By Daniel Livingston, Partner

For a company that is in financial difficulty, but which is still ultimately a viable going concern, a debt for equity swap can be an effective way to restructure its capital and borrowings and, in doing so, strengthen its balance sheet and deal with issues such as over gearing.

A debt for equity swap involves a creditor converting debt owed to it by a company into equity in that company. The effect of the swap is the issue of the equity to the creditor in satisfaction of the debt, such that the debt is discharged, released or extinguished.

For a creditor, a debt for equity swap may be a way of avoiding the costs associated with commencing processes to recover debt (which may not be fully recoverable in the current environment) and may provide a means by which a creditor can participate in any future growth of the company.

Debt for equity swaps can be utilised in numerous situations, including:

• to restructure debt with a major non-bank creditor;
• to change the proportion of debt and equity held by shareholders to strengthen the company’s balance sheet; or
• to create a strategic alliance with a major supplier.

Regardless of the circumstances, debt for equity swaps provide an opportunity for a company to deal proactively with creditors before creditors take steps to recover debts and, in the case of secured creditors, enforce its security and/or appoint an external administrator.

Commercial terms of the debt for equity swap

Key terms to be decided are:

• the value of the company and whether equity is to be issued at a discount to that value;
• the amount of debt to be substituted for equity and the extent to which existing shareholders will be diluted;
• the type of equity interest which will be acquired (e.g., ordinary shares, fixed dividend / preference shares, shares, redeemable shares or convertible securities);
• the rights which will attach to the equity interest (e.g., priority as to income and capital, veto rights over certain decisions of the company or the right to appoint directors); and
• the restrictions which will be imposed on the equity interest (e.g., restrictions on transfers or limits on voting rights).

Implementing a debt for equity swap

Carefully planned engagement with shareholders and participating creditors is crucial to successfully undertaking a debt for equity swap.

Contractual (i.e., non statutory) debt for equity swaps between the company and the participating creditors can be simple and flexible. The company takes the lead role (together with their lawyers) on preparing and negotiating the documents necessary to effect the debt for equity swap, including debt forgiveness, share issue and shareholder agreements.

In contrast, debt for equity swaps implemented using a statutory procedure can be complex, costly and are generally administered by an insolvency practitioner, meaning that the company and its directors have significantly less control over the process. An example of where a company may be able to implement a debt for equity swap using a statutory procedure is where the company executes a Deed of Company Arrangement (DOCA) in accordance with the statutory procedure set out in Part 5.3A of the Corporations Act 2001 (Cth). However, a statutory procedure can be useful where the company is unable to negotiate with its creditors, as it will bind all creditors if they are agreed to by the requisite majority and therefore can be used to “cram down” objecting or more junior creditors.

Other matters to have regard to consider when considering a debt for equity swap include:

• the required shareholder consents and approvals;
• the tax and accounting treatment of the debt for equity swap;
• any other matters to be dealt with in connection with the debt for equity swap (creation of new shares, amendments to the constitution or shareholders agreements and disapplication by shareholders of their pre-emptive rights);
• (for listed companies) the rules of the exchange on which they are listed; and
• the takeover provisions under the Chapter 6 of the Corporations Act 2001 (Cth).

If you would like any further information on debt for equity swaps, or other ways in which you can restructure your debt or equity, please contact: