Risk & Economy » Regulation » Waving not drowning.

With foggy economic outlooks for many market sectors, increasing numbers of FDs will find themselves focused on steering clear of insolvency. Could new measures provide a practical survival aid?

The measures in question reside in the incoming fast-track administration process introduced by the Enterprise Act 2002, a process more in tune with the debtor-friendly Chapter 11 procedure in the US. Directors will be able to appoint an administrator by simply filing a Notice of Appointment at court, with no hearing before a judge required. This means companies will be able to shelter rapidly behind the protective barrier to creditor action that administration offers.

In addition, the objectives of the administrator have been changed. The Enterprise Act has made the primary purpose for an administration process – to save the company as a going concern as opposed to the underlying business. “The philosophy behind this is that of the rescue culture,” says Jonathan Rushworth, an insolvency expert and partner at Slaughter & May. “The emphasis is on trying to save the company itself.”

Only if the administrator decides that the corporate entity cannot be saved does he move on to the next objective – achieving a better result for the creditors as a whole than would be achieved on a winding up. Failing that, the administrator’s final objective is to realise the company’s property to make a distribution to secured or preferential creditors, provided this does not unnecessarily harm the unsecured creditors’ interests.

As far as directors are concerned, the new streamlined administration process gives them an opportunity to take the initiative in putting the company into administration rather than, for example, letting a secured creditor – typically the bank – take control by appointing an administrative receiver. In fact, banks or other lenders that obtain security against their loans will no longer be able to appoint an administrative receiver.

They will be able to veto the company’s choice of administrator, or appoint one themselves, but the emphasis will be on saving the company.

Even if a lender still has the right to appoint a receiver because security was obtained prior to the Enterprise Act, the lender may well still support an administration. Alan Bloom, head of corporate restructuring at Ernst & Young, says banks are proving themselves more willing to back the more collectivist administration process rather than appoint their own receiver.

“There are many situations where banks are allowing companies to file for administration, even where they have a floating charge,” he says.

“You can only assume that if this is happening before the new legislation, we will only see more of it afterwards. Banks want to demonstrate to the market that they genuinely make a distinction between responsible and irresponsible management teams.”

The emphasis on ‘responsible’ is important. It means taking a pro-active stance once there is any doubt about the company’s solvency, whether on a balance sheet basis (where assets have become less than liabilities), or on a cashflow basis (being unable to pay debts as they fall due). Being pro-active includes stepping up activity for collecting debts and focusing on cashflow management. “As soon as you experience financial difficulties, managing for cash is vital,” says Nick Dargan, head of the insolvency team at Deloitte & Touche. “It’s important to prepare short-term cashflow forecasts and rolling cashflow forecasts for, say, a 13-week period, so you can see if you’re going to run out of cash.”

Management teams should also take legal advice, bearing in mind that trading when a company is insolvent exposes directors to personal risk through charges of wrongful or fraudulent trading. Not only is there a risk of financial responsibility – having to make a personal contribution toward the company’s liabilities – but it could lead to potential disqualification as directors.

“Directors need to understand the risks to them personally,” says Jeremy Willmont, insolvency partner at Moore Stephens. “Once you know or believe there’s a possibility the company will become insolvent, your prime duty is to protect the creditors.”

Mike Jervis, business recovery partner at PricewaterhouseCoopers, suggests that the new streamlined administration process may increase the pressure on directors to take action fast. Let’s say a director knows his company is likely to encounter financial difficulty in three months’ time, yet takes no mitigating action. “If you don’t make use of the new administration process, people might point the finger and ask, ‘Why not?’,” he says.

Advice on the company’s options – be it on restructuring, refinancing and/or entering an insolvency procedure – should be sought from corporate recovery specialists. Directors have traditionally been wary of calling in corporate recovery or insolvency firms, fearing they would be too eager to push for receivership or liquidation. The prime objective of the administration procedure should provide some reassurance that this won’t happen, as long as there is a practical possibility that the company can be saved.

Seeking help from corporate recovery experts needs to take place early. “The earlier you file … the greater the pressure on the administrators to come up with a corporate solution rather than a business and assets solution,” says Bloom. “If you leave it until the last moment, the administrator may say, ‘I can immediately dismiss the possibility of rescuing this company because it has been left to the point where there’s nothing left. The assets are miles less than the liabilities.'”

The potential for a company to emerge intact from an administration also depends on the causes of the insolvency. If the company is floundering because a change in the market has made it uncompetitive or rendered its products obsolete, then the realistic option may be to close down. In this case, traditional liquidation is likely to be the outcome and the new streamlined administration will not increase the company’s chances of survival.

For the new streamlined administration process to have some practical value, there has to be a viable business – in part, even if not in total.

For example, if the company’s solvency is threatened by a one-off event, such as problems with funding the pension fund, then the new streamlined administration process may be of help. “We often see companies where the main business is viable, but then they are hit by a big liability,” says Jervis. “There may be a big hole in the pension fund, which it is obliged to fill. The new administration process may be invoked by the directors to avoid insolvent trading from a personal perspective, but it can also put pressure on extraneous (pension fund) creditors to come to the table and do a deal within the insolvency process. Then the company can come out and it’s business as normal.”

Alternatively, if a retail business is suffering through the underperformance of a few outlets, entering administration early may facilitate a restructuring – selling off or closing down the bad performers to leave profitable units intact. “Say you have a retail business with 10 shops and a rent review is coming up in June,” says Jervis. “You know the rents are going to soar because there hasn’t been a rent review in five years, and that’s going to turn you from a marginally profitable company into a loss-making one. Add to that the fact that the retail market looks pretty soft at the moment. The management team may think the business is worth #1m, but if they stick their heads in the sand, come 1 July, if they can’t pay the rent on their stores, it may be worth -#1m because they have creditors they can’t pay.”

Imagine that in this scenario the management team knows the bank won’t increase its exposure and the directors don’t want to give personal guarantees.

Jervis says directors could consider wrapping the company in the protective blanket of an administration in April. “Then they could get rid of the underperforming stores to improve the profitability of the remaining business,” he says. “They could try to do deals with the landlords inside the protection of the legislation.”

Opting for a fast-track administration not only brings the advantage of protection from creditors petitioning for a winding up, it can also help to strengthen the company’s negotiating position. For example, a landlord may prefer to do deal than face the tenant being wound up and risking a period of empty office space.

Assuming there is a viable, profitable business struggling to get out, the key to survival is to prepare a business plan that will persuade lenders, creditors and other important stakeholders, such as shareholders, that the business deserves their ongoing support. This plan then needs to be presented to the stakeholder groups.

Getting the lenders onside is critical. “They are the people who can extend your credit,” says Dargan. “They need to understand why you are experiencing problems and how you are going to turn around the underperformance to ensure the business remains viable. You need to keep your lenders informed about the steps you are taking to achieve profitability and to manage your cash.”

The rescue plan may well involve getting agreement from creditors to write off a proportion of past debts. This requires keeping creditors informed. “If you communicate with people you have a better chance of getting their co-operation than if you bury your head in the sand,” says Dargan.

There is no doubt that keeping the support of suppliers can be a challenge. Directors need to persuade them they will do better in the long run if the company continues to trade and the suppliers retain its custom. “There are upsides (of administration) for creditors in terms of continuity of supply,” says Jervis. “It’s also the case that where receivership is followed by liquidation, the process tends to be elongated and costs increase because you can’t have the same insolvency practitioner handling the liquidation. So creditors are likely to benefit from keeping the company intact.”

Famous corporate rescues, such as Railtrack and Canary Wharf, suggest that the administration process not only saves the company, it may also save the directors. In both cases, most of the directors remained in situ.

Bloom points out that these are not typical examples, nevertheless, they offer the hope of a positive outcome for directors who act swiftly.

“To suggest that all directors will survive an administration is definitely not the case,” says Bloom. “But the earlier you move and the more responsible you are, the greater the chance you will survive.”

“Credit control systems should ensure that payment policies are being adhered to,” says Stuart Hopewell, credit manager at Fujiphotofilm UK. “There’s not much use having 30-day credit terms and allowing debtors to pay in 60 or more.”

Retention of title clauses should also be reviewed. They should be an ‘all-monies’ type, not reliant on tracing back to specific shipments.

Although such clauses will be rendered inapplicable after an administration order is granted, having them in place will allow creditors to reduce exposure in the preceding period. “Such terms and conditions should be acknowledged in writing by the debtor concerned at the outset of trading if they are to be effective,” says Hopewell.

Such clauses no longer apply once small companies preparing proposals for a company voluntary arrangement have entered the protective moratorium period.

Applying strict credit-control procedures when supplying smaller companies is therefore doubly important.

Hopewell points out that the removal of Crown Preference, another result of the Enterprise Act, may backfire. Now that government departments, such as Customs & Excise, are no longer able to recover taxes ahead of other creditors, they may put more effort into collecting debt on a timely basis, in effect, competing with ordinary creditors for funds.

For such ordinary creditors, communicating with customers is vital. “Given that directors can now apply for their own administration order, that old mantra ‘get close to the customer’ has never been more valid,” says Hopewell. “All finance directors and credit managers should cultivate closer ties with their major accounts so that if problems arise, they are not surprised.” If a customer does enter administration, creditors should take an active interest. “When the axe falls, a proposal will be put to creditors by the administrator, and this is their opportunity to have a say in the outcome,” says Hopewell. “… it is incumbent on creditors to play a part if they are to reap rewards.”