Rising from the ashes

30 September 2021

Creditors can often confuse (i) the outlawed practice of “phoenixing” with (ii) pre-pack administrations. The former is an abuse of the privilege of limited liability through (often repeatedly) liquidating a company laden with debts only to emerge shortly after under the guise of a new limited company, debt free, effectively carrying on the exact same business with the same name, premises and people. Section 216 Insolvency Act 1986 (“Act”) was introduced to tackle this practice by making it a criminal offence for anyone who was a director (including shadow director) in the previous 12 months before a company goes into insolvent liquidation from becoming concerned or taking part in a new company with the same or similar name for a period of 5 years except with the court’s permission. The latter is a perfectly legitimate (indeed, valuable) restructuring tool whereby a business or assets (but not the liabilities) may be sold by administrators upon (or shortly after) their appointment to a newco operated by persons previously connected with the insolvent company under a deal that was negotiated prior to the administration. Pre-pack deals can often be vital in extracting maximum value from a failing business for the benefit of creditors faced with an alternative scenario of liquidation. Part of the pre pack deal is likely to include a sale of the goodwill and intellectual property rights allowing the newco to carry on the same business or under the same brand, as before. To the outside world there may not appear to be much difference between the two – both result in the “death” of one company and the birth of another but, legally, they are different despite raising similar concerns/issues for creditors.

One of those concerns is the lack of transparency and accountability. Often the speed in which a pre-pack sale and administration is executed behind the scenes (or in a creditor’s eyes “behind their back”) has led to criticisms that the process is not necessarily in the best interests of the creditors. This criticism can be particularly acute in respect of sales to related third parties and in relation to whether the administrators can be said to have complied with their duties to market a sale of the business/assets at the best available price for the benefit of all creditors.

Attention has also, sometimes quite rightly, focussed on the directors of these companies, their conduct and whether they were, or had been, acting in creditors’ or their own best interests.

In response to these two concerns, the government has introduced two separate pieces of legislation aimed at redressing the abuse of “killing off” companies to escape liabilities. One recently came into force, the other is currently before parliament.

Pre pack reform

The Administration (Restrictions on Disposal etc to Connected Persons) Regulations 2021 (the “Pre Pack Regs”) came into force on 30 April 2021 with the aim of addressing concerns over the lack of transparency for creditors in the pre-pack administration process, specifically, pre packs involving sales to “connected persons”. “Connected persons” is not redefined in the Pre Pack Regs but is defined by cross reference to sections 435 and para 60A of Schedule B1 of the Act.  In other words they are previous directors or officers and/or any associates (relatives etc) of any director and/or any companies in which the previous directors are or have been a director.

The Pre Pack Regs now make it a legal requirement that prior to a “substantial disposal” (a sale of all or a substantial part of the business or assets to one or more connected persons within the first 8 weeks of administration) the administrators must either: (1) obtain the prior consent of the creditors through the usual administrators’ proposals procedure under para 49 of Schedule B1; or (2) ensure that the purchasers obtain a “Qualifying Report” from an “Evaluator” prior to the sale. Readers will note that the “substantial disposal” definition in the Pre Pack Regs captures not just a pre-pack arrangement but also sales by administrators in the early days of the administration (first 8 weeks).  The aim is to prevent early disposal of businesses and assets before creditors have had a proper opportunity to scrutinise the sales.

The qualifying report must be a made by an evaluator who self certifies as to having the relevant knowledge and experience to make a report. The evaluator is taken to have met the requirements unless the administrator has reason to believe otherwise. One obvious criticism is that there appears to be a relatively low bar to entry for an evaluator. The qualifying report must contain certain prescribed information but the crux of the report is that it must contain a statement by the evaluator that they are satisfied that “the consideration to be provided for the relevant property and the grounds for the substantial disposal are reasonable in the circumstances or, as the case may be” or confirm if they are not satisfied (a “not satisfied” statement). The evaluator must also provide their principal reasons for their statement and a summary of the evidence relied upon. There is protection within the Pre Pack Regs to prevent directors obtaining multiple qualifying reports before they obtain one that is favourable to them by imposing obligations to disclose all reports to creditors.

It is important to note that whilst the qualifying report must be obtained and disclosed to creditors (it should be disclosed at the same time as the administrators’ proposals under para 49 of Schedule B1) there is nothing within the Pre Pack Regs that gives the evaluator the power to terminate the sale if not satisfied. In theory, therefore, a pre-pack deal could be completed prior to creditors coming to vote on the administrators’ proposals provided that a qualifying report was obtained first. That said, whilst each case will be determined on its own facts, it would be a brave administrator to march steadfastly on with a pre-pack sale following receipt of a “not satisfied” statement without very compelling reasons. Not only would they face the very realistic prospect of having creditors reject the proposals and take action against them but it is also difficult to see how an administrator might justify their actions in their SIP 16 statement and demonstrate compliance with SIP 16. They also risk potential regulatory or disciplinary proceedings.

Thus, whilst the Pre Pack Regs might lack real teeth in terms of detail the onus is still very much on voluntary compliance and the ability of administrators to explain and justify the steps they are taking to creditors.

Rating (Coronavirus) and Directors Disqualification (Dissolved Companies) Bill (the “Bill”)

The Bill is currently on its second reading in the House of Lords although it is anticipated it will be made into law in the coming months. It is designed to close a current loophole in the law that prevents the Insolvency Service from investigating the conduct of previous directors of a dissolved company and instigating disqualification proceedings against them. Currently, a director’s fitness for office can only be investigated for live companies or currently insolvent companies (usually following the statutory report of administrators/liquidators). Disqualification proceedings are covered in both scenarios by Company Directors Disqualification Act 1986 (“CDDA86”), section 6 and 8 respectively.

The Bill intends to amend the CDDA86 by including a reference to its application to the directors of dissolved companies. Moreover, the current intention is that the amendments will have retrospective effect although the ordinary rules of limitation will still apply, limiting the scope of the retrospective effect. The Bill’s changes will allow the conduct of directors of both live and “dead” companies to be investigated without the need for a time consuming and expensive company restoration application. The explanatory memorandum accompanying the Bill suggests that the policy behind it is driven, in part, by concerns over the Covid-19 pandemic and abuse by directors of claiming relief under the various government rescue schemes e.g. furlough payments, CBILS/BBLS loans with no intention of repaying them but opting to voluntarily dissolve the companies to avoid insolvency scrutiny and avoid investigations into their conduct under the CDDA86. We have written before about how the government rescue schemes were susceptible to fraud which you can read here and here.

Comment

Whilst a company might be put out to “die” through insolvency or a dissolution process, the government’s focus in the new legislation is certainly to, in certain circumstances, raise it again from the ashes at least in terms of holding both directors and administrators accountable to creditors for their prior actions.

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