Event-driven creditor activism - a corporate perspective

Introduction

Interventions from activist debt investors - normally hedge funds - are familiar in crisis and insolvency scenarios. A flurry of recent news stories and claims have highlighted that companies can attract the attention of activist funds as a result of corporate events which may be unrelated to financial distress.

This type of event-driven creditor activism (named to distinguish it from strategies focussed on distress) is opportunistic, often arising out of unforeseeable or unforeseen events. Successful claims are not common, but when they arise, they can be a significant distraction to manage.

In this article, we consider the nature and incidence of event-driven creditor activism in the UK and Europe and the key risk indicators for claims. We look at some examples of the types of claims that arise, which often turn on competing interpretations of contractual terms. Finally, we outline some strategies for anticipating and responding to activist claims when planning for disposals and other corporate events.

Shareholder activism vs. creditor activism

Shareholder activism has become a feature of listed company life in the UK and Europe. The potentially adverse implications of shareholder challenges in public forums such as the AGM mean that many companies devote significant resource on an ongoing basis to managing equity investors with an agenda for change. The activist agenda may be driven by economic returns but increasingly, the primary motivation may be an ethical or sustainability outcome.

The strategies of activist debt investors (normally hedge funds) are similar to those of activist equity investors. Both debt and equity activists acquire participations in a company’s capital structure, with a view to using the rights that come with their status as investors to influence the company’s decision making. The difference between debt and equity investment is that debt activism requires the existence of a particular set of

circumstances and is almost always a financial play. There is no regular rhythm to creditor interventions, so debt activism tends not to be a constant feature of the board or treasury agenda.

The credit activist’s strategy involves monitoring corporate activity, analysing publicly available information on the company’s financial position and debt terms and identifying when an event or transaction might give rise to an arguable default.

Debt activism can be a standalone strategy. We have also seen instances where shareholder activism and creditor activism are related, for example, equity investors campaigning for a business to be demerged which, in turn, gives rise to activism on the creditor side with bondholders alleging that the demerger triggers an event of default under the bonds.

Careful attention to certain contractual terms when negotiating debt documentation (discussed further below) can mitigate the risk of future transactions being derailed or delayed by creditor intervention. However, the full range of circumstances down the line that could prompt debt investment with unwelcome intent can be difficult or impossible to predict.

What are the risk indicators for creditor activism?

The ability to implement an activist agenda through debt typically relies on a combination of three factors: the existence of transferable debt, which is trading below par, and which is either in default or at risk of default.

The nature of these risk indicators is explained in more detail in the box below.

Incidences of event-driven creditor activism

The purpose of most events of default in debt documentation is to enable the creditors to take enforcement action if the debtor’s credit deteriorates. Interest rate movements, inflation, and macroeconomic uncertainty have exposed borrowers of all types to refinancing risk and the prospect of financial covenant or payment defaults. The extension of the sources of debt funding beyond bank loans into leveraged loans, private credit, high yield and other instruments opens both private equity portfolio companies and corporates to a wider investor base, including hedge funds and distressed debt funds, who are more willing to take activist positions where financial difficulties are apparent. Against this backdrop, activist funds can acquire debt at a discount with the explicit intention of influencing the company’s restructuring or driving divestments. Campaigns are often proactive and assertive, intended to extract value in advance of formal insolvency processes when recovery prospects may become less certain.

Corporate transactions such as disposals and reorganisations (even if not related to financial difficulties) can, however, also trigger the attention of activist debt funds, as can other events such as legal and regulatory changes which impact debt terms. In these circumstances, the impending or possible default will usually be analysed when planning for the transaction. This is the prompt for the company to consider whether and when to engage with its stakeholders and develop strategies for doing do, taking into account the possibility of activist dissent.

Event-driven creditor activism is not widespread and the fact pattern that triggers a claim in relation to one borrower or issuer may not be capable of replication. As discussed above, claims usually stem from a cocktail of circumstances which reveal an unexpected vulnerability in the company’s debt documentation - or simply a provision, the interpretation of which is not clear-cut - which investors are able to spot and then exploit. The availability of these claims is dependent on the terms of the relevant instrument.

For investment grade corporates, the prospect of creditor activism may seem remote in the absence of financial stress. High grade corporate loans contain only a limited and light touch covenant package. Eurobond terms and conditions contain even fewer but interestingly, this is where a number of recently publicised examples have arisen, many of which relate to cessation of business events of default, discussed further below. It is relevant, in this regard that bond terms and conditions are publicly available, while loan terms, in the vast majority of cases, are not.

Example - cessation of business events of default

In February, the Financial Times highlighted that certain bond investors have been challenging disposal transactions on the basis that the transaction in question breached the cessation of business event of default in the relevant bonds. The article describes the provision as “obscure” and “unique”. In fact, while the combination of drafting and fact patterns that trigger any particular clause can be unique, cessation of business events of default are not unusual. While terms vary quite considerably, they are a common feature of bonds of all types.

There are variations in the scope of cessation of business events of default in bonds i.e. with regard to which entity or entities must cease business for the cessation of business event of default to be triggered – is it the issuer or the guarantor only, their material or principal subsidiaries (typically a defined term) or even any member of the group? There are also variations in what constitutes a cessation of business i.e. whether the event of default requires the cessation (or threatened cessation) of all of the relevant entity’s business, or substantially all, or a substantial part – or even a “material” part.

Cessation of business events of default also feature in some sub-investment grade loans. Drafting varies, but where included, the formulation is often slightly different to that applicable in the bonds context. Drafting is often based on the cessation of business event of default in the LMA’s leveraged facility template, which is as follows: “Any member of the Group suspends or ceases to carry on (or threatens to suspend or cease to carry on) all or a material part of its business”.

