Insolvency: so what is a pre-pack?

What do MFI, Whittard of Chelsea and Postman Pat1 have in common? The answer
is that they have all been the subject of a pre-packaged (or pre-pack) sale in
administration during the last year. Pre-pack sales and the so-called ‘phoenix’
company situations have rarely been out of the news recently, often portrayed as
sly and unjust schemes perpetrated by unscrupulous businessmen to avoid their
creditors and restart a business debt-free.

With the Enterprise Act 2002 came the ability for a company and/or its
directors to appoint an administrator without judicial scrutiny through the ‘out
of court route’. The speed and ease of this route lent itself to the pre-pack
sale, and hence their increased use.

However, an administrator will not accept an appointment unless the company
is insolvent. If the directors of a solvent company cause it, or let it become,
insolvent in order to put it through a pre-pack process, they risk personal
liability under the insolvency law anti-avoidance provisions.

Further, the administrator has to believe that an administration will be
capable of fulfilling one of the following objectives: rescuing the company as a
going concern; achieving a better result for the creditors than would be likely
if the company were wound up; or realising the property of the company in order
to make a distribution to one or more of the secured or preferred creditors. If
none of these objectives are likely to be met, the administrator should decline
the appointment. He is an officer of the court and has a duty to act fairly – if
he acts negligently or in breach of his duties, he can be held personally
liable.

The pre-pack process has been criticised for its lack of transparency and
accountability. One complaint is that unsecured creditors are not given the
opportunity to participate in negotiations and often end up with a nil return.
Further, business sales may be carried out without market exposure, prompting
would-be purchasers to complain that the sale takes place to existing management
before they have had a chance to express an interest.

This also accounts for some of the bad press which has surrounded such
‘phoenix’ companies, due to a minority of cases where directors have abused the
system to acquire the profitable parts of the business, leaving the creditors of
the original company out of pocket.

Pre-packs do have laudable objectives and some safeguards. They can be the
best way of realising the value of an insolvent business without negative
publicity. The Insolvency Service has stated that ‘a pre-pack may offer the best
chance for a business rescue, preserve goodwill and employment, maximise
realisations and generally speed up the insolvency process’.

The widespread concern about the use and potential abuse of pre-packs led to
R3 (the Association of Business Recovery Professionals) issuing the Statement of
Insolvency Practice 16 (SIP 16), which came into effect in January. It aims to
increase the transparency of pre-packs. It sets out basic principles and
procedures with which insolvency practitioners are required to comply to avoid
disciplinary or regulatory action by the practitioners’ regulatory authority.

Partly in response to the bad press and following the introduction of SIP 16,
the government has announced that it will be producing a report on the use and
abuse of pre-packs during the first half of this year, which is expected next
month. Although most pre-packs are undoubtedly the best result that can
realistically be achieved in the circumstances and most administrators act
entirely fairly and within their guidelines, anecdotal evidence suggests that
abuse can occur.

Unsecured creditors can technically challenge a pre-pack sale after the event
if they can show that the administrator did not act fairly or in their best
interests, although this may be difficult and often amounts to shutting the
stable door after the horse has bolted.

Ultimately therefore unsecured creditors have to put their faith in the
judgment and propriety of the insolvency practitioners and the effective
supervision of the insolvency regime. The introduction of SIP 16 is a starting
point, although it is generally felt that further steps need be taken either
with direct government intervention by amending current legislation or
indirectly by reporting on abusive practice and shaming the insolvency
authorities better to self-regulate its members.

Pre-packs defined

Administration is an insolvency procedure, introduced by the Insolvency Act
1986 and revamped by the Enterprise Act 2002. It is designed to hold the
business together whilst one of the stated objectives is met. An administrator
may either be appointed by an application to the court or, since the Enterprise
Act, without an application on simply lodging prescribed forms at court (a route
favoured by directors in a pre-pack scenario).

A pre-pack sale involves the sale of the assets of the insolvent company
prior to the company going into administration. The administrator usually
completes the sale shortly after his appointment. There is very rarely any
disclosure to the unsecured creditors of the insolvent company until after the
pre-pack has completed.

A ‘phoenix’ company arises where the assets of one company (often in
financial difficulties) are acquired by another company which then trades under
the same or similar name as the failed business and some or all of the directors
are the same. The directors, operating the new company may become personally
liable for the debts of this new ‘phoenix’ company (often if it too becomes
insolvent) and are also liable to imprisonment or a fine.

Key points in SIP16

An administrator when considering the disposal of the business and assets of
a company: must perform his functions in the interest of the company’s creditors
as a whole; and where the objective is to realise property in order to make a
distribution to secured or preferential creditors, to avoid unnecessarily
harming the interests of the creditors as a whole.

Unsecured creditors should be provided with a detailed explanation and
justification of why a pre-pack was undertaken so that they can be satisfied
that the administrator has acted with due regard to their interests.

There is a long list of information that should be disclosed to creditors in
cases where there is a pre-pack sale, including the extent of the
administrators’ involvement prior to appointment, any marketing activities
conducted by the company and/or the administrator, any valuations obtained , the
date of the sale and identity of the purchaser and whether there was any
connection between the purchaser and the insolvent company.

Tim Carter is head of insolvency and David Kendall is
senior associate in the corporate team at law firm
Stevens & Bolton
LLP.

1In loose terms Entertainment Rights plc, the company that owned the
rights to Postman Pat and Basil Brush, sold its business by way of a pre-pack to
New York based Boomerang Media on 1 April 2009.