Government restructuring and insolvency proposals

The UK government has published plans to modernise the corporate insolvency and corporate governance frameworks. The plans could significantly change the landscape of corporate restructuring in the UK. They will introduce a new restructuring plan procedure, which draws inspiration from the UK's existing scheme of arrangement process but with a new ability to cram down classes of creditors, as well as a new restructuring moratorium process. The government also introduced potentially far-reaching plans to prevent the enforcement of ipso facto clauses in contracts (provisions allowing termination of contracts on grounds of insolvency), which previously were allowed with minor exceptions for utilities and essential IT supplies.

The meat of these proposals originates from the 2016 Review of the Corporate Insolvency Framework (although the plans in 2016 to overhaul the rescue finance regime have since been dropped).  Since 2016, a number of high-profile corporate failures have made headlines including the insolvencies of BHS and Carillion, and several European jurisdictions have begun reforming their own insolvency regimes.  Against that backdrop, the government appears to be concerned that the UK's current framework could be improved to better support the rescue of viable but financially distressed companies. These plans revisit the 2016 proposals, and are combined with the government's response to the March 2018 Consultation on Insolvency and Corporate Governance. This note focuses on the changes to the corporate insolvency framework.

The planned changes in overview

The government intends to legislate for:

• A new restructuring plan procedure to encourage corporate rescue;
• A new moratorium process to support restructuring planning;
• A prohibition on the termination of contracts by suppliers on grounds of insolvency or restructuring;
• A new disqualification ground for holding company directors when selling a distressed subsidiary that subsequently enters into an insolvency process;
• Amendments to the existing transaction avoidance law to strengthen office holder powers against "value extraction schemes"; and
• An inflationary increase in the maximum "prescribed part" available to unsecured creditors in formal insolvencies from £600,000 to £800,000.

New restructuring plan procedure

The new restructuring plan procedure would be an alternative to the UK's existing scheme of arrangement process although it contains some features of the US Chapter 11 process, including the ability to bind dissenting classes of creditors who vote against a restructuring plan (referred to as 'cross-class cram down'). This is a significant difference to the existing scheme of arrangement process which can bind dissenting creditors who are out-voted by creditors within the same class but does not allow cross-class cram down.

The new procedure will be open to both solvent and insolvent eligible companies of all sizes and will, like the existing scheme of arrangement process, be supervised by the court.  Companies ineligible for the restructuring plan are those excluded from other mainstream insolvency procedures (such as credit institutions and insurance undertakings), as well as those involved in specific financial market transactions.

The process will share many similarities with that of a scheme of arrangement: the company will send a proposal to creditors and shareholders, and will file it at court.  There will be classes of shareholders and creditors, the composition of which will be examined in a first court hearing according to the dissimilarity of their rights and interests.  The plan will require court sanction at a second hearing, which will examine whether the procedure has been completed with and decide whether to sanction the restructuring plan.

On the other hand, there will be some significant differences to the scheme of arrangement process.  Most notably, there is the ability for the court to sanction a cross-class cram down (i.e. approve a scheme notwithstanding the dissent of a class (or classes) of creditors). The voting threshold required of each non-dissenting class will be 75 per cent by value of those who vote, which is the same as for a scheme. However, the requirement in a scheme of arrangement that a majority in number of voting persons in each class approve the proposal has been replaced by a requirement that more than half of the total value of "unconnected" creditors vote in support. There are also plans to allow for voting to take place electronically.

Creditor safeguards will aim to mitigate the potential for the new cross-class cram down feature to unfairly prejudice classes of creditors.  The safeguards will include a requirement that the claims of a dissenting class of creditors must be satisfied in full before a more junior class may receive any distribution (referred to in the US as the 'absolute priority rule'). However, to allow some flexibility, the court may approve a plan which departs from this absolute priority rule where it considers (a) it is necessary to achieve the aims of the restructuring and (b) is just and equitable in all the circumstances.  A further hurdle will be that at least one class of impaired creditors (that is, creditors who will not receive payment in full under the restructuring plan) must vote in favour of the restructuring plan. Further, in determining whether the restructuring plan which is being crammed down onto dissenting classes is fair, creditors must be no worse off under the restructuring plan than they would under the 'next best alternative.' Often the 'next best alternative' valuation comparator will be what the creditors would receive in an administration (as opposed to a liquidation). While valuation evidence is often crucial to the court's assessment of the fairness of a scheme of arrangement (as part of the court's consideration of the 'counterfactual' if the scheme did not proceed), it is unclear whether this protection in the new process will be more burdensome.

