Off the hook

Insolvency has always been an emotive subject especially for the debtors and creditors at the sharp end. It is no surprise then that in the present economic and political climate our legal framework for managing insolvencies is coming under intense and repeated scrutiny.

Personal insolvencies continue to sky rocket setting new records year on year. Corporate insolvencies remained relatively flat until the second quarter of 2010 but are expected to rise. In the last two years enquiries into various aspects of insolvency law and practice have been conducted by parliamentary select committees and the Office of Fair Trading.

So, whether or not the system is 'fit for purpose' is a question that, in less anxious times, would be unlikely to command column inches or acquire the status of political priority. In any complex system which is prey to competing vested interests and about which most of us can only ever hope to have limited knowledge and partial information, questions about 'fitness for purpose' are not easy to answer. Media stories about 'bingeing' debtors, 'ripped off' creditors and, in light of the growing trend of foreign debtors (both individual and corporate) relocating to take advantage of our insolvency laws, 'bankruptcy brothel' Britain, are great copy but tend to obscure rather than aid public understanding.

Pre-pack to the rescue

A case in point is the torrent of negative publicity about pre-packaged administrations (pre-packs). In a pre-pack, a sale of the insolvent company's business is agreed in principle before the administrator's appointment and completed shortly after. If it is not reasonably practicable to save the company, the Insolvency Act 1986 enables the administrator to take steps to achieve a better result for creditors than would otherwise be achieved were the business to be closed down and broken up. Pre-packs may often be the only commercially viable option available to salvage going-concern value and achieve such a result.

Once a company is known to be in administration, confidence quickly erodes and asset values diminish. Skilled employees are 'assets with legs' who may choose to walk away. Often there will be no source of funding available to enable the administrator to trade the business. Used appropriately, pre-packs can deliver 'better than liquidation' outcomes and their record in preserving employment has been noted. The fact that businesses can be recycled through pre-packs so that they may carry on, having rid themselves of their unsecured debts, accords with public policy objectives enshrined in the 1986 Act and, despite popular perception, can hardly be characterised as legalised chicanery.

But not all pre-packs are free from criticism. The insolvency practitioner must take care pre-appointment not to compromise his independence and the legal duty he owes to creditors once he becomes administrator. In a conventional administration, the administrator is required to assess the company's prospects after taking office and put his proposals to a creditor vote, whereas a pre-pack is presented to the creditors' meeting as a fait accompli. Concerns about practitioner independence, transparency and creditor disenfranchisement are legitimate and acutely so where the business is 'pre- packed' back to incumbent management.

However, there are reasons for thinking that abuse of pre-packs is under control. Insolvency practitioners are heavily regulated and the professional standards applicable to pre-packs were tightened in January 2009. Statement of Insolvency Practice 16 imposes detailed and prescriptive disclosure requirements which place the onus on the practitioner to justify his course of action and provide concrete marketing and valuation evidence.

The courts are reinforcing these standards. In Clydesdale Financial Services Ltd v Smailes [2009] EWHC 1745 (Ch), administrators were removed from office so that the circumstances of a pre-pack could be independently investigated even though the administrators were not found to have acted improperly. In Re Kayley Vending Ltd [2009] EWHC 904 (Ch), the court ruled that matters identified in SIP 16 should generally be disclosed to the court on an application for an administration order insofar as such matters are ascertainable at the date of the application.

There are also controls on pre-packs to incumbent management. Some major banks block sales back to management of insolvent businesses over which they have security as a matter of policy. HM Revenue and Customs '“ often the biggest unsecured creditor '“ is well placed to police pre-packs. Furthermore, since Re Johnson Machine and Tool Co Ltd [2010] EWHC 582 (Ch), costs incurred by the insolvency practitioner in setting up the sale before appointment as administrator will not generally be recoverable as an expense of the administration payable in priority to unsecured claims. In practice, this means that the management will have to underwrite pre-appointment costs from their own pockets.

In most cases, pre-packs entail a legitimate use of administration to achieve a going-concern realisation. The impact on unsecured creditors cannot be underestimated but this is not a function of pre-packs or insolvency law per se. It is a function instead of our system of commercial law which privileges secured credit. The outcome for unsecured creditors in a liquidation fire sale will be no better and invariably worse.

