The economic upheaval of COVID-19 is a story businesses are all too familiar with. Firms across the globe are all dealing with the ramifications of a business environment radically transformed by supply chain disruptions, remote working attitudes, and shifts in consumer behaviour. For regulatory bodies, business resilience quickly took centre stage in the face of ongoing uncertainty, and this has proven the importance of a pivotal tool that companies can rely on to navigate financial distress: restructuring.
Financial Health and Distress
Consultants at auditing firms, like PwC, are like doctors for companies, and just like when GPs diagnose us with an illness, they will be looking out for certain signs and thresholds to judge whether a company is in good financial health or not. For example, just as blood pressure measures the pressure of blood against the walls of arteries, the Interest Coverage Ratio assesses a company’s ability to handle its debt obligations. It’s calculated by dividing earnings before interest and taxes (EBIT) by the interest expenses. Another important concept is a “going concern,” which refers to a business that is operating normally and is expected to continue its operations without the risk of shutting down in the foreseeable future. In other words, it’s a company that is considered financially stable and capable of meeting its financial obligations, such as paying its bills and debts, and continuing its operations for at least the next year. This concept is important in financial reporting because it helps assess a company’s ability to remain viable and functional over a certain period of time. However, if auditors feel that a company cannot meet their obligations, it will either face insolvency or restructuring in a bid to revive its business operations.
Legislation of a Financial Restructuring Plan
Let’s address the technical information first; COVID-19 instigated the reform of current English law on restructuring. The UK Corporate Insolvency and Governance Act 2020 came into force on 26 June 2020, introducing a new ‘Restructuring Plan’ procedure (RP). This is a new tool that gives directors another option when considering restructuring. Being new, it’s less well-known than other formal compromise agreements such as Company Voluntary Agreements (CVAs) or Schemes of Arrangements (SoAs). All such tools can be used in isolation or in tandem, perhaps to create a moratorium against creditor enforcement. Imagine you’re playing Minecraft on survival mode (you love the thrill) when suddenly you see a creeper about to explode in front of the mansion that took you forever to build. If a court grants a business a moratorium period, it’s like you quickly switching to creator mode; the creeper vanishes, and you have some breathing space to get your house in order. During this time, the company gets protected from legal actions by creditors, giving it a chance to come up with a plan to get back on track. The revised RP and SoAs are quite similar at first glance. They both sit under the Companies Act 2006, and both processes require members and creditors to be grouped into ‘classes’ based on their rights. This is the really important bit because the success of an RP rests on the shoulders of these classes who vote on whether to accept the proposed scheme. Final approval rests with the court. You may sense a problem here, which is that the proposed plan is unlikely to benefit everyone; in some cases, it may be a zero-sum game. Some creditors will be classed as ‘in the money,’ meaning if the company were to sell off its assets, there would be enough money to pay off these creditors in full or at least a substantial portion of what they are owed. ‘Out of the money’ creditors might receive a smaller portion of what they’re owed or different treatment altogether. The goal is to find a fair solution that maximizes the chances of the company’s successful recovery while addressing the interests of all involved parties. To address this conflict of interest, the key feature of the RP is a mechanism called the ‘cross-class cram-down,’ which is a concept borrowed from the U.S Chapter 11 bankruptcy process. It allows a company to apply to the court to approve a restructuring scheme even where there are notable classes of creditors who vote against the plan.
What a Restructuring Plan Involves
So, what can restructuring involve? Virgin Atlantic, like many airlines, needed restructuring due to the severe impact of the COVID-19 pandemic on the aviation industry. The pandemic led to a significant reduction in global air travel, border restrictions, lockdowns, and decreased consumer confidence in flying. These factors resulted in a sharp decline in revenue for airlines, causing financial distress across the industry. To navigate these challenges and secure its future, Virgin Atlantic embarked on a restructuring plan. This plan aimed to reduce costs, restructure debts, and streamline operations to ensure the airline’s survival and recovery. Streamlining involves a controlled wind-down of a division to mitigate its impact on the remaining entities within the group. Therefore, a restructuring plan may be employed by a company that feels efficiency can be drastically improved, which is often the case after a merger, for example. Incentive alignment across divisions may even call for the need for a review of transfer pricing policy. This leads us to the idea that good directors will be constantly reviewing their company health, and even in times of macroeconomic uncertainty, reducing investment in areas of growth needed for the future would be a fatal error. A firm’s chance of survival will revolve around protecting liquidity by focusing on what really matters and creates value. But in the eleventh hour, a restructuring plan is more of a tactical negotiation, really. Debt-for-equity swaps, rescheduling, and compromising debt amounts and adjusting ‘covenants’ are all common restructuring components. Covenants are designed to protect the lender’s interests by ensuring that the borrower maintains a certain level of financial health and meets specific obligations throughout the duration of the loan.
Outlook
In a post-pandemic world, it’s never been clearer that the macroeconomic climate is beyond entrepreneurs’ sphere of control. Financial distress can impact any company, and business restructuring is a significant action undertaken to modify and reshape operations to improve the business going forward. Often, it’s a lifeline.
Written by Alok Jadva
Produced by Madhav Bhimjiyani