Rescue Culture Under Insolvency Law

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Structure: Issues, Legal rules and application

1. 1. Rescue culture under insolvency law
   2. what is C V A and moratoria available under it
   3. what is Administrations and moratoria
   4. contractual rights of creditors, how they are protected

Introduction

The Enterprise Act 2002 has a significant impact on how financial failure of a business is dealt with in the UK. The rescue culture is strengthened by streamlining the administration procedure on which the court is based. It also prevents lenders holding security over companies business and assets, including floating charges, from appointing an Administrative Receiver to realise assets to such an extent that it satisfies their debt. This was seen as UK’s pro-creditor approach. This does not prevent the fixed charge holder from appointing a receiver however if an Administrator is appointed then such a receiver has to relinquish his office.

The previous insolvency regime did not provide enough transparency and accountability to the range of stakeholders especially to the creditors who have an interest in a company’s affairs. The Administration is an important tool which can be used to give breathing space for a company in financial difficulty so as to put together a rescue plan or provide better returns for creditors. To achieve this the formalities have been reduced and administration as well as Company Voluntary Arrangements have been made more accessible to the companies.

Only small companies^[1] are eligible to apply for a CVA moratorium only if there are no formal insolvency proceedings in place. The initial moratorium lasts for twenty-eight days. During this time the meetings of the company and creditors must be held to consider the proposals.

Administration

The statutory purpose of an administration is the rescue of the company as a going concern. This procedure is available by order of the court if the court takes a view that the business of the company or at least part of it should be saved or a view to a more beneficial realisation of assets than could be achieved winding up that company, or with a view to obtaining approval for a voluntary arrangement with the creditors of the company.

The petition for the administration order may be presented by the company, or its directors, or by a creditor on the grounds^[2] that the company is unable to pay its debts or is likely to become unable to pay its debts. As a consequence of the presentation of the petition a ‘moratorium’ is imposed on the company’s debts and creditors may not enforce any security over the company’s property, but can appoint an administrative receiver, repossess goods, start or continue proceedings or levy distress against the company’s property. However, the company cannot be wound up during this time.

The directors must notify everyone who is entitled to appoint an administrative receiver of the company or who is entitled to appoint an administrator of the company. The administrator would sell property to pay off secured and preferential creditors instead of putting the company in to liquidation. Such an action would not harm the creditors’, as a whole, contractual rights unnecessarily. In WBSL Realisations 1992 Ltd ^[3] Administrators could pay creditors on the basis of a notional winding up. The distribution was done on the basis of special circumstances of the preferential creditors of PLC and on pro rata basis to the unsecured creditors.^[4]

Company Voluntary Arrangements

A major problem in bringing about corporate voluntary arrangements has been the difficulty in holding off individual creditors whilst a rescue strategy is put into place. By applying for an administration order a moratorium could be achieved. The problems posed by the often insurmountable difficulty in obtaining a moratorium have been resolved by the Insolvency Act 2000 which contains provisions that enable an insolvency practitioner who can put a moratorium into place for a short while without recourse to the court.^[5] The moratorium comes into force as soon as all the relevant documentation is filed at the court. This prevents creditors from filing a winding up petition during the period of moratorium. The floating charge cannot crystalise during the moratorium as it takes place regardless of the Bank’s wishes^[6].

Often in practice the Banks or other security holders have to be pursued to hold back and not to enforce their security. During the moratorium the company may dispose of property, which is the subject of security such as fixed or floating charge, and property in the possession of the company under a hire-purchase agreement.

The arrangement becomes binding on all creditors entitled to attend and vote at the meeting^[7] unless there is an appeal within 28 days on the basis of either procedural irregularity or unfair prejudice^[8]. This actually preserves the creditors’ contractual right to take the necessary action to recover the debt. In Tager v Westpac Banking Corporation [1998] BCC 73, Judge John Weeks QC, sitting in the Chancery Division said that the court has jurisdiction to extend the 28 day period for challenging the decision of a creditors’ meeting to consider a debtor’s voluntary arrangement.

