THE DISTRESS DIARIES

Unravelling the Causes & Solutions to Corporate Distress 1st Edition April 2023

Insolvency Magazine

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...In the absence of weak financial performance, a management team can still pursue business turnaround in response to structural changes in their industry, e.g. due to technological advancements, regulatory changes allowing for importation of competing goods, changes in capital requirements resulting in lower barriers to entry. Identifying the need for business turnaround early, goes a long way in improving chances of a successful turnaround - a stitch in time saves nine!...

PREFACE

Kananu Mutea Partner, Head of Disputes & Risk Advisory Gikera & Vadgama Advocates Welcome to our magazine on insolvency, a collaboration between GVA and Kestrel Capital. As the economic landscape continues to evolve rapidly, business continuity has become a critical issue. It is a challenging and often stressful topic for many businesses. Financial difficulties, unexpected market shifts, or unforeseen crises can result in the need for companies to restructure their operations, seek insolvency protection, or even seek administration or liquidation. These situations can be difficult to navigate and require a deep understanding of the legal and financial landscape, as well as innovative and practical solutions. In this magazine, we have brought together a collection of articles offering insights and analysis on trends, strategies, and challenges in insolvency. Our contributors come from legal and financial backgrounds and include a team of GVA’s lawyers and Kestrel Capital’s financial advisors, and business consultants. The articles delve into topics such as the latest legislation and case law, restructuring options, creditor rights, debtor obligations and other issues

Francis Mwangi Executive Director Kestrel Capital East Africa arising before, during and after insolvency. We hope that this magazine will serve as a valuable resource for anyone looking to avert or manage insolvency By combining our legal and financial perspectives, GVA and Kestrel Capital aim to provide a unique and comprehensive approach to insolvency and turnarounds, to serve as an indispensable resource for anyone looking to understand the factors that lead to and militate against insolvency. We believe that our combined insights and expertise will provide readers with the most current and practical insights. We would like to express our gratitude to our principal contributors: Julie Mulindi, Nelson Otiende, Munyiva Mbevi and Lewis Kamau whose commitment, dedication and hard work have made this magazine possible. We also extend our thanks to our readers for their interest and support. We hope that you find this magazine informative and insightful, and we look forward to your feedback. Sincerely, Kananu Mutea and Francis Mwangi

EDITORIAL PAGE THE EDITORIAL TEAM

Kananu Mutea Partner, Head of Disputes & Risk Advisory Gikera & Vadgama Advocates

Francis Mwangi Executive Director Kestrel Capital East Africa

CONTRIBUTORS

Julie Mulindi Senior Associate, Disputes & Lead, Insolvency Practice Gikera & Vadgama Advocates

Nelson Otiende Associate, Disputes & Risk Advisory Gikera & Vadgama Advocates

Munyiva Mbevi Associate, Disputes & Risk Advisory Gikera & Vadgama Advocates

Lewis Kamau Associate, Corporate Commercial & Risk Advisory Gikera & Vadgama Advocates

CONTENTS

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NAVIGATING THE LABYRINTH A Guide to Kenyan Corporate Insolvency

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BUSINESS TURNAROUND Take Actions Early!

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WARNING SIGNS OF Financial Distress

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ADMINISTRATION Corporate Resucitation

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A VOICE FOR CREDITORS In Insolvency

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I’M SLIPPING, I’M FALLING, I’VE GOT TO GET UP: Helping The Debtor In Insolvency DEBT RESTRUCTURING Tough Decisions! UNPACKING THE MYSTERIES An Analysis of Administration of Companies in Kenya UNPACKING THE MYSTERIES PART 2 – The Place of Secured Creditors in Insolvency UNCOVERING THE REAL CULPRIT BEHIND CORPORATE DISTRESS: Company-Specific Factors or Operating Environment?

NAVIGATING THE LABYRINTH A Guide to Kenyan Corporate Insolvency

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ometimes companies face difficulties which threaten or cause their continuity and financial status to decline. When a company’s distress is poorly managed, it may become irredeemable grappling with management and financial challenges that may lead to crippling of the business, turnover of personnel, inability to meet financial obligations which result in demands, arbitration or litigation. If the distress of a company is severe, the company may elect to turnaround its affairs by addressing the factors giving rise to difficulty whether these relate to governance or financial planning. Where turnarounds are not implemented timeously, liquidation may be the only viable option that provides respite to the company allowing it to sell its assets, meet its financial obligations, in so far as practicable, and conclude its affairs. In Kenya, there have been highly publicized insolvencies which have been poorly managed, and these include: Uchumi Supermarkets Limited, Karuturi 6

Limited, Nakumatt Holdings Limited. There are many more and we shall share those with you covering lessons learnt and red flags in succeeding articles that we shall post. In this article, we discuss the avenues available to distressed companies. Some of these procedures can be used strategically to manage distress. It is for the directors and shareholders to consider their circumstances and elect, with good advice, the option most suitable to it.

Shareholders’ Voluntary Liquidation Not all companies involved in insolvency are insolvent! There are cases where a company is solvent, but the shareholders want to cease operations and pursue other interests, it may be that the company lacks a succession plan, or that there are other more lucrative opportunities you wish to explore. It may well be that the company has fulfilled the commercial objective for which it was set up. These circumstances allow directors to voluntarily Insolvency Magazine | First Edition | April 2023

liquidate the company by declaring solvency. It will need to demonstrate that it can meet or has met all its creditor obligations, including accrued interest, within a reasonable period. This process is private and relatively straightforward. Its directors will sign a declaration of solvency after which a general meeting of the shareholders is called to pass a resolution to voluntarily wind up the company. This is advertised and recorded by the Registrar of Companies.

