UK: Corporate Restructuring and Insolvency: Administration Pursuant to Section 8 of the Insolvency Act 1986: Two Recent Cases of Interest to the US

Last Updated: 21 May 2003

The Meaning of Insolvency — A Message to US High-Yield Investors and Acquirers of Distressed Debt in Europe

In Re Colt Telecom Group Plc [2002] EWHC 2815, the English Court has sent a clear message to US high-yield investors and acquirers of distressed debt that when considering the meaning of insolvency for the purposes of an English administration, it will not tolerate "shaky, tentative and speculative" arguments as to the financial health of companies.

Colt carried out business through its trading subsidiaries. Its business comprised the provision of advance telecommunications services to corporate and government customers across Europe (totalling £2.6 billion as at 30 September 2002). Its assets consisted primarily of cash held by it and investments in its subsidiaries comprising shareholdings in, and long term funding to, those subsidiaries. Its liabilities consisted principally of its indebtedness under 9 series of Notes issued by it between 1996 and 1999. Its business had also been funded by raising equity capital totalling more than £2 billion, the most recent being approximately £500 million in December 2001.

The Petitioners, Highberry Limited (an English company incorporated in November 2001) and its affiliate Highberry LLC (a Delaware Corporation incorporated in September 2002) were hedge funds which formed part of the US Elliott Associates group, specialising in the taking of short positions in company shares and acquiring debt securities at a discount in the hope of a rise in price.

At the time of the Petition, Highberry held approximately 7% in value of the Notes. There was no indication of any support for the Petition from the holders of the remaining 93%.

The Petition was considered to be unusual in that Highberry’s principal argument was that Colt was or was likely to become insolvent notwithstanding that it was a constituent member of FTSE mid-250 index and had a market capitalisation of £550 million, not to mention its net assets of £977 million. In addition, the various series of Notes issued by Colt were not in default and did not fall for repayment until the period 2005 to 2009. In their proposals, Highberry relied upon a dramatic fall in the Colt share price since the year 2000 and its substantial operating losses and negative cash-flows.

The object of the proposed administration was purportedly to achieve a restructuring through a transfer of value of the company from the shareholders to the bondholders either by a debt for equity conversion or by payment out of Colt’s cash or both. Highberry had made an initial approach to Colt suggesting a 100% payment of the face value of the Notes, even though repayment of capital was some years away and Highberry had obviously bought the Notes at a discount. The Court considered that Highberry was "after a large and quick profit" and it was accepted that companies associated with the Elliott group had taken short positions in the shares of Colt.

Colt submitted that it believed the Petition to be part of a strategy to make a speculative profit from Highberry’s acquisition of Notes at a discounted price and also from their (or their affiliated companies’) short position in Colt’s shares and that Highberry was seeking to achieve the profit by forcing an unjustified transfer of value from shareholders to Note holders.

Highberry had previously brought a fair amount of pressure to bear upon Colt such as by sending letters to each Colt director at home threatening an investigation into the directors’ conduct and, by implication, wrongful trading proceedings.

Against that background, the Court had to determine six issues:

Must a Petitioner prove that the company is "likely to be unable to pay its debts" within section 8(1)(a) IA 1986, on a balance of probabilities or is it sufficient for it to prove that there is a real prospect of that being so? According to the Judge, the meaning of the word "likely" is in effect "more likely than not". In other words, where a Petitioner alleges that a company is likely to become unable to pay its debts, the Petitioner must show that this is more probable than not. A company should not be put into administration where there is only a "real prospect" of insolvency, and the Judge did not consider in this case that insolvency had been proved on the "real prospect" test in any event. The Judge stated: "To put a company into administration is a serious matter. Creditors, as well as the company itself, can apply. To expose the company to all the expense, danger, and problems associated with administration is a serious matter. It is most unlikely that Parliament intended this when there was only a real prospect of insolvency rather than where insolvency was more probable than not".

