A New UK Debt Restructuring Regime? A Critique of the Insolvency Service’s Consultation Paper – Part 1

Introduction

It is well understood that an effective business rescue regime can support business growth and can add value to an economy. The global financial crisis and the business failures that resulted from it have increased the focus in this area. In the EU, for example, the Commission published a Recommendation in 2014 with the aim of ensuring that all Member States have in place a procedure that will facilitate business rescue. Recent work by the World Bank and UNCITRAL has also focused on this issue, and has led the UK Insolvency Service to publish a consultation paper to determine whether the UK regime needs to be updated to ensure that it contains the necessary tools to encourage business rescue. Although this Consultation Paper is titled ‘A Review of the Corporate Insolvency Framework: a consultation on options for reform’ it is clear that the remit of the paper is narrower than the corporate insolvency system as a whole, and is in fact focused on debt restructuring mechanisms. The timing of this Consultation Paper may be somewhat surprising given that the UK response to the EU’s Restructuring Recommendation effectively gave the UK a clean bill of health in this regard in August 2015.

The UK already contains a number of debt restructuring mechanisms, including a contractual workout between a company and its creditors, a scheme of arrangement, a company voluntary arrangement (CVA) and administration. The difficulty is that none of these arrangements, when used as a standalone device, provides all of the features necessary for an effective restructuring mechanism. In particular, in order to access a cram-down, whereby the restructuring can be imposed on whole classes of dissenting creditors (such as unsecured creditors), and some form of statutory stay that will provide the company with a breathing space within which to negotiate with its creditors and put the restructuring in place, UK practitioners have had to twin schemes with pre-pack administration (see my paper here). This combined mechanism has been used repeatedly in recent years to restructure the debts of both UK companies and those elsewhere in the world (see my paper here), but it is costly and cumbersome, not least because it involves the business and assets being transferred to a new entity. The UK has been the destination of choice for financially distressed companies needing to be restructured in recent years, but other jurisdictions offer standalone mechanisms combining all of these attractive features. Some have existed for many years (such as US Chapter 11) but others have been introduced more recently (see eg recent reforms in Spain and the Netherlands). The UK should not rest on its laurels.

One further issue that needs to be addressed is that of debtor-in-possession financing. It can be difficult for the company to obtain financing during the period of its restructuring and yet such financing can be vital for the company. Other jurisdictions, such as the US, have introduced specific provisions to deal with this issue, but no statutory provisions exist in the UK.

The Consultation Paper proposals

The proposals put forward by the Insolvency Service address these issues and put forward three broad proposals: (i) the introduction of a new moratorium to help business rescue; (ii) the introduction of a cram-down option; and (iii) the introduction of a rescue finance regime. These are broadly in line with the proposals for the reform of this area that I have previously put forward (see Payne, Schemes of Arrangement: Theory, Structure and Operation (2014, CUP) esp chs 5 and 9). Unsurprisingly, therefore, I am in favour of the thrust of these reforms. It is clear, however, that more thought needs to be given to some of the details being put forward.

The introduction of a new moratorium

General

A moratorium can be valuable for a company seeking to rescue its business, especially if it takes the form of a broad statutory stay, as it prevents creditors asserting their rights against the company in this period, buying the company time to conclude a restructuring agreement. One difficulty in structuring a moratorium, however, is to ensure that the desire for a breathing space on the part of the company is not abused, and that the right balance is struck between debtors’, creditors’ and suppliers’ rights.

Contractual workouts and schemes currently don’t have a statutory stay and only the very smallest CVAs can make use of this option. Only administration offers a full statutory stay. The Insolvency Service has consulted on this issue before, in its June 2009 ‘Encouraging Corporate Rescue’ consultation paper. It initially suggested that a statutory stay should attach to all of these restructuring mechanisms, before dropping these proposals in 2011, citing a lack of demand for such a moratorium. It is true that contractual agreements can be reached between the parties to much the same end, and practitioners have become skilled at putting in place work-around measures to deal with the lack of a moratorium in this area. Nevertheless, it seems clear that an effective moratorium could add value in this area (as evidence for which see the work-around required of the judge in Bluecrest Mercantile BV [2013] EWHC 1146 (Comm).

The proposed moratorium would be available for all forms of restructuring (including a contractual workout, CVAs, schemes and administration); would be available from an early stage (covering initial negotiations, for example); would last no longer than 3 months (with the possibility of an extension); would remove the risk of liability for trading from directors for the period of the moratorium, providing the conditions of the moratorium are met; and would involve the oversight of a supervisor (although the power to appoint the supervisor is left unspecified in the Consultation Paper).

Scope of the moratorium

The breadth of the statutory stay is broadly the same as that which exists in administration and under the small company CVA option, with one significant addition. Specifically, the company is given the right to designate some contracts as essential contracts (in addition to the continued provision of IT and utilities) and it would then not be possible for these contracts to be terminated or varied during the moratorium. This stems from a recognition that the withdrawal of vital services can reduce the chance of a successful business rescue and that this knowledge may lead some suppliers to demand ‘ransom’ payments at the expense of other creditors.

