UK Plans Debtor-Based Moratorium

In an important consultation paper, the UK Government has stated that it will introduce a debtor-in-possession moratorium procedure for insolvent companies as soon as parliamentary time allows. This proposal, if it becomes law, will represent a fundamental change in English insolvency law and a shift away from the existing bias towards secured creditors.

The principal reforms covered by the consultation paper are:

• The introduction of a moratorium as part of the Company Voluntary Arrangement (CVA) procedure: The moratorium will be extendable by creditor vote and an insolvency practitioner will be required to oversee and certify the process. Secured creditors will have to give notice before enforcing their security, to give the company an opportunity to file for a moratorium. This proposal is not for consultation - the Government intends to legislate when parliamentary time allows.
• Means of enabling companies to raise finance during reconstructions: The paper considers several options. But it cites research showing the effectiveness of the US debtor-in-possession (DIP) financing laws, and seems to favour introducing a similar form of super-priority security.
• Ways of making rescue procedures more available: Of these, the most significant reform would be the introduction of a "single gateway" into insolvency. Under this proposal, administrations, receiverships and CVAs would all commence with a debtor-in-possession moratorium while an insolvency practitioner reviews the business, after which an appropriate court order would be made.
• Other proposals include allowing solvent companies to file for administration, and providing that floating charges can only be enforced by a court appointed receiver. Disappointingly, the paper does not consider the possibility of abolishing the floating charge altogether.

The consultation paper, entitled Review of Company Rescue Mechanisms, was published on September 20, and is the product of a Working Party set up by the Department for Trade and Industry (DTI) and HM Treasury, with input from the insolvency profession, businesses and the banks. The Review is aimed at small and medium sized companies, but it is unlikely that large companies will be excluded from the scope of any resulting legislation. The proposals are one of several initiatives commenced by the DTI to promote the rescue culture and a more entrepreneurial approach to business. By limiting the scope of its suggested reforms, the Working Party has made it more likely that the changes can be introduced rapidly and will not get bogged down in lengthy consultation. The DTI invites submissions by November 12.

The Review concludes that there are significant barriers to the rescue of businesses in the UK, including the veto over company rescue procedures enjoyed by secured creditors, the difficulty of financing reconstructions, the proliferation of corporate financing structures, the reluctance of management to alert creditors at an early stage, and management fear that a secured creditor will enforce security for its own benefit, even if this does not benefit the general body of creditors. The Review concludes that the UK insolvency regime is more (secured) creditor-friendly – and therefore more rescue-unfriendly - than the regimes of other major industrialised countries. It cites studies suggesting higher recovery rates for creditors generally under US Chapter 11 proceedings compared with UK receiverships.

The Review announces that the Government intends to legislate, when parliamentary time allows, to provide a short moratorium (i.e. stay of creditor actions) as part of the CVA procedure. If introduced, the moratorium will be supervised by an insolvency practitioner whose role will be to observe and to provide assurance to creditors. The moratorium will initially last for a short period (perhaps 28 days) but may be extended by creditors’ resolution. The moratorium will be strengthened by a requirement that secured creditors must give notice before enforcing their security.

This will be the first experience in the UK of a debtor-in-possession moratorium. The company administration procedure provides for a moratorium, and the Review found that in most cases administration eventually offers better returns to unsecured creditors than liquidation. But the price of the moratorium is the appointment of an insolvency practitioner as administrator, and an administration order can be vetoed by the holder of a floating charge. The appointment of the insolvency practitioner has been a disincentive to company managers, who fear the company being taken out of their control and the prospect of an investigation of their conduct in the run-up to insolvency.

The main goal of the moratorium will be to prevent the appointment of receivers by secured creditors. During the last recession there were frequent criticisms from businesses that banks were precipitate in their appointment of receivers and denied management the opportunity to mount rescues. The Review accepts that receivership is an effective way for secured creditors to realise their security and provides some encouragement to secured lending to business. However, it is not a collective procedure and receivers owe few duties other than to their appointor. Most important, a receiver has little incentive to maximise returns on assets beyond those required to repay the secured creditor and to discharge his own expenses, and the Review found that receiverships result in poorer returns to creditors than CVAs.

The moratorium is to be introduced as a reform of the CVA procedure. This is a collective procedure under which a majority of creditors holding 75% by value of creditor claims are able to bind all creditors. The Review found that CVAs invariably lead to better returns for creditors than they would achieve in a liquidation. The CVA is attractive to management as they remain in control of the company, and there is no requirement for the company to be insolvent. However, the lack of a moratorium has meant that any creditor can pursue individual remedies and frustrate collective agreement. The proposed reforms are intended to remedy this defect.

It is not proposed that the moratorium should be available in support of a planned scheme of arrangement. This is a pity. A scheme of arrangement is a collective procedure and is much more flexible than a CVA.

