On 25 May, the Insolvency Service published a consultation paper on options for reform of the UK's corporate insolvency regime. Their impetus is for the UK to remain at the forefront of insolvency best practice to ensure businesses, investors and creditors remain confident that best outcomes can be achieved when faced with financial difficulty, and to give a company the best possible chance to restructure its debts and return to profitability while protecting employees and creditors.
Their suggestions include new provisions, for all entities who currently have access to the UK's administration and company voluntary arrangement insolvency procedures to:
- create a new (single gateway) three-month moratorium against creditor action whilst a business develops a restructuring plan;
- ensure preservation of "essential supply contracts" during an insolvency procedure to enable businesses to continue trading in a restructuring;
- make restructuring plans bind both secured and unsecured creditors and introduce a "cram-down" mechanism so that a majority of creditors can bind the rest to a restructuring plan; and
- develop the rescue financing market, so important to the rescue culture in the US.
Dentons has now responded formally to the consultation, and intends to issue a series of releases about the various changes suggested by the government, including their relevance post-Brexit. Indeed, it remains to be seen whether there will now be parliamentary time to table the proposals or whether they will need to be reconsidered in view of, and in the context of, the Brexit debate.
Putting the consultation in context
This consultation follows hot on the heels of a recent World Bank survey which placed the UK behind its European and international counterparts in the World Bank league tables because of the lack of a debtor-led process applicable to all UK insolvency procedures. Dentons questions the accuracy of this league table ranking: we consider the UK has one of the most flexible insolvency regimes, unburdened by high costs and lengthy court procedures and, perhaps most importantly, one of the best recovery rates for creditors worldwide.
With other EU countries amending their insolvency legislation and the recent calls for closer harmonisation of insolvency laws within the EU, the UK was under pressure to amend its insolvency procedures and has, perhaps unsurprisingly, turned to the US for inspiration.
The US underwent their own review of Chapter 11 with the ABI Commission to Study on of Chapter 11 producing some ideas for reform in 2014.
Hailed as Chapter 11 in the UK, the consultation as drafted, however, seeks to add bolt-ons to the existing UK framework rather than a complete overhaul to replicate Chapter 11.
Dentons partner, Rachel Anthony, comments: "Preservation of contracts is one area where the proposals are not 're-creating Chapter 11 in the UK' per se. In the US, if an 'executory contract' is assumed, the debtor is required to honour it in full, including payment of all arrears and providing adequate assurance of future performance. What is envisaged by the UK consultation, as far as we can tell, is an extension of our current s.233 IA 1986 which deals with essential contracts (mainly utilities, as extended to IT supplies from October 2015 onwards). These provisions only cater for cost of supplies going forward, 'parking' historic arrears. They are a rather blunt instrument which will not lend themselves to the much more complex supply chains or arrangements in place in the wider commercial world. In any event, my own view is that this element of the UK proposal is unlikely of itself to increase the rate of business rescues. It is rare that the cost of paying off a few genuine ransom creditors is the stumbling block to a successful business rescue."
The proposed three-month moratorium
Although the idea of the moratorium in principle is, according to Dentons partner, Ian Fox a "welcome and overdue development", and while we agree in principle with the proposals including the cram down proposals (which would work in a slightly different way to the current scheme of arrangement), Dentons has suggested the government should reconsider the proposed length of the moratorium, specifically, that it should be shorter.
The proposal to preserve "essential supply contracts"
It is not clear how any extension of the current s.233 will deal with issues such as ROT, trade credit insurance, liens and other protections, contractual or otherwise, that many suppliers benefit from.
Dentons partner, Rachel Anthony, gives an example of the difficulties that might arise: a ROT supplier may be in a position where he cannot uplift his stock and is forced to carry on supplying anyway – he will be prejudiced if stock levels are eroded as the company is allowed to continue to trade on.
Another major issue is the impact on trade credit insurance. Rachel Anthony comments: "It's one thing to make an electricity supplier carry on providing the electricity – it's another thing to force a supplier who has the benefit of trade insurance and will lose that benefit if it continues to supply. They will potentially lose the benefit of the insurance not just in respect of the one debtor, but in respect of every debtor covered under the policy." The impact of these proposals on pricing and availability of such cover needs to be considered.
