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The Most Efficient Way to Treat Insolvent Companies

Info: 5350 words (21 pages) Essay
Published: 28th Jun 2019

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Jurisdiction / Tag(s): UK Law

INTRODUCTION:

The adverse effect of the collapse of corporate enterprise is the principal concern of Corporate Insolvency Law. Its dramatic implications on the society at large, both locally and internationally, are so drastic, that corporate insolvency law, putting the repercussions of this cankerworm into serious considerations, is always torn between the two options of either protecting the private rights which is basically maximizing returns to creditors on the one hand, or preservation of the company or its business [1] , considering the effect of such on the public at large.

In a bid to strike a balance between the above alternatives to ensure that best results are achieved in addressing the insolvency issues, Insolvency Law, following the recommendations of the cork report [2] , which is the bedrock of modern corporate insolvency regimes, legislations including the Insolvency Act 2000( as amended) and the Enterprise Act 2002, has made provisions for five insolvency regimes [3] ,that can be applied in the case of a financially distressed company depending on the state of such company. This essay attempts to provide an exposition on liquidation, which is the oldest and the eventual outcome of a financially distressed company, and to critically analyze it as the best option for an insolvent company. To begin with, the origin, fundamental principles and objectives of this insolvency regime will be discussed, bringing out its importance and effectiveness in Insolvency Law. It also discusses on the criticisms against liquidation, bringing out its disadvantages by comparing it with other insolvency regimes which has been described as corporate rescue procedures; looking into their relevance, and finally drawing a conclusion as to the best option for an insolvent company in the light of the procedures discussed.

THE POSITION OF LIQUIDATION IN INSOLVENCY LAW.

The origin of liquidation stemmed from Bankruptcy Law, which explains their similarity in a couple of ways [4] , but differs in respect of the insolvent entity involved. In the United Kingdom, bankruptcy applies to an individual debtor who has been given a clean slate by wiping off all the liabilities accruing to him, and giving him an opportunity to start afresh, while liquidation is the ending of the legal life of an insolvent company [5] . However, note be taken that this is contrary to what is obtainable in some jurisdictions were liquidation of a company means same as bankruptcy [6]

Legal effect was given to liquidation by the passing of Winding up Act of 1844 which pronounced for the “winding up of the affairs of joint stock companies unable to meet their pecuniary engagements” [7] .The essence of such legislation, was to protect creditors by providing an avenue through which debts owed them by companies can be obtained out of the companies property [8] .

That protection of private rights of creditors is still a basic objective of the present Insolvency Act, but done, borrowing the words of Professor Warren in “collectivism” [9] , in that the individual rights of creditors are given up in ensuring the payment of debts, to a collective one in which rights of creditors are dealt with collectively as a group, and company assets, distributed in a collective manner to the creditors according to the respective rights existing before liquidation [10]

The liquidation of a company which can be effected either through compulsory liquidation by the court on the petition of a creditor, or through a voluntary winding up agreed to by creditors of the company, must involve the appointment of a liquidator who through acting as an agent of the company, carries out the winding up of the affairs of the company bearing the purposes of winding up in mind, which are as follows;

Ensuring an equitable and ratable distribution of the assets of the insolvent company among creditors;

Putting an end to the existence of a company that is terribly insolvent;

Creating room for an effective investigation into the affairs of the insolvent company so as to ensure that the standard of conduct was not contravened [11]

COLLECTIVITY IN THE INTEREST AND PROTECTION OF CREDITORS, AND THE PUBLIC AT LARGE.

When a company is in a hopeless situation, that, it is better, officially dead than alive, the liquidation of such company is initiated so as to discharge its liabilities through the distribution of its assets to creditors. Liquidation, which can be described as, “the immediate or almost immediate selling off of the company’s assets” [12] , though recognizing the fact that both secured and unsecured creditors have individual proprietary (not available for the unsecured creditors), and contractual rights against the insolvent debtor company [13] , frowns at such rights being exercised individually, hence the need for the collective protection of all creditors by the orderly and speedy distribution of assets, with interest of all creditors put into considerations [14] , so that valuable collection of assets is guaranteed [15] . The event of winding up will see that secured, preferential and unsecured creditors are protected by making sure that they get something out of the distributed assets of the company. Some creditors are not given full payments while others will be left with nothing [16] . Take for instance the provisions of the Enterprise Act 2002, in its section 176A, made provision for the unsecured creditors to be given a percentage out of the assets accruing to the floating chargee [17] .

One might ask, is liquidation all about the private rights of creditors? How does it protect the interest of the public?

