Insolvency is not the only answer

Sheena Frazer and Amy Jacks at Mayer Brown describe the restructuring options that are available for businesses, aside from insolvency

Two years ago, the restructuring community was anticipating a wave of formal insolvencies as the Covid-19 pandemic hit businesses across industries and geographies with the impact of Brexit also biting. Two years on, overwhelming financial support has kept insolvency rates low and supported otherwise weak businesses who now enter 2022 with greater debt from government-backed Covid loans.  

This year brings further challenges - the conflict in Ukraine is impacting an already fragile supply chain with global shortages of key commodities and substantial increases in raw material and freight costs now driving up energy prices globally to unprecedented levels.  In April, UK inflation reached a 40 year high of 9% leading to interest rate rises in March and May 2022. 

Against this backdrop, many businesses are having to invest to get fit for the future and remain viable while, at the same time, adapting to some of the permanent cultural shifts such as the need for focus on ESG in order to obtain investment and remain attractive to their client-base.

At the height of the pandemic, insolvency rates dropped significantly in part due to temporary legislation preventing certain enforcement action and the state support. From January 2022 we have seen a steady increase in insolvencies.  However the majority are liquidations, often an eventuality when steps have not been taken early enough to avoid business failure.

Pre-packaged administration sales (“pre-packs”)

Whilst attracting controversy over the years due to the perceived lack of transparency, pre-packaged administration sales (commonly known as “pre-packs”) are recognised as a valuable and important tool for rescuing businesses. 

Essentially, a pre-pack operates whereby marketing and negotiations for a sale of the company’s business and assets take place before administration, with the sale occurring moments after the administrator is appointed. 

Over the years, concerns around transparency of the marketing process and often connected party nature of many pre-packs led to regulations being introduced in 2021 requiring an independent evaluator to review any connected party transaction. 

Pre-packs are likely to remain centre-stage for some time, particularly in the retail and hospitality sector, in part due to the speed and cost at which they can be executed as well as having minimal court involvement.

Company Voluntary Arrangements (CVAs)

In recent years, a number of high profile Company Voluntary Arrangements (CVAs) have been launched in the retail and hospitality sector, for example, by New Look and Café Nero. 

In simple terms, a CVA is a legally binding agreement between a company and its creditors, setting out how the company’s debt will be repaid over a period of time.  It has regularly been used by retailers to renegotiate lease terms, with landlords of unprofitable stores often bearing the brunt.  

During a challenging time in the real estate market, companies have been able to propose significantly reduced market rent, with landlords having little recourse.  The CVA has been an incredibly useful tool for businesses with substantial leasehold portfolios as they adapt to a post-Covid era where many consumers have switched to online purchasing.  

That said, historic data has shown that, notwithstanding the CVAs popularity in certain sectors, many CVAs do not go far enough in dealing with operational issues within a business, and a number of companies that have had CVAs approved nevertheless ended up in an insolvency process.

Standalone moratorium and restructuring plans

The pandemic accelerated legislative reform in the insolvency industry with the introduction of the standalone moratorium and the restructuring plan in June 2020.

Whilst the standalone moratorium (designed to provide companies with short term relief from certain debt payments whilst leaving the management in charge) remains more relevant to small and medium sized business, the restructuring plan has been more widely used by larger groups or those with complex finance structures. 

Unlike a CVA, restructuring plans enable secured creditors to be bound as well as offering a “cross class cram down” i.e. the ability to bind a dissenting class of creditors.  This can be very powerful and broadens the scope of what businesses can propose and have sanctioned – arguably enabling a more viable plan to avoid future insolvency.

The fact that the restructuring plan is very new, with market standard norms still to be fully developed, coupled with the court-driven nature of the process means it can be an expensive tool to utilise and execute. Many industry professionals query whether it will have place in the mid-market beyond complex capital structures.

Choosing the right tool

There are a number of tools available to distressed companies and the availability of these is dependent on boards acting early and proactively when faced with financial difficulty. 

Periods of economic distress can give rise to significant challenges and are uncomfortable times for businesses and boards, with directors having to consider the shifting nature of their duties and the risks of wrongful trading.  Boards may be inclined to bury their heads in the sand and not seek the necessary financial and legal support to explore the variety of rescue options available to the business. 

Engaging with stakeholders, obtaining accurate financial data (as well as robustly interrogating cashflows), and carefully and clearly documenting board decisions are all critical to ensuring that a board is taking the appropriate steps for the company and its creditors.  

At an operational level, it is important to understand potential weaknesses in the supply chain, the financial and legal implications of critical supplier insolvency and what a contingency plan looks like.  Being cognisant of these factors enables a business to put itself in the best position to protect its future.

Sheena Frazer and Amy Jacks are Restructuring Partners at global law firm Mayer Brown

Main image courtesy of iStockPhoto.com