Insolvency - Down but not out
Stephen Byers wants to make it easier for "good" companies to avoid going under. It's a nice theory - if you can tell good from bad.
Stephen Byers wants to make it easier for "good" companies to avoid going under. It's a nice theory - if you can tell good from bad.
These are changing times in Carey Street. Quietly, a revolution is taking place in the laws on insolvency and bankruptcy. It’s more far-reaching than anything since the debtors’ prison was closed in the 19th century. And it could pose a new raft of problems for business.
At the heart of the issue lies an unresolved conundrum: just how should the law balance the rights of insolvent companies and individuals and their creditors? Stephen Byers, secretary of state at the Department of Trade and Industry, wants to promote a “rescue culture” in which ailing firms are nursed back to health. For individual bankrupts, he is considering cutting the automatic discharge period from the current three years to just one.
On the face of it, measures such as these sound sensible and civilised. But there are concerns that solvent businesses could find themselves picking up the bill in the shape of bigger bad debts if companies or individuals abuse a more relaxed insolvency regime.
What makes everything difficult is the fact that getting to the heart of the government’s plans involves unpicking a cat’s cradle of legislation, consultation documents and white papers to uncover the government’s intentions. Joined-up government is yet to penetrate insolvency law. The key markers are:
– The Insolvency Act 2000 which tidies up the 1986 Insolvency Act and also provides powers for the government to introduce the United Nations’ “model law” on cross-border insolvency (see panel, page 44) into British law.
– The Insolvency Service’s Review of Company Rescue and Business Reconstruction Mechanisms which lays out further proposals for reform. Byers has announced he is “broadly content” with its findings.
– The DTI white paper Opportunity for All in a World of Change, published in February, which confirms Byers’ intention to reform the law on personal bankruptcy in line with an earlier consultation document from the Insolvency Service called Bankruptcy: a Fresh Start.
Let’s start with the Insolvency Act 2000. Its main provision is the option of a moratorium for those small companies in financial difficulty that want to make a voluntary arrangement with their creditors. The aim of the moratorium is to provide enough time for the company to put a rescue plan to creditors. In this case, a “small company” has to meet at least two of three criteria – a turnover of not more than #2.8m, a balance sheet total of not more than #1.4m, and not more than 50 employees.
David Marks, a barrister at leading insolvency chambers 3/4 South Square, welcomes this provision. “It removes the risk of a sideways attack outside the courtroom on the assets of a company in a voluntary arrangement, so it ought to be encouraged,” he says.
But Stephen Gale, president of R3, the Association of Business Recovery Professionals, believes the moratorium doesn’t go far enough. “I don’t think the new provision will be used as much as the government thinks.
It will be a damp squib,” he says. It would be more effective, Gale says, if the moratorium was extended to all companies.
He also believes the government has failed to understand the reality of how voluntary arrangements are agreed. “They are not prepared overnight and take some thought and time. The idea that the voluntary arrangement has to be in final form before you seek the moratorium ironically makes the old administration procedure more attractive. You can go into court and get a (temporary) administration order to protect the assets from the creditors which enables the business to continue under that protection while it formulates and codifies a voluntary arrangement.”
In any event, in the review of company rescue and reconstruction mechanisms, Byers has suggested he wants to see administration rather than voluntary arrangements become “the most commonly used insolvency/rescue procedure”.
He says he is prepared to change the law so that creditors that hold a floating charge against a company’s assets don’t have the right to veto an administration order.
The review says: “This change is, we think, required to establish (or re-establish) the primacy of administration as a collective insolvency procedure and not one that automatically gives way to the interests of a secured creditor.”
This is potentially good news for trade creditors, although it arouses fury among banks. They often take a floating charge when they advance a company loan or overdraft. What’s made the working of the floating charge insidious is that banks have sometimes been prepared to scupper an administration which could return a company to financial health in order to get early repayment of loans, even though this means dumping trade creditors.
Running alongside insolvency law reform are the proposed Fresh Start changes to bankruptcy law. Byers’ approach is summed in his Opportunity for All white paper. He says: “We will ensure that those whose failure is honest are not punished or stigmatised, while increasing penalties for those who set out to defraud and those who are otherwise culpable.”
But firms with experience of pursing bankrupts’ assets are far from convinced they are so easily divisible into sheep and goats. “There are probably a small number of people who are rogues, but there is a huge number of people who are honest and incompetent,” says John Thirlwell, a director of the British Bankers Association. “We feel the government doesn’t really understand the reality of what goes on.”
Martin Hall, director general of the Finance and Leasing Association, whose 95 members advance 28% of the UK’s consumer credit and up to a third of its asset finance and leasing, agrees with this assessment. “There’s a middle ground occupied by the majority of bankrupts which lies somewhere between the rogue and the naive innocent,” he says.
But, according to critics, there’s a bigger flaw still at the heart of Byers’ proposals: it’s that entrepreneurs will be encouraged to take more risks by making it easier for people to recover from bankruptcy. Fresh Start suggests bankrupts should be able to keep up to #20,000 of the equity in their home providing they can prove they introduced a like amount of capital into their failed business.
Keith Mather, director general of the Consumer Credit Trade Association, is concerned about the broader reasoning behind Byers’ thinking. “If you have a true entrepreneur, the last thing he or she is thinking about when starting business is bankruptcy,” he says. “The existence of bankruptcy doesn’t deter an entrepreneur from starting a business. The only sort of person it might deter is someone who isn’t a risk taker anyway.”
Gale believes Byers has studied the US experience and drawn completely incorrect conclusions. “The fact that the US has an enterprise culture alongside benign bankruptcy laws doesn’t mean you can create the same culture in this country by introducing similarly benign laws. The premise is wrong and the analysis is flawed. I think it leads to confusion about what they mean by bankruptcy, because in England and Wales bankruptcy is a term used only for personal debt. In the States, it is used for all debt. Even at that basic level, the government has confused what it’s dealing with.”
Gale is concerned that Fresh Start’s headline proposal – reducing the discharge period from three years to one – is “bound to make bankruptcy more attractive than voluntary arrangements. But our statistics have constantly shown that the return to creditors in voluntary arrangements is better than bankruptcy.”
But Byers believes the worst downside from the more relaxed regime can be avoided by two proposals. The first is a greater use of income payment orders (IPOs) to compel bankrupts to make a contribution to creditors from future surplus earnings. At the moment, Official Receivers obtain around 2,500 of these orders every year, most with the consent of the bankrupt. This represents 10% of bankruptcies. The government concludes the remaining 90% don’t have enough surplus to bother about.
The second proposal is for post-bankruptcy individual voluntary arrangements (IVAs) supervised, for the first time, by the Official Receiver. Creditors should be no worse off than if they forced a liquidation of assets and a contribution from future income. The carrot for the bankrupt: automatic annulment of the bankruptcy when creditors have agreed to the IVA. This, suggests Fresh Start, would leave bankrupts in the same position as if a bankruptcy order had not been made.
But what about “bad guy” bankrupts? There’s a problem with serial bankrupts and with people – often dishonest company directors or sole traders – who play the system or resort to fraud. To deal with these, Byers proposes “bankruptcy restriction orders”. The idea is that they would work in much the same way as the current company directors’ disqualification regime. The Official Receiver would report to the Secretary of State that a bankrupt’s conduct warranted a restriction order. The Secretary of State would direct, at his discretion, that restriction order proceedings should be started. The order would continue the restrictions imposed by a normal bankruptcy. The main ones are a ban on acting as a company director and limits on obtaining credit.
So far, Byers hasn’t announced timescales for legislating on the company rescue or the Fresh Start proposals. But with bad debt an ever-present problem, FDs will be concerned that any new laws don’t make it more difficult to recover cash. Encouraging risk taking is all very well, but FDs won’t want to pick up the bill for anybody else’s bad decisions.
THE REVENUE CHANGES TACK
The government plans to do something about the perennial complaint that the Inland Revenue and Customs & Excise pull the plug on viable companies by scuppering voluntary arrangements. When this happens, the business goes down leaving unsecured trade creditors with nothing, while the taxman grabs what’s owing to him.
From April, the Inland Revenue and the Customs & Excise have been told to take a “more commercial attitude” to voluntary arrangements, especially when they are preferential creditors.
The two departments have set up a unit to handle voluntary arrangements. They say they will then consider voluntary arrangements in the same way as commercial creditors – on individual merits with a close look at whether the arrangement will make it more likely they will recover more debt.
They are also publishing the criteria they will use to judge voluntary arrangements. And they are setting out tight turn-round targets for responding to proposals.
Both departments will encourage insolvency practitioners to obtain confidentiality waivers so that the new joint unit can disclose its reasons when it rejects a proposal. Both say they want to avoid the accusation they’re acting under a cloak of secrecy when they turn down proposals – as they inevitably will.
However, the move is likely to amount to more spin than substance because both departments retain their status as preferential creditors. So it won’t generally mean that unsecured creditors – usually the trade creditors – get a larger slice of the pie.
Stephen Gale, president of R3, the Association of Business Recovery Professionals, says: “The measure sounds good. Whether in practice it changes the departments’ attitudes, we will have to wait and see.” Gale believes the best way to make government take a more commercial view is to remove its preferential status as a creditor. “The real mischief in preferential status isn’t that the government gets the top slice of money. That gives the government, through its various agencies, significantly greater power over the rescue process because it is preferred rather than part of the solid ranks of unsecured creditors.”
All of which means that the taxman will still have a first grab at any assets when companies go bust.
FOREIGN DEBT COLLECTION
It could become easier to collect debts from insolvent companies in other countries when the government implements the new “model law” on cross-border insolvency into British law. The model law was adopted by the United Nations Commission on International Trade Law (UNCITRAL) in 1997. The Insolvency Act 2000 gives the government power to make it operational in Britain.
When the model law was introduced, UNCITRAL chairman, Joseph Bossa, said it was designed to provide a “modern, harmonised and fair legislative framework” for cross-border insolvency. So far, only three countries have written it into their law – Eritrea, South Africa and Mexico. But the pace looks like picking up. After being vetoed by President Clinton, the model law is being introduced by the Bush administration. There is also movement in Japan, Australia and New Zealand.
Neil Cooper, president of INSOL, the international organisation of insolvency practitioners, says he believes that the UK government does have plans to reform section 426 of the 1986 Insolvency Act to incorporate the model law into UK legislation. According to Cooper, a partner at accountant Kroll Buchler and Phillips, the government will also use the opportunity to incorporate the European Bankruptcy Regulation into English law. It is due to come into force across Europe in May 2002.
David Marks, a barrister specialising in insolvency law, says harmonisation of European and international cross-border practices is long overdue.
“It will make the administration of cross-border insolvencies, which are bound to become more frequent, easier, and ensure there is proper harmony between insolvencies in more than one country,” he says.