The magic spongers

The Enterprise Act 2002 has introduced significant reforms to the insolvency regime. In particular, the administration procedure has been streamlined and it is now possible to appoint an administrator without recourse to the court. This is in line with the Government’s desire to encourage a rescue culture for troubled companies.

One of the Government’s stated aims was “facilitating the rescue of viable companies, and if that is not practicable, or it would not produce the best outcome for creditors, achieving a better result for the company’s creditors as a whole. The act will achieve this… by shifting the balance in favour of administration (which takes account of the interests of all creditors).”

During the consultation period preceding the act’s passage through Parliament, the Government published a white paper entitled ‘Insolvency – a second chance’. In the foreword, Trade and Industry Minister Patricia Hewitt promoted a rescue culture and a “collective approach”, where all creditors have a fair say. The administration procedure was to be “the most favoured option for the directors of a company in financial difficulty where there are prospects of rescue”.

The Government has therefore nailed its colours to the mast in promoting administration as its preferred solution. This article looks at how the rules applicable to professional football clubs in financial difficulty fly in the face of the Government’s favoured rescue culture and militate against the collective approach intended by the reforms.

Penalty points

The FA Premier League has introduced a rule, effective from the beginning of next season, providing for a nine-point deduction for any of its member clubs going into administration. The Football League and the Football Conference have similar rules.

The rule was introduced to prevent clubs from gaining a competitive advantage by entering into administration. Its introduction followed Leicester City’s controversial administration in 2002-03. Leicester emerged from its administration shorn of debts of over £30m, kept its best players and gained promotion to the Premiership. However, the docking of points is likely to impede the use of administration as a rescue mechanism. The points deduction may lead to relegation for some clubs and a consequent drop in income. Rather than buying the club breathing space to trade through or reorganise its finances (as intended by the administration procedure), it could lead to financial disaster.

Banks have voiced their concern about the points deduction rule and may refuse to lend clubs additional sums for expansion or to solve short-term financial difficulties if they consider there is a risk, however small, of a club going into administration. So much for the Government’s wish for administration to become the favoured option for promoting rescue of a company wherever possible.

On the other hand, a balance needs to be struck between the desire to promote rescue and the use by clubs of administration to gain an advantage. Some argue that sport is a special case where special rules should apply.

In its February 2004 report ‘Football and its Finances’, Parliament’s All-Party Football Group set out its support for the penalty points rule, and commented: “While the best antidote for a club going into administration is a chairman and board that prudently refuse to spend more than they can afford, we recognise that not all directors fit this bill. We have been most impressed, however, by the response of the Football League and the Football Conference to introduce measures aimed at preventing clubs entering into administration as an easy way out of their financial troubles. We also welcome the Premier League’s decision to address this issue.”

There is, of course, a risk that, in attempting to avoid these penalties, the directors will attempt to trade through the financial difficulties for longer than is prudent rather than face the music and put the club into administration. This could lead to personal liability for the directors for wrongful trading should the club subsequently become insolvent.

The ‘football creditor’ rule

Since October 2003, Football Conference team Exeter City has been subject to a Creditors’ Voluntary Arrangement (CVA). The Inland Revenue has challenged Exeter’s CVA as unfairly prejudiced by its terms, because the CVA proposes that the club’s ‘football creditors’, totalling approximately £450,000, are to be paid in full over five years, whereas the general body of unsecured creditors are likely to receive only 10 pence in the pound.

Exeter included the provision that football creditors be paid in full because of the so-called ‘football creditor rule’. The rule is contained in the Articles of Association of the Football Conference and provides that a club that enters into a CVA is liable to expulsion from the Conference. The Conference may allow a club to retain its membership if it can establish that football creditors, which include other clubs and a club’s full-time employees, will be paid in full. Full-time employees include players. The rule has been criticised in the football community because its effect is that players are paid off in full, while part-time employees such as cleaners and catering staff can be left unpaid. The FA Premier League and the Football League have similar rules favouring football creditors.

The football creditor rule effectively creates a special category of preferential creditors and has the effect of ensuring that these creditors are paid in full. This goes to reduce the assets available for distribution to the general body of unsecured creditors.

Following the introduction of the act, the Inland Revenue has lost its preferential creditor status, which explains its newfound interest in the effect of the football creditor rule. It now has to take its place among unsecured creditors, giving it the incentive to launch its challenge to Exeter’s CVA. More recently, the Inland Revenue has challenged the CVA proposed by Wimbledon on similar grounds.

Justification for the rule

In a paper entitled ‘Current Insolvency Policy’, the Football League sets out its guiding principles. The starting point is that no club should seek to obtain an advantage over other clubs by not paying its creditors in full. However, the League recognises that clubs have and will become insolvent. The paper classifies a club’s creditors into football creditors and other, non-football, creditors. It states that its choice is whether it should expel automatically any club that cannot pay its creditors in full, or compromise. It adds that “a policy of expulsion would have significant impact on the constitution and continuity of the League”. On football creditors, the League says it is “not tenable” to allow a club to remain a member if fellow clubs are not paid in full. The sentiment is understandable: the League does not want to preside over a competition where spendthrift clubs put in jeopardy the finances of prudent clubs.

The League’s paper goes on to say that, in respect of other limited categories of football creditors, the justification for payment in full is “different but equally valid”. With players, the fear is they may refuse to join clubs considered to be in financial difficulty.

John Nagle, the Football League’s spokesman, has said: “If the rule was removed, clubs could unilaterally terminate players’ contracts, which would jeopardise the future of the transfer system and allow clubs to wipe out huge swathes of player-related debt. A club in administration could simply write off the financial consequences of bad decisions made in the past. Clearly, this would be unacceptable to the other clubs in the same division.”

In support of the rule, it will no doubt be argued at the hearing of the Inland Revenue’s applications that sport should be treated differently from other businesses. In sporting competitions, unlike in the commercial world, participants have a vested interest in the survival of their competitors. In the football environment, clubs have no choice but to deal with one another to buy and sell players. By contrast, trade creditors are not obliged to do business with football clubs.

Against the maintenance of the football creditor rule is the fact that its effect is at odds with the Government’s efforts to promote a collective approach to insolvency and put unsecured creditors on an equal footing.

The All Party Football Group, although supportive of the penalty points rule, wants to see the football creditor rule abolished. It states in its recent report: “Whilst we understand the motives for introducing such a rule in the first place, we believe that it can be iniquitous to other suppliers, to football clubs and other non-playing members of staff. The group, therefore, recommended the abolition of the rule”.

The effect of the football creditor rule leaves clubs in an invidious position. On the one hand, the rule means that the club has to pay its football creditors in full if, after a CVA, it is to continue as a member of its league. However, by complying with the rule, Exeter and Wimbledon have found themselves under attack from the Inland Revenue.

The Inland Revenue’s applications, if successful, will not mean the end of the football creditor rule. However, a decision in its favour will be a powerful precedent that the Inland Revenue would almost certainly use to challenge other CVAs with similar provisions to those of Exeter and Wimbledon. If the football creditor rule is diluted or abolished as a consequence, unsecured creditors will see their position improve. The losers will be the players, who will have lost their ‘super-creditor’ status, and they will need to be careful about which clubs to join. Indeed, a club’s financial prudence may become as big a selling point to a prospective player as the size of its trophy cabinet.

Amanda Milsom is a partner, and Sohrab Daneshku a solicitor, at Lewis Silkin