When is Pre-Packaged Administration Appropriate? –

A Theoretical ConsiderationDr Peter Walton

University of Wolverhampton

What is a pre-pack?

Statement of Insolvency Practice 16 (“SIP16”):

“An arrangement under which the sale of all

or part of a company’s business or assets is

negotiated with a purchaser prior to the

appointment of an administrator, and the

administrator effects the sale immediately

on, or shortly after, his appointment.”

What are the perceived problems with pre-packs?

Re Kayley Vending Limited [2009] BCC 578 at 583:

“A general summary of these concerns would be that the speed and secrecy which give rise to the advantages claimed for pre-packs maytoo easily lead the directors and the insolvency practitioner to arrive ata solution which is convenient for both of them and their interests(perhaps also satisfying a secured creditor who might be in a positionto appoint his own receiver or administrator), but which harms theinterests of the general creditors because:

(i) it may not achieve the best price for the assets; (ii) credit may be incurred inappropriately in the pre-

appointment period; (iii) they are deprived of the opportunity to influence the

transaction before it takes place; and (iv) having been presented with a fait accompli , they have

insufficient information to make it worthwhile investigating and challenging the decisions taken.”

Benefits of pre-packs?

Peter Sargent, the president of R3:

“Pre-packs are a very misunderstood

insolvency tool, and the benefits – for

example, the numbers of jobs saved – are

often lost in concerns over the impact on

unsecured creditors.”

Insolvency Service Consultation possibilities

1. No change2. Give statutory force to the disclosure requirements

required by SIP 16 3. Following a pre-pack administration, restrict exit from

administration to compulsory liquidation, so as to achieve automatic scrutiny by the official receiver of directors’ and administrators’ actions

4. Require different insolvency practitioners to undertake pre and post administration appointment work

5. Require the approval of the court or creditors, or both, for the approval for all pre-pack business sales to connected parties

• Pre-packs – how best to develop a policy?

• Evidence already out there – are we nearer a solution?

• Due to an almost total absence of statutory intervention in the area we have a blank canvas to paint

• Why not consider legal theory?

Possible theories underpinning insolvency law:

• Contractarianism

• Communitarianism

• Forum

• Multiple values/eclectic approach

Contractarianism

• Law and Economics School• Wealth Maximisation model rests on the notion

that with any given set of entitlements creditors would prefer a system that kept the size of the pool of assets as large as possible

• Hypothetical Creditors’ Bargain: the contractual terms to which at the time credit is extended, a creditor and debtor would agree should govern in the event of the debtor’s insolvency.

Contractarianism

• According to the Insolvency Service’s consultation letter of June 2007, the proposed changes recognised the policy imperative of pre-packs is to maximise the return to creditors.

• In doing so there is a need to strike a balance between the “informational interests of creditors” whilst leaving the administrator free “to act expeditiously and without undue hindrance” in maximising asset realisations and returns to creditors.

Contractarianism

• There remain real doubts as to whether pre-packs lead to wealth maximisation due to the lack of transparent and open marketing of the business. This is particularly a concern where the incumbent management team buy the business (e.g. Clydesdale Financial Services Ltd v Smailes [2009] BCC 810 ).

Contractarianism

• A judgment can be made as to whether or not wealth maximisation has been achieved by the court, a creditors’ meeting, a subsequent liquidator or by the appointment of an independent administrator

• The Insolvency Service’s suggested amendments would lead to more certainty as to wealth maximisation

Contractarianism

• Contractarian theory assumes that the insolvency procedure will be collective in nature. This requires that all creditors get a say in the process or at least have their interests fairly protected.

• Real concerns in this regard have been expressed by real creditors

Contractarianism• A view expressed by the Association of British

Insurers suggests that creditors perceive a lack of independence in management buy-out pre-packs:

• “We do not believe that insolvency practitioners can fully and properly discharge their duty to act independently in the interests of creditors, when they have already been engaged by the distressed company to achieve a pre-agreed outcome (particularly where that outcome is a sale of parts of the business to the existing owners).”

Contractarianism

• Would hypothetical creditors agree to a process where the insolvency practitioners involved freely admit that a pre-pack “offers the secured creditors a high level of control and certainty”?

• The pre-pack process appears to have more in common with receivership

• It would therefore seem sensible to require an independent insolvency practitioner (“IP”) to be appointed to assess the pre-pack

Contractarianism

• Even if the requirement for an independent assessment of the deal were introduced, would hypothetical creditors, contracting ex ante from their original position, agree to a process whereby two or possibly three practitioners are paid fees for dealing with one insolvent company?

Contractarianism

• One of the concerns that contractarians express in relation to reorganisations is they “invite dissipation of the common pool by specialists, lawyers, accountants, and economists, who are similarly motivated to secure individual advantage at group expense.”

