Reconstruction: a more efficient judicial debt negotiation procedure

Covid-19 has resulted in several companies experiencing dramatic loss of income and major financial difficulties. This entails, among other things, unnecessary bankruptcies, as well as loss of values and jobs. To remedy the situation, the government proposed a temporary Act on Reconstruction (Prop. 75 L (2019-2020)). The Temporary Act on Reconstruction as of 7 May 2020 no. 38 was passed by the Parliament, and entered into force on 11 May 2020. In this newsletter we provide a brief overview of certain main elements of the Reconstruction Act.

For a brief summary of this newsletter, click here.

1             Introduction

Prior to the temporary Act on Reconstruction entering into force, the rules on debt negotiations were set out in the Bankruptcy Act. In order to make such rules more effective, the Government passed the new temporary Reconstruction Act, which temporarily replaces the Bankruptcy Act’s rules on debt negotiations.

The Reconstruction Act has changed the terminology. Debt negotiations in the Reconstruction Act is referred to as reconstruction and reconstruction negotiations. This is to emphasize that reconstruction is not only debt restructuring, but also, if necessary, restructuring of the company and its business.

2            Changes

2.1        Exemptions to public debt priority

Under the Satisfaction of Claims Act, public debts including tax are first ranking claims to be covered prior to other claims in judicial debt negotiations. This often decrease chances of dividend to other creditor classes. 

As pointed out in the underlying report to the Ministry, this likely results in several companies, rather than entering into debt negotiations, file a petition for bankruptcy and subsequently start new a company, taking over all or parts of the bankrupted company’s business. This is detrimental both for prioritized and other creditors.

As a result, a regulation to the Reconstruction Act has been passed, which provides exemptions to the priority rules normally applicable to tax and VAT claims (etc.).

The purpose is to incentivize reconstruction rather than bankruptcy and thereby increase chances of dividend to other creditor classes.

2.2        Lower threshold for opening judicial debt negotiations

Pursuant to the Bankruptcy Act, reconstruction/debt negotiation proceedings may be petitioned by a debtor that cannot meet its obligations as they fall due, i.e. the debtor must be illiquid.

In the report to the Ministry, it was pointed out that one problem with this is that reconstruction proceedings often are requested at a too late stage, where the debtor has little or no funds or liquid or assets. Reference is also made to the importance of the debtor having liquidity to carry out a successful reconstruction.

According to the Reconstruction Act, reconstruction proceedings may be petitioned by a debtor that has or will in foreseeable future have significant financial difficulties. Reconstruction can, in other words, be initiated at an early stage to increase the likelihood of achieving sensible solutions, even at a time where a company is not illiquid, provided it likely will have significant financial problems in relatively near future.

2.3        Financing the reconstruction period

During the reconstruction proceedings, a debtor cannot settle debt or mortgage its assets without the consent of the creditors. Neither the Bankruptcy Act nor the Mortgage Act provides a legal basis for granting priority or priming security to financing of debt negotiations or continued business during such process.

The report to the Ministry pointed out that it is assumed that several debtors fail to request debt negotiation because there are no prospects of financing its operations during the debt negotiation period.

As a solution to this,  the Reconstruction Act provides that a statutory first priority priming lien (senior to existing first priorities) may be established for costs and operations during reconstruction. The purpose is to enable financing of the process and continued business with reduced risk for a super senior lender.

2.4        Debt to equity conversion

2.4.1    Shareholders’ resolutions

The Bankruptcy Act does not have specific rules on the conversion of debt into equity in connection with debt negotiations.

The Ministry pointed out that it may be to the benefit of the creditors if the creditors, as an alternative to or in addition to dividend, are granted rights in the company e.g. by converting the debt into equity. This decision will have to be made in accordance with applicable Norwegian company law rules.

Normally, resolutions necessary to implement solutions whereby debt is converted to equity require a qualified majority in the general meeting (normally 2/3). Consequently, a relatively small minority of shareholders may block such decisions.

