Debt restructuring

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Debt restructuring is a process that allows a private or public company or a sovereign entity facing cash flow problems and financial distress to reduce and renegotiate its delinquent debts to improve or restore liquidity so that it can continue its operations.

Replacement of old debt by new debt when not under financial distress is called "refinancing". Out-of-court restructurings, also known as workouts, are increasingly becoming a global reality.^[1]

Motivation[]

Debt restructuring involves a reduction of debt and an extension of payment terms and is usually less expensive than bankruptcy. The main costs associated with debt restructuring are the time and effort spent negotiating with bankers, creditors, vendors, and tax authorities.

In the United States, small business bankruptcy filings cost at least $50,000 in legal and court fees, and filing costs in excess of $100,000 are common. By some measures, only 20% of firms survive Chapter 11 bankruptcy filings.^[2]

Historically, debt restructuring has been the province of large corporations with financial wherewithal. In the Great Recession that began with the financial crisis of 2007–08, a component of debt restructuring called debt mediation emerged for small businesses (with revenues under $5 million). Like debt restructuring, debt mediation is a business-to-business activity and should not be considered the same as individual debt reduction involving credit cards, unpaid taxes, and defaulted mortgages.

In 2010 debt mediation has become a primary way for small businesses to refinance in light of reduced lines of credit and direct borrowing. Debt mediation can be cost-effective for small businesses, help end or avoid litigation, and is preferable to filing for bankruptcy. While there are numerous companies providing restructuring for large corporations, there are few legitimate firms working for small businesses. Legitimate debt restructuring firms only work for the debtor client (not as a debt collection agency) and should charge fees based on success.

Among the debt situations that can be worked out in business-to-business debt mediation are: lawsuits and judgments, delinquent property, machinery, equipment rentals/leases, business loans or mortgage on business property, capital payments due for improvements/construction, invoices and statements, disputed bills and problem debts.

Methods[]

Debt-for-equity swap[]

In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company.^[3]

Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors. This is because both the debt and the remaining assets in these companies are so large that there is no advantage for the creditors to drive the company into bankruptcy. Instead the creditors prefer to take control of the business as a going concern. As a consequence, the original shareholders' stake in the company is generally significantly diluted in these deals and may be entirely eliminated, as is typical in a Chapter 11 bankruptcy.

Agreements to swap debt for equity also often occur because companies are obliged to comply, per the terms of a contract with certain lending institutions, with specified debt to equity ratios.^[4]

Debt-for-equity swaps are one way of dealing with sub-prime mortgages. A householder unable to service his debt on a $180,000 mortgage for example, may by agreement with his bank have the value of the mortgage reduced (say to $135,000 or 75% of the house's current value), in return for which the bank will receive 50% of the amount by which any resale value, when the house is resold, exceeds $135,000.

Bondholder haircuts[]

A debt-for-equity swap may also be called a "bondholder haircut". Bondholder haircuts at large banks were advocated as a potential solution for the subprime mortgage crisis by prominent economists:

Economist Joseph Stiglitz testified that bank bailouts "are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this". He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.^[5]

Economist Jeffrey Sachs has also argued in favor of such haircuts: "The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices."^[6]

If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute dollars and the government may be able to just provide guarantees in the short term to buttress confidence in the recapitalized institution. For example, Wells Fargo owed its bondholders $267 billion, according to its 2008 annual report.^[7] A 20% haircut would reduce this debt by about $54 billion, creating an equal amount of equity in the process, thereby recapitalizing the bank significantly.

Informal debt repayment agreements[]

Most defendants who cannot pay the enforcement officer in full at once enter into negotiations with the officer to pay by installments. This process is informal but cheaper and quicker than an application to the court.

Payment by this method relies on the cooperation of the creditor and the enforcement officer. It is therefore important not to offer more than you can afford or to fall behind with the payments you agree. If you do fall behind with the payments and the enforcement officer has seized goods, they may remove them to the sale room for auction.

In various jurisdictions[]

Canada[]

Two common avenues for restructuring debt exist in Canada: a Division 1 Proposal and a CCAA filing. The former is available to both corporations and individuals who owe $250,000 or more to creditors.^[8] The latter is available only to larger companies owing more than $5 million to their creditors.

