Missing Pieces

[First published on Linkedin on 2 October 2016]

The Australian Government’s Improving bankruptcy and insolvency laws Proposals Paper has a much narrower focus than the comparable UK proposals A Review of the Corporate Insolvency Framework. The Australian proposals are quite tightly focused on three aspects: one-year bankruptcy, ipso facto, and safe harbour; but there are other aspects of restructuring that would benefit from reform. This below is a personal wishlist of further reforms in the restructuring and insolvency space.

Voting rights where debt is sold

Under current law, corporate debt is voted at face value in all types of formal corporate insolvency appointments. One of the most striking examples of the current position was in the Walton Constructions administration – discussed in the Senate Economics References Committee Report into Insolvency in the Australian Construction Industry (available here).

In Walton an associated party purchased a debt for $30,000, which it then voted for the full $18.5m face value, arguably resulting in a different outcome for a key resolution. Some might argue that voting rights are a just another form of asset, and that parties should be free to buy and sell at any value, however there are other considerations at play. In my view decisions about restructuring a company should be made by the most significantly affected creditors, not arbitragers who chose to enter an impaired capital structure, or parties associated with former owners or management who may have access to inside information. For that reason I strongly support recommendation 42 of the Senate Committee Report – that the law should be changed to align with the position in personal insolvency so that the voting value is the price paid, not the face value of the debt.

Where do employees stand?

Whilst liquidation and restructuring are clearly two very different processes, the position in liquidation is important in restructuring. Not only does the legislation mandate the liquidation position as a formal reference point for Deeds of Company Arrangement, creditors themselves use it as a reference point in assessing whether or not to accept a compromise or support a restructure.

The New South Wales Supreme Court recently held that the priorities set out in section 556 of the Corporations Act ‘do not apply in respect of trust assets’ if the employer is a trust (see in the matter of Independent Contractor Services (Aust.) Pty Limited), and that determination has since been followed by the Federal Court (re Woodgate, in the matter of Bell Hire Services Pty Ltd). Without intending to make any comment on the correctness of that decision; its consequences – that statutory priorities will apply to some employers, but not all, in such a way that it may be quite difficult for employees to understand where they stand – is quite problematic in a practical sense. It makes sense to change the law so that position is consistent and predictable for all employers and employees.

Multi-class restructuring

Voluntary Administration has several advantages as a restructuring tool. It has an administrative rather than a courtroom focus, so it avoids the delays and costs of legal proceedings unless there is a specific reason to invoke them. It offers creditors a very wide flexibility to negotiate whatever arrangement suits all parties. And, with a twenty three year “life” the procedure is well understood, with precedents that mean most interpretative issues have already been resolved. However, there is a significant gap – the absence of a capacity to bind secured creditors or owners of property (such as intellectual property licensors, or landlords) unless they themselves agree to be bound.

The requirement for unanimous agreement means that any single lender or property owner has leverage conferred by the ability to veto a restructure. The only current statutory restructuring option to address this is a scheme of arrangement, which have proven to be extraordinarily expensive, and quite slow. It would be relatively simple to create a low cost statutory multi-class restructuring option by applying the UK proposals that so that creditors in a class statutory are bound by a 75% by value majority of class creditors, with a cram down of out-of-the-money classes – provided that those creditors will not receive less in a restructuring than they would in liquidation.

Fix scheme classes

As discussed above, Schemes of Arrangement are currently the only option to deal with multi-class restructuring – but the composition of those classes is problematic. In Australia, classes are constituted by grouping together those creditors treated in the same way by the Scheme rather than by grouping together based on common rights. In practice this allows scheme promoters the scope to manufacture a majority by bundling together creditors with different rights. In my view we need reform to ensure that voting classes are determined by rights, not treatment, to avoid such contrived outcomes.

Debt for Equity

Debt for equity can be a very effective restructuring tool. Permanent balance sheet repair addresses any going concern and solvency issues, making it easier secure trade credit and win tenders, and long term contracts. However there are constraints which make it difficult for banks to enter into such arrangements. The restrictions that quite properly limit the ability of Authorised Deposit-taking Institutions to invest in non-banking ventures apply equally to debt for equity restructures. This means that ADIs must consult with APRA before committing to any proposal to hold more than 20 per cent of equity interest in an entity.

If ADIs had the capacity to more easily take equity stakes below a minimum value, and hold them off balance sheet, then a rarely used restructuring tool might be more widely deployed.

Rescue Finance

In Australia rescue finance is typically provided by existing lenders either through informal workouts, or by providing finance to the receivers they appoint. Administrators are free to incur credit but they cannot grant a priority security over circulating assets (such as book debts and inventory) without the consent of existing security holders. If there is a change to allow multi-class restructuring on a majority, then there should be a similar change to the rules allowing an administrator to pledge security to secure rescue finance with the consent of a majority of existing security holders.

The Bluenergy decision

A charge over a future asset is a very clever, and very useful idea. It means that a security arrangement will automatically adjust when assets change form – from raw materials into finished goods when manufacturing is complete, from finished goods into a receivable when the goods are sold, from a receivable into cash on collection, and back into raw materials when the cash is reinvested into the working capital cycle. Without such a flexible device lenders would need to either scale back their lending, or impose restrictive conditions and require additional paperwork to track assets through the cycle.

In July 2015 the Bluenergy decision (in the matter of Bluenergy Group Limited here) imposed a significant rider to the well-understood rule that a Deed of Company Arrangement did not bind a secured creditor – unless they agree, or vote in favour of the deed. In Bluenergy the Court held that whilst a Deed will not bind the secured creditor, it limits their security to precisely those assets that it captured at the time that the deed released creditor claims: in other words the security will no longer be a charge over future assets, which means that the assets captured by the security will steadily diminish through the normal operation of the working capital cycle.