According to the Reconstruction Act, for the purpose of a reconstruction, the relevant resolutions shall only require simple majority decisions (more than 50%). This will include resolutions on capital increase, capital reductions and issuance of financial instruments.

2.4.2    Creditor consent

Within four weeks of opening of reconstruction proceedings, the debtor shall present a draft plan for reconstruction of its debt. The plan may include deferral of debt and/or a pro rata reduction of debt, a sale of assets or business, and debt write-off. Unless the draft plan is rejected by a simple majority of creditors (calculated by amount), the debt negotiations will continue. Voluntary reconstruction is achieved if the plan is accepted by all creditors. A plan for reconstruction including compulsory debt composition may be achieved with simple majority creditor consent, provided the court approves the plan.

One question is whether a debt to equity conversion will be optional for creditors, or if a plan including such conversion will be binding also on a minority of non-consenting lenders. The preparatory report to the Ministry sets out that, for the purpose of a successful reconstruction, it would be an advantage if a reconstruction plan would be binding for all creditors, as that would provide a higher degree of predictability, in particular for potential investors.

On the other hand, as discussed in the report, it would likely not be preferable to make creditors shareholders of a company against their will. If a creditor is dissatisfied with a plan the creditor voted against, such creditor may use that argument in court when the plan is to be approved, and there is a risk that the plan is then rejected by the court. On this basis, the Reconstruction Act has a mechanism whereby debt to equity conversion as a main rule is voluntary and shall require each relevant creditor’s consent. However, the Reconstruction Act also has a “security valve” mechanism whereby the court is given authority to rule that a debt conversion is to apply to all creditors if there are weighty arguments in favour thereof, and the opposing creditors obviously have no reasonable grounds to object. The Ministry pointed out that such exception to the main rule is to be applied with caution. It is further held that public offices (state and municipalities) normally will have reasonable grounds to reject a debt to equity conversion. Whether a creditor has reasonable grounds to reject may also depend on how liquid the relevant shares are. It should also be taken into account what other options there would be for reaching a sensible solution for the debtor and the other creditors.

According to the Reconstruction Act, a debt to equity conversion will generally be an option for the creditors, and they may object to such conversion. The exception will have a very limited application. As a main rule, the consent of each relevant creditor would be required for debt to equity conversion.

2.5        Simplified rules for smaller businesses

Pursuant to the Bankruptcy Act, the rules on judicial debt negotiations apply regardless of the size and nature of the company’s business. Debt negotiations may, however, be cost and time consuming, which may be more challenging for the smaller companies.

The Ministry refers to how the Covid-19 pandemic has affected many small businesses like restaurants, hair salons, shops and others that would otherwise not have been on the verge of debt negotiations or bankruptcy. Simplified rules on reconstruction may thus enable continuation of such businesses, and, as a result, a regulation to the Reconstruction Act concerning small businesses has been passed. The purpose is to further simplify and shorten the reconstruction process for small businesses, and, with this, limit the reconstruction costs for this group of debtors.

2.6        Impact and proposed duration

The above is a summary of certain of the new rules, valid until the temporary Act on Reconstruction is repealed as of 1 January 2022. The purpose of the Reconstruction Act is to facilitate a reconstruction of the company with either a voluntary arrangement with creditors or a compulsory debt composition, and, as a result, reduce the risk of unnecessary bankruptcies. The act was expected to be of great significance for struggling companies, however, statistics portray a different story – only 12 companies have utilised this new arrangement as of 21 October 2020. It remains to be seen whether it will be utilised to a greater extent as the Covid-19 situation continues to progress.

Readers should note that while the temporary Act on Reconstruction will be repealed as of 1 January 2022, the Norwegian Ministry of Justice is in the process of evaluating whether permanent reconstruction legislation should be proposed. This work is currently in its early stages, and it is therefore unlikely that permanent reconstruction rules will be proposed anytime soon. We will keep you updated on any developments on this front.