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Annual Report 200

Corporate Insolvency

The current recession is testing the robustness of the UK’s corporate insolvency procedures. Creditors’ Voluntary Liquidations, which currently represent 75-80% of insolvency procedures, averaged 7,500 a year between 2004 and 2007 but rose to over 15,000 in 2008 and 19,000 in 2009. However, by the second half of 2009 the quarterly numbers were lower than those in 2008. Whether this decrease continues depends on the strength of the economic recovery.

The main change introduced by the Enterprise Act 2002 (EA 2002) was the reformed administration procedure. However this change failed to achieve the government’s stated aim of promoting more corporate rescue. In general the new procedure, which has largely replaced administrative receivership, seems to be working satisfactorily. It has welcomed by most IPs as a useful gateway into other insolvency procedures, which gives them greater flexibility to decide on the most appropriate strategy. The early evidence from research commissioned by the IS is that realisations from the sale of businesses and assets have increased under the new procedure, but that this has been offset by higher costs, leaving returns to creditors broadly unchanged. Unsecured creditors seem to get slightly higher, but still low, returns from administration. The main criticism of current corporate insolvency procedures has been the increased use of “pre-packs”, ie, the negotiated sales of struggling businesses before they enter administration, followed by an immediate execution of the sale without further marketing or consultation of the general body of creditors. “Pre-packs” have been used regularly since the 1986 Insolvency Act, though the reformed administration procedure may facilitate their use. As we have stated in previous Annual Reports, we accept that “pre-packs” can be effective as a means of realising higher returns for creditors in cases when public advertisement of the business on the open market would diminish its value or when finance cannot be obtained to run the business in administration. A “pre-pack” will often be an attractive solution to the main secured creditors as a way of protecting their position now that administrative receivership is normally not available. Other reasons for the rise in “pre-packs” are probably that many of the
companies entering insolvency have even fewer unsecured assets which can be realised than in previous recessions and because the banks will not lend to run a business in administration. Trade suppliers to the insolvent company complain about “pre-packs” because, as unsecured creditors, they get little or no benefit from them. Their complaints are understandable, but where a “pre-pack” is justified it is unlikely that they would get a higher return from any other outcome to the insolvency. Their concerns do, however, emphasise the importance of both IPs and the Insolvency Service checking rigorously that there has been no wrongful trading by the company in the run-up to the sale of the business. Business competitors, who see a failing competitor enabled to continue taking business from them, also complain about the sale of businesses back to previous directors through “pre-packs” (“phoenix” sales). We comment on this below.

The RPBs which regulate IPs responded to these criticisms by requiring administrators to produce a full explanation of why they had opted for a “pre-pack” sale for their creditors as soon as possible after the event. We fully support the RPBs’ initiative (though it took far too long to produce SIP 16). We also welcome the Insolvency Service’s decision to monitor IPs’ compliance with this requirement. The IS has now produced its second monitoring report, and we understand that a disturbing number of SIP 16 reports still fall below the level of disclosure intended. We agree that SIP 16 needs to be clarified and believe that there is a case for putting SIP 16 on a statutory footing, which is suggested as a possible option in a recent consultation paper by the IS.

In this context we are not persuaded by arguments that there would be any benefit in introducing some form of the Chapter 11 provisions of the USA’s insolvency legislation to allow companies in financial difficulties to continue trading under court- administered protection from their creditors with the aim of saving the protected company. The US Chapter 11 provisions take place in a quite different economic, financial and legal setting, in which the balance between the interests of creditors and debtors is markedly different from that in the United Kingdom, where most successful company rescues are achieved by remedial action before the company is insolvent. The legal costs associated with Chapter 11 “rescues” are prohibitive. Moreover, introducing the greater
protection for the “debtor in possession” characteristic of Chapter 11 could well lead to more frequent and vociferous complaints from the protected companies’ commercial rivals for exactly the same reasons as we now see in the case of “pre-packs”. The argument advanced that “pre-packs” and Chapter 11 help to save jobs should be taken with a particularly large dose of salt, when viewed in a wider macro-economic context. Many of the companies currently going into recession in the UK are retail businesses or their suppliers. The sharp fall in the UK's GDP combined with the equally sharp fall in the personal savings ratio means that personal consumption levels are likely to remain well below the peak levels of the boom years for the foreseeable future. So protecting insolvent businesses through a Chapter 11 regime may merely shift some of the burden of adjustment to a lower level of demand onto their healthier competitors. Any jobs “saved” in the protected companies could well be offset by job losses in their competitors and suppliers. In the case of the “pre-packs” Dr.Sandra Frisby’s research (which can be found at: www.r3.org.uk/uploads/documents/preliminary%20analysis%20of%20prepacked%20administrations.pdf) shows that there is a high level of second failures of the businesses sold, particularly for sales to previous directors and any saving of jobs may be temporary.