Rachel Anthony adds: "The only terms on which, traditionally, merchant acquirers have been prepared to release funds held back to protect against charge-back liabilities arising from consumer card purchasers has been the provision of a personal guarantee from an Insolvency Practitioner, which I doubt the Supervisor of a moratorium would agree to do." As such, one of the bars to availability of working capital to support a rescue in a retail context is unlikely to be alleviated.
The issue of rescue finance is perhaps the most controversial/unwelcome part of the consultation, particularly from the perspective of stakeholders such as the banks. It is unlikely the banking community will agree to have their negative pledges in security documents overridden. However, query whether, in view of Brexit, this is something they will consider, in order to remain competitive.
Combining DIP finance with the proposed moratorium, during which any unencumbered assets can be used to secure the DIP financing the banks, faced with losing their negative pledge on any existing financing once a company faces financial difficulty, may not even be willing to lend from the outset to healthy companies on current terms. The market players most likely to provide DIP finance are likely to be expensive and take sufficient collateral to enable them take all the assets of the business on a subsequent insolvency process, leaving the banks with little in the way of collateral.
Dentons partner, Will Gunston, comments: "A regime that gave third party rescue finance providers priority over existing fixed charge holders, including those existing fixed charge holders that have the benefit of a negative pledge, would very likely encourage rescue finance providers to fund businesses in financial difficulty. However, the ability to lend in such circumstances would likely be at the expense of higher costs for, for example, an originating lender, and a reduction of the availability of funds in a non-distressed trading environment. The current lending regime has the benefit of a clear and unambiguous risk profile for fixed charge holders. To disrupt such a risk profile would undermine the incentive for lenders to support young and growing businesses."
The cram-down proposals in the consultation are aimed at and are most relevant to smaller businesses who would not otherwise have had the resources (financial or otherwise) to propose a scheme or arrangement. Many see schemes as attractive because they are outside the insolvency legislation and therefore more flexible. The issue of cram-down is a complex one which needs serious thought as to its operation in practice. The proposals would, in effect, make schemes part of the UK's insolvency legislation (rather than Companies Act 2006 as currently) to take the benefit of cross-border recognition and enforcement of insolvency proceedings under existing European legislation. Following Brexit, the UK will need to revisit how it achieves this cross-border recognition within Europe.
Dentons partner, Neil Griffiths, comments: "The cost and complexity of the consultation's proposal for a Flexible Restructuring Plan should be minimised, in order to make it available to as many debtor companies as possible. We agree with the proposed voting requirements, except that we would jettison the numerosity test, which is not a feature of CVAs and can be an unnecessary and artificial (and therefore potentially abusive) obstacle to approval. We believe that the Flexible Restructuring Plan should be simpler than a scheme, where there is such a test. Liquidation is not always the correct comparator for scheme purposes, depending on the circumstances - see for example Re T&N Ltd (No 4). The same principles should apply to the Flexible Restructuring Plan."
In the US, the ABI Commission to Study the Reform of Chapter 11 has recently identified areas where the US process can be improved, the issue of cram-down being one of them. Dentons partner, Farrington Yates, who is based in New York, comments on the US Model and proposals for reform: "The standards by which a debtor can confirm a chapter 11 plan of reorganization over the objections of creditors are predictable and transparent because they are embodied in the US Bankruptcy Code as interpretated through numerous reported judicial decisions and local practice. However, questions about fairness, particularly around the issue of cram-down continue to exist and can become the subject of extensive and costly litigation. As an example, the timing of cram-down, although beneficial to bind hold-out creditors, can take place so that senior creditors recover more when the debtor is valued the least to the detriment of "just out of the money" junior creditors. As a result, as a matter of fairness, the Reform Commission proposed a 'redemption option value' to be awarded to junior creditors just below the valuation fulcrum to capture for their benefit potential increases in enterprise value resulting from the reorganization." If it intends to incorporate concepts from the US regime through the Consultation, then the Insolvency Service should take care not simply to bolt-on mechanisms used in the United States but also to take advantage of our experience so that "best practices" can be considered.
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