In practice, the consequence of the Bluenergy decision has been a universally acknowledged change in position for secured lenders: rather than give an administrator the opportunity to negotiate a deed of company arrangement, there will now be times when they should appoint ‘over the top’ to preserve their security. That is the antithesis of encouraging restructuring, and in my view we should be looking for legislative change to reverse the practical consequences of the Bluenergy decision.

Conclusion

The changes to Australia’s restructuring laws under the National Innovation Agenda proposals are significant. The safe harbour reforms will symbolise a new restructuring mindset, and the ipso facto changes have the potential to impact every formal insolvency and restructuring. However, there is significantly more that could be done, and it would be a crying shame if those were the only reforms for a further twenty-three years!

UK Restructuring Reforms: A Review of the Corporate Insolvency Framework

[First published on Linkedin.com on 14 June 2016]

Within a month of the Australian Government’s Improving bankruptcy and insolvency laws Proposals Paper, the UK government has released a comparable document – A Review of the Corporate Insolvency Framework – available here:

A quite formal, and public, moratorium

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.

Rescue finance

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.

Conclusion

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.

The National Innovation Agenda – improving Australia’s bankruptcy and insolvency laws

[First published on Linkedin.com on May 24, 2016]

On 29 April 2016 the Federal Government released a Proposals Paper which follows up on the National Innovation Agenda commitment to improve Australia’s bankruptcy and insolvency laws.

There are three areas of focus:

Reducing the default bankruptcy period from three years to one year

The proposal is more nuanced than a simple reduction in the bankruptcy period. Critically, the Income Contribution regime will continue to apply for three years i.e. potentially for two years after the bankruptcy itself has ended. However, there would be no restrictions on overseas travel or incurring credit after the initial twelve month period had expired.

The trustee will retain the ability to object to the bankrupt’s automatic discharge – thereby extending the period of bankruptcy to eight years – but it appears that it would be necessary to file that objection in the initial twelve month period. Such a change will mean that trustees need to accelerate their investigation to ensure that misconduct is identified before the initial period expires. It may also mean that in the last two years trustees must collect information and contributions without the benefit of what is currently an inexpensive and practical avenue to ensure compliance.

Safe Harbour

The current insolvent trading regime imposes personal liability on company directors if their company incurs credit whilst it is insolvent. The practical effect of the regime is that it provides a strong incentive for company directors to place an insolvent company (or a company that may become insolvent) into administration – even though a restructure might offer the prospect of a better return to creditors.

The proposal outlines two alternative methods of dealing with that statutory conflict of interest. The first approach – Model A – will create a “safe harbour” by establishing an additional defence to the current insolvent trading regime, whereas Model B will create a safe harbour by identifying circumstances in which the insolvent trading regime will not apply. Probably more significantly, Model A requires the directors to formally engage a “restructuring adviser,” whereas Model B does not.

My own experience with large corporate turnarounds is that the range of issues can be very broad – from balance sheet restructure to operational turnaround – and that in many cases there will be a team of advisers assisting the directors rather than a single person. I believe that the focus should be on what the directors do, rather than whom they appoint,

A process that requires the appointment of a restructuring adviser will almost certainly trigger the rigorous continuous disclosure requirements that apply to ASX listed companies. This will present additional challenges in a restructuring because publicity about possible financial difficulties can become self-fulfilling as suppliers rein in credit terms, and customers take their business elsewhere. For this reason it is important that any Model A approach also includes a prohibition on disclosure, otherwise there is the risk that directors of ASX listed companies will not take advantage of the safe harbour.

Ipso facto clauses

Ipso facto or insolvency event clauses allow contracts to be terminated if there is an insolvency appointment, even if there is no other breach of the contract.

In my view, restricting the operation of ipso facto clauses is the most significant of the proposed reforms because it will make it far easier for administrators and receivers to maintain a business as a going concern without losing the benefit of key contracts

It is essential that the restriction be permanent rather than a temporary stay (which in any event is the current position for voluntary administration), otherwise there is the risk that the clause can be invoked even after the insolvency has been ‘cured’ by a restructuring.

One of the key questions is whether the restriction on ipso facto clauses would operate to prevent a secured lender from appointing a receiver. Lenders will often waive defaults under loan agreements in the knowledge that the insolvency ground will provide a ‘reserve’ capacity to act. If the ipso facto restriction eliminates that reserve capacity, then secured creditors may be less willing to waive defaults – which would be problematic for both directors and auditors. Clearly I have an interest in this point, but it would be disappointing if a law reform intended to encourage restructuring instead had such an effect

The government is seeking feedback by Friday 27 May. I encourage everyone with an interest in the area to read the Proposals Paper and respond on points that concern them. For more information: see here.

Total Control? The Bell Group decision and its impact for lenders and their advisers

[I should highlight that this article was co-authored with Jason Harris, Senior Lecturer, UTS Faculty of Law (https://au.linkedin.com/pub/jason-harris/43/170/691) a leading academic specialising in Insolvency/Reconstruction and Corporate Governance. It first appeared in the September 2015 issue of the Australian Insolvency Journal, and is reproduced here with permission]

The issue of directors’ duties during times of financial distress and insolvency has been hotly debated for decades. It took centre stage in the long-running Bell Group litigation. Given the large sums involved and the importance of the issues, it was no surprise that the High Court granted special leave to appeal in 2013.

However, those who hoped for clarification of this difficult area of law by the High Court were disappointed when the matter settled prior to being determined by the Court. This leaves the controversial split decision of the Western Australia Court of Appeal (Westpac Banking Corp Bell Group Ltd (in liquidation)[i]) as the last word on duties to consider creditor interests.

With the case now settled, our purpose is to outline some of the practical impacts for lenders in a workout situation, and their advisers. However, before discussing the practical implications it is useful to outline in brief the facts involved in the Bell Group restructuring.

Background to Bell Group

There were two bank syndicates which provided finance to the Bond group: one to an Australian borrowing entity, one to a European based borrowing entity. Originally the two syndicates were wholly unsecured, with any comfort provided by a negative pledge – an undertaking not to grant security to other creditors.

