venturecompanyconsultants.com

What is a “Pre-Pack” sale?

A “Pre-Pack” is not a special type of insolvency procedure and no reference is made to “Pre-Pack” sales in English insolvency legislation. It is simply a term used to describe:

• a sale of the business or assets of an insolvent company (which could include the sale of shares in its subsidiaries);
• by an insolvency officeholder (typically an administrator);
• where the preparatory work (identifying the purchaser and negotiating the terms of the sale) takes place before the appointment of the insolvency officeholder; and
• the sale is then concluded almost immediately after the appointment of the insolvency officeholder without the sanction of either the court or creditors, and often with limited formal marketing of the business or assets being sold.

It is the fact that the preparatory work takes place before the appointment of the insolvency officeholder which distinguishes a “Pre-Pack” from any other sale by an insolvency officeholder. It is the rapid conclusion of the sale, the absence of court or unsecured creditor involvement and the fact that many “Pre-Pack” sales are to the insolvent company?s previous shareholders or directors, which have together generated much of the current debate surrounding “Pre-Packs”.

Although concerns regarding the use of “Pre-Packs” have been expressed, research relied on by the UK Government has shown that, in over 80% of “Pre-Pack” sales, returns to unsecured creditors, while low, were nevertheless marginally better than returns to unsecured creditors in non “Pre-Pack” sales.

When would a “Pre-Pack” sale process be used?

There are three main commercial reasons for considering a “Pre-Pack” sale:

• Lack of liquidity: If there is insufficient funding available for the company to continue trading while looking for alternative potential purchasers, an administrator may have no real choice but to pursue an immediate “Pre-Pack” sale strategy. This often results in a sale to the company?s existing shareholders, directors or secured creditors, as they are normally best placed to act quickly, not needing to conduct an extensive, and time-consuming, due diligence exercise.
• Preserving the value of the business: If administration has become inevitable, a rapid “Pre-Pack” sale may be necessary in order to limit the potentially detrimental impact of an insolvency procedure on a business, allowing the sale to be completed before suppliers, customers and employees become aware that the company has gone into administration. This scenario is most likely to arise where a business relies on skilled staff who might be tempted to seek employment elsewhere amid the uncertainty surrounding any formal insolvency process.
• Transferring control of the business and economic upside: A company?s secured creditors might suggest that a “Pre-Pack” sale strategy should be adopted, where the company is facing insolvency, but those secured creditors want to acquire its business (typically using a special purpose company or “SPV” owned and financed by those secured creditors), retaining it under their control until market conditions improve and thereby ensuring that they receive any future economic upside arising from the business.

Lenders have an advantage if bidding for the business because the acquisition price paid for the business is effectively round-tripped (assuming that those creditors funding the SPV have security over any amounts paid by the SPV to the administrator of the selling company), so the secured creditors are often in a position to significantly outbid other potential purchasers. They may therefore argue that, as they would be willing to pay more than the business was currently worth (as long as the amount which they paid was used to repay their secured debt) conducting an extensive sale process would be an expensive and, in all probability, pointless exercise.

Where such reasons exist, an administrator has to strike a balance (taking into account the nature of the company?s business and the availability of liquidity) between the need to preserve value by conducting a quick “Pre- Pack” sale and the potential benefits of a wider marketing process which could attract more potential purchasers.

How common are “Pre-Pack” sales?

To put the popularity of “Pre-Pack” sales into context, figures released by the Insolvency Service estimate that almost 1 in every 3 administrations involve a “Pre-Pack” sale by the administrator.

A typical “Pre-Pack” sale process

• Who sells? The company?s business (potentially including shares in its subsidiaries) will be sold by an insolvency office holder (typically a administrator, but possibly an administrative receiver or a liquidator), rather than by the company?s directors.
• When are the sale documents negotiated? Agreement of the purchase price, the negotiation of the business sale agreement, the completion of any due diligence and obtaining any necessary consents or clearances will normally be completed before the proposed administrators are appointed. The latter will, however, need to approve the terms of that business sale agreement, including the purchase price, as it is they who will be selling the business.
• The duties of the administrator: Prospective administrators need to satisfy themselves that:
• the decision to go down the “Pre-Pack” sale route can be commercially justified;
• the “Pre-Pack” sale option provides the companys creditors with the best price reasonably obtainable for the business, given its current situation; and
• the proposed “Pre-Pack” therefore protects, rather than erodes, value.

