UK: The Insolvency Bill – The End Of The Enterprise Culture?

For centuries, British commercial life has revolved around the availability of credit. In the majority of businesses, goods and services are bought on credit to enable the business to sell its own products, also on credit. But this dealing on credit carries with it a fundamental problem. If all of the links in the chain are extending the same credit terms, each will have to be able to pay for goods purchased before he receives payment for them on resale. This can lead to a significant amount of capital tied up in the funding gap, even though the gap may be of a fairly short duration. In the 19^th century a canny Scottish banker developed a financial product to solve this dilemma – and the overdraft was born.

The overdraft is now the cornerstone of the corporate finance of most small and medium sized companies. It is relatively cheap, flexible and has up until recently been fairly easy to obtain from most high street banks. Indeed, the availability of such working capital finance is so important to most trading companies that it seems inconceivable that any commercially aware government should legislate against it.

And yet we now have the Insolvency Bill 2000, issued on 3 February of this year and set to become law in July. If the Insolvency Bill becomes law in its current form, it may well seriously affect the availability of overdraft finance to some small (and not so small).

The key to most working capital (and particularly overdraft) funding, from the banker's perspective, is that it is repayable on demand. He is therefore able to manage his risk by carefully monitoring his customer's performance. If (as is usually the case) he has security from the company for his exposure, he will be able to demand repayment as soon as he feels he may otherwise be facing a loss, realise that security and exit from the relationship intact.

Whilst this seems harsh on the customer at first sight, it is inherently reasonable and is a function of the price charged by the banker for the provision of facilities. In simple terms, if a banker is charging a margin of between two and three per cent per annum for his money, and loses it all, he must lend between thirty and fifty times as much money in the same year (and not lose a penny of it) to avoid showing a loss at the year end. He cannot therefore afford to lose any significant amount in relation to any single customer, and will want to be able to control the realisation of any security he holds to enable him to minimise his potential loss. The position might be less justifiable if the bank were receiving an "equity" return on his money. However, in most cases it is not and many small companies would not be able to afford bank finance if it was.

It is this need to control the realisation process which led directly to the number of bank induced receiverships (as opposed to liquidations) in the last recession. The reason for this is historical and can be found in the 1986 Insolvency Act. That act introduced the concept of the administrator into English insolvency law. Previously, a bank with security could rely on that security at any time up to and during the insolvency process. However, if an administrator is appointed, no security can be enforced without his consent or the leave of the court. The bank may not like the identity of the administrator and will certainly not like being prevented from exercising its own judgement in realising the security it holds for its exposure.

As a counter balance, the act provides that a bank with a floating charge over all of the assts of the company is entitled to notice of the appointment of an administrator and can prevent his appointment by the appointment of an administrative receiver. As a concept, the floating charge is an unusual beast, invented in Victorian England and found only in those Commonwealth countries whose legal system is based on ours. But it works. It allows a borrower to continue to trade, turning stock into debtors and from debtors into cash to enable it to complete the working capital cycle without undue administrative involvement from the bank, despite the fact that the bank has a mortgage which "floats" over all of those assets. It is generally enforced by the appointment of a receiver (since the 1986 act, an administrative receiver) who takes control over the assets the subject of the floating charge and sells them to the highest bidder, often after a brief period of trading to maximise current value and achieve a sale of the borrower's business as a going concern. The flexibility of the floating charge fits hand in glove with the overdraft.

Before 1986, floating charges were common but not universal. As a consequence of the 1986 act, however, all lending banks took floating charges from their customers almost as a matter of course so as to maintain control of the insolvency process. The high proportion of receiverships amongst the corporate failures in the early 1990s was a direct and unpopular result.

The modern attitude is that corporate insolvency procedures should be directed at the rescue of companies (rather than the businesses they operate, which can be rescued, and frequently are rescued, by a receivership). The emphasis is now upon the salvage of shareholders' and directors' stakes in their company in a more debtor orientated "Rescue Culture": hence the Insolvency Bill.

