Taming the Phoenix: New Pre-Pack Regulations Come Into Force

As the first May bank holiday weekend began, the Administration (Restrictions on Disposal etc. to Connected Persons) Regulations 2021 (the Regulations) were enacted and came into effect for all companies entering administration on or after April 30, 2021. The Regulations are, in the main, a policy response to enhance independent scrutiny of so called “phoenix transactions.”

The Regulations are a welcome progression from existing, non-mandatory measures that have failed to make a meaningful impact. However, as this article sets out, there is a series of missed opportunities in the Regulations that could undermine their effectiveness and should be addressed in any subsequent amendments.

The Basics

Pre-packs

A pre-pack administration is an arrangement under which the sale of all or part of an insolvent company’s business or assets is agreed prior to the appointment of an administrator. Immediately on or shortly after the appointment, the sale will be effected. Pre-packs allow the trading business to be rescued with minimal disruption to operations as a result of the insolvency, preserve brand integrity, and maximize the retention of employees, customers and suppliers.

Phoenix

A phoenix, of course, is a creature of mythology, thought to burst into flames and rise again from its ashes. The term has been applied in the context of pre-packs where the sale is made to a Newco purchaser controlled by the same directors and/or owners of the existing insolvent trading company. The announcement of a sale to existing management or other connected parties (such as shareholders or companies in the same ownership group) is often criticized for allowing the same business and management and/or owners to re-emerge but leave behind unsecured creditor liabilities.

Pre-Pack Pool

The concerns around pre-pack sales to connected parties are not new. In 2014, the UK government commissioned the Graham Review, an independent review of pre-pack sales. The review proposed that connected party sales should be independently evaluated to rebut transparency and fairness disputes, which led to the introduction of the Pre-Pack Pool in November 2015. However, referrals to the Pre-Pack Pool were voluntary and its decision not binding.

The need for the new Regulations

Pre-packs are increasing

Pre-packs are an important rescue tool and are on the rise. From 2016 to 2019, there was a 37% increase in pre-pack sales (from 345 cases in 2016 to 473 cases in 2019). In 2020, following the impact of COVID-19, pre-packs accounted for 29% of the 1,526 UK administrations and were particularly popular across the retail, casual dining, and travel and tourism sectors. High-profile examples included Azzurri and Travelex.

Phoenix transactions are increasing

Pre-pack sales to connected parties are also on the rise both in number and as a share of the total number of pre-packs.

Source: https://www.gov.uk/government/publications/pre-pack-sales-in-administration/pre-pack-sales-in-administration-report 

Pre-Pack Pool applications are decreasing

Referrals to the Pre-Pack Pool are clearly on the wane. The voluntary nature of the application and the onus being on the purchaser to make the referral have clearly not worked to provide greater transparency or justification to other creditors for why a Phoenix transaction is in their best interests.

The Regulations

Under the Regulations, an administrator will not be able to complete a sale of the business or assets to a “connected person” within eight weeks of the commencement of administration unless it has either

(a) an independent written report from an independent evaluator — whether they agree with the sale or not — or

(b) the approval of (both secured and unsecured) creditors.

“Connected person” includes:

• any company that has common present or past directors, other officers or shadow directors with the insolvent company
• any company that has a non-employee associate (such as a spouse or close relative) of the director, other officer or shadow director
• a non-employee associate (i.e., a controlling party) of the company; a person or entity will be deemed to have control if it is entitled to exercise, or control the exercise of, one-third or more of voting rights in respect of the company

Flaws in, and recommended amendments of, the Regulations

Evaluator’s report

It is the connected purchaser’s responsibility to obtain the evaluator’s report, and it may commission multiple reports from multiple independent evaluators, provided all of the reports are circulated to creditors and filed at Companies House. Further, the administrator may proceed with the sale even if it is not recommended by the report, again provided the report is circulated to all creditors and filed at Companies House with a statement justifying the decision.

• Recommendation: It seems as though the objective of the Regulations ought to prevent the purchaser from being able to “shop around” for favorable reports, so future amendments may restrict the ability to do so. In practice, however, it is unlikely multiple reports will need to be commissioned as the purchaser will have an indication of what recommendation will be made before the evaluation is finalized.

Evaluator

The evaluator can be anyone deeming themselves to have the “relevant knowledge and experience” as long as they are independent.

• Recommendation: Certain industry bodies such as R3 have already remarked that a list would have been a better way of ensuring valuations are properly carried out.

Creditor’s consent

If creditor’s consent is sought then — although the Regulations do not stipulate how creditors provide consent — administrators will likely rely on the deemed consent process used for approval of the administrator’s proposals more generally. Under this process, approval from a simple majority of creditors is required and consent is deemed to be given if less than 10% of creditors (by value) object. The administrator must provide all creditors with 14 clear days’ notice before consent can be deemed, and if more than 10% object, the administrator must proceed to a qualifying consent process whereby all creditors are requested to actively consent to the proposal. As with several other areas of the Insolvency Act and associated regulation, there is no requirement for independent creditor consent. This means connected companies holding intercompany debt can otherwise help “approve” a sale to a connected person.

• Recommendation: Connected party creditors should be excluded from the approval process to prevent the approval threshold for a qualifying consent process from being manipulated by the support of connected party creditors. It seems somewhat inconsistent to focus on connections between the group and purchaser but to not have considered or addressed this at the creditor level.

Secured creditors

Earlier drafts of the regulations suggested that secured creditors would be specifically carved out from the scope of connected persons within the Regulations. However, the draft passed by Parliament failed to do so. This is unfortunate. Secured lenders will need to consider whether their existing rights under their security documents, or the exercise of those rights, would make them a connected party.

• Recommendation: We recommend that the Regulations are amended to confirm that creditors should not be considered as connected persons in circumstances where they are not involved in the governance of the group — for example by virtue of holding a substantial shareholding in the insolvent company.

Phoenix transactions via liquidation sales

The Regulations target Phoenix transactions by policing pre-pack administration sales to connected persons. However, Phoenix transactions can also arise in the context of a liquidation. There are several situations in which liquidators have been appointed in order to sell all of the assets to existing management or other connected parties. This is particularly concerning in the context of voluntary liquidations where connected party creditors are able to push through the appointment of their preferred liquidator.

• Recommendation: As the Regulations are intended to provide greater rigor and oversight of connected party transactions that might be said to unfairly disenfranchise unsecured creditors, then their scope should rightly be extended to liquidation too.