Adopting employees in a COVID administration: Insolvency law finds a way

First, some basics.  If an administrator is going to rescue or sell an insolvent business as a going concern, they are surely going to need to retain employees during the administration, yes?

Those retained employees need to be paid in priority to unsecured creditors. Accordingly, an administrator must be taken to have adopted the contracts of employees whose employment is knowingly continued for more than 14 days into an administration, right?

But what happens when your insolvent business is mothballed by COVID; and the government invents a scheme to pay employees for you – but only if you don't use them? 

This is the problem that faced Geoff Rowley and Phil Reynolds of FRP Advisory, as administrators of Carluccio's Limited, advised by Drew Sainsbury and Inga West of Ashurst LLP and Felicity Toube QC and Madeleine Jones of South Square.   

In a judgment that is important for all administrators intending to use the Government's Job Retention Scheme (the "Scheme") under which grants are available to fund payments to furloughed employees, the Hon. Mr Justice Richard Snowden answers the question of how the employment contracts of furloughed employees can be reconciled with the purposes of the administration regime, and the extent to which their contracts are adopted by the administrator, entitling them to super-priority payments.

This judgment, arrived at in the heat of the first 14 days of the Carluccio's administration and before seeing the detail of the legislation that will bring the Scheme formally into effect, will have significance for every administrator intending to make use of the Scheme in the COVID-19 lock-down period.

The Hon Mr Justice Richard Snowden has highlighted the importance of the judgment being shared and understood as widely as possible in the market.  This briefing is an initial contribution to that objective from the firm who advised (and is advising) the joint administrators on these issues. We explain the key elements of the decision as covered in the public judgment, and consider its impact on the wider market.

Adoption of employees in administration and why it matters

Adoption of employment contracts in administration is key for both employees and administrators because employees whose contracts are adopted are entitled to super-priority payments of qualifying wages and salary  as an expense of the administration.  That means they don't have to claim as an unsecured creditor at the back of the queue.  It is therefore crucial for administrators to only adopt those employment contracts that they can afford to pay.  

The rules provide that nothing the administrators do in the first 14 days of the administration counts towards adoption of employment contracts.  So in normal times, administrators have a 14 day period of grace at the start of an administration to set their strategy and decide which employee contracts to adopt and which to terminate according to which employees are needed for the purpose of the administration.

In normal times, therefore, employees are either retained and continue to provide services while being paid their qualifying wages and salary as a super priority expense, or they are dismissed within the first 14 days.  

In COVID-19 times, however, the picture has changed: the combined effect of trading restrictions and the Scheme is that rather than paying employees to provide services for the benefit of the administration, furloughed employees will instead be paid not to provide services.

The Scheme and its terms

Many businesses have closed for an indefinite period due to the COVID-19 pandemic measures and so employees cannot continue to work.  The Government has introduced the Scheme to enable employers, including those in administration, to furlough employees whose services cannot be used.   Furloughed employees are not permitted to work for their employer during the period of furlough.  The employer will be able to apply for a grant from the Government to cover the cost of continuing to pay the employees 80% of their regular salary (up to a maximum of £2,500 per month).

The Scheme Guidance was published on 26 March (and has been updated twice since).  It will cover the period from 1 March 2020 and is expected to be available for 3 months, but may be extended.  However, the corresponding legislation has not yet been passed and the online application service will not be available until at least the end of April.  Much detail is as yet unknown.

Carluccio's administration and its employees

Before the COVID-19 pandemic hit the UK, Carluccio's operated a chain of Italian restaurants but it was forced to shut its doors on or around 16th March in accordance with the Government's lock-down measures.  Carluccio's subsequently went into administration on Monday 30th March.  The administrator's strategy is to mothball the business so far as possible and seek a buyer for some or all of the business. 

With that purpose in mind, the administrators wrote to 1788 restaurant employees (the "Variation Letter") offering to furlough them in accordance with the Scheme, provided they consented both to the furlough conditions (i.e. not turning up to work for at least three weeks) and to cap their pay during the furlough period to the maximum amount available to them under the Scheme.  Further, the offer was limited to the extent that funds were received from the Government under the Scheme to enable the company to pay the furlough payments to the employees.  Employees were asked to email their consent by a certain date, and were informed that, if they did not consent to the terms, the administrators would need to consider whether to make them redundant.  At the same time, the administrators applied to court for directions on the question of if, when, and on what terms the administrators would adopt these employees' contracts.