A Division 1 Proposal is a last resort. Created by the Bankruptcy and Insolvency Act of 1985, the option to file Division 1 is not an option to be taken lightly as, in the event that the stipulations within the proposal get voted down by creditors or not signed off by the court, one falls into bankruptcy.^[9] Division 1 proposals allow companies to be briefly relieved of lawsuits by creditors, as well as they allow companies to stop paying money to their unsecured creditors while the proposal is being reviewed. A Division 1 Proposal to restructure debts must secure 66% of the creditors' votes set in proportion to how much they are owed, and 50% plus one of all creditors votes in terms of number of creditors. On top of such democratic approval, the court itself has to approve how the debts get restructured. Withstanding all such approval, a business or individual can continue operating as normal; otherwise, a business or individual is obliged to proceed into bankruptcy filing.^[10]

CCAA filings were created by the Companies' Creditors Arrangement Act, a piece of legislation first put forward and passed in 1933 and updated later in 1985.^[11] A CCAA filing allows a Canadian company to have a window in time (typically between 30 and 90 days) in which they can renegotiate and reorganize their debt payment plans with creditors. During this brief period, creditors cannot seize any money that is owed to them. These windows of time may be renewed multiple times over. Once a CCAA application gets finally rejected, the company in question can be forced into receivership or bankruptcy. This could happen for a number of reasons, chief among them being a failure to come to an agreement with creditors as to how to restructure the debt.^[12]

Switzerland[]

Under Swiss law, debt restructuring may occur out of court, or through a court-mediated debt restructuring agreement that may provide for a partial waiver of debts, or for a liquidation of the debtor's assets by the creditors.

United Kingdom[]

The majority of debt restructuring within the United Kingdom is undertaken on a collaborative basis between the borrower and the creditors. Should this be unsatisfactory in the first instance, the court may be asked to mediate and appoint administrators.

United States[]

Among the most common forms of in-court debt restructuring for firms in the United States are Chapter 11 and Chapter 12 bankruptcy.

Under Chapter 11, firms form a plan to reorganize their credit obligations, such that they are able to continue operating while they are going through with their debt repayment plans and after they become solvent. Creditors are given promises to be paid back with firms' future earnings. The nature of these promises can be shaped in a number of ways. In situations where every single impaired creditor of a firm agrees to a settled schedule of repayment, the plan formed is known as a "consensual plan." When a certain class a firm owes does not accept a restructuring plan, said plan may still be approved pursuant to the United States Bankruptcy Code. Such plans are colloquially referred to as "cramdown plans."^[13] Chapter 11 is considered to be one of the most expensive and complicated forms of bankruptcy to file.^[14] The vast majority of Chapter 11 bankruptcy cases filed end up allowing company management to go forward running the business as usual; however, in certain exceptional cases (fraud, gross incompetence, etc.) the courts do not allow the business the privilege of simply maintaining a "debtor in possession" status. In said cases, a trustee is appointed by the court to run the business until all bankruptcy proceedings are completed.^[15]

Chapter 12 Bankruptcy is a form of debt restructuring in the United States available to farms and fisheries exclusively; said businesses could be family-owned or owned by corporations. The special debt restructuring rights accorded to farmers and fisheries consequent line 12 of the United States Bankruptcy Code were first granted by Congress in 1986 amid an agricultural debt crisis.^[16] Food commodity prices were caught in a downward spiral in the years leading up to 1986, pushing U.S. farmers' debts to levels above $200 billion.^[17] This 12th line of the U.S. Bankruptcy Code was initially added only as a temporary measure and remained as a temporary measure until 2005, when it became permanent.^[18] Chapter 12 was of great benefit to farmers, because Chapter 11 was often too expensive for family farms and generally only useful for sizeable corporations, while Chapter 13 was mainly of use to individuals attempting to restructure very small debts.^[19] Farms and fisheries, being midsize and seasonal in nature, were thus in need of a more flexible legal framework through which they could restructure their debts.^[20]

Firms in the United States are not limited to only using the legal system to manage debts they are incapable of repaying. Out-of-court restructuring, or workouts, constitute consensual agreements between firms and their creditors to adjust debt obligations, mainly for the purpose of evading the costly legal fees associated with Chapter 11.^[21] The decision as to whether to enter a workout or take the issue into court is, in large a part, a function of the creditors' and debtors' respective perceptions of how much can be gained or lost through a Chapter 11 proceeding. Creditors know that once Chapter 11 has commenced, a degree of negotiating leverage is lost, as judicial authorities may impose alterations of claims without regard to creditors' consent. On numerous occasions, merely throwing out the threat of filing bankruptcy has initiated the process of coming to a private agreement.^[22]

Italy[]

Debt restructuring within Italy may occur either out of court (ex article 167 of the Italian Bankruptcy Law) when a waiver or simple debt rescheduling is required, or through a court-mediated debt restructuring agreement (ex article 182/bis of the Italian Bankruptcy Law) and may provide for a partial waiver of debts, mandatory recapitalization of the debtor, or for a liquidation of certain debtor's assets to repay privileged creditors.

