Q&A: Insolvency litigation in 2022
June 2022 | SPECIAL REPORT: INTERNATIONAL DISPUTE RESOLUTION
Financier Worldwide Magazine
June 2022 Issue
FW discusses insolvency litigation in 2022 with Craig Montgomery at Freshfields Bruckhaus Deringer, Richard Boynton at Kirkland & Ellis and Fiona Huntriss at Pallas Partners LLP.
FW: In broad terms, how would you characterise general trading conditions for companies over the last year or so? To what extent is the current environment likely to lead to a rise in struggling, distressed and failed businesses?
Montgomery: The coronavirus (COVID-19) pandemic period has not been characterised by a significant number of insolvencies, despite the trading challenges resulting in depressed revenues across many sectors. This is due both to government support and intervention in relation to fixed costs such as labour and rent, but also an extremely receptive market for refinancing. Neither of those factors apply any longer – government support has now rolled off, at least in the UK, meaning any rent arrears now have to be paid by most businesses and the credit markets have significantly tightened. For that reason, I expect formal restructurings and insolvencies to rise significantly this year.
Boynton: The combination of COVID-19 financial support measures tapering off and macroeconomic headwinds, ranging from increasing costs, particularly energy and freight, supply chain pressures and the unabated threat of pandemic restrictions, has left many sectors struggling. There is no doubt the pressure on certain sectors is rising, particularly in the construction and property development markets, but the availability of relatively cheap private finance means the impact is not quite as significant yet as it might have been. The anticipated surge of insolvencies that has been predicted for the past two years has not yet materialised, but with interest rates creeping up and substantial increases in raw material costs, the tide is certainly starting to rise.
Huntriss: The financial position of most companies appears to have weathered ‘COVID-19’ remarkably well, aided by governmental support, and a relatively smooth uptick in business and activity as restrictions eased. However, it looks like there will be more troubled times ahead: supply chain disruption and rising living costs will necessarily impact businesses, and resultant interest changes will also have a huge effect. We are also expecting creditors to become more aggressive. While some of them were willing to wait it out through COVID-19, particularly as they found valuation difficult to predict, they are now showing signs of taking more aggressive action. Put another way, we are expecting a rise in distress and insolvency – perhaps not a tidal wave, but definitely an uptick in activity in this space.
“Winning in court is not always the optimum outcome. What must be done is to understand which cases need to go all the way through a litigation process, and which can and should be settled to protect or preserve value.”
FW: How would you characterise insolvency litigation activity in the current market? What types of insolvency-related disputes are typically being seen?
Boynton: Over the past 12 months, the restructuring plan has solidified its status as a major tool for restructuring practitioners. As confidence grows in its use, we are seeing signs of it being used as a regular alternative to the company voluntary arrangement (CVA), although there are still several untested elements, and the full reach of the plan is still unknown. A court recently approved the restructuring plan of Smile Telecoms, which is the first to exclude out-of-the-money stakeholders from voting on the plan, and the first to compromise shareholders’ rights in a foreign company. Where possible, courts are applying concepts familiar to schemes of arrangement, and they are extremely focused on procedural fairness and the evidence provided by the companies, particularly relating to valuation.
Huntriss: In England, we continue to see a steady stream of contentious restructurings, particularly through the use of the relatively new restructuring plan, and consistent and continued use of older tools such as schemes of arrangement. Within the usage of these tools, insolvency litigation is focusing on cramdown issues, including cross-class cramdown in restructuring plans, and valuation issues. We have also seen a spate of litigation by landlords, unsuccessfully seeking to correct an insolvency litigation landscape which is traditionally against them. English courts heard a number of cases through 2021, including New Look, Virgin Active and Regis, which rejected challenges brought by landlords to restructurings that involved distressed tenants comprising claims against them.
Montgomery: We are seeing increasing challenges to schemes of arrangement and restructuring plans, though recently there have not been that many such restructurings. Those that have been proposed have more often than not faced opposition from creditor groups or other stakeholders, such as shareholders. As the number of companies proposing formal compromises increases, I expect so will the proliferation of challenges, covering class issues and valuation in particular. The relatively new restructuring plan allows for cross-class cramdown where a plan has been approved by at least one class and where dissenting classes are no worse off than in the relevant alternative. The focus is therefore on identifying the relevant alternative and showing by valuation evidence that the dissenting class would be better off under the plan.
FW: What specific changes have been made to insolvency regimes in response to the coronavirus (COVID-19) pandemic? How have these affected litigation tactics and dynamics?
Montgomery: There have been restrictions on statutory demands and winding-up petitions during the pandemic, where the financial difficulties have been caused by COVID-19. This has particularly hit landlords, which have also been restricted from exercising their remedy of forfeiture. Those restrictions are now largely unwound and there is a special arbitration procedure in place to determine whether arrears should be paid. It remains to be seen how widely that will be used. The impact of the removal of restrictions is more likely to be felt in the small and medium-sized enterprises (SME) market, as there are more structural issues for landlords and tenants in the large-unit retail sector, where tenants are also more able to access company voluntary arrangements and restructuring plans, subject to certain restrictions. Commercial deals are therefore quite common.
