Category Archives: Finance

A VIEW ON SOURCES OF POST COMMENCEMENT FINANCE IN SOUTH AFRICA

I recently concluded that banks or other financial institutions are not sources for post commencement finance (“PCF”) in business rescues as is envisaged in terms of Chapter 6 of the Companies Act 71 of 2008. It also became clear that none of the South African commercial banks have thus far developed any “products” that can be described as ideal for “distressed funding”.

I suspect that commercial banks might feel that it is simply not an area where they will find a return or where there will be sufficient volumes to justify the development of such banking products. It is also understandable that conventional governance of depositors’ and shareholders’ funds will not permit distress lending.

It is must however also be understood that where a bank is exposed as a creditor in a business rescue matter that they will evaluate the matter on its own merits been made clear that the availability of and the providing of PCF is not entirely “embargoed” by banks.

We have found that the bank, as a PCF lender, would consider granting PCF when, under circumstances where the bank can be described as a “defensive pre- commencement lender” seeking to maximize the value of its pre-commencement claim. The bank may then agree to provide PCF in an amount designed to ensure a successful reorganization and which may be conditional upon them being involved in the business rescue decision making process.

At a minimum, such PCF would be expected to cover anticipated working-capital and the expenses in the business rescue process needed for the period necessary to effect operational changes or restructure the debtor’s business. In some instances, however, the nominal amount of the PCF may significantly exceed the debtor’s working-capital needs, even with the additional costs that will be incurred because of the debtor’s filing for business rescue. The effect of such a higher nominal amount of PCF may be that that the company under BR will have the benefit of increased creditor confidence and as consequence of which suppliers may be more willing to provide products on terms more advantageous to the company than what they would have been prepared to do under regular uncertain business rescue circumstances.

Furthermore, customers may continue to utilise the company’s service with the confidence that the company will ultimately emerge from Business Rescue. It is therefore so that a relatively large PCF facility can decrease the negative operational impact of a BR filing. I suspect that South African banks have thus far provided the most PCF to date but also believe and will not be surprised if all this is “defensive” PCF financing.

It has been alleged that there is an unwritten rule or understanding amongst banks in South Africa that the one bank will not bail out a company with PCF to enable a company to repay its debts with another bank. We have practically experienced in recent dealings with a parastatal lender that the borrowers had to certify the lender that the finance being obtained by shareholders (two levels up) were not to be utilised for purposes of settling the debts of a company under business rescue.

We have also found in practice that a further major stumbling block for potential PCF financiers arises when there is a pre-commencement cession of book debts in favour of a bank as security for its overdraft of whatever is owing to the bank. There is a view that banks are in terms of its cession of book debts entitled to rely on book debts created post the commencement of business rescue proceedings as additional security. This is despite them not having provided the finance that enabled the BRP on behalf of the company to render the service or manufactured the product that enabled to BRP on behalf of the company to create the invoice. All of this post the commencement of business rescue proceedings.

Its seems untenable that the PCF financier may not, as first charge, rely on the proceeds of the post BR book debts. The law in this regard needs to unfold We are of the view that in order for PCF to succeed under such circumstances the BRP needs to enter into an agreement with the bank in order to have future debts released from the cession.

It is clear to us that distressed funding or, PCF, remains one of the most topical issues in restructuring businesses and for the business rescue process to work. There is no doubt that the ability of a company under business rescue to continue trading or carrying on with its business activities depends entirely on its ability to procure PCF in some form or another.

Internationally the motivation of distressed investment funds to get involved in PCF of debtor in possession finance under Chapter 11 in the USA (“DIP finance”) is often very different from that of commercial banks. While a commercial bank may seek to profit through fees and interest earned over the course of a long-term relationship with a borrower, the business model of distressed investment funds is entirely different.

We need to look at the various forms of PCF that are available. First, there is conventional post commencement trade credit and in terms of the Companies Act the BRP may incur credit in the ordinary course of its business. This will be treated as PCF and suppliers and trade creditors typically extend this credit on similar terms as existed before the commencement of BR proceeding if they are comfortable that the debtor has sufficient cash flow to pay them on a timely basis. Such PCF enjoys the protection of section 135 of the Act and must be repaid in the order that such debts were incurred.

Second, Secured PCF which is permitted in terms of the Companies Act and under which circumstances the BRP obtains post commencement credit secured by either a lien or pledge or any other agreed form of security over assets that are otherwise unencumbered. This may appear to be preferable and safe in theory but distressed businesses under business rescue usually do not have unencumbered assets, any equity in assets that are already encumbered, or all their assets are fully encumbered by other lenders. Security for the PCF lender is therefore a logical option to have, but usually of little practical assistance.

However. an alternative, in rare cases, is a second or reversionary form of pledge or lien over assets already encumbered. This is done in the USA under Chapter 11 procedure in terms of what is called Super Priority Secured Financing. How it is works is that, under circumstances where a debtor under Chapter 11 is unable to obtain credit in any of the traditional DIP finance ways, the Bankruptcy Court can allow the debtor to obtain financing secured by a first lien on already encumbered assets of the estate. This means that secured creditors that already have liens on the assets will be pushed down or “primed”. This must be done with Bankruptcy Court approval, and creditors whose liens are being “primed” must have the opportunity to object.

The only way the Bankruptcy Court will allow such financing is if  the debtor makes an appropriate case that it is unable to obtain credit in any other way and it must be demonstrated that the creditor whose security is eroded is “adequately protected.” This essentially means that the creditor whose lien is being primed needs to be shown that even though its lien is being pushed down, it will not be unduly harmed by this event.

Author:

Hans Klopper of Independent Advisory

References:

  • Perlman F.G, Baer H.P, Kevane H, Bagby I, Corbi R.J, Farnsworth S, Krause S, Kriegel M, Lucas J.W and Maman M : “Debtor-in-Possession Financing: Funding a Chapter 11 Case” American Bankruptcy Institute
  • Salerno TJ, Kroop J.A and Hansen C : “The Executive Guide to Corporate Bankruptcy” – Second Edition (BeardBooks 2010)

REVIEWING SOUTH AFRICA’S POST COMMENCEMENT LENDING CULTURE

Background to Debtor in Possession (“DIP”) Finance in USA

The Common Law Origins of Debtor Financing

In the USA the modern Bankruptcy Code’s DIP financing provisions are codifications of practices developed in the common law era prior to the enactment of a national bankruptcy law.

Modern DIP financing grew out of practices developed in nineteenth-century railroad receiverships, which were governed by a special body of common law.

When a large rail company became insolvent back then the bondholders would approach the courts appoint a receiver. The receiver took control of the rail company’s property as the “hand of the court.”

Akin to a moratorium under the modern Bankruptcy Code this stayed the process while a recapitalization of the railroad was being formulated.

The receiver was authorised to issue new debt in the form of “receivers’ certificates” which were made attractive to new and existing investors by securing a first lien on the bankrupt rail company’s assets.

This was the background that led to the introduction of debtor financing into the Bankruptcy Act in the 1930s.

Pre 2011 – in South Africa

In cases of financial distress prior to the enactment of the Companies Act of 2008 and a restructuring of its affairs was possible, a moratorium was achieved by the granting of a provisional order of liquidation.

When a provisional liquidator was appointed to the company and found that there was merit in continuing with a company’s trading operations, leave to borrow money was obtained by applying to court.

Such loans became a cost of administration and were repayable as a first charge and protected by the Order of Court.

Ensuring access to finance is available for businesses in business rescue

Where does a Business Rescue Practitioner (“BRP”) look to obtain Post Commencement Finance? Shareholders, creditors or the companies’ customers?

In South Africa, BRP’s came to the conclusion that they must look elsewhere than to commercial banks for PCF funding.

Much has been said about the formation of funds here in SA such as distressed hedge funds in other jurisdictions but not much of it has been seen.

The challenges for BRP’s in obtaining PCF are:

  • The majority of funders that are prepared to provide funding, mostly proved too slow in making decisions.
  • The harsh reality is that PCF is mostly required at a time when a company is almost at the end of its ability to provide security.
  • Where the PCF funder cannot secure his PCF and have only the relative cold comfort of ranking ahead of all pre commencement creditors the appetite to provide PCF seems to be waning.
  • There is also uncertainty as to whether a PCF funder will rank ahead of a secured creditor under circumstances where they provided funding to maintain or preserve a secured creditor’s security. This position should surely be akin to section 89 of the Insolvency Act where the costs of maintaining and preserving security rank ahead of the claim of the secured creditor?
  • The reality is therefore that PCF will only be attracted where the business model is sound, where there is a prospect that the business will be a going concern going forward.

Understanding current decisions from Financial Institutions and Courts on Funding

In our Law reports until 31 December 2016 the mention of PCF is limited to three cases and also not really relevant to funding as such.

These cases are:

Copper Sunset Trading 220 (Pty) Limited v Spar Group Limited and another 2014 (6) SA 214 (LP)

In this case the BRP contended that the procuring of PCF was conditional upon a business rescue plan being adopted.

