In May 2016 the UK government published its Review of the Corporate Insolvency Framework - A Consultation on options for reform.
- In November 2016 the European Commission published proposals for a directive on 'preventative restructuring frameworks and second chance for entrepreneurs'.
- Both sets of proposals include, in broad terms, a moratorium against creditor enforcement, preservation of essential supplies, a restructuring or cram down plan, and measures to protect rescue finance.
- Brexit may have taken over the economic and political landscape, but in the meantime other nations are reforming insolvency law in this direction. If the UK does not, does it risk compromising its reputation at the forefront of international corporate restructuring?
I recently attended an excellent interactive seminar on India's new Insolvency and Bankruptcy Code 2016, which received presidential consent on 28 May 2016 and has been hailed as a great step forward for the existing Indian insolvency and bankruptcy framework. During a lively debate, questions discussed included:
- How long should a pre-insolvency moratorium last?
- What should be the valuation basis for cramming down creditors as part of a rescue?
It occurred to me straightaway that these issues were by no means confined to the new Indian code, but were being considered in various parts of the globe.
They arose in this jurisdiction during the UK Insolvency Service's ('Government') recent Review of the Corporate Insolvency Framework - A consultation on options for reform, May 2016 (the 'Consultation') with which I was involved during a brief secondment to the Insolvency Service's Policy Unit in 2016.
Readers will also be aware that on 22 November 2016 the EU produced its proposals for a directive on 'preventive' restructuring frameworks and second chance for entrepreneurs.
Whilst the UK will, of course, be exiting the EU, certain core issues have been raised by both the EU's consultation and by the UK's Consultation. These include a temporary stay of enforcement proceedings (moratorium), preservation of essential supplies, a new type of restructuring plan or cram down mechanism and protection for interim financing. These issues transcend national boundaries and are as prevalent as ever. The potential impact of the proposed reforms raises numerous questions, but there follows a brief discussion of certain key issues and ongoing bones of contention.
The Consultation suggested a preliminary moratorium lasting up to three months, with the possibility of an extension. This was to be a gateway to a rescue or turnaround, with directors remaining in control, subject to an authorised supervisor or monitor ('Monitor') to ensure compliance with entry requirements and fairness to creditors.
Whilst administrations regularly benefit from their own statutory moratorium, the 'small companies' moratorium when putting forward CVA proposals under Sch A1 Insolvency Act 1986 (the 'Act') is understood to be very seldom used.
The Government published its summary of responses in September 2016. Some 67% of Consultation respondents were in favour of a moratorium; 37% of these respondents as proposed by the Government, and 63% subject to refinements. A few of these 'refinements' were straightforward, such as whether the Monitor role should be opened up beyond IPs to solicitors or turnaround managers; some 60% rejected that in favour of the skills and experience of licensed and regulated IPs. Equally strident was the concern at abuse by directors on the one hand, weighed against onerous monitoring by the IP on the other - the latter often seen as the reason why the Schedule A1 moratorium is seldom used. For the moratorium to work effectively it must surely earn creditor trust, and not be disproportionately expensive or bear an unhelpful insolvency stigma.
Most of the debate, however, was reserved for how long the stay should last. R3 had suggested 21 days in its own proposals. The UK Government suggested up to three months, but with power to extend. Seventy-six per cent of those responding disagreed with that. The EU's proposals suggested four months. The Consultation responses varied hugely, from fear of suppliers having to wait so long they risked contagion of knock-on insolvencies, to recent experience of multi bank restructurings where it had taken three months alone just to obtain a short standstill agreement from the banking syndicate.
It might be argued that a one size fits all approach would only work with a short initial stay of say 28 days, with powers for the Monitor to extend for one further fixed period only. Any subsequent extensions would require something concrete, such as the debtor having filed its CVA/Scheme proposals, or formal sanction from the creditors or the court.
Whilst opinion on the duration and the details were somewhat diverse, one feels that a consensus could eventually be reached. The bigger challenge is how to ensure directors would make use of a moratorium responsibly to obtain professional advice and take meaningful steps to address their company's finances whilst there is still time.
No matter how well intentioned, a moratorium won't be enough to rescue a viable business if the key supplier exercises its right to terminate, or demands a significant so-called 'ransom' payment for ongoing support. Utilities, and since 1 October 2015, certain IT services, already enjoy protection in CVAs, administrations and liquidations under ss 233 and 233A of the Act. R3 had recently expressed similar concerns in its campaign entitled 'Holding Rescue to Ransom'.
The Government proposed to extend essential supplies:
- to the moratorium and to the new restructuring plan (see below); and
- beyond the IT and utilities sectors, with what is 'essential' justified by the debtor.
The company would designate a certain supply contract as essential, whereupon the supplier concerned would not be able to enforce payment of arrears and would have to continue the supply at the same price, but would be paid for the new supplies in full.
The Government's suggested criteria are:
- the supply being essential to a successful rescue/ongoing viability;
- no alternative supply available within a reasonable timeframe at a reasonable cost;
- enough liquidity to meet ongoing payments (although not necessarily the arrears); and
- whether the supplier can objectively justify to the court a refusal to supply.
A majority of those responding thought this would lead to more business rescues, but just under half agreed with the criteria under consideration. Broad support in principal was tempered by concern that it was too debtor friendly.
Many thought some supply sectors - such as financial services - should be carved out. Some recognised the need for a hardship test; for example, what if the supplier's own supplier was insolvent and had ceased production? Carillion's recent liquidation has reminded us of the unfortunate risk of insolvency contagion.
