Distressed disposal clauses after the Galapagos case

Background to Distressed Disposal provisions 

Before turning to the Galapagos case, it is useful to consider the scope and purpose of the Distressed Disposal clauses. The provisions are detailed, but can be broadly summarised as follows: 

• What is the purpose of a Distressed Disposal clause? Any intercreditor agreement will seek to set out which group of creditors is entitled to make decisions around enforcement against the debtor group (for the purposes of this note, the "instructing group"). Usually, the senior creditor(s) would constitute the instructing group with the junior creditor(s) only having the right to take control of enforcement in certain circumstances. Distressed Disposal provisions are intended to ensure that the instructing group can implement an effective enforcement by instructing the security agent to transfer the assets which are subject to the enforcement free of all creditor claims and liabilities. In particular, the provisions ensure that creditors outside of the instructing group (typically the junior creditors) cannot frustrate enforcement by refusing to release their claims against the assets to be disposed of. The ability to transfer enforcement assets free from all creditor liabilities is frequently required in order to ensure maximum value of achieved from the enforcement.  

The way that this is dealt with is by having all of the creditors contractually agree up front in the intercreditor agreement that, upon a qualifying Distressed Disposal, the security agent (acting on the instructions of the instructing group) may release the rights and claims which all creditors have against the relevant debtors and the assets being disposed of. This allows the instructing group (through the security agent) to transfer the relevant assets free from all creditor liabilities and security. 

• What constitutes a Distressed Disposal? A Distressed Disposal is intended to capture a disposal which is undertaken in an enforcement or recovery situation. Under the terms of a typical LMA based leveraged finance intercreditor agreement, a Distressed Disposal is defined as a disposal of charged property effected (i) at the request of the instructing group where the transaction security has become enforceable, (ii) by enforcement of the transaction security or (iii) through a sale by a debtor after the occurrence of a "Distress Event" (i.e. acceleration of payment obligations or enforcement of transaction security). In the Galapagos case considered below, all parties accepted that the proposed disposal constituted a Distressed Disposal. The points of disagreement centred on whether the junior value protection conditions applicable to Distressed Disposals had been satisfied. 

- Junior value protection conditions – how are junior creditors rights protected? It will usually (although not invariably) be the senior creditors (as the instructing group) who have the ability to instruct the security agent to take enforcement action. However, it is the junior creditors (who are subordinated in right and priority of payment) who are most likely to lose out if the proceeds of enforcement are less than the amount of the total debts owed to all creditors. 

In such circumstances, what incentive do the senior creditors have to ensure that the proceeds of any enforcement are maximised in order to minimise the loss to the junior creditors? It is in this context that the creditors may agree certain value protection conditions which any Distressed Disposal must satisfy in order to give the junior creditors comfort that enforcement proceeds are being maximised via a genuine price discovery exercise. The Galapagos Distressed Disposal provisions were based on a version of the LMA's Intercreditor Agreement for Leveraged Acquisition Finance Transactions (Super Senior Revolving Facility and Senior Secured Notes) which contain a form of such value protection conditions. Notably though not all versions of the LMA intercreditor agreement contain these conditions (albeit that they might be "negotiated in" if the junior creditors are advised of the potential benefits). It was the application of the value protection conditions which was the subject of the Galapagos case considered below.  

Background to the Galapagos Case 

The Galapagos Group 

Galapagos Bidco S.à r.l. ("Bidco") was an intermediate holding company within a group of companies (the "Galapagos Group") which specialised in the supply of heat exchangers and cooling systems. The Galapagos Group had a three-tiered debt financing package in place consisting of a combination of loan facilities, senior secured notes (together the "senior debt") and junior high yield notes (the "junior debt"). All of the debt was secured by common security granted over the shares in Bidco and the assets of the Galapagos Group. The ranking and rights of the various creditor groups was regulated by an English law governed intercreditor agreement (the "ICA"). GLAS Trust Corporation Limited (the "Security Agent") was the security agent tasked with holding and dealing with the secured assets on behalf of all of the secured creditors in accordance with the terms of the ICA. 

Restructuring and Litigation 

Following a period of financial difficulty and consequential attempts to implement alternative corporate strategies (which were ultimately unsuccessful), the Galapagos Group was restructured in October 2019. The restructuring involved (i) the sale of Bidco to a new entity, Mangrove LuxCo IV S.à r.l. ("Mangrove IV")¹; and (ii) the associated release and discharge of all claims of the creditors against Bidco and its subsidiaries and the release of the transaction security granted by the members of the Galapagos Group. The restructuring was implemented by the Security Agent acting on the instructions of the senior lenders (and without the consent of the junior creditors) in reliance on the Distressed Disposal provisions set out in the ICA. The price paid by Mangrove IV for Bidco was sufficient to satisfy the senior debt but not the junior debt. As a consequence, the junior creditors had their claims against the Galapagos Group (including the junior debt and related security) released but received no proceeds from the disposal. 

