A second chance strategy for an insolvent SME: A pre-pack insolvency arrangement

What is a pre-pack insolvency arrangement?

A pre-pack insolvency arrangement is an instrument for rescuing a business through a legally binding transaction either before or after the formal appointment of an insolvency practitioner.

Pre-pack insolvency arrangements should be distinguished from “phoenix activity” which regulators are intent on discouraging as illegal.

The essential preconditions for a pre-pack are an insolvent business and an intention to restructure the affairs of the business to rescue it operationally by giving the directors a second chance.

A pre-pack insolvency arrangement has the following elements:

  • A company (Oldco) is insolvent; and then
  • Oldco’s business is transferred for commercial consideration to a related entity (Newco); and
  • This transaction results in the best outcome for creditors, employees and other stakeholders.

There are two types of pre-pack insolvency arrangements:

  1. The transaction takes place after Oldco is placed in insolvent administration (i.e. liquidation or voluntary administration); or
  2. The transaction takes place before Oldco is placed in insolvent administration.

A pre-pack insolvency arrangement was acknowledged as a legitimate restricting transaction by a recent government report stating that:

“A genuine business failure where the business has been responsibly managed and subsequently continues using another corporate entity is a legitimate use of the corporate form” – Action against fraudulent phoenix activity, November 2009, Treasury Australian Government, p 1.

What is a pre-pack voluntary administration?

A pre-pack voluntary administration occurs when there is an arrangement in effect before the appointment of a voluntary administrator. The arrangement is likely to include the transfer of business assets of Oldco but the transaction may be completed either before or after the appointment of the voluntary administrator.

The main difference between a pre-pack and a ‘regular’ voluntary administration is that the negotiation of the business transfer takes place prior to the appointment of an administrator in a pre-pack. In a pre-pack, valuations would have already been obtained, contracts drafted and the sale price agreed before the appointment of a voluntary administrator.

In a ‘regular’ voluntary administration, the administrator takes over the management of the insolvent business and only begins sale negotiations after their appointment. The deed of company arrangement (DOCA) is the primary instrument to bind creditors, the directors and the voluntary administrator into any compromise with the directors. A DOCA proposal is subject to a vote of creditors and it therefore needs creditor support.

The obvious benefit of a pre-pack voluntary administration is that the directors of the insolvent business retain control of the business throughout the insolvency process. This follows the Chapter 11 process in the United States where the management retains control of the business during insolvency and it is known as a “debtor-in-possession”.

Who is suitable for a pre-pack insolvency arrangement?

The two key characteristics of an insolvent SME that is suitable for a pre-pack insolvency arrangement are:       

  • There is a serious commercial issue with the goodwill in a business being lost in a formal appointment scenario; and
  • The costs of a voluntary administration are uncommercial.

The goodwill of a business is the value of a business over and above the price of all the assets of the business. Accountants would say that goodwill amounts to the excess of the “purchase consideration” (i.e. the money someone is willing to pay to purchase the assets of the business) over the total value of the assets. If a formal appointment (i.e. a liquidation or voluntary administration) is likely to destroy goodwill or otherwise significantly reduce a potential purchase price of the business this may be a valid commercial justification for a pre-appointment transfer of the business of Oldco.

In a liquidation scenario the liquidator is under no obligation to continue trading a business and further, they are at personal risk if a liquidation trade-on suffers a loss. Therefore, a liquidation will be likely to involve the business being terminated and this could foreseeably result in a total loss of good will. A liquidator does have the right to licence the business of the company in liquidation, however, as a means of ensuring the continuity of a business.

The problem with the licencing and subsequent sale of a business after the appointment of a liquidator is that the damage to goodwill value is likely to have already been done by the notification to the suppliers and customers of the liquidation. In Australia an ipso facto clause of a contract is not illegal, unlike in the United States. An ipso facto clause gives a customer or supplier of a company in administration or liquidation the right to terminate a contract based upon insolvency. This means that upon a formal insolvency appointment the customers and suppliers of Oldco have the right to stampede and the effect would reduce the goodwill value of Oldco.

There is very little empirical research into the costs of voluntary administration but it may be observed that the costs of a voluntary administration are continuing to increase. It may be expected that a voluntary administration for an SME will cost at least $50,000.00. Particularly for micro SMEs (i.e. with 1-4 employees) it may be uncommercial to appoint a voluntary administrator because the costs would consume all the goodwill in the business.

Pre-packs are generally quick sales where the insolvent company (i.e. Oldco) can usually continue trading (i.e. through Newco). This would enable the company to retain the value of their brand, their employees and key customers.

What is important to consider when planning a pre-pack arrangement?

The benefit of a pre-pack insolvency arrangement is that a restructure can be executed without publicity and the consent of creditors. The transaction however, will be carefully examined by a subsequently appointed liquidator.

The difficulty with a pre-pack insolvency arrangement is making sure that the approach is coherent, legal, and worthwhile:

  • Coherent: It must make sense to all parties to avoid an allegation of secrecy or opacity
  • Legal: If the transaction isn’t commercial (i.e. undervalued) it could be the subject of litigation by a liquidator
  • Worthwhile: If the business is unsustainable, the directors may be putting themselves in a worse position and lose the opportunity to work on or in a profitable business elsewhere

What results can a pre-pack arrangement reap?

A pre-pack insolvency arrangement is a structural change of the business but it can be part of significant operational change to ensure that the business is viable. A pre-pack is a structural change because the legal organisation of the business is changed and the nexus of contracts that keeps the business together are varied, terminated or novated. It does not directly change the operational nature of the business, and strategic thought may be required to address the cause of the business collapse, such as poor management, in the medium to long term.

There are a number of ways the business can be changed through the pre-pack process to facilitate operational change. One way is for Newco to only acquire those parts of Oldco which are profitable. This results in Newco being a newly efficient enterprise, with the less profitable or loss making parts of the business being left for the liquidator of Oldco to wind up.

Where a problematic big project has led to a cash flow crisis, the pre-pack can allow for the termination of the big project or transfer of the profitable elements into the new trading entity. The pre-pack arrangement also creates an opportunity for the business to start from scratch with improved business measurement and financial tools. Where a big project has involved optimistic assumptions, these assumptions can be revised. The new company can take a
fresh approach to managing its financial information to achieve more accurate knowledge of the business’ financial position. More accurate reporting will allow the business to improve its business metrics, such as return on investment and asset utilisation. A more thorough understanding of the business’s financial performance will also allow management to eliminate unnecessary expenses and focus on profitable services or products. This operational turnaround can result in global change for the business with a completely new strategy and vision for the new trading entity. Alternatively, change could be restricted to a micro level with the addressing of issues such as the termination of underperforming staff.

Most importantly, a pre-pack can create the breathing space necessary for managers to review their performance and the performance of the business. Rather than spending their time responding to demands from creditors, managers would be able to review their  processes and improve those parts of the business which contributed to the business’s cash flow crisis. It is important at a pre-pack stage for the end game of the business to be defined.

Conclusion

Pre-pack arrangements, although sometimes difficult to execute, can be a saving grace for insolvent SMEs. In determining whether it is the right course of action for your business, make sure to carefully evaluate your business’ position and consult with a professional advisor.

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