UK: Pre-Packs: A Coming Of Age?

Last Updated: 16 December 2009
Article by Richard Baines and Andrew Carpenter

Originally published in the November 2009 issue of In-House lawyer.

The Pre-Pack Administration, after some difficult formative years, appears to have emerged as a legitimate restructuring tool. Criticisms levelled by creditors, certain that they are getting a bad deal, have been numerous and, as a consequence of actions by creditors, the pre-pack has been put under the microscope in court. Out of all this has emerged something that appears to be seen by the court as a process that is compliant with statutory rules and policy. This article looks at the development of the prepack and asks whether it has now 'come of age'.

The Enterprise Act (EA) 2002 paved the way for a company and/ or its directors to appoint an administrator without judicial scrutiny through the out-of-court route. This soon led to the mushrooming use of the pre-pack administration: a pre-arranged sale of a distressed business that is executed by the administrator immediately after their appointment. There are no statutory provisions referring to pre-packaged sales as a permitted business rescue tool and, because statute itself does not provide a clear answer in relation to their legality, it has been left to the courts to decide whether it is a legitimate procedure.

Pre-Enterprise Act 2002

Critics of pre-packs argue that they are essentially no different from an old-fashioned liquidation sale to a 'phoenix' company controlled by the same directors. Is this really fair comment?

In the well known case of Re Centrebind Ltd [1967], the members of an insolvent company resolved to go into voluntary liquidation and appointed a liquidator who, ahead of the creditors' meeting, took action to prevent a creditor (the Inland Revenue) from exercising a right of distraint over company assets. The court held that the process was valid. The liquidator had power to act in the period between appointment and the creditors' meeting. Subsequently, the loophole created in the Centrebind decision was often abused and Centrebinding became a device too often used by rogue directors. By this route, working with the liquidator, management could effectively sell the company's business and assets to a new company controlled by themselves, usually leaving the creditors with nothing.

Of course, Centrebinding emerged in the days when there was no requirement for liquidators to be licensed insolvency practitioners and there was nothing like the degree of regulation of the insolvency profession that now exists. The law was revamped in the Insolvency Act (IA)1986, including the introduction of s216 – restriction on re-use of company names, which was specifically intended to prevent Centrebinding. Section 216 is aimed at directors who take part in the promotion, formation or management of 'phoenix' companies (whether as a director or not) following an insolvency sale and breach of its provisions will, if convicted, lead to imprisonment or a fine. As well as this criminal sanction, s217 imposes personal liability for the company's debts on those involved in the management of a 'phoenix' company in contravention of s216. Clearly, these 'phoenix provisions' need to be complied with by those taking part in or advising on a prepack sale if it is likely that the company will go into liquidation following administration, as they apply during a period of five years beginning with the day on which the company went into liquidation.

Throughout the 1980s and 1990s the prevailing judicial view was that permission was needed if the administrators wished to sell the business prior to the creditors' meeting1. However, Neuberger J's judgment in Re T & D Industries [2000] went against the grain. The court held that administrators have the power to sell the whole of the assets and business of the company in advance of convening a creditors' meeting, and without the need to go to the court for directions. The legislation on this point remains the same under the post-EA 2002 regime.

Consistent with the policy decision in T & D, the court accepted in Re Transbus International Ltd [2004] that the administrator will often need to move quickly to preserve value in the business which would otherwise be lost. Of course, while T & D and Transbus bear most of the hallmarks of a pre-pack, they were not pre-pack cases as such. In fact, these cases were actually concerned with an accelerated sale of the business. Accelerated sales, in common with pre-packs, involve a sale of the business prior to a creditors' meeting, but in an ordinary accelerated sale the deal is not arranged prior to the appointment of the administrator.

Post-EA 2002: out-of-court appointment regime

The post-EA 2002 regime allows an administrator be appointed out of court under paragraph 68 of Schedule B1 of IA 1986. The out-of-court appointment allows the administrator to enter into an immediate sale of the company's assets without any involvement of the creditors or any court scrutiny.

