Restructuring

Contributed by Sally Willcock

The UK Insolvency Service recently published draft legislation proposing what were presented as limited procedural changes to pre-packaged sales in UK administration proceedings under the Insolvency Act 1986. The measures are intended “to improve transparency and confidence in pre-packaged sales in administration’ and ‘to help ensure that… as much is fairly returned to creditors as possible.”  The proposals have, unusually, perhaps even uniquely, met with overwhelming opposition from UK insolvency and restructuring professionals and from many stakeholder groups.  The Insolvency Service is currently considering the recent response and reaction to its proposals, and the profession awaits further developments, hoping, but not necessarily expecting, a policy u-turn.  So what is all the fuss about?

Pre-packaged Administrations in the UK – the Context

By way of background, administration is the principal rescue procedure available under UK insolvency law.  For small and medium-sized companies with secured creditors, administration is in practice the only procedure that can be used to rescue companies in financial difficulties (whereas larger companies with significant secured debt increasingly use schemes of arrangement under the Companies Act 2006).  The UK administration procedure is broadly analogous to chapter 11 of the Bankruptcy Code.

Administration operates as a type of gateway process with the administrator required to put together proposals to creditors for their approval as to how the best outcome can be achieved.  The legislation contemplates that the company’s creditors will meet to vote on the administrator’s proposals within ten weeks of the start of the administration at a creditors’ meeting convened on 14 days’ notice.  The proposals are approved if they enjoy the support of a majority in value of those creditors who exercise their rights to vote at the creditors’ meeting either in person or by proxy.  The administrator then implements the proposals.

Where a business is in financial difficulty, often the best commercial outcome is achieved (for both creditors and the wider stakeholder community) by selling the business or part of it as a going concern.  In the context of administration, it will often be the case that the highest value can best be achieved through a pre-pack in which the terms of the sale are negotiated and agreed by the prospective administrator before the administrator’s formal appointment, with the deal being completed immediately following the appointment.  Unlike the Bankruptcy Code, UK law does not protect debtors from the effects of ipso facto clauses, and in the UK counterparties are free to exercise contractual termination rights triggered on insolvency.  Consequently, in many cases the initiation of any UK insolvency procedure is likely to result in significant erosion of goodwill, thereby reducing the value available for distribution to creditors.  Given this context, it is hardly surprising that about 40% of business sales in administration have been done on a pre-pack basis.  Clearly, however, wherever a pre-pack strategy is pursued, the business sale will necessarily be agreed before the creditor approval procedures contemplated in the legislation can be implemented. This mismatch between commercial exigencies and the legal framework is nothing new – as long ago as the 1990s the UK courts confirmed that the administrator has the power to agree to pre-pack sales if he or she considers such a strategy to be in the best interests of creditors.  The UK courts‘ approach is to look to the administrator to exercise his or her professional skill and judgment as to what is in the creditors’ interests, and the UK courts do not have (or want) a role in approving business sales.  If creditors consider that an administrator has acted improperly, they can pursue the administrator in a misconduct claim and/or report any misconduct to the administrator’s licensing body.

Criticism of pre-pack sales, however, has in recent years often made the headlines, including in the tabloid press, and the concern has largely focused on what are dubbed “phoenix sales,” i.e., sales of the business and assets back to the current management. Some of these sales have attracted criticism or suspicion that the deal done with management short-changes, and is at the expense of, unsecured creditors.

In January 2009, the various UK regulatory bodies that license administrators put in place a Statement of Insolvency Practice (“SIP 16”) which must be followed where a pre-packaged administration is undertaken.  Its primary purpose is to strengthen the information available to creditors, after the event, where a pre-packaged administration had been concluded.  SIP 16 was put in place because of concerns that had been voiced in some instances of pre-packs being open to abuse, particularly where businesses were sold to existing management.  One of the principal concerns was whether fair value was given for sales.  SIP 16 requires administrators to provide creditors with details about the marketing of the sale and the valuation of the business.

In March 2010, the UK government launched a consultation and call for evidence on improving the transparency of and confidence in pre-packs, having noted that SIP 16 was not always (albeit was increasingly) complied with.  This was followed by a ministerial announcement in March 2011 that new legal measures were to be introduced aimed at improving transparency and increasing confidence in pre-packs.

The New Pre-pack Proposals  – Notice Provisions Backfiring?

The draft legislation consists of three measures.  The first and third of the measures involve the administrator providing a written statement supporting the pre-pack procedure at the time of his or her appointment and a statutory requirement to provide information to creditors, broadly analogous with the SIP 16 requirements, after the sale has been concluded.  Except as to finer points of drafting, these measures have not met with significant opposition.

The real controversy arises as to the second of the proposed measures.  This requires that administrators give three days’ notice to all known creditors of the terms of any proposed sale where the administrator intends to sell a significant portion of the assets of a company to a “connected party” where there has been no recent open marketing of the assets.  The draft legislation then goes on to define “connected party” extremely widely as one who is connected with the company or an associate of a member or secured creditor of the company.  There are cross-references to existing complex sections dealing with these definitions in other contexts, the detail of which for present purposes is not material.  What is material is that the provisions would be likely to apply not just to sales to existing management, but also to private equity houses and lenders, where the assets have not been made available for sale in the open market in the three months immediately prior to the company entering administration.  Notified creditors are to be permitted rights to make representations about the pre-pack, but it is not clear to what purpose.

Although the notification requirement supports the ministerial policy of greater transparency in pre-packs, the overwhelming view of UK restructuring and insolvency professionals is that the measure is inconsistent with other specified government objectives of ensuring that creditors receive the best recoveries possible and that real benefits are provided to businesses.  In essence, the proposed legislation appears completely to miss the point as to where and how pre-packs can add value and appears to disregard or downplay administrators’ existing  statutory duties to act in the interests of all of the creditors.  A notice of an intended pre-pack is in practice likely in very many cases to trigger an immediate risk of loss in value with counterparties free to terminate valuable contracts and inviting employees, customers, suppliers and credit insurers to consider whether to continue their commercial relationships with the company.

The provisions also appear to open up an opportunity for creditors with no economic interest in the company to make nuisance objections or to try to adopt ransom positions as the price of not challenging a pre-pack.  The bottom line is that the proposals appear to promote the goal of transparency, but at the expense of creditors, as the proposals appear fundamentally to undermine the value of pre-packs, leading to fewer businesses being rescued.  Putting it another way, this could be described as the proverbial tabloid tail wagging the dog.

We will update blog readers as to further developments in this area as and when they are known.