Communitarianism

• Communitarians look to balance a wide range of different stakeholders in the insolvency of the debtor and to consider the welfare of the community at large

• Communitarianism considers limiting the rights of high ranking creditors to give way to some extent to others including the community at large

• On this basis, it might be possible to increase the prescribed part set aside for unsecured creditors where there is a pre-pack to sweeten the pill

Communitarianism

• In order that insolvency law acts to benefit society at large, communitarians would favour the survival of businesses where feasible as well as orderly windings up where survival is not possible

• The economic life of a region or the nation should be considered as significant

• The ripple effects of a business failure and its long term consequences should be factored into insolvency law

Communitarianism

• Turning around a financially distressed business may have many community benefits in terms of continued business for suppliers, continued employment for workers and in the context of three reported pre-pack cases continuity of legal services for clients where the failed business was a solicitors’ firm

• Communitarians would also argue that it is in the interest of the community at large not to have an insolvency procedure which brings the law into disrepute

Communitarianism

• Road Haulage Association: “… within the road haulage sector, far from protecting jobs pre-packs undermine quality and sustainable jobs within the industry and that far more importance should be attached to the damaging impact that a pre-pack company has on its responsible competitor firms and their employees within the sector.”

• A high proportion of of pre-packed businesses fail subsequently

Communitarianism

• It does consider society’s needs in general but articulating those needs in a legislative form may prove problematic. Such considerations could be taken into account in assessing whether or not a pre-pack was appropriate in given circumstances but such a judgment would be potentially problematical for a court and could lead to a lack of certainty.

Forum Theory

• Procedurally there should be a forum available where all interests affected by a business failure can be heard. This would apply to those with a direct financial interest in the failure and those with non financial claims but still an interest in the ongoing business (such as employees, suppliers and customers).

• In order to satisfy Forum theorists, some form of representation, of creditors at least, would need to be introduced

• This could be achieved by the introduction of a subsequent liquidation with its creditors’ meeting and independent liquidator

Multiple Values/ Eclectic Approach

• Lists a number of distributional priorities• Includes the relative ability to bear the costs of

default, transaction avoidance, treating creditors with similar characteristics equally, impairment of some creditors’ pre-insolvency rights to ensure fairness and the:

“almost axiomatic principle of business law…that, because equity owners stand to gain the most when a business succeeds, they should absorb the costs of the business’s collapse – up to the full amount of their investment.”

Multiple Values/ Eclectic Approach

• In the context of the revival of failing business the interests of those who are not directly “creditors” are also to be recognised such as older employees who would struggle to retrain for other jobs, customers who would have to resort to less attractive suppliers of goods and services, suppliers who would lose current customers, nearby property owners who suffer declining property values and tax authorities suffering a reduction in taxation revenue

Multiple Values/ Eclectic Approach

• A policy focussing on such values assists the decision making process “even if it does not dictate specific answers.”

• The critical questions under this approach include asking a number of questions about the business failure:

• Who may be hurt by it? How might they be hurt? Can the hurt be avoided? At what cost can it be avoided? Who is helped by the business failure? Who can efficiently evaluate the risks of business failure? Who contributed to the failure? Who can best bear the costs? Who is expected to bear the costs?

Multiple Values/ Eclectic Approach

• The main criticism of the multiple values approach is that it is too widely expressed to be of much specific assistance in developing a policy. There is little guidance provided as to how much emphasis needs to be given to each of the priorities identified. It is not clear which principles are to be seen as core and which are of peripheral relevance.

• It is arguable that insolvency law needs to balance the rights of all these different stakeholders

Multiple Values/ Eclectic Approach• The answer to this conundrum may lie in the

origins of pre-packs in the UK • When pre-packs first became common following

the EA 2002 they were considered as useful in certain specific types of situation e.g.

1. where the business was regulated (e.g. by the Solicitors’ Regulatory Authority),

2. there was a “people” business with few physical assets or

3. where a brand, intellectual property or lease portfolios would be irrevocably damaged

Conclusion

• Something needs to be done• Whether the new policy is informed by the

hypothetical creditors’ bargain or communitarian, forum theory or multiple values principles – the main problem:

• The apparent lack of independence of the pre-pack administrator and the consequent suspicion that unsecured creditors get a raw deal

Conclusion

• It may have been possible for the profession to sort these problems out with the drafting of SIP 16 and the new Code of Ethics

• The perception is that, especially with management buy-out pre-packs that the management get all the benefits and the unsecured creditors all the pain

• The process needs to be seen to be more collective

Conclusion

• It might be interesting to introduce provisions balancing out that loss more in favour of unsecured creditors

• Pre-packs could be limited to certain types of situations only and then only with the approval of the court

• As a minimum an independent IP needs to appear in the process and there needs to be a creditors’ meeting – a liquidation subsequent to the pre-pack

Conclusion

• Requiring a creditors’ meeting prior to the pre-pack may defeat the whole object of a pre-pack

• Paying two or even three IPs may not lead to wealth maximisation from the viewpoint of the unsecured creditors

• Any solution to the ongoing furore around pre-packs would need to emphasise honesty and fair dealing