Corporate Acquisitions Through Debt-Equity Swaps in Germany.By Dr. Volker Kammel and Dr. Markus Bauer The German economy has experienced minimal growth for a number of years. Insolvencies have reached record levels, and the number of businesses outside of formal insolvency insolvency Condition in which liabilities exceed assets so that creditors cannot be paid. It is a financial condition that often precedes bankruptcy. In the context of equity, insolvency is the inability to pay debts as they become due; insolvency under the balance-sheet proceedings, but in need of restructuring restructuring - The transformation from one representation form to another at the same relative abstraction level, while preserving the subject system's external behaviour (functionality and semantics). , is significant. Recently, however, a number of positive factors have fueled hopes for a revival of the German economy. There has been a strong increase in German industrial production activity and a substantial increase in the generation of new orders and capital expenditures by German businesses. Agreements with employees regarding wage and salary increases have been moderate on the whole, and financing conditions for businesses have been favorable fa·vor·a·ble adj. 1. Advantageous; helpful: favorable winds. 2. Encouraging; propitious: a favorable diagnosis. 3. . Although German companies have undergone significant operational restructuring in the past, many continue to exhibit weak balance sheets. Not surprisingly, economic stagnation Economic stagnation, often called simply stagnation is a prolonged period of slow economic growth (traditionally measured in terms of the GDP growth). By some definitions, "slow" means that it is significantly slower than a potential growth as estimated by experts in and record insolvency levels have left many German banks with large amounts of bad debt on their books. Estimates of aggregated bad debt range from C160 to C300 billion. German banks have historically held bad debt due to strong customer ties. However, beginning in 2003 and continuing in 2004 and 2005, German banks have sold non-performing loan A non-performing loan is a loan that is in default or close to being in default. Many loans become non-performing after being in default for 3 months, but this can depend on the contract terms. portfolios as well as loans to single borrowers. Banks have become motivated mo·ti·vate tr.v. mo·ti·vat·ed, mo·ti·vat·ing, mo·ti·vates To provide with an incentive; move to action; impel. mo to sell their non-performing loans for a number of reasons. Among them are the new risk-weighting criteria introduced by the Basel II Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations banking accord, which will significantly increase the equity costs associated with banks holding non-performing assets and therefore create a strong incentive for them to sell. The current market conditions provide excellent investment opportunities with respect to distressed companies and have attracted international investors, particularly U.S. investors who are familiar with distressed asset transactions. Investors typically acquire high-risk loans to companies with turnaround potential at a purchase price significantly below par. They attempt to generate high returns by performing an intensive workout Workout Informal repayment or loan forgiveness arrangement between a borrower and creditors. workout 1. The process of a debtor's meeting a loan commitment by satisfying altered repayment terms. of the acquired loans, usually in connection with a restructuring of the target company. Structure of the Investment The structure of the investment depends largely on the needs of the target company. While the specific restructuring measures are normally identified on a case-by-case basis by means of a restructuring plan drafted by turnaround advisors, target companies are invariably in·var·i·a·ble adj. Not changing or subject to change; constant. in·var  i·a·bil in need
of new funds and a reduction of their debt burden.
The recapitalization Recapitalization Restructuring a company's debt and equity mixture often with the aim of making a company's capital structure more stable. Notes: Companies often want to diversify their debt-to-equity ratio to improve liquidity. of a distressed company typically involves a reduction of its statutory share capital to reflect the real amount of equity remaining after netting out historical losses. The registered share capital is then increased and new equity is contributed either in the form of cash or by releasing the company from a portion of its debt (debt-equity swap). Frequently, both types of capital increase are combined. The deal structures in this context are flexible and can be adapted to the requirements of different types of investors. Traditional private equity investors typically will seek to acquire 100 percent of the corporate debt in order to take control of the target company after the debt-equity swap and realize their return through an exit after three to five years. More passive investors, on the other hand, might only seek to provide financial resources for the restructuring without taking an active role in the process. These investors are more inclined to execute a modified debt-equity swap where instead of shares, they take convertible bonds or similar mezzanine mez·za·nine n. 1. A partial story between two main stories of a building. 