The difficulty which administrators face is that the nature of the “Pre- Pack” sale often means that there will only be a very limited marketing process to support their judgment.

• Obtaining valuation evidence: In seeking to get comfortable with the agreed purchase price, the administrators will take into account any recent attempts to sell the business. If the business has not recently been exposed to the market, a potential administrator would ideally like to see the business marketed. If this is not practical, an administrator may instead consider:
• seeking desktop valuations from independent valuers; and
• obtaining advice from experts in the relevant sector in relation to recent M&A activity, the most appropriate marketing strategies for businesses in that sector and the possibility of there being a „special purchaser? willing to pay a premium for the business.
• Appointment of the administrators: Once the business sale agreement has been finalised and any due diligence has been completed, the proposed administrators will be appointed, either following an application to court or using the out-of-court appointment procedure. Our Guide to administration contains further detail on the administration process.
• No court approval: A “Pre-Pack” sale does not require court approval. Courts have historically taken the view that the question of whether a “Pre-Pack” sale is justified, and the commercial terms of any such sale, are both a matter for the administrators? commercial judgement and that it is not the courts role to second-guess or validate that judgement. If, however, the administrators are appointed by the court, rather than using the out-of-court route, there is recent case law suggesting that the court may, in deciding whether or not to make the administration order, take into account the merits of any proposed “Pre- Pack” sale.
• Sale of the business: The administrators will, following their appointment, execute the business sale agreement. The gap between their appointment and the completion of the sale of the business could only be a matter of hours, given that every step in the process is normally finalised prior to the administrators? appointment. The sale proceeds, after deducting the administrators? costs, are typically used to repay secured creditors, with, in many cases, little or nothing being left to satisfy the claims of the selling company?s unsecured creditors.
• Subsequent steps: Those creditors whose claims remain unsatisfied will typically require an explanation for the proposed “Pre-Pack” sale and may, if they have concerns surrounding the circumstances of the sale, seek a review of the administrators? conduct. The selling company will almost inevitably be dissolved once any such review has been completed.

How long does a “Pre-Pack” sale process take?

While the gap between the appointment of the administrator and the subsequent sale of the business can be a matter of hours, the length of the process running up to the sale will largely depend on | how long it takes to negotiate the sale price and documentation | how long it takes the administrators to get comfortable with the process and | what consents and approvals are required for the proposed sale. The length of the preparation process could be impacted by the need, for example, to obtain merger control clearances (where the “Pre-Pack” sale involves a sale to a competitor) or a specific clearance from the Pensions Regulator (where the selling company has a defined benefit pension scheme).

Potential purchasers in a “Pre-Pack” sale

Statistically, most “Pre-Pack” sales are to a purchaser with existing links to the business being sold. Figures released by the Insolvency Service indicate that over 70% of all “Pre-Pack” sales are to connected parties, such as current or former management or shareholders.

“Pre-Pack” sales are also frequently used by competitors or specialist investors who follow sectors closely and are able to act swiftly. Such purchasers should understand the business and the issues facing it and will therefore often be able to proceed relatively rapidly without carrying out extensive due diligence.

A “Pre-Pack” sale may also, as noted above, involve a sale of the business to a SPV owned and financed by the companys existing secured creditors.

Why can “Pre-Pack” sales be controversial?

There are two major criticisms of “Pre-Pack” sales. The first, a technical argument which has become much less of an issue as case law and practice have developed, is that conducting a “Pre-Pack” sale is incompatible with an administrators statutory duties. The second is a sentiment, particularly noticeable in press reports about “Pre-Packs”, that the “Pre-Pack” sale process lacks transparency, is open to abuse by unscrupulous officeholders, and, if not unlawful, is at least morally wrong.

Concerns relating to transparency arise from the fact that unsecured creditors have little or no input in, or even knowledge of, the “Pre-Pack” sale process. They are often simply presented with a done deal, which will often result in them not receiving any payment. Such creditors may suspect that they might possibly have received some repayment, had the administrators decided to market the business more extensively, instead of going down the “Pre-Pack” route.

The negative impression caused by the lack of transparency surrounding “Pre-Packs” has been increased by the fact that it is, as noted above, often the companys current or former shareholders or management who buy the business, leaving behind much of the companys unsecured debt (a process sometimes referred to as a “Phoenix Pre-Pack”). The Government has announced its intention to improve the transparency of such “Phoenix Pre- Packs” and to enable creditors, in certain circumstances, to raise concerns before the “Phoenix Pre-Pack” sale takes place by requiring administrators to notify creditors where no open marketing of the assets has taken place.