Administration Administration provides the company reprieve, breathing space as it were, to adjust its affairs and manage creditor expectations. To facilitate this, an administrator is appointed with the mandate to: •

rescue the company as a running business

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improve the distress value to meet obligations

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realize the true value from the sale of assets and pay off creditors

Administration can be elected normally by the company/ directors, or forced by hostile creditors or contract by secured creditors. Like with all other options, time is of the essence to facilitate efficiently for the company 7

and creditors. To take on the reins, administrators must publicize their appointment to the creditors and the Registrar. They are expected to provide clear plans to facilitate the management of the company’s obligations with reporting to the Registrar and seeking consent from creditors, who may agree to take haircuts to avoid the consequences of liquidation. If there are impediments to the realization of the objectives of the administration, the administrator is expected to inform the Registrar and the creditors, with clear justification. The administration lapses after a year but can be extended by the Court to allow the administrators to meet their objectives and once those are met, the administration will end. If the objectives cannot be met, it may end with a court order on application by an administrator or a creditor. If this happens, notice should be provided to court and the Registrar. The company may then be dissolved or liquidated depending on availability of company assets. Once the administration procedure commences, a moratorium takes effect. As such, proceedings and execution against the company are stopped and creditors may only exercise their rights against Insolvency Magazine | First Edition | April 2023

the company with the consent of the court or administrator upon giving justifiable reasons. This protection allows company to regain its footing, however some wily directors may use the process to delay and obfuscate the payment of liabilities. For creditors, this process gives prospects, that can be evaluated, as to whether they will recover any of the debts. It allows for meaningful evaluation of the odds of recovery while giving the distressed company a lifeline. Administration is most ideal when a distressed company is in the early stages of corporate decline, it has a clear turnaround plan - which its secured creditors are likely to support.

Arrangement with Creditors The company can agree on terms with its creditors and submit a proposal to address claims for acceptance by court. Whatever proposal is presented, it must be approved by at least 75% in number and value of the debt held by each group of creditors at the creditors’ meeting. The proposal will be binding on all creditors and shareholders of the company. Like all other aspects that involve companies, any arrangements entered must be advertised and information sent to the court and Registrar of Companies who should be informed of progress in

the implementation of the arrangement. This process gives the company greater control than liquidation by court, the directors also cede decision making to the creditors who have greater say in company affairs such as credit control procedures, the corporate and debt management strategies to ensure they receive payment under the terms of the arrangement. Once the arrangement is satisfied the Registrar of Companies is notified to make the proper record at the registry. If the arrangement is revoked or suspended for any reason, the Registrar should be notified. If arrangements with creditors are entered into early, they result in satisfactory outcomes for both the company and the creditors. This, as with any contract, requires structure and good follow through to ensure satisfactory outcomes. As an arrangement relies heavily on the consensus of creditors, it is most ideal for small and medium sized distressed companies that have viable businesses, access to long term funding, few creditors and do not have significant tax obligations.

Liquidation by the Court This type of liquidation has publicity and is usually presented where companies cannot pay their debts. The threshold for this is approximately USD $1,000.

This type of liquidation has publicity and is usually presented where companies cannot pay their debts. The threshold for this is approximately USD $1,000. If a company owes that sum, and this is demanded of it, in the absence of a dispute, and it does not pay within 21 days of a demand, then a creditor can initiate proceedings against the company for liquidation.

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If a company owes that sum, and this is demanded of it, in the absence of a dispute, and it does not pay within 21 days of a demand, then a creditor can initiate proceedings against the company for liquidation. A company can also have liquidation proceedings initiated in this way: a. the company itself b. the company’s directors

For the company’s management team, this type of liquidation exposes them to reputational harm from which it can be hard to recover. The process calls into question the management of affairs preceding the liquidation that often unearths unsavory tales. Liquidation by court is seldom ideal but may be necessary for distressed companies that have deadlock in management, are in the final stages of corporate

c. a contributory or contributories d. an administrator This is the least desirable action because it has serious consequences on the company’s contracts most of which are likely to contain events of liquidation as “material breach”. The publicity from this process makes management of creditors difficult and the company can easily lose control of the process that becomes protracted, unpredictable, and expensive. Many creditors elect this as a last resort and primarily out of frustration by the company where there is no communication, inaccurate and unreliable statements on payment timelines. Some decide to pursue this option to have tax relief from the debts while others believe they can recover from the sale of the company’s assets. The process is skewed in favor of secured creditors with those who are unsecured facing considerable hurdles in realizing any percentage of what is due to them.

decline, or have been unsuccessful in administration or arrangements with creditors.

Conclusion Although the insolvency of a company may lead to an end of a business, there are situations where taking control of the process, deciding on the correct timing for turnaround strategies, administration or liquidation is an imperative. Timeous actions may allow the company reprieve and absolve directors of liability for wrongful or fraudulent dealings. If immediate corrective action is taken, directors may also avoid being in breach of event of default clauses, or entering into reviewable transactions that may be subsequently reversed by a liquidator/administrator or be liable under personal guarantees. A distressed company should therefore seek advice at the earliest opportunity as it will have more time and options.