The respondents voted against the plan and upon application the court set that vote aside as inappropriate and adopted the BR Plan. It would be interesting to hear as to whether PCF was ever procured.

Prior to the above mentioned case, there were the cases of Commissioner South African Revenue Services v Beginsel NO and another 2013(1) SA 307 (WCC) and the Cape Point Vineyards case. In both cases the references to PCF was obiter.

Suffice to say that our law has not as yet developed much and we are therefore bound to look at what happened in other jurisdictions.

What transpired under Chapter 11 in the USA is no different from what happens here and the Americans refer to “defensive DIP Financing” as the typical DIP financing situation.

This happens when a pre-commencement lender (pre-petition in the USA) secured by a form of security over the assets of the company under Chapter 11 is faced with two primary choices:

  • extend additional financing post-business rescue to permit the company to either reorganize, or sell its assets in an orderly fashion under Chapter 11, or, alternatively,
  • risk the uncertainty of a piecemeal liquidation of the debtor’s assets.

Therefore, rather than taking a chance with a fire sale, many lenders conclude that financing a case is more likely to protect the going-concern value of the borrower.

American studies have shown that commercial banks have provided the majority of DIP financing in the USA by way of such “defensive DIP Finance”.

The experience in SA to date, would also appear to indicate that the banks and financial institutions involved in matters where business rescue was filed, have reluctantly agreed to provide post commencement finance and mostly only because they had to protect their pre-business rescue debt and/or maintain their security.

By HANS KLOPPER
Independent Advisory

BETWEEN A ROCK AND A HARD PLACE

by Dirk Kotze

It is trite that the ultimate fate of a financially distressed company, unable to pay it creditors, are liquidation. Once in liquidation and should creditors elect to proceed with an insolvency enquiry, the directors of the company might, in appropriate circumstances, be faced with the uncomfortable question, “why did the board not timeously inform the stakeholders and creditors of the fact that the company was financially distressed and why did you not resolve to place the company under business rescue”.

Why would this be a relevant question? The relevance of this question is found  in the duty imposed on the board of directors in section 129 (7) of the Companies Act 71/2008 (“the Act”), which states that, “if the board of directors of a company has reasonable grounds to believe that the company is financially distressed, but the board has not adopted a resolution contemplated in this section (referring to a resolution to place the company in business rescue proceedings), the board must deliver a written notice to each affected person, setting out the criteria referred to in section 128 (1)(f) that are applicable [i.e. choose and explain the financially distressed scenarios as per the definition provided in section 128 (1)(f)] to the company, and its reasons for not adopting a resolution. Simply stated, if a company is in financial distress and it has not filed for business rescue, their is a positive duty on its board of directors (“the board”) to advise the affected persons being the creditors, shareholders and employees of the company that it is financially distressed, and also advance reasons why they have elected not to file for business rescue.

The language used in this section is not directory, but peremptory and it suggest that once the definition of financial distress in section 128 (de facto and commercial insolvency foreseen in the ensueing 6 months) of the Act are met, the board has a positive duty to act. Not only must they inform stakeholders of the fact that the company is in financial distress, but they must also advance reasons why they have not adopted a resolution and filed for business rescue.

A  further question that arises automatically is whether a failure of the board of directors to comply with this duty in terms of  section 129 (7) (hereinafter referred to as “this duty”) will have adverse consequences for the board, especially in circumstances where the company is eventually liquidated and creditors suffer huge losses as a result of unpaid claims, which losses could have been lessened if this duty had been complied with

The answer to this question is by no means staightforward. At the outset, section 129(7) does not contain any sanction if the board fails to comply with this  duty, nor does the Act provide any specified time limits within which such compliance must occur.  The main and obvious reason for the absence of a sanction, is the fact that such notice to creditors will in all likelihood be tantamount to commercial suicide by a company, as its creditors may no longer be willing to supply goods and services on favourable credit terms, if any at all. Banks and financial institutions will, in all likelihood, withdraw all credit facilities or at least substantially reduce such facilities.

Does this mean that the board could simply ignore this duty if they have reason to believe that the company is financially distressed? The answer should be a clear NO.

Although I do not propose that that a failure to comply with this duty will automatically lead to the directors being liable for the losses suffered by creditors in a liquidation, the following should be kept in mind.

Firstly, the Act, via section 218(2), makes it clear that, “any person who contravenes any provision of this Act is liable to any other person for any loss or damage suffered by that person as a result of that contravention”. Thus for instance, an aggrieved shareholder (who continued to invest his money into a financially distressed company whilst not having been informed of its financially distressed status), and a creditor (who continues to supply goods and/or services to a financially distressed company whilst being blissfully unaware of its financially distressed status) might well choose to claim their losses from the directors of the company should the company end up in liquidation.

