Financial difficulty as a term covers a multitude of sins, ranging from short-term embarrassment to outright insolvency. Companies need to be aware of the circumstances which lead, or should lead, a board to question the ability of the company to continue to trade in its current form, actually or prospectively. They need to know the legal triggers and concerns, and the principal tools for dealing with them.
Insolvency tests
The starting point in determining the level of a company's distress will often be for the directors to assess whether or not the company is solvent – whether it is able to pay its debts. Under the Insolvency Act 1986 (the Act), there are in essence two alternative tests for this.
The cash flow test is satisfied if the company is unable to pay its debts (both present and future) as and when they fall due (section 123(1) of the Act). The balance sheet test is deemed satisfied if it is proved to the court that the value of the company's assets is less than the amount of its liabilities, taking into account its contingent and prospective liabilities (section 123(2) of the Act).
Each of these tests brings different considerations to the fore. But it is clear (and the case of Re Cheyne Finance deals with this), that each includes an element of looking forward. Applying the forward looking element to the balance sheet test can be an intrinsically difficult exercise. This is particularly true when it comes to determining asset values (as evidenced by Re Colt Telecom Group) and what scope there is to bring prospective assets, which are not expressly included in the balance sheet test, into the equation. The courts will be wary of taking into account any hope or expectation that a company may have that it will acquire assets in the future unless the company has an accompanying right to such assets (Byblos Bank SAL v Al-Khudhairy). Whilst not considering prospective assets may seem harsh if, in the past, prospective liabilities have been met out of current income, in reality they should not be altogether ignored as a court will have the discretion to look at the surrounding facts, including the company's prospects of acquiring further assets.
The crux of both insolvency tests is that a board may not close its eyes to the consequences solely on the basis that it can continue to pay current creditors. It must look to prospective liabilities in assessing solvency. What that means in practice will vary greatly from case to case, and a trading business will have more scope for judgment than a closed vehicle, but the analysis must test the same issues.
Consequences
The key issue is the result of applying the tests. If they demonstrate that the company cannot carry on without the risk of an inability to pay its debts leading to an insolvent liquidation, then the directors have a critical issue on their hands. Some fundamental decisions need to be made.
First, where the prospect of insolvency looms, in addition to the statutory duties owed by directors under the Companies Act 2006, the directors must have regard to certain additional liabilities which may arise. Principally: fraudulent trading under section 213 of the Act, wrongful trading under section 214 of the Act, misfeasance, voidable transactions (i.e. any preference or transaction at an undervalue) or potential claims brought by a regulator. Any disposition of property, unusual deals with creditors or other transactions will potentially be subject to retrospective examination and challenge, and the terms, motivation for and arms' length nature of such transactions must be tested. Second, there needs to be an examination of just how acute the risk of insolvency is.
Liability for wrongful trading in particular will be a key concern and a number of the issues which should be on directors' minds at this time flow from the test for that liability – as discussed below.
Wrongful trading
The test for wrongful trading set out in section 214 of the Act provides that:
- if a company goes into an insolvent liquidation; and
- at some time prior to the commencement of the liquidation (the critical point), a director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation; then
- on the application of a liquidator the court may declare that the director (including a former director) is liable to make such contribution (if any) to the company's assets as the court thinks proper; but
- the court shall not make an order declaring that director liable to contribute if the court is satisfied that, from the critical point, that director took every step with a view to minimising the potential loss to the company's creditors as (assuming him to have known that there was no reasonable prospect that the company would avoid going into insolvent liquidation) he ought to have taken.
This means that there is a personal duty on all directors to minimise loss to creditors once the reasonable prospect of avoiding insolvency has been reached. To minimise the risk of a breach of this duty and any consequent personal liability, it is vital that directors are well informed about the state of the company's financial health, hold (and properly minute) regular board meetings and obtain independent legal, financial and other appropriate professional advice on a continual basis. It is equally important at this stage to avoid panic and precipitative action. The directors do not have to believe that insolvent liquidation will be avoided; only that there is a reasonable prospect that it will be. This gives in practice significant scope to continue to take steps to better the position of the company: negotiating with lenders or prospective lenders, exploring disposals of assets or businesses (see further Re Continental Assurance Co of London), seeking white knight bidders. These actions can continue for extended periods of time, subject in the case of listed companies to the disclosure issues noted below. What is equally clear is that a fanciful idea does not constitute a reasonable prospect, but a series of delicate and difficult negotiations where the outcome remains uncertain are capable of doing so, and frequently do.
Restructuring options
The first step will usually be to explore the possibility of some form of consensual restructuring with the company's stakeholders. For creditors, the key advantage is that they should see more of their value preserved than would be the case if the company were forced into a sale or a winding up. For the company, negotiating a successful restructuring will ensure its survival, although this will almost inevitably come at a price, with lenders (who will typically drive the process) looking for some form of return in the future.
There are a whole myriad of restructuring options which could be pursued by the company and its stakeholders, and the appropriate approach to take will depend on the company's debt and capital profile.
