From a provider of financing to an owner of the business: the debt-equity swap
As a result of the continuing financial and economic crisis, over recent years the debt-equity swap has gained in importance as a means of restructuring the balance sheet. This option has been given an additional boost by the ESUG, because in future claims by creditors may also be converted to shareholder and partnership rights in the corporate debtor as part of insolvency plan proceedings even without the cooperation of the legacy shareholder. This results in a debt-equity swap over the objection of the legacy shareholder – previously this had only been possible with the cooperation of the legacy shareholder.
The debt-equity swap is one structuring option as regards the conversion of claims into equity participations. Compared to other reorganisation vehicles, the debt-equity swap offers a series of advantages:
- Elimination of potential over-indebtedness
- Increase in the debt-to-equity ratio and a decrease in financing costs
- Resulting increases in profitability and company creditworthiness
- Retention of the operating entity.
Claim holders may acquire participation in a company by two means: an increase of capital through in-kind contributions (Sachkapitalerhöhung) or a share deal. Both capital measures had previously required the consent/cooperation of the legacy shareholders. This is no longer required under the ESUG.
However, the debt-equity swap brings with it not only advantages but also risks, which has to date resulted in a certain degree of caution on the part of creditors when considering debt-equity swaps. While the ESUG alleviates a number of these risks, others remain. Historically, one of the largest risks associated with an increase of capital through in-kind contributions has been the possibility of liability for undervaluations resulting from a lower value for the contributed claim. The investor was subject to the risk of being required to make subsequent cash contributions in the event the contributed claim turned out to have been overvalued. This has now – and this represents the primary advantage of the ESUG with regard to debt-equity swaps – been excluded in the case of claims converted as part of an insolvency plan, Sec. 254, para. 4 InsO – new version.
There is an additional risk with regard to remaining debt components/loans granted in future represented by the danger of a subsequent challenge to the insolvency proceedings. However, this risk is mitigated by the "reorganisation privilege", Sec. 39, para. 4, sent. 2 InsO – new version, which had been in place previously as well. If a debt-equity swap is accomplished by means of a share deal, there is a risk that the acquiring party may be subject to joint and several liability for past-due payments associated with the shares under Sec. 16, para. 2 German Limited Liability Company Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung “GmbHG”). The ESUG provides no protection against this risk. The objective of the ESUG is, amongst others, to increase the competitiveness of the Insolvency Act internationally.
Conclusion
The debt-equity swap has already established itself as a restructuring vehicle in the US and the UK. Germany's insolvency plan proceedings are also expected to become more attractive by simplifying debt-equity swaps.
Further ESUG issues...
(free for publication)
The debt-equity swap is one structuring option as regards the conversion of claims into equity participations. Compared to other reorganisation vehicles, the debt-equity swap offers a series of advantages:
- Elimination of potential over-indebtedness
- Increase in the debt-to-equity ratio and a decrease in financing costs
- Resulting increases in profitability and company creditworthiness
- Retention of the operating entity.
Claim holders may acquire participation in a company by two means: an increase of capital through in-kind contributions (Sachkapitalerhöhung) or a share deal. Both capital measures had previously required the consent/cooperation of the legacy shareholders. This is no longer required under the ESUG.
- In the case of an increase of capital through in-kind contributions, company equity is first reduced to the actual remaining equity amount in order to then perform an effective increase in capital. In the course of this process, the creditor contributes its claim as an in-kind contribution.
- By contrast, in the case of a share deal, the legacy shareholders transfer existing shares to the holders of claims who in return waive their claims.
However, the debt-equity swap brings with it not only advantages but also risks, which has to date resulted in a certain degree of caution on the part of creditors when considering debt-equity swaps. While the ESUG alleviates a number of these risks, others remain. Historically, one of the largest risks associated with an increase of capital through in-kind contributions has been the possibility of liability for undervaluations resulting from a lower value for the contributed claim. The investor was subject to the risk of being required to make subsequent cash contributions in the event the contributed claim turned out to have been overvalued. This has now – and this represents the primary advantage of the ESUG with regard to debt-equity swaps – been excluded in the case of claims converted as part of an insolvency plan, Sec. 254, para. 4 InsO – new version.
There is an additional risk with regard to remaining debt components/loans granted in future represented by the danger of a subsequent challenge to the insolvency proceedings. However, this risk is mitigated by the "reorganisation privilege", Sec. 39, para. 4, sent. 2 InsO – new version, which had been in place previously as well. If a debt-equity swap is accomplished by means of a share deal, there is a risk that the acquiring party may be subject to joint and several liability for past-due payments associated with the shares under Sec. 16, para. 2 German Limited Liability Company Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung “GmbHG”). The ESUG provides no protection against this risk. The objective of the ESUG is, amongst others, to increase the competitiveness of the Insolvency Act internationally.
Conclusion
The debt-equity swap has already established itself as a restructuring vehicle in the US and the UK. Germany's insolvency plan proceedings are also expected to become more attractive by simplifying debt-equity swaps.
Further ESUG issues...
- Enhancing the influence of creditors
- Structuring shareholders’ rights in insolvency proceedings
- Self-Administration: from the exception to the rule
(free for publication)