The legal basis IN THE CURRENT ECONOMIC CLIMATE IT WOULD The - - PDF document

March 2009 The In-House Lawyer 79

INSOLVENCY AND CORPORATE RESTRUCTURING Jones Day

IN THE CURRENT ECONOMIC CLIMATE IT WOULD appear that almost every week another company is placed into administration and its business and assets are immediately sold, sometimes back to the former management, owners or other persons connected with the insolvent company. The process by which an insolvent company is placed into administration and then its business and assets immediately sold is commonly referred to as a ‘pre-pack’. Recent pre-packs widely reported in the press include tea and cofg ee chain Whittard of Chelsea, menswear retailer The Offj cers Club and the restaurants Tom’s Kitchen and Tom Aitken. The use of pre-packs is increasingly common. However, opinion is divided as to the use and desirability of this process. This article considers the legal basis for pre-packs and reasons why the process is subject to criticism and mistrust. LEGAL BASIS FOR PRE-PACKS The Insolvency Act 1986, as amended by the Enterprise Act 2002, (the 1986 Act) provides that the administrator of a company must perform their functions with the objective of: a) rescuing the company as a going concern; b) achieving a better result for the company’s creditors as a whole than would be likely if the company were wound up (without fi rst being in administration); or c) realising property in order to make a distribution to one or more secured or preferential creditors (paragraph 3(1) of Schedule B1 to the 1986 Act). The administrator must perform their functions with a view to achieving objective a), unless they think either that it is not reasonably practical to achieve that objective, or that objective b) would achieve a better result for the company’s creditors as a whole (paragraph 3(2) of Schedule B1 to the 1986 Act). The administrator may perform their functions with the objective specifi ed in c) only if they think that it is not reasonably practical to achieve either

• bjective a) or b) and they do not unnecessarily

harm the interests of the creditors of the company as a whole (paragraph 3(4) of Schedule B1 to the 1986 Act). In all other circumstances, the administrator must also perform their functions in the interests of the company’s creditors as a whole. As soon as is reasonably practical after the company enters administration, and in any event within ten weeks of their appointment, the administrator must, save as otherwise provided in the 1986 Act, call an initial meeting of the company’s creditors. In advance of the initial meeting, the administrator must send to all known creditors of the company a report setting out the administrator’s proposals for the management of the company. If the administrator’s proposals are approved at the initial creditors’ meeting, the administrator must manage the business and afg airs of the company in accordance with the approved proposals. If the administrator’s proposals are rejected, the administrator must apply to court for directions. A review of the 1986 Act would not appear to provide for or contemplate the pre-pack procedure. Instead, the legal basis for pre-packs is set out in case law. The most recent case involving pre-packs is DKLL Solicitors v Her Majesty’s Revenue and Customs [2007]. DKLL SOLICITORS v HM REVENUE AND CUSTOMS DKLL Solicitors involved the insolvency of a limited liability partnership, which are subject to the 1986 Act in substantially the same way as a limited

• company. The insolvent fi

rm had liabilities of approximately £2.4m, of which £1.7m was owed to HM Revenue & Customs (HMRC). HMRC presented a winding-up petition against the fi

• rm. However, before the petition was

heard, an application was issued at court for

The legal basis and future role

• f ‘pre-pack’

administrations

‘Creditors may feel particularly aggrieved that the management is permitted to buy the business at a heavily discounted price.’

Kay Morley , associate, Jones Day E-mail: kmorley@jonesday.com

>

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its administration. Upon their appointment, the proposed joint administrators of the fi rm intended to sell the business and assets of the fi rm to two

• f its partners for a total sale consideration of

£400,000. HMRC seemed to accept that, following the decision in Re T & D Industries plc [2000], an administrator had the power to complete a sale

• f the business and assets of a company without

the sanction of a creditors’ meeting or a direction

• f the court. However, HMRC objected to the

administration application on the basis that the sale consideration to be paid for the business and assets

• f the fi

rm was too low. HMRC argued that as the majority creditor it would be entitled to oppose the administrators’ proposals at the initial creditors’ meeting. Accordingly, it was argued that the court ought not to make an order for administration in circumstances where it was known that the majority creditor was opposed to the proposed sale, and would, in efg ect, be disenfranchised by a pre-pack sale without any creditors’ meeting taking place. The judge made the administration order in respect