Is the ability to present a Petition forbidden by the "no action" clause under the terms of the Notes and their associated Indenture - a question of New York Law? Clause 6.6 of the Indenture stated: "A holder may not pursue any remedy with respect to this Indenture or the Notes…". Each side produced an expert witness on New York Law, who both agreed that there was no direct New York authority in point. Highberry’s expert witness contended that the no action clause had no application prior to an event of default and in any event only applied to "contractual claims", being those based on the terms of the Indenture or Notes and not claims such as for the appointment of a Receiver or the equivalent of an Administrator.

However, the Court preferred the evidence of Colt’s expert witness for various reasons:

  • Colt’s expert had very considerable practical experience of the issue of bonds, unlike Highberry’s witness;
  • The suggestion that the clause did not apply to pre-Event of Default situations produced an illogicality — freedom for all to act at a time when the situation is not so serious as a default, but a restriction when there is a default. This made no commercial sense. The Court could see no rational purpose for individual bondholders being able to rock the boat before default but not after.
  • In addition, there was no rational purpose in limiting the bar to "contractual claims". If it were so limited then individuals could undermine the policy by applying for a Receiver or the sort of action taken in this case.

Even if the no action clause is effective as a matter of New York law, does English law public policy override its effect? The Court found this submission and its potential effect startling. It would mean that English companies could not readily issue bonds with no-action clauses; whatever the terms of the bond, and whether pre or post default, they would be exposed to the potentiality of a single bondholder bringing an administration Petition. It was not self-apparent why the clause should be overridden by public policy. Such bonds were regarded as enforceable under New York law with no harm to public policy.

In essence, Highberry argued that the principle that the right of a contributory to petition cannot be abrogated or restricted by provisions in the Memorandum or Articles of the Company, should be extended to contracts made by companies with their Creditors.

The Court rejected Highberry’s argument. The clause did not fetter the rights of the Company but was merely restricted to the creditors’ rights created by contract and not statute. The application of a rule of the law of a foreign country may only be refused if such application is manifestly incompatible with English public policy. Even if the English Court took the view that no action clauses were invalid if governed by English law, they did not have such an inherent vice that English law would not respect a foreign law which permitted such clauses.

Is Colt cash-flow insolvent? Highberry argued that there was no risk of cash-flow insolvency until 2006. But, by then, some of the capital due on the Notes would be repayable and the company would not, if things carried on as they had, have the ability to pay. In particular, it was not clear whether the company would be generating enough cash-flow from its assets. Nor was it clear that anybody would be willing to re-finance the company in 2006.

The Court was not impressed with this argument and described it as "a shaky, tentative, and speculative peering into the middle-distance", and formed no basis for placing the company into administration.

Balance Sheet Insolvency. This was Highberry’s primary allegation, based upon the application of Financial Reporting Standard 11 - impairment of fixed assets and goodwill. In essence, FRS 11 deals with the valuation over a long term of an asset in use.

A key element of the necessary analysis comprised the calculation by discounting of the expected future cash-flows of the asset in question. A discount rate should be an estimate of the rate that the market would expect on an equally risky investment. Estimates of the market rate may be made by a variety of means including reference to the current weighted average cost of capital (WACC).

The Court held that the proposed administrator had calculated WACC simply by reliance on the bond price, despite that price itself depending on the promised yield to redemption, general yields in the market, and a factor representing the risk of default. Such reliance upon an instantaneous bond price alone was not a rational fair way of valuing in accordance with FRS 11, and the 24% WACC suggested by the proposed administrator was rejected by the Court without hesitation. It followed that the company was not balance sheet insolvent.