Though public interest is not a pre-requisite for initiating insolvency proceeding, has stuck with it that it is frequently alleged in insolvency cases [18] . This is as a result of the adverse effect of insolvency of companies on the society as a whole, hence the need to protect them. To ensure this protection, liquidation involves the investigation of the affairs of an insolvent company, to make sure that the standard of conduct as laid down by insolvency law, has not been contravened by the management of the company which otherwise led to its insolvent state [19]

Professor Fletcher, making a case for the society, stated that “this standard can be achieved by the insolvency law, providing for criminal and regulatory sanctions which can be applied on behalf of the society at large against individual debtors or against the directors or managers of insolvent companies, whose conduct amounts to a violation of, or a sufficiently serious threat to the norms of acceptable commercial behavior” [20] .

Thus a need arises for an investigation to be carried out in liquidation as regards the affairs of the insolvent company, for a duty is owed to the public by ensuring that they are convinced no fraud has been perpetrated by the insolvent company [21] .

Supporting the above view, R.Morkal [22] argues that liquidation, aside taking care of private interest of the creditors, also regards the public interest by making sure the insolvent company has not gone against commercial morality.

However, it is important to note that liquidation does not always mean complete failure. Alice Belcher [23] pointing out the concern of liquidation over public interest, states that there are cases, where, though the company may come to an end legally, its business is preserved, either by selling off the assets to same workers of the insolvent company, thus securing jobs, or another company takes the insolvent company, in that the legal name of such company is wiped off, but the business is preserved but owned by another legal entity.

THE CENSURE OF LIQUIDATION

The major failing of liquidation, is the immediate winding up of viable companies which otherwise would have survived had it been given an opportunity. This and many more which will be considered hereunder, have led to the criticisms against liquidation as an option for insolvent companies.

The fact that a company is in financial difficulty, does not necessarily mean it is totally insolvent. There are cases where a company may be short of cash momentarily, but has assets which are far more than its liabilities, including potential businesses. The question is, why liquidate such company due to its short term cash flow? Is there no way of arranging a payment process between the debtor company and its creditors, than immediate liquidation? Furthermore, where failure of a large company will affect the nation because of its dependency on the company, why allow it to fail if the adverse effect of such failure is economic hardship on the nation at large?

The restoration of a viable company to profitable trading has been provided as one of the overriding objectives of Insolvency Law [24] , how can this be done where insolvent companies are immediately liquidated?

In consideration of the above questions and more, that other insolvency regime known as corporate rescue procedures were provided by Insolvency Law.

Corporate rescue, which involves both formal and informal procedures [25] , have been described as, “a major intervention necessary to avert eventual failure of the company” [26] , and involves the following procedures:

Administration

Administration, as an insolvency regime, is provided for in schedule B1 of the Insolvency Act, 1986, and has been set out to achieve three purposes;

“The rescuing of insolvent companies as a going concern;

To cater for the companies’ creditors collectively so as to yield better result than would have in liquidation;

Realization of companies’ properties for distribution among secured and preferential creditors where it is impractical to achieve the options above.” [27]

It involves the carrying on of company’s business through raising or borrowing funds, and also granting of security over the assets of the company. [28]

Therefore, principle aim of administration is to cater for all persons involved in the insolvency through an administrator, either by the preservation of company’s business where possible, or trading the business of the company in such a way that will be productive; this it does by the use of moratorium, which has the effect of freezing the rights of all creditors, thus preventing them from taking action against the insolvent company [29] .

Arguments in support of this regime as the best option for insolvent companies have been established by various scholars, especially in the improvement of its application in insolvent cases due to changes made by the Enterprise Act 2002.

Roy Goode [30] , speaking, in support of this regime, states that there is an advantageous realization of company’s assets in administration than liquidation, as companies are allowed to trade without harassment by creditors due to the hold put on their right to enforce action. This also extends to suppliers under retention of title. Hence, a breathing space is given the company to sort itself out of the insolvent state and return to profitable trading. [31]

Aside the fact that there is continuous trading, John Armour [32] argues that the interest of creditors are catered for collectively, thereby leading to the maximization of assets, which he refers to as “expected overall size of the pie”

Another side of the argument by Gary Cook [33] points out the lack of subtlety in liquidation, which sends out wrong signals to creditors. Buttressing this point, A.Keay [34] stresses that the attitude of prospective buyers matters a lot in producing profits to creditors. Where a company is to be liquidated, the prospective buyers usually see that desperation to sell off assets of the company thus leading to an under price of assets, which is remedied in administration, where such wrong signal is mitigated, and assets sold at a rate which will yield more profit to all parties concerned.

