Pre-pack administrations and the Insolvency (Amendment) (No.2) Rules 2011
Insolvency Lawyers' Association's Response to the draft Insolvency (Amendment) (No.2) Rules 2011
I thoroughly endorse the Insolvency Lawyers' Association's response to the Government's proposed amendments to the law on pre-pack insolvencies, which is accessible at http://www.ilauk.com/news/insolvency_and_restructuring_news/ and is reproduced below.
1.1 This is the ILA's summary response to the draft Insolvency (Amendment) (No.2) rules 2011 (the "Draft Rules") published by the Insolvency Service on 16 June 2011. It has been prepared on behalf of the ILA by its Technical Committee (the "Committee").
1.2 The ILA provides a forum for c.450 full, associate, overseas and academic members who practise insolvency law. The membership comprises a broad representation of regional and City solicitors, barristers and academics, and overseas lawyers. The Committee is responsible for identifying and reporting to members on key developments in case law and legislative reform in the insolvency marketplace.
1.3 The Committee welcomes the opportunity to provide its view on the Draft Rules 2011 relating (amongst other things) to pre-packaged sales in administration and administration sales to connected parties.
2. General comments
2.1 In general, the Committee is in agreement with the policy objective of achieving greater transparency in pre-pack sales in administrations to address a perception that they can sometimes work to the disadvantage of unsecured creditors (the "Transparency Objective"). However, the Committee disagrees that the current Draft Rules represent a proportionate way of achieving the Transparency Objective. The Committee considers that the Draft Rules, if introduced, are likely to cause considerable damage to the business rescue market, ultimately resulting in reduced returns to creditors, an increase in job losses, and a consequential increased burden on the welfare state. These effects would be contrary to other stated policy objectives such as improving value for unsecured creditors. We understand from the stakeholder meeting that we attended on 21 June that we are not alone in our concerns.
2.2 Whereas the Draft Rules seek to address the concern as to "phoenixism" mentioned in the ministerial statement of 31 March 2011, by giving unsecured creditors a voice through the notice mechanism, the Draft Rules will likely create a new unfairness by enfranchising those creditors who are "out of the money" (a function of the insolvency itself) at the risk or expense of those who have an economic interest in the realisations. This unintended consequence might operate against the value maximising objective. There are few cases in which values improve (or even hold up) when the transactional momentum is paused.
2.3 The Draft Rules will make connected party pre-pack transactions at both ends of the value spectrum unworkable in practice, and will marginalise the use of a valuable business-rescue tool. Pre-pack sales to connected parties are used both by owner-managed businesses in situations where it often represents the best deal available to creditors (frequently, the only one capable of generating any going concern premium), as well as in high value group restructurings with syndicated lender groups, some of which migrate to this jurisdiction in order to be able to make use of it. The strong anecdotal evidence we have received from our members is that, if the Draft Rules are implemented, this is much less likely to happen.
2.4 The Draft Rules undermine the way in which pre-packs assist in retaining value. Once there is an announcement of an intended pre-pack to creditors, a business' value is likely to be eroded, and, without the certainty of a completed solution to the business' financial problems, its customers, suppliers and key employees may disappear. Valuable assets and contracts, for example licences may become terminable, with counter-parties able to walk away. It is difficult to predict with certainty what could happen in the 3 days after notice is given to creditors, but the risk of value destruction may cause the pre-pack buyer to offer less in the first place, or to reduce its price once notice is given. This so-called "gazundering" is a known phenomenon in the distressed market in which the seller is a forced seller. Without simultaneously addressing such things as "ipso facto" contract termination clauses, the Draft Rules are not a holistic approach to the objectives sought to be served. Indeed, a pre-pack notice of the sort envisaged by the Draft Rules will itself become a common termination trigger clause in commercial contracts.
2.5 Another major concern with the Draft Rules is the definition of "connected or associated party", which is broader than existing similar statutory definitions, including as it does persons connected with, or associates of, secured creditors and members. We think that this definition could have far-reaching and probably unintended consequences.
2.6 We are also concerned with how the Draft Rules might operate in practice. Supposing a creditor, on receipt of a 3-day notice of an impending pre-pack sale, does make representations: how should these representations be dealt with? By a costly application to the court? The court has made it abundantly clear that it prefers to leave commercial decisions to the office holders. It will not act as a "bomb shelter" for administrators (T&D Industries). Also, any delay caused by a creditor's response to a 3-day notice may cause a purchaser to walk away, forcing the insolvent company into liquidation (through lack of funding for a trading administration), resulting in lower returns to creditors. Creditors may be encouraged to adopt ransom positions by threatening formal objections to proposed pre-packs.