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BUSINESS TURNAROUND Take Action Early!

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n the fast-paced business world, characterized by shorter business cycles, low barriers to entry, technological disruptions and shifting consumer demands, business should continuously renew themselves – adapt or die! However, the sobering reality, especially for mid-sized businesses with scarce financial & human resources, is that time is mostly spent putting out fires and chasing financial resources to meet immediate needs. There is not time and money left for continuous business renewal! Eventually, the absence of continuous business renewal manifests itself in the form of weak business outcomes which if not attend to in good time, accelerates to business distress – ultimately requiring notable resource reallocation towards averting business closure/insolvency. The action of focusing on business rejuvenation is referred to as business turnaround. Mostly, weak financial performance is the key trigger of business turnaround. More often, weak financial performance is the manifestation of other things in the business going wrong. In the absence of weak financial performance, a management team can still pursue business turnaround in response to structural changes in their industry, e.g. due to technological advancements, regulatory changes allowing for importation of competing goods, changes in capital requirements resulting in lower barriers to entry. Identifying the need for business turnaround early, goes a long way in improving chances of a successful turnaround - a stitch in time saves nine! The starting point is accepting that something is fundamentally wrong with the business – it is not a one quarter problem and this will improve next quarter. This requires a detailed analysis of the business’ key performance measures and objectively assessing the future outlook – at this stage honesty & objectivity are your best friends, and denial is your worst enemy! After accepting that there is a problem, the second step calls for identifying the root cause of the problem. Here the quality of analysis carried out on key business 10

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performance measures & future outlook matters the most. If business revenue underperformance has been identified as a key issue, management needs to discern whether this is caused by external factors e.g. - emergence of new cheaper or better-quality offerings, a shift in consumer needs; or internal factors e.g. - delays in deliveries to customers, weakened customer service following the exit of key personnel & lackluster product/service innovation. Once the root cause of the problem is clear, the next step calls for taking action to rectify the problem – this is where the rubber meets the road! As noted earlier business turnaround, depending on the stage of business decline, requires notable resource reallocation – management spending more time

identifying causes of business decline and coming up with appropriate solutions, re-organization of the business to make it more customer centric, replacing key personnel if personnel fit is identified as a key issue, accelerating the roll out of new products and services, pivoting to new market segments so as to service changing consumer needs/ tastes, re-branding the business/ products, closing certain business segments, exiting certain product/ service offerings, changing supply chain, renegotiating contracts (lenders, suppliers, employees) – the list is endless and it all feeds back to what triggered the need for business turnaround. Taking action calls for strong leadership from senior management/ business owners and continuous engagement with employees and

customers so as to ensure all parties are aligned and that they understand why business turnaround is necessary. It also mostly calls for engagement with experienced external financial and legal advisors whose main role is to offer un-biased and honest guidance and feedback. Business turnaround squarely fits into the adage – nothing is certain but the unforeseen! Majority of business turnarounds fail. To improve chances of delivering a successful turnaround, regular reviews of the turnaround progress – to identify key challenges & corrective actions, is a must. Upon delivery of a successful turnaround, a cultural shift to continuous business renewal is paramount. At the end of the day business turnaround is both hard and quite uncertain, keeping it at bay should be the cornerstone of every business! In collaboration, Kestrel Capital and GVA Law Firm are happy to walk with you on your business turnaround journey.

The starting point is accepting that something is fundamentally wrong with the business – it is not a one quarter problem and this will improve next quarter. This requires a detailed analysis of the business’ key performance measures and objectively assessing the future outlook – at this stage honesty & objectivity are your best friends, and denial is your worst enemy!

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WARNING SIGNS OF Financial Distress

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inancial distress often arises because of a business having inadequate operating cash flow that impedes its ability to meet obligations. The business is likely to experience loss, breach agreements (to suppliers and consequently trading partners), encounter difficulty with shareholders and regulator requirements on compliance. When business partners, suppliers, employees, regulators are concerned about the continuity of a business, they treat it with caution that limits the likelihood of revival. Despite this, an entity in distress can take remedial measures to return in to profit and growth, if it identifies the cause of distress early and addresses these timeously to avoid liquidation. Most entities face distress because of financial factors that include: Poor liquidity – this is usually because of having too many account receivables, reduction in revenue without a commensurate reduction in overhead.

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Athi River Mining (ARM) faced liquidation because of the foreign denominated debt spiraling its beyond asset base . Unsustainable dividend policies where owners take out profit •

Poor governance structures where co-mingling funds of the business funds with other unrelated interests is unchecked

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Poor debt to equity ratio – this can contribute to distress due to increased interest costs on debt

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Increased working capital requirements that do not have increase in working capital

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Continuous loss-making

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Opaque distinction between opex and capex where the operating funds are deployed towards capital expenses -this normally occurs when a company expands too fast

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These factors manifest in various ways including: •

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Reduced profitability that turns into losses – Kenya Power and Lighting Corporation had corporate governance concerns that impeded its profitability, with spiraling costs that are not matched by revenue leading to reduced profitability and then continuous losses Delayed payments to suppliers, staff, regulators – Uchumi, Nakumatt and Tusky’s poor corporate governance in these retail companies led to siphoning of supplier/stakeholder funds rather than prioritizing repayments to suppliers

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Reduction quality

in

product/service

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Forced sale of capital assets – where assets are sold to meet short term obligations. East Africa Portland Cement

Company (EAPCC) has been trying to sell its assets to meet short term obligations. There have been attempts to change the management, but the distress signs remain evident. ARM went through similar cycles trying to sell assets but was ultimately liquidated. •

Disrepair of infrastructure – Mumias Sugar is an example of this as it faced frequent closure to repair critical machinery before it was put under receivership.