Still on the issue of wrong signal, the directors of the insolvent companies are also affected, as they tend to react negatively when winding up petitions are filed against the company, in which case they might deny the existence of the debt claimed, or can make a claim of set off in relation to the debt claimed [35] . It is therefore easier for the creditors to convince the directors to go into administration which is less hostile as it requires little or no investigation into the affairs of the company on the one hand, and also beneficial to creditors as no cost is incurred in getting a winding up order on the other hand. [36]

This whole issue of trading on, preservation of business and other arguments in favour of administration, are they without shortcoming? Where a company is allowed to trade in its insolvent state, does it not amount to wrongful trading, thus against the principle of commercial morality, as set out in the cork report in its issue 3, which specified a “punishment for an insolvent company whose conduct so merits” [37]

Furthermore, if there will be eventual liquidation as seen in most administration cases, why investing the money and time in resuscitating such company which involves great risk?

M. Kahl [38] , criticizing administration, in respect of this continuous trading, emphasizes that where resuscitation of company back to profitable trading was not achieved, including the sale of company at a value expected, the end result will be the reduction in cash that would have been made had the company been immediately liquidated. In other words, delay in liquidation leads to reduction or loss of value in the assets of the company.

The continuous funding of an already distressed company, is not without its risk; the method of injecting new funds exposes the company and insolvent practitioners to the legal liability of trading on, thus the preference for liquidation in this regards, which otherwise eliminates this risk by the rapid disposal of these insolvent companies [39] . Franks J. and Torous W, supporting the above view, made it known that there is less risk in the rapid sale of the business of an insolvent company, than in raising new funds to continue trading, but that care should be taken to avoid what he termed “premature liquidation” of companies, which is the immediate liquidation of viable companies, that could have survived. [40]

A.Keay [41] , joining in this criticism, points out another problem seen in administration. He stressed on the selfish interest of directors of the insolvent companies, being the driving force towards the avoidance of liquidation and the quest for administration, even when the former, is the best option for the company. The whole idea for administration might be for the transfer of assets to themselves or related parties, which creates room for manipulation as no adequate investigation is carried out into the affairs of the insolvent company unlike the strict process of liquidation, which involves adequate investigation.

A resultant effect of the above is that, the company drops form administration to dissolution which is worse scenario compared to liquidation. [42]

Considering the above analysis, administration has its peculiar inadequacies, though has its edge over immediate liquidation of companies. The ability to give viable companies opportunity of survival encourages the support for it, for if all companies were to be liquidated at the slightest distress, how many would be left standing, especially in this present day financial crisis. However, caution must be applied in its use to avoid the above stated discrepancies.

Company Voluntary Arrangement [43]

Various forms of arrangement schemes, both formal and informal as recommended by the cork committee and approved by Insolvency Law, are used by insolvent companies to save their financially distressed companies. [44] The choice of arrangement to be used, will largely depend on factors like; the size of the company, the nature of debts, number of creditors etc [45] , but whichever is the case, an arrangement will always involve any of the following;

An agreement to a forfeiture of part of debts owed by the debtor company

Postponement of payment

Company restructuring or reorganization

Granting creditors interest in the company in form of equity shareholding. [46]

Company voluntary arrangement, which is mostly used in respect of small companies, and has the statutory effect of being binding on all unsecured creditors once agreed to by majority of members, requires a temporary moratorium, to be obtained by the debtor company, to freeze the rights of action of the secured creditors, until a company voluntary arrangement proposal is drafted. [47]

Comments pointing out the benefits of this regime have been made by various writers. Gary Cook and Keith Pond [48] , ascertaining this benefit, state that with the use of company voluntary arrangements, there is high probability of business survival, this is due to the fact that the problem of the insolvent companies, is looked into, and solved either by providing funds for rehabilitation, or in the case where the arrangement will lead to liquidation, will be done in such a manner as to yield profitable returns to the creditors. Bryan Gladstone and Jennifer Lane Lee [49] argues that if these company voluntary arrangements are properly used, there is a good chance of getting insolvent companies out of problems, which will lead to preservation of assets, and increase, in the chances of paying the creditors the amount due to them; and at the same time, saving the jobs of employees. He further discouraged the idea of immediate winding up of insolvent companies, by stating that “concerning UK insolvency law, we are still thinking first about burial rights for struggling companies, rather than acting as paramedics who can save them” [50]

Kahl M, also agrees to the possibility of bringing a firm back to business through an arrangement process of swapping debt to equity shareholding in the insolvent company, thus giving room for continued trading, he however went a step further to stress that in considering this arrangement process, distinction should be made between viable companies, and companies that ought to be liquidated. [51]

However, arguments have been raised against the use of this regime. Pointing out one of its demerits, Alice Belcher [52] states that, it can be quite disadvantageous to the economy, when companies that ought to be liquidated are preserved, thus the problem with the practice of trading on.