Discretion. On the basis of the above findings, the Court considered that it did not have jurisdiction to put Colt into administration. There had never been any substance whatsoever in the Petition and it should never have been launched. If the Court were wrong however, the Judge considered that he would not exercise his discretion in any event for various reasons, including:

  • The making of the administration Order would be an event of default under the terms of the Indenture which would mean that all of the debt was repayable immediately. That would destroy the entire business rather than serve the statutory purpose of the survival of the company and the whole or part of its undertaking;
  • The Petition had very little support if at all;
  • It was premature. There was no suggestion of urgency given the concession that creditors would not have to be paid until at least 2006;
  • There was no indication that an administrator with knowledge of the telecoms business could improve the current specialised management and it would almost certainly stop the business in its tracks;
  • The administration Order would simply add to the company’s costs, if its business survived.

In the course of the judgment, the Court addressed the nature of the evidence given by the proposed administrator, as author of the report prepared pursuant to Rule 2.2 of the Insolvency Act 1986. The Judge stated that:

  • Part 35 of the Civil Procedure Rules in respect of expert evidence governed expert opinion evidence given in the Rule 2.2 report;
  • Where a Petition is likely to be contested, the author of the report ought to re-read the Rules and the Code governing expert evidence before writing the report;
  • Where the Petition is likely to be contested, the insolvency practitioner asked to give evidence to support such a case should not propose himself as the administrator. This did not apply, however, to Petitions initiated by directors, notwithstanding that there is a small conflict of interest in those cases;
  • Where a Petition is contested, the author of the Rule 2.2 report has a direct interest in the outcome of the proceedings, and he should make an express and full statement of this fact in the report, since the existence of a conflict has an effect on the weight to be attached to the evidence in the report;
  • Where evidence in support of a Petitioner’s opinion evidence is not within the expertise of an insolvency practitioner, individuals who are "true experts" should give evidence. The proposed administrator in this case appeared to set himself up as the relevant expert valuer for the purposes of FRS 11, when it transpired that he had no expertise whatsoever in FRS 11. Saying, "I know a man who knows and he has explained it to me", is not expert evidence.

Conclusion. The judgment makes clear that given the serious consequences of administration, the Court will not tolerate speculative arguments about a company’s future financial health and therefore whether one of the purposes of administration could possibly be achieved.

Jurisdiction to Make an Administration Order in Respect of a US Company under the EC Regulation on Insolvency Proceedings

In Re BRAC-Rent-a-Car International Inc [2003] EWHC Ch 128, the English Court held that a company incorporated in Delaware could have its "centre of main interests" in England and accordingly be placed into administration pursuant

to the EC Regulation on Insolvency Proceedings.

Although the company was incorporated in Delaware, it had never traded in the US. Its operations were conducted almost entirely in the UK. Until a short time before the judgment, it was part of the Budget group and its business entailed managing the European, Middle Eastern and African operations formerly carried on by the Budget group.

The company traded from an address in England and for a long time had been registered under the English Companies Acts as an oversea company. It had no employees in the UK, and all its employees worked in England with contracts of employment governed by English law, apart from a small number in a branch office in Switzerland. Its trading activities were carried on by way of contracts governed by English law with subsidiaries and franchisees.

Along with other members or former members of the Budget group, the company was in Chapter 11 administration in the US. However, since the Chapter 11 moratorium effect as regards creditors is not directly effective in the UK, it was considered that an administration order by way of protection against creditors in England was necessary. One judgment creditor with the benefit of an Italian arbitration award in Italy for a sum exceeding £1.1 million, had obtained an interim charging order over property of the company.

EC Council Regulation 1346/2000 of 29 May 2000 on Insolvency Proceedings ("the Regulation") has direct effect in all of the EU member states as of 31 May 2002. Nevertheless, the English Insolvency Act 1986 was amended in various respects including Section 8(7) to the following effect:

"In this Part a reference to a company includes reference to a company in relation to which an administration order may be made by virtue of article 3 of the EC regulation".

