Australian debt dilemma

An Australian court case could have a revolutionary effect on the local debt market, according to managing director for Standard & Poor's in Australia and New Zealand, Christopher Dalton.
International lenders and investors have always viewed Australia favourably in terms of the rights of creditors and shareholders. But this perception may change with a landmark 6-1 majority High Court decision handed down recently in relation to failed mining giant, Sons of Gwalia. The ruling sets a precedent for shareholders' claims, in certain circumstances, to be elevated to the status of ordinary creditors in a liquidation of a company, ranking them alongside unsecured financers.

In the view of Standard & Poor's, this decision diminishes the clarity between the rights of debt and equity holders in the winding up of a company and is a negative development for Australia's financial and capital markets, whose development has historically benefited from a relatively clear set of laws governing insolvency and the rights of the two main providers of capital - creditors and shareholders.

AustraliaÆs capital markets are among the world's most sophisticated and efficient. The liquidity, vibrancy and sophistication of the debt market reflect, among other things, a relatively clear distinction between the rights of creditors and shareholders in the liquidation of a company. Indeed, the rapid evolution of a world-class securitisation market has benefited from a creditor-friendly insolvency regime.

The majority decision in the Sons of Gwalia case sets a precedent for shareholders' claims, in certain circumstances, to be elevated to the status of ordinary creditors in a liquidation of a company, ranking them alongside unsecured financers.

This lessens the clarity of creditor and shareholder rights in the event of a company defaulting on its financial obligations. It also has the potential for financers and investors - particularly foreign - to be less confident about their rights to recover debt when lending to Australian companies.

As a result of the decision, lenders may be more reluctant to lend on an unsecured basis to speculative-grade companies, or they may charge a higher interest rate for the potential for delay or difficulty in recovering the debt in the event of insolvency.

Furthermore, under these "new rules", if shareholders in a failed company can prove loss and misrepresentation on the part of the company, the administration and liquidation of the failed company will take longer and cost more as all claims are assessed. Hence, there will be less for all to share from any recoveries realised, and most subordinated debt holders (if there are any) are going to rank behind everybody else.

It has already been said that debt markets are capable of looking after their own interests, and this is true - the debt markets can take action to protect lenders in a less creditor-friendly environment. One immediate response, however, could be that the cost of debt goes up.

Almost inevitably, deals will take longer to complete, due diligence will become more rigorous and assurances will be sought from company directors as to full and complete disclosure.

Indeed, covenants and undertakings in loan and bond documentation may well become more restrictive, and taking security over assets may even come back into vogue.

In short, the laissez-faire approach to lending that has facilitated the private equity boom may be curtailed. Hastily put together, covenant-lite transactions and cheap debt could be much harder to obtain.

Moreover, if US bond holders keep their promise, the offshore funding that has been secured for a number of these transactions may well be harder to attract or dry up completely.

At the more macro level, the Sons of Gwalia case is also significant for the impact on Australia's substantial need for financing from foreign lenders and investors.

While federal and state government indebtedness to foreign investors has declined over the past decade, indebtedness of the private sector has increased dramatically. It is important that the current level of international debt investor confidence be maintained to support Australia's need for foreign capital and the development of liquid and efficient capital markets.

Standard & Poor's supports the call by the Australian Bankers' Association and others for the federal government to carefully review the ramifications of the High Court case.

It is the view of Standard & Poor's that Australian capital markets will benefit from the clarification of the distinction between debt and equity investors through legislative changes to the laws governing insolvency.
¬ Haymarket Media Limited. All rights reserved.
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