Review of the corporate insolvency framework

09 Jun 2016

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What are the changes to the UK corporate insolvency framework proposed in the recent consultation launched by the Insolvency Service? What might the consequences of the new cram down procedure and the rescue finance proposal be?

Original news

Proposals to bolster the insolvency regime

The government is consulting on four proposals designed to improve the existing corporate insolvency regime. The intention is to enable more corporate rescues of viable businesses and ensure the insolvency regime delivers the best outcomes. One of the proposals is to create a new moratorium which will provide companies with an opportunity to consider the best approach for rescuing the business while free from enforcement and legal action by creditors.

What has been proposed?

The government is consulting on four proposals which would significantly change the options available to a company in financial distress. The proposals are:

the introduction of an automatic and standalone moratorium

continuance of 'essential contracts'

a flexible restructuring plan including cram down

rescue finance

Automatic and standalone moratorium

The consultation proposes a new automatic and standalone moratorium that would be available to all businesses (except for insurance companies, banks and other companies involved in specific financial market transactions) lasting for up to three months, with the possibility of an extension. The rationale behind the standalone moratorium is that it would provide debtors with time to negotiate a restructuring without the threat of individual creditors taking precipitous individual action. The key features are:

it would precede and act as single gateway to different forms of restructuring

the moratorium would commence when the company files the relevant papers at court (there would not be a court hearing to sanction the moratorium)

the moratorium would follow the existing small company moratorium provisions in schedule A1 of the Insolvency Act 1986 (company voluntary arrangements (CVAs))

when the company enters the moratorium, the arrears owed to creditors would be frozen, but the business would be obliged to meet ongoing trading costs and debt obligations during the moratorium

in order to be eligible for the moratorium, the company must demonstrate that it is already or imminently will be in financial difficulty, or is insolvent. There is no proposal to restrict eligibility according to the size of the company, however, if a company has entered into a moratorium, administration or CVA in the previous 12 months or is subject to a winding-up order or petition, it will not be able to qualify for a moratorium

the company must be able to show that it is likely to have sufficient funds to carry on its business during the moratorium, meeting current obligations as they fall due as well as any new obligations that are incurred (the qualifying conditions). This is to ensure that no existing creditors are worse off

creditors would have the right to apply to court during the first 28 days of the moratorium only. There is no creditor right to challenge the moratorium prior to the moratorium coming into force

directors will be protected from liability for trading a company through a moratorium period provided the qualifying conditions continue to be met

the three month period can be extended with the consent of all secured creditors and over 50% of unsecured creditors by value

In addition, a supervisor is appointed at the commencement of the moratorium. The supervisor must be satisfied that the company is eligible for the moratorium and ensure that the company continues to meet the qualifying conditions throughout the duration of the moratorium. The supervisor, who could be an insolvency practitioner, solicitor or accountant, would be prohibited from taking any subsequent appointment in a formal insolvency process.

The proposal for a three month moratorium will give the company a strong right against creditors who will find their position frozen for three months (and potentially longer). Is this tipping the balance too far in favour of the debtor ignoring the reality that it is the creditors who commonly have the economic interest in the company at the time of a restructuring? For some companies the moratorium will merely be a delay of the inevitable end of the company and with no notice to creditors required before a company enters a moratorium, it may become a source of frustration to, for example, secured creditors who are seeking to take control of a company to protect their position.

The three month period is considerably longer than the 21 days (extendable to 42 days) proposed by the industry body, R3. The view of Andrew Tate, president of R3, is that 21 days:

should be long enough for a company to put in place a rescue plan and for it to bring creditors on board with what it is trying to do. A longer moratorium increases the risk of harm to creditors and could allow companies in the moratorium to ‘drift’ rather than sort their problems out.

The implementation of the three month moratorium proposal may see a rise in the number of court applications requesting permission to bring proceedings against a debtor during this time. This is particularly so given that a creditor will only have the first 28 days of the three month period to bring proceedings. In such applications, it will be interesting to see whether the balancing exercise and criteria currently considered by the court in an application to lift the administration moratorium will be applied. It will also be interesting to see how creditors react to the new moratorium regime and seek to protect their position in different ways, for example, asking for more personal guarantees or attempting to introduce notice periods in loan documentation before any application may be made for a moratorium.

