Expert Opinion (#07-08 July-August 2016)

Resolving Insolvency: Viability of Pre-Insolvency Sanation Restructuring

Vsevolod M. Volkov

Ukraine has undergone a couple of insolvency law reforms aimed at improving the insolvency procedures: making them faster, less bureaucratic and more efficient. The primary target, of course, was to ensure that insolvency proceedings are able to restore the solvency of the debtors or, increase the recovery rate to the creditors of insolvent companies.

There is no need for rhetorical questions as to whether the reforms were successful. The latest statistic reports show very unpleasant figures. Based on the latest figures from reports of the World Bank, the recovery rate of Ukrainian insolvency proceedings remains very low — 8.3 cents per dollar in Ukraine compared to 82.04 cents per dollar in the United Kingdom, or 58.3 cents per dollar in Poland. The average duration of insolvency proceedings is 2.9 years in Ukraine, 1 year in the United Kingdom and 3 years in Poland.

One of the main indicators of the efficiency of insolvency proceedings is how many companies have continued their operation as a business of going concern after insolvency proceedings were completed. This statistic in Ukraine is discouraging. In 2014 there were only 12 motions to approve the amicable settlement and only 9 of they were granted. During the same period there was only one motion to approve the rehabilitation (sanation) plan and it was not even considered by court. The statistics for 2013 are not that different, there was only one motion requesting approval of the rehabilitation plan and it was not considered and there were 16 motions to approve amicable settlement, of which 10 were granted. Given that in 2015 bankruptcy related cases amounted to almost 22.3% of all cases before commercial courts in Ukraine there remains tremendous demand to establishing such a legal framework that would offload the insolvency burden from Ukrainian courts.

One of the attempts to off-load such burden and to improve insolvency statistics in Ukraine was amendments which were introduced to Article 6 of the On Rehabilitation of Debtor’s Solvency or Declaring Debtor Bankrupt Act of Ukraine (the Bankruptcy Act) regulating the sanation or rehabilitation proceedings before an insolvency petition is filed to a court. The idea of that amendment was very simple and straightforward; to allow the debtor and its creditors to agree on the terms of restructuring before creditor or debtor file for insolvency proceedings. The novelty was warmly welcomed among legal practitioners, financial advisors and companies, but did it find its way into practice?

Based on the review of records in the Single State Register of Court Judgments, starting from 1 January 2013, when amendments to Article 6 of the Bankruptcy Act came into force, there was only one pioneer for this new option and its attempt was not rewarded with success. The pioneer is the Joint Stock Company Yantsevskiy Gravel Pit and on 6 May 2016 it filed a request to the Commercial court of Zaporizhzha Region to approve the rehabilitation plan without instituting insolvency proceedings. The request was rejected for failing to provide the evidence of proper notification of creditors in accordance with the requirements set out in the Regulation on the procedure of conduct of sanctions before initiation of insolvency proceedings. It is not worth discussing the reasons on the basis of which the court had refused to consider the motion from Yantsevskiy Gravel Pit because the striking circumstances here is not the refusal but the fact that it appears to be the first, and so far the only, motion under article 6 of the Bankruptcy Act. The sole attempt to use the option under Article 6 of the Bankruptcy Act during the two and a half years of its existence hints that there are internal disadvantages in the legal framework which makes this option unpopular. There is no need to blame the lack of readiness in Ukrainian companies to use this option because during 2015 and 2016 quite a lot of international holdings with Ukrainian origins used analogous options in foreign jurisdictions. Such examples include DTEK, Avangard, Metinvest and Privatbank who successfully applied for such remedy as a scheme of arrangement under English law. Such use of analogous remedies in foreign jurisdictions and opposition to using it Ukraine is based on the differences in principles on which they are based.

As a first principle, it shall be noted that the sanation procedure provided for in Article 6 of the Bankruptcy Act is part of Ukrainian legislation regulating the insolvency process. Although, the sanation procedure under Article 6 is not strictly an insolvency proceeding, the fact has it is imbedded in insolvency legislation makes many bank fear about reserves and capital adequacy requirements if they start to use it. Unlike in Ukraine, in the UK the scheme of arrangement is governed by a set of statutes which do not belong to statutes regulating insolvency proceedings. A scheme of arrangement is, therefore, not an insolvency process but a statutory procedure under Part 26 (sections 895-901 CA) of the Companies Act 2006. This minor difference has very far reaching ramifications in terms of making the scheme of arrangement attractive not only to banks but also to companies.