Improving the image of “Pre-packs” – SIP 16

In January 2009, partly in response to criticisms and in recognition of the increasing role “Pre-Pack” sales are playing in insolvencies, R3 (a body representing insolvency practitioners) released a Statement of Insolvency Practice – SIP 16 (Pre-Packaged Sales in Administrations). Although currently non-binding in nature, SIP 16 contains best practice guidance for insolvency practitioners, requiring them to be able to explain to the companys creditors why a “Pre-Pack” sale was entered into.

Paragraph 9 of SIP 16 suggests that, in order to allow creditors to satisfy themselves that the administrator acted properly and with due regard for their interests, the creditors should be provided with details of:

• why it was necessary to sell the business immediately, rather than to trade the business and then to offer it for sale as a going concern during the administration process;
• any marketing activities conducted by the company and/or the administrator;
• any valuations obtained for the business or the underlying assets;
• the alternative courses of action considered by the administrator, with an explanation of possible financial outcomes; and
• the identity of the purchaser and the consideration, terms of payment and any condition of the contract that could materially affect it.

Although SIP 16 does not impose any specific timescale within which this information should be disclosed to creditors, the Insolvency Service has made it clear that it would normally expect the information to be sent to creditors within a fortnight of the completion of the sale, other than in exceptional cases.

Potential liability for the administrator in relation to a “Pre-Pack” sale

Administrators may face potential liability if they sell the business for less than its proper value. Administrators? actions could also be challenged by creditors under paragraphs 74 and 75 of Schedule B1 of the Insolvency Act 1986. Paragraph 74 enables creditors to challenge the actions or proposed actions of administrators where they unfairly harm the creditors? interests, while paragraph 75 gives the court the power to examine the administrators? conduct, on the application of (among others) a creditor, where such conduct may have breached a fiduciary or other duty in relation to the company or where the administrators may have been guilty of misfeasance.

An administrator may also face being removed from office by a court exercising its powers under paragraph 88 of Schedule B1, where creditors have concerns about a “Pre-Pack” sale and want an independent insolvency practitioner to conduct a review of the circumstances surrounding the sale and the valuation arrived at. Having this right may, however, be of little comfort where the “Pre-pack” sale has already been completed.

Finally, the circumstances surrounding a “Pre-Pack” sale could also result in an administrator being reported to their authorising body. For example, during 2010, 15 insolvency practitioners were reported by the Insolvency Service to their authorising bodies.

One final point – terminology

Care should be used in relation to the term “Pre-Pack”. In a UK context, the term is generally used to refer to a pre-agreed business sale by an insolvency practitioner which does not require prior court and/or creditor sanction. In other jurisdictions, the term “Pre-Pack” may instead be used to describe a fast tracked implementation of a restructuring plan which is agreed by the debtor and its creditors prior to the insolvency filing, but which is then sanctioned by the court on an expedited basis.

OTG v Barke is the most recent judgment by the Employment Appeal Tribunal (EAT) on whether the Transfer of Undertakings (Protection of Employment) Regulations 2006 (known as ‘TUPE’) apply to sales by companies in administration under schedule B1 to the Insolvency Act 1986.

The EAT decided on 16 February 2011 that an administration could not be a bankruptcy or analogous proceeding instituted with a view to the liquidation of the transferor’s assets. Therefore regulation 8(7) of TUPE did not apply to sales of a business by administrators – with the result that employees of a company in administration will automatically transfer under regulation 4 of TUPE to the buyer of the business.

In reaching its decision the EAT disagreed with an earlier EAT judgment given in 2008 in the case of Oakland v Wellswood (Yorkshire) Ltd. There, the EAT held that on the facts of that case (involving a pre-pack) the transferor employer in administration was in an insolvency proceeding that was a form of ‘terminal insolvency’. Therefore regulation 8(7) did apply and employees did not automatically transfer.

In practice the later decision in OTG vs Barke is likely to be followed by an employment tribunal. This will make a marked difference to sales of a business by administrators because purchasers will take the costs of the transferred employees into account and it can be expected that some sale prices could be materially reduced as a result of the decision.

Whether a transfer of a business by a company in administration falls within TUPE was considered in five joined appeals, all consisting of similar facts.