Continuance of 'essential contracts'

The aim of this proposal is to make it easier for companies to maintain contracts essential to the continuation of the particular business (in addition to the existing continued supply provisions for IT and utilities). By filing an application at court, the company (or officeholder) would be able to designate certain supplies as essential when the company entered into a moratorium, administration, a CVA or the new restructuring plan outlined below.

The government envisages the officeholder or company would consider the following, and asks for views on this:

whether the continued provision of a supply will be essential to the successful rescue of the business and its ongoing viability

an alternative supply can be found within a reasonable time frame at a reasonable cost

the business will still be able to meet its payments as they fall due

the supplier can objectively justify the refusal to supply

The consultation envisages that the supplier would have the ability to challenge the application, in which case, the court would be required to approve the application.

The government's view is that it 'does not wish to create an unnecessary legal burden by providing a definition of essential that is too stringent and would involve specifying what goods and services would constitute essential supplies'. An example given in the consultation is a printing company that needs specialised paper from a particular company to continue its operations.

It is clear that maintain of essential contracts is important if a business is to continue during the period in which it is in a procedure. It will be interesting to see how the proposed change (if implemented) will impact on a suppliers terms and conditions to ensure they have some protection in the contracts and whether such changes stand up to challenge.

Flexible restructuring plan

The government is proposing to introduce a statutory, multi-class restructuring procedure, time-limited to 12 months, to aid company rescue. This will include the use of a cram down mechanism and the ability to bind secured creditors into a restructuring plan. The key elements of the proposed procedure are:

the cram down mechanism would allow the plan to be imposed on impaired classes on the basis that they would not receive any less in a restructuring than they would in a liquidation—this must be supported by a valuation and it is proposed that a minimum liquidation valuation is used

the cram down mechanism and the ability to bind secured creditors would either be introduced as a new optional type of plan within the existing CVA framework or developed as part of a separate restructuring procedure

creditors will be grouped into classes for the purpose of voting on the basis of similar rights or treatment, similar to the current treatment of creditors in a scheme of arrangement

the restructuring plan must be approved by the court who would apply two tests to determine whether a class can be crammed down:
- at least 75% and more than 50% of each remaining class of creditors have agreed to the terms of the restructuring plan, and
- the plan is in the best interests of the creditors as a whole, in that it 'recognises the economic rights of "in the money" creditors and all other creditors are no worse off than they would be following liquidation'

insurance companies, banks and other companies involved in specific financial market transactions will be excluded, in line with the proposed moratorium

The proposal is one of the less well defined areas of the proposal but it does represents a potentially wide power to end the power of hold out creditors. However, the ability to cram down secured creditors and leave out of the money creditors behind is already available by using a scheme of arrangement and pre-pack administration—albeit, the costs of such procedures may be prohibitive to all but the larger business. Will the new proposal keep costs down to open up the ability to cram down and bind secured creditors to a wide range of businesses?

Rescue finance

The UK lacks a broad and long-established market in specialist rescue finance and the consultation states that the government is keen to encourage greater access to finance for distressed companies seeking new funding. Their view is that greater availability of rescue finance should contribute to a reduction in the number of companies with viable futures failing.

This part of the consultation is fairly open in that it seeks views on how the objective of encouraging rescue can be achieved. It does provide some possible options being:

super-priority status to rescue finance in administration expenses—this was the subject of a previous consultation in 2009

negative pledges—views are sought on the government's proposal that where an existing charge holder who has the benefit of a negative pledge refuses consent to grant security to support rescue funding (where doing so has no negative effect on them), the negative pledge clause could be overridden

The latter is potentially a significant development as the existing charge would be subordinated even where consent was not given. Views are sought on what safeguards would be required to ensure protection for existing charge holders. The consultation envisages that any such approvals would have to satisfy the court that:

the granting of security for the rescue finance is necessary in order to obtain that finance

the interests of existing charge holders are adequately protected and

obtaining the rescue finance is in the best interests of the creditors as a whole

The proposal raises a number of questions and it will be interesting to see how secured lenders will react to it and whether the proposal will be successful this time around. Will lenders insist on being given first refusal to provide rescue finance so they are not trumped by a new lender at the 11th hour? Will lenders see this as an erosion of their ability to influence the restructuring process and protect against their exposure to an ailing borrower?