2.7 For these reasons, the Committee is not in favour of introducing the Draft Rules. We are in favour of a complete re-think of how the Transparency Objective should be addressed. Our preferred option would be to use a much simpler and less damaging mechanism, which already exists in the Draft Rules in principle. This is that the administrator certifies in his proposals to the creditors, that the pre-pack sale (whether or not to a connected party) represents the best value reasonably obtainable in the circumstances, and is in the interests of creditors as a whole. Good administrators will already satisfy themselves of this conclusion even if they do not all currently include it expressly in a statement to creditors, and so it should not be an unreasonable additional burden to them. And if the statement was unfounded, then an action would lie against the administrator to reimburse the estate for any deficiency (under paras 74 or 75 of Schedule B1 to the Insolvency Act 1986 or using the court's inherent jurisdiction in relation to the administrator as an officer of the court). This should eradicate any rogue IP activity, should not trouble diligent and competent IPs (who undertake significant due diligence to satisfy themselves that a pre-pack is the right option already), and it should give creditors the assurance that the pre-pack sale was genuinely in their interests, and that any creditor shortfall was as a result of the company's insolvency and not a consequence of the pre-pack. . In addition we do not have any objection, in principle, with a requirement that information equivalent to that which is required by SIP16 be filed at Companies House. We see both of these proposals as sensible and proportionate ways of addressing the Transparency Objective.
3. Specific comments
3.1 If, notwithstanding our general objections above to the current form of the Draft Rules, they are nevertheless to be introduced, we make the following specific comments.
3.2 Rule 2 (Review): The Draft Rules cannot sensibly be measured against the Transparency Objective: transparency is a perception, which cannot be measured empirically. And any attempt to review the Draft Rules, as suggested in rule 2, will require a funded research project of the sort previously carried out by Dr Sandra Frisby in order to measure returns to creditors. Notably, the study published by R3 in March 2010 entitled "Pre-packs and SIP 16" provided statistical evidence that pre-packs were by and large to connected parties, but resulted in 90% of jobs being saved and a better return to creditors. In light of the existing "success" of pre-packs, how do you plan to measure the impact of the Draft Rules?
3.3 Rule 4 (definition of pre-pack): We are concerned that this definition could lead to the decision on TUPE in OTG v Barke being overturned in respect of pre-pack sales. If the intention when entering into administration is that company's business will be sold via a pre-pack sale, then there is little scope for arguing that the primary objective of the administration is still (even momentarily) to rescue the company. This was one of the main reasons relied upon by the Judge in OTG v Barke. It might follow that reg 8(7) of TUPE will apply to pre-pack administrations, with the effect that employees cease to transfer automatically in pre-pack sales, resulting in a higher burden on the National Insurance Fund.
3.4 Rule 5(1)(b) (opinion that the pre-pack represents best value for creditors) (and in subsequent rules where the same drafting is repeated): The drafting of "...will achieve a better result for the company's creditors as a whole than anything else" is unreasonably wide and will act as a deterrent to IPs to accept appointments. It goes beyond the administrators' duty to achieve the objective in paragraph 3(b) of Schedule B1 to the Insolvency Act 1986 (i.e. a better outcome than liquidation). The prospective administrator can only provide an opinion based on the information provided to him by the directors, not an absolute statement that the pre-pack sale is better than "anything else". Moreover, if this wide duty on administrators is retained, this could lead to creditors reverting to the appointment of LPA receivers where assets are sold piecemeal instead of as a going concern, realising lower values, to the detriment of creditors. It should be replaced with a statement along the lines of the pre-pack sale representing the best value reasonably obtainable in the circumstances, and being in the interests of creditors as a whole.
3.5 Rule 6 (application to winding up): The inclusion of this provision is unnecessary and odd. A "pre-pack liquidation" does not make sense. In a CVL, the liquidator has no power to sell before the creditors' meeting, of which the creditors will have at least 7 days notice, and will be fully aware of the company's pending insolvency. Transparency, therefore, would not appear to be a problem. In a compulsory liquidation, the office holder is the Official Receiver until he organises a Secretary of State appointment himself or holds a creditors' meeting to make a liquidator appointment. It seems unlikely that the OR will become involved in a pre-pack liquidation sale. Therefore we do not expect liquidation to be used as a method to effect a pre-pack sale of a business.
3.6 Rule 7 (definition of "connected or associated party"): Apart from the confusing footnotes (which are easily mistaken for grammatical errors), the Committee is strongly concerned that the definition used for connected party extends the existing definition in ss249 and 435 considerably and unjustifiably. These definitions are already some of the most complicated provisions to apply in practice and we do not think that transposing the existing difficulties with these sections (in particular s435) is sensible. To add another layer of complexity by introducing "secured creditors" is (a) not transparently justifiable (b) likely to lead to significant uncertainty in its application and (c) likely to make large financial restructurings which involve pre-packs impossible. Such restructurings are usually concerned only with the restructuring of the debt as between financial institutions and do not adversely impact on unsecured or trade creditors, in fact they have a positive impact on such creditors by ensuring the business continues and the trade creditors get paid.
