What do Lehman Brothers, Nortel Networks and Oi (Brazil) have in common, apart from the fact that they were or remain large multinational enterprise groups, which at some point went insolvent? They have been characterised by the integrated nature of their business, facilitated through the elaborate networks of intercompany financing arrangements. These arrangements have made the group-wide resolution of financial problems more challenging but also more desirable or even necessary in order to achieve the insolvency law goals of estate value maximization and fair and equitable treatment of creditors.
In the ‘The Code of Capital’ (Princeton University Press 2019), Katharina Pistor describes the structure of Lehman Brothers as follows: ‘Lehman Brothers […] developed the legal partitioning of assets with the help of corporate law into an art form. The business operated as a fully integrated global financial services provider, but its operations, liabilities, and profit centers were divided among hundreds of legal entities.’ This organisational complexity was accompanied by various group liability arrangements, which either perforated limited liability (eg, cross-guarantees) or closely tied the fates of separate entities (eg, intercompany cross-defaults and cross-entity ipso facto clauses). Similar financing mechanisms have been used by Nortel Networks and Oi. As a result, the idea of separate legal personality, underpinning modern rules of company and insolvency law, may not have fully reflected the economic and legal realities, as corporate legal shields did not protect individual entities from group-wide crises.
The question that arises in a group insolvency and restructuring context is how to establish a balance between protection of legitimate expectations and contractual freedom of parties to frame their obligations and risks through cross-guarantees and ipso facto clauses, on the one hand, and efficient group restructuring, on the other. I address this question in my recent article ‘Promotion of group restructuring and cross-entity liability arrangements’, which looks into the legal mechanisms that aim at establishing this balance. Two relevant mechanisms are examined: (i) prohibition or limitation of ipso facto clauses and their operation in a group setting, and (ii) enforcement stays and the possibility of their intra-group extension.
The rationale and problems of cross-entity liability arrangements
The first part of the article investigates the justification of cross-entity liability arrangements, mainly focusing on their economic rationale and analysing their ex ante and ex post effects on agency cost of debt, access to finance, managerial behaviour and creditors’ incentives. Cross-guarantees ensure beneficial lending terms and are prevalent in the context of raising funds in capital markets. They grant extra security to a guaranteed creditor, as it acquires access to the asset pools of two or more companies. Because of this extended access, such a creditor gets protection from intra-group asset shifting or asset stripping—a transfer of key assets from one group entity to another.
The rationale behind and the mode of operation of intercompany cross-default and cross-entity ipso facto clauses are different from group guarantees. Cross-default provisions seek to discipline the debtor and produce additional monitoring benefits, because creditors can better calculate risks arising from group operations. In anticipation of financial problems, a cross-default clause entitles the creditor to refuse future performance or accelerate existing claims. Cross-entity ipso facto clauses have a similar effect. They entitle the creditor to terminate or amend the contract or to refuse performance, should a group member initiate restructuring or insolvency proceedings. Consequently, the risk of prospective (potential) non-performance may be reduced.
At the same time, intercompany liability arrangements intensify interdependence and increase correlation between group entities. Enforcement of intra-group guarantees, setting into motion cross-defaults and cross-entity ipso facto clauses create contagion, enabling the spread of distress across legal boundaries of group members. The threat of a group-wide enforcement action could be a significant deterrent to initiating restructuring proceedings or even starting negotiations over an out-of-court workout. Hence, debtor’s management may be reluctant to take early measures to address financial difficulties before it is too late. This goes against the prevailing ideology of early reaction and insolvency prevention.
Cross-entity liability and group restructuring: The way forward
While insolvency law has traditionally been entity-centric, we are witnessing the emergence of legal tools which give consideration to the group economic reality and allow group-mindful restructuring. In my previous OBLB blog entry, I have examined one of them, namely third-party releases. This blog post continues the discussion by looking at the treatment of cross-entity ipso facto clauses and the possibility to extend an enforcement stay to (non-debtor) group entities.
The comparative overview of legal responses to ipso facto clauses reveals that more and more jurisdictions restrict their application to promote restructuring efforts. Yet, it is not obvious how this restriction should operate in the environment of an enterprise group, where the trigger is linked to a group entity, other than the debtor itself. In my article, I argue that it is sensible to embrace the underlying reasoning of the prohibition of ipso facto clauses and limit their legal force in a group setting, while at the same time avoiding overreaching encroachment on freedom of contract. This requires taking into account debtor’s financial position, the contract in question and viability of the debtor and the affected group entities.
The extension of enforcement stays is possible under laws of the USA, Singapore, Germany and the Netherlands, even if on different conditions. This may be necessary to achieve efficient restructuring of an enterprise, preserve group synergies and operational continuity of group entities. However, it must pursue a legitimate goal and provide sufficient safeguards to avoid abuse. With this in mind, my article argues that the extension should not be automatic and is only justified where the group is interdependent and interconnected and where the affiliate plays an integral part in debtor’s restructuring. I also emphasise that the extension of a stay should be available only to economically viable companies and shall not unfairly prejudice rights of a guaranteed creditor or cause substantial detriment to it.
Ilya Kokorin is the Meijers PhD candidate at the Department of Financial Law, Leiden University.