Changing Residual Claimant and Loss of Efficiency on Infrastructure Projects in Times of Doubtful Solvency

Introduction

This article considers the period of doubtful solvency on infrastructure projects which are often highly leveraged with a lender club having sole security over all of the project’s assets and future cashflows and with a substantial portion of the revenues going towards regular debt service. In these cases, the borrower-creditor dynamic is very unique, and is very symbiotic almost to the exclusion of all other creditors which are unsecured, and are few in quantum and number. Generally speaking when a corporate is of doubtful solvency, decisions need to be made as to whether to restructure and save the business or let it proceed to liquidation. During this period, if the borrower can reasonably conclude that it is not able to pay its debts, the directors should declare the company insolvent and are exposed to local law for not doing so.

Armour surmises that the grant of a security interest entitles lenders to ‘priority of payment and to control of the collateral’, however both only arise when a debtor is actually insolvent.[1] In the period of doubtful insolvency beforehand, there is an implied but very real threat, of both corporate insolvency and director liability for not filing for insolvency which hangs over the debtor and its directors like the sword of Damocles all the while the debtor continues to trade. Insolvency laws control the behaviour of the company and its directors to protect the company’s assets for all creditors that have a valid claim against the company, however continued trading can be the best and most efficient outcome for an infrastructure project which has high visibility of future cashflows. Directors therefore have more confidence in being able to trade out of a time of doubtful insolvency, albeit at their own liability.

Residual claimants

Companies are started by one or more shareholders who often consider themselves “owners” of the company but in reality they are simply a different type of financier and are often known as the ‘residual claimant’.[2] As Fama and Jensen go on to say, ‘[t]hese residual claims have property rights in net cash flows for an indefinite horizon’.[3] Bainbridge instead calls them ‘nominal owners’ who ‘exercise virtually no control over either day-to-day operations or long-term policy’.[4] As the residual claimants, the shareholders have sole rights to unlimited upside or profit from the company which is which is why they may be considered as owners. Cowton argues that it is the role of residual claimant that gives shareholders their primacy vis a vis all other stakeholders, not ‘their role as a capital provider’.[5] Put differently, as Klein and Coffee observe, shareholders ‘are more likely to be interested in and to have control of the firm than are the holders of the debt, or fixed claim’.[6]

It is useful at this point to contrast the different property rights of both shareholders and creditors. At times of solvency, a creditor’s right to a distribution is governed by contract whilst a shareholder’s right to a distribution is limited to when the directors declare a dividend. Whilst the company remains solvent, shareholders, as the residual claimants, have variable return, alienable and transferable property rights where the valuation reflects (ordinarily) the long-term (unlimited) prospects of the company. All investment decisions by the directors and which give positive net returns to the company should accrue to the shareholders as residual claimants, i.e. the value of the business is in excess of the liabilities. In contrast, when a company is insolvent, by definition liabilities equal or outweigh assets, so ‘shareholder money is no longer in jeopardy because, by definition, there is no residual claim’.[7] In fact at this point the creditors have become the residual claimants, as illustrated below in Figure 1, and all company value accrues to them. Put differently, they bear all the risk of the company’s cashflows and ‘their fixed claims are vulnerable’.[8]

Figure 1: Examples of Residual Claimant in Solvent and Doubtful Solvency Companies

Notwithstanding that the creditors have become the residual claimants in insolvency, their return of the credit lent to the borrower can only be funded by the company’s short-term prospects or, if the company is in liquidation, whatever assets of the company can be sold and distributed. The very best outcome achievable for creditors is simply receiving what they are owed. The shareholders, at this time, must stand in line and will only receive a return, and indeed the reins to company, once all creditors have been fully paid and/or the company returned to solvency.

Changing residual claimants and loss of efficiency

Infrastructure projects have a finite life, and if the year-on-year cashflows are reduced, the creditors simply need to wait longer to be repaid.[9] Whilst in default, the debt will take 100% of the lower annual cashflows and the shareholders will need to wait until the debt is fully repaid before seeing a return, as shown below in Figures 2 and 3. In Figure 2, the shareholders remain the residual claimants whilst in Figure 3, it can be seen that the financing creditors are the (temporary) residual claimants until they are fully repaid at which point the shareholders return to being the residual claimants.

Figure 2: Example of Cashflow Sharing in a Solvent Project

Figure 3: Example of Cashflow Sharing in an Insolvent Project (with reduced annual cashflows)

In times of doubtful solvency, when much uncertainty prevails, both creditors and the shareholders can lay claim to being the residual claimant and, directors are obliged to consider both;[10] as Keay states, ‘the trigger for the obligation to take into account creditor interests is not precise’.[11] At this point, creditors, whose returns are capped, prefer the directors to focus on near term value preservation whilst shareholders would prefer the directors to go for long-term value maximisation.[12] Whilst directors need to have indirect regard for both shareholders and the creditors in the vicinity of insolvency, having two sets of stakeholders stating to be residual claimants and requiring the directors to undertake different strategies is inefficient for the directors.

Fama and Jensen identify that director duties have evolved to control agency problems with directors in limited liability companies arising because of the separation of control and ownership.[13] They go on to say that organisational forms can be ‘distinguished by the characteristics of their residual claims on net cash flows’ and in particular, the shareholder’s property rights are alienable because shareholders are ‘not required to have any other role in the organization’.[14] Conversely with financing creditors who become residual claimants, there is a much closer relationship with the company. In particular, in the case of infrastructure lending, there is significant debt governance contained within the loan agreement.[15] This means that the financing creditors are able to “instruct” the company to pay all available free cash to the lenders. With a closer relationship between governance and residual claimant status, the organisational form more closely resembles a partnership rather than a limited liability company, and as such decision-making is more conservative.[16]

In the case of infrastructure projects, and as shown in Figure 3 above, the financing creditors would remain the residual claimants until the debt was fully repaid or restructured. However, the financing creditors could be content to allow the debt to continue in doubtful solvency for two reasons. Firstly, either there is no material increase in the regulatory capital cost to the lenders under Basel III for non-performing loans, or such increased cost was insufficient (considering the default interest being earned by the creditor) to incentivise the banks to restructure so as to benefit from the lower regulatory capital requirement for a performing loan. Secondly, restructuring the debt would have two implications – the shareholders would be returned to residual claimants and the repayment of the loan would be extended even further to restore day-to-day solvency, potentially taking the final maturity of the debt close to the end of the project’s life. As shown in Figure 3, in the current default scenario, all free cash is going to the financing creditors; in a restructuring that would restore solvency, the annual cashflows must be sufficiently greater than the debt service obligations (i.e. an annual debt service cover ratio of greater than 1.0x) which means in any given year the financing creditors should take less than they receive in the current situation, thereby extending the time for full repayment.

Conclusion

In sum, the extended insolvency twilight period, where the residual claimant is uncertain, has introduced inefficiency for the directors in managing the debtor. Additionally, it would seem that the financing creditors could prefer the default status quo, i.e. the benefits of default (higher) interest, 100% of the projects free cashflows so as to repay the loan in the shortest possible time, all whilst remaining the residual claimant. It is worth noting that this strategy runs counter to the objective of the EU’s Restructuring Directive which was to reduce the level of non-performing loans in Europe.[17] Whilst it is known that the intention of Basel III was to incentivise creditors to restructure non-performing loans, this can be defeated by the creditors choosing to leave the project in default, earning the lenders increased interest rates and having the loan repaid sooner than if it was restructured. But this is to miss the overall point; contrary to local insolvency law, and given the highly predictable nature of infrastructure project cashflows, the best and most efficient outcome was for a project in times of doubtful solvency is to continue trading. This is overall a better outcome for the debtor, creditors and the shareholders.

[1] John Armour, ‘The Law and Economics Debate About Secured Lending: Lessons For European Lawmaking?’ in Horst Eidenmüller and Eva-Maria Kieninger (eds) The Future of Secured Credit in Europe (De Gruyter 2008) 4-5 (original emphasis)

[2] E.F. Fama and M.C. Jensen, ‘Organizational forms and investment decisions’ 19 (1985) Journal of Financial Economics 102

[3] Ibid 102

[4] Stephen M. Bainbridge, ‘Director primacy’ in Claire A. Hill and Brett H. McDonnell (eds) Research Handbook on the Economics of Corporate Law (Edward Elgar Press, 2012) 17

[5] Christopher J. Cowton, ‘Putting Creditors in Their Rightful Place: Corporate Governance and Business Ethics in the Light of Limited Liability’ (2011) J Bus Ethics 24

[6] William A. Klein and John C. Coffee, Business organization and finance: Legal and economic principles (3 edn, Foundation Press 1988) 42

[7] Anil Hargovan & Timothy M. Todd, ‘Financial Twilight Re-Appraisal: Ending the Judicially Created Quagmire of Fiduciary Duties to Creditors’ (2016) 78 U Pitt L Rev 141

[8] Christopher J. Cowton, ‘Putting Creditors in Their Rightful Place: Corporate Governance and Business Ethics in the Light of Limited Liability’ (2011) J Bus Ethics 28

[9] Sarah Paterson, ‘The Paradox of Alignment: Agency Problems and Debt Restructuring’ (2016) 17 Eur Bus Org Law Rev 506

[10] Ryan Purslowe, 'Decisions in the Twilight Zone of Insolvency - Should Directors Be Afforded a New Safe Harbour' (2011) 13 U Notre Dame Austl L Rev 120

[11] Andrew Keay, ‘Office-holders and the duty of directors to promote the success of the company’ (2010) Insolvency Intelligence 132

[12] John Armour, Gerard Hertig, and Hideki Kanda, ‘Transactions with Creditors’ in Reiner Kraakman et al (eds) The Anatomy of Corporate Law (2 edn, OUP 2009) 111

[13] Eugene F Fama and Michael C Jensen, 'Agency Problems and Residual Claims' (1983) 26 JL & Econ 331

[14] Fama and Jensen MC (n 2) 101-102

[15] Charles K. Whitehead, 'Creditors and debt governance’ in Claire A. Hill and Brett H. McDonnell (eds) Research Handbook on the Economics of Corporate Law (Edward Elgar Press 2012) 72

[16] Fama and Jensen (n 13) 106

[17] Jonathan McCarthy, ‘A Class Apart: The Relevance of the EU Preventive Restructuring Directive for Small and Medium Enterprises’ (2020) 21 European Business Organization Law Review 898