2. The lowest balcony in a theater or the first few rows of that balcony. instruments that are flexible and can be tailored to the specific needs of the investor. Over and above the actual capital measures, the investor may have to provide new lending facilities to the company and/or extend the maturity of any loans remaining after the debt-equity swap. A successful implementation of a debt-equity swap transaction requires both (i) substantial restructuring expertise and an in-depth knowledge of the target's industry by the investor and (ii) the full support of at least a majority of the existing shareholders. If these conditions are fulfilled ful·fill also ful·fil tr.v. ful·filled, ful·fill·ing, ful·fills also ful·fils 1. To bring into actuality; effect: fulfilled their promises. 2. , the debt-equity swap can both save the target company from a possible winding-up and be a very interesting investment. A number of issues under German law need to be addressed when implementing an investment that involves a debt-equity swap. Restructuring Plan Before undertaking the investment, an investor will need to convince himself of the turnaround potential of the target company. Normally, a restructuring plan drawn up by turnaround advisors on the instructions of the target company will be available. Management of a German company in financial difficulty is required to explore restructuring opportunities. Management typically will involve external turnaround specialists when approaching banks for new loans. In order to avoid lender liability exposure, banks will extend loans to companies in financial difficulty only after a restructuring plan has been drawn up that demonstrates that the company is capable of being successfully restructured. The German Institute of Chartered Accountants char·tered accountant n. Chiefly British Abbr. CA A member of one of the institutes of accountants granted a royal charter. (Institut der Wirtschaftspr'fer) requires a restructuring plan to set forth an analysis of the situation of the company together with the causes of the crisis and to specify the concrete measures that need to be implemented in order to return the company to profitability, including any necessary contributions by the various stakeholders Stakeholders All parties that have an interest, financial or otherwise, in a firm-stockholders, creditors, bondholders, employees, customers, management, the community, and the government. (e.g., investors, existing shareholders, employees, creditors, etc.). Consent of Existing Shareholders To restructure a company successfully through a debt-equity swap transaction, it is important to obtain the consent of at least a majority of the existing shareholders, for both legal and practical reasons. The implementation of the capital measures, in particular the capital decrease and the ensuing en·sue intr.v. en·sued, en·su·ing, en·sues 1. To follow as a consequence or result. See Synonyms at follow. 2. To take place subsequently. capital increase, requires approval by the existing shareholders. Depending on the corporate form of the target and the provisions in the articles of association, the required shareholder approval percentage is usually at least 75 percent. In order to allow the investor to subscribe to Verb 1. subscribe to - receive or obtain regularly; "We take the Times every day" subscribe, take buy, purchase - obtain by purchase; acquire by means of a financial transaction; "The family purchased a new car"; "The conglomerate acquired a new company"; the desired number of shares, the subscription rights of the existing shareholders must be waived. In order to convince shareholders whose shareholdings are being diluted di·lute tr.v. di·lut·ed, di·lut·ing, di·lutes 1. To make thinner or less concentrated by adding a liquid such as water. 2. To lessen the force, strength, purity, or brilliance of, especially by admixture. that this waiver The voluntary surrender of a known right; conduct supporting an inference that a particular right has been relinquished. The term waiver is used in many legal contexts. is necessary for the implementation of the restructuring, the support of a majority of the shareholders and the management of the company is vital. The same is also true for the discussions with the tax and securities authorities regarding necessary exemptions, which are described in more detail below. Where the investor is unable or unwilling to obtain the consent of the existing management and shareholders to the investment and wants to pursue a more hostile approach, he can theoretically purchase the loans without the consent of the target company, provided that the bank -- which typically has a long-standing business relationship with the target -- is willing to sell. As the new owner of the non-performing loans, the investor then has significant leverage in the negotiations with management and shareholders. While an acquisition of shares may need to be disclosed, there are no disclosure obligations regarding the holding of certain portions of outstanding corporate debt. Needless to say, the risk that the investor will not achieve his aims with respect to equity in the target company is much higher with a hostile approach than with a consensual CONSENSUAL, civil law. This word is applied to designate one species of contract known in the civil laws; these contracts derive their name from the consent of the parties which is required in their formation, as they cannot exist without such consent. 