Overall, we do not believe that any major changes are needed in corporate insolvency legislation. The UK gets reasonably high ratings in the Organisation of Economic Co-operation and Development’s review of its members, insolvency regimes both in terms of recoveries for creditors and in terms of costs. We recommend however that: The Insolvency Service should continue to monitor the effectiveness of the EA 2002 in achieving the objectives of the Act and in terms of its returns to creditors; The Insolvency Service should continue to monitor SIP 16 reports on pre-packs until there is a satisfactory level of compliance and RPBs should subsequently continue to monitor an adequate sample of such reports for each IP. If levels of disclosure in SIP 16 reports remain unsatisfactory, consideration should be given to SIP 16 having statutory backing; The IS is currently consulting on a number of suggestions for tightening the regulation of “pre-packs”. We agree that IPs who have negotiated a “pre-pack” sale (whether to the directors of the company or a thirdparty) no longer have the necessary objectivity to act as the administrator in judging whether the sale is in the interests of the generality of creditors and should refuse such appointments in line with the provisions already in the Code of Ethics for IPs. The RPBs should give specific guidance to this effect;

The IS should commission continuing research on the performance of “pre-pack” sales to previous directors to ascertain and, if there is evidence of abuse, should consider how best to deal with it. Finally, we continue to believe it is essential that the Insolvency Service should have sufficient resources to police the Company Directors’ Disqualification Act by investigating all reports by IP office-holders which contain primafacie evidence of misbehaviour. We were also dismayed to learn that neither the IS nor Companies House have the resources or a system for monitoring compliance with disqualification orders or undertakings by directors. We recommend that as a first step the IS and Companies House should work together to set up a monitoring system at the earliest opportunity.

The Insolvency Profession and how it is regulated

All the lay members of the IPC have a high respect for the work of IPs as a profession. IPs have to master and apply a formidable body of legal, accountancy, financial and commercial knowledge and skills. In corporate insolvencies they often have to take decisions in difficult circumstances and with imperfect information. As officeholders in a corporate insolvency they can only recover their fees and costs from the insolvent estate and so have to make early judgements on whether they can afford to take a case on. They are generally well rewarded when things go well but, if they get things wrong, they can be exposed to significant legal (and personal) risks. Given the pressures on them to take rapid decisions, IPs may sometimes be faced with temptations to exploit apathetic creditors and to cut corners with regulatory requirements, which they may regard as unnecessary. The latter may have been evident in the response so far to SIP 16. We believe the great majority of IPs do a competent and conscientious job for their clients and as office-holders. On the evidence from litigation and complaints there seem to be few serious misdemeanours in corporate insolvency. As regards personal insolvency we believe that standards have improved since the early days of the IVA boom. In general, with the exception of the complaints system on which we have commented in our last two Annual Reports, we believe the current system of devolved regulation is broadly satisfactory. The work done by IPs as office-holders is heavily (sometimes over heavily) regulated. The monitoring system is relatively “light-touch”. Visits to firms regarded as low-risk are infrequent and focus on systems and procedures. There may be a case for monitors inspecting larger samples in “high-risk” areas (such as “pre-packs” and on the personal insolvency side firms and IPs with relatively high IVA failure rates). But we recognise that in a relatively small profession, regulatory costs must be tightly controlled and in the case of corporate insolvencies, the creditors are also able to challenge serious abuses through the courts.

The delegation of authorisation and regulation to seven bodies (eight including the Secretary of State) allows differences of approach, which are sometimes questionable.

There is also a risk that those RPBs, which represent the legal and accountancy professions, may give priority to what is appropriate for most of their members (who are not IPs) rather than what may be desirable for the insolvency profession.

The question of a single regulator is not currently on the agenda and there are arguments both for and against such a change. Within the present system the RPBs should be encouraged to move towards a single set of monitoring standards and a uniform frequency of monitoring visits carried out by a joint monitoring team and to set up a single reformed complaints and disciplinary system which allows complainants to take their case to a fully independent arbitrator.

 

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