Various companies in the Bell Group had also issued bonds to both domestic and foreign investors and there was uncertainty as to whether these were subordinated to the bank debt or not. Heading into 1989, the group had been involved in a lengthy asset sale program to pay down debt, which had left few substantial assets in the group, namely publishing and brewing assets. These were not sufficient to repay all of the debts, so a debt restructure in some form was necessary.

Bank negotiations

In July 1989, the Group advised the banks that it was unable to meet the debt pay-down obligation by the end of September, which prompted what the Court described as ‘a hostile reaction’ with two lenders serving formal notices of demand. The failure to meet debt reduction targets appeared to create tension between the group and its lenders and this would colour future negotiations.

Following a period of presumably tense negotiations, the two bank syndicates and the respective borrowers agreed a restructure and extension of the finance facilities which was executed on and shortly after Australia Day in 1990. The key terms of the agreement were:

The facilities were extended until 30 May 1991
The banks were provided with a comprehensive security package
All asset sale proceeds were to be used to pay down debt, except that the Group could retain the proceeds of asset sales to a maximum $5million in each six month period
Almost all intra-group indebtedness was subordinated to the bank.

Importantly, there was no new money being provided by the banks as part of the restructuring. For the Bell Group the sole benefit of the restructuring agreement was the additional time provided to formulate a longer-term work out proposal to address its financial situation, although in the end the banks did not accept any of the proposals made by the Bell Group.

Through 1990 the lenders allowed the Group to access asset sale proceeds on five occasions, and the directors began work on various further restructure proposals. However those restructure negotiations were not fruitful: in March 1991 the lenders declined a final restructure proposal, and in April 1991 issued notices of demand.

Insolvency appointments

In response, after obtaining legal advice concerning potential insolvent trading liability, the directors turned to formal insolvency appointments obtaining an order on 18 April 1991 for the appointment of provisional liquidators, who later became liquidators.

In 1995 the liquidators filed claims initially against both the directors of the company and the lenders in relation to claimed breaches of director’s duties, although the claim against the directors was later discontinued. The liquidators claimed that the security upgrade took place at a time when the group was insolvent, and critically, that the directors knew that to be the case.

The liquidators claimed that the directors had breached their fiduciary duties by causing disadvantage to other unsecured creditors, and claimed that the banks knew not only that the group was insolvent but also that the directors were breaching their duties by granting the security because they knew that without access to asset sale proceeds the Bell group would inevitably collapse. In addition the liquidators argued that the banks’ conduct contravened fraudulent transfer laws. The liquidators claimed that the banks should refund the proceeds of the security realisation together with interest, or pay compensation for the losses that their actions had caused.

The lenders said that they had no knowledge of any insolvency or breach of directors’ duties. They said that in any event the extension of the facility was of real and substantial benefit to the companies because it gave them time to restructure so that the group could continue in business as a going concern and avoid liquidation.

Finally, they said that the bondholders (who comprised the majority of the unsecured creditors) could not have been prejudiced because there was a subordination arrangement – albeit clearly not documented as comprehensively as it could be – by which intra-group loans were to be ranked behind the bank’s debt. If that sub-ordination was not effective, the banks argued, it did not matter because their borrower had represented to them that the subordination was effective, and they were entitled to rely on that representation.

The original hearing and later appeal covered an enormous range of issues and factual matters: closing submissions were 36,932 pages long and the appeal raised 1,179 points.

Summary of findings

By way of summary:

The majority found that subordination was not effective.
Insolvency was not even disputed at trial, and all judges found that the banks had knowledge of the insolvency.
A majority held that the directors had breached their duties, and that the banks would have been aware of that breach. The breach involved failing to properly consider the creditors by agreeing to give security to cover the restructuring agreement at a time when the principal debtor under the agreement was insolvent. Little or no consideration was given by the board as to how the transaction would affect the non-bank creditors.
All judges held that the duty to act in good faith in the interests of the company was to be subjectively assessed, but a majority decided that the directors’ evidence of acting in good faith had to be tested against the circumstances and whether a reasonable person would have believed them. All judges agreed that the duty to act for a proper purpose was to be objectively assessed.
All judges agreed that the duties were fiduciary in nature. This was crucial to the liquidator’s claim for liability of the banks under the rule in Barnes v Addy for knowing receipt of assets by reason of breach of fiduciary duty.[ii]
One of the appeal judges (Lee AJA) held that the banks had engaged in equitable fraud in obtaining security during the insolvency of the Bell Group. The majority on appeal also held that the banks’ conduct breached fraudulent transfer laws.
The duty owed by directors of insolvent companies to creditors – disputed by the banks, who described it as a purported duty – was ‘well established.’ One of the appeal judges (Drummond AJA) characterised this duty as a duty to act in the best interests of all creditors during insolvency, not merely as a duty to consider creditor interests and balance them with the interests of other stakeholders such as shareholders.

With that brief overview, what are some of the practical takeaways for lenders?

TOTAL CONTROL

The Court held that by requiring virtually all asset sales proceeds to be paid to the lenders, the restructure transactions denied the group access to funds it would need to meet its obligations. Rather than restore solvency, the transactions locked in a state of insolvency.

The majority held that the extension was ‘an illusory benefit’ that was ‘immediately destroyed’ by the sequestration of asset sale proceeds, and that the Group was in default of the new facility immediately following the transactions. The banks had been provided with cash flow statements up to September 1989 and then financial statements up to November 1989, which provided grounds for the banks to be aware of the group’s insolvent state.

It was this knowledge that both the directors and the banks shared that put the banks in the position of being in ‘knowing receipt’ of the assets under the security agreement which was obtained by the directors breaching their fiduciary duties by giving security in the first place.

