despite this, the court inferred that a going concern valuation (assuming a non-distressed, arm's-length, going concern sale) could be appropriate in other circumstances.^[6] We are yet to see this valuation methodology being adopted by the courts in respect of section 444GA applications.

Valuation evidence in schemes

Similarly, when proposing a creditors’ scheme of arrangement, the scheme company will invariably need to satisfy the court based on expert valuation evidence that if the scheme of arrangement is not approved, the only alternative is liquidation, and that creditors will receive a superior return under the scheme than if the borrower was wound up.^[7] The valuation evidence needs to be, wherever possible, incontrovertible. For example, in Re Boart Longyear Ltd,^[8] the expert evidence concluded that, amongst other things, the amount owing under the group’s finance facilities exceeded its enterprise value by more than US$500 million, that secured scheme creditors would receive a better return under the schemes than on a liquidation, and that unsecured scheme creditors and subordinated claim holders would likely receive no recovery on either a winding up or under the schemes.

Interestingly, the scheme of arrangement jurisprudence is developing such that an assessment of value can now also be a relevant factor when determining class constitution. The courts have consistently held that creditors should be in separate classes for voting purposes if their “rights” are sufficiently dissimilar as to make it impossible for them to consult together with a view to their common interests.^[9] In the decision of First Pacific Advisors LLC v Boart Longyear Ltd^[10] the Court of Appeal held that if the only alternative to the scheme proposal is a liquidation of the scheme company, when determining whether the creditors in a particular class have rights which are sufficiently dissimilar, the court should have regard to the creditors’ rights afforded by the scheme as compared with their rights in a liquidation of the scheme company. This affirmed the decision of the judge at first instance and, although the applicant pursued special leave to appeal to the High Court of Australia, the application was subsequently withdrawn.

Can you take too much equity?

The courts in Australia have not yet been asked to consider in detail whether the amount of equity to be issued to a party or group under a debt to equity transaction was too much (or too little) having regard to the value of the debt being compromised. Instead, the court applications involving a transfer or issue of equity have broadly involved:

• an acquisition of all of the shares in a private company^[11] — for example, Weaver, Re Kupang Resources Ltd (Recs and Mgrs Apptd) and Re Western Work Force Pty Ltd concerned applications under section 444GA of the Corporations Act pursuant to which an incoming investor sought to acquire 100% of the equity in the distressed company as part of a broader deleveraging proposal
• an acquisition of all of the shares in a listed company that was to be delisted^[12] — this was the case in Nexus where the DOCA proposal involved a transfer of 100% of the shares in Nexus Energy Ltd (then ASX listed) to SGH Energy (No 2) Pty Ltd (a related entity of Nexus’ sole secured creditor) and a subsequent delisting of Nexus Energy Ltd
• an acquisition of a parcel of shares in a listed entity to ensure compliance with an ASX direction — this was the case in Shepard, Re Quest Minerals Ltd v Mutual Holdings Pty Ltd^[13] where, in connection with a recapitalisation proposal, the ASX indicated that it would only allow the proposal to proceed if the shares held by certain related entities were subject to restrictions on their transfer for a period of 12 months. As the related entities refused to sign the restrictive agreements, the deed administrators sought orders under section 444GA of the Corporations Act to compel the transfer of the shares to the deed administrators so that they could sign the restrictive agreements to allow the recapitalisation to proceed or
• an issue of new shares to an investor group (resulting in a dilution of the existing shares)^[14] — for example, in both Re Atlas Iron Ltd^[15] (Atlas Iron) and Re Boart Longyear Ltd, the scheme proposals involved an issue of shares to creditors of the scheme companies in exchange for a significant reduction in their debt.

In each of the above scenarios the number of shares proposed to be transferred or issued was not in dispute (the challenge instead focused on the fact of the transfer or issue of shares). Having the value of the company or enterprise less than the outstanding debt (as was the case in each of the above examples) is not uncommon.

Having said that, the acquisition by an investor group of all of the equity in a distressed company may not always be an available (or viable) option. If the company, for example, is listed on the ASX and it is intended that the entity remain listed following completion of the transaction, compliance with the ASX Listing Rules will be key.^[16] In particular, ASX Listing Rule 1.1, Condition 8 requires that, for an entity to be admitted to the official list as an ASX Listing it must, amongst other things, have a minimum of 300 non-affiliated shareholders.

Accordingly, we have seen a number of transactions structured in a way that facilitates continued compliance with the ASX Listing Rules. In both Atlas Iron and Re Boart Longyear Ltd the respective schemes of arrangement provided that the existing shareholders would continue to hold their shares but be substantially diluted as a result of the issue of new shares to the investor groups. Similarly, in Re Mirabela Nickel Ltd (subject to Deed of Company Arrangement),^[17] the existing shareholders were ordered to transfer 98.2% of their shares under the section 444GA application, but continued to hold 1.8% of their shares following completion of the DOCA.