2. approach. Acquisition of the Loans Once the investor has decided to invest, he must acquire the company's debt from the banks. The level of complexity associated with the debt acquisition varies greatly, depending on the structure of the loans, the security (in particular if a security pool agreement is in place), and the selling bank(s) involved. Providing information regarding the loans and the debtor One who owes a debt or the performance of an obligation to another, who is called the creditor; one who may be compelled to pay a claim or demand; anyone liable on a claim, whether due or to become due. to the investor during a due diligence Research; analysis; your homework. This term has caught on in all industries, because it sounds so "wired." Who would want to do analysis or research when they can do due diligence. See wired. review can be an issue under German banking secrecy secrecy see confidentiality. rules unless management has consented to the investment and agrees to the provision of due diligence information to the investor. The acquisition of the loans can be structured as (i) a subparticipation in the loans and the underlying security, (ii) an assignment of the claims under the loans and the security, or (iii) a complete transfer of the loan agreements and the security agreements. A complete transfer of the loan agreements will usually be chosen where revolving or partially undrawn un·draw tr.v. un·drew , un·drawn , un·draw·ing, un·draws To draw to one side, as a curtain. Adj. 1. undrawn - not represented in a drawing undelineated - not represented accurately or precisely credit lines are acquired that need to remain available to the company. A transfer requires the consent of all the parties to the agreements that are being transferred and is more complicated as a result. If the loan is part of a syndicated loan Syndicated Loan A very large loan in which a group of banks work together to provide funds for one borrower. There is usually one lead bank that takes a small percentage of the loan and syndicates the rest to other banks. Notes: Also known as a "syndicated bank facility. or the underlying security is subject to a security pooling agreement, the bank must also transfer its contractual position under these agreements in order to allow the investor to assert his rights against the other members of the syndicate or the security pool. Under German law, the transfer of these contractual positions requires the consent of all other members of the syndicate or the security pool, which adds to the complexity and may delay the process. Specific issues arise where the loans are secured by a government guaranty As a verb, to agree to be responsible for the payment of another's debt or the performance of another's duty, liability, or obligation if that person does not perform as he or she is legally obligated to do; to assume the responsibility of a guarantor; to warrant. . The investor is well advised to approach the government at an early stage because its approval is generally required for a transfer of the guaranty to the investor. In any case, the investor and his advisors must ensure that the contractual positions assigned to the investor allow him to implement the workout strategy, in particular, contribution of the loans to the company in the debt-equity swap and the associated release of security. Restructuring in Formal Insolvency Proceedings In Germany, companies in financial difficulty are usually restructured outside of formal insolvency proceedings. The impact of a formal insolvency proceeding on business relations with suppliers and customers is usually severe, and there is a substantial risk that key employees will leave the company due to speculation that the company will be unable to continue with its business operations Business operations are those activities involved in the running of a business for the purpose of producing value for the stakeholders. Compare business processes. The outcome of business operations is the harvesting of value from assets . However, the high volume of insolvencies in recent years has resulted in a number of successful restructurings in formal insolvency proceedings. Examples such as these are beginning to change the stakeholders' perception that a formal insolvency process will most probably result in a winding-up of the business. Formal insolvency proceedings offer a number of advantages for the restructuring of the company, in particular the ability to terminate (and possibly renegotiate re·ne·go·ti·ate tr.v. re·ne·go·ti·at·ed, re·ne·go·ti·at·ing, re·ne·go·ti·ates 1. To negotiate anew. 2. To revise the terms of (a contract) so as to limit or regain excess profits gained by the contractor. the terms of) contracts and the easing of restrictions on the dismissal of employees. Restructuring in formal insolvency proceedings is achieved by means of an insolvency plan. It can be proposed by the insolvent INSOLVENT. This word has several meanings. It signifies a person whose estate is not sufficient to pay his debts. Civ. Code of Louisiana, art. 1980.. A person is also said to be insolvent, who is under a present inability to answer, in the ordinary course of business, the responsibility company itself as a prepackaged pre·pack·age tr.v. pre·pack·aged, pre·pack·ag·ing, pre·pack·ag·es To wrap or package (a product) before marketing. Adj. 1. plan in conjunction with the commencement of insolvency proceedings. The plan can be freely arranged and include all provisions that could be made in an ordinary restructuring agreement (e.g., waiver and deferral deferral - Waiting for quiet on the Ethernet. of claims, alteration of security, an undertaking of the investor to contribute the acquired loans and/or to provide new capital to the company, or an undertaking of a stakeholder stakeholder n. a person having in his/her possession (holding) money or property in which he/she has no interest, right or title, awaiting the outcome of a dispute between two or more claimants to the money or property. to extend financing to the company to fund the reorganization). Increasingly, an insolvency plan