The Insolvency Act 1986 was amended on 1 October 2015 to ensure the continuity of supply of utilities and IT goods and services to insolvent businesses. This proposal would expand the concept of essential supplies, and would apply to companies entering into a moratorium, administration, CVA or debt restructuring as set out in this Consultation Paper. The designation would be made by the company or relevant office holder and would involve a filing at court. A safeguard is built in for the supplier, as they would have the right to challenge the designation in which case the court would be required to approve the application. However, this safeguard is reduced somewhat since the burden seems to be cast on the supplier to provide an ‘objective justification’ as to why the supply should not be designated as essential. No definition of what constitutes ‘essential’ is provided, and although some indicators are given these are rather vague (para 8.15). Given the seriousness of a designation for the relevant supplier, the lack of clarity is a potential concern.

Eligibility tests

On the commencement of the moratorium the supervisor will need to be satisfied that the company is eligible (see paras 7.18-7.20). Companies would have to demonstrate, first, that they are already or imminently will be in financial difficulty, or are insolvent. The precise meaning of ‘imminently’ in this context is unclear. Second, the moratorium is not available to certain companies, such as banks, insurance companies and companies involved in certain financial market transactions. This is broadly sensible given that companies such as banks are subject to their own special resolution regimes. Third, if a company has entered into a moratorium, administration or CVA in the previous 12 months or is subject to a winding up order or petition, it will not qualify for a moratorium. Again the purpose behind this provision, to safeguard creditor interests, seems unarguable, but it may have the unintended consequence of encouraging creditors to present a winding-up petition early in order to prevent a moratorium being put in place.

This Consultation Paper avoids one of the problems of the 2009 proposals, which attempted to restrict the moratorium to UK incorporated companies. Leaving this moratorium potentially open to use by non-UK companies is to be applauded, particularly given the widespread use of UK debt restricting mechanisms (especially schemes of arrangement) by non-UK companies in recent years.

Qualifying conditions

The qualifying conditions are largely unchanged from those proposed in the 2009 consultation. For the duration of the moratorium the supervisor’s role will be to ensure that the qualifying conditions continue to be met. The first is that the company must be able to show that it is likely to have sufficient funds to carry on its business during the moratorium, meeting current obligations as and when they fall due as well as any new obligations as they arise (para 7.22). This suggests, as a minimum, that the lender(s) providing funding during the moratorium will need to consent to the proposals.

Second, the company must satisfactorily demonstrate that although it is experiencing financial difficulties, at the outset there is a reasonable prospect that a compromise or arrangement can be agreed with its creditors. It is unclear how a company will ‘satisfactorily’ demonstrate this point. Will the company need to consult with its creditors in advance in order to meet this test? And, if so, which creditors? All creditors? Only secured creditors? Only those with a remaining economic interest – and, if so, measured how? If creditor approval is required, what proportion of the creditors would need to consent to it in order for the company to satisfy this reasonable prospects test? Alternatively, will it be enough if the supervisor has been consulted and forms the view that the proposed plan meets the reasonable prospects test? This may be difficult in the absence of consultation with creditors.

Creditor protection

Creditors would have the right to apply to court to challenge the moratorium during the first 28 days. This raises an issue about how creditors will receive notice of the moratorium in order to take the view about whether to challenge it, and also about what would be the effect, if any, if creditors do not receive notice. The Consultation Paper is unclear on this issue.

The position of directors

As regards directors, the Consultation Paper states that ‘for consistency across insolvency and restructuring procedures, directors’ duties will remain unaltered in the moratorium’ (para 7.31) so, presumably, directors will remain liable for wrongful and fraudulent trading and other breaches of duty. It is contemplated, however, that directors would be protected from liability for trading, under s 214 of the Insolvency Act 1986 for example, ‘if the conditions for a moratorium are maintained and the directors perform their duties as required under law’ (para 7.34). This makes it all the more important that there is clarity around the conditions for the moratorium.

In addition, the Consultation Paper proposes new sanctions for actions including obtaining credit without first disclosing that a moratorium is in force and failing to supply information required by the supervisor. These mechanisms are clearly intended to provide creditors with protection but further details will be required about these potential claims and the sanctions that will attach to them before they can be properly judged.

International recognition

Finally, it is notable that many large restructurings (where such a moratorium is most likely to be used) have an international dimension and such a moratorium might be thought to have most value if it is recognised and capable of being enforced in other jurisdictions. This point is not addressed in the Consultation Paper.

Part 2 of my post on the Insolvency Service’s Consultation Paper deals with the proposals for a cram-down mechanism and rescue finance.

Jennifer Payne is Professor of Corporate Finance Law at the University of Oxford.