Goodwin Insights
February 26, 2021

Balancing between “Restructuring” and “Insolvency”

Note: This article originally appeared in Paperjam.

2020 did not see a clear rise in Luxembourg restructurings due to State measures, lack of contractual protection and valuation uncertainties. By the second half of this year, it should become clear whether parties are willing to kick the can further down the road or proceed with a root-to-branch restructuring instead.

When the pandemic hit, the economy entered into a freeze where many companies were kept afloat by various forms of State aid, bank financing with State guaranteed loans, short-term employment schemes and forms of tax postponement. A Luxembourg company is only technically bankrupt when it can no longer pay its debts when they fall due (cessation de paiements) and is no longer in a state to raise further credit to satisfy those debts (ébranlement de crédit). In other words, for so long as the debt machine is running, companies are in principle able to carry on their activities. An entire arsenal of potential funding is available in addition to regular bank or private debt, including aid from the Société nationale de crédit et d'investissement, the Office du Ducroire, the European Investment Bank and, as a subsidiary tool, the State Guarantee Scheme where the participating banks agree to make available loans benefiting from a State guarantee of up to 85% of the loan. These funding options, and the fact that directors are suspended until 30 June 2021 from their obligation to file for bankruptcy proceedings (aveu de faillite) within one month of the bankruptcy conditions being cumulatively met, explains why in 2020 there have been slightly less bankruptcies than in 2019. 

In addition, contractual recourse for lenders has been gradually weakened with the rise of so called “covenant-lite” loans. These loans contain few maintenance covenants (most deals only having incurrence covenants) which provide for a lot of flexibility, especially around the calculation of EBITDA, generally contain less asset security (but rely on a share security and single point of enforcement) and provide for borrower consent rights around transfer restrictions. The covenants in such transactions do no longer function as an effective early warning system and now make up to vast majority of leveraged loans in the European market. Restructuring specialists have been quite busy with restoring protection in loan documents by inserting a Luxembourg holding structure where key security is granted in exchange for waivers or extensions requested by borrowers, as Luxembourg law financial collateral arrangements provide a powerful tool to remedy financial distress whilst keeping operating companies out of a formal process thanks to its well tested out-of-court bankruptcy remote and quick enforcement process.

However, even if a covenant-lite loan provides for a robust a single point of enforcement, concerns arose around the qualifications contained in valuation reports due to uncertainties in and illiquidity of the market. Whilst the right to enforce is generally less debatable, the value attributed to the enforced assets is often challenged by the borrower. Therefore, lenders did generally not enforce in financings where the event of default was triggered (only) by a breach of covenants such as a loan-to-value breach, but only where there were also payment defaults such as in the hotel, retail, leisure and transportation sectors. Enforcing lenders preferred to step in, albeit at a potential loss, and prevent a further decrease in value. Most of these assets are currently being marketed which provides new opportunities for investors.

The Luxembourg authorities took care to mitigate the risk the Scheme would create zombie companies by limiting access to companies that were viable before 18 March 2020 (date on which the state of emergency was declared) and limiting the loans to a maximum of 25% of the turnover of the applicant. Perhaps precisely because of these requirements, only EUR 170 million of State guaranteed loans had been granted and a further EUR 260 million of Covid-19 loans without State guarantee as at December 2020, whereas the Scheme was introduced for a maximum amount of EUR 2.5 billion. We notice that many companies apply caution in incurring additional debt as the current debate questions which levels of debt are sustainable considering profitability and the prospects of future economic activity. Incurring or restructuring debt remains a patch-work solution in case the right answer would be implementing structural changes instead. A clear rise in new infections, the development of variants and slow roll-out of Covid-19 vaccines in the EU makes a strong economic rebound, supported by accumulated forced consumer savings, unlikely before the Summer. The coming months will be crucial and will likely divide companies into a group that will continue to be restructured and others for which collective insolvency proceedings will be inevitable.