In OTG Ltd v Barke, a pre-pack administration occurred and the business of the company in administration was transferred to a different company. The claimants (employees of the company in administration) were dismissed at the time of the transfer and brought proceedings for unfair dismissal. The fact pattern in the joined cases of Olds v Late Editions Ltd and The Secretary of State for Business, Innovation and Skills v Coyne and others are identical. Both of these cases also involved a pre-pack administration sale.

The facts in Key2Law (Surrey) LLP v Antiquis are slightly different – here a pre-pack administration had been envisaged but fell through. The administrators entered into a management contract with the transferee company within days of the administration and the claimant was made redundant.

Head Entertainment LLP v Walker concerns the administration of Zavvi Retail, which went into administration in 2008. In early 2009 Head agreed to buy the stock and essential equipment of the Zavvi stores and started trading. Head also employed the previous Zavvi staff. The issue was whether the contracts of employment of the previous Zavvi staff had automatically transferred to Head and thus whether these staff were entitled to bring claims against Head on their redundancy.

As the EAT set out, the facts are in some way non- material to the underlying question that was on appeal – namely, do the automatic transfer of employee provisions contained in TUPE apply to a sale by an administrator of the business?

The relevant provisions of TUPE

TUPE applies to transfers of the whole or part of a business or undertaking or a change of service provider (a relevant transfer), subject to certain exceptions. Regulation 4 provides that a relevant transfer does not operate to terminate the contract of employment of employees who are working in the business at the time of the transfer but transfers their contracts to the transferee.

Regulation 7 provides that a dismissal because of a relevant transfer or for a reason connected with it that is not an economic, technical or organisational one is automatically an unfair dismissal.

Regulation 8(7), however, disapplies these regulations to any transfer where there is what has been called a ‘terminal insolvency’ – ie ‘the transferor is the subject of bankruptcy proceedings or any analogous insolvency proceedings that have been instituted with a view to the liquidation of the assets of the transferor and are under the supervision of an insolvency practitioner’. The wording ‘bankruptcy proceedings or any analogous insolvency proceedings which have been instituted with a view to the liquidation of the assets of the transferor’ was directly copied from article 5(1) of the Acquired Rights Directive 2001, which in turn reflects European Court of Justice case law on the previous directive.

The position in administrations

The Department for Business, Innovation & Skills (BIS) issued guidance on regulation 8(7) in June 2009. Its view was that ‘“relevant insolvency proceedings” means any collective insolvency proceedings in which the whole or part of the business or undertaking is transferred to another entity as a going concern. That is to say, it covers an insolvency proceedings in which all creditors of the debtor may participate, and in relation to which the insolvency office-holder owes a duty to all creditors.’

Earlier guidance stated that BIS takes the view that regulations 4 and 7 will always apply in relation to a relevant transfer that is made in the context of an administration. The earlier guidance stated that ‘the correct approach is to look at the main or sole purpose of the procedure rather than its outcome in a particular instance. The main purpose of bankruptcy proceedings is to realise free assets and expenses amongst all the debtor’s creditors. This is not the main purpose of administration.’

The BIS guidance is not binding and has been widely criticised in the market.

The 2008 decision in Oakland v Wellswood (Yorkshire) Ltd

In 2008 the EAT held in Oakland (a case where the claimant was dismissed by reason of redundancy following a pre-pack sale of the business by the administrators to a new company) that where administrators are not able to trade the business with a view to its sale as a going concern one could conclude that the administrators’ appointment was with a view to the eventual liquidation of the company’s assets by way of a creditors’ voluntary liquidation. Therefore regulation 8(7) applied and employees did not automatically transfer to the new company.

The judgment in OTG

In OTG the EAT reached a different conclusion from the one in Oakland. It favoured what was called the ‘absolute approach’, ruling that administration proceedings can never constitute insolvency proceedings instituted with a view to the liquidation of the transferor’s assets and that therefore TUPE would always apply. The EAT preferred the absolute approach over what was termed the ‘fact-based approach’ – in which the application of TUPE’s automatic transfer provisions would depend on the individual circumstances of each administration.

The EAT gave the following reasons for favouring the absolute approach.