Another feature of the Ukrainian pre-insolvency sanation procedure is that it is aimed at restructuring agreement on the terms of financial rehabilitation with all the creditors and for the whole indebtedness. The UK scheme of arraignment, however, uses a different approach. The UK statutes provide that the scheme may be implemented with special classes of creditors. The purpose of a scheme of arrangement is to allow the company to reach agreement for a consensual restructuring with a certain percentage of a certain class of its creditors, agreement on then binds all creditors in that class (even if they vote against the scheme or have not had notice). It shall be noted that Article 6 of the Bankruptcy Act permits the company to divide the creditors taking part in the sanation into separate categories, based on the type of their claims and existence or absence of security. The terms of settlement of claims belonging to different categories of creditors may differ. The “all-in” approach in Ukrainian legislation plays a negative role here since reaching an agreement with all creditors may be very problematic and often impossible. However, the UK scheme of arrangement procedure allows companies to reach agreement within a specific class of creditors and it is the company that shall determine with which class of creditors it wants to have an agreement. The classification into classes may be a difficult task but as a rule of thumb the creditors may usually be split into preferential creditors, secured creditors and unsecured creditors. The traditional test of splitting creditors into classes was that a class “must be confined to those persons whose rights are not so dissimilar as to make it impossible for them to consult together with a view to their common interest”. This test has recently been developed so that, in one case, bondholders were treated as members of the same class, despite the fact that the bonds were denominated in different currencies and had different maturity dates. More recent cases have tended to treat all creditors as being capable of consulting together in a class unless it is possible to identify very significant differences between their rights.

Another key feature that impacts the viability of the pre-insolvency sanation under Ukrainian law and the scheme of arrangements under UK law is voting requirements. It shall be well expected that any reorganization or restructuring is connected with creditors pursuing a different target, so any voting is then very likely to have dissenting or “hold-out” creditors. The regulatory framework has to provide the procedures on how to deal with them and the way it is usually dealt with is through establishing a voting requirement beyond 100%. At first glance, Ukraine seems to have a very favourable regime since the requirement is to have the pre-insolvency sanation plan approved by creditors owning more than 50% of claims. There is, however, a secondary requirement at the pre-insolvency sanation plan that shall be approved by all secured creditors and this requirement is often disastrous. The key point here is that secured creditors usually have no incentives to approve any sanation plans because their claims are ensured that they may be doing better in case they enforce their security. Such hold-out behavior is particularly relevant for secured creditors with small claims of a company, as they do not have a long-term interest to ensure that the companies continue to do business as a going concern.

The reason for the reduced voting requirements is often the need to cram the minority non-participating creditors into the scheme. For that reason the intention of the scheme of arrangement is that it binds those creditors who voted in favour of the scheme of arrangement but also that it binds those creditors who voted against it or who were not notified of the creditor’s meeting. If the voting requirement is met, it is then the task of the court to approve the scheme and the reasons to reject the scheme are very limited. The major test which the court has to satisfy itself when it is approving the scheme is reasonable and fair that the majority creditors were acting in a bona fide way, it means that creditors were not discriminating against one another, that all make close to an equal contribution to restructuring. The court will need to be confident that the terms and conditions of the restructuring are the ones that an intelligent and honest man, within a class of creditors acting in due respect of his interest, might reasonably approve. If the terms were approved by creditors with 75% of votes it will rarely be the case that the terms are not reasonable unless there specific circumstances. The view that must be taken here is that there is no need to make a second guess with respect to decisions made by creditors who are acting honestly, provided that they have had sufficient information and enough time to properly consider their options.

The situation with the regulation of the grounds on which a Ukrainian court may reject the pre-insolvency sanation plan differs to a material extent. Thus, the court may reject the pre-insolvency sanation plan if a creditor manages to prove that recovery under his claims in case of liquidation of the company will be higher than under the pre-insolvency sanation plan. This requirement is in direct contravention of the entire idea of pre-insolvency sanation where creditors and the company have mutual concessions to ensure appropriate recovery in the future.

Unfortunately, there are also other requirements which impose limitations on the terms of pre-insolvency sanation plan, but those are less important when considering whether or not to try this option. As primary steps for making the option more appealing to companies at the edge of insolvency and to its creditors, the amendments shall be made with respect to the voting requirements what will enable dealing with hold-out creditors within a class and permission for offering pre-insolvency sanation plan to a specific class of creditors or to a couple of their classes. And taking into account the outcome of the application of Yantsevskiy Gravel Pit it is advisable to set a rule that the proof of notification requirement may be ignored if at least the voting threshold of creditors were present at the creditors meeting.

 

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