[First published on Linkedin.com on 14 June 2016]
The measures include a proposal for a three month moratorium against recovery actions by creditors. The moratorium is intended as a step prior to a formal insolvency appointment, but nonetheless it will be initiated by a Court filing and overseen by a “Supervisor.”It appears that the fact of a company entering a moratorium will be disclosed publicly, which will certainly present challenges for the business. A visible signpost to financial difficulties will surely lead to suppliers tightening credit terms, perhaps requiring cash on delivery, and some customers of the business may turn to competitors seen as more financially stable.
Eligibility to enter and remain in the moratorium
To enter a moratorium a company must be in “financial difficulty,” or insolvent, with a “reasonable prospect” that a restructuring can be agreed with its creditors. At the same time however, it must “be likely” to have sufficient funds to carry on its business during the moratorium, and be able to meet any new obligations that are incurred.
An independent supervisor must be appointed, who will be responsible for ensuring that the company meets the eligibility criteria, and continues to meet the eligibility criteria.
It is clear that there will be a need for some concentrated and urgent due diligence prior to entering the moratorium, perhaps also requiring disclosure of the possible moratorium to key creditors. The company and the supervisor will need to urgently determine how bad things are, whether there is in fact a reasonable prospect of restructuring, and precisely what resources will be required to allow a conclusion that it is “likely” that moratorium creditors will be paid.
Presumably the company will then work to create a fund for the expected moratorium creditors, quite possibly by short-paying current creditors – where would funds come from otherwise?
The role of the moratorium supervisor
It is proposed that the supervisor will be a solicitor, accountant, or insolvency practitioner meeting minimum standards including expertise in restructuring. The proposed supervisor will be nominated by the company, but presumably there might be circumstances when the Court will overrule that nomination.
It appears that the supervisor is not intended to take over the management of the company – the directors’ powers remain undisturbed. The supervisor’s role is specifically to monitor the company’s ongoing compliance with the eligibility criteria, and report to Court if a restructuring no longer seems a reasonable prospect or if the company no longer appears likely to be able to pay moratorium creditors. The supervisor will also act as a contact point for creditors, providing information that is reasonably requested and not commercially confidential.
The ipso facto problem
The UK paper refers to “termination clauses,” in Australia we describe them as “Ipso facto” clauses – contractual provisions which allow contracts to be terminated if there is an insolvency appointment, even if there is no other breach of the contract.
In Australia the proposed response is a blanket restriction against such ipso facto clauses. The UK proposal is that businesses entering into a moratorium, formal insolvency, or a restructuring plan will be able to make an application to Court to have specific contracts designated as “essential,” and thereby protected from termination for insolvency for a period not exceeding twelve months.
The applicant will need to show that the continued provision of the essential supply would contribute to the success of the rescue plan, and that it is not possible to make alternative arrangements at a reasonable cost within a reasonable time. The supplier will be able to challenge that application, but would need to provide objective evidence that the criteria was not met.
The UK model would therefore only disturb specific contracts, and is therefore lower impact for that reason. However it will require an application to Court and therefore impose legal costs on a company which by definition has limited financial resources, as well as on the supplier.
Notably, it is proposed that the moratorium will have a limited life, as is likewise proposed in the Australian version. Unless the prohibition is permanent, it means that those suppliers will be able to wait out the moratorium, and terminate later – not at all a foundation for a stable business.
A flexible restructuring plan
Like its Australian counterpart (a Deed of Company Arrangement) the UK Company Voluntary Arrangement currently does not bind secured creditors without their consent. The Government proposes a statutory multi-class restructuring procedure that will bind a 75% by value majority of class creditors, and cram down of out-of-the-money classes – provided that those creditors will not receive less in a restructuring than they would in liquidation.
The UK proposes to allow flexibility to determine voting classes by either by “rights” or “treatment,” on a case by case basis, rather than specify a mechanism in the legislation. For mine, this is a very significant missed opportunity. In Australia, classes for schemes of arrangement are, bizarrely, constituted by treatment rather than rights, allowing promoters to bundle together creditors with different rights to ensure a majority. It is hard to understand why legislators would want to replicate such an inequitable mechanism.
The restructuring plan must be approved by the Court, which must be satisfied that:
- The restructuring plan is fair and equitable, and will last no more than twelve months
- There was proper notice and each class was fairly represented by those voting
- Voting requirements have been met
- Junior creditors have not received a treatment worse than liquidation.
Valuations are key
The proposals recognise that the test of whether junior creditors are worse off requires a careful assessment of value. The proposal is that valuations be conducted on the basis of the current value of a company’s assets without adjustment for the value of any potential future earnings they may provide. The proposal notes that there are a number of valuation methodologies, and suggests but does not conclude that the Government should legislate the use of a minimum liquidation valuation, with flexibility for the use of other methods of valuation where appropriate.
Although CVA administrators already have statutory powers to borrow funds and grant security, the UK Government has formed the view that they are rarely used because existing secured lenders will not agree to any subordination of their security.
Under the regime in the proposals paper, if a secured creditor declines to give consent, the borrower can advise the secured lender that at they intend to proceed without consent, which gives the secured creditor a 14 day window to apply to Court to challenge the financing proposal. If challenged the burden of proof would fall upon the borrower to satisfy the Court that:
- Obtaining the rescue finance is in the best interests of creditors as a whole
- The new security was necessary to obtain the rescue finance
- The interests of existing secured creditors will be “adequately protected”
The paper seeks any alternative options to enhance the take up of rescue finance.
Although we deal with a different regulatory and legislative framework, the Australian and UK proposal papers have the same objective – to improve the prospects for business turnaround and rescue – and it is interesting and useful to see how another jurisdiction is attempting to solve the same problem.
A far-distant observer should be cautious in criticising, but I do think that the proposals are flawed in making the moratorium public, and by specifying entry requirements which may deny protection to companies unless they demonstrably have a level of funding. The limited term of the ipso facto restriction is likewise problematic, but other parts of the proposals are well thought out such as the capacity to bind classes of creditors, which could also be considered in the Australian context.
Of course this is a proposals paper, with an extensive consultation process intended to allow market participants to identify and address any shortcomings, and it will be interesting to see how the proposals continue to evolve.