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Distressed debt guide: Overview of the UK insolvency regime

Stewart Perry and Jonathan Richards of DLA Piper UK examine insolvency issues pertaining to distressed debt investing. An excerpt from PEI Media’s new book: The Definitive Guide to Distressed Debt and Turnaround Investing: A comprehensive resource for making, managing and exiting investments in distressed companies and their securities.

The United Kingdom incorporates a number of different legal jurisdictions, and whilst the basic rules behind most of these jurisdictions remain the same, the details of the various insolvency laws differ. This chapter is a brief summary of the insolvency law of England and Wales: to the extent any distressed structures involve, for instance, entities in Scotland or the UK Channel Islands, the laws might vary.

For many decades the English court has recognised and supported secured creditors rights in distressed scenarios. As such, the options available to first-ranking secured creditors, especially if more junior creditors would receive no return in a formal liquidation of the debtor, are numerous. In addition, England recognises a form of security known as a ‘floating charge’. This is a form of security over movable assets of the borrower, which crystallises upon certain events, and then creates a fixed charge over those assets. In reality, this means that most borrowers in England and Wales have granted security over all of their assets. Realisations from floating charge assets are distributed to certain preferential creditors (including insolvency office holders’ fees and certain employee claims), a small percentage is thereafter set aside for unsecured creditors1 whilst the remainder is paid to the floating charge holder.

Directors in the UK are given much greater flexibility in distressed situations than some of their European counterparts. For instance, there is no absolute deadline by which the directors of an insolvent English company are required to cause the company to commence an insolvency proceeding.

Potential liabilities would fall upon directors if they knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation and failed to take every step with a view to minimising the potential loss to the company’s creditors. Such liability is usually calculated by reference to the increase in the company’s debts during that period and is known as ‘wrongful trading’. In reality, however, claims for wrongful trading are rarely brought, and successful claims are exceptional.

There is very limited criminal sanction in respect to directors’ insolvent trading. An offending director may be disqualified from acting as a director or other manager of a company for a limited amount of time, pursuant to the provisions of the Company Directors Disqualification Act 1986.

In many situations, the lenders intent on obtaining a suitable restructuring outcome face a difficult balancing act. They will want to place enough pressure on the directors to force through the restructuring but without threatening action to the extent that the directors believe the company cannot escape insolvent liquidation, and in order to protect themselves from personal liability, place the company into a process before the restructuring can occur.

Contrary to a number of other jurisdictions, in particular the US, the UK courts have very little to do with the day-to-day management of insolvency processes. As such, the licensed insolvency practitioners who are appointed as office holders in any formal process are given a great deal of discretion in the management, rescue and/or wind down of the company’s business.

In addition to the many consensual restructuring methods available, UK legislation has three forms of ‘rescue’ processes and two forms of terminal insolvency processes. The closest parallel to a US chapter 11 proceeding in the UK is administration. Due to the speed in which it can be commenced and the protection given to the company during the course of the administration, this is a most popular ‘rescue’ process.

Administrators can be appointed in different ways. It is possible for the holder of a floating charge over the whole or substantially the whole of the borrower’s assets (‘qualifying floating charge holder’, or QFCH) to use an ‘out-of-court’ process to appoint administrators over the borrower. It is also possible for the company (acting through its shareholders) and the directors to appoint administrators ‘out of court’ but notice must first be given to any QFCH. The out-of-court process is simple and requires the filing at court or certain standard form documents. It is even possible for a QFCH to appoint administrators outside of court hours by lodging the papers by fax or email. In addition, the company, the directors or a creditor can apply to court for the court to place the company in administration.

Administrators, as with other insolvency office holders, are licensed insolvency practitioners and tend, in the UK, to be practicing accountants. They are officers of the court, and are therefore under the control of the court and owe duties to all creditors. In 2003 legislation was passed in the UK so that a previous form of enforcement called ‘administrative receivership’ has been phased out. Administrative receivers could also be appointed by floating charge holders and had similar powers to those of an administrator, save that they primarily owe duties to the secured lender. Now, save for certain exceptions, administrative receivers can only be appointed pursuant to floating charges which predate 15 September 2003.

On appointment, the administrator takes over management of the company and its business.

There is no ability for the existing management to exercise any ‘management power’ without the administrator’s consent, and in reality, it is very unusual for existing senior management to remain in control once an administrator is appointed. The purpose of an administration and the goal for which an administrator of a company must perform his functions are the following (in order of priority):

• rescue the company as a going concern;

• achieve a better result for the company’s creditors as a whole than would be likely if the company were wound up (without first being in administration); and

• realising property in order to make a distribution to one or more secured or preferential creditors.

This partial chapter is one of 15 in The Definitive Guide to Distressed Debt and Turnaround Investing: A comprehensive resource for making, managing and exiting investments in distressed companies and their securities, a new book from PEI Media. Edited by Probitas Partners, this guide provides investors and fund managers with valuable tools and practical guides, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/books.