Financial Distress: An Action Plan for Corporate Restructurings in Mexico
This chapter addresses specifically the Mexican context of financial distress. While in many respects, there may be some similarities to the context of insolvency phenomena in other Latin American jurisdictions, this chapter addresses how to best formulate an action plan for insolvency in Mexico only. Insolvency is an economic phenomenon with economic, social and legal consequences. When a debtor is unable to pay its debts as they become due, the legal system provides for a mechanism to address the collective satisfaction of the claims from the assets of the debtor.
When a debtor experiences emerging problems, most of the solutions rely upon the debtor’s management-led corrective actions. When management is unable to resolve emerging problems, these could evolve into acute and worsening problems. At this stage, the debtor will try to reach an out-of-court workout plan with creditors. Since a private workout will only be effective upon consenting creditors, court assistance is sometimes necessary to achieve a successful reorganisation or make broadly effective an otherwise private workout plan.
In Mexico, if a debtor and its creditors are unable to reach an out-of-court agreement, or such agreement is not supported by creditors representing a sufficient amount of claims so as to make it economically viable, the debtor may unilaterally file for voluntary insolvency, or, jointly with a majority of creditors, file for pre-pack insolvency proceedings. A debtor may also be pushed by creditors for involuntary insolvency.
The Mexican Insolvency Law regulates bankruptcy in Mexico and provides for a single insolvency proceeding, encompassing two successive stages. The first is the reorganisation stage. The second is the liquidation stage. Prior to a debtor being declared bankrupt, the process includes a preliminary visit stage to verify whether the commencement standards have been met.
The stated purpose of the reorganisation stage is to conserve or save the business enterprise through a restructuring agreement. The reorganisation stage is designed to be completed within 185 calendar days; however, a 90-day extension may be granted if the conciliator or creditors representing more than half of all recognised claims request it, and an additional 90-day extension may be granted if the debtor and creditors representing at least 75 per cent of all recognised claims request it. The Insolvency Law clearly provides that in no event may the reorganisation stage be extended beyond 365 days. After this time, if there is no restructuring agreement, the liquidation stage immediately begins.
A debtor will be declared in liquidation if it does not successfully complete a restructuring agreement during the reorganisation stage. Insolvency proceedings may also initiate at the liquidation stage if the debtor so requests upon its voluntary petition or thereafter, or if a demanding creditor petitions the court to go straight into liquidation and this petition is unopposed by the debtor.
The stated purpose of the liquidation stage is to liquidate the business, as a whole or by sale of productive units or its individual assets, to repay recognised claims pursuant to the statutory priority of payments.
In summary, a debtor in Mexico that encounters financial distress should not only be prepared to deal with this situation, but also with the consequences of eventually being subject (voluntarily or involuntarily) to insolvency proceedings. To that end, the debtor must:
- avoid situations that could result in liability;
- actively manage its workout process; and
- identify when to file for voluntary insolvency proceedings, and be prepared to file.
Sources of liability
The debtor must be aware of any actions that could result in liability from a Mexican legal perspective and, therefore, should be avoided. This section discusses general sources of liability for directors and officers (D&O), liability arising from defective accounting, liability resulting from preferential transactions and liability arising from the failure to pay taxes.
General sources of liability
D&O are liable under applicable Mexican insolvency laws for certain detrimental actions taken from the moment the debtor is found in general cessation of payment. Unfortunately, the legal framework is modelled based on the liability regime applicable to publicly traded companies, which results in certain punishable actions that make sense from a securities market perspective, but are completely unrelated to any solvency issues of the debtor. Actions that result in liability include:
- voting at directors’ meetings or making decisions with respect to a debtor’s assets with a conflict of interest;
- knowingly favouring a shareholder or group of shareholders to the detriment of all other shareholders;
- as a result of their position as D&O, obtaining an undue economic benefit for themselves or a third party, including a shareholder or group of shareholders;
- generating, disclosing, publishing, providing or ordering information while knowing that this information is false;
- ordering or causing the omission of recording a debtor’s transactions;
- altering or ordering the alteration of accounts to hide the true nature of a debtor’s transactions;
- ordering or accepting the registration of false data in a debtor’s accounting;
- destroying, modifying or ordering the destruction or modification of accounting systems or entries;
- altering or ordering the alteration of accounts or contractual terms; and
- registering or ordering the registration of inexistent expenses or exaggerating real ones.
D&O are shielded from liability arising from good-faith decisions taken in compliance with statutory requirements; based on information provided by debtor’s officers, external auditors or expert opinion; having selected the most adequate course of action or the damage to the debtor could not have been foreseen; or having obeyed a licit shareholders’ meeting mandate.
A debtor must pay special attention to the quality of its accounting.
The Insolvency Law provides for certain criminal activities and their sanctions in connection with an insolvency procedure. The criminal actions generally imply bad faith on the part of the debtor, including carrying out deliberate actions to cause or aggravate its cessation of payments and the destruction, alteration or hiding of books and records.
This liability includes carrying out its books and records is such a manner that does not allow knowing its true financial condition. This means that a debtor with defective accounting may be exposed to criminal liability. Criminal liability extends to D&O of a debtor.
A debtor must refrain from entering into certain transaction that will be thereafter set aside in the case of insolvency proceedings. Entering into these preferential transactions is also another source of D&O liability.
Some types of transactions carried out prior to the bankruptcy declaration can be set aside. Pre-commencement transactions are set aside if carried out within the retroactive period, which is the period that begins 270 days before the bankruptcy declaration. This period is doubled with respect to related-party transactions. The judge may extend such period to an earlier date upon the request of the conciliator, the conservators or any creditor up to a maximum of three years.
Preferential transactions can be grouped as per se fraudulent transactions, cases of constructive fraud, objective preferences and subjective preferences.
Per se fraudulent transactions
Transactions entered into before the bankruptcy declaration, in which the debtor knowingly defrauds creditors, are set aside if the transaction is gratuitous or, not being gratuitous, the third party shares the fraudulent intent.
Cases of constructive fraud
The following transactions carried out during the retroactive period shall be set aside. These transactions are conclusively presumed to be fraudulent:
- gratuitous transactions;
- transactions under which the debtor pays consideration of a substantially higher value, or receives consideration of a substantially lower value, than that of its counterparty;
- transactions in which conditions or terms significantly differ from then prevailing market conditions or from trade usage or practices;
- any debt remission made by the debtor;
- any payment of unmatured obligations; and
- the discount of a debtor’s payables by the same debtor.
The following transactions shall be set aside if carried out in bad faith during the retroactive period (bad faith is rebuttably presumed):
- granting of collateral or additional collateral if not originally contemplated in the transaction documents; and
- payments-in-kind if such method of payment was not originally agreed to in the transaction documents.
Transactions carried out between the debtor and its related parties during the retroactive period shall be set aside if made in bad faith. Bad faith is rebuttably presumed.
Payment of taxes
The debtor shall continue making payment of taxes and other contributions (such as social security contributions), especially if those taxes payable result from withholdings to third parties.
Failing to file tax returns for more than 12 months or failing to pay taxes withheld from third parties is a criminal offence.
Out-of-court restructuring is aimed at securing contractual agreements, both between creditors themselves and between the creditors and the debtor, for the restructuring of the debtor. In Mexico, this type of restructuring is governed by scattered substantive and procedural rules, but mostly by non-binding internationally recognised principles of conduct and professional practice in the field. There are no binding rules as to how the process is conducted or what the final product will look like, so most private workouts are carried out in an ad hoc fashion.
The coordinated approach of creditors needs to overcome the inherent differences in the creditors’ attitudes and interests, and in the nature of their claims. Not all creditors will have the same level of interest in the restructuring. For example, secured creditors may have a preference for liquidation, while unsecured creditors may prefer the continuation of the business as a going concern; some creditors with a big exposure may be willing to devote more resources to the workout process, while others may consider it not worthwhile owing to the relatively small size of their claims. To complicate things further, a workout process presents a typical case of the prisoner’s dilemma: creditors are better off if all creditors cooperate, but each creditor is better off being uncooperative.
Coordination between different creditors and different constituencies of creditors reduces the risk of asset dilapidation caused, for example, by early-moving creditors attaching assets; and the cost and time to achieve restructure, for example, by pooling advisers, sharing costs and reducing the emergence of miscommunication issues.
Participating creditors are expected to refrain from enforcing their claims during the negotiation period. This is achieved by entering into a standstill agreement. Standstill agreements may provide for undertakings by each creditor refraining from pursuing individual action against the debtor or its assets, challenging other participating creditors’ claims and taking any action to improve the relative position of a creditor to the detriment of other participating creditors. They also include similar undertakings from the debtor, and other terms such as a sharing of information and lock-up covenants.
Some of the shortcomings of standstill agreements are that the validity and enforceability in Mexico of undertakings by creditors refraining from exercising procedural rights is questionable, and specific performance may be unavailable. The exchange of information raises another legal issue: Mexico does not have a rule preventing shared information from being used as evidence in a court of law, and confidentiality agreements may not be strong enough to prevent disclosure of such shared information as evidence in a judicial process.
The rescheduling agreement
The end-product of a private workout is a rescheduling agreement. In broad terms, a rescheduling agreement may be implemented in two forms: by providing a new money facility in the rescheduled terms, to be used to repay the old debt (the refinancing approach); or by changing the terms of the debt to conform to the rescheduled terms (the restructuring approach). Each of these approaches has its advantages and disadvantages from a legal perspective, as is discussed hereafter.
Under the refinancing approach, new money could get ‘trapped’ en route to payment to creditors. Another creditor may be able to attach the money-in-transit, or the debtor may be violating a covenant with a non-participating creditor by incurring additional indebtedness or using proceeds in a manner inconsistent with a prior agreement.
Under the restructuring approach, there is no exchange of money; therefore, the risk of money being trapped or a covenant being violated is mitigated.
Validity of original claim
Under the refinancing approach, the risk that the validity of the original claim will be questioned is not eliminated but is, at least, mitigated. However, the invalidity of the old claims would not, in itself, affect the validity of the new claim.
Under the restructuring approach, the original claim is still susceptible to challenge on the grounds of validity, and its invalidity would impact the validity of the new claim.
This issue of the validity of the original claim is especially relevant in the case of novel or complex obligations for which there are little or no precedents, such as those arising under exotic derivative transactions or structured off-balance transactions.
Survival of security interest
Under the refinancing approach, existing secured claims would be discharged and new security interests would have to be set up for the new facility secured claims. This means that creditors under the new facility risk losing the time preference they may have had by perfecting their security interests at an earlier time. A provision of Mexican law stipulates that, under certain conditions, a creditor whose loan proceeds are used to repay a debt will, by operation of law, be subrogated in the right of the primitive creditor. The author knows of no precedent concerning this provision of law, so the risk of losing the time preference of a security interest under the refinancing approach could still exist.
The restructuring approach could pose a similar risk of losing the time priority of a security interest. This depends on whether the rescheduling agreement in essence constitutes a new obligation (i.e., it legally qualifies as a novation), in which case the creditor runs the risk of losing the time preference of its security interest, or simply a change in some of the original terms not implying a substantive change in the essence of the obligation, in which case an argument can be made in favour of the survival of the primitive security interest and its time preference. Each case requires an individual analysis to determine whether it escapes qualifying as a novation and its consequences on security interests.
Under the refinancing approach, care should be taken that the primitive obligation is due and payable before making a repayment, since prepayment could thereafter be set aside if the debtor is subsequently declared bankrupt.
Under either of the two approaches, care should be taken that the rescheduling agreement does not result in the imposition of additional guarantees or in conditions that differ from current market conditions.
Regardless of the approach taken, it is worth mentioning that the rescheduling agreement will be binding only upon participating creditors; that is, non-participating creditors’ claims will not be subject to its terms. Since a private workout will not be binding upon all creditors, court assistance is sometimes necessary to achieve a successful reorganisation or make broadly effective an otherwise private workout plan.
A debtor requiring new money to continue operating during the standstill period raises the question of how the new money provider will be recognised in priority over pre-existing creditors. One of the risks that suppliers of new money face is that, in the case of failure of the private workout and placement of the debtor insolvent, the privilege may be set aside. Furthermore, particular (i.e., not general) subordination agreements may only be enforceable among creditors (that is, not vis-à-vis a receiver in case of liquidation), so the new money provider will have to bear the additional risk of creditor insolvency.
Holders of publicly traded debt securities are generally represented through indenture trustees. The indenture trustee has broad authority to exercise all actions and rights on behalf of the debt holders, carry out all corresponding conservatory actions, and enter into documents and agreements with the debtor on behalf of the security holders.
The level of authority of the indenture trustee raises two important issues. The first issue is whether the indenture trustee has sufficient authority to enter into a standstill agreement in a private workout. An argument can be made that the standstill agreement constitutes a conservatory act (lack of cooperation in the private workout could frustrate attempts to reorganise) and, therefore, within its scope of authority; however, there are compelling arguments to the contrary (the indenture trustee must seek repayment and has no duty with the other creditors). Since there is no specific authority to enter into a standstill agreement and carry out interim actions, in practice, indenture trustees will call a meeting of security holders to resolve whether to enter into standstill agreements. This practice causes delays and multiplies the opportunities for miscommunication and opposition to the reorganisation process. Some security holders choose to allow their custodians to represent them in the holders’ meetings, which mitigates (but does not eliminate) the problem.
The second issue is whether the indenture trustee will be able to accept a rescheduling agreement or a reorganisation plan on behalf of security holders. A statutory provision requires the approval of the holders’ meeting to consent to extensions or carry out ‘any other amendment’ to the debt instrument. The expression ‘any other amendment’ is considered to include a change in the covenants in general but it is not clear whether it includes a change in the financial conditions (e.g., a reduction of principal or ‘haircut’), in which case it shall be a decision of the individual holders and not the subject matter of a holders’ meeting. Consenting to extensions or carrying out ‘any other amendment’ to the securities is considered a major event and requires a qualified majority (holders representing a 75 per cent interest) for the meeting to be validly convened. This quorum requisite is relaxed in the second or subsequent call, in which a meeting will be legally convened with the presence of any number of security holders. The note or the indenture may impose higher majorities.
The issue is further complicated if the rescheduling agreement or the reorganisation plan requires creditors to accept haircuts or otherwise change the financial conditions of the debt instrument (e.g., converting principal to a different unit of account or reducing the rate of interest), or to convert the original debt instrument into another type of debt or equity instrument. In these cases, agreement from the ultimate security holder of record (not the indenture trustee or even the custodian) may be required. Depending on the level of dispersity of the debt instrument in question, the practical hurdle of seeking the consent of each ultimate holder of record can delay or even frustrate the process.
Often, a rescheduling agreement is implemented through an exchange offer. An exchange offer also poses registration costs and delays, and participation is individually voluntary. Some additional obstacles imposed by Mexican securities laws prevent broad acceptance of the exchange offer. For example, consideration has to be the same for all participants (staggered pricing to incentivise early tender or acceptance is theoretically allowed, but the author is not aware of any case where it has ever been used), and exit-consent mechanisms are not a permitted means for changing the terms of holdouts unless carried out in the context of a security holders’ meeting. For these reasons, the existence of publicly traded debt securities often makes court assistance necessary to achieve a successful reorganisation.
A reorganisation plan would be enforced on public debt holders without the need to carry out an exchange or similar registered offer.
Dealing with employees
This is a delicate matter. Employees may cooperate or frustrate any restructuring attempts. In Mexico, employees cannot legally waive accrued and unpaid salaries or benefits, and bankruptcy has little, if any, impact on labour and employment obligations. Dealing with prospective obligations is also tricky: the laws concerning labour allow very limited leeway on rescheduling labour conditions. These tools include carrying out administrative procedures to amend economic conditions, temporarily suspending or definitively terminating labour relationships:
- To amend economic conditions, the debtor or employer must carry out administrative procedures with the labour courts, evidencing that there are economic circumstances that justify the amendment.
- To temporarily suspend labour relationships, the debtor or employer must carry out administrative procedures with the labour courts, evidencing either that there is excess production, the notorious infeasibility to continue exploiting the business or the absence of required funding to continue with the ordinary course of business.
- To definitively terminate labour relationships, the debtor or employer must carry out administrative procedures with the labour courts, evidencing the notorious infeasibility to continue exploiting the business.
Voluntary and involuntary insolvency proceedings
When to file
While there is no definitive consensus on the issue and each case must be analysed on its merits, filing for insolvency in Mexico on the outset may not be optimal since it imposes costs, is riddled with uncertainties and taxes the daily operations of the business.
There are, however, situations under which a debtor would be better served by filing for voluntary insolvency, for example, to suspend payments of pre-petition debts, to stay execution proceedings or lift garnishments or seizures of assets, reject onerous contracts, or obtain other injunctive relief from the courts. The debtor, jointly with a majority of creditors, may also file for a pre-pack insolvency so as to make broadly applicable an otherwise unfeasible reorganisation plan.
Suspension of payment
The suspension-of-payments benefit is one of the most powerful tools for preserving the bankruptcy estate, as it legally suspends the enforcement of pre-commencement claims and allows for an orderly reorganisation of the debtor’s affairs. The judgment declaring the debtor insolvent shall include an order to the debtor to suspend the payment of its pre-commencement indebtedness, except for essential expenses for the ordinary course of business, labour-related payments and tax claims.
Stay of execution
Like the suspension of payments benefit, the stay of execution is also a very powerful tool to preserve the bankruptcy estate. Once a judgment that declares the debtor bankrupt is entered, attachment and foreclosure on assets are stayed during the reorganisation stage, with the sole exception of cases involving privileged labour-related claims. The stay will apply to any and all attachment and foreclosure processes concerning the debtor’s assets.
The benefits of the stay of execution are not absolute: secured creditor may begin or continue foreclosing on assets that, in the opinion of the judge and the conciliator, are not essential for the ordinary course of debtor’s business.
As a general principle, the declaration of insolvency does not affect the provisions of an executory contract, unless the conciliator rejects it on grounds that rejection is in the best interest of the estate. This is a tool that allows the debtor to cause the termination of an onerous contract, which may be unavailable outside of insolvency proceedings.
The Insolvency Law does not provide for automatic relief upon the filing of a petition. The debtor and other third parties may request that the judge issue temporary measures to preserve the assets of the debtor pending a determination of whether the debtor is eligible to be declared bankrupt. These measures may include the prohibition to make payments; the stay of enforcement proceedings; the enjoining of the debtor from disposing of or encumbering assets, or transferring funds or valuables; and the seizure of property. In practice, the measures will vary in nature and will attend to the factual circumstances surrounding the debtor’s operations and its needs.
Prepack insolvency proceedings
If the debtor has reached agreement with creditors representing a majority of its outstanding debt, but not with a sufficient number so as to emerge from financial difficulties, the debtor may file for prepackaged insolvency proceedings.
The debtor may file for prepackaged insolvency proceedings if the petition is signed by the debtor and creditors representing a majority of its outstanding debt, and if the petition is accompanied by a proposed plan, also signed by the debtor and creditors representing a majority of its outstanding debt.
Prepackaged insolvency proceedings avoid the visit stage and allow the debtor to request that the judge implement injunctive relief upon accepting the petition. If a debtor files for prepackaged insolvency, it will not need to establish that it is insolvent (but will need to declare that its insolvency is imminent) and there is no need for the appointment of a visitor.
The conciliator must use the plan submitted with the petition as the actual reorganisation plan proposed to all creditors.
Voluntary insolvency petition
The Insolvency Law establishes precise rules that determine when a debtor has ceased, in general, paying its debts as they become due. These commencement standards are (1) the failure of a debtor to comply with its payment obligations in respect of two or more creditors, and (2) the existence of the following two conditions: 35 per cent or more of the debtor’s outstanding liabilities are 30 days past due; and the debtor has insufficient current assets (cash, demand deposits, 90-day time deposits, accounts receivable maturing no later than 90 days and marketable securities realisable within 30 days) to cover at least 80 per cent of its obligations that are due and payable. A debtor may commence insolvency proceedings if it meets any of the cases described in (1) or (2) above, or if it declares under oath that it will inevitably fall in any of them within the next 90 days.
The insolvency petition must be furnished with the following information:
- the debtor’s name;
- the debtor’s domicile; corporate domicile; address of offices and establishments, including plants and warehouses; and indication of the location of the principal place of its management;
- a description of the causes that led to its general cessation of payments;
- the debtor’s audited financial statements for the past three fiscal years;
- a list of the debtor’s debtors and creditors, indicating names and domiciles, stated maturity dates of claims, the ranking of claims, main characteristics of the claims, and a description of collateral;
- an inventory of all of the debtor’s assets;
- a list of litigation in which the debtor is involved;
- the debtor’s offer to post collateral for the payment of the visitor’s fees;
- the corporate resolutions required to file for insolvency;
- a preliminary proposal of restructuring plan; and
- a preliminary proposal of a conservation plan for the business.
Additionally, the debtor will also be entitled to petition the court to issue temporary measures. The nature and extent of these measures will vary depending on the circumstances.
While not an essential component of the petition, the debtor may want to consider petitioning the court to appoint a specific person as foreign representative in case the debtor subsequently needs to carry out recognition proceedings outside of Mexico. A foreign representative is a person or body, including one appointed on an interim basis, authorised in a foreign proceeding to administer the reorganisation or the liquidation of the debtor’s assets or affairs or to act as a representative of the foreign proceeding.
Automatic restraining order
The bankruptcy judgment will result in an automatic restraining order (arraigo) issued against the debtor or its D&O so that they may not leave the place of their respective domiciles without appointing, by means of a power of attorney, an agent with sufficient instructions and financial means to meet expenses. The debtor and its D&O should be prepared to grant these powers of attorney to lift any such restraining orders.
When finding itself in financial distress, a debtor must avoid any action, or remedy any deficiency, that could result in additional liability for itself or for its D&O. It must be prepared to identify the strategic reason to file for insolvency and to avoid liability if a creditor files for involuntary insolvency proceedings. A debtor and its D&O will be well served by repairing any deficiency in its accounting, continuing to pay taxes (especially those resulting from withholding obligations) and having appointed an agent with the required qualifications to avoid or lift the arraigo restraining order.
The following is a list of recommended actions the debtor should take (dos), as well as those it should avoid (don’ts).
- remedy any accounting deficiency;
- continue paying tax and other contributions (such as social security contributions), especially if those taxes payable result from withholdings to third parties;
- prepare to file for insolvency proceedings when the need arises and, to that effect, produce:
- a description of the causes that led to the general cessation of payments;
- audited financial statements for the past three fiscal years;
- a list of debtors and creditors, indicating names and domiciles, stated maturity dates of claims, the ranking of claims, main characteristics of the claims and a description of collateral;
- an inventory of assets;
- a list of litigation in which the debtor is involved;
- the corporate resolutions required to file for insolvency;
- a preliminary proposal of a restructuring plan;
- a preliminary proposal of a conservation plan for the business;
- a list of temporary measures; and
- powers of attorney in favour of an agent with sufficient instructions and financial means to meet expenses, to lift the arraigo restraining order; and
- prepare to take decisions in connection with out-of-court restructuring, interim financing, securities market issues (if applicable) and employment matters.
- take actions resulting in generic liability, such as those mentioned under ‘Sources of liability: General sources of liability’;
- make preferential transactions, such as:
- entering into any transaction knowingly defrauding creditors;
- entering into any gratuitous transaction;
- entering into transactions under which the debtor pays consideration of a substantially higher value, or receives consideration of a substantially lower value, than that of its counterparty;
- entering into transactions in which conditions or terms significantly differ from then prevailing market conditions or from trade usage or practices;
- making any debt remission;
- paying unmatured obligations;
- discounting its own payables;
- granting collateral or additional collateral if not originally contemplated in the transaction documents;
- making payments-in-kind; and
- carrying out transactions with related parties.
 Eugenio Sepúlveda is a partner at Galicia Abogados.