Disclosure of lender-imposed conditions

The 2019 Financial Reporting season has thrown up examples of very specific disclosure of the conditions imposed on listed borrowers by their lenders.

Case 1 – The amount and timing of an equity raise.

Case 2 – A requirement to conduct a ‘strategic review’ of ‘funding options.’

Case 3 – The timing and requirement for an equity raise to meet a balance sheet ratio.

Two-edged sword

Such disclosure is a two-edged sword.

Certainly, potential purchasers of the shares will be very well informed – but at the same time, the disclosure is likely to make it harder for management to achieve a turnaround. Perceived financial fragility may lead key staff to look elsewhere, and will probably make it harder for the businesses to win new business.  In some cases, it will also create liquidity problems if suppliers decide to reduce trade credit limits.*

Why is such disclosure required?

Listed companies have multiple disclosure requirements.  The Listing Rules impose a continuous disclosure regime, with limited exemptions – for example where negotiations are underway, or are confidential to another party.  The Accounting Standards also impose further disclosure requirements.

If disclosure was made to comply with the continuous disclosure regime then arguably it should have been made earlier – when the companies received notice of their lender’s requirements.

Disclosure in the Annual Report suggests that the disclosure was prompted by the auditor’s review of the financial statements – but for an outsider it is difficult to say whether it reflects a belated ‘catch up’ of continuous disclosure, or whether it is intended to ensure compliance with Accounting Standards.

Theoretical arguments about the reasons for the disclosure and whether it is strictly required may not be much help up for companies up against a deadline.  Two of the case studies had audit reports signed on the latest possible date – perhaps they simply ran out of time?

How should directors mitigate harmful disclosure?

Of course it is important that directors ensure that investors are adequately informed – but they should try to avoid do so in a way that makes it harder for the business to achieve a turnaround.

Harmful disclosure can be mitigated – but it becomes so much harder after balance date.

Businesses in turnaround mode should be projecting their compliance with covenants as part of their normal board reporting.  If non-compliance seems likely, then it is important to negotiate with lenders well ahead of any deadline.  Of course, those negotiations are far easier if supported by a well thought-out and comprehensive turnaround plan that will provide comfort that any underlying issues have been identified, and will be addressed.

* That’s also the reason why I won’t identify the companies here.

Continuous Disclosure, Class Action Regulation, and Restructuring

The continuous disclosure regime presents additional challenges for directors trying to turn around a listed company.  The turnaround itself will probably mean that that there is more to keep the market informed about, but there is more to it than that.  A perceived failure to properly disclose may well lead to a class action, adding to the workload of an already busy management team and board, as well as adding to the list of creditors.

Perhaps the most extreme example is that of Surfstitch, where on one analysis the commencement of a class action claim resulted in a majority of directors concluding – incorrectly in the view of the administrator that they appointed – that their company was insolvent. For these reasons, turnaround and restructuring professionals should have a keen interest in the outcome of a recently commenced Australian Law Reform Commission review.

Background

In December 2017, the Attorney-General asked the ALRC to inquire into the regulation of class actions and those who fund them, with a report due by 21 December 2018.

After a series of bilateral consultations with forty-three parties: regulators, funders, lawyers and other industry participants, the ALRC issued a discussion paper (available here) on 31 May 2018.

A ‘standard approach’

The discussion paper identified what it described as a ‘standard approach’ by litigation funders:

Litigation funders and/or plaintiff law firms (or their hired experts) identify a significant drop in the value of securities.  This is analysed to determine whether it is likely that the relevant drop had been occasioned by the late revelation of material information.

Typically, the analysis determines whether or not it is likely that there is a sufficient basis for assuming the existence of contravening conduct during a period prior to the eventual announcement of the material information.  The litigation funders and/or plaintiff law firms then determine the size of the potential loss that may have been occasioned by the suspected period of contravening conduct.  The duration of that period may extend back for a considerable period, as in the recently announced class actions against AMP where a period of five years has been identified.

