Welcome to our latest edition of Collateral. In this edition, we are talking insolvency and focusing on some recent legislative changes which are expected to have a significant impact on pre-pack administrations in the UK.
Unlike a standard administration sale where administrators commence marketing of the business post-appointment, a "pre-pack" is an arrangement where a sale of some or all of a company's business and assets is negotiated with a buyer prior to the appointment of an administrator and completes either upon or shortly following their appointment.
Pre-packs have long been a key tool in the corporate rescue toolbox and are becoming more prevalent. Despite low headline insolvency numbers in 2020, pre-packs accounted for around 30% of UK administrations and were particularly noticeable in the retail, dining and travel sectors.
But pre-packs are not popular with everyone. They have come in for criticism particularly when businesses are sold to a "connected person", such as to directors or shareholders where those parties are closely involved in the company's management. This has led to arguments that pre-packs lack transparency and prejudice the rights of creditors.
Partly as a response to criticism of pre-packs, the government introduced The Administration (Restrictions on Disposal etc to Connected Persons) Regulations 2021 (Regulations) which impose requirements on pre-packaged administration sales to connected parties commencing on or after 30 April 2021 and aim to provide creditors with reassurance that pre-pack transactions to connected parties are fair, appropriate and transparent.
This article explores 5 key effects of the Regulations on creditors and other stakeholders and our observations on some of the key reforms.
1. Greater transparency
Unless it has been approved in advance by the creditors, an administrator will only be able to dispose of a substantial part of a company's assets to a person connected with the company within the first eight weeks of administration if it obtains a written opinion from an evaluator, which is made available to all creditors and which is also filed at Companies House. The evaluator must be independent and cannot have provided any insolvency advice to the company in the 12 months prior to providing the opinion.
Comment: In the absence of creditor approval, the requirement to obtain a written report from an independent evaluator which is made publicly available is a step in the right direction and should provide more transparency around a connected party sale which did not exist before the Regulations were introduced. Although a 'pre-pack pool' 1 was established to oversee pre-pack sales to 'connected persons' following the Graham Review in June 2014, approaching the pre-pack pool was on a voluntary basis for a purchaser. And with no legal requirement for purchases to be referred, referrals were low. What is 'substantial' is not defined, but the guidance which accompanies the regulations sets out certain criteria which an administrator should consider including the value of the business, assets or both and whether the trading style and goodwill of the business forms part of the disposal.
2. More scrutiny
The Regulations introduce heightened scrutiny during the administrators' decision-making process leading up to the pre-pack sale. The Regulations stipulate that the evaluator's written opinion must assess whether or not the grounds for the substantial disposal are 'reasonable' (see further below). The opinion should contain details of the transaction, the nature of the relationship of the connected party with the company and a summary of the evidence relied upon to make the recommendation. If the report does not recommend a sale, an administrator can still proceed with the disposal but the administrator will be required to provide a statement setting out the reasons for proceeding with the sale as part of its SIP 16 Statement,2.
Comment: Although additional scrutiny is to be welcomed from a creditor perspective, it is unclear from the Regulations what recourse any creditors may have should the administrator proceed with the sale despite a negative report from the evaluator. Likewise, although there is clearly risk in ignoring a negative assessment, there is no appeal mechanism against the evaluator's decision and nothing to stop a purchaser from (literally) obtaining a second opinion. A prudent administrator will therefore likely advise a potential purchaser to engage with an evaluator as early as possible in the process so that they can work through all options before any decisions are made.
3. 'Reasonable grounds'
As mentioned above, the evaluator must state whether it is satisfied that the sum payable for the business or assets and the grounds for the substantial disposal are 'reasonable' in the circumstances.
But it is unclear how the evaluator makes this reasonableness assessment and whether the evaluator is also being asked to decide whether alternative options for the company (rather than the substantial disposal) can be justified.
Comment: To make a recommendation based on 'reasonable grounds', we would expect an evaluator to have to review a wide array of information, including from the seller (via the administrator). Therefore, although the evaluator acts independently, the information it relies on may not be impartial. Evaluators are naturally likely to be cautious and we can see situations where evaluators opt to review more information rather than less and take independent professional advice before providing their recommendations.
Under the Regulations, there is (somewhat surprisingly) no qualification criteria for the independent evaluator and the evaluator is not required to be a member of a regulated professional body, for example. Instead, the Regulations leave it up to the evaluator to self-certify that they have the requisite knowledge and expertise to provide the report, though the administrator also needs to consider whether there are any grounds to believe the evaluator does not meet the requirements. An evaluator must also have professional indemnity insurance in place and provide details in their report.
Comment: The guidance accompanying the Regulations states that the most likely candidates for the role of evaluator are accountants, surveyors, lawyers and insolvency practitioners. But every transaction is different so not imposing a formal qualification requirement and allowing someone with specialist knowledge of the business to take the role may prove helpful to getting a transaction away.
However, it remains to be seen whether insurers can operate to effectively regulate the suitability of evaluators in the absence of clear qualification criteria. Some industry bodies have suggested that a 'white-list' of approved evaluators should be agreed up-front and the members of pre-pack pool have also indicated that they will be providing evaluation services under the Regulations.
5. Secured Lenders
The Regulations adopt a broad definition of a 'connected person' purchaser reflecting how that term is used in The Insolvency Act 1986, to include a party who has a significant prior connection to the company such as directors, shareholders and any family members of such directors or shareholders. The wide definition theoretically means secured lenders who have taken security over more than one third of shares in the debtor company and have the ability to exercise voting rights in respect of those shares could fall within the definition of 'connected person' and within the parameters of the Regulations for any pre-pack in their favour.
Comment: It will take a fair amount of due diligence to confirm whether or not a buyer is 'connected' for the purpose of the Regulations but the inclusion of secured lenders is quite a radical change given that SIP 16 previously stated that secured lenders were outside the scope of connected parties. The inclusion of secured lenders as a connected person does not prevent pre-pack sales to them but any loan to own strategy pursued by such parties inevitably becomes more complex and time-consuming and if they fall within the connected persons definition, they too will need to go through the process of seeking creditor consent or getting a report from an evaluator.
Contrary to some expectations, the Regulations have not banned pre-pack sales to connected parties! Instead, the introduction of the Regulations seems to suggest that the government has recognised, at least for now, that pre-pack sales to a 'connected person' can be an appropriate tool to maintain the going concern of a business. Equally, the Regulations are a step in the right direction towards promoting more transaction scrutiny, which subsequently should reduce criticism of these transactions from creditors and improve public perception. But it remains to be seen who will fulfil the crucial role of the evaluator role in practice, and how the additional cost and time in obtaining the evaluator's opinion will impact pre-pack sales, which are often time critical. In the final analysis, only the future use of connected party pre-packs will determine whether the Regulations hit the mark in increasing stakeholder confidence and transparency.
1 A group of experienced insolvency professionals who
could be consulted on the appropriateness of a proposed pre-pack
2 A statement prepared by the administrator setting out how the decision to opt for a pre-packaged sale was reached and the other alternatives that were considered.
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.