THE RISE OF THE PRE-PACK
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[Insolvency Reform Edition 10 - April 2017] here
With the pending implementation of the Government’s safe harbour proposal. We should now consider the potential outcomes of the safe harbour mechanism. One of those we expect will be the rise of the pre-pack.
What is a pre-pack?
A prepack is a description for an insolvency administration that involves both formal and informal processes. The distressed company and its creditors conclude an agreement to restructure the company or sell the business of the company in advance of a formal insolvency administration through which the agreement is implemented. Agreement is solicited from major stakeholders prior to the formal insolvency appointment.
The Origin of the pre-pack
Pre-packs were first used in the United States often in conjunction with a Chapter 11 administration. They involve negotiating a restructuring plan and soliciting approval of the plan before the commencement of the Chapter 11 process.
The degree of pre-packaging can vary and may be either pre-negotiated or pre-voted. An important distinction is that the US Bankruptcy Code (“US Code”) incorporates provisions to facilitate these alternative mechanisms. Chapter 11 is also now regularly used to effect pre-plan sales of all or a substantial part of the debtor’s assets prior to confirmation of a reorganisation plan. The US Code allows sales in the ordinary course of business with no scrutiny by creditors, or outside the ordinary course of business with some creditor scrutiny and court approval.
Spread the business rescue culture
The voluntary administrations provisions in 1993 was Australia’s initial attempt at fostering a business rescue culture. The UK’s first efforts were included in their consolidated Insolvency Act 1986 (“IA”). Changes to the IA enacted in 2000 and 2002 facilitated the rescue culture.
It is worth noting that secured creditors in the UK also lost their ability to appoint receivers, trading this right for enhanced rights of intervention and appointment in the collective administration procedure.
Use of pre-pack in UK
Since the 2002 changes pre-packs have become a common occurrence in the UK turnaround and insolvency market place. UK pre-packs typically involve the negotiation of the sale of the business and/or proposed arrangement with creditors, negotiation of approval of major creditors of the sale and or arrangement prior to the commencement of an Administration.
Advisors or insolvency practitioners are normally engaged by management to assist in consulting creditors and marketing and negotiating the sale of the business and seek the support of various major creditors prior to the commencement of the formal process.
The administrator when appointed is presented with a sale and or the terms of a proposal for approval by creditors.
Advantages of pre-packs: The purported advantages associated with pre-packs include:
- Lower costs
- Faster implementation of restructuring plan
- Protection for and retention of employees
- Maximisation of return to creditors
- Maximise value realised in sale
- Minimise risks associated with trading
- Preservation of value
Disadvantages of pre-packs: The purported disadvantages associated with prepacks include:
- Unsecured creditors interests do not align with those of directors, advisors and secured creditors
- Favour secured creditors
- Market not properly tested
- May facilitate phoenixing
- Suppliers may be victimised
- Advisors conflicted
- Statutory protections of formal appointment weaken
Pre-Packs and the safe harbour
A director will not be liable for insolvent trading in regard to a debt if after suspecting the company is, or may become insolvent, the director starts to take a course of action reasonably likely to lead to a better outcome for the company and its creditors.
The person seeking to rely on the defence will bear the onus of the proof. The test a person must satisfy is a reasonable standard.
One of the tests proposed to establish whether a course of action is reasonably likely to lead to a better outcome for the company and its creditors is seeking advice from an appropriately qualified entity who has been given sufficient information to give appropriate advice.
This carve out provides an ideal opportunity for a company to formulate, negotiate and obtain the agreement of key creditors to a sale of the business and or restructuring proposal to be implemented through a formal insolvency process.
The conundrum for creditors
However, the qualified entity appointed by directors will owe no duty to creditors generally. The qualified entity may be representing the interests of the secured creditor, the directors, the shareholders, the purchaser or the incoming financier. Trade creditors and involuntary creditors (such as the ATO, employees and statutory suppliers) may have little input to, or representation of their interests in this process.
Yet, despite the potential for a large body of creditors to be left unrepresented in the pre-pack process, without any surety that the negotiated deal is the best outcome, it may still provide the directors with a defence under the safe harbour.
Implementing the pre-pack
The agreed pre-pack plan may then be implemented through either a scheme of arrangement or voluntary administration. In regard to the voluntary administration route it would appear nearly impossible for the qualified entity to act as administrator.
Despite the predetermined nature of the pre-pack the administrator will be required to reach his or her own conclusions on the sale of the business and or the restructuring plan. Unsecured and involuntary creditors will be reliant on the independence and commercial competence of the administrator. The administrator will be expected by creditors to ensure the pre-pack, be it a sale of the business or restructuring proposal, provides the best outcome for them.
Role of the regulator and professional associations
ASIC and ARITA will need to be on their toes to ensure appropriate practices are adopted by those making use of the safe harbour and insolvency professionals involved in administering pre-packs that arise from the safe harbour.
The costs associated with the engagement of a qualified entity will not be visible to creditors or regulators. The qualified entity will have no obligation to act in the interests of creditors. The directors will be responsible for demonstrating the course of action undertaken is reasonably likely to lead to a better outcome for the company and its creditors.
Insolvency professionals in justifying implementation of a pre-pack sale and or pre-pack-plan to creditors should be required to:
- Explain how creditors return has been maximised
- Disclose valuations
- Disclose marketing undertaken and by whom
- Identify the purchaser, the purchaser’s funding and any relationship to the company or its officers
- Identify the risks of trading and maintaining asset values
- Provide an analysis with supporting assumptions of theoretical outcome of forced sale in external administration and pre-pack sale or pre-pack plan
ARITA should start work on amendments to their code of professional practice to ensure IPs know their obligations in regard to pre-pack sales and plans when the safe harbour is opened.
The safe harbour if implemented as proposed and use of pre-packs may fundamentally change the restructuring and insolvency market.
Of some concern for creditors will be the lack of visibility of the professional fees paid to the qualified entity for the provision of their services. Further the lack of a broader accountability of the qualified entity may be of concern to some stakeholders. It should be remembered that an administrator seeking to formulate a restructuring plan or dispose of the company’s business is personally liable for debts incurred in undertaking the role. Directors will be protected from personal liability and qualified entities will have no accountability to those effected by their advice.
Will the fees of the qualified entity be recoverable for the benefit of creditors if things go astray? They may be recoverable as unfair preferences.
The success or failure of the safe harbour in engendering a rescue culture will depend to a large degree on the attitude of secured creditors having a general security agreement. They maintain the right to appoint a receiver or receiver and manager.
1. Finch, Vanessa 2009, Corporate Insolvency Law Perspectives and Principles, Second Edition, Cambridge Univerity Press, Cambridge.
2. McCormack, Gerald 2008, Corporate Rescue Law- An Anglo-American Perspective, Corporations, Globalisation and the Law, Edward Elgar Publishing Limited, Cheltenham.
3. The Treasury Australian Government 2017, Exposure Draft Treasury Laws Amendment (2017 Enterprise Incentives No 2) Bill 2017
4. Xie, Bo 2016, Comparative Insolvency Law The Pre-pack Approach in Corporate Rescue, Edward Elgar Publishing Limited, Cheltenham.