This is not to suggest that the banks could have avoided this situation by merely refusing to see the relevant financial information, as wilful blindness is sufficient knowledge under both limbs of Barnes v Addy.

As much as lenders may like to maintain a tight scrutiny over proposed transactions and the disposition of significant cash flows, ‘total control’ would appear to be a double-edged sword if it means that restrictions are so tight that a borrower will be unable to pay its obligations as they fall due without the exercise of a discretion by lenders.

In such a case it may be preferable to ensure that a minimum level of funding is provided during the restructuring period even if it is provided subject to conditions such as monitoring and regular reviews. Such an arrangement needs to be fully discussed up front so that the borrower’s directors can be satisfied as to how the arrangement will assist the borrower meet the obligations of all of its creditors.

The Restructuring Plan was inadequate

The Court held that the transactions demonstrated that the directors knew that a restructure was necessary for the survival of the Group. However, it held that the transaction that was actually implemented restricted the directors’ ability to affect a restructure because it gave control over all the group’s assets to the banks, leaving the Group without any leverage to negotiate.

It was true that the banks allowed the Group to retain of the asset sale proceeds on five occasions. But the Court held that they only did so to prevent liquidation action by the bondholders during the six months hardening period.

Borrowers need to have a reasonable prospect of restoring solvency prior to expiry of the loan term or possible default, with either cash reserves or access to funds sufficient to meet creditor payments and cover any trading losses until solvency is restored whether by a combination of improved profitability, asset sales or equity raise.

File Notes

There were various internal bank documents created to recommend the release of asset sale proceeds so that the Group could make bond interest payments, which evidenced a very clear focus on the six month hardening period.

For example, one memo identified the importance of avoiding liquidation ‘before the six months period has finished as the security documentation may not stand up in a court of law,’ and another celebrated the passing of the six month period: ‘Our arrival at 1 August marks a valuable step forward in the hardening of our security, as six months have elapsed since execution of the Australian Security.’

Those and similar documents were taken as evidence that the banks only approved the release of asset sale proceeds to avoid a liquidation that would render their security void. This is certainly a difficult balance for lenders: the credit approval process requires written explanation of transactions and detailed justification for decisions made, but care should be taken with the words and phrases used in those documents.

In addition, the directors had been provided with pro forma corporate benefit resolutions and pre-prepared minutes by the company’s external lawyers with input from the banks and their lawyers. These were drafted so as to include wording that would purportedly satisfy the legal requirements. They were insufficient to satisfy the court that the directors actually considered the benefit to each individual company and to the effect of the transaction on the creditors of each company.

The failure to consider the position of each company was one of the key elements in finding a breach of directors’ duties. It is therefore important for lenders to recognise that while a group may operate as a single business it is treated in law as separate entities and the directors must ensure that they act in the best interests of the company on whose board they sit, not merely for the interests of the broader group.

It should be noted that s 187 of the Corporations Act which allows wholly-owned subsidiaries to include constitutional provisions allowing their directors to act in the best interests of the parent company, did not exist at the time of the Bell Group facts.

Abandoning the requirement for a Solvency Certificate

The early drafts of the terms sheet included a fairly standard requirement for certificates of solvency. However, this requirement was dropped in December 1989 and did not appear in later versions.

The Court held that the banks had been unable to provide ‘any plausible explanation’ for its removal and concluded that it was dropped because the Banks had formed the opinion that the directors would be unable to certify that the companies were solvent. In other words the dropping of the requirement was taken as a ‘smoking gun’ – clear evidence that the banks knew the companies to be insolvent.

If a certificate of solvency is a standard requirement then lenders need a strong justification to drop it. This is true at the start of negotiations, but even more important as negotiations progress.

A requirement for additional due diligence?

The Court said that lenders are generally entitled to rely on an assurance from the directors that they have given due consideration to their duties. However such an entitlement may be displaced.

In this case the presumption had been displaced because the banks were ‘aware of facts that raised doubts about the presence of a real and substantial benefit for the Bell companies’ and had no other evidence that the directors had properly considered the relevant issues.

It would appear that in some circumstances it may be appropriate for lenders to commission due diligence to confirm that directors are acting reasonably in forming their assessment of benefit and the viability of the restructuring plan. In this situation the banks needed a clearer demonstration that the directors had thoughtfully considered the separate position of their companies and determined that the transaction would benefit each company.

Merely relying upon pro forma resolutions, prepared in part by the bank’s lawyers, was not sufficient where the circumstances demonstrated insolvency and the restructuring plan did nothing to address those circumstances other than given more time.

Lessons Learnt

The duty of company directors to consider creditor interests is a minefield for both directors and their advisers. The Bell Group litigation demonstrates that lenders are not immune from these risks. Common actions that lenders take to strengthen their position in the face of borrower distress may fall within the scope of liability determined by the Bell appeal, a situation that is commercially unfortunate as it may make lenders less likely to support restructuring efforts.

As all parties acknowledged in Bell, the only alternative to the restructuring on the table was liquidation and destruction of value. Lenders will be best placed if there is a restructuring plan that establishes an endpoint of solvency and business viability, and a clear, funded pathway to get to that point. It may be appropriate for lenders to confirm the existence of appropriately detailed plans and board papers, and to commission specific due diligence if not satisfied by those documents.

There may be some bright news on the horizon. Recent parliamentary and government inquiries have recommended that more policy work needs to be done to encourage restructuring and corporate rescue. One of the proposed measures is the introduction of a safe harbour defence.

While the debate has centred on insolvent trading liability, it is certainly possible to extend such a safe harbour to include liability for breaches of fiduciary duties and thereby limit financier’s exposure under Barnes v Addy. Commercial parties need confidence that good faith participation in restructuring efforts will not lead to liability. No one wants to be sucked into a destructive vortex of complex litigation because they sought to restructure a struggling business.