Once the funders and/or lawyers are satisfied that there is a sufficient basis for assuming the existence of contravening conduct, funding terms are discussed and (at least prior to the advent of the common fund order) there is an effort to sign up institutional and other group members (complex questions relating to issues of privacy and data sets are likely to arise in this context).  During this developmental stage, an announcement might be made of a potential class action, attracting media attention which may augment the number of affected shareholders who wish to participate in the proposed class action

To address the problems it identifies, the discussion paper has recommended:

The Australian Government should commission a review of the legal and economic impact of the continuous disclosure obligations of entities listed on public stock exchanges and those relating to misleading and deceptive conduct contained in the Corporations Act 2001 (Cth) and the Australian Securities and Investments Commission Act 2001 (Cth) with regards to:

  • the propensity for corporate entities to be the target of funded shareholder class actions in Australia;
  • the value of the investments of shareholders of the corporate entity at the time when that entity is the target of the class action; and
  • the availability and cost of directors and officers liability cover within the Australian market.

The impact of the continuous disclosure regime is is arguably outside the terms of reference so perhaps it is difficult for the ALRC to do more than it has, but the recommendation of a further review will not quickly take us closer to a solution.

Those with practical suggestions should make a submission, due before 30 July.

 

 

Safe Harbour Restructuring Plans: Would the Carillion turnaround plan pass muster?

The investigation in the UK  into the collapse of Carillion Plc by a House of Commons select committee provides rare public access to the restructuring plan for a large company.  Would the plan meet the requirements of Australia’s Safe Harbour regime?

The Collapse of Carillion

Carillion was a UK-headquartered construction company with worldwide operations employing 43,000 staff.  It was placed into liquidation on 15 January 2018 following the UK government’s refusal to provide emergency funding,

With only £29 million in cash and creditors of more than £4.6 billion the position was so dire that – according to the select committee report – the company was forced into liquidation because it could not find a administrator prepared to take on the job in light of uncertainty about whether there was enough money to cover their costs.

Investigations into the conduct of the directors and auditors by the Insolvency Service, Financial Reporting Council, Financial Conduct Authority, and the Pensions Regulator are underway.  In addition, the House of Commons Work and Pensions Committee launched an inquiry within a fortnight of the collapse.

As discussed here, the 16 May committee report (available here) is scathing in its criticism of directors, auditors, and regulators.  The Inquiry has also made public a large number of documents which would not ordinarily be available – most notably including the 100 page turnaround plan.

Australia’s Safe Harbour regime

Australia’s severe insolvent trading laws make company directors personally liable for debts incurred when a company is insolvent.

By comparison the UK’s ‘wrongful trading’ regime imposes liability if directors ‘knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation’ and did not take ‘every step with a view to minimising the potential loss to the company’s creditors.’

The Australian Safe Harbour regime provides company directors with protection against insolvent trading claims but only if their conduct and actions, and the conduct of the company, meet minimum standards.

Would the Carillion plan meet the Australian Safe Harbour requirements?

The plan does articulate an appropriate objective that is clearly a better outcome than liquidation, and it does identify the use of a big 4 accounting firm as an appropriately qualified adviser.

However the plan is silent about any steps the directors had taken to conclude that they are properly informed about the financial position of the company, or that they proposed to take to stay informed.  The document identifies a number of actions that have been taken, but it doesn’t really set out a future action plan, identify those responsible for each action, or set milestone dates.

Those omissions may not be fatal – perhaps there were other documents that provide appropriate detail.  The biggest difficulty that the directors would have in meeting the Australian criteria is that the forecasts in the plan exclude employee pension contributions from the company budgets, and paying employee entitlements ‘as they fall due’ is a key requirement of the Australian regime.

Too little, too late

Of course the Carillion turnaround plan was never designed to meet the Australian requirements, so it’s not a huge surprise that it doesn’t.  But nonetheless, that ‘failure’ highlights that it is essential for directors seeking to access safe harbour to ensure that they have a plan that is fit for that purpose.