Debt restructuring
In its most basic form, a debt restructuring could entail entering into a standstill arrangement in order to give the company time for a survival strategy to be put in place, or a waiver or amendment of certain covenants. Debt restructuring could also involve the injection of new debt in order to reset covenants, or a buyback of the company's debt in order to de-leverage the company's capital structure. Investors, particularly private equity players, may also have rights to an equity cure under the company's facilities allowing capital raised through the issue of equity to the investor to make up a shortfall in the company's revenues, cash flow or profits and thereby protecting the company from breaching its covenants. Alternatively, a lender may agree to subordinate its debt so that it ranks behind other debts but ahead of equity. (Although typically any subordinated debt will be structured with warrants to subscribe for equity thereby allowing the lender to share in any upside.)
Debt restructuring, particularly in its more basic form, may only provide superficial benefits and it may need to be pursued along side an M&A solution or a capital raising exercise. Often, in fact, a debt restructuring is pursued not just to enable the company to trade more securely but also to make it a more attractive vehicle for the injection of new capital.
Debt for equity swaps
An alternative would be to pursue some form of debt-equity restructuring with lenders such as a debt for equity swap, where a lender takes an equity interest in the company in exchange for a write off of all or a proportion of its debt. A more complicated debt for equity structure might use a pre-pack administration (discussed further below), with the distressed company going into administration, and a new company funded by way of debt and equity (provided by lenders and other investors, often including the company's management) being established to acquire the business.
The need for consent from multiple layers of the capital structure and the possibility of investors' dilution makes debt for equity swaps difficult to negotiate and, whilst they were quite popular in the previous recession, this time around they are proving less so, at least in the public company sphere. To the extent that debt for equity swaps return to favour with listed companies, there will be additional legal considerations to take into account, such as the requirement in Listing Rule 6.1.19 for 25% of shares to be in public hands.
CVAs
Another alternative is to enter into a company voluntary arrangement (CVA). The CVA was introduced by the Act to enable companies to reach informal, yet binding arrangements with their creditors. Once approved by the requisite majority of creditors and members, the arrangement is binding on all members and creditors, except secured or preferential creditors (unless these creditors agree to the CVA). The effectiveness of a CVA as a standalone restructuring vehicle has in the past been limited because it is often a difficult process to implement, particularly as there is no automatic statutory mechanism preventing creditors from taking action (except in relation to small companies). But the tides may be turning. The recent approval of JJB Sports' novel CVA proposal which allowed it to continue to trade (without administration or a suspension of shares) may prove to be a model for listed companies looking to avoid a formal insolvency process, particularly those operating in the retail sector. JJB entered into a CVA to compromise claims of landlords of approximately 140 closed stores and temporarily vary the terms of the leases of approximately 250 open stores to permit monthly rent payments.
Whichever option is pursued, during this period, the directors' duties remain those owed to the company. But a sensible board will clearly have particular regard to the position of creditors, not only when incurring new liabilities but also when settling existing ones. The detail of the regime governing preferences is outwith the scope of this commentary, but it is safe to say that a board will have to listen to a creditor who has the right to pursue a claim and does so aggressively. It must also consider the consequences of failing to do so, even if there is a doubt about the ability to pay all creditors as they fall due. But at some stage, let us assume that the reasonable prospect disappears, and the critical point is reached. The directors have a duty to take every step with a view to minimising loss to creditors, and must conduct themselves accordingly.
The fundamental decision is likely to be whether the company should keep trading in some capacity. It is absolutely not the case that a company must cease trading as soon as liquidation has become inevitable. It depends in all the circumstances how best to minimise creditors' potential losses, and in many cases the right answer is to continue to trade, albeit with great caution and on close advice – payment by payment. In reality, in most cases the company's lenders will not permit this to continue and that withdrawal of support, or demand for terms which are inconsistent with the directors' duties, will lead to the appointment of an insolvency practitioner. Again, the detailed regime for that is outside the scope of this commentary.
Listed company disclosure issues
For directors of UK listed companies, there will be an extra layer of obligations to bear in mind, principally in ensuring that the company complies with its obligations to keep the market updated of its financial condition and of any steps taken to address that condition, in accordance with the Disclosure and Transparency Rules (DTRs). The possibility of causing value destruction by publicising a state of financial distress will go against a board's natural instincts. Independent advice from lawyers and brokers will play an important part in establishing clarity about what must be said and what can legitimately be held back while the company addresses its situation.
The principal point is that the company will still need to comply with DTR 2.2.1 in notifying the market as soon as possible of any inside information which directly concerns the company. The question then is whether there is scope for it to hold information back from the market under the exception to DTR 2.2.1 in DTR 2.5.1. This permits delay in the public disclosure of inside information such as not to prejudice the company's legitimate interests provided that: (i) such omission would not be likely to mislead the public; (ii) any person receiving the information owes the company a duty of confidentiality; and (iii) the company is able to ensure the confidentiality of that information.