[i] [2012] WASCA 157

[ii] It should be noted that the Appeal Court’s consideration of the second limb of Barnes v Addy (knowing assistance) has been rejected by the subsequent NSW Court of Appeal in Hasler Singtel Optus Pty Ltd

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’).

Auditors, Bankers, and Company Directors

[Originally published in the December 2014 issue of Governance Directions, and reproduced here with permission]

In September 2014 CPA Australia released ‘Audit Reports In Australia 2005–2013’ which identified that almost one-third of all ASX-listed companies, and more than half of the bottom 500, received ‘going concern warnings’ from their auditors.

Overview

Such public disclosures about the possibility of financial difficulties tend to be self-fulfilling. Credit insurers adjust their cover, suppliers rein in credit terms, and customers switch to suppliers seen as more financially stable. As a result going concern warnings can have an immediate negative impact on liquidity as well as a loss of future income and profit, and so it is no wonder that company directors work hard to avoid them. The purpose of this article is to explain when and how those disclosure requirements can lead to renegotiation with bankers, and what that renegotiation may entail.

As set out in the joint 2009 AICD/AASB publication ‘Going Concern issues in financial reporting: a guide for companies and directors,’[i] there are a number of accounting and regulatory requirements for disclosure of banking arrangements[ii] — however the most significant disclosures are around the availability of the ‘going concern assumption,’ and the classification of liabilities into ‘current’ and ‘non-current.’

Disclosure requirement —going concern

Companies have two separate reasons to assess going concern status.

First, the Corporations Act 2001 requires directors of a listed entity to provide users with sufficient information to allow an informed assessment of the financial position of the entity. According to ASIC Regulatory Guide 247 this should include ‘any doubt about the solvency of the entity, or any issues or uncertainties about the entity as a ‘going concern’.[iii]’ Secondly, accounting standard AASB101 requires an assessment of an entity’s ability to continue as a going concern when preparing financial statements.

Curiously, there is no definition of going concern contained in any of the Corporations Act, RG 247, the Australian Accounting Standards, or the International IFRS framework. The sole source of guidance in Australia is Auditing Standard ASA 570 Going Concern, which sets out an auditor’s responsibilities around the use of the going concern assumption in the preparation of the financial report.

Auditing Standard ASA570 Going Concern

ASA570 gets no closer to a definition of going concern than paragraph 2 ‘under the going concern assumption, an entity is viewed as continuing in business for the foreseeable future’ which in effect is the period from the date of the current audit report until the expected date of the next audit report.

More helpfully, ASA570 provides an extensive list of issues that ‘may cast significant doubt about the going concern assumption.’ Those relevant to lending arrangements include:

fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment or excessive reliance on short-term borrowings to finance long-term assets
indications of withdrawal of financial support by creditors
inability to comply with the terms of loan agreements.

If the auditor’s initial work gives rise to concerns about going concern status, then further work is necessary, which includes:

reading the terms of loan agreements and determining whether any have been breached
confirming the existence, legality and enforceability of arrangements to provide or maintain financial support, and assessing the financial ability of such parties to provide additional funds
confirming the existence, terms and adequacy of borrowing facilities.

Disclosure requirement — current/ non-current classification

AASB 101 sets out rules for classification of liabilities into current and non-current. Ordinarily, liabilities that provide financing on a long-term basis are to be treated as non-current.

However, there are important limitations contained in paragraph 74 — if the borrower ‘breaches a provision of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand’ then the borrower may need to classify the liability as current. There is an exception if before the end of the reporting period the lender agrees to provide at least twelve month’s grace, otherwise reclassification is mandatory.

Such a re-classification is likely to result in a very severe imbalance between current assets and current liabilities, casting significant doubt about solvency and going concern status.

Terms of loan agreements

Loan agreements for corporate borrowers include a wide range of obligations, including reporting and information requirements which are usually referred to as reporting covenants, and requirements about financial metrics which are usually referred to as financial covenants.

Financial covenants focus on financial ratios, most commonly interest cover, debt service cover, leverage and gearing ratios; and will typically be referenced against a benchmark. Bankers will often speak of ‘headroom’ as shorthand for the gap between the actual rate and the benchmark — for example, a borrower with an actual leverage ratio of 2 and a requirement to maintain a rate below 2.5 has headroom of 20 per cent.

Reporting covenants typically include the provision of financial accounts as well as certificates which report on compliance with financial covenants. Bankers may seek monthly, quarterly, six-monthly or annual reporting: as a general rule the frequency of reporting will provide guidance as to the banker’s view of risk and the need for closer monitoring.

Consequences of a breach of covenants

The consequences of a breach of covenant will be set out in the loan agreement. Usually a breach will constitute an Event of Default which allows a lender to call in the loan — but that is not always the case. Sometimes a breach may constitute an Event of Review which leads to a good faith renegotiation of terms. In other cases a borrower may have the option to provide additional equity to avoid a default — known as an ‘equity cure.’

In practical terms the financial covenants regime is linear. Borrowers prepare their financial statements after the end of the reporting period. Once the accounts are finalised then the borrower will prepare a compliance certificate to send to the lender. A borrower might withhold a certificate to avoid a breach of a financial covenant but would usually then be in breach of their reporting covenants. Depending on the terms of the loan agreement non-compliance with a financial ratio may be automatic on receipt of the certificate, or it may require the lender to take a further positive action — but absent specific drafting in the loan document it is a well-established principle of banking law and commercial practice that a breach of a financial covenant cannot occur before the receipt of the compliance certificate.

Avoiding a breach of covenants

Lenders are usually well aware of the negative impact of public disclosure of default, and will often be prepared to work with their customer to sidestep the problem — although they may seek concessions in return. If borrowers and lenders do agree to renegotiate financial covenants to avoid an event of default there are several options:

waive the requirement to test altogether
reset the benchmark to a lower threshold so the test becomes easier
defer the test date until a time when it is likely that the borrower will be able to comply
defer the date of delivery of the financial information.

