Pre-pack sales of the business or assets of companies entering administration have always been controversial. Depending upon your standpoint, they can be perceived and characterised as:

1. an effective means of ensuring the rescue of viable businesses and the saving of jobs; 2. a legitimate re-structuring tool subject to occasional abuse at the small and medium-sized business (SME) end of the market; or 3. a ruse that allows bad management teams to dump debts and carry on trading at the expense of smaller trade creditors and more scrupulous market rivals and, in the process, subsidising inefficiency and creating market distortions.

At a time when use of this controversial procedure is on the increase its future is extremely uncertain. With the stated aim of improving the transparency of, and confidence in, pre-pack sales, the government published draft regulations in June 2011. This followed a consultation with trade association, legal and insolvency firms and professional bodies, creditors and others in 2010. The draft rules proved to be a blunt instrument that pleased no-one and in September 2011 the government announced that the draftsmen were going back to the drawing board and would produce new draft regulations in January 2012.

The task before the draftsmen was to retain the benefit of pre-packs whilst tackling the perception of unfairness. In the 2010 consultation, the Association of Chartered Certified Accountants voiced concern as to the danger of introducing regulations to deal with perception rather than evidence of abuse.

The draft rules

The draft rules published in June propose that administrators be required to give creditors three days’ notice of the pre-pack where sale to a connected party is proposed and where the business or assets have not been openly marked. This is intended to give creditors an opportunity to apply to court to stop the pre-pack sale where abuse is suspected or to make a better offer for the assets. In addition to this, there are provisions requiring the administrator to file detailed Statement of Insolvency Practice (SIP) 16-type disclosure at Companies House as well as to certify that he or she is satisfied that the pre-pack sale offers a better outcome for creditors than any alternative.

Making mischief

A chief objection to these proposals voiced by the insolvency and legal professions is the risk that notifying creditors will allow even those who do not stand to receive a dividend (whatever the insolvency route chosen) to make mischief and hold up pre-packs whilst the value in the business seeps away.

In practice though, creditors who have lost out in the administration and are not ‘in the money’ are unlikely to incur the expense of bringing a doomed court application merely to make mischief and if they do, adverse costs decisions are likely to discourage future actions. But the risk certainly remains that notification of creditors will increase the likelihood of customers cancelling contracts and suppliers withholding their goods and thereby affect the value of the business and, in turn, returns to investors.

A better offer?

The proposed notice requirement is also intended to deal with the possibility that there is someone somewhere who might be prepared to pay more than the connected party for the assets or business on sale, thereby increasing returns to creditors. But this is a calculation that the insolvency practitioner (IP) has to make in circumstances where in his professional judgement it may prejudice the value in the business to openly market the company.

The requirement for him to do this properly is contained in SIP 16 which already requires the IP to explain why it was not appropriate to trade the business and offer it for sale as a going concern; detail what efforts were made to consult with major creditors; provide details of any valuations obtained; and set out the alternative courses of action with possible financial outcomes.

In any event, it is not clear that notifying only creditors (as the draft rules propose) will necessarily address the possibility that the sale is undervalued or that wider publicising of the company’s financial difficulties will encourage more competitive bids.

Three or seven days?

Whilst trade associations and other groups representing creditors welcomed the draft rules they called for an extension of the notice period to seven days to allow creditors time to raise finance to mount their own bid.

Likely re-draft

If the notification requirement survives the next draft of the regulations it seems unlikely that the notice period will be extended. It is more likely that the three-day notification requirement, if retained, will be modified to take on board the suggestions of the Insolvency Lawyers Association and others which effectively tighten and narrow the circumstances in which it will bite. The non-exhaustive list of possible changes to the current proposal includes:

  • a provision that the requirement only applies to small and medium transactions (thus distinguishing between large restructurings where the creditors are sophisticated and resourced enough to mount a challenge - which may itself be a check on abuses at the lower end of the market where the perception (if not the evidence) of abuse is greatest;
  • limiting the definition of connected persons to the management team or those closely connected to it (thus excluding those connected to secured creditors who are currently included in the definition);
  • clarity on the consequences of failure to give notice;
  • clarity on the definition of open-marketing (the test for the notice requirement to bite);
  • a provision that the requirement only apply in more circumscribed scenarios such as where in the IP’s opinion there are unsecured creditors who are likely to be adversely affected by the pre-pack sale as against alternative insolvency procedures;
  • court power to disapply the notice requirement in circumstances where the IP can show that notice would be likely to prejudice the creditors as a whole.

This final proviso points up the flaws in the notice requirement. Clearly it is sensible and necessary to allow the court to disapply the requirement in these circumstances but, in my view, the court is likely in the vast majority of cases to be persuaded that notification would be likely to prejudice creditors (the interests of creditors who are not ‘in the money’ not meriting consideration for these purposes). If this is right, then the only impact of the notice requirement will be to increase the IP’s costs.

My view

It is to be hoped that the prospect of a notification requirement making creditors (and the public in general) feel better about pre-packs does not cloud what in my view ought to be the real issue: whether it is likely to make pre-packs more fair to creditors and less abusive.

It is my view that the objective of protecting creditors’ interests and preventing abuse ought to be adequately satisfied by (i) the obligation on IPs, already contained in SIP 16 and the insolvency legislation but bolstered by the proposed rules, to make a proper assessment as to whether the proposed sale is in the interests of creditors as a whole and to certify as much before proceeding with the pre-pack; and (ii) the machinery, already in place in the insolvency legislation, enabling creditors to challenge the administrator’s decision after the event.

There is nothing to suggest that the courts’ historic disinclination to interfere with an administrator’s commercial assessment where pre-packs are concerned would change as a result of the proposed new rules. This suggests that except in the most clear cut cases of abuse, the courts are likely to be reluctant to prevent a pre-pack sale from going ahead if it is the IP’s considered view (exercising his professional judgement in his capacity as a regulated professional and as an officer of the court) that it is in the interests of creditors. The proposed advance notification of creditors will add little of substance to this but risks prejudicing the sale.

The objective of enhancing public confidence in the process might be more effectively achieved by ensuring that creditors aggrieved by pre-packs in the context of SME insolvencies are aware of their right to bring post-administration challenges to the actions of administrators.

And in terms of the need for public protection and the threat of serial ‘phoenixism’ that the pre-pack procedure is said to embody, the current company directors disqualification legislation already provides a perfectly adequate mechanism for preventing directors of insolvent companies (who can be demonstrated to have engaged in behaviour that makes them unfit) to act in the management of a limited company for a specified period.

The most popular of the five options that the government proposed in the 2010 consultation was ‘No Change’. The debate has served to draw attention to the need for tighter regulation of SIP 16 compliance but it is not clear that the way to do that is by new rules that in fact threaten to undermine the purpose of the pre-pack.

Ruth Jordan is a barrister at Serle Court specialising in insolvency and directors disqualification proceedings