The 1986 Insolvency Act contained a mechanism for achieving such a rescue – the Company Voluntary Arrangement (CVA). Under a CVA, proposals are put by a company to its creditors for the postponement/settlement of its debts, enabling it to shed a burden of debts that it cannot repay, or buy itself time for payment. However, one of the problems perceived with the 1986 act has been the marked lack of Company Voluntary Arrangements agreed between companies and their creditors, when compared with the number of Individual Voluntary Arrangements. The reason for this is that the procedure for putting into place an individual arrangement involves a statutory moratorium before the debtor's proposals are put to his creditors, preventing them from taking any precipitate action which might scupper the proposed scheme of arrangement. The procedure for putting into place a company arrangement does not involve this step. The only way in which this can currently be achieved in relation to a company arrangement is by applying to the court for the appointment of an administrator. This is expensive for a small company. Of course, it also has the effect of denying a lending banker the ability to enforce his security if an administrator is appointed and so, in practice, frequently requires bank support.

Should the Insolvency Bill become law as drafted, it will introduce a statutory moratorium in circumstances involving small companies. Small companies are defined as having any two of the following attributes:

• Annual turnover of less than £2,800,000;
• Gross assets of less than £1,400,000; and
• Less than 50 employees.

Under the new procedure a company in distress can file with the court notice of an intention to make proposals to its creditors for a voluntary arrangement. This notice must be accompanied with a statement of a Licensed Insolvency Practitioner indicating that:

• the proposed arrangement has a reasonable prospect of success and that
• the company is likely to have sufficient funds available to it, whilst the moratorium is in force, to carry on the business to the extent it proposes to carry it on during that period.

Once these papers are filed, together with a statement of affairs of the company, you have a 'fait accompli'. The company has the benefit of complete protection from any aggressive action by any creditor. In particular, no security can be enforced against the company and no receiver can be appointed whilst the moratorium is in force. Whilst the moratorium is in place, in theory, no assets can be disposed of which are subject to any security without the consent of the secured creditor or the leave of the court. This saving of secured creditors' rights does not extend to assets which are caught by a floating charge only. These can be sold and the floating charge re-attaches to assets acquired in their place (including, presumably, cash receipts – so long as they can be traced). The wording used in the new bill for this purpose tracks wording in the existing legislation concerning administrations which itself has been the subject of academic and technical criticism and is another reason why banks are prone to distrust the administration procedure.

It is to be hoped that the involvement of a reputable licensed professional, together with the other prohibitions on dealing with assets during the period of the moratorium will minimise the number of cases in which the procedure is abused. Further, the requirement that the insolvency practitioner should provide an indication as to the company's working capital resources would suggest that a bank with a floating charge (and probably a fixed charge on debtors) will be involved early on in the CVA rescue process, as being the first potential source of funding. However, not all companies in distress will talk to their bankers at such an early stage, and there is no obligation to do so imposed by the Bill if funding might be obtained from another source. In forming his opinion as to the availability of funds, the insolvency practitioner concerned is entitled to rely on the information provided to him by the company, unless he has reason to doubt its accuracy. Clearly, therefore, the existence of a window in which the bank cannot enforce its security gives an opportunity for unscrupulous debtor/shareholders to save their own positions at the expense of the bank.

The experience with administrations and the 1986 Act shows that bankers are not prepared to accept the risk of not being in control at all stages of the insolvency realisation process. The CVA moratorium imposes just this risk on the banks, only this time they cannot put themselves into a position whereby that control is preserved. Having regard to the commercial constraints upon a banker to avoid losing a penny, if the proposed legislation becomes law, banks are going to be even more cautious in lending working capital to the small company sector than they are at present. It is likely that they will now only do so against fully supported personal guarantees. Whilst such security has its own issues, the real risk of personal loss to the directors of a company will be the bank's only protection against the director's use of the moratorium mechanism. It should be noted that the advice usually given to directors of companies by their legal advisers (and, more particularly, to their spouses in relation to the creation of security over the family home) is that no such guarantee should be given!

Asset finance may step into the void to provide the necessary credit in certain situations. Whilst the moratorium would prevent hire purchase/leasing financiers from repossessing assets funded, it does not prevent an invoice discounter from collecting the debts he has factored. But invoice discounters are, of necessity, selective about the businesses they are prepared to fund. Those small businesses which rely on a small customer base, or are involved in any form of long term contracting, may find that working capital finance is not available at all and that the only way to fund those businesses is from the private resources of the directors themselves. These may be so limited as to prevent growth altogether.

It would be a shame if the regulatory imposition of the rescue culture were to lead to the end of the enterprise culture. Unfortunately history, experience and cold commercial logic would suggest that it might!