‘On or before’

In the aftermath of the GFC many auditors adopted a more cautious stance. One consequence was a reinterpretation of the rules around the current/non-current distinction, such that some auditors took the view that a breach arising from the delivery of a certificate after the end of the period was in fact a breach arising ‘on or before’ the end of the period. This view if correct would mean that some breaches — most notably those arising because of an accounting treatment mandated by the auditors themselves after the end of the accounting period — were not capable of waiver under any circumstances whatsoever!

More recently it appears that most auditors now follow the plain wording of the standard, recognising that a breach of financial covenant can only occur after the end of the accounting period that it measures.

Conclusion and summary

Companies usually prepare comprehensive three-way projections — balance sheet, profit and loss and cashflow. It is essential that this be taken one step further to create a forecast of financial covenant compliance, to confirm that the company will be able to meet financial covenants, and has a reasonable amount of headroom. If there is uncertainty over a likely future compliance then management should either develop an action plan to improve financial performance capable of satisfying the auditors, or engage with lenders as early as possible to negotiate waiver or modification of the covenant regime.

[i] Available online at auasb.gov.au/Publications/Other-Publications.aspx

[ii] For completeness, AASB 7 Financial Instruments requires information about any defaults and whether the default was remedied or the terms of the loans payable renegotiated, and AASB 107 Cash Flow Statements requires details of undrawn borrowing facilities together with any restrictions on their use

[iii] ASIC Regulatory Guide 247 Effective disclosure in an operating and financial review, available at asic.gov.au/asic/asic.nsf/byheadline/Regulatory+Guide+247+Effective+disclosure+in+an+operating+and+financial+review?openDocument

The Tomlinson Report and its Aftermath

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

In November 2013 a UK government adviser issued what is now referred to as The Tomlinson report. It was highly critical of the workout function of the Royal Bank of Scotland (RBS) and the insolvency professionals who advise it.

The report was the subject of a great deal of media attention in the UK, and has been reported, albeit less intensively, in the US, Asia, and Australia. In the UK, the Financial Conduct Authority has initiated its own review, and in Australia the report has been linked with the upcoming Murray inquiry.

Later media reporting raises questions about whether Lawrence Tomlinson himself has a conflict of interest in criticising RBS, and arguably the report itself is an aggregation of complaints rather than an objective review. In one sense however, such complaints are irrelevant – the response to the report highlights the very challenging reputational issues faced by banks and the insolvency profession, whether in the UK or Australia.

Background to Tomlinson

An engineer by training, Tomlinson is the owner and chairman of the LNT Group, which employs over 2,000 people in five separate businesses, with significant reported net wealth.[i] Tomlinson was appointed as an Entrepreneur in Residence for the Department for Business, Innovation and Skills (BIS) in April 2013. With hindsight it is notable that on appointment he identified his key focus as addressing ‘some of the key concerns around access to finance and improving bank lending to business’, and advised his intention to ‘share the views and experiences of my peers with Ministers and officials’[ii].

Looking back it is clear that by issuing his report, Tomlinson has done exactly what he said he would do. But in another sense his report appears to have been a surprise to the Government, RBS and the insolvency profession, none of whom were consulted or invited to provide input or comment.

Independent Lending Review and Large Report

In July 2013 RBS appointed former Deputy Governor of the Bank of England Sir Andrew Large and the management consultancy Oliver Wyman to undertake an independent review of lending standards and practices for small business lending.[iii]

The objective of the Independent Lending Review (ILR ) was to: ‘identify steps that RBS/ NatWest can take to enhance its support to SMEs and the economic recovery whilst maintaining safe and sound lending practices’, and ‘promote a common understanding of the way in which the bank makes its judgements and decisions on SME lending’.

The ILR was a wide-ranging review of all aspects of SM e business lending, drawing on a very wide range of internal data, customer surveys and comprehensive stakeholder consultation.

Relatively late in the ILR process BIS made a submission prepared by Lawrence Tomlinson that raised concerns about the work undertaken by the Global Restructuring Group (GRG), the RBS workout function.

On 25 November 2013 the ILR issued its report (the Large report). While the majority of the 95-page report deals with origination and ‘front-end’ issues, there is some discussion of the GRG function.

The report observed that: ‘GRG has been successful in executing its mandate’, noting that ‘over half of all customers under the relationship management of GRG are returned to normal relationship management … around a third refinance with another bank or repay through asset disposals and only a minority (~10 percent) enter insolvency proceedings.’

The Large report referenced ‘more extreme accusations’ made by ‘a small minority of RBS customers’ primarily based on the Tomlinson material, which it summarised as a perceived conflict of interest such that RBS ‘may even be profiting by working against the best interests of financially distressed customers’.

The report also referred to the role of West Register, an RBS subsidiary that acquired properties from RBS customers for later sale, with the end result that any uplift in value would accrue to RBS rather than the former owners.

The report explained that an inquiry into individual cases was outside its scope and recommended that RBS ‘address the concerns that have been raised by some customers and external stakeholders about its treatment of SMEs in financial distress and minimise the perceived conflict of interest within GRG’ through a formal forensic inquiry.

The Tomlinson Report

Presumably it was no coincidence that Tomlinson issued a 21-page redacted version of the material that he had provided to the ILR (now widely referred to as the Tomlinson report) on the same day that the ILR released the Large report.[iv]

The Tomlinson report sets out conclusions drawn by Tomlinson following his own investigations into complaints he had received, apparently without input from RBS. The absence of RBS input does not of itself render his conclusions invalid. But critics of Tomlinson would point out that the assessment was conducted based on ‘one side of the story’ and risks a lack of context.

The redacted report provides a small number of examples, but there is no reference to data or data analysis. Again though, we should note that of itself this omission does not automatically render the conclusions invalid. Tomlinson later clarified that the full report provided 23 examples drawn from around 200 complaints. [v]

The report does include a number of very quotable observations and it is no surprise that media attention focused very heavily on the Tomlinson report in preference to the Large report:

The trigger point [for transfer to GRG] … is sometimes so insignificant, given the otherwise positive performance of the business, that the reaction by the bank can only be considered as utterly disproportionate at best and manipulative and conspiring at worst.