Various court challenges have been brought in relation to the restructuring (including in the US and Germany), but this article focusses on the claims for declaratory relief sought in the English courts. Here Bidco sought confirmation from the English courts that the restructuring was effective. One of the junior creditors, Signal Credit Opportunities (Lux) Investco II S.à r.l. ("Signal"), opposed this confirmation. Signal sought alternative declarations that the "steps taken by the Security Agent were not in accordance with the terms of the ICA, and that the liabilities and security in respect of the [junior debt] were not validly released." Specifically, Signal argued that the junior value protection conditions to a Distressed Disposal under the ICA were not satisfied and that therefore the Security Agent lacked the power to release the claims of the junior creditors.  

In the ICA these protections were based on a negotiated version of the LMA's "Intercreditor Agreement for Leveraged Acquisition Finance Transactions (Super Senior Revolving Facility, Senior Secured Notes and High Yield Notes)" and can be summarised as follows: 

• the proceeds of such sale or disposal must be in cash (or substantially in cash) ("Condition A"); 

• all claims of the creditors against any member of the group which is subject to the sale must be unconditionally released and discharged concurrently with the sale, and all security in respect of any assets sold must be simultaneously and unconditionally released and discharged concurrently with the sale ("Condition B"); and 

• either the sale or disposal must be made by public auction or a Financial Advisers' Opinion must be obtained ("Condition C"). 

The last of these was satisfied by way of an opinion from Grant Thornton and was not disputed by the parties. However, Signal maintained that the first two conditions had not been satisfied.  

Analysis 

The court considered three key questions in determining whether the declaratory relief sought regarding the effectiveness of the restructuring should be granted. Two of these related to the interpretation of the junior creditor value protection provisions summarised above. The third was put forward by Bidco as its fallback position if the other points were judged not to have been satisfied. 

• If existing lenders provide funding to the restructured group is there still a good discharge of creditors' claims? – the "Condition B" Argument 

• ICA provision – "Condition (B)" of the value protection provisions required that all claims of creditors must be unconditionally released and discharged concurrently with the distressed disposal.  

• Argument – the purchase of shares in Bidco was in part funded by new financing provided to the Mangrove group and the post-restructuring group by certain of the existing senior creditors. Signal argued that not all claims of creditors were unconditionally released on the basis that, as part of the new financing, certain of the existing senior creditors would have equivalent claims against the debtors immediately following completion of the disposal. 

Their argument was that in substance the claims of the existing lenders who were participating in the new financing were not in fact released, but were being reconstituted within the post-acquisition group. That therefore it would be artificial to separate the release of the existing debt from the new financing as they were both part of a single restructuring transaction. Releasing the existing debt would, in Signal's view, defeat the purpose of the condition which was to prevent senior creditors from releasing the liabilities of more junior creditors if the senior creditors were (in substance) preserving their claims. 

• Judgment – Mr Justice Trower (the "judge") did not agree with Signal's arguments and was of the view that Condition (B) had been satisfied. 

He could find no basis in the language used in the ICA for Signal's contention that the existing lenders were restricted from participating in the new financing arrangements. In his view the language makes it clear that it is the claims of the creditors in their capacity as creditors under the existing financing (not the new financing) which needed to have been released. These claims under the existing financing were indeed released and it would be uncommercial to prevent existing lenders from participating in a new financing to the group as existing lenders were the "potential pool of refinancing lenders who are most likely to have an appetite to continue to support" the borrower group. 

• Can the requirement for sale proceeds to be "in cash" be satisfied by way of set-off? – the "Condition A" Argument 

• ICA Provision – "Condition (A)" of the value protection provisions required that the proceeds of the distressed disposal must be in cash (or substantially in cash). 

• Argument – the shares in Bidco were sold to Mangrove IV for c.€425 million with the majority (c.€275 million) being discharged by way of set-off as a result of certain of the existing senior lenders agreeing to set off their right to receive the sale proceeds against the amounts payable by them for the subscription to the new notes being issued by Bidco as part of the new financing. Signal argued that discharge by way of set-off did not equate to the proceeds being paid in cash and Condition (A) had not therefore been satisfied. 