In the case of Carillion, history shows that the plan was too little, too late: the company was in liquidation within a fortnight of the plan being finalised.

Surfstitch: Avoiding wipeout?

ASX listed Surfstitch Ltd was placed into voluntary administration by its directors on 24 August 2017, less than four weeks before the safe harbour reforms came into effect on 18 September.

The Australian Financial Review has reported the administrators’ conclusion that the company was in fact solvent when the appointment was made.  At first glance it seems surprising that administrators were appointed to a solvent company, but the threshold question is whether:

“in the opinion of the directors voting for the resolution, the company is insolvent, or is likely to become insolvent at some future time”

It is the directors’ opinion at the time that matters, not the conclusions drawn later with the benefit of hindsight – and solvency is not always clear even with the benefit of hindsight.

According to an ABC interview, however one of the directors was not satisfied that Surfstitch was insolvent, and abstained from the vote for administration.  This highlights the practical problems that directors face, and underscores one of the advantages that safe harbour now offers: the opportunity to more carefully assess and understand the financial position of the company.

On 4 April creditors will choose between two rival deed of company arrangement proposals.  One proposal will see the business sold in return for three-year convertible notes issued by the purchaser, the other will see a debt for equity restructure and later relisting.  Trade creditors and employees will be paid in cash under both proposals.Update: on 4 April the creditors accepted the three year convertible note proposal, putting their faith in a valuation uplift over that period.


First published here on

Restructuring: Singapore or Australia?

In March 2017 Singapore enacted a raft of changes to its insolvency and restructuring laws, apparently with the intention of positioning itself as the dominant international debt restructuring jurisdiction for Asia.

There are two key components to the changes, which are operative from 23 May:

  • First, a move away from a predominantly informal framework to a Chapter 11-style regime, via a mechanism that Herbert Smith Freehills describe as a ‘turbo-charged Scheme of Arrangement.’
  • Secondly, adoption of the UNCITRAL Model Law on Cross-Border Insolvency, some twenty years after its introduction in 1997.

Despite its name, the Model Law does not actually prescribe an insolvency law template to apply across all jurisdictions – instead it prescribes processes for the recognition of whatever law applies in the ‘principal jurisdiction’ of an insolvent company. The end result is that the restructuring and insolvency regime of the principal jurisdiction is effectively ‘exported’ to the countries in which the business operates.

In adopting the Model Law, Singapore joins over 40 countries – a list that significantly, does not include either Hong Kong or China.

If the initiatives are successful, Singapore may displace the current incumbent – Hong Kong – as the predominant debt restructuring jurisdiction in the region. This raises the question: how can there be a choice as to which jurisdiction applies?

The answer is that the Model Law relies on an identification of the ‘centre of main interest’ (COMI) of the insolvent company, and then applies the law of the COMI jurisdiction.  In a world where operations may span across several countries, with multiple administrative locations, and shareholders and directors located elsewhere, identification of ‘the’ COMI may be far less black and white than some would think, and there may be more than one COMI to choose from.

It is in this context that Singapore has moved to create a regime that facilitates restructuring.  If the new restructuring regime becomes widely utilised through Asia, then there will be work opportunities for its professionals throughout the region.

Australia has just tabled legislation to implement a safe harbour protection for company directors of struggling companies and protect those companies from the risk of ipso facto termination of their contracts, discussed in more detail here.  When that legislation takes effect in mid-2018, where will we fit in the Hong Kong v Singapore battle?

To US investors and lenders seeking the familiar features of the Chapter 11 approach: cram downs, debtor in possession financing, and so on; Singapore may be the most attractive option.

But there is a notable divergence between the US regime and the Singapore regime, in the protection against ipso facto clauses: clauses which provide a contractual counter-party with the option to terminate if the other party to the contract becomes insolvent.  Chapter 11 provides a debtor with ipso facto protection however the Singaporean ‘turbo-scheme’ only imposes a temporary moratorium on the exercise of those rights.

The ipso facto protections in the yet-to-commence Australian regime are not just closer to the US model, in fact they will be arguably amongst the most comprehensive in the world.

For businesses where so much enterprise value is captured inside legal agreements – and therefore at risk if there is formal insolvency – that the ipso facto protection outweighs any other considerations, Australia may well be a better jurisdiction to restructure than Singapore.  It won’t be a surprise to see Australian restructuring lawyers making travel plans to visit offshore investors and owners, to explain the advantages that our modified regime will offer.

* There is one shortcoming: unfortunately it seems the protection will not apply to clauses in existence before the provisions come into effect, even if they are later modified.

Thanks to Michael Murray for his assistance especially with regard to UNCITRAL, and to Rachel Burdett-Baker for her helpful input and suggestions.


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Auditors, Bankers, and Company Directors

In September 2014 CPA Australia released ‘Audit Reports In Australia 2005–2013’ which identified that almost one-third of all ASX-listed companies, and more than half of the bottom 500, received ‘going concern warnings’ from their auditors.

Overview

Such public disclosures about the possibility of financial difficulties tend to be self-fulfilling. Credit insurers adjust their cover, suppliers rein in credit terms, and customers switch to suppliers seen as more financially stable. As a result going concern warnings can have an immediate negative impact on liquidity as well as a loss of future income and profit, and so it is no wonder that company directors work hard to avoid them. The purpose of this article is to explain when and how those disclosure requirements can lead to renegotiation with bankers, and what that renegotiation may entail.

As set out in the joint 2009 AICD/AASB publication ‘Going Concern issues in financial reporting: a guide for companies and directors,’[i] there are a number of accounting and regulatory requirements for disclosure of banking arrangements[ii] — however the most significant disclosures are around the availability of the ‘going concern assumption,’ and the classification of liabilities into ‘current’ and ‘non-current.’

Disclosure requirement —going concern

Companies have two separate reasons to assess going concern status.

First, the Corporations Act 2001 requires directors of a listed entity to provide users with sufficient information to allow an informed assessment of the financial position of the entity. According to ASIC Regulatory Guide 247 this should include ‘any doubt about the solvency of the entity, or any issues or uncertainties about the entity as a ‘going concern’.[iii]’ Secondly, accounting standard AASB101 requires an assessment of an entity’s ability to continue as a going concern when preparing financial statements.

Curiously, there is no definition of going concern contained in any of the Corporations Act, RG 247, the Australian Accounting Standards, or the International IFRS framework. The sole source of guidance in Australia is Auditing Standard ASA 570 Going Concern, which sets out an auditor’s responsibilities around the use of the going concern assumption in the preparation of the financial report.

Auditing Standard ASA570 Going Concern

ASA570 gets no closer to a definition of going concern than paragraph 2 ‘under the going concern assumption, an entity is viewed as continuing in business for the foreseeable future’ which in effect is the period from the date of the current audit report until the expected date of the next audit report.

More helpfully, ASA570 provides an extensive list of issues that ‘may cast significant doubt about the going concern assumption.’ Those relevant to lending arrangements include:

  • fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment or excessive reliance on short-term borrowings to finance long-term assets
  • indications of withdrawal of financial support by creditors
  • inability to comply with the terms of loan agreements.

If the auditor’s initial work gives rise to concerns about going concern status, then further work is necessary, which includes:

  • reading the terms of loan agreements and determining whether any have been breached
  • confirming the existence, legality and enforceability of arrangements to provide or maintain financial support, and assessing the financial ability of such parties to provide additional funds
  • confirming the existence, terms and adequacy of borrowing facilities.

Disclosure requirement — current/ non-current classification

AASB 101 sets out rules for classification of liabilities into current and non-current. Ordinarily, liabilities that provide financing on a long-term basis are to be treated as non-current.

However, there are important limitations contained in paragraph 74 — if the borrower ‘breaches a provision of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand’ then the borrower may need to classify the liability as current. There is an exception if before the end of the reporting period the lender agrees to provide at least twelve month’s grace, otherwise reclassification is mandatory.

