28 May 2012

Prefab doubts

Insolvency is a spectre lurking in the boardrooms of an increasing number of companies, and they are turning to controversial pre-pack administrations to minimise the damage. Gavin Hinks investigates the pros and cons

Companies experiencing the pain of going bust grab the business headlines. And the recession and stalling of the UK economy have produced notable corporate casualties. Acquascutum, Whittard of Chelsea, MFI and Woolworths are but a few of the victims forced into some form of insolvency procedure.

Going bust is painful for everyone. Owners and creditors stand to lose money, clients risk losing a service, staff face losing their jobs. It is a desperate time, emotions run high, lives and businesses are transformed. But during the current economic turbulence, attention has focused on the number of businesses choosing to use so-called pre-pack administrations as a route out of their troubles.

Practitioners have got to go that extra mile to convince themselves what they are doing is right and that they are able to defend it

Nick Hood, Company Watch

Insolvency and especially pre-packs have become highly controversial during the course of the crisis. Last year the BBC’s File on Four programme devoted time to investigating insolvency, including an examination of pre-packs. They became a bête noire and detailed proposals for reform emerged. But in January the government decided not to go ahead with the change. So concern continues about its use. Elsewhere, especially among insolvency practitioners, the line is that the pre-pack has its uses and that it is much maligned by insubstantial complaints.

Tool in the armoury

What’s certain is that the pre-pack, however controversial, remains a tool in the armoury of insolvency practitioners and is frequently brought into play. Insolvencies in general started to climb from the end of 2007. Two years later, in 2009, they had reached their crisis peak with 4,161 companies going through some form of administration. At the same time criticism of pre-packs reached such a pitch that the government’s Insolvency Service introduced new rules ensuring practitioners had to submit special reports, SIP 16s, on each pre-pack after it was completed.

This allowed figures to be compiled on their use. The first year showed that, of total administrations, almost a third, 29%, were pre-packs. The following year pre-pack use was down marginally but still formed 27% of all administrations. And that’s if the regulatory returns are correct. The Insolvency Service, in its 2010 report on the use of SIP 16, says it is possible that not all practitioners submit the required reports – in which case, the number of pre-packs may be higher than current estimates.

Notable pre-packs make the news, underlining just how common they have become. Outdoor retailer Blacks Leisure was recently sold to JD Sports using a pre-pack, as was lingerie chain La Senza to Alshaya, the Middle East retail group. But as their use increases, the controversy surrounding them shows no sign of diminishing.

In essence the pre-pack takes place in two parts. The first part is consultation with an insolvency practitioner in which a suitable buyer is sought for an ailing business. This is done quietly and without disclosing the business is in trouble. Once a buyer is found, the business is formally declared insolvent and sold immediately to a new owner. They might be external buyers, they could be connected parties; for instance the existing company directors.

A more common procedure would see control of a company passed to an administrator, as part of a trading insolvency, who would attempt to either trade the business before a sale, or sell its assets in the interests of the creditors. The administration may happen as the result of a court application by creditors, or out of court as a result of action by company directors or the holders of a floating charge. But all in the glare of potentially fierce publicity and with the attention of all creditors.

So the main complaint about pre-packs is the very thing that practitioners see as their distinct advantage – they happen swiftly and offer none of the disclosure to creditors that would come with a trading insolvency. This in turn provides the opportunity for claims that pre-pack use is abusive – a stitch-up allowing directors, or in the jargon "connected parties", to buy back a company unburdened by its old debts.

The claims are unlikely to go away. But Nick Hood of Company Watch, specialists in tracking corporate financial health, says abusive behaviour must amount to more than simply selling to connected parties. After all, former managers might just offer the best price. He says telltale dodgy behaviour would include no effort to go outside the company to search for prospective buyers, and scant indication of tough price deliberations.

"Pre-packs are abusive where there is no evidence of testing the market for third-party buyers, and where there is no hard-nosed negotiation between the proposed administrator and the prospective buyers," says Hood. If the likely buyers are existing managers, the insolvency practitioner must be prepared to do their research and use it to push for a better price.

"Practitioners have got to go that extra mile to convince themselves that what they are doing is right and that they are able to defend it," he says.

The solution, Hood believes, is to involve corporate finance specialists in researching and helping determine whether the right value is being obtained. It’s in this that others see themselves protected too, as well as ensuring that value is attained. Mike Jervis, an insolvency practitioner with PwC, insists that practitioners must be able to "demonstrate" they got the best price. That involves research. "You have to reach out to as many potential buyers as possible in a traditional M&A process," he says.

Complaints about the lack of disclosure will also continue. When, in January, the government decided against reform that would have given creditors three days notice of an impending pre-pack, it was the Association of British Insurers (ABI) that responded most vociferously, calling the decision a "climb down" and insisting "unsecured creditors will continue to lose out to deals carried out behind closed doors". In a consultation submission to the Insolvency Service, the ABI insisted that pre-packs do not allow suppliers, or unsecured creditors, to intervene in an insolvency and that nearly half of all pre-packs involve no action to establish the company’s "true worth".

Frances Coulson, former president of the insolvency practitioners body R3, says that the three-day notice would have "thrown pre-packs out the window" and points to their ability to keep people in employment as a real strength. "You have to remember that they do save jobs – a much higher percentage than other forms of insolvency."

R3 says research by Sandra Frisby at The University of Nottingham in 2010 reveals that around 92% of pre-packs see all the jobs transferred to the new company. Other procedures save all jobs in only 65% of cases, according to the figures.

Plus for creditors

These figures form a big part of the argument in favour of pre-packs, but the core claim from practitioners is that pre-packs protect value in stricken companies, and that is a plus for all creditors, whether secured or unsecured. Richard Fleming, UK head of restructuring at KPMG, and one of the administrators responsible for the Blacks pre-pack, describes the lack of transparency as essential in making sure the best price is achieved for a struggling company up for sale.

When it becomes known a business is foundering, stakeholders begin to run away, deepening the company’s woe. The fact that there is little in the public domain about the company’s troubles means that employees don’t flee, supplier relationships are maintained, clients remain attached. In short, the process does less damage. And that’s crucial, Fleming says, because it’s the administrator’s obligation to maximise value for creditors.

"In doing that you have protected value and minimised the car crash that comes with administration," Fleming says. He adds that the opportunities for unsecured creditors to recover their money is broadly the same as a trading insolvency. He says: "What creditors don’t like is that one day the business is not in an insolvency process and the next it has a new owner."

PwC’s Jervis agrees. "The advantages are all about continuity of business. A lot of businesses, if you trade them in insolvency, see their value reduced."

Member panel view

"Pre-packs have helped salvage distressed businesses and preserve jobs but there is scepticism where they enable directors to buy back companies at a bargain price while walking away from large trade debts. Regulation of the insolvency profession has improved the reputation of the sector, but there is more to be done." – Fiona Hotston Moore, Crowe Clark Whitehill