If the C V A is appropriate then it will improve the returns to creditors than would have been in the case of company going into liquidation or receivership. C V As allow secured creditors such as, the holders of a fixed or floating charges, to leave the arrangement without the need to enforce its security by appointing an Administrative Receiver. This allows for maximising the interests of all creditors and at the same time allows the company to continue trading.

The Pari Passu Rule

The pari passu principle is said to be ‘the foremost principle in the law of insolvency around the world’. It is thought to be ‘all-pervasive’, and its effect is to ‘strike down all agreements which have as their object or result the unfair preference of a particular creditor by removal from the estate on winding up of an asset that would otherwise have been available for the general body of creditors.’ Equal distribution to creditors is an overwhelming aim in any insolvency regimes unless a different class of preferential creditor is created. This priority to one class of creditor is usually obtained by setting aside some of the available assets of the company which are otherwise available for general body of creditors. The obvious example is a floating charge holder, debt and asset financing and retention of title. By exerting control in this way this class of creditors can keep the assets beyond the reach of general body of creditors and may have adverse effect in rescuing the company.

If we analyse the claims of the various parties then it can be seen that the pari passu principle has a rather limited effect in governing distributions of the funds realised from the assets of the company in liquidation or the bankrupt’s estate. The rationale behind this is the existence of the various types of secured creditors who obviously take priority and hence their claims fall beyond its ambit. Even unsecured claims do not have application of pari passu principle. When a company goes into liquidation the claims from various types of creditors commence with an incantation of the pari passu principle. There is an inherent tension between the fundamental principle of contract that is freedom to enter in to a contract and expect to get a priority on the one hand and the mandatory pari passu principle on the other.^[9] Under the new insolvency regime, the priority of preferential creditors such as the Crown has been abolished but there still seems to be a question of secured creditors.

The law as it stands today allows a company to be able to grant security over all of its assets. However if the company imposes restriction on these secured creditors then it is likely that the credit facilities will become more expensive regardless of rescue procedure in place. It may become more difficult to obtain finance, which is less flexible. This may lead to more personal guarantees and securities from directors of the company being demanded by the secured lenders to reduce their exposure. On the other hand when the company runs into financial difficulties then secured creditors would want to protect their position, which could be detrimental to the unsecured creditors.

It should be noted that if a company enters into Administration then the benefits go to the unsecured creditors. Under new provisions the administrator has been given new powers to make distributions to secured and preferential creditor. A Special Fund, which an administrator can create, has been introduced exclusively for the benefit of unsecured creditors. In brief, share of the assets have to be ring fenced for the unsecured creditors to preserve their contractual rights under the new regime. It is not yet clear exactly how much will be kept aside for the unsecured creditors; my guess is that it depends upon the size of the company and the amount of creditors involved. However it is likely that 10% of the assets may be ring fenced for this purpose.

The principle was established in order to conduct a systematic liquidation of insolvent estates by adhering to the principles of fairness. It is quite obvious that the principle has invocation as the starting point for a full analysis on the priority of secured or preferential claims. The principle has been recognised widely and depended upon for a just and equitable distribution to all creditors in any type of liquidation, any deviation from it will most certainly give rise to concern.

Under new legislation, the main thrust is to restrict considerably the use that can be made of administrative receiverships and extend and streamline the administration procedure. The holder of a floating charge loses the right generally to appoint an administrative receiver under a floating charge. On the other hand an administrator can be appointed by a court order, by a floating charge holder or by the company or its directors. The main purpose of the administration is to rescue the company as a going concern.

The Insolvency Act 2000, has made several important changes, particularly to company voluntary arrangements and directors’ disqualification. This is an attempt to strike the balance between enterprise and abuse of limited liability.

Majority of creditors’ concerns are being informed and involved in the process of managing company’s affairs. The new changes have been welcomed by the creditors because of the fact that the interests of all creditors have to be taken into account. However, under C V A the existing management remains in control and would like to increase value of shareholders. On the other hand under administration, the office holder is effectively running the company and has a statutory duty to consider the interests of all the creditors and not just one group of creditors. It is difficult to reconcile the pari passu principle and the propriety rights of creditors.

