Mind the pre-pack
3 July 2006
Pre-pack administrations have been getting a bad press of late. They are seen as a less-than-transparent sale process where creditors are faced with a fait accompli at the creditors' meeting with no practical sanctions save to sue the administrator for misfeasance - an unattractive and costly course of action.
Pre-packs occur predominantly where there is a need to sell the business without publicity to avoid a negative reaction from customers and staff, and where there is a failure of any party to fund the administration period to enable a more sophisticated rescue option to be pursued.
With pre-packs attracting so much criticism at present, there has been talk within the corporate recovery community that the time may be right for the introduction of 'super priority' or 'debtor in possession' (DIP) funding as an alternative.
So would the introduction of super priority funding enable a company to avoid a hurried sale of its business and assets after the start of the administration and allow it time to find a better solution for its creditors?
In 2002, during the parliamentary debates on the Enterprise Act, the Government declared that no court should be required to make commercial decisions as to whether DIP funding should be allowed and that the ramifications of the process were too difficult to consider in the time available. However, the criticism of the use of the pre-pack administration sale process and the perceived taint of such a sale has reopened the debate.
So what is DIP funding? Does it really displace the rights of existing secured creditors, creating an uncertain world for lenders and businesses alike? Looking at the US example, Section 364 of the US Bankruptcy Code sets out how the court will allow DIP funding to be introduced by a company filing for Chapter 11 protection.
Subsection 364(a) states that the court may authorise the debtor to obtain unsecured credit in the ordinary course of business, covering essential payments to utilities, suppliers and payments necessary to preserve the estate, including professional fees. These will be paid as administrative expenses ranking in priority to other unsecured debts, but coming after the secured lenders.
It is common for office holders to make such payments to enable a business to continue trading during the administration period. The difficulty arises when the administrators have to arrange an overdraft facility for which they may be personally liable and take on the risk that payment of administration expenses may jeopardise their own ability to receive their remuneration, which ranks lower down the pecking order set out in Rule 2.67(1) of the Insolvency Rules 1986.
Current experience suggests that lenders would not be prepared to fund solely on the basis that it would be repaid as an administration expense. However, in the US there are other DIP funding options available that might be more attractive to the English office holder.
The American way
In the US, the debtor can apply for leave to receive some form of secured post-petition credit. It is for the debtor to demonstrate that there are no alternative sources of funding and that this is the best option to enable its reorganisation plan to be implemented.
Secured post-petition credit can be granted in three forms or as a combination of all three. First, the lender can be given priority over administrative expenses and pre-petition unsecured claims by having a first claim on the sale proceeds of all unencumbered assets and on the residual proceeds from the liquidation of assets with pre-existing encumbrances. Second, a charge can be given over the unencumbered assets of the debtor - an unlikely solution since most companies in distress will have few unencumbered assets. Finally, the lender can be granted a second charge on property already encumbered. Existing lenders can only be crammed down if they are already adequately protected. The debtor must demonstrate that the secured creditor is oversecured and that it will not be harmed by its position being subordinated to an extent, particularly if current interest is paid.
The secured debt still ranks ahead of both super priority claims and the administration expenses. The parties most expected to suffer in such a reorganisation are the unsecured creditors and the shareholders. However, the US experience shows that, once DIP funding is in place, the company is more likely to move successfully out of Chapter 11, paying a higher dividend to unsecured creditors and increasing the value of the stock held by shareholders.
Will it work here?
So could this be used in England? The amendments tabled in the debate on the Enterprise Bill provided that an administrator could apply to court for approval of the provision of super priority financing to the company. This funding would rank as an expense in the administration with priority over existing secured and unsecured creditors. The court would not grant such an application unless it was satisfied that:
The Government rejected the proposed amendments. It had reservations about putting the judiciary into a position where it would have to make commercial decisions on the administrator's proposals. However, this disregards the scrutiny to which a judge would have subjected any report prepared under the old Rule 2.2 of the Insolvency Rules - experienced insolvency judges had no difficulty in considering cashflows and assessing whether the proposed plan would be to the benefit of creditors overall. The consideration of whether super priority funding should be allowed would presumably follow a similar analysis of the administrator's proposals. Of greater concern is how such a procedure would impact on floating charges generally.
In the US, the security structure favours fixed charges over specific assets. The fixed and floating charge structure is commonplace in England and effectively means that all of the company's assets are likely to be subject to security in one form or another. Thus, on the amendments noted above, it is unlikely that there would be many situations where the secured creditors were not prejudiced by the provision of super priority funding, thus rendering any benefit to be achieved from the above amendments nugatory.
However, with the decision in Re Spectrum Plus (2005) and the move towards invoice discounting and factoring of book debts, is the floating charge really so important? Stock is commonly subject to retention of title claims and the prescribed part regulations have reduced the value that a lender might put on its floating charge anyway. With the decrease in the true value attributable to the floating charge, a bank might be amenable to super priority funding secured over surplus recoveries or as a second charge on assets, which are worth considerably more than the debt owed to it.
With appropriate safeguards to enable creditors to be represented at any hearing for approval of super priority funding, there is no reason why a court could not exercise its inherent jurisdiction and grant such priority along the lines discussed above. With funding in place the need for a pre-pack would be eradicated and the rescue process would be more transparent.
The primary objective of 'saving the company' would more likely be achieved, since administrators would have the time and funding to put together a restructuring plan rather than following the pre-pack sale route.
Carolyn Swain is a partner at Halliwells