The question of whether the English Court had jurisdiction to make an administration order in relation to the US company turned on article 3, paragraphs 1 and 2, which state:

"1. The courts of the Member State within the territory of which the centre of a debtor’s main interests is situated shall have jurisdiction to open insolvency proceedings. In the case of a company or legal person, the place with the registered office shall be presumed to be the centre of its main interests in the absence of proof to the contrary.

2. Where the centre of a debtor’s main interests is situated within the territory of a Member State, the courts of another Member State shall have jurisdiction to open insolvency proceedings against that debtor only if he possesses an establishment within the territory or that other Member State. The effects of those proceedings shall be restricted to the assets of the debtor situated in the territory of the latter Member State."

According to recital (12) of the Regulation, the Regulation enables the main insolvency proceedings to be opened in a Member State where the debtor has his centre of main interests.

There is no definition of "centre of a debtor’s main interests" in the Regulation, apart from the rebuttable presumption in article 3.1, but the meaning of the phrase is merely illuminated by recital (13) which states: the " ‘centre of main interests’ should correspond to the place where the debtor conducts the administration of his interests on a regular basis and is therefore ascertainable by third parties".

Recital (14) states: "this regulation applies only to proceedings where the centre of the debtor’s main interests is located in the Community".

In essence, none of the other articles of the Regulation assist in determining the question whether debtors in relation to whom the insolvency proceedings governed by the Regulation may be taken are limited to those incorporated in the Community or not. The only test stated in the Regulation was that of the location of the centre of a debtor’s main interests.

Other EU legislation, such as the Eleventh Company Law Directive 89/666/EEC, extended to companies incorporated outside the EU. In this particular case the Company was registered as a branch under Section 690A of the Companies Act 1985, which itself gave effect to the relevant provision of the Eleventh Company Law Directive.

Furthermore, in relation to the Brussels Convention (now replaced by Regulation 44/2001) the Court of Appeal in The Deichland [1990] 1 QB 361, held that a company incorporated in Panama but in relation to which central management and control was exercised in Germany, had its "seat" in Germany. On that basis the Brussels Convention applied, and the company was entitled to insist on being sued in the Courts of its domicile, being another contracting State rather than in England. The Court of Appeal was therefore persuaded that Community legislation was by no means necessarily limited to legal persons incorporated in a Member State.

In all the circumstances, the Court in the BRAC-Renta-Car case accepted that the Regulation gave jurisdiction to the Court of a Member State to open insolvency proceedings in relation to a company incorporated outside the EU if the centre of the company’s main interests was in that Member State. If it had been intended that, as regards legal persons, only debtors incorporated in the relevant Member States should be affected by the Regulation, it would have been easy to say so. If such a limitation were intended, it was surprising that it did not appear at all in the 33 discursive recitals to the Regulation, not to mention the substantive provisions of the Regulation.

Even on a purposive interpretation, the Court considered that to read the Regulation as being limited (as regards legal persons) to debtors incorporated in any of the Member States, would prevent the Regulation from achieving some of the purposes described in the recitals and would leave it open to avoidance by means of, for example, forum shopping among the Member States.

Accordingly, the Regulation did give the Courts of Member States jurisdiction to open insolvency proceedings in relation to a corporate debtor incorporated in Delaware, if the centre of the debtor’s main interests was within that Member State, as was the case in this instance.

Comment. The case is widely considered to be correct. However, its use is likely to be of more relevance to off-shore companies with operations in the UK, rather than US companies. Today, most US groups which operate in the EU, will incorporate in Europe. In this particular case, Budget itself was incorporated in the 1960s, and the structure of the business was probably a throw-back to that time. Therefore, the significance of the case probably goes no wider than that a wide variety of commentators thought that the Regulation could only apply to companies incorporated in another Member State. Whilst it has been hailed as giving the Regulation global reach and opening up the availability of administration for the UK operations of US companies, this particular US company had its centre of main interests in the UK, and that simply is the test going forward.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

©2003 Jones Day Gouldens. All rights reserved.

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