• The legislator of the Acquired Rights Directive on which TUPE was based was likely to have intended the distinction of insolvency proceedings instituted with a view to the liquidation of the assets to depend on the legal character of the relevant procedure – in other words, the object of the procedure rather than the object of the individuals operating it.
• The distinction was explicitly concerned with the object of proceedings when instituted. An administrator must always consider first whether the primary objective of rescuing the company as a going concern is overridden by the second or third objective – namely, achieving a better return for creditors as a whole or realising property with a view to making a distribution to secured or preferential creditors. The EAT concluded therefore that at the moment of institution of administration proceedings their object is not to liquidate the assets.
• There is no requirement for an administrator at the outset of the administration to state which objectives he is pursuing. The first occasion on which these have to be declared is when the statement of proposals is filed. There is thus no authoritative way in which an employee or other person affected by a transfer by an administrator can establish whether regulation 8(7) applies.
• The fact-based approach inevitably increases the likelihood of disputes over who is liable for the transferor’s obligations, resulting in costs, delay and uncertainty. The EAT concluded that a bright-line rule has clear advantages.
• The purpose of TUPE is to protect employees in the event of a transfer. The absolute approach safeguards this objective whereas a fact-based approach means that in many cases employees will be left without the protection afforded by TUPE.

Two conflicting EAT decisions

There are now two conflicting decisions of the EAT. Without a clarifying appeal, the existence of two conflicting EAT decisions on the same point has potential to cause uncertainty. However, the EAT panel in OTG included Underhill J, the EAT president, and so it would seem likely that it is this decision that future employment tribunals will follow.

Bright-line rule

The decision itself has the merit of providing a bright-line rule – TUPE’s automatic employee transfer provisions will apply to all cases of administration. This at least gives certainty to administrators, employees and potential buyers of businesses from a company in administration.

Protection of employees

There will certainly be some circumstances in which employees will be better off as a result of the OTG decision, because TUPE will apply and if employees are made redundant they will be able to bring a claim for unfair dismissal against the new employer. However, this is to be balanced by the possibility of fewer businesses being bought from a company in administration due to the TUPE costs – thus leaving those employees without a job where on the fact-based approach employment may have continued.

Impact for administrators

The bright-line rule means that the cards of the seller in administration and the buyer are on the table at the outset, which is likely to prevent some dispute over whether TUPE applies after a sale. It may be harder for administrators to sell the business given that any potential buyer will reflect the TUPE cost in the offer price.

Impact for creditors

Creditors (apart from employees) are likely to feel the biggest impact from this decision, because any buyer of the business will reflect any redundancy-related TUPE costs in the offer price. Depending on the size of the business these costs may stifle any sale.

The Government has at last confirmed that the Bribery Act 2010 will commence on 1st July 2011.

The start date was delayed to await the publication of guidance by the Ministry of Justice. The guidance was published  and can be found on the MoJ website at www.justice.gov.uk/guidance/bribery.htm.

The Act is set to modernise old and outdated anti-corruption laws.

Of particular significance, is the new corporate offence of failing to prevent bribery by persons working on behalf of a business. As well as employees, this may extend to agents both here and overseas. This will cause some concern for those organisations seeking to develop their business in expanding economies, such as those in the Far East.

The corporate offence carries potential penalties of unlimited fines and possible permanent exclusion from public contract works for any convicted organisation. Companies will also be concerned at the damage to their reputations, if they do find themselves appearing in court.

However, companies will have a defence if they can prove they had in place ‘adequate procedures’ to prevent bribery taking place. This will include suitable policies and procedures to deter employees or agents from paying bribes to improperly influence others, such as customers or potential clients.

Companies are advised within the guidance to undertake due diligence when dealing with other businesses to ensure they are not exposed to the corporate offence by association. This will include requesting a copy of the anti-bribery policies of those organisations with which they have a business relationship or are looking to enter into such agreements. It is expected that a request for such policies will become the norm in tendering processes, particularly those in the public sector.

The Act also creates personal criminal liability for the senior officers of a company, such as the directors or senior management. They could face up to 10 years in prison if their business becomes involved in bribery with their consent or even if they have turned a blind eye to it.

Assess your risks in terms of corruption and put systems in place to ensure compliance. Any organisation that has not yet started this process should now be doing so.

It is inevitable that when an individual or a family has devoted a lot of time and effort in developing their business or enterprise, they will wish to pass on the fruits of what they have achieved to the next generation.  But any desire to benefit the next generation through a seamless succession is meaningless without careful planning, and without the flexibility to address unexpected events.

Two recent cases have served to illustrate some of the dangers that can be associated with succession planning for a family business that has been less than comprehensive.

The first case is Vinton v Fladgate Fielder [2010] EWHC 904 (Ch) which illustrates the extent to which it is important to keep estate planning constantly in mind, not only when preparing the Wills of the current owning generation, but also in making other commercial arrangements in relation to the business.

