In this episode, how will businesses emerge from Covid-19 as things start to normalise in 2021? What will happen to the addition debt many businesses have built up over the past year and what are the options for company directors dealing with debt, liquidity and insolvency issues?
Hello and welcome to the Mishcon Academy Digital Sessions podcast. I’m Paul McLoughlin, Restructuring and Insolvency Partner at Mishcon de Reya and I’m joined remotely by my colleague Raza Khan, a Legal Director in the Restructuring and Insolvency Team.
Raza, I don’t know about you but I’ve certainly seen an increase in enquiries over the last few weeks from companies large and small concerned about the additional debt that they’ve incurred over the past ten months and concerns about how they’re going to deal with it going forward as things start to normalise. What about you? Are you seeing similar things with your caseload?
Hi Paul. Yes. No, absolutely. Very similar kind of enquiries that we’re receiving and dealing with. I suppose what you do feeds into what we do which is concerns around debt feed into larger concerns about solvency and restructuring and whether or not a formal insolvency process may or may not be appropriate. There is, however I would say, generally speaking, a gap between what’s happening in the real economy and what feeds into the kind of work that we do and given that there are also plenty of Government support measures in place, I think what we and the clients that we act for have a feeling about is that it’s probably not going to be until spring or so that some of the leads and the enquiries that we’re dealing with now turn into more formal pieces of work and more sort of restructuring options come to fruition. But just going back to what you were mentioning at the start there Paul, in terms of indebted companies and companies with, with liquidity issues, what sort of issues are you getting enquiries about and what sort of work are you dealing with right now?
Well, I suppose the key thing is that over the past ten months there have clearly been a number of sectors, hospitality, leisure, casual dining, retail, where business has been enormously distorted and a number of those companies have had to take on additional debt both in the form of bounce-back loans and business interruption loans through the Government support scheme, but also additional debt with their own lenders. In addition to that we have the VAT deferral scheme which is due to come to an end in March 2021 where companies will have to start paying back that deferred debt at some point next year. Either at one go or possibly through instalments. We will see the end of the business rates relief for retail and leisure and hospitality which is due to come to an end in April 2021 and I think probably the most pressing thing for many is the fact that the restriction on landlords in particular issuing winding-up petitions for unpaid rent will come to an end towards the end of this year and I think when you put all of that together there is a sense of a potential storm brewing for those companies that in some way, shape or form are going to have to deal not just with the, the problems they may have had before the pandemic but certainly the problems that they’ve accumulated with taking on additional debt or deferring obligations to creditors. And I think looking ahead it’s great that the vaccine is coming through and I think there’s a lot of positive feeling about that and I’m sure there’ll be a positive rebound for many businesses but I think the fact remains that a lot of businesses will still have to deal with this debt hangover and depressed revenues through 2020. And 2021 is going to be the year where those problems have to be fixed in one way or another. And so what we’re going to have are many businesses saddled with debt, playing catch-up with their trading position and I think for any company with an excess of debt burden, it’s going to cause some fairly fundamental problems. And I think the things that are going to be on the minds of most directors will be basically insolvency. Both cash flow test insolvency and balance sheet test insolvency. I think as you and I know, the cash flow test issue is much more relevant for directors who want to continue trading the business. But related to that is how do they preserve liquidity? Cash is going to be tight and decisions will have to be made about who they pay and who they may defer for a period of time. I think particularly on the landlord side there is a risk of creditor action. It could come from landlords to enforce payment of deferred rents. It could come from suppliers or it could come from secured lenders who aren’t willing to accommodate any further time or help to, to some businesses in distress. But I think the thing that’s probably on the minds of many directors right now will be their own personal position, their own duties in situations where they’re looking at dealing with significant debts. But I know you’ve certainly been looking at that recently and perhaps you can just share with us your thoughts on that particular issue?
Sure Paul. We have been dealing with a number of distressed companies who have directors on the Boards of those companies who have various concerns and we’ve been advising them, obviously, this is the sort of work that we did prior to the pandemic but these kind of issues are occurring more and more and obviously as you’ve mentioned this is a concerning time for a number of businesses. There are liquidity issues. There are cash issues. And that feeds into the concerns that the directors have because as we know, in a solvent company the duty of directors is to do the best for the shareholders of the company and that duty shifts as soon as a company is deemed to be insolvent according to the test that you referred to, the cash flow test and the balance sheet test. So, you have a number of companies now who fail either of those tests and because they fail either of those tests the duty of the director shifts from being one that’s primarily owed to the shareholders of the company to being a duty that is owed to creditors of the company and that really is a very significant shift in a number of different ways. Because what it means is that each and every director has to consider every decision that they take in the context of what is in the best interest of the creditors of the company rather than the company shareholders, a very significant shift in mindset and operationally as well. And the reason why that shift is important and the reason why directors need to be very mindful about the way in which they act and the way in which their decision-making process works is that if they don’t, then they do potentially expose themselves to various different heads of liability because if and when a company goes into a formal insolvency process there are certain claims that can be brought against directors personally by a subsequently appointed administrator or liquidator. And I guess the one that directors have always been probably most concerned about is what we call ‘wrongful trading’ which is an offence under insolvency legislation. And in a nutshell what that is, is where a director knew or ought reasonably to have concluded that there was no prospect of a company avoiding liquidation and they also didn’t take any steps to minimise losses to creditors. It’s really akin to a negligence action so that there doesn’t have to be any malice or fraud involved here. This is why it’s a concern for directors. They don’t want to have a Court scrutinise all the decisions that they took and they absolutely don’t want to have to personally contribute to the company’s losses which is what would happen if a successful wrongful trading claim was prosecuted. I think you mentioned that there’s been some Covid-related legislation that’s been passed that prevents for example, landlords issuing winding-up petitions against defaulting tenants. Well, there has been as part of the same legislation some other provisions that restrict wrongful trading claims between March and the 30 September. And basically, in essence it makes it very difficult for a claim during that period to be brought and the thinking behind that is they realise that companies are going to be in difficulty. They don’t want to prevent them from trading or they don’t want to see them shut down and on that basis what the legislation says is that there’ll be a presumption that the directors of the company are not responsible for any worsening of its financial position for that period, the period being from March to the end of September. So, you’re not really going to see in practice any wrongful trading claims being brought during that period but it’s not the end of the story. It’s not a rogues’ charter because there are lots of other offences that a director needs to be concerned about such as fraudulent trading which as the name suggests does require an element of fraud to have been committed by a director. There’s also misfeasance, although again that probably bleeds into the general climate that the legislation has created which is far more forgiving of directors.
There are various other risks that a director also needs to be aware of in this climate. So, for example you were talking about debts that the companies had incurred or credits that they had incurred and quite often especially with smaller companies these debts are guaranteed personally by directors. Now, clearly there might be issues with repaying the underlying debt which would cause those guarantees to be called and that’s clearly of concern to a director and they need to navigate through that. They need to understand what that will mean for them. What rights they may or may not have under the documentation. And they also more generally need to consider whether or not they are good for these guarantees if they are called. Another issue that directors need to be aware of and concerned about are some of the other claims that an administrator or a liquidator could bring. We call them antecedent transaction claims. So, for example a preference, a so-called preference where a company is influenced by a desire to prefer one creditor over another. That is quite often what we see when companies are in distress. They decide to pay one creditor in full or in part and ignore all the other creditors. That could be a preference. Equally there’s an offence called a transaction at an under value and that’s where a company gifts an asset or transfers an asset for considerably less than the value of that asset. And in both those circumstances, if an administrator or liquidator makes good a claim like that then the Court has very wide powers to for example, reverse the transaction but more importantly for a director they can require a director to personally contribute in respect of any losses suffered by the company arising out of that transaction. So, that’s another real concern for, for directors of distressed companies and something that they definitely need to be aware of. A lot of these kind of issues are mitigated by taking advice early, the advice of independent solicitors, the advice of insolvency practitioners as appropriate. A lot of this is mitigated by paper trails. By good governance, by meeting regularly. By preparing and considering financial information. The more of that you can do as a director, the less likely it is that a legal claim will be made good. So, that’s very important for a director to bear in mind and it really does make getting early advice extremely important to try and mitigate future legal risk. I mean, I mentioned consensual restructuring Paul and that’s obviously an area that you work on. What sort of issues do you see in this kind of climate and how do you see consensual restructuring working?
Well, it’s a good point Raza. I mean, restructuring has been a big buzz word over the last twelve months and even before that and certainly with a lot of large retailers restructuring their balance sheets using company voluntary arrangements in particular. There’s been a lot in the news about companies using schemes of arrangements and indeed a lot about the new regulatory regime that came in earlier this year with a new Corporate Insolvency Act, which is certainly designed to help businesses that have been struggling as a consequence of Covid to try and put in place measures to go through some kind of business rescue process. But I think for most businesses there are two kinds of restructuring. There is a consensual restructuring regime and a non-consensual and broadly speaking a consensual restructuring is typically used where there can be an agreement or a compromise with certain creditors or landlords or suppliers and it’s all done on a consensual basis and so there’s no need to use any kind of statutory scheme or process or insolvency mechanism. It really is just about an agreement between the company and its various creditors. But it’s fair to say that that kind of restructuring tends to be more typically used for companies that have a more simple capital structure. Perhaps with a few lenders or a small number of landlords, that when the capital restructure becomes more complicated and there might be different kinds of lending in place whether it be some kind of syndicated lending or high-yield or unitranche facilities. I think in those situations consensual restructuring becomes ever more complicated simply because it’s always difficult to try and get all of these individual creditors to line up and agree to a consensual restructuring plan. But having said that it is usually the cheapest and the easiest way to go about things. I think in terms of all of those stakeholders it really is the banks, the lending banks, who tend to be the most important stakeholder. That is because they will tend to be secured creditors and if they get to a stage where they lose faith in the business or the ability to implement a restructuring process, they always have the ability to enforce their security. And enforcing security really is the end of the line for most companies. It will involve the appointment of a receiver or an administrator which is basically an insolvency process. But there is now a very long tradition of banks, particularly English banks, UK banks, being amenable to working with borrowers to help them through difficulties and to try and help them to restructure their balance sheets in some way, shape or form. That tradition certainly predates the 2008 financial crash but I think after 2008 there was a lot of activity and most banks had dedicated restructuring teams or workout teams or business support teams, they call them different things, and there was certainly a mentality that businesses should get the benefit of support where possible. Of course, in the aftermath of 2008 there, there were criticisms of certain banks about the way they were treating customers and there were certainly reports by the FCA which made reference to certain behaviours and so I think, you know, it’s fair to say that a lot of businesses may be reluctant to approach banks with some of that noise in the background. But I think the key thing is that particularly with the Government support for business restructuring coming through the Corporate Insolvency Act and some of the new measures that have been put in place and certainly because of some of the financial assistance that the Government has put in place for many, many businesses, I think the prevailing mood will be that stakeholders should work together and they should try and find solutions. When we talk about a consensual restructuring it’s really about the debt and the creditors of a company and in terms of fixing that, it may be a case of putting new debt in place to preserve liquidity. It may be a case of trying to take some debt off the balance sheet, either by selling assets and paying down debt but also by measures such as a debt equity swap, which is effectively converting debt into equity. So, all of these regimes have been tried and tested and they certainly have been used in the past but I guess many people will say to themselves, “Why would their lenders? Why would their banks agree to do something like that?” And what it boils down to is quite simply a lender will take an economic decision as to whether it’s likely to recover more from an insolvency process or from enforcing security or whether it’s likely to get a better return on its exposure by continuing to support a business and allowing it to go through some kind of restructuring process so that in the longer term that bank will get a better financial return if the business is allowed to survive and continue trading. And that’s really at the heart of the decision for most banks.
I guess the other thing that is very relevant, again particularly to UK banks, regulated banks, is the reputational and political rationale for supporting businesses as well. It’s fair to say that traditionally many banks have valued their relationships with business customers. Banks make profits not just from interest on debts but from all manner of business services and payment systems and so where they can support, they will support. I think one thing that we should just mention there is that since 2008 there have been more examples of traditional bank lenders selling their debt exposure to distressed borrowers into the secondary debt market where distressed buyers and hedge funds and other similar parties will effectively buy this debt and step into the shoes of banks and try and go through some kind of restructuring process. But it’s fair to say that dealing with that kind of lender is very different to dealing with a traditional bank lender so it’s just something to flag and it’s something I think that anybody who has a debt exposure to a bank should be mindful of. They need to know who they are dealing with and they should be conscious that most banks have the right to sell these loans into the market at any time.
I think that’s a really important point, Paul because that’s something that we’ve certainly been dealing with over the last number of years. It didn’t happen in 2008 but from about 2010 onwards you saw these hedge funds buying large property portfolios for example. It definitely completely changes the landscape and I suspect quite a lot of that may well happen again, albeit may not happen immediately. I don’t know what your view on that is?
Well, I think it will. I’m certainly conscious that a lot of banks have made it very clear in their facility agreements, loan agreements with borrowers, that they do have the right to assign or sell those loans into the secondary market. Sometimes only after an event of a default but increasingly without an event of default. So, it’s really a freedom that the banks have. And I think the important thing for banks is that certainly after 2008 when there were problems they would often deploy debt equity swaps where effectively the bank would end up taking equity in the borrower in the expectation that as things improved the banks would recover value through the equity. Post-2008 the regulatory regime for banks has changed and it’s much more difficult for a bank to be able to deploy that kind of restructuring strategy. And so increasingly they might be more inclined to move towards sale of assets or sale of businesses to repay debt or indeed to sell this debt into the secondary debt market. And I think that’s where borrowers need to be mindful about that particular problem arising and how they might deal with that because it is very different to dealing with their traditional lending banks.
Just in terms of the consensual process, I mean it is important to emphasise that this is a well-trodden path. It’s happened a lot. Banks are used to dealing with these situations and banks are used to supporting these situations. And so for those businesses that do have balance sheets which are over-inflated with debt, the best thing to do is to recognise that, to take it on board and to start thinking sooner rather than later about how to engage with stakeholders and creditors in terms of reaching some kind of accommodation or compromise in how that problem is going to be resolved going forwards. It is recognised that where borrowers are in difficulty, banks and lenders should wherever possible try and give time and breathing space to directors to try and work through those problems and, and usually in a formal way, either in a waiver or a standstill, which is a temporary period of time for banks to effectively stand still, not to enforce debt claims and not to enforce security and give directors time to work through problems with their advisors and with the Board and with their shareholders and come up with different proposals. Clearly, one of the biggest issues is access to new money and sometimes that is an urgent matter and again there are principles which say that where new money is required by a business in distress, that anybody providing that new money will effectively get super-senior priority both in terms of repayment of that money before existing creditors and in the event that the company should go into an insolvency process, it will get first ranking call on the assets. Assuming it’s secured. On the company side, there is a principle that directors who get that kind of accommodation with their lenders, should be prepared to disclose information to the lenders and to their advisers so that everybody has good and accurate and timely information so that they can plan and make decisions going forwards about restructuring the business and restructuring the balance sheet. And related to that clearly some businesses may have fairly simple capital structures with one or just a few lenders which makes it much easier. Others might have different layers of debt through an inter-creditor process. But the key principle for all parties is that the rights of all lenders should be respected from the date of any standstill or any waiver and it wouldn’t be right for example to sell assets and then start repaying one creditor after a waiver has been given by other creditors. And typically banks will impose restrictions on what a Board can do or can’t do and so typically if there is this kind of waiver period directors, companies won’t be able to pay dividends, they won’t be able to sell assets without consents. They won’t be able to make payments to directors or repay loans to directors. But really, that’s all designed around preserving the asset base and preserving cash through this period of instability whilst people work out what the options might be. So, in terms of the consensual restructuring process, it is a well-trodden path. It is possible creditors, banks are amenable to this but the more creditors or the more stakeholders there are, the more difficult it is to achieve that kind of consensus. And I think when you get to that stage there are different mechanisms which can be deployed which mean that any creditors who might not agree or might dissent or might have different objectives, can in some way, shape or form be dealt with. But that’s using more statutory processes either Companies Act or Insolvency Act processes. But again, they are well-trodden and well-used and I think Raza you’ve certainly looked at some of those recently for some of your clients.
Yeah, that’s right Paul. You mentioned that quite often you have a situation where the debt can’t be restructured. You have too many creditors, too many stakeholders that aren’t prepared to give any forbearance to the company and in those kind of situations the company has no alternative but to consider whether a formal insolvency process may be appropriate. I guess one type of process we’ve seen a lot of recently has been in the news a lot is what’s called a company voluntary arrangement. Now, this is a kind of debtor and possession type remedy and it’s been used in a lot of high street retailers. So, you have retailers who have large property portfolios on the high street. Most of these or some of these are over-rented. They decide in order to compromise some of those lease liabilities to enter into what’s called a company voluntary arrangement. And what that is really that’s just a contractual plan that’s agreed with creditors and I suppose the advantage for the company is that there is what’s called a cramdown. So, if 75% plus in value of the unsecured creditors of the company agree to the proposal put forward by the company supported by the insolvency practitioner who, if the proposal’s implemented becomes what we call the Supervisor of the arrangement. If all that goes through and it’s all voted upon then potentially 25% of dissenting creditors are crammed down and have to agree to and abide by whatever plan has been voted on and approved by the creditors. And so what that is is it’s quite a useful tool to effectively cramdown dissenting landlords and that’s what it’s being used for and there’s been a lot of case law where aggrieved landlords feel that they’ve been disadvantaged and they’ve applied to Courts to effectively overturn the CVA. So, we have seen quite a lot of that as well and I think we might well see more of those going forward.
I think on that Raza, it’s interesting that you’re right that CVA regime has been used principally for retailers and others with large leasehold portfolios to effectively cramdown their landlords. But it was interesting to note that a couple of months ago R3 which is effectively the professional body for restructuring lawyers and bankers and accountants published a new form of CVA proposal and it's a standard form of proposal with standard terms and conditions but it’s certainly not aimed at landlords. And it’s interesting that it's effectively recognising a lot of companies will have creditor pressure going forwards. And this particular CVA proposal aims to bind all creditors not just landlords, supplier creditors, HMRC and others. And effectively it’s not, the way the proposal is drafted, it's not suggesting that there is a variation to the terms of contracts other than to defer payments that are due for a period of time. And it’s typically between two and five years under a CVA. And so again the question is, why would creditors agree to do that? And I think the answer has to be that it is possible that by doing so they will get a better return over a longer period of time than they would if the company fell into an insolvency process today. But it was interesting that that CVA process has now effectively been extended beyond the landlord creditor community to a wider audience. And helpfully there was some guidance issued by HMRC which recognised this very issue and said that in certain circumstances, providing certain conditions had been satisfied, that HMRC would in principal be willing to support that kind of proposal.
As you say, perhaps given the climate that we are in companies may seek to use it in a slightly different way to the way in which it so far has been used. And I guess even if a CVA doesn’t work, even if the company has to go into a more terminal insolvency process, that’s not necessarily the end of the story for a company or its directors because one thing that is fairly commonly used is what we call a pre-pack insolvency sale. And that makes a lot of news. It’s quite controversial. I’ll just to explain what that is, I mean that’s where administrators or prospective administrators are engaged and approached with a view to putting the company into administration and what they do is they market discretely and attempt to agree a sale of the business and assets of the company. They do that. They agree and negotiate that sale. They are appointed and then immediately upon their appointment they execute that sale documentation which means that the business and assets of the company is transferred to a different company which can often be associated with the existing directors or shareholders. The reason why that’s, or can be controversial is that creditors feel they have somehow been stiffed and that the very same people who have run the company into the ground are now carrying on with impunity. But I mean there are very good reasons why a pre-pack may be a good option. You know, in that the goodwill of the company is preserved and the value is preserved in that way. You avoid the cost of the administration process. The continuity of employment of employees is preserved. One thing I was going to say was that we’ve talked about consensual processes. We’ve talked about CVAs and pre-pack administrations. There is almost a halfway house between formal insolvency processes we mentioned there and consensual restructuring. And that is in the form of some new legislation that was introduced as part of the Corporate Insolvency and Governance Act and that provides for a freestanding moratorium which gives a short period during which a company is protected from external legal processes including enforcement. We haven’t seen a lot of these to be honest since the legislation was introduced but it may be something that could be used in, in certain cases where a company is perhaps on the cusp of agreeing some new cash injection or agreeing some sort of compromise with the banks or creditors. So, it may be an appropriate option for some companies, albeit as I said we haven’t seen a huge amount of them since the legislation was introduced.
Great, thanks, Raza. Well, look that’s really helpful. I think there’s a lot to think about for any directors that are grappling with issues around debt and banks and lenders and solvency and liquidity. The biggest thing for any director is to make sure you look ahead and spot these issues before your business runs out of money. It’s much easier to go through this process with some cash, with some liquidity than it is when cash runs out and the company faces a real risk of insolvency. And I think finally, because of some of the changes in legislation over the past year and some potential changes coming in in 2021 the UK legal regime is now debtor friendly. It is designed to help businesses and companies and directors who are in difficult times. So, there are lots of options. But again, the key message is to start looking at those options before there’s a real liquidity crunch.
Well, for now let’s end it there. I’d like to say thanks so much to Raza Khan for joining me for this Mishcon Academy Digital Sessions podcast. I’m Paul McLoughlin and do look out for the next episode in the series.
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