• f the fi

rm and the pre-pack proposed by the administrators was allowed to proceed. In reaching its decision, the court placed considerable weight

• n the fact that the administrators provided to the

court a detailed and considered analysis as to why administration would achieve a better result for the fi rm’s creditors as a whole than would be likely if the fi rm were wound up (without fi rst being in administration). On the facts of the case, if the administration

• rder was not made and the fi

rm was subsequently placed into liquidation, the Solicitors Regulation Authority would intervene and the break-up value of the fi rm was estimated to be considerably less than the proposed going-concern value. By comparison, while HMRC argued that the proposed sale consideration was in its view too low, it provided no further evidence as to the alternative market value for the business. In circumstances where a creditor is in a position to provide a robust alternative going-concern value to the court, the court may be more inclined to consider any such

• bjections when exercising its discretion.

The court stated in DKLL Solicitors that a majority creditor did not have the right of veto on implementation of the administrators’ proposal and that the court could exercise its discretion to authorise the implementation of such proposals if there was a real prospect that the statutory purposes of administration would be achieved. It was also noted by the court that in exercising its discretion it could take into account the interests

• f other stakeholders. The judge was particularly

infl uenced by the fact that the proposed sale would safeguard the jobs of 50 employees. If the fi rm was not placed into administration, it was most likely that these employees would be made redundant. While the decision in DKLL Solicitors will give some comfort to insolvency practitioners, in circumstances where the commercial justifi cations for a pre-pack are less convincing it cannot be assumed that pre-packs are beyond challenge. CRITICISMS OF PRE-PACKS The main criticisms levelled at pre-packs are the apparent lack of transparency and the fact that creditors are denied the opportunity to vote on the administrator’s proposals for the management

• f the company. Concerns have also been raised

with regard to the perceived objectivity of an administrator where they have in the fi rst instance been engaged by the company to advise it on its insolvency options. On the face of it, how can creditors be confi dent that the administrator has achieved the best possible price for the assets of the company when there has been no prolonged period of marketing for the business and assets of the insolvent company? Suspicions are particularly raised in circumstances where the business and assets of the insolvent company have been pre-packed to its existing

• management. In this situation, creditors may feel

particularly aggrieved that the management, who they usually consider to be responsible for the debts of the insolvent company, is permitted to buy the business and assets of the company at a heavily discounted price and then continue trading through the same business without interruption or recrimination, while the company’s creditors are left with an unsecured claim against an insolvent shell. Although the 1986 Act provides creditors with an opportunity to vote on the administrator’s proposals, in circumstances where there has been a pre-pack, creditors are efg ectively presented with a fait accompli . In this situation, if a creditor is of the view that the administrator has acted in a way that has caused it unfair harm, the creditor may bring an application against the administrator pursuant to paragraph 74 of Schedule B1 to the 1986 Act, or paragraph 75 in the case of misfeasance. It should be noted at this point that an administrator is unable to sell fi xed-charge assets free of security without the prior consent to the relevant

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INSOLVENCY AND CORPORATE RESTRUCTURING Jones Day

security holder or the permission of the court. In practice, therefore, while pre-packs do not give the company’s unsecured creditors an opportunity to vote on the administrator’s proposals, the prior consent of secured creditors, who are also usually the largest creditors of the company, is almost always obtained. It is therefore not accurate to suggest that in seeking to achieve the statutory purposes of administration, the administrator can simply ignore the views of the company’s creditors. ROLE OF THE ADMINISTRATOR As discussed above, the objectives with which the administrator must exercise their powers are clearly set out in the 1986 Act. However, whether these

• bjectives are achieved will depend on a number
• f factors that are often outside the control of the

administrator. The potential outcome for creditors of an insolvent company will often depend on how long it takes the directors to acknowledge that the company has reached the ‘zone’ of insolvency and then seek the appropriate professional advice. Past the point of no return In circumstances where a company has not appreciated the extent of its fi nancial diffj culties before it is too late, the administrator will have limited options available to them. Assuming that there is no money available to fund a trading administration, a pre-pack is often the only means by which any value in the insolvent business can be achieved and the jobs of its employees saved. Once a company is placed into administration, the value of the company’s goodwill is likely to deteriorate rapidly. As news of the company’s insolvency circulates, contracts will be terminated, customers will seek alternative suppliers and debtors may seek to withhold payments. In most cases, it will therefore be of vital importance to the administrator that they fi nd a purchaser for the business and assets of the company as soon as