Wilton Antiques Limited (“Wilton”) was a company that belonged to the Dugan-Chapman family.  Matters began to unravel after the death of Mr Dugan-Chapman.  At that time his daughters Anna Vinton (Mrs Vinton) and Jennifer Green (Mrs Green) held 506,500 shares in the business. His widow, Mary Dugan-Chapman (“the Widow”) held 750,500 shares and Mrs Vinton personally held 1,244,000 shares. At that time the widow was the sole surviving director. She had an outstanding loan due from Wilton to her of £300,000.  Although the company did not have cash it did hold significant stock principally valuable paintings.

In the autumn of 2002 the private client department of the defendant solicitors were acting in relation to the estate of the late Mr Dugan-Chapman and were seeking to obtain a grant of representation for the executors, Mrs Vinton and Mrs Green. The corporate team from the same firm was acting for the business in relation to certain restructuring issues.

In late 2002 the executors met with the representatives of both departments and it was agreed that the loan to the Widow would be converted into equity (which would eliminate the risk that in the event of the Widow’s death her loan would be called in and Wilton would be obliged to sell stock at a low point in the market in order to effect repayment).  The conversion of the loan into equity would also have the advantage that, whereas the loan would be valued in her estate at £300,000, shares in Wilton would be subject to business property relief, so there would be an inheritance tax saving.

A rights issue of 999,733 shares at £1 each took place on 23 December 2002.  The Widow was allotted 300,000 shares and she took up her allotment accepting it in satisfaction of her loan account.  Mrs Vinton and Mrs Green as executors took up the allotment of 202,465 shares to which the estate of the late Mr Dugan-Chapman was entitled.

497,268 shares were allotted to Mrs Vinton personally under the rights issue, but it was never intended that she should take them up. Instead she signed a letter of renunciation in favour of the Widow, who took up this allotment using funds from her free estate.

At that point it was decided to raise a further £1 million for Wilton. Unfortunately, however, rather than utilising the mechanism of a rights issue the solicitors proceeded by way of an offer of shares for subscription. The Widow subscribed for all the shares on offer, paying for them using £1 million from her free estate.  She did so in the belief that they would attract business property relief (so that what would otherwise be £1 million in her free estate would be converted into shares attracting inheritance tax relief). This was on 27 December 2002.

Even more unfortunately, two days later on 29 December 2002 the Widow died.

The usual rule is that business property must be retained for two years before it attracts relief from inheritance tax. The only exception is if the shares owned can be identified with other shares previously owned by the same person, and those other shares had been held for at least two years prior to death. Consequently, the 300,000 originally allotted to the Widow, which were allotted to her by virtue of her existing share-holding, also attracted business property relief. But the shares that the Widow acquired on the renunciation by Mrs Vinton of her rights, together with the shares which the Widow acquired under the offer for subscription were not acquired by her in right of any existing holding of hers, they were simply acquired by her for reasons entirely unconnected with her existing holding.

The result of all of this that the estate was chargeable to an additional £359,344 chargeable as inheritance tax upon the 1,497,268 shares acquired by the widow in respect of which no business property relief was available.

The second case of relevance to family businesses is Mason v Mills & Reeve [2011] EWCA Civ 14. Mr Swain had built up a very successful business and was 72% share-holder in a group of companies in which each of his four daughters also held 5.3% of the shares. Two of his daughters were also employed by the business.

During 2006 Mr Swain had negotiated a management buy out of his business. He was at that stage sixty-one years old and had a history of heart problems. His shares and those of his daughters were to be bought out by the current management of the business. This transaction was due to complete in January 2007. Shortly after the due completion date, Mr Swain was scheduled to have a routine surgical procedure in relation to his heart condition. The completion went ahead and two weeks later Mr Swain unexpectedly died during his surgery.

The case came before the Court as a claim of negligence against Mr Swain’s solicitors, on the basis of an allegation that they ought to have taken into account his impending surgery in advising on the timing of completion of the MBO. In the circumstances of the case as it developed that point has yet to be determined, but the reasons for seeking to bring the claim are a good illustration of the points that family businesses need to keep in mind.

If, contrary to what actually happened, Mr Swain had died prior to completion, he would still have held the shares in the business at the time of his death and this share-holding would have attracted business property relief. Furthermore, there would have been a deemed disposal of the shares for capital gains tax purposes as at the date of death, with the result that if his executors had then completed the transaction shortly after his death, CGT would only have accrued on the increase in value of the shares between the date of death to the date of disposal.

