Smile Telecoms - Out of the money means out of the vote

In what is the first landmark restructuring case of 2022, Smile Telecoms made history last month: for the first time, the English court has made a convening order that excluded its shareholders and all but one creditor class from voting in a restructuring plan on the basis they were "out of the money". The sole creditor class which will now vote on the plan is the group's super senior lender who will be taking full ownership of the group as part of the restructuring plan. 

What does this mean for companies proposing a restructuring plan?

This is the first case where a company has sought the exercise of the court's power to exclude creditors and shareholders from voting on a restructuring plan, even though the plan levies substantial compromises on those stakeholders, on the basis that they have no genuine economic interest in the company.  The key takeaways are as follows:

• Whether creditors or shareholders have a genuine economic interest in the company is to be tested by reference to the returns to them in the relevant alternative to the restructuring plan.

• A court will test the valuation evidence very carefully but will ultimately have little difficulty in concluding that parties have no genuine economic interest where the valuation evidence shows that they are clearly "out of the money" in the relevant alternative and no competing evidence is provided by anyone in the classes proposed to be excluded.

• Where the valuation evidence is more marginal, classes will have a better chance of successfully resisting an attempt to exclude them from voting. And the court will likely be reticent to exercise its discretion to exclude classes from voting where there is uncertainty about the outcome (as we saw in Hurricane Energy last year where the court refused to exercise its cross-class cram down power – see our prior briefing on that case).  

• In a more marginal scenario, we expect companies may avoid seeking the exclusion of relevant classes from voting, and may instead ask the court to cram down those classes if they vote against the plan. The test for the exercise of cross-class cram-down is lower (see below), and we have seen the cross-class cram-down power used successfully four times already.

• That said, where certain classes are clearly "out of the money", this process excluding them from voting potentially allows for a "streamlined" process after the convening hearing, with fewer classes voting on the plan and, at least in theory, no ability for excluded creditors to challenge at the sanction hearing. In such cases, we may well see it argued in the future that the period from convening hearing to creditor meeting, and therefore the period to sanction, should be shortened from the usual 21 day period to reflect this dynamic.

• As becomes clearer with each plan judgment, the quality of valuation evidence is imperative, as is giving the proposed disenfranchised creditors time to interrogate the evidence and the opportunity to provide competing evidence. If valuation evidence includes the results of a properly conducted, arm's length, marketing process, this is going to be difficult for the excluded creditors to challenge. But in any event, it is crucial that if creditors or shareholders want to make a challenge, they need to provide the court with alternative valuation evidence. 

Surely classes of creditors and shareholders that are being so substantially impaired by a plan should at least be allowed a vote?

The starting point for a restructuring plan is that every creditor or shareholder of the company whose rights are affected must be permitted to vote on the restructuring plan by participating in a meeting convened by the company with the approval of the court. 

Where you have one or more dissenting classes of creditors, the cases in 2021 show that the court is willing to exercise its power to sanction a restructuring plan notwithstanding the votes of the dissenting class(es) (the "cross-class cram down" power) as long as:

• at least one "in the money" class voted in favour by the requisite majority; and
• it is  presented with valuation evidence showing that the dissenting classes would be no worse off under the plan than in the "relevant alternative" if the plan was not sanctioned.

Clearly it is one thing to sanction a restructuring plan when faced with one or more classes of dissenting creditors, but it is quite another to simply exclude those classes from voting in the first place. That power to exclude a class from voting (under section 901C(4) of the Companies Act 2006) requires the company to satisfy the court that none of the members of the classes to be excluded have a "genuine economic interest" in the company. 

In other words, whilst cross-class cram-down requires a comparison of the outcomes for the affected classes under the plan as opposed to under the relevant alternative (the so-called 'no worse-off' test), for a company to exclude classes from voting altogether the court has to be satisfied that the excluded classes have a complete absence of economic interest in the relevant alternative.

What does this case tell us about the future for valuation disputes?

This was not a marginal case – the senior lenders were found on the evidence accepted by the Court to have repeatedly admitted to the Company that they were out of the money; and they had been given the time, with advice, to review the valuation evidence and did not provide any competing evidence at the convening hearing to counter the position of Smile. A more marginal case, or situations where lenders have not made such admissions in negotiations, will fail to provide such a clear route to the utilisation of 901C(4). 

It will be interesting to see how such cases play out in light of the unwillingness and, in our view justified, reticence of English judges to date to engage in lengthy and protracted valuation disputes as part of the main restructuring plan proceedings. Those valuation disputes appear in Chapter 11 reorganization plans in the US and can delay the proceedings for months, with substantial costs incurred by the estate as the court has to reach a valuation determination in the presence of competing arguments from valuers providing expert evidence for varying levels of creditors. 

Speed and expediency seems to be the UK's differentiating factor. In this regard it will need a fairly borderline mix of factors to depart from this premise: it will be where you have a marginal case, with competing evidence in front of the court as to where the value breaks, and perhaps where there are questions as to the quality of any market testing in support of the valuation.

This case answers one of the key unknowns about restructuring plans and further reinforces their power

In our last legal update, we predicted that 2022 will be the year that the restructuring plan takes off, and this case significantly develops our understanding of when the power to exclude "out of the money" stakeholders from voting will be available. That was one of the key points that we hadn't seen analysed by the courts in the detailed judgements on restructuring plans since their introduction into English law in June 2020. 

Restructuring plans have not in any way displaced creditor schemes of arrangement in the UK. But the impact on senior creditors of Smile's two restructuring plans in as many years highlights how powerful the tool can be: the first plan saw the dissenting senior lenders have further super senior debt layered in ahead of them and the second plan sees the senior debt and related security released in full without the beneficiaries' consent. The potential to use a plan to implement balance sheet restructurings of this nature, as well as a compromise of operational liabilities (as seen in Virgin Active), means we now have the tool, and a supportive judiciary, to envy the world.