• possible. The longer it takes for the administrator to

fi nd a purchaser, the more likely it is that a potential purchaser will seek for force the sale consideration down and dictate terms accordingly. Another key issue for the administrator is

• employees. Following their appointment, the

administrator has 14 days to decide if they will retain some or all of the company’s employees. After 14 days, in respect of those employees who have not been made redundant, the administrator is required to pay their respective wages as an expense of the administration and in priority to the administrator’s own fees. If the company has insuffj cient funds to enable it to trade in administration, the administrator may have no

• ption but to dismiss all employees if a purchaser

has not been found within this 14-day period. In the nick of time In the alternative, a company that recognises the precarious state of its fi nances at an earlier stage and engages insolvency professionals to assist is more likely to either achieve a restructuring of its business outside of a formal insolvency process or to rescue the company as a going concern. If these objectives can not be achieved, the administrator should at least be in a position to achieve a better result for the company’s creditors as a whole. The benefi t of time usually gives the proposed administrator a better opportunity to test the market and seek a suitable buyer for the business and assets of the company. However, even in these circumstances the administrator must tread carefully and discreetly. While the administrator will want to advertise the sale of the company or its business and assets, if third parties become aware that the company is in fi nancial diffj culty, this could in itself result in a rapid deterioration in the value of the company’s goodwill and potentially force the company into administration at an earlier stage. For instance, if credit insurance is suddenly withdrawn, the company may fi nd itself unable to purchase vital goods and materials to enable its business to continue trading. A savvy investor who becomes aware that a company is in fi nancial diffj culty will also wait as long as possible to make an ofg er in the knowledge that, in the absence of alternative bidders, the potential sale price for the business will decrease as its cash evaporates and a formal insolvency process becomes inevitable. Accordingly, in exercising their functions with a view to achieving the statutory objectives in administration, the administrator has the diffj cult task of trying to achieve the best return for the company’s creditors while delicately balancing the commercial reality of the situation in which the company fi nds itself. FUTURE OF PRE-PACKS The prevailing credit crunch means that fi nancial institutions are less likely to fund a trading administration in the expectation of achieving higher realisations. Equally, the pool of potential purchasers with funding available has evaporated.

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INSOLVENCY AND CORPORATE RESTRUCTURING Jones Day

The professional fees incurred in a trading administration, coupled with the risk of not achieving an acceptable ofg er for the business and assets of the company, means that these factors taken together are likely to result in an increased use of pre-packs in the short term at least. For its part, the insolvency profession is seemingly aware of the criticisms raised in respect of pre-packs and, on occasion, the conduct of the administrators

• themselves. On 1 January 2009 a new Statement
• f Insolvency Practice (SIP) (number 16) came into

force with regard to pre-pack administrations (see ‘Reference point’, below right). SIPs are issued by a committee of regulatory bodies for insolvency practitioners, with the purpose of setting out basic principles and essential procedure with which insolvency practitioners are required to comply. In circumstances where an administrator decides that it is necessary to conclude a pre-pack, SIP 16 sets out what information the administrator should provide to creditors in respect of the circumstances

• f the sale and why the administrator was of the

view that the purposes of administration would be best achieved by a pre-pack. Although SIPs are non-binding, they represent a code of good conduct that administrators should follow if they wish to avoid criticism or potential challenge for misfeasance and unfair prejudice. SIP 16 recognises that a pre-pack denies a company’s unsecured creditors the right to vote

• n the administrator’s proposals before they are

efg ectively completed. However, the information to be provided or otherwise made available to creditors pursuant to the SIP should assist in providing greater transparency to creditors in respect

• f the pre-pack process and provide a better

understanding with regard to the commercial reality

• f the company’s fi

nancial position and the options available to the administrator in this situation. By Kay Morley, associate, Jones Day. E-mail: kmorley@jonesday.com. DKLL Solicitors v Her Majesty’s Revenue and Customs [2007] EWHC 2067 (Ch) Re T & D Industries plc [2000] 1 WLR 646

REFERENCE POINT

Statement of Insolvency Practice 16 is available on the Solicitors Regulation Authority website: www.sra.org.uk/documents/solicitors/ accreditation/insolvency-practitioners- statement-16.pdf