proposal is combined with a motion for "self-management" by the management of the insolvent company, which is similar to the concept of a chapter 11 "debtor in possession debtor in possession n. in bankruptcy proceedings when a debtor has filed for the right to submit a plan for reorganization or refinancing under Chapter 11, and the debtor is allowed to continue to manage his/her/its business without an appointed trustee, that debtor " under U.S. law. Under self-management, the management of the insolvent company remains in control of business operations but is placed under the supervision of a creditors' trustee. To date, German insolvency courts have rarely left management in control, generally appointing an insolvency administrator who takes control of the company's business operations. Self-management has the distinct advantage of retaining the experience and market know-how of existing management. An insolvency administrator who is unfamiliar with the company and its operations has very little time to acquaint himself with the business. The chances of prevailing on a motion for self-management can be improved if the insolvent company appoints proven restructuring experts to its board prior to filing an insolvency application. The main advantage of self-management is that the identity and expertise of the personnel who will be implementing the restructuring are known to the stakeholders at the outset of the proceedings. Investors are much more reluctant to invest if it is unclear who is managing the business, and whether such manager will implement the restructuring plan, as is frequently the case when an insolvency administrator is appointed. Valuation of the Debt During the course of a debt-equity swap, the non-performing loans will be contributed to the target company as a contribution in kind in exchange for the issuance of new shares that are issued in connection with the increase in the target's capital. If the loans are contributed to a corporation (either a stock corporation ("AG") or a limited liability company ("GmbH")) or by a limited partner of a limited partnership ("KG"), the fair market value of the contribution (i.e., the claims against the target company based upon the loans) must be at least equal to the nominal value Nominal Value The stated value of an issued security that remains fixed, as opposed to its market value, which fluctuates. Notes: When referring to fixed-income securities, the nominal value is also the face value. of the shares or partnership interest issued for it. Should the fair market value of the contribution in kind be below the nominal value of the shares, the investor runs the risk that (i) the commercial register will refuse to register and thus prevent the capital increase, or (ii) if the deficiency in the value is discovered after the registration, the investor will be personally liable to pay the shortfall. Because in turnaround situations the fair market value of the loan will be substantially below its nominal value, the exact value has to be determined by means of an expert opinion of an auditor. In the case of a capital increase in a stock corporation, such opinion has to be provided by a court-appointed neutral auditor. In the case of a limited liability company, an expert opinion will typically be requested by the commercial register before the capital increase is registered. Equitable Subordination of Loans Typically, an investor will convert only a portion of the purchased loans into equity and will retain the remainder in the form of shareholder loans. Shareholder loans to a company in financial difficulty may be subject to the rules of equitable subordination and may be treated as if they were equity. During an insolvency, equitably subordinated loans In the field of finance, a subordinated loan is a type of loan which ranks after other debts should a company fall into receivership or be closed. It is also known as subordinated debt, or as junior debt. rank behind the claims of normal creditors. Outside of formal insolvency, the company may be entitled en·ti·tle tr.v. en·ti·tled, en·ti·tling, en·ti·tles 1. To give a name or title to. 2. To furnish with a right or claim to something: to refrain from repaying such loans until its financial difficulties have been resolved. In order to provide an incentive for investors to provide new funds to distressed companies, the rules of equitable subordination were modified by the introduction of the so-called restructuring privilege. Under these rules, existing and new loans by an investor will not be subject to the rules of equitable subordination, provided that the investor becomes a shareholder of the company in a crisis situation with the aim of restructuring the company. Nevertheless, an investor should carefully review whether the requirements of the restructuring privilege have been met. Tax Exemption tax exemption, immunity from the requirement of paying taxes. Federal, state, and usually local law provide exemption from taxation for a wide variety of organizations, usually not-for-profit, such as churches, colleges, universities, health care providers, various for "Restructuring Profits" Because the nominal amount of the shares issued as consideration for the contribution of the non-performing loans in a debt-equity swap will be significantly lower than the nominal amount of such debt on the books of the company, the target company will show a restructuring profit in the amount of the difference. If this restructuring profit were subject to regular taxation (i.e., income and trade tax), the benefits of the restructuring to the company would be largely eliminated. In order to address this conflict between