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Staff attrition

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Debt re-financing – renegotiating terms with creditors to allow flexibility in payment plans, where the need for re-financing is internally driven rather than macro factors such as a pandemic like COVID. In the case of Kenya Airways

it attempted to refinance and ultimately issued shares, in a debt equity swap, to financial institutions to avoid collapse. •

Significant business contraction as focus shifts to cutting costs

What to do when you see the signs of Distress? As a business facing distress you should at the earliest opportunity seek professional advice from financial advisors and lawyers to address all factors that have led to distress and employ remedy at the earliest. As a business trading with another in distress as early as possible lower your exposure by seeking other trading partners, implement cash 13

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Financial stability, that is: the ability to honour financial obligations, is critical for the survival of any trading entity.

payment terms only with the distressed entity, collecting (if possible) on receivables, cease supply and agree on a repayment plan for receivables, weigh debt equity swaps if there is viability in a turnaround plan, collateralize the debt, where possible. Financial stability, that is: the ability to honour financial obligations, is critical for the survival of any trading entity. Companies experiencing financial distress are likely to end up in dissolution or liquidation unless they mitigate early. We shall, in collaboration with Kestrel Capital, be providing you with information on implementing business turnaround.

ADMINISTRATION: Corporate Resucitation In our previous article, we discussed business turn arounds and the need to ensure that business rescue measures are taken quickly once the signs of corporate distress are evident. In this piece, we look at how administration can be used to grant companies breathing space to reorganize financial affairs.

the need to restore financial viability to the business. A company will need to identify an insolvency expert to guide it in the rescue of the company and in the worst case, provide effective management of assets for creditors.

Administration, whether initiated in or out of court, is attractive because it has implicit protection for the company from its creditors during its continuance.

To initiate the process, there are 2 options (a) under court, requiring scrutiny of the application, or (b) out of court, which is much simpler requiring presentation of documentation to the Registrar of Companies and court.

The process to facilitate administration requires technical ability and teams that understand

The directors or creditors may approach court, with justification for the invocation of administration.

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Financial distress, with a clear strategy for the turnaround of the company forms credible basis to permit a company to go into administration. In the case of Nakumatt Holdings Limited, its first application for administration failed because its directors did not present a viable turnaround plan. If they had done so, the company may have received timely assistance and had an opportunity to avoid liquidation. If the company prefers the simpler, out of court process, administration may be initiated by either a director or a secured creditor by presentation of documents to the Registrar Insolvency Magazine | First Edition | April 2023

For administration to be successful, a company must take advantage of this mechanism early, manage relationships with creditors and co-operate with the administrator.

of Companies and court. This process allows the parties privacy to decide to alleviate financial distress, removes the risk of court delay, and grants an automatic moratorium on presentation of the documents. This avenue is more expedient than court administration, and it is advisable for companies seeking to enter administration to pursue this route. Deacons East Africa Limited took advantage of this process and reorganized its affairs, without the publicity associated with court process. When 15

a

company

enters

administration, its creditors cannot pursue legal action against it without a court order or the administrator’s approval. In this period, the creditors’ rights are suspended, meaning they cannot initiate or continue court action against the company, possess or sell the company’s assets, or evict the company from leased premises. The directors, creditors or court may appoint an administrator for a specific duration, with clear mandate to turnaround the company. The administrator is accountable to the court and

creditors, and any extensions to the duration of the appointment is dependent on the reporting made on the business rescue. The directors of the company cease control and are required to cooperate with the administrator providing information on the company and its operations. They are not permitted to perform any managerial functions unless the administrator consents to this. The directors may be removed or changed by an administrator to manage the affairs of the company. The administrator is required to table to creditors a recovery plan Insolvency Magazine | First Edition | April 2023

for consideration and this may be accepted, with or without modifications. If the recovery plan is approved, this grants time for implementation and in the unfortunate situation that this is not acceptable to the creditors the company will be at risk of liquidation. In Kenya, administration automatically ends after 12 months from the date it took effect unless the duration is extended by court. Many companies remain in administration for more than 12 months. For example, Nakumatt Holdings Limited has been in administration for almost 4 years. If the administrator believes that the objectives of administration cannot be achieved, he may make an application to liquidate the company, as was the case with Spencon Kenya Limited. If the company has no assets available for distribution, the administrator may apply for the company’s dissolution. For administration to be successful, a company must take advantage of this mechanism early, manage relationships with creditors and co-operate with the administrator. Should a company delay in placing itself under administration it risks incurring negative publicity, erosion of good will from creditors, and higher costs in liquidation,

A VOICE FOR CREDITORS In Insolvency In addition to the Insolvency Act, Kenya has credit rating systems, although nascent, they can be used to provide creditors information through Credit Reference Bureaus (CRBs). CRBs complement the central role played by financial institutions in extending financial services within an economy

