Avoidance actions and prohibited set-off in debt-to-equity swaps - International La...
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Insolvency & Restructuring - Switzerland
Avoidance actions and prohibited set-off in debt-to-equity swaps
Contributed by Homburger
October 29 2010
Introduction
Debt-to-equity swaps
Legal framework and insolvency risks
Comment
Introduction
In recent Swiss restructurings the question has arisen of whether a debt-to-equity swap, executed as a
restructuring measure, can be challenged through an avoidance action or can constitute a prohibited – and
thus voidable – set-off if the company becomes bankrupt upon execution of the debt-to-equity swap.
This update elaborates on these risks and describes a scenario where bankruptcy proceedings are opened
or a composition moratorium is announced shortly after the completion of a debt-to-equity swap.
Debt-to-equity swaps
Debt-to-equity swaps are frequently used to restructure a distressed company's balance sheet. By
swapping debt into equity, a company can:
eliminate an already incurred or imminent situation of overindebtedness;
improve its debt-to-equity ratio; and
going forward, reduce the financial burden caused by interest payments.
Typically, a debt-to-equity swap is structured as an issuance of new share capital, which is taken up and
paid by creditors against a set-off of loans or other debt owed by the company to such creditors. Frequently,
a debt-to-equity swap is preceded by a reduction of the share capital, leading to a full or partial loss of the
former shareholders' participation. In order for a Swiss corporation to execute a debt-to-equity swap, the
consent of a qualified majority of the shareholders and the participating creditors is required.
Whether such a restructuring will lead to a sustainable improvement in the distressed company's situation,
or simply defer bankruptcy by some time, often remains uncertain. Therefore, for all involved parties it is key
that in the case of a post-restructuring bankruptcy, the debt-to-equity swap will not be voidable or, worse,
may even lead to damage claims against or the double exposure of the involved creditors.
Legal framework and insolvency risks
Legal framework
Avoidance actions
The Debt Enforcement and Bankruptcy Act sets out two basic categories of avoidance action. The first
category applies to certain specifically mentioned acts, such as donations or gifts (Article 286, "action to
avoid a gift"). Additionally, pursuant to Article 287 of the act ("voidability due to insolvency"), this category
also includes actions such as:
the granting of collateral for an existing obligation even though the debtor was not obliged to secure the
obligation until that point in time;
the settlement of monetary debt in a manner other than in cash or by other unusual means of payment;
or
the repayment of debt not yet due.
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These actions are voidable if the debtor was already insolvent when it undertook the actions and if it did so
during the year before the opening of bankruptcy proceedings, unless the recipient proves that it was
unaware of the debtor's overindebtedness.
There is a second, more general type of avoidance action. Pursuant to the catch-all provision of Article 288
of the act ("voidability for intent"), all acts that a debtor carried out within the five-year period before the
opening of bankruptcy proceedings or the granting of a stay or a moratorium are voidable if the debtor acted
with the intention to favour certain creditors over others. However, this discrimination need not be the
purpose of the transaction; it is sufficient that the debtor acts taking into account such a result. Finally, the
debtor's intention must be apparent to the counterparty to the transaction.
All types of avoidance action require the challenging creditors to have incurred damage.
Set-off of claims against bankrupt entity
In general, the opening of bankruptcy does not deprive a creditor of its right to offset its claims against a
claim against it by the bankrupt debtor. However, the following two exceptions could be relevant in case of a
debt-to-equity swap.
Pursuant to Article 213 of the act, set-off is not permitted if:
the debtor of the bankrupt entity became a creditor only after the opening of the bankruptcy
proceedings, or
vice versa (ie, if a creditor of the bankrupt entity became a debtor only after the opening of the bankruptcy proceedings). In addition, the unpaid capital contribution of a legal entity cannot be offset in
bankruptcy by the equity holders.
Pursuant to Article 214 of the act, a set-off can be challenged by an avoidance action if the debtor of the
bankrupt entity has acquired the claim before the opening of the bankruptcy proceedings, but in
awareness of the bankrupt's insolvency, in order to generate an advantage for itself or a third party to the
detriment of the bankruptcy estate.
Value of debt in case of set-off
It has been disputed in Swiss legal literature whether a set-off of debt against issuance of new shares may
occur at the nominal value of the debt, or whether the set-off must occur at the market value of such debt
(ie, taking into account the debtor's situation of financial distress and the risk of default). This would result in
a situation where only a fraction of the debt's nominal value could be offset and swapped into equity.
Since neither the Code of Obligations nor legal precedent provides a clear answer to this dispute, a creditor
subscribing shares against the set-off of debt bears a certain risk that its contributions could be deemed to
be insufficient, resulting in an obligation to make an additional payment in cash to the extent that the debt
was overvalued (ie, the nominal share capital of the newly issued shares was not covered by the debt).
Although, in practice, this risk can be mitigated by a proper structuring of the debt-to-equity swap, since
Swiss corporate law is currently under revision it is hoped that the legislature will resolve this dispute in
favour of restructuring. According to the first draft of the amended Code of Obligations, in a restructuring
situation a set-off at nominal value would be explicitly permitted, but the final outcome of the ongoing
legislative process remains to be seen.
