Guide

Grey Swans: managing through multiple uncertainties

Gateley Legal

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Unlike a Black Swan event, a Grey Swan event may be extreme but predictable. How does a board of directors deal effectively with multiple extreme events?

What is a Black Swan event?

You have probably heard of the term ‘Black Swan’, most likely following the best-selling book by Nassim Nicholas Taleb.

A Black Swan event is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black Swan events are characterised by their extreme rarity, severe impact and the widespread conclusion that they were obvious with hindsight. The events leading to the dot com bubble bursting in 2001 and the global financial crisis in 2008 are examples.

What is a Grey Swan event?

By contrast, events such as the COVID-19 pandemic, the immediate impact of Brexit and the war in Ukraine were foreseen by commentators and experts and are therefore often referred to as Grey Swans rather than Black Swans. They raise a wide variety of issues, often with conflicting severity for stakeholders of a business.

This article focuses on the impact of Grey Swan events on businesses and the issues their directors might face. Most of these issues will ordinarily be faced by directors during a ‘business as usual’ period. The difference is that, depending on the type of shock, the severity and timing of these issues might be worse, and everything might occur all at once or more frequently than anticipated with a Grey Swan event. In these circumstances, business as usual will shift to a stressed position and might turn into a fully distressed situation.

In the UK, the challenges of COVID-19 and initial Brexit issues have been compounded by the war in the Ukraine and the energy crisis. Businesses are already dealing with the unwind of Government support, the repayment of Covid loans, the cost of living crisis, rising inflation and future anticipated interest rate rises. This is no doubt an incomplete Grey Swan list of macro-issues facing directors and the list of day-to-day matters is already resulting in overflowing in-boxes.

What issues will directors be facing from Grey Swans (and myriad other issues) and what should they be doing about it? We’ve highlighted below some thoughts on the key issues that will likely arise from Grey Swans.

Liquidity, funding needs and managing cash including potential creditor negotiations

As demonstrated by various previous Grey Swan events, the immediate concern for businesses is to ensure they have adequate liquidity to trade through any immediate shocks. A company may be technically balance sheet insolvent but this itself is unlikely to trigger immediate negative consequences for a business. Directors’ primary concern during Grey Swan events should be how much cash they hold, where that cash is, and how much they are entitled to hold if they have third-party funding in place. In certain circumstances the cash held in bank accounts may not be immediately accessible (for example, if a financial institution is sanctioned and can no longer operate in the UK, either on a bilateral basis or as part of a syndicate of lenders). In the worst case scenario, it may take a long time to recover assets if your lender is sanctioned or becomes insolvent.

Therefore, directors need to consider the various sources of funding available to the company and, depending on the cost to the business, ensure adequate amounts have been drawn down from lenders or made available to it from other capital providers, such as shareholders, asset-based lenders and invoice discounting facilities. When capital in the market is scarce, or in higher interest rate periods, the decision to have higher cash buffers is potentially prohibitively expensive to the business. This is a fine line to manage while in a Grey Swan event and will take a lot of skill and consideration on the part of directors.

Read our article on accessing funding and debt advisory here.

Directors should also ensure that their debtor book is regularly reviewed by the board and managed effectively by their finance team during a Grey Swan scenario. This will involve maintaining regular communication with their debtors, understanding the counterparty credit risk they are facing and ensuring they have robust debtor collection systems in place.

To read more about what to do in situations such as a customer not paying, click here.

The flip side to this is ensuring that the business itself has adequate breathing space from its creditors. It may be appropriate to re-negotiate terms with trade suppliers and to seek a loosening of terms from its main financial creditors.

Click here to read more about a breaching lender covenants.

In Grey Swan situations, the directors need to ensure they have a keener understanding of the contractual terms of supply contracts and third-party finance documents, as well as overarching legal limitations, within which they are required to operate. There may be contractual obligations that are only relevant during such periods and certain events may result in more onerous terms applying, such as an increased margin, prepayment obligations, increased cash buffers, increased information and access for creditors and potentially accelerated sales or triggering of call options or other pseudo-security enforcement.

Trading and supply chain

In addition to liquidity, this is the other immediate concern for a business following a Grey Swan event. Will demand for their goods or services dry up? Are counterparties at risk of collapse? Can the business source all the necessary supplies to produce their goods or supply their services? A number of external factors are clearly out of a directors’ control but ensuring some ongoing diligence of counterparties is advisable. The COVID-19 pandemic required businesses to stress test the strength of supply chains and, to the extent this was not undertaken previously, is clearly going to form a part of good business practice going forwards. Businesses are also considering alternative or secondary supply chains to diversify the risk of interruptions from Grey Swan events.

You can read about a retention of title clause in our guide here.

Restructuring including debt rescheduling or compromises and potential divestment of parts of your business or certain assets

Any restructuring proposals that arise as the result of Grey Swan events will be geared towards changing the liability profile facing the business. This will be achieved by reducing the overall debt burden or lengthening the period for repayment of such liabilities. It may involve a rescheduling of debt, some form of compromise being agreed with creditors or other steps such as the divestment of certain parts of the business or assets.

Click here to read about trading through financial difficulties.

Click here to read about organisational restructuring.

A solvent restructuring is delivered with the consent and participation of all relevant stakeholders. But this doesn’t necessarily mean that there are no changes to the corporate structure or to the debt and equity structure. A solvent restructuring within a Grey Swan event tends to involve creditors amending their debt terms to allow a company to keep meeting its liabilities on a basis which matches as closely as possible anticipated future cashflows.

This could be done by converting existing debt into other forms of indebtedness that are only payable if affordable (so payment in kind or PIK instruments) or into another form of instrument (for example subordinated loan notes, preference shares or ordinary equity).

You can read more about statutory creditor compromises in our guide here.

A restructuring implemented on an insolvent basis during a Grey Swan event means the outcome of the agreed restructuring will be delivered through an insolvency process. And the reason for doing this is to leave behind, in other words disenfranchise, certain creditors and potentially shareholders. There are various routes for achieving this with the predominant approach to date tending to be by way of a pre-packaged administration.

To read about statutory insolvency processes, click here.

Click here to understand more about pre-pack administrations.

So, the outcome of any restructuring or divestment programme should be a reduction of the immediate cashflow impact of such liabilities on the company. In other words, there should be a positive impact on the liability side of the balance sheet but also an improvement to cashflow and potentially profitability.

Acting in the best interest of creditors and personal liability

In the situation of a Grey Swan event where directors are concerned about ongoing solvency, as already mentioned, they will be advised to take note of their directors’ duties whilst continuing to trade and, in particular, to creditors. They will be advised to start thinking about whether their actions (or inaction) could be subsequently reviewed and challenged by an administrator or liquidator, or creditors themselves, in particular if the directors did not take all reasonable steps to minimise loss to creditors. This is primarily a defence to wrongful trading but important from a broader perspective too. These are real concerns for directors and if taking professional advice they will have been advised on personal risks associated with potentially worsening the position of creditors.

To read more about directors’ duties, read our guide here.

We also have a guide on personal liability for directors, which you can find here.

In conclusion, a number of Grey Swan events have occurred recently and UK businesses have to date, through their own measures and the wider support available, charted their way through difficult times. This in turn has allowed many directors to take steps to shore up balance sheets and reorganise their funding and operations. This will put companies in better shape to deal with any future Grey Swans but in the meantime they will need to deal with the many current headwinds.

Our Restructuring Advisory team has the required expertise and experience to assist you with any restructuring challenges you may face. Please contact us if you would like to discuss any aspect of this article or series.

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