The lenders of the finance, usually banks, hold floating charges and are very sophisticated creditors as they monitor the performance of the companies they lend money to and therefore any problems company might be facing are spotted relatively early.

The 1986 Act introduced the company voluntary arrangement procedure as a means of rescuing companies. However, the recession of the early 1990s demonstrated that it was not particularly appropriate for a small company in financial difficulty. The reason for this was there was no moratorium on creditors’ action, before an arrangement could be agreed and therefore creditors were able to resort to their own recovery action for the debts against the company, for example, a creditor might try to execute the judgment it has obtained against the company by levying section on the company’s goods. This often resulted in the company losing its stock which it needed to continue trading and would be unable to continue trading.

Obviously that rendered any proposed voluntary arrangement unworkable and the rescue attempts liable to almost certain collapse. There was a need to prevent other creditors’ rights to take action during the period when the voluntary arrangements were being considered in order for the company’s management to come up with a rescue plan for the creditors to consider.

In addition to this, the management of the company especially the owners were very reluctant to use the administration procedure as they knew they would be displaced by the administrative receiver if the bank exercised its effective veto or by the administrator if the court appointed one. There were also cost issues to consider.

A major problem in bringing about corporate voluntary arrangements has been the difficulty in holding off individual creditors while a rescue strategy is put into place. A moratorium could be achieved by an application for an administration order^[10] . Under the Insolvency Act 2000 a small company’s management has an option of a short moratorium without recourse to the court so long as the appropriate criteria are satisfied. This will prevent creditors taking enforcement action, initially for a period of up to 28 days while the proposed voluntary arrangement is put to creditors.

Conclusion

The new changes in the Enterprise Act are based on the principle of equity and efficiency. These are the collective insolvency proceedings in which all creditors take part and not just fixed and floating charge holders have a say in it. Under these collective proceedings a duty is owed to all classes of creditors and an office holder has to account for his dealings with a company’s assets to all creditors.

The new Act attempts to strike a balance by introducing collective insolvency proceedings which would give all creditors an opportunity to participate. To certain extent unsecured creditors now have a greater say in the whole process than before. They can also influence its outcome while ensuring secured creditors are not put at risk in any way. However, under these changes, creditors will not be able to enforce action for an initial period of 28 days.

The Right Honorable Stephen Byers MP, Secretary of State for trade and Industry stated that “It is our intention to introduce legislation to provide for a moratorium to be part of the company voluntary arrangement procedure. Such a moratorium has long been identified as a missing element that has restricted the use of C V As”. This is why the government is keen to undertake review of current rescue mechanism and reach robust view.

The administration procedure and C V A are contracts between the company and its creditors which regulates the manner in which they wish to pursue the repayment of the debt and the time scale within which it should be completed. Although C V A is an invaluable tool in any company rescue it used to be one of the statutory purposes of an administration.

Bibliography

1. 1. www.insolvency.gov.uk/consultation

2. Department of Trade and Industry web site, www.dti.gov.org

3. 3. Insolvency Law 1986

4. 4. Enterprise Act 2000

5. 5. The Association of Business Recovery Professionals, R3

6. 6. www.bixhelp24.com/insolvency
   7. www.nabarro.com/legal article by Patricia Godfrey Head of Insolvency and Corporate Recovery
   8. www.pkf.co.uk
   9. An empirical study undertaken by Professor Julian Franks and Dr Oren Sussman of the London Business School, published with the Review Group’s report in November 2000

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Footnotes

^[1] s247(3) Companies Act 1985

^[2] section 122 of the Insolvency Act 1986

^[3] 1995 BCC 1118

^[4] Also see case Re John Slack Ltd 1995, BCC 1116

^[5] Insolvency Act 2000, Schedule 1

^[6] National Westminster Bank v Spectrum plus Ltd (2000)

^[7] Insolvency Act 2000, Section 5 (2)

^[8] Tager v Westpac Banking Corporation [1998] BCC 73, Judge John Weeks QC, sitting in the Chancery Division

^[9] University College London; Centre for Business Research, Cambridge University, Cambridge Law Journal, Volume 60, Part 3, November 2001, RIZ MOKAL, the Author

^[10] Insolvency Act section 8 to10