Debt restructuring is a process that allows a private or public company – or a sovereign entity – facing cash flow problems and financial distress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its operations.
Replacement of old debt by new debt when not under financial distress is referred to as refinancing.
A debt restructuring is usually less expensive and a preferable alternative to bankruptcy. The main costs associated with a business debt restructuring are the time and effort to negotiate with bankers, creditors, vendors and tax authorities. Debt restructurings typically involve a reduction of debt and an extension of payment terms.
In the United States, small business bankruptcy filings cost at least $50,000 in legal and court fees, and filing costs in excess of $100,000 are common. By some measures, only 20% of firms survive Chapter 11 bankruptcy filings.
Historically, debt restructuring has been the province of the large corporation with the in-house or retained resources to undertake the process and the financial wherewithal to successfully see it to conclusion. In the on-going economic downturn that began in 2008 a sub component of debt restructuring, known as debt mediation emerged for small business entities (usually revenues of <$5m). Like debt restructuring debt mediation is a business to business activity and should not be confused with or considered in the same manner as the more blurry world of individual debt reduction involving credit cards, unpaid taxes and defaulted mortgages.
In 2010 Debt Mediation has become a primary means for small businesses to refinance as the market for lines of credit and direct borrowing have shrunk dramatically. The use of debt mediation can be cost effective for the small business, help end or avoid litigation and is highly preferable to filing for bankruptcy as it gives once successful small businesses the chance to recapture that success.
While there are numerous companies providing restructuring for large corporations, there are few legitimate firms working for the small business community. Legitimate debt restructuring firms only work for the debtor client (not as a debt collection agency) and should charge fees based on success.
Among the debt situations that can be worked out in business to business debt mediation are: Lawsuits and Judgments, Delinquent Property, Machinery, Equipment rentals/leases, Business Loans or Mortgage on Business Property, Capital payments due for improvements/construction, Invoices and Statements, Disputed Bills and Problem Debts.
Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors. This is because both the debt and the remaining assets in these companies are so large that there is no advantage for the creditors to drive the company into bankruptcy. Instead the creditors prefer to take control of the business as a going concern. As a consequence, the original shareholders' stake in the company is generally significantly diluted in these deals and may be entirely eliminated, as is typical in a Chapter 11 bankruptcy.
Sub-prime mortgage crisis
Debt-for-equity swaps are one way of dealing with sub-prime mortgages. A householder unable to service his debt on a $180k mortgage for example, may by agreement with his bank have the value of the mortgage reduced (say to $135k or 75% of the house's current value), in return for which the bank will receive 50% of the amount by which any resale value, when the house is resold, exceeds $135k.
A debt-for-equity swap may also be called a "bondholder haircut." Bondholder haircuts at large banks were advocated as a potential solution for the sub-prime mortgage crisis by prominent economists:
Economist Joseph Stiglitz testified that bank bailouts "...are really bailouts not of the enterprises but of the shareholders and especially bondholders. There is no reason that American taxpayers should be doing this." He wrote that reducing bank debt levels by converting debt into equity will increase confidence in the financial system. He believes that addressing bank solvency in this way would help address credit market liquidity issues.
Economist Jeffrey Sachs has also argued for bondholder haircuts: "The cheaper and more equitable way would be to make shareholders and bank bondholders take the hit rather than the taxpayer. The Fed and other bank regulators would insist that bad loans be written down on the books. Bondholders would take haircuts, but these losses are already priced into deeply discounted bond prices."
If the key issue is bank solvency, converting debt to equity via bondholder haircuts presents an elegant solution to the problem. Not only is debt reduced along with interest payments, but equity is simultaneously increased. Investors can then have more confidence that the bank (and financial system more broadly) is solvent, helping unfreeze credit markets. Taxpayers do not have to contribute dollars and the government may be able to just provide guarantees in the short-term to further support confidence in the recapitalized institution.
For example, one of the largest U.S. banks owed its bondholders $267 billion per its 2008 annual report. A 20% haircut would reduce this debt by about $54 billion, creating an equal amount of equity in the process, thereby recapitalizing the bank significantly.
Informal debt repayment agreements
Most defendants who cannot pay the enforcement officer in full at once enter into negotiations with the officer to pay by installments. This process is informal but cheaper and quicker than an application to the court.
Payment by this method relies on the co-operation of the creditor and the enforcement officer. It is therefore important not to offer more than you can afford or to fall behind with the payments you agree. If you do fall behind with the payments and the enforcement officer has seized goods, they may remove them to the sale room for auction.
Debt restructuring in individual jurisdictions
Under Swiss law, debt restructuring may occur out of court, or through a court-mediated debt restructuring agreement that may provide for a partial waiver of debts, or for a liquidation of the debtor's assets by the creditors.
The majority of debt restructuring within the United Kingdom, certainly in the commercial sector, is undertaken on a collaborative basis between the borrower and the creditors. Should this be unsatisfactory in the first instance, the court may be asked to mediate and administrators appointed.
Debt restructuring within Italy may occur either out of court (ex article 67 of the Italian Bankruptcy Law) when a waiver or simple debt rescheduling is required, or through a court-mediated debt restructuring agreement (ex article 182/bis of the Italian Bankruptcy Law) and may provide for a partial waiver of debts, mandatory recapitalization of the debtor, or for a liquidation of certain debtor's assets to repay privileged creditors.
As the incidence of corporate failures has increased in part due to current economic climate, so a more 'standard' approach to restructuring has developed. Although every case has unique characteristics, the process of restructuring follows a number of important phases.
Initially, a downturn in trading performance is identified typically through management accounts or as a result of revised management projections. This triggers a gathering of lenders (and perhaps other stakeholders), in anticipation of a breach of financial covenants or a crisis of liquidity.
The lending group (typically comprising corporate finance divisions of banks) will normally commission a review of the business and its financial position and outlook. This will normally be undertaken by a corporate advisory group. This will form the basis of any restructuring of facilities.
The lending group will typically appoint a Corporate Restructuring Officer or CRO, to assist management in the turnaround of the business, and embracing the recommendations presented by the banking group and the corporate advisory report.
- Buljevich, Esteban C.,Cross Border Debt Restructuring: Innovative Approaches for Creditors, Corporate and Sovereigns ISBN 1-84374-194-6
- Jeffrey Sachs-Our Wall Street Besotted Public Policy
- Wells Fargo-2008 Annual Report