3.7 Rather than adding further complexity to the definition of "connected or associated party", could the Transparency Objective be achieved proportionately and more simply by limiting the application of the notice provisions of the Draft Rules to sales to (i) directors, and/or, (ii) using the test in s216 (phoenix provisions), to companies or businesses in which the directors are directly or indirectly concerned or take part in the promotion, formation, or management? Arguably, the mischief that the Transparency Objective is seeking to eliminate is more closely aligned with the phoenix provisions than with other provisions where the "connected" and "associate" definitions are used. It would therefore be more consistent to use the phoenix criteria here than the suggested "connected or associated party" definition.
3.8 Rules 8 and 9 (Notice to Creditors): the definition of "open market" requires re-consideration. The language is not clear and is open to differing interpretations. For example, is it meant to refer to a full M&A process with financial advisers, a data room and an information memorandum (and if so, how is that appropriate for smaller businesses) or a smaller marketing exercise of contacting a few known prospective buyers to gauge interest. In our view, targeted marketing to identify potentially interested purchasers should be sufficient, rather than advertising in the open market. In addition, a full M&A process may not be feasible where the company is sliding rapidly into insolvency. Even if it is feasible, the disadvantage of the open market is that it will alert the company's suppliers, customers and employees, eroding the value of the business.
3.9 Rules 8-11 (information to be provided): We recall that the proposal from the previous consultation was to put SIP16 on a statutory footing. By comparison, the required information in the Draft Rules goes far beyond the equivalent information in SIP16. If the requirement is to ensure that SIP16 information is available to the public at large, then it would be simpler to require all pre-pack administrators to file their existing SIP16 report with their proposals at Companies House. Many already do. In any event, the breadth of information set out in the Draft Rules is likely to intrude upon the commercial confidentiality requirements of many purchasers, which will either deter interested parties and/or suppress the price offered.
3.10 In addition, in SIP16 there is an ability to withhold certain information in "exceptional circumstances". For business efficacy and by analogy, this exceptional circumstances option should be replicated in the Draft Rules, perhaps with the permission of the court. Otherwise, future headlines might announce that a deal that could have saved employees their jobs and returned value to creditors was made impossible by the uncommercially harsh requirements of the Draft Rules.
3.11 Carve Outs from Rules 8-11 : The problem that the Transparency Objective is trying to address concerns the (often perceived) impact on trade and supplier creditors of connected party sales, almost exclusively at the middle to lower value end of the market. We therefore do not think that it would detract from the Transparency Objective if the Draft Rules contained some or all of the following carve outs, all of which would assist in preserving the value of pre-packs as a business rescue tool (consistent with the ministerial statement's recognition of the utility and value of pre-packs):
3.11.1 The notice and information provisions in Rules 8-11 could be applied only to SMEs without significantly compromising the Transparency Objective. The value at stake in pre-packs used at the higher end of the market tends to provide its own checks and balances against the inappropriate use of pre-packs.
3.11.2 Another consideration would be to provide an exception from the 3-day notice provisions for pre-pack sales in which all creditors other than finance creditors are paid in full. Clearly the trade creditors' financial interests are protected by such a restructuring and so a 3 day notice period would not serve any useful purpose.
3.11.3 An exception from the 3-day notice provisions for pure holding companies would equally not dilute the Transparency Objective. The concerns driving the case for reform simply do not arise in these financial restructurings. As for 3.11.1, in these larger cases, the sophistication of the parties involved, the number of professional advisers and the value at stake provide their own checks and balances on the uses of pre-packs without the need for any further controls or restrictions.
3.11.4 Finally, and in any event, we consider that it is absolutely necessary to provide the court with a power to disapply the notice provisions in cases where it is in the best interests of creditors to do so. We do not expect that a court would use the power lightly, especially in view of its reluctance to be a "bomb shelter" for administrators, but it would provide a last resort option for administrators to try to salvage a deal for the creditors which might otherwise be in jeopardy.
3.12 The Draft Rules do not provide what the effect of a sale that is entered into in contravention of them (either because an incorrect, or no, rule 5 statement is provided, or because of a failure to give the requisite notice). Given the complexity of the definitions, it is conceivable that a distant connection with the purchaser could be missed. If a connection was subsequently discovered, what would be the effect on the transferred business, its employees, suppliers and customers? Should/could the sale be void or voidable several weeks, months or years after it took place? Would this benefit creditors of the insolvent company? It seems unlikely that a purchaser could rely on the usual bona fide purchaser for value without notice exception. The Draft Rules should prescribe the result of contravention, or at least give the court power to make such order as it thinks is just in the circumstances, rather than leaving the point uncertain.
Chris Laughton is a Restructuring & Insolvency partner at Mercer & Hole. The views given in this blog are personal to the author, if you would like to discuss the contents of this post with Chris you can call him on 020 7353 1597.
Date: 3rd August, 2011
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