The ‘Rescue Culture’ in Financially Failing Businesses

Introduction

There has been a major impact on how financial failure of a business is dealt with in the UK after the introduction of the Enterprise Act 2002. The rescue culture is reinforced by reforming the administration procedure on which the court is based. Lenders are now unable to hold security over companies business and assets and this includes floating charges. They are also prevented from appointing an Administrative Receiver to realise assets so that it satisfies their debt. This was known as the UK’s pro-creditor approach. It must be noted though that this does not stop the holder of the fixed charge from appointing a receiver. Although, if an Administrator is appointed then any receiver has to surrender his office.

The insolvency regime that was in place beforehand didn’t offer enough clearness and accountability to the variety of stakeholders, especially to the creditors who have an interest in the affairs of the company. The Administration procedure is an important instrument that is used to give a company in financial difficulty breathing space so as to assemble a plan of rescue or to give better returns for creditors. To achieve this, the formalities have been cut down in number and the administration along with Company Voluntary Arrangements have been made more easily reachable to the companies.

Only small companies^[1] are entitled to apply for a CVA moratorium but only if there are no formal insolvency proceedings already in place. The primary moratorium lasts for twenty-eight days. In this time the proposals must be considered at meetings between the creditors and the company.

Administration

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

The company can present the administration order petition, or its directors, or by a creditor on the grounds^[2] that the company is not capable of paying of its debts or is likely to become not capable of paying its debts. As a result of the petition being presented a ‘moratorium’ is imposed on the company’s debts and the creditors are not allowed to impose any security over the property of the company, but they can assign an administrative receiver, repossess goods and start or continue proceedings or levy distress against the property of the company. For the duration of this time the company is unable to be wound up.

Notification to everyone who is entitled to appoint an administrative receiver of the company must be done by the company directors or who is entitled to appoint an administrator of the company. The administrator would sell property to pay off secured and preferential creditors. This would be done as an alternative to putting the company in to liquidation. This would not damage 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 allocation was done on the basis of special circumstances of the preferential creditors of PLC and on a pro rata basis to the unsecured creditors.^[4]

Company Voluntary Arrangements

A major difficulty in bringing about corporate voluntary arrangements has been the complexity involved in holding off individual creditors whilst a rescue strategy is applied. By applying for an administration order a moratorium could be achieved. The problems posed by the often overwhelming difficulty in obtaining a moratorium have been sorted out by the Insolvency Act 2000. It includes provisions that allow an insolvency practitioner to put a moratorium into place for a short while without resorting to the court.^[5] The moratorium comes into effect the instant all the applicable documentation is filed at the court. This stops creditors from filing for a winding up petition during the period of moratorium. The floating charge cannot crystalise during the moratorium as it occurs regardless of the Bank’s wishes^[6].

Frequently in practice security holders such as Banks have to be pursued so that they hold back and don’t enforce their security. Throughout the moratorium the company can 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]. If the C V A is appropriate then it will give higher returns to the creditors than would have been received if the company had gone into liquidation or receivership. C V As allow secured creditors such as, the holders of a fixed or floating charges, to leave the agreement without the need to enforce its security by appointing an Administrative Receiver. The creditors therefore maximise their interests and as well as this allows the company to continue trading.

This essentially preserves the creditors’ contractual right to take the required action in order 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.

The Pari Passu Rule

The pari passu rule is said to be ‘the foremost principle in the law of insolvency around the world’. It is believed 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.’ Insolvency regimes have a main aim to get equal distribution for creditors unless a different class of preferential creditor is created. This priority to one class of creditor is usually acquired by putting to one side some of the available assets of the company. These are otherwise available for the general body of creditors. An example of this is a floating charge holder, debt and asset financing and retention of title. By controlling in this way, this class of creditors can keep the assets beyond the reach of general body of creditors and it could result in an adverse effect in rescuing the company.

If the various parties’ claims are looked at then it can be seen that the pari passu principle only has some degree of effect in governing distributions of the funds realised from the assets of the company in liquidation or the bankrupt’s estate. The principle behind this is the existence of the different types of secured creditors who take priority and hence their claims fall beyond its ambit. Even claims which are unsecured don’t have application of pari passu principle. When a company enters into liquidation, all the claims from different types of creditors begin with an incantation of the pari passu principle. There’s an inherent tension between the fundamental principle of contract that is freedom to enter into a contract and expect to get priority on the one hand and the mandatory pari passu principle on the other.^[9] With the new insolvency regime, the priority of preferential creditors like the Crown has been eliminated but there is still questions regarding secured creditors.

Currently the law today allows a company to be able to grant security over all of its assets. Yet if the company imposes restriction on these secured creditors then it is likely that the credit facilities will become more expensive regardless of any rescue procedure in place. There is the possibility that it will become more difficult to obtain finance, which is less flexible. This could result in more personal guarantees and securities being demanded by the secured lenders from directors of the company in order to lessen their exposure. On the other hand when the company comes into financial difficulties then secured creditors would want their position protected, which could be detrimental to the unsecured creditors.

It should be pointed out that if a company enters into Administration, then it will benefit the unsecured creditors. The new provisions allow the administrator to be given new powers to make distributions to secured and preferential creditors. An administrator can create a Special Fund and this has been introduced exclusively for the benefit of unsecured creditors. The share of the assets have to be ring fenced for the unsecured creditors to preserve their contractual rights under the new regime. It is unclear how much will be kept aside for the unsecured creditors; it probably 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. The principle has invocation as the starting point for a full analysis on the priority of secured or preferential claims. The principle is recognised widely and depended upon for a just and equitable distribution to all creditors in any type of liquidation and any variation from it will give rise to concern.

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

The new legislation’s main thrust is to limit the use of administrative receiverships and extend and streamline the administration procedure. The holder of a floating charge is unable generally to appoint an administrative receiver. However a floating charge holder, or the company or the directors can get an administrator appointed through a court order. The main function of the administration is to rescue the company as a going concern.

The 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 due to the fact that the interests of all creditors have to be accounted for. However, under C V A the existing management stays in control and would want to increase the 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 1986 Act introduced the company voluntary arrangement procedure as a means of rescuing companies. Yet, the recession of the early 1990s showed that it was not appropriate for a small company in financial difficulty. This was because there was no moratorium on creditors’ action, before an arrangement could be agreed. So creditors were able to resort to their own recovery action for the debts against the company. An example of this being that a creditor may attempt to execute the judgment it has obtained against the company by levying section on the company’s goods. This would often result in the company losing its stock which it needed to carry on trading and so would be unable to continue trading.

That rendered any proposed voluntary arrangement unworkable and the rescue attempts likely 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.

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. 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 stop creditors from taking enforcement action, initially for a period of up to 28 days while the proposed voluntary arrangement is put to creditors.

Also 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. Cost issues needed to be considered as well.

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 fixed and floating charge holders are not the only ones who 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 tries to strike a balance by introducing collective insolvency proceedings which would give all creditors an opportunity to participate. To a certain extent unsecured creditors now have a greater say in the whole process. They can also influence its outcome and ensure that 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 Secretary of State for trade and Industry, the Right Honorable Stephen Byers MP, 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”. It is for this reason why the government is keen to undertake a review of the 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. www.insolvency.gov.uk/consultation
2. Department of Trade and Industry web site, www.dti.gov.org
3. Insolvency Law 1986
4. Enterprise Act 2000
5. The Association of Business Recovery Professionals, R3
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

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