Wednesday, 12 May 2010

Preconceptions and pre-packs

There has been growing concern in some quarters about the rationale of using pre-packaged administrations (pre-packs). These involve negotiating and executing (often rapidly) sales of companies that are unable to discharge financial obligations before they enter administration. Judge Purle QC sitting as High Court Judge in Johnson Machine and Tool Co Ltd and Another [2010] EWHC 582 (Ch) (18 March 2010) stated emphatically that the scope of a costs order should only concern additional costs that the bringing of the administration application occasions. Hence, any advice given before the decision to seek administration was made and the pre-administration costs of considering and arranging the pre-pack ought to be excluded. Although he does not question the legitimacy of pre-packs (re Kayley Vending Ltd [2009] BCC 578), he notes that the jurisdiction of courts to make an order allowing pre-appointment costs is discretionary (para 13 of Schedule B1 of the Insolvency Act 1986). Thus, in his opinion, recognising the steps taken by insolvency practitioners to protect themselves either by requiring payment in advance or taking a guarantee from the directors of the company would seldom be appropriate. This is because they are done pre-appointment. The argument here is that pre-appointment costs involving pre-packs are usually for the benefit of the directors and not the creditors. This is evocative of pre-incorporation contracts that do not bind companies unless they enter into a post-incorporation contract (section 51 of Companies Act 2006).

This also reflects the view of the Insolvency Practices Council (IPC) stated in its Tenth Annual Report. Although the IPC recognises that pre-packs may sometimes be a means of realising higher returns for creditors (in instances where advertising the business would diminish its value) it insists that pre-packs are not appropriate because the general body of creditors is not consulted and the latter often gets little or no benefit from the sales. Also, business rivals complain about the protection offered to their failing competitor allowing it to simply shed its debt and unfairly take business from them. Moreover, the IPC does not believe pre-packs save jobs when examined in a wider macro-economic context. The fall in the GDP of the United Kingdom and in the personal savings ratio implies that pre-packs constitute some sort of moratorium that merely postpones the job losses. The Report cites the analysis of pre-packs by Dr Sandra Frisby[1] to the effect that there is a high level of second failures of businesses that were sold to previous directors. In the same vein, the IPC notes that any jobs saved by the pre-packs may be offset by losses in their rivals.

In light of the above, one may be tempted to advance that the opinions of Judge Purle QC and the IPC were formed without adequate evidence. It is difficult to argue that pre-packs are usually for the benefit of the management and not the creditors in cases where the creditors are unlikely to get a higher return from any other outcome to the business failure. Winding-up or liquidation would seldom provide better results for the creditors. Even Judge Purle QC admits that it is often difficult to ascertain where the balance of advantage as between the creditors and directors purchasing the business lies. Nonetheless, he believes the creditors would hardly be favoured where the directors are purchasers.

The Statement of Insolvency Practice 16 (SIP 16) requires Insolvency Practitioners (IP) to report with little or no delay and in a comprehensive manner to the full body of creditors about any pre-pack they conduct. Recognised Professional Bodies (RPBs) that regulate IPs also require them to do so. Although the IPC notes that far too many IPs do not account to the creditors, where there is no wrongful trading, there is hardly room to suggest that creditors get the short end of the stick. It must be noted that it is often very difficult to obtain finance to run businesses in administration as banks do not lend to run a business in such circumstances. Moreover, public advertisement is likely to diminish the value of the business. Also, without administrative receivership, the pre-packs appeal to secured creditors as a way of securing their position. Thus, pre-pack sales ought to be quick and will most likely involve secured creditors or directors given that few others will find such a business attractive.

Unsurprisingly, the Insolvency (Amendment) Rules 2010 (effective from 6th of April) ordains that “pre-administration costs” are fees charged and expenses incurred by the administrator or another person qualified to act as an IP before the company entered administration but with a view to its doing so; and “unpaid pre-administration costs” are pre-administration costs which had not been paid when the company entered administration. Thus, pre-appointment costs involving pre-packs will be allowable as administrative expense and the jurisdiction of courts to make such an order is not discretionary. It will be interesting to see whether the number of pre-packs increases as a result of the new law and in light of Dr Sandra Frisby’s quantitative analysis, it may also be important to capture and compare developments in practice that took place in the run up to the new law and immediately after the law came into force.

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