Clients engage transactional lawyers for two reasons. First is to identify risks to the client’s transactional objectives. Second, but equally important, is to advise on how to eliminate those risks, or at least reduce them to an acceptable level. For this predictive exercise, counsel relies on knowledge and experience, frequently utilizing time-tested solutions. But knowledge and experience can be disrupted by a variety of forces. Globalization is one such force that has changed the advice given to clients engaged in cross-border transactions. Recent insolvencies in countries such as Brazil, India, Mexico and Korea are a reminder that transactions do not always fulfill their promise, illustrating the importance of insolvency risk assessment and planning on the front-end of transactions.
Globalization and Enforcement Risk
Globalization is alternately cited as the cure for, or the cause of, many of the world’s problems. There is little doubt that the lowering of trade barriers has stimulated global economic activity, encouraging development and investment across national boundaries. But it is also disruptive.
Market participants try to optimize the balance of return and risk; and, commonly used structures for trade and finance require predictability. When a lender or investor is unable to anticipate how its rights will be adjudicated in a particular jurisdiction, it must accommodate the additional risks and associated costs when evaluating, pricing and structuring a transaction. International financings have always required additional analysis and attention to structure, most often to minimize taxation in multiple jurisdictions. But, transactions in foreign countries introduce enforcement risks beyond those in a domestic transaction. This enforcement risk escalates as businesses diversify operations and capital is deployed into more jurisdictions, many of which are trying to attract investment by modernizing their legal systems.
Several nations, including Mexico, India and the Dominican Republic, have in recent years revised, or implemented, debt restructuring laws that incorporate some concepts adapted from British schemes of arrangement or U.S. Chapter 11 cases. In some cases these are welcome reforms that, in the long run, may help save distressed business and allow lenders and investors to better protect their positions. But, enacting legislation and implementing a viable system to deal with insolvencies are distinctly different exercises. And, no one wants to be the test-case for a newly designed legal system.
As businesses diversify operations, the value on which investors and lenders rely in making their transactional decisions can be spread across multiple jurisdictions. The tried-and-true methods developed for domestic transactions are inadequate when a business has operations and assets deployed in different countries. Relying on a well-developed body of commercial law is not enough.
Over the last several years, acquisitions of foreign businesses having little or no presence in the United States have been financed with debt raised in the United States using New York law governed finance documents. What happens if this debt needs to be restructured? Lenders and investors must plan for the possibility of distressed investments and insolvencies in countries with different, and sometimes irreconcilable, legal systems and policies. Moreover, recent U.S. government policy initiatives have complicated the international commercial landscape and undermined some of the cross-border initiatives that were expected to help lenders and investors navigate among these obstacles.
Eliminating risk is relatively simple: if your client doesn’t close a transaction you never have to worry about enforcement risk. But, making a return on capital requires accepting some amount of risk. So, a balance needs to be found. The key is to reduce risk to an acceptable level through transactional structuring. The most basic elements of structure will involve the ability to realize on collateral and credit support.
Planning Across Borders
When the business or assets are located outside the United States, a restructuring will have to take place under, or at least comply with, foreign law. Depending on the location of assets and creditors, the restructuring could require taking action in multiple jurisdictions. Generally, to effect a cross-border reorganization, the main proceeding will be commenced in one country with related or ancillary proceedings filed in other nations as needed to make a plan of reorganization or scheme of arrangement binding on creditors in those jurisdictions.
To ensure that a lender or investor receives the hoped-for benefits of its bargain, counsel needs to structure and document a transaction utilizing experience with, and knowledge of, a developed body of commercial law and the expectation that this body of law will be consistently applied by an impartial judiciary through an efficient legal process. Changes, no matter how well intentioned, undermine the requirement for predictability. Even in countries where the insolvency laws remain unchanged, many participants in cross-border financings have discovered that all of the elements needed for predictability may not be present.
The selection of the main forum is important since differences in foreign insolvency law and practice introduce both uncertainty and delay into debt restructuring. Foreign insolvency laws often involve different dynamics in the creditor-debtor relationship, which require different strategies. In the United States, for example, involuntary filings by creditors are relatively uncommon since they can only be filed by a group of unsecured creditors; this gives debtors significant control over the whether, when and where of a filing. By contrast, in many foreign countries insolvency cases are routinely filed by creditors, particularly in legal systems that do not offer robust mechanics for restructuring debt. If foreign creditors have the ability to force a business into insolvency, they will probably have significant leverage that can be used to their advantage during negotiations.
Ideally, a secured lender should be able to act without resorting to the legal system in the borrower’s jurisdiction. Several techniques used by project finance lenders can be effective in confining enforcement to predictable venues, such as England or the United States. Although they do not offer complete protection, they can reduce the risk that realization of claims or collateral will be delayed by foreign insolvency proceedings.
One of the most common of these techniques is to perfect a pledge of the stock of a holding company that owns the operating business or the entity owning the valuable collateral. Preferably, the pledgor is a borrower, although with proper structuring and drafting it might be a guarantor. This pledger, organized in a reduced-risk jurisdiction, should be the sole owner of the foreign entity. This holding company enters into a pledge agreement, which is governed by the law of a jurisdiction with a sophisticated and well-developed body of commercial law such as New York or the United Kingdom. Upon a default the lender can enforce the pledge and sell the foreign entity as a going concern. An insolvency proceeding by the borrower should not prevent the lender from enforcing its pledge. Of course, it is critical to ensure that the borrower’s home jurisdiction will recognize the resulting change in ownership. This illustrates the importance of having sophisticated counsel in the foreign jurisdiction that can provide advice on commercial and regulatory issues.
Isolating and protecting revenue generating assets such as receivables is common for asset-based lenders wanting to ensure access to their collateral. This can be especially important when structuring deals in jurisdictions that have bankruptcy systems that are not creditor-friendly. Lenders could require the sale of such assets into a special-purpose vehicle, but devising a workable “bankruptcy remote” structure is challenging in jurisdictions where the bankruptcy laws are unsettled. The legal and accounting requirements for bankruptcy isolation are predicated on consistently applied principles that may be difficult to predict, particularly if the legal system is not based on an Anglo-American legal tradition.
Parent and affiliate guaranties are a common form of credit enhancement that merit particular attention in cross-border transactions. They are most useful when assets or value move, whether intentionally or otherwise, from the original obligor to an affiliated entity, thereby keeping them within the reach of the lender if the obligor defaults. Guarantees provide recourse when the obligor is insolvent or bankrupt but the guarantor is not, since guarantees are independent and distinct from the underlying obligations. However, guarantees are secondary obligations that are contingent on the obligation of the third party. It therefore becomes important to understand how the guarantees will be treated if the underlying obligation is compromised or satisfied in an insolvency. This will be dependent on the governing law, which should be the law of a sophisticated commercial jurisdiction such as New York or the United Kingdom, and the court enforcing the guarantees. To enhance the lender’s position, guarantees should include indemnification provisions that can protect against the satisfaction or discharge of the guaranteed obligations, since they are primary obligations that are independent of the underlying guaranteed obligations.
Of course, there are no absolute protections against the downside risk in any transaction. This is especially the case in cross-border transactions that span multiple jurisdictions. Nevertheless, some careful planning and drafting can improve the prospects for the outcome.
Michael Venditto is a partner at Reed Smith. He represents lenders, investors, indenture trustees, debtors and creditors in business reorganizations, out-of-court restructurings, cross-border insolvencies, bankruptcies and commercial disputes.