The bank artificially distresses an otherwise viable business and through their actions puts them on a journey towards administration, receivership and liquidation … it became very clear, very quickly that this process is systematic and institutional.

It is undeniable that some of the banks, RBS in particular, are harming their customers through their decisions and causing their financial downfall.

Tomlinson also raises criticisms about the scope and role of the Investigative Accountant (IA):

The potential for conflicts of interest in insolvency is also rife … there are many occasions in which the IBR who works with the business whilst in business support is also the business administrator.

There is also often a requirement for an Independent Business Review (IBR) … at great cost to the business, who often do not even get to see the report.

At best, there is little accountability for the IBR and resulting actions, denying the business of the ability to respond to parts of the report or challenge it (sic) accuracy.

Tomlinson concludes by calling for bank break-ups: ‘The ideal scenario would be the creation of six banks out of RBS and Lloyds … to create fully functioning challenger retail and commercial banks.’

Media Response

One of the first reports was an article in The Independent on 25 November 2013. It focused on the high-profile head of GRG, Derek Sach, known for ‘treading on toes and slaying sacred cows’ by calling for tenders for receiverships and blocking IAs from taking a later role as administrator or receiver of the same company. This second point is noteworthy because it contradicts Tomlinson’s first complaint about IAs.

On the same day, the BBC summarised the two reports and reported that RBS had instructed the law firm Clifford Chance to investigate the allegations. The Daily Mail provided a spectacular headline ‘A State-owned Bank that kills small firms to feed off their corpses. and still not a hint of shame!’ above an article that referred to ‘new-wave grave robbery’.

The Independent returned to the story the following day with two articles. The first called for a break up of RBS, describing it as ‘a vertically integrated, systematically organised asset stripping machine’. The second focused on the information in RBS’s 2012 Annual report which showed that only six percent of GRG customers were returned to normal management.[vi]

The following day, The Guardian published a case study of an aged care home business which had reportedly ‘never missed a mortgage payment’ and was in credit across all bank accounts when it made a request to change one loan to an interest-only basis. According to the story, this led to a transfer to GRG, a visit from a pink-Porsche driving RBS staffer who ‘said she knew nothing about care homes’ so would have to engage an IA.

The Tomlinson report also attracted international interest, and was reported in the New York Times, The Irish Times and The Australian. The Australian reported that ‘similar allegations have been aired in Australia by customers of the major banks’, and quoted Senator John Williams as saying that he had ‘no doubt’ that issues similar to those in the Tomlinson report would be brought before the Murray inquiry.[vii]

The British weekly The Spectator covered the issue with a case study, ‘How our company was nearly bullied to death by a desperate RBS’, describing how RBS had threatened to call a default because a borrower had commenced ‘negotiating with a creditor with a view to rescheduling indebtedness.’

In fact those negotiations were with RBS itself; the borrower had asked RBS to consider changing a repayment schedule. Notably, the article described the GRG bankers as ‘the warrior trolls of Orwellian “corporate recovery”’ and the ‘sharp-suited’ IA team as charging ‘£600 per valueless hour as they tap us for the knowledge that will reappear, beautifully presented, in a report to RBS that we will never be allowed to see in full’.

Tomlinson’s Conflict of Interest?

On 3 December 2013, The Financial Times raised concerns about selective editing in the Tomlinson report, explaining that similar criticism of Lloyds appeared in an early draft, but had been removed in the final version[viii]. The paper said that Tomlinson’s ‘willingness to make such a fundamental change to his report at a late stage, and to direct his criticisms at a single named bank, has caused some to question his methods and motivation.’

The Financial Times also referred to an unnamed government minister that Tomlinson was ‘gunning for RBS from the start’, and reported that he had made a formal complaint about the behaviour of two executives at the bank and expressed ‘frustration’ at the lender’s approach to a refinancing a four-bank £100m facility to his ln T Group which cost £1.4 million in fees to arrange.

Tomlinson did not deny the reports of his personal dissatisfaction with RBS but pointed out, rightly, that any dissatisfaction with RBS did not mean that the complaints were unfounded.

Uncertainty over the RBS Repatriation Rate

The repatriation rate (the percentage of workout customers that return to normal management) is a key performance indicator for a turnaround function. By contrast, a recovery team is more likely to focus on a loss rate.

The Tomlinson report referred to an ex- RBS whistleblower unable to recall any examples of repatriation. The Large report referred to repatriation of ‘over half’, but unhelpfully provided no more data than Tomlinson. RBS’ own 2012 annual report, scrutinised by auditors, refers to a six percent repatriation rate.

The numbers are different, but they will not necessarily reconcile. Firstly, the annual report speaks to repatriations achieved in a 12 month period, the whistleblower is presumably intending to describe a broader period, and we simply don’t know which time period the Large report describes. Secondly, the annual report appears (and it’s not as clear as it could be) to measure repatriation of incorporated borrowers, whereas Large may be referring to both incorporated and unincorporated borrowers.

However, with all the uncertainty about the data noted, an outsider can reasonably conclude that:

The discrepancy between six percent (annual report) and ‘over half’ (Large report) is so great that it is difficult to believe that both are correct.
A repatriation rate of six percent must be regarded as disappointing for a team working towards a turnaround objective.

RBS’ Response

RBS provided an initial response on 25 November 2013 via an open letter from the CEO[ix]. It was careful to show that it accepted the Large report, describing it as ‘a thorough and balanced analysis of the business’ which at the same time provided ‘a tough read for the bank’.

However, they also used their response to provide some context for their actions, explaining the impact of regulatory pressure via regulators who ‘want the bank to remove problem loans more quickly’.

