The insolvency twilight zone

ASIDE from the duty to promote the success of the company for the benefit of its shareholders, directors are also subject to a duty to exercise reasonable care, skill and diligence.

There is usually a period in retail when trading deteriorates, perhaps due to new competition, increased costs in the business or reduced customer spending. This ‘twilight zone’ poses more difficulties for directors in terms of their duties than when the company is insolvent. At the point of insolvency, the director’s efforts must be switched to considering creditors’, rather than shareholders’ interests. During the twilight zone it isn’t so clear, so directors will, in practice, seek to consider both shareholder and creditor interests.

Identifying entry into the twilight zone is difficult. There are insolvency law provisions which look at a period of up to two years, ending when an insolvency practitioner is appointed. It is easy, once an insolvency practitioner has been appointed, to determine the start of the period, but not so easy to predict when insolvency is inevitable.

Directors must be alert to when the company begins to decline and when it is on an unstoppable downwards slide. It is vital for each director to identify the point at which he knew or should have realised that there was no reasonable prospect of the company avoiding insolvent liquidation. From this point the director can be personally liable for debts incurred by the company unless he has taken every step with a view to minimising losses to the company.

Retailing with private equity investment

Private equity and exiting owners usually hold loan notes issued by the Topco which reflect their investment and expected return on investment. Any bank debt the group requires is usually lent to an intermediate holding company. The trading subsidiaries will not typically directly borrow bank debt, relying instead on intercompany borrowings for working capital purposes. They will be guarantors of the Intermediate Holding company debt and part of the security nexus.

When things begin to go wrong and issues arise with banking covenants and ability to service debt, the directors will have to consider their duties to differing constituencies of creditors depending on which entity within the group they are looking at.

At Topco level it is unlikely that there will be any debt other than the Loan Notes, probably unsecured, and the contingent liability to the bank through the guarantee. It is probable that creditors at this level are not immediately repayable and no additional credit is being incurred. These creditors are likely to see it as being in their interests for trading to continue, in the hope that all will come good in the long run.

At intermediate ‘Holdco’ level, the main creditor is likely to be the Bank. Here, debt continues to accrue in the form of interest and debt service is also an issue. Other than some overheads such as head office space and utilities there is likely to be little other debt. The bank will have a very clear idea of what it sees as being in its best interests and once the Holdco becomes stressed, the directors will need to pay close attention to the requirements of the bank.

Difficulties often arise when the interests of the bank do not align with the interests of the shareholders and loan note holders. Occasionally, directors at Holdco level can find that their ability to comply with the bank’s wishes can be impeded by an Investors Agreement which restricts the ability of management from taking certain steps such as disclosing information or starting a disposal programme without Majority shareholder consent. Much time is spent on negotiations between the secured creditor and shareholders, particularly private equity.

Curiously, at Tradingco level the directors can have less difficulty because it is in the secured creditor’s interests for the trading company to keep meeting its obligations to creditors. If security is to be enforced, it is likely to be at Intermediate Holdco level allowing a disposal of the entire shareholding of the trading companies. If this is the case, the directors of the trading companies may be more comfortable in continuing trade in the knowledge that creditors at this level will be paid in full, even if the secured creditor does eventually enforce its security.

Whatever the eventual outcome, directors must recognise that they are dealing with different constituencies of stakeholders in each company within a group and to consider their duties to each separately. Sometimes the fact that there are different groups of creditors is of help when directors have to consider whether they can keep a company trading for long enough to allow for a successful restructure and rescue.

With many commentators predicting that the economy will flat-line during 2012, retail directors should stay alert to the changes in their duties and to the position of the company, rather than the group, especially as trading conditions for their business change.

Patrick Cook is head of corporate turnaround and insolvency at Burges Salmon