Does the UK
need Chapter 11?
orporate failure is a source of increasing concern in the UK economy. The current economic downturn is already reducing the chances of survival of a large number of companies. Figures produced by the Insolvency Service in February show that there were 15,535 company liquidations in England and Wales in 2008 (an increase of almost 25 per cent over 2007). This amounts to the failure of 0.7 per cent of the total number of active companies.
Current government policy in support of the business sector has, so far, focused on measures to encourage bank lending and the supply of credit. However, the UK insolvency framework could also work better to rescue companies that have a viable future as going concerns. Important lessons can be learned from the operation of the Chapter 11 bankruptcy regime in the US, which does more to sustain companies in difficult times.
Before considering the merits of the Chapter 11 approach, it is useful to outline the existing UK insolvency system, and to evaluate its effectiveness as a mechanism for corporate survival and rehabilitation.
THE STARTING POINT –
THE INSOLVENCY ACT 1986
The existing UK insolvency framework is defined by the Insolvency Act 1986. According to the Act, failing companies are either liquidated or submitted to an insolvency process that may allow them to be rescued as going concerns.
Firms are liquidated if they become the subject of a compulsory liquidation order obtained from the court by a creditor, shareholder or director. Alternatively, the company may itself decide to pass a liquidation resolution – subject to the approval of a creditors' meeting – for the company to be wound-up (a Creditors Voluntary Liquidation). Either way, the result of both these procedures is the winding-up of the company. Neither process makes any attempt to rescue or sustain the company as a legal entity.
Dr Roger Barker, Head of Corporate
Governance at the IoD, looks at whether
the UK would benefit from a similar
insolvency framework to Chapter 11 in
the US.
Corporate insolvencies jumped 25 per cent – to just over 15,000 – in 2008 and are likely to increase much more over the next two years. In the last recession total liquidations peaked at almost 25,000 a year.
The UK insolvency framework could work better to rescue companies that have a viable future as going concerns. Important lessons can be learned from the operation of the Chapter 11
bankruptcy regime in the US.
Although administration is more widely used since the Enterprise Act 2002 (effective September 2003), this is likely to be the result of ‘liquidity substitution’ rather than the emergence of a genuine rescue culture in the UK.
Both the UK and the US offer the possibility of rescue as well as liquidation, but the evidence suggests that Chapter 11 is better than administration in achieving a rescue culture.
We need to think again about how the insolvency system can play a more effective part in sustaining UK enterprise in an exceptionally difficult economic environment.
SNAPSHOT
Table 1 shows that there was a significant upturn in company liquidations in the third and fourth quarters of 2008. Most worryingly, the fourth quarter figure for total company liquidations was more than 50 per cent higher than the equivalent figure for the fourth quarter of 2007.
Figure 1 provides a longer-term perspective on company liquidations. This shows that liquidations are still significantly lower than the record levels reached in the early-1990s. However, given the severity of the current downturn, it is not implausible that levels of corporate failure will soon be comparable.
Number of company liquidations in England and Wales – quarterly data
YEAR
Quarter Compulsory
Creditors’
Total
company
Liquidations
Voluntary Liquidations
liquidations
2006 2007 2008 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 (prov) 1,478 1,198 1,332 1,410 1,392 1,334 1,277 1,162 1,098 1,340 1,495 1,562 2,023 2,000 1,909 1,787 1,815 1,760 1,890 1,877 2,075 2,299 2,623 3,045 3,501 3,198 3,241 3,196 3,207 3,095 3,167 3,039 3,172 3,639 4,118 4,607TABLE 1
NB: Quarterly figures are seasonally-adjusted. Source: The Insolvency Service (February 2009).
0 5,000 10,000 15,000 20,000 25,000 30,000
Company liquidations in England and Wales since 1960
FIGURE 1
1960 1966 1972 1978 1984 1990 1996 2002 2008
Source: The Insolvency Service.
Total company liquidations Compulsory liquidations Creditors voluntary liquidations
YEAR
The Insolvency Act 1986 also introduced three new procedures that held out the possibility of a company being brought back to life as a viable entity. These measures represented an attempt to emulate the ‘rescue culture’ that characterised the corporate sector in the US.
The first of these procedures – ‘company voluntary arrangements’ (CVAs) – provides a way in which a company in financial difficulty can come to a binding agreement with its creditors. The second procedure – ‘administration’ – offers companies a breathing space during which creditors are restrained from taking action against them. During this period, an administrator is appointed by a court to put forward proposals to deal with the company’s financial difficulties. A third option – ‘administrative receivership’ – permits the appointment of a receiver by certain creditors (normally the holders of a floating charge) with the objective of ensuring repayment of secured debts.