Finally, RBS announced it would engage a newly – appointed panel law firm Clifford Chance to undertake an independent inquiry, and undertook to address any shortcomings identified and share all findings with the Financial Conduct Authority (FCA ).

A statement on 27 November explained that Clifford Chance would focus on ‘the most serious allegation’ that ‘RBS conducted a “systematic” effort to profit’ from customers in financial distress[x]. This second announcement appears to quite significantly narrow the focus of the review: Clifford Chance might find widespread poor treatment of customers yet reasonably conclude that it had not been systematic.

Political Response

The Tomlinson report generated immediate political interest. The BBC analysis quoted Chancellor George Osborne describing the reports as ‘shocking,’ Andrew Tyrie, chairman of the Treasury Committee, as saying ‘The reports … make clear that there is a fundamental cultural problem with RBS’s lending to and treatment of SMEs’, and Business Secretary Vince Cable as saying ‘we are pretty confident that the evidence is solid’.

A Treasury Select Committee questioned the Bank of England governor Mark Carney, who told them he thought the allegations were ‘both deeply troubling and extremely serious’.

Both Sir Andrew Large and Lawrence Tomlinson were invited to appear before the Treasury Select Committee in January 2014. Introductory remarks by the chairman that ‘We have all had huge problems with RBS in our constituencies one way or another’ were typical of the members’ views, and there was very little challenge to Tomlinson’s evidence or independence.[xi]

Responses discussed by the Committee included an expansion of the role of the Financial Ombudsman Service (FOS). FOS is an independent statutory body available to private individuals and micro-enterprises (businesses with an annual turnover of less than two million Euros and fewer than 10 employees) with complaints against financial businesses. FOS can order compensation of up to £150,000.

Regulatory Response

The FCA is an independent government authority with a strategic objective ‘to ensure that the relevant markets function well’. Its operational objectives are ‘to secure an appropriate degree of protection for consumers, to protect and enhance the integrity of the UK financial system [and] to promote effective competition in the interests of consumers.’

On 29 November 2013 the FCA issued a statement in response to the Tomlinson and Large reports.[xii] The FCA explained that while commercial lending was not directly within its purview, the nature of the allegations in the reports gave rise to concerns about governance and culture, which are. Thus they announced the statutory appointment of ‘an independent skilled person’ to review the allegations and report to the FCA.

The FCA would also write to other banks seeking confirmation that they ‘do not engage in any of the poor practices alleged in the reports’.

On 17 January 2014 the FCA announced that consulting firm Promontory Financial Group and accountants Mazars had been engaged to review a sample of GRG customers including some of the Tomlinson complainants. The review would specifically assess whether any poor practices identified were widespread and systematic, and if so make recommendations to address any shortcomings. The FCA advised that it expected to publish the outcomes of the review in the third quarter of 2014.

Conclusions

The nature of the allegations and their headline-friendly wording has attracted the attention of a public that was clearly prepared to believe the worst of bankers and insolvency practitioners, highlighting the reputational issues that both face.

Critics have raised questions over Tomlinson’s independence as well as the strength of the evidence and analysis to support his allegations. In a sense these criticisms are almost irrelevant, because they emerged only after the FCA had already initiated a review. It is also noteworthy that the original allegations received heavy media coverage, whereas the questions over Tomlinson’s independence have been mostly confined to the specialist finance media.

Once the crisis broke RBS handled it in text-book fashion. If we ask ‘what could they have done differently?’ the challenge is clear because RBS appear to have been excluded from Tomlinson’s process altogether. Two points stand out:

If RBS had engaged with Tomlinson immediately after his on-appointment comments they may have had the chance to inform and influence him.
RBS has not been able to present a clear and understandable picture of the success of their turnaround function i.e. their repatriation rate.

RBS will incur costs in running the Clifford Chance investigation and responding to the FCA inquiry. However, those costs will not be material. In my view, the more significant impact will be on senior management in dealing with the inquiries and their consequences.

To this observer at least it seems unlikely that the review will result in the bank break-up that Tomlinson calls for. But an expansion of the role of the Financial Ombudsman might be proposed even in the absence of any evidence of systemic wrongdoing.

Update: For more recent developments please see The beginning of the end? The RBS – GRG saga

[i] Biographies at http://www.tomlinsonreport.com and http://www.ginetta.com/lnt

[ii] Department for Business, Innovation & Skills media release http://www.gov.uk/government/news/you-re- hired-entrepreneurs-in-residence-to-advise-government

[iii] The background to and the report itself is available at http://www.independentlendingreview.co.uk/index.htm

[iv] available at http://www.tomlinsonreport.com

[v] Tomlinson’s evidence to the Select committee on 29 January 2014 is available as a transcript http://data.parliament.uk/writtenevidence/Writtenevidence.svc/evidence html/5629 , or via Parliament TV: http://www.parliamentlive.tv/Main/Player.aspx?meetingid=14764 ; evidence from Sir Andrew Large on 22 January 2014 is available at http://data.parliament.uk/writtenevidence/Writtenevidence.svc/evidence html/5605

[vi] RBS Annual report 2012, page 174

[vii] More correctly this is the Financial System Inquiry, headed by David Murray AO, the former CEO of the Commonwealth Bank, announced by the Government on 20 November 2013, http://www.pm.gov.au/media/2013-11-20/financial-system-inquiry.

[viii] ‘Criticism of Lloyds removed from Tomlinson report’ by George Parker and Andrew Bounds http://www.ft.com/intl/cms/s/0/550c5360-5c31-11e3-931e-00144feabdc0.html#axzz2oxojGGic

[ix] http://www.rbs.com/news/2013/11/distressed-business-customer-review-terms-of-reference.html

[x] http://www.rbs.com/news/2013/11/final-lending-review-report.html

[xi] See footnote 5

[xii] http://www.fca.org.uk/news/press-releases/statement-regarding-royal-bank-of-scotland