Bidco contended that the proper construction of "in cash" included settlement of cash consideration by way of set-off and therefore Condition (A) was satisfied; that an actual transfer of cash was not required as the exercise of a contractual right of set-off was sufficient in law to satisfy an obligation to pay in cash. 

• Judgment – the judge agreed with the construction put forward by Bidco and confirmed that Condition (A) had been satisfied. 

In doing so, he cited a line of authorities confirming that payment in cash can be made by way of set-off where the effect of the set-off is a circular payment. The judge confirmed that the sale proceeds are what is generated from the promise to pay in cash and that this could be satisfied in several ways – including the transfer of legal tender, the transfer of money between bank accounts and the operation of legal set-off. The important point was that the original obligation was to pay in cash. The judge also considered the background to the qualification and commented that its purpose was "to ensure that the proceeds of the Distressed Disposal are identified and valued in cash" in order to give "immediate certainty as to the value of consideration". This purpose was met regardless of the application of set-off. 

• Do junior creditor value protections need to be satisfied if the junior creditors are out of the money? – the "Fallback" or "Additional Construction" Argument 

• ICA Provision – this point centred around the value protections generally and whether Conditions (A), (B) and (C) should apply at all if the junior creditors were "out of the money"²? This was a fallback position put forward by Bidco as an alternative argument if the court found that Conditions (A) and (B) had not in fact been satisfied. 

• Argument – Bidco argued that it was an implied term of the ICA that none of the junior creditor value protection conditions needed to be satisfied if the junior creditors were out of the money. The logic being that if the junior creditors would have no economic interest in the absence of a Distressed Disposal, then they lack any legitimate interest in enforcing compliance with the conditions required to effect such Distressed Disposal.  

• Judgment – Although not necessary for his judgment given his position in relation to Conditions (A) and (B), the judge disagreed with Bidco's interpretation and held that the value protections were applicable regardless of whether the junior creditors would be out of the money.  

The judge noted the similarity between Bidco's "out of the money" argument and the circumstances in which it was unnecessary to permit a creditor to vote on a restructuring plan. Each looked to whether creditors would have an economic interest in the company if the proposal (i.e. the distressed disposal or the restructuring plan, respectively) did not go ahead in determining whether or not that creditor should have certain rights (here, the right to the application of the value protection provisions and in the case of a restructuring plan, the right to vote).  

However, the judge noted that adopting the position proposed by Bidco would require the court to imply a term into the ICA. He did not consider that the test for implying a term into a contract - that, without the term, the contract would lack commercial or practical coherence³ – had been satisfied. He observed that in any event that the ICA worked without implying the term suggested by Bidco. Had the draftsperson intended the application of the conditions to be limited in this way, the judge held that language would have been included to this effect. 

Comment 

The judgment will be welcomed by all stakeholders as providing confirmation that Distressed Disposal provisions can be applied in line with current market practice. In particular, senior creditors are likely to be relieved that the ruling supports their ability to use the Distressed Disposal provisions to deliver an enforcement sale whilst continuing to provide financial support to the debtor group following the restructuring.  

Will junior creditors seek stronger value protections to prevent the senior creditors and a sponsor collaborating in an enforcement which results in the junior debt being written off whilst the sponsor retains its economic interest? We may see junior creditors push for additional protections particularly where the deal dynamics allow them to dictate terms. However, in practice, any improvement in the junior creditor position would require the senior creditors to compromise on their protections and will be heavily resisted. It is possible that we will instead see junior creditors looking to explore other avenues for value protection. This may take the form of credit support from elsewhere in the deal structure (if available) or through a direct sponsor undertaking to ensure that the junior creditors have the opportunity to participate in any post-enforcement structure where the sponsor retains its economic interest.  

More generally, the ruling supports the continued use of 'out-of-court' restructuring proceedings based on contractual intercreditor rights rather than forcing lenders to have to avail themselves of costly statutory processes such as schemes of arrangement, restructuring plans or formal insolvency processes. This is to the benefit of all stakeholders and lends some support to the UK's continued position as a pragmatic and flexible jurisdiction for both creditors and debtors alike.  

^[1] Mangrove was ultimately owned by the Galapagos Group's original sponsor, Triton Investment Partners.

^[2] Meaning that the junior creditors, as a result of their subordinated position, have no realistic prospect of recovering on their debt claims regardless of whether the Distressed Disposal occurred or not and therefore no economic interest in the matter.

^[3] Trower, J citing Lord Neuberger in Marks and Spencer PLC v BNP Paribas Securities Trust Co (Jersey) Ltd [2015] UKSC 72 at [21]