Pre - Packs: A lesser evil?

What is a pre-pack?

The term "pre-pack" or "pre-packaged sale" refers to an arrangement to sell all or part of a company's business or assets to a buyer which is made before an administrator is appointed. The administrator then implements the sale immediately on, or shortly after, his appointment.

Due to the current economic climate it is inevitable that more and more companies will be pushed into administration during 2009. A pre-pack strategy may be the only route available to stakeholders to retain some value.
What are the benefits?

The benefits of a pre-pack strategy include:

1. it can result in a quick and relatively smooth transfer of a business;
2. it can minimise the erosion of supplier, customer and employee confidence that an insolvency proceeding inevitably causes;
3. it can save more jobs than a normal administration;
4. it may be the only option. If there is no funding available, it may not be possible for the administrator to continue to trade the business through a normal administration. The alternative would be liquidation and the immediate cessation of the company's business;
5. companies which are pre-packed are by definition insolvent so unsecured creditors are unlikely to recover their money anyway. When unsecured creditors lose out in a pre-pack, it is not necessarily as a result of the pre-pack process but the company's underlying financial difficulties; and
6. because the process is relatively quick compared to a normal administration, the costs of the process are reduced, which results in a better return for creditors.

Why are they controversial?

The main criticisms of pre-packs are:

1. a lack of transparency;
2. a lack of accountability;
3. they do not maximise returns for unsecured creditors;
4. they are similar to the outlawed practice of creating "phoenix" companies;
5. the proposed administrator has an inherent conflict of interest; and
6. writing-off liabilities using a pre-pack is a short-term fix.

What is the courts’ approach?

The courts have broadly supported the use of pre-packs. In a series of cases, the courts have confirmed that administrators have the power to sell a company's business and/or assets without the prior approval of the court or creditors, if the circumstances justify it.

What are the guidelines for administrators?

Administrators are subject to professional guidelines that relate specifically to pre-packs. The Insolvency Service's Statement of Insolvency Practice 16 (the “Statement”) took effect on 1 January 2009. The Statement was introduced in response to creditor concerns about pre-packs.

The Statement provides that administrators should disclose certain information to creditors including:

1. the extent of the administrator's involvement with the company prior to his appointment;
2. any valuations of the business or underlying assets which have been obtained;
3. any alternative courses of action to a pre-packaged sale which were considered by the administrator;
4. whether major creditors were consulted;
5. the price paid;
6. the name of the buyer; and
7. whether there is any connection between the buyer and the company.

The information should be provided by an administrator to creditors as soon as reasonably practicable after he is appointed, usually at the time of the first notification to creditors.

The Statement also requires administrators involved in a pre-packaged sale to:

1. keep a detailed record of the reasons why a pre-packaged sale has been undertaken; and
2. be able to explain and justify why it was considered appropriate to undertake a pre-packaged sale.

What are the issues for directors?

The Insolvency Act 1986 (the “IA”) imposes personal liability on directors for wrongful trading. The directors of a company who are involved in a pre-pack need to make sure that they do everything they can to minimise loss to creditors. Directors should take independent legal advice, especially if they will acquire an interest in the company's business and/or assets through the pre-pack.

The Insolvency Service has indicated that it will use its enforcement powers to penalise any directors who misuse the administration process to disadvantage creditors or to seek to gain benefit for themselves.

How are employees affected?

Pre-packs are frequently used to rescue companies which are "people" businesses, such as retail businesses. This is because much of the value in such a business lies with its employees. If the company is subject to a drawn out normal administration process then key employees are more likely to lose confidence that the company can be saved and seek alternative employment.

A companion article dealing with this issue is available to read either online or in this newsletter.

Do unsecured creditors have any right to challenge?

Creditors have a statutory right to bring an action against an administrator where his conduct causes unfair harm to their interests or where he is not performing his functions quickly and efficiently or there is misfeasance. The requirements of the Statement may provide creditors with the information that they need to bring such an action.

A less formal and cheaper way of challenging a pre-pack is to contact the Insolvency Service's pre-pack complaints hotline. Administrators could face regulatory or disciplinary action if they have failed to comply with the Statement and directors of a company that is pre-packed can be disqualified if their conduct in the period leading up to the pre-pack is considered to be unfit.

Are there any proposals for law reform?

There have been calls for the Government to amend the IA to expressly legislate for pre-packs. This could make them subject to court or creditor sanction. However, expressly legislating for pre-packs would not be easy not least because of the likelihood that parties would simply structure their transactions so that they fell outside any statutory definition.

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This article may contain information of general interest about a current issue but does not constitute legal advice.

Keith Dempster is a Partner in the Corporate and Commercial Department at Kerman & Co LLP. If you have any enquiries in relation to corporate matters, please contact Keith on 020 7539 7081 or by email at [email protected]