The answer is not an easy one. The combination of these rules means that whilst there is a clear need to apprise the market if the company is missing targets or experiencing financial problems (even where it is not entirely clear what these are), there is a limited exception allowing for delay in disclosure of how the company intends to fix the problem provided (and this is important) that the company can preserve confidentiality. So the detail, for example, of refinancing negotiations need not (absent a leak) be announced until those negotiations constitute an agreement. But if an announcement is made (for example of continuing negotiations) and the nature of the facts announced materially changes, a further announcement will be needed.
How to get it right
There are many examples of companies getting it right, including by informing the market of potential financial difficulties or covenant reviews in trading and other financial updates (Wolseley, July 2008, prior to an eventual rights issue and Taylor Wimpey, November 2008, prior to an eventual deferral of covenant testing dates); and of discussions with debt providers and the possibility of asset sales without naming counterparties in the face of a falling share price (JJB Sports, December 2008). If a company is unable, or unwilling, to make some form of holding announcement, there is a risk that it will be suspended from trading (under DTR 2.2.9(3)), although it would still need to comply with its Listing Rule obligations during any suspension (LR 5.1.1(2)).
There are also high profile examples of companies getting it wrong and which highlight the importance of seeking advice from lawyers and brokers. The FSA's recent £140,000 ($214,000) fine against Wolfson Microelectronics for breaching DTR 2.2 and Listing Principle 4 demonstrates that the loss of a material contract cannot be delayed because the impact to the company's finances may be reduced by the award of a separate contract. The crucial point is that a company cannot delay or withhold disclosure of its distress merely because it foresees better news on the horizon, nor can it attempt to net good against bad as a means of avoiding disclosure.
Administrators: a different seller
Finally, a few words on disposals following an administration. Purchasers should be aware that dealing with an administrator is very different from dealing with a normal corporate seller. Any perceived gain in consideration should be viewed against a backdrop of reduced deal protection. The administrator will drive the process and will be limited in what he can offer by his duties and powers: his paramount duty will be to creditors and he will be under a duty to get the best price reasonably obtainable in the circumstances. These considerations will feed into the terms of the share purchase agreement. Typical features include:
- the administrator will not give any covenants as to title: he will only sell "such right and interest as it may have";
- the administrator will generally not give warranties (not least because he will have a very limited knowledge of the business being sold) and the purchaser will need to price in any associated risk;
- any other obligations that the purchaser may receive are likely to be of limited value;
- the administrator will exclude his personal liability and will often seek indemnities from the purchaser to that effect, in particular in relation to the accidental transfer of third party assets; and
- assets delivered to the insolvent company on retention of title will typically be dealt with by the administrator agreeing to deal with retention of title claims in the first instance, but having the right to transfer the handling of such claims to the purchaser.
Pre-packs
One popular form of distressed M&A solution in this recession has been to structure the purchase from the administrator by way of a pre-packaged disposal. A pre-pack is an arrangement to purchase the assets or target before an administrator is appointed, with the administrator effecting the sale immediately on, or shortly after, his appointment. Pre-packs seek to take the benefit of the administrative moratorium without the business suffering the reputational devaluation brought by the publicity of formal insolvency. They typically involve a management or lender owned special purpose vehicle. The process has proven to be controversial with unsecured creditors who are given no opportunity to input on the sale before it takes place. The insolvency industry has attempted to deal with these concerns by introducing guidelines and a number of well known retailers have been able to secure their survival on the high street in the face of the credit crunch by way of a pre-packaged administration (including The Officers Club, Whittards of Chelsea and USC).
Conclusion
A continuation in corporate difficulties over forthcoming months is to be expected. Many boards have not had to deal with financial difficulty before. Market changes have also affected the ground rules, and the lack of a large buyer market for distressed assets will affect creditors' appetite for instituting insolvency processes, even if they are dealt with in a coherent and thoughtful manner. A well advised board will open its eyes early to the possible chain of events ahead. If it does so, its chances of steering a course through the difficulties is greatly enhanced. If it simply reacts to short term events, its chances of survival will be small.
| Author biographies |
Gareth Roberts
Herbert Smith
Gareth Roberts joined Herbert Smith in 1983 and has been a partner since 1991. He advises a wide range of corporate clients on corporate governance and transactional activity. Experience includes advising JJB Sports Ltd on its recent restructuring, refinancing and company voluntary arrangement; BAA on many general corporate matters such as its £15.6 billion takeover by Ferrovial and a competing bid from a Goldman Sachs-led consortium; Virgin Group on the £1.7 billion recommended offer by NTL for Virgin Mobile and Foster's Group on the sale to Scottish & Newcastle of the Foster's brand in Europe and elsewhere.
Gail Watt
Herbert Smith
Gail Watt is an associate in Herbert Smith's corporate division and has worked on a range of corporate finance and M&A transactions, including reorganisations, joint ventures, public takeovers and private acquisitions for clients including BAA, Pearson and 3i.
Gail also advises listed and non-listed companies on general corporate law matters and has worked in-house on secondment for BAA. Gail is a graduate of the University of Aberdeen. Prior to joining Herbert Smith, Gail trained with a leading Scottish law firm. |