A new instrument
In corporate restructuring, success or failure is often determined by the company’s shareholders. A new restructuring instrument was recently introduced in the Netherlands that expands the range of options available to companies. Under the Dutch Act on Confirmation of Extrajudicial Restructuring Plans, abbreviated to “CERP Act” and sometimes referred to as the “Dutch Scheme” (in Dutch: Wet homologatie onderhands akkoord, or “WHOA” for short), distressed companies now have the option of agreeing on an extrajudicial but enforceable composition, suspension of payments or proceedings to seek court-mandated equity injections (noodzaakfinanciering). These added possibilities make it more likely for the company to successfully turn around, while also leaving control with the company, rather than an insolvency trustee (“debtor in possession”).
Combining features of both the Scheme of Arrangement from English law and Chapter 11 proceedings from the US, the new Dutch Scheme is described as offering the best of both worlds. As an added benefit, it makes provision for the pre-insolvency composition proceedings required by the European Restructuring Directive. While this is all very well, does the CERP Act actually offer any advantages for the company’s shareholders? As legal literature highlights, under the CERP Act they run the risk of losing their shareholdings entirely, while at the same time concerns have been expressed about the potential for abuse by shareholders. This contribution discusses the implications, risks and possibilities for shareholders under the CERP Act.
Life before the CERP Act
Until recently, any restructuring arrangements had to be formalised in a composition, which needed to be approved by every party that the composition would affect. This included the shareholders, who could not be forced to cooperate – except in the rare event of abuse of the law. In practice, however, shareholders are not always eager to cooperate in a debtor’s efforts to restructure or offer a composition, even if the company represents little value and insolvency would leave the shareholders with nothing at all. One reason for that unwillingness is that shareholders involved in a restructuring or composition are often asked to agree to a debt-for-equity swap that favours another existing shareholder, or a new one. A debt-for-equity swap involves creditors exchanging debt for an equity interest, causing the other existing shareholdings to dilute. The original shareholders then benefit less, if at all, if the company’s value increases after the restructuring. As this requires a share issuance, however, or a waiver of a pre-emption right, it requires the shareholders’ consent. This means that shareholders with enough control can prevent this by voting against the motion. As a consequence, shareholders often hold the key to success or failure of a rescue attempt.
This is subject to an important exception, though: in the event of (1) an impasse at the level of the shareholders, (2) an urgent (and immediate) need and (3) an absence of alternatives, it is possible to seek a court-mandated equity injection in preliminary relief proceedings before the Enterprise Chamber. In proceedings to seek a court-mandated equity injection, shareholders can as yet be forced to tolerate the financing, and in some cases suffer substantial dilution. Shareholders may also be forced to accept a debt-for-equity swap by means of a temporary transfer of shares “for administration purposes” (ten titel van beheer), or by temporarily amending or setting aside provisions from the company’s articles of association and clauses from its contracts.
How the CERP Act impacts shareholders
Binding force of compositions extended to include shareholders: After a composition has been confirmed in court, it can be enforced in respect of the shareholders. This means that, with the introduction of the CERP Act, shareholders – even those shareholders that voted against the composition, abstained from voting or cast blank votes – may also become obligated in spite of what they want, and that their shareholder rights can be altered against their will.
A class of shareholders is deemed to agree to the composition if at least two thirds of that class’s total issued capital votes in favour. This means, then, that it is not the number of shareholders that matters, but what shareholdings they represent in the company. If a shareholder votes against the composition, but the overall class votes in favour, that composition will then nevertheless be binding, regardless of what the shareholder wants. Compositions under the Dutch Scheme also offer the possibility of a “cross-class cram down”: a class that votes against the composition may be overruled by the court. Once the court has ruled on the request for confirmation, its judgment is not open to any other legal recourse: the shareholders cannot appeal.
The binding effect under the CERP Act also extends to creditors with security interests, whose rights may be affected. As such, the Dutch Scheme could offer interesting solutions in situations where the shareholders have reached an agreement among themselves, but a third party with a security interest for instance decides to block them from financing the company: unlike a court-mandated equity injection, an impasse at the shareholder level is not required for the CERP Act to come into play.
Complete elimination of interests: The CERP Act makes it possible to completely eliminate the interests of existing shareholders, regardless of what they might want. For example, the shares might pass to the financier as part of a debt-to-equity swap, in exchange for new or old funding. This option does not exist under the system of court-mandated equity injections or the other compositions that the law recognises. Previously, the only way in which shareholders could formally be stripped of their shares was through a statutory dispute resolution process. Governed by strict rules (though set to be updated shortly), that process is moreover costly and time-consuming.
