Disclosure of lender-imposed conditions

The 2019 Financial Reporting season has thrown up examples of very specific disclosure of the conditions imposed on listed borrowers by their lenders.

Case 1 – The amount and timing of an equity raise.

Case 2 – A requirement to conduct a ‘strategic review’ of ‘funding options.’

Case 3 – The timing and requirement for an equity raise to meet a balance sheet ratio.

Two-edged sword

Such disclosure is a two-edged sword.

Certainly, potential purchasers of the shares will be very well informed – but at the same time, the disclosure is likely to make it harder for management to achieve a turnaround. Perceived financial fragility may lead key staff to look elsewhere, and will probably make it harder for the businesses to win new business.  In some cases, it will also create liquidity problems if suppliers decide to reduce trade credit limits.*

Why is such disclosure required?

Listed companies have multiple disclosure requirements.  The Listing Rules impose a continuous disclosure regime, with limited exemptions – for example where negotiations are underway, or are confidential to another party.  The Accounting Standards also impose further disclosure requirements.

If disclosure was made to comply with the continuous disclosure regime then arguably it should have been made earlier – when the companies received notice of their lender’s requirements.

Disclosure in the Annual Report suggests that the disclosure was prompted by the auditor’s review of the financial statements – but for an outsider it is difficult to say whether it reflects a belated ‘catch up’ of continuous disclosure, or whether it is intended to ensure compliance with Accounting Standards.

Theoretical arguments about the reasons for the disclosure and whether it is strictly required may not be much help up for companies up against a deadline.  Two of the case studies had audit reports signed on the latest possible date – perhaps they simply ran out of time?

How should directors mitigate harmful disclosure?

Of course it is important that directors ensure that investors are adequately informed – but they should try to avoid do so in a way that makes it harder for the business to achieve a turnaround.

Harmful disclosure can be mitigated – but it becomes so much harder after balance date.

Businesses in turnaround mode should be projecting their compliance with covenants as part of their normal board reporting.  If non-compliance seems likely, then it is important to negotiate with lenders well ahead of any deadline.  Of course, those negotiations are far easier if supported by a well thought-out and comprehensive turnaround plan that will provide comfort that any underlying issues have been identified, and will be addressed.


First published here

Ipso Facto regulations: now with a ‘mega-project’ exemption

The ipso facto regulations – more technically, the Corporations Amendment (Stay on Enforcing Certain Rights) Regulations 2018 – were released on 22 June 2018.

The regulations represent the last stage of reforms that are intended to limit the availability of so-called ipso facto clauses (aka ‘insolvency event’ or ‘termination for insolvency’ clauses, and discussed in more detail here), providing a list of exemptions: contracts to which the reforms will not apply.

Such clauses allow a party to terminate a contract if the other party becomes insolvent – even if there is no other default – making it harder to restructure a business that enters formal insolvency administration.

Those responsible for updating existing contracts (which disappointingly will remain unaffected by the ipso facto reforms) will say that the eight-day gap between the release of the regulations and their taking effect will leave very little time to make those changes, but perhaps that was intended.

SPV exemption tightened

The draft regulations included a very wide exemption for ‘a contract, agreement or arrangement of which a special purpose vehicle is a party.’  Sensibly this has been narrowed to securitisation, public/ private partnerships and project finance arrangements.

National Security

The final version of the regulations adds an exemption for contracts relating to ‘Australia’s national security, border protection or defence capability.’ 

Such an exemption suggests that the ipso facto reforms are seen by some as having the potential to threaten Australia’s current security arrangements and capability, when in fact they could equally operate to ensure that current security arrangements are maintained!

‘Mega-Projects’

The final version also adds a five-year exemption for construction contracts where the total payments ‘under all contracts, agreements or arrangements for the project’ is more than $1 billion. 

ipso facto racehorse
Retired racehorse Ipso Facto is unperturbed by the mega-project exemption

There is no mechanism to ensure that sub-contractors to such mega-projects will know whether the key billion dollar threshold will be reached, and whether the exemption will therefore apply.  The consequences of acting in ignorance of such an exemption would seem problematic, but thankfully in practice there will be only a small number of such mega-projects.

 

 

The final version of the regulations is available here.

 

 

 

Continuous Disclosure, Class Action Regulation, and Restructuring

The continuous disclosure regime presents additional challenges for directors trying to turn around a listed company.  The turnaround itself will probably mean that that there is more to keep the market informed about, but there is more to it than that.  A perceived failure to properly disclose may well lead to a class action, adding to the workload of an already busy management team and board, as well as adding to the list of creditors.