the taxation of restructuring profits and the aim of the German Insolvency Code to facilitate the restructuring of a distressed company, the German Federal Finance Ministry on March 27, 2003, issued a letter to the state tax authorities providing that income tax on restructuring profits shall be deferred and subsequently waived under the principles of equity (sachliche Billigkeitsgr'nde) if the following conditions are met: the company is (i) in a crisis but (ii) capable of being restructured and (iii) the tax waiver is a suitable and sufficient restructuring measure and (iv) the investor intends to restructure the company. The tax authorities will normally require the company to provide them with its restructuring plan to determine whether these conditions have been fulfilled. Once the tax authority has qualified the profits as privileged restructuring profits and agreed to defer de·fer 1 v. de·ferred, de·fer·ring, de·fers v.tr. 1. To put off; postpone. 2. To postpone the induction of (one eligible for the military draft). v.intr. and waive To intentionally or voluntarily relinquish a known right or engage in conduct warranting an inference that a right has been surrendered. For example, an individual is said to waive the right to bring a tort action when he or she renounces the remedy provided by law for such the respective income tax, the company can apply to the municipality MUNICIPALITY. The body of officers, taken collectively, belonging to a city, who are appointed to manage its affairs and defend its interests. where the company's operations are located for a similar decision with respect to the trade tax. Although these are two separate proceedings and the municipality is not bound by the decision of the tax authority, the municipality generally follows the lead of the tax authority, particularly if the waiver of the trade tax is necessary for a successful restructuring of the company and the decision will keep jobs and a (potential) taxpayer in the city. Exemption From Mandatory Tender Offer If the target company is listed on a stock exchange, the rules of the German Takeover Code (Wertpapiererwerbs- und 'bernahmegesetz) apply. Pursuant to the German Takeover Code, an investor who acquires shares in a listed company listed company n → compañía cotizable listed company n → société cotée en Bourse listed company list n → as a result of a debt-equity swap or otherwise and subsequently directly or indirectly holds at least 30 percent of the voting rights Voting rights The right to vote on matters that are put to a vote of security holders. For example the right to vote for directors. voting rights The type of voting and the amount of control held by the owners of a class of stock. in the company must make a mandatory tender offer for all of the remaining shares of the company. This obligation generally makes any debt-equity swap transaction regarding a public company unattractive for an investor who, alone or jointly with other investors, intends to take a controlling interest controlling interest The ownership of a quantity of outstanding corporate stock sufficient to control the actions of the firm. Controlling interest often involves ownership of significantly less than 51% of a firm's outstanding stock because many owners fail in the company in order to implement the restructuring plan. In order to address this concern, the Federal Financial Supervisory Authority (Bundesanstalt f'r Finanzdienstleistungsaufsicht, or "BaFin") may exempt an investor from the obligation to make a tender offer if the investor gains control of the target company in connection with the restructuring of the company. The decision to grant an exemption is in the discretion of BaFin. However, the exemption will generally be granted if the interests of the other shareholders are not negatively affected and the investor can demonstrate to BaFin that the target company is in a serious crisis and that the planned restructuring measures are suitable to restructure the company. In addition, the investor seeking the exemption must make a substantial restructuring contribution to the company, which in the case of a debt-equity swap will be the waiver of the claims under the acquired loans plus, in most cases, the provision of new money. The investor can apply for the exemption either before he assumes a controlling interest in the company or within seven days thereafter. Conclusion German companies in financial difficulty continue to provide interesting investment opportunities for international investors. The acquisition of controlling stakes by means of debt-equity swaps is no longer a novelty Novelty is the quality of being new. Although it may be said to have an objective dimension (e.g. a new style of art coming into being, such as abstract art or impressionism) it essentially exists in the subjective perceptions of individuals. in the German market. Although it is potentially more complicated than a straightforward M&A transaction, a debt-equity swap can still offer extremely attractive returns. The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. Jones Day North Point 901 Lakeside Avenue Cleveland 44114 UNITED STATES United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. Tel: 2165863939 Fax: 2165790212 E-mail: mimakarchuk@jonesday.com URL URL in full Uniform Resource Locator Address of a resource on the Internet. The resource can be any type of file stored on a server, such as a Web page, a text file, a graphics file, or an application program. : www.jonesday.com Click Here for related articles (c) Mondaq Ltd, 2006 - Tel. +44 (0)20 8544 8300 - http://www.mondaq.com |
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