The level of equity to be issued or acquired will also depend on whether any required waivers have been obtained from the Australian Securities and Investments Commission (ASIC) or the ASX where the transaction would result in a breach of the Corporations Act or ASX Listing Rules (for example, the prohibition on a single shareholder acquiring greater than 20% of the shares in a listed entity or increasing their hold from greater than 20% to greater than 90%). This was relevant to the Atlas Iron restructuring, following which it is now clear that ASIC and the ASX are prepared to grant such waivers in connection with these types of transactions.

Finally, it may be that the debt to equity transaction contemplates that certain steps are taken by the existing shareholders. In these circumstances, we have seen a nominal amount of equity being offered to the relevant shareholders to incentivise them to support the proposal (for example, in Re Nine Entertainment Group Ltd (No 1)^[18] where the entity that held all of the shares in the parent of the scheme company was offered a cash payment and a nominal percentage of shares in the restructured group as incentive to give up its shares).

Where to from here?

As deleveraging to control transactions continue to be part of the legal landscape in Australia, we anticipate seeing further examples, particularly where the distressed company is a listed entity (we note, the example of Ten Network Holdings Ltd, which was recently the subject of an application under section 444GA of the Corporations Act).^[19] We also expect that the insolvency law reforms approved by the Australian Government, especially relating to “safe harbour”, will assist further in promoting these types of restructurings.^[20]

It will, however, be interesting to see whether these reforms influence the type of structures that investors have been using to implement their control transactions. Given that the gating issue to most consensual transactions is unanimity in stakeholder consent, it may be that formal procedures will continue to be deployed to address dissenting minorities even where there is a supportive corporate board acting in “safe harbour”. The toolkit then typically involves voluntary administration coupled with a DOCA and section 444GA application, receivership with a credit bid, scheme of arrangement or a combination of elements of the above. Whatever the path to the restructuring might look like, the intent will be the same for each investor group — a deleveraging of the capital structure that delivers control in a manner or form that can be monetised at a future point to provide a desired return.

This article was first published in the Insolvency Law Bulletin, Vol 18 No 10, December 2017

^[1] Weaver and Ors in their capacity as Joint and Several Deed Administrators of Midwest Vanadium Pty Ltd v Nobel Resources Ltd (2010) 41 WAR 301; 79 ACSR 237; [2010] WASC 182 (Weaver); Re Lewis; Diverse Barrel Solutions Pty Ltd (Subject to a Deed of Company Arrangement) [2014] FCA 53; Re Mirabela Nickel Ltd (subject to Deed of Company Arrangement) [2014] NSWSC 836 (Re Mirabela); Re Nexus Energy Ltd (Subject to Deed of Company Arrangement) (2014) 105 ACSR 246; [2014] NSWSC 1910 (Nexus) at [22].^{Back to article}

^[2] Nexus, above n 1.^{Back to article}

^[3] Weaver, above n 1, at [54].^{Back to article}

^[4] Weaver, above n 1; Re 3GS Holdings Pty Ltd (subject to deed of company arrangement) & Ord v Stone & Ors [2015] VSC 145 (3GS); Re Mirabela, above n 1.^{Back to article}

^[5] Nexus, above n 1, at [40].^{Back to article}

^[6] Nexus, above n 1, at [96].^{Back to article}

^[7] Re Nine Entertainment Group Ltd (No 1) (2012) 211 FCR 439; [2012] FCA 1464; Re Atlas Iron Ltd (2016) 112 ACSR 554; [2016] FCA 366 (Atlas Iron); Re Boart Longyear Ltd (2017) 121 ACSR 328; [2017] NSWSC 567.^{Back to article}

^[8] Re Boart Longyear Ltd, above n 7, at [16], [81].^{Back to article}

^[9] Sovereign Life Assurance Co v Dodd [1892] 2 QB 573 at 583.^{Back to article}

^[10] First Pacific Advisors LLC v Boart Longyear Ltd (2017) 320 FLR 78; 121 ACSR 136; [2017] NSWCA 116.^{Back to article}

^[11] Weaver, above n 1; 3GS, above n 4; Re Kupang Resources Ltd (subject to a deed of company arrangement) (Recs and Mgrs Apptd) [2016] NSWSC 1895; Re Western Work Force Pty Ltd [2017] FCA 342. ^{Back to article}

^[12] Nexus, above n 1. ^{Back to article}

^[13] Shepard, Re Quest Minerals Ltd v Mutual Holdings Pty Ltd (2016) 118 ACSR 166; [2016] FCA 1559.^{Back to article}

^[14] Atlas Iron, above n 7; Re Boart Longyear Ltd, above n 7. ^{Back to article}

^[15] Atlas Iron, above n 7.^{Back to article}

^[16] ASX Listing Rules (at 19 December 2016) Ch 1 r 1.1 Condition 8. ^{Back to article}

^[17] Re Mirabela, above n 1. 18. Re Nine Entertainment Group Ltd (No 1), above n 7.^{Back to article}

^[18] Re Nine Entertainment Group Ltd (No 1), above n 7. ^{Back to article}

^[19] This matter was filed on 25 September 2017 but had not been listed for hearing at the time of writing.^{Back to article}

^[20] See the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017 (Cth).^{Back to article}