Perhaps the most extreme example is that of Surfstitch, where on one analysis the commencement of a class action claim resulted in a majority of directors concluding – incorrectly in the view of the administrator that they appointed – that their company was insolvent. For these reasons, turnaround and restructuring professionals should have a keen interest in the outcome of a recently commenced Australian Law Reform Commission review.

Background

In December 2017, the Attorney-General asked the ALRC to inquire into the regulation of class actions and those who fund them, with a report due by 21 December 2018.

After a series of bilateral consultations with forty-three parties: regulators, funders, lawyers and other industry participants, the ALRC issued a discussion paper (available here) on 31 May 2018.

A ‘standard approach’

The discussion paper identified what it described as a ‘standard approach’ by litigation funders:

Litigation funders and/or plaintiff law firms (or their hired experts) identify a significant drop in the value of securities.  This is analysed to determine whether it is likely that the relevant drop had been occasioned by the late revelation of material information.

Typically, the analysis determines whether or not it is likely that there is a sufficient basis for assuming the existence of contravening conduct during a period prior to the eventual announcement of the material information.  The litigation funders and/or plaintiff law firms then determine the size of the potential loss that may have been occasioned by the suspected period of contravening conduct.  The duration of that period may extend back for a considerable period, as in the recently announced class actions against AMP where a period of five years has been identified.

Once the funders and/or lawyers are satisfied that there is a sufficient basis for assuming the existence of contravening conduct, funding terms are discussed and (at least prior to the advent of the common fund order) there is an effort to sign up institutional and other group members (complex questions relating to issues of privacy and data sets are likely to arise in this context).  During this developmental stage, an announcement might be made of a potential class action, attracting media attention which may augment the number of affected shareholders who wish to participate in the proposed class action

To address the problems it identifies, the discussion paper has recommended:

The Australian Government should commission a review of the legal and economic impact of the continuous disclosure obligations of entities listed on public stock exchanges and those relating to misleading and deceptive conduct contained in the Corporations Act 2001 (Cth) and the Australian Securities and Investments Commission Act 2001 (Cth) with regards to:

  • the propensity for corporate entities to be the target of funded shareholder class actions in Australia;
  • the value of the investments of shareholders of the corporate entity at the time when that entity is the target of the class action; and
  • the availability and cost of directors and officers liability cover within the Australian market.

The impact of the continuous disclosure regime is is arguably outside the terms of reference so perhaps it is difficult for the ALRC to do more than it has, but the recommendation of a further review will not quickly take us closer to a solution.

Those with practical suggestions should make a submission, due before 30 July.

Safe Harbour Restructuring Plans: Would the Carillion turnaround plan pass muster?

The investigation in the UK  into the collapse of Carillion Plc by a House of Commons select committee provides rare public access to the restructuring plan for a large company.  Would the plan meet the requirements of Australia’s Safe Harbour regime?

The Collapse of Carillion

Carillion was a UK-headquartered construction company with worldwide operations employing 43,000 staff.  It was placed into liquidation on 15 January 2018 following the UK government’s refusal to provide emergency funding,

With only £29 million in cash and creditors of more than £4.6 billion the position was so dire that – according to the select committee report – the company was forced into liquidation because it could not find a administrator prepared to take on the job in light of uncertainty about whether there was enough money to cover their costs.

Investigations into the conduct of the directors and auditors by the Insolvency Service, Financial Reporting Council, Financial Conduct Authority, and the Pensions Regulator are underway.  In addition, the House of Commons Work and Pensions Committee launched an inquiry within a fortnight of the collapse.

As discussed here, the 16 May committee report (available here) is scathing in its criticism of directors, auditors, and regulators.  The Inquiry has also made public a large number of documents which would not ordinarily be available – most notably including the 100 page turnaround plan.

Australia’s Safe Harbour regime

Australia’s severe insolvent trading laws make company directors personally liable for debts incurred when a company is insolvent.

By comparison the UK’s ‘wrongful trading’ regime imposes liability if directors ‘knew, or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation’ and did not take ‘every step with a view to minimising the potential loss to the company’s creditors.’

The Australian Safe Harbour regime provides company directors with protection against insolvent trading claims but only if their conduct and actions, and the conduct of the company, meet minimum standards.

Would the Carillion plan meet the Australian Safe Harbour requirements?

The plan does articulate an appropriate objective that is clearly a better outcome than liquidation, and it does identify the use of a big 4 accounting firm as an appropriately qualified adviser.