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enya has put its insolvency legislation to the test in several cases where various companies, such as Sameer Africa, Mumias Sugar, Kenya Airways, Nakumatt, Karuturi, East Africa Cables, East Africa Portland Cement, Athi River Mining, and Britania Foods Limited, among others, have undergone the rigors of restructuring. When companies are in financial distress, there are competing interests between creditors and debtors. There is no doubt that the efficiency of any insolvency process depends on a good balance of power between creditors and debtors. Creditors provide access to finance, labor, and products. Their assessments on viability of the debtor’s business are critical to determining the likelihood of recovery or collapse. Undoubtedly, the expertise and knowledge of creditors is useful in extracting value from the debtor. An insolvency process that is predictable and offers creditor protection is essential for effective insolvency processes. Insolvency processes should address creditor concerns

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on determining and distribution of available, value among creditors. A system that maximizes the value of assets allows recovery by creditors, whether financial lenders, employees, or trade creditors. It also caters to the appetites of different creditors: secured, unsecured, sophisticated, unsophisticated, aggressive, and nonchalant. Good legal frameworks establish express provisions allowing specific rights and safeguards for creditors as a group or to the individual creditor protecting a specific interest. Kenya has this framework; however, its robust utilization is limited by the lack of awareness of the safeguards, and absence of dedicated judicial officers in the insolvency processes. These limitations drive innovative responses one of which is permitting considerable creditor participation in the insolvency process to compensate for the institutional inadequacies.

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easy or quick. The duration taken and repeated attempts of salvage for Uchumi, the complexities that plague the completion of the Nakumatt administration, the perennially changing positions of the secured creditor in Karuturi all show that the balancing of interests is delicate.

Judges in the Commercial & Tax Division of the High Court consider creditor representations, that often differ with those of the debtor or insolvency administrator as to whether the debtor should continue as a going concern or be liquidated. The attempt is usually to make fair and economically sound decisions. Understandably, this is not always easy to determine as sifting through conflicting claims is not

The legal framework established by the Insolvency Act protects the interests of lenders under the liquidation waterfall prioritizing by providing the right to initiate liquidation proceedings or reorganization of the debtor. There is no obligation on creditors to do so however, it is an offence, in some cases, for directors of the debtor not to initiate liquidation. Once the liquidation or reorganization plan is initiated, creditors retain voting rights on any recommendations made by a debtor or insolvency professional. This allows deliberate commercial engagement by the creditors

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in developing a plan to reorganize the business or maximize value, if liquidation is inevitable. The Kenyan Insolvency Act distinguishes creditor classes, allows them to vote separately, while allowing them all a voice in the process. Like other jurisdictions, priority is given to secured creditors. The creditors are free to determine the representatives in the process, the insolvency practitioner they would like to manage the process. They also have the freedom to change the representatives in the process. If the creditors determine that it is beneficial to sell any substantial assets of the debtor,they may do so to extract what they believe to be the best value from the debtor.

and object to decisions on creditor claims. All these safeguards apply even when the debtor is foreign because Kenya recognizes cross-border proceedings. In addition to the Insolvency Act, Kenya has credit rating systems, although nascent, they can be used to provide creditors information through Credit Reference Bureaus (CRBs). CRBs complement the central role played by financial institutions in extending financial services within an economy. The consolidation of insolvency laws is intended not only to provide for and regulate the liquidation process, but also to allow the debtor’s affairs to be managed for the benefit of its creditors.

It is reassuring to creditors that, at any time during the insolvency process, they can request information

I’M SLIPPING, I’M FALLING, I’VE GOT TO GET UP: Helping the Debtor In Insolvency

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nsolvency laws are an essential component for stability in a financial system. They are the foundation for orderly dissolution and reorganization of businesses facing financial distress. Insolvency laws facilitate efficient reallocation of capital locked in failed businesses. As discussed in the preceding article “A Voice for Creditors in Insolvency ”, there are distributional consequences in insolvency processes as it inherently demands balancing competing interests between creditors and debtors.

Some in East Africa will be aware of the plight that Karuturi Limited, a leading floriculture company, has faced since liquidation proceedings were initiated against it in 2014. There were different categories of creditors: secured and unsecured, pre and post receivership all of whom have had to make commercial decisions regarding the debt. Several unsecured creditors wrote off the debt and elected to watch the proceedings unfold from the sidelines as they were aware of the considerable security that was in place for institutional lenders. In the economic climate following

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the COVID-19 pandemic, many companies had to restructure to accommodate what became the “new normal”: altering business fundamentals, evaluating the debt ratios, liquidity ratios and sustainability of enterprises. Many companies exhibited distress that showed lapses in governance, financial planning, and business continuity plans. One of the fundamental aspects in managing corporate distress is ensuring prudent management of the debtor and working on early intervention to avert spiraling of the distress that results in collapse. There are some debtors who take

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steps early such as were the attempts by the retailer, Uchumi Supermarket. Although this company elected, in one of its attempts at revival, to enter into voluntary arrangement, other factors, already discussed in our piece “Warning Signs of Corporate Distress ”, militated against its recovery. Kenya’s Insolvency Act is “borrower-friendly” because it seeks to protect debtors and has mechanisms designed to allow restructuring before they are liquidated. If a debtor can demonstrate that it has taken steps to pay its debts or made reasonable proposals to pay the debt, creditors will have an uphill task in having such an insolvent. The provisions in the Act are “borrower-sensitive” to the extent that they make consensual restructuring through involvement of debtors and creditors attractive. This is achieved through provisions requiring cooling off periods once demands are issued to the debtor, it allows for reporting to court of steps taken and the demonstration of basis. Additionally, the recognition and encouragement of the use of insolvency practitioners allows the parties more independence in creating solutions that balance the need to recover the debt and to have business continuity. The Act has a distinct emphasis on providing the debtor a fighting chance as going concerns in the hope that the debtor will act prudently and take advantage of time to engage professionals to allow rescue through voluntary arrangements, or administration. These processes afford debtors time to realistically evaluate turn around options and make changes that may change its tides. Debtors may invoke a 30 day preinsolvency moratorium (that can be extended for an additional 30 days’ period). The pre-insolvency 19

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moratorium is an emergency ‘out-of-court’ mechanism intended to offer debtors breathing space to agree with creditors on informal restructurings or formal insolvency procedures. Debtors should take advantage of Kenya’s legal framework that allows them reprieve and accommodates reasonable proposals that facilitate rescue and revival of operations. In the case of Nakumatt Holdings, a retailer in East Africa, the courts extended as much latitude as they could to stave off evictions from commercial premises until this

was no longer tenable: a factor of balancing interests. In appropriate cases, debtors may seek to enter schemes of arrangement to pay back all, or part of the debt over a predetermined period. Many debtors find this to be a more realistic, cheaper, and flexible option compared to liquidation. The process can be private and due to the informality of the process, it gives greater latitude to creditors and debtors to devise solutions that allow the debtors’ directors to retain control. A lack of orderly and effective insolvency procedures can

exacerbate economic and financial crises and we recommend that debtors act early to manage the insolvency process. It is early engagement that will allow for exploration of options which may be limited if the distress is sustained and becomes unmanageable. If effective procedures are not employed early, creditors may press for liquidation which will invariably affect the debtor’s reputation, credit scoring, and continuity. Debtors’ rights may not be adequately protected in the absence of early engagement of insolvency reliefs.

A lack of orderly and effective insolvency procedures can exacerbate economic and financial crises and we recommend that debtors act early to manage the insolvency process. 20

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DEBT RESTRUCTURING Tough Decisions!

Quick fixes could be; (a) delaying payment to suppliers (they need to agree), (b) cutting expenses (e.g. advertising, training, business trips & senior management salaries), (c) selling non-core assets (e.g. company vehicles, land & machinery), (d) new equity or debt capital from existing shareholders, and (e) seeking the conversion of the short-term debt into long-term debt.

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ontinuing with our Insolvency Series, in this article we discuss debt restructuring - what is it, how to go about it and how to increase the chances of a successful restructuring. To date our Insolvency Series has addressed signs of financial distress, business turnaround process, how to navigate Kenya’s insolvency laws and how best debtors & creditors can safeguard their rights. Debt restructuring is a key, and in certain instances superior, option available to a company in financial distress – understanding the various aspects discussed in previous articles shapes the debt restructuring conversation. Debt restructuring entails negotiations between debtors 21

and creditors to reorganize the terms of existing debt obligations – the core pursuit being to make existing debt sustainable by either extending the repayment period and/or reducing the value of current obligations via partial principal forgiveness. Debt restructuring can be initiated by the company or, in some cases, be enforced by its creditors – no matter who commences the negotiations, in most cases, tough decisions have to be made. Debt restructuring is a subset of the wider company restructuring process. During company restructuring, the debtor pursues multiple initiatives to boost the company’s cashflow so as to be able to service existing debt obligations. Some of the common immediate Insolvency Magazine | First Edition | April 2023

USD 1,000 “...in outstanding none disputed claims, and after the lapse of 21 days of a demand notice, can initiate the court led insolvency process....”

initiatives include; cutting operating costs, calling up amounts owed to the company, disposing non- core company assets and new equity injection by existing shareholders. Which of the cashflow boosting initiatives works best? There is no single solution and in most instances a combination of the outlined initiatives have to be deployed. The company under financial distress needs to drive the process by tabling serious workable solutions. To begin with, the company needs to review its current financial circumstances, evaluate immediate liquidity constraints in servicing short-term debt. Quick fixes could be; (a) delaying payment to suppliers (they need to agree), (b) cutting expenses (e.g. advertising, training, business trips & senior management salaries), (c) selling non-core assets (e.g. company vehicles, land & machinery), (d) new equity or debt capital from existing shareholders, and (e) seeking the conversion of the short-term debt into long-term debt.

Once a workable solution has been developed for the short-term debt, the company needs to refocus on the long-term debt – this is unless the company is able to secure a significant equity injection (that will support servicing of the longterm debt as the company rollsout solutions to boost and sustain its cashflow) or a debt-to- equity conversion. Armed with current and future company performance forecasts, 22

the debtor must clearly demonstrate how the various cashflow boosting initiatives will improve the creditor’s chances of being paid back in full. Assumptions used in arriving at future cashflow need to be reasonable, incorporate higher interest expense – most creditors demand additional compensation for taking on the restructuring risk; not be solely dependent on creditors accommodating the debtor – the debtor must show willingness to share in some of

the pain; and not be significantly dependent on uncertain future events – e.g. sale of a unique assets or business unit, equity injection from a yet to be identified new investor & disproportionate growth in revenues from new customers or products. Given that any creditor with at least USD 1,000 in outstanding none disputed claims, and after the lapse of 21 days of a demand notice, can initiate the court led Insolvency Magazine | First Edition | April 2023

insolvency process, honest early negotiations with creditors improves the likelihood of a successful debt restructuring. Securing the buy-in from secured creditors, especially when the secured creditors hold title to assets whose market value is greater than the outstanding loan amount, is critical for the debt restructuring to succeed - this is because fully secured creditors have minimal incentive to take part in an uncertain restructuring process. Fully secured creditors also hold the key because they have to consent to the company raising new secured debt that ranks equal to the existing secured debt – raising unsecured debt, at a sustainable price, when a company is in distress is extremely difficult. 23