Whereas CVAs do not involve the granting of a moratorium against creditors, this is a feature of both administration and administrative receivership. However, whereas an administrative receiver is appointed by a specific creditor – and primarily owes a duty of care to that party – administration is intended to be a collective procedure that takes account of the interests of all creditors.
Consequently, administration is the most important method by which distressed companies may be rescued as going concerns, and has been the centrepiece of government policy efforts to create a rescue culture in the UK.
A SECOND ATTEMPT –
THE ENTERPRISE ACT 2002
In the period after the 1986 Act, take-up of the administration procedure was disappointingly low relative to other insolvency liquidation procedures. The use of administration tended to be reserved for ‘larger’ insolvencies, and was seen as a costly and bureaucratic option for small or medium-sized enterprises.
The Enterprise Act 2002 – which came into effect in September 2003 – was a second attempt to embed a rescue culture in the UK, through more widespread use of
administration. It created entry routes into administration that did not require a court order, and simplified the means by which a company could ‘emerge’ from administration. It also prohibited – with certain exceptions – the right of creditors to appoint an administrative receiver (which had previously blocked a company’s ability to opt for administration).
In addition, the Act explicitly established a ‘hierarchy of purposes’ for the administration process. The primary duty of administrators was defined as rescuing the company as a going concern (a duty that does not exist for an administrative
receiver). Only if this is not practicable – or not in the interests of creditors as a whole – is the administrator allowed to consider
1‘Enterprise Act 2002 – Corporate Insolvency Provisions: Evaluation Report’. The Insolvency Service (January 2008).
2‘Report on Insolvency Outcomes’. Sandra Frisby (26 June 2006).
other options, such as realising the value of property in order to make a distribution to creditors.
Since 2003, the Enterprise Act has had a significant impact on the insolvency behaviour of companies in the UK. Administration is more widely used than in the pre-Enterprise Act regime (see Table 2), and has become a less costly option for small and medium-sized companies. Most administrations are now initiated by directors without a court order.
However, a study undertaken by the Insolvency Service in January 20081
– based on the research of Dr Sandra Frisby at Nottingham University2
– raises significant doubts about the effectiveness of administration as a corporate rescue technique. The study found that the proportion of companies rescued from administration was no different to the proportion rescued from administrative receivership. Furthermore, there were proportionally fewer rescues from administration in the post-Enterprise Act period than under the pre-Act regime (although absolute numbers have increased).
These results are summarised in Table 3. The data suggests that administration – in the period since 2003 – is more likely than administrative receivership to result in a break-up of the company. The data also implies that administration is currently less likely to lead to a corporate rescue or sale as a going concern (in whole or part) than in the period before the Enterprise Act.
Receiverships, administrations and company voluntary arrangements (England and Wales)
YEAR
Receivership
Administrator In
Administration
Company
Appointments
Appointments (excl.
court)
Voluntary
(by court)
Arrangements
Arrangements
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 (prov) 1,618 1,595 1,914 1,541 1,261 864 590 588 337 867 440 438 698 643 497 1 4 0 3 2 – – – – 247 1,601 2,257 3,560 2,509 4,820 475 557 597 651 726 597 604 534 418 587
TABLE 2
3 See ‘Study of Administration Cases’ by Alan Katz and Michael Mumford (October 2006), and ‘The Impact of the Enterprise Act 2002 on Realisations and Costs in
Corporate Rescue Proceedings’ by John Armour, Audrey Hsu, and Adrian Walters (December 2006).
Although administration has been more widely used since 2003, this is likely to be the result of ‘liquidation substitution’ rather than the emergence of a genuine rescue culture. The costs associated with administration have declined and it has become more accessible. Consequently, it has become increasingly used by companies that should more properly proceed directly into liquidation.3
This is a concern for creditors, as administration blocks them from nominating an office-holder for the liquidation process (which reduces their influence over liquidation
proceedings).
Although the administrator has had a statutory duty since 2003 to evaluate the possible rescue of a company as a going concern, this is not pursued if the administrator thinks that a rescue is impracticable, or it would not achieve the best result for the company’s creditors as a whole. The data presented in Table 3 suggests that these are the conclusions reached by the
administrator in most cases. Furthermore, there exists little scope to challenge these assessments – it is unusual for courts to attempt to overrule the commercial judgments of an administrator.
