Fitch Warning on Next Default Cycle

Losses from the next leveraged finance default cycle may be significantly in excess of previous cycles, according to a report by Fitch Ratings.

The credit ratings agency (CRA) says this reflects weakening new-issue rating mix in bond and loan markets as leverage levels rise and covenants become increasingly lax in both the US and European markets.

“Knowledge of insolvency regimes will be critical to cross-border investors when determining recovery and pricing in relative creditor rights,” says Sharon Bonelli, Fitch’s managing director in US corporates.

The comparative study of insolvency regimes in the US, the UK, Germany, France and Luxembourg reflects strong high yield and leveraged loan issuance volumes out of these countries and they represent the mix of separate legal traditions attempting to keep pace with the complexities of global business operations and capital flows.

The report describes the traditionally different approaches between regions and puts them into the context of the development of capital markets. While the US system has historically put much more emphasis on a debtor in-possession framework with the goal to rescue and rehabilitate the distressed company, the European systems have the legacy of creditor-in-possession frameworks. Legacy European regimes assumed debtors and creditors exhausted all potential remedies and resulted in liquidation via sale of the company or its assets as the principal means of resolving creditor claims.

“In recent years, as European corporate finance has emphasised more diffused US-style capital market products and practices, insolvency laws have been amended to include mechanisms that aim to replicate the spirit of the US Chapter 11 framework, while the specifics continue to differ substantially,” says Karsten Frankfurth, senior director in the EuRope, the Middle East and Africa (EMEA) leveraged finance group.

Historically different approaches towards companies in distress have a profound impact on the structural developments of capital markets. Europe’s privately rated loan market, minimal covenant-lite loan issuance and structurally subordinated high yield bonds all reflect the influence of legacy creditor-in-possession frameworks in contrast to the US.

While there is a general trend towards more rehabilitative processes in Europe, substantial differences remain with regard to the application of established yet competing concepts like priority and prioritisation. Consequently, forum shopping, with the UK Scheme of Arrangement process the established pre-insolvency forum of choice, and ad hoc judicial activism highlight greater uncertainty in comparison with established US tenets. While reforms towards more accommodative and rehabilitative frameworks develop in Europe a major review of US bankruptcy practices is also underway.


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