The possibility of stripping shareholders of their interests entirely can have disastrous consequences deriving from the “absolute priority rule”, which implies that the value realised through the composition should be allocated according to the statutory or contractual order of priority for seeking redress against the company’s equity. Any request for the court to confirm a composition that derogates from this absolute priority rule will be refused, unless all classes of creditors have given their consent. The basic rule therefore is that derogation from the statutory order of priority is only permitted if it does not present any disadvantage to a non-consenting class. Generally, this will not work to the shareholders’ benefit: the debtor’s reorganisation value will be used first to pay creditors, meaning that generally no residual value will be left for the shareholders. Essentially, the shareholders come last. This rule therefore prevents shareholders from retaining value in the restructured company, against the creditors’ will, and the question of whether or not the shareholders lose their shareholdings lies principally with the creditors.
However, it is important to realise that financiers will not always be eager to acquire stock in the company, and it is moreover highly plausible that the creditors will in fact want the organisation to continue with some of the existing shareholders. It is best, therefore, to stay on a good footing with the company’s creditors, and to make a shareholder’s role in the company transparent if that role has any bearing on the company’s future success moving forward from the restructuring. Furthermore, as explained below, it is also possible under the Dutch Scheme to derogate from the absolute priority rule.
Restrictions on the general meeting’s control: The company’s board of directors does not need the general meeting’s consent to offer and carry out a composition, nor the consent of a shareholders’ meeting that goes by any other name. If the articles of association or contractual terms state that a resolution is required, the court-confirmed composition takes the place of that resolution. Various statutory provisions that govern voting rights, consent requirements or publication and information requirements or rights also cease to apply. Similarly, provisions in the company’s articles of association and contractual terms that are at odds with this also lose their applicability. This significantly curtails the rights of shareholders and their formal influence over the board during the restructuring.
Modification of shareholder rights: Compositions can also modify the rights that shareholders are granted by the law, under the articles of association or in a shareholder agreement – for example setting aside individual shareholders’ pre-emption rights or the general meeting’s authority to issue shares, in order to effect a mandatory debt-to-equity swap. Other possibilities include modifying dividend rights and shareholdings. Where this differs from the court-mandated capital injection proceedings (described above) is that in those proceedings the court will seek to minimise any changes in control. The Dutch Scheme does not assume this necessity: instead, the focus is on apportioning the enterprise value based on the statutory order of priority. Potentially, this will make it more likely than before that outside partners will be brought in as new shareholders.
Restrictions on the freedom of contract: Shareholder agreements and investment contracts regularly state that shareholders may suspend their obligations or amend or even terminate the contract if the company in which they hold shares or have invested is granted a suspension of payments or goes into insolvency. However, if the company is involved in proceedings under the Dutch Scheme, this does not offer grounds for suspension, amendment or termination. Any provisions that stipulate automatic consequences if composition proceedings are initiated under the CERP Act are rendered ineffective. Shareholders and investors cannot even rely on a change-of-control clause if the composition results in a debt-for-equity swap that they oppose. Nor can contractual arrangements about financing or a court-mandated equity injection apply. At the same time, however, the company or its restructuring expert may suggest amending or terminating contracts, and even (subject to a number of conditions) cancel contracts if they impose a heavy or excessive burden on the company; the composition might then even include (if necessary in modified form) an obligation under the contract to compensate loss or damage that the other party incurs.
Due observance of shareholders’ interests: All this does not imply a free hand to disregard the shareholders’ interests, though: the law demands due observance of those interests. Precisely how this should be reflected, however, and what weight they should carry remains unclear, at least for the present. The company’s interests will take precedence, and the statutory rules of priority allow exceptions in no more than a few cases (see below). The shareholders’ interests might therefore formally only play a peripheral role, for example if those interests would otherwise suffer unnecessary harm. Still, this does not mean that the shareholders are left entirely without practical influence.
Obligation to share information: If a restructuring expert has been appointed, the shareholders are under an obligation to provide whatever information the expert requests, in whatever form the expert wants. Not only that, but on their own initiative the shareholders must also share any relevant facts and circumstances that they know, or should reasonably know, would be useful to the restructuring expert. Their cooperation is required in every way necessary. However, the restructuring expert may then only disclose that information to third parties if the expert’s duties so demand. It is important, therefore, to clearly explain and record what information is confidential and what is essential to the expert’s duties.