According to the case report, the total value of these adverse tax consequences was said to be in the region of £1.3 million.

No-one likes to think about their own mortality, and business people are just as susceptible to this as anyone else. Nevertheless, for those businesses wanting to “keep it in the family” these cases demonstrate the vital importance of always anticipating the worst, if the business’s best interests are to be protected.

In the current economic climate most businesses will experience temporary or longer term cash flow pressure resulting in stressful trading and creditor pressure.

Managing creditors within reasonable cash flow parameters is not only an essential part of business operations but also an integral part of effecting a successful turnaround. A business can initially approach its creditors with a view to trying to implement informal revised repayment terms or a “standstill” agreement.  Such agreements are achievable in the short term but, one of the issues with informal agreements is that they may not bind all of the creditors and may be neither realistic nor certain depending on the circumstances. It only takes one creditor unilaterally to break ranks for such an arrangement to fail.

Alternatively, a company may use a Company Voluntary Arrangement (“CVA”) to come to a legally binding agreement with all of its unsecured creditors to pay off historic debt over a period of time thereby ring fencing liabilities to allow the company breathing space to trade on. A CVA is a useful restructuring tool where the underlying business is sound, the management are committed to a return to profitability and the continued trading of the business of the company will produce funds sufficient to service the CVA obligations as well as ongoing trading commitments.

To effect a CVA, the directors will propose terms to creditors aided by a licensed insolvency practitioner acting as nominee. The nominee will need to provide positive feedback on the efficacy of the proposal before it is presented to creditors and members. If the proposals are not realistic and place the company under too much financial pressure too quickly, at a time when it is already struggling financially, the CVA is unlikely to succeed.

A CVA must demonstrate that it satisfies a number of criteria, particularly the ability of the company to continue with profitable trading activity throughout the term of the CVA based on realistic forecasts and cash flows.

From the company’s perspective the CVA proposal will permit lower contributions at the start of the CVA increasing towards the end as the company recovers and becomes profitable. The CVA should be structured so that, as the company’s finances improve, then so do its contributions to creditors through the CVA.

The CVA must offer a greater potential dividend return to creditors than would be achieved if the company were to enter into insolvent liquidation. The creditors must approve the proposal by an excess of 75% in value. Some creditors will require standard or other terms to be included within a CVA before it will be approved particularly those creditors with whom there will be an ongoing relationship post CVA.

The term of the average CVA used to be 3 to 5 years. More recently the term has been shortened to, in some cases, a period of no longer than 12 months (with any time period over 12 months only being accepted in exceptional circumstances), on the basis that payment to creditors is to be made as quickly as possible. If creditors will only accept a 12 month CVA then consideration should be given as to whether the company will obtain any benefit at all from entering the CVA.

The nominee will usually become the Supervisor (of the arrangement but not the business) upon approval. Once approved the CVA becomes a contract between the company and its creditors. However, the rights of secured or preferential creditors cannot be adversely affected by the proposals for a CVA without their express consent.

CVA’s are an effective tool to ring fence all or just certain liabilities. An example would be those owed to landlords (where the survival of the company depends on mid to large property portfolio liabilities being dealt with). However, care needs to be exercised in any CVA involving the composition of liabilities to landlords who have the benefit of parent or group company guarantees, where it is proposed to remove or strip out the guarantee.

CVA’s are frequently considered as part of a toolkit to assist in the restructure of corporate groups where they may be proposed for the group as a whole or for just a small number of (or one) under performing subsidiary/ies within the group. In such cases, the subsidiary benefits from the CVA, allowing it time to get back on its feet, which in turn benefits the group as a whole. Such CVA’s may need continued support from the parent or removal from the group structure in any event and will always depend on any cross guarantee group liability.

One of the perceived weaknesses of a CVA for the majority of companies is the absence of any moratorium on creditor action whilst the CVA is being approved.  As such, it has become necessary in some cases for a company to enter into administration to achieve the purpose of “survival of the company” through a planned CVA exit from administration.  For the directors of “small companies” there is a statutory moratorium available designed to protect the company from creditor actions whilst the CVA proposal is put to the creditors. A “small company” is defined as one whose turnover does not exceed £5.6 million; its balance sheet total does not exceed £2.8 million and has no more than 50 employees.