A significant advantage of the existing scheme of arrangement process is that it has benefitted from cross-border recognition within the EU without the EU Insolvency Regulation's rules limiting the scope of the UK courts' jurisdiction to companies with their centre of main interest in the UK.  It remains unclear what the jurisdictional hurdles will be for the new procedure in the context of the UK's departure from the EU.  The EU is itself consulting on its own proposals for a harmonised EU restructuring framework which shares many of the same features. Exactly how this will develop and what will be the UK's involvement in that dialogue also remains unclear.

New moratorium procedure

A new moratorium procedure will be introduced for distressed, but still viable, businesses to consider options for addressing financial and economic problems.  It will be modelled on the existing administration moratorium, and triggered by an out-of-court filing. 

It will be supervised by a licensed insolvency practitioner acting as a "monitor".  During this period the powers of management of the company will remain with its directors except for sales or other disposals of assets outside the normal course of business or the granting of any new security, which must be sanctioned by the monitor.

The moratorium will be open to eligible companies that: (i) would become insolvent if action is not taken; (ii) whose rescue is more likely than not; and (iii) which have sufficient funds to carry on their business during the moratorium, meeting current obligations as and when they fall due as well as new obligations that are incurred in the moratorium (in each case, as assessed by the monitor).  The moratorium will not be available to companies that are already unable to pay their debts or which become unable to pay their debts during the course of the moratorium. Companies eligible for the moratorium will be as for the new restructuring plan procedure (see above).

The moratorium will last for 28 days unless extended.  There is no limit to the extension period although extending beyond 56 days will require approval of 50 per cent by value of each of the secured creditors and the unsecured creditors, or an application to court for an extension where creditor approval is impracticable.

Creditors will be able to challenge the moratorium by application to court on the grounds that the qualifying criteria were not, or are no longer met, that the company was not, or is no longer eligible, or that the moratorium is unfairly prejudicial to creditors. Applications to lift the moratorium to enable individual rights to be pursued will be permitted along the same lines as for the existing administration moratorium procedure.

Monitors, who have a duty to terminate the moratorium if the qualifying conditions cease to be satisfied, will be immune from claims that the moratorium was terminated prematurely provided that they acted in good faith. They will be an officer of the court.  A monitor is prohibited from acting as the company's liquidator or administrator for 12 months (but may act as a CVA supervisor). The Government has dropped its suggestion that the role of "monitor" could be undertaken by someone other than a licensed insolvency practitioner.  However, it is arguable that the role itself, which involves policing the moratorium, may not necessarily require an accountant to perform it, particularly given the downside that the accountant would then be unable to take a subsequent insolvency appointment.

Costs incurred during a moratorium will be treated in a similar way to an expense of an administration and will have priority over costs and expenses of any subsequent administration or liquidation (save for the official receivers fee's in a compulsory winding-up), with super priority being given to the claims of suppliers who were prevented from relying on contractual termination clauses.

It is intended that this process will replace the more restricted Schedule A1 moratorium for small companies, which will be repealed.

Protection for ongoing supplies in the event of insolvency

Suppliers will be prohibited from enforcing termination clauses where the clause allows a contract to be terminated for entry into an insolvency process.  Termination will also be prohibited for other grounds "connected with the debtor company's financial position", which would include a moratorium or restructuring, although the exact breadth of this is unclear.  Suppliers will be able to terminate on other grounds, such as non-payment of liabilities incurred following entry into a moratorium, restructuring plan, or insolvency procedure, or after giving ordinary notice under the terms of the contract.

Protections will exist to allow suppliers to exercise rights of termination if doing so would avoid "undue financial hardship" (which will require evidence that it would be more likely than not to enter an insolvency process if it cannot terminate the contract) but the supplier will need permission from the court to do so, which will weigh the supplier's detriment against the impact on the debtor's prospects of rescue.

