Debt Restructuring Risks: How to Avoid or Manage Them Effectively

Debt restructuring is a process of modifying the terms and conditions of existing debt obligations to achieve some financial benefits for the debtor. It can be a vital tool for businesses that face financial difficulties or want to optimize their capital structure. However, debt restructuring also involves various risks that can affect the creditworthiness, legal status, and operational performance of the debtor. This article aims to provide an overview of the main risks associated with debt restructuring and how to avoid or manage them effectively.

Understanding Debt Restructuring

Debt restructuring can be defined as a change in the contractual terms of debt agreements between a debtor and one or more creditors. The purpose of debt restructuring is to improve the financial situation of the debtor by reducing the debt burden, extending the maturity, lowering the interest rate, or converting debt into equity.

There are different reasons why a debtor may opt for debt restructuring. Some of the common ones are:

• Financial distress: When a debtor is unable to meet its debt obligations due to insufficient cash flow, liquidity crisis, or insolvency, it may seek debt restructuring as a way to avoid default or bankruptcy.
• Liquidity problems: When a debtor faces temporary or cyclical cash flow shortages that make it difficult to service its debt, it may resort to debt restructuring as a means to enhance its liquidity and solvency.
• Strategic reasons: When a debtor wants to take advantage of favorable market conditions, reduce its cost of capital, or align its capital structure with its business strategy, it may initiate debt restructuring as a part of its financial planning.

There are different types of debt restructuring that can be classified according to the nature and extent of the changes in the debt terms. Some of the common ones are:

• Debt rescheduling: This involves extending the repayment period, postponing the principal or interest payments, or granting a grace period for the debtor. This type of restructuring can provide temporary relief for the debtor by easing its cash flow pressure and improving its liquidity.
• Debt refinancing: This involves replacing existing debt with new debt that has more favorable terms, such as lower interest rate, longer maturity, or different currency. This type of restructuring can reduce the debt servicing cost and risk for the debtor by lowering its interest expense and currency exposure.
• Debt conversion: This involves exchanging existing debt for equity or other securities that give the creditor a stake in the debtor’s business. This type of restructuring can reduce the debt burden and leverage for the debtor by increasing its equity base and improving its solvency.

Credit Rating Downgrade

One of the major risks associated with debt restructuring is the potential impact on the credit rating of the debtor. Credit rating is an assessment of the creditworthiness and default risk of a borrower by an independent agency, such as Standard & Poor’s, Moody’s, or Fitch. Credit rating affects the borrowing cost and access to capital markets for the debtor, as it reflects its ability and willingness to repay its debt obligations.

Debt restructuring can have negative consequences on the credit rating of the debtor, as it may signal financial distress, deterioration in credit quality, or loss of creditor confidence. A credit rating downgrade can result in higher interest rates, tighter covenants, reduced financing options, or increased collateral requirements for the debtor. Moreover, a credit rating downgrade can trigger cross-default clauses or acceleration clauses in some debt contracts, which can worsen the financial situation of the debtor by requiring immediate repayment or termination of existing debt agreements.

Some examples of companies that experienced credit rating downgrades due to debt restructuring are:

• Argentina: In 2001, Argentina defaulted on its $95 billion sovereign debt and entered into a series of negotiations with its creditors to restructure its debt. As a result, Argentina’s credit rating was downgraded from B- to SD (selective default) by Standard & Poor’s in 2002. Argentina’s credit rating remained at SD until 2005, when it completed its first debt exchange offer with 76% of its creditors accepting a 70% haircut on their claims.
• General Motors: In 2009, General Motors filed for Chapter 11 bankruptcy protection and underwent a massive debt restructuring that involved converting $27 billion of unsecured debt into equity and receiving $50 billion in government aid. As a result, General Motors’ credit rating was downgraded from CCC+ to D (default) by Standard & Poor’s in 2009. General Motors’ credit rating was upgraded to B+ in 2010 after it emerged from bankruptcy and repaid part of its government loans.
• Hertz: In 2020, Hertz filed for Chapter 11 bankruptcy protection and sought to restructure its $19 billion debt amid the COVID-19 pandemic that severely affected its car rental business. As a result, Hertz’s credit rating was downgraded from B- to D by Fitch in 2020. Hertz’s credit rating was upgraded to CCC+ in 2021 after it reached a deal with its creditors to reduce its debt by $5 billion and exit bankruptcy.

To mitigate the risk of credit rating downgrade, debtors should adopt the following strategies:

• Maintain a proactive and transparent communication with the credit rating agencies and provide them with timely and accurate information about their financial situation, debt restructuring plans, and future prospects.
• Seek the consent and cooperation of their creditors and avoid unilateral or coercive actions that may damage their reputation and credibility.
• Demonstrate their commitment and ability to restore their financial health and repay their debt obligations by implementing sound business strategies, improving their cash flow generation, and strengthening their balance sheet.

