English Pre-Packs: Regulatory Framework and Legislative Developments

Introduction

Until April 2021, there was no bespoke statutory framework in respect of administration pre-packs. However, since 2009, insolvency practitioners have been obliged to adhere to the Statement of Insolvency Practice 16: Pre-packaged Sales in Administrations (SIP 16).^[2] SIP 16 is a set of principles of best practice for administrators when conducting a pre-pack; that is, in SIP 16’s terms:

an arrangement under which the sale of all or part of a company’s business or assets is negotiated with a purchaser prior to the appointment of an administrator and the administrator effects the sale immediately on, or shortly after, appointment.

Technically, these principles are not legally binding, but failure to adhere to SIP 16 may result in an administrator facing disciplinary action by their professional body.

While there have been a number of cases where the court has recognised the legitimate use of pre-packs, the court has not interfered with the administrator’s decision to pursue a pre-pack: the court has treated this ultimately as a commercial decision for the administrator. There is therefore little purely judicial guidance on when a pre-pack sale may be appropriate.

Administrators remain subject to SIP 16, which has been updated a number of times since 2009 and which applies to all pre-packs. Where the pre-pack concerns a sale to a connected party, the Administration (Restrictions on Disposal etc. to Connected Persons) Regulations 2021 (the Regulations) are also applicable. The Regulations entered into force on 30 April 2021.

Regulatory and legislative development

The regulatory and legislative framework essentially derived from negative press around pre-packs. The industry-driven introduction of SIP 16 in 2009 did not sufficiently allay the government’s concerns, leading to a government-commissioned review by Teresa Graham CBE in 2014 (the Graham Review), which concluded that the pre-pack sales process lacked openness and often led to lower returns for creditors due to inadequate marketing being undertaken. It also noted that insufficient attention was often given to the potential viability of the purchasing entity and the higher rate of failure of that entity when the sale was to a party that was connected to the failed business. These problems appeared most acutely when the pre-packs involved sales to parties that were connected to the business in financial distress. The primary recommendations of the Graham Review were as follows:

• the establishment of a pre-pack pool to consider sales to connected parties and opine on their suitability (i.e., the Pre-Pack Pool);
• the completion of a viability review by the connected party in respect of the purchasing entity; and
• a re-draft of SIP 16 to provide guidelines for officeholders on how a pre-pack should be approached and conducted and suggesting the content for a report to creditors in which the justification for the pre-pack can be explained (which would include the viability review).

These recommendations were acted upon.

The Pre-Pack Pool

The Pre-Pack Pool was set up in 2015 as a body of 19 individuals who can review the terms of a potential pre-pack sale to a connected person and opine on whether the sale appears to be reasonable. This was designed to enhance the transparency of the process as the terms of the proposed sale are subject to independent scrutiny by an experienced professional. If a negative opinion was provided by the Pre-Pack Pool (i.e., that the proposed sale gave cause for concern), but the sale nonetheless went ahead, the administrator was obliged to explain to creditors in the SIP 16 report why the sale was considered to be appropriate.

However, the government did not make it mandatory in 2015 for a connected party to apply to the Pre-Pack Pool for an opinion. At this stage, the government appears to have preferred to let the perceived problems around connected party pre-packs be resolved by self-regulation and the good intentions of the parties involved, rather than seeking to impose confidence through regulation. A power for the Secretary of State to issue regulations governing sales to connected parties was included in the Small Business, Enterprise and Employment Act 2015, which amended the Insolvency Act 1986 by including a new Paragraph 60A of Schedule B1. That power expired on 26 May 2020.

Information published by the Pre-Pack Pool shows that the total number of pre-packs during the period from 2016 to 2019 increased each year (from 245 in 2016 to 473 in 2019), and the number of sales to a connected party also increased (from 163 in 2016 to 260 in 2019). However, the number of referrals to the Pre-Pack Pool by connected parties during this period was very low, and the proportion of connected party referrals dropped from 22 per cent in 2016 to 9 per cent in 2019. For example, in 2017, there were 356 pre-packs, of which 203 involved a sale to a connected party and were therefore eligible to be referred to the Pre-Pack Pool for an opinion. However, of those, only 23 were referred (11 per cent). The inference that could be drawn was that self-regulation was not working.