The fact that directors are left to run the affairs of the company during the arrangement process, though has its advantages, is not without shortcoming. Where a company became insolvent due to mismanagement by its directors( as seen in some cases), what is the probability of their managing it properly when placed under their care during voluntary arrangement, when they could not perform effectively when the company was solvent? It is in respect of this, that Gary cook and Keith Pond [53] argue that, placing the company in the hands of its directors, in whose inefficiency the company became insolvent, will likely result in the failure of the arrangement procedure. They also pointed other problems faced by these insolvent companies, who are required to pay out creditors, while at the same time, avoiding new debts that are not included in the moratorium on creditors; the length of time it takes to get the companies back to their feet.

Another side of argument in respect of this company voluntary arrangement, though not entirely against the process, but against the use of it in small firms, is put forward by Keasy and Watson [54] , where they bluntly warned against the risk of further advancing of capital into such firms, which they termed to be of “high failure rates”. They stressed that, where sufficient funds have been raised for the survival of the insolvent company, it can be gambled away by these directors who have been left to continue the run of the affairs of the company, all in a bid to save a company that is probably as good as dead; or their expectation of positive returns not being met as envisaged by them, it would have therefore being better that such company was outrightly liquidated.

Supporting the above view, Gladstone [55] also argues that investment into this arrangement in respect of small firms, is too expensive to venture in its rescue.

From the arguments above, does it mean that small firms are so insignificant to be outrightly liquidated? Alice Belcher [56] , countering this view by pointing out the importance of small firms in the growth of the economy of a nation, states that these small firms make recognizable contribution to the growth of an economy through the creation of jobs, innovations etc. hence the need for their rescue.

One obvious problem that can be deduced from the arguments above is, allowing non viable companies to trade on, even when it is obviously beyond the string of survival, thus leading to waste of fund, and reduction in assets, that would have been avoided if liquidated. Company voluntary arrangement, obviously a good regime, if applied in appropriate cases, should also be extended to small firms that are viable thus reducing the risk of failure.

Workouts:

Workout, otherwise known as the London Approach, is an informal procedure

initiated by the Bank of England to prevent large companies from failure due to huge debts owed by the insolvent company to many lenders, which would otherwise affect such lenders if allowed to be liquidated; thus no action is enforced by the lenders, as there is collective response and agreement in form of a moratorium, preventing such force of action [57] . The procedure which involves various phases, has its objective, as opined by Flood [58] , set at, “providing a flexible framework whereby banks can continue to extend support to companies in financial difficulty pending the agreement as to the way forward, which may include the provision of additional short term liquidity”

There is therefore, a level of cooperation between these lenders with a major bank leading the procedure, to see what can be done in the financial state of the insolvent company [59] ; and its unique features, have been commented by some writers to be of great help in insolvency issues.

Workout, which is usually done in secret, prevents the adverse effect of publicity as seen in formal insolvency regimes, which goes a long way in damaging and reducing the confidence of the public in the company; the fact that a bank is involved, builds the confidence and creates the impression that the company is still viable [60]

Kahl [61] , also speaking for this approach, comments that the chances of raising new funds are increased through its exchange of debt for equity in the insolvent company. Also where debts are not cancelled completely, with the promise of having super priority over other debts, outsiders will be willing to invest in the firm.

However, the major issue is, what is the position of the non conforming lenders who do not agree to the workout? This and other issues are the setback in this regime, which forms the basis for its criticisms.

The issue of lack of cooperation by some lenders can be seen in this regime, but the question is, can they withstand the pressure being exerted on them by others, especially the lead bank? There is usually fear of being treated badly if faced with such problem, thus the indirect pressure to succumb to the procedure [62] .

Franks and Sussman [63] , not seeing this as a problem, stated that were a lead bank is in charge, having the liquidating right concentrated on it, there is less likely to be a coordination problem or failure, as the lead bank is the decision maker. They however pointed out another issue as the problem facing this approach which stems from the concentration of liquidating right on the lead bank, which according to them, causes laziness in the lead bank. They are of the opinion that the lead bank might get too lazy, and tries to avoid the risk involved in resuscitating an insolvent company, by liquidating insolvent firms prematurely. Emphas

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