Legal Challenges

Another risk associated with debt restructuring is the potential legal challenges that may arise from the changes in the debt terms. Debt restructuring involves modifying the contractual rights and obligations of the debtor and the creditor, which may require the consent of both parties or the approval of a court or a regulator. Legal challenges can delay, complicate, or derail the debt restructuring process and increase the cost and uncertainty for the debtor.

Some of the legal aspects of debt restructuring that need to be considered are:

• Bond covenants: These are clauses in bond contracts that impose certain restrictions or conditions on the debtor’s actions, such as maintaining a minimum level of liquidity, limiting dividend payments, or restricting asset sales. Bond covenants can affect the feasibility and desirability of debt restructuring, as they may require the consent of a certain percentage of bondholders or trigger adverse consequences for breaching them.
• Contractual obligations: These are commitments that the debtor has made to other parties, such as suppliers, customers, employees, or regulators, that may affect its ability or willingness to restructure its debt. Contractual obligations can limit the flexibility and options of debt restructuring, as they may entail penalties, termination, or renegotiation for changing them.

Some of the common legal challenges in debt restructuring are:

• Bondholder resistance: This occurs when some bondholders refuse to accept the proposed changes in the debt terms or demand better terms than other bondholders. Bondholder resistance can hinder or prevent the completion of debt restructuring, as it may require lengthy and costly negotiations, litigation, or arbitration to resolve the disputes.
• Regulatory hurdles: These are obstacles that arise from the laws and regulations that govern the debt restructuring process in different jurisdictions. Regulatory hurdles can vary depending on the type and location of the debt, such as domestic or foreign, secured or unsecured, public or private. Regulatory hurdles can pose challenges for debt restructuring, as they may impose additional requirements, restrictions, or approvals for implementing the changes in the debt terms.
• Cross-border legal complexities: These are difficulties that stem from the differences and conflicts among the legal systems and practices of different countries involved in debt restructuring. Cross-border legal complexities can complicate debt restructuring, as they may create uncertainty, inconsistency, or inefficiency in applying and enforcing the changes in the debt terms across different jurisdictions.

Some examples of successful debt restructuring cases that overcame legal challenges are:

• Ecuador: In 2009, Ecuador defaulted on its $3.2 billion sovereign bonds and offered to exchange them for new bonds at a 65% discount. Despite facing resistance from some bondholders who sued Ecuador in U.S. courts, Ecuador managed to complete its debt exchange with 91% of its creditors accepting its offer in 2010. Ecuador’s legal strategy involved invoking a collective action clause (CAC) in its bond contracts that allowed it to bind all bondholders to the terms of the exchange if a supermajority of them agreed to it.
• Dubai World: In 2009, Dubai World announced that it would seek to restructure its $26 billion debt amid a global financial crisis that hit its real estate and investment businesses. After facing regulatory hurdles from its creditors in different countries, Dubai World reached a deal with 99% of its creditors to extend its debt maturity by five to eight years in 2011. Dubai World’s legal strategy involved creating a special tribunal under Dubai law to oversee its debt restructuring process and ensure its compliance with international standards.
• Thomas Cook: In 2019, Thomas Cook filed for liquidation after failing to secure a rescue deal for its £1.7 billion debt. As part of its liquidation process, Thomas Cook transferred its profitable assets, such as its airline business and hotel brands, to its creditors through a court-approved scheme of arrangement under UK law in 2020.

Operational Disruption

Another risk associated with debt restructuring is the potential operational disruption that may occur during the process. Operational disruption refers to any negative impact on the business activities, performance, or reputation of the debtor due to debt restructuring. Operational disruption can affect the profitability, competitiveness, and sustainability of the debtor.

Some of the factors that can cause operational disruption during debt restructuring are:

• Stakeholder dissatisfaction: This occurs when the stakeholders of the debtor, such as employees, customers, suppliers, or regulators, are unhappy or concerned about the debt restructuring process or its outcomes. Stakeholder dissatisfaction can lead to reduced morale, loyalty, or cooperation, as well as increased complaints, disputes, or litigation.
• Resource diversion: This occurs when the debtor has to allocate significant time, money, or attention to the debt restructuring process at the expense of its core business operations. Resource diversion can result in lower productivity, efficiency, or quality, as well as missed opportunities or competitive threats.
• Market uncertainty: This occurs when the debt restructuring process creates doubt or confusion in the market about the financial stability, creditworthiness, or strategic direction of the debtor. Market uncertainty can lead to lower demand, sales, or prices, as well as higher volatility or risk premiums.