It appears that the popularity of the CVA is on the increase as a useful process in the right circumstances. The key to successful approval and implementation is to act proactively in relation to predicted cash flow difficulties based on up to date accounts and forecasts.

It is a sign of the times that lenders and other businesses extending credit are taking security wherever possible, and frequently that security is in the form of personal guarantees.

It is equally a sign of the times that more and more guarantors are being called on to honour their guarantees.  It comes as no surprise then that lawyers are looking at ways in which guarantors can try to escape liability when faced with a demand under their guarantee. The law relating to domestic arrangements and guarantees given by wives for their husbands’ businesses was hammered out in the downturns of the 1980s and 1990s in Barclays Bank –v- O’Brien and definitively resolved in the House of Lords in 2002 in RBS –v- Etridge.

Commercial sureties – directors giving personal guarantees for their own companies – are in a different position.  The general rule is that (as with any other contract) they are bound by the documents that they sign.  In general the creditor, usually a bank, does not owe a duty to explain the guarantees or to advise the commercial surety to seek independent legal advice.

Necessity being the mother of invention, are we now to see a wave of new and ingenious ways for guarantors to try to escape liability?  Maybe, maybe not.  In NorthShore Ventures –v- Anstead Holdings Inc. and Others (2010) the High Court has considered on one such possible escape route: non-disclosure of risks to the guarantor.  The guarantors were unsuccessful but perhaps the door has been left ajar for future attempts.

In North Shore the lender was a company associated with the Russian oligarch Boris Berezovsky.  Anstead drew down funds under a loan agreement with North Shore and paid them into Swiss bank accounts whereupon they were frozen by the Swiss authorities because of North Shore’s association with Berezovsky, who was under investigation.

Anstead was able to use some of the funds, and made repayments to North Shore, but in 2008 North Shore brought proceedings against two guarantors based on a demand for some $35million.

The guarantors argued that the guarantee was void because North Shore had failed to disclose that Berezovsky was under investigation and that, therefore, there was a risk of the monies being frozen.  Of course, if asked, a creditor must not give a misleading answer to a question.  Other than that, however, the House of Lords had stated in Etridge that the only duty on a creditor was to disclose any unusual feature of the contract between the debtor and creditor (or between the creditor and other creditors) that might affect the rights of the guarantor.  The precise ambit of the disclosure obligation, however, was unclear.

In North Shore the High Court ruled that the guarantee was valid and would not be set aside on grounds of non-disclosure.  The Judge came to the following conclusions as to the law:

• The obligation of a creditor to make disclosure to a prospective guarantor need not, even in the case of a guarantee for a loan, be limited to features of the contract between the creditor and the principal debtor.  Where such an obligation arises, therefore, it can go beyond the features of the relevant contracts.
• A creditor need not, on the other hand, disclose anything which the prospective guarantor could reasonably be expected to know.  The creditor is not to be taken to have made a representation in respect of a matter unless he could expect the guarantor not to know it.  Hence, for example, a loan creditor is not normally under an obligation to disclose matters bearing on the principal debtor’s credit-worthiness.
• It is immaterial that a prospective surety could be expected to be ignorant of a particular matter if he could be expected to know of the risk in general terms.
• While a creditor does not have to disclose every material risk, a risk must be material to be disclosable.  A creditor need not, therefore, disclose a matter unless it is capable of rendering the risk the guarantor is undertaking more onerous than the guarantor would otherwise expect.
• This leads to a final point which is that a guarantee can be avoided only if the non-disclosure was in fact significant to the guarantor.  A surety cannot therefore seek to avoid a guarantee for non-disclosure by the creditor unless disclosure of the relevant information would have made a difference to him.

The Swiss investigations into Berezovsky could therefore in principle have been disclosable.  However, no duty to disclose arises if the guarantors could reasonably have been expected to know of the risks in general terms, and the Judge concluded that the guarantors knew, and could reasonably have been expected to know, about the investigations into Berezovsky.  They could not therefore avoid the guarantee on grounds of non-disclosure.

The Court also ruled that certain “protective clauses” in the guarantee would have been effective to protect the bank against non-disclosures before the guarantee was entered.

Comment

Another attempt to circumvent a well-drafted guarantee thus ends in failure. The door remains open, however.  There is still scope to argue that a failure on the part of a lender to disclose a material risk could cause the guarantee to be set aside but plainly this is only going to arise if there are very unusual circumstances.  Commercial lenders will also take heart that they can avoid that consequence with well-drafted protective clauses.