Debt Reorganisation: Business Survival Post-COVID-19 in Uganda

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Debt Reorganisation: Business Survival Post-COVID-19 in Uganda

Debt Reorganisation: Business Survival Post-COVID-19 in Uganda

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April 3, 2020

Background

Since the first report of an outbreak of COVID-19 in the People’s Republic of China, the disease has spread across the globe, resulting in the declaration of a global pandemic by the World Health Organisation.

The extent and speed of the spread of COVID-19 has led to the imposition of both inland and cross-border travel restrictions including countrywide and citywide shutdowns in many countries. Business activity has been restricted to essential services while several businesses have been forced to either close or scale down production during this period. The fear of the implications COVID-19 has also caused stock market upheaval that has wiped out significant value from many companies.¹

At the time of writing this, the Government of the Republic of Uganda has confirmed 44 cases of COVID-19 in Uganda. With the nation yet to register its first death from this novel virus, the Government has imposed several measures to curb its spread, including closure of educational institutions, bans on public gatherings and restrictions on domestic and cross-border travel.

Financial Implications

COVID-19, though calamitous on its own, is also projected to induce a serious economic downturn through the disruption caused to the economy. The International Monetary Fund has recently announced that disruption caused by COVID-19 may precipitate a recession worse than the 2008 global financial crisis (also known as the “Credit Crunch”).²

Prior to the outbreak of COVID-19, the global financial situation was promising with various businesses expanding and investing more. A report by the Organisation for Economic Co-operation and Development on 2 March 2020 showed that the global economic situation was stabilising before the outbreak of COVID-19.³ This economic stability in turn encouraged business investment, which has been partly financed through borrowing. Bank of Uganda, in its State of the Economy report released in September 2019 indicated an increase in private sector credit due to the improved state of the economy.⁴

Unfortunately, the restrictions imposed in the race to curtail the spread of COVID-19 have resulted in the disruption of supply chains, production and sales, which in turn is expected to significantly affect the profits of businesses, potentially triggering a global recession.

Uganda may not escape this global march towards recession. The country is extremely reliant on imports, a significant chunk (about US$ 3.3 bn as at 2018⁵ ) of which comes from China. Factor in disruption to imports from the American continents, Europe, the Middle East and other Asian countries and the risk of contagion to our economy from economic failure in those countries becomes more pronounced. Domestically, the temporary closure of businesses, the expected slowdown in Foreign Direct Investment and reduction of tourist traffic will hit the economy hard.

A recession would make debt even more burdensome to businesses - creditor and debtor alike. In an economic downturn, two seemingly competing interests are bound to exist, that is, those of creditors and debtors. Creditors will need to recover their money and balance their books, while making a profit. Debtors, on the other hand, will need to sustain their day-to-day business activities while servicing their debts.

However, the interests of these two groups are not necessarily mutually exclusive. The profitability of creditors is reliant on them having businesses to lend to and in turn, businesses will always require access to capital.

In the face of this looming financial crisis, debt reorganisation provides an avenue for the reconciliation of these interests. Debt reorganisation is an arrangement under which a creditor and debtor agree to alter the terms of repayment of the debt.

Importance of debt reorganisation

Financial troubles should not always result in the insolvency or winding up of business operations, and the time has come for the business world to embrace business continuity for the mutual benefit of everyone involved. This type of thinking has resulted in the evolution of the debt recovery process over time that is aimed at the survival of the business.

Debt reorganisation provides an avenue for debt recovery on the part of the creditor while at the same time providing a route to business survival on the part of the debtor.

Bank of Uganda, in a statement released on the 20 March 2020 took cognisance of the potential harm of COVID-19 to businesses and signalled its support for measures to protect business from the economic fallout from both its spread and the measures meant to curtail its spread including:⁶

Putting in place measures to minimise the likelihood of sound businesses going insolvent due to lack of credit; and
Waiving restrictions on restructuring of credit facilities by financial institutions that may be at risk of going into distress

The statement of the Central Bank acknowledges the fact that both financial institutions and borrowers will be impacted by COVID-19.