Some examples of companies that faced operational disruptions during debt restructuring are:

• Toys “R” Us: In 2017, Toys “R” Us filed for Chapter 11 bankruptcy protection and sought to restructure its $5 billion debt amid declining sales and increased competition from online retailers. However, during its debt restructuring process, Toys “R” Us experienced operational disruptions that worsened its financial situation and led to its liquidation in 2018. Some of the operational disruptions that Toys “R” Us faced were:
  • Stakeholder dissatisfaction: Toys “R” Us faced backlash from its employees who protested against its decision to close hundreds of stores and lay off thousands of workers without providing severance pay. Toys “R” Us also faced lawsuits from its suppliers who claimed that it owed them millions of dollars for unpaid invoices.
  • Resource diversion: Toys “R” Us spent millions of dollars on legal fees, consulting fees, and interest payments during its debt restructuring process. Toys “R” Us also had to divert its management’s attention and resources from its core business operations to deal with its creditors and stakeholders.
  • Market uncertainty: Toys “R” Us lost customers and market share during its debt restructuring process, as consumers were unsure about its future viability and availability of products. Toys “R” Us also faced difficulty in securing inventory financing and merchandise from its vendors who were wary of its credit risk.
• Kodak: In 2012, Kodak filed for Chapter 11 bankruptcy protection and sought to restructure its $6.75 billion debt amid declining revenues and profits from its traditional film business. During its debt restructuring process, Kodak faced operational disruptions that hampered its efforts to transform its business model and regain its market position. Some of the operational disruptions that Kodak faced were:
  • Stakeholder dissatisfaction: Kodak faced opposition from its retirees who objected to its plan to terminate their health and welfare benefits as part of its debt restructuring. Kodak also faced resistance from some of its bondholders who rejected its proposed debt-for-equity swap and demanded better terms.
  • Resource diversion: Kodak spent hundreds of millions of dollars on legal fees, advisory fees, and interest payments during its debt restructuring process. Kodak also had to divert its management’s focus and resources from its core business operations to negotiate with its creditors and stakeholders.
  • Market uncertainty: Kodak lost customers and market share during its debt restructuring process, as consumers were uncertain about its future prospects and innovation capabilities. Kodak also faced challenges in securing new financing and partnerships for its emerging digital businesses.

To avoid or manage operational disruptions during debt restructuring, debtors should adopt the following best practices:

• Maintain a regular and clear communication with their stakeholders and address their concerns and expectations in a timely and respectful manner.
• Prioritize their core business operations and allocate sufficient resources and capabilities to sustain their competitive advantage and customer satisfaction.
• Communicate their vision and strategy for their post-restructuring future and demonstrate their commitment and ability to achieve their goals.

Risk Management Strategies

Debt restructuring can be a complex and risky process that requires careful planning and execution. To minimize the risks and maximize the benefits of debt restructuring, debtors should adopt a proactive and comprehensive approach to risk management. Some of the key risk management strategies that debtors should implement are:

• Proactive financial management: This involves maintaining healthy financial ratios, such as liquidity, solvency, profitability, and efficiency, that reflect the financial strength and performance of the debtor. Proactive financial management also involves diversifying funding sources, such as equity, debt, or hybrid instruments, that match the financing needs and risk profile of the debtor.
• Effective communication: This involves engaging with various stakeholders, such as creditors, investors, employees, customers, suppliers, regulators, and media, and providing them with accurate and consistent information about the financial situation, debt restructuring plans, and future prospects of the debtor. Effective communication also involves managing public perception and reputation, as well as building trust and confidence among the stakeholders.
• Legal and regulatory compliance: This involves staying informed about the changing laws and regulations that affect the debt restructuring process and ensuring that the debt restructuring plans and actions comply with them. Legal and regulatory compliance also involves working closely with legal counsel and advisors who can provide guidance and support on the legal aspects and implications of debt restructuring.
• Operational contingency planning: This involves building resilience into the business operations and processes of the debtor and preparing for potential disruptions or emergencies that may occur during debt restructuring. Operational contingency planning also involves creating a dedicated task force for restructuring that can coordinate and oversee the debt restructuring process and ensure its smooth and successful implementation.

Conclusion

Debt restructuring is a valuable tool for businesses that need to improve their financial situation or optimize their capital structure. However, debt restructuring also entails various risks that can affect the credit rating, legal status, and operational performance of the debtor. Therefore, debtors should be aware of the risks and challenges associated with debt restructuring and adopt effective risk management strategies to avoid or manage them effectively. By doing so, debtors can enhance their financial health and stability, as well as prepare for an uncertain and dynamic financial landscape.

The responses below are not provided, commissioned, reviewed, approved, or otherwise endorsed by any financial entity or advertiser. It is not the advertiser’s responsibility to ensure all posts and/or questions are answered.