Secondly, a failure to comply with this duty, in conjuction with other relevant evidence, may lead to a conclusion that the directors of the company acted recklessly and with gross negligence. Section 424 of the old Companies Act (which still applies under our new company law regime) and the judicial pronouncements thereon [see Philotex (Pty)Ltd and Others v Snyman and Others 1998 (2) SA 138 (SCA)] makes it clear that directors will be held personally liable for the debts of a company if they traded recklessly.  When the Philotex judgement was handed down, this duty did not exist and under our new company laws it could well be argued that a failure to comply with this duty is an important factor from which an inference of “recklessness” can be made in event of a company continueing to trade and incurring huge debts in a financially distressed scenario. Filing for busines rescue could certainly and in appropriate circumstances be regarded as a reasonable step that a board of directors could and should have taken to prevent the losses being uncurred by creditors and shareholders.

Thirdly, the failure to act in terms of section 129(7) of the Act could also impact on an inference that a director acquiesced in the carrying on of the company’s business despite knowing that it was being conducted in a manner prohibited by section 22(1) of the Act (i.e. recklessly, with gross negligence, with intent to defraud or for any fraudulent purpose). This may lead to personal liability for any loss, damage or costs sustained by the company [see section 77(3)(b) of the Act].

Taking into account the risks involved, directors of companies should at least take note that a failure to comply with section 129(7) may in appropriate circumstances lead to personal liability for the debts of the company. The real conundrum is however that you are, in no way, “damned if you do and damned if you don’t.

It will be interesting how the Courts will interpret this provision, which, due to its possible adverse commmercial consequences, will not in isolation lead to personal liability, but will most certainly in appropriate circumstances be an important factor when considering reckless trading.

Dirk Kotze LLB (Stell) LLM (Unisa) is an attorney who practices for his own account in Stellenbosch.  www.dirkkotze.co.za

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice.

THE IMPORTANCE OF CAPITAL PROTECTION

by GERBRANDT KRUGER 

One of the many pearls of wisdom dispensed by Warren Buffett is “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”. Unfortunately this is easier said than done in the real world. Fund managers are acutely aware of investor aversion to losses.

Losses on portfolios can be due to market movements in the price of the investments or when investments go under or default on their obligations. The latter is permanent capital loss, as there is no opportunity to recover the losses suffered. African Bank is an example of this. Investors may get some of their capital back, but will unlikely get a material portion of it back.

When suffering losses, an investor requires a return higher than the loss to return to breakeven. The graph below shows the subsequent required return needed to breakeven for a particular levels of loss.

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From the above graph we can see that the breakeven return required grows exponentially as losses increase. When investors suffer a 10% loss, they only need 11% to get back where they were. At a 50% loss the investments needs to have subsequent return of 100% to breakeven.

Fund managers have different ways in trying to minimise possible capital losses. If the fund manager is managing a multi asset class fund he/she will be able to underweight or avoid asset classes that are expensive (high in risk) and rather allocate capital to asset classes that are cheap (low in risk). An active fund manager can also try to reduce possible losses by individually picking the instruments he/she wants to include in their portfolio. They can select the companies that are undervalued and avoid ones that are expensive.

No fund manager is exactly alike and each has a different way in classifying risk and varying levels of risk aversion. The more aggressive fund managers will tend to outperform a conservative manager at the end of strong bull market. In bull markets a conservative manager will typically start taking profits from the stocks that performed well and deploy the capital into asset classes where there are opportunities. The aggressive manager will tend to ride the run as far as possible and will experience a bigger drawdown when the markets correct. Managers that avoid deep drawdowns typically perform better over full market cycles.

The graph below is a drawdown comparison between two funds (blue and green) and the category’s average fund (yellow). The blue line is a typical conservative manager and the green line a more aggressive manager. Both of these funds fall into the (ASISA) South African MA High Equity category.

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Source: Morningstar Direct

During the financial crisis of 2008 the blue fund manager was able to protect capital much better than the green fund. The maximum drawdown of the blue fund was 11.8% compared to the green’s 23.4% and the average manager’s 16.8%.

This is one of the reasons one should take time to understand a fund manager’s philosophy and investment process. You might just be able to spare yourself some heartache by avoiding making an investment with an aggressive fund manager at the peak of a market cycle.

Gerbrandt Kruger www.vitalconsult.co.za

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice.