Category: Loan workouts

Surfstitch: Avoiding wipeout?

On By Geoff GreenIn Continuous Disclosure, Loan workouts, Safe Harbour2 Comments
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.

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Restructuring: Singapore or Australia?

On By Geoff GreenIn Loan workouts, Safe Harbour, TurnaroundsLeave a comment

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.

First published here on

Auditors, Bankers, and Company Directors

On By Geoff GreenIn Accounting Standards, Continuous Disclosure, Loan workoutsLeave a comment

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.