Huntriss: The UK had major new insolvency legislation – the Corporate Insolvency and Governance Act 2020 (CIGA) – enter into force in June 2020, just as the impact of the pandemic was being felt. To English courts’ and court users’ credit, the implementation of this new legislation during this time of upheaval was smooth, and there has been a widespread embrace of the more wide-reaching and flexible tools made available through CIGA, particularly the restructuring plan. The other major change – not insolvency specific but COVID-19 specific – has been the use of virtual hearings and other online tools to allow litigation to continue, notwithstanding the physical and health restrictions that have been imposed. These have allowed English courts to continue to hear their cases, urgent and non-urgent, throughout the pandemic.
Boynton: One particularly interesting dynamic of the COVID-19 response has been the moratorium process introduced in June 2020. The process has not been as nearly widely used as the UK government anticipated, primarily owing to the limited nature of the payment holiday and various eligibility exclusions. In a case involving the Corbin & King group earlier this year, the court ruled for the first time on a contested moratorium process, clarifying a critical aspect of the procedure regarding the requirement for monitors to terminate a moratorium if they think that the company is unable to pay certain debts. The case is a notable example of the successful use of a moratorium to constrain secured creditor action and particularly illustrates the ‘balance of harm’ exercise that the court will conduct when considering whether to exercise its discretion to terminate a moratorium.
“There is no doubt the pressure on certain sectors is rising, particularly in the construction and property development markets, but the availability of relatively cheap private finance means the impact is not quite as significant yet as it might have been.”
FW: What developments have you seen in litigation involving directors and officers, and their responsibilities related to insolvency?
Huntriss: We are seeing increased scrutiny of directors and officers, and an uptick in litigation and threatened litigation against them. Out-of-the-money creditors are now looking more often to litigate against these parties, particularly where there are sufficient insurance policies to meet claims. Against that backdrop, the circumstances created by the COVID-19 pandemic, and as we may now see emerge through supply chain issues and rising living costs, may create more fertile ground for these sorts of claims. Companies on the edge of distress, or nearing the zone of insolvency, create difficult quandaries for their officers, and creditors are only too willing to unsympathetically apply hindsight when assessing the decisions taken in those moments of crisis.
Boynton: Courts in the UK now have more efficient powers in disqualifying company directors of dissolved companies under the Rating (Coronavirus) and Directors Disqualification (Dissolved Companies) Act 2021. The extension to the investigatory powers of The Insolvency Services (IS) is, unusually, retrospective in respect of the conduct of directors at any time before, as well as after, the passing of the Act. The efficacy of the Act will depend on the reporting by creditors and other interested parties, as well as the capacity of the IS to investigate and prosecute, but as the government looks to recover as much as possible following the pandemic, we expect to see the increasing use of these new powers.
Montgomery: Where there have been insolvencies, there has been an increase in claims against directors. This will be an interesting area of focus as some businesses now begin to fail, having been in a zombie state for a couple of years. There was some pandemic-related relaxation of wrongful trading liability, but it did not affect directors’ general duties to the company, which in a period of financial difficulties means its creditors. We may therefore see more of this type of litigation. We have also seen a hardening of the market for directors and officers insurance, which will be an additional dynamic in this part of the cycle.
FW: Have any recent insolvency litigation cases caught your eye in particular? What insights might be drawn from their outcome?
Boynton: Many of the most significant judgments in the past year have come in respect of restructuring plans. By way of example, the judgment which sanctioned the Smile Telecom plan covered a large amount of ground, but of particular interest was the way in which Lord Justice Snowden provided guidance to those who may wish to challenge a restructuring plan. The court made it clear that it would not allow a dissenting creditor to ‘shout from the sidelines’ and that anyone who wished to challenge the company’s proposal must appear in person, submit evidence which complies with the Civil Procedure Rules and make submissions to the court, rather than complain about certain aspects of the company’s valuation evidence with which the creditor wishes to take issue. In short, a dissenting creditor must act in the way it would if it were a party to litigation, not just ask questions in correspondence in a half-hearted manner.
Montgomery: A recent case saw a successful restructuring plan for commodities trader ED&F Man, which was the first example of the paradigm use of the new process, involving a major European business with a full debt stack and a restructuring of the equity. The plan faced some opposition from certain bondholders that were fairly, but not entirely, out of the money. Identification of the reasonable alternative and valuation were therefore key. The case was important in reinforcing that in the absence of cogent contrary evidence, the directors’ view of the reasonable alternative is to be given great weight, because they are best placed to know what they would do in the absence of a successful restructuring. The courts have also reinforced that opposition which is shouted from the sidelines will not generally be sufficient, and creditors wishing to oppose will have to instruct counsel and prepare proper expert evidence.
Huntriss: The Restructuring Plan for Smile Telecom, which was sanctioned by Lord Justice Snowden in March 2022, was the first case to consider the exclusion of out-of-the-money creditors from voting on a restructuring plan, something which was acknowledged to be “draconian” by the judge, but nevertheless found to be permissible subject to valuation evidence and deep examination of the relevant alternatives. The case also stands as support for the proposition that opposing creditors and members must ‘step up to the plate’ and appear before the court to raise objections rather than merely ‘shouting from the sidelines’. I also watched with interest the Amigo Schemes of Arrangement where, recently, the High Court permitted two rival schemes to be put to creditor vote. A sensible and useful development, in my view.
