When a company is in financial difficulties, an Insolvency Practitioner (“IP”) will often be called in to review the options available to the directors.
In increasing numbers, the answer will be to place the company into administration. Administration is a procedure under the Insolvency Act 1986 by which a company may be (a) re-organised, or (b) its assets realised, in each case whilst being protected from angry creditors. An administrator is appointed to supervise the procedure.
Controversy has arisen where the administrator’s first act is to sell the business to a newly formed company in a sale known as a pre-pack. Used in high profile insolvencies such as Whittards, Land of Leather and the Officers Club, pre-packs are receiving greater attention in the media than ever before.
Complaints have arisen because often the pre-pack sale will be to connected parties (such as to existing shareholders and/or directors). This type of phoenix sale, sees the business continuing to trade, usually with the same name, as if no financial difficulties had occurred. This is much to the chagrin of unpaid suppliers, landlords and other creditors, whose debts are left behind with the company in administration and with no right of action against the new business.
Intention and Actual Usage of Administration Orders
When the administration procedure was introduced into the UK, it was hoped that it could replicate the perceived success of the Chapter 11 procedure in the US. Chapter 11 is a chapter of the United States Bankruptcy Code under which an ailing company can re-organise itself. The original corporate entity may “emerge” from a Chapter 11 bankruptcy within a few months or within several years, depending on the size and complexity of the procedure. In Chapter 11, in most instances the officers remain in control of its business operations as “debtors in possession”, and are subject to the oversight and jurisdiction of the court.
This has drawn praise and criticism in equal measure. Advocates argue that existing management know the business better than anyone else and are best placed to turn the company around. Critics believe that you are “leaving the fox in the hen house”.
Chapter 11 can be contrasted with Chapter 7 in the US, where the business entity ceases operations, a trustee realises all of its assets, and then distributes the proceeds to its creditors.
The Rise of the Pre-Pack
In the UK, administration has tended to follow the Chapter 7 realisation model rather than a Chapter 11 re-organisation.
A company may now be put into administration without having to go to court and, as a result, costs have reduced, making administration a far more attractive option.
UK legislation lists the grounds for administration in the following order:
In practice, the primary objective is rarely achieved (or even aspired to). The business is usually sold and the original company subsequently liquidated.
Supporters of the pre-pack argue that:
The Problem with Pre-Packs
Creditors have argued in some cases that the pre-pack option has been abused. This idea that pre-packs are a ‘stitch-up’, is often understandable, particularly as the unsecured creditors are only informed of a deal after the sale has been completed. In the past, they have had little ability to challenge the terms of the sale.
Creditors have been particularly vocal on a phoenix sale when the directors or shareholders of a struggling company have used the pre-pack option to “buy-out” their company.
In fact, the sale of a business back to connected parties is not exclusively a feature of pre-packs. In just over half of all UK business sales, the business is sold to a connected party. This figure rises by only approximately 10% in pre-packs.
Regulation under SIP 16
In response to creditor concern, a Statement of Insolvency Practice (“SIP”) 16 was introduced at the beginning of 2009.
SIP 16 requires administrators, acting on pre-pack sales, to demonstrate that they have performed their functions in the interests of the company’s creditors as a whole.
There is now an obligation to disclose, amongst other facts, the following information in relation to a pre-pack sale:
Although such information doesn’t need to be provided before a sale, it should be provided with the first notification to creditors. In any case where a pre-pack sale has been undertaken, the administrator should hold the initial creditors’ meeting as soon as possible after his appointment.
Some IPs consider SIP 16 to be a codification of existing “best practice” that they were already following prior to the implementation of SIP 16.
However, it is clear that the new obligations imposed on IPs by SIP 16, has increased the amount of work that an IP must undertake when advising on a pre-pack sale. This increase in workload, together with a greater risk that a creditor of the company, will have grounds to bring an action against the IP for a failure to meet the requirements of SIP 16, has led to an increase in the fees being quoted by IPs for a pre-pack administration.
Too early to tell
The reduction in fees brought about by the out of court route into administration, led to an increase in the number of administrations. It will be interesting to see whether increased fees and a greater degree of scrutiny on administrators will lead to a reduction in the number of pre-packs.
It is still too early to tell. However, with those elusive green shoots of recovery still underground, the current economic climate will probably ensure that the pre-pack remains on centre stage of UK business rescues for many years to come.
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