Such a re-classification is likely to result in a very severe imbalance between current assets and current liabilities, casting significant doubt about solvency and going concern status.

Terms of loan agreements

Loan agreements for corporate borrowers include a wide range of obligations, including reporting and information requirements which are usually referred to as reporting covenants, and requirements about financial metrics which are usually referred to as financial covenants.

Financial covenants focus on financial ratios, most commonly interest cover, debt service cover, leverage and gearing ratios; and will typically be referenced against a benchmark. Bankers will often speak of ‘headroom’ as shorthand for the gap between the actual rate and the benchmark — for example, a borrower with an actual leverage ratio of 2 and a requirement to maintain a rate below 2.5 has headroom of 20 per cent.

Reporting covenants typically include the provision of financial accounts as well as certificates which report on compliance with financial covenants. Bankers may seek monthly, quarterly, six-monthly or annual reporting: as a general rule the frequency of reporting will provide guidance as to the banker’s view of risk and the need for closer monitoring.

Consequences of a breach of covenants

The consequences of a breach of covenant will be set out in the loan agreement. Usually a breach will constitute an Event of Default which allows a lender to call in the loan — but that is not always the case. Sometimes a breach may constitute an Event of Review which leads to a good faith renegotiation of terms. In other cases a borrower may have the option to provide additional equity to avoid a default — known as an ‘equity cure.’

In practical terms the financial covenants regime is linear. Borrowers prepare their financial statements after the end of the reporting period. Once the accounts are finalised then the borrower will prepare a compliance certificate to send to the lender. A borrower might withhold a certificate to avoid a breach of a financial covenant but would usually then be in breach of their reporting covenants. Depending on the terms of the loan agreement non-compliance with a financial ratio may be automatic on receipt of the certificate, or it may require the lender to take a further positive action — but absent specific drafting in the loan document it is a well-established principle of banking law and commercial practice that a breach of a financial covenant cannot occur before the receipt of the compliance certificate.

Avoiding a breach of covenants

Lenders are usually well aware of the negative impact of public disclosure of default, and will often be prepared to work with their customer to sidestep the problem — although they may seek concessions in return. If borrowers and lenders do agree to renegotiate financial covenants to avoid an event of default there are several options:

  1. waive the requirement to test altogether
  2. reset the benchmark to a lower threshold so the test becomes easier
  3. defer the test date until a time when it is likely that the borrower will be able to comply
  4. defer the date of delivery of the financial information.

‘On or before’

In the aftermath of the GFC many auditors adopted a more cautious stance. One consequence was a reinterpretation of the rules around the current/non-current distinction, such that some auditors took the view that a breach arising from the delivery of a certificate after the end of the period was in fact a breach arising ‘on or before’ the end of the period. This view if correct would mean that some breaches — most notably those arising because of an accounting treatment mandated by the auditors themselves after the end of the accounting period — were not capable of waiver under any circumstances whatsoever!

More recently it appears that most auditors now follow the plain wording of the standard, recognising that a breach of financial covenant can only occur after the end of the accounting period that it measures.

Conclusion and summary

Companies usually prepare comprehensive three-way projections — balance sheet, profit and loss and cashflow. It is essential that this be taken one step further to create a forecast of financial covenant compliance, to confirm that the company will be able to meet financial covenants, and has a reasonable amount of headroom.   If there is uncertainty over a likely future compliance then management should either develop an action plan to improve financial performance capable of satisfying the auditors, or engage with lenders as early as possible to negotiate waiver or modification of the covenant regime.


[i] Available online here.

[ii] For completeness, AASB 7 Financial Instruments requires information about any defaults and whether the default was remedied or the terms of the loans payable renegotiated, and AASB 107 Cash Flow Statements requires details of undrawn borrowing facilities together with any restrictions on their use

[iii] ASIC Regulatory Guide 247 Effective disclosure in an operating and financial review, available here.


*Originally published in the December 2014 issue of Governance Directions, and reproduced here with permission.