A further concern that was brought to light in 2017 was the increasing number of pre-packs that resulted in the insolvent companies’ pension schemes being placed into the Pension Protection Scheme, particularly as a result of pre-packs involving connected parties. An investigation by the Financial Times estimated that approximately 17 per cent of the schemes managed by the Pension Protection Fund were from companies whose businesses had been sold in pre-packs. Two-thirds of those pre-packs had involved sales to connected parties.^[3]

It was against this background, as well as the disruption to businesses caused by the covid-19 pandemic, that the government took another look at whether legislation was needed to curtail the perceived abuses of the prep-pack process. In October 2020, a report was published by the Insolvency Service,^[4] which noted that, while work undertaken to market businesses had improved, there were still ongoing issues over transparency and whether the interests of creditors were being protected, particularly in the case of sales to connected persons. This was of particular concern given the expectation of an increased number of business failures as a result of covid-19.

The report concluded that the voluntary measures introduced as a result of the Graham Review had not produced the increased confidence and transparency of connected person sales that had been hoped for, and consequently legislation was necessary. The power that had expired in May 2020 was restored by the Corporate Insolvency and Governance Act 2020, which extended the expiry date to the end of June 2021.

The resulting Regulations can therefore be seen partly as a reaction to the lack of independent scrutiny of connected party pre-packs and partly as a result of the insolvency legislation that was fast-tracked because of covid-19. The Insolvency Service’s report provided the following mission statement:

The government believes that introducing new regulations to ensure an independent opinion, or creditor approval, of the pre-pack sale is obtained will positively build on the existing voluntary measures and will help to mitigate any adverse consequences in the increased use of pre-pack sales arising from the pandemic.

The Regulations

The Regulations came into force on 30 April 2021 and apply to administrations commencing from that date. The Regulations extend not only to pre-packs in the strict sense of those negotiated prior to the administrator’s appointment, but also to any disposals to connected persons within eight weeks of the company entering administration.

The Regulations were brought in with the intention of:

• improving the transparency of pre-pack sales;
• increasing confidence in sales to parties connected with the insolvent company;
• preventing those with previous involvement with the insolvent business from using the pre-pack sale as an artifice to continue operations using the business and assets purchased out of the insolvency process; and
• ensuring that the connected party purchaser pays a reasonable price.

The Regulations prohibit the administrator of an insolvent company from making a substantial disposal within the first eight weeks of an administration to anyone connected to the insolvent company unless the administrator has obtained either the approval of the company’s creditors or a qualifying report.^[5]

A disposal is ‘substantial’ if it is made to one or more connected persons during the eight-week period from the date of the administration, of what is, in the administrator’s opinion, all or a substantial part of the company’s business or assets. This definition includes a disposal effected by a series of transactions.^[6]

A ‘connected person’ under the Regulations not only includes directors and managers of the pre-administration company and their relatives, and companies associated with the failed company, but also anyone who is in control of the company, which includes any person entitled to exercise or control one-third or more of the voting power at the general meeting of the company or of another company that has control of it. This means that secured creditors with share security, who may be looking to enforce their security, and as part of that process take ownership of the substantial property, could be deemed to be connected parties for the purposes of the Regulations. Previously, SIP 16 included a special exemption for secured creditors, but despite representations being made to continue this exemption, the Regulations and the amended SIP 16 do not provide a specific carve-out for the holders of security.

The Regulations envisage that approval of the company’s creditors will be sought at the same time as creditors consider the administrator’s proposals that are required pursuant to Paragraph 49 of Schedule B1 to the Insolvency Act 1986. Consequently, the administrator is required to include details in respect of the disposal in these proposals. The company’s creditors can approve the disposal with or without modification (in the former case, if the administrator consents). If creditor approval is obtained, there is no need for an administrator to obtain a qualifying report. In practice, however, it will not always be feasible to obtain the creditors’ approval (for example, where a sale needs to be effected quickly to avoid destruction of value or where there is no consensus among creditors) and administrators are therefore permitted to obtain a qualifying report in place of creditor consent.

The qualifying report must be obtained by the connected person who is the prospective purchaser from a suitably qualified evaluator. The evaluator essentially takes on the role previously intended for the Pre-Pack Pool. The evaluator can still be derived from the Pre-Pack Pool, but the Pre-Pack Pool is no longer the only source of independent review. Any evaluator must meet the qualifying criteria set out in Part 3 of the Regulations and must:

• be satisfied that they have a sufficient level of knowledge and experience to provide the report;
• have professional indemnity insurance to cover potential liability to the administrator and other interested persons; and
• be independent from the company and the connected person and free of any conflict of interest.

With regard to the evaluator’s independence, there is a prohibition on professional advisers from acting as evaluators if in the 12 months before the date of the report they have provided advice to the company or group in connection with the company’s corporate rescue, restructuring or preparations for insolvency filings. The Regulations also list a number of factors that disqualify a person from being an evaluator, such as having a conviction for dishonesty or having been bankrupt.