Germany[]

While being famous for its efficiency in other matter, this is not true for debt restructuring. Many German companies prefer to restructure their debts using the English scheme of arrangement proceedings because they believe that the German restructuring law is not very helpful. The main reason for this is that binding a dissenting minority is only possible under formal insolvency proceedings in Germany.^[23]

Personal restructuring[]

Example 1

Sherry is earning $100,000 with $30,000 of credit card debt and very high expenses. Her balances are very close to limits and some over the limits. She wants to pay her creditors but can’t handle the high interest rates and increased minimum payment. She owns a condo in Manhattan with a little equity and had a piece of property upstate with a value of $30,000. She was denied a loan against her property because of low scores from her very high balances on her revolving credit card debt and although her property was on the market it was not selling. Debt Consolidation may be the best choice for Sherry since her interest rates could be reduced to 6% rather than the 23% she is paying currently. She will pay them a small fee plus a reduced monthly payment which they will deliver to her creditors. It is important that she knows the Debt Consolidation Company may make her reduced monthly payments late or put a mark on her credit profile stating she is in a debt consolidation plan. This mark can affect the scores negatively. She can also ask the DC Company to keep this info off her credit profile and to make sure payments are made on time but there is no guarantee this will occur. We have seen the scores drop dramatically because of these marks. The credit can always be cleaned up in the future when she gets a handle on her debt. If Sherry is saving 17% interest on her $30,000 and her payments are not drawn out for 10 years it could be a good choice in this situation.

Example 2

Debtor 2: Andrea & Chris

Type of Debt: Credit cards, House mortgage, Personal Loan

Debt Amount: 400,000

The Backstory: This married couple, like many, weren’t thinking ahead with their finances, and naturally, fell behind because of it.

“We would spend three hours researching the best flat screen television to buy, and about seven minutes a year to decide on our investment strategy for our pathetic retirement goals.”

Living paycheck to paycheck, finally, in spring 2011, they could no longer keep pace with their frivolous spending—even with good jobs. That’s when the couple finally got on the same page with their finances.

How They Overcame Their Debt: After a gut-wrenching Excel budgeting experience, they are aiming at 1500 savings per month by squeezing their budget. A $1500 was a small dent in their overall goal, but a huge confidence boost that they could actually eliminate their debt with hard work. The couple then cut up their credit cards: Chris had three, and Andrea had Nine because the credit payment time period is forty months personal loan spread is on seven years. The house mortgage is financed over the term of ten years. The pair is confused between the snowball method and snow avalanche to tackle the following balances.

Debt #1: Credit Card for $50,000 with monthly payment of 1250

Debt #2: Personal Loan for $100,000 with monthly payment of 1918

Debt #3: House Mortgage for $250,000 with monthly payment of 3304

Example 3

Debtor 3: Leo Babauta

Type of Debt: Auto loans, mortgage, credit card debt

Debt Amount: Undisclosed

The Backstory: Leo Babauta is a little different from the other people on this list. He’s created the immensely popular blog, Zen Habits, where he writes about integrating mindfulness and healthy practices into daily life, mainly drawing from his own life experiences. But before Zen Habits came to fruition, Leo was saddled with debt, and this was, surprisingly, after a young adulthood spent living frugally and debt-free.

From his own words, Leo says he entered a period of “frugal irresponsibility,” where he got a car loan, a credit card with a higher limit, spent without a budget, and tried to support his family (of six) on a single income with no medical insurance.

How He Overcame His Debt: Leo’s three biggest building blocks to conquering his debt was eliminating his credit cards, increasing his income and building an emergency fund. But these other habits kick-started his momentum.

• • Eliminating non-essential expenses
  • Paying all bills and debts online, then withdraw cash for spending categories
  • Practicing the snowball repayment method
  • Treating debt as his first bill
  • Rewarding himself for accomplishments (e.g., paying off a debt)

See also[]

• Debt relief
• Debt settlement
• Troubled debt restructuring

Books[]

Innovation in financial restructuring: Focus on signals, processes and tools, Vurtus Interpress, Marco Tutino and Valerio Ranciaro, 26 April 2020

References[]