Risk of avoidance actions
General considerations
From an economic point of view, there is no reason for any of the other creditors to challenge a debt-toequity swap, since such a transaction not only does not damage or discriminate against other creditors, but
even improves their situation. By swapping the outstanding debt into equity, the respective creditors agree
to move their claims from third class into equity which, in case of a bankruptcy, would be ranked behind any
debt. In legal terms, this means that one of the preconditions for a successful avoidance action – the
incurrence of damage by the other creditors – will not exist in case of a debt-to-equity swap. Therefore,
avoidance actions against such a restructuring measure would be doomed to fail.
Moreover, the ultimate goal of any avoidance action is to increase the pool of assets available for
distribution to the creditors. Such a goal cannot be achieved by way of challenging a debt-to-equity swap,
since a successful challenge and subsequent reversal of a debt-to-equity swap would not make available
any additional assets, but on the contrary, would only increase the liabilities of the debtor. Therefore, an
avoidance action against a debt-to-equity swap cannot achieve its ultimate goal.
Specific considerations regarding potential voidability due to insolvency
Based on the wording of Article 287(2) of the Debt Enforcement and Bankruptcy Act, it could be argued that
a debt-to-equity swap constitutes a voidable action because the bankrupt debtor settled its monetary debt
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(ie, the loans due to the creditors) in a manner other than in cash or by other unusual means of payment (ie,
by way of issuance of new shares).
However, there are no grounds to uphold this argument. First, avoidance actions serve only to challenge
dispositions of the debtor. If a creditor offsets its claim against that of the debtor, this action (ie, the
declaration of set-off) is performed by the creditor. Such an act does not fall within the scope of the
avoidance actions, but rather is subject to the provisions regarding the set-off of claims against a bankrupt
debtor.
Further, the issuance of new shares cannot be perceived to occur in direct repayment of the debtor's or
issuer's debt. By subscribing new shares and participating in the debt-to-equity swap, the creditor
undertakes to pay in the subscription price explicitly by way of set-off and not in cash for the shares to be
newly issued. Rather, it is this undertaking of the creditor which it fulfils by declaring the set-off with its own
claims against the debtor.
Risk of voidable set-off
There is a further risk for creditors that participate in a debt-to-equity swap in entering into a voidable setoff. As outlined above, shareholders are not allowed to offset unpaid capital contributions after bankruptcy
proceedings have been opened.
In light of this provision, one could argue that in a situation where the company falls into bankruptcy shortly
after the creditors have subscribed to the capital increase by way of a debt-to-equity swap, but before the
set-off has been declared, the new shareholders (ie, the former creditors) are obliged to contribute the
nominal value of their shares in cash instead of offsetting their claims.
Again, there are strong arguments against this view. The purpose of Article 213(4) of the Debt Enforcement
and Bankruptcy Act is solely to ensure that the creditors of a company can rely on their expectation that the
registered share capital of a company serves as liability reserves for the company's debts. The provision
prevents a creditor which is also a shareholder from satisfying its own claim in full by offsetting it against its
outstanding capital contribution. If that were permitted, the other creditors could never seize the company's
equity to cover their obligations. However, this situation cannot be compared to the case of a debt-to-equity
swap, in which a creditor commits to pay in the share to be newly issued by way of set-off explicitly, but
such creditor does not have a pre-existing or newly created obligation to pay in an outstanding capital
contribution in cash. Finally, as shown above, a debt-to-equity swap does not lead to a reduction of the
assets available for distribution to the other creditors, but on the contrary, reduces the liabilities of the
debtor and thus increases the potential bankruptcy dividend.
That said, it is also clear why the voidability of a set-off pursuant to Article 214 of the act cannot be
applicable to a debt-to-equity swap. As set out above, this provision explicitly requires that a set-off occur in
order to generate an advantage for the creditor or a third party to the detriment of the bankruptcy estate. A
debt-to-equity swap is beneficial for the bankruptcy estate as it relieves the bankrupt estate from the debt
which has been converted into equity. The result is that only those creditors which participate in the debt-toequity swap are disadvantaged, while all others benefit.
Besides the material weakness of the argument that a debt-to-equity swap could constitute a voidable setoff, in practice the risk of such an argument arising can be partially mitigated by a simple but effective
measure: the subscription undertaking and the declaration of set-off can and should be executed
simultaneously, so that the set-off occurs at a point when the debtor is still a going concern, and thus the
creditors do not face a situation where they must offset their claims against a bankrupt entity.
Comment
There are no reasonable grounds to argue that a debt-to-equity swap could constitute a voidable act
challengable in a subsequent bankruptcy of the debtor, for three reasons:
A debt-to-equity swap results in no damage to the other creditors;
The set-off is not an act carried out by the debtor, but rather an act carried out by the creditor; and
The reversal of a debt-to-equity swap would not result in the remedy which avoidance actions are
intended to create (ie, the capture of additional assets or the reduction of liabilities for the benefit of the
generality of the creditors).
The risk that the creditors could be legally obliged to contribute the nominal value of the newly issued
shares in cash instead of offsetting against their claims on the opening of bankruptcy proceedings can be
further mitigated by ensuring that the creditors' declaration of set-off is made simultaneously with the
signing of the subscription form.
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Therefore, it can be concluded that Swiss insolvency law should not provide grounds to challenge a debt-toequity swap aimed at the restructuring of a financially distressed company.
For further information on this topic please contact Ueli Huber, André Terlinden or Simon Lang at
Homburger by telephone (+41 43 222 1000), fax (+41 43 222 1500) or email ([email protected]).
The Homburger website can be accessed at www.homburger.ch.
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Authors
Ueli Huber
André Terlinden
Simon Lang
© Copyright 1997-2010 Globe Business Publishing Ltd
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