To the debtor, reorganisation of its financial situation enables survival of the business during difficult economic times. For small close-knit businesses, the survival of the business is key to maintaining family-like relationships.

To the creditor, survival of the debtor enables the Creditor to recover its money while enabling the survival of a client with whom more business transactions (and more money) will be made. The primary business of institutional creditors is lending. The survival of businesses ensures that the Creditors have people to whom they can advance loans.

Allowing the Debtor to restructure its debt also buys the creditor significant goodwill as a future partner of the business.

Forms of debt reorganisation

Debt reorganisation may take the following forms:

Debt restructuring; or
Debt refinancing.

Debt restructuring

Debt restructuring is a process through which a business facing financial distress reduces and renegotiates its debt by agreement with its creditor(s) to allow it improve or restore liquidity so that it can continue its operations.

Debtors may restructure debt by entering into direct negotiations with creditors to reorganize the terms of their debt payments by either extending the period for repaying the loan, reducing interest thereupon or providing grace periods for the repayment of the loan(s).

Debt restructuring may take the form of Debt-for-Equity swaps, bondholder haircuts or informal debt agreements.

A Debt-for-Equity swap involves creditors agreeing to forego a certain amount of outstanding debt in exchange for equity in the company, and usually occurs where the debtor has a large base of assets and liabilities and forcing the debtor into bankruptcy or liquidation would create little value for the creditors.

A Debt-for Equity swap is also known as a debt conversion because the creditor converts some or all of its debt into a share in the business.

Bondholder haircuts, on the other hand, involve a debtor negotiating with its bondholders to offer repayment at a discount, and the debtor may achieve this by reducing or omitting any principal or interest payments due to the creditor.

The debtor may also reach out to his/her/its creditors and negotiate for more lenient repayment terms on the loan, or request that the creditor write a portion of the debt off altogether. This arrangement is called an “informal debt agreement” owing to the fact that this usually comes down to the bargaining power of the debtor and evidence of adherence to the payment terms in the past may go a long way in helping the debtor along in these negotiations.

The restructuring process loosens the ever-constricting noose of the debt burden on the debtor, and enables the company to manage its output and stabilise cash flows necessary to fulfil the loan obligations.

A borrower requiring more working capital to jump-start its business after the inevitable slump may seek a follow on facility from the same lender during the process of restructuring the existing debt. This will, in most cases, result in a win-win situation for both parties.

Debt refinancing

Debt refinancing involves the acquisition and deployment of a secondary debt with better and more favourable terms of repayment to the debtor, to pay off an already existing (primary) debt.
Under debt refinancing, the debtor has the option of paying off the existing debt by taking out a fresh loan(s) from either a single lender or several, depending on the circumstances of the case.

Where one lender is used, we refer to this process as debt consolidation.

The most common reasons for refinancing debt are:

To take advantage of better interest rate terms on the new debt;
To reduce the monthly repayment amount by entering into new debt with longer terms on repayment; and
To switch from a variable-rate debt to a fixed-rate debt or vice versa (commonly done in changing interest rate environments).

Variable rate debt consists of a loan whose interest rate changes depending on market forces. With fixed-rate-debt, the interest rate does not fluctuate with changes in the market. Creditors, especially commercial banks, may reserve the right to vary interest on a loan depending on market conditions. The creditor will use such a provision to raise interest rates during bad economic times. The effect of this on the business is that it now has to bear with difficult times while repaying more money to service the loan making it more burdensome. The debtor may therefore ask the creditor to fix the amount of interest payable in order to ensure certainty of how much is due.

While refinancing may be quite attractive to debtors, it may not be achievable in some instances, such as a situation where reorganisation is an event of default in the loan agreements.

An eye must also be kept on guarantee obligations during any loan reorganisation.

Conclusion

The scale and breadth of the disruption caused by the outbreak of COVID-19 is unprecedented in modern times. Its full impact is yet to be felt and cannot be fully estimated at this time.

In this regard, it is important for businesses to start formulating and implementing short and long-term survival strategies beforehand to ensure preparedness for the hard times that may lie ahead.

At Dentons, we remain committed in our resolve to help our clients, wherever they might be, to navigate through the great challenges raised by this pandemic.