Mezzanine lenders are finding themselves pushed out of U.K. restructuring proceedings with no value for their loans. This trend could chill U.K. mezzanine lending long after the credit markets thaw.

Before the downturn, a U.K. company in financial difficulties often could agree on an informal restructuring with its lenders. As lenders recognize now that they may lose much of their debt, formal processes have become more common in the U.K. The prepackaged administration and the scheme of arrangement have been the most controversial, with lower-ranking creditors wiped out and excluded from participation if the value of the senior debt exceeds the value of the company. U.K. courts have shown little sympathy to the increasingly unhappy mezzanine lenders, with the recent decision in the IMO Car Wash Group Ltd. case dealing them a further blow.

In a U.K. administration, an administrator (a court-appointed insolvency practitioner) takes charge to rescue the company. If rescue is not reasonably achievable, the administrator may liquidate the company for the benefit of the creditors. In a prepack, the administrator arranges a sale with the directors and, typically, the most senior creditors. The sale can be to a company controlled by the senior lenders, leaving liabilities in the existing company. A prepack is thus attractive to creditors whose interests are above water, but very undesirable for junior creditors.

Prepack proponents argue that the relative speed of the process results in less value destruction than alternatives, but critics contend the value may not be fully exploited in a "done deal." Also, administrators do not have to obtain the approval of the courts or the other creditors. A prepack is arguably a "phoenix" -- an ostensibly new company with the same assets and management as its predecessor -- which is prohibited under English law.

An English court recently held that an intended prepack sale should be in the best interests of the creditors as a whole. In cases arising from the collapse of Lehman Brothers Holdings Inc., however, courts were reluctant to interfere, suggesting that the English courts will continue to defer to administrator decisions in prepacks.

A scheme of arrangement is another method to "cram down" minority creditors. A scheme of arrangement in an insolvency context is a compromise between a company and its creditors (or any class of them) to avoid liquidation. If approved by a majority in number who represent at least three-quarters in value of any class of creditors who vote at the meeting to approve the scheme, the scheme binds all of the parties. The company's assets can then be transferred into a new company.

The company determines who will be a party to a scheme, which must include all creditors whose rights will be altered. A company may exclude creditors if their rights are left untouched or they lack an economic interest in the company. Moreover, the company may group holders of different securities with similar rights together as a single class. Lenders are concerned that class determinations may be manipulated. "Stretched" senior tranches with thin mezzanine tranches exacerbate this concern. If mezzanine lenders are lumped together with senior lenders and the senior tranche is, by value, 3 times the mezzanine tranche, the mezzanine lenders can be dragged along by the senior lenders.

Court decisions have underlined mezzanine lenders' weak position in restructurings. The courts have reaffirmed that when a company's value is less than the outstanding senior debt, the junior creditors can be excluded from a scheme because they lack an "economic interest."

The recent decision in IMO Car Wash addressed whether subordinated lenders have an economic interest in a company with competing valuations. The judge accepted the senior lenders' lower valuation, finding that the mezzanine lenders' higher valuation was based on an analysis of possible outcomes rather than a true estimate. He held that the mezzanine lenders had no economic interest and no right to object.

With more companies pushed close to insolvency, England's insolvency procedures have come under scrutiny. Private equity sponsors and investors should be aware that developments in restructuring may affect not only existing investments, but the structure of English financing for years to come.

Katherine Ashton is a partner and Katherine Baker an associate of Debevoise & Plimpton LLP in London. A version of this piece appeared in the Debevoise & Plimpton Private Equity Report.