One way to assuage public concern about pre-packs would be to give the requirements of SIP 16 statutory force. This is actively contemplated in an Insolvency Service green paper, Improving the transparency of, and confidence in, pre-packaged sales in administrations, issued in March 2010. More generally, policymakers may wish to consider to what extent the administration procedure, whether the administration is pre-packaged or not, functions merely to prop up businesses with unsustainable business models that should have been put out of their misery. A rigorous evaluation of the procedure would require systematic tracking of administration outcomes and post-administration business survival rates.

A restructuring moratorium?

At the top end of the market, financial restructuring of large companies and groups is generally achieved informally or through the mechanism of a Companies Act scheme of arrangement without resort to collective insolvency procedures such as administration. The general pattern in such restructurings is for the finance creditors to agree an informal standstill as a precursor to negotiating the terms of a deal.

However, as balance sheets have become more complex and fragmented the obstacles to successful restructuring have increased. Where large numbers of creditors who have potentially divergent interests are involved, there is a greater risk of hold-out behaviour by individual creditors which may diminish the prospects of doing a deal and impact what is otherwise a viable business.

Concerns about the refinancing of yet-to-mature loans obtained in the leveraged buy-out market at the height of the credit boom have prompted the government to propose the introduction of a statutory restructuring moratorium. Under the proposals, directors of companies seeking a contractual compromise or a statutory compromise '“ through a Companies Act scheme or a company voluntary arrangement under part I of the Insolvency Act '“ would have the option of applying to court for a moratorium restraining individual enforcement of creditor claims. The moratorium would last for an initial three-month period but could be extended in the case of complex negotiations for up to a further three months.

It may be doubted whether the availability of a statutory moratorium will facilitate the swift resolution of informal restructuring negotiations. Troublesome creditors will still be able to hold out safe in the knowledge that the moratorium will not last indefinitely. However, it could prove useful as a means of protecting the company while creditor approval of a scheme or company voluntary arrangement is being sought.

Debt-laden consumers

In relation to individuals, the system has been transformed since the late 1990s from one which dealt predominantly with small traders to a mass system for the resolution of consumer over-indebtedness. Against a background of expanding consumer credit, there was a huge expansion in formal personal insolvencies in the five years or so before the credit crunch. The numbers entering bankruptcy and individual voluntary arrangements jumped from just under 30,000 per annum in England and Wales in 2000 to over 100,000 per annum in 2006. After a brief pause in 2007 and 2008, the numbers rose to in excess of 130,000 in 2009 reflecting the impact of the recession on the incomes of households already struggling under the burden of debts incurred during the boom years. The picture in other parts of the UK has been similar.

Debt-laden consumers are confronted by a diverse and complex matrix of options for dealing with their debt problems in an evolving market populated by a bewildering array of public, private and voluntary sector advisory provision. As well as bankruptcy, debt relief orders and individual voluntary arrangements, the formal Insolvency Act mechanisms for discharging or compromising debts, there is a wide range of statutory and non-statutory alternatives such as debt consolidation, debt management plans and county court administration orders. The policy of fostering public availability of a range of debt solutions tailored for differing individual circumstances, levels of indebtedness and preferences is laudable.

However, from a consumer standpoint, the marketplace is confused and its regulation is fragmented and variable. There are concerns that debtors do not always receive appropriate advice. There is a persistent feeling in some quarters that 'for profit' providers are prone to channelling debtors into fee-generating debt solutions such as individual voluntary arrangements or debt management plans which involve long-term repayment commitments and have high breakage rates when bankruptcy may often be the best answer.

The Insolvency Practices Council, a public interest body that forms part of the regulatory framework for insolvency practitioners, has recommended in its annual report for 2009 that policy making on personal indebtedness and insolvency should be concentrated in a single government department and that volume providers which market both statutory and non-statutory forms of debt resolution to the public should be subject to more systematic 'joined up' regulation. It is hard to disagree with these recommendations and it is hoped they will be given due consideration by the joint Treasury-BIS review of consumer credit and personal insolvency announced in July.

While there is a case for overall simplification, each of the various procedures may be fit for purpose in isolation. The more pressing issue is the operation and regulation of the market as a whole. This is no longer purely an issue of insolvency law and policy. Indeed, the market for debt resolution now closely resembles the market for retail financial services where the regulatory emphasis is firmly on consumer protection.