Regulation 7 sets out the required content of the evaluator’s report. It must confirm that the evaluator meets the eligibility criteria and state the value of the consideration to be provided by the connected person. The report must then provide the evaluator’s opinion on the proposed sale: that either the evaluator is satisfied that the consideration provided for the property and grounds for the disposal are reasonable in the circumstances; or that the evaluator is not satisfied that the consideration and basis for the disposal are reasonable (referred to as a ‘case not made’ opinion). Further, the report must contain a copy (or details of) any previous reports obtained by the connected person in respect of the same transaction.

If upon receipt of the report, the proposed sale is concluded, the administrator must send a copy of the report to the registrar of companies and every creditor (other than a creditor who has opted out of receiving notices from the administrator). If the report includes a ‘case not made’ opinion or if it refers to a previous report that reached a similar conclusion, the administrator must also provide a statement setting out the reasons for proceeding with the disposal.^[7]

Practical effect of the Regulations on pre-packs

The Regulations effectively replace the existing voluntary referral mechanism where purchasers could apply to the Pre-Pack Pool with a mandatory referral obligation where the sale is to a connected party. In practice, the connected party must seek an independent evaluator’s report on all substantial disposals taking place within the first eight weeks of an administration, where the sale is to a connected party (i.e., not just pre-packs). The Pre-Pack Pool remains operational, and its members are likely to qualify as evaluators. The Regulations do not state that the evaluator must work in the insolvency industry, and the choice of a suitable evaluator may depend on the nature of the company and the assets being sold.

Although an administrator must now receive an evaluator’s report if a sale is effected to connected parties within eight weeks of the report being issued, as with the Pre-Pack Pool regime, an administrator can still proceed with the proposed sale even without the support of the evaluator. The Regulations require the administrator to consider the evaluator’s report and be satisfied that the evaluator is suitably experienced and that the report contains the information required by the Regulations. However, the administrator is not obliged to agree with the report and can proceed with the sale if they consider it to be justified in the circumstances. For example, there may be reasons around urgency or lack of prospective buyers that might lead the administrator to conclude that the sale is in the best interests of creditors notwithstanding a ‘case not made’ opinion.

Potential concerns and weaknesses

While the underlying objectives of the Regulations and the process through which an evaluator’s report is obtained seem reasonably clear, there are certain practical issues that require further consideration and that may need to be refined further.

The evaluator

The role of the evaluator raises four key issues. First, the Regulations do not require the evaluator to have any particular professional qualifications or, as noted, have any insolvency experience. The evaluator is simply required to self-certify that they have sufficient experience to provide a report. It seems a small, but logical, step for there to be some sort of register of approved persons who are qualified to be evaluators; this would certainly assist with providing more transparency in the pre-pack process. However, to date this register has not been established (outside of the members of the existing Pre-Pack Pool) and there is no regulation or oversight in respect of the persons acting as evaluators. The fact that an evaluator has to be able to obtain professional indemnity insurance may provide some level of comfort (although this requirement may in itself also deter some persons from acting as evaluators).

Second, the choice of evaluator rests with the connected party purchaser. This may seem surprising, given that the purchaser will have a vested interest in the sale going ahead and in the price it is offering being deemed reasonable by the evaluator. However, in addition to the requirements that the evaluator be independent and free of conflicts, the ultimate safeguard for the best interests of creditors remains the fact that the decision to proceed with the disposal rests with the administrator. As an officer of the court, and duty bound to act in the best interests of all creditors, the administrator will always be the final arbiter of whether a pre-pack sale can be justified in the circumstances. That said, the Regulations appear to suggest that the onus is on the administrator to be satisfied that the evaluator is sufficiently qualified, which does appear to add an additional burden on the administrator and suggests that they ultimately bear some responsibility for the choice of evaluator.

Third, even if the evaluator is a seasoned insolvency professional, they may not have sufficient time or knowledge to thoroughly assess the proposed sale terms or form a view as to whether the proposed consideration is sufficient. Ultimately, the evaluator can only opine on the information provided by the connected party, which may be incomplete or otherwise deficient. This was always a weakness of the voluntary Pre-Pack Pool system and is probably an endemic problem with the pre-pack process – the sale will usually be completed very quickly, and any independent reviewer can only rely on the veracity of the information provided.