A key case in the development of the pre-pack sale was DKLL Solicitors v HM Revenue & Customs [2007]. It concerned an application for an administration order by the two equity partners of DKLL Solicitors. Amongst DKLL's liabilities of £2.4m was a debt to HM Revenue & Customs (HMRC) of £1.7m, making HMRC DKLL's majority creditor. The underlying purpose of the application was to preserve value by enabling the proposed administrators to effect a pre-pack sale of DKLL's business to a newly incorporated limited liability partnership for a total consideration of £400,000. The application was made urgently because HMRC had issued a winding up petition against DKLL that was due to be heard the day after the hearing of the application. HMRC opposed the application.

In a decision that demonstrated the support of the court for pre-packs, the administration order was granted despite HMRC's opposition. The court did so on the following grounds:

  • In cases such as this it is appropriate that the court 'places great reliance on the expertise and experience of impartial insolvency practitioners' and the evidence presented to the court by such experts to determine whether the administration order was reasonably likely to achieve the purpose of the administration. No evidence had been produced by HMRC to suggest that the business could be sold for more than the price that would be achieved in the administration.
  • In relation to HMRC's opposition to a pre-pack sale in administration, even a majority creditor did not have a veto on the implementation of the administrators' proposals. The court can authorise the implementation of the administrators' proposals, notwithstanding the opposition of the majority creditor or, indeed, any other creditors. Accordingly, HMRC's opposition did not make it 'reasonably likely' that the objective of achieving a better result for creditors in an administration than in a winding up would not be achieved.
  • HMRC submitted that if this was not a pre-pack, then their opposition to the proposed sale would mean that it was not 'reasonably likely' that the purpose of the administration would be achieved. The judge disagreed. There was a real prospect that the court would authorise the sale regardless.
  • In exercising its discretion as to whether to make an administration order, the court ought to take HMRC's opposition into account. But it should also consider the interests of the other stakeholders, and the proposed sale appeared to be the only way of saving the jobs of the 50 or so employees of the partnership. It was also likely to result in the affairs of the partnership's clients being properly dealt with and with the minimum of disruption to those clients.

The decision in DKLL also showed that the court accepted that in light of T & D and Transbus, the administrators had power to complete the proposed sale without the sanction of a creditors' meeting or a direction of the court. So now, pre-packs are not limited to administrators appointed out of court.

In the Re Bluebrook Ltd [2009] case, examined in detail on p40 IHL174, the court again endorsed the pre-pack. This was a restructuring involving schemes of arrangement coupled with the transfer of business and assets to newcos by pre-pack and was viewed by the court as entirely legitimate.

Criticisms

So what specifically are the criticisms of the pre-pack?

  • Lack of accountability: administrators involved in pre-packs do not have to obtain prior approval for their actions from the court or creditors.
  • Lack of transparency: while secured creditors have the benefit of their consent being required, unsecured creditors usually will not realise that a pre-pack is going to happen. Consequently, they have no opportunity to protect their interests by considering and voting on the pre-pack proposal.
  • No maximised returns: in a pre-pack situation, there is no time for full exposure of the business to the market, although often the business will have been marketed for sale in advance of the pre-pack. The administrator accepts that they must act quickly so as to preserve the value of the business and minimise the potential dangers of open marketing, which might lead to a loss of confidence in the company, or a delay to the sale, which would result in the erosion or complete evaporation of the value of the company's assets, especially intangible assets, such as goodwill and intellectual property rights.
  • Pre-packs are similar to the outlawed practice of creating 'phoenix' companies: there are in fact key differences owing to reform of the law, as noted above. Under the pre-pack guidelines (see SIP 16 on pxx), administrators now have to disclose to creditors the name of the buyer and whether there is any connection between the buyer and the company.
  • Conflict of interest: often the administrator is chosen by the directors of the company in the context of a proposal that the business and/or assets of the company be sold back to them. It follows, it is argued, that if he wants to be appointed as the company's administrator, he will have an inherent preference for the proposed pre-pack sale. However, the administrator has to be satisfied that the best available market price is paid or suffer potential personal liability.
  • Writing-off liabilities using a pre-pack is a short-term fix: a pre-pack does not subject the company to a restructuring, which is often necessary if the business is to survive in the long term.

