The impact of draft anti-phoenix measures on restructuring and corporate turnaround

‘Phoenixing’ – the process by which the assets of an insolvent company are transferred to another company so that creditors miss out – is a significant problem in Australia. On budget night the government announced several headline anti-phoenix measures, with greater detail provided last week through the release of draft legislation for consultation. Although the measures are aimed at those who act unscrupulously, they have a wider ambit, and there is the potential for them to have a broader impact if they do become law.

Overview of the measures

There is more detail here but in summary, the key concept is a ‘Creditor Defeating Disposition’ (‘CDD’). A CDD is a transaction entered into either:

when the company was insolvent; or
in the twelve months prior to the company entering formal insolvency administration;

which prevents, hinders or significantly delays the property of a company from becoming available for the benefit of creditors.

If there is a CDD:

Officers whose conduct resulted in a CDD will commit an offence.
Those involved in ‘procuring, inciting, inducing or encouraging’ a company to engage in a CDD will commit an offence
Both ASIC and the Courts will have power to make orders to reverse the transaction to recover the property.

A CDD will not be voidable if the sale was for market value consideration, or was entered into by a liquidator, under a deed of company arrangement or scheme of arrangement, or as part of a Safe Harbour restructuring plan.

Market value

‘Market value’ sounds like an objective measure but in the absence of a public sale process it will be assessed retrospectively. By comparison, the duty of care imposed upon receivers requires them to conduct an effective sale process but it does not mandate an outcome.

Safe Harbour is a defence

Specific protection for transactions entered into by liquidators and deed administrators is obvious and as expected. A similar exemption for companies in Safe Harbour (more detail here) is a sensible and consistent policy alignment.

Application to transactions with third parties

Many would think of a phoenix transaction as a sale to a related party, but significantly it seems that the draft legislation has the potential to apply to sales to third parties, if the proceeds of sale are ‘diverted.’

The type of transaction described in an extract from hypothetical email from a CFO to a CEO highlights some of the real world issues:

We have a received an unsolicited offer for our New Zealand operations. The offer is less than I think we would get if we took the business to market but that would take another six months, and a sale now would leave us one less headache to manage, so I recommend that we accept….

If those sales proceeds are used to pay the trade creditors of the New Zealand business, and the Australian business collapses a month later with employees unpaid, should that transaction amount to a CDD which can be reversed? Is that email the ‘smoking gun’ which might expose directors and advisers to the transaction to the risk of prosecution?

Potential purchasers who believe a vendor to be under financial pressure may be concerned about whether they can take clear and irreversible title to business assets, or whether there may be a risk of later claw back. Such a purchaser has a theoretical access to the general good faith defence that is available to purchasers without ‘knowledge of insolvency’, but they may need to think carefully about when exactly a suspicion about financial stress might amount to ‘knowledge of insolvency.’ Some potential acquirers may decide they need more information, or details of how the funds will be dispersed, and some may decide that it is safer to walk away and wait for a formal insolvency to deliver clear title.

Conclusion

Measures to address the serious problem of phoenixing are appropriate, and alignment with Safe Harbour measures is commendable. However, phoenixing by its very definition involves transaction with related parties. Extending the ambit of anti-phoenix measures so that they also apply to transactions with third parties risks the ability of stressed companies to promptly execute genuine sales, and should be implemented with great care. If anti-phoenix measures need to be applied beyond those currently defined as ‘related parties,’ perhaps a better approach might be to broaden that definition.

UK Pre-Packs: where to next?

A “pre-pack” insolvency is one that involves a business sale negotiated in advance of a formal insolvency, implemented by the liquidator or administrator shortly after his or her formal appointment.

Pre-packs will achieve a quicker and cheaper sale than a full blown process by an insolvency practitioner – however if a related party ends up as the purchaser, questions are often asked about how the sale price was set. A report issued this week in the UK raises doubts as to the effectiveness of a voluntary regime intended to mitigate those problems, and further change now seems likely.

Pre-packs in different jurisdictions

In the US, pre-packs are used for the very largest insolvencies – such as Chrysler in 2009 – to try to avoid the worst of the time delays and runaway legal costs of their cumbersome Chapter 11 process (a recent example reported here).

In the UK, pre-packs are typically used to deal with the very smallest businesses, where the costs of a normal sale process and settlement would swallow most of the sale proceeds. Whilst they are an established part of the UK restructuring scene, pre-packs involving a sale to a related party – which most Australians would describe as a ‘phoenix’ transaction – have been controversial in the UK for precisely the same reasons that phoenix transactions are controversial here.