“Correspondence with opponents, provision of documents, the shape and focus of the company, and expert evidence are all key components of a successful restructuring, requiring specialist advice from insolvency litigators.”
FW: What essential advice would you offer to parties engaged in the insolvency litigation process, in terms of how best to protect their interests and further their claims? To what extent is the ability to compromise a key aspect?
Huntriss: Winning in court is not always the optimum outcome. What must be done is to understand which cases need to go all the way through a litigation process, and which can and should be settled to protect or preserve value. On one hand, insolvency litigation is just another form of litigation, and should be assessed in the same way, looking primarily at merits to drive an outcome. However, it is important to remember the broader context which can differentiate some insolvency litigations from ‘standard’ litigation. Time can be a cruel factor in restructurings and insolvencies, and parties must balance the time that it can take to resolve contentious issues with their broader view on what ‘success’ means. This does mean that it is important that parties have an open mind on compromise throughout any process.
Montgomery: It is clear now that every major restructuring should be treated as a potential piece of litigation from the start. Correspondence with opponents, provision of documents, the shape and focus of the company, and expert evidence are all key components of a successful restructuring, requiring specialist advice from insolvency litigators. However, it is always better to avoid a dispute if that is possible and it is important to find ways to engage directly with creditors to allay concerns. The skill of the restructuring adviser is in finding creative ways of doing that to address the concerns and requirements of all parties.
Boynton: It is trite, but important to say, that parties need to trust one another. Creditors are generally going to be disappointed and often angry that they will not recover all that they are owed if a company ends up in an insolvency process. A company needs to recognise that and ensure that creditors understand that the alternative to a company’s proposal would be even worse for them: and that means open, honest communication about what the company can and cannot afford at an early stage. Once creditors understand what is, and is not, possible, it is important that they are realistic about the position. It is difficult for a company to negotiate with creditors who refuse to accept that difficult decisions must be made, and the almost inevitable result of that dynamic is less communication, a process which has less support, a potential challenge and more money spent on legal fees for the company and creditors.
FW: How do you anticipate the insolvency litigation landscape evolving through 2022, and beyond? What issues do you expect to dominate this arena?
Montgomery: We will continue to see a proliferation of challenges to formal restructurings, but with the anticipated wave of insolvencies, we will also see claims against directors and officers, fraud and transaction avoidance claims and eventually negligence claims against auditors and other professionals with accompanying regulatory proceedings. With the added pressure of the sanctions and shifts in business sentiment arising from the war in Ukraine, we will also see litigation around contract termination and the rights and wrongs of refusals to make payments. All of this will play out over the best part of a decade, as we saw from the last financial crisis.
Boynton: We anticipate that parties will continue to test the boundaries of what can be achieved via a restructuring plan and that CVAs will remain a popular tool for mid-market companies. We also expect interest rate increases, coupled with increases in the costs of raw material, will push increasing numbers of companies into insolvency processes. Such processes have, in the past few years, been challenged far more frequently than previously. Creditors are, as a general rule, quicker to mobilise and alive to the areas where a challenge may gain traction, so we expect that trend to continue.
Huntriss: Advisers have been anticipating a wave of restructuring and insolvency litigation for the last two years. That has not materialised, but we do now expect an uptick in the coming months. As there is that increased work, we are expecting to see more valuation disputes, and more attempts to shut out-of-the-money creditors from the process at the earliest possible chance, and therefore litigation by those creditors to seek to be involved and create risk. This will be in the context of litigation of restructuring tools such as restructuring plans and schemes of arrangement, and also non-insolvency specific contexts such as oppression of the minority and bad faith purposes.
Craig Montgomery is a partner in Freshfield Bruckhaus Deringer’s dispute resolution practice and restructuring and insolvency practice. He has a broad practice, advising on a range of matters, including contentious restructuring and insolvency matters, especially complex matters in regulated industries or involving cross-border issues. He also specialises in aviation disputes and restructurings. He is a fellow of INSOL International. He can be contacted on +44 (0)20 7936 4000 or by email: craig.montgomery@freshfields.com.
Richard Boynton is a partner in Kirkland & Ellis’ international litigation and arbitration group in London. He has extensive experience leading teams representing multinational corporations, credit funds, private equity funds and international banks in litigation and arbitration throughout the world. His cases cover a variety of sectors and areas of law. He can be contacted on +44 (0)20 7469 2180 or by email: richard.boynton@kirkland.com.
Fiona Huntriss’ portfolio encompasses high-profile finance litigation, restructuring and insolvency-related litigation, commercial litigation, shareholder disputes and sovereign debt disputes. She frequently litigates both before English courts and other fora, in complex, multijurisdictional and novel situations. She also has a strong advisory practice working with clients to understand litigation risk and develop litigation strategies ahead of time. She can be contacted on +44 (0)20 4574 1003 or by email: fiona.huntriss@pallasllp.com.
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