Debt for equity swaps—an introduction

Debt for equity swaps—an introduction
Marc Trottier, restructuring and insolvency partner at Berwin Leighton Paisner, looks at the benefits and drawbacks of swapping debt for equity in the restructuring of a company.

How can debt for equity swaps add to the restructuring of a company?

Debt for equity swaps are an important consensual restructuring tool used to help deleverage a company’s balance sheet in a tax efficient manner. They essentially involve one or more of the creditors of a company exchanging their debt for some form of equity. They can be used where a company is over-geared and the value of a company is less than the value of the debt it is seeking to service.

In what circumstances would a debt for equity swap be appropriate?

Debt for equity swaps are usually considered when they can’t re-bank and there is no possibility of a further equity injection. From a creditor’s perspective, they will be looking to a debt for equity swap to increase the likelihood of non-equitised debt being repaid, to preserve any enterprise value and to give them a share in any potential equity upside.

What constitutes an equity interest for the purposes of the swap?

The type of equity can take different forms such as a separate class of shares (which should have the rights or ordinary shares for tax purposes) or other equity-based instruments, such as warrants or options.

The rights associated the equity instrument are key and are usually heavily negotiated. These include:

negative controls (which are particularly important for consolidation/shadow director issues)
a priority of return in favour of the creditor, and

restrictions to preserve that priority (anti-dilution, no dividends etc)

The rights may also include the right for the creditor to appoint a director to the board of the company. Finally, the equity stake needs to be freely transferable so that the creditor is able to exit easily at an appropriate time.Consideration is often given to separating the economic rights from the voting (and other control) rights attached to the equity instrument to help mitigate against the risk of consolidation by the creditor.The main area of contention is often the amount of equity reserved for the original shareholders (ie cost of getting existing shareholders/management on side)—a small stake of between 2.5–15% is current market standard.

Who can participate in the swap?

In theory there is no restriction on who may be included in the swap—all creditors can be included. However, in practice, ordinary trade creditors are usually dealt with separately.

What is the tax position?

Tax considerations are central to planning a debt for equity swap and need to be carefully considered. Tax can impact on the transaction in a number of areas. For instance:

Degrouping considerations

The debt for equity swap may reverse previous group relief obtained during the previous six years.

Carry forward/loss of relief

The debt for equity swap must be carefully planned to ensure that the structuring does not ‘soak up’ unutilised losses. Also, consideration should be given to the impact of the creditors taking control of the company on their ability to claim relief on future bad debts or write-offs.

Secondary liabilities

Due diligence by the ‘swapping’ creditor is key to avoid taking on any secondary liabilities (debt for equity is akin to an acquisition and therefore caveat emptor—beware of liabilities being assumed).

Giving rise to tax charges

The key to debt for equity swaps is ensuring that the shares are issued in consideration of the release of debt, not two separate steps (otherwise the forgiveness/waiver of debt could give rise to a taxable charge in the borrower).

What are the key concerns/drawbacks?

While debt for equity swaps are relatively flexible and can be implemented either within or outside of a formal process, their main drawback is that they are consensual (ie they require the buy-in of all affected creditors, including the existing equity holders). This often leads to difficult negotiations on the economics of the transaction as existing stakeholders who may be ‘out of the money’ are given a say in the transaction because of the hold-out value of their equity or debt stake.

Further reading

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Marc Trottier is a restructuring and insolvency partner at Berwin Leighton Paisner. He specialises in corporate restructuring, with experience primarily in non-contentious restructurings, from both the creditor (syndicated and bilateral) and debtor perspectives. He also has significant experience in business turnarounds and both creditor and debtor led restructurings.

Interviewed by Lucy Karsten.

The views expressed by News Analysis interviewees are not necessarily those of the proprietor.

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About the author:
Kathy specialises in restructuring and cross-border insolvency. She qualified as a solicitor in 1995 and has since worked for Weil Gotshal & Manges and Freshfields. Kathy has worked on some of the largest restructuring cases in the last decade, including Worldcom, Parmalat, Enron and Eurotunnel.