In Australia, pre-packs are seen by many restructuring and turnaround professionals as problematic, because a practitioner who is involved in pre-appointment negotiations probably falls foul of the ARITA requirements for professional independence.

The Graham Review and its recommendations

In 2013 the UK government asked prominent Chartered Accountant Teresa Graham to review the use of pre-packs, and make recommendations to improve their outcomes. The recommendations in her 2014 Report (discussed here) included a process by which related-party transactions could be referred to a ‘Pre-Pack Pool’ – a panel of experienced business people – for review. Notably, this is a voluntary process, and those involved must choose to refer the transaction to the PPP.

As explained on the PPP website, a randomly selected panel member will provide an independent opinion to be shared with creditors. That opinion, provided within two business days and at a cost of £800, will not include any reason or explanation, but will simply set out one of the following three conclusions:

“Nothing found to suggest that the grounds for the proposed pre-packaged sale are unreasonable”
“Evidence provided has been limited in some areas, but otherwise nothing has been found to suggest that the grounds for the proposed pre-packaged sale are unreasonable”
“There is a lack of evidence to support a statement that the grounds for the proposed pre-packaged sale are reasonable.”

The 2017 Annual Report

This week the PPP issued its report for the 2017 calendar year (available on their website). Key statistics include:

28% of the 1,289 administrations in the UK were pre-packs (2016: 22%).
57% of those pre-packs involved sales to related parties (2016: 51%).
Only 11% of the related party pre-packs (28%) were referred to the PPP (2016: 28%).

Of those referrals:

49% received a ‘not unreasonable’ opinion (2016: 64%).
34% received a ‘not unreasonable but with limitations as to evidence’ opinion (2016: 25%).
17% received a ‘case not made’ opinion (2016: 11%).

What next for UK pre-packs?

The UK passed legislation in 2015 which created a framework to allow for later regulation if the process proposed by Teresa Graham did not deliver the hoped-for outcome.

The PPP’s 2016 Annual Report noted a slow take up rate in the first year of operation – but recognised that the program was still new. However, the 2017 report shows that against the hopes of the PPP, the referral rate has fallen, and fallen significantly.

It seems likely that a review announced by the UK Insolvency Service in December 2017 will conclude that the voluntary regime has not worked. The next step is less clear: will the UK endorse the referral regime but make it compulsory, restrict or ban related-party sales altogether, or find another option?

For further reading, Michael Murray has written an excellent article recently on pre-packs: here

Pre-pack Administrations – would they work in Australia?

[Originally published in the September 2014 issue of the Australian Insolvency Journal, and reproduced here with permission]

One of the regular discussions among insolvency and workout professionals is whether we need the capacity to undertake pre-packs in Australia, with the UK experience often used as a reference point. Unavoidably but unfortunately, most of that debate has been undertaken in the absence of meaningful data.

Now, following the June 16 release of the Graham Review Report[i] which is supported by a large scale study undertaken by the University of Wolverhampton, we have hard data. As a consequence we now have far greater insight into the background and outcomes of the pre-pack process.

The Graham Review

In mid-2013 the UK government commissioned a review of pre-packs by Teresa Graham CBE to assess the usefulness and impact of pre-packs and consider any aspects or practices which cause harm, with special attention to the position of unsecured creditors. A prominent accountant, Graham was the former head of the Business Advisory practice for accounting firm Baker Tilly and has been appointed to a number of advisory and statutory boards.

Critics of pre-packs in the UK point to a lack of transparency, with limited details provided to creditors only after a sale has been concluded. Pre-packs involving sales to connected parties come in for particular criticism as at best they allow ‘bad businesses’ with poor business models to continue to operate and that at worst they are a sham to avoid debt i.e. a phoenix.

What is a Pre-Pack?

Although UK legislation does not make any reference to pre-packing it is universally accepted that pre-packing is permitted by the law, and since 2009 it has been the subject of a guidance note issued by the insolvency regulatory authorities: Statement of Insolvency Practice (SIP) 16.

SIP 16 defines a pre-pack as ‘an arrangement under which the sale of all or part of a company’s business or assets is negotiated with a purchaser prior to the appointment of an administrator, and the administrator effects the sale immediately on, or shortly after, his appointment.’[ii] The practitioner has a level of involvement with the company prior to his or her appointment which in Australia would probably amount to ‘a professional relationship’ in the two years prior to appointment, sufficient to prevent the practitioner from accepting the appointment under the ARITA Code of Conduct – but which is acceptable in the UK.