It was felt to be onerous on the supplier to incur the costs and risks of challenging its 'essential' nature in court. Could the supplier not make its challenge in the form of a notice, compelling the debtor to obtain a court order or accept the supply was non-essential? This would reverse the burden of proof, and the debtor would bear more of the risk. However, if almost any supply sector can potentially be caught, we need something to prevent debtors abusing the proposed reforms by designating (or threatening to designate) supplies as essential when they are not essential. Therefore defining what is 'essential' and having a clear and fair process to challenge particular designations will be critical to the proposals working fairly.
New restructuring plan
Perhaps the most radical suggestion was to introduce a new restructuring procedure which could be imposed upon a dissenting minority of creditors. Restructurings are becoming ever more complex. CVAs cannot affect secured or preferential debtors without their consent, although at times they have been successful at cramming down landlords. Overall the post-CVA survival rate is thought to be on the low side. Schemes of arrangement work well at the top end of the market, but they cannot cram down dissenting creditors, at least not without an additional assignment of assets and retained debt to a new corporate entity which can be prohibitively expensive. There are also contractual workouts under a standstill agreement without a statutory process.
The Government felt there was a gap in the legislation in the space between a CVA and a scheme, where a flexible restructuring plan could divide creditors into classes for voting purposes (including secured or preferential creditors whom CVAs cannot prejudice) but unlike a scheme, cram down a class of, say, junior or mezzanine creditors who are out of the money, even where that particular class votes against the proposals. Court sanction of the creditor class categorisation and of the plan generally could ensure fairness, but the Consultation proposes that junior creditors who are out of the money could not automatically vote down a rescue, provided that they would not receive less than they would in a liquidation.
That brings us back to the point debated at the seminar on the Indian Insolvency and Bankruptcy Code, namely whether a liquidation or forced sale valuation is the right approach for a trading company which successfully restructures and returns to profitability. Only 40% agreed that this is the correct approach. Many recognised that valuation was a highly contentious issue, but that liquidation should not be the default option. Instead the comparison should be more flexible and focus on the next best restructuring outcome, be that a scheme, an administration, or a going concern sale. That the valuation issue is a contentious one has been borne out in Chapter 11 litigation in the US, as well as the debate surrounding India's new legislation as mentioned above.
The compensation question does not stop there, as many would consider it inequitable if certain creditors' debts were crammed down or written off entirely, only for the company to return to profit to the benefit of its shareholders. There may be a strong argument for giving such creditors a new class of shares, ahead of existing shareholders so that the existing priority is not altered, in order that the crammed down creditors can be compensated in equity if the restructuring succeeds. Shareholder voting would obviously be required, subject to the same cram down provisions as creditors.
Some 61% of those responding thought that a court approved cram down should be possible in some circumstances. A number acknowledged that such a procedure would be expensive and only used by the larger companies and groups. If the restructuring plan is to work best, it will need to be fit for purpose; more streamlined than a scheme, but with a wider reach than CVAs.
The final proposals included in the Consultation were designed to encourage rescue finance. A previous consultation back in 2009 included proposals for super-priority for rescue funding in administrations and CVAs, but in the light of the responses received, the proposals were not progressed. The Government believed that changes in market conditions warranted taking the temperature again, and put on the table fresh proposals to give super-priority to new lenders and to override negative pledge clauses in existing lenders' security.
Of those responding, 73% did not agree with these proposals. Views were expressed that it was rarely the lack of rescue finance which prevented a business rescue, that there was no shortage of funding for genuinely viable businesses, and that the existing legal framework did permit rescue finance. Concern was expressed that changing the priority of security could increase the cost of borrowing.
The response in the UK may have been less than lukewarm, but it is worth noting that the draft EU Directive seeks to encourage and protect interim financing, and to allow member states to grant such financing priority status over unsecured creditors at least.
At the time of the UK Government's Consultation, the context appears from the Consultation Document to have been firstly an opportunity to review the corporate insolvency regime (which was largely unchanged since 2004 notwithstanding the financial crisis), and secondly to assist achieving the Conservative Party's 2015 election manifesto to bring the UK in the top five in the world, and number one in Europe, in the World Bank's annual Doing Business Report.
Since then the UK has voted to leave the EU. Not only does it seem unlikely that the UK can remain within the Recast EU Regulation on Insolvency Proceedings, but the UK's role in European trade and financial services generally remains very unclear. On any view, the context to these proposals has shifted significantly since the Consultation.
Yet there is still a certain 'noise' surrounding insolvency reform. Nations such as India (moratorium) and Singapore (cram down structure) have recently included parts of these. There is currently no real reason to believe the EU Directive will not go ahead, albeit modified. Whilst the corporate reforms are still being considered, HM Treasury has launched a call for evidence inviting views on the best design for a scheme to give debt stricken individuals a breathing space of up to six weeks without accruing further interest, charges or enforcement action. This would widen considerably the scope of the interim order pending approval of IVA proposals. It would seem odd to introduce a new moratorium for individuals, but not for companies.
The proposals may be somewhat radical, and the challenge of Brexit overwhelming, but despite the turmoil, as the debate on India's recent reforms made clear, these are international issues, not just domestic ones, and they show no signs of going away. If the UK is to remain at the forefront of international restructuring, these reforms will need renewed impetus.
This article was first published in the February 2018 edition of Corporate Rescue and Insolvency Journal.