Fourth, the requirement that the evaluator has professional indemnity insurance suggests that there are circumstances in which the evaluator might be sued by affected parties. However, there is little guidance as to what liability the evaluator might have and what duties of care are owed to whom. Is it envisaged that the evaluator might owe some duty of care to the company’s creditors or even the administrator? If so, on what basis? Is it fair to place responsibility on the evaluator, given that the evaluator’s report will be based almost exclusively on information provided by the connected party? This issue has not been addressed in the Regulations and will probably need to be considered in case law.

Opinion shopping

The Regulations permit situations where the connected person purchaser has commissioned more than one evaluator’s report. This inevitably raises a concern over whether a connected person may seek to ‘shop around’ to find an evaluator that would give the most favourable opinion in support of the proposed transaction.

As noted above, the Regulations require the evaluator to append to the report details of any previous reports disclosed to them or, to the extent these details are not disclosed to them, a statement as to why that is the case. However, this does not remove the risk of a connected person failing (willingly or otherwise) to disclose the existence of any prior reports to the evaluator; not does it prevent a connected person from commissioning a number of reports and simply choosing the one that is most favourable to the proposed transaction.

However, in practice, the administrator again must be satisfied with the choice of evaluator, and their report, and therefore has oversight as to whether there is justification for a proposed pre-pack to proceed. Many insolvency practitioners will be accustomed to this level of responsibility.

Creditor approval

The independent evaluator’s report is not the only avenue to the approval of the substantial disposal; an alternative route is to obtain the consent of creditors.

Obtaining creditor consent presents inherent challenges, however. It involves the provision of potentially large amounts of information to creditors and with sufficient notice for creditors to make an informed decision on the sale. Given that pre-pack sales tend to be negotiated on an accelerated time frame, and often in a controlled and confidential basis (to minimise the risk of business disruption and erosion of value of the business), in practice this option is only likely to be utilised in circumstances where timing is not of the essence or where there are a limited number of creditors.

As such, while the creditor approval route may appear in principle to be the most cost-effective and robust approach, it may not be practically possible for pre-packs, and obtaining a written evaluator’s report is likely to be the preferred method.

Sanctions for non-compliance

While the referral regime is now mandatory, the Regulations do not provide any sanctions for non-compliance. It is likely that if an administrator effects a sale to a connected party without following the procedure set out in the Regulations, that administrator will be liable to creditors and potentially others for breaches of statutory and other duties, and the sale will be challengeable. However, it would be unfortunate if a bad sale based on a poor report from the evaluator resulted in the administrator being taken to court by one or more creditors.^[8] Therefore, it may be necessary for the precise responsibilities of the various parties to be set out in further legislation.

Impact on secured creditors

The Regulations may impose an additional step for secured creditors if they are seeking to acquire the business as part of their strategy to minimise their exposures in a distressed situation.

While the Graham Review and the consultation period prior to the Regulations discussed the inclusion of a carve-out for secured lenders who could by definition be considered ‘connected persons’ by virtue of voting rights held in relation to debt or security in respect of the selling company, this potential issue was not ultimately reflected in the Regulations. A situation may arise where security is taken over one-third or more of the shares (and attached voting rights) in the selling entity. Secured lenders should consider the terms of their security documents and whether the rights attached to them would lead them to fall under the definition of a connected person for the purpose of the Regulations.

The decision not to include the carve-out for secured lenders is, arguably, in keeping with the objective of the Regulations of ensuring greater transparency and scrutiny of disposals to connected persons. However, the corollary of this is that the Regulations create an additional hurdle for secured lenders in enforcing their rights as creditors. Should an evaluator’s report be unfavourable, those creditors may find that they will have to wait a longer time before receiving any monies due to them.

In practice, for these transactions, secured creditors (who are ordinarily simply third-party credit providers) would usually, and in the ordinary course, seek a valuation. It may also be possible to structure the transaction in such a manner that the connected party provisions are not engaged, but this will not obviate the desire for those creditors (in ensuring that the disposal is for the appropriate value) to avoid later challenges.

Potential for change

At the time of writing, it is difficult to fully assess the impact of the Regulations, as the market has been relatively inactive as a result of the pandemic. For example, it is too early to say whether the introduction of the mandatory referral regime has resulted in companies entering liquidation rather than administration, so as to avoid the ambit of the Regulations. Recently, however, it is fair to say that there has been a significant increase in the number of administration proceedings commenced,^[9] so no doubt the Insolvency Service will continue to monitor the effect of the Regulations and whether any adjustments are required. It will also be interesting to see whether the government decides to continue with mandatory regulation, perhaps in respect of some of the issues identified above, or leaves it to the insolvency industry and the market to ensure that there is increased transparency and confidence in the pre-pack process.

Notes