By the time of the hearing, the vast majority of these employees had consented to vary their contracts in accordance with the terms of the Variation Letter (the "Consenting Employees"), a very small number had responded that they did not consent and would prefer to be made redundant (the "Objecting Employees"), and 77 had not responded at all (the "Non-Responding Employees").  

It was this latter group for whom the directions application was the most significant.  The lack of response from the Non-Responding Employees could have been for a number of practical reasons. Nevertheless, unless the administrators could be comfortable that they would not be adopting the contracts of the Non-Responding Employees if they allowed them to continue beyond 14 days from appointment, then the administrators would likely have to make these employees redundant within those 14 days.

The Judge's decision

After an urgent hearing spanning four days, the Judge handed down a comprehensive judgment that provides administrators with a means of reconciling the furlough scheme and the administration regime.  Accordingly, there is now no need for administrators to make pre-emptive redundancies in order to avoid the risk of adopting unaffordable furlough employee liabilities.

The Judge's conclusions were as follows:

1. In relation to the Consenting Employees: their contracts had been varied in accordance with the Variation Letter and would be adopted on the earlier of the administrators making (i) payments to them under the Scheme; or (ii) an application in respect of them under the Scheme.
2. In relation to the Objecting Employees: their contracts had not been varied by the Variation Letter and their contracts had not been adopted by the administrators.
3. In relation to the Non-Responding Employees: their contracts had not been varied in accordance with the Variation Letter unless or until they subsequently accepted the offer prior to termination of their employment contract.  Adoption of the contract of such a late-consenting employee would take place as in 1 above.
4. Objecting Employees' and Non-Responding Employees' claims referable to the period before termination of their contract will be an unsecured claim in the administration.
5. The administrators are not under any duty to apply for a grant under the Scheme in respect of any Employee, other than a Consenting Employee, or a late-consenting Non-Responding Employee whose contract is varied as in 3 above.
6. Failure to terminate a contract, by itself, does not amount to adoption.
   

Comment

The new point of law is that mere failure to terminate an employment contract within the first 14 days does not, of itself, amount to adoption for the purposes of paragraph 99(5) of Schedule B1 of the Insolvency Act 1986.  Adoption requires some additional conduct on the part of the administrators that amounts to an election or decision that those liabilities arising under the continued contract will be a 'separate' (i.e. prior ranking) liability in the administration.  Here such conduct would be applying for a furlough grant in respect of a particular employee under the Scheme, or paying them under their varied contract (whichever occurs first).

Crucially, the Judge's conclusions mean that there is no need to dismiss the furloughed employees merely because of the risk of adoption: the Non-Responding Employees can have a little longer to see if they wish to consent to being furloughed and vary their terms, and therefore they do not need to be made pre-emptively redundant just yet.  No adoption of their (or the Consenting Employees' contracts) will occur unless or until the administrators apply under the Scheme, or pay them.

Impact on the market

However, the decision does not provide an answer to every furlough question.  Significantly, administrations commencing in the next few weeks will likely inherit employees who have already been 'furloughed' under the Scheme by their employer before it entered administration.  The details will differ according to how each employer has treated the Scheme.  Some, like the administrators of Carluccio's, will have required employees to indicate their consent to the varied terms (noting that the Scheme guidance envisages that changes to employment contracts will be undertaken by agreement with employees) but other larger employers on grounds of expediency may have unilaterally written to employees notifying them of the change.  Some employers will have agreed to continue paying 100% of contractual terms and to reclaim what they can under the Scheme, while others, like the administrators of Carluccio's, will have varied contract terms to match the Scheme. One can conceive of practitioners striving to push things even further – challenging whether elective adoption and super-priority under para 99(5) is a necessary pre-requisite to using the CJRS. Could payments under the CJRS be made by other means (for example under paragraph 66 of Schedule B1)? Each case will have to be considered on its own facts, but this decision provides sound answers some of the most fundamental questions.  

As for Carluccio's – the case highlights that sometimes administrators have to jump off the cliff and build the aeroplane on the way down.   It is to the great credit of Hon. Mr Justice Snowden and our court system that it has been able to assist, with urgency and creativity, administrators and their advisors with that invidious task.  It is a fair prediction that they will be asked to do so again before the COVID-19 crisis passes into history.