Bank creditors, who mostly are also secured creditors, require special attention because banking rules, in particular recognition of provisions against weak debtors, limit the extent to which banks are willing to take part in a restructuring. Bank creditors, unlike private investors, also tend to have rigid debt covenants that are difficult to loosen. Robust and enforceable insolvency laws nurture a pool of private investors willing to invest in distressed debt, further increasing the likelihood of positive debt restructuring outcomes. Such laws must be supported by timely resolution of debt related disputes – time is a key input when valuing distressed debt.

To be successful, debt restructuring requires a lot of objectivity from both debtors and creditors at a point when the future outlook of the company is uncertain. Debtors must cultivate the creditor’s objectivity by ensuring timely sharing of key aspects affecting the business, both financial and non-financial, and being quick to offer reasonable solutions when the going gets tough. Debtors should also continuously nurture strong relationships with existing creditors and potential future capital providers – having a good mix of capital providers, both banks & non-banks, adds to financial flexibility which comes in handy when things don’t go as planned, in business they mostly don’t! Insolvency Magazine | First Edition | April 2023

Until 2015 liquidation was the only avenue available in corporate insolvency.

...Most creditors and companies are familiar with liquidation its process and outcome, which is perceived to be straightforward, predictable, less costly, and faster compared to administration. This perception may be informed by high-profile administrations...

UNPACKING THE MYSTERIES An Analysis of Administration of Companies in Kenya The Insolvency Act of 2015 transformed the legal insolvency regime in Kenya by providing a legal framework, that could help ailing companies recover and maintain themselves as going concerns through administration.In our previous article, we discussed how administration can be used as a lifeline for troubled companies to turn their fortunes around where it is probable. In this piece, we analyze administration in Kenya as a corporate rescue mechanism. The statistics from the Official Receiver show that at the peak of the pandemic and in early 2022, when most insolvent companies could have benefited from corporate rescue mechanisms, there were 91 liquidations, 22 administrations, and no company voluntary arrangements. These numbers show that more companies are being shut down because less than 24% of creditors and companies are exploring corporate rescue options. 24

The poor uptake of administration, coupled with the underlying attitudes held towards debt, also frustrates the administration of companies. Our Kenyan courts have observed that the country espouses a culture of liquidation, where creditors are ready to punish distressed companies for their indebtedness by shutting them down even if corporate rescue is possible. This might be partly because, until 2015, liquidation was the only avenue

available in corporate insolvency. Most creditors and companies are familiar with liquidation its process and outcome, which is perceived to be straightforward, predictable, less costly, and faster compared to administration. This perception may be informed by high-profile administrations such as Spencon and Nakumatt Limited, which suggest that administration on average takes 3 years, but it conveniently ignores long drawnout liquidations of other high-profile companies such as Karuturi Limited, which took 9 years, or Nzaa Kuu Cement Limited, which took almost 30 years, where creditors had no limited or no favourable outcomes. Kenya’s Victorian attitude towards debt is slowly shifting with the number of companies entering administration increasing each year. If empowered with the right advice and presented with viable options, distressed companies will take advantage of administration early enough to mitigate financial distress. Insolvency Magazine | First Edition | April 2023

In our previous articles, we have emphasized that the timing of placing a company under administration can have a significant impact on its success. If a company is placed under administration too late, it may be too far gone to be saved, as the financial difficulties may become too severe to overcome, as in the case of Nakumatt Limited. There is also a progressive increase in out-of-court administrations. Court administrations, like any other insolvency litigation, have shown that publicity associated with such litigation negatively impacts the recovery process and wastes efforts of an administrator, who would otherwise be pursuing a turnaround strategy. The sustainability of Deacons EA Limited as a going concern highlights the benefits of out-of-court administration, where distressed companies have better control, and can preserve relationships with creditors and other stakeholders in the administration process.

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The management of debt levels by companies exploring administration has also presented difficulty in formulating an implementable recovery plan, particularly where distressed companies are overleveraged with a substantial amount or all of their strategic and critical assets secured to financial institutions. The result is that when such companies are placed under administration, the financial institutions quickly sell the company’s assets to avoid bad debts or suffer writedowns associated with administration, leaving behind a shell that has no realistic chance of turning around, as was the case with Re- Hi Plast Limited and Tusker Mattresses Limited. With improved awareness and understanding of administration, early engagement of insolvency expertise, and a shift of attitudes; we expect that administration and its benefits will continue to steadily gain popularity in Kenya.

Insolvency Magazine | First Edition | April 2023

UNPACKING THE MYSTERIES PART 2: The Place of Secured Creditors in Insolvency

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ollowing our last article which analyzed administration of companies in Kenya, we received a couple of questions from our readers on the place of secured creditors in insolvency. In this piece, we address their questions on the privileged position of secured creditors in insolvency.

Who is a secured creditor? A secured creditor, usually a financial institution, is one that has collateral over the assets of a company. In insolvency, a secured creditor has the right to be paid before any other creditors out of the proceeds of its collateral, to receive interest, fees, costs, and charges against the collateral, and to receive adequate protection for any decrease in the value of their interest in the collateral resulting from any use, sale, or lease.