Exemptions will exist for certain "financial products and services", although no further detail has been provided at this stage of whether this could extend to financing arrangements themselves. It is not yet clear whether they will apply to existing contracts or only those entered into after a certain (yet to be published) date.

New directors' disqualification action when selling a large, distressed subsidiary

It is proposed that a director of a holding company who does not give due consideration to the interests of the stakeholders of a financially distressed large subsidiary when it is sold may be subject to disqualification if that subsidiary enters insolvent liquidation or administration within 12 months after the sale. It will be a defence if they had a reasonable belief at the time of the sale that the sale would likely deliver a no worse outcome for the stakeholders of the subsidiary than placing it into a formal insolvency. Whether a belief is reasonable will take into account whether professional advice was considered, the extent of consultation with the subsidiary's stakeholders before sale, and other steps taken by directors to prevent a sale being a worse option than a formal insolvency. A disqualified holding company director who has caused loss to one or more creditors of the subsidiary could also be subject to a compensation order imposing personal liability.

Value extraction schemes – transaction avoidance

The government plans to address the problem of unfair value extraction schemes from ailing companies by enhancing existing office holder recovery powers in the Insolvency Act 1986.  The proposed amendments include clarifying the definition of extortionate credit transactions and amending the insolvency requirement for preferences to connected creditors. The government is also considering removing uncertainty about whether the granting of security can be challenged as a transaction at an undervalue, clarifying whether shadow directors can be targeted under the provisions providing a remedy against delinquent directors, and addressing difficulties in pursuing wrongful trading claims against directors.

Powers to investigate and disqualify former directors of dissolved companies

The government intends to amend the Company Director Disqualification Act 1986 to extend the current investigation and disqualification regime to include former directors of dissolved companies, to avoid the cost and delay of restoring the company to the register.  This is to address the problem of directors of SMEs repeatedly dissolving companies and leaving behind debts and other liabilities.

Comment

As ever, the devil will be in the detail when this draft legislation is published, the timing of which will be "when parliamentary time permits".  Given the status of Brexit negotiations and the parliamentary time reserved for Brexit in the coming months (and years), it is not clear when parliament will set aside time for this large tranche of new primary legislation.

On the whole, these plans represent a considerable improvement from the initial sets of proposals published in 2016 and 2018.  In particular, the objectionable erosion of limited liability and new transaction avoidance powers proposed in the 2018 Insolvency and Corporate Governance consultation have now been watered down, although the restrictions on selling subsidiaries which remain may still have the effect of encouraging the entry of subsidiaries into insolvency processes before a sale. While some proposals have been dropped, including changes to the law to encourage super-priority rescue finance, the restructuring plan and moratorium proposals (first published in 2016) are in much better shape and are to be welcomed.

The UK needs a standalone court-driven restructuring plan and moratorium in line with both the World Bank's Doing Business methodology, and the UNCITRAL Legislative Guide on Insolvency Law to bring its regime into the twenty-first century and to stay ahead of the European and global competition.  It is also interesting that many of the features of the proposals already exist in the bank resolution regimes that have emerged out of the 2008 financial crisis, with the potential for some of the detail from those regimes concerning valuation and creditor safeguards to germinate in general corporate insolvency and restructuring law.

Nevertheless, these proposals herald some significant changes for the UK's restructuring and insolvency regime, and not just in the form of the new restructuring procedures.�� For example, the prohibition on enforcing insolvency termination events is a substantial reversal in policy from the previous freedom of contract, and will take some adjustment. It is not yet known whether these changes will be retrospective, or will only affect contracts entered into after a certain date. It may take a while for the full contractual impact to be felt and without the detail it remains to be seen whether suppliers will have scope to find other ways of drafting around the restrictions. Similarly it remains to be seen how companies will make use of the new moratorium process.  Whether it could be used by companies to keep their finance creditors and trade creditors at bay may depend on how strict the solvency qualifying condition is.

For more information on these reforms please contact your usual contract in Ashurst's Restructuring and Special Situations Group.