According to Graham, around 3.5 percent of the around 20,000 insolvency procedures each year in the UK are pre – packs.

Since 1 January 2009, SIP 16 has required the administrator to provide creditors with specific information including the price obtained, details of valuation of the assets, and whether the purchaser was connected. These SIP 16 statements are sent to creditors after the sale and provided to the UK Insolvency Service. It is this disclosure which provided the base data for the quantitative analysis by the University of Wolverhampton.

The University of Wolverhampton research

The Graham Review commissioned this research into data extracted from SIP 16 statements for a sample of 499 pre-packs implemented in 2010.

That research found that the typical pre-pack:

Was a small business (81 percent having turnover below £6.5m), at least five years old (a median age of 8.6 years), with median debt of £565,000 (about $1.02m at the time of writing).
Was not marketed by the Insolvency Practitioner – with either no marketing at all (39 percent) or marketing conducted prior to the IP’s involvement (21 percent).
Was sold to a connected party (in 63.3 percent of cases), [iii] probably for less than £100,000 (60 percent of cases) which was often part- deferred (more than 50 percent of cases).
Was almost always tested against an independent valuation (91 percent of cases) however those valuations were often desk-top valuations, and limited to tangible assets only.
Provided unsecured creditors with a ‘paltry benefit’ – no distribution in 60 percent of cases and a median return of 4.3 percent for those where a distribution was made.
Survived for longer than three years (76 percent of cases). Notably, connected party purchasers had a failure rate almost twice the rate of that with an unconnected purchaser.

The Wolverhampton University research team expressed concerns about the quality of information about marketing, describing the standard of reporting as ‘very variable,’ with practitioners sometimes doing nothing more than accepting the view of directors that there was no ready market for the business without testing that assumption.’

Report Conclusions and Recommendations

Graham made a number of recommendations to improve the pre-pack process, most noteworthy:

A voluntary process by which connected parties would be required to provide details of their offer to a member of a panel of experienced business people. After a review that would not exceed half a day, the panel member would provide an opinion that would be included in the SIP 16 statement. Critically, a negative opinion would not block a deal.
Marketing should comply with six principles identified by Graham, with any divergence to be detailed in the SIP 16 statement.
Greater detail about the valuation process should be disclosed in the SIP 16 statement, with a firm requirement that valuers hold professional indemnity insurance.

Graham did not recommend any regulatory change – but this was only because there is already a separate review into the regulation of insolvency practitioners and their remuneration underway[iv] and she noted that absent that review she would have made further recommendations.

Overall Graham was reasonably positive about pre-packs: she found that there were ‘significant’ cost advantages of a pre-pack over formal procedures, and said that although the SIP 16 information regarding employment preservation was ‘often poor’ she was able to conclude that they helped to preserve employment.

Pre-packs Down Under?

The picture presented by the University of Wolverhampton research is that of a process which provides a moderate enhancement to the recoveries of secured small business lenders in the 3 percent to 4 percent of formal insolvency procedures where they are deployed.

Tangible assets are sold for a price close to their standalone value without any deduction for auctioneers costs and commission, and the insolvency practitioner’s fees are minimised. Unsecured creditors typically won’t see a return – but they would not have received a dividend anyway.

UK practitioners have raised queries about the practical working of the panel referral process, but have welcomed Graham’s views that a pre-pack option should continue to be available.

Using the UK experience as a template, pre-packs are certainly one option to facilitate the relatively quick and inexpensive sale of a small business. A key point however is that almost two-thirds of sales are made to connected parties. Given the widespread concern and black and white views around phoenix transactions in Australia, a change to a process that accommodates sales to connected parties may meet stiff resistance, and require careful justification and management.

Postscript – 16 August 2017: SiN reports Moves afoot to propel pre-packs onto political agenda

[i] Both the report and the statistical analysis are available at (see: Graham Review into Pre-pack Administration).

[ii] Available at http://www.gov.uk (see SIP 16) updated in November 2013 to expand the requirements for disclosure around valuations and marketing of the business.

[iii] The connected party sale rate is remarkably consistent with a the 62 percent rate reported in a 2007 study ‘A preliminary analysis of pre-packaged administrations’ by Dr Sandra Frisby (available at http://www.r3.org.uk/publications) and 65 percent reported in a 2010 survey conducted by the Association of Business Recovery Professionals (65 percent) available at http://www.r3.org.uk

[iv] Details at http://www.gov.uk (search for ‘Insolvency Practitioner regulation and fee structure’).