However the plan is silent about any steps the directors had taken to conclude that they are properly informed about the financial position of the company, or that they proposed to take to stay informed.  The document identifies a number of actions that have been taken, but it doesn’t really set out a future action plan, identify those responsible for each action, or set milestone dates.

Those omissions may not be fatal – perhaps there were other documents that provide appropriate detail.  The biggest difficulty that the directors would have in meeting the Australian criteria is that the forecasts in the plan exclude employee pension contributions from the company budgets, and paying employee entitlements ‘as they fall due’ is a key requirement of the Australian regime.

Too little, too late

Of course the Carillion turnaround plan was never designed to meet the Australian requirements, so it’s not a huge surprise that it doesn’t.  But nonetheless, that ‘failure’ highlights that it is essential for directors seeking to access safe harbour to ensure that they have a plan that is fit for that purpose.

In the case of Carillion, history shows that the plan was too little, too late: the company was in liquidation within a fortnight of the plan being finalised.


First published here

‘Timid’ regulators, ‘complicit’ auditors, ‘rotten culture,’ and ‘ineffective’ directors

When Carillion PLC collapsed in January 2018 it had 43,000 employees and owed more than £4.6 billion, including a pension liability of around £2.6 billion.

Carillion’s financial position was so dire that it went straight to liquidation.  According to the 16 May report issued by the UK House of Commons Work and Pensions Committee, insolvency practitioners were unwilling to act as administrators because there was no ‘certainty that there was enough money left in the company to pay their costs.’

The report follows the collapse so quickly that it cannot reflect a full forensic analysis, and it is issued under Parliamentary privilege, but the criticisms are fierce.  The report says:

  • The was a ‘chronic lack of accountability and professionalism’ and the board was ‘either negligently ignorant of the rotten culture at Carillion or complicit in it.’
  • The non-Executive directors were ‘unable to provide any remotely convincing evidence of their effective impact.’
  • The resignation and sale of shares by a former finance director ‘were the actions of a man who knew exactly where the company was heading once it was no longer propped up by his accounting tricks.’
  • The auditors ‘were complicit’ in the company’s aggressive accounting judgements through their failure ‘to exercise—and voice—professional scepticism.’
  • The Pensions Regulator ‘failed in all its objectives.’
  • The UK’s Financial Reporting Council was ‘too passive,’ and ‘wholly ineffective’ in taking the auditors to task.
  • The committee had ‘no confidence’ in the FRC or the PR, who it said shared ‘a passive, reactive mindset and are too timid to make effective use of the powers they have.’

The full report is available here, together with video of some of the key evidence.

Draft ipso facto regulations – for consultation

The final piece of the ipso facto reform is almost in place, following today’s release of a draft-for-consultation version of the regulations.

Ipso facto clauses (also known as ‘termination for insolvency’ clauses, and discussed in more detail here) allow termination of a contract if a party to the contract becomes insolvent – even if there is no other default.

Such clauses can be immensely damaging to businesses that enter formal insolvency administration because essential assets and services can be unilaterally withdrawn: landlords can lock out insolvent tenants, franchisors can withdraw access to franchise systems, and lessors can repossess leased equipment.

It’s true that voluntary administration will ‘stay’ such action – but the effect is only temporary.  The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill passed in September 2017 creates a permanent stay – albeit only for clauses in contracts entered into on or after 30 June 2018.

It was always intended that final detail – a list of exemptions – would be left to the regulations (now available here).  The most notable aspects are:

  • The ipso facto stay will not apply to derivatives, margin lending facilities, and invoice finance arrangements.  This is sensible, and as expected.
  • The draft regulations propose an exemption for ‘a contract, agreement or arrangement of which a special purpose vehicle is a party.’  This will be under careful scrutiny: it can’t be intended that the ipso facto stay can be defeated by simply adding an SPV entity to any contractual arrangement.
  • The stay will not affect contractual rights to combine, set off, or net out, multiple accounts.  Again, this is sensible and expected.
  • As anticipated, there is a specific protection of a secured creditor’s ability to appoint a controller, and step-in rights are likewise protected.

The most significant deficiency in the ipso facto reforms – that the stay will not apply to contracts entered into before 30 June 2018 even if they are modified after that date – remains unaddressed.

Submissions on the proposals may be made until 11 May 2018.


(For those who noticed the photo: I haven’t tried Ipso Facto wines but the Cabernet gets great reviews!)

Surfstitch: Avoiding wipeout?

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.