SIP 16

The widespread concern about the use and potential abuse of pre-packs led to the issue of the Statement of Insolvency Practice (SIP 16) by the Association of Business Recovery Professionals, under procedures agreed between the insolvency regulatory authorities with effect from 1 January 2009. This document sets out basic principles and procedures with which insolvency practitioners are required to comply to avoid disciplinary or regulatory action. SIP 16 does not have the force of law, but insolvency practitioners ignore it at their peril if they wish to retain their licences.

A key point addressed by SIP 16 is the matter of transparency and it sets out a detailed list of the information that the administrator should disclose to creditors where there has been a pre-pack. In practice, many firms of insolvency practitioners report to creditors within seven days of completing a pre-pack, setting out the required details of the transaction. An interim report on compliance with SIP 16 has concluded that, so far, 'a significant number of SIP 16 reports failed to live up to full compliance' and concludes:

There does remain to be significant room for improvement in the information provided in a good proportion of cases.

This is on the basis that 370 out of 572 companies in administration (65%) were compliant with the requirements of SIP 16. Concerns were also expressed that there are likely to be many more insolvency practitioners who do not report their prepacks to the service.

Recent case law also suggests that there may still be problems out there with pre-packs. For example, in Clydesdale Financial Services v Smailes [2007], an insolvency practitioner, Mr S, suggested a pre-pack to an insolvent law firm to rescue the business. The sale was concluded just prior to the appointment of S and his partner as joint administrators. The major creditor contested the sale and applied for removal of the administrators alleging that S had been closely connected with the negotiations of the sale, that the sale was at a gross undervalue and, in breach of SIP 16 and otherwise, the administrators had failed subsequently to conduct the administration with transparency or with independence. The judge noted the need to have regard to, although not be bound by, the wishes of the majority of creditors and concluded that the evidence demonstrated that S had been intimately involved in the negotiations that led to the challenged sale and that, taken as a whole, the evidence raised a serious issue for investigation.

While it is early days in the life of SIP 16, it is likely that the judgment in Clydesdale will not be the last of its type. However, the decision should provide a degree of comfort for creditors and it highlights the importance of consulting with major creditors ahead of completing a pre-pack sale.

Conclusions

The courts have recognised that a pre-pack deal is a legitimate restructuring tool in appropriate circumstances and, in a series of cases, have confirmed that administrators have the power to sell a company's business and/or assets without the prior approval of the court or creditors if the circumstances justify it. SIP 16 is in itself a recognition by the insolvency regulatory authorities that pre-packs are a useful tool for saving jobs and rescuing businesses.

The benefits to all stakeholders of pre-packs used properly are clear. Pre-packs can result in a quick transfer of a business, therefore minimising the destruction of supplier, customer and employee confidence. This makes a good deal of commercial sense in a world in which communications are instant and rumour can spread quickly. Research has found that in 92% of cases where a pre-pack was used, all of the employees were transferred to the newco2. Compare this with a 65% retention rate in a business sale. The insolvency regulatory authorities recognise that the benefits of a pre-pack to all stakeholders – including employees – make their use expedient in the modern business world.

Footnotes

1. Re Consumer & Industrial Press Ltd (No 2) (1988) 4 BCC 72, re Smallman Construction Ltd [1989] BCLC 420, re Montin Ltd [1999] 1 BCLC 663

2. Frisby, Dr S, A Preliminary Analysis of Pre-Packaged Administrations, 2007, p70-71.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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