Why do secured creditors hold a privileged position in insolvency? Without legal recognition of a secured creditor’s right to seize and sell the assets put up as collateral by the company, it is doubtful that financial institutions would finance the activities of companies. This is because

To facilitate business, the insolvency regime recognizes, protects, and ranks the rights of a secured creditor above unsecured creditors.

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in insolvency they are likely to be the most exposed creditors, if their rights over the collateral are ignored.

It is important to note that this right will not extend to assets that have not been put up as collateral.

To facilitate business, the insolvency regime recognizes, protects, and ranks the rights of a secured creditor above unsecured creditors.

The secured creditor’s right to seize and sell the collateral cannot be impaired by administration if there is a separate legal regime that regulates the processes of executing these rights. In Kenya, a secured creditor will therefore be permitted to enforce its security under the Land Act, or the Movable Securities Property Act, or the Hire Purchase Act irrespective of the administration.

Will a secured creditor be entitled to seize and sell the company’s assets put up as collateral in an administration? Yes, the courts have held that secured creditors in an administration will have the right to take enforcement action against the collateral securing the debt.

Noting the supremacy of the rights

Insolvency Magazine | First Edition | April 2023

of secured creditors, distressed companies intending to enter administration must engage their secured creditors early and obtain their support in the process. This can only be achieved by providing clear and realistic turnaround plans. Excluding and isolating a secured creditor, particularly one that holds substantial and critical assets, in an administration can be disastrous to a distressed company.

A secured creditor’s right to enforce security will only be limited by the courts if the secured creditor fails to comply with mandatory statutory provisions of the relevant legislation that confers the priority of its rights.

What recourse does a distressed company have against a secured creditor in insolvency?

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Insolvency Magazine | First Edition | April 2023

UNCOVERING THE REAL CULPRIT BEHIND CORPORATE DISTRESS: Company-Specific Factors Or Operating Environment? It is all not rosy, however – 49% of the distressed companies are facing petitions for liquidation, which paints a grim picture when it comes to possible turnaround.

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or our 10th Insolvency Series installment, we take stock of where we are with respect to the state of private businesses in Kenya.

We assess the state by reviewing recent business trends. Armed with an appreciation of the trend and going by publicly disclosed names of companies in distress, we offer our high-level view on whether the current state sets the stage for better or worse business outcomes. Our view will be guided by key factors; new company registration trends stacked up against the number of companies in distress (based on various applications under the Insolvency Act), and whether common broad factors are to blame for companies of different sizes and

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Insolvency Magazine | First Edition | April 2023

in various industries falling into distress. Owing to the absence of data, our review runs from 2017 to 2022. We aim to build on this in future. Notwithstanding, a tough operating environment in 2021 and 2022, triggered by far-reaching COVID restrictions, the number of new private company registrations remained above the preCOVID average. Shifting to the number of companies facing corporate distress, these being companies that entered into a formal publicly disclosed process, the number peaked in 2019 at 85 before tapering off to 75 and 78 in 2021 and 2022 respectively. In our view, the low number of distressed companies relative to new registrations signals the absence of significant economic-wide or policy-gap factors limiting private company performance – extreme factors would accelerate corporate distress and delay new investments. It is all not rosy, however – 49% of the distressed companies are facing petitions for liquidation, which paints a grim picture when it comes to possible turnaround. Our third level of review entailed gaining an appreciation of the nature (industry & size) of distressed companies by reviewing public literature. Our review revealed a wide distribution across multiple industries, the most

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Insolvency Magazine | First Edition | April 2023

“...between 2012 and 2021 nonperforming loans in the banking industry increased from KES 62bn (4.7% of gross loans) to KES 460bn (14.7% of gross loans)...”

500 400 300

14.7%

200 4.7%

100 0

2012

2021

common being (retail, manufacturing, banking, insurance, real estate, hospitality, and agriculture). A review of commercial banks’ data showed companies having higher non-performing loans (signal of increased probability of distress) compared to loans issued to individuals. In addition, among companies, non-performing loans were higher amongst small and mid-sized (SME) companies as compared to large companies – for some banks, the rate of SME non-performing loans has nearly doubled over the last 5 years. Guided by the above analysis our findings are detailed below; a. Despite COVID-related challenges and a stagnant economy, the business environment has remained compelling enough to attract new investments, both local and foreign. There are, however, evident weaknesses in the current operating environment

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that need to be resolved to sustain continued new investments - between 2012 and 2021 nonperforming loans in the banking industry increased from KES 62bn (4.7% of gross loans) to KES 460bn (14.7% of gross loans). b. While the operating environment has weighed more on certain sectors, e.g. hospitality owing to COVID restrictions, other less affected sectors have reported increased levels of distress primarily due to company-specific deficiencies. c. There have been two recurring company-specific deficiencies fueling distress; poor corporate governance (evidenced by poor business practices, short-term business planning, and misuse of company resources) and excessive debt levels (impairing debt repayment ability following slow-down in business or delayed completion of expansion projects).

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CHARTING A NEW PATH An Insightful Guide to Insolvency & Restructuring

GVALAWFIRM 56 Muthithi Road, Westlands, Nairobi Office Line: +254714919112 [email protected] Kestrel Capital (East Africa) Ltd. Orbit Place, 1st Floor, Westlands Road Phone: +254 (0)20 225 175

[email protected]