Consequently, producing better returns for company creditors – rather than rescuing companies – appears to be the current reality of the administration procedure in the UK. Outright corporate rescue – defined as being where the company emerges from the procedure under the same ownership – is a rare
administration outcome. In short, the UK insolvency system does not yet appear to have attained the objective of being able to sustain viable companies in hard times.
Corporate rescues
Total going concern sales (in whole or part)
Asset sales on a break-up basis Ongoing or uncertain
Number of cases examined
4.7 45.1 42.4 7.7 403 2.4 37.9 56.3 3.4 707 0.2 36.8 57.1 6.0 587 0.0 47.3 48.1 4.6 366 Source: ‘Enterprise Act 2002 – Corporate Insolvency Provisions: Evaluation Report’. A report produced by The Insolvency Service, January 2008. Based on table 46, p.92. All companies surveyed between 2001 and 2005.
% OF ADMINISTRATIONS
% OF ADMINISTRATIVE
RECEIVERSHIPS
TABLE 3
A comparison of outcomes from administration and administrative receivership
Pre-Enterprise
Post-Enterprise Post-Enterprise Post-Enterprise
THE CHAPTER 11 ALTERNATIVE –
KEEPING FAITH WITH THE MANAGEMENT
Although both the UK and US have reorganisation schemes for ailing companies, there are significant differences in the way they operate.
In the US, Chapter 11 of the Bankruptcy Code 1978 governs corporate reorganisation proceedings. They are normally initiated by a court petition filed by the company. There is no requirement of insolvency before a company can make such an application. If successful, the filing brings about a moratorium on enforcement proceedings by creditors.
Chapter 11 is based on the premise that necessary adjustments can be brought about without court supervision, and that the decision to initiate reorganisation proceedings should be made by management. Another assumption is that the incumbent
management should generally remain in place (although legally transformed into a quasi-trustee in bankruptcy: the so-called ‘debtor in possession’). This contrasts with the UK administration procedure, which displaces the incumbent management.
A successful Chapter 11 outcome results in a plan of reorganisation agreed by a majority of creditors. The existing board of directors continues to run the business in the ordinary way (although it needs court approval for substantial asset sales). For the first few months, only the existing board
can propose a reorganisation plan. Creditors need to approve the plan, although the overriding of creditor objections is possible under certain conditions. In general, creditors are protected by a ‘best interests’ test – each creditor must receive at least as much under the plan as it would in liquidation – and a ‘feasibility test’ – the company must be reasonably able to fulfil the promises made in the plan.
A key advantage of the Chapter 11 approach is its encouragement of an early reorganisation. Chapter 11 protection safeguards the position of directors as well as providing them with the
exclusive right to propose a reorganisation plan. It is often critical for a successful outcome that a company seeks protection when there is a realistic prospect of survival, rather than after the potential for reorganisation has been exhausted. If managers believe that their jobs will be preserved, they are more likely to do this.
In contrast, the UK approach to insolvency is based on the threat of legal sanctions against directors, rather than
constructive encouragement. According to the ‘wrongful trading’ provisions of the Insolvency Act 1986, as soon a director knows – or ought to have concluded – that there is no reasonable prospect of avoiding insolvency, he should consider placing the company into administration or another insolvency procedure. If he fails to take such steps, he runs the risk of being declared personally liable for the debts of the company. Further, allowing a company
Chapter 11
protection
safeguards the
position of
4 See R Posner, ‘Foreword’ in J Bhandari and L Weiss (eds), ‘Corporate Bankruptcy: Economic and Legal Perspectives’ (1996).
to trade while insolvent may lead to subsequent director disqualification proceedings.
Nonetheless, despite the threat of such sanctions, it seems likely that the initiation of administration will often occur too late to permit a realistic rescue of the
company. Once an administrator is appointed, it is the end of the road for existing management.
Consequently, directors are likely to resist a decision about administration for as long as possible. In the meantime, any remaining going-concern surplus may be dissipated, to the detriment of the creditors and other stakeholders.
A second advantage of the Chapter 11 approach is that professional management is more likely to be successful in rescuing the enterprise as a going concern – once the reorganisation process has begun – than an accountant/insolvency practitioner. A leading American scholar, Richard Posner, makes the point as follows: “The reason for giving the right to continue the operation of the firm to management is that only management, and not a committee of creditors, a trustee, auctioneer, venture capitalist or other acquirer has the knowledge to continue the firm in operation, as distinct from reviving it (maybe) after an interruption for a change in control”.4
Chapter 11 does have potential downsides. One criticism is that it gives bankrupt companies a substantial temporary advantage vis-à-vis their competitors. A Chapter 11 company is protected from its creditors, thereby freeing-up significant cashflow that can be used to expand capacity or cut prices. This may distort the operation of markets and harm the interests of other healthy companies. Consequently, an effective Chapter 11 framework requires scrutiny from courts to ensure that
protection is not being sought in bad faith or without reasonable hope of a successful outcome for the company.