A significant disposal will generally require a company to seek consents under its loan documentation (so whether or not an additional event of default may be triggered under any cessation of business provision is most likely a secondary consideration). Cessation of business events of default tend to come into particular focus in the context of disposals in debt instruments such as Eurobonds, which do not contain restrictions on disposals.

We have been asked to advise on the applicability of cessation of business events of default many times, in the context of both solvent and distressed disposals. The more recent claims, and the suggestion that hedge funds are drawing up “shopping lists” of companies that could be potential candidates for claims should a disposal be proposed, have prompted queries from corporate clients. Low interest rate-era bonds are trading at a discount, which lays the ground for activist investment with a view to forcing repayment or buyback above market value, if an arguable and actionable event of default can be found to have occurred.

Analysing cessation of business events of default

It is important to re-emphasise that opportunities for activist intervention are in this instance, very case specific, turning on the drafting of the event of default and the fact pattern (the nature of the disposal or transaction in question). There are often a number of layers of analysis in terms of the likelihood of the event of default being triggered, which creates a significant practical barrier to claims in many cases.

Is the disposing entity subject to the event of default?

Does the event of default apply to the Issuer, the Guarantor(s), Material/Principal Subsidiaries and/or any member of the Group? If it bites on Material/Principal Subsidiaries, how is that term defined?Definitions vary but are often defined as subsidiaries of the Issuer/Guarantor whose revenues, assets, or EBITDA comprise 5-10% or more of the revenues, assets, or EBITDA of the group.

What is meant by “cessation” in this context?

Does the transaction in question engage the event of default? Is the clause intended to restrict disposals? The effect of the proposed disposal may be that the business disposed of ceases to be conducted by the disposing entity, but there is often a debate as to whether that is truly what the clause is intended to restrict.

It is sometimes argued that the purpose of cessation of business events of default in eurobonds is to give bondholders comfort on the issuer's/group’s ability to service the bonds. That ability could be prejudiced by material disposals of the issuer's business, even in a solvent context. The counterargument is that this is not a natural interpretation, and that the clause should be viewed in context.

Cessation of business events of default are often placed under the heading of insolvency events of default. The more natural interpretation in that context (it might be argued) is that the clause is directed at an insolvent or extremely distressed scenario, rather than a solvent disposal by a solvent issuer.

It is often highlighted in support of this narrower interpretation that if creditors wish to restrict disposals (in loans or bonds), disposals would be controlled explicitly, rather than by a provision buried within the insolvency events of default.

Are there exceptions to the event of default and do they apply?

In some instances, the drafting of the clause may include negotiated exceptions that are relevant (and potentially helpful) to the key point of how “cessation” should be construed. For example, solvent group reorganisations are commonly carved out from the event of default.

When might a “threatened” cessation occur?

Some cessation of business events of default are triggered by a threatened cessation of business as well as an actual cessation. Where the clause is engaged(i.e. when the transaction occurs, it is likely there will be an event of default), this can be a tricky question, and advice tends to be nuanced. In broad terms, initial discussions about a disposal or transaction without a clear deal in mind may not present a material risk. As the deal is agreed and the terms fleshed out (assuming the disposal constitutes a “cessation of business”) – the higher the risk that the deal is “threatened” becomes. Clearly an important consideration in this instance is confidentiality – i.e. whether the deal or potential deal can legally be kept under wraps from investors.

How do you measure “substantially all”, a “substantial part” or a “material part” of the business?

Pinning down whether the disposal or transaction meets the threshold specified in the relevant documentation is often the key area of focus. Although advice is often sought on the interpretation of these terms, there is no English caselaw that is precisely on point. The analysis therefore typically considers the question through both a quantitative and a qualitative lens to take into account the full range of possibilities[1].

If an event of default has occurred, is it actionable?

In bonds constituted using an English law trust structure, it is the bond trustee, rather than the individual bondholders, who must take action to accelerate the bonds following an event of default. A trustee may accelerate at its own discretion or will be obliged to do so if directed by a minimum proportion of bondholders (for example, 20% by value) who must indemnify the trustee to its satisfaction before the claim can be pursued.

An additional hurdle applicable in many eurobonds is that before pursuing an enforcement claim, the trustee must determine that the event of default is “materially prejudicial” to the interests of the bondholders.

Where the bonds use a fiscal agency structure, the enforcement process is different. The fiscal agent is an agent of the issuer and therefore does not perform the same role as a trustee, with each bondholder typically entitled to accelerate their bonds following an event of default.

Fiscal agency structures are used in a number of cases, including in jurisdictions which do not recognise trusts, which includes a number of European countries. The hurdles to creditor enforcement are fewer in fiscal agency structures, which puts more focus on ensuring the triggers for enforcement are appropriately drafted.

Who can enforce the cessation of business event of default in bonds?

An interesting dispute, currently before the English courts, relates to the alleged breach of the cessation of business event of default in the bond terms of Essity, the Swedish hygiene products maker (one of the issuers mentioned in the FT article).

The claimants, who are beneficial holders of the bonds, allege that Essity’s 2024 disposal of a majority stake in one of its subsidiaries constituted a disposal of a substantial part of its business, and therefore an event of default. The issuer is seeking to have the bondholders’ claim thrown out in part, based on a technical argument that the claimants have no standing to make the claim. This is in reliance on the so-called “no look through” principle under English law.

Under the “no look-through” principle, an investor with an interest in securities that are immobilised in a clearing system has no claim against the issuer. The issuer is arguing therefore, that only the custodians and/or clearing systems should be able to bring the claim.

The dispute remains ongoing at the time of writing.