The role of sureties, co-debtors, warranties and security: In the Dutch Scheme, creditors retain all their rights in respect of sureties and co-debtors. Sureties and co-debtors (commonly the debtor’s shareholders or group entities) that make payments to the company’s creditors under the composition (based on their joint and several liability) cannot subsequently seek redress against the company to recover the amounts paid. Essentially, therefore, the debtor’s shareholders/group entities become responsible for paying the debt. However, if the composition also awards rights to a creditor for a debt that has been paid, those rights then pass to the paying entity in so far as the value awarded to the creditor exceeds the amount of the original debt.
Nevertheless, a company that offers a composition may include warranties, statements of joint and several liability under section 403, Book 2 of the Dutch Civil Code and securities from group companies under its scope. This will also benefit the shareholders: the composition (if it meets certain conditions) can also affect the creditors’ rights in respect of group companies. In some cross-border situations, the CERP Act also allows companies to centralise their entire group’s debt in the Netherlands for restructuring. This might specifically come into play with closed compositions. In those cases, it is also important to pay mind to the rules on recognition and effect outside the Netherlands.
Shareholders as creditors: Many shareholders are also creditors of their companies. Even if the shareholders’ rights are not affected, they may still be involved in the composition in their role as creditors, and have the associated voting rights. Under the Dutch Scheme, shareholders-as-creditors have greater rights of set-off: set-off is permitted even after a restructuring expert has been appointed, provided that it is related to financing the company’s continued operations and does not restrict that financing. The company may also continue to pay off debts to shareholders that have fallen due, without risking those payments being declared void, as long as applications for insolvency or suspension of payments have been suspended, as the Dutch Scheme requires. Legal acts that are potentially harmful may also be performed, provided that the court has authorised them. That authorisation will be granted if the act is necessary to continue the company’s operations while the composition is being prepared, and if it is safe to assume that the act is in the interests of the collective creditors. However, a cooling-off period might significantly limit the enforcement measures available to shareholders/creditors.
Dutch Scheme more likely to come into play than a court-mandated equity injection: Although the purpose of both is to provide continuity of a distressed company’s operations, proceedings to elicit a court-mandated equity injection require an urgent and acute necessity that is not necessary for proceedings under the CERP Act: just as with a suspension of payments, the CERP Act requires only that that necessity will arise in the near future and a plausible case be made that the company will be unable to pay its debts. As such, the Dutch Scheme is more likely to come into play than a court-mandated equity injection. As an added benefit, this makes it possible to act sooner.
No formal insolvency while the CERP Act proceedings are pending: Once a composition is in the making under the Dutch Scheme, the debtor cannot be declared insolvent, nor granted suspension of payments, while the proceedings are still pending. Similarly, a request to appoint a restructuring expert (herstructureringsdeskundige) will take precedence over any attempt to apply for a suspension of payments or file for insolvency: by asking the court to appoint a restructuring expert, therefore, the shareholders can block such an attempt. The court will hear matters relating to a composition under the Dutch Scheme in either open or closed proceedings; in the event of closed proceedings, the company’s problems will not become public knowledge beforehand – unlike initiating proceedings to seek a court-mandated equity injection, which can sometimes inadvertently trigger an insolvency. Similarly, however, shareholders that would rather see the company be declared insolvent or granted a suspension of payments could find their preferences (and decisions) blocked if another party – even another shareholder – asks the court to appoint a restructuring expert.
How shareholders can give shape to compositions under the Dutch Scheme
As mentioned above, the CERP Act contains the possibility to derogate from the absolute priority rule already discussed. Derogation is possible – even without the consent of every class of creditors – provided that (1) that derogation is based on reasonable grounds and (2) derogation does not harm the shareholders or creditors. If the composition does not satisfy both these conditions, confirmation will be refused.
This presents possibilities for shareholders to retain value, even if the creditors do not receive full payment. Although it is not entirely clear at this time what qualifies as acceptable for “reasonable grounds”, legal literature generally assumes that this ground for exception will apply in situations involving: (1) new capital, (2) key shareholders and (3) “gifting”.
New capital is quite likely to benefit both the company and its creditors. Shareholders that make a large enough investment, on reasonable terms, can maintain or even increase their shareholdings. While shareholders that provide capital are not automatically subordinated, nor are they granted any superior security interests compared with existing secured financiers.
Key shareholders might have a valuable network or reputation. This concept also covers shareholders with knowledge or expertise that is vital to the company and that the shareholder shares with the company (either in an executive role or otherwise). In some cases, holding vital assets, intellectual property rights or control of an essential contracting party might conceivably be enough to qualify as a key shareholder. The court will consider whether sufficient objective grounds exist to justify derogation from the absolute priority rule, particularly in situations with potential conflicts of interest, and any shareholder claiming to be indispensable will need to be able to back that up. Presumably, the courts will adopt a conservative approach in these matters.
Gifting describes situations where a more senior class of creditors passes on an allocated sum to a less senior class – for example if a creditor that holds a mortgage right relinquishes part of their allocated value to a class of shareholders. Gifting, which is possible only if the recipients represent an entire class of creditors, relies on the more senior class’s generosity, and so a class of shareholders might benefit from gifting while shareholders in another class lose their entire shareholdings in the company. Shareholders need to be alert and proactive, therefore. If gifting is a possibility, it is also important to take a critical look at the classification of the creditors.
These exceptions have drawn criticism. One argument that has been made, for example, is that allowing derogation for key shareholders or gifting will always be detrimental to the creditors. Given the frequent overlaps between companies’ boards and their shareholders, parties might be too easily inclined to argue the existence of a key shareholder. Another concern is lack of transparency on the part of the shareholders and the board, meaning that information might go undisclosed. The concept of gifting has also been criticised in legal literature, with authors worrying that shareholders might prepare for it by making arrangements with the secured creditors. The shareholders can then act in the knowledge that, if the company finds itself struggling, they can rely on the CERP Act and the possibility of gifting. That knowledge might lead the company to take or accept excessive risks in its business dealings that it would otherwise have avoided.
To counter these concerns, it should be noted that sufficient means are available to take appropriate action if matters get out of hand. The same standards of due care that apply in normal situations also apply in the Dutch Scheme. Although shareholders are permitted to act in their own best interests, at the same time they need to recognise the company’s interests in all respects. Existing laws also require shareholders to be reasonable in their dealings with each other, with the board and with the company. The obligations of shareholders to share information and be cooperative have already been described above.
However, the CERP Act also states that shareholders may not block efforts to restructure the company for reasons that are improper or unprofessional. It does not seem likely that in practice this obligation will yield any outcome that it has not had before, particularly since a breach of this standard of conduct is not a condition for curtailing the shareholders’ rights under the composition. At a minimum, shareholders may not, without valid reasons, prevent the board from granting its consent, either when the composition is offered or when the court is asked to confirm it. This means that board members cannot be threatened with dismissal if they refuse to do as the shareholders wish. However, some room to manoeuvre remains between the ban on blocking the composition and the freedom for shareholders to pursue their own interests, and of course any derogation from the absolute priority rule will also be reviewed by the court. In short, shareholders still have a number of ways to intervene.
Other ways for shareholders to bring their influence to bear
Through negotiations: The Dutch Scheme is based on the “debtor-in-possession” principle: the company may give shape to the substance of the composition as it sees fit. Even if the composition was prepared by a restructuring expert, the debtor’s consent is still required if the company is an SME. In practice, therefore, the details of the composition will generally depend in part on the negotiations with the shareholders, for example if they have an essential and visible/acknowledged role in the company, or if their votes are important in the vote on the composition. Potentially, this will even mean that the shareholders need to be on board in order for the composition to succeed (otherwise the company and/certain key creditors might not agree).
Choice of closed or open proceedings: Compositions under the Dutch Scheme can be handled in either open or closed proceedings, as chosen by the party making the request to the court. If the party making that request is a shareholder, therefore, the shareholder should also decide the type of proceedings. Generally, shareholders will benefit from closed proceedings. Additionally, although shareholders that did not make the request do not have any right to be heard on this issue, the company is always allowed to express its views, and if parties express differing preferences the court will decide. The voting shareholders are at all times entitled to examine any statements that have been filed, the report on the vote, and of course the actual composition, which must contain all the information that the shareholders need to form a carefully considered opinion.
Exercising voting rights in the Dutch Scheme: The greatest formal influence that shareholders have on the composition is through their voting rights. However, this is restricted to shareholders whose rights are affected by the composition; shareholders whose rights remain unaffected do not have a vote. Even shareholders with non-voting shares may have a vote if the composition will affect their votes. If the beneficial ownership of the shares lies entirely, or at least largely, with other parties, for example holders of depositary receipts or bonds, those holders may be invited to vote as they see fit. Shareholders do not vote as a group, but individually, in one or more classes. If the rights that shareholders and creditors have (or would have) in the event of an insolvency, or the rights offered to them under a composition using the Dutch Scheme, change to such a degree that the situations cannot be compared, they must be classified differently.
Request to appoint a restructuring expert: Any shareholder may ask the court to appoint a restructuring expert. This does not require the general meeting’s consent. If the request is made not by a shareholder, but by the board for example, this again does not need the shareholders’ agreement, nor will the shareholders be informed of the request or given the opportunity to express their views.
It can be useful to appoint a restructuring expert if a shareholder has no faith in the board, or simply believes that the board is not the right party to handle the composition. The restructuring expert is impartial and independent, but above all must act in the best interests of the collective creditors – though without losing sight of the shareholders’ interests. The court may also dismiss or replace the restructuring expert, either on its own motion or if for example the expert or a creditor so requests. Although shareholders cannot ask for the restructuring expert to be dismissed or replaced, shareholders that originally requested an expert’s appointment will be given the opportunity to express their views.
Request to refuse confirmation: As a rule, shareholders will object if the composition leaves them without any value. Objections may be presented until the day on which the court handles the question of confirmation. Voting shareholders, acting either singly or collectively, may submit and substantiate a request to refuse confirmation. This is only possible, however, if those shareholders did not themselves (including through their class) vote in favour of the composition, or else they must have been wrongly barred from voting (and would otherwise have voted in a class that voted against the composition).
A plausible case must be made that those shareholders would be worse off with the composition than if the company’s equity were liquidated in insolvency. This is unlikely to be very often. The next requirement is that they must present grounds for turning down the composition. The valid grounds are described in the CERP Act, and include non-compliance with an obligation under the CERP Act in respect of the shareholder, derogation without valid grounds from the statutory or contractual order of priority, admission for an incorrect amount or lack of sufficient assurances of compliance with the composition. Other possibilities are unfair preferential treatment or unfair formation of the composition.
For each of these grounds, the objections must first have been presented to the company at the appropriate time. It is important, then, not to wait but rather raise objections as soon as possible. The court’s decisions under the CERP Act are not open to any legal recourse, and the possibilities to object are therefore limited. However, the court may refer questions about the application of the CERP Act to the Dutch Supreme Court for a preliminary ruling, although this will rarely offer the shareholders a practical outcome.
In court: The court may rule on all manner of relevant aspects, including whether a particular shareholder has a vote, what value the company represents and how much a share is worth. Acting either on its own motion or at the request of the company or the restructuring expert, the court may also impose other forms of relief that it considers necessary to secure the interests of the shareholders and other parties. Shareholders do not have the authority to ask the court to do so, although of course a shareholder may endeavour to convince the court to do so on its own motion. For example, if no restructuring expert has been appointed, the court may appoint an observer to oversee the preparation of a composition by the company. Shareholders will be given the opportunity to express their views if the decision directly affects their interests. Shareholders that are not given the opportunity to present their views, but should have been, are then not bound by the decision.
Conclusion: feast or famine?
The Dutch Scheme can mean either feast or famine for the shareholders, formally involving a number of restrictions and risks for them, and offering few formal methods to influence the process. As was the case before the CERP Act, any shareholders that do not contribute could suffer. With the Dutch Scheme, however, those consequences are potentially worse than before, possibly even resulting in a loss of the entire shareholding. The formal possibilities for influencing the Dutch Scheme seem limited.
At the same time, the CERP Act also offers possibilities for investing shareholders or key shareholders to consolidate their future position in the company. In some cases they can gain more control if they increase the share capital by injecting sufficient new equity. Simply by maintaining their shareholdings at the same level (or even accepting a reduction) shareholders can benefit from an increase in the value of the restructured company. A second chance could yield benefits for the company, and therefore for the shareholder – particularly if the alternative is insolvency. If the shareholder is also a board member, and/or has strong actual ties to the board, the shareholder will undoubtedly play an important role in determining the details of the composition, even if a restructuring expert is appointed. That freedom is not without limitations, though: the shareholder may not abuse that influence, obviously, nor may the board suffer unreasonable interference. Common sense should serve as a guide here.
One factor that will determine whether a shareholder is successful is whether they have been involved from the start. It is important for shareholders to become actively involved (whether individually or collectively) in the negotiations and therefore be part of, and help to create, the solutions that are needed for the restructuring. Shareholders should not be late to the party with financing suggestions. They should make sure that key creditors are properly aware of the added value that they bring as shareholders. It can also be helpful for shareholders to stay in close contact with the company’s mortgage lender and/or regular banker, for example, to maximise the possibilities for gifting. It is vital for shareholders to be proactive in the Dutch Scheme. Their maxim should be: stay alert and get ahead of the game. Only then will the Dutch Scheme also bring success for shareholders.