SHOULD THE UK ADOPT A CHAPTER 11
INSOLVENCY APPROACH?
Clearly, the insolvency frameworks of both Britain and the US offer the possibility of company rescue as well as liquidation. Both countries are, in principle, committed to the concept of a rescue culture. However, the evidence suggests that Chapter 11 is better than administration in achieving this objective. The US approach is more supportive of management in difficult times,
5 See R Goode, ‘Principles of Corporate Insolvency Law’ (2005, p.328).
6 ‘A Review of Company Rescue and Business Reconstruction Mechanisms: Report by the Review Group’, Department of Trade and Industry and HM Treasury (May 2000).
whereas the UK framework retains a strong pro-creditor bias (despite the efforts of the Enterprise Act).
Part of the reason for the different approaches may derive from cultural attitudes. Professor Sir Roy Goode – a leading legal scholar – has argued that insolvency law
in the UK is based on an ingrained belief that insolvency represents a failure of management.5
Consequently, the last people to leave in control are those responsible for the problems in the first place. In contrast, the US attitudes are more tolerant of risk-taking and business failure, and are consequently more willing to give management another chance (albeit within a carefully-defined legal framework).
A further problem in the UK is that administration has grown out of receivership, which is essentially a creditor-oriented procedure. Despite
attempts at reform, the similarities between administration and administrative receivership remain strong. This has led a number of critical observers to describe administration as ‘receivership-plus’, ie. receivership with a few add-ons.
Does this mean that the UK should move decisively in a Chapter 11 direction? Some modest steps have already been taken to achieve this. The Insolvency Act 2000 introduced a procedure for small companies that combines a company voluntary
arrangement (CVA) with a debt moratorium. The moratorium lasts for 28 days, prevents creditor recovery actions during the period, and is designed to facilitate shareholder and creditor approval of the plan. Analogously to Chapter 11, the existing management remains in control during the moratorium period.
To obtain the moratorium, the board of the company must persuade an insolvency supervisor of the viability of its proposed restructuring plan. It must also demonstrate that the company will have sufficient funds to carry on business during the period. However, only small companies – defined in terms of turnover (according to the standardised EU definition, this is a turnover of less than € 10m), balance sheet totals (less than € 10m) or number of employees (fewer than 50) – are currently able to benefit from this procedure. Its effect on corporate survival in the current downturn is, therefore, likely to be limited.
Due to the limited success in establishing a rescue culture in the UK, it is time for a rethink on the issue. The last major review of the UK insolvency framework was undertaken almost a decade ago.6
Given the severity of the current economic downturn, it is essential for policymakers to revisit the operation of that framework, and to consider if lessons can be learnt from the experience of other major economies.
Although it is not a panacea, the Chapter 11 approach is worthy of detailed consideration as part of that process. It
In the US, some
investors prefer to
back businessmen
with failures
7 Address to the British–American Chamber of Commerce, quoted in The Times (14 October 1998).
provides struggling companies with a structured framework in which they can be open about their financial problems at an early stage. They can then benefit from a breathing space in which to implement a fundamental reorganisation with a reasonable chance of success. The US insolvency process is also less punitive than that of the UK towards business failure, which is helpful in fostering a pro-enterprise climate.
As an initial step, it is relevant to reconsider the words of Lord Mandelson during his first period as business secretary:
“We need to examine all our regulatory systems to ensure that they do not needlessly deter entrepreneurs, such as our bankruptcy laws. Are we sure that they create confidence in enterprise and commerce? I don’t think that we are confident. I think we need fundamentally to re-assess our attitude in Britain to business failure. Rather than condemning it, and discouraging anyone from risking failure, we need to encourage entrepreneurs to take further risks in the future. Here in the US, I am told that some investors actually prefer to back businessmen and women with one or more failures under their belt, because they appreciate the spirit of enterprise shown, and recognise the experience that has been gained. Can you imagine that in Britain?” 7
There is still some way to go before that question can be answered in the affirmative. In the meantime, we need to think again about how the insolvency system can play a more effective part – alongside other more high profile policy initiatives – in sustaining UK enterprise in an exceptionally difficult economic environment.
