Italian insolvency law keeps popping up on the political agenda. Following the collapse of dairy giant Parmalat, there was widespread recognition that a new legal framework was required for large-scale insolvencies. From 2003 through until the end of 2007 there have been four significant amendments to Italian insolvency laws. Happily, Parmalat is now in much better shape than before and many present this as proof that the reforms have been successful. However, as the credit crunch begins to bite it is becoming increasingly clear that the Italian distressed market still faces some difficult questions – and yet provides some clear opportunities.

Operational v functional

Restructuring Parmalat was not difficult: it had a good underlying operation overburdened by enormous indebtedness. The success of the so-called 'Parmalat law' depended on the fact that, for the first time, the 'debt/equity swap' arrangement was introduced in order to deal with the insolvency of a company. Parmalat creditors had a very liquid exit when the new Parmalat was listed. The company now relies on litigation to fund its operations and the restructuring has been successful.

However, the law for the restructuring of large enterprises may not prove so successful for a company with operational problems. For example, there is much speculation that legislation developed in response to Parmalat's collapse is not appropriate to deal with Alitalia's operational issues. The restructuring of a company with a weak business operation requires an industrial plan which cannot be implemented easily within the current legal framework. Further reforms may therefore be required to suit firms whose difficulties are more operational than financial.

Cultural issues

Further, the Italian economy is still largely based on 'family' companies. Essentially, Italian entrepreneurship lacks a corporate culture. Distressed investors might appreciate the directness of dealing with an owner-manager but the feeling is not always mutual: owner-managers are aware that by inviting a fund into the fold their influence will be reduced. Thus, if the company is not perceived as an asset for the stakeholders (and not only shareholders) there is no incentive, other than a sentimental one, for the founder to rescue it

This is not the end of the story, however. When a restructuring approaches, Italian banks gather into an exclusive club. Foreign investors are rarely invited, especially now that a period of consolidation has allowed the largest Italian banks to compete in terms of balance sheet capacity with the largest European institutions. The preferred exit strategy is recapitalisation of the debtor by an industrial buyer. If this is not feasible the Italian banks try to restructure the indebtedness among the original lenders. As a last resort, they might eventually consider the involvement of a foreign player.

Occasionally, situations arise where a certain degree of activism does become apparent – for instance, where a large target such as a private equity fund is involved. In such a scenario there is rarely a continuing family interest in the business; these are financial institutions and their interests are as international as private equity firms. The trading of the debt, however, is not pushed to the limit. This reduces the risk of a potential collapse of the debtor's capital structure; aggressive investors are not able to establish a dominant position whereby they could block a restructuring and thus dictate terms to other creditors – effectively holding them to ransom.

In certain cases even this is not possible. The market is familiar with the Italian fronting structure used by international lenders. If the lender is Italian it receives repayment of the loan net of withholding tax. The Italian fronting bank then sub-participates the loan to other banks. This participation is available for trading. However, the banks do not have direct recourse against the borrower, and can only exercise very limited influence on the management of the loan by the Italian fronting bank against the borrower. For fiscal purposes, should this direct influence be established, the Tax Authority could qualify the Italian lender as a 'conduit', alleging a direct relationship between the borrower and the banks. As a result, withholding tax should apply on interest paid by the borrower to Italian banks. Ultimately distressed traders tend to stay clear of Italian fronting structures since they do not give any leverage to the investor to renegotiate the capital structure of the Italian borrower.

Scope for change

There are indications that the landscape is changing. New funds are setting up in Italy, such as pure domestic hedge funds supported by a solid fundraising. Their partners are Italian executives with previous experience either in the UK or US. These funds are relatively small: none of them have more than A1bn (£792m) assets under management. Currently their main mission is to introduce opportunities to large financial institutions – hedge funds or distressed desks of investment banks, but also industrial players – and to invest alongside them.

More important is the broader impact of the credit crunch. Increased interest rates and new financial constraints have hemmed in many Italian companies. As a result, Italian banks may become less conservative in dealing with the crisis simply because they cannot be intimately involved with each ailing business. Italian funds may act as a gateway through which new players in the restructuring arena are introduced to local shareholders. The market will hopefully open up over coming months.

In the short term Italy will experience several restructurings as businesses seek to take advantage of the new legal framework. Some question-marks remain over the implementation of the new remedies provided by insolvency law reforms, particularly in relation to turnaround plans.

Turnaround plans

A turnaround plan is an agreement with creditors that seeks to restructure a company's liabilities, staving off insolvency. Under the previous insolvency law, a turnaround could only be achieved by means of an injection of equity by way of capital increase that could not be unravelled or 'clawed back' on a subsequent insolvency. Changes in the structure of the company's debt were not 'fenced off' from the risk of claw-back on a subsequent insolvency. It is now possible to achieve a turnaround by means of a debt transaction that is protected from later challenge, thus placing the lenders in a more comfortable position. In particular, the protection is applicable to acts and payments made by the debtor and securities given over the company's assets, provided these have been entered into pursuant to a turnaround plan on which an opinion as to 'reasonableness' has been given by an expert. For large limited liability companies (societa per azioni), such an expert is appointed by the court. However, save for such appointments, there is no further court involvement or approval required. There are no specific requirements as to the financial condition of the debtor; the debtor does not have to be insolvent to implement a turnaround plan. The plan can be kept confidential, although disclosure is required for listed companies. The plan is not filed at court or at the Register of Companies and it does not provide a moratorium on legal proceedings. The advantage of the turnaround plan is that its implementation (the payment made by the debtor or securities given on its assets) cannot be challenged on a subsequent insolvency.

Best practice is still being developed in relation to turnaround plans. There is a fear that improper use and consequent adverse rulings may have a negative impact on the restructuring market.

In parallel with the opening of the restructuring market, there is a need to encourage case law in judicial proceedings that integrates and supports the set of rules provided by the reform of the insolvency law.

The underlying theme of the reform is to protect the goodwill of a company in financial difficulty for the benefit of the creditors, who are better in a restructuring than in an insolvent liquidation. While litigation should be avoided, the flexibility provided for restructuring cannot be pushed further to the detriment of the majority by value of unsecured creditors.

The Italian distressed market is therefore becoming more attractive. However, the legislative framework will be tested over coming months. While uncertainty still exists, there is also cause for optimism.

Silvio Tersilla is a business restructuring and insolvency partner at Lovells in Milan.

ItalyJune2008