Financing is often central to the prospects for a successful company reconstruction. Unless the company has free trading income (i.e. book debts) or surplus assets which can be charged, it may not have access to sufficient working capital during a rescue. Traditionally, reconstructions have only been possible with the support of bank lenders, who could be relied upon to ensure the company had sufficient working capital during the reconstruction. A debtor-in-possession moratorium will require a different approach.

The Government has not yet decided how funding should be provided during a reconstruction, and the Review considers various means of facilitating the raising of finance. Possibilities include banning fixed charges over book debts, allowing a company to collect and use a portion of book debts or floating charge assets. The difficulty with these options is that, while they might be of value in some situations, there will be companies which have short-term collection problems which prevent their raising sufficient finance from existing resources – and which may be the cause of their financial problems in the first place.

The Review notes that Chapter 11 of the US Bankruptcy Code provides for super-priority status for money lent during a rescue (i.e. DIP financing). It reports on recent research that 135 out of 326 US firms filing for Chapter 11 secured DIP financing and that about 50% of the new finance is advanced by pre-petition lenders. It concludes that the greater the level of DIP financing, the greater the recovery rates for creditors generally. The use of this research strongly suggests that the Working Party favours introducing super-priority financing, so that a lender during a rescue or reconstruction is permitted priority over existing secured creditors in respect of realisations.

The Review also invites views on a number of possible procedural reforms:

• The Review suggests the possibility of a "single gateway" through which all insolvent firms must pass. This would address the concern that the range of options available to insolvent companies is confusing to management and may sometimes lead to inefficient outcomes. The Review notes that Germany has recently implemented reforms take this approach and suggest that a single gateway process might entail: (a) a period of observation by an insolvency practitioner appointed by the court, (b) a moratorium while the insolvency practitioner observes, and (c) a report to court and creditors by the insolvency practitioner and a recommendation as to the procedure to be adopted subject to a creditor vote and court approval.
• The Review invites views on whether solvent companies might be allowed to use the administration procedure.
• The Review suggests the promotion of collective insolvency procedures by the removal of the right of a floating charge holder to veto an administration, and by providing for the enforcement of floating charge security by way of a court appointed receiver.
• Finally, the Review seeks views on whether it would be desirable to reduce the requirement that a CVA be approved by a 75% vote by value of creditors voting.

The Review seeks views on the means by which the management and/or directors of companies might be encouraged to take early action in response to financial distress. It asks whether lending institutions should encourage the acquisition of financial and managerial skills by offering reduced interest rates on borrowing to companies whose managers acquired such skills.

The Review considers the Crown’s status as a preferential creditor in respect of income tax, national insurance contributions and VAT. It notes that the Crown is an involuntary creditor which cannot either choose its debtors or the terms on which it becomes a creditor, and that repayment of Crown debts benefits society as a whole by the collection of taxes. It also points out that the abolition of preferential debts might benefit secured creditors rather than unsecured creditors. It invites discussion about whether the removal or diminution of the Crown’s preferential statement would assist in achieving CVAs.

Finally, the report seeks views on whether it would be desirable to forbid investigating accountants from being appointed by banks as administrative receivers to companies they have investigated. The report notes that there is a moral hazard risk that, to further his own interests, an investigating an accountant might recommend receivership over viable alternatives. In the light of the moratorium proposals, this issue may well now be academic.

High yield debt investors should welcome the Government’s proposals. The introduction of a debtor-in-possession moratorium, together with a requirement for secured creditors to give notice before appointing a receiver, will prevent secured creditors - and particularly holders of floating charges - from controlling the timing and form of insolvency proceedings. If the reforms become law, company management will be able to continue trading while implementing reconstructions for the benefit of the whole body of its creditors. The moratorium should also result in substantial cost savings, by eliminating the need for an insolvency office holder and his staff to take over the management of the company. In the absence of evidence of wrong-doing, the existing directors and managers will continue to manage the company under the supervision of an insolvency practitioner.

The fundamental ranking of creditors under English insolvency law will not be changed by the reforms, which are procedural in nature. Accordingly, the current debate about the right subordination structure for UK high yield issues will not be greatly affected by the proposals. However, constraints on the secured creditor’s rights to enforce its security and its inability to veto a reconstruction, will mean that even structurally subordinated creditors may have greater influence and the ability to promote reconstructions that benefit the whole body of a company’s creditors.

The proposals will be of most importance in relation to medium sized companies. Larger companies have a long history of achieving out-of-court reconstructions, both under the London Approach and otherwise, without the need for a moratorium, where secured creditors have voluntary foregone their right to enforce security to enable the reconstruction to proceed.

The Review’s favourable treatment of the US experience of DIP financing suggests that super-priority security may be introduced for financing provided during the moratorium period. That aspect of the reforms is, however, still under discussion.