CFM11180 - Understanding corporate finance: raising finance: restructuring debt

Restructuring debt

A company standing in the position of debtor may at some point need to restructure its debt, either as a consequence of default or to avoid it. This could take the form of changing the terms of the debt or converting debt into equity.

Restructuring may take many forms. If no debt securities have been issued, the contractual arrangements may be renegotiated and changed. Debt securities may be cancelled, replaced by other debt securities or replaced by equity.

Changing the terms of debt

A company may need to postpone the repayment date of a debt. If it has short-term debt which it will not be able to repay it may negotiate with its creditor to extend the term of the debt. More generally, it might negotiate a change to the interest payable, perhaps with a period without interest or with interest at a lower rate. More or different security may be given. The borrower might take out new borrowing on completely different terms, with the new borrowing being treated as repaying the old borrowing. If the terms of the existing debt are altered it will depend on the extent of the changes whether, legally, they bring about the rescission of the first debt and the substitution of a new debt.

If securities have been issued the securities may be cancelled and replaced with new securities evidencing the changed arrangements. This does not necessarily mean that the original debt has ceased to exist (rescission).

Converting debt to equity

Where a borrower company is unable to repay its borrowings it may be that the creditor agrees to convert the debt into shares. Where this happens the terms of the conversion will indicate the extent to which debt is released or treated as repaid in exchange for the issue of shares.

(By way of contrast, where a company has issued convertible debt, it has agreed in advance that the creditor has the right to have the debt settled by the issue of shares; in such case the conversion right held by the creditor is likely to be exercised because the debtor company has become more valuable rather than because it is in financial difficulties.)

From the lender’s point of view this release is simply likely to recognise what the accounts will have indicated already, which is that the debt was unlikely to be repaid in full. The shares issued at the time are likely to be worth less than the principal amount of the debt released or treated as repaid in exchange for the issue of shares and the value of the shares may be less than the amount treated as equity of the debtor in its accounts. It is possible that there may also be some further debt release for which shares are not issued as consideration.

From the borrower’s point of view the borrowings have been replaced by share capital. In accounting terms, release of debt will create a credit in the accounts of the borrower which may be to shareholders’ equity or may give rise to an amount recognised as an item of profit or loss or some combination thereof. Through the transaction the borrower has reorganised its capital structure. Instead of borrowings it now has share capital in issue. This may enable the company to raise more money through issuing further debt or through borrowing.

Guidance on tax issues

The tax issues involved in a restructuring of debt are complex. The loan relationships provisions contain extensive provisions dealing with rules on debt forgiveness, corporate rescue and debt for equity swaps. For guidance see CFM33180+.