"Taking the Keys": Six things to consider for credit investors contemplating share pledge enforcement
5 min read
Rises in energy costs, disruption to global supply chains, the situation in Ukraine, soaring inflation and higher interest rates are pushing several major European economies towards recession. Borrowers and issuers in the leveraged loan and high yield markets are feeling the impact and the benign refinancing conditions of 2021 are long gone. The natural consequence is rising default rates – S&P's global corporate default count for 2022 surpassed 2021's year-to-date tally during September.
In the current market, investors will inevitably turn their attention to those credits in their portfolio showing signs of stress or distress and consider their options. Lenders will always be mindful of considerations such as stakeholder relationships but in some circumstances they may wish to consider the "nuclear option" in a distressed secured financing: enforcing their share pledge over a holding company of the group. Such an enforcement can entail either a pre-planned sale to a third party or the creditors taking ownership of the business themselves, which is often described informally as "taking the keys".
This piece outlines some of the most important issues lenders should consider prior to any negotiations with other key stakeholders and certainly well in advance of a putative enforcement.
1. A Viable Single Point of Enforcement
Enforcement analysis should begin with an assessment of whether the creditors have security over the shares in a holding company which gives them a "single point of enforcement" over the target group. The terms and governing law of the security are critical as these will prescribe the process which the enforcement must follow. The steps, timing and risk of challenge vary widely from jurisdiction to jurisdiction, with mortgages over shares in England & Wales and share pledges in Luxembourg and the Netherlands typically viewed as more tried-and-tested and creditor-friendly enforcement tools than those in certain other European jurisdictions. A careful review of the finance documents is also essential, including to establish whether and on what terms the creditors are able to "credit bid" their debt as part of the enforcement.
2. Identifying and Assessing the Default
Prior to enforcement, creditors should be confident that an event of default has occurred under the terms of the finance documents and that such event of default is capable of giving rise to the right to instruct the security agent or trustee to enforce – both under the terms of the documents and any relevant governing law. Separately to this legal question, creditors will want to consider the commercial question of whether the event of default is one in respect of which they wish to enforce.
3. Valuation and Marketing
The finance and share security documents and the governing law will provide how the shares subject to the enforcement will be valued. For example, it may be necessary to engage an independent accountancy firm or investment bank to perform a valuation. Commercial and practical considerations, such as the time available and the degree of co-operation from the target group, will influence the decision as to whether to go beyond what the documents require; for example, whether to pursue a full M&A-style marketing process. Creditors should not underestimate the time required to take these steps.
4. The Agent and Security Agent
In most mid-market and large-cap financings, the power to enforce the share security lies with a security agent or trustee acting on the instructions of an agent who is in turn instructed by the majority lenders. A creditor which holds all or the majority of the debt, such as in a typical direct lending structure, should not overlook the fact that it is another institution which will take the enforcement action and bear a share of any associated risk. The practical impact of this depends on the size and complexity of the deal and the perspective and experience of the agent and security agent. In any case, time and money will need to be spent to bring the agent and security agent (or any replacements) up to speed on the situation and the enforcement plan to put them in a position where they are ready and willing to act.
5. Regulatory Approvals
Depending on the nature of the target business, there may be antitrust, foreign direct investment or other regulatory approvals which must be sought prior to enforcement. Investors should take into consideration the time it can take to obtain such approvals and factor this into the enforcement timeline. Timescales vary depending on the regulator. For example, the UK's Competition and Markets Authority has a statutory period of 40 working days for a Phase 1 review. The public nature of some approval process may also be a relevant consideration.
6. Due Diligence
Investors should allow time to run a due diligence process to identify and address any "red flag" issues.
- Value leakage: Are there any claims owned by members of the group to the shareholders which cannot be released upon enforcement
- Claims which could pierce the corporate veil: Is there a risk that the group may be subject to claims for which the new owners might be liable?
- Change of control provisions: What are the consequences of the enforcement under the group's key finance documents and commercial contracts? For example, will waivers of change of control provisions be required?
- Sanctions: Whilst not at issue in every deal, the expansion of sanctions against Russian entities has had a far-reaching impact. Due diligence on sanctions compliance will often be viewed as essential.
- Jurisdiction-specific issues: Given the widely differing legal regimes across Europe applicable to commercial financing, restructuring and insolvency, it may be prudent to obtain advice in each jurisdiction where members of the group are incorporated to "issue spot" and reduce the risk of unintended consequences.
A rise in defaults under leveraged financings in the short- to medium-term seems inevitable. Well-prepared lenders will have considered the above well in advance of commencing restructuring negotiations with other stakeholders